A crisis unfolds
For the first time in its one hundred year history, Lebanon has defaulted on its debt after its government opted not to repay a US$ 1.2 billion Eurobond that reached maturity on 9 March. Although it can be difficult to predict sovereign defaults, the decision comes as no surprise. Lebanon has been marching down an unsustainable economic path for almost a decade now.
Prime Minister Hassan Diab put the country's total public debt at approximately US$ 90 billion or 170 per cent of GDP – the world’s largest debt-to-GDP ratio after Japan and Greece. The unsustainable debt figures are attributed to Lebanon’s poor domestic and external economic performance. For almost three decades, the country has continually registered a twin deficit – in both current account and budget. Based on data from the Ministry of Finance and UNCTAD, in 2018 the budget deficit stood at 13 per cent of GDP, while the trade deficit hovered around 26 per cent. The poor performance is partly attributed to the long-standing monetary policy of pegging the Lebanese pound to the US dollar, which is a manifestation of the country’s domestic political, social and economic interests.
The default comes at a time when the Lebanese economy is at a crossroads, putting the State’s capacity to provide for those less privileged to the test. While the 2020 state budget proposes a US$ 700 million spending cut to curb the deficit, the COVID-19 pandemic outbreak has exposed deficiencies in public healthcare despite colossal efforts by public health personnel to alleviate the problem.
This invites the question: What is next for Lebanon and who will bear the brunt? A handful of non-mutually exclusive scenarios exist.
The implications of default
Firstly, a default effectively means a haircut on the debt. A conventional haircut would reduce the amount repaid to creditors. Yet, another implicit type of haircut could mean restructuring the dollar-denominated debt currently held by Lebanese banks by converting assets into the domestic currency. Such a move would alleviate pressures on the Central Bank’s (BDL) foreign currency reserves.
According to the Association of Banks in Lebanon (ABL), the total capital adequacy ratio (CAR) – a bank’s ability to avoid insolvency and losing depositors’ money – was at a desirable 15 per cent at the end of 2018. It therefore stands to reason, that bank owners rather than depositors should bear the cost of restructuring. This becomes all the more reasonable considering that banks amassed fortunes thanks to decades-old economic policies and several rounds of financial engineering, which prioritised the interests of financial capital over social justice considerations.
A caveat. Current reports indicate that Lebanese banks sold Eurobonds to several international investment firms and vulture funds at discounted rates in order to prop up liquidity. Whereas the ratio of domestically-held debt to that held by foreigners was around two-thirds in 2019, the ratio today may paint a largely grim picture as foreign-held debt, including by vultures, is on the rise. This will jeopardise Lebanon’s position in future negotiations.
Here, caution is warranted. Evidence suggests that vulture funds frequently target distressed debt of sovereign states with a weak capacity for legal defence. They then sue for reimbursement of the debt’s original value plus interest. By their very modus operandi, these funds pose a grave threat to Lebanon’s capacity to restructure its sovereign debt and could divert necessary spending meant to guarantee basic human rights, health, water, food, housing and education in particular.
Despite international efforts to incorporate Collective Action Clauses (CAC) – a mechanism that grants power to debtors and curbs the capacity of vultures to undermine sovereign debt restructurings – into debt contracts, CACs remain limited. Furthermore, they protect sovereign states only against recognised strategies of vulture funds while overlooking new financial shenanigans.
Secondly, a haircut alone is not enough. According to a former deputy governor of BDL, a bailout of up to a US$ 25 billion is needed for Lebanon to navigate its financial crisis. To that end the government may resuscitate CEDRE, the Economic Conference for Development through Reforms with the Private Sector, which pledged to support Lebanon's ailing economy with developmental funding in the vicinity of US$ 11 billion. For reasons that are mainly geopolitical, there is hardly anyone in line to inject bailout money at the moment.
Thirdly, and most likely, the government may resort to IMF lending, which comes laden with conditions. Conditionality is focused on fiscal sustainability, of which austerity and a devalued currency constitute key ingredients. Between 2011 and 2014, the IMF imposed a total of 331 conditions on Arab States that received loans. Inter alia, conditions encompassed cuts in government expenditures, higher VATs, and currency devaluations. In Lebanon, with the existing fragile institutional structures, such conditionality is likely to amplify social costs and force wage earners to bear the brunt of reforms.
The outlook for debt restructuring
Nonetheless, Lebanon may be able to turn crisis into an opportunity. In the more immediate term, restructuring negotiations with creditors must be transparent. The government must heed progressive forces and ensure that the cost of restructuring is not shouldered by depositors. It must also step up efforts to advocate for a fair multilateral debt restructuring mechanism.
Similarly, potential negotiations with the IMF over a bailout package must be transparent and disclosed to the public. Any IMF lending arrangement must not contradict Lebanon’s right for positive structural change, which enhances its competitiveness without worsening working conditions. In fact, contrary to mainstream policy advice, Lebanon needs measures that boost aggregate demand amid an already austere state budget as well as faltering growth exacerbated by the COVID-19 pandemic. In parallel, various stakeholders including academics, civil society organisations, as well as trade unions, the private sector and the media should be engaged in a national dialogue to devise a comprehensive strategy that would oversee Lebanon’s transition to a more just economic model.