The global credit rating agency FitchRatings has downgraded Lebanon from B- to CCC over “intensifying pressure” on the country’s financing model and an increasing reliance on “unorthodox” measures to attract currency inflows.

The drop from junk into distress territory came as Standard & Poor’s on Friday maintained Lebanon’s rating at B- after a week of speculation that it too would downgrade the Middle Eastern country, whose debt to GDP ratio is over 150%.

“We will deal responsibly with the reports,” Lebanese Minister of Finance Ali Hassan Khalil told Reuters in the wake of the decisions. “We are confident we will be able to get out of the crisis.”

Lebanon has never failed to honor its debt obligations.

Fitch acknowledged that the “close-knit nature of the financial sector,” namely the interdependence among the banks, monetary authority and state, as well as non-resident deposits being mainly from a heavily invested diaspora, has helped the government stay afloat.

This may not hold, the ratings agency cautioned.

“The downgrade reflects intensifying pressure on Lebanon’s financing model, increasing risks to the government’s debt servicing capacity. Downward pressure on banking sector deposits and central bank foreign reserves and increasing dependence on unorthodox measures by the central bank to attract inflows illustrate increased stress on financing,” Fitch said Friday.

The unorthodox measures refer to a practice that has come to be known as “financial engineering” whereby the private banks provide the central bank, Banque du Liban, with foreign currency to shore up its reserves and pay off the country’s debt, in exchange for profits in the form of steep interest rates.

“Recent financial engineering operations have placed an increasing financial burden on BdL’s Lebanese pound operations,” Fitch said.

The Lebanese state is heavily dependent on financing from the central bank to keep up its debt and Eurobond payments.

“With the current account deficit at 20% of GDP, we forecast BdL’s gross FX reserves (excluding gold and other foreign currency assets) to decline to around US$29 billion by end-2019,” Fitch said.

It predicts that negative trend will continue in the years to come, with foreign reserves dropping $3 billion per year. Despite the negative trajectory, Lebanon lacks a “credible medium-term plan” to stabilize its debt to GDP ratio.

A man reads a copy of the Lebanese local English-language newspaper The Daily Star in Beirut. The paper refrained from publishing news articles in its print edition on August 8 in protest against the ‘deteriorating situation’ in Lebanon. Photo: AFP / Joseph Eid

Warning signs

The peg of the Lebanese pound to the US dollar has long been upheld as the key guarantee of stability, serving to attract high-interest deposits in the local currency.

But over the past year, there have been growing concerns that the sacrosanct peg may not hold indefinitely.

Even Standard & Poor’s, which maintained Lebanon’s B- rating, said: “Continued weakness in foreign currency inflows and the use of [central bank FX] reserves to meet government debt-service could test the country’s ability to maintain the currency peg.”

October saw a major run on Lebanese pound accounts, with more than half a billion dollars worth of funds reportedly transferred to dollars.

“Dollarization reached 71.5% in June, up from 68% a year earlier,” Fitch said.

Foreign exchange deposits rose 3.6% year-on-year in June – not due to fresh inflows, the credit agency noted, but because people converted their accounts from the local currency into dollars.

In the wake of the Fitch downgrade, Finance Minister Khalil sought to downplay fears about the viability of the peg, warning against those who “play with” the confidence of the Lebanese in their currency.

“We are confident in the capacities of the nation, the central bank and the lira [Lebanese pound] to maintain its value,” he said on Twitter. 

Drones over Beirut

The risks to the Lebanese economy are related not only to its financing model, but also to political factors.

The country has yet to unlock $11 billion in  funds pledged 16 months ago by international financial institutions and partners CEDRE (Conférence économique pour le développement, par les réformes et avec les entreprises), a failure that’s a symptom of persistent gridlock and wrangling among various political factions.

The US “maximum pressure” campaign against Iran extends to Lebanese Hezbollah, which participates in the cabinet of Lebanese Prime Minister Saad Hariri and the government as a whole. The Lebanese ministry of health – a major recipient of international aid – was in January placed under the stewardship of Jamil Jabbak, a physician close to Hezbollah.

The downgrade represents a message from Washington, according to a Hong Kong-based analyst speaking on condition of anonymity.

“Lebanon can continue using its peg to the dollar to generate funds, so long as no sanctioned currency or entity is benefiting and getting clean cash,” he said, referring to Iran and its Lebanese ally Hezbollah.

Regional rivalries, including between Saudi Arabia and Iran as well as Israel and Hezbollah, are all “material” risks to the Lebanese economy, Fitch said.

In November 2017, the Lebanese premier resigned under duress from Saudi Arabia, sparking fears of a new phase of aggression between the oil-rich kingdom and Iran with Lebanon as the battleground.

The risks of open conflict with Israel were driven home over the weekend, when two drones – found to be Israeli by the Lebanese military – entered the southern suburbs of Beirut. The first one, a surveillance craft, was brought down by local residents according to the Hezbollah secretary-general, while the second – which was armed – exploded near a media station. It was not clear if the second drone was sent to destroy the first or to attack the station.

Hezbollah Secretary-General Hassan Nasrallah called the drone incursions a “major breach of the rules of engagement” and vowed that his forces would now change their posture and shoot down any Israeli drone flying over Lebanese airspace.

Nasrallah further warned that his fighters would no longer confine their attacks on Israel to the relatively isolated Shebaa Farms, but would attack from any location along Lebanon’s border with Israel.

This could mean ambushes of border patrols or attacks on military bases and installations inside Israel proper,” tweeted Amal Saad, a Lebanese University professor who has a forthcoming book on Hezbollah’s transition from a local resistance group to a regional actor. 

Israel did not comment on the drone incident, but its warplanes in the past three days have carried out multiple strikes against Iran-allied groups in Iraq, Syria and Lebanon, an apparent escalation met with approval by US Secretary of State Mike Pompeo.