Prospects for major fiscal adjustment measures and much-needed financial support from donor countries and institutions are also dim, according to S&P.
S&P also lowered Lebanon's short-term ratings on Lebanon to 'C' from 'B' with negative outlook.
"There are concerns over the government's ability to reverse the growth of the public debt burden, estimated at 178 percent of GDP this year, in a timely and effective fashion," said S&P's Navaid Farooq.
"Unless the government implements a credible fiscal program soon, prospects for substantial concessional financing from the international community will remain elusive, and a restructuring of public debt will become increasingly likely," he added.
Figures released by the Association of Banks in Lebanon show that Lebanon's gross public debt reached $28.83 billion in February, up 0.94 percent from $28.56 billion in January 2002. Gross domestic debt increased 1.3 percent to $19.2 billion, while external debt rose by 0.18 percent to $9.63 billion.
Lebanon's central bank has been successful so far in containing speculative selling of the Lebanese pound, which is pegged to the US dollar. However, falling foreign exchange reserves suggest that this strategy has a limited shelf life and that the prospect of some sort of debt default or devaluation is a real possibility in the medium-long term.
The government of Rafiq Hariri has had some success in improving public revenue through this year's introduction of Value Added Tax and the abolition of subsidies among other cost-cutting measures.
Yet analysts believe that only substantial progress on the privatization of telecommunications, the national flag carrier Middle East Airlines and other state-owned companies, will bring sufficient revenue to dramatically change the dynamics of the public debt burden.
Fitch Ratings agrees that public finances remain on an unsustainable path. "Privatization is moving ahead very slowly and the willingness and ability of domestic banks -- the government's largest creditors -- to continue to purchase more government securities is not without limit," it warned in a recent research note.
Fitch noted that local banks' were reducing their holdings of locally denominated government securities and that concerns about the stability of the currency were limiting their interest in holding sovereign Eurobonds.
The agency warned that time was running short for the government, and with the risks of devaluation and a further slowdown in growth of the banks' deposit base, the authorities must act to avoid a financial crisis.
According to one local trading source, the political turmoil in Israel and the occupied territories has undermined sentiment in the credit market in the last two weeks, bringing the average yield on traded Eurobonds well above 10 percent.
Yet according to Fitch, the country is not likely to face imminent default. Fitch noted that the country's external liquidity ratio -- measuring liquid external assets as a share of amortizations plus short-term liabilities -- remains comfortably over 100 percent. "Although the currency composition of bank deposits is changing, the deposit base is still growing, albeit slowly," it added.
Moreover, Lebanon continues to build relationships regionally, despite its shaky economic position and current difficult geopolitical circumstances. The free-trade agreement signed by Lebanon and Iraq in early April calls for the elimination of all tariff, taxes and fees on goods and services traded between the two countries, widening the emerging Arab free trade zone. Lebanon has already signed similar agreements with Syria and Egypt.
The Iraq agreement, which is mainly aimed at boosting private sector activity, will also lay the ground for Lebanon to recapture the Iraqi export market. Iraq was Lebanon's main export market before the Gulf War of 1991, accounting for almost 25 percent of Lebanese exports.
Beirut is also expected to sign three agreements covering economic and trade development at the upcoming Euro-Med meeting in Valencia on April 22-23. Foreign Minister Mahmoud Hammoud is expected to sign the EU association agreement -- part of the Barcelona process that aims to create a duty-free area for industrial goods involving the 15 EU nations and the non-European countries bordering the Mediterranean.
According to Lebanese media reports, Hammoud will also sign an interim agreement that will allow the immediate implementation of the association agreement, which will short circuit the parliamentary ratification process both in the EU and Lebanon. This will allow Lebanon to begin exporting to Europe at preferential rates immediately.
Lebanon's association agreement with the EU replaces a more limited 1977 cooperation agreement. Under the terms of the interim and association agreements, Lebanon will benefit from various tariff cuts on agricultural and agro-industrial products spread over a 12-year period.
Europe, for its part, has granted Lebanon a five-year grace period to begin dismantling tariffs on European exports to Lebanon. The EU will also assist Lebanon in cutting its tariffs through a financial assistance program.