Lebanon has taken a significant step toward political stabilization with the election of General Joseph Aoun as President and the appointment of diplomat and Judge Nawaf Salam as Prime Minister in early January 2025, international investment bank J.P. Morgan said in a report titled “Lebanon: Politics and Stability Before Economics.” While these developments mark a breakthrough in ending the political deadlock, the report noted they remain insufficient to bring the country back to full normalization.

J.P. Morgan highlighted that Lebanon’s economy has suffered another severe shock due to the ongoing Middle East conflict, which has triggered massive displacement and widespread destruction. According to the World Bank’s Interim Damage and Loss Assessment, the total estimated economic impact stands at $8.5 billion. The report emphasized that Lebanon has been grappling with a prolonged financial crisis long before the recent regional turmoil, citing the country’s sovereign default in March 2020. The economic situation has been further aggravated by the COVID-19 pandemic, the devastating Beirut port explosion, and the global repercussions of the Russia-Ukraine war in 2022.

Despite the economic strain, Lebanon’s Eurobond prices have shown signs of recovery, returning to their 2020 levels following the political developments in January. J.P. Morgan reported that Eurobond prices had risen to approximately 16-17 cents to the dollar, making Lebanon the best-performing country in the EMBIGD index for 2024. However, the investment bank cautioned that political risks remain high, warranting continued vigilance.

J.P. Morgan projected that Lebanon’s deteriorating conditions, particularly in the aftermath of the Middle East conflict, would prolong the country’s path to medium-term stability. As part of its debt restructuring analysis, the investment bank outlined a package involving a 10-year maturity extension for bonds maturing between 2030 and 2047. The plan includes a phased coupon structure, with a 1% rate until 2027, increasing to 2% in 2027 and reaching 7% from 2028 onward. Applying an exit yield of 16%, J.P. Morgan estimated that markets are currently pricing in a 70% notional haircut on Lebanese bonds.

The report underscored that Lebanon’s economy has become overwhelmingly dollarized, with U.S. dollar banknotes accounting for around 95% of deposits and cash held outside the banking system. However, J.P. Morgan warned that such high levels of dollarization, combined with the pegged currency, are unsustainable given Lebanon’s depleted foreign exchange reserves. The investment bank stressed the urgent need for the central bank to curb money supply growth, restore confidence in the banking sector by safeguarding small depositors, and rebuild its foreign currency reserves.

Looking ahead, J.P. Morgan noted that financial markets would be closely watching Lebanon’s political landscape, particularly the formation of a credible and competent government capable of asserting state authority. The report highlighted that international support would be essential for Lebanon to implement much-needed reforms. J.P. Morgan suggested that the country’s reform strategy should begin with reconstruction efforts to address the damages from the Middle East conflict, followed by a focus on stabilizing the banking sector before tackling Eurobond restructuring.

Since Eurobond holdings constitute a small fraction of the banking sector’s total assets, a significant haircut on Eurobonds would have a limited direct impact on banks’ balance sheets, the report noted. However, it pointed out that banking sector recapitalization would likely require additional concessional debt, meaning Lebanon may need greater debt relief from existing creditors to achieve financial sustainability. J.P. Morgan cited the IMF’s 2022 scenario, which projected that Lebanon could reduce its debt-to-GDP ratio to 80% by 2027—down from around 200%—provided it secures a 75% notional haircut on its sovereign debt.

The investment bank referenced the IMF’s Article IV consultation report, which estimated financial system losses at over $70 billion, leaving the central bank (BDL) with a net negative equity position of approximately $60 billion. The IMF’s findings also indicated that around 80% of commercial banks’ assets are tied up with the central bank. To return to at least a neutral equity position, BDL would likely need to write down most of its liabilities to banks, a move that could result in the loss of 60-70% of commercial banks’ balance sheets.

Furthermore, the report warned that losses in the banking sector are even more substantial when factoring in the rise of non-performing loans since the onset of Lebanon’s economic crisis. With around 60% of bank liabilities linked to resident customer deposits, the report cautioned that there is a risk that some deposits may ultimately be lost.

J.P. Morgan concluded that while recent political advancements offer a glimmer of hope for Lebanon’s economic recovery, significant challenges remain. Political stability, banking sector restructuring, and international financial support will be crucial for Lebanon’s path to sustainable recovery. Markets will continue to assess the government’s ability to implement reforms and secure the necessary international backing to stabilize the economy in the long term.