There has been a growing concern over Lebanon’s debt outlook. True, the fiscal deficit at end of Q3 2018 was twice that of 2017 for the same period. Two main factors contributed to its escalation: First, the wage and salary increases that were adopted during the last quarter of the 2017 budget and extended through the first three quarters of 2018, generated a rise in personnel costs of 21 percent; and second, the escalation in the debt service cost by 8 percent, reflecting both higher debt and higher interest rates.
Bleak fiscal outlook
Rates are likely to post a further rise as the latest treasury bill issues commanded an interest rate rise of 2.5 percent to reach 10 percent on the 10 year note. Shorter term rates rose by 1 percent to the range of 6-7 percent. Real rates, however, are near zero at the current inflation rate. Nominal rates are expected to remain high and the primary instrument to support the peg.
Revenues have remained subdued, rising at 3 percent, reflecting slower economic activity in most tax bases. In addition, revenues of 2017 included a significant windfall transfer of over LL1 trillion that resulted from the financial engineering operations of Banque du Liban (BDL), Lebanon’s central bank. A repeat of these operations is very unlikely.
The overall fiscal outlook for the whole of 2018 is expected to post further deterioration, and the overall deficit may reach the LL9 trillion ($6 billion) mark, thus raising the deficit ratio to 10 percent of GDP compared to 7 percent in 2017.
This implies that a more serious effort is needed in order to comply with the CEDRE commitment to reduce the budget deficit annually by 1 percentage point of GDP in the coming five years. The budget for 2019 has not yet been approved by the new government in order to be submitted to Parliament and to be passed into law. But no major changes are expected, as the inflexible wages and debt service are built in, and constitute 70 percent of total spending.
The fiscal risk for Lebanon is high and is generating considerable damage to the whole economy. First, it weighs heavily on the current account of the balance of payments through the saving-investment gap of the public sector. Second, the high debt service, reaching nearly 50 percent of revenues, has limited the options for public spending. It has forced cuts in capital spending in order to have sufficient resources for current spending; a first priority for the government, as evidenced by the generous wage increases. Third, the high capital cost that is being generated is abating investment in all sectors.
Recent media statements reporting on potential debt restructuring damaged confidence in the financial secondary markets. These statements, sparked by a local press report where the then-caretaker finance minister was quoted as having raised the possibility of debt restructuring (comments he quickly refuted, reassuring the markets that no such plan was on the table), were based on unrealistic perceptions of the structure of the debt and the legal implications of such a measure.
The repeated analogy to the Greek case is certainly faulty. Greece owed substantial external debt to European banks, and, given that it does not have its own currency, could not service its debt except through generating substantial surpluses in its balance of payments—quite an impossibility in the presence of perennial fiscal deficits. Foreign banks (mainly European) could offer a reduction in debt (haircuts) to Greece, as each holder had insignificant amounts of Greek debt relative to its assets. Such reductions could have been done without implications for depositors, but certainly at the expense of shareholders’ profit.
In the case of Lebanon, banks have significant holdings of public debt, amounting to 14 percent of their assets, and 64 percent of total bank loans. Any debt reduction of significance, therefore, would have an impact on depositors, and could engender a legal battle. Furthermore, politicians and prominent businessmen would be affected in a tangible way, likely prompting them to block such a move. It is estimated that the distribution of deposit holding is significantly skewed in Lebanon, with 1 percent of depositors holding about 50 percent of dollar deposits.
Debt cuts are a serious matter and are undertaken only when a country is on the brink of a default or de-facto defaulting. Lebanon is not in this category now for the following reasons:
Lebanon’s debt is issued mostly in lira (60 percent), and is being held almost totally by domestic financial institutions. These are as follows: BDL with 45 percent, commercial banks with 40 percent, public enterprises with 9 percent, foreign bilateral and official institutions with 3 percent. Private non-bank debt holders carry only 3 percent of total debt, and this is split among foreign and domestic holders.
The risk of debt could emerge from market risk principally. Banks and the other private non-bank holders account for 43 percent of total debt, of which $16 billion is denominated in foreign currencies (mostly US dollars), forming only 20 percent of total debt. The ratio of market debt to GDP becomes significantly less at 55 percent, which mitigates debt default risk.
Reform needed
As sovereign debt is one of the major revenue generating instruments for banks, in addition to being constrained by maturities, sudden downloading of government securities is not seen as an immediate threat. International private holders carry less than $1.3 billion, and would have a limited impact on the domestic and international markets in the event that they discount and redeem their holdings. Furthermore, substantive and sudden outflow of capital from Lebanon is technically not feasible due to maturities and clearance constraints.
The current situation does not portend a financial meltdown or crisis. The government can serve its debt in Lebanese currency without difficulty, at the risk of higher inflation, of course. In an emergency it could also pay back its Eurobond debt in local currency. This has undesired consequences, but is likely to be perceived better than a full default. Considering that BDL reserves (at $45 billion) are equivalent to two and a half times market debt in Eurobonds, those risks are quite mitigated.
Nevertheless, the government’s need for reform is very urgent and a continued deterioration of the fiscal outlook could precipitate a forced market adjustment that would reveal itself in a currency depreciation and de facto de-pegging of the lira from the dollar. It is important to pursue reform in order to achieve balanced growth and create job opportunities for our youth and the unemployed, and to reduce economic inequality, which would very likely worsen in a recession phase. Reform could commence in areas that are relatively less controversial, as in the power sector. Leasing power from international producers combined with a power purchase agreement and a tariff adjustment could save the economy $2.5 billion annually, including a cut in the deficit by one third. Hope remains that the new government will address reform issues seriously.
