Lebanon needs to substantially reduce its gross public debt, which stands around $85 billion; with ongoing political and economic stagnation, it can neither grow nor inflate out of the problem. Restructuring is the only option.
External debt is estimated at about 190% of GDP in 2018, according to the IMF’s most recent Article IV report. Of this, 77% is non-resident deposits with maturities of less than one year, while government debt accounts for 10% of external debt, of which roughly a third is held by foreign investors.
“They can’t live with this debt-to-GDP [ratio]; servicing those debt levels is killing them,” says Michael Doran, a partner at Baker McKenzie.
Dollar bond spreads now stand at more than 2,300 basis points – greater than in Argentina – and credit default swap premia imply a 92% chance of the government defaulting within the next five years, according to Capital Economics.
The Banque du Liban’s policy of continuing to pay bond obligations may be viewed positively by international investors, but it is at the same time rationing access to dollars for the likes of medical equipment and basic food-stuffs, which is politically dangerous, says a London-based credit analyst.
“Lebanon does not have the luxury to avoid default; they need every dollar, and you cannot pressure people when you are paying coupons on the bonds,” the analyst says. “It is only a matter of time before the protests become about Eurobond payments.”
Any agreement with the IMF would require Lebanon to reduce its debt liabilities, and analysts say it is the only way to ensure the complete political and economic reset the country needs.
This could take the form of a restructuring – imposing a haircut on bondholders – or a re-profiling – whereby the maturity date of bonds is pushed out and/or coupons are lowered.
But resistance to this idea is strong.
‘Default’ is a dirty word in Lebanon, according the credit analyst, with the prevailing belief that defaulting would prevent all future market access.
This is not necessarily the case. Ukraine defaulted in 1999, restructured in 2015, returned to the international markets as the best performing EM dollar bond of the year.
Another issue is that 80% of Eurobond debt is held by domestic institutions, meaning that imposing a haircut on the bonds will be an ‘own goal’, crippling the country’s banking system in a similar vein to what happened in Greece.
“The banking sector would be devastated if they restructure the Eurobonds,” says Anthony Simond, an investment manager at Aberdeen Standard Investments.
Reuters reports that without collective action clauses on the bonds, any restructuring may be protracted and messy.
“It is correct there are no CACS [collective actions clauses], but if you hold 75% of any series you can do whatever you want,” says the credit analyst. “They government can do dirty tricks. They can change the local law, can tap some bonds to increase the percentage of local ownership.”
2. Plug the gap with money from the banks
It is unlikely Lebanon’s banks will survive this crisis unhurt; any restructuring – whether of local, Eurobond debt or both – will result in big equity losses for the banks.
Former prime minister Saad Hariri has said the sector will contribute L£5.1 trillion ($3.4 billion) to deficit reduction, including through an increase in the tax on bank profits.
Lebanon has in the past financed the budget deficit by selling government paper to local banks, as well as undertaking debt swaps with the central bank. The swap operations have resulted in a large chunk of government FX debt being held by local banks.
Local banks are expected to take a haircut on their holdings of domestic government bonds, with Lebanese media reporting that a draft 2020 budget outlines around a $3 billion trim.
They hold approximately 80% of Lebanon’s $30 billion Eurobond debt and 53% of Lebanon’s local currency bonds.
Detractors warn that forcing the banks to shoulder the fiscal adjustment through cuts on interest payments and new levies will stagnate growth.
In addition, banks have suffered a decline in total deposits by $10 billion since the end of August, according to the IIF.
“The authorities should agree on strong measures to fight tax evasion and improve revenue collections, privatization, etc, rather than restructuring the debt,” says Garbis Iradian, chief economist for Middle East and North Africa at the Institute of International Finance.
But private-sector lending by banks is tiny, and development in this part of the economy has been totally crowded out by the government.
Tim Ash, strategist at BlueBay argues that the banking system needs a radical overhaul because the banks no longer serve the basic purpose of moving savings to investment in the real economy.
“The banking system at present appears more of a liability than an asset to the economy, and indeed, seems to be part of the problem, rather than the solution,” Ash wrote in a note in October.
While the losses may hit the banks hard, there are measures the government could take to minimize the impact, the London-based analyst says: “They will need to ask shareholders for equity – a cash injection – and then the government needs to issue a bond which can be put on the asset side of the bank’s balance sheet. The government can issue a bond without exchanging any cash, and then you have equity in the bank.”
Another way to minimise the impact would be to haircut the largest deposits.
“If you don’t want to have riots, you choose a high threshold and go after the rich,” the analyst says.
3. Central bank to save the day
The Banque du Liban will also continue to act as a source of government liquidity. The BdL has said it will cover Lebanon’s FX debt obligations, but analysts advise this will simply serve to further drain the BdL’s FX reserves, which are stated as just shy of $40 billion.
But analysts warn foreign currency reserves are dwindling and that even despite the strong guidance of governor Riad Salamé, BdL will not be able to support the country’s needs indefinitely.
“But if we see political uncertainty for a long period of time with no financial access or support from the international community in the next few months, then the economic situation could deteriorate further and foreign currency reserves could decline at rapid pace,” says the IIF’s Iradian.
In its Article IV report, published in October, the IMF advised the BdL to step back from government bond purchases and from providing other financing facilities including a zero-interest overdraft facility and bridge financing, and let the market determine yields on government debt.
As of yet, the Banque du Liban has not imposed formal capital controls, though the banks have been restricting access to dollars to stem the rush on FX.
The IIF notes that capital controls could promote financial stability if well managed, but must be supported by strong macroeconomic fundamentals and credible institutions.
4. Secure an IMF programme
With no government but an urgent need for reform and for sustained fiscal adjustment, Lebanon could benefit from an IMF programme. But the Fund will need to see some form of political stability before it engages.
“If the country wants to make big changes, it is easier with an IMF programme,” a source from a large international development bank tells Euromoney. “If their funding suddenly becomes limited, they have less room for adjustment, so working with the IMF is a good idea.”
The IMF has not yet had a discussion on policies, nor have the authorities asked to begin a programme, though it concluded its Article IV consultation visit in September and is in technical discussions with its counterparts in the country, Gerry Rice, IMF communications director, said earlier this month.
Some analysts argue that Lebanon would be unable to unlock access to other sources of funding without an IMF programme.
Creditors will not want to “throw good money after bad,” says Doran at Baker McKenzie, but with no government with which to negotiate, a programme may be difficult to secure.
“The IMF wants to know who it is negotiating and engaging with and be sure that any support is accepted by the political leadership in the country and will be followed,” he adds. “The IMF position is simple – the Board needs to be sure before it lends into any situation via emergency liquidity lines or credit facilities that it will be repaid."
But acceptance of a programme will bring austerity, as well as put pressure on Lebanon’s peg, and be unpopular with the people of Lebanon.
“It’s unlikely they’ll ask for it in the near term,” says the IIF’s Iradian. “The economy is contracting, and it is highly unlikely they will have an IMF programme that may impose tough measures to reduce the fiscal deficit, including cut spending and raising taxes.”
5. Float the Lebanese pound
Lebanon’s currency is artificially strong, but the peg is seen as a hallmark of economic stability and a key reason for Lebanon’s rich diaspora to keep sending money back home.
Analysts note that the Fund may insist Lebanese authorities devalue the pound as a pre-condition to any agreement, but the IMF has leant to other countries with a pegged currency in the past, such as Jordan.
“We don’t tell a country that it should have a peg or a floating exchange rate, it is their choice,” David Lipton, the Fund’s first deputy managing director, told Euromoney earlier this month.
Most agree however that a managed or part devaluation of the currency is imperative to stimulating economic growth, though this will certainly be felt in the banking system. In addition, given the large proportion of foreign currency debt, a devaluation would merely exacerbate the government’s debt problem.
A real depreciation shock of 30% would increase external debt to over 300% of GDP, the IMF says.
6. Go cap in hand to third parties
In the past, Lebanon’s Gulf and European partners have provided bilateral assistance, but such funding has not been forthcoming this time.
The political situation in Lebanon is complex, but much focus is on the influence of Hezbollah, a Shia Islamist political party with close links to Iran.
Support for Lebanon in the Gulf has waned, partly because Saudi Arabia and its allies do not want to give any support to the Iran-backed Hezbollah.
In addition, while much has been made of some $11 billion of international concessional loans pledged at the CEDRE conference – which would come in the form of project financing – creditors are keen to see more stability or IMF support before extending any more liabilities.
7. Radical structural reform and strong governance
The bottom line is that Lebanon needs a strong government to enact the structural reforms needed for a complete economic and political reset.