Event

In recent weeks, the dark clouds that were hanging over the Lebanese economy have transformed into an all-out storm. Initially triggered by a reduction in non-resident deposits flowing into the Lebanese economy and by a lack of credible reforms to reduce the structurally large fiscal deficit, the situation has now escalated into an all-out confidence crisis. The crisis has led to doubts over the country’s sovereign creditworthiness and the health of its banking sector. At the same time, the economic troubles have led to protests in the country. These protests are now entering their fifth week. The anti-government protests are driven by complaints about economic conditions; they are aimed at the rampant corruption and mismanagement of the economy. They have already led to the resignation of Prime Minister Saad Hariri on 29 October 2019. On Monday, they further escalated when anti-government protesters clashed with Hezbollah supporters who oppose the current protests.

Impact

The current crisis is both economic and political and will prove difficult to solve. At the heart of the economic crisis lies the issue that the government has kept running structurally large fiscal deficits. These averaged around 8.5% of GDP over the period 2012–2018. The large public deficits and the significant import needs of the country have led to large current account deficits which the country has funded by attracting non-resident deposits from the Lebanese diaspora living abroad, by borrowing abroad and by incentivising Lebanese banks to repatriate funds previously held abroad. When the inflow of deposits has slowed in the past, Lebanese banks have responded on multiple occasions by offering higher interest rates in coordination with the Lebanese Central Bank. This happened for example last June when investors were offered a juicy 14% interest rate if they risked depositing funds in a three-year Lebanese term account. While this strategy worked for a number of years, the inflow of non-resident deposits slowed in 2018 and at the start of 2019. Additionally, investors have grown increasingly concerned about the government’s inability to reduce the large fiscal deficit. As the Lebanese banking sector is heavily exposed to sovereign risk, this has also led to distrust, putting an end to the years of trust the Lebanese economy enjoyed as a stable financial centre.

The outcome has been a clear drop in confidence in both the Lebanese pound (which is pegged to the US dollar) and the banking sector among the population and foreign deposit holders. This has triggered a bank run and a run on the Lebanese pound. The Lebanese Central Bank currently holds gross reserves sufficient to cover 11 months of import coverage but has been in practice faced with a liquidity squeeze, as years of financial engineering have led to a deterioration of its balance sheet and thus much lower usable reserves (estimated to be only USD 6–8 bn). Thus they have been unable to meet all the demands to exchange Lebanese pounds into US dollars. This has led to foreign exchange shortages and the introduction of restrictions by the Lebanese banking sector that limit the conversion of Lebanese pounds to USD. The result has been a parallel exchange-rate regime that developed on the black market where Lebanese pounds trade at a steep discount. Additionally, importers are increasingly facing difficulties obtaining hard currency to pay suppliers.

As far as the political crisis is concerned, the protests were originally triggered by the government’s announcement to impose a tax on WhatsApp calls but are reflective of much more structural issues, as there is strong discontent among the population over the mismanagement of the Lebanese economy. Initially the protests led to the abolition of any new taxes in the budget proposed by Prime Minister Saad Hariri. Later on, they led to the resignation of his government. Therefore, the economic crisis has further escalated into a political crisis as the different sectarian political parties and protesters demanding an end to sectarian politics and a technocratic government will need to agree on a new government. Reportedly, Saad Hariri would like to head a new government that would consist of both technocrats and less controversial politicians but it is unclear if he will gain sufficient support and if this would meet protesters’ demands. A purely technocratic government might not be the solution, as this government would still need to push legislation through the deeply sectarian parliament.

The formation of the last government took 9 months, involved careful negotiations between the various political factions and resulted in a unity government with 30 ministries; this time there is not as much time. Even if a government were to be formed rapidly and urgent reform measures were taken, it is becoming increasingly unlikely that Lebanon would be able to overcome the economic troubles by itself without restructuring part of its bloated public debt load (public debt stood at around 150% of GDP at the end of 2018). A bailout package could avoid this but Western creditors that put together the USD 11 bn soft loan package in 2017 made it conditional on clear economic reforms, which so far have not happened. For the countries in the Gulf, structural reforms are also likely to be a condition. While Saudi Arabia voiced support for the Lebanese economy in January, it has not put together a clear package since then. Here the main source of uncertainty is how they will deal with Hezbollah, which is likely to be present in any future government in Lebanon and is backed by Iran and strongly opposed by Saudi Arabia. Currently Credendo has maintained Lebanon in category 6/7 for short-term political risk, after downgrading it last October. However, given the current crisis situation, this rating is clearly under pressure and a further downgrade is increasingly likely.

Analyst: Jan-Pieter Laleman – jp.laleman@credendo.com