Graphics by Rose Lee
The BRB Bottomline: Lebanon has been caught in a financial crisis that has only grown worse with the COVID-19 pandemic. Although it may be out of the question to have completely avoided a financial crisis for Lebanon, perhaps early indicators of distress, if adequately recognized by the correct institutions, could have mitigated the severity of the crisis. However, the “this-time-is-different” syndrome, a shortcoming that tends to plague many institutional creditors, has caused important systemic issues to be ignored. History has once again repeated itself, this time in the emerging market of Lebanon, where a financial crisis has gripped the nation since late-2019 and has caused substantial, but possibly necessary, setbacks to their economy.
A Fire in Lebanon
To add salt to a wound that was created by rampant political corruption and societal turmoil, the government of Lebanon decided to implement a six dollar monthly tax on internet voice-call services (WhatsApp, Facebook Messenger, etc.) on October 17th, 2019. Though later that day the government withdrew the tax, this ended up being the last straw for citizens. Shortly after, protests against the country’s elites erupted in Beirut, the capital of Lebanon.
These protests ultimately forced the resignation of Prime Minister Saad Hariri on October 29th and sparked a confidence crisis among citizens. The Lebanese economy had been facing months of economic slowdown, partly due to their massively levered central bank balance sheet, and a political void wasn’t going to help. To top it all off, wildfires in the mountains of central Lebanon were found out to be due to a lack of proper government maintenance on surveillance helicopters.
A Forklift Blocks the Banks Doors
As a preliminary measure for the surely imminent bank runs to come, commercial banks made implicit withdrawal restrictions explicit and blocked money transfers abroad. However, this did little to calm the storm, as citizens collapsed on the bank, hoping to withdraw their U.S. dollar denominated deposits, but to no avail. Commercial banks had been lending a majority of their assets directly to the central bank because of Lebanon’s high interest rates; an inflow of transfer and withdrawal requests would have wiped out the central bank’s balance sheet.
A total of 101 incidents at various banks across Lebanon from November 1 to January 13, including sit-ins, minor and violent scuffles, hostage taking, and forklifts blocking bank entrances, have only contributed to the exponential decline in consumer confidence in local banks. To regain political balance and hopefully reinvigorate foreign stimulus to abate the rising economic disaster, a new Prime Minister, Professor Hassan Diab, was installed. However, this decision—one that was backed by the US-delegated terrorist militant group Hezbollah—has not sat well with citizens, as they believe the new candidate was selected by the same political elites behind past political corruption in Lebanon.
To add to the seemingly endless list of Lebanese misfortunes, the economic crisis combined with the COVID-19 pandemic has impacted Syrian refugees (¼ of Lebanese population) in Lebanon especially hard.
Flashing Red Lights
With bond yields spiking 1000% (February 2020) on $1.2 billion of Lebanese government bonds, it was becoming quickly impossible for Lebanon to refinance debt payments and ignore the problem. This eventually led to Lebanon’s first-ever external debt default on March 9th. Since then, the economic situation in Lebanon has worsened as, despite US-pegged exchange rates (~1500 lebanese pound to USD), local money exchangers sell the dollar for 3,250 Lebanese pounds. The homeless population continues to rapidly rise.
As the country is faced with new turmoil thanks to continued political unrest, COVID-19 shutdowns, and a defaulted balance sheet, it is important to look back and identify where it all went wrong.
1. Banque du Liban’s Burgeoning Debt Balance
Lebanon is known to be a country with a very high debt ratio; at the end of 2018, debt to GDP was 150%. How did these levels get so high?
The origins of the high debt balance can be traced to the Lebanese civil war, which concluded in 1990. After the war, Lebanon was in dire need of aid from foreign creditors to rebuild their economy. In order to raise capital, Lebanon attracted foreign investors with high interest rates and coupons tied to the U.S. dollar. This effectively attracted foreign capital seeking high returns on investment with the credibility of a currency peg. Other foreign aid came from organized conferences like the 2001 and 2002 Paris conferences, where countries lent Lebanon around 4.4 billion USD in the form Eurobonds paying 5% a year due in fifteen years.
Although Lebanon has survived with debt-to-GDP levels greater than 100% for over a decade (compared with other Middle Eastern countries like Israel with 60% and UAE with 20% in 2018), investors should have started getting worried after seeing Lebanon’s ratio continue to increase from 130% in 2012 to 150% in 2018. On the contrary, financial backers believed solving Lebanon’s struggling economy simply required more debt! They continued to invest in Lebanon, as high interest rates (weighted average of 5.9%, 2016) and beliefs of sound reputation erased doubts of danger. In addition, the foreign debt was justified as a hedge against the domestic debt and further support for the currency peg.
This is a clear example of the “this-time-is-different” syndrome; false claims of security clouded investors’ judgement forcing them to underestimate Lebanon’s true risk. Institutions trusted the Lebanese economy as a good investment, while agencies continued to praise its credibility. Reports like the “Global Entrepreneurship Monitor Report” and stress tests conducted by the IMF in 2017 continued to underscore the true risk to the banks (worst-case scenario of a 9.5% CAR, which remains above Basel III requirement of 8%) and “hyped-up” the attractiveness of a Lebanese investment. In fact, the debt management strategy proposed in 2016 by the Lebanese Ministry of Finance actually suggests a heavier reliance on foreign borrowing to finance current interest payments and to extend (rollover) maturities for debt in the portfolio.
With hindsight, we know that the impression of sound reputation was ill-placed, or at least, in recent years it has been. More emphasis should have been placed on Lebanon’s capacity to continue servicing their debt amidst a ballooning federal balance sheet.
2. Deposits: In Through the Door, Out Through the Window
An investigative approach to the makings of this current Lebanese financial crisis reveals a history of dangerous financial activity that was conducted between commercial banks, the BDL, and the Lebanese government. Commercial banks in Lebanon, in order to entice citizens to deposit more money, have been raising already-high interest rates for deposits (9% average for local currency deposits, 6% average for USD deposits). This has led to a steady increase of around 106.97 trillion LBP (lebanese pound) in commercial bank deposits over the past 10 years, a growth of 66%.
This may seem natural at first glance. However, what the banks were doing with the deposits was definitely not. The commercial banks would take deposits and place a large share of the money into central bank accounts. In addition, they would purchase high volumes of government bonds. An annual report from 2015 (more recent dates not published) issued by the Bank of Beirut, one of the largest banks in Lebanon and one with aforementioned forklift, reveals that 45% of the funds from deposits were allocated to central bank accounts and government bonds. This wouldn’t be a dire concern had it not been for Lebanon’s high debt levels, which were becoming increasingly hard to service due to high interest rates (refer to point 1 above).
Deposits into commercial banks by citizens and non-citizens alike were being used to support a growing debt balance and to pay public-sector employees. This had two (probably more) consequential effects. The first is that it made it appear to creditors that Lebanon had a viable way to safely raise additional debt. Such a mechanism is bound to fail once debt simply becomes too expensive to finance, as it is now, with its defaults on the March Eurobonds. Secondly, these dealings, once made public, only contributed to growing concerns that public officials were corrupt. Cue the 2019-2020 protests.
The people in charge of the commercial banks were incentivized to continue lending to the central banks. This is because a large portion of the banks net earnings, which mainly came from interest on central bank deposits and government bonds, were distributed as dividends. Roughly 60% of the Bank of Beirut’s earnings were paid out in dividends in 2015, as reported in their statement of cash flows. What’s even more surprising is that the majority shareholder of the bank (24.40%) is International Century Corporation, which is “currently of unknown status.”
Even with an active effort to maintain high liquidity ratios (15% for USD deposits, and 10% for LBP deposits), the commercial banks’ other financing activity of funding the government’s debt essentially reduced the effectiveness of such risk management efforts. In fact, a study showed that higher levels of liquidity in Lebanese banks actually increased their total risk profiles.
This analysis has highlighted clear systemic issues that have caused Lebanon to be in its current financial crisis. The next question we hope to address is how could we have ascertained that the critical mass of the crisis was approaching? To answer this, we look towards waning confidence levels.
3. Signs of Declining Confidence
Lebanon has been in a tumultuous state for the past two decades, a situation that has impeded its growth as an economy. Although the slowing Lebanese GDP growth (0.2% in 2018) could have been a blaring indicator of an impending crisis, other variables provide additional suggestive material.
For one, declining real estate prices may have been a sign that government aid to the land development sector was insufficient, probably because most of the funds were being used to service the government’s debt. This is even more significant considering that reconstruction during the postwar period of Lebanon’s economy was heavily characterized by real estate speculation from non-specialist private investors. Given the high demand yet continued decline in prices, this suggests that not enough private investors were getting the capital required to make certain investments due to the fact that commercial banks were lending too heavily to the central banks. Clearly, this reveals a decline in confidence concerning the Lebanese economy and financial sector.
Another indicative factor of confidence decline was the general reaction of Lebanon’s economic and political scenes to the massive influx of Syrian refugees that began in the early 2010s. A study has shown that the inflow of new people contributed to the deterioration of an already weak Lebanon by decreasing security, exhausting social services, and regressing the economy. Overall, this hardened the life of a majority of Lebanese citizens as well as the Syrian refugees, and added to the already mounting stress caused by systemic social and political issues.
Take Home Points
It is difficult to determine when the current financial crisis in Lebanon will subside, especially given the current situation with the COVID-19 pandemic. However, if things do begin to look better, it is important not to become complacent with bouncing back to already low levels. It is far more likely that further defaults on Lebanese debt will follow and that mass restructuring and currency devaluations will follow this political, health, and economic nightmare. Unfortunately, Syrian refugees and other already struggling groups will be the most affected by a more prolonged crisis.
The financial crisis in Lebanon is different from other financial crises spread by this pandemic. It is a financial crisis fueled by greed, cronyism, and the collapse of a country’s confidence in its leaders. It could have been stopped if only people stopped to ask, were things really different this time? As with most old adages, they’re rarely proved wrong.