Important documents in relationship with Aid Coordination Newsletter Issue 28, March 2010 Eleventh Progress Report-International Conference for Support to Lebanon Paris III more QIII 2009- Public Finance Quarterly Report more Debt and Debt Markets Report QIII 2009 more S&P raises Lebanon Sovereign Ratings To B/B; Outlook Positive more Moody's changes outlook on Lebanon's B2 ratings to positive more

2009 Budget Law Proposal - A Detailed Report more

Recently, a research by Morgan and Stanley has tried to put some numbers on the inflation risks inherent in the current and prospective US fiscal position (see The Return of Debtflation? February 10, 2010). Even if we look at a hypothetical scenario whereby Lebanese policymakers attempt to stabilise debt to GDP at the current 160% level over the next ten years; debtflation is bound to be the next reality .

Interest payments, as a share of GDP, remain constant. True, this is a strong assumption. But even if interest to GDP increases with inflation, we don't think it will be by enough to prevent substantial debt erosion - at least for some time. Here's why.

The Figures released by the association of banks in Lebanon indicate that gross public debt reached LP 77,024 billion , or US $ 51.1 billion , at end -2009, up by 8.7% from end-2008. Net public debt, which deducts public sector deposits at commercial banks and the central bank from gross public debt , rose by 6.3 % from end -2008 to reach LP 66,502 billion , or US $ 44.1 billion by end-2009. The rise in Lebanon’s gross public debt throughout 2009 has primarily been the result of growing local currency gross debt, which totaled LP 44,976 billion ,up by 15.3% from end -2008, while foreign debt increased by a trifling 0.5%

What matters most for successful debtflation, our colleagues rightly point out, is whether the (effective, i.e., maturity-weighted) nominal interest rate on the debt can be pushed below the rate of growth of nominal GDP. Put another way, the question is whether, and for how long, inflation can lower the effective real interest rate on the debt. We believe that's possible for a sustained period: debt does not roll instantaneously; and bond yields are slow to incorporate changes in inflation. These two factors can be thought of as the crucial frictions that allow for debt erosion.

1. Debt maturities

The fact that the whole stock of debt does not roll every period means that the effective nominal interest rate on the debt is slow to respond to an increase in market yields. For the US, average maturity on Treasury debt is poised to exceed the postwar average of about 5 years by the end of fiscal 2012 (September), on our forecasts. The implication is that even if market yields were to adjust instantaneously to the higher inflation regime, effective nominal interest rates on the debt would respond only partially. So there is a debt erosion effect even if inflation were to be perfectly anticipated.

2. Yields are slow to adjust to a new inflation regime

Inflation - especially a change in the inflation regime - is rarely, if ever, perfectly anticipated. Inflation expectations lag behind actual inflation. In turn, bond yields lag behind inflation expectations. Evidence is abundant:

• Historically, yields lag behind inflation. Throughout the 1970s, bond yields never meaningfully caught up with the inflation takeoff: real interest rates were mostly very low - indeed negative for sustained periods - a bad time for bonds. Exactly the opposite happened during the Great Moderation of the 1980s and 90s. The sustained decline in inflation meant real interest rates were high, giving rise to a long bull market for bonds.

This case was strongly demonstrated in the New Eurobond issue which was oversubscribed, and the fact that Treasury bills issuance suspended; the treasury cannot sustain high yields anymore. There is an excess of liquidity in the market that is also coupled with a high appetite for susbscribing in government paper. Hence; the debt is inflated.
The Ministry of Finance declared that it raised its Eurobond issue $1.2bn from $1bn originally due to increase demand, as the issue was three times oversubscribed . The new issue has a 10-year maturity of March 2020 and carries a coupon rate of 6.375% paid semi- annually . Domestic subscribers, mainly commercial banks , accounted for 70% of subscriptions and were allocated amounts on a prorate basis , with the balance of 30% subscribed by non-resident institutions.

This is still high for a country like Lebanon. The ministry previously announced that it is issuing new Eurobonds under the Republic of Lebanon’s Global Medium Term Note Program, and that proceeds will be used to refinance upcoming maturities in March. The government has $2.15bn in Eurobonds maturing this year , of which $1.1bn mature this month .,In parallel , the ministry announced that will suspend temporarily the issuance of Lebanese pound-denominated Treasury bills , as it plans to use its excess liquidity to finance the government’s operations.