Lebanon, a politically troubled but upper-middle-income Middle Eastern state, is in the midst of a deep financial and political crisis. Banks have been intermittently closed since mid-October and depositors across the country are finding it impossible to gain access to dollar balances.
While capital controls have not officially been introduced, it seems banks have taken it upon themselves to conserve liquidity and capital by dictating what level of funds clients can withdraw or transfer abroad. Dollar scarcity has led to a 30 per cent premium for physical cash dollars over the official exchange rate. (The economy is both highly dollarized and cash-oriented).
On December 12, Prime Minister Saad Hariri, who is currently serving as caretaker leader following his resignation on October 29, was forced to ask the IMF and the World Bank for assistance.
So how did it get here?
Lebanon has a long history of high public debt and external imbalances that dates back to the post-civil war reconstruction period of the 1990s. While a series of donor conferences, co-ordinated by then French President Jacques Chirac over 2001–2007, pledged substantial financial assistance, it never managed to restore fiscal and external sustainability, as can be seen in these two charts:
What’s clear in retrospect is that the period immediately following on from the global financial crisis of 2008 – when about $30bn of capital (around 100 per cent of GDP at that time) flew into Lebanon – was rendered a wasted opportunity to turn things around.
The majority of the inflows resulted from the repatriation of foreign assets in the context of low global interest rates. While the central bank of Lebanon (the Banque du Liban, known as the BdL) used part of these inflows to beef up its reserves, about one-third ended up financing the expansion of an already large current account deficit. More than half of the expansion in the current account deficit, meanwhile, was linked to an increase in primary (net of interest) government expenditure. Inflows also led to a burst in inflation, which peaked at 10 per cent in 2008, and to a real appreciation of the Lebanese pound.
In that context, high nominal growth led to a reduction of the debt-to-GDP ratio, but much more could have been done to use the favourable global conditions to improve Lebanon’s fiscal accounts, and to channel productive investments into the country that could stimulate long-term growth.
Instead, the capital inflows of 2008–2009 saw the central bank become overly obsessed with the sanctity of foreign currency. Soon enough, foreign reserves became the be-all-and-end-all of all policy, with the central bank going into panic mode if and when reserves began declining even slightly – despite them remaining well above pre-crisis levels.
A RESERVE PONZI IN THE CENTRAL BANK
The simultaneous desire to keep reserve levels high and to bail out troubled banks eventually led to the implementation of unconventional – and controversial – financial engineering policies. These included the provision of subsidies to commercial banks that were willing to increase dollar deposits at the central bank. Such policies introduced large fiscal costs. But they also, in other respects, resembled a Ponzi scheme since the central bank was paying ever-higher interest rates to attract dollar funds, even though those funds were not generating sufficient returns to repay the interest and capital.
Paradoxically, the attempt to protect gross foreign reserves then led to a large reduction of the central bank’s net reserves (ie, total foreign reserves minus gross central bank FX liabilities, adjusted for the Lebanese pound-denominated monetary base) which, according to credit rating agencies, are now negative to the tune of 100 per cent of GDP.
While it’s true the war in Syria, which started in 2011, put a strain on the Lebanese economy, it’s unlikely it was the root cause of the financial crisis. The war’s effects were mainly on Lebanese exports as well as on immigration (Lebanon has received more than 1m Syrian refugees since the beginning of the war.)
In 2013, the World Bank estimated the war’s total fiscal cost of refugees amounted to some $2.6bn, a figure more than offset by the $8.1bn in development aid disbursed to Lebanon over 2012–18 relative. To compare, it had $3.9bn received in aid between 2006–11. Moreover, rather than observing a negative financial shock, the start of the war coincided with another acceleration of capital inflows, driven by $13bn worth of foreign asset repatriation by residents over 2012–14.
THE WAY OUT OF CRISIS
The economic reform package put together by the national unity government – formed in early 2019 by a coalition of all the main political parties (which besides having different political ideologies also represent different religious groups) – was perceived as punishing for ordinary citizens, without dealing with the endemic corruption that benefits the political and economic elites. On October 17, reports of a possible tax on internet-based call services became the straw that broke the camel’s back, leading to street protests and bank closures.
Since the fiscal and external situation remains unsustainable, some sort of haircut or restructuring will be needed to curb the crisis. But any such solution will be difficult and painful. It is paramount therefore for policies to be perceived as fair by all the various stakeholders, especially given Lebanon’s many economic, social, and religious cleavages.
While currency depreciation is often a good solution for restoring external sustainability, this is not advisable in Lebanon for at least two reasons. First, Lebanon has almost no export sector so any currency adjustment would have to be accompanied by an import contraction. This would incur dire consequences for the most disadvantaged economic groups. Second, Lebanon’s exposure to dollar debt means depreciation would further deteriorate the fiscal situation and also have negative balance sheet effects for the private sector. Import taxes on luxury goods are probably a wiser option.
Equally, because Lebanon’s primary deficit – the total government deficit excluding interest payments on public debt – is low, a well-designed reprofiling of the public debt (ie a lengthening of the maturity at lower interest rates without a face value reduction) could go a long way in restoring fiscal sustainability. However, the banks hold large amounts of government debt and would suffer from such action. While a haircut on depositors may be necessary it is important not to continue to bail-out bank shareholders. Furthermore, it’s important that all depositors be treated equally.
While many ordinary citizens have lost full access to their bank accounts, some well-connected depositors have been able to move their funds abroad. Accordingly, to really be effective and fair, the haircut on bank deposits would have to be applied on balances before banks started imposing limits to withdrawals, and possibly exempt small depositors to compensate for this unfair treatment.
The key question, however, is who is going to do all this? The Lebanese population has lost trust in its political elite. And yet, this painful programme needs to be implemented transparently by a trusted government.
It also has to be implemented soon. If any specific group was to be given an easier ride than others, this could dramatically destabilise an already complicated political equilibrium.
While we would like to be optimistic, we are fearful that until a government that holds the full trust of the Lebanese people emerges, things could get worse.
