Lebanon's Ponzi scheme likely to hit investors when it collapses

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      By Emerging Markets Debt TeamEaton Vance Management

      Boston - Throughout its politically fractious history, Lebanon has racked up one of the world's largest debt burdens, while still managing to meet its obligations to creditors and maintaining its reputation as a Middle East banking hub. The country paid its bills yet again last week — a eurobond of $1.5 billion plus the coupon matured on November 28 — but investors are skeptical that Lebanon will continue to find it a good idea to do so.  

      For a long time, Lebanon has relied on investment from abroad — principally citizens who leave to work in neighboring countries and send their U.S. dollar earnings back to Lebanon to earn high interest on their deposits.

      But this reserve stream has slowed, as Lebanon has recently endured widespread protests stemming from decades of government corruption, low economic growth and high unemployment. The government also has borrowed heavily from local banks and institutional investors to bolster reserves and pay back existing creditors.

      The central bank has created a hole in its balance sheet to pay depositors, depleting foreign exchange reserves, while the country's heavy reliance on imports compounds the problem. The central bank has been forced to pay increasingly high rates to keep attracting new depositors and repay bond investors, without economic growth to back it up — in effect, creating a Ponzi scheme.

      But Ponzi schemes eventually collapse and the question then becomes, who will bear the brunt? Depositors, local banks and institutional investors are all vulnerable — most likely, all will take losses. Bond prices are currently reflecting such an outcome.

      There is increasing conviction that this situation is unsustainable. Lebanon is being run by a caretaker government, after Prime Minister Saad Hariri resigned on October 29, and there is little sign of leadership or political consensus for reform that might precede any agreement with the IMF for assistance.

      Bottom line: Lebanon has been forced to pay increasingly high interest rates to keep foreign investments flowing into the country. As those reserves diminish, the chance that investors face some variant of default, as in a haircut or reprofiling, becomes increasingly likely.