Lebanon defies odds to keep its finances afloat

Lebanon’s government is laboring under a debt pile equivalent to 147 per cent of the country’s gross domestic product, rendering it the third most indebted public sector in the world, after Japan and Greece. The IMF estimates this will climb to 165 per cent by 2022, overtaking the economic basket case that is the Hellenic Republic in the debt stakes. Servicing this debt now soaks up half of government revenues, up from 38.5 per cent in 2014. A current account deficit of 15.9 per cent of GDP, among the highest in the world, means the Middle Eastern country is dangerously dependent on attracting capital inflows to pay its way in the world.
Lebanon’s weak economic growth, just 1 per cent in 2016, according to the IMF’s estimates, hardly seems an obvious draw for this much-needed foreign money. Moreover, the country is located in one of the world’s most dangerous neighborhoods.
Yet Lebanon has never defaulted on its debt in its history and its foreign currency-denominated debt trades at a blended yield of 6.22 per cent, little more than the Middle Eastern average of 5.84 per cent, suggesting few are worried about repayment.
“Lebanon emerges as a prime suspect for facing a debt crisis based on its weak solvency metrics. Standard debt-sustainability models, derived rules of thumb and other countries’ experience suggest that these are early signs of a debt crisis,” says Carla Slim, Middle East and North Africa economist at Standard Chartered, who is herself Lebanese.
“To add to the concerns, both short and medium-term fiscal planning is non-existent given the lack of a medium-term plan to ensure debt sustainability and parliament’s failure to endorse a budget since 2005.”
Gabriel Sterne, head of global macro research at Oxford Economics, a consultancy, adds: “If you look at spreads versus any debt measure, Lebanon is too tight. You are not getting paid enough.”
Yet fears of an impending debt crisis are nothing new for Lebanon, with the country of 6.2m long having successfully juggled seemingly implausible debt metrics. Indeed, its debt/GDP ratio was once markedly higher still, reaching a peak of 185 per cent in 2006.
“When I was at the IMF from 2004-06 working on crisis resolution, the one country that the IMF staff really wanted to work on then was Lebanon,” says Mr Sterne.
“It was the crisis that was going to happen. It had huge debt, really difficult politics and there were concerns that the central bank might be going bust,” because of circular lending, with “the central bank, government and commercial banks all lending to each other”.
“But a colleague came back and said there is never going to be a crisis. The banks will carry on lending to the government because if one goes down they all go down.”
Ms Slim adds that “Lebanon’s debt has long been dubbed unsustainable”. The key question is whether this is about to change.
Lebanon’s finances have long been propped up by its large and reasonably successful diaspora, estimated by StanChart to number anywhere between 5m and 16m, who happily remit money back to Lebanese banks.
These inflows are supported by the pegging of the Lebanese pound to the US dollar, deposit rates of around 3.5 per cent for dollars and 5 per cent-plus for pounds, the prospect of an eventual return to Lebanon, particularly for those living in Gulf states where naturalization is not possible, and the fact that “the banking system in general in Lebanon has a fairly good reputation”, in the words of Ms Slim.
“They have such a loyal diaspora of wealthy people around the region who keep their money in the banks,” says Mr Sterne. “During the global financial crisis banks were going bust elsewhere, and we also had a war in Lebanon [in 2006], but Lebanon sailed through all of that. It’s a fascinating case.”
These inflows not only cover the current account deficit but also provide the funds for the commercial banks to buy government debt, keeping the system afloat.
This “virtuous cycle” wobbled last year, however. Growth in non-resident deposits fell to a decade low of less than 3 per cent in the second quarter of 2016, from 10 per cent-plus in the same period a year earlier, says Ms Slim, leading to a 10 per cent fall in foreign exchange reserves to $35bn as assets were sold to cover the current account deficit.
Ms Slim attributes this slump to lower oil prices, which may have hit the fortunes of many Lebanese working in the Gulf and African oil exporters, as well as “low confidence” in Lebanon itself due to “overall policy paralysis”, weak growth, the hosting of the Syrian refugees and a 29-month presidential vacuum, which finally ended in October 2016.
The Banque du Liban, the central bank, reacted by issuing about $12bn of dollar-denominated eurobonds that it sold to the commercial banks, replenishing its FX reserves.
This drained commercial banks’ foreign currency liquidity, which they plugged either by sourcing funds from their correspondent banks abroad or by upping their deposit rates to attract more foreign deposits. “Some tried to attract existing private bank clients with money in Switzerland or elsewhere by offering them high deposit rates,” says Ms Slim. This seems to have worked. As of April, the most recent month for which figures are available, deposit growth is back to 7 per cent, year on year.
Given the appointment of President Michel Aoun in October and a national unity government two months later, Ms Slim believes it is unlikely the country will face another political impasse that saps depositors’ confidence, in the near-term at least, even if parliament remains suspended. Even if that was to happen, she is confident another eurobond issue would work, even if the obvious alternative, a rise in interest rates, remains difficult given the already weak economy.
Nevertheless, given the possibility of an extended period of depressed oil prices and below-trend growth in the Middle East, deposit flows may remain weak by historical standards.
Longer term, Ms Slim believes the only solution to Lebanon’s financial problems is medium-term planning and budgeting to bring the government’s finances under control.
Mr Sterne believes that as long as Lebanon can generate economic growth of, say, 4 per cent it is “probably going to be all right” as its debt/GDP ratio will probably remain stable or even fall. This could be touch and go, though, with growth currently “pitiful” and the IMF forecasting an expansion of just 2 per cent this year and longer-term growth of 3 per cent.
Nevertheless, Mr Sterne warns: “People who call a crisis in Lebanon have been wrong until now but one day something might come along and knock it over. We are still only one shock away from something nasty happening. It’s the sovereign crisis that is inevitable.”
Ms Slim adds: “If one piece of the system goes, the whole system goes. If they lose these deposits then everything falls apart.”
Financial Times