Rafik Hariri was an inevitable figure in Lebanese politics and economics. The man was greatly responsible for driving Lebanon towards the 21st century and gave the country (admittedly via a hefty debt) a world-class infrastructure, including a major airport, a much improved road network and telecommunication system, and a pristine city center. But most importantly, Hariri was a heavyweight local leader of international stature and credibility.
His death has had a significant impact on the country’s banking sector, which is inextricably linked to the country’s other sectors. Most of the large banks have substantial exposure to the tourism industry as well as Solidere and other businesses in the BCD.
Taking a hit
The drop in profitability and cash flow of businesses involved in tourism, including those operating in the BCD, such as hotels, restaurants and shops, will probably see a return to the 1998 to 2002 period, when cash flow was barely enough to service the interest on their debt. Real estate and construction companies may also be affected as residential and commercial projects are stopped, due to the withdrawal of purchase commitments from Gulf Arabs and Lebanese expatriates. Construction companies may see a slow-down in private and public infrastructure projects, and may have to resort to the unpleasant task of bargaining with banks in order to gain more time.
For their part, the banks should be forced at some stage to start reserving against their exposures to the tourist, real estate and construction sectors. A high level of profitability that was supposed to be re-injected into equity would be seriously depleted by forced provisioning or reserving. Lebanese banks need to increase their capital in view of the forthcoming Basel II regulations on bank capital, and must rely on profitability and organic growth to increase their equity levels. They also need to decrease their non-performing loans levels, which are among the highest in the region (the average non-performing loans to loans ratio for Lebanese banks stands at around 20%), and improve the quality of their placements. These latest events are likely to affect most bank counterparties, and will inevitably make it harder for banks to seek out better quality placements.
The financial flexibility of local banks’ is also likely to be affected, if a number of deposits are expected to be withdrawn by Gulf Arabs and Lebanese expatriates in the coming months, as a result of a potentially worsening political environment. Although banks are liquid and are well prepared to cope with any rush on deposits, the end result could very well see balance sheet contractions for some, if not most, banks and a deterioration in deposit funding flexibility. Lebanese banks’ main funding source comes in the form of customer deposits, and a weakening of that source would leave domestic banks with few alternative funding options. Unless the political situation improves radically, such a scenario is very much on the agenda.
Some banks could resort to issuing bonds, notes, certificates of deposits or even preferred shares, but investor appetite for Lebanese paper, even if it comes from banks, should reach an all time low in the current environment. Moreover, these debt and hybrid securities usually command a higher interest (or coupon) rate to be paid by the issuing banks, and the expected decrease in profitability should make it more difficult in terms of servicing these market funds. Another way to maintain a decent level of deposits could be to raise deposit rates, although this too would have a profoundly negative effect on profitability, as well as bring banks back to a pre-Paris II situation, in terms of higher interest rates. Some banks have already raised interest rates, albeit slightly, on deposits in an effort to contain a possible deposit flight. At the moment, every piaster of profit has to be carefully set aside for capital strengthening and provisioning purposes.
How low can you go
But the most direct and significant consequence of the Hariri killing on banks will be the potential drop in the country’s credit rating, which is already very low at B- (Standard & Poor’s rating). Rating agencies give a lot of weight on the political and security environment when rating a sovereign, and the climate that has been brought about by the killing of a major opposition political figure could very well push international rating agencies such as Standard & Poor’s (S&P), Moody’s or Fitch to decide to downgrade Lebanon to the CCC bracket. Although S&P has recently issued an update on Lebanon stating that the central bank’s foreign currency reserves should weather the storm of a short-term political crisis, it is clear that a downgrade would be very much in the cards if the current political turmoil takes too much time (more than three months) and the momentum of the popular “white revolution” gets gradually killed off.
A downgrade in the medium- to long-term would bring about a significant rise in the government’s cost of funds, and will make it more difficult for the monetary authorities to manage the current debt portfolio of the country, which, as we all know, stands at around 200% of GDP (the highest among rated sovereigns). Banks, as a consequence, would find themselves holding lower quality government paper, which would be more difficult to get rid of, and which would penalize their capital adequacy, given the future higher risk weighting on low rated assets, as advised by the Basel II capital accord.
Hariri’s killing has also forced another issue to rear its ugly head again, which is that of the depreciation of the Lebanese pound. As soon as the bomb went off on Valentine’s Day, thousands of depositors had already called their branch managers asking for the conversion of their Lebanese pound deposits into dollars. The closing of the foreign exchange markets immediately after the attack and for three days of mourning prevented an immediate massive purchase of dollars by Lebanese depositors. At the opening on Friday February 18, central bank intervention still amounted to around $500 million in one day, despite reassurances by the monetary authorities and the central bank governor. Intervention slowed down a little bit in the second week after the assassination, but remained abnormal.
It is therefore clear that the central bank would not be able to sustain such a pressure if the crisis takes too long to be solved. A depreciation, to say LL1,600 to LL1,700 to the dollar in the medium- to long-term could very well be an eventuality, as the $12 to $13 billion of foreign currency reserves, would prove to be insufficient in the case of constant assaults on the local currency for a period of more than two to three months. The central bank may indeed decide to call it quits with regards to sustaining the pound in order to preserve what would be left of its foreign currency reserves. A depreciation in the Lebanese pound should affect the banks through their profitability and asset quality, especially considering that they hold significant proportions of their assets in the form of Lebanese pound government debt securities.
Funds promised in the Paris II conference could also be impossible to obtain, as the international community may deem any counterpart other than Hariri to be ineligible to negotiate with on behalf of Lebanon. International donors and lenders may also believe that Lebanon has become too high of a risk, and may therefore decide to cancel their financial pledges towards Lebanon. Although it is worth noting that Kuwait has recently announced that it stands firm in its commitment to release funds pledged during Paris II to Lebanon, in a clear sign of confidence and solidarity.
Lebanon lost a mover and shaker. With Hariri gone, the financial flexibility that was his leitmotif is in jeopardy. Indeed, few can see any other politician with his stature to raise funds at sovereign levels in most corners of the planet. Although the immediate outlook appears bleak, a smooth solution to the political situation that meets the demands of the domestic and international opinion could open the gates of prosperity for Lebanon. After all, everybody knows that the country’s economic woes have been and are still due to the nightmarish political quagmire that was created immediately after the end of the civil war in 1990.
Solidere, with its strong links to the late Rafik Hariri, should expect a certain period of time in the doldrums, as tourists and investors decide to stir away from Lebanon for the time being, particularly in this current political and security climate. Even Solidere-located restaurants should suffer, as fewer tourists flow in, and locals fear explosions while they are having lunch or dinner. The hotel industry within the area should also be closed for business for a few months, as the damage is being repaired.
The lack of business for a few months would definitely affect Solidere’s financial performance, as well as it share price. Already on Monday, February 21, Solidere’s share price had decreased by 15%, well below the $7 mark, only to regain some value the next day. As the largest market capitalization and most liquid stock listed on the Beirut Stock Exchange, Solidere should be the only company in the domestic capital markets to witness fluctuations in its share price, together with government bonds, which should also see frequent changes in their yields.
Such turmoil in the domestic capital markets should be expected as long as the political environment remains tense and a solution to the current crisis elusive. If the country’s fortunes improve in the coming weeks, then we can all expect share prices and bond yields to go up, perhaps even dramatically. Solidere’s Kuwaiti listing should also resume, adding much needed liquidity and investor diversification to the stock. The Kuwaiti listing would also be a first for Lebanon as it is the first Lebanese stock to be listed on a Gulf exchange, signaling the beginning of an era of prosperity for the entire country.