MIDEAST DEBT-Loyal banks, diaspora help Lebanon ride out region's turmoil
* Capital inflows to Lebanon falling sharply
* But remittances staying strong
* This allows banks to continue buying government debt
* Less pressure on currency peg than in past crises
* Sovereign bonds have outperformed this year
DUBAI, Aug 1 (Reuters) - Lebanon's politics are descending into sectarian conflict and its economy is starved of investment. But its sovereign bonds are steady, foreign reserves are holding up and there is no sign of serious pressure on its currency.
That striking contrast suggests the country may avoid the economic crisis which has engulfed other nations during the Arab Spring uprisings, even though it is suffering increasing damage from the civil war in neighbouring Syria.
An overseas diaspora of around 14 million people, more than three times the size of Lebanon's domestic population of about 4 million, continues to send billions of dollars back to the country each year.
This is swelling bank deposits and allowing banks to keep buying government debt, which means the government can boost spending to try to ease social tensions - and maintain a minimum level of political stability needed to attract more remittances.
It is a three-pronged arrangement based on mutual need that has sustained Lebanon during repeated political crises since the end of its civil war in 1990, and which is so far working well in the current instability, bankers and economists say.
"The situation is not ideal but people aren't panicking," said Nassib Ghobril, chief economist at the Byblos Bank Group in Beirut. "The country has coped with similar situations before."
By triggering a flare-up of sectarian tensions in Lebanon, the Syrian civil war is taking a heavy toll on the Lebanese economy.
Prime Minister-designate Tammam Salam has been unable to form a cabinet since March, when his predecessor quit, and parliamentary elections have been delayed until November 2014. Rival militias and the army have been battling in the coastal cities of Sidon and Tripoli.
This has slashed inflows of portfolio and direct investment; tourism revenues have also tumbled as wealthy Gulf states and other countries have issued travel warnings to their citizens because of poor security.
The result has been a sharp reduction of capital flows into Lebanon. Net private capital inflows shrank to $2.4 billion last year from a peak of $12 billion in 2009, and are expected to drop further to just $1.6 billion in 2013, according to the Institute of International Finance, a global banking body.
For an economy with a gross domestic product of about $45 billion, that is a big blow. From levels around 8 percent in 2007-2010, economic growth slipped to just 1.3 percent last year, and it is expected to be close to that level this year.
But inflows of remittances from Lebanese abroad have been stable. The World Bank estimates they totalled $7.5 billion last year, flat from 2011, and bankers in Beirut say the latest political turmoil has not affected them significantly.
This has allowed deposits at Lebanese commercial banks to continue growing; combined deposits of private sector residents and non-residents at commercial banks climbed to 182.6 trillion Lebanese pounds ($121 billion) in May from 168.3 trillion pounds a year earlier, according to central bank data.
Philippe El Hajj, deputy general manager at Fransabank in Beirut, estimated banking system deposits grew 3 percent in the first half of 2013 and predicted a 5-6 percent increase in 2013.
"This is mainly driven by Lebanese expats and by the accumulated interest on deposits. I don't see why remittances to Lebanon should decrease - those helping their families at home won't stop and will find many ways to continue supporting them."
Rising deposits have in turn permitted Lebanese banks to continue buying their government's debt, and to buy into any selling by foreign investors, keeping prices of the country's bonds remarkably stable.
Bid at 6.05 percent, the yield on Lebanon's $650 million bond maturing in 2019 is up just 40 basis points since mid-May, outperforming many emerging market bonds, where yields have jumped 100 bps or more because of concern about rising U.S. Treasury yields.
One potential threat to Lebanese remittances is a political backlash against Shi'ism in the Sunni Gulf; Gulf Arab states are punishing Lebanon's Hezbollah for its intervention in Syria by expelling Lebanese expatriates linked to the group, and are keen to block any illicit fund flows to Lebanon.
But it is not clear that the number of people affected will be nearly large enough to cut the global amount of remittances. Meanwhile, other events abroad have helped Lebanon; the debt crisis in Cyprus caused Lebanese to bring back hundreds of millions of dollars from that country this year, bankers said.
Lebanon's dependence on remittances is not without costs. For example, its banks keep their interest rates about 3 percentage points higher than U.S. rates in order to attract deposits, even though the Lebanese pound is pegged to the U.S. dollar. This slows lending and economic growth.
But as long as the currency peg holds, sustaining the diaspora's confidence that their remittances will not lose value, the system is a robust one.
So far, in contrast to some other crises in the past two decades, the current political instability has not appeared to threaten a run on the pound. The central bank's combined holdings of foreign currencies and gold edged up to $44.4 billion in May from $44.0 billion a year earlier.
Ghobril said the pound came under pressure three times in recent years. The assassination of former prime minister Rafik al-Hariri in 2005 caused an outflow of bank deposits worth 5 percent of GDP over several weeks; Israel's attack on Hezbollah in 2006 prompted a 3 percent outflow; and the 2011 fall of Saad al-Hariri's government led to an outflow of under 1 percent.
Since the peg survived those incidents, a bigger political shock would be needed to even raise the possibility of it being dislodged in future, he said.
Another vulnerability is the risk that state debt, now about 140 percent of GDP, could expand beyond the capacity of the banks to fund it. The current disarray in the government could worsen the problem by blocking efforts to control spending; the International Monetary Fund expects the budget deficit to rise to 9.7 percent of GDP this year from 9.0 percent in 2012.
But with commercial bank deposits at roughly twice the level of government debt, there appears to be little risk of banks losing their capacity to buy bonds for the foreseeable future - as long as deposits do not fall sharply.
"The pound's peg to the dollar survived throughout the past 30 years despite a 15-year civil war, conflicts with Syria and multiple Israeli wars," said a source close to the central bank, declining to be named because of the sensitivity of the subject.
"Why would that change now? It's quite impossible."