Home Banking & Finance An infamous debt build up

An infamous debt build up

Economic reform first, then debt rescheduling will follow

by Mounir Rached

Lebanon’s fiscal policy over the past decades has been in most years very expansionary. Fiscal deficits at the end of the civil war relied heavily on domestic currency financing. Foreign exchange had been largely depleted by disruption to trade, while inflows declined as families immigrated. Due to the scarcity of financing in US dollars, combined with a need to start reconstruction, the government started to rely to a larger extent on borrowing domestically and internationally in dollars. 

Central bank reserves in the 1990s were quite low as the war years depleted Banque du Liban (BDL) of its foreign exchange. Relying only on domestic markets for foreign currency financing was perceived to exert further pressure on the exchange rate. Borrowing in dollars was prompted by two factors: the need to finance reconstruction and the need to have sufficient FX to maintain the peg that was adopted in 1997.

During that period, the Lebanese pound (LBP) interest rate was quite high, in the double-digit range, which also contributed to the worsening of the deficit. The government was attracted to foreign borrowing to secure needed foreign money for the budget, ease pressure on the exchange rate, as well as lowering its cost. The higher return rate provided by Lebanese banks, relative to regional and international markets, attracted increased inflow of FX into Lebanon; and banks discovered it as a lucrative channel to borrow from international markets through short-term deposit inflows and lend locally at a good interest rate with differential margin in its favor. This process made it easier for the government to borrow in dollars without straining the FX market. The government then made an official arrangement to issue Eurobonds under the jurisdiction of the state of New York later on in 1990s.

Political division and the absence of clear fiscal and debt policy encouraged the government to expand its spending as long as financing was available and its service was guaranteed by further borrowing. It created a vicious circle – borrow to finance FX needs and borrow again to service FX debt.

As is well known, public debt is generated by fiscal deficits, and even in years when a primary surplus was achieved, it served as an illusion that current operations excluding debt service provided a sustainable debt scenario. Only a manageable deficit, preferably with a primary surplus, a low interest rate, and a high growth rate can provide debt sustainability, which means placing the debt to GDP ratio on a declining trend. These ingredients were not stable and also difficult to attain in Lebanon due to several factors. Government spending for the most part was current in nature, capital spending was sustained at a very low level and priority was being given to current spending, while cost of capital remained at a high level.

The sustainability of debt has to have reliable ingredients and based on the determinants of the debt ratio to GDP. It is presented in this simple relationship:

D=(1+i-g) *D-1 – PS
Where D is debt to GDP ratio i is the effective real rate of interest rate on debt, g is real growth rate and PS is primary surplus as a ratio of GDP. The growth rate of the economy, the primary deficit, and interest cost are the three dominant outcomes used to determine the debt outlook and sustainability. These variables can be displayed in nominal terms as well but the substance of the analysis remains the same.

Debt increases whenever a real interest rate exceeds growth, and with a negative primary balance (overall deficit without interest payment). The primary balance comprises total revenues less total current expenditure (excluding interest) and capital spending. Current spending contains mostly wages and salaries and spending on goods and services. 

The distinction between primary balance and total balance (deficit) is largely connotative. When a surplus is realized in the primary budget it means that, had the debt of a country been nonexistent and there was no debt service, then the budget could have realized a surplus. It is meaningful when a country has a potential to undertake a debt rescheduling; reducing interest payments or spreading them over a longer period. It could help the country either to significantly reduce its deficit or even achieve a balanced outcome. Therefore, the larger the primary surplus, the better the sustainability outlook, as part of interest cost can now be covered from the primary balance. 

The post-war strategy of Lebanon was based on several critical choices that led to a rapid accumulation of fiscal deficits and debt.  These included the need to accelerate growth, enhance security, law and order, provide social services, rebuild infrastructure, recover trust in the Lebanese currency, and improve living conditions.

This vision required increased spending at all levels while the room to advance tax collection remained limited with a weak tax base in an economy emerging from 15 years of war. At that time, the government perceived that it was essential to increase public wages, including retirement compensation for the civil and security service, increase spending on infrastructure, health and education, and allocate funding to return refugees to their towns and villages. The government’s vision to boost spending despite a limited tax base, necessitated embarking on a grand borrowing scheme from internal and external sources. The monetary policy then strived, without success, to lower interest rates in order to pacify the escalating debt service cost while maintaining Lebanon as an attractive destination for capital inflows. The challenges facing the economy limited the opportunities created by foreign borrowing under the umbrellas of Paris I and II conference in 2001 and 2002.

To have a declining debt ratio, the real growth in the economy should be greater than the real interest rate, and revenues should exceed expenditures. Debt sustainability is interpreted as the condition that stabilizes the debt ratio which is satisfied if the ratio of excess revenue to GDP is at least equal to the excess of interest rate over growth. In simplified words, the debt ratio is stable when change in debt to GDP ratio becomes zero. 

Debt progression 2011-2019

In spite of political turmoil that prevailed following the assassination of former Prime Minister Rafic Hariri in 2005, successive governments had been able to arrest economic deterioration; growth rebounded, the balance of payments (BOP) achieved significant surpluses, and interest rates stabilized. Exceptional performance was recorded between 2007 and 2010. Growth was recorded in the range of 8 percent for four consecutive years (2007-2010), and the debt ratios declined for the first time in a decade. Certainly, external aid under Paris II and III aided in lowering interest rates and in improving the debt dynamics. Fiscal deficits reductions were supported by growth rates, lower interest rates, and stable expenditure.

Following 2011, the period witnessed political and economic terrain change for the worse, alongside the backdrop of political instability in Syria, growth rates declined as well as state revenues, and interest rates started rising again, leading to higher deficits. Debt accumulation escalated since then and the BOP recorded large deficits.

Several factors have pointed to the fact that the beginning of 2011 was a turning point for both the fiscal and the balance of payments. In 2011 and 2012, a commitment was made to increase wages and retirement payments by more than 10 percent. But at the same time, no revenue measures were taken to compensate for the wage increases. Resultingly, deficits started escalating due in part to irregular recruitment on  a contractual basis without recurrence to official standards. Increased spending and deficits coincided with a slower pace of growth. Deficits continued to rise in excess of 7 percent of GDP in most years.

In 2017, another decision was taken to increase wages and retirement payments by more than 20 percent, though it was not implemented until the following year.  Electricity sector subsidies, especially in years of higher oil prices, posed an additional burden on spending and the deficits. 

The debt profile was on an unsustainable path even before the beginning of the crisis in 2019. Lebanese banks were already hesitating to lend to the government in the ten years prior.  The central bank with induced interest rates became the major debtor to banks, instead of the government. Higher interest rates attracted banks to lend their foreign exchange reserves that were placed in international markets to BDL and benefit from their higher interest rates. BDL became a main source of financing for the government and most domestic debt was financed by BDL, as well as a sizable portion of the dollar debt issued as Eurobonds.

Debt profile (Billion LL) using official exchange rate of LL 1506.5 to the Dollar

Banks then would deposit most of their dollar reserves with BDL and in turn BDL would lend the government. The higher interest rates, inducing slower growth, contributed to the worsening of the fiscal and debt outlook. Banks did not respect prudential guidelines nor did the Banking Control Commission impose any. Nearly 70 percent of bank deposits were channeled to BDL and the government, in violation of the guidelines of the Code of Money and Credit. Banks, as well as depositors, came under the absolute control of BDL. Higher interest rates were provided for longer maturity CDs, which made bank operations rather simple but involving much higher risk, due to the concentration of their loans in the public sector at a time when net reserves of BDL were declining.

The government’s access to easy financing, in spite of its higher cost, lured it away from engaging in genuine reform. To the contrary, it continued its pattern of high spending without any concern for the consequences.

Certainly, the debt build-up that evolved to a crisis level in October 2019 reflects mismanagement of the economy on every level. Expenditure strategy and government plans were not designed to achieve a clear framework objective. Often economic targets were disengaged from the needed policies to achieve them, while government budget responded to the needs of politicians.

The major causes of debt build up and derailed debt policy can be summed up as follows:

• The political spectrum revealed deep divisions that ended in a protracted formation of the legislative body as well as the executive body. Formation of parliaments suffered a cumulative delay of 2,321 days between 2006 and 2018.  

• The parliament which was supposed to end its term in December 2006 was extended until June 2013, and the parliament that ended it term on June 20, 2013 was extended until the May 6, 2018.  Government formation at the Council of Ministers level during the same period took 1,449 days. 

• Presidential elections were delayed 1,073 days in 2007-08 before the election of President Michel Suleiman and in 2014-16 before the election of President Michel Aoun.

• The continued deficit in the power sector.

• The size of the debt itself.

• The previous two actors absorbed  nearly 90 percent of the debt service.

• The number of public sector workers  has expanded exponentially during the past decade.

• Currency stabilization often required higher interest rates to attract a continued inflow of capital, which constituted an increased cost.

The confrontation between the public and government came heads on when, on October 17, 2019, a proposed policy to impose levies on voice-over-IP calls of the popular application, WhatsApp, was the climax in a culmination of mismanagement and state distrust.  The public expressed its anger in a nationwide protest movement demanding political upheaval and revealing major state and governmental mistrust.

Fiscal and debt problems peaked when the government defaulted on its Eurobond debt in the spring of 2020.The default induced banks to sell Eurobonds in order to generate liquidity as BDL announced that it no longer supports the peg. 

As the government suspended payment of debt amortization and interest on Eurobonds to domestic and foreign holders, debt accumulation built up. Since then, arrears on debt service have been accumulating and the debt issue has worsened today. The issue of debt service in dollars resulted in sizable balance of payments deficits since 2011 and the decline in BDL reserves. Under pressure to preserve foreign exchange as much as possible, BDL took the decision to terminate the exchange rate peg prematurely. At that time, June 2019, BDL still held a comfortable level of reserves at $34 billion, sufficient to finance the BOP for another several years; although the net reserve position of BDL was negative even before then. There was concern that in the absence of any corrective fiscal adjustment and potential to correct the BOP deficit, BDL took a pre-emptive decision to terminate its commitment to finance banks. Then, over $60 billion were held as FX liabilities to banks.

It’s apparent that sovereign debt is on an upward trajectory due to continued fiscal deficits and accumulation of arrears on Eurobond principal and accrued interest.

The depreciation of the currency has certainly changed the debt profile. The total debt in dollars shrank from $100 billion to $42 billion, as the pound lost 95 percent of its value. Since GDP data in dollars remains dubious (according to the World Bank it is in the $25 billion range), the debt ratio is about 168 percent. The debt profile did not change much from the pre-crisis period as a result of gains recorded in Lebanese pound debt which compensated significantly for the dollar drop in GDP.

The profile of debt financing sources has changed since the crisis. Banks reduced their financing of the government in both domestic and foreign currencies. Commercial banks financing of the government in Lebanese pounds declined from LL25 trillion at the end of December 2019 to LL18 trillion at the end of April 2022.  Domestic debt held by BDL grew and its holdings of treasury bills increased from LL51 to LL59 trillion. 

Foreign currency debt holdings of banks dropped sharply from LL20 trillion or $13 billion, to LL6 trillion in an attempt by banks to obtain foreign exchange as the supply line of BDL dried up. Most of the decrease was absorbed by international financial institutions. These bonds were offered at a highly discounted price; ranging from 15 percent to 25 percent in the later transactions. Foreign financial institutions, in spite of the government default, wanted to increase their holdings to above 40 percent of total issues in order to maintain a decisive role in a resettlement or rescheduling agreement.

Need to change

The view of successive governments, especially those of the numerous Councils of Ministers headed by Prime Minister Rafic Hariri between 1992 and 2005, did not foresee the complications that face Lebanon: the limited administrative capacity, weak government institutions, widespread corruption, deep political divisions, and the long-term damage exerted by the pegged exchange rate. The latter actually was strongly supported as an anchor of stability, ignoring the high cost of debt service that accompanies massive borrowing schemes. All these factors have hindered the planned progress of any government.

The elder Hariri built his vision for Lebanon’s reconstruction and development in the 1990s on the assumption that peace in the Middle East is inevitable and substantial aid could flow into Lebanon in compensation for settling the Palestinian issue and the return of internally displaced Lebanese to their towns and villages. However, none of these optimistic scenarios was fully realized. Lebanon was provided with European financial support thanks to several Paris agreements under the auspices of French President Chirac. But ineffective successive governments did not make full benefit of such generosity. Billions of dollars were wasted due to both mismanagement and corruption. Policies were never fully implemented and many were not in the proper frame for Lebanon. It became apparent that debt build up would continue year after year, into the future. Since the current crisis began, no significant reform has taken place and debt has reached the LL152 trillion.

To get out of its dilemma, Lebanon has to embark on a serious and massive reform plan first, rather than reschedule its debt without it. Reform has to take place in all branches of the public sector, fiscal, monetary, civil service, and the public enterprise sector. The energy sector alone has been a major cause of foreign currency debt accumulation. Simply rescheduling debt is not enough to place Lebanon on a sustainable debt track.

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Mounir Rached

PhD, is the president of the Lebanese Economic Association (LEA) and a former IMF Senior Economist (1983-2007).

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