Public finances – Slave to a ravenous debt

Domestic banks feed the government

 

Lebanon’s outstanding debt reached $51.5 billion at the end of the first quarter, while this year’s budget — if endorsed by Parliament — has slated $4.3 billion for debt servicing, accounting for as much as one third of overall spending. The stock of debt, currently estimated at 147 percent of gross domestic product, towers over the economy and only looks set to grow, while the biggest holders of the debt, Lebanese commercial banks, appear to be largely unfazed as they eye their mounting credits.

Lebanese commercial banks — the tycoons

Commercial banks represent the biggest demand for sovereign paper. They are the main subscribers of the $30 billion outstanding debt denominated in Lebanese lira. Their share of total subscriptions to treasury bills (T-bills) and notes in lira in the first quarter of 2010 stands at 65 percent, according to the Ministry of Finance’s quarterly bulletin, followed by public institutions (with 13 percent of subscriptions), then Banque du Liban (BDL), Lebanon’s central bank, and the public banks with 10 percent each.

 

Commercial banks also own an estimated 60 to 80 percent of the $18 billion outstanding Eurobonds denominated in foreign currency, a substantial chunk of the total $21 billion in foreign currency debt (see charts above). The two largest creditors among Lebanese banks are BLOM Bank and Byblos Bank, with total holdings of more than $4 billion each.

On the bright side, “commercial banks [acting as a stable investor base] spared the country from the tumultuous effects of the global financial crisis, as they continued to buy the debt and prevented the country from facing refinancing risk,” says Walid Raphael, general manager of Banque Libano-Française (BLF).

This high ownership share has been an advantage to the country “in the sense that it represents an internal debt, which might not be subject to international market behavior and risks,” explains Nabil Khairallah, general manager of Banque de l’Industrie et du Travail.

While this may be true to an extent, the largest Lebanese banks’ mixed ownership structure means they are not strictly Lebanese. Moreover, Khairallah adds that local ownership has also been “negative in the sense that the banks are financing the budget deficit rather than financing the economy in productive investment opportunities.”

With the United States Federal Reserve funds rate likely to rise from its current near-zero level by 2011, the problem of refinancing risk will surge in Lebanon as the country’s Eurobonds, T-bills and certificates of deposit will need to show higher interest payments to maintain the appetite for Lebanese papers, competing with subscriptions to less risky debt abroad.

Consequently, not only will the debt servicing burden grow for the government, but commercial banks will also face problems on their balance sheets because assets (such as sovereign bonds) receive fixed rates, whereas liabilities (such as customers’ deposits) pay variable rates according to market trends.

This would then be particularly challenging for banks holding Eurobonds. The Eurobonds’ lengthy maturity dates and fixed rates mean that their subscribers could suffer prolonged exposure to coupons paying lower percentages than the market-rate, while having to pay out higher rates to customers on their deposits.

However, “it is only a conceptual mismatch because deposits are sticky [, or stable],” claims Freddie Baz, chief financial officer of Bank Audi. “Interest rates have nothing to do with insolvency, but rather profitability. This incurs risks of losing money for a transitory period until the banks address and manage their mismatch, which they have always succeeded in doing, given that 50 percent of assets are short-term and can therefore be adjusted quickly.”

Additionally, “one should not overestimate the banks’ direct exposure to the sovereign debt since it only concerns a quarter of their balance sheets,” says Raphael. “At BLF our exposure to Lebanese Eurobonds is only 4.4 percent of our total assets.”

Despite reassurances, some banks have already started working to reduce risk and diversify their balance sheets to minimize sovereign debt exposure. For instance, Bank Audi’s investments in foreign currencies “were channeled toward placements in highly rated sovereign bonds or sovereign-related corporates (essentially from Qatar and Abu Dhabi), at the detriment of foreign currency denominated Lebanese sovereign bonds,” according to the Audi’s 2009 annual report.

The banks’ exposure to sovereign bonds in lira also declined in 2009. Nevertheless, such a process must be done gradually, as banks cannot make large adjustments in their portfolios without increasing sovereign risk and triggering a large sell-off.

BDL, Lebanon’s ‘last resort’ card?

The BDL holds 23 percent of the total local currency debt, according to the Economic Letter published by the Association of Banks in Lebanon in April 2010. In the first quarter alone, the BDL subscribed to 10 percent of Lebanon’s T-bills and notes, according to the Ministry of Finance’s first quarter bulletin. But “most of the share owned by BDL corresponds to debt that is being rolled over,” said Nabil Yamout, an advisor to Finance Minister Raya el-Hassan.

The Central Bank bought that debt a decade ago, when there was pressure on the local currency and it wanted to bridge the gap in the deficit in auctions. A wane in commercial banks’ appetites for Lebanese T-bills in the first six months of 2001 prompted the BDL to increase its holdings by $1.7 billion to reach $3.3 billion, in order to provide the government with sufficient liquidity in local currency.

Today it is a different story. “The main role of a central bank is to monitor interest rates but once you get to a level of zero, it is difficult to take initiatives, so we focus on managing the liquidity,” says Central Bank Governor Riad Salameh. Most of its current actions relate to monetary policy, explaining why BDL sold certificates of deposit in March to absorb excess liquidity in the market at the same time that the Ministry of Finance suspended issuance of T-bills for the month.

Indirectly, the reason behind such policies seems to be the nominal currency peg in Lebanon. Over the last 15 years, the country’s money supply has sustained year-on-year growth higher than financing in both the private and public sectors, with the monetary supply increasing 38 percent more than the increase in loans to both sectors.

If the Central Bank did not absorb this excess liquidity, banks would incur decreased returns resulting from increased interest payments to depositors, and would be reluctant to attract more deposits. In turn, if the money supply slowed or even decreased, there would be less funding available for the government’s ever-larger refinancing needs. The local currency would then come under pressure, causing problems for BDL’s dollar peg policy. In short, part of the policy of the Central Bank and the Ministry of Finance is to issue debt instruments — even to the point where they exceed Lebanon’s financing requirements — to absorb the high level of liquidity flowing into the banking sector.

International creditors: a volatile creditor base?

A rough estimate by leading bankers puts the level of international subscription to Lebanese Eurobonds between 20 percent and 40 percent of total subscriptions. In 2009, non-residents subscribed to $100 million (or a 40 percent share) of the $250 million Eurobond issuance, which will mature in 2014 and yield a 7 percent coupon.

“We want to diversify our investor base and we need to involve more institutional investors,” Minister Hassan tells Executive.

“As we successfully reached 30 percent subscription from international investors in the latest Eurobond issue,” she says, referring to the March 2010, $1.2 billion 10-year Eurobond with a coupon of 6.375 percent, “we want to expand that trend because we understand the implications of a ‘crowding out’ effect.”

However, international creditors should have little reason to be interested in the paper. The Lebanese yield is similar to Egypt’s (5.75 percent on a 10-year maturity), but far more risky, being that Lebanon has a lower credit-quality rating of B1/B compared to Egypt’s BB+. Moroccan Eurobonds should be sapping even more demand from Lebanon’s, with yields at 6.375 percent but carrying a BB+ rating.

One could also look at Lebanon’s credit default swap (CDS) spread — effectively the market’s perception of a county’s default risk — versus countries with similar credit ratings (see table below); Lebanese Eurobonds have a significantly lower interest rate yield than peers’, meaning subscribers are rewarded less for taking equivalent risk.

For example, Venezuela’s credit quality is comparable to Lebanon’s, given that Moody’s rates Venezuela one notch lower than Lebanon (B2 versus B1), while Standard & Poor’s rates the South American’s credit worthiness higher (BB- versus B). With such a straddle, one would think that the CDS spreads of the two countries would be close to one another, but Lebanon trades much lower at 305 basis points (bps) while Venezuela is at 1,325 bps (as of June 18).

Nevertheless, “comparing Lebanon to countries with similar ratings is a delicate endeavor,” said Georges Saghbini, chief financial officer of Société Générale de Banque au Liban (SGBL). “One major point to be considered is that investors rarely carry Lebanese paper for speculative purposes; the market has proven it several times in a row. Thus, you cannot speculate against Lebanon’s debt.”

He adds that a major difference between Argentina and Lebanon is that the later has never defaulted on its external debt, “nor has the International Monetary Fund been intrinsically involved in the country’s economic and social policies… Not to mention that the country’s foreign currency reserves — maintained at comforting levels — have been a good confidence driver.”

The international interest in Lebanese Eurobonds stems from the fact that the country turned out to be a safe-haven during the recent credit crisis, insulated from systemic market risk, explained Melhem Samaha, director Global Markets at Credit Suisse for the Middle East and North Africa region.

“This environment would provide a natural bidder in times of crisis, should an international creditor decide to sell its paper,” he says.

 

However, “there has always been some 20 to 30 percent of international holders in Lebanese Eurobonds,” noted founder and chief executive officer of Arabia Monitor research and advisory firm, Florence Eid. “But the question is whether the percentage corresponds to Lebanese accounts abroad or non-Lebanese foreign holders. I would not be surprised if foreign investors, and particularly emerging market (EM) fund managers, placed more interest in the paper on the back of two years of macroeconomic growth along with healthy foreign direct investment and bank reserve figures.”

Indeed, EM-based accounts, such as pension funds, benchmark themselves to indices such as the JP Morgan Emerging Market Bond Index (EMBI), and thus are forced to buy Lebanon’s paper to keep tracking the index, all the more since Lebanon’s weighting has increased to 2.99 percent (see graph to the left), up from 2.24 percent at the beginning of 2009.

And for that matter, non-Lebanese international holdings — considered the ‘volatile’ part of Lebanon’s outstanding debt — will remain stable only as long as the country’s current economic performance is maintained.

The shift toward an increase in lira denominated debt has been apparent since 2008 and the share now represents 59 percent of the total debt. In fact, where total outstanding debt has increased by 32.8 percent since 2005, local currency debt increased by an astounding 54.3 percent, whereas foreign currency debt increased by just 11.1 percent. Issuing more in Lebanese lira is a positive by-product for the country: Lebanon can borrow in lira at decreasing costs because the dollar denomination usually drives the rates up, given that Eurobonds have longer maturities.

Domestic dependence

“Reliance on domestic finance is definitely a strength,” says Andreas Bauer, the IMF mission chief for Lebanon. Firstly, “you need to issue debt in the currencies of your liability and decrease potential foreign exchange risks; therefore, if de-dollarization is the trend, then issuing in Lebanese lira makes more sense,” he said.

 

Secondly, “commercial banks cannot do much with their inflows in lira [so] their liquidity needs to be absorbed by T-bills and credit deposits,” explains Marwan Salem, head of research and advisory at FFA Private Bank. “Thus, issuing in Lebanese pounds is the logical choice and helps the banks.”

Thirdly, because the foreign currency debt is mostly held locally, it is a burden for Lebanese commercial banks — directly or indirectly on behalf of their clients — since they are lending in a currency for which the BDL is not the lender of last resort. As a result, banks need to sustain deposit increases in the specific foreign currencies of the Lebanese debt they subscribe to, otherwise if there is pressure on these foreign resources, it can put that debt at risk. The more Lebanon can convert its debt to lira, the stronger the country stands, as it will prevent an unhealthy dependence on a foreign currency.

Lastly, if international creditors had held the majority of Lebanon’s foreign currency denominated debt in recent times of crisis — say when former Prime Minister Rafiq Hariri was assassinated in 2005, or the July 2006 War — there might have been a collapse in the financial system. But, “this scenario would not happen in Lebanon because whatever the currency, our creditor base is mostly stable; our debt is not so volatile, contrary to many emerging markets and developing economies that have a large international institutional investor base,” said Nassib Ghobril, head of economic research and analysis at Byblos Bank.

Banking on growth

Worryingly, there is no plan to pay back the principal of the debt. Decision-makers are counting on our debt-to-GDP ratio to sail downstream with the winds of favorable economic conditions. On the one hand, the IMF forecasts 8 percent real GDP growth for 2010, which will help the debt denominator increase, while simultaneously the numerator should grow at a slower pace because the cost of debt is decreasing. Indeed, although the weighted interests on outstanding T-bills and Eurobonds are 8.3 percent and 7.3 percent respectively, current interest rates on new issues are far less. Furthermore, Lebanese Eurobonds are trading far above issue prices, therefore the overall effective yield is only 5.2 percent.

“This is bound to reduce the debt burden, especially given the expected decline in future interest rates and the fact that a 1 percent decrease reduces interest payments by $400 million,” said Saad Azhari, chairman and general manager of BLOM Bank. With such numbers, Central Bank Governor Salameh expects our debt-to-GDP ratio to drop to 138 percent. But this macroeconomic outlook is far from foretold and growth in Lebanon is not ensured. Years of neglect have left the country lacking the infrastructure to sustain high productivity and healthy growth across a variety of sectors to support the economy. Instead, Lebanon’s economic growth is dangerously undiversified into three sectors — banking, real estate and, to a lesser extent, tourism.

The country is neither implementing far reaching solutions in the sectors facing challenges, nor actively addressing potential bubbles in areas of the economy that are currently working — and yet it is sustained economic growth that policy makers are counting on to avoid the debt becoming unmanageable.

Of the 40 bankers, government officials and corporate leaders Executive interviewed for this article, not one presented a feasible plan to reduce the escalating stock of debt, estimated to reach $55.4 billion by the end of the year; the ‘solutions’ they provided — such as public-private partnerships, privatization and securitization — were solely intended to decrease debt accumulation or pay down the volatile part of the country’s debt held by non-Lebanese institutions.

The finance ministry, along with the BDL, is coordinating efforts with the World Bank and the IMF to elaborate on such debt management policies. Needless to say, the Lebanese should have the prerogative to have their debt monster slain.

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