Lebanon defaults on its Eurobonds – what comes next?

On Saturday, March 7, Lebanese Prime Minister Hassan Diab announced that Lebanon would not pay the $1.2 billion worth of Eurobonds due on March 9. In other words, for the first time in its history, Lebanon would not be meeting its international debt requirements.

This was not unexpected, particularly as it came off the back of an earlier speech by the PM in which he conceded that the Lebanese state was no longer capable of ‘meeting the needs of its citizens’ and that harsh measures would be needed to pull the country out of the abyss.

As outlined in the PM’s speech, broad measures are to include restructuring Lebanon’s debt – which will require negotiations with creditors – fighting corruption and focusing on encouraging investment in productive sectors such as tech and manufacturing in order to diminish the country’s reliance on what the PM acknowledged was a bloated and outsized financial sector.

While the speech contained all the populist elements one might expect to hear under the current circumstances, it was also careful not provoke those who the country seemingly cannot afford to antagonise.

By making rather vague references to a "battle for the country’s independence" against forces that "are stealing the Lebanese people’s present and future", the PM seems to be treading a very thin line between acknowledging reality – which Lebanese politicians often avoid doing – and provoking either the street or elements of the powerful political and business class that are currently under the microscope.

Credit should be given where it is due, however. The speech delivered by the PM Diab represents – perhaps for the first time in Lebanon’s post-Civil War history – what seems like an honest and candid assessment of Lebanon’s current predicament.

But when he referred to Lebanon’s upcoming battle, who is this enemy and how did the country get to where it is today?

Lebanon’s debt – a largely internal issue

The present situation is most-often characterised the inability of Lebanon to manage its foreign currency liabilities resulting in a shortage of foreign assets caused by mismanagement and widespread corruption in conjunction with a number of both regional, local and international factors. Because this is occurring in the fiscal, monetary and banking sectors simultaneously, none are able to support the other.

What is not often discussed, at least not in the international media, is that a significant portion of Lebanon’s debt – estimated to be worth at least 150 percent of the country’s GDP – is held locally.

Out of Lebanon’s estimated $175 billion in debt (including deposits held by the country’s central bank), approximately $32 billion are held in US dollar-denominated Eurobonds. Out of this $32 billion - $1.2 billion of which was due on March 9 – somewhere between $5-12 billion are foreign held.

By this calculation, only 5-6 percent of the country’s debt is held externally. By not differentiating between locally and foreign held debt, the caretakers of the country’s finances arguably missed a golden opportunity to take strong measures to right the ship of state.

From this perspective, much of the economic pain the people continue to deal with on a daily basis – from severe capital controls at the banks, to rapidly increasing unemployment rates and rising prices – is intimately related to the unwillingness of wealthy and connected Lebanese to accept that they must incur losses and take responsibility for a crisis that they had a primary role in creating.

If there were ever any doubt left about the categorical dysfunctionality of the Lebanese system, this fact should be enough to alleviate it.

With all the understanding that should be given to the government’s decision to default, it arguably represents a huge missed opportunity. Highly respected financial voices in the country, such as Dan Azzi, a former CEO of Standard Chartered Bank Lebanon, have argued that carefully distinguishing between foreign and locally-held debt would have allowed Lebanon to maintain its commitment to external creditors. This would in turn preserve what is left of its reputation in international markets as well as effectively claw back what the protest movement has been referring to as ‘stolen money’ since demonstrations broke out across the country in October of last year.

Given that approximately 24,000 accounts owned by about 6,000 people own an estimated $83 billion worth of US dollar deposits, having had the luxury of other-worldly 12-15 percent interest rates on their deposits, the situation was rife for what experts refer to as a ‘haircut’.

As Azzi and others have argued, a ‘haircut’ of 50 percent on these accounts would yield enough to essentially solve the country’s Eurobond obligations, both internal and external, while at the same time recovering at least some of the so-called ‘stolen money’.

There is of the course the matter of the nearly $4 billion in capital flight that was reportedly shipped out of the country starting in October even after the banks imposed capital controls, which requires a type of investigation that could only be possible if and when Lebanon’s historically unbreachable banking secrecy is lifted.

While this approach remains a possibility, the decision to take the path of default and restructuring has arguably curtailed government options and is demonstrative of a lack of political will to tackle the issue.

Debt default and the IMF – What’s next?

The fact that the decision to default and pursue a restructuring plan was taken unanimously by the cabinet is indicative of the limited space the government feels that it has to move.

Firstly, there are genuine concerns in the country regarding the ability to finance the import of essential goods amid a foreign currency shortage and a depreciating Lebanese Lira, which formed a major justification for the decision.

Secondly, even under a ‘haircut’ scenario, creditors will want to ensure that they will have access to the rest of their deposits. By all accounts, the money owed to the country’s creditors – whether internal or external – is gone, wasted in notoriously inefficient sectors (such as electricity) and on financial engineering schemes ultimately designed to buttress an artificially high currency peg that maintained an illusion of middle-class wealth in the country.

Under any scenario, Lebanon has a massive funding gap. Over the next 4-5 years, the country will require $25-30 billion simply to finance imports. At present, Lebanon’s traditional donor countries – including those in the Gulf – are unwilling to provide the relief the country needs without a ‘credible’ economic plan.

Enter the IMF. As part of negotiations with creditors, Lebanon will have to provide a clear roadmap to repayment. Developing a plan along with the IMF is the conventional and arguably the most obvious route to take in this regard.

Even Hezbollah, which just last week indicated what seemed like a total rejection of involving the IMF, appears to have softened its stance, although seemingly still under the impression (or hope) that foreign currency liquidity can be secured without the Fund’s involvement.

The reality today is that no obvious source of foreign currency coming from the outside is forthcoming. While the potential issues that are likely to arise from the harsh conditions the IMF is likely to impose, to work with the IMF or not is choice that is quickly fading away day by day.

The main – and fundamentally immoral – problem that IMF-imposed reforms pose is what we can call unfair burden sharing. This was alluded to by the PM in his speech where he indicated that all Lebanese are going to have to make difficult choices in the months and years to come.

The notion that the entire population will have to bear the burden of Lebanon’s recovery from a crisis that they did not cause is highly problematic, and this is exactly what an IMF program is likely to institutionalise.

The notion that corruption ‘starts at the bottom’, as was recently argued by  Marwan Mikhael – former head of research for BlomInvest Bank – may be true in some instances, however it effectively erases the responsibility of those at the pinnacle of a system which has encouraged the type of rent seeking, clientelism and corruption that has facilitated Lebanon’s race to the bottom.

Any honest assessment of the current situation entails a realisation that there is no way out without losses. What remains to be determined is who will bear the brunt of those losses.