What's happening to Lebanon's credit rating?

What's happening to Lebanon's credit rating?

Lebanon has a new government with a bold programme for economic and budgetary reform. Meanwhile, the war in neighbouring Syria is winding down. This contrasts starkly with the position a few years ago when, for an extended period, the country had no government and no budget, and faced an influx of millions of Syrian refugees as war raged next door. 

So why, over the course of this year, have two rating agencies downgraded Lebanon, while a third maintains a negative outlook? 

When Fitch took its rating to CCC from B- on 23 August, it cited increasing dependence on "unorthodox measures by the central bank" to attract inflows as a sign of inceasing stress on public financing. While recognising recent policy initiatives to reduce the budget deficit, Fitch said that a "credible medium-term plan to stablise government debt/GDP is lacking." 

Fitch added that commercial bank deposits (excluding public sector deposits) had fallen in the first half of 2019, with the increase in foreign exchange deposits attribuable to conversions from local  currency, rather than foreign exchange inflows. 

Fitch's analysis – and its decision to downgrade – takes into account the formation of the government, the contents of the budget, and first impressions of the government's reform initiatives, such as the plan to eliminate the deficit of Electricité du Liban, which has amounted to about 3% of GDP in recent years. 

In contrast, Moody's decision to downgrade earlier this year was taken before the formation of the government and appeared to be driven by some specific semi-official statements rather than underlying factors. 

In December 2018, Moody's had changed the outlook on its rating to negative from stable, but left the rating itself unchanged at B-. The changed outlook reflected deteriorating financial ratios, but the change to the rating, five and a half weeks later, was driven by a higher possibility of default as a result of policy measures. Moody's press release announcing the downgrade noted the, "heightened risk that the government's response to the increased liquidity and financial stbility risks will include a debt rescheduling..."

A few days before Moody's rating action, Finance Minister Ali Khalil had been quoted in a local newspaper saying that Lebanon might restructure its debt, although he quickly back-tracked and said that the goverment was committed to making all payments on time.

S&P's statement on 23 August, confirming the negative outlook on its B- rating, explained that the outlook, "reflects that we could lower our ratings on Lebanon in the next six - 12 months if banking system deposits and the Banque du Liban's...foreign exchange reserves continue to fall." On the other hand, improved foreign investor confidence, arising from credible steps to implement fiscal consolidation and medium-term electricity sector reform plans could lead the outlook to be revised to stable, S&P said.

If you talk to many Lebanese, they believe that the formation of the new government and the composition of that government represent a turning point. They also believe that this new government is both committed and able to implement fiscal and budgetary reforms in a way that previous governments were not. 

But optimism is one thing (and Lebanon always has an abundance), while debt service ratios and bank deposits are another. There's no refuting the fact that debt ratios have declined in recent years. Furthermore, optimism is nothing new. Since the country came back together in the early 1990s – the civil war ended in 1990 – minister after minister has explained why his new initiative is going to turn the page on the old way of doing things. I remember being told by Basil Fuleihan, who was then an official in the Finance Ministry, how a new system of taxation would finally lead to higher receipts. That was in 1996, and yet the low level of tax receipts remains one of the biggest budgetary challenges today. (Fuleihan, a decent and highly intelligent man, was sitting beside Rafik Hariri when he was assassinated in 2005, and died of his wounds.)

Lebanon can of course point to its track record over the last 25 years. Despite periodic financial crises, Israeli agression, domestic political gridlocks, and war in Syria, the country has never defaulted and, incredibily, its exchange rate has remained stable at $1 = LP1,500. Anyone who has visited Lebanon over the course of the last 25 years cannot fail to have noticed the imprroved infrastructure and the higher disposable income of middle class Lebanese. 

But sovereign credit ratings focus on whether a country will be able to repay its debts, not the quality of the roads or the opening of a fancy new supermarket, apparently modeled on Whole Foods, downtown.

Lebanon's financial ratios are among the weakest in the world and it is hard for a rating agency to make an exception – in the form of a higher rating – when these objective indicators place the country squarely within a certain rating peer group. Making an exception is even more difficult when decades of public commitment to economic reform have had little appreciable impact on the budget or fiscal deficits. 

From the rating agencies' perspective, Lebanon only needs to slip once – and default – for ratings of C, or lower, to be correct. As debt ratios become even more stretched, it becomes harder for the agencies to believe that such a slip could never happen.