Grace under fire

The central bank is withstanding Lebanon

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The Central Bank (BDL) has coped with great professionalism and efficiency with the resulting monetary and financial crisis, sparked by the Hariri assassination. Not only has it kept a low profile and worked diligently towards supporting the Lebanese pound, but it has also provided significant liquidity in support of local banks, while its significant foreign currency reserves of almost $14 billion, amassed up to combat such liquidity scares have allowed the Lebanese pound/US dollar exchange to remain unchanged since 14/2 and the subsequent panic that gripped Lebanese and foreign depositors at Lebanese-domiciled banks.

BDL has also recently put in place a mechanism that improves the Lebanese pound liquidity of commercial banks, and prevents deposit or capital flight for the banking system. Such a structure implies the sale by the commercial banks of their Lebanese pound three-year Treasury bills to the BDL in exchange for Lebanese pound liquidity. With this liquidity in local currency, the banks can therefore buy US dollars or convert Lebanese pound deposits into US dollar deposits in a more comfortable manner, but they must place these dollar deposits in three–year US dollar bonds issued by the Lebanese government.

Such a mechanism allows local banks to remain liquid in Lebanese pounds and avoid any potential crisis on the local currency, and improves dollar margins for the bank, as lower yielding dollar deposits are placed in high yielding Lebanese government dollar debt securities (e.g. with an average of 4.25% on dollar deposits and a coupon or interest of 8.5% on government dollar bonds, banks would be making a hefty 4.25% margin).

Stemming capital flight

The mechanism also allows banks to be slightly more generous in terms of interest rates on US dollar deposits, defusing as a result any potential flight of deposits to banks abroad. This is most crucial for the banking system and the BDL, as deposits are almost the sole source of funds for banks. Their flight would destroy the credibility that was built with great difficulty over the last five years. It is very important, therefore, that foreign and Lebanese expatriate investors/depositors maintain their faith in the Lebanese banking system and the economy, as the injection of deposits into the banking sector is one of the rare investments into the Lebanese economy. The last thing local banks want to see is a contraction in their balance sheet, and a significant slow-down in their activities, as such outcomes would create financial and social crises.

This is a solid temporary solution and gives some breathing space to the banks, allowing them and the BDL to sustain the crisis for a longer period. However, the BDL has not stopped using its foreign currency reserves since 14/2. The rush on Lebanese pound deposits and the willingness of depositors to convert into US dollars or other foreign currency has not slowed and the fact remains that around $5 to $6 billion dollars have been already been spent.

The BDL’s foreign currency reserves are not inexhaustible and at some stage it will seek to stop the haemorrhaging to preserve what would be left of the foreign currency reserves, needed to finance ongoing business (e.g. trade finance), as there will come a point when preserving the good running of the domestic economy becomes a greater priority than sustaining the pound. Lebanon’s imports amount to around $7 billion per year, and the BDL would be keen to preserve reserves amounting to at least three months of exports. Of course, such a scenario would only occur if the political quagmire is prolonged for weeks and months, with no real solution in sight.

Going down

The Lebanese pound would then depreciate significantly as it became exposed to market forces. This is not as bad as it would at first seem. Deposits in the banking system would be expected to be more than 80% dollarized, and a depreciation in a few months’ time would have much less impact than a voluntary devaluation during more stable times, such as in 2002, 2003 or 2004. A depreciation now (or in a few months) would have an immediate impact of knocking out an important chunk of the country’s public debt in Lebanese pounds, which currently stands at around $20 billion in US dollar equivalent. If the currency is depreciated by 100% to LL3,000 to the dollar, around $10 billion of debt will be erased in one stroke. Banks would witness a re-balancing of their balance sheet, while the cost living would decrease in the long-term, as a depreciation usually reduces prices in the medium and long-run and creates a more competitive job market. Of course, a currency depreciation would be disastrous if it is not accompanied by a minimum of 30% to 50% adjustment in salaries both in the public and private sectors, as well as a strict control on prices of goods and services.

A depreciation would definitely affect the deposits, which would not have been converted into a refuge foreign currency, companies and individuals who borrow in US dollars and have revenues in Lebanese pounds, and the capital of those banks and companies that would not have taken their dispositions to protect their capital. However, with time, such negative effects are generally absorbed, as productivity rises and local goods and services become more competitive. In summary, currency depreciation has only short-term negative effects, and is considered a springboard for growth to the domestic economy. For example, Turkey’s currency depreciation in 2001 was regarded as a major catastrophe back then, but has allowed the country to become more competitive and growth-oriented.

In this context, it is important to note the effectiveness of BDL policies. Indeed, it has shown tremendous ingenuity in coping with crisis and has explored all avenues to help banks withstand a liquidity crisis and even maintain and improve profitability during difficult times. With limited hedging instruments available (Lebanon does not have a derivatives or other similar instruments market to use as hedging tools) the BDL has proven that it ranks amongst the most professional and able regulatory bodies in the region, and is comfortably coping with a situation that few other regulators in other countries would have been able to withstand.

Saved by the dept swaps

It is also worth noting that the government’s and BDL’s active debt management, which included debt swaps in the last quarter of 2004, have lowered the 2005 foreign currency debt maturities by around $1.2 billion, and as a result reduced the country’s financing requirement in 2005. Were such preventive action not to have been taken, the BDL would have found itself in a very constraining and difficult position, and the support of the Lebanese pound and the banks’ liquidity would have been seriously jeopardized. The current crisis is also postponing to a later date further debt swaps planned for this year, which would have the effect of lengthening maturities and reducing the interest cost. For the moment, foreign currency debt maturities ahead of the May elections amount to only $650 million and should be easily met.

In addition to being endowed with a solid regulator, there are more reasons to look on the bright side. Syrian troops and military intelligence have started their pull-out and are expected to leave Lebanon by the end of April, while the massive popular demonstration of March 14 has shown the very strong impetus for change. Other issues remain, but are minor when gauged against the massive drive for positive change, expressed by the majority of people in Lebanon. Such a drive or impetus can only lead the country towards economic prosperity in the medium-term. If political changes occur relatively quickly and smoothly, as it has more or less been the case so far, then the Lebanese pound would be expected to hold comfortably and fiscal and monetary imbalances would be erased.

Boosting ratings

The country’s credit rating of B- (see box) would then improve dramatically over a short-period of time. The significant improvements in the budget deficit, government revenues, and GDP growth, mainly as a result of the eradication of the financial corruption and racketeering, and of the significant increase in tourism activities, would make the international rating agencies change their views on Lebanon and upgrade the rating. A real sovereignty would also finally allow Lebanon to resume its paralyzed administrative reforms and privatization program, and allocate newly-found investments more efficiently and fairly.

The monetary authorities have succeeded in creating a sufficient cushion and an economic condition favorable enough to withstand crises of such magnitude. Most of the domestic commercial banks have also improved their liquidity and profitability during 2004 in such a way to be impacted as little as possible by a political crisis. Their capitalization has improved as a result of the strong internal profit injections of previous years, while their funding flexibility in terms of deposits and liquidity position have also strengthened considerably. The local banks have already raised the interest rates on both US dollar and Lebanese pound deposits (some banks have offered rates of 15% on Lebanese pound deposits for just one month) in order to simultaneously slow-down the rush on the dollar, through the conversion of Lebanese pound deposits into dollar deposits, and to discourage the flight of dollar deposits outside the Lebanese banking system. This higher interest rates method is likely to slightly affect the banks’ profitability in the short-term, but would be regarded as a low price to pay for the preservation of the banking system’s deposit base.

Exchange controls (whereby the withdrawal of deposits in foreign currency is controlled by the State) is highly unlikely, as such an action would hurt the credibility of the country’s banking system and would put an end to the flood of deposits from non-residents, which has been rising substantially since the 9/11 terrorist act in America. For example, around $200 billion in Saudi investments have been withdrawn from the US and are being re-injected in the Arab world, including Lebanon.

For the moment, the BDL and the banks are solidly sustaining the political crisis, thanks mainly to their foresight, which allowed them to build a favorable economic framework prior to the assassination of Hariri. With the rapid positive evolution of the political situation, one can only hope that the current pressure on the Lebanese pound is only temporary. A political solution linked to a full Syrian withdrawal, the election of a parliament made up of independent political figures, and the consequent appointment of a technocratic and efficient government, would then be the perfect platform for a long-term economic prosperity.

Standard & Poors’ Outlook

S&P the world’s largest rating agency, which currently rates Lebanon at B-, issued an update on Lebanon on February 21, seven days after the assassination. In its update, the agency shows clear signs of confidence in the Lebanese economy by confirming the ratings of B- and the “stable” outlook. The agency believes that the country should be able to weather the storm in the short-term, due to a favorable economic conjuncture “underpinned by replenished reserves, accelerating economic growth, robust financial sector liquidity and active debt management that mitigate the risk of an immediate financial crisis”. In other words, the agency is confident in the monetary authorities’ ability to face a political crisis and to sustain its currency over a short-period of time.

For the agency, the strong capital flows from the Gulf (averaging 11% annually since 2001) and the strong 5% growth in GDP during 2004, coupled with the improvements in external liquidity, provide the BDL with significant liquidity to weather the political storm created by the assassination. The agency also believes that an active debt management, which included debt swaps during 2004, which have lowered foreign currency maturities by $1.2 billion, has reduced in a significant way the government’s gross financing requirement for 2005. In hindsight, such a debt swap in 2004, which was then heavily criticized, has been very important for the country, as it has allowed the BDL to concentrate its efforts on supporting the pound and the local banks’ liquidity. Were the country not to have carried out the debt swap a few months before the assassination of February 14, chances of keeping the Lebanese pound at its current level would have been remote. The country, according to S&P, still has a $650 million maturity to reimburse before May 2005, but should be able to cope with it comfortably. For the agency, the financial sector continues to enjoy a comfortable level of liquidity, and should be able to continue the financing of the government’s short-term needs.

The agency has stressed on the need for a sustained period of fiscal consolidation that would include reforms and privatization, as these are essential to maintain recent improvements in the country’s debt dynamics. In the words of S&P, “failure to step up the implementation of reforms after the elections of 2005 would undermine growth and investment inflows, and would erode confidence and increase the risk of a financial crisis, bringing the rating under downward pressure”. If we are to interpret what the rating agency is telling us, we could make our own conclusion by saying that a positive political outcome to the current crisis that would go beyond everybody’s dreams, coupled with the necessary economic reforms advised by the rating agencies, would definitely put the country on the right track, and, in time, lead to a succession of rating upgrades. An upgrade would place Lebanon firmly amongst emerging market countries, and would allow for the gradual reduction in the cost of borrowing and an improvement in the ability of the country to service its debt, and even for the repayment of the principal on its debt with its cash flow alone. Dizzy prospects indeed.