Frontier Markets

Pakistan’s economy and stock market are currently going through painful but necessary adjustments. The country has been suffering from a severe balance-of-payment crisis. Its exchange rate has already depreciated by 30% versus the U.S. dollar since December 2017. Its stock market in U.S. dollar terms has plunged 55% from its May 2017 peak. A bottom in the stock market is likely to occur when the currency stabilizes. Odds are that the Pakistani rupee is in its late phase of adjustment (Chart III-1). First, a US$ 6 billion worth IMF bailout fund is on its way. The country reached a staff-level agreement with the IMF on May 12. The IMF will release the funds in phases over a period of 39 months. Meanwhile, Pakistan will likely also receive US$ 2-3 billion from the World Bank and the Asian Development Bank (ADB) in the next three years. Altogether, multilateral financing will amount to about US$3 billion per year over the next three years. The country will also likely continue its bi-lateral borrowings from China, Saudi Arabia and the UAE. Last year, about US$10 billion of external borrowing and a nearly US$7 billion reduction in the central bank’s foreign reserves helped fund the US$18 billion current account deficit. Over the next 12 months, we expect the financing needs to be considerably smaller due to shrinking twin deficits (Chart III-2). Chart III-1Pakistan's Rupee: Close To A Bottom? Pakistan's Rupee: Close To A Bottom? Pakistan's Rupee: Close To A Bottom? Chart III-2Twin Deficits Are Likely To Shrink Twin Deficits Are Likely To Shrink Twin Deficits Are Likely To Shrink Both trade and current account balances have started showing improvement in U.S. dollar terms due to a steep contraction in imports. Going forward, we expect export growth to turn positive on the back of currency devaluation but import contraction will deepen. Lastly, the IMF agreement might allow Pakistan to issue some Eurobonds while higher local rates might attract some foreign portfolio capital. Second, Pakistan’s top leadership has cooperated with the IMF. Just earlier this month IMF economist Reza Baqir was appointed the new central bank governor. In addition, the Finance Minister and the Federal Bureau of Revenue chairman have been replaced. These new appointments increase the odds that the IMF program will be enforced in Pakistan. Indeed, after only two weeks on the job the new central bank governor raised the policy rate this Monday by 150 basis points to 12.25%. Meanwhile, significant fiscal consolidation is on the way, as the new policymakers will be committed to the IMF program. The budget for the next fiscal year (June 2019 – May 2020), which will be presented in Parliament on May 24, will likely show a considerable reduction in non-interest expenditures. Finally, the IMF is also pushing for increased central bank independence. In the last 17 months, the central bank purchased massive amounts of government securities – a de facto monetization of public debt. This has exacerbated domestic inflation and currency depreciation. So long as the country is under the IMF program, it is reasonable to expect no public debt monetization. In summary, the ongoing substantial monetary and fiscal tightening and accompanying reduction in the twin deficits, coupled with the increased availability of foreign funding are positive for the exchange rate. It is possible that Pakistan will follow the 2016-2017 Egyptian roadmap. Egypt experienced a severe balance-of-payment crisis and agreed to a similar IMF bailout program. In the case of Egypt, a 55% depreciation in its currency in late 2016 was followed by a 77% rally in share prices in U.S. dollar terms over the subsequent 18 months (Chart III-3). We are putting Pakistani stocks on our upgrade watch list. We are reluctant to upgrade it now because currency weakness might persist for a couple of months. Further, monetary and fiscal tightening will amplify the economic downturn weighing on corporate earnings. Banks’ NPL ratios and provisions will likely rise considerably. Chart III-3The 2016-2017 Egyptian Roadmap The 2016-2017 Egyptian Roadmap The 2016-2017 Egyptian Roadmap Chart III-4Pakistani Equities: A Long-Term Profile Pakistani Equities: A Long-Term Profile Pakistani Equities: A Long-Term Profile Bottom Line: We are putting Pakistani equities on an upgrade watch list. This bourse’s technicals are becoming interesting – it might bottom at its previous highs (Chart III-4). In addition, both absolute and relative valuations of Pakistani stocks appear attractive (Charts III-5 & Chart III-6). Chart III-5Equity Valuations Look Attractive Equity Valuations Look Attractive Equity Valuations Look Attractive Chart III-6Relative Equity Valuations Also Look Attractive Relative Equity Valuations Also Look Attractive Relative Equity Valuations Also Look Attractive We are waiting for share prices and the currency to stabilize before recommending an overweight position in Pakistani equities.   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com

Over the next six to nine months, we believe both UAE equities and corporate spreads will outperform their respective emerging market (EM) benchmarks. The UAE economy is set to improve marginally this year (Chart III-1). It will benefit from expansionary fiscal policy, rising oil output, a buoyant tourism sector, a resilient banking sector and less of a drag from the real estate sector. First, sizable fiscal spending will lead to rising non-oil economic growth. The UAE’s federal budget spending for 2019 will increase by 17.3% from a year ago, much higher than the 5.5% year-on-year growth in 2018. Second, UAE oil output could increase by 15% later this year from current levels (Chart III-2). The U.S. announced on April 22 that all Iran sanction waivers will not be extended beyond the early-May expiration date. The U.S. administration also stated that it has secured pledges from Saudi Arabia and the UAE to increase their oil production in order to offset disrupted supply from Iran. Rising oil output will mitigate the negative impact of potentially lower oil prices on the UAE’s economy. Chart III-1Improving UAE Economy Improving UAE Economy Improving UAE Economy Chart III-2Rising Oil Output Rising Oil Output Rising Oil Output   Third, the outlook for the tourism sector is also positive. The number of tourists is set to rise as Expo 2020 approaches. The government is targeting 20 million visitors in 2020, 26% higher than last year’s levels. The UAE is building theme parks, museums, hotels and infrastructure to attract more tourists. Fourth, the UAE’s banking sector will enjoy rising credit growth, robust profitability and improved asset quality this year. The banking system has been in consolidation mode since January 2016, with a 15% reduction in branches and a 14% drop in the number of employees. This has improved the banking sector’s profitability by cutting operating costs and increasing efficiency. The improving growth outlook will lift credit growth. The central bank’s most recent Credit Sentiment Survey suggests banks’ lending standards for both business and personal loans are loosening (Chart III-3). Chart III-3Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Credit Growth Is Likely To Increase Chart III-4Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers Rising NPLs, But Still Large Capital Buffers   In addition, UAE banks enjoy large capital buffers. Despite rising non-performing loans (Chart III-4), UAE banks still reported a Tier-1 capital adequacy ratio of 17% as of December 2018. Lastly, the real estate markets in both Dubai and Abu Dhabi have suffered from oversupply (from both mushrooming supply and weaker demand) over the past several years. Property prices have already fallen over 20% in both Dubai and Abu Dhabi from their 2014 peaks (Chart III-5). Odds are high that the most dangerous phase of the property market downturn is behind us. Chart III-5Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced Real Estate Adjustment Is Advanced In addition, the government’s efforts to attract people to stay in the country longer will somewhat offset the ongoing exodus of expatriates. Last May, the UAE introduced a new visa system that will allow investors, innovators and talented specialists in the medical, scientific, research and technical fields to stay in the country for up to 10 years. Overall, a potential bottom in property demand and restrained supply will likely make the real estate sector less of a drag on this bourse this year. Finally, the authorities are also more open to increasing the foreign ownership cap in the banking sector, albeit not up to 100%. For example, in early April, the largest UAE lender – First Abu Dhabi Bank – obtained regulatory approval to increase its foreign ownership limit to 40% from 25%. This has boosted foreign equity purchases and has supported the equity index. Bottom Line: We recommend an overweight position in UAE equities within an EM portfolio this year (Chart III-6). For fixed income investors, we recommend overweighting UAE corporate credit in an EM corporate credit portfolio. UAE corporate credit is a lower beta market and will outperform as EM corporate spreads widen (Chart III-7). Most UAE-dollar corporate bonds have been issued by banks. Banks in the UAE do not suffer from structural overhangs, and the cyclical downturn in the property market is well advanced. This is why they have been, and will remain, a lower beta sector within an EM corporate credit portfolio. Chart III-6Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Overweight UAE Equities Within An EM Portfolio Chart III-7UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark UAE Corporate Credit Will Likely Outperform EM Benchmark   Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com

The Argentine peso remains vulnerable due to deficient external funding and public debt sustainability concerns. A lack of external funding and a depreciating peso are causing rising inflation and interest rates. The latter are spurring a downfall in the economy diminishing incumbent President Mauricio Macri’s re-election chances. Importantly, a depreciating peso, as well as high and rising external and domestic borrowing costs are making public debt unsustainable. All of these dynamics are feeding into plunging investor confidence creating a powerful negative feedback loop. Chart III-1A Point Of No Return? A Point Of No Return? A Point Of No Return? Argentina may have reached a point of no return (Chart III-1). The odds that the authorities can stabilize financial markets are rapidly diminishing. Foreign currency-denominated public debt currently stands at $250 billion, and the country’s foreign debt service obligations for 2019 alone are $40 billion. We estimate the country will require an additional $10 billion of external funding this year (Table III-1). Chart III- Given worsening investor sentiment, both the public and private sectors will not be able to raise external funding. As icing on the proverbial cake, potential U.S. dollar appreciation and portfolio outflows out of EM will reinforce the turmoil in Argentine markets. Hence, without the IMF’s authorization for the central bank to use a large share of its foreign currency reserves to defend the exchange rate, the peso will continue to fall. How much more downside could there be in Argentina’s financial markets and economy? When compared with the major financial crises, bank share prices could drop much more. For example, Argentine banks stocks plunged by 95% in U.S. dollar terms during the nation’s 2001-2002 crisis (Chart III-2, top panel). During the 1997-1998 Asian financial crisis, bank equities in Korea and Thailand on average dropped by 95% in dollar terms (Chart III-2, bottom panel). By comparison, since their peak in January 2018, Argentine banks are down 66% in dollar terms. Hence, more downside should not come as a surprise. Chart III-2History Suggests More Downside In Argentine Equities History Suggests More Downside In Argentine Equities History Suggests More Downside In Argentine Equities Chart III-   As to currency depreciation, the peso’s real effective exchange rate has so far depreciated by 36% and remains undervalued by one standard deviation (Chart III-3). This compares with median and mean of 52% devaluations during previous crises in Argentina (Table III-2). Thus, more downside is likely in the currency in both real and nominal terms. The contraction in economic activity in this recession has so far been 6.5% (Table III-2). This is on par with median and mean contractions of 7% during previous crises but economic activity can undershoot this time. Chart III-3The Currency Can Get Cheaper The Currency Can Get Cheaper The Currency Can Get Cheaper Bottom Line: Investors should continue to avoid Argentine financial markets, as the downside could still be substantial. Do not catch a falling knife.   Andrija Vesic, Research Analyst AndrijaV@bcaresearch.com

Our negative call on Vietnamese stocks since last May has turned out well.1 The significant deceleration in export growth alongside the selloff in broader emerging markets has generated a double-digit drop in Vietnamese stock prices over the past 12 months (Chart II-1, top panel). Looking forward, a new upturn in Vietnamese equities is in the making. The structural outlook for Vietnam is strong and improving. Investors should overweight Vietnamese stocks within an EM equity portfolio (Chart II-1, bottom panel). Shifting Supply Chain For some time, companies in China have been moving their supply chain to Vietnam due to its cheap labor, inexpensive land and supportive policies. The geopolitical confrontation between the U.S. and China that began last year has served to accelerate this process. The U.S. and China may soon reach a trade deal. This will give Chinese manufacturers and multinational companies more time to prepare for their relocation, but it will not stop the ongoing supply chain shift. Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come.2 Chart II-2 shows that Chinese companies have nearly tripled their foreign direct investment in Vietnam over the past nine months. Chart II-1Vietnamese Equities: An Upturn Is Ahead Vietnamese Equities: An Upturn Is Ahead Vietnamese Equities: An Upturn Is Ahead Chart II-2Accelerating Supply Chain Shift Accelerating Supply Chain Shift Accelerating Supply Chain Shift   The surge in relocations from the mainland has boosted land prices and wages in Vietnam significantly. For example, the rental price of industrial land at Giang Dien industrial park on a long-term lease of up to 50 years has risen as much as 50% to US$90 per square meter last October from US$60-70 a year ago. The relocations have occurred not only for low-value-added companies such as textile and footwear makers, but also for high-value-add companies like electronics assembly producers. According to the Chairman of Shenzhen-Vietnam Industrial Park, most of the companies that established factories in the park last year have been focused on light processing such as electronic assembly. Chart II-3 shows that U.S. imports from Vietnam have been much stronger than those from China and the rest of the world. This may be the result of both the accelerated supply chain shift last year and the structural competitiveness of Vietnamese goods. Vietnam continues to take market share from China in global markets such as footwear, garments and electronics (Chart II-4). Chart II-3Strong U.S. Imports From Vietnam Strong U.S. Imports From Vietnam Strong U.S. Imports From Vietnam Chart II-4Vietnam: Taking More Market Share From China Vietnam: Taking More Market Share From China Vietnam: Taking More Market Share From China In fact, rising FDIs have already led to a growth rebound in imports among foreign invested enterprises (FIE), heralding an export growth acceleration in the months ahead (Chart II-5). FIEs import most of the input materials they need to manufacture their goods, which are then exported overseas. This is why this segment’s imports lead export growth.   Escaping A Global Slowdown In Smartphone Demand The biggest contributor to Vietnam’s current account and trade surplus has been the smartphone sector (Chart II-6). However, the ongoing downturn in global smartphone shipments may not affect Vietnam due to the latter’s gains in the global smartphone production and assembly market share: Chart II-5Rising FIE Imports Herald Export Growth Acceleration Rising FIE Imports Herald Export Growth Acceleration Rising FIE Imports Herald Export Growth Acceleration Chart II-6Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus   Vietnam mobile phone output (mostly Samsung smartphones) fell only slightly (1.2%) last year when Samsung smartphone shipments contracted by 8% (Chart II-7). This reflected Vietnam’s strong competitiveness relative to the other five countries where Samsung smartphones are manufactured: China, India, Brazil, Indonesia and South Korea. Over half of Samsung smartphones were produced in Vietnam last year. Last December, Samsung closed its Chinese Tianjin plant. Without any additional production reductions in other plants, total Samsung capacity will be cut by about 7%. This further lowers the odds of a considerable production cut in Vietnam in the case of a further drop in global smartphone demand. Other Encouraging Signs Many other positive signs have emerged that point to a cyclical upturn ahead for Vietnam: Retail sales growth has been accelerating, and automobile sales have reached new highs, suggesting strong domestic demand (Chart II-8). Despite declining visitor arrivals, the country’s tourism revenue still grew at a robust 10% pace last year. In 2019, the country is expecting a 15% year-on-year growth in visitor arrivals. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which came into force for Vietnam in January, and the EU-Vietnam Free Trade Agreement (EVFTA), which will take effect later this year, will be highly beneficial to the Vietnamese economy. Both headline and core inflation are low. The country’s foreign reserves also jumped by 14% over the past 12 months to a record high of US$63.5 billion, equivalent to 26% of GDP. Chart II-7Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Chart II-8Strong Domestic Demand Strong Domestic Demand Strong Domestic Demand   Investment Recommendations We recommend buying Vietnamese equities on dips. Dedicated equity investors should overweight Vietnam in an EM equity portfolio: The Vietnamese property market is booming on surging income growth and low interest rates. The real estate sector accounts for 45% of the MSCI Vietnam Index and 28% of the VN All-Share Index. According to CBRE Vietnam, there was a sharp rise in overseas investors in Vietnamese real estate in 2018, particularly from China. The real estate services firm reported that Chinese customers accounted for 44% of total transactions in the first nine months of 2018. In 2017, there was a 21% year-on-year increase in Chinese buyers. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Vietnamese corporate earnings will outpace broader EM EPS, warranting equity market outperformance (Chart II-9). Vietnam's inclusion into some influential EM equity indices would significantly boost interest from foreign investors (Chart II-10). Chart II-9Vietnamese Corporate Earnings Growth: Better Than EM Vietnamese Corporate Earnings Growth: Better Than EM Vietnamese Corporate Earnings Growth: Better Than EM Chart II-10Rising Interest From Foreign Investors Rising Interest From Foreign Investors Rising Interest From Foreign Investors   Technically, it seems the correction in Vietnamese stocks is late, and that the equity market will resume its upturn sooner rather than later.   Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com   1 Please see Frontier Markets Strategy Special Report titled “Vietnamese Equities: Take A Step Back For Now, ” dated May 15, 2018. Available at fms.bcaresearch.com. 2 Please see Geopolitical Strategy and China Investment Strategy Special Report titled “China-U.S. Trade: A Structural Deal?” dated March 6, 2019. Available at gps.bcaresearch.com.

Argentina's Achilles Heal: Twin Deficits Argentina's Achilles Heal: Twin Deficits Argentine financial markets have been rioting, with the currency plunging by 11% versus the U.S. dollar since the beginning of April. What is the underlying cause of turbulence, and what should investors do? Argentina's macro vulnerability stems from the following factors: First, the country has very large twin deficits, and has relied on foreign portfolio flows to finance them (Chart II-1). Second, private credit growth has lately surged as households and companies have borrowed to buy imported consumer goods and capital goods (Chart II-2). This has created demand for U.S. dollars at a time when the greenback has begun to rebound and foreign investors' appetite for EM assets has diminished. Finally, progress on disinflation has been slow. Core inflation is still above 20% as sticky regulated prices have kept inflation high (Chart II-3). Faced with a market riot, the Argentine central bank hiked its policy rate from 27.25% to 40% in the span of 8 days. Furthermore the government has requested a $30 billion IMF credit line. The aggressive rate hikes prove that the Argentine authorities, unlike many of their EM counterparts, have been adhering to orthodox macro policies. This makes Argentina stand out versus others in general, and Turkey in particular. Argentina: Credit Growth Has To Be Reined In Argentina: Credit Growth Has To Be Reined In Argentina: Inflation Is Still A Problem Argentina: Inflation Is Still A Problem Such orthodox macro policy responses leads us to maintain our long position in Argentine local bonds. The central bank has hiked interest rates well above both the inflation rate and nominal GDP growth (Chart II-4). Real interest rates are now at their highest level in the past 13 years (Chart II-5). We reckon that this policy tightening will likely be sufficient to stabilize macro dynamics, albeit at the cost of a growth downturn. Argentina: Are Interest Rates High Enough? Argentina: Are Interest Rates High Enough? Argentina: Highest Real Interest Rates In Over 13 Years! Argentina: Highest Real Interest Rates In Over 13 Years!   The drastic monetary tightening will crash credit growth and hence depress domestic demand and imports (Chart II-6). This will help narrow the trade deficit. The monetary squeeze with some fiscal tightening, shrinking real wages (deflated by headline consumer inflation) and a minimum wage nominal growth ceiling of 12.5% for 2018, will bring down inflation, albeit with a time lag (Chart II-7). The fixed-income market could look through the near-term spike in inflation due to the currency plunge. Argentina: High Borrowing Costs Will Crash Domestic Demand Argentina: High Borrowing Costs Will Crash Domestic Demand Argentina: Real Wage Growth Is Moderate Argentina: Real Wage Growth Is Moderate   Finally, the authorities have been gradually implementing their structural reform agenda. Crucially, recent tax and pension reforms were major wins for President Mauricio Macri's Cambiemos coalition, and should help ameliorate the country's fiscal balance. This stands in stark contrast to Brazil, which has so far failed to enact social security reforms despite a mushrooming public debt burden. High interest rates and a domestic demand squeeze are negative for corporate profits, including banks' earnings. However, they are positive for local bonds and ultimately for the currency. The diminishing current account deficit - due to contracting imports - and IMF financing will ultimately put a floor under the Argentine exchange rate. In turn, a cyclical growth downturn, moderating inflation, orthodox macro policies and high yields will entice investors into local currency bonds. Investment Recommendations Wait for the currency to depreciate another 5-10% versus the dollar in the next several weeks, and use that as an opportunity to double down on local currency bonds. While the peso could still depreciate by another 10% in the following 12 months, the extremely high coupon and potential for capital gains as yields ultimately decline will more than offset losses on the exchange rate. This makes the risk-reward of local bonds attractive. Maintain long Argentine sovereign credit and short Venezuelan and Brazilian sovereign credit positions. Orthodox macro policies, a continuation of structural reforms and an IMF credit line will likely cap upside in sovereign credit spreads versus Venezuela and Brazil, where public debt dynamics are worse. The difference between Argentine local currency bonds and U.S. dollar bonds is as follows: Local currency bond yields at 18% offer better value than sovereign credit spreads trading at 300 basis points over U.S. Treasurys. This is the reason why we are taking the risk of an unhedged position in domestic bonds, but remain reluctant to bet on the nation's sovereign U.S. dollar bonds in absolute terms. In addition, correlation among EM nations' sovereign spreads is much higher than correlation between their local bonds. We expect more turmoil in EM financial markets, but there is a chance that Argentine local bonds could decouple from the EM aggregates in the coming weeks or months. We are closing our long ARS/short BRL and long Argentine banks/short Brazilian banks trades. We had been expecting a riot in EM financial markets, but had not anticipated that Argentina would be affected more than Brazil. Finally, structurally we remain optimistic on Argentina's equity outperformance versus the frontier equity benchmark. Tactically (say the next 3 months), however, Argentine equities could underperform. Andrija Vesic, Research Analyst andrijav@bcaresearch.com

Highlights Lebanon is facing genuine debt deflation, which is partially a by-product of its fixed exchange rate regime. To defend the exchange rate peg in the face of the country's chronic current account deficit, the central bank needs to keep interest rates sufficiently high to attract large foreign portfolio inflows. Higher rates in turn depress nominal growth and worsen the government's creditworthiness, which then leads to a higher risk premium and rising borrowing costs. A vicious cycle is probably commencing. Interest payments on government debt are unsustainably large and will continue rising as a share of government spending. Government debt restructuring and a major currency devaluation are only a matter of time. Feature Lebanon's sovereign credit (U.S. dollar bonds) offer enticing spreads and yields. Should investors buy/overweight or avoid/underweight these securities? Our analysis shows that this sovereign credit market should be avoided as spreads will widen further due to unsustainable fiscal dynamics (Chart 1). In short, Lebanon is facing a genuine debt deflation environment, which is partially a by-product of its fixed exchange rate regime. Image The Currency Peg: The Economy Bears The Brunt In the late 1980s and early 1990s, Lebanon was overshadowed by hyperinflation, which led to a plunge in its currency. A new government was formed in 1992 that instituted extremely tight monetary and fiscal policies, and the Lebanese pound was fixed to the U.S. dollar in 1999. The peg has been maintained ever since. These policies made sense in the post-war and hyperinflation era, when fiscal and monetary discipline were entirely lacking. The policies were initially successful as they brought down inflation, revived confidence and allowed the economy to grow. However, the authorities overstayed the currency peg. Over time, the currency has become expensive, as evidenced by the mushrooming current account deficit, which today stands at 20% of GDP (Chart 2). To defend the exchange rate peg in the face of the country's chronic current account deficit, the Banque Du Liban (BDL) - Lebanon's central bank - needs to keep interest rates sufficiently high to attract large foreign portfolio inflows. Please refer to Box 1 below for more information on Lebanon's peg and its damaging effects on the Lebanese economy. The ultimate outcome of these misguided macro policies is debt deflation where government borrowing costs rise above nominal GDP/government revenue growth, leading to interest expenses mushrooming as a share of income. Indeed, the interest payments the government makes on its debt have been extremely high, ranging between 25% and 49% of expenditures since 1993. The government, as a result, has been forced to squeeze fiscal spending and run primary surpluses - i.e. excluding interest payments - to afford these payments (Chart 3). Image Image   Moreover, high government borrowing costs have encouraged commercial banks to lend to the government at the expense of the private sector. On the whole, what the Lebanese economy needs today is lower interest rates and a cheaper currency in order to reflate the economy - boost nominal GDP growth - and place Lebanon's fiscal position and debt dynamics on a sustainable path. Doing so will also revive the private sector, as lower borrowing costs will free up government resources to be used on much-needed capital investments that will kick-start the economy. Further, if government bond yields drop, then local commercial banks will be incentivized to lend to the private sector. Productivity gains will then be realized, which is a key pillar for achieving sustainable and non-inflationary growth. Yet there are major blocks to implementing this policy regime shift of cutting interest rates and tolerating a weaker pound. Lebanese commercial banks are closely linked to the country's ruling political class, as a large number of banks have current or former government officials as members of their board of directors. Both commercial banks and the political class benefit from this arrangement.1 These limitations will not be overcome in the near future and the deflationary environment will deepen. Consequently, Lebanon's debt burden will continue to mushroom, and creditworthiness will deteriorate further. This will exert more upward pressures on Lebanese interest rates. Higher borrowing costs will in turn worsen these dynamics even more and put the Lebanese economy in a vicious circle. Bottom Line: The Lebanese economy is in a classic debt deflation environment. Dramatically lower interest rates and currency devaluation are the ultimate solutions. Global Tailwinds Are Disappearing One factor that has helped Lebanon in the past 10 years has been low U.S. short-term rates and bond yields. However, U.S. bond yields have risen quite a bit lately, and they will likely drift higher. The Federal Reserve will continue to raise rates in response to higher U.S. inflation and improving growth (Chart 4). The BDL will then be forced to increase interest rates in tandem to maintain an attractive interest rate differential versus the U.S. and keep attracting foreign capital to finance Lebanon's current account deficit (Chart 5). Image Image Worryingly, this involuntary tightening cycle by the BDL will come at a time when cyclical growth is already depressed in Lebanon, with no visible catalyst to reignite it on the horizon: The domestic loan impulse is weak and turning negative (Chart 6, top panel). This means purchasing power will remain subdued. Image Construction activity is depressed and loan growth for construction has stalled (Chart 6, panels 2 and 3). The tourism sector is hurting (Chart 6, panel 4). Gulf Cooperation Council (GCC) countries are still warning their citizens and dissuading them from travelling to Lebanon. This cautious policy by GCC countries is unlikely to change as Saudi-Iranian tensions continue to mount and have repercussions on Lebanon's fractured politics. Moreover, rising regional geopolitical tensions also mean that there is no clear resolution to end the Syrian civil war yet. This will remain a major constraint on Lebanon's economic outlook. Bottom Line: The Fed is raising rates and the BDL will have to tighten monetary policy in tandem. Growth will slump further and this will have major ramifications on Lebanon's fiscal outlook. Fiscal Sustainability: The Clock Is Ticking (Again) Given the dire economic outlook discussed above, Lebanon's fiscal dynamics are on a dangerous and unsustainable path: Government revenues will remain weak going forward as the growth outlook is uninspiring. Importantly, the government's tax revenues saw a one-off spike in 2017 due to a one-time increase in taxes related to income and capital gains, which will fade (Chart 7). The government's decision to increase the VAT by 1% to 11% will only raise government revenues on a one-time basis as well. Higher VAT taxes are also negative for consumption. Meanwhile, public sector waste is elevated and inefficiencies in this sector run high. In particular, around 34% of government expenditures accrue to personnel costs, and another 9% goes to Électricité du Liban (EDL), the country's power producer. The latter requires constant handouts by the government due its endemic lack of profitability. Budgetary cuts in these two sectors are unlikely to materialize given the ongoing political gridlock and numerous vested interests.2 We performed a debt simulation to project the fiscal trajectory in Lebanon and, according to our baseline scenario, the fiscal deficit will deteriorate to around 9% by the end of 2018 and remain at 9% in each of 2019 and 2020 - down from around 7% in 2017 (Chart 8, top panel). Image Image   Worryingly, public debt to GDP will reach 166% by 2020 and debt interest payments will hit 43% of total expenditures by 2020 (Chart 8, middle and bottom panels). This is a crucial threshold that is getting dangerously close to levels last seen in the early 2000s when the bond market rioted. Remarkably, even after Lebanon successfully raised $11 billion from international donors in the CEDRE Conference - which took place in Paris last month - sovereign yields have continued to creep higher (Chart 1, shown on page 1). For more information on our baseline scenario assumptions, please refer to Box 2 below. In addition, there are major risks to Lebanon's sovereign credit and economic activity that we do not take into account in our baseline scenario: First, U.S. inflation could rise much faster than the market expects, prompting higher rates in the U.S. This means the BDL will have to pursue even fiercer tightening, destroying the economy and causing a steeper selloff in the bond market. Second, oil prices could plunge anew. If this occurs, it would cause inflows from GCC countries to dry up and that would exert major downward pressure on the Lebanese pound. Bottom Line: There are significant risks that Lebanese sovereign spreads will widen substantially as the government's fiscal position deteriorates. What Reforms? Lebanon's structural outlook is dismal and meaningful reforms are unlikely due to permanent political paralysis. Accordingly, negative structural trends will persist: Image The productivity outlook is disastrous (Chart 9). Productivity has been falling sharply since 2011, partially due to a large influx of refugees fleeing the Syrian civil war. There is a lack of employment opportunities in Lebanon, and the brain drain phenomenon continues to darken the country's potential growth outlook. The public sector is bloated and inefficient; it also overshadows a private sector that is largely influenced by the interests of powerful government officials and business tycoons. Lebanon ranks 143 out of 180 countries in the Corruption Perceptions index. Further, Lebanon ranks below the 20th percentile in Rule of Law and Control of Corruption according to the World Bank.3 The private sector is also starved of credit. Commercial banks are incentivized to lend to the public sector at high interest rates rather than take risks and bet on the private sector (Chart 10, top panel).4 Finally, bank financing has favored industries that do not contribute to productivity, such as construction, real estate, trade and consumption, while lending to the manufacturing and agricultural sectors has stagnated (Chart 10, bottom panel). This phenomenon has hurt productivity and curtailed the economy's potential dynamism. Bottom Line: The structural growth outlook in Lebanon is dismal. Image Concluding Thoughts Lebanon is facing a dire economic and fiscal outlook, partially because of its tenacious decision to maintain the exchange rate peg. Image Low interest rates in the U.S. over the past 10 years have significantly delayed the date of reckoning on its public debt. But for the first time in almost a decade, the Fed is raising rates and U.S. dollar interest rates are mounting. The BDL will be forced to do the same, causing Lebanon's economy to slump into a downtrend. Nominal GDP and government revenue growth will continue to lag government bond yields, making the government's debt dynamics toxic. Government interest expenditures will rise to dangerous levels (43% of GDP by 2020) beyond which the public debt becomes unsustainable. Lebanon will in turn continue to convene in Paris with its international creditors for more short-term and unsustainable sugar fixes - as it did earlier this month. Ultimately, debt will reach unmanageable levels, and another Paris conference might not do the trick. The government will have no choice but to default. The public debt will then have to be restructured and international creditors (like the IMF) could insist on a major one-off devaluation as a precondition for a rescue package. Given the unsustainable fiscal trajectory and the untenable currency peg regime, we recommend global investors to stay away from Lebanese sovereign credit (Chart 11). In the long run, the currency will have to be devalued. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com   Box 1 Understanding Lebanon's Peg Any country that pegs its currency to another has to sacrifice the independence of its monetary policy. In the case of Lebanon, the BDL is being forced to follow U.S. monetary policy. When the Fed hikes interest rates, risks of capital flowing out of the Lebanese economy rise, exerting downward pressure on the Lebanese pound. In response, the BDL is forced to hike rates to attract foreign deposit flows into the country and create upward pressure on the currency. On the other hand, if the Fed lowers rates, then the BDL has to reduce rates and preempt funds flowing into Lebanon, which exerts upward pressure on the pound. Image Further, the BDL is forced to follow the fed funds rate regardless of the state of the Lebanese business cycle. This causes unnecessary boom/bust cycles in the real economy. A somewhat flexible exchange rate is akin to a relief valve that behaves as a shock absorber, alleviating these boom/bust cycles. Pegging the currency ultimately means the economy bears the brunt of absorbing external shocks rather than exchange rates. For a currency peg to make economic sense, the business cycles of the two countries involved have to be somewhat in sync. Chart 12, however, shows that Lebanon's business cycle has no relation with that of the U.S. In fact, the relationship may even be inversed.5 Image Image Despite not being an oil exporting nation, Lebanon has largely depended on inflows from neighboring Gulf countries since the end of its civil war, which has made oil prices a crucial driver of its economy (Chart 13). The U.S. on the other hand is a much more diversified economy, and oil prices and its growth cycle do not always positively correlate. The Fed can and does raise rates regardless of what oil prices are doing (Chart 14). Therefore, Lebanon and the U.S. do not form an optimal common currency area, and pegging the Lebanese pound to the USD is a bad decision for the economy in the long run.         Box 2 Assumption For Debt Simulation Analysis The above analysis presents our baseline scenario which assumes the following for 2018, 2019 and 2020, respectively: 4.5%, 2.5% and 2% for nominal GDP growth; 4%, 3%, 3% for government revenue growth; 3% government expenditure growth in 2018 and 2% for each of 2019 and 2020; We also assumed an average interest on debt of 7%, 7.5% and 8% in 2018, 2019 and 2020, respectively.   1 For more details on the links between Lebanon’s banking sector and the ruling class, please refer to the following study authored by Dr. Jad Chaaban: “I’ve Got the Power: Mapping Connections between Lebanon’s Banking Sector and the Ruling Class”, Economic Research Forum, Working Paper, October 2016 2 For more information on the inefficiencies of Lebanon's electricity sector, please refer to the following article: http://www.georgessassine.com/electricity-sector-edl 3 Percentile rank among all countries in the World Bank ranges from 0 (lowest) to 100 (highest) rank 4For more information on the banking sector’s lending behavior and its implications on the Lebanese economy, as well as the wider economic inefficiencies in Lebanon that have led to dismal productivity growth, please refer to the following study authored by Dr. Toufic Gaspard: “Financial Crisis In Lebanon”, Konrad Adenauer Stiftung and Maison du Futur, August 2017 5 In order to measure the Lebanese real business cycle we use construction permits instead of real GDP growth. The former has more history than the latter. Further, construction tracks GDP growth very closely in Lebanon being one of the most important pillars of growth in the economy.