Legacy of political unrest complicates debt crisis in Lebanon
(Bloomberg) – The deadliest outbreak of sectarian violence in Lebanon in years threatens to derail the new government’s talks with the International Monetary Fund and foreign creditors before they even begin.
Formed five weeks ago after 18 months of political paralysis, the government’s priority was to end one of the most serious financial crises in modern history. But last week’s shooting in Beirut left seven people dead, sparking rumors of civil war and distracting attention from economic reforms.
At stake is the future of a population already grappling with hyperinflation, drug shortages and chronic power outages – and the fate of the $ 32 billion Eurobonds the government has made default since March 2020.
While the overall size of the debt is smaller than other recent sovereign defaults, like those of Argentina or Venezuela, the speed of the collapse and the lack of official efforts to stop it make the situation unique. .
1. How did it go wrong?
The crisis had been brewing for decades. To keep the Lebanese pound strong and imports cheap, Lebanon has relied on millions of citizens abroad to send hard currency remittances through local banks. For more than 20 years the approach worked, but as the government continued to overspend and the amount of debt increased, foreign donors who had supported Lebanon in its earlier difficulties turned away.
From 2016, the Banque du Liban, or Bdl, carried out a series of so-called financial engineering operations to maintain inflows and increase reserves. Via increasingly complex swaps, it essentially offered high returns on new dollar deposits made by banks to the BdL. The IMF estimates that the operations attracted more than $ 24 billion from lenders through February 2019. Commercial banks have clawed back the money by offering savers skyrocketing returns, trapping retirees and wage earners in a scheme. increasingly risky that critics have since compared to a Ponzi scheme.
The central bank warned the measures were meant to be temporary, to help the country navigate a succession of political crises. The international community has urged Lebanon to tackle endemic corruption, balance the budget and restructure a bloated public sector to unlock billions of dollars in aid.
Even when the flows started to dry up in 2019, the government did not act. Nationwide protests erupted in October of the same year, demanding the withdrawal of a political class that had bled state coffers. The banks closed and when they reopened 10 days later, depositors could no longer transfer their money overseas and were only able to withdraw small amounts of dollars. The banking system was in crisis.
The dollar shortage pushed people into a black market where the pound ultimately lost over 90% of its value, triggering hyperinflation, decimating savings and wages, and pushing three-quarters of the population below the poverty line. .
With foreign exchange reserves no longer replenishing, the government announced in March 2020 that it would default, for the first time in its history, on $ 32 billion in Eurobonds, in order to save money for food and fuel imports.
2. Hasn’t she already tried to restructure her debts?
Yes it is. Then Prime Minister Hassan Diab promised, when he announced the default, that the government would work with creditors to restructure the debt and also draft a comprehensive economic overhaul plan.
Lebanon had already hired Lazard as a financial advisor in February 2020. He quickly proposed a stimulus package that the government presented to the IMF as a basis for negotiations for a $ 10 billion bailout. The document estimated the central bank’s “built-in losses” and those incurred by other lenders at around £ 241 trillion, or $ 69 billion at a proposed new exchange rate of 3,900 pounds to the dollar. The currency has been pegged at 1,507.5 per dollar since 1997 and the peg remains technically in place, although other semi-official bank and import rates have since been introduced as the crisis worsened. .
The plan also proposed restructuring the balance sheets not only of the central bank but of all banks in a process that would have forced most to merge or close.
The central bank and the banking sector, which together hold more than 60% of the defaulted bonds, opposed the plan. The lenders have instead proposed that the government sell or otherwise monetize the state’s assets and put the money in a “bad fund” used to settle its debt to the central bank.
Meanwhile, Bdl Governor Riad Salameh argued that there was no loss on the central bank’s balance sheet since longer-term contributions could be written off by printing change. Quarrels between Lebanese stakeholders undermined negotiations with the IMF which have also reportedly released billions of dollars in aid from other donors. Talks quickly came to a halt and the central bank began printing money, accelerating a depreciation that inflated the local currency segment of government debt at the expense of soaring prices for the public.
The arrival of Covid-19, which has stifled an already struggling economy, has resulted in mass unemployment in the absence of monetary or fiscal stimulus. Then, on August 4, 2020, an explosion in the port of Beirut left more than 200 dead and devastated entire swathes of the capital. The government resigned soon after.
3. Is there a way out?
It depends on the policy. After an 18-month standoff, a new government headed by billionaire telecoms mogul Prime Minister Najib Mikati got to work in September, promising a stimulus package.
The cabinet announced in early October that it had resumed talks with the IMF. In a sign that it is serious, he also agreed that Alvarez & Marsal conduct a forensic audit of the central bank accounts.
The new government has also promised to negotiate with foreign creditors to restructure its Eurobonds. International investors, including BlackRock Inc., Ashmore Group Plc and Fidelity, formed an ad hoc group of post-default bondholders, advised by law firm White & Case, but without a full-fledged government in place for so long, no serious discussion has taken place.
Sovereign debt restructuring usually involves a discount to the face value of the debt and lengthening maturities, in the hope that the economy will recover and the government will eventually be able to pay or refinance.
If the government presents a credible reform plan, resolves disputes over financial sector losses and comes to an agreement with the IMF, Eurobond holders could see a 75% haircut, Goldman Sachs believes.
Sovereign bonds sometimes include a collective action clause which allows a majority of holders to agree on a restructuring and force detractors to accept it. As of 2014, the threshold is 66%, but Lebanon’s ratings predate the change and have a higher threshold of 75%, potentially complicating negotiations.
Lebanon’s collective action clause is also by series, which means that in order for the government to restructure a series of bonds, it would require the approval of 75% of the bondholders and each bond must be negotiated on its own. Local banks initially held some $ 11 billion in debt, although they have already started provisioning ahead of an expected haircut. The central bank holds around $ 5 billion of the paper but would be excluded from any discussion.
However, the government is working against the clock. With parliamentary elections slated for March, he now has five months to resolve these complex issues before another wave of bargaining over the next government.
Meanwhile, clashes last week have drawn attention to a campaign by Iran-backed Hezbollah to impeach the judge investigating the port explosion. The deadlock could lead to protracted political turmoil, even triggering further violence, and undermine economic reforms that will require buy-in from key political players.
4. Why is the restructuring of Lebanon so complex?
In the case of Lebanon, the government must restructure its debt, which includes $ 32 billion in international bonds and what is equivalent to $ 58 billion in local currency notes at the official exchange rate (which is now only worth one fraction of that of the black market). also overhaul its entire banking system, devalue or liberalize its exchange rate and find a way to manage both its fiscal budget and its trade balance in a more sustainable manner.
All of these issues are entangled in its complex political system. One of the most controversial issues is the electricity sector. Before the crisis, Lebanon was able to meet just under 60% of its electricity needs, with subsidies, failure to collect bills and rampant corruption resulting in some $ 2 billion in annual losses.
With the supply of dollars dwindling, the state can no longer afford enough fuel for power plants, resulting in longer blackouts. Authorities recently agreed with Jordan, Egypt and Syria to import natural gas through an existing pipeline to one of the country’s pipelines, but have yet to secure funding.
The budget deficit has narrowed since the default, but any government will struggle to cut public sector jobs and improve tax collection as poverty levels soar. The dollar crisis reduced the import bill, but the government did little to encourage profitable exports.
And many of the country’s powerful politicians are bank shareholders as well, giving them every incentive to oppose a stimulus package that forces lenders and their owners to bear the brunt of the crisis. If the past few months are any indication, they’ve already felt they can get away with passing the burden onto the public.
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