Key sectors: banking; all
Key risks: Default; sanctions
On 7 March new Prime Minister Hassan Diab announced Beirut’s intention to default on US$1.2bln Eurobond repayment due on 9 March. The default was Lebanon’s first ever sovereign debt default. On 17 March the one week-grace period in which to repay the issuance passed, sending the county officially into default and triggering a cross-default on all other outstanding 26 debt issuances to the tune of US$34bln in global debt markets. The US$34bln is estimated to be only the tip of the iceberg of Lebanon’s debt. IMF estimates in October 2019 indicated that Lebanon’s government debt was over 150 per cent of growth domestic product (GDP), although that this did not account for a ‘Central Bank’ bridge loan. Total external debt is projected at around 191 per cent
Many Lebanon observers did not believe default would happen, as Beirut has consistently met its repayment obligations. This includes throughout a brutal civil war between 1975 – 1990, Israeli occupation from 1982 to 2000 and the Syrian occupation from 1976 to 2005, the assassination of President Rafiq Hariri in 2005 and a further war between Hizbullah and Israel in 2006. Furthermore, during Syria’s civil war international donors including Gulf states have kept Lebanon afloat in the belief that destabilising the country could trigger further regional instability. However, the economic, security and political conditions that faced this incoming government under new Prime Minister Hassan Diab were unlike previous years.
After Independence
Under the French mandate which ended with Lebanon’s independence in 1943, Beirut became a regional financial hub for international banks. It thus developed a modern banking and financial system. After 1943 the banking system further developed, and as European banks no longer monopolised Lebanon’s foreign financing requirements, global banks began establishing headquarters in the country. This development also allowed enough space for over 40 independent Lebanese banks to establish, many of which persist today, including household names such as; Eastern Commercial Bank (currently known as the Banque de la Mediterrannee), Banque Libanaise pour le Commerce, Banque G. Trade (currently known as Credit Lyonnais), Banque Belgo-Libanaise (currently known as Societe General Libano-Europeene de Banques), Bank of Beirut, Beirut Riyad Bank, Byblos Bank, Credit Libanais, Banque Audi, Banque du Credit Populaire and Beirut Universal Bank.
By the 1960s Beirut had become known as the ‘Paris of the Middle East’ for its cultural and economic vigour. Lebanon’s economy, characterized by low inflation, high levels of economic growth, and a large balance-of payments surplus, was one of the region’s strongest. It was classified as a middle-income country with a per capita income equivalent to that of Portugal. During this time and with the establishment of Lebanese banks, the economy grew rapidly, a trend which had started about 25 years earlier. Growth peaked in the 1970s when foreign capital, especially from Arab oil exporting countries, found safe haven Lebanon’s banks system. Statistics indicate that Lebanon’s economy grew by more than 8 per cent year on year between 1970-1974 as compared to 7 per cent rate over 1950- 1974, and at a faster rate than most neighbouring countries.
The civil war which erupted in 1975 paralysed the central government’s ability to collect tax revenues. Nonetheless, it continued to spend to maintain essential services using previously accumulated reserves, pay the civil service, and subsidise some basic imported goods but which all led to substantial budget deficits. By 1986 however the government had found a way to finance its spending by borrowing directly from commercial banks which continued to hold excess reserves which was used to buy treasury bonds. In a war-torn country, banks usually have excess liquidity and surplus of funds because of lack of investment opportunities. The excess liquidity prevented an increase in interest rates from high levels of government spending which would have resulted had the banks been indebted. The main effect of the emergence of a huge budget deficit and the way it was financed was to increase the money supply at an unprecedented rate and to contribute significantly to a rising inflation rate and depreciation of the Lebanese lira (LBP). The process set the stage for the ‘financial engineering’ which until 2019 kept Lebanon afloat.
Lost output from the beginning of the war to 1986 was US$24bln and a reduction in GDP per capita by around 67 per cent. Much of the Lebanese conflict fought in the streets and boulevards of Beirut. Total damage to the city was estimated at least US$25bln, with the international airport, sewer systems, electrical grid, and telephone lines destroyed. To compound the damage, many of Lebanon’s highly skilled professionals, estimated at 500,000 to 800,000 persons, left to work in other countries and with them an estimated US$40bln in capital fled too.
The war also led Beirut to lose its pre-eminence as the bridge between Europe and the Middle East. Expatriate firms relocated headquarters or regional offices to Cyprus and Gulf businesses fled, primarily to Bahrain which became the new hub of many banks and insurance firms. Firms that did not leave often lacked electricity or telephone lines. Lebanon’s once-thriving tourism industry was crippled. Such damaged required reconstruction then came in the form of international aid and soft loans. Following the end of the war in the early 1990s the government of Rafiq Hariri, Lebanese-born Saudi billionaire successfully attracted outside funding for reconstruction, with the World Bank, the European Union, and various Gulf countries contributing to the rebuilding of the country, society and economy.
Thus the post war boom to Lebanon’s economy came from aid flows, soft loans and diasporic remittances. Even by 1996 the Economist magazine commented that ‘the country balances its books only by attracting capital inflows and these could move elsewhere at the merest hint of political or social trouble’. To curb inflation during this, lira was pegged to the dollar at LBP1,507.5 in 1997. Following the boom, Lebanon faced a period with real negative growth in 1998-2002. This recession was accompanied by disinflation and deflation, diminished credit to the private sector and accelerating credit by the banking sector to the public sector.
The fiscal crisis, coupled with the policy of exchange rate-based stabilisation, was causing high real interest rates, unsustainable deficit, and public debt growth and economic recession. The growing public debt and economic slowdown were tackled with the convening of the donors’ conference, Friends of Lebanon, in Washington in December 1997 when the government proposal included projects valued
at US$5bln over five years through grants and soft loans. Pledges of around US$1bln were made for 1998. Such pledges of soft loans and aid deposited with the central bank occurred in 1997 and 2001 and started the country on the addition to aid which became the main policy- response of successive Hariri governments used for resolving the macroeconomic imbalances during this period. It took another 20 years for the diaspora to lose their belief and/ or patience the government and the banking system.
Banking on the diaspora
Between the end of the war and the time of writing Lebanon has witnessed many shocks, some so hard that real growth plummeted again. Lebanon experienced Israel’s ‘Grapes of Wrath’ operation in 1996, the assassination of Prime Minister Rafiq Hariri in 2005, and the July war led by Israel against Hizbullah 2006, as well as the repercussions of the global financial crisis in 2008, which was destabilising given the contribution of the banking sector to the economy. Lebanon’s survival was dependent on its large depositor base. The estimated size of the Lebanese diaspora varies now between 10 to 18 million people compared to 4.2 million residents. This base contributed to over 20 per cent of the country’s GDP through annual, only slightly declining to 16 per cent after the start of the Syrian civil war in 2010.
Thus the solid flow of remittances has long supported Beirut’s dual trade and fiscal deficits, resulting in a cumulative balance of payments surplus nearing US$16.7bln between 2007 and 2010. The banking sector continued to attract diaspora cash, alongside regional and international financing alongside with high interest rates. Other regional countries had not yet developed a mature banking industry and regulations – Beirut’s was merely restarting, leading Gulf cash to return to Lebanon’s banks. Furthermore, Lebanon’s secrecy law was an attractive element too – making it into a Switzerland-type haven with fewer restrictions. By end-2013 deposits at Lebanese banks was over three times its US$46bln GDP.
Financial Engineering
For years the central bank, the Banque du Liban (BdL), borrowed dollars from commercial banks to sustain the currency peg and cover the country’s fiscal and current-account deficits, which in 2018 were 11 per cent and 26 per cent of GDP respectively. In return, the banks received above-market interest rates. 1) BdL swaps its treasuries denominated in Lebanese Lira (LBP) for USD treasuries issued on the global debt market. 2) BdL, on the back of its dollar inflows, sells certificates of deposits to commercial banks (which own over 40 per cent of Lebanese LBP debt) using USD treasuries as collateral. 3) Commercial banks then deposit their customers’ USD at BdL which ensures that BdL has enough foreign reserves to shore up lira against the current account deficit. 4) Commercial banks then sell LBP treasuries back to BdL for 50 per cent upfront, and all future coupon payments and the bonds’ par value discounted to 0 per cent.
This state-sanctioned scheme appeared to function well while diasporic remittances and aid continued to flow. The IMF even predicted default in 2005, not anticipating the level of loyalty – or the lure to the interest rate – of the Lebanese diaspora. Now however after years of sluggish or low growth triggered by the Syrian civil war, a large refugee population, and high levels of sect-based clientelism and corruption, the system no longer has sufficient remittance inflows to sustain itself.
The crisis: In April 2018 Beirut under Sa’ad al-Hairi secured over US$11bln in pledges at the CEDRES donor conference in Paris. 41 nations, including US, Russia, Saudi Arabia and Qatar, as well as the World Bank and the EBRD contributed US$10.2bln in loans and US860m in grants, but conditionally. The projects were to be unlocked upon reform efforts by the government including anti-corruption, increasing public sector efficiency, supporting economic growth, and fiscal consolidation. Protracted political deadlock prevented such loans being released.
Concurrently, bank deposits, which grew at healthily for years levelled off in 2018 and started to decline. At this point the banking sector was about three times the size of Lebanon’s economy. Commercial banks had US$160bln, at the official peg of LBP1507.5, in deposits in December 2018, an 8 per cent drop from a year earlier, and the central bank did not have enough dollars to repay what it owed. At the end of January 2019, it had a US$37bn in gross foreign-currency reserves and US$52.5bn in liabilities, mostly owed to local banks according to Fitch.
In July 2019, monthly imports spiked sharply in July to US$21.9bln, skewed by a new 3 per cent VAT. Concurrently the central bank’s foreign assets excluding gold, had fell by around 15 per cent from an all-time high in May 2018, to US$38.7bln in mid-September. Thus, in September Sa’ad al-Hariri announced an economic emergency following a downgrade by all major credit ratings agencies of Lebanese debt further into junk and as indicators showing GDP growth at 0 per cent. By October the government, after days of devastating wildfires for which Lebanon was unable to finance the emergency effort, announced a barrage of taxes in desperation at the crisis. The new taxes included levy on calls made on free application WhatsApp, triggering widespread and protests which shut down all business activity.
Hariri travelled, begging bowl in hand to Saudi Arabia and France on whom Beirut could previously rely. Both Riyadh and Paris re-affirmed their support but did not commit funds. From October, dollar shortages caused banks to begin unofficially limiting, then stopping altogether to allow depositors to withdraw dollars, when many vendors would not accept the lira. Fuel stations and bakeries closed as they could not afford imports, and unofficial inflation, which was still being denied by central bank governor Riad Salame rocketed by over 25 per cent. By 29 October, Hariri resigned and Salame stated the country was days away from collapse. Nonetheless, Beirut met a US$1.5 repayment on 28 November.
Restructuring
Prime Minster Hassan Diab’s new cabinet was approved on 11 February, over three months after Hariri resigned and his ‘financial rescue plan,’ the same day. This included pleas for financial support from previous donors such as Paris and Riyadh and asking banks to sell their assets and foreign investments to protect the sector’s stability. Banks, the main creditors balked. Nonetheless, in this new cabinet, Hizbullah Shi’ah militia-turned-political party deemed terror organisation has more influence, which finally alienated the possibility of support from EU and Gulf countries. Iran, Hizbullah’s historical patron can no longer afford to back the group and US sanctions on Hizbullah have already caused smaller banks to fail. Such sanctions will only increase, adding to the list of burdens on the economy.
Banks which owned around two thirds of Lebanon’s debt, sold some of their holdings to outside investors specifically Ashmore, which specialises in distressed EM debt. Officials believe foreigners now hold more than 25 per cent of some bond issues, enough to block any restructuring deal as there is no collective action clause in Lebanon’s debtor contracts which means they do not legally can restructure unless everyone agrees. One bondholder thus can block any restructure. Beirut temporarily attempted to freeze bank’s funds for selling these their bonds, only to backtrack as a total collapse appeared imminent.
It is difficult to envisage the right path forward for Lebanon. Some have erroneously compared Lebanon’s crisis to post-war Iraq, others to Argentina. One main lesson is that Lebanon’s economy is tiny compared to these, and it has little in the way of possible exports. Indeed, its trade deficit for the first five months of 2019 stood at US$7.32B, widening from US$6.64B year on year. Total imports were US$8.76bln while total exports hit US$1.45bln. Lebanon functioned like a rentier state, with its resources not oil and gas but aid and remittances.
Lebanon will now have some hard calls to make. They must negotiate a deal not only on their outstanding bonds, but also on the deposits held by the BdL. If BdL defaults on deposits, it would shatter the financial sector which has 55 per cent of its assets tied up in the central bank. IHS Markit estimates that a haircut of just 18 per cent would leave commercial banks insolvent, requiring recapitalisation worth at least 25 per cent of GDP. Beirut has previously suggested up to a 70 per cent haircut.
Since the default, the government has made few announcements, however a simultaneous restructuring of the central bank’s balance sheet and the sovereign’s balance sheet appears one option to prevent a wider crisis. Nonetheless unwinding the tangle of transactions appears extremely complex and will take years to resolve. IMF technical guidance which was provided in February pre-default, included sever austerity measures such as mass public sector cuts and slashing subsidies. This will further pressure the floundering society. Unemployment is estimated at as high as 25 per cent, certainly an underestimation. Amid a COVID-19 lockdown, this figure will soar due to the lack of social support and the outsized impact on such shutdowns on the informal economy. The World Bank estimates unemployment will soon rise to 50 per cent. It will only get worse for Lebanon before it gets better.
