A lot of rumors have been circulating lately regarding the economic situation in Lebanon. Every citizen, whether an economic expert or not, is worried about the liquidity in the system and is trying to analyze the different scenarios and probabilities of occurrence of an economic and/or financial crisis.
On the economic front, growth in the Lebanese economy was capped between 0 percent and 0.5 percent in the first nine months of 2019, as indicated by the BLOM Purchasing Managers’ Index (PMI) level, and inflation remained subdued (see table below). The PMI shows private sector activity stalled at an average of 46.8 by September 2019, capped below the 50-mark separating contraction from growth. Meanwhile, inflation eased to 2.77 percent by August 2019, down from last year’s 6.29 percent, mainly owing to a 10.7 percent annual downtick in oil prices to $64.8/barrel.
Within an environment of high interest rates and persistent slowdowns, markedly in real estate and the housing market, tourism was the only sector pulling up growth. Tourism was a bright spot in 2019 as it grew by an annual 8.3 percent to 923,820 tourists in the first half of 2019, close to 2010’s highs. However, the number of real estate transactions, which may include one or more realties, dropped by a yearly 18.30 percent to stand at 31,131 transactions by August 2019. In turn, average interest rates on loans in lira and in US dollars that reached highs of 11.13 percent and 9.9 percent by July 2019, compared to 9.97 percent and 8.57 percent, respectively, in December 2018, contributed to the crowding out of the private sector. These high rates make many projects unprofitable, discouraging companies from taking loans. Banks would prefer to place their money at the central bank as it would be less risky than in the private sector.
A historical perspective on the Lebanese economy may help understand the current economic and financial situation. Since the 1960s, the partial dollarization of deposits has always existed in Lebanon, fluctuating between 25 percent and 30 percent before the 1975 war. The dollarization rate reached 86.2 percent in 1987, following a period of hyperinflation and a deterioration of the exchange rate, and stayed above 70 percent until 1993.
The successive governments following the civil war were never able to restore investors’ confidence to pre-war levels. Dollarization rates never went below 50 percent and, most of the time, interest rates were much higher than their US counterpart. During episodes of shocks, like in 1995, interest rates went up to 38 percent, while in 2005, 2006, 2008, and more recently, credit default swaps (CDS) crossed the 1,000 basis points. (CDS are an insurance against the risk of default of the Lebanese government. When their price increases, it means that the risk of default is going up. Theoretically, the five-year CDS should be equal to the difference between five-year Lebanese Eurobonds and five-year US bonds.)
The reason why stress is increasing in the financial markets is related to the length of the current shock—which began with the onset of the Syrian war—when compared to the previous ones. The previous shocks had a limited time span of around three months on average, while the current one has been ongoing since 2011. Many shocks have hit the system since 1993. First, the 1996 Israeli aggression called Operation Grapes of Wrath remained for several weeks. Second, the assassination of prime minister Rafik Hariri in 2005 led to an outflow of capital for several months. Third, the 2006 Israeli war paralyzed the economy for more than three months. Finally, the 2008 global financial crisis had a very short impact on Lebanon as the Lebanese banks were not exposed to the subprime market of the US. The economy’s shock absorption capacity was never tested for more than a few months.
The balance of payments (BOP) surplus accumulated from 2006 to 2010 has been wiped out in the last eight years (see table above). Lebanon recorded a surplus of $19.5 billion from 2006 to 2010, while the BOP (the difference in total value between payments into and out of a country) turned into negative grounds from 2011 onward, recording a cumulative deficit of $18.5 billion by end July 2019.
An aggregation of shocks
What took place since 2011 is a combination of multiple shocks that led to a progressive drying up of capital inflows and investments in Lebanon. The Syrian war cut the land routes of exports, pushed ISIS into the Lebanese territory, and instigated an unstable political and security environment. Then, the economic slowdown in the GCC countries following the large decline in oil prices since 2014 and the war in Yemen exhausted the resources of countries involved, and tensions in the region increased to levels not seen in the last decade. In addition, the two-year long presidential vacancy and the crisis of the sudden (and since rescinded) resignation of Prime Minister Saad Hariri in November 2017 weighed heavily on investors’ confidence.
The result was a deficit in the BOP and an increase in the financial stress. The BOP deficit has increased drastically since 2018 when it registered $4.8 billion; in the first seven months of 2019 it reached $5.3 billion. Other financial stress indicators such as credit default swaps and spreads with international interest rates have also deteriorated substantially, particularly following the downgrades of the sovereign by two ratings agencies.
In order to preserve the peg, Banque du Liban (BDL), Lebanon’s central bank, intervened repeatedly in the market and increased interest rates to continue attracting capital. BDL used financial engineering schemes to boost the returns for commercial banks placements and allow them to provide higher interest rates to their customers at a time of low international interest rates.
The central bank adopted a tightening of monetary policy in order to halt the increase in money supply. The latter declined by 0.67 percent in the first seven months of 2019, compared to an average increase of 5.8 percent from 2013 to 2017. BDL tried and succeeded in sucking most of the liquidity from the market through its financial engineering schemes, starting in 2016 and implemented repeatedly since then. In order to reduce money creation, BDL terminated the subsidies program for housing loans and offering high returns to banks that place their excess reserves with it. Banks were no longer interested in lending to the private sector or even to the government. Loans to the resident private sector declined by 9.5 percent or by more than $5 billion between end 2017 and July 2019.
Since banks’ liquidity was placed at the central bank for medium to long term, maturity mismatch between their assets and liabilities increased. Although banks were able to increase the average maturity of deposits from 45 days in the past 20 years to six months by the end of 2018, it remains far lower than the average maturity of their placements at BDL. As the economic situation deteriorated and demand for dollars outstripped the offer because of the negative balance of payments and the erosion of confidence, banks reduced their foreign assets, particularly over the past two years, to face the demand for dollars.
As both the central bank and commercial banks are keen to keep their foreign assets at levels that preserve confidence, some shortage in dollars appeared on the markets, which led, in the past two months, to the creation of a very thin parallel foreign exchange market. Some of the restrictive measures adopted by some banks were to counter the abuse of the system exercised by some customers that began to exploit the arbitrage opportunities presented between the official and the parallel market. The latter constitutes less than 2 percent, in size, of the official market, and the exchange rate used in this parallel market is less than 5 percent higher than the rate used in the official market.
The problem is summarized into a vicious cycle of self-fulfilling expectations whereby the lost confidence is the starting point, and people are aggravating the situation by acting, all of them, in the same direction. Individuals are afraid to lose their deposits, thus some of them are withdrawing their money from banks and keeping it at home and others are opening accounts abroad and transferring part or the total of their deposits to Europe.
However the cushion that the banking system holds is more than sufficient in the foreseeable future. The central bank foreign assets, excluding gold, cover 75 percent of lira deposits, and the banking system foreign assets cover more than 40 percent of dollar deposit. Therefore, the situation is not as bad as portrayed in the media.
The banking sector has the ammunition to defend the peg, which has served the economy well, and opinions about de-pegging the currency are misplaced. In a region full of uncertainties and shocks, any policy that ensures some stability and a clearer vision for consumers and investors may have a positive effect on growth. The importance of the peg is in its ability to provide a stable business environment when it comes to anchoring inflation expectations.
Moreover, evidence from economic research indicates that “floating exchange rates are far from a panacea for emerging markets and that this policy advice misses a number of important real world considerations that are crucial for developing countries” (see Guillermo A. Calvo and Carmen M. Reinhart 2000 paper at the National Bureau of Economic Research). As stated in my own research paper, co-authored with Andy Khalil last year: “Large exchange rate volatility in emerging and developing countries, such as large depreciation has a recessionary impact. When investors’ confidence is lost, domestic interest rates volatility will become chronic and exchange rate swings seem to be more damaging to trade with the pass-through to inflation far higher in emerging and developing economies than in developed countries.”
Hence, whatever the cost of pegging the exchange rate, it will remain more advantageous for emerging economies when compared to a pure floating regime. In fact, as noted in the 2018 paper, “currency crises become credit crises as sovereign credit ratings often collapse following the currency collapse and access to international credit is blocked.” Studies agree that if trade consists of a large fraction of a country’s GDP, i.e. the country is small and open, the costs that come with currency instability are substantially higher in the aggregate.
To restore investors’ confidence, the government has to set a clear timetable for reforms, as opposed to simply mentioning a list of projects and a 1 percent decline in fiscal deficit per year. Until now, the situation is blurry for investors about the necessary reforms that, if implemented, will unlock CEDRE funds pledged by international donors in April 2018, but contingent on fiscal reforms.
To turn the cycle
In this context, the government has taken some important measures that unfortunately have passed unnoticed by investors. The Parliament has approved a law that updates and modernizes the code of commerce. The government has also passed a decision to stop hiring in the public sector for the next three years. It has started to tackle state pensions by imposing a tax on highly paid pensioners. The authorities increased some taxes like VAT and the tax on interest income in the 2019 budget and reduced some expenditure. Moreover, cabinet approved an updated electricity plan to tackle the sector’s deficit, on which some progress has been made. Aside from the CEDRE funds, the government has approved several infrastructure projects to reduce traffic congestion in Beirut. The government has also filled vacancies in the judiciary sector to accelerate the work related to fighting corruption in the public sector.
If these measures had been outlined in a clear work program, within a clear time frame, their impact on investors’ confidence would have been tremendous. The reforms should have been prioritized and spelled out in a program that would show, on a quarterly basis, which reforms are to be implemented. This would keep the government to a set schedule that can be monitored by investors on a regular basis, and if kept will result in donors distributing funds.
Setting and monitoring such reform programs is the bread and butter of the International Monetary Fund (IMF). The IMF would tick a box whenever the government implemented a reform and inform donors and investors, on a quarterly basis, about the progress achieved. When the government is on the right track and is respecting its commitments, the IMF will give a green light for donors to disburse money.
An important game changer will remain the drilling for oil and gas that will start before the year’s end, especially if oil and gas are discovered from the first drill. In this case, consumers’ and investors’ expectations will change drastically with a likely positive impact on the economy but, more importantly, it will be able to turn the vicious cycle into a virtuous one.