Eurobonds 2020, paying vs defaulting vs buying vs swapping

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As a result, some big insurance companies will close doors with customers losing their life insurance savings, while bankrupt banks will be taken over by the Central Bank for liquidation (or sale) purposes

by Nicolas Chikhani -Source: Annahar

In this photo released by the Lebanese Government, Lebanese President Michel Aoun, center, meets with political and financial officials to discuss the economic situation, at the Presidential Palace in Baabda, east of Beirut, Lebanon, Thursday, Feb. 13, 2020. (AP Photo)

In the current financial crisis, can the Government still honor its Eurobonds due in March 2020? And in case the State decides to default, why then did it pay circa USD2bn to service the Eurobonds debt in Q4 2019 ?

Currently the March 2020 Eurobonds market price trades at less than 50% while longer ones are even way cheaper, and some have even reached the 30% threshold. This means that Eurobonds holders have lost a big part of their initial investment.

In a scenario, where the State of Lebanon decides NOT TO PAY the Eurobonds due in 2020, the price of such bonds will drastically drop, while the price of the ones with a later maturity will reduce even further.

Foreign investors, Lebanese Banks, Insurance companies and the Central Bank holding such bonds will be “forced” to immediately take provisions and account for future potential losses in full compliance with IFRS9. In Lebanon, Insurance companies hold circa USD1bn of Eurobonds and Banks’ holdings is estimated at USD15bn (excluding any recent sale of bonds to foreign entities); when compared to their respective equity, such provisions will lead Banks and Insurance companies to be considered as technically bankrupt, and the Central Bank which also hold Eurobonds will have its financial stability at stake.

As a result, some big insurance companies will close doors with customers losing their life insurance savings, while bankrupt banks will be taken over by the Central Bank for liquidation (or sale) purposes and their depositors could stand to lose most of their deposits. As a consequence, the economy would halt for a while as a result as nobody would be (is) able to financially transact without a banking sector.

In addition to that and in a worst-case scenario, foreign Eurobonds holders could also raise “Class Actions” against the Lebanese Government: An international court could freeze (for collection purposes) state assets outside the country such as Gold deposited in the US (as the Central Bank in view of its specific structure could be assimilated to a Government entity and hence would be jointly liable along with the Government – see “note” below). Finally, the Lebanese Government solvency reputation would be at stake a matter which would adversely affect its rating and shake international stakeholders’ trust. This makes even more difficult the set-up of any economic plan to enable growth or attract “fresh” funding, and thus save the country.

On the other hand, if the Lebanese Government decides TO HONOR its Eurobonds due in 2020, it can only achieve this through pulling funds from the Central Bank foreign reserves since the Government is in deficit and hence has inherently no funds. Reducing the “usable” foreign reserves to service the debt will on one side put more pressure on the Lira peg and on the on the other will diminish Government capabilities to cover the foreign currency needs required for the trade balance basic imports (food, oil and medicine…). In this scenario, ultimately, the money paid to honor the Eurobonds due in 2020 will be unfairly penalizing depositors. Indeed, the payment process will end by “sucking” depositors’ money to pay-back the Government, the Central Bank and banks failures, together with the cumulated shortcomings of mismanagement and “unwise” governance over the last 30 years.

Last, paying means that the Government accepts the decision of some banks that have sold their 2020 Eurobonds to foreign investors at 70 to 80% pull fresh liquidity and avoid an adverse P&L impact of a possible “swap” mechanism (while promising by the same token to new buyers that the Government will still be honoring those at 100%); a selfish behavior to say the least which increases Eurobonds “foreign holdings” and complicates much further any Eurobonds debt resolution.

The best solution to recommend is that the Government FIND FUNDS (either locally or through a private foreign investment) and BUY-BACK the bonds at market price (<50%). Alternatively, find 1 fund which will bulk-buy the bonds and strike a well-defined swap deal with the State. Another approach could be to have Government highlight default while promising to pay part of 2020 dues (such as part of the interests), thus gaining power to initiate negotiations and to propose a SWAP of the bonds against longer maturity ones at lower interest. If achievable, either solution could represent a good alternative, as it will cost less and slowly reduce both Government debt and State deficit giving a strong positive signal to the international community. Although these two approaches (buy or swap) would be considered as a “default signal” by major rating agencies, and even if such solutions would reduce Banks profitability in the short run, they will still have a positive impact on addressing the Eurobonds dilemma.

In Summary, defaulting without a strong strategic backup-plan to hedge the risks on financial institutions is clearly a suicide. On the other hand, paying will reduce the foreign reserves which could shake the lira peg and reduce import capabilities. It will also unfairly treat depositors while legitimating the selfish behavior of some Banks. Between the bad and the worse, the best option remains to buy-back or to swap the bonds; two mechanisms that could drastically reduce the Eurobonds debt impact on the country in readiness for a full solution to the financial crisis.

Note: The Lebanese Central Bank is an independent decision-making entity; however, its capital is totally appropriated by the State. Ultimately the State owns the Central Bank, hence owns all what the Central Bank owns. In such case the Central bank “could” be considered as jointly liable with the Lebanese State in case of defaulting.

Nicolas is an economist and banker. He is a Harvard Business School graduate and the former CEO of Arab Bank Switzerland.

 

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