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Ratings removed from reality

Credit rating agencies cannot account for Lebanon’s unique economics

by Natacha Tannous

Lebanon is an anomaly in many ways, and no less so when it comes to international credit ratings. While most of the world still depends on Fitch, Standard & Poor’s (S&P) and Moody’s to grade investment risk — even after their errors in the lead up to the global financial crisis — the reports of these ratings agencies simply do not carry the same weight in Lebanon.

Take, for example, S&P’s downgrade of the United States’ credit rating from AAA to AA+ last summer; the US equity index S&P500 fell 6.66 percent to 1,119 points the next day of trading. S&P’s recent lowering of its outlook for Lebanon, however, followed by a Moody’s downgrade of three Lebanese banks, resulted in… nothing.

There was no perceptible impact in the markets, with Lebanon’s credit default swap (CDS) spread — a proxy for default risk — remaining stable after both announcements, and shares of Bank Audi — the country’s largest by assets — staying level. 

Examining the ‘downgrades’

On May 28, S&P cut its outlook on Lebanon’s long-term sovereign credit rating to negative on the back of “domestic tensions and the escalation of violence in Lebanon [which could] potentially lead to a breakdown in the government.” As a result, on May 30, it also revised the outlooks of Bank Audi, BankMed and BLOM Bank from stable to negative due to their high exposure to the sovereign, given that “the banks’ financial performances are closely linked to Lebanon’s solvency.”

The following day, Moody’s revised the standalone credit assessments of 13 banks in Jordan, Lebanon, Pakistan and Ukraine. Bank Audi, BLOM Bank, and Byblos Bank, the three affected Lebanese banks, saw their credit assessment downgraded by one notch from Ba3 to B1 on the back of high exposure to Lebanese government debt, which Moody’s described as equivalent to 350 percent, more than 400 percent and just under 400 percent, respectively, of tier one capital, the core measure of a bank’s financial strength.

Moody’s said a second factor in its assessment was “moderate geographical diversification” outside of Lebanon, with foreign assets making up less than 30 percent of consolidated assets of Bank Audi, and around a third of those of BLOM Bank and Byblos Bank.

Limited market impact of agencies

“The valuations are not based on fundamental weaknesses of the Lebanese banks or [of] the economy,” emphasizes  Riad Salameh, governor of Banque du Liban, Lebanon’s central bank. “Hence the impact of these ratings on our markets have not been felt because most participants in Lebanese markets are players who know exactly the situation and can see the strong balance sheet at the Central Bank.” 

Salameh concludes that “downgrades in Lebanon don’t really affect the performance of banks and financing of the country.”

In fact, credit rating actions have less of an impact in Lebanon than in Western countries for three reasons: first, the country’s small international investor base; second, a sustained increase in deposits, and finally, a resilient population that trusts the banking system, allowing for competitive yields.

Small international investor base

The nature of the public debt and its holders makes any credit action somewhat irrelevant. In reality, even though banks have been trying to reduce their exposure to the sovereign, roughly 97.5 percent of the dollar denominated debt is still held by local investors, with the remainder mostly held by European and US funds forced to hold the Lebanese debt as part of their emerging market index-tracking strategy, according to Nassib Ghobril, head of economic research & analysis at Byblos Bank. 

When compared to the total amount of debt out there, Lebanon maintains a relatively small stock at some $54 billion, as well as a minor representation in broadly tracked indices (only 2.34 percent of JP Morgan’s EMBI Global index) — thus, international investor interest is low.

“The fact that the highly resilient and very well-capitalized banks hold most of the Lebanese debt… keeps a lid on credit default swap spreads and yields relative to the associated risks,” says Florence Eid, founder and chief executive officer of Arabia Monitor research and advisory firm.  “Additionally, given that banks tend to hold this debt to maturity, the illiquid secondary market also plays a part in eliminating some of the volatility.”

As a result, due to limited external funding, such revised outlooks or downgrades have limited impact.

Sustained increase in deposits

“Banks ratings are not as relevant in Lebanon, given that around 88 percent of their funding depends on private sector deposits; additionally they are concentrated,” explains Ghobril. “In fact, between 15 to 25 percent of depositors, depending on the bank, account for 75 to 85 percent of deposits, so if there is a panic, banks will rush to their large depositors to reassure them of market conditions.”

Ghobril adds that, “for events to truly affect deposit inflows or the rates, you would need extreme scenarios.”

Lebanon has only seen outflows of deposits three times since 2004, with a 5 percent outflow during the eight weeks after the Hariri assassination, which reversed afterwards, a 3 percent decrease in July 2006 when the war with Israel started (which stopped after the cease-fire) and a less than 1 percent outflow when the Hariri government collapsed in January 2011.

And currently, given the global uncertainties and near-zero interest rate environments in developed economies, there is evermore reason to believe that Lebanese deposits will stick, as moving them elsewhere would be just as risky.

Trust and competitive yields

Lebanon is one of the world’s largest recipients of remittances as a share of gross domestic product, with remittance inflows reaching $8.4 billion in 2010 (the latest figures available), totaling around a  fifth of GDP, according to the World Bank. The Lebanese Diaspora generally ‘believe’ in the country, notes the International Monetary Fund, and thus as long as there is trust in the banking system, the outlook of ratings will not affect markets. This is reflected in lower yields on Lebanon’s sovereign debt, even though political and geopolitical risks are growing. Depositors trust Lebanese banks even when things go wrong since the banks pay them relatively attractive interest rates, which have been effective over the past 20 years.

The Lebanese difference

History and experience provided enough confidence for investors to make their own assessment of the embedded political risk in the country, explaining Lebanon’s competitive yields compared to countries with similar credit ratings. The Lebanon 2026 bond issued in November 2011 with a 6.6 percent coupon, for a size of $725 million, currently trades above its offer price.

“This reflects mainly two aspects, which are unique to Lebanon credit risk,” explains Jamil Hallak, head of credit trading MENA at Deutsche Bank. “First, the bond is trading at a premium above re-offer and performed nearly 2 percent; and second, the average credit risk spread of Lebanese bonds curve is trading 100 basis points (bps) tighter than the CDS, which reflects the strong and real appetite for Lebanon credit risk.” 

In fact, markets have a dissociated attitude from the rating, since the debt is trading at rates that are similar to those of BBB rated countries. Looking at Egypt — which has the same S&P rating as Lebanon (rated B) but had a relatively stable political situation for years until the start of the uprising last year — the Egypt 2020 bond, with a 5.75 percent coupon carries a credit risk spread of 610 bps, compared to Lebanon’s 2020 bond with a spread of 428 bps. Further, Egypt’s five-year CDS is trading at around 700 bps, whereas Lebanon trades at only 490 bps.

Hence, political uncertainty is reflected in the case of Egypt and shows pure distress, whereas the Lebanese bond market is enjoying historically low yields. Lebanon’s five-year CDS yield is even lower than that of Spain and Italy, which trade at 573 bps and 512 bps, respectively, and are both rated BBB+.

A revision upwards?

If Lebanese banks continue to cut their exposure to government, while at the same time the government does not intend to decrease its borrowings, then the country will have to rely more on external funding — assuming that the Central Bank will not continuously fill the gap. In this case, credit ratings will begin to matter, as “the rating of Lebanon is an important issue for the international investor, especially when the country is not investment grade,” says Governor Salameh.

However, in order to have its outlook revised, the country must address several issues; Lebanon must reduce public spending, implement structural reforms — such as balancing the budget and establishing a proper debt management plan — as well as restore political stability and security. This will lead to an improvement in the country’s credit rating and its access to international capital markets.

Until these issues are tackled and international investors drawn to the country, ratings from companies like Moody’s will likely remain little more than letters.

NATACHA TANNOUS is Executive’s foreign correspondent in New York

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