Fitch Ratings has recently downgraded Lebanon’s long-term foreign-currency issuer default rating (IDR) from B- to CCC.
The downgrade reflects intensifying pressure on Lebanon’s financing model, increasing risks to the government’s debt servicing capacity. This is consistent with the rating actions by Moody’s (Caa1) and S&P (B-). According to Fitch, Lebanon requires substantial capital inflows to fund its large twin budget and current account deficits.
The ratings agency has estimated Lebanon's gross external financing needs at 24 per cent of GDP in 2019. However, total deposits in commercial banks (excluding public sector deposits) have declined since the end of last year to June 2019.
Downward pressure on banking sector deposits, central bank foreign reserves and increasing dependence on unorthodox measures by the central bank to attract inflows, has illustrated an increased stress on financing.
The government is largely relying on financing from the central bank, both in domestic debt markets and for the repayment of Eurobonds. While recent policy steps point to nascent fiscal adjustment, a credible medium-term plan to stabilise government debt/GDP is lacking. Fitch has projected a deficit of 9.2 per cent of GDP in 2019.
Revenue projections seem optimistic given weak economic growth and inefficient tax collection. A nominal GDP growth of 3.3 per cent is anticipated by Fitch, lower than the government’s estimation of 5.7 per cent.
The overall spending allocation may prove realistic, provided that the government can maintain discipline on no new hiring, and that the stock of arrears is not higher than estimated. In January-June, the deficit was around 4.2 per cent of Fitch’s forecast annual nominal GDP.
Even if the budget plan were fully realised, it would only be a first step towards stabilising government debt/ GDP (152 per cent at end-2018). Given the weak growth outlook, the ratings agency estimates that the government would need to run a primary surplus of at least five per cent of GDP over the next four years to stabilise government debt/GDP.
This indicates the extent of fiscal and structural reform required to put government debt on a sustainable footing, unless Lebanon can access a period of cheap financing or experiences a positive shock to growth.
The banking sector
Lebanon’s banking sector is believed to be the country’s strength. The unblemished track record of public debt repayment and the depth of the financial system (deposits in commercial banks are around 300 per cent of GDP), remain the rating strengths, said Fitch.
Public debt is predominantly held by the country’s large banking sector and monetary authority and non-resident depositors are mostly diaspora Lebanese. This close-knit nature of the financial sector has helped the government manage its large burden of debt over an extended period of time. Lebanon has had very few episodes of deposit outflows in the last 15 years.
KPMG in a recent whitepaper has suggested that consolidation within the banking system is a positive for this debtladen nation. A total of 65 local, regional and international banks operate in the country, of which 49 are commercial banks and 16 are investment banks.
“The Lebanese banking system has a solid foundation that has been supporting the economy for many years, but the current economic conditions in Lebanon have been unstable for a prolonged time. So, it is the right time to look into the sector with a critical eye to avoid a downfall that might be triggered by a slip of one of the small banks,” suggested Nafez Almorhabi, CEO & Partner of Advisory, KPMG Lebanon.
The Central Bank of Lebanon has offered banks several incentives under law number 192 (dated 04/01/1993), to encourage M&A activity within the banking sector. These incentives include, granting the acquiring bank necessary loans on concessional terms, exemption on income tax, stamp, transfer and notary public fees, tax benefits and endof-service indemnities for dismissed employees, etc.
The whitepaper pointed out that with the number of active commercial banks considered to be relatively high in Lebanon when compared to international norms, the Central Bank of Lebanon’s move to consolidate the banking sector is a right step and will promote healthy competition among banks and benefit bank stakeholders.
“The Central Bank of Lebanon may need to should follow footprints of other local and international regulatory authorities and take necessary actions that would further encourage consolidation and ensure that the promised synergies are fully exploited, while post-consolidation challenges are reasonably mitigated,” added Almorhabi.
Mergers and acquisitions can be a valuable tool to diversify a bank’s portfolio which allows for employing more of the reserves and reaching higher profitability rates while maintaining a comparable risk matrix.
“Consequently, with every successful merger, the banking system gets sounder, creating larger and more resilient banks, while customers get wider access to credit at lower rates, hence, mergers benefit local economies. We believe the Central Bank of Lebanon needs to push for more bank consolidation by offering additional incentives,” said Almorhabi.
Analsts have suggested that the main factors that could, individually or collectively, lead to positive rating action is an improved outlook for external financing, such as nonresident deposit inflows into the banking system or other substantial inflows of external support.
An improvement in public debt dynamics, whether through fiscal tightening or stronger economic growth will also get Lebanon back into the green.
However, a deterioration in the situation such as the critical weakening of the government’s capacity to secure financing to meet debt servicing needs, the inability of the central bank to maintain sufficient gross foreign exchange reserves to retain confidence in the currency peg, or indications that the government is planning for debt restructuring, could, individually or collectively, lead to another negative rating action.
In spite of all this, industry reports have indicated that the Lebanese government is confident that it would be able to get out of the crisis. Time will tell.