• Fiscal & Budget
    Apr 01, 2020

    Why Lebanon's Debt Problem Is Super Hard to Sort Out

    • Ishac Diwan
    Why Lebanon's Debt Problem Is Super Hard to Sort Out
    The local saying, Ahliyye Mahalliye, meant to imply that internal problems can easily be solved in the family, is increasingly being used to depict our multiple crises. But in reality, the fact that Lebanon’s public debt is largely owned by local banks makes our debt problem much harder to resolve than if it was largely owned by foreign creditors instead. I will argue first that because our debt problem grew up “in the family”, it was allowed to fester and become really large; second, that family problems can be harder to solve than disputes with neighbors; and third, that wrong remedies risk being administered that will in fact make things even worse.
    The first point is about the size of public debt. Lebanon’s debt is extraordinary large—very few countries have been able to reach a debt ratio of 150% of GDP without defaulting. The reason why debt grew so much is that it has been, until recently, negotiating with a handful of domestic banks only. After economic growth plummeted after 2011, and as the state continued with its highly irresponsible fiscal and monetary policies, each bank had too much skin in the game to consider exiting the relation and, as a group, it was in the banks' interests to continue rescheduling debt, betting on the upside and hoping for a miracle.[1]
    The crisis finally exploded when some depositors lost trust in the system and started withdrawing their funds, causing a bank run by the second half of 2019. According to recently leaked data from the National Institute for the Guarantee of Deposits, about $28 billion of deposits were withdrawn during 2019, 98% of which by the top 1% depositors.[2] The run revealed to the less informed depositors that most banks were insolvent, as more than 70% of their assets are invested in government paper. We have moved in a few months from one extreme to another: From a situation that favored over-borrowing, to a banking crisis in which it is very complicated to resolve the resulting debt overhang.[3]
    The second point is about the difficulties of solving family problems. There are two main reasons why internal debt can end up causing a graver crisis than one generated by external debt. First, in a debt overhang, a larger share owned to foreigners allows to share a greater part of the burden of default with external actors. Second, when internal debt is owned to local banks, as in the case of Lebanon, the overhang metastases into a banking crisis, which can impose very high costs in lost economic output.
    This is confirmed by global experience. Comparing all external debt crises, Reinhart, Reinhart, and Rogoff compute the cost of debt overhang in terms of lost output at 24% of the GDP on average over history. In comparison, looking at all the recent banking crises, Lavens and Valencia find an average loss of 34% of the GDP. While the two sets intersect to some extent, the point is however clear: External debt crises have tended to be less costly than internal banking crises.
    The losses in the value of public debt, now more apparent after the moratorium on Eurobonds of 7 March, need to be distributed among taxpayers, state employees, bank owners, and depositors small and large. These losses are huge, if as suggested by Eurobond prices, debt is to be cut by about two-thirds. Because the ongoing devaluation reduces real GDP, these losses can be estimated to be of at least the same magnitude as GDP, and probably more. This is manyfold larger than the magnitude of losses absorbed by society in other cases around the world. Thus, one can expect that allocating the losses will be extremely divisive and politically difficult. In the meanwhile, the banking sector will remain hostage: As long as the losses are not allocated, the banks' balance sheets cannot be cleaned up, banks will not re-open, and capital flows into Lebanon cannot be re-attracted. This is a super hard problem—complicated to solve, and costly not to solve.
    The third point is about pitfalls to be avoided. Given the challenging politics ahead, decision makers will be tempted to pick politically easier routes, rather than economically and socially efficient solutions. So, moving forward, there are many pitfalls to avoid. Here are three prominent ones that we are grappling with these days:
     1- If decision makers myopically advantage the short term, they will be tempted by a shallow debt reduction, not enough to solve the debt overhang. This will lead to low growth and the need for more debt reduction in the future. Many countries got stuck in such high debt-low growth situation for years—Latin America lost a full decade in a slow adjustment mode in the 1980s, as did Greece more recently. In contrast, countries in Asia recovered rapidly from their crisis in the late-1990s. Ideally, debt reduction has to be so deep to allow the country to credibly promise to never to do it again, so as to be able to attract again and rapidly the capital flows and investments necessary to rebuild the economy.
    2- One tempting method to avoid a transparent allocation of losses is to force a liralisation of dollar deposits (75% of total deposits), which together with rising inflation, would reduce the real value of deposits rapidly, as what happened in Argentina in 2001, and in Lebanon in the mid-1980s. This would be distributionally disastrous, taxing small depositors as much as large ones, and advantaging banks’ owners. This would also lead to many more bankruptcies among private firms than necessary. Losses should be allocated instead in a transparent and socially fair fashion.
    3- Until the banking sector is restructured, banks will remain distressed. There will be no credit to the real economy, and all transactions will take place in cash. Moreover, it is well known around the world that insolvent (or zombie) banks are tempted to gamble with depositors' funds: They have no capital left to lose if the bet goes sour, and much to gain on the upside. In similar circumstances, their management is taken over by regulators until their balance sheets are repaired. If the cleaning up of banks is delayed, then they need to be put rapidly under temporary state control. This means that the Central Bank needs to be reformed quickly and staffed in a meritocratic rather than political manner so that it can fulfill this new responsibility.
    Other pitfalls include refusing to negotiate with the IMF in spite of the urgent need for fresh money, allowing the banks to manage capital controls by themselves, adopting populist spending strategies that are unaffordable, or pledging national assets and future gas receipts to shore up banks at the detriment of citizens.
    Ahliyye Mahalliye? Quite the opposite unfortunately. Family problems are hardest to resolve because, unless the solution is perceived to be fair, its members cannot continue to live together harmoniously. It is high time to start talking honestly about loss-sharing, avoid complicating an already dramatic situation, and take the decisions needed to put the country on a new path that can rebuild a future.
    Laeven, L., and F. Valencia. 2013. ‘The Real Effects of Financial Sector Interventions During Crises.’ Journal of money, credit and Banking 45.1. pp.147-177.
    Reinhart, C., V. Reinhart, and K. Rogoff. 2012. ‘Public Debt Overhangs: Advanced-Economy Episodes Since 1800.’ Journal of Economic Perspectives 26.3. pp.69-86.

    [1] While economic growth was modest until 2010 for a country catching up after a civil war, at 5.7% between 1995 and 2011, this was sufficient to start reducing the debt ratios after 2005. However after the start of the Syrian war, growth collapsed to about 1.7% between 2011 and 2019.
    [2] The information was leaked in a tweet by financial journalist Mohammad Zbeeb.
    [3] A debt overhang is defined as a situation where the debt is too large to be fully repaid.
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