Country Risk: What Happened to Investors in Lebanon

Country Risk: What Happened to Investors in Lebanon

Country risk is the uncertainty that may harm you financially as an investor when you invest in a particular country. The risk may arise from the country’s political system or economic structure. In financial terms, it shows the possibility of a country falling into a state of inability to pay its debts. For example, if the country you bought the bonds from goes bankrupt, you may not be able to get back your coupon payment or principal. I decided to tackle this subject because of a piece of surprising news I read a while ago.

Maybe you’ve heard of it. Lebanon has been experiencing a severe economic crisis for a long time. Reuters has reached a plan developed by Lebanon’s Government to solve this crisis. According to this plan, the Lebanese Government plans to devalue the local currency by 93% against the US dollar. On the other hand, only $25 billion of deposits in USD will be paid to beneficiaries in USD within 15 years. The remaining foreign currency accounts will be paid by converting them to local currency at different rates. There will be a loss of value of close to 75% in some reports.

Let’s look at what happened to investors who took a country risk.

History of the liquidity crisis

Wikipedia calls Lebanon’s crisis a liquidity crisis. A liquidity crisis means a shortage of cash. In the case of Lebanon, one could call it a shortage of foreign currency or US dollars. The World Bank uses the word depression to describe the crisis. Anyway, let’s not get hung up on words. According to Wikipedia, this crisis became visible in August 2019. So how did this crisis come about?

Unsustainable fixed exchange rate regime

When I was a kid, the Lebanese civil war was indispensable to the leading news bulletin. It was like it had been going on forever. It seemed like it would last forever. Nevertheless, the civil war lasted long ago. However, it appears that Lebanon has a problem of high inflation and devaluation as a result of the civil war. To stabilize the exchange rate and reduce inflation, they pegged the local currency to the US dollar in 1997. Surprisingly, they managed to maintain this fixed exchange rate regime for 15-20 years. Then all of these came to an end suddenly. But how?

Seeking to perpetuate the inherently unsustainable

There must be a constant flow of capital into the country to maintain an artificial exchange rate level. Lebanon provided this capital flow for a certain period. This capital flow has also closed the high current account deficit and increased government debt. On the other hand, the variety of Lebanon’s foreign exchange income sources seems pretty limited. Revenue sources include tourism, real estate, remittances from overseas employees, and financial services. Among those, financial services caught my attention. Hmm. They paid high interest to the dollar deposits of domestic and foreign investors by keeping their identities anonymous.

Financial engineering

However, in 2016, the inflow of foreign currency to the country decreased drastically. The Central Bank of Lebanon solved the foreign exchange deficit by swapping Eurobonds with local public debt. I mean, the bank did financial engineering. Thus, they postponed the liquidity crisis to the future. Moreover, they continued to apply this method in the following years. But the cost was too high. According to the estimates made by the IMF, they paid a 40% return or interest in dollar terms to the other party for this swap!

End of the story

Despite all these genius ideas and inventions, the foreign exchange supply could not meet the foreign exchange demand. At the end of 2018, commercial banks began restricting access to customers’ foreign currency accounts without explanation. They have implemented high surcharges to prevent customers from withdrawing dollars from their accounts. Such problems continued to increase. The probability of the Lebanese state’s inability to pay its debts has also increased. As a result of these developments, official rates and market rates (black market) have started to diverge since 2019.

Exchange rate and inflation

Naturally, the market exchange rates have increased rapidly. The exchange rate (Dollar/Lebanese Pound) rose from 1,600 to 3,000 between 2019 and April 2020. In the following year, it reached 15,200. According to Reuters, the market rate hit 34,000 in the past weeks and then retreated to around 21,000 with central bank intervention. Let’s add that inflation reached triple digits with the rapid depreciation of the local currency. Food prices increased by 500-600% within a year. Of course, exchange rate pass-through is not the only source of inflation. Not to mention that they had to close their budget deficits by printing money. Deteriorating expectations after a while filled the wind of inflation.

Country risk means

As of today, the country cannot pay its debts. The Lebanese Government cannot make the due coupon payments of the Eurobonds it has issued. Savers who have accounts in Lebanese banks cannot get their money back. The country’s entire financial system has collapsed. According to the World Bank, the Lebanon crisis can be counted among the three most difficult situations since the 19th century. They are trying to negotiate with the IMF. However, the financial system has a total loss of $69 billion. This loss must be split between investors, depositors, banks, and the Government. However, the parties cannot come to an agreement. I mentioned the new plan of the current Government on this issue at the beginning of the article.

How did Lebanon get into this situation?

According to the World Bank’s report titled The Great Denial, it was none other than the country’s political elite that created the crisis. These political elites took over the state machinery a long time ago. They continue their lives on the economic rents provided by their political identities. Despite this, these fellows continue to sit at the helm. I don’t know Lebanese politics. Maybe they still have popular support behind them. Perhaps there is no way for the people to remove these politicians from power. I do not know.

Country risk and home country bias

Those living and investing in Argentina, Venezuela and Lebanon were not stupid. However, most of them did not see the tsunami coming upon them. Perhaps they were patriotic people and could not imagine their country falling into this situation. One possible explanation for taking so much country risk may be home country bias. As far as I can observe on social media, most small investors in Turkey have limited their horizons to Borsa Istanbul. People invest in companies they know in a familiar environment. So they usually restrict themselves to national capital markets. The phenomenon is called “home country bias” in the literature.

Today, individual investors can access the entire global capital market thanks to the advancement in information and communication technologies. There are more than 150,000 financial assets that we can invest in globally. About 43 thousand of this is traded in stock and organized capital markets. The number of stocks traded in Borsa Istanbul is only around 400. If you ask me, an intelligent investor should consider how much country risk he will take. Especially if he lives in an emerging country ruled by populist politicians who care about nothing but their own well-being. What do you think?

Recommendations

Thank you for your interest in breakingthetreadmill.com. Below are some services that I find pretty helpful. It might work for you, too. I suggest you check it out. Best wishes.

You may use Wise to make low-cost money transfers to overseas brokerage houses or to withdraw money at low cost via a multi-currency Visa debit card.

With Interactive Brokers, you can access 135 markets in 33 countries using 23 different currencies. You can trade stocks, bonds, options, futures, FX, and funds at a very low cost. I’ve been using it for about four years. Open an investment account at Interactive Brokers.

 

Breaking the Treadmill Newsletter

Get updates and exclusive surprises

Leave a Reply

Your email address will not be published. Required fields are marked *

Back to top
error: Content is protected !!