What’s next for Lebanon’s crisis-hit economy?

Lebanon is facing a combined political and economic crisis that has led to widespread bank closures, and semi-official capital controls limiting the amount of cash that individuals and businesses can access.

A sharp rise in demand for cash and a perilous drop in the value of the lira on the black market have also added to the country’s pressures.

But the country’s economic fallout has been a long time in the making. Below we take an in-depth look at the origins of the crisis:

So where did all the dollars go?

Lebanon’s economy is highly dollarized. Since 1997, the official exchange rate has been fixed at between 1,507.5-1,515 lira per dollar, creating a point of stability for the turbulent Mediterranean country. Despite periods of instability, Lebanon has never defaulted on its external debt.

If the peg were removed, inflation would skyrocket, and the lira’s value would drop drastically.

To maintain the dollar peg, the central bank requires a constant inflow of dollars. The country also needs billions of dollars to be able to pay for imports of goods, such as fuel, wheat, and medicine – all goods that Lebanon does not produce. The Lebanese budget has also been running at a deficit, funded by public debt which has ballooned to $86 billion, or 150 percent of gross domestic product (GDP) – the third-highest debt ratio in the world when compared to the size of the economy.

To service this enormous debt and pay for imports, Banque du Liban, the central bank, has pulled in fresh dollars by offering commercial banks high returns on dollar deposits. In return for these deposits, the central bank issues Certificates of Deposits (CDs).

The central bank’s lavish returns have damaged the Lebanese economy. The bank owes an estimated $4 billion per year to commercial banks in interest alone and the state spends half of its revenues on debt servicing.

It has also resorted to “financial engineering,” in which it printed lira currency to reward commercial banks for depositing dollars. This money printing has contributed to the devaluation of the lira in the black market and downgrades by global ratings agencies deeper into junk territory.

Real cash versus fake money

Now in the midst of a crisis, there is only $40 billion in cash left in the Lebanese economy – a quarter of the $170 billion in deposits showing on banks’ balance sheets, former banker and Harvard fellow Dan Azzi told Al Arabiya English.

Other estimates put that figure even lower, as the bulk of deposits are either locked up at the central bank or loaned to the private sector. Around third of these private sector loans are non-performing, by Azzi’s estimation, meaning that the banks are unlikely to recover their money.

“It’s like a movie from the 1990s where you have two worlds: the real world and a cartoon world,” Azzi said. The real world, according to Azzi’s analogy, represents goods that must be purchased in dollars from abroad, including essentials such as fuel, medication, and wheat. The fake, or “cartoon” world is the Lebanese economy in local currency.

“Now the cartoon world is spilling into the real world. Now guy with fake money wants to take out real money. The guy in the hospital wants to buy a syringe. The fuel station owner wants to buy fuel. They are all are competing for Riad Salameh’s dollars,” said Azzi.

Central bank governor Riad Salameh has repeatedly promised that the country has enough cash to pay for imports on top of servicing its bulging debt. The latest debt repayment – a $1.5 billion Eurobond – was paid today, local media reported.

Meanwhile, the supply chain of goods tells a different story. Many suppliers are now demanding that shipments be paid in full before delivery – previously, suppliers gave clients between 90 and 120 days to make payments. Food shortages are also looming. The Chairman of the Syndicate of Importers of Foodstuffs, Hani Bohsali, voiced concerns earlier this month that basic imported foodstuffs such as pasta may soon be cut off.

With Lebanon in political gridlock after former Prime Minister Saad Hariri resigned last month, it seems solutions will come neither easily nor quickly. But good statesmanship could still turn the ship around, according to Mohammad al Akkaoui, an economist for the political reform lobby group Kulluna Irada.

Akkaoui’s said that any reform plan – which includes a medium-term fiscal framework, debt restructuring, haircuts on deposits and equity, formal and temporary capital controls and a social safety net – must be “swift, fast and effective.”

To swiftly implement these reforms, the government needs a cabinet of “politically independent experts … who have special and limited legislative powers in time and scope,” Akkaoui added. This would allow officials in charge of fiscal and monetary policies to take decisions without going through parliament.

“It is not important who does it. It matters that it gets done. A fully functional crisis management government is needed. There is an emergency right now,” he continued.

Getting out of the hole

The term “debt haircut” has become popular among Lebanese analysts recently, describing a situation where creditors agree to write off a percentage of the money they are owed in return for a new promise to pay according to a new interest rate and timing schedule.

“There is an excess of fake money. A haircut reduces the claims on the real money. It is good for a balance of payment problem… It doesn’t have to be brutal,” Azzi explained.

The mechanics of such a measure are hotly debated. One way of applying a haircut would be to apply a 50 percent haircut to bank deposits above $1 million, but this affects only the wealthy, Azzi continues. Another method would be to apply a progressive haircut, meaning that savers who earned excessive interest when the going was good – above 10 percent, for example – pay more.

A third way would be a forced conversion of all deposits and liabilities into lira, leaving all consumers worse off.

As for the third option, “it sounds fair, but you hit the little guy the same as the big guy,” Azzi continued. Azzi believes the latter solution may be the most likely, since “rich folk are the ones making the decisions” and are therefore more likely to spread the cost around.

In any case, a debt haircut would require the government’s approval – which is difficult to achieve without a functioning parliament. Last week, protesters, who are demanding the fall of the sectarian ruling class, forced MPs to postpone sessions by blocking roads leading to Nijmeh Square.

“Until now there has been denial on a political level of the extent of crisis … Some people want to kick the can down the road. People with the least to lose are those for full reshuffling,” added Akkaoui.

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