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For better or for worse

The tricky task of unpegging Lebanon’s lira

by Thomas Schellen

It was the financial markets’ first big surprise of the year. In January 2015, the Swiss National Bank (SNB), the Alpine republic’s central bank, scrapped its 1.20 ceiling that limited the franc’s ascendancy vis-à-vis the euro. The franc suffered a rare appreciation shock that has been reflected by a higher valuation versus the euro throughout the end of last month with no end in sight. In June, around 1.05 Swiss franc (CHF) sufficed to buy one euro, and as the SNB acknowledged in its June 18 monetary policy assessment update, estimates saw Switzerland’s real GDP at a slight decline in the first quarter of 2015. “In several sectors” profit margins came under significant pressure, “goods exports suffered from the strong Swiss franc appreciation” and unemployment increased slightly, according to the SNB statement.

Outside of Switzerland, the franc’s double-digit percent leap in exchange value against Eastern European currencies hit home loan borrowers from Bucharest to Zagreb and Warsaw. In Poland, about half a million home buyers who had financed their mortgages in Swiss francs were affected. In response, the winner of the presidential election in May 2015, Andrzej Duda, said last month that he wanted to force banks to assume part of the borrowers’ cost burden created by the zloty’s drop against the franc.

The SNB had removed its cap despite the predictability of negative impacts. The bank thus even had to accept temporary doubts about its reputation as guardian of stability, as globally renowned investment whizz Mohamed El-Erian opined last month in a comment for Bloomberg.

But perhaps the worst disappointment was that the SNB had promised something else just in December 2014. In its monetary policy assessment that month, it observed that deflation risks had increased and the Swiss franc was still high. “Consequently, the SNB will continue to enforce the minimum exchange rate with the utmost determination,” it said, adding that the central bank was “prepared to buy foreign currency in unlimited quantities for this purpose.”

In the perception of an adroit Lebanese observer of international finance and politics, investor Roger Eddé, the Swiss central bank’s decision was “a shame” precisely because “they changed the exchange rate even though they had just said they would not do that. This is anathema in the history of the Swiss central bank and any central bank. They should have done what other central banks have shown: prepare the investors and public opinion ahead of time before implementing such a decision.”

Far beyond causing bad emotional vibes, the evidence in the case speaks for itself. As one European economist noted, in the immediate aftermath of the SNB’s about-face, the Swiss franc experienced its strongest appreciation since the Bretton Woods’ system’s switch to flexible exchange rates 44 years ago. Unless one is prepared to mislabel the Swiss central bank — a primmer than prim entity among the world’s most staid institutions, praised in 2007 on the occasion of the SNB’s centenary ceremony as a “stronghold of unity” by then Swiss president Micheline Calmy-Rey — as some sort of rogue financial agent or monetary authority gone insane, one has to accept that this paragon of independent monetary policy found itself forced into an unwanted direction by an irresistible currency pressure from outside — the euro’s weakness.

If it can happen to the Swiss…

Central banks have committed errors, both forced and unforced, in many instances. A notorious example of a forced error was the Mexican currency crisis (Tequila Crisis). Bad bond issuance choices, political instability, an outbreak of domestic violence and a hike in interest rates by the US Federal Reserve converged in late 1994 to coerce the Mexican central bank into abandoning its dollar peg, thus devaluing the peso. The result was an economic crisis that made it into the history books — and is until today seen as a risk formula for the country with a $1.4 trillion economy in terms of nominal GDP.

It is also worth remembering that history’s worst-ever unforced error by central bankers was the United States’ contractionary monetary policy in the 1930s. This miscalculation early in the annals of the Federal Reserve System is today understood as one of, or even the, decisive factor that escalated the crisis of 1929 into the Great Depression.

Switzerland’s central bank-triggered problems of 2015, which are of the opposite polarity to the vast majority of monetary policy problems anywhere in the world over the past 50 years, are of course a walk in the park when compared with what Argentina, Turkey, Thailand, Indonesia, Russia, Brazil, Mexico and others suffered in various economic crises — which all had exchange rate components. But even for the Swiss, it bears repeating, it was a three-year spell of pegging theirs to another currency the too much that forced their incommode action.

[pullquote]That currency pegs are problematic is, today, a standard assumption[/pullquote]

That currency pegs are problematic is, today, a standard assumption. A study of the Tequila Crisis by noted American economist Frederic Mishkin back in 1999 concluded rather urgently that the first lesson for emerging markets to draw from the Mexican experience is that: “pegged exchange rate regimes are extremely dangerous.” A pegged exchange rate is precisely what Lebanon has maintained for more than 20 years, with no change to the peg since 1997.

However, although factors such as political instability, cost of conflicts, mismatched borrowing, unwise fixed exchange rates and external interest rate or price shocks on the currency seem to play into next to every monetary and economic crisis, it would be unsound and extremely unwise to pretend that every such crisis is cut from one and the same cloth and that one could prescribe, by way of some economic ideology or other, infallible recipes against or even for triggering a national economic crisis anywhere. The variables, ratios, and interactions within a country’s economy and with political factors are just too many. This is true for every country, and decidedly for Lebanon.

The track of our peg

To investigate the specificity of the Lebanese monetary situation, the consideration does best start from the turning point between multi factional conflict and national reconstruction — the time just after the end of the Lebanese Civil War. In 1992, the Lebanese lira suffered from a devaluation shock (the largest of several that have occurred since 1987), where the exchange value plummeted from better than 1,000 to the dollar to 1,500, 2,000 and finally over 2,700 in August 1992.

The arrival of a new government with massive Saudi backing and other foreign support in October 1992 signaled a change in confidence and reversed the slide of the lira. It was a time when transparency in the institutional division of labor appears to have been an extremely minor concern, but a stability target for the lira was set and a currency peg to the dollar was gradually implemented.

“It would be speculation on my part if I said it was the government or the central bank which set the ultimate target back then. But what I can say is that they worked in harmony, in good collaboration in the first part of the 1990s, combining an expansive fiscal policy to boost economic growth and a restrictive monetary policy to fight inflation,” says Joseph Gemayel, professor of economics and dean of the economics department at the Saint-Joseph University (USJ).

“That stopped the fall of the Lebanese pound and the inflation rate was maintained,” he continues. “We can understand that during a period of reconstruction and development this is smart. A more negative result was the crowding out effect, namely the pushing up of the interest rates and its negative effect on economic growth.”

From today’s vantage point, and despite its drawbacks for social equity, that period looks rather good to many chroniclers and economists. “The central bank has definitely played a major role in stabilizing the currency, which was key to attracting investors and key to the market. This [currency peg] decision was very wise and I don’t buy the view of the critics who are saying that this was artificial,” says Sami Nader, an economist and director of the Levant Institute for Strategic Affairs, a think tank in Beirut.

So far, so history

It is one thing to open an emergency patient’s windpipe with a tracheotomy when she or he is unable to breathe. It is another thing if the same status is maintained for 20 years. But that is the case for the central bank’s dollar peg and monetary policy approach.

For Ghassan Hasbani, founder and chief executive of management and business development consultancy Graycoats, it is obvious that such a modus operandi needs rethinking. “It’s a risky strategy if too much intervention from the central bank on the monetary policy takes place,” he says. “The central bank is the lender. The government is becoming more and more indebted without anything new on the horizon to at least show for repayment, and without economic growth to give confidence. So the central bank is now operating, in my view, in emergency mode, but emergency mode cannot become permanent mode because this is unsustainable.”

The question why, devised as a temporary emergency mechanism, the currency peg has remained daily practice of BDL is answered by economists broadly with reference to the political and security risks that Lebanon is exposed to, but the reasons they see range further from the psychological to the political and constitutional.

Nader says he is in favor of a less foreign-dependent monetary policy, but calls political risk the real key issue. “The question if we can loosen our monetary policy is directly related to political risk; the lower the political risk, the greater your ability to have an independent or national monetary policy. Our monetary policy is a hedging policy, first of all hedging the political risk,” he opines.

As Executive found when engaging a good number of bank economists and academics in the past year in monetary policy conversations, the general consensus is that the issue of an independent monetary policy is ripe for being addressed. However, according to the viewpoint of many, this discussion should be undertaken not now, but at a time of greater political stability.

Gemayel reasons that the central bank should have acted differently when it had a chance to modify the currency peg from one with the US dollar as nominal anchor to one tied to a basket of currencies. “BDL is an institution working in a difficult environment and performing better than many other public institutions in Lebanon. There were errors, of course, and I criticized the way of pegging to the dollar instead of switching to a basket of currencies about 15 years ago. But they are trying,” he says.

The USJ professor also points to negative psychological impacts of a currency float and drop in the lira’s exchange value. Abandoning the currency peg would harm the middle class most of all, because this population segment comprises many borrowers of dollar-denominated loans, he explains. A weakening in the lira’s exchange rate would negatively affect the middle class the most and this should absolutely be avoided because the middle class had already been hit with a wealth destruction trauma back in the 1980s when they were net lenders in the financial system.

[pullquote]“We are in a crisis management and not in a normal management and I think we will remain in a crisis management as long as we have not remade the constitutional structure of Lebanon”[/pullquote]

For investor Eddé, who is also a political stakeholder as head of the National Peace Party, the current situation of Lebanon’s monetary policy and the path towards a solution of the issue are both connected to fundamental change needs. “We have no monetary policy — we have a crisis management policy and we have been doing it since Prime Minister Rafik Hariri came to power and brought his stock broker from Merrill Lynch to be the governor of the central bank. That won’t happen in any [developed country] but it still worked because of the backing of Saudi Arabia and … our friends in the Arab World. We are in a crisis management and not in a normal management and I think we will remain in a crisis management as long as we have not remade the constitutional structure of Lebanon.”

Having said all that, honest debating over Lebanon’s monetary policy, fiscal policy and the politics of everything economic appears prudent and called for more than ever because, in the present global economic setting, pressures and dichotomies are on the rise. For well over a year, the monetary policy divergences between the Fed and the European Central Bank have influenced and often dominated public discussions — to the point that more than a few European and American central bankers were worried because they sensed increased politicization of monetary policy in tandem with unrealistic heightening of expectations for monetary policy to deliver impossible results.

Even if one disregards the absolute obvious — that the Lebanese monetary policy of the past two decades has been, and still is, indiscriminately bound to follow Federal Reserve decisions because of the Lebanese pound’s dollar peg — it seems undeniable that management of money supply and interest rates of the next few years, i.e. monetary policy, would have to be responsive to US decisions in pursuit of the Fed’s necessary reduction of its balance sheet.

The caveat is that economic research has been delivering new data and new interpretations of the value or non-value of independent monetary policy that provide questions that were not understood when Lebanon initiated its “emergency” dollar peg in the early 1990s.

The bloody global cycles

A recent challenge stems from research by French economist Hélène Rey. She points to evidence for the existence of a global financial cycle where “gross capital inflows, leverage, credit growth and asset prices dance largely to the same tune.” Using the Chicago Board Options Exchange Market Volatility Index (VIX) as a gauge, Rey finds that this global financial cycle’s pattern of capital inflows and outflows “is synchronized with fluctuations in world market risk aversion and uncertainty as proxied by the VIX.”

What she says her research implies is a fundamental dilemma that developing countries — and especially small developing economies that have previously been victimized by superpower indifference to their wellbeing — will not be able to evade.

“Fluctuating exchange rates cannot insulate economies from the global financial cycle, when capital is mobile,” Rey says, arguing that “Monetary conditions in large financial centers such as the United States shape the global financial cycle.” This concentrated monetary power in the centers of financial might influences all countries connected to it that embrace the free movement of capital, irrespective of whether these small players adhere to a floating exchange rate or to a currency peg to the US dollar or basket. In the bottom line of this perspective, free movement of capital and independent monetary policy are mutually exclusive choices.

Joseph Kaï | Executive

The reality of a country’s participation in the global economy when seen from this angle suggests a practical revision of another economic thought about the limits of monetary policy freedom. This discovery was that of the economic trilemma, highlighted in the late 1990s by economists Maurice Obstfeld and Alan Taylor, which explained that countries delude themselves if they believe they can simultaneously permit free movement of capital, maintain a currency peg and pursue an independent monetary policy, in the sense of independence from the monetary policy of the economic power whose currency they use as nominal anchor.

The three sides of this triangle are important because each represents a desirable goal for a nation. Free movement of capital is perceived as a prime avenue for wealth creation for a country’s investors who can act on opportunities abroad, and for the country by attracting investments and money into one’s own economy. Having one’s currency linked to a nominal anchor is a fine thing for securing exchange rate stability and warding off volatility and risk for economic stakeholders, especially corporate foreign investors and local exporters. The capability to decide when and how to infuse money into the own economy and the ability to determine the interest rates that apply to the national market is highly valued in order to direct economic development to the maximum benefit of the central bank’s ultimate sovereign, the people.

The trilemma, or impossibility of it all, is that a state cannot pursue all three goals at the same time. By Rey’s reasoning, the practical reality is that small developing economies don’t need to worry if they have control over their monetary policy because they did not adopt a floating currency. If they move against a country’s interests, the big global cycles will ruin their day anyway — even with a float installed.

Economic choices: Follow the leader or — just follow

It may be non-exclusionary insights that the interconnectedness of the global financial economy and the role of market maker Fed makes it illusionary to believe in central bank autonomy on the one hand and on the other hand that skillful and self-guided application of monetary policy tools is crucial for managing the minutiae of growth and financial sustainability in a national economy even under or especially in the presence of extraneous influences that restrict independence.

[pullquote]“Now in the fourth consecutive year, our debt is growing five or six times faster than the economy”[/pullquote]

When viewing the challenges to monetary policy in Lebanon, all bank economists, academic economists and political economists who engaged in conversations with Executive exhibited parallel views that durable solutions for the country’s economic challenges will have to be anchored on structural reforms. The monetary policy ownership should be reclaimed as far as independent monetary policy is a realistic proposition in the evolving global context that all economic stakeholders are mandated to understand better and better. But for the moment, perhaps better not to rock the boat too much while it swims in choppy waters. The risk du jour, and de l’année, for the Lebanese financial balancing act is the widening growth of debt when compared with the growth of GDP. “Debt is increasing at 8 percent, GDP is increasing at less than 2 percent. That’s the main concern,” says Hasbani. “Everyone is concerned about the situation where, now in the fourth consecutive year, our debt is growing five or six times faster than the economy; so we need growth in order to absorb the burden of the debt. If we don’t [grow], we are heading to the crisis scenario,” says Nader.

This mismatch of growing debt finance needs and slow growth could become a wider challenge for the central bank and all participants in the Lebanese economy, Gemayel says in ever so measured words. “Today we have a situation of decreasing economic growth rates for already several years. I am not saying that everybody is happy with this but the problem comes in when the balance of payments turns negative. This will cause pressure on the Lebanese pound. Until now we don’t have this pressure but we are just at the limit. The main risk is the balance of payments because if, and I am speaking hypothetically, the balance of payments will be negative for many consecutive periods [quarters], the central bank in my view may be pushed to manage the exchange rate by a different policy.”

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Thomas Schellen

Thomas Schellen is Executive's editor-at-large. He has been reporting on Middle Eastern business and economy for over 20 years. Send mail

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