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Lebanon's mounting woes spark red flags in the bond market

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      By Global Income Team, Eaton Vance Management

      Beirut - For the past seven years, Lebanon has scrounged by with an economy based on finance, tourism, construction, remittances and investors attracted by high deposit rates.

      As the economy muddled along, Lebanon has always prided itself on the ability to guard its financial stability from its often tumultuous politics and geopolitics. But that reputation has taken a hit lately, as last May's general election - the first in nine years - has yet to yield a government. In a concerning new development, the Amal party has been using the language of "economic crisis" to advance its negotiation position.

      With this kind of rhetoric in the background, combined with the steady recent decline in the country's fundamentals, the bond market is signaling its concern with widening credit spreads on Lebanon's debt. The country's woes can't be pinned on one particular event, but corruption, turmoil in the Arab world since Arab Spring and the Syrian war have all taken their toll. We are in Lebanon for due diligence, assessing the country's capacity to rebound.

      According to IMF and Banque du Liban, construction activity fell almost 30% year over year in the second quarter, and bank lending to the private sector has dried up as deposit growth has slowed. Real GDP growth has fallen from about 3% in 2013 to 1.2% last year. The government debt-to-GDP ratio has steadily climbed to 150% in 2018, up from 130% in 2012, and the International Monetary Fund estimates it is on a trend to hit 180% in five years. Budget deficits and inflation have been increasing.

      To bolster reserves, the central bank in 2016 introduced a complicated debt-switching scheme that effectively allows it to offer extremely high interest rates to attract foreign currency. This did gain some traction initially, but the costs to the economy are mounting. Confidence is deteriorating rapidly as FX deposit growth continues to fall.

      Bottom line: Locals are proud to state how resilient Lebanon's financial system is. But we believe it is a dangerous game to constantly test this. Bond spreads are sounding the alarm that the status quo is unsustainable. In our view, Lebanon is one shock away from serious trouble.