Introduction by Executive Editors When the Council of Ministers approved an economic reform program at the end of April, 2020, then-Prime Minister Hassan Diab hailed the plan with the epithet that ”the State has in its possession, for the first time in history, a complete and integrated financial plan.”
However, Diab’s optimistic assurance that this document, based on a study prepared for the Lebanese government by US-headquartered financial advisory firm Lazard, would “put an end to floundering financial policies that brought the country to the current state of collapse” was disputed long before the cabinet’s resignation in the aftermath of the August 4, 2020 Beirut Port explosion.
Diverse voices, from the banking industry to economists, academics, and economic media, offered critical responses, amendments, and counter proposals to the government rescue plan from the moment of its release. In one, from today’s vantage point ironic, example, a document by various authors at the American University of Beirut (AUB) asked if the government’s financial recovery plan was a “Rescue or Jeopardizing Plan.” The introduction to the document noted that the plan does not call for celebration but rather “generates valid concerns about its directions and goals.” This introduction was penned by Nasser Yassin, then director of the American University of Beirut’s Issam Fares Institute and today minister of environment in Prime Minister Najib Mikati’s cabinet.
Other criticisms and counterproposals to the plan were listed on a webpage of the library of finance at the Institut des Finances Bassil Fuleihan. Issues of Executive Magazine that contain comment and analysis pieces on the numerous rescue proposals under discussion at the time include the February, March/April, and June/July issues of 2020. Given that a new rescue plan for the much worsened Lebanese economy is a matter of high importance, and that there have been references to Lazard in remarks by Prime Minister Mikati, Executive aspires to inform the debate by publishing, for the first time in an English-language magazine, the detailed critique of the Lazard plan by Mounir Rashed.
In his introduction to his critique of the Lazard plan, Rashed noted “several gaps” in the so-called reform agenda adopted by the former Lebanese Government. “Reviewing the government’s plan makes it evident that the plan sets the stage for further restrictions on the Lebanese economy while dismantling its vital private institutions, including banks, which may cause a rift between the country’s social classes,” Rashed wrote in an assessment that is as concerning today as it was then. He elaborated further that the plan in his analysis represents, among several erroneous assumptions on the economic structure of Lebanon, a blatant violation of the Lebanese constitution, submission to foreign interests, and is apt to further corrode citizens’ trust in the state.
The following article has been adapted from a confidential report written in May 2020. Most references in the text below are to the 2020 plan and the cabinet of Hassan Diab. The author has updated the text in November 2021 after Prime Minister Mikati started negotiations with the International Monetary Fund (IMF) and the Cabinet presented a revised financial recovery plan in end-November. Material changes in the updated text are italicized in the text.
In general, the Lazard plan’s framework displays a clear confusion between instruments and objectives, failing to differentiate between these two fundamentally different paths. Likewise, several of the proposed remedies are not expected to yield any short-term results in addressing the current crisis, such as fostering good governance and repatriating looted funds. Their proposals do not offer current solutions for the current bottlenecks, as they do not differentiate between immediate and long-term measures as demonstrated in the program’s main list of pillars.
The purpose of these pillars is also not evident. It appears that the first objective consists of securing a financial recovery plan from the international community, thus perpetuating the crisis and the suffering of the Lebanese people, rather than adopting immediately effective measures with quick wins that would alleviate the burden befalling the Lebanese citizens. The plan solicits the assistance of foreign institutions, which are oblivious to the Lebanese economic and social context. It also clearly does not take into account the recommendations of direct stakeholders, including the Lebanese central bank, Banque du Liban (BDL), banks, depositors, and the business community. Apparently, the plan assumes these interests have no role to play in the reform process.
The plan fails to indicate that resorting to foreign institutions for funding will come at a hefty price, as it entails several conditions that will undermine governance and the State’s ability to fulfill its obligations towards the Lebanese citizens. This will also perpetuate, and increase foreign debt servicing, and will weaken the resilience of reserve management and of the exchange rate.
It is important to note that the IMF’s funding will be part of the overall debt plan and that its debt service will be due in only a few years. In contrast, given that the interest of Lebanese citizens is directly aligned with that of the state, the plan could have resorted to generating domestic savings for funding, without resorting to a deposit “haircut.” Above all, deposits should be safeguarded. The prevailing circumstances in Lebanon do not call for foreign funding. The current account of the Balance of Payments witnessed a significant drop in 2020 and was absorbed by BDL. As such, the Balance of Payments can still secure sufficient self-financing without having to resort to BDL’s reserves.
On the other hand, according to US investment bank Lazard Ltd., the “godfather” of the original financial recovery plan, foreign funding is estimated at a staggering amount of $27 billion for the period of 2020-2024, meaning that in the next five years foreign debt will go from about $8 billion to $35 billion in the least, and to $45 billion if we add the expected CEDRE loans, the majority of which will be classified either as bilateral debt or debt to international institutions.
The plan suggests a gradual ending the Lebanese pound peg to the US dollar at the official rate of 1,507 Lebanese pounds per $1. It stipulates that such a decision falls within BDL’s competence, even though the decision has always been in the hand of the cabinet and Central Monetary Council.
Since 1997, successive cabinets pegged the Lebanese pound to the dollar, with BDL’s Central Monetary Agency’s approval. Therefore, it is recommended to inform citizens of the entity responsible for setting the exchange rate policy. The decision to unpeg the exchange rate and its subsequent depreciation were the outcome of the government’s unsound fiscal policy. The accumulation of financial deficits, particularly in the electricity sector, have weakened the state’s Balance of Payments and depleted a substantial chunk of BDL and the commercial banks’ foreign currency reserves. The total debt in US dollar indicates that net foreign reserves were exhausted years ago. Additionally, the adoption of the previous cabinet’s budget by the new government has also contributed to weakening the Lebanese pound further.
The government’s and Lazard agenda suppose that the exchange rate is set at 3,500 Lebanese pounds per $1 in 2020. Yet we are well aware that the current rate has exceeded 4,000 Lebanese pounds per $1 when the plan was formulated. This implies continuing to have multiple exchange rates practice, even though the government aware of the repercussions this will entail. The current system of multiple rates engenders substantial untargeted subsidies and weakens the balance of payments.
Furthermore, the plan of 2020 had set the target exchange rate at 4,297 Lebanese pounds per $1 by 2024, but the free market’s exchange rate has escalated to over 27,000 Lebanese pounds per $1 at the date of publishing this article.
The government’s policy on capital control is yet to be announced. With the unpegging of the exchange rate, it is recommended that banks remove all discretionary controls on capital transactions for current account financing and transferring capital. Additionally, any restrictions imposed by banks in this regard must be governed through clear laws. Even the IMF has announced that reform should precede imposing capital control measures. As evidenced over the past 18 months, banks’ foreign exchange has been depleted.
It is recommended that the government set objectives for its monetary policy in consultation with the BDL. The plan called on BDL to gradually eliminate monetary funding to purchase treasury bonds. This proposal supposes that the government’s fiscal policy will generate surpluses throughout the plan’s duration, allowing BDL to retrieve treasury bonds, while the overall fiscal deficit will likely remain at an average of 4 percent of GDP throughout the plan’s duration.
Balance of payments
In this context, the plan indicates that it would be unrealistic to think that the deposit flow will change direction in the near future, or that international markets will open their doors to Lebanon once again without a clear blueprint; the plan assumes that it will succeed in redirecting the money flow back into the country. However, assuming that the plan will generate a flow of foreign aid to Lebanon once it is adopted, constitutes an oversimplification of reality.
Donors usually provide gradual support based on the progress of reforms and the fulfillment of performance criteria. However, the latter will not necessarily be to the government’s expectation as they are not a mere set of measures. Instead, the state must prepare a roadmap for implementation, which is likely to encounter several hurdles, including the restructuring of debt and banks.
Furthermore, the state’s calculations of foreign aid are highly far-fetched. The plan estimated the government’s needed support to be equivalent to $28 billion over five years (Table 1). Following the drop in the foreign exchange rate and bank restrictions on foreign transactions payment, it cannot be expected that the cumulative deficit will settle at this level. It is also likely that the debt service account will be slashed by half for the same reasons. The current account is expected to shrink by $10 billion per annum, starting 2020. As such it will be difficult for Lebanon to secure the aforementioned amount in foreign aid, given its low quota at the IMF, amounting to only $850 million (SDR633 million).. Donor countries may not rely on the Lebanese state’s estimations and its plan of providing foreign funding. Foreign funding estimations also take into consideration the country’s total reserves which currently amounts to around $14 billion (excluding gold), and its ability to service its foreign debt and its amortization.
Moreover, the CEDRE-related funding mentioned in the plan does not aim to restructure the debt and banking system, but rather to implement a development program. The plan further assumes that Lebanon cannot undertake a self-reform scheme, an unrealistic assumption, especially that the road towards reform is quite clear. The question then is why the Lebanese government is waiting for the IMF’s approval. Lebanon undoubtedly harbors substantial potential that has not been utilized. Instead, the government resorted to foreign entities to chart the course towards reform, without realizing the cost of such interference, primarily in delaying reform until an agreement with donors has been reached.
The Ministry of Finance has devised most fiscal reform proposals in the plan, the most realistic of which are those that limit spending. However, it is recommended at this junction that taxes be deferred until the economy recovers, while spending increases can be deferred and consequently could be decreased as a percent of GDP, with the exception of capital expenditures. Increasing, locally funded capital expenditures boosts economic growth. Likewise, resorting to funding through CEDRE requires local counterpart funding of at least 25 percent, which in turn calls for increasing locally funded capital spending, while the plan suggests otherwise.
The plan aims to bring Lebanon’s financial deficit down to 1 percent by 2024. However, it is recommended that the country’s public finance achieve a balance within a shorter period of time. A persisting financial deficit for another multi-year period (either the five years from 2020 to 24 in the original plan or the three years from 2022 to 24) will weaken the state’s current account balance and continue to put pressure on the exchange rate. It is unlikely that the plan will succeed in bridging the aforementioned deficit, while at the same time propose public wage increases, whereas the revenue outcome is uncertain.
The debt restructuring policy was not built on sound foundations, but rather consisted of defaulting on the payment of foreign currency (Eurobonds) in March 2020, and local currency debt, without consulting with local and international creditors. As a result, Lebanon’s credit rating fell to a junk rating, and private banks’ finances were exhausted, making it increasingly difficult for the private sector to secure foreign funding.
The unilateral decision proposed by Lazard made to deduct local debt has deepened the gap between the assets and liabilities of banks along with BDL. It undermined BDL’s ability to continue implementing its monetary policy of alleviating the pressure on the exchange rate. As such, the government’s decision to default on its debt payments has contributed to the collapse of the currency, although at that time the BDL didn’t support such a measure.
The Lebanese state was able to service debt until then. Defaulting on payment and classifying government bonds as distressed assets was an unsound measure and led to further economic collapse.
The state’s compliance with the Lazard proposals, which suggested defaulting on payment, was devoid of logic and did not serve the public interest. The state had better service the due debt and then consult with financial institutions on debt restructuring, noting that international financial institutions’ share of the debt in US dollars did not exceed $5 billion until the end of February 2020, according to Bloomberg figures.
Restructuring the financial sector
The scale of financial losses estimated by Lazard consisted of fictitious and overstated losses, which have primarily resulted from the State’s unnecessary decision to default on debt payment. The reform program also called for deducting most of the principal of the local debt, to restore it to a sustainable level. Therefore, based on the default in payments, the government assumed that banks were bankrupt, rather than admit their own bankruptcy.
This uncalled-for decision led to an acceleration of the economy’s regression, and deterioration in local and international trust. In fact, the aftermath has started to burden the poor predominantly, while claiming to protect them.
Restructuring the central bank (BDL)
BDL’s losses were inaccurately estimated and overstated. Pumping liquidity through seigniorage was BDL’s response to the government’s flawed fiscal policies, which exacerbated debt, increased interest rates, and contributed to the economic recession.
The government’s decision to peg the Lebanese pound to the dollar has also played a role in this regard, leading to the subsidization of imports, causing acceleration of deficits in the Current Account. The plan, meanwhile, admits that seigniorage cannot be considered a loss. “Transfer of losses through seigniorage is a common practice widely practiced by central banks around the world during crises.” (See: The Lebanese Government’s Financial Recovery Plan, p. 40).
Why does the plan, then, assume that Lebanon’s situation is different? Why are seigniorage costs considered as a loss of $40 billion? The plan suggests these losses are the outcome of the Lebanese pound/US dollar peg policy, approved by successive cabinets to safeguard the currency exchange rate.
The government also assumed that the central bank was subjected to additional losses, resulting from Treasury bond holdings amounting to $20.8 billion, raising the total losses to $61.8 billion. The plan stipulates that compensating for these losses must come from bank deposits. In other words both resident and non-resident Lebanese citizens have to absorb these losses along with bank deposits at BDL. And while the government’s justification does not align with BDL’s view, the latter reserves the right to ask the government to settle all dues, including deposits and bonds, which would be the right measure to take instead to having depositors and BDL carry the entire cost. The central bank can adopt this measure as it is an institution with an independent policy, while the funding provided to the Lebanese state exceeds the ceilings set forth by the Code of Money and Credit. As such, depositors (particularly non-resident ones) are willing to resort to legal measures, disabling the state both internally and externally, in case the government fails to carry its responsibility towards depleted banks’ deposits at BDL.
Restructuring the banks
Both the Lebanese Government’s Financial Recovery Plan and the earlier Lazard plan assume that banks have incurred losses amounting to $20.6 billion, for owning Lebanese State bonds, Eurobonds and Lebanese pound bonds, as well as non-performing private sector loans. As such, the banking system’s overall losses amounted to $84 billion, according to Lazard calculations. The plan further assumes that the Lebanese economy will not recover unless banks are restructured, making all losses incumbent on bank depositors. Is liquidating banks the ultimate objective? The plan adds, “Authorities are convinced that law-abiding citizens should not bear the brunt of these measures.” But where will the Lebanese state possibly acquire the bail-in sums needed for its law-abiding depositors?
Issuing licenses for new banks, as the plan suggests, is by no means easy at a time of economic recession. How would these banks secure deposits, especially foreign currency deposits? Therefore, it is recommended to coordinate and consult with the central bank, as it is directly responsible for issuing licenses and assessing the need for new banks.
The alleged losses of the banking and financial sector mentioned in the Lazard plan were fictitious. As mentioned earlier, seigniorage cannot be considered a loss, as it is the result of measures taken to secure monetary stability. Likewise, one cannot assume that some of the state’s bonds now have no value (40 percent of state-issued bonds) and are considered total losses. Does this mean that the remaining bonds are of value?
The banks’ actual losses only amount to 47 trillion Lebanese pounds ($13.3 billion) and primarily consist of private-sector loans. However, the net value of losses must be calculated, as most loans are approved against collaterals that compensate for such losses. The government predicts that it will be able to retrieve $10 billion of looted funds over the next five years (See: The Lebanese Government’s Financial Recovery Plan, p.32). If this is the case, why rush to secure foreign loans? After all, this is the sum needed to bridge the gap with foreign funding.
The plan also seeks to cover losses by deducting most of them from client deposits in banks by resorting to a bail-out measures and replacing deposits with bonds and assets in the Deposit Recovery Fund, the fate of which is uncertain. In principle, these measures fall short of a haircut and will cause an endless confrontation with depositors that could end tragically in total economic collapse. It is inevitable that many depositors will resort to local and international justice to resolve the issue.
On the other hand, establishing a Public Asset Management Company to compensate for deposit losses will not succeed in addressing the issue, as it will take decades to do so, while the state lacks the resources needed to manage it.
As such, the plan will likely yield the following outcomes:
- A continued drop of the Lebanese pound rate against the US dollar;
- Undermining trust in the banking system;
- Reducing consumption, production, and investment due to shrinking individual wealth;
- Discouraging foreign investment;
- Curbing foreign remittances;
- Increasing financial deficit; and
- Exacerbating poverty
The banking system will be unable to retrieve billions of dollars’ worth of locally saved cash in foreign currency stashed outside banks.
Therefore, the agenda, which is extensively based on fictitious assumptions, will yield severe repercussions. It harbors unfair practices towards both wealthy and poor citizens and seeks to destroy the Lebanese economy, oftentimes to the ignorance of those responsible for it. The plan was built on wrong foundations, including the alleged state bankruptcy, inflated foreign aid, and the assumption that Lebanon cannot overcome the crisis alone without dependence on the IMF.
According to Lazard, the IMF had initially had a similar position, estimating that losses were tragic and called for an $80.7 billion bail-in and a 79 percent deduction from deposits.
From a financial standpoint, the plan misleads citizens into believing that deficits are substantial and cannot be resolved without external support.
The government can actually overcome obstacles and address the high demand on the US dollar through taking the following steps:
- Fully unpegging the exchange rate and making all current transactions at the current market rate. In this context, BDL can be in charge of announcing the official rate on daily basis;
- Liberalizing Current Account transactions;
- Reducing the fiscal deficit to 1 percent of GDP by consolidating the state’s debt in local currency at BDL and lifting subsidies on the electricity and other sector. These two measures will secure over 6 trillion Lebanese pounds to the Lebanese Treasury;
- Decreasing compulsory US dollar reserves on deposits;
- Providing liquidity through the gold reserves, which falls under the competence of BDL pursuant to the Code of Money and Credit;
- Liberalizing interest rates on all deposits immediately and allowing the restructuring of debt and deposits, under these exceptional circumstances;
- Gradually transforming money supply into the local currency through trust-building measures.
As such, Lebanon’s President, PM, and Speaker must announce that the state is keen on preserving citizens’ deposits in the deposited currency and that compromising the deposits of residents and non-residents is a breach of the Lebanese constitution and a threat to civil security. The very mention of the term “haircut” has terrified Lebanese citizens whether locally or abroad, noting that an important share of deposits belongs to the Lebanese diaspora.