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Lebanon: key issues facing the country as efforts to form cabinet continue

Political uncertainty continues to grip Lebanon after the country missed a deadline set by French president Emmanuel Macron to form a government and unlock critical financing this week. As efforts to fill a cabinet led by premier Mustafa Adib continue in earnest, we outline the main issues facing the crisis-stricken country and how they impact its USD 90bn sovereign debt restructuring.

The  “Macron plan”

France has spearheaded international efforts to root out deep-seated corruption and institutional mismanagement in Lebanon following the 4 August Beirut explosion. The blast left nearly 200 dead, thousands injured and displaced, and caused USD 5bn in damages. The government resigned shortly afterwards amid accusations of gross mismanagement, and attempts have been made to channel urgent humanitarian aid by  bypassing local authorities.

In early September, Macron set out a list of conditions needed to unlock vital aid packages, such as the USD 11bn pledged in a May 2018 CEDRE conference. The French president is seeking a “new political pact”, with the swift formation of a government of technocrats. The plan also calls for a full audit of the Banque du Liban (BdL), the introduction of formal capital controls, an overhaul of the public and judiciary sector, and fresh elections to be held in a year's time under a new election law. Macron has gone as far as to threaten sanctions if credible reform measures are not passed.

“[Macron is attempting] a realpolitik solution, a way to combine the desire from Lebanese people and international donors to see fresh-faced, independent technocrats in charge, with a realisation that the old guard is never really going to go away,” said Nafez Zouk, lead emerging markets economist at Oxford Economics.

Competition among Lebanon’s different factions is fierce, in particular for the much-coveted spot of Finance Minister. Although the initial deadline to form a cabinet was missed, the French president was holding calls with key Lebanese stakeholders on Friday to find a solution to the impasse.

“At this stage, deadlines are about creating momentum through international pressure, more than anything else, but knowing the Lebanese systems, two weeks was unrealistic,” said Dr Florence Eid-Oakden, CEO and chief economist at Arabia Monitor. “Macron’s plan remains the country’s best hope of moving toward securing an international donor package, perhaps with IMF involvement, and the various parties, including the Central Bank, appear to be keen on playing ball again, on the back of the momentum created by Macron.”

Government  recovery plan

In April, Lebanon’s now acting government and its advisors put forward a recovery plan, which served as the basis of its negotiations with the International Monetary Fund for USD 10bn in financial assistance.

The plan provides initial details on how to conduct a USD 90bn sovereign debt restructuring including USD 31.3bn in Eurobonds, on which the government suspended payments in March. The government also outlined plans to restructure its financial sector via a bail-in of shareholders and large depositors at commercial banks.

The IMF has endorsed the plan, but negotiations have been on hold since the summer due to internal political differences, particularly over the extent of the  financial losses to Lebanon’s banking system. Three officials have resigned from the Lebanese negotiating team with the IMF, out of frustration at the establishment’s lack of will to reform.

For all the political back and forth, whichever new government is formed will likely pick up the core of the existing government plan, said Oxford Economics’ Nafez Zouk.

“If Lebanon had a government in place, the first order of business would be to revise the government's recovery plan with updated forecasts, to be able to restart the engagement with the IMF and get started with the banking system recapitalisation,” said Zouk.

The  local bank plan

Lebanon’s banks are another key player in the restructuring of Lebanon’s sovereign debt and banking sector. In May, the Association of Banks in Lebanon (ABL) and their advisors also put forward an alternative recovery plan.

In it, banks rejected the government’s proposal to bail-in bank shareholders and large depositors. Instead they proposed the creation of a defeasance fund, privately managed but owned by the government, which would use close to USD 40bn in government assets to pay back debt owed by the government to the Banque  du Liban (BdL). The BdL in turn owes about USD 80bn-equivalent to commercial banks, primarily through placements in US dollars but also Lebanese pounds, according to the ABL plan.

Given the stark differences in approach, government and banking sector figures have been entrenched in a very public spat over the way forward for the country. This week, the ABL reportedly lobbied the French government against the government’s rescue plan, stating that it threatens Lebanese expatriate remittances.

“The primary objective of the banks’ plan is not so much getting repaid, but avoiding hyperinflation, which would make BdL insolvent,” said a source familiar with the discussions. “If this happens, we are all dead. Banks could get BdL to repay them by other means, but the plan put forward avoids this nefarious consequence.”

The fault-lines between the commercial banks and an eventual new government are set to remain in place, although the BdL’s position seemed to veer towards compromise in recent days. Long-time governor Riad Salameh said this week that he agreed with the government  figures for financial losses in the system. The BdL has also issued circulars asking banks to recapitalise and repatriate funds, to help revive the country's crippled banking sector by boosting liquidity.

“These circulars allow [Salameh] to say he is pushing for a solution to the monetary crisis within the remit of his power, and in the absence of an executive power,” said Oxford Economics' Zouk. “But in in reality [they] amount to less than a piecemeal solution. Ultimately, one would think his interests are more aligned with the banks.”

The  central bank audit

Another key event to watch is the ongoing audit of the BdL, which has the support of both the IMF and many international donors. Alvarez & Marsal, KPMG and Oliver Wyman have been appointed to lead the forensic, financial and accounting auditing of the bank, which is expected to produce a report in the next 10 to 15 weeks.

The audit should provide more detail on the level of the BdL’s real foreign assets (i.e. gross FX reserves and gold), as well as balance sheet losses and an assessment of the financial engineering transactions with the banks since 2016, Oxford Economics' Zouk explained. Still, the audit’s impact may be limited.

“The contract with Alvarez & Marsal is for a preliminary report, on what is needed to further dive deep into the problems at the BdL, so it seems like the results could be quite superficial,” said Zouk. “And whatever the audit turns up, it will be down to political will to implement the recommendations and follow through with action.”

The audit may also face certain legal obstacles. The BdL's code of money and credit forbids from discussing any transaction that has taken place at BdL, Zouk explained. The audit could also run foul of Lebanon’s banking secrecy law, complicating the auditors’ jobs. Although Lebanon’s parliament passed a law to lift the decades old secrecy law in May, some lawmakers have said the move did  not go far enough.

All  eyes on the White House

Lebanon’s fate will also be impacted by whoever takes over the White House following presidential elections in the United States in November.

A Republican White House is expected to remain hawkish on Iran-backed Hezbollah, whose grip on Lebanon’s institutions has been an obstacle for both US backing and hence IMF financial assistance. Earlier this month, the US Treasury placed sanctions on former ministers with links to Hezbollah, including former minister of finance Ali Hassan Khalil.

A Democrat presidency is expected to be more lenient in its position towards Iran, as previously demonstrated by former  president Barack Obama. A Joe Biden presidency administration may be more inclined to engage in dialogue and push for conditional aid along the lines of what Macron is doing, according to Arabia Monitor’s Dr Eid-Oakden.

“In either case, we see US disengagement from the region as a source of volatility, at least “drift” for Lebanon,” said Dr Eid-Oakden. “Things will take even longer to change in Lebanon than they did in the past, unless there is a serious and cohesive international effort, buttressing the Macron initiative. Traditionally this would be accompanied by Gulf financial assistance, but today this is harder to come by.”

Bonds  in the doldrums

Meanwhile, Lebanon’s US dollar-denominated bonds, with maturities between 2020 and 2037, have been quoted in the mid-to-high teens for months, according to IHS Markit. As political stagnation delays any orderly resolution to the country's financial and monetary crisis, severe bondholder losses appear inevitable.

"Currency collapse in the parallel market and surging inflation drive an unstable macroeconomic environment," Moody's said in a research note on 16 September. "Without steps towards economic and fiscal reform, official external funding support to accompany debt restructuring will not be easily available; bondholder losses are likely to exceed 65%."

Lebanon defaulted on a USD 1.2bn bond in March, its first ever sovereign-debt default, precipitated by months of battling with a financial crisis and social unrest. It subsequently announced it would withhold payments on USD 31.3bn worth  of Eurobonds, and begin discussions to restructure USD 90bn-worth of sovereign debt.

The Government of Lebanon subsequently mandated Lazard Freres and Cleary Gottlieb to advise on the restructuring. The Association des Banques du Liban mandated Global Sovereign Advisory and DLA Piper.

White & Case is advising a group of bondholders including Ashmore, Fidelity and BlackRock.

International bondholders have said they want IMF engagement to be a full part of any debt restructuring discussions.

Lebanon is rated SD by S&P Global, C by Moody’s and RD by Fitch.

Laura Gardner Cuesta Senior Reporter Debtwire CEEMEA

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Laura Gardner Cuesta Senior Reporter Debtwire CEEMEA

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