Over the past few decades, public debt, sectarian nepotism, and fixed exchange rates have been three significant challenges to the Lebanese economy; albeit there are many others. In terms of the monetary financing of the public sector, the historical perspective shows that the current situation is comparable to that of the second half of the 1980s, yet very different from the period before the start of the civil war, i.e., 1965 to 1975.
As short as it may have been, the period stretching from 1993 until 2004 gave rise to the factors behind the current Lebanese dilemma. Both the country’s devastating civil war and the appointment of Riad Salameh as the governor of “Banque du Liban” (BDL)—the central bank—in 1993 were accompanied by significant junctures in monetary policy.
Additionally, Lebanon has undergone incompatible economic fundamentals since 1998. Increasing the country’s debt has made monetary policy hostage to the public budget, a situation that prevented the central bank from achieving any objective other than investing in public debt securities. To be sure, the dollarization of the economy led Salameh to play a populist’s role; one that aimed to constantly fix the exchange rate. The result was thus a central bank that was torn between two essential needs: reconciling the debt of public finances and maintaining the exchange rate.
The Public Debt Dynamics: A Snowball Effect
This paper is concerned not with the general problem of public debt for which there are many reasons, but more precisely in explaining how the budget deficit had a coercive effect on monetary policy.
Since monetary policy is not enshrined in the Taif Agreement of 1989—which amended the Lebanese constitution—to force the BDL to ensure a steady rate of money growth, the Lebanese financial collapse is undoubtedly an economic phenomenon that is exclusively the fruit of a faster increase in the mass of money than in productive activities. Consequently, the roots of the crisis feature a rapid rise in public spending and its financing by creative monetary mechanisms. As a result, Lebanese debt interfered severely with determining the exchange rate, escalating a vicious circle of unpleasant budget deficits since 1990.
There have been two lasting competing forces in the Lebanese financial sector. On the one hand, public debt interest rates tend to increase that debt. On the other, economic growth has not been able to boost tax revenues, especially given the skewed tax structure. Therefore, the monetary strategy followed by the BDL faked a gross domestic product development (GDP) where the interest rates were higher than the actual GDP.
Moreover, the country’s insolvency that became apparent some time ago, posed many quandaries originating in low tax revenues and high expenditures. As tax revenues decreased faster than public expenditures, government funding needs became acute, which created a snowball effect that was more substantial than the lift in revenues allowed by economic growth.
To face Lebanon’s unstable public debt dynamic, and under the severe limits on reforming the political system, creating money remained the government’s only available option. Once the former continued, the latter had to adjust the strategic game between fiscal policy and cash flow. The ruling class’s decision to stabilize inflation through a unilateral economic approach failed, forcing the central bank to adopt a financial strategy that used innovative techniques to secure money sources and postpone the inflationary impact on the wider economy.
In November 2002, the worrying situation of Lebanese public finances had already begun. A significant international financial conference—the so-called Paris II—supported fiscal customs duties and the implementation of a value-added tax (VAT). At the end of the meeting, the Lebanese government obtained financing on preferential terms to implement a program of reforms and privatizations aimed at stabilizing public finances, with BDL cancelling some treasury bills to restructure its balance sheet, and commercial banks participating by providing cash or initiating debt swaps. Indeed, according to the Lebanese Ministry of Finance, Paris II generated a combined $10.1 billion of revenue, a good one-third of public debt in November 2002.
Still, the fact remains that the Lebanese economy became caught up in the explosive dynamics of the public debt. This forced the macroeconomic policies of the government to be placed under the fiscal domination described above and made the BDL practically responsible for the monetary financing of a chronic deficit. The BDL replaced direct loans to finance the public sector with treasury bonds whose main advantage was to enhance the liquidity of the markets. However, in terms of the monetary approach to finance day-to-day operations, the result remained unchanged.
Net lending is the balance of the central bank’s assets and liabilities vis-à-vis the government. Macroeconomic theory, particularly that of public debt dynamics, most often neglects the government’s holdings with the central bank to focus on its debt to it. But in reality, in the Lebanese case, two types of public assets exist: public sector deposits (public sector accounts) and the reserve for the re-valuation adjustment of gold and currency assets that increased sharply because of the depreciation of the Lebanese pound during the war. Articles 115 and 116 of the Lebanese Money and Credit Code clearly show that the government owns this reserve. The cancellation of the public debt held by the central bank that was decided at the Paris II conference was in fact “financed” through this re-evaluation reserve of gold and currency assets.
The logical consequence of the tremendous public debt in the central bank’s assets is a decline in the share of private sector financing. In other words, this commitment to finance public debt has severely constrained the activity of the banking sector, preventing it from fulfilling its regular role as a financial intermediary that collects household deposits and grants loans to businesses; thus, supports economic activity. In order to manage public debt, the central bank chose to use the most sophisticated financial engineering techniques, mainly lengthening maturities and placing securities to the point of saturating local banks. Along these lines, the banking sector failed to conduct a genuine monetary policy to regulate economic activity and inflation.
Limiting credits to private domains because of financing the government sector explains why the evolution of public debt has not resulted in a quick inflationary surge. Another explanation is the fixed exchange rate regime: rather than putting the whole stress level on prices, the pressure was on the Lebanese pound’s (LBP) exchange rate.
Dollarization and the Lebanese Economy
The term “dollarization” is, schematically, the use of a foreign currency in parallel with the national currency through various economic activities of the country. “Monetary substitution” is the use of a foreign currency as a means of exchange and constitutes an advanced stage of dollarization. An economy can be eminently “dollarized” if many bank deposits are denominated in foreign currency.
Dollarization is caused by the absence of confidence in the national currency, in response to economic instability and inflation, possibly due to political unrest, or even armed conflicts, as in the case of Lebanon. Thus, the dollarization of deposits increased with the persistence of instability in the country, the acceleration of domestic inflation, and the depreciation of the pound. However, the degree of dollarization could remain high even after an economy has stabilized. In Lebanon, the dollarization rate of resident deposits was much higher after the 1993-94 stabilization than before the civil war. The lack of political credibility may explain the unwillingness of depositors to convert their dollarized assets into national currency. The dollarized Lebanese economy was a natural result of the susceptibility and the gravity of the banking and currency crises.
Indeed, it is all a matter of risk, the first of which is the liquidity needs of the public sector and the role of banks in transforming maturities. Commercial banks, as intermediaries, usually receive short-term deposits and grant long-term loans. They thus give over a colossal risk of illiquidity. Usually, banks manage this risk by keeping a portion of their assets in banknotes to deal with withdrawals from depositors, as well as bonds and treasury bills that are easier to liquidate in the financial markets. The banking system’s legal code also includes measures designed to prevent a bank from going bankrupt, causing a general rush of depositors, which can lead to a systemic crisis.
The second risk is that of insolvency, which occurs when the value of the bank’s assets does not cover commitments to depositors. The management of this risk is the core of the banking business and depends highly on the “quality” of borrowers. Prudential regulatory elements limit the risks taken by banks (such as ratio of capital or minimum reserves). The dollarization of deposits weighs heavily on bank solvency, essentially by generating a currency risk since, in the event of depreciation of the local currency, the value of the liabilities in foreign currencies increases mechanically. To achieve excessive profits, on the one hand, and to consolidate their investments, on the other, banks adopted the policy of granting foreign currency credits in order to avoid the exchange risk. Rather than facing the risk themselves, borrowers became the ones who had to deal with this threat. However, there are laws that protect bank clients, especially those whose income is in national currency. The risk of bank insolvency linked to the foreign exchange position becomes indirect, but very consequential. In the event of depreciation of the national currency, borrowers indebted in foreign currencies but receiving income in national currency become insolvent, causing a deterioration of the bank loans and threatening the solvency of banks.
While the dollarization of Lebanese bank loans for the public sector was highly risky, the differences in maturity between bank assets and foreign currency liabilities increased financial uncertainty. The balance sheets of Lebanese banks have a further complexity in the current situation since BDL’s ability to provide liquidity in US dollars is limited by its depleted foreign exchange reserves. Moreover, the ill-advised capital control on bank deposits and the political lack of trust and confidence created exceptional demands on foreign currencies and developed into a deep exchange crisis symbolized by the banking system’s vulnerability to capital movements and the sudden disappearance of outflows.
The following and last constraint on Lebanese monetary policy is the pegged exchange rate regime followed since the late 1990s, and it was undoubtedly the BDL’s only strategy for postponing inflation.
A “First-Generation” Financial Crisis
Since the end of the civil war in 1990, the Lebanese exchange rate regime went through three stages:
- 1990-1992: a de facto free float (independently floating) that, according to the International Monetary Fund means an exchange rate that is determined by the market, with possible official interventions to limit unjustified fluctuations;
- 1993-1997: a prospective sliding parity (forward-looking crawling peg) in which exchange rate adjustments were periodic in response to circumstances;
- 1998-2021: a conventional fixed ratio to one currency (traditional fixed peg to a single currency). This began with pegging the US dollar to 1,507.00 Lebanese pounds.
The success of stabilization depends on the commitment of the authorities to maintain the exchange rate. As the credibility increases, the rate gap gradually narrows.
Having chosen a pegged exchange rate regime since 1998, the BDL must renounce the use of its monetary policy instruments for purposes other than the stabilization of the foreign exchange market and the maintenance of the dollar rate. Consequently, the evolution of interest rates in Lebanon must follow closely or at a distance, depending on the country’s specific risk for the financial markets. The BDL must stand ready to raise the interest rate on the pound as soon as the expectations of economic operators become unfavorable.
The turmoil in Lebanon, according to the scenario just described, was inevitable. To avoid collapse, unfortunately, it was not BDL’s priority to rearrange the exchange system and the international financial integration of Lebanon. The central bank engineered its fraudulent financial engineering to attract capital instead of confronting the reality. The economy must free itself from the constraints pushing it down this disastrous path to collapse.
At the level of “value,” the Lebanese pound has already lost the battle, with its value to the dollar fluctualing wildly and ever so negatively. Any exit from the current limit regarding the exchange rate should be renouncing the current monetary policy definitively rather than removing its constraints. Indeed, the Lebanese pound should be allowed to float so that the market can determine its value, not the BDL that no longer has the ability to fix it. Such a decision would not solve the problem of public indebtedness, but it may help in arresting the continuing slide of the national currency.
The views expressed in this paper are the author’s own and do not necessarily reflect the position of Arab Center Washington DC or its Board of Directors.
