Monday, January 6, 2014

Lebanese Sovereign Debt: A TikingTime Bomb

This column has devoted a number of columns over the past few years what it labeled as the dire need for Lebanon to take major active and meaningful steps to deal with the danger that the sovereign debt posses for the whole country. Well, I do hope that you resist the temptation to argue that since nothing drastic has happened in that specific field then this must mean that all the warnings can be dismissed as false alarms. That would be the furthest thing from the truth.

There are a few reasons why Lebanon has been given a pass so far despite its mishandling of its sovereign debt. The geopolitical strategic position of the country in addition to its relatively small size of sovereign debt in absolute terms plus the good sum of annual immigrant remittance and its substantial holdings of gold stocks have combined to shelter the economy from what would have been normal attacks given its weak sovereign debt data. It is to be noted that a few countries that are in a stronger economic shape than Lebanon yet they have been subjected to substantial economic pressures that have forced them to adopt certain policies that will strengthen their financial foreign accounts.

Please allow me to pose a question that I hope will help illustrate the difficulties that are threatening Lebanon on the economic front. Let us assume that the reader has an annual income of $43,000 and that the total debt accumulated for a variety of reasons amounts to about $62,000. Assume furthermore that the debt service averages about 7% per annum while the revenue is not expected to rise by more than 1.5-2% per annum. As you can see from the above a very simple calculation will show that the increase in revenue per annum would approximate $800 while the debt service would amount to about $4300 each year. This means that this typical reader will experience an increased debt load every year and that the debt/income ratio must climb.

At times inflation can come to the rescue of debtors that have obtained their borrowings at a fixed long term rate. But this ‘trick’ commonly known as repression will not work in Lebanon since the Lebanese authorities depend on constantly refinancing the accumulated sovereign debt. It is also to be noted that even the domestic portion of the sovereign debt will experience higher interest rates as a result of a high rate of inflation. The rationale for that is very simple, the banks will not settle for , say 8% interest rate if the rate of inflation is 7%. Ads the rate of domestic inflation increases so would the interest rate paid on the domestic portion of the debt. The same would also hole for the external debt since a high rate of inflation would affect the rate of foreign exchange and would thus increase the premiums demanded to insure the Lebanese debt. That in turn will translate into higher financing burden.  Even the gold reserves cannot help rescue the economy since once sold then the heath of the economy would weaken substantially.

The lesson from the above is that the current debt/GDP ratio of about 144% will deteriorate each and every year even if Lebanon manages to grow at 3-4% each year. A rough calculation would indicate that by 2020 the debt/GDP in Lebanon would be expected to be about 175%. That would be one of the highest rates of indebtedness in the world besides Japan whose total debt is essentially issued in its own currency.

I am willing to stick my neck out one more time to warn that the special circumstances that have combined thus far to prevent a severe financial crisis in Lebanon cannot be relied upon to last forever. Actually, as Nassim Taleb, the leading financial philosopher in the world has been preaching for a few years: plan for and expect black swans. Many risk distributions have thick tails and the probabilities of avoiding major breakdowns are not as large as what used to be expected even under normal distributions. So how likely is it for a weak distribution to avoid a major breakdown when it is built on weak foundations? Not very likely.

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