Lebanon's protests and the debt crisis

Protestors in Nabatieh, Lebanon on 20 October. They are raising the Lebanese flag in the sky against the Government

For years, Lebanon has been a hotbed of dissenting views and religions. With about 20 religions this is not surprising. Indeed, since 1943 the government is organized along religious lines, giving everyone a say. The President must be a Maronite Christian and the Speaker of Parliament must be a Shi'a Muslim. The Prime Minister must be a Sunni Muslim. These are all made up of dynasties.

Once again a Hariri is Prime Minister, this time the second son of assassinated Prime Minister, Rafik Hariri, who was allegedly killed by Syrian forces in 2005. Syria occupied Lebanon from 1976 to 1995.

This time the protests are different. They are not along religious lines- everyone agrees. The government is corrupt. It's not surprising this has happened. When I was covering Lebanon about six years ago people were then complaining about corrupt politicians and the money they were spending. The CBD rebuild was built with "corrupt" money, according to many  people with whom I spoke.

At the end of last year, public debt stood at 140% of GDP, according to Wikipedia. But according to the Financial Times (FT), the debt-to-GDP ratio has stood at over 150% for the past 20 years. It is not surprising that protesters want a new government and a new system of government as well.

Here's what Carlos Abadi wrote in the FT.

Time is running out for Lebanon's unsustainable debt

Carlos Abadi October 21 2019

It is well known that Lebanon is a highly indebted country. Its debt-to-GDP ratio has been stuck above 150 per cent for two decades while its economy has somehow managed to keep growing, albeit at lacklustre rates. Prophets of doom have been predicting a sovereign default for years, only to be proved wrong by the resilience of Lebanon's financial sector and the savvy of its central bank. This is not to say that international investors were happy holding Lebanese eurobonds at a spread hovering around 500 basis points above the equivalent US Treasuries. In fact, most have exited and virtually none have subscribed to new issues in any meaningful volume over the past decade. Meanwhile, the country has kept running big budget deficits and the government has gone on being funded. The source of that funding has been the oversized Lebanese banking system which, with bank deposits at more than 300 per cent of GDP, is the third-largest in the world (trailing only Hong Kong and Luxembourg). Those deposits, mostly from diaspora Lebanese and citizens of rich GCC countries, have proved to be extremely sticky and have kept growing through times of sectarian upheaval, political assassinations and even the Great Recession. Lebanese banks, which don't lend much to their customers (barely 25 per cent of the aggregate system's balance sheet), have found it advantageous to apply their excess deposits to finance the government (through the purchase of US dollar-denominated eurobonds and Lebanese pound-denominated T-bills) and to hold "liquidity" in the form of excess reserves at the Banque du Liban (BDL), the country's central bank (also matching the currency of denomination of the deposits). The regulatory risk-weighting on some of these assets was zero and, in all cases, less than that necessary to fund commercial loans. From the viewpoint of the banks and the sovereign, this circular arrangement could coexist with Lebanon's 20-year currency peg and persistently high public sector financing requirements as long as deposits kept growing. However, it is clear that, should for any reason the deposit flow ebb, the entire financial edifice would come tumbling down, since even moderate deposit withdrawals would result in the banking system's inability to continue financing the government, which would bring the banks down with it. Things have been fraying at the edges of this "magic circle" for the past three years. Existing depositors' withdrawals have been compensated by "financial engineering" transactions aimed at replenishing the BDL's reserves (which must be kept at a substantial level to avoid the disappearance of demand for Lebanese pounds and the ensuing collapse of the peg) but at a hefty price: the banks and, eventually, the public sector, were forced to pay rates of more than 20 per cent to attract enough dollar deposits. These exercises in financial engineering were designed to give the government time to implement structural reforms aimed at producing non-trivial primary surpluses. But that time was wasted. The financial engineering transactions were costly (further increasing the deficit) and have progressively lost their effectiveness, leaving the government in the most financially vulnerable position I have yet witnessed. The central bank's balance sheet has been considerably weakened. Its $38bn headline reserve figure is partially offset by $22bn in dollar liabilities with the banking system, resulting in the lowest — by far — net reserve coverage ratio of the money supply since the peg's inception. The BDL's net financial results are even more worrisome. Indeed, I calculate that, this year alone, the bank will make a loss of more than $3.5bn. This is composed of: i) about $1bn caused by the differential in interest it pays the Lebanese banks on their excess reserves and what it receives on its offshore reserves; and ii) about $2.5bn of "negative seignorage" caused by the difference between the modest expansion of high-powered money and the interest paid to banks on their excess Lebanese pound reserves. I further project that this quasi-fiscal deficit will grow next year to somewhere between $6bn and $8.5bn (11-15 per cent of GDP). This line of inquiry led me to the conclusion that the BDL has very limited room for further financial engineering of the kind it has carried out over the past three years: the Lebanese government is on its own. I also examined the question of whether Lebanon's public debt was sustainable. A positive answer would have led me to the conclusion that, the travails of the banking sector notwithstanding, Lebanon could make its case to international investors or, more realistically, multilateral financing institutions. Although debt sustainability is the linchpin of sovereign finance, there are no hard-and-fast rules, not even good rules of thumb, to calculate it. Indeed, the IMF has two different frameworks, one for rich countries, the other for poor ones, neither of which fits Lebanon's middle-income economy. Consequently, I developed my own econometric framework, consisting of an attempt to reject the "Ponzi hypothesis" that, in the absence of meaningful policy action, both budget deficit and debt would continue to grow with no bounds. To do that, I gathered 20 years of data and tested the null hypothesis that any one out of the budget balance, total government debt, government external debt or government domestic debt contains a "unit root", the presence of which would confirm that the variables under study are non-stationary (ie, that their unconditional joint probability does not change when shifted over time). I used both the Augmented Dickey-Fuller and the Phillips-Perron tests and found that all four relevant series contained unit roots. In other words, I concluded that, under the current fiscal, monetary and exchange rate policy mix, Lebanon's public debt is unsustainable. All four series — the budget deficit, total government debt, and both foreign and domestic government debt — are bound to continue growing ad infinitum. It is important to note that the deficit and debt variables were all considered as a fraction of GDP. It would be possible for them to grow unbounded in nominal terms and still be stationary as a percentage of GDP. The importance of my finding is that, in the absence of a policy shift, they will continue to grow unbounded as a share of GDP. One big caveat that practitioners tend to overlook is that unsustainability is not synonymous with insolvency. A sovereign may be on a non-stationary path but never default if it adopts an economic policy conducive to the generation of steady and meaningful primary surpluses. To be sure, such policy shifts are inevitably traumatic, especially at the social level, but multilateral lending institutions exist precisely to ease the pain of such transitions and to allow fiscal goals to be achieved over time rather than as a big bang. Also to Lebanon's advantage is the adeptness and versatility of its central bank, which, although low on financial resources, is rich in creativity and intellectual wherewithal. It may still have some cards to play while the government comes to the inevitable conclusion that any structural reform programme will be less costly than a default and associated meltdown of the banking sector.

Carlos Abadi is managing director of DecisionBoundaries, LLC, a New York-based international financial advisory firm. beyondbrics is a forum on emerging markets for contributors from the worlds of business, finance, politics, academia and the third sector. All views expressed are those of the author(s) and should not be taken as reflecting the views of the Financial Times.

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Wednesday, 04 August 2021