Lebanon Should Default On Its Debt Service and Save Its Army Instead

Friday 24 January 202003:23 pm

Lebanon is on the verge of economic collapse that will bankrupt its banking sector and destroy what remains of Lebanese state institutions. While the Lebanese economic, fiscal and monetary problems are manifold, an immediate concern is the crumbling of the peg of the Lebanese pound to the U.S. dollar, which has lasted since 1997. The pound has already depreciated over 40% on the parallel market. Lebanon depends on the fixed exchange rate regime to import necessities such as fuel, wheat, and medicine.

Any import interruptions will inflict a humanitarian disaster on the Lebanese people. Meanwhile, the national security consequences for Lebanon, the broader Middle East and the United States would be dire. Immediate bold steps, both in Beirut and Washington, are needed to avoid this outcome.

Since the Lebanese civil war ended in 1991, the country’s external and internal debt has ballooned. Total government debt is $86 billion -- 150% of the country’s GDP -- making Lebanon the third most-indebted country after Japan and Greece. Lebanese banks—the largest sector of the economy—hold 70% of these assets in the form of Lebanese government and central bank debt. This relationship guarantees that, should Lebanon default on its debt, Lebanese banks’ equity would be wiped out.

Lebanon is saddled with a 35% youth unemployment and a 25% female labor force participation rate. More than 40% of male, and nearly half of all female Lebanese graduates emigrated between 1999 and 2007. Any country losing that much of its youth is doomed

Lebanon’s fiscal dynamics are toxic. Its annual budget deficit is 10% of GDP, or around $6 Billion. Some $14 billion in sovereign debt must be refinanced in 2020 and 2021. The chances that the Lebanese government can refinance expiring debt and continue paying interest on current debt are virtually nil. Price actions from global markets confirm this. The price of Lebanon’s 5-Year Credit Default swap - an instrument which allows investors to offset sovereign credit risk - has spiked close to the unheard level of $2,500. Furthermore, yields on Lebanese U.S. dollar-denominated government bonds/Eurobonds have reached 30%. This is unsustainable as Lebanese government debt interest payments already consume close to half of its budget. Lebanese stocks – which are dominated by banks and real estate companies – have fallen by more than 60% in U.S. dollar terms since January 2018.

The question is “when” Lebanon will default, not “if.” The three international rating agencies have already downgraded its rating to the lowest (or near the lowest) level. And, since no company or bank in Lebanon can have a higher credit rating than the sovereign, Lebanese banks and business are effectively cut off from the global capital markets. Even if they were able to secure financing, the interest rates would be prohibitive. This will soon push Lebanon’s economy into an outright depression.

What this economic snapshot shows is that the Lebanese government is already essentially bankrupt. When it defaults, Lebanese banks would become insolvent. The fate of individual depositors is very uncertain. Capital is already fleeing and banks have responded by imposing unofficial capital controls.

Moreover, as per World Bank statistics, Lebanon is saddled with a 35% youth unemployment and a 25% female labor force participation rate. More than 40% of male, and nearly half of all female, Lebanese graduates emigrated between 1999 and 2007. Any country that loses that much of its youth has no future.

It is imperative that Lebanon default on its debt servicing and ensure the army is paid to keep some form of Government in place.  Per capita, Lebanon has one of the largest armed forces in the world, with a payroll of 180,000 active duty and retired personnel

While economic and banking collapse would visit tremendous hardship on all Lebanese, the most consequential national security repercussions would arise from the disintegration of the Lebanese army for lack of pay. Lebanon has one of the largest armed forces, per capita, in the world, with a payroll of 180,000 of active duty and retired personnel. Many, if not most, already live hand-to-mouth. They cannot afford to go a month without being paid. Even if they do manage to get paid, the expected currency depreciation of Lebanese pound, and inflation that would accompany any collapse of this magnitude, will make whatever they earn essentially worthless.

If the army dissolves, the risk of Lebanon devolving into a Syrian model would be significant. Once Lebanese government collapses, the most organized party on the ground – Hezbollah -- would rise to fill that void. A Hezbollah regime would likely bring increased U.S. sanctions at the worst possible time for Lebanon. Moreover, very few of Lebanon’s neighbors in the region would accept a Hezbollah takeover. They will begin arming anti-Hezbollah factions, fostering a new and bloody civil war.

This catastrophe can and must be averted. To begin with, given the certainty of default— either by missing a coupon payment or failing to refinance expiring Eurobonds—the better approach for Lebanon is to default now. This would save the money that would otherwise be spent on paying coupon on existing debt, so as to maintain the government’s ability to pay the armed forces and other government employees for as long as possible, while a recovery program is put in place.

Broad economic and political reforms are also necessary, accompanied by the recognition that Lebanon’s current ruling class cannot lead the way. Neither the Lebanese people, nor Lebanon’s Western and regional allies or the international financial institutions, has confidence in Lebanon’s existing leadership. In the short term, Lebanon needs a purely technocratic government, made up of civil servants. Political appointees, who have zero experience in the work of their ministries, must be sidelined.

The new government must take aggressive action to recover a large portion of misappropriated public funds. Since the Taif Agreement in 1989, an estimated $90 billion has been looted from the Lebanese treasury by corrupt Lebanese politicians and their cronies. The current fiscal and economic situation in Lebanon is so dire, no international emergency recovery packages can succeed without a major claw back of at least 50-70% of the misappropriated funds. This solution would still entail a very difficult path for Lebanon, but is at least one that would eventually lead to a sustainable recovery. And, eradicating corruption would also put Lebanon on the path to tackle the problems of sectarian violence and seek to rebuild a more harmonious civil society where all ethnic and religious groups can flourish.

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