Dubai: The recent political developments in Lebanon such as the election of President Michel Aoun and the designation of Saad Hariri to form the government is expected to boost investor confidence in the country’s financial system. However analysts say in the short to medium term, banks’ foreign asset holdings paint a grim picture.

In mid-October, Banque du Liban (BdL), Lebanon’s central bank, published data showing that Lebanese banks’ foreign assets, mostly in the form of foreign bank placements, had declined by $1.9 billion (Dh6.9 billion) between May 2016 to August 2016, and by $1.1 billion in August alone. As a result, Lebanese banks’ net foreign liabilities increased to $18 billion in August from $15 billion at the beginning of the year.

The repatriated $1.9 billion of foreign assets were invested in long-term Lebanese government Eurobonds and BdL certificates of deposits (CDs) that increased the banks’ overall exposure to the sovereign.

The large reduction in Lebanese banks’ foreign assets is the result of a BdL financial operation that began in May. Although the BdL has not disclosed details of this operation, according to Moody’s estimate, BdL bought $2 billion of Eurobonds from the Lebanese Ministry of Finance in exchange for an equivalent amount of debt denominated in Lebanese pounds.

Additionally, there are reports that BdL bought roughly $6 billion of Lebanese pound denominated Treasury bills over the summer from commercial banks at a premium and sold them the $2 billion in Eurobonds and an additional $4 billion in CDs. Banks were required to keep the profits generated from these transactions as Lebanese pound-denominated reserves ahead of the implementation of International Financial Reporting Standard No 9, which takes effect in 2018.

These transactions increased BdL’s foreign assets to a record $40.6 billion at the end of September 2016 from $34.6 billion in May. Including gold, BdL’s foreign assets now cover a record 26 months of imports.

Budget deficit

Speaking at the opening of a banking conference organised by the Union of Arab Banks last week, Central Bank Governor Riad Salameh said the Central Bank’s foreign currency reserves in September 2016 have risen 5 per cent and reached a historical record.

Political paralysis and ongoing regional instability led to almost flat GDP growth, and deposit growth slowed in the first half of the year to $3.2 billion from $4.2 billion in the year-ago period. Lebanon continues run a large budget deficit, which Moody’s analysts forecast at 8 per cent to 9 per cent of GDP for 2016-17, and relies on the domestic banking system to finance that deficit.

“The [central bank] transactions have significantly reduced Lebanese banks’ dollar liquidity and have increased banks’ already large exposures to Lebanese government Eurobonds, which we estimate are at 1.2 times banks’ Tier 1 capital as of July 2016. We estimate the banking sector’s overall government exposure to be more than 5 times banks’ Tier 1 capital,” said Marina Hadjitsangari, Associate Analyst at Moody’s.

To shore up dollar liquidity banks raised interest rates on dollar deposits in May. Some banks were also able to recover some of their foreign liquidity by selling Eurobonds in the secondary market to foreign banks.

Despite the recent political developments, rating agency Standard & Poor’s said in the context of sluggish growth rates in the country the banking sector is likely to face further deterioration in operating conditions resulting in pick up in credit losses.

“Our view is underpinned by the banking system’s high direct and indirect exposure to the real estate sector, totalling 35.6 per cent of the banks’ loan book at year-end 2015,” S&P said in a recent note.