Fitch, the powerful international rating agency, warned in July that Lebanon risked being downgraded if the government failed to act on its much promised monetary reforms and privatization, the two conditions that determined the Paris II donor conference. While the first condition has been more or less met, the second has been postponed ad vitam eternam, while politically, a consensus of complete stagnation has been reached, and will remain, until after the presidential elections.
So, while the Lebanese party through the summer, the bottom line is that the country is still teetering at the edge of the abyss and remains the laughing stock of the international capital markets and investors. Its B- rating is shorthand for the fact that we are one step away from default and collapse.
Lebanon’s credit rating (which determines the country’s ability to repay the principal on its debt and service interest) has stabilized to B- (by Standard and Poor’s) and B2 (by Moody’s) since 2002. When the country was rated by these international rating agencies for the first time in the mid 1990s, the rating was not significantly higher and was below investment grade anyway, at BB- (S&P) and B1 (Moody’s). As of 1994, when Lebanon became a successful and frequent bond issuer, the necessity for a credit rating was imperative. International investment banks and the global capital markets needed a rating in order to accurately price the bond issues that were sold to institutional investors world-wide, and benchmark them against issues made by other countries.
Lebanon’s sovereign credit rating is one of the lowest of the world. Indeed, only Bolivia, Suriname, Uruguay and Venezuela have a similar rating on S&P’s scale, while Argentina, the Dominican Republic, Ecuador and Paraguay are rated below B- at CCC and selective default (SD) levels. The remaining 106 rated countries all have credit ratings above B-, including Mongolia (B), Pakistan (B), the Philippines (BB), Ukraine (B), Benin (B+), and the Cook Islands (B+). With a higher credit rating, these countries can borrow slightly more cheaply than Lebanon, which is at the top end of the table in terms of credit risk. Lebanon’s B- rating signifies that the country “generally lacks characteristics of the desirable investment” or is a country where “significant credit risk is present, but a limited margin of safety remains.”
As we all know, the reason for Lebanon’s low rating stems principally from its large fiscal deficit and public debt burden, which accounts for more than 180% of GDP and is the highest amongst rated countries. The fiscal deficit, at above 10%, is also regarded as high and has not shown signs of going below the 10% mark for some time. Furthermore, the country’s external financing or liquidity remains heavily strained, despite the Paris II. Lebanon has not delivered on its promises and therefore cannot expect aid from foreign governments and institutions such as the World Bank or the European Investment Bank. Moreover, the central bank is believed to have little if not negative net foreign exchange reserves, which can only be replenished with external, non-debt, capital inflows.
Another reason for the country’s low rating is the uncertainty surrounding the government’s ability to generate additional revenues (despite the introduction of the VAT) and diversify the economy. But the most serious reason, which triggers a negative reaction from rating agencies, is the political infighting that has been plaguing the country’s economic reform efforts for more than six years and which has brought about a substantial drop in confidence from international investors. In other words, the outside world sees Lebanon as having too much debt, insufficient revenues and lacking political will. The rating agencies see Lebanon’s strategy to raise funds to finance its fiscal deficit as backfiring. By raising public debt to unsustainable levels, the government has become highly reliant on attracting investor funding to Lebanon, and has also become extremely vulnerable to external conditions. Indeed, if the world’s capital markets experienced a downturn and the flavor for emerging market debt once again disappeared, the government would not easily be able to turn to local banks, saturated with Lebanese government debt securities. This financial flexibility will then be substantially weakened, and the credit rating may then go below the single B bracket. The most immediate and obvious consequence of a low credit rating is the high cost of borrowing for Lebanon. International capital markets determine the price of indebtedness (or the level of interest) according to how risky the borrower is, and the credit rating assigned by internationally recognized and accredited rating agencies, such as Standard and Poor’s (S&P), Moody’s and Fitch, is used by these markets as the symbol that distils all credit information into a single letter and as a benchmark, according to which pricing is determined. Lebanon’s B- rating means that the cost of borrowing is extremely high, not only for the government, but also for the whole economy, which has to align by the benchmark set up by the government’s rating. If Lebanon is downgraded further, the cost of borrowing for the state would increase by 200 basis points (2%). Therefore, Lebanese Eurobonds would carry a coupon of around 520 basis points (5.2%) over US Treasuries, compared to the current spread of 340 basis points. If on the other hand, Lebanon were to reach the holy grail of investment grade (probably not in our life time) and get upgraded to BBB level, it would pay 200 basis points less than it currently pays, or a spread of around 140 basis points over US Treasuries (similar to Mexico, which is rated BBB- by S&P). Simply put, the government would have more money to channel into growth projects. At the moment, the high cost of borrowing, coupled with the high level of indebtedness has forced Lebanon to direct most of the country’s revenues into debt servicing, leaving virtually nothing to fund badly needed growth projects. The low credit rating firmly embeds Lebanon amongst the world’s third world countries, and puts the country on an equal footing with some pretty mediocre nations.
An even worse case scenario would be the discontinuing of the country’s rating, which would cause the cost of borrowing to shoot up to astronomical levels. Raising funds at whatever the cost would be extremely difficult, and the global capital markets would completely marginalize Lebanon. We would be the Phnom Penh, rather than the Hong Kong, of the Middle East.
So what to do? First and foremost, the country needs to establish political stability. Rating agencies loathe politically unstable sovereigns and have frequently stated that Lebanon needs to establish a consensus within its fragile political coalition. The public and investors alike need to know that there are no more political conflicts within the ruling coalition and that there is a clear and firm intention to carry out an efficient recovery program. Second, social stability must be solidified. The strengthening of democracy and transparent governmental efforts to create jobs and slow down the country’s brain and youth drain are vital. The government today is ignoring this issue and is focusing instead on fiscal and monetary economics. Ignoring social economics has been a major error.
Third, Lebanon must navigate skillfully in very rough regional and international diplomatic waters. The regional environment has never been worse, and the country cannot afford a faux pas if it wants to carry out an efficient fiscal, monetary, and social economic adjustment program. Fourth, the Lebanese government must finally carry through on its promises to revive a moribund privatization and reform program. Until now, Lebanon has been sluggish at best in its attempts to carry out privatization. As regards to the latter, the timing is awkward: emerging market initial public offerings (IPOs), an essential method through which a successful privatization is made, are virtually dead, whilst strategic institutional investors are either not attracted by the Lebanese market or simply have too many problems of their own to contemplate investments overseas. In addition, factors such as divisive domestic politics, the unclear and most often deteriorated financial situation of companies to be privatized, labor union staunch resistance and endemic disputes between the government and the rare foreign bidders, make privatization an insurmountable task.
It is therefore vital for the government to start using securitization tools to restructure public entities that are candidates for privatization, in order to make them more attractive to increasingly choosy foreign bidders, and carry out successfully a couple of privatization transactions. This would kick start the privatization program in a serious manner, show a clear political will, and bring in much needed cash into the coffers (the partial privatization of the telecommunications and the electricity sectors could very well bring in revenues in the range of $2 billion to $3 billion).
Last but not least, the Lebanese government should actively explore the growth route. A clear option for the Lebanese government is to grow itself out of a debt trap. The rating agencies always preach for the diversification of revenues and for the protection of cash flow. Lebanon has lost sight of its growth-orientation and has focused more on fiscal and monetary economics. The introduction of the VAT and attempts to boost the tourism sector are moves in the right direction, but remain insufficient. The government should seriously tackle the strengthening and the restructuring of existing inefficient sectors to further boost government revenues.
The communication of a clear political will and commitment as regards to privatization and securitization to the world financial community, the execution of a large, immediate and transparent privatization, and more importantly the immediate halt in the political infighting and the announcement to the world’s diplomatic community that all is well within the triumvirate, are merely quick ingredients for a small upgrade. However, the BDL’s monetary tools have bought the country some time, but are insufficient and cannot be sustained without parallel reforms and privatization. However, the BDL could also crack down on inefficient banks and restructure and “specialize” the financial sector, and get permission to use the idle $4 billion worth of gold reserve (either sell it partially or obtain cheap funding with it as collateral). These are only the immediate steps that need to be taken by the Lebanese government, in order to stabilize the current rating situation. If carried out efficiently, together with the provision of much needed financial aid, Lebanon would probably move up a few notches on the rating scale. But it would take much more efforts by the country in the long-term to attain the elusive investment grade rating (BBB).
You have been warned.
Nicolas Photiades is an independent financial adviser on financial, capital optimization and strategy.