The risks of collapse for Lebanon’s national currency evaluated in 7 key points by one of Lebanon top macro economists.
Recent articles in the media have insinuated that Lebanon is heading towards a “dangerous financial crisis that could destabilize banks”, lead to a devaluation of the national currency, and impoverish citizens. According to these analyses, the crisis is rooted in Banque du Liban’s policy and the high interest rates prevailing in the market. This evaluation is far from reality for the following reasons:
1. Financial crises may cause the collapse of the currency of a country, as was previously seen in Greece and Latin American countries; however, this could happen only when the banking system and particularly the central bank of a country lacks sufficient foreign exchange reserves to intervene and maintain the value of its own local currency, and when a country fails to adopt corrective policies. In Lebanon, the BDL balance sheet shows that the BDL has acquired $43 billion in net foreign assets and $12 billion in gold (see BDL website) by the end of October 2017. It’s true that local bank deposits in foreign currencies at the BDL are the main source of BDL’s foreign exchange assets, but these deposits are considered domestic liabilities rather than foreign liabilities and have long-term maturities ranging from seven to thirty years. It’s a serious misinterpretation to consider, as some analysts do, that these bank deposits are foreign liabilities rather than domestic liabilities in foreign currency, by overlooking the maturity period of these deposits. This distinction is important to make, and it is made by all international financial institutions and credit assessment agencies as it follows International Monetary Fund accepted classification of assets and liabilities.
Banks obtain most of their foreign currency assets from customer deposits in foreign currencies. These resident deposits in foreign currencies are considered domestic liabilities rather than foreign liabilities. Banks in turn deposit some of these accounts at BDL which are also considered domestic liabilities in foreign currencies in the balance sheet of the BDL, and not foreign liabilities. Confusing domestic liabilities in foreign currencies with foreign liabilities is a very serious error which leads to the wrong conclusion that the BDL does not have sufficient net foreign assets to intervene in the market to maintain the value of the Lebanese Lira. While the contrary is true, central banks, except in oil producing countries, procure their foreign reserves from the domestic banking sector. Therefore, net foreign assets of BDL are quite substantial to comfortably intervene in the foreign exchange market to maintain the stability of the Lira.
2. Assessing Lebanon’s need for foreign currencies and the extent of its availability to complete external transactions are also important, and can be done by evaluating the balance of payments performance. Since the beginning of the Syrian crisis, the balance of payments has recorded annual deficits averaging $1.8 billion over the past five years. If the situation persists as is, BDL would have sufficient liquidity to cover the balance of payments through its foreign assets for another 24 years without even resorting to the use of its gold reserves. Additionally, commercial banks possess about $21 billion in foreign assets, which permits them to finance the balance of payments for another 12 years. Therefore, the banking system has an abundance of foreign assets to finance the balance of payments and maintain the value of the Lebanese Lira.
3. The question that could be raised is what might cause Lebanon to have a financial crisis and experience a forced currency collapse. This can only happen if citizens and local institutions lose confidence in the Lebanese economy and banks at a large and unprecedented scale, which ultimately leads to massive outflow of foreign exchange and a “meltdown” of the banking system. Is this possible? This scenario is very imaginative and requires the loss of most of the foreign assets currently in the banking system, and is surely unrealistic when we consider Lebanon to be a country that attracts foreign capital worth 10 to 13 billion US dollars annually.
4. Another question that arises relates to where the Lebanese will transfer the foreign currency funds they have deposited in Lebanese banks. To Western banks? The investor finds that the return on his/her investments in advanced Western markets is much lower than the rate of return in Lebanon by about 4 percent. This is the investor’s choice, but he/she finds Lebanon to be a lucrative option. The high interest rate differential is a magnet for the inflow of capital and other transfers into Lebanon and has been taking place for decades. It’s only during the peak of the civil war years that Lebanon suffered a severe devaluation as the government lost control over all of its revenue sources, and relied largely on printing Lebanese pounds to finance its spending on all sectors (education, the army and police, health, etc.). Financial institutions such as the International Monetary Fund have been supportive of the governments pegged exchange rate policy. Only a major security threat could destabilize the exchange rate, one that’s even larger than the impact of the 2006 War.
5. Rather than reflecting the monetary policy of Banque du Liban, the high yield (interest on deposits) in Lebanon has several other prime reasons: The high fiscal deficit which led to the accumulation of debt and the need for financing since the early ‘90s; the adoption of a fixed exchange rate (a governmental decision) which requires high interest rates to attract inflows of foreign capital and create reserves to maintain the fixed currency peg; and the unstable political and security situation due to the Syrian crisis, the closure of borders, and internal disputes. These factors combined raise the risk of investing in the Lebanese market and raised the domestic interest rates on all financial assets and liabilities, resulting from the normal risk valuation. This is typical of similar cases such as Turkey and other countries with a higher risk profile, especially political risk.
6. Another recurring question is whether the $78 billion gross public debt (equivalent to 145 percent of the 2017 domestic income) could lead the country into a fiscal crisis that could lower the value of the Lebanese Lira. Lebanon experienced in the past a much higher public debt ratio that reached 180 percent of the national income in previous years. Lebanon did not undergo a monetary crisis then. The Lebanese economy has both the ability and willingness to finance and refinance debt, which in turn signifies market confidence in government bonds. Additionally, 95 percent of Lebanon’s public debt is local debt and the remaining 5 percent is funded externally, mostly from international and regional financial institutions, and from bilateral official country sources. Countries that had financial crises historically had substantial foreign debt.
7. Is the current fiscal deficit, estimated at about $4.5 billion in 2017, a possible cause of financial collapse? State revenues have been exceeding primary expenditures (expenditure less interest payments – debt service) for the past four years. Had there been no debt service, a surplus in the budget could have been recorded ranging between 1 and 2 percent of income. This is an important indicator showing that the current fiscal situation is healthy hadn’t the country accumulated debt in previous years. Furthermore, the fiscal outcome in Lebanon can easily be improved if we were to solve the electricity crisis and the fiscal subsidy burden behind it. A number of other sources of overspending can be fixed , which could improve the fiscal outlook. These include mismanagement of other subsidies, serious over-employment in many public agencies, and corruption at many levels and in public procurement in particular.
Finally, I call for avoiding hasty conclusions about Lebanon’s risk of plunging into a financial crisis, a conclusion that stems from the apparent lack of comprehension of factors affecting financial markets. The Lebanese financial situation is not the same as that of Greece, as some believe. Greece lost its reserves and defaulted on its debts to European banks. The Lebanese debt is mostly local and more than half of it (61 percent) is in Lebanese Liras issued by Banque du Liban. While this does not mean that we do not require reforms in several areas, there is a difference between the need for reform and being at the brink of a monetary crisis that will impoverish the Lebanese citizens. Improving the fiscal situation is urgent and fundamental, as is addressing the shortcomings in all public services, the electricity sector in particular, which also makes increasing tax revenues necessary to maintain and strengthen financial solvency.