Lebanese banks, majority holders of the Middle East’s lowest rated bonds, may be at risk should Syria’s popular uprising hurt Lebanon’s political stability and economic growth.

“The main risk for the banking sector is that rich Lebanese expatriates who deposit their cash in Lebanese banks would withdraw their money because of a deterioration in the nation’s politics,” Rami Sidani, the Dubai-based head of Middle East and North Africa investment at Schroder Investment Management Ltd., which oversees about $230 billion of investments worldwide, said in a phone interview yesterday.

Syria, Lebanon’s only land link with the Arab World, has been gripped by protests against President Bashar al-Assad’s 11- year rule since March. Assad backs the Hezbollah-dominated government of Prime Minister Najib Mikati, formed on June 13. His predecessor, Saad Hariri, lost power in January when Hezbollah and its allies resigned from the cabinet amid an investigation by a United Nations tribunal into the 2005 assassination of his father, Rafiq.

The cost of protecting against Lebanon defaulting on its debt is the highest in the Middle East. Five-year credit-default swaps gained four basis points to 354 this week, according to data compiled by CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent if a government or company fails to adhere to debt agreements.

Banks Attract Deposits

Lebanese banks hold about 70 percent of the nation’s debt which is rated B1 by Moody’s Investors Service, four notches below investment grade, and B by Standard and Poor’s, the fifth- highest junk rating.

The lenders attracted money with interest rates as high as 8 percent and the Lebanese pound’s stability, which has been pegged at about 1,500 to the dollar since the 1990s. Local banks are “highly” liquid with an average loan-to-deposit ratio of 35 percent, according to Credit Libanais SAL.

“If we go to other markets and invest in an investment grade bond, it wouldn’t give us the same yield that we’d get on Lebanese government debt,” Credit Libanais’ head of capital markets, Gaith Mansour, said in a telephone interview from Beirut yesterday.

Higher Bond Yields

The yield on the republic’s 6.375 percent dollar bond maturing March 2020 fell 1 basis point to 5.9 percent today, according to Bloomberg prices. The difference between Lebanon’s debt and Abu Dhabi government’s 6.75 percent dollar security maturing April 2019, which has the third-highest rating on S&P, is 191 basis points.

The average yield on sovereign securities in the Middle East was little changed at 5.05 percent yesterday, according to the HSBC/NASDAQ Dubai Middle East Conventional Sovereign US Dollar Bond Index.

Growth in bank deposits may slow to 7 percent this year after expanding 10 percent in 2010, Central Bank Governor Riad Salameh said in a July 11 interview. Lebanon’s banks largely avoided the global financial turmoil in 2008 and 2009 because Salameh banned banks from buying non-Lebanese risky assets, including non-investment grade paper and derivatives in 2004.

The banks have a “long-term vulnerability” to their dependence on “foreign depositors and on Lebanon’s debt- servicing capacity,” the London-based Economist Intelligence Unit said in a report June 25.

Foreign Investors

Most foreign investors have avoided Lebanon’s bond market because of its growing debt, according to Edwin Gutierrez, who helps manage about $6.5 billion of emerging-market debt at Aberdeen Asset Management in London. The nation’s debt is equivalent to 134 percent of economic output, the highest in the Arab world, IMF data shows.

“The Lebanese need to reduce their debt-to-GDP to attract investors,” Gutierrez said in a phone interview on July 13. “The general perception is that it’s an expensive credit considering its fundamentals.”

Lebanon’s economic growth rate will drop to 2.5 percent in 2011, the lowest since 2006, according to IMF figures. Gross domestic product expanded 7.5 percent last year.

Syria’s uprising is exacerbating Lebanon’s economic slowdown as tourism, which accounted for about 20 percent of the nation’s GDP in 2010, has declined this year, according to Tourism Minister Fady Abboud. The conflict in Syria has stopped holiday makers in neighboring countries from driving to the Mediterranean nation, he said.

Syrian Unrest, UN Tribunal

More than 1,700 people have been killed and at least 20,000 people arrested since the demonstrations began, Ammar Qurabi, head of the National Organization for Human Rights in Syria, said by telephone July 11.

Assad’s father, Hafez, sent thousands of troops into Lebanon in 1976 as the country entered a second year of civil strife. The forces withdrew in 2005 after mass rallies accused Syria of killing former Prime Minister Rafiq Hariri, a charge Assad denies.

The UN tribunal has asked Interpol to issue so-called red notices this week to alert all states that warrants have been issued for the arrest of the defendants in the case. Hezbollah wanted Saad Hariri’s government to end Lebanon’s financing of 49 percent of the UN tribunal’s costs. The political rift has threatened a return to sectarian violence in a country that emerged from a 15-year civil war in 1990.

Hurting Economy

“What is happening around us is affecting us,” Abboud said in a telephone interview July 7. “We receive more than half a million tourists per annum by road and this is not counting the Syrians.”

Exports to Syria fell 17 percent in the first five months compared with the same period a year earlier. The budget deficit jumped 41 percent to 1.83 trillion Lebanese pounds ($1.2 billion), the Finance Ministry said July 12.

Lebanon’s new government under billionaire Mikati pledged to cut spending, increase revenue, reduce the national debt and change the tax system, it said in a policy statement.

“The banking sector expects to see a clear strategy and concrete steps from the new Cabinet to reduce the government’s borrowing needs and its reliance on banks to finance its operations,” Nassib Ghobril, head of research at Lebanon’s Byblos Bank SAL said in a telephone interview July 10. “The Cabinet should not take for granted the banking sector’s automatic financing of the fiscal deficit.”

Still, local bondholders will help keep down yields on Lebanon’s debt, even when foreign investors exit the market, according to Ray Majdalani, a Beirut-based fixed-income trader at First National Bank. “When international investors sell, we buy them off,” Majdalani said in an e-mailed response to questions on July 12. “We own too much of the debt to let the prices fall. And we need them, because we have so much liquidity.”