Report by S & P Global Ratings
On Aug. 23, 2019, S&P Global Ratings affirmed its ratings on Lebanon (B-/Negative/B). In our view, the central bank's foreign currency (FX) reserves remain sufficient to fund the government's borrowing requirements and the country's external deficit over the next 12 months. However, we believe there is a risk that customer deposit flows, particularly by nonresidents, could continue to decline, resulting in an accelerated drawdown of FX reserves that would test the country's ability to maintain the currency peg to the U.S. dollar. A continuation of these trends during the next six months could trigger a downgrade to 'CCC' rating category.
Below we address key questions posed by investors regarding Lebanon's FX position, and provide our view on the country's ability to meet FX payments.
How does S&P Global Ratings calculate Lebanon's usable reserves?
We estimate that Lebanon's usable reserves will decline to $19.2 billion by end-2019, from $25.5 billion at end-2018. The table below outlines our calculations of gross and usable FX reserves.
Our calculation of gross FX reserves includes gold but excludes Lebanese Eurobonds held on the balance sheet of the central bank, Banque du Liban (BdL). The government has directly issued Eurobonds to BdL–including $1.75 billion in November 2017 and $5.5 billion in May 2018–and swapped local currency treasury bills on BdL's accounts for the U.S.-dollar equivalent. We view these transactions as an accounting procedure that does not generate foreign currency until the Eurobonds are issued to investors. We therefore deduct the residual unsold amount on BdL's balance sheet from FX reserves, which stood at $2.9 billion at end-June 2019.
How does S&P Global Ratings view the quality of Lebanon's FX reserves?
BdL's financial engineering operations, implemented four times since 2016, were intended as stopgap measures to shore up FX reserves and improve the capital position of banks by offering them large incentives, including high interest rates on U.S.-dollar deposits and certificates of deposit (CDs). Foreign reserves have declined nonetheless, but could have reduced further without these measures. These operations have, however, created offsetting liabilities in the form of FX deposits placed in BdL by domestic commercial banks, and diminished BdL's net FX position. Theyhave also come at a high financial cost to BdL. We estimate BdL's net FX position (gross FX reserves minus gross FX liabilities, excluding public sector liabilities) will reach $2.0 billion at end-2019, down from an estimated $11.5 billion at end-2018. After adjusting for the monetary base, we estimate the net position would be about negative $6 billion at end-2019.
Although BdL's net FX position is notably weaker than its gross levels, we note that these liabilities are mainly in the form of long-term U.S-dollar deposits and CDs. After deducting our estimate of BdL's FX liabilities maturing in 2019 from usable reserves, we estimate that reserves of slightly above $13 billion would be available for debt servicing at end-2019.
What is S&P Global Ratings' assessment of Lebanon's reserve adequacy?
In the near term, we expect Lebanon's FX reserves, along with other external inflows, will remain sufficient to finance our projected current account deficit of about $13 billion in 2019, and upcoming government FX debt service obligations in November 2019. These comprise a Eurobond maturity of $1.5 billion and coupon payments of about $1 billion.
We estimate that usable reserves, as defined by our criteria, can cover about seven months of current account payments (CAPs), and about 42% of short-term debt (original maturity; mostly comprising nonresident deposits) in 2019. The generally accepted minimum adequacy thresholds are about three months of import cover (our measure of CAPs coverage is more conservative), and 100% coverage of short-term debt ("Greenspan-Guidotti" rule).
We expect Lebanon's adequacy metrics will steadily decline through 2022. Drains on reserves include large external financing needs, repayment of Eurobonds given impaired market access, and rising dollarization levels. However, as according to our forecasts, usable reserves will still cover three and a half months by 2022.
The traditional adequacy thresholds stated above suggest that while Lebanon's FX reserves remain sufficient for immediate financing obligations, they may not be adequate to cover significant outflows of nonresident and resident deposits.
It is difficult to assess what level of FX reserves would cause confidence in Lebanon's currency peg to collapse, resulting in a widespread run on deposits. In the event of a currency devaluation or an end to the dollar peg, we believe Lebanon's debt levels and debt-servicing requirements would soar substantially, significantly increasing the risk of payment default. A de-peg would also carry other material economic and social costs.
BdL's overriding aim is to maintain the currency's peg to the U.S. dollar, which has been in place since 1997. Lebanon faces pressure to maintain sufficient levels of FX reserves to preserve confidence in the currency peg if levels of remittance inflows, nonresident deposits, and foreign direct investment do not improve.
How can Lebanon reverse the decline of its FX buffers?In our view, the government's short-term implementation of announced fiscal and economic reforms could support nonresident depositor and foreign investor confidence. External support, such as the partial disbursement of $11 billion pledged at the Cedre conference by international donors in April 2018, or other financial support from Gulf Cooperation Council countries, could also provide a strong confidence boost and support infrastructure investment in the country.
Here are a few benchmarks that would gauge the ability and willingness of the government to implement structural reforms to reduce the large budget gap, and improve business activity:
– Fiscal performance during 2019. While we do not expect the government will meet its fiscal deficit target of 7.6% of GDP, a significant deficit reduction from 11% in the previous year could urge some donors to disburse pledged Cedre funds.
– Ability to pass the 2020 fiscal budget before the end of this year. Authorities have indicated that the new budget will encompass major changes to the pension system and public sector, as well as new procurement, customs, and tax evasion laws.
– Steps to implement the medium-term energy sector plan to improve electricity generation and Electricité du Liban's financial position. This includes a significant reduction in the technical losses and successful tenders of new power plants in the next few months.
If the government fails to implement substantial reforms, or if geopolitical tensions were to escalate, the decline in Lebanon's FX reserves could accelerate and the country's ability to repay its financial liabilities could deteriorate further, in our view.