Lebanon's worst bond market shock in a decade has raised doubts about whether the country's banks are willing and able to continue to bankroll the government, raising pressure on Beirut to step up reforms or risk a destabilising currency crisis.
In September the cost of insuring Lebanese sovereign debt against default soared to its highest level since the global financial crisis of 2008, implying a more than 40 percent chance of default in the next five years. Many of the government's dollar-denominated bonds hit record lows, while yield spreads over US Treasury debt scaled historic peaks.
The panic was triggered partly by a wider selloff in global emerging market debt. But when Lebanon's international bonds have fallen in the past, local banks could typically be relied upon to buy up the securities. Not so this time.
"When foreign entities found out Lebanese banks were selling their portfolios heavily, they started to dump theirs," said Marwan Mikhael, chief economist at BlomInvest Bank in Beirut.
Anthony Simond at Standard Aberdeen Asset Management, pointed to a shift in the bond holder structure. "In the past, local banks were the marginal buyers of the Eurobonds, always. So Lebanon used to really outperform in down markets, because you always had that bid as a backstop," said Simond, a London-based investment manager.
Just over two years ago, Lebanese banks held just under $20 billion of the country's Eurobonds. By July, those holdings stood at just over $16 billion, having fallen to $13 billion in April while the overall debt burden has been rising. The waning of local banks as reliable bond buyers shifted markets' attention to Lebanon's credit quality when pricing its debt, said Simond. "And the story isn't great."
Lebanon suffers from persistent budget and current account deficits. Credit ratings agencies have classified Lebanon as sub-investment grade - or junk - on a par with Egypt or Angola. S&P Global Ratings warned in August that debt levels would continue to rise from already high levels. In June, the International Monetary Fund sounded the alarm, urging Beirut to make "immediate and substantial" fiscal adjustment.
With growth low and traditional sources of foreign exchange - tourism, real estate and foreign investment - undermined by years of regional tension and war in neighbouring Syria, Lebanon is now relying more on the billions of dollars expatriate Lebanese deposit in local banks. The central bank has been offering high returns to commercial banks depositing dollars, and since mid-2016 has conducted a series of complex financial operations - including debt exchanges with the Ministry of Finance and financial swaps with banks - to obtain even more dollars, helping it to shore up hard currency reserves.
Yet this has reduced the amount of additional hard currency banks can plough into sovereign Eurobonds. "Do they want to add another $20 million or $50 million (to their holdings)? Probably not, and that makes a huge difference in this market just now," said Simond.
Lebanon has prioritised high FX reserves to defend its two-decade old currency peg, which came recently under pressure following the shock resignation of Prime Minister Saad al-Hariri in November. Since then, central bank foreign assets, excluding gold, recovered what they had lost defending the pound to hit an all-time high of $45 billion at the end of May, before tapering to $43 billion by mid-September.
Over the past few days, the debt market has calmed down somewhat. Five-year credit default swaps fell back to just over 700 basis points from a peak of 803 bps in mid-September, though they ended August at 642 bps. Yet foreign investors are trying to gauge the risks if Lebanese bonds face more weakness, which could make it difficult for the government to tap markets abroad at affordable rates.