In light of the ongoing financial crisis in Lebanon, the government’s debt management strategy is at the center of a growing public debate. The government’s ability to pay its maturing Eurobonds in 2020, totaling $2.5 billion (of which $1.2 billion are due on 9 March 2020), is in question, as diverging opinions emerge.
To this end, the Lebanese Center for Policy Studies (LCPS) solicited the analyses of four persons that have helped shape the public debate on Lebanon’s economic crises and proposed solutions: Dan Azzi, Amer Bisat, Nisreen Salti, and Nada Mora. The primary question posed was: Should Lebanon default? In responding, roundtable participants were asked to consider the primary and secondary effects of a default, potentially differentiating between foreign and domestic, an alternative approach to manage the debt in the absence of default, and/or the viability of paying its March 2020 commitments and defaulting on the April and June 2020 maturities.
Dan Azzi: “If We Default, We Do It Now”
Our public debt is $87 billion, added to it is the $112 billion worth of deposits from commercial banks at Banque du Liban (BDL). Adjusted for double counting, our total debt is approximately $165 billion. Our foreign-held debt is $5-12 billion, at face value, even lower at market rates, making it around 5% of the total. Therefore, our problem is primarily internal—circular debt among locals—which can be solved with a few strokes of a pen, by an empowered, competent authority.
Using our reported BDL reserves of $30 billion, we have the capacity to pay all the external debt to Euroclear (which completes our legal obligations), and then convince local holders to refund our dollar payments using an appeal to their patriotism, or, if that fails, regulatory tools at our disposal. These include unleashing a Banking Control Commission audit, requiring proper mark-to-market of their books, increasing the liquidity premium from 20% to 2000%, taxes, forced equity stakes... and I’m just getting warmed up.
The upside of paying the Eurobonds is that, sooner or later, we will have to go back to the international markets to rebuild the carnage resulting from this crisis. The only thing we have going for us is our unblemished record of never having defaulted since 1943. We are neither Argentina nor Ukraine, for those using the flawed comparison to demonstrate that “it’s no big deal.” For instance, Argentina was blocked from capital markets for years. None have an armed group with a foreign policy independent of the central government, sanctioned by the most powerful nation, while using its currency, making us especially vulnerable.
Our clean record, with some credible reform measures, will allow us to go back to the financial markets and refinance our debt after 2020, in a way that achieves the objectives of restructuring, without the stigma of decimating our record.
The downside of not paying is that we have no leverage. Our legal representatives have already failed to include an enhanced collective action clause in the documentation, weakening our negotiating position. These creditors are brutally adept at twisting arms of inexperienced, weak opponents like us. The recent investors are not accidental logs who stumbled upon us through an unexpected deterioration in our credit—this type of scenario is their bread and butter. They came in gunning for a fight, to extract maximum concessions. They will almost certainly file an attachment order against our gold holdings—conveniently held in New York, in close proximity to the judge deciding the case—our MEA airplanes, and even our deposits and reserves held at custodial banks, also in New York, due to our dollarized economy.
There have been previous precedents, when funds for the central bank were frozen until the cases were settled. While the probability of their winning is low, it’s all about drowning us in attacks that will exhaust us and weaken our defenses, so we agree to a disadvantageous settlement.
The statistics on this type of thing are ugly, with 50% of defaults ending up in expensive litigation. The best case scenario would be to save a measly $200-$400 million dollars this year, out of the $783 million owed to foreigners in 2020, after racking up massive legal bills.
Regardless what is decided, one thing is certain: We should have a plan either way. If we default, we do it now. If not, we execute a plan to never default. Paying March and defaulting in April or June would be the foolish course of action.
Amer Bisat: “Restructuring Is Inevitable: The Sooner, The Better”
At 150% of GDP, Lebanon’s debt is unsustainable. Assuming 7% interest rate on the debt, the annual interest bill is 10% of GDP. Further, assuming the debt’s average maturity is 10 years, repaying the principal will absorb an additional 15% of GDP every year. As such, if not restructured, one out of every four units of Lebanon’s income will be used to service the debt. The IMF projected government revenues to be at 21-to-23% of GDP, meaning that the cost of servicing the debt will absorb the totality of government revenues, leaving literally nothing for all other public services. All these make restructuring inevitable.
Then why wait? Using valuable reserves to pay the March Eurobond, when an eventual restructuring is inevitable, is akin to “throwing good money after bad”.
Another argument for why a moratorium should be declared is that, according to banking sector data, commercial banks have more than $100 billion worth of people’s deposits parked at BDL. Those deposits are partially backed by BDL’s foreign exchange reserves, and therefore, using those reserves to service the debt will render the deposits less secure. By extension, if banks can’t withdraw their deposits from BDL, they will find it even harder to honor people’s deposits with them. Servicing the debt at this juncture increases the probability of a deposit haircut.
Will the restructuring ruin Lebanon’s reputation? It is not clear it will. Surveys of sovereign crises (including by the IMF), indicate that, over the past 30 years, 111 countries have restructured their debt, and the vast majority of them were eventually able to re-access capital markets. Investors will be open to lending to Lebanon once it reduces its debt stock and if, and this is crucial, it has put itself on an economic path that credibly promises future payment.
To be clear, this does not mean that the restructuring is painless. First, the formal recognition of a default is de facto an acknowledgement that the banking sector, which is heavily indebted to the public sector including BDL, is insolvent. While some would reasonably argue this is nothing more than an accounting acknowledgement of an economic reality, it will remove the past “luxury” of delaying the needed banks’ recapitalization. Second, given how the bond contracts have been written, restructuring will be legally very messy. The restructuring effort will surely be measured in years and will almost certainly be contaminated by creditors’ legal suits. Since restructuring is inevitable, the sooner we start the process—and more prepared we are for it—the better.
Others argue against restructuring, believing that we should instead push out obligations over the next few years rather than embark on a comprehensive restructuring. Advocates of this view contend that this would give the country the option of waiting for a better medium term situation, with oil and gas exploration and/or regional peace. I would not recommend this approach, which keeps the economy in a “zombie” state while waiting for an uncertain future. Also, it is worth noting that changing payment terms, required to get the cash flow relief, is a technical default, so nothing would be really solved with this tactic.
Likewise, a selective default—which is defaulting on Lebanese debt but remaining current on Eurobonds—is not a feasible option. If the default’s objective were to bring down the debt stock to a sustainable level, then treating some debt as “senior” would mean that the remaining “junior” part of the debt stack would have to be hit much harder. Put in starker terms, sparing foreign debt means pushing the burden onto Lebanese debt, which, of course, is both politically and morally a very tenuous proposition.
Nisreen Salti: “Debt Restructuring Is Risky and Complex, but Should Happen”
Paying Lebanon’s $1.2 billion in Eurobonds in March involves tapping into the Central Bank’s rapidly dwindling dollar reserves, to pay bondholders that are increasingly foreign. The stated advantage of honoring the Eurobond contracts is to save the country’s reputation on the international borrowing market in order to preserve its ability to borrow again. This perceived gain holds if the decision is not just to pay the dues in March, but also all those in the near future, which amount to another $3.73 billion by April 2021. Proponents of repayment believe that doling out another $5 billion of our reserves over 14 months is a worthwhile cost just to avoid the stigma of restructuring. Unless they know of an upcoming windfall in the next 14 months, or an expected reversal in our now-chronic balance of payments deficit, this would set our reserves back by 16%, by the Central Bank’s own account.
Yet experience suggests that countries that have restructured their debt have suffered only a short-lived drop in credit ratings. The world is replete with examples of past defaulters who are borrowing again, and at reasonable rates. The past few months have also shown that reputation (as measured by credit ratings and interest rates on public borrowing) is just as sensitive to measures that have resulted from resistance to any debt restructuring thus far: Using reserves to repay debt, barring depositors from accessing their money, discretionary capital controls, and dual exchange rates.
There are, of course, alternative uses of the country’s foreign reserves. Importing essential needs (fossil fuels, foods, medicines, and medical equipment) remains a more pressing use of our limited foreign reserves, and one with a far wider beneficiary base. Another more progressive use of dollars is slowing down, to the extent possible, the depreciation of the Lebanese Lira. This would amortize the currency shock on salaried workers, retirees, and the largely un-pegged lower and middle classes.
Having said that, reticence to debt restructuring is not pure folly. Negotiating a debt restructuring requires expert legal, financial, monetary, and economic planning. The bind the Lebanese economy currently finds itself in is not simply a crisis of debt sustainability. So without addressing the concurrent balance of payment, monetary, and banking crises, no negotiation will bring us large enough concessions from our creditors to put the economy on a path to sustainable debt. The goal should be to negotiate repayment schedules, coupons, and principals that create fiscal space in the short and medium runs to manage the comprehensive reforms needed.
The openness of many foreign Eurobond holders to debt restructuring is a reassuring sign. Understandably, local banks, which still hold a substantial share of the maturing bonds, are less inclined to support it. It is therefore essential that the right set of incentives and constraints be implemented so that the costs of restructuring on creditors are neither prohibitive for the local banking sector, nor passed onto depositors. Another challenge for the government will therefore be to push for a workout that distributes the costs of restructuring equitably.
A debt restructuring plan is risky, delicate and, with Lebanon’s web of inter-connected crises, complex. The more practical question then becomes: Why should people trust a system as corrupt, short-sighted, and inefficient as the one we have to embark on an uncertain and collectively arduous reform path? After all, the risks involved are the reason that governments consistently wait too long before they decide to restructure debt. Incumbency is, in such an instance, a disadvantage. The recent change in government could have been an opportunity to form a cabinet free from that specter of blame. In embarking on reforms that constitute real departures from past policies, the government now stands to show if it is indeed, as it claims, “new.”
Nada Mora: “Lebanon Needs Unified Debt Restructuring along with Bank Recapitalization”
To evaluate whether Lebanon should default on its international debt—with a Eurobond dollar payment due 9 March—one must weigh the benefits against the costs. For those not familiar with the financial jargon added newly to our daily conversations, sovereign default means debt rescheduling on terms less favorable to creditors, rather than outright failure to pay. When a country’s debt becomes unsustainable, governments reduce spending and increase taxes, and when that is not enough they restructure their debt. Sovereign default is not uncommon: There have been more than 180 international debt restructurings since 1970, and countries typically re-access capital markets within 2-5 years.
What are potential benefits of debt restructuring? The greater the country’s “bargaining power” in debt negotiation, the greater investor losses—or what is known as haircut—it can extract. Losses arise even when debt is rescheduled without face value reduction. There are various benefits to debt restructuring like the reduction of the debt, release of debt-service funds for alternative payments (imports), reduced fiscal austerity in a recession, and in the longer-term, lower borrowing costs as long as debt falls to sustainable levels and growth resumes.
The theory of sovereign default emphasizes the reputational costs this would cause, with the loss of future market access and/or higher borrowing costs. The latest research shows these costs increase with the haircut and last for several years (e.g., bond spreads increase by 250 basis points (bp) in the first year post-restructuring for the average haircut of 37%, remaining 100 bp higher in the fourth and fifth years). Another theory emphasizes sanctions and legal enforcement. However, enforcing sovereign debt is limited. Sovereign bonds like Lebanon’s are issued in financial centers like New York and are subject to foreign jurisdiction. While lawsuits have increased by “holdouts”—bondholders refusing to participate in debt exchange—they have not been successful at judgment enforcement (cannot seize assets such as sovereign property and central bank assets), but holdouts succeed more as nuisance, leading countries to settle out-of-court. In addition, domestic costs, particularly to the national banking system, increase when domestic banks hold sizable international debt, and this is the case for Lebanon. If banks are not well capitalized, debt write-offs increase instability and potential losses to depositors.
If we divide the question into two parts: Should there be debt restructuring? And if so, how large should the haircut be? On balance, yes, Lebanon’s debt unsustainability makes it a candidate for debt restructuring. But it is better to manage restructuring as a unified strategy—domestic currency debt together with Eurobonds—along with bank recapitalization. Doing so provides a higher degree of certainty on the size of expected write-offs, and therefore of the recapitalization needed to avoid default turning into a full-blown banking crisis.
In negotiating over the size of the haircut, Lebanon is also negotiating over its future borrowing terms. Future borrowing costs increase because of reputational cost but the net long-term effect can be lower if debt becomes sustainable. Therefore, higher haircuts have greater benefits but at the same time they cause greater reputational costs, risks to the domestic banking system, and a higher likelihood of lawsuits. Lebanon’s bargaining power in negotiations depends on its ability to pay, the prospect of securing access to other financial assistance, its legal capacity, and how soon it wants to re-access capital markets.
Research has shown that it is not possible to discriminate by defaulting on foreign creditors only, because Eurobonds are traded in secondary markets where foreigners can sell to domestic agents. It may be possible to offer less favorable terms to Lebanese banks because their large holdings cannot be easily sold en masse and the government has more leverage over them. This would however still be considered a selective default by rating agencies. The 2012 Greek restructuring followed a similar approach to avoid litigation by honoring existing bonds to creditors who did not participate in debt exchange.
The only economic advantage of delaying default would depend on the probability of securing financial assistance in the interim to restructure on better terms. Otherwise, concerning the argument of possibly defaulting in April compared to March, this reduces benefits without reducing costs—as costs are longer-term and might increase if “vulture” funds increase their strategic exposure to Lebanon’s debt.
[These responses were originally published separately by the Lebanese Center for Policy Studies (LCPS)]