Untangling the Paradox of Lebanon’s Eurobond Placement - DecisionBoundaries

Untangling the Paradox of Lebanon’s Eurobond Placement

Lebanese Eurobonds maturing in late 2024 yield close to 17%, yet the Lebanese government has just mandated a syndicate of four local banks to place $2 bb 5-year Eurobonds at a 12.50% yield…and the issue will be a success.

Before you rush to short the when-issued bond, let me rain on your parade: Lebanese Eurobonds are impossible to borrow1.

Actually, my goal here is not to make an explicit trading recommendation (although I have an opinion and you are free to infer how I would trade it) but rather to explain the paradox and derive some conclusions.

By any objective measure, Lebanon’s $80 billion government debt is unsustainable and, although it’s been hovering at around 150% of GDP for some time now, I believe that a sovereign default is now inevitable. In order to understand why, we need to understand the basics of Lebanon’s economy and public finances.

Lebanon produces very little (its total output is just shy of $55 bb), exports even less, and traditionally had only three vibrant sectors: construction, tourism, and financial services. At the same time, a sectarian political system did not allow the enactment of a budget for years (which is not hard to believe from a country where the parliament is dominated by a bloc led by the terrorist group which assassinated the prime minister’s father).  As a consequence, the country is bedeviled by the twin deficits; a current account deficit of roughly 20% of GDP, and a budget deficit of almost 10% of GDP2. Add to that the fact that, in the absence of a positive shock, Lebanon’s economy is slow growing (projected <1% in 2019), and you get the picture: the public debt is on an unsustainable path. In fact, according with our calculations, Lebanon gross external financing requirements hover around 24% of GDP.

In addition, Lebanon’s price level has been anchored for 25 year by a peg at 1,507 LBP/USD. This peg, which was never backed by a formal monetary board, turned 20 this year and survived wars, oil shocks, tourism boycotts, slow growth periods and high inflation periods, all thanks to the deft management of the Central Bank (Banque du Liban, BDL)by Riad Salameh who is, in my opinion, the best central banker in the world.

So, how is this textbook economic basket case financed? Enter the uniqueness of Lebanon’s financial sector, with aggregate deposits exceeding 300% of GDP, trailing only Luxembourg and Hong Kong. This “Switzerland of the Middle East” phenomenon came to be just like its Alpine counterpart: super-tight bank secrecy laws, which made Lebanon’s banks a favored destination for petrodollars from the GCC and from other persons and entities seeking or needing secrecy3. Thus, the government, which produced and guaranteed the laws that led to the banking sector’s explosive growth held significant sway over the banks, which it used to finance its perennial deficits. And vice-versa: the banks were in a position to demand robust returns from their purchase of the government bonds because they were the only actors willing to give credit to the Lebanese government. Thus, banks and government became co-dependent in a symbiotic relationship reminiscent of the 19th century one between the Rothschilds and the Austro-Hungarian Empire: Lebanon’s banks would finance the government, and, in return, the government would make the banks’ shareholders happy.

Today, over 60% of the banks’ balance sheets consist of claims against the government or BDL, which explains the current extreme degree of co-dependence: should Lebanon’s banks refuse to extend further credit to the government, the country would default and bring the banks down with it. Neither party can afford for the music to stop and that is precisely why new paper which should be issued to yield over 17% will sell like hot cakes at a 12.50%.

Past refinancing crises have traditionally been addressed through concessionary lending (the Paris 1 and Paris 2 conferences) predominantly funded by GCC powers. This time is different. Alienated by Iranian encroachment in the country’s politics, neither Saudi Arabia nor the UAE are prepared to front a bailout. Qatar, traditionally straddling a middle, mercantilist, path has expressed willingness to purchase Lebanese bonds in the secondary market but not to fund the government directly. An $11 billion package (CEDRE) of concessionary loans and grants from multilateral organizations and governments has been pledged in February but, unlike past GCC bailouts, is conditioned upon structural reforms conducive to debt sustainability. Pending the enactment of those reforms, the management of the economy has fallen squarely on BDL’s shoulders which, for the past three years, executed several financial engineering transactions with the banking system aimed at bolstering its headline gross reserves figure (currently above $40 bb) in an effort to keep dollars flowing into the banking system and thus keep the sovereign afloat.  These ad-hoc transactions have not been without cost; in fact, BDL has been incurring massive “negative seignorage” costs by issuing USD-denominated CDs to the banks (currently yielding 14%) and causing a massive quasi-fiscal deficit4 not reflected in the sovereign’s national accounts. But, worst of all, BDL’s gross reserve position is not reflective of the country’s ability to access dollars to service its Eurobond debt: the $40 bb gross reserves are more than offset by at least $55 bb in dollar liabilities.

Mr. Salameh is a magician and does great tricks, but he is not God – he cannot make miracles. Unless the Lebanese political class (including the terrorist group implanted in parliament) undertakes a serious fiscal adjustment program aimed at generating 8-9% primary surpluses on a consistent basis, the music will stop. It will not be the result of the banks refusing to lend to the government which, as we have seen, they cannot afford to. The end will come when depositors realize that their deposits sit at institutions which are already insolvent on a mark-to-market basis and are at risk of a haircut à la Cyprus. At that point, the steady (albeit slowing) deposit growth of the last two decades will turn into a rush for the exits.

This post is just a highly simplified teaser of a complex dynamic which has several more additional dimensions. The opportunity for a soft landing still exists. I will expand in an article coming to your mailbox soon.


1 You can buy Lebanon CDS at about 1,200 bps, but good luck finding liquidity.
2 This budget deficit reflects almost exclusively the high (and growing) debt service cost. The primary balance straddles 0%.
3 Lebanon’s bank secrecy laws have been relaxed simply, mainly due to US pressure and the country’s banks are now FATCA-compliant.
4 The magnitude of this quasi-fiscal deficit is unknown. BDL has not published and income statement since 2010.


 

 

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