Finding a way out of Lebanon’s crisis: the case for a comprehensive and equitable approach to debt restructuring

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

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. 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.

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