Finding a way out of Lebanon’s crisis: the case for a
comprehensive and equitable approach to debt restructuring
prepared
by Alia Moubayed and Gerard Zouein
February
2020
The findings,
interpretations, and conclusions expressed in this paper are entirely those of
the authors. They do not represent the views of their respective employers.
This paper was
finalized based on numbers published at the end of 2019, and before the
outbreak of the Corona Virus. It does not reflect most recent developments and
implications on the Lebanese economy
Synopsis: This
paper advocates for an urgent comprehensive growth and fiscal adjustment
program supported by the international donor community to deal with Lebanon’s dangerous
economic and financial crisis while ensuring an equitable burden sharing of the
losses. At the heart of this program, a consolidated balance sheet approach is required
for restructuring the country’s debt (both sovereign and Banque du Liban’s) and
recapitalizing a right-sized banking sector while protecting small depositors. Using
a model-based approach, the scenario analysis argues for taking Lebanon’s debt
to GDP to sustainable levels (60-80% of GDP) over the next 10 years. It stresses
that the debt restructuring strategy should: 1) encompass BDL’s USD
liabilities; 2) design and implement a banks’ recapitalization program that
supports a right-sized and solid banking sector able to finance the growth
recovery; and 3) ensure the cost of bank recapitalization and the burden of
fiscal adjustment are equitably shared through a multipronged socio-economic policy
reform framework. The paper estimates that reducing total debt to these levels
by 2030 would require no less than a 60-70% principal reduction if the
authorities wanted to reduce the extent of an inevitable currency devaluation,
and create the fiscal space to support growth and expand social safety nets. Therein,
the objective should not be to cut primary spending indiscriminately, but
rather to improve its composition and efficiency. The paper warns that inaction
and/or delays by using piecemeal solutions is regressive, exacting bigger
losses on small depositors and the most vulnerable in society.
Note: The numbers presented in
this paper are based on publicly available information as of December 2019 and
estimates (e.g. the banking sector USD deposits at BDL, government arrears and
contingent liabilities, etc.). As such, the analysis that follows could be
subject to material changes should some of this information prove to be
substantially different from what is publicly disclosed (e.g. the foreign
currency liquidity at BDL). The material is used as part of various citizens’
initiatives which aim to engage stakeholders inside and outside Lebanon in
order to shape the priorities and direction of future economic reforms while
stressing the importance of an evidence-based policy framework for dealing with
the crisis. The authors welcome any comments and suggestions for improvements as
the objective of this paper is to help raise awareness about Lebanon’s multifaceted
crisis and contribute to the public debate. They also recognize that some aspects
of the analysis need further study notably in terms of the legal and regulatory
feasibility of some proposals.
EXECUTIVE SUMMARY
- Lebanon is facing
a dangerous multifaceted crisis: an economic, financial, and socio-political one. The country has been living beyond its means for years,
running double digit current account and fiscal deficits (averaging
respectively 18% and 9.5% of GDP per annum during 2002-18) in an environment of
anaemic growth. It relied on borrowing and attracting non-residents[1]
deposits (mainly from the diaspora) to its banking system in order to fund these
twin deficits and maintain an unsustainable currency peg at an increasingly
prohibitive cost. Acute levels of state capture and weakened accountability
mechanisms perpetuated loose fiscal discipline and increased budget rigidity
bringing debt to 175% of GDP in 2019. Debt monetization through costly
financial engineering operations since 2016, weakened the balance sheet of the
sovereign, the Banque du Liban (BDL) and banks’, precipitating a sudden stop of
capital that exacerbated a pestering currency and banking crisis.
- The entanglement
among the balance sheets of the sovereign, BDL and banks’ increased overtime in
terms of size, complexity and opacity. At end 2019, the estimated net
negative foreign currency position of the consolidated balance sheets of these
entities (hereby called “Lebanon Inc”), amounted to $48bn or ~90% of GDP
(including ~$15bn of gold reserves). This may be a conservative estimate
should some of BDL’s foreign currency assets be encumbered, rendering an
independent audit of these balance sheets necessary in order to devise sound
policy decisions. In a Venezuela-like scenario of no action, where efforts to
contain the crisis are delayed or an ad-hoc piecemeal approach prevails,
Lebanon Inc’s net negative FX position will deteriorate rapidly as BDL’s
foreign currencies reserves dwindle quickly, endangering further Lebanon’s
social stability and national security.
- Countries that
faced similar crisis[2] underwent painful adjustments and
socio-economic hardships for years, despite external support, strong domestic
ownership of the reform plans and robust institutional capacity. Even if
external support is secured, Lebanon’s required adjustment will be more severe
given weaker initial conditions and institutions, larger balance sheet losses,
and a fragmented political landscape. A sharp cumulative real GDP contraction
of 31% in 2019-2022 and soaring levels of unemployment will lead to a collapse
in government revenues in the short-run. The sizeable contribution of the
financial sector to the economy will exacerbate the downturn and fiscal
imbalances. A rapid increase in banks’ non-performing loans (NPLs) will add to
solvency pressures as confidence in banks wanes and the deposit base shrinks. The
World Bank forecasts already that 45% of Lebanese residents will live below the
poverty line in 2020, up from 37% in 2019.
- Given the
large size of the actual and expected losses in foreign currency, a
comprehensive macro-fiscal program for growth recovery and social cohesion should
ensure an equitable burden sharing of the adjustment. This requires immediate measures to “stop the bleeding”
through a non-discretionary law on capital controls, a strategic management of
remaining foreign currency liquidity at the BDL and a mobilization of external funding
to support economic activity and expand social safety nets. In parallel, the
macro-fiscal plan should directly address the need for public debt
restructuring, recapitalizing the BDL and rebuilding its positive net FX
reserve position, recapitalizing a right-sized banking sector while protecting
small depositors, and devising a credible exchange rate and monetary policy
framework. Fiscal reforms should strengthen the equity of the tax system and create
the fiscal space for efficient social spending targeting the most vulnerable
(incl. pensions), while supporting job creating private sector growth and
productive investment and exports.
- In order to
do that, debt restructuring should target sustainable debt levels of 60% to 80%
of GDP by 2030. Using a model-based
approach, an upfront 60% to 70% haircut on the existing total stock of debt will
be required to avoid the low growth-high debt trap in the future. It will not be
sufficient however. Liability management should encompass $70-80 bn of USD
liabilities on BDL balance sheet, and tackle its large net foreign currency
position of ~$29bn (~$44bn excluding gold) in order to avoid a disorderly
currency devaluation and gradually lift capital controls.
- Recapitalizing
the BDL will add to the losses resulting from debt restructuring and higher NPLs
(respectively up to $15bn and up to $10bn) and impose key policy trade-offs. A partial forced conversion equivalent to BDL’s losses
(~40% of banks’ $ CDs / deposits at BDL) will result in $14bn of additional capital
losses (assuming LBP settles at 2,600). However, this option may stoke inflation
adding to exchange rate pressures, and may open doors for an undesirable forced
conversion of deposits at banks’ level, hurting smaller depositors. Opting for
a direct 40% haircut on banks’ deposits/CDs at BDL will entail higher
recapitalization needs ($33 bn) and therefore a larger depositors’ bail-in. Alternatively,
the government could issue a new debt instrument, but tackling a structural
solvency problem with more foreign currency denominated debt is not a real
solution.
- The banks’
recapitalization requirements could thus reach $31 bn[3]
after existing shareholders’ equity write-off ($21 bn). Given weak balance sheets of the sovereign and BDL,
funding should be sought through existing shareholders, potential new ones,
donor funding, and if needed through a large depositors’ bail in program. Under
the latter, rules to enhance fairness in loss distribution may be considered,
including targeting accrued interest first, and differentiating accounts based
on the nature of their economic activity (e.g. exempting offshore FX generating
nature of account, large employers, etc.). Disposing of public assets to
recapitalize the banks is not advisable given the weak governance environment
and would go against the principle of equitable burden sharing, to which this
study subscribes.
- The more
robust the public debt/BDL liabilities restructuring and banks’ recapitalization
plans are, the better the chances of attracting external funding, and the
smaller the deposit bail-in will be. Under
the proposed sustainable debt scenario, $4-5bn of external capital injection would
be required in order to limit the bail-in to 25% of the principal for deposits
above $100k[4]. This can be achieved through
raising capital from existing shareholders or strategic investors, the sale or
revaluation of banks assets (e.g. foreign assets, real estate), etc. Maintaining
the status quo however is deeply regressive as it erodes people’s savings and
will require larger bail in (>40%), hurting smaller depositors.
- A forced
conversion of USD deposits to LBP deposits (lirafication) at official exchange
rate, could bring the foreign currency position of Lebanon Inc and BDL to
positive territory more quickly. As tempting as it is to do so, lirafication
of USD deposits should be the option of last resort and ideally avoided as it will
exact significant losses onto smaller depositors and will exacerbate
inequalities.
- A joint-IMF donor
supported program and financing package of up to $30bn at least is necessary
over the next three years to support Lebanon’s large funding needs. In addition to the cost of bank recapitalisation (33%
to 67% of which could be funded through the large depositors’ base), Lebanon’s
external financing needs is estimated at $7 per annum. An IMF program of $30 bn
at least over three years supported by donors that builds on a national
home-grown reform plan is thus necessary. Rethinking the CEDRE framework and financing
package to anchor it into Lebanon’s new macroeconomic realities and take into
consideration societal aspirations for overhauling its economic and financial
sector model towards a productive sustainable one, is a must.
[ Read full paper ]
[1] Non-resident deposits are accounted for
as external debt by the IMF
[2] The
study includes comparative analysis with Greece, Cyprus, the Baltic countries,
Iceland, Ireland, Egypt…
[3] This represents bank recapitalization
requirements for 8% Risk Weighted Assets under a scenario of partial forced
conversion of banks’ deposits at BDL to close its negative net foreign currency
position, and a 70% haircut on public debt.
[4] This
study used deposit distribution data from the National Deposit Guarantee
Institution and based the analysis on $100k threshold for illustrative purposes
only.