Friday, June 17, 2011

Lebanese Sovereign Debt Default: An Inevitability.

Some things are preordained and I do not mean only philosophically. There is often a strong rationale that predetermines an outcome once a certain sequence of events is unleashed. Once the trigger of a loaded hand pistol is pulled then a bullet is released and if that hand pistol was directed to ones leg then that leg would be seriously wounded. It cannot be otherwise. Such logical conclusions always follow from certain actions and therefore these consequences cannot be considered to be accidental since they were designed to follow once an act is committed. To exceed the speed limit by passing a highway patrol is to expect a speeding ticket just as to fail to present a research paper on time is to earn a failing grade. This is not any different than to expect to borrow if the level of expenditures is to exceed the flow of income and this is exactly what is happening to the ability of some countries, such as Greece, to carry successfully their debt burden. The same exact logic applies to Lebanon. Lebanon has over borrowed and must face the consequences. The logic of default is just as impeccable and straight forward as that of pulling the trigger while aiming at a leg.

Historically, the Greeks were the first to develop the concept of tragedy. They even developed a particular genre where the events become totally complicated and appear to defy any solution when out of the blue a divine solution is presented through outside forces. This solution became known as Deus Ex Machina, a resolution by divine powers unrelated to the actual dynamics of the problem. I mention this in order to stress that in the Greek current debt crisis and to a larger extent in the case of Lebanon we do not have the right to depend on such an irrational and highly unlikely solution. Deus Ex Machina just does not exist in the real world. Lebanon has borrowed beyond its capacity to service these loans and the longer we persist in our denial then the bigger the problem will become.

I am not interested in asking why we borrowed and whether the decisions were proper or not. I am obviously not interested also in whether the borrowed funds were put to good use or not. All of these are academic issues that are not significant at this phase. We need to devise a way to manage the debt problem so that it will not crush us and crush all the hopes of the next generation. We have to look at the numbers objectively and allow these numbers to tell the extent of our financial woes. The details might overwhelm some but the logic is quite simple.

A country, any country, passes an annual budget that shows its planned expenditures and its planned revenue stream. Whenever the expenditures exceed the projected revenue then the deficit represents the amount that is borrowed. The sum of these annual deficits makes up the national debt.

With that in mind let us take a look at Lebanon. Each and every year for decades to come the projected level of expenditures exceeds that of revenue. The current level of annual deficit is almost $3 billion and that figure will rise every year if for nothing else but for the fact that our national debt will have to rise and consequently the required level of interest needed to service that debt. Almost 40% of all expenditures are allocated to debt service. This means that only 60% of our expected expenditures go to pay wages and run the basic government services. This relatively small figure carries great implications, it simply means that Lebanon is already running a very austere budget, there is no room for any additional cuts, and Lebanon has already cut to the bone. But some will point out to the fact that as the level of national debt rises every year so does the GDP and therefore the burden could stay the same. That would be true if the GDP is to grow at a faster rate than the rate of interest used to finance the debt. Lebanese debt, in general, carries an average interest rate of around 7%-7.5% although our growth rate cannot be expected to average even 4%. This growth rate might even be excessive given the potential for political instability and war in the region not to mention the lowered economic growth expectations worldwide.

So where are we and what should we expect? The Lebanese Debt/GDP ratio is approximately 137% and it is expected to grow every year for as far as the eye can see. One rather conservative scenario projects a growth of this ratio to about 163% by 2020 when the level of sovereign debt is expected to have ballooned to over $90 billion with an interest burden of about $6.7 billion or about 12 % of the GDP. That is unconscionable and is a ticket to perdition. The Lebanese people deserve better.
There is only one painless solution for those who believe in dreams; A Deus Ex Machina where a wealthy Western country and/or a group of Arabian officials ride down in the basket from the sky to write off a substantial portion of the Lebanese national debt, our Scarlet letter.


Oussama Hayek said...

I'm not sure I agree about inevitability, though I completely agree the situation is risky. Turkey has been a similar situation in the past and managed through without a default. Argentina was in a more comfortable position than Lebanon, and still defaulted!

The problem, of course, is that the debt is held by Lebanese banks, so a default will wipe out everyones savings, too. This also means we are on our own in this one: a default by Lebanon impact no one other than the Lebanese. We are our own largest creditor.

I wrote about this on my blog on 23 January

Prophet said...

I usually avoid topics, such as economics, which, I' m not fully knowledgeable about. But your analysis of Lebanon’s economic situation makes sense. I always wondered how Lebanon’s economy seems ,on the outside at least, to be prosperous when the political and security situation is nothing but stable. I learned years ago in economic 1 that good economy and prosperity requires stability and security, yet this formula never seemed to apply to Lebanon. My American born nephew , who graduated from the same institution you lecture at , have been

Prophet said...

I'm sorry,pasting and copying failed me;

My American born nephew , who graduated from the same institution you lecture at , have been echoing your analysis for a long time, and I could see where He got his training

ghassan karam said...

No country can ever allow its debt to keep growing at a rate that is larger than the growth rate of the GDP. When a country adopts a budget that is expected to show a deficit on its primary account this means that every single dime paid to service the debt is borrowed and then some. That is why the Lebanese sovereign debt will grow at least at the average cost of financing. As that happens then the debt service burden grows also.I think that if one is willing to project 20 years out then the Lebanese sovereign debt will be approaching $200.
Inflation will help coutries such as the US, Japan and the UK where they can control the debt service but a small country as Lebanon has no contro; whatsoever over the interest rate.
Actually the Lebanese banks are the largest beneficiaries of the Lebanese debt. Government bribes them with extraordinary high rates and they turn around and attract funds by paying them a smaller rate.
The veracity of the story that numbers tell is unquestionable. Lebanon cannot afford this debt and must restrucure. Restructuring does not mean total default. We can seek grants, moratoriums, lower interest rates ...
I do not think that Lebanese hold 85% of the bonds but even if they did does that change the arithmetic? Of course not especially due to the fact that Lebanon has already issued almost 40% of its debt indenominated in dollars.

ghassan karam said...

As I told Sebouh once, Lebanon is like the guy who overborrows to pay for school but once she graduates she finds out that 3/4 of her earnings are allocated to the debt payment.
The original debt probably helped the Lebanese complete some projects but what is very clear is that these projects did not turn out to be as productive as hoped and so we are stuck with a debt burden that is literally speaking crushing us.

Maybe I know your nephew?:-)

Oussama Hayek said...


I don't disagree with your arithmetic, but despite several budgetary plans that would have led to a primary deficit, the country has managed a primary surplus. This is why the debt ratio improved. I don't think the surplus is large enough to give the right boost to confidence. Turkey ran a primary surplus of 8.5% of GDP for several years in a row, and confidence boosted growth as a result. Lebanon's measly primary balance will not do the trick, for sure. But I don't think that they have cut expenditures to the bone. They can cut more. The subsidies to EDL is one area, and enforcement of payments of electricity bills! EDL savings alone could turn the arithmetics around.

Turning to the issue of a restructuring, everyone who has looked at emerging markets over the past decade is familiar with the options between a "disorderly" or an "orderly" restructuring. But however you slice it, you are talking about a reduction of the debt in Net Present Value terms - otherwise, the exercise is pointless.

The fact of the matter is: the only orderly restructuring a that have taken place are in Uruguay, Dominican Republic, the Seychelles. These are economies smaller than Lebanon with a handful (literally) of outstanding Eurobonds. Lebanon has too many debt instruments to be orderly, and frankly, Lebanon is neither strategic enough or economically relevant to expect a serious bailout.

One option - since a lot of the debt is in Lira nowadays - is a whopping devaluation (say 70%). But I am not sure how much of the debt is linked to foreign currency (I need to do the maths on the net impact on the debt, since FX debt will increase in Lira terms).

All of these options are ugly, but not "inevitable" if the country can politically cut spending, and raise revenue. Ask the Lebanese this question: Would you rather see half the civil service fired, or most of your savings evaporate? Maybe I'm expecting too much of the Lebanese to expect that they would prefer to fire the civil service?

ghassan karam said...

The budget as it stands cannot be cut effectively except in the arae of subsidies to EDL of slightly over $1.2 billion a year. All other areas ,whether health care, education, defense, social programs are practically non existant. Besides an improvement in efficiency of service delivery there is another possible item that can lend relief and that is a better and a more progressive income tax and property tax structure. VAT is is a regressive tax which is already high enough. If Lebanon can increase its tax revenue to become say 25% of GDP then that would provide a meaningful outlet. Unfortunately that is not likely at the moment or anytime soon.
Most of the potential benefits from floating the Lebanese currency have been counterbalanced by the misguided decision to issue debt in dollars. If devaluation is off the table then inflation i.e. a nominal increase in the GDP could help provided that the inflation does not get reflected in higher interest rate to finance the debt. I have no idea why our politicians do not pay enough attention to economic policy, maybe it is because most of the public does not show an interest in the details of the macroeconomy. But if the best that we can do to manage the national debt is to appoint Ria Hasan as a finance minister whose only accomplishment , according to her official resume, is to have been on the Deans list for 2 semesters then we are in trouble. I hope that Mr. Safadi will at least admit that he does not understand these nuances and listen to some good advice.

Prophet said...

True that money borrowed by Lebanese governments helped pay for projects that turned out to be less productive then originally expected, but it is also true that big portion of these monies were pocketed through different means of corruption by Lebanese politicians and officials. That leads to the question of whether these projects would have been as productive as expected, if the cost paid for them had been the actual cost, instead of the amount borrowed to pay for it.
Of all money borrowed, what is your estimate of the percentage of money pocketed by Lebanese and Syrian officials? And how much of differences would it have made, had there been no corruption and theft?

ghassan karam said...

That is a fascinating question. I wish that I can provide a credible answer. The fact of the matter your question is not purely academic. If one can go back in time and get the details that were issued to justify the initial borrowing a rather interesting case can be made.
I would like to put my neck out and take a very rough stab at answering your question. My gut feeling is that the development policy that was used right from the start was flawed. It targeted fancy projects rather than basic infrastructure. Lebanon needed an airport but did not need the Rafic Hariri airport. Lebanon needed electricity more than fancy buildings in downtown ... If one is to assume that we have run very seldom a surplus on the primary account then it would be safe to suggest that the debt has grown and grown as a result of the interest to finance it.
So my best gueaa, and remeber it is only a guess, is that not more than $20 billion, was borrowed to implement programs. These $20 billion have mushroomed as a result of the interest to the current debt burden of over $50 billion. If I am anywhere close to being right then this shows that the borrowing was overdone. Borrowing is an alternative when it is self financing but is not a panacea when projects are mismanaged or badly planned to begin with.
Yet what is important is not to point fingers. We did whatever we did and now we have to live with it. We need to construct a detailed cost benefit analysis to find out what is the best course of action.

joseph said...

What would be the consequences of a debt-default by the Lebanese government?

ghassan karam said...

A default is serious business and it has serious implications. That is the way that it should be otherwise countries would not feel the need to honour their obligations.
What usually hapens is that the capital market will stop lending to the country and when they do they demand stricter terms until the country rebuilds its financial reputation.
But the severity depends on the way the default is handled. No one is suggesting a total repudiation of the debt. That rarely happens. (I think that the Soviets were the last to repudiate all the debt by the Czars). The most likely scenario in the case of Lebanon is a negotiated rescheduling similar to Paris! and ParisII.
Lebanon can open its books to show the huge burden of debt service and request that a group of countries; say US, UK, France, Saudi Arabia, Qatar, Kuwait will come up with a substantial package of 15-20 billion withstrings attached. The Lebanese government must in exchange meet some reforms in electricity, telecom, speed of project approval .... If the debt can be brought down in size so that normal budgetary operations will reflect a decrease in the sidebt ratio then the debt would have essentially become sustainable.
The smart thing is to work for an orderly restructuring instead of a chaotic one. That will reduce the damage to the financial reputationbut should be taken only when it is clear that the benefits exceed the costs.
The most recent example of restructuring in the region was Dubai. It could have been much smoother.

joseph said...

Are you familiar with what happened in Iceland? I wonder if that same situation could apply to Lebanon.

It is hard to see Lebanon acting seriously towards its debt obligation. I mean, you raise the point about a finance minister whose greatest accomplishment was to be on a dean's list in consecutive semesters.

On the other side, you have HA who have specifically said they do not have an economic policy.

Talent aside, I think the political will is just not there to seriously tackle the problem.

ghassan karam said...

You have hit the nail on the head!!. No one seems to think that this is an important issue and it has the potential to sneak on us with a left-right combination.
I am not so sure that we are capable of handling a crisis of the magnitude of the one that hit Iceland. My feeling is that half of the Lebanese would then fall back on the traditional explanation that this is a Zionist conspiracy.

Prophet said...

I’m in total agreement with you that the priorities of Lebanese governments have been in the wrong places ,and in the wrong projects all along.
I always wondered how can Lebanese officials who travel all over the world bragging about the Lebanon a s a tourist country , ignore the fact that they have failed to provide electricity, clean running water, and basic services.
You heard me , many times, echo my disgust with all Lebanese policies for their lack of responsibilities toward their followers, and my anger toward the public for blindly following these so called leaders.
Lebanon reminds me of a beautiful blondy who lived in a filthy run down house, yet she drove a nice BMW, and always went out looking like a Hollywood superstar, until one day the bank confiscated her car after defaulting on her hefty monthly payment.
It’s the show off mentality and the attitude that things will sort themselves out somehow.
I’m off to a family wedding.
Happy father’s day

ghassan karam said...

You are right, we seem to be a people that are in love of outer appearances.
Enjoy the wedding. I have to go and start the BBQ for the clan in the backyard.

danny said...

Great informative analysis as usual. Not that it matters..but who is Sebouh?

ghassan karam said...

Unfortunately, you are right , it does not matter. There is something wrong both with the system and the governance ( Nazzam wa Hukum). I saw an 11 minute video of an interview that was done with Safadi by Agence France. It was not encouraging.

Sebouh is a regular commentator on Yalibnan and Prophet is sometimes there also .Take care.

joseph said...

Given the LBP is tied to the USD - do you think it is in Lebanon's interest that the US keep printing money or carry on with quantitative easing?

ghassan karam said...

At a purely theoretical level I do not advocate artificial exchange rates. I believe that they are very costly.
Yet we have them and I imagine we have to accept that they do exist and do the best that we can under the circumstances.
A weaker dollar would not necessarily leave a major negative imprint on Lebanon. The ultimate impact is determined by the import mix of goods and services into Lebanon and where do we primarily export to.

Oussama Hayek said...

"Most of the potential benefits from floating the Lebanese currency have been counterbalanced by the misguided decision to issue debt in dollars."

Ghassan, check the data on the MoF website. More than half the debt is in Lebanese pounds, not foreign currency. The issue is not clear cut. One should also be careful with the numbers. Comparing real growth with an average interest rate on foreign debt is fine as a quick rule of thumb, but for Lebanese debt, you really should be comparing nominal growth with the nominal interest rate.

I'm also not sure issuing debt in dollars was a "misguided decision", but rather a reality the country had to accept. This is not unusual for many developing countries: we didn't have enough institutional investors willing to take the duration risk. For more on these issues, I recommend you read any of Ricardo Hausmann's papers on "Original Sin."

It sounds to me like you have an axe to grind with Rayya el-Hassan. I don't know her well enough to express an opinion, but I can say that Lebanon did have some excellent economists in government during the last 20 years. Alas, economists, no matter how dedicated, can't always outmanoeuvre special interest groups. I would guess Nabih Berri Inc is a bigger source of debt than the airport.

Again, I do not disagree with you on the seriousness of the debt problem. The claim that a default is "inevitable", though, is in my opinion somewhat reckless.

ghassan karam said...

You are right on both points but I think that you have misrepresented what I said.
(1) On the issue of dollar denominated debtI am totally aware tat the approximte composition is 40% in dollars and 60 a5 in domestic currency and that was prcisely why I used the qualifier almost most of the benefits....
(2)Again I believe that I also made it clear that the important issue is to compare the effective rate on the debt vs the nominal rate of growth but I also hastned to add that Lebanon is not in a positioin to control interst rate like the US, Japan and the UK who are actually practising repression. The US debt service burden is under 3% of the GDP. In Lebanon on the other hand a high rate of inflation will immediately translate into less confidence and higher interest rate on the debt.
I do not know Ria Hasan and I was glad to find a female occupy such a position. My disappointment arose from listening to her during press conferences. It isn't that she failed to understand some basics but she rarely spoke the truth. I am not sure that Safadi will be much better, that is the fault not of individuals but of the system. Appoint people to positions that they are not qualified to occupy.

As for dollarization of many third world economies, it looks like we are on opposite end. I have dealt with this issue over the years and I also lecture about it, I am not a fan of peggs.

And finally the issue of restructuring. Well the possible outcomes is limited only to two: Lebanon will either have to restructure or not. I think that Lebanon has no choice but to restrucure and furthermore I am convinced that an objective analysis of the current limitations on the Lebanese fiscal policy will show that Lebanon will be better of in restructuring its debt. We are paying a very high price in order not to retructure and the heaviest burden is on the shoulder of the poor Lebanese who probably form 50aaaaaaaa5 of society. Can you imagine what can be done with an additional 2$ billion a year???

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