Battling debt

The Lebanese government turns to T-Bills, once again

The Lebanese government’s successful efforts to put on hold the almost weekly auction of Lebanese Pound Treasury Bills some nine months ago is a positive development many. Local and international economists attributed the move to the substantial increase in liquidity levels pursuant to the Paris II donor conference held during the fall of 2002. The $4 billion drawn during the Paris II conference, coupled with the $4 billion interest-free loan provided to the government by Lebanese banks, have resulted in a surge in liquidity levels, which allowed the government to stop borrowing locally through T-Bills.

As the year draws to a close, however, the treasury is opening up its auction doors once again, borrowing domestically through the issuance of new T-Bills, with maturities ranging from one year to three years. The motives behind such a move have been debated often among leading bankers and economists, in the light of the performance of the government in 2003, and the new draft budget for 2004.

Initially, the conditions set during the Paris II donor conference included radical fiscal and monetary reforms, proper initiation of the privatization of some state assets, and efforts to securitize the proceeds of others. However it seems that the funds attracted during the conference, as well as the interest-free loan by the banks, have been used to partially reduce interest on some of the public debt, and mostly to cover the steep deficit in the budget.

As such, the money was never intended to solve the problems of the government, but was rather a means to undertake economic reforms and privatization. Such efforts are ultimately used to significantly trim the deficit, spur economic growth and stop the need for additional borrowing – all of which are seemingly beyond any imminent materialization in the case of Lebanon. The money raised in 2002 was used rapidly to cover the budget deficit and has since dried up in less than a year. The direct consequence of such developments is the recently highlighted return to T-Bill auctions.

A major portion of the funds obtained during and pursuant to Paris II was used to replace existing debt obligations with new ones at lower interest rates. This has resulted in the much-lauded reduction in general interest rates in the country. As such, the new T-Bills auctioned by the ministry of finance yield between 6.85% and 8.72%, a significant drop from the 14% or higher yields common prior to Paris II, to levels unseen in over 20 years.

Moreover, it should be taken into consideration that if the government succeeds in maintaining such low interest rates while simultaneously replacing existing high yielding debt with such T-Bills, the overall cost of debt burden would be significantly reduced.

On the other hand, the government’s ability to succeed in such an endeavor should be assessed, given the sizeable deficits in the budget, and the slow pace in the implementation of reforms and privatization plans.

A comparison between borrowings through Treasury bills and the interest rates on such securities shed some light as to the government’s ability to maintain low interest rates (see chart). Historically, lower interest rates have been accompanied by lower levels of borrowing. In essence, there have been rare periods where the levels of T-Bill issues have been sustained with dropping yields.

In economic terms, the yield on any security rises with the risk associated with such a security. In this regard, the government had managed to improve its image and comfort investors following Paris II, with the central bank foreign exchange reserves reaching record highs. Such developments reduced the perception of default risk on the government, devaluation risk on the national currency, and thus justified the lower interest rates on the newly issued T-Bills. Recent developments, however, have begun to raise concerns once again, and political bickering has delayed many critical reform plans. A number of adverse factors are appearing on the horizon and are likely to render investors more risk averse. The regional arena is plagued by the situation in Iraq, increased terrorist activities in Saudi Arabia and Turkey and the slow pace of the peace process. On the domestic front, the scene does not look any better. The year 2004 is expected to witness heated presidential and municipal election campaigns, overshadowed by the Hariri-Lahoud feuds. Furthermore, much uncertainty surrounds the government’s ability to take concrete steps towards economic reforms, privatization, and securitization, and ultimately reduce the debt burden. In essence then, such increasing uncertainties are likely to push interest rates higher in the market, and consequently force the government to offer higher yields on T-Bills if it chooses to pursue this method of borrowing.

On another front, positive signs are beginning to show in the western economies, increasing the likelihood of higher interest rates globally over the next 18 months. Such increases will also have to be reflected in the yields of any securities sold on the Lebanese market, including the government’s Treasury Bills. Some argue that since the central bank will absorb a considerable portion of each issue of T-Bills – as it has done previously – interest rates may be more resilient to upward pressures. Nevertheless, although the central bank has done so occasionally, the bulk remains in the hands of banks and private investors (see chart). This renders interest rates much more sensitive to market pressures.

Banks in Lebanon are known to have profited substantially from T-Bill investments in the past, and are not likely to appreciate the sharply lower returns on similar investments offered currently. Nevertheless, the currently low rates of return on alternative uses of funds may encourage banks to invest in T-Bills. The credit situation in the country has been severely damaged by the economic recession of the past three years, while global interest rates remain at record low levels. In such a sense, the yields of 7% and 8% offered on the new T-Bills do appear attractive. On the other hand, rising global interest rates and improvements in the economic situation in the country could spawn various alternative investment opportunities. A direct correlation exists between the T-Bill yield spread over LIBOR and banks’ portfolios of such securities. As such, it is expected that as global interest rates rise and the spread between Lebanese T-Bill yields and LIBOR narrows, Lebanese banks are likely to trim their T-Bill portfolios in favor of other investments (see chart). Therefore, the government will be forced to raise interest rates to maintain or increase the spread over LIBOR in order to entice banks to keep purchasing T-Bills.

On the income side, recent figures released by banks in Lebanon reveal a marked improvement in the bottom line, despite the lack of T-Bills over the past nine months. Such a development indicates that perhaps banks are no longer as dependent on T-Bill returns as they were in previous years, and that they have successfully sought alternative sources of income.

Pressures on the Lebanese Pound have always been a major topic debated in government circles over the past years and have often put a strain on the central bank’s foreign reserves during its efforts to stabilize the currency.

As the government attempts to lower interest rates across the board through the issuance of T-Bills at markedly lower interest rates, concerns arise as to the impact of such a move on the Lebanese pound. Basic economics stipulate that as interest rates drop in one country relative to others, demand on the domestic currency also drops. In the case of Lebanon, this would theoretically reignite pressures on the Lebanese pound, forcing the central bank to tap into its foreign reserves to offset the pressure.

On the other hand, even the sharply lower interest rates on the Lebanese Pound remain at a significant premium to interest rates on international currencies. As such, the drop in demand on the currency resulting from lower interest rates is likely to be limited in the near term. Conversely though, if global interest rates were to rise, reducing the premium offered on Lebanese pound investments, demand on the currency would begin to drop, and pressures would begin to mount. Nevertheless, such a concern is somewhat distant and of little concern, especially since the central bank has recently accumulated record levels of foreign currency reserves, enough to defend the national currency if need be.

However, while the significantly lower interest rates on the securities would be a welcomed move in terms of reducing the cost of debt burden on the budget, a number of concerns arise based on historical developments and expected future ones.

The ability of the government to maintain the low interest rates is questionable. The use of the funds obtained through such auctions should be closely assessed. Debt levels are continuing to rise, and efforts to trim the budget deficit have yet to meet reasonable success. In such a sense, will the funds obtained through T-Bills be used to facilitate the implementation of economic reforms, privatization and securitization… or will they be used to just cover the deficit and contribute to the growth in our public debt levels?