Debt Sustainability in Lebanon: an Econometric Approach

Lebanon is one of the most indebted countries in the world. In addition to have an elevated debt/GDP ratio, much of its debt is denominated in dollars and the value of the Lebanese pound has been pegged to the dollar at a fixed rate for the last 20 years. To complicate matters further, this currency peg is not backed by a currency board. Instead, it is being supported by the supply of dollars at the fixed exchange rate by the central bank (Banque du Liban, BDL) to the commercial banking system. Although BDL’s gross reserves are sufficient to cover its monetary liabilities (the amount of Lebanese pounds outstanding), its net reserves (BDL USD assets – BDL USD liabilities) is not. Further, Lebanon suffers from low growth relative to the United States, which further challenges the peg. In addition, Lebanon has been consistently running elevated and growing budget deficits, composed almost entirely of debt servicing cost (i.e. the country runs a close to balanced primary result). Also, BDL runs a very elevated quasi- fiscal deficit caused by the interest differential between the CDs it sells to domestic banks and the interest it receives on its gross reserves. Finally, Lebanon is a large net importer which cause its net external financing needs to levels well above those required to finance its budget deficit. We believe that Lebanon’s public sector debt is unsustainable per se and that a flotation of the currency (which we view as almost inevitable)will further deepen its insolvency. Unless either the government’s and the central bank’s balance sheets are reengineered or decisive fiscal adjustment is made, Lebanon’s current financial stress could become an economic crisis.