The impossible reform

of the Lebanese financial system

This story was produced within the framework of a collaborative network of independent media outlets on the Arab world, including Al-Jumhuriya, Assafir Al Arabi, Mada Masr, Maghreb Emergent, Mashallah News, Nawaat, 7iber and Orient XXI.

Hélène Aldeguer, 2018

In recent months, Lebanon has been alive with rumours about a forthcoming devaluation. In mid-September, the governor of the central bank, Riad Salameh, was obliged to officially deny a hearsay that he was ill and had to resign. President Michel Aoun, in another declaration, came out and stated that the Lebanese pound was indeed in good health, and the country was not on the road to bankruptcy. The health of the Lebanese pound and the ability of the state to pay back its debt are indeed closely related in the minds of all Lebanese, as the country is deeply indebted.

The Lebanese debt in 2017 was $80 billion, amounting to 150% of the GDP which is estimated at $51.85 billion. This is the third highest ratio worldwide, just after Japan and Greece. If no effort is made in the years to come, economists foresee a rate of 160% or more by 2020.

The Lebanese debt in 2017 was $80 billion, amounting to 150% of the GDP.

“The level of debt is worrying, but what’s even more worrying is the fact that it’s unsustainable,” says Sibylle Rizk, in charge of public policy studies at Kulluna Irada, a centre for research and analysis created by some members of the Lebanese civil society.

“The service of the debt is so important that it dictates all the financial and economic policies of the country.”

Why this risk?

The debt service, in other words the interest paid by the Lebanese government, amounts to nearly $5 million, which ends up representing 25% of the annual budget, estimated at $19.1 billion in 2018. This is only an estimation since Lebanon has not published the official figure. International Monetary Fund (IMF) economists believe that this service could amount to 60% of the state budget by 2021, which would be obviously untenable.

The Lebanese government is issuing more debt each year, just to finance itself.

In order to both repay the debt and finance its expenditures at the same time, the government needs to collect more money – because today, the incoming cash-flow is less than the expenditures. So far in 2018, all combined taxes and the revenues of various administrations and government properties (the state casino, telecom transfers from the diaspora) will bring in $13 billion. This means that the budget deficit will amount to some $7 billion, and so 37% of the budget expenditures will again increase the burden of the debt this year. In other words, the Lebanese government is issuing more debt each year, just to finance itself.

There is something that makes the situation quite attractive for depositors: 60% of the debt is denominated in Lebanese pounds and 40% in dollars, remunerated at the relatively high rate of 9% for the pound and 7% for the dollar. The largest share of the debt is subscribed by Lebanese banks and Banque du Liban (BDL), the country’s central bank, which at present holds over 85%.

The reason why Lebanese banks are in a position to buy so much of the debt is that they hold sizeable deposits, amounting to $200 billion – nearly four times the volume of the country’s entire economy in 2017. Nearly 40% of these deposits comes from the Lebanese diaspora, precisely because of the advantageous interest rates offered by Lebanon as opposed to other countries. And over 80% of the deposits are denominated in dollars.

Thus far, all is well.

“This inflow of deposits is essential to finance the debt and the balance of payments, $11.6 billion in 2018, denominated in foreign currency,” says Rosalie Berthier, an analyst with the research centre Synaps.

Indeed, the country imports 80% of its consumer goods and pays for them in hard currency, mostly euros and dollars. And there’s the rub. The IMF considers that in order to finance its trade deficit and the ever-increasing interests on its sovereign debt, Lebanon needs to increase its dollar deposits by 6 or 7%, i.e. between $6 billion and $7.2 billion, per year.

Now, over the past few years, deposits have grown more slowly than in the past for various reasons: there is less money around; interest rates have risen, especially in the USA; and sovereign risk – the possibility of the country to default on its debt – is relatively high.

“The country spends a lot of dollars, and it is no longer able to attract them.”

“In short, Lebanon has a highly dollarised economy. The country spends a lot of dollars, and it is no longer able to attract them,” says Berthier. Hence the risk of having to devalue its own currency.

The exchange rate between the dollar and the Lebanese pound has been fixed since 1997, at $1=1,507.5 LL. This set exchange rate is known as the “peg”. It is so deeply embedded in people’s ordinary lives that the Lebanese economy functions with both currencies. In any shop in the country you can pay in either dollars or Lebanese pounds, with the guarantee that the two are interchangeable. But this parity depends on BDL’s capacity to underwrite it, which is why it always must make sure to have enough dollar reserves to buy Lebanese pounds and vice versa.

Today, no one knows exactly the amount of BDL’s foreign currency reserves, for the detailed figures are not made public. What is certain is that the slower increase in dollar deposits has endangered these reserves and, consequently, the bank’s capacity to support the Lebanese pound.

The challenge: making the debt sustainable

Unfortunately, Lebanon does not create enough wealth to generate savings and fill the coffers of the state. Economic growth is very slow (less than 2% forecast for this year), inflation is at a record high (6.3% during the first eight months of 2018), infrastructure including highways, telecom, water supply and waste management is in urgent need of repair and modernisation (a need accentuated by the arrival of more than a million and a half refugees from Syria since 2011), and above all, productive investments represent less than 1% of the GDP (the world average is 8.2%).

Unfortunately, Lebanon does not create enough wealth to generate savings and fill the coffers of the state.

“The problem today is that it’s impossible to revive the growth when all the pillars of the economy are that weak,” says Rizk.

We need massive investments in the physical and institutional infrastructure.”

Earlier this year, at the Cedar Conference in April, Lebanon was promised loans for a total of $11 billion at relatively favourable rates of interest. The idea was precisely to raise funds to finance infrastructure development and stimulate the economy.

“But that’s just more debt that we can’t sustain without an adjustment plan of our public finances”, says Rizk.

Today, the main issue is to make the debt more sustainable, which means reducing the debt to GDP ratio. The objective of the Cedar Conference was to increase the GDP, but an alternative path would be to shrink the debt. To do so, the government has a choice: either new taxes, such as the widely criticised VAT increase from 10% to 11% in 2017, or budget restrictions, in particular by wage-cuts for civil servants.

In some regions less than 65% of electricity bills are actually paid, and the government must make up the difference to Electricité du Liban.

But aside from the fact that five months after the last elections a new government has not been formed, the country is up against an endemic system of corruption and clientelism which makes any reform very complicated. For example, in some regions less than 65% of electricity bills are actually paid, and the government must make up the difference to the public company, Electricité du Liban. In 2018, this will amount to 7% of the national budget. Another example: the collection of VAT depends on the share of transactions actually declared. But most Lebanese companies keep two account books, one “white” and one “black”, in order to pay as little VAT as possible to a state that is quite rightly deemed corrupt (Lebanon is 136th on the list of the world’s most corrupt countries).

And far from placing restrictions on the aggregate civil service payroll, which represents 35% of the national budget, salaries were actually raised last year, and new jobs were created.

“The public sector payroll heavily impacts the country’s public finances, but this problem is doubled by a social stake: for years, hiring has been used as a tool to capture the state resources for clientelist purposes, but the end result is that these civil service jobs represent, whether you like it or not, a safety net which a country at the end of its rope cannot do without.” Such is Rizk’s analysis.

Hélène Aldeguer, 2018

Then what is to be done?

There is one way of easing the debt burden which no one has dared to mention yet: restructuring the debt by mutual agreement with the country’s creditors. This could mean rescheduling payments, reducing interests or even reducing the total amount due.

Most of Lebanon’s debt, some 85%, is in the hands of Lebanese banks and BDL.

Most of Lebanon’s debt, some 85%, is in the hands of Lebanese banks and BDL. This means that over 60% of Lebanese merchant banks’ assets are composed by Lebanese debt. We don’t know the proportion of the Lebanese debt in the banks profits, but it’s not far fetched to think that some banks are profitable only because of the Lebanese debt.

In all cases, the relationship between Lebanon’s banks and the government is very close, since both of them profit from a system that neither wishes to see collapse.

“Which is why a Greek or a Turkish scenario, where international creditors pressured a bankrupt country into making drastic reforms that bled the population white and the national currency was quickly devalued, would make no sense,” says Nassib Ghobril, head of the research analysis department at Byblos Bank.

“Our debt is a family affair”.

This leaves the government with the option to borrow from local banks, and pay them back generously, as it has been doing for decades.

For a government, says Rizk, restructuring the debt is something to opt for when the breaking point is near and it can no longer fulfil its obligations.

“The question of debt restructuring is still taboo, because it implies a political agreement to share losses. For now, and in the absence of such agreement, the favoured option is to buy time by doing monetary operations that are more and more costly.”

So how long can this system last before devaluation becomes inevitable?

“That is a question of trust,” says Berthier.

“Today, maintaining the peg sends a message of stability. As long as the governor of the central bank, Riad Salameh, keeps the job he has held for 25 years and continues to inspire trust, things will be alright. The day the trust in him fails, the day the Lebanese pound fails to hold its own, anything may happen. If the banks refuse to give loans to each other for example, there will be a cash-flow issue and we’ll have a Lehman Brothers type scenario where the whole system seizes up.”

Ghobril tries to see the situation in relative terms.

“The Labenese pound-dollar parity has survived four big shocks in the past. Rafic Hariri’s assassination in 2005, the war with Israel in 2006, the fall of Saad Hariri’s cabinet in January 2011 and his “resignation” in November last year. Only the first two actually put pressure on the Lebanese pound. And each time the peg held, despite episodes of capital flight which were always quickly squelched. So it would take a shock more severe than the assassination of the prime minister or a war to put the Lebanese pound at risk.”

The cost to the economy

What many Lebanese do not realise is that everyone benefits in one way or another from the peg. The Lebanese pound, says Berthier, is overvalued.

“If the Lebanese pound was left to float, the manoushe, our flatbread staple food which costs 1,000 LL today, would cost much more, if only because the wheat it is imported. That would be a catastrophe for the lower middle class and the poor.”

The rate of interest on loans to small and medium-sized enterprises is high enough to discourage most entrepreneurs.

To make things worse, the banks are reluctant to finance productive investments, although the economy needs them, because the government’s debt brings in such a comfortable income. Indeed, the rate of interest on loans to small and medium-sized enterprises is high enough to discourage most entrepreneurs. From one of the biggest Lebanese banks, you have to expect an interest rate of at least 12% on a loan in dollars and 14% on a loan in Lebanese pounds. In France, this rate is at less than 2%.

The problem is that political inertia on the one hand, and the steps taken by the central bank to avoid crises on the other, only kick the can down the road, leaving future generations to worry about the debt.

“Since the end of the civil war, except for the following two years, successive governments have been on a spending spree, with no thought for fiscal discipline,” says Sami Makdessi, an economist at the American University in Beirut.

“Lebanon has a great many experts capable of coming up with solutions. Unfortunately, what it lacks is proper governance to put them into practice.”

Lebanon ranks 140th in terms of governance according to the World Bank’s classification. And without governance, even if solutions exist, hard as they are to apply, no reforms or improvements are conceivable.

Looking at the country today, it appears paralysed by its crisis, endemic corruption and waste, with few solutions in view. For the moment, the financial system is holding its own, backed by a trust which has already survived many shocks. But this situation is not sustainable – and no one can say when that confidence will be shaken and the system will collapse.

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