Confidence in Lebanon’s ability to avoid default on either its domestic or international debt is starting to fade as the country’s debt burden grows while reform measures continue to appear inadequate and slow. This is the case despite the successful issuance recently of yet another Lebanese eurobond that was oversubscribed allowing the borrower to increase it from the originally planned $400 million to $750 million.
The main challenge of economic policy in Lebanon is finding a feasible solution to the sharply deteriorating fiscal situation and the mounting public debt, both of which are undermining confidence in the domestic currency and in the economy as a whole. Lebanon has one of the highest debt levels in the world with total public debt last year at 35,034 billion Lebanese pounds ($23.27 billion), equivalent to 145 percent of gross domestic product (GDP). The annual debt service bill now accounts for almost all government revenues or 44 percent of the national budget for 2001. A third of the external debt is denominated in foreign currency and 80 percent of it is on the books of the Lebanese banks. The deficit target in this year’s budget of $3.36 billion is equivalent to 20.4 percent of GDP, with the debt to GDP ratio rising to 163 percent and is forecast to reach 200 percent in 2002.
Moody’s revised recently its long-term ratings of Lebanon for the first time since it rated the country in February 1997, downgrading its foreign currency debt to B2 from B1. Furthermore, and to conclude a review for possible downgrade that started in September 2000, Moody’s cut the government’s domestic currency issuer rating from B1 to B3. However the country ceiling for foreign currency bank deposits remained unchanged at B2. According to Moody’s, all of the above ratings carry negative outlooks. Moody’s ascribed the downgrade to the significant deterioration of Lebanon’s government debt dynamics that were intensified by the sluggish economic growth. According to the agency, the rapid accumulation of foreign currency debt over the last two years is a source of worry and a greater effort will be needed to reverse it, particularly with the existence of a heavy interest rate schedule that is creating a debt trap since new borrowing is required to settle interest on maturing debt.
The financial strength ratings of the top Lebanese banks continue to be constrained by the difficult operating environment in Lebanon. The slowdown in economic activity over the past few years has negatively affected the Lebanese corporate sectors and with it the asset quality of banks. In 2000, the aggregate level of non-performing loans (NPLs) for the entire banking sector reached 16.5 percent of gross loans ? its highest level in a decade. However, the increase in NPLs is in part attributed to more stringent control from the Lebanese regulatory authorities.
Despite efforts by the current government to revive the economy, no growth in GDP is expected this year, nor a significant improvement in the banks’ asset quality. Moody’s negative outlook on the “D+” average financial strength ratings of Lebanese banks is largely a reflection of their significant exposure to a government with weak financial fundamentals. More than 33.8 percent of Lebanon’s total banking assets is exposed to the Lebanese government (of which 68 percent in Lebanese Treasury (bills and 32 percent in foreign currency eurobonds). Banks’ ratings may be downgraded in the medium term if they do not manage to reduce their exposure to the government or if the country’s debt dynamics does not improve.
Another factor influencing Moody’s negative outlook on the Lebanese banks is the risk of a devaluation of the Lebanese pound, which would imply significant losses for the banks. The banking sector in Lebanon is sounder and has shown a better resilience to shocks than that of Turkey, for example. Unlike Turkish banks, Lebanese banks do not have currency mismatches other than for hedging purposes. Devaluation therefore should not affect the solvency of the large banks in the country, but it would affect their capitalization and profitability ratios.
A recent report by the International Monetary Fund suggested that the contemplated privatization program would raise $2.7 billion rather than the $8 billion hoped for by the government. The latest bond is part of an effort to reduce the cost of borrowing — finding longer-term, cheaper international loans to replace the 70 percent of the debt raised through short-term, internal borrowing at around 14 percent interest. Lebanon can borrow internationally at such competitive rates because its bonds are sold mainly to Lebanese banks, sympathetic Gulf investors and the Lebanese diaspora. Lebanese investors bought 75-80 percent of the latest bond issue, which makes it more like a private placement than a public offering. Like Turkey, Lebanon relies heavily on its domestic banks to roll-over the debt. However, unlike Turkey, Lebanon has a strong banking sector, with large Syrian and Arab Gulf deposits and consolidated balance sheets of $46 billion. Central bank regulations prevent Lebanon’s banks from lending to other emerging markets — such as Brazil — where they would receive a higher return.
With so much already loaned to the government, the fear is that depositors may lose confidence and start to withdraw their deposits from Lebanese banks and trigger debt default. However, the Lebanese government, with the backing of the international community, can avoid such a crisis. The initiatives that the government has recently introduced to trim current public sector expenditure, privatize certain public services, liberalize and modernize the economy and introduce a VAT tax are all steps in the right direction. However, the results of these policies will not be felt immediately. More assertive actions need to be taken in order to convince markets that the current difficulties are manageable and the budget deficit is put on a declining trend.
Markets are expecting the government to introduce a reduction in the public wage bill (which consumes 40 percent of the budget), and come up with an alternative source of income to replace the loss of revenues from the recent cut in custom duties, estimated to cost the government around $1 billion. All this should be part of a well-accepted plan to bring forth a balanced budget over the coming few years. Another message that the government could send to the market place is that there is an agreement among the various political powers in the country that a major economic and administrative restructuring plan is needed. This plan should be supported openly by all parties, irrespective of the sacrifices and political repercussions associated with it. The country also has the option to call on the IMF for support and to help avoid a financial crisis.
