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February 19, 2020
Should Lebanon Default? A Take by Nada Mora

Nada Mora lecturer at the Lebanese University and is an LCPS senior fellow.

Lebanon needs unified debt restructuring along with bank recapitalization

As part of its effort to build constructive dialogue on important national issues, LCPS solicited the opinion of key experts who have varying perspectives on whether Lebanon should default. We invite you to read their different views in the next few days.
To evaluate whether Lebanon should default on its international debt—with a Eurobond dollar payment due 9 March—one must weigh the benefits against the costs. For those not familiar with the financial jargon added newly to our daily conversations, sovereign default means debt rescheduling on terms less favorable to creditors, rather than outright failure to pay. When a country’s debt becomes unsustainable, governments reduce spending and increase taxes, and when that is not enough they restructure their debt. Sovereign default is not uncommon: There have been more than 180 international debt restructurings since 1970, and countries typically re-access capital markets within 2-5 years.
What are potential benefits of debt restructuring? The greater the country’s “bargaining power” in debt negotiation, the greater investor losses—or what is known as haircut—it can extract. Losses arise even when debt is rescheduled without face value reduction. There are various benefits to debt restructuring like the reduction of the debt, release of debt-service funds for alternative payments (imports), reduced fiscal austerity in a recession, and in the longer-term, lower borrowing costs as long as debt falls to sustainable levels and growth resumes.
The theory of sovereign default emphasizes the reputational costs this would cause, with the loss of future market access and/or higher borrowing costs. The latest research shows these costs increase with the haircut and last for several years (e.g., bond spreads increase by 250 basis points (bp) in the first year post-restructuring for the average haircut of 37%, remaining 100 bp higher in the fourth and fifth years). Another theory emphasizes sanctions and legal enforcement. However, enforcing sovereign debt is limited. Sovereign bonds like Lebanon’s are issued in financial centers like New York and are subject to foreign jurisdiction. While lawsuits have increased by “holdouts”—bondholders refusing to participate in debt exchange—they have not been successful at judgment enforcement (cannot seize assets such as sovereign property and central bank assets), but holdouts succeed more as nuisance, leading countries to settle out-of-court. In addition, domestic costs, particularly to the national banking system, increase when domestic banks hold sizable international debt, and this is the case for Lebanon. If banks are not well capitalized, debt write-offs increase instability and potential losses to depositors.
If we divide the question into two parts: Should there be debt restructuring? And if so, how large should the haircut be? On balance, yes, Lebanon’s debt unsustainability makes it a candidate for debt restructuring. But it is better to manage restructuring as a unified strategy—domestic currency debt together with Eurobonds—along with bank recapitalization. Doing so provides a higher degree of certainty on the size of expected write-offs, and therefore of the recapitalization needed to avoid default turning into a full-blown banking crisis.
In negotiating over the size of the haircut, Lebanon is also negotiating over its future borrowing terms. Future borrowing costs increase because of reputational cost but the net long-term effect can be lower if debt becomes sustainable. Therefore, higher haircuts have greater benefits but at the same time they cause greater reputational costs, risks to the domestic banking system, and a higher likelihood of lawsuits. Lebanon’s bargaining power in negotiations depends on its ability to pay, the prospect of securing access to other financial assistance, its legal capacity, and how soon it wants to re-access capital markets.
Research has shown that it is not possible to discriminate by defaulting on foreign creditors only, because Eurobonds are traded in secondary markets where foreigners can sell to domestic agents. It may be possible to offer less favorable terms to Lebanese banks because their large holdings cannot be easily sold en masse and the government has more leverage over them. This would however still be considered a selective default by rating agencies. The 2012 Greek restructuring followed a similar approach to avoid litigation by honoring existing bonds to creditors who did not participate in debt exchange.
The only economic advantage of delaying default would depend on the probability of securing financial assistance in the interim to restructure on better terms. Otherwise, concerning the argument of possibly defaulting in April compared to March, this reduces benefits without reducing costs—as costs are longer-term and might increase if “vulture” funds increase their strategic exposure to Lebanon’s debt.
For more details on these and other point made, read here.

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