First-ever sovereign debt default as financing model of persistently huge fiscal deficits collapsed
The non-payment on the USD1.2bn Eurobond loan maturing in March 2020 was the first ever debt default for Lebanon, the third-most indebted country in the world, with public debt at about 171% of GDP at the end of 2019.
How did Lebanon get there? The government has run huge fiscal deficits for decades, averaging -11% of GDP during 2000-2019, including -10.7% in 2019. Debt-servicing alone consumed about 50% of revenue (10% of GDP) and energy requirements (transfers to the public electricity supplier) were 14% of revenue (3% of GDP). The deficit is forecast to rise further to -18% of GDP in 2020 as revenues decline and GDP contracts sharply, with the gap likely to be financed by debt monetization, which will stoke inflation.
In the past, the huge deficits made Lebanon highly dependent on capital inflows (remittances from expats and aid flows mainly from Gulf region). That financing model has collapsed over the past two years as confidence in both the fragile political system and the banking system was unravelling rapidly, resulting in increasingly frequent non-resident (expat) deposit outflows. In 2019, Banque du Liban (BdL, the central bank) began to repay maturing Eurobonds on behalf of the Lebanese government. In order to halt the resulting drawdown of BdL’s reserves, the new government eventually put on the emergency brake.
The ambitious debt restructuring plan entails a banking sector crisis
In March 2020, the government also announced that it would suspend payments on all USD31bn of its Eurobonds to preserve FX reserves. It hopes that its creditors will accept a write-off of about 75% of those Eurobonds. However, according to an IMF report, Lebanon has issued about USD15bn of international bonds since October 2014 without collective action clauses, which exposes the country to potential holdout litigation on these bonds. The government is further seeking to restructure its domestic T-bills and bonds, which could be swapped into longer maturity notes with lower interest rates.
Of the public debt of 171% of GDP at end-2019, FX-denominated debt was 63% of GDP or USD34bn, of which market-issued Eurobonds were USD31bn. Local currency debt (T-bills and bonds) was 108% of GDP or LBP87trn. Lebanon’s banks held 31% of government debt, including 25% of local currency debt and 41% of foreign currency debt (49% of Eurobonds), totaling 12% of banking system assets. However, banks also have indirect exposure via their deposits at the BdL, which were 54% of banking system assets. The BdL in turn held 43% of government debt, including 58% of local currency debt and an estimated 19% of sovereign Eurobonds. Only 13% of sovereign debt was held by non-resident investors, consisting of one-third of Eurobonds.
Negotiations on an IMF program have stalled
The government is seeking an IMF program to accompany the debt restructuring in order to put the economy on a sustainable path. After a seemingly good start to negotiations in May 2020, there was hope for IMF financial support of up to USD8.5bn, plus an additional USD11bn in loans pledged by bilateral and multilateral donors back in April 2018. This could have restored confidence gradually, stabilized markets and halted the economic downturn.
Meanwhile, however, negotiations have stalled amid a failure to implement an economic rescue plan which the government unanimously agreed in April 2020, as well as disagreements between governing factions on financial sector losses (the planned restructuring of the banking system includes a bail-in of bank deposits and a proposed haircut of bank deposits to pay off debt and finance bank recapitalization). Any external financial support would also have attached conditionality such as exchange rate liberalization, fiscal consolidation and energy reform.
It is likely that any sizeable austerity measures will intensify ongoing violent public protests. Moreover, funding from Gulf countries is less likely than in the past, owing to the current low oil price environment and given the influence of Hezbollah in the government.