More than 120 countries in the world have some form of a pegged exchanged rate system, in either soft or hard pegs mainly to the US dollar or the euro. Small economies benefit from pegging their currencies to reduce macroeconomic volatility and improve predictability for investors and visitors of the country.
Leaning tower of Lira
The Lebanese Pound before the civil war benefited from a period of floating exchange rate system driven by strong influx of dollars from tourism and banking. During the civil war, political money took over remittances and tourism and capital flows, and these murky funds of conflict finance were the only source of foreign currency. In 1987, the Lebanese Pound witnessed its biggest crash ever with a devaluation in excess of 400 percent in less than two years, crossing 800 Lebanese Pounds to the dollar. When the Lebanese Pound was pegged to the dollar at the end of 1992 and settled at 1,507.5 Lebanese pounds/$1 in 1997, Lebanon had a lot to benefit from exchange rate stability and predictability.
Pegged exchange rate systems require adjustments over time when macroeconomic features of a country witness a change. Countries with free capital flows and fixed exchange rate lose monetary policy autonomy, a concept known as the impossible triemma. For Lebanon, this means that to maintain stability in Lebanese pounds and free movement of capital, the Lebanese central bank, Banque du Liban (BDL), has to follow interest rate movements in the base currency (USD in this case) plus a certain risk premium, otherwise capital would exit the country.
At the onset of the Syrian civil war, the Lebanese pound was already suffering from an overvaluation due to dollar inflows to the economy from Lebanese expatriates, which were not channeled to the productive sectors in the economy but rather to bank accounts chasing high interest rates. This rendered price levels in the services industry very high, a concept knows as an increase in the value of non-tradable goods and services in a Dutch disease scenario. Simply compare the cost of a hotel room in Lebanon in US dollars in 2010 vs. 2021. A gradual adjustment of the soft peg’s 1,507.5 rate was long overdue.
Repercussions of Financial Engineering
In the past decade, remittances, personal capital flows and tourism income declined gradually due to regional instabilities and a host of adverse factors, leading to an erosion in the balance of payment surpluses of the previous decade. This in turn led to a dwindling of BDL reserves. In the three years preceding the crash in 2019, BDL raised interest rates to high levels without controlling capital flows or imposing exchange rate rules. The Lebanese government failed to induce reforms that were requisite to receiving CEDRE funds. For instance, if interest on deposits in Lebanese Pounds had to be raised to 20 percent to attract inflows, depositors collecting that interest should not have been allowed to exchange it for Dollars and then transfer this profit abroad because they would practically have been taking someone else’s Dollar deposits. These repercussions, which enriched large depositors and banks, eroded tens of billions of much needed dollar reserves. The government failed to deliver promised reforms expected by Riad Salameh, some of which include infrastructure investments, consequently losing a chance at receiving CEDRE money.
Following the crisis, further depletion of BDL reserves was caused by subsidies of essential and some non-essential imports and further capital flight by those powerful enough to manage it. Now the economy has multiple exchange rates operating at the same time, three official rates for the Lebanese pound to the dollar (1,507.5; 8,000; 12,000) and one market rate. The real market rate, standing at around 27,000 Lebanese Pounds/$1 at the time of writing this article, will always be ahead of any official rate as long as there are no proper macroeconomic measures being taken. BDL claims to have only around $14 billion of depositors’ money left in its reserves. Where will the Lebanese Pound go from here?
Million-pound chicken dinner
The devaluation of the Lebanese Pound technically has no limit; with the vicious cycle of inflation and devaluation, the Venezuelan Bolivar reached such a devaluation in 2018 that it would have been cheaper to use the currency as toilet paper rather than buy toilet paper with it. Will the Lebanese pound get there? Maybe not to that extent, because a few billion dollars of remittances are still coming in every year from expatriates who support their families. However, Lebanon is highly dependent on imports, especially for its energy needs, which means that reserves will continue to be exhausted for the operation of the economy. The first step to halt degradation is confidence. When a government was formed in September 2021, the Lebanese Pound appreciated to 14,000 Lebanese Pounds/$1. It has halved since then because literally no action was taken yet to save the country from one of the worse crises in history.
Prime Minister Najib Mikati is still debating with BDL Governor Riad Salameh about the losses of the financial system two years after the crash while depositors’ purchasing power is evaporating by the minute. Let us hope they conclude their argument before the cost of a chicken reaches 1,000,000 Lebanese Pounds. It is to be hoped that before then, they would have restructured the central bank, the financial system, and the public sector, then designed the right macroeconomic policies that provide confidence so the very long recovery can begin. Should we wait for that, or would waiting for Godot be less painful?