Juggling debt wisely

The sound of management of debt, and the implementation of outstanding economic reforms, will be crucial priorities for any new government

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The key to Lebanon’s short term economic future rests with its ability to get on a trajectory of reform and debt management. With the real economy bleeding and GDP expected to shrink this year, the importance of Lebanon’s debt management takes on a primary role, especially since gross public sector debt amounted to the equivalent of 170% of GDP in 2004, a more than three-fold increase over the past decade. Net public debt amounted to the equivalent of just over 160% of GDP in 2004 or around 120% netting out central bank foreign exchange reserves. This represents close to double that of Turkey, and is among the highest of rated credits. Understandably servicing this debt represents a huge drain on the public coffers, and will be a main obstacle to growth.

A bit of history Lebanon has a track record of always meeting its obligations, even in difficult circumstances. The fact that the banking and financial sector has remained at the core of the economy has instilled a strong “willingness to pay”. Paris II did also bring a marked improvement in both the stock and structure of debt: To recap, $2.4 billion in donor funding was provided in the form of 15-year Eurobonds with a 5% coupon and a 5 year grace period; Domestic commercial banks agreed to tender around $3.6 billion in cash and securities in exchange for new longer dated zero-coupon Eurobonds; Banque du Liban (BDL) agreed to cancel debts equivalent to around 10% of GDP, with obligations equivalent to a further 10% of GDP restructured into 15 year Eurobonds with a 4% coupon and a five year grace period; A further $400m in T-bills was restructured into new 5-year instruments, with a 4% coupon. The total value of the debt restructured under the Paris II agreement was some $9.5 billion, with the absolute stock of debt cut, the maturity significantly extended, and the share of market debt also cut.

The problem is that the government has failed to fulfill many of the commitments it made under the Paris-II agreement, particularly with respect to privatization and structural reform. Actual revenues from state asset sales in 2003 amounted to less than one-tenth of the official target, as bickering between the country’s business and political elites stalled key privatizations (e.g. telecoms). Arguably, Lebanon has managed, despite the absence of these privatization revenues, but it has been fortunate in facing a favorable global financing backdrop. International capital markets may no be as forgiving beyond next elections, and hence it is vitally important that state asset sales accelerate. Failure would likely leave the government reliant on rapid real GDP growth, and the maintenance of very high primary surpluses

(which they have thus far failed to achieve). Necessary action

In terms of broader budgetary reform, the government will need to do the following next:

? Streamline the civil service, to reduce the wage drain on the budget. Some progress in this regard has already made, and the wage freeze adopted in 2003 has helped reduce wage cost on the budget.

? Reform, overhaul and streamline the whole taxation system. VAT rates may need to rise and a general system of income tax needs to be introduced.

? Reform the social security system/healthcare system, which remains under-funded and represents a huge drain on the Treasury.

? Reform pensions.

? Reform the energy sector. In particular, the state owned electricity company (EDL), continues to exert a drain on the public purse, equivalent to around 2.5% of GDP. The company has huge debts (over $800 million) and has been heavily impacted by hikes in world fuel prices, which it has been unable to fully pass on to end-users. It has also been a favored target of political fighting and outright theft.

Although the BDL has spent some reserves on defending the currency, and local banks have pushed up interest rates on Lira deposits as incentives for holders to be patient, the BDL and the commercial banks are relatively liquid and could ride out a significant period of low level political instability, albeit a more marked deterioration in the security situation, encouraging significant capital flight from the domestic banking sector, would cause significant stress on the entire system.

From the external debt perspective, Paris II shifted a large part of the public sector debt burden from the domestic to the external sector. As a result the ratio of external debt GDP has continued to rise. Indeed, the ratio of external debt/GDP has more or less doubled since 2000 to stand at around 114% by 2004 and over 300% of exports and good and services. Both ratios are high by international standards, and indeed above levels deemed sustainable; generally a ratio of external debt of 180% is regarded as being at the threshold of sustainability. Paris II did, however, significantly lengthen the maturity of external debt albeit the external debt service ratio still stands at a relatively high level of 20%. A particular problem exists in 2005, with over $3 billion in Eurobond obligations maturing. The government is known to be in discussions with local banks and institutions (holders of 80% of the stock of Eurobonds) and an exchange offer is likely to be agreed.

The chart shows that the banks remain key holders of debt and given their high level of liquidity, and thus ability to take on more debt stock, it is unlikely that the banks will be the factor to pull the rug from underneath the country’s fiscal situation. Again, all this assumes no catastrophic shift in the security situation. The critical situation remains one of confidence. The holding of elections, supervised internationally, and leading the way to a balanced and committed government are pivotal in restoring economic order. As it stands, the country is hostage to unrealistic GDP growth needs. As is seen in the chart, what has added to the fiscal strain has been the weak growth of the real economy.

The ability of the next government to orchestrate a smooth roll over, swap, and rescheduling of debt remains the most vital element to watch for, which is why this government must be credible not only from a popular perspective, but also must have the manpower and vision to convince debt holders that the trajectory of reform and growth initiatives is unshakable. The current environment in global emerging market debt, having turned recently toward slightly more risk aversion and higher yields, will prove challenging for anything other than a strong and representative government. What is clear is that the economic imperative, so dear to Hariri, will need to be the clear focus. This is a tall order, considering another key priority is political reform.

The banking sector is probably the only bright spot in this whole panorama. The banking and financial sector presents both a strength and a weakness for the economy. The sector is huge relative to the size of the economy, with the ratio of banking assets/GDP amounting to over 300%, comparable to service sector/banking hubs such as Hong Kong. The banking sector has traditionally attracted huge inflows from the Middle East region, which, in turn, have been channeled by the banks to fund the government’s huge public debt burden. Officially, non-resident claims on the sector amount to around 20% of assets. However, with a large transitory population it is difficult to draw a clear distinction between residents and non-residents. Actual foreign claims on the banking sector may thus be much larger. Around one-quarter of banks’ portfolio’s comprise public sector debt (over $7bn in Eurobond holdings, and a similar amount in domestic T-bills). The sovereign exposure of the banks is thus high (helped by zero risk weighting attached to sovereign Eurobonds and T-bills), creating a symbiotic relationship between the banks and the Treasury; the banks face a strong incentive to rollover public sector debt or face serious capital losses (as reflected in the Paris-II agreement). Arguably the high ratio of assets/GDP also make the sector much better able to fund a higher nominal level of public sector debt. Generally the sector is better capitalized than its peers in other similarly rated EM credits (capital adequacy is around 20%). The NPL ratio is though high at around 30%, albeit these are relatively well provisioned (NPLs net of provisions stand at around 12%) while the sector is relatively liquid (the ratio of net liquid assets/total assets stands at around 50%). The sector is also currently benefiting from rapid asset growth, with deposits currently rising by around 11% YOY (20% growth in deposits by non-residents). Nevertheless, the sector does present a potentially large contingent liability on the state (equivalent to around 15% of GDP, albeit this is small relative to the existing huge burden of public sector debt). The sector is highly dollarized, with around 70% of deposits and over 80% of loans denominated in foreign currencies. Unlike in Argentina, foreign ownership in the sector is small (less than 10%), although the fact that the sector is highly dependent on deposits made by foreign investors, it is still being propped up by foreign capital. The banks hold the key. Yes, it is crucial for the next elections to be fair, with all the ramifications this will have on confidence, but most crucially, the economy must stabilize. As it stands, if the current international focus continues, and political tensions ease, the economy will need to generate outsized gains in the remainder of the year to avoid a massive crunch on banks and thus the country’s ability to manage and restructure debt obligations. With the spectacular popular protests, what seems clear is that future reforms will have to be built on consensus, and that the political stability will in effect dictate our ability to restructure our obligations, and more importantly, keep funds flowing into the banking system. The loss of Hariri as a point man in pleading the cause for investing in Lebanon will be felt for years to come, but the confidence boost from renewed sovereignty and a vibrant internal debate will play a positive role in avoiding fiscal disasters.