Lebanon’s new government appears to be warming to the idea of going to the IMF, which would reduce the risk of a disorderly debt default that causes severe strains in the local banking sector. But even if the authorities go to the Fund, any deal is still likely to involve (an orderly) debt restructuring and a devaluation – we think the currency could fall by 50% against the dollar. And in the meantime, the economy is likely to fall into an even deeper recession.
- Lebanon’s new government appears to be warming to the idea of going to the IMF, which would reduce the risk of a disorderly debt default that causes severe strains in the local banking sector. But even if the authorities go to the Fund, any deal is still likely to involve (an orderly) debt restructuring and a devaluation – we think the currency could fall by 50% against the dollar. And in the meantime, the economy is likely to fall into an even deeper recession.
- Investors’ focus in recent weeks has been on whether the Lebanese government will make good on a $1.2bn Eurobond repayment due next month. (See Chart 1.) In order to avert default, the new government seems to be scrambling to secure external financing. Indeed, recent comments from key politicians suggest that the authorities are coming round to the idea of seeking a bailout from the IMF.
- It’s difficult to say for certain how large an IMF package would need to be but it’s worth noting that former Lebanese officials have suggested that the country needs a bailout of $20-25bn. What’s more, an IMF deal would probably be accompanied by the release of at least some of the $11bn of financing pledged at last year’s CEDRE conference as well as support from other bilateral and multilateral partners.
- There are concerns that Lebanon might not be able to secure financing from the IMF as there is the possibility that the US and its allies veto a bailout request given the influential role of Iran-backed Hezbollah in the Lebanese government. Assuming, however, that Lebanon is able to access financing from the Fund, the government will be required to take steps to restore macro stability.
- The immediate priority will be to put the government’s debt position on a sustainable footing. Crucially, the Fund would be precluded from lending to Lebanon unless it can deem government debt to be sustainable, which it almost certainly won’t be able to do.
- We’ve argued for some time that a debt restructuring is inevitable (see here) and past experience suggests that this will involve haircuts of up to 70%. (See Chart 2.) We’ve previously estimated that a haircut of 70% would wipe out banks’ capital and recapitalisation of the banking sector would amount to around 25% of GDP. With IMF technical assistance, a debt restructuring could at least be managed in a way that limits any resulting strains on local banks’ balance sheets.
- But a debt restructuring would only provide a sustainable solution to Lebanon’s public finances if it is backed up by fiscal tightening. In the event of a restructuring, we estimate that a fiscal squeeze of 3-4% of GDP will be needed to prevent the debt ratio from rising. Austerity will focus on reining in the public sector wage bill and pushing through an overhaul of the state electricity company (EdL). (See here.) Spending on wages and transfers to EdL account for almost half of total government expenditure. (See Chart 3.)
- Meanwhile, similar to Egypt’s experience in 2016, the Fund is likely to insist that – as a pre-condition to a deal – the authorities devalue the Lebanese pound. On the black market, the pound is already trading at a discount of more than 30% to the official exchange rate (see Chart 4) and, in its most recent Article IV consultation, the Fund estimated that the official exchange rate is overvalued by 50%.
- A weaker pound would boost Lebanon’s external competitiveness. The country’s exports would be cheaper and more attractive to foreign customers. And local firms and households would be enticed to shift their demand away from imports and towards locally produced goods. This would help to narrow the current account deficit, which currently stands at more than 20% of GDP. At the same time, removing the lingering threat of devaluation would entice some foreign investors back to the country. (See here.)
- But there is likely to be a lot of near-term pain. Indeed, the pound’s tumble on the black market has already started to push up price pressures – inflation jumped from 3.2% y/y in November to 7.0% y/y in December. And in the event of a devaluation, we think that inflation will spike and peak at more than 30% y/y. (See Chart 5.) Higher inflation will erode households’ real incomes and cause consumer spending to slump.
- This combined with the effects of fiscal consolidation and tighter financial conditions will cause the downturn in Lebanon’s economy to deepen. Overall, we expect GDP to contract by 5% this year. Our forecast lies right at the bottom of the consensus range.
- Beyond measures to restore macro stability, the IMF will put pressure on the authorities to implement structural economic reforms. There are numerous issues that need to be addressed, but perhaps the most important are steps to clamp down on rampant corruption and improve the business environment. Both are currently considered to be the worst in the region. (See Chart 6.) But so long as the current political order remains in place, vested interests mean that any major steps are unlikely see the light of day.
Chart 1: Government FX Debt Repayments
Chart 2: Investor Losses in Restructurings & Gov’t Debt-to-GDP Ratios
Chart 3: Government Spending by Category
Chart 4: Lebanese Pound (vs. US$, Inverted)
Chart 5: Consumer Prices (% y/y)
Chart 6: World Bank Control of Corruption Score
Sources: CEIC, Refinitiv, Bloomberg, Moody’s, lebaneselira.org, CE
Jason Tuvey, Senior Emerging Markets Economist, +44 20 7808 4065, email@example.com