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Lebanon is in the eye of a perfect storm; including simultaneous political, financial, banking, and currency crises which could lead to a major economic and social disaster, as the eye progresses in its trajectory and the country risks becoming prey to the storm’s most destructive elements.
I don’t mean to waste ink retelling the historical buildup, but to just recap my own awareness of what was coming. I first “cried wolf” in June 2015 at the Beirut Euromoney Conference by bringing the audience’s attention to the central bank’s (BDL) balance sheet, which revealed certain weaknesses. Plenty could have been done by the government at that time on the fiscal policy front to address that frailty and the associated financial system overexposure to dollar-denominated government obligations. Not only was nothing done, but the Lebanese banking system increased its government and BDL hard currency credit exposure, converting their custodial (offshore) dollar reserves into BDL dollar certificate of deposits (CDs). While this credit migration strengthened the banks’ profits, it negatively affected BDL’s financial position by adding an additional challenge to its existing balance sheet woes: substantial losses representing the difference between what BDL earned on its own custodial deposits and the rates it paid to encourage the repatriation of the banks’ own. This negative seignorage, exacerbated by ad-hoc super high-yield “financial engineering” transactions led me to conclude that, if nothing was done on the fiscal level, BDL’s net interest losses could potentially exceed the government’s own deficit in 2020.
Such an impending disaster led me to write an article last October forcefully warning that, unless Lebanon took decisive structural steps to start generating substantial and sustained primary surpluses, it was headed towards an inevitable disorderly bankruptcy. I presented my article on a Friday evening during the 2019 IMF meetings. I was graphic but did not engage in “negotiation by exaggeration”; I plainly stated that, unless significant and credible fiscal reform measures were announced over that weekend, the banks could not open their doors the following Monday. My appeal was met, to put it charitably, with the bank's bosses’ skepticism In contrast, while BDL recognized the gravity of the situation, it doesn’t have the ability to make fiscal policy. As a result, the partial bank closure it engineered acted as just a leaky band-aid of decreasing effectiveness in avoiding the financial crisis becoming an economic-social one. Urgent government action was needed. Although I am precluded by confidentiality undertakings to reveal the contents of any of my conversations with the (now resigned) government during that weekend it is public that, following a marathon cabinet meeting, outgoing PM Hariri announced a bold fiscal plan projected to result in an 8-9% primary surplus in 2020 and 6-7%on a recurring basis. The enactment of the above ministerial resolution would have resulted in Lebanon’s debt re-entering a sustainable path; a good likelihood of the inflow of previously committed concessionary official financing and grants (CEDRE, $11 bb); and breathing space to reform the banking sector and the FX regime in the context of a stable environment. Alas, this was not to be. Hariri’s government resigned and the economy ground to a halt. Unlike last October, a softlanding is no longer possible. While, by virtue of its privileged geographic location, high level of education, and entrepreneurial spirit, Lebanon’s long-term economic prospects are bright, the country now faces the certainty of short-term pain. One big reason is that, unlike other big EM borrowers, Lebanon does not have much of a foreign investor base to share the losses with. With just slightly over 25% of the government debt (and an even lower percentage of the consolidated public sector liabilities) held by foreigners, most of the pain will be suffered at home.
Except for its most enlightened beacons, the Lebanese population seems not to realize that the cost of the crisis keeps growing by the day as the newly elected government struggles to take decisive action. To be clear, at this stage addressing the crisis means: Firstly, implementing the structural reforms needed for the achievement of a primary surplus sufficient for the servicing of the stock of public sector debt resulting from the restructuring. These structural reforms should also seek the redeployment of resources from the financial sector to sectors capable of generating dollar revenues necessary for the financing of Lebanon’s large import needs (e.g., insertion of Lebanon into the knowledge economy); Secondly, stopping the further accumulation of losses (via the restructuring of the liabilities of the banking system and the consolidated public sector); Thirdly, allocating those losses in an equitable way with the dual goal of sheltering the most vulnerable sectors of Lebanon’s population and maximizing future growth (e.g., through a speedy return to the capital markets); Fourthly, cushioning the effects of the inevitable large output contraction which will start in 2020 through the obtention of catalyst off-market financing (e.g., CEDRE, multilaterals). Lastly, developing a realistic medium and long-term vision of Lebanon’s sustainable economic and human development consistent with the country’s resources and comparative advantages. All of the above require that the new government act in a competent and credible fashion. Competence is needed because the tasks at hand are technically complex and will require decision-makers with the intellectual wherewithal to understand the various solutions which will be presented to them by their advisors (which, it goes without saying, should themselves be competent). Credibility is also required because the fallout resulting from the procrastination in addressing the crisis may reach catastrophic proportions (in terms of output contraction, inflation, poverty levels, etc.) unless the new government can secure off-market adjustment financing. No government lacking widespread support, and especially one backed only by forces with a poor international reputation, will command the credibility necessary to attract international financial support. For too long, BDL was the only functioning institution in Lebanon. Although this is not a popular view, I believe that, within the confines of its very narrow legal authority, BDL has done a masterful job at avoiding the full-blown explosion of the crisis in the absence of a government capable to respond. But BDL’s capacity to act was severely constrained by its legal authority. BDL did not have the power to bind Lebanon to a debt restructuring, to resolve the banks’ dollar liability overhang, much less to enact a budget. Now Lebanon has a government and its citizens should clamour for their new government to do policy and not politics and to take action to address the crisis head on, because they alone can determine whether the country’s fate will be decent or disastrous.
by Carlos Abadi
Carlos Abadi is Managing Director at DecisionBoundaries, a financial advisory firm focused on litigation support, financial restructuring, creditors’ rights and financial engineering.