In the aftermath of the default of the Lebanese government on its debt on March 19th in 2020, the Lebanese pound reached abysmal lows versus the US dollar. Up to that point, the Lebanese government, or more precisely the Banque du Liban, had always followed a policy of strict pegging of the local currency to the US dollar, at a rate of 1507.5 LBP for a Dollar, to instill confidence that investments, typically in bonds, will retain their purchasing power in US dollars when they mature. This rate had been constant since 1997. The Lebanese pound intrinsic weaknesses started to unravel around October 2019 and the peg to the US dollar started to fall apart.
The unofficial FX rates on the local market have surged in the past months, reaching values as high as 15000 LBP per USD according to sources. These sources rely on polls from exchange houses and currency changers on the local market. Given the relatively small size of the Lebanese money market and its opacity, the local unofficial FX rate could benefit from a proxy on international marketplaces with a high enough correlation to allow a coarse evaluation of the fairness of the unofficial FX rate, and identify under or over valuations of the Lebanese Pound.
Lebanese sovereign Eurobonds (Bonds issued by the Lebanese government in a foreign currency, in this case USD instead of LBP) might be a good proxy for the specific case at hand with the following assumptions:
- The currency had been successfully pegged to the US dollar for decades before a first default and an economic downturn.
- The country has successfully issued Eurobonds in the past decades, until a first default
When investors buy such a Eurobond at par (at 100% of the face value of the bond, quoted as 100 on fixed income markets), they are expecting full repayment of the principal amount at maturity. In the case of the Lebanese Eurobonds, the investors are expecting full repayment of the principal in USD from an issuer whose domestic currency is the LBP. In other words, they trust the central bank to keep the Lebanese Pound pegged to the US Dollar on a rate close or equal to the current peg rate, allowing the Lebanese government to easily finance itself in USD to repay the principal at maturity.
If the Eurobond is bought at a heavy discount, for example 20% or 30% of the bond face value, it means that the investors foresee a higher risk of default, which in the case of sovereign Eurobonds is due in part to the weakness of the domestic currency. In other words, the investor does not expect the central bank to have the means of enforcing a peg of the Lebanese pound to the USD and hence, the Lebanese government of easily financing itself in USD to repay the principal.
At the time these lines are being written, the Lebanese Eurobonds being considered are quoting at around 12 or 13. One could argue that this price can be seen as a “recovery rate”: the investor accepts to pay 12% of the face value of a Eurobond because it does not expect a scenario worse than a 12% repayment of the principal. The value of every dollar of principal must be reduced by 88% for the investor to incur a loss, having bought the Eurobond at 12% of its face value. For an issuer like Lebanon which had successfully pegged the domestic currency to USD for decades at 1507.5 LBP per USD, it can be said that the value of every 1507.5 LBP of principal (one US dollar at the time the bond was issued) must be reduced by 88% for the investor to incur a loss, or that the central bank has to sustain an 88% downturn of the USD/LBP rate for the investor to incur a loss, at which point 1507.5 LBP is worth 0.12 USD.
Hence the proxy: USD/LBP black market = USD/LBP peg * 1/Eurobond price = 1507.5 * 1/0.12 = 12562.5. This value is very close to the unofficial FX rate quoted by different sources on the local Lebanese market.
To ensure the soundness of the idea, I have back tested the values of the black-market FX rate for the past year against the price of a Lebanese Eurobond, ISIN XS0250882478, as quoted on the Luxembourg exchange. It is an eight-year Eurobond maturing on April 12, 2021, which makes it old enough to have been issued at a time when the USD/LBP peg was effective and maturing around a year after the first bond default following the economic downturn of the Lebanese republic. This ISIN was suspended on the Luxembourg exchange where the values were taken shortly before its maturity.
In the figure above, on the day of the bond default in March 2020, the bond price used as a proxy gives a USD/LBP rate much higher than the black-market value. This is probably due to the fact that an economy has a given inertia due in part to capital restrictions and other measures imposed by commercial banks and the central bank of Lebanon on depositors to avoid a bank rush and to try to control the FX rate to a certain extent.
Starting July 2020, the curves seem to be much more correlated. In fact, the correlation (Pearson) is computed as 0.771 on the values of both curves between July 29 and March 31. The gap towards the end of October 2020 could be explained by rumors on the formation of a new government by the nominated prime minister, which drove the local unofficial rate down through a relative increase of the confidence in the Lebanese Pound. This gap has persisted until right before the bond maturity, where we see a correction. It could also be due to other biases linked of the exchange where the Eurobond prices were sourced.
Further steps are planned, to refine the findings on this proposed proxy. They include running a back testing exercise on another Lebanese Eurobond and using quotes from a different exchange, for example, USD/LBP rate based on Eurobond XS0471737444 maturing in 2024 and quoted on the Frankfurt exchange.
Let the board sound