Eurobonds default: a one-year anniversary

Is Lebanon running out of options?

It has been one year since the Lebanese government defaulted on a USD 1.2 billion Eurobonds issuance that was due on March 9th 2020. One year on, negotiations with Eurobond holders have still not begun, and no good faith discussions with the International Monetary Fund (IMF) have been engaged in order to help negotiate a financial aid package and also on engaging stakeholders.

The default on the payment, the first in Lebanon’s history, resulted in a default on all Eurobonds issuance, due to specific clauses in the Eurobonds issuances: should a default on a Eurobonds issuance occur without agreeing on restructuring terms with 75 percent of the holders of this issuance, this would trigger a default on all outstanding Eurobonds, which totals USD 31.3 Billion, of which USD 11 billion are held locally by Lebanese banks.

The origins of the default

Lebanon, for years, had been on a path of debt accumulation, reaching a debt level of 143 percent of GDP in 2017. This situation was the result of years of excessive government spending, corruption, and public sector growth compared to GDP. As a result, debt servicing was taking up a higher place in the budget every year, second only to public wages, retirements, and pensions. In addition, a revised salary scale was implemented in 2017, resulting in higher wages and pensions for public sector employees, and therefore more government spending, originally estimated at USD 800 million, only to be later revised at USD 2.3 billion.  Budgetary transfers to Electricite du Liban (EDL) alone accounted for more than USD 15 billion since 2010.

Due to these high budget deficits, successive Lebanese governments have had to resort to debt, either in Lebanese pounds (by issuing T-Bills), or by issuing dollar-denominated bonds (Eurobonds) on international markets. In addition, growth having been slower than the rise of debt, the Lebanese debt burden became every year harder to bear. In 2018, debt levels reached USD 85 billion (denominated in dollars and Lebanese pounds), equivalent then to 153 percent of GDP. In 2018, interest payments amounted to 39.53 percent of Lebanese government revenues

In past years, the Lebanese Ministry of Finance (MOF) became the main source of foreign currencies to the BDL.  Between 2009 and 2019, the MOF issued USD 17.5 billion in Eurobonds in exchange for swapping T-Bills (Lebanese Pound denominated debt). As a result, the MOF became the main source of dollar financing for the BDL, swapping T-Bills for Eurobonds which were then resold to the banking sector. Of these USD 17.5 billion Eurobonds, USD 5.5 billion remained on the BDL’s balance sheet, and USD 11 billion were then sold to the local banks. These swaps also resulted in a very high concentration of government dollar denominated debt on the balance sheets of Lebanese banks, up to 55 percent of their equity at the time of the default.

These swaps between the MOF and the BDL also resulted in a higher concentration of foreign currency debt in the Lebanese banking sector, with the default hitting the sector even harder had it not occurred. As a result, Lebanese banks’ balance sheets have been hit and, as per BDL circular 567, banks have had to take provisions of 45 per cent on the Eurobonds, in addition to being mandated to raise their capital by 20 percent in dollars by end February 2021. 

Could the default have been prevented?

The government could have avoided a default by agreeing on restructuring terms in advance of the non-payment and effective date. This would have required the consent of 75 percent of the holders of each Eurobond series, voting on a series-by-series basis. Such a negotiation could have resulted in rescheduling the debt, renegotiating the interest rates, and even a coupon reduction.

In practice, such negotiations occur several months before the due repayment date of the issuance, according to Nassib Ghobril, chief economist at Bank Byblos: “In the past 40 years, 97 percent of countries whose governments defaulted took this decision in conjunction with negotiations with the IMF or after reaching an agreement with it.” In principle, such a default could have been organized in a timely manner, constructively with all stakeholders involved. “Most countries that decide to default on their foreign obligations start communicating with their bondholders several months before D -day,” says Ghobril. Indeed, with enough reserves at the BDL at the time, Lebanon could have paid the issuances due in 2020, amounting to USD 2.5 billion for 2020, noting that the next maturity was due in April of 2021. The Lebanese Government, having honored its obligations for 2020, could have then prepared a restructuring plan in coordination with the IMF for 2021, and engaged stakeholders with regards to the terms of the default, which would have been organized and in line with international practice, thus preventing Lebanon from being cut out of international trade and finance markets.

Nevertheless, after the default, the Hassan Diab government had put in place, in conjunction with the financial advisory firm Lazard, a government reform plan which had been presented, and would have, in principle, allowed for negotiations with the IMF to be kick-started in order to engage stakeholders and allow for a restructuring of the foreign-currency debt. This plan was never put in place and it remains to be asked why such a default was disorderly and what the real consequences of this lack of diligence are.

In addition, one element of the Eurobonds in question was the fact that, in order to engage in a restructuring, holders of up to 75 percent of the coupon holders should agree on the restructuring terms. This highly complicated the possibility of an organized default in March 2020 when Ashmore, a London-based asset manager, bought more than 25 percent of the Eurobonds due to be repaid on March 9th, in addition to holding more than 25 percent of Eurobonds that were due to mature in April and June of 2020. In principle, Ashmore could have prevented a restructuring of these bonds, which resulted in a backlash on the civil and political side in Lebanon due to the financial difficulties the country was facing.

Consequences on banks and the financial sector

The first consequence was to affect banks’ liquidity. Even though the liquidity crisis in Lebanon did not start at the time of the default, but earlier in September 2019, as the Lebanese were rushing to their banks to withdraw money from their deposits, the default nevertheless worsened this liquidity problem as banks could not obtain paid interests on their Eurobonds investments. In addition, foreign liquid assets of banks had already declined from 8.4 percent of Lebanese bank assets at the start of 2017 to 5.6 percent by the third quarter of 2019. The BDL, also a holder of Eurobonds worth USD 5.3 billion at book value, was equally hit by the default. This, in turn, affected banks’ liquidity as interest rates paid to banks on certificates of deposits, due to a lack of liquidity at BDL, were then paid half in dollars and half in Lebanese pounds.

Overall, the Lebanese financial sector was sidelined from international financial markets, according to Ghobril. With the Lebanese government having defaulted on its obligations towards Eurobond holders, Lebanon has been rated in default, and as Lebanese banks cannot be rated higher than their sovereign, this has resulted in a rating of RD (Restricted Default) by Fitch and to SD (Selective Default) by S&P Global Ratings. This has resulted in foreign correspondent banks not accepting letters of credit emitted by Lebanese banks for export purposes unless these letters are back-to-back (100 percent backed by liquidity), and as a result banks were cut off from international trade markets, affecting imports to Lebanon.

The other casualty has been confidence, according to Ghobril: “it led to the evaporation of any confidence that existed at the time.” Indeed, with the Lebanese government having defaulted, the logical procedure would have been to engage the IMF, prepare a restructuring plan, but also impose capital control laws to better organize monetary transfers. Instead, both the executive and legislative branches have done next to nothing on this level, and therefore international markets are weary of Lebanon at this stage.

The road ahead

The Lebanese government’s latest budget proposal was presented by Minister of Finance Ghazi Wazni, on January 26. According to the budget proposal, interest expenses on the state’s foreign currency debt fell from USD 2.4 billion in 2020 to USD 80 million, reflecting for the moment the fact that the government does not factor in a reimbursement of Eurobond interests and principal. In addition, the major expenditures, according to the budget, are related to wages, salaries, and pensions of public servants.. This is easily explained by the fact that their purchasing power has been heavily reduced by the depreciation of the Lebanese pound, although for years these expenditures had been labelled as cronyism amidst criticisms of countless “absent” public servants. At this stage, the Lebanese government is not advancing any serious reform plan in the budget proposal.

For Ghobril, the choice is clear: “We have no other choice than to go through the IMF.” Indeed, the only plausible way to regain access to financial markets and trade networks would be to start negotiations with the IMF, after stakeholders agree on estimations of losses with the BDL, and proposing a reform plan that would unlock foreign financial help. The reform plan, in addition, would help unlock money promised at the international conference in support of Lebanon development and reforms, CEDRE (“Conférence économique pour le développement, par les réformes et avec les entreprises”), which was held in paris on April 6th 2018. These reforms would have to include a reform of the EDL authority, procurement laws, and others. Such a reform plan would not only help unlock funds from international donors, but would also result in improved governance, which could help attract foreign direct investments to Lebanon.

Negotiations with the IMF are difficult, but the IMF has been willing to accommodate countries in need with regards to reforms and deficits. The example of Egypt is revelatory in this regard: Egypt approached the IMF in 2014 and obtained the required funds, after having presented an economic plan that had been adapted to the needs of Egypt and its citizens, which included cutting on subsidies and implementing reforms. As a result, Moody’s reviewed Egypt’s credit outlook from negative to stable in a matter of one year. The government’s plan was negotiated with the IMF at the time, and implemented by the latter.

Since the publication of a report in 2018, the IMF has changed its modus operandi and has stopped insisting on reform plans that would massively reduce public deficits and often result in economic contractions, as had been the case in the 1990s. Joseph Stiglitz, winner of the Nobel Prize in economics, had argued against the IMF’s “one-size-fits-all approach” in his 2002 book “Globalization and its discontents,” arguing that its insistence on deficit reductions in developing countries produced counter-cyclical results. In the past years, the IMF has reviewed this approach and has become more accommodating with regards to debt reduction and the need to allow for pro-growth policies. 

In the end, at the current rate, foreign reserves are being reduced at the BDL due to the government’s policy of subsidizing essential goods, such as food and fuel, which would not last for long, according to recent comments by BDL’s governor Riad Salameh. It is only a matter of time before subsidies are lifted, which would result in more inflation and a greater depreciation of the Lebanese pound to the dollar. The only sensible solution would therefore be for a new government to engage with the IMF and Eurobonds holders, with a unified set of numbers regarding the losses, in order to obtain the financial help of foreign financial institutions such as the IMF, unlock CEDRE money, and engage in the necessary reforms that would allow for Lebanon to regain access to capital markets and international trade networks. As a result, Lebanon could be back on track towards sustainable growth, should effective reforms be implemented and governance improved.

Note: We modified this text on March 11th and 12th 2021, firstly by substituting the term “cross-default” with the term “default” in the title and lead paragraphs after an anonymous reader had questioned its correct use. We also removed a citing error based on a misreading of the comment piece “Lebanon’s financial collapse: a post mortem” by Mr. Toufic Gaspard.

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