Lebanon’s financial and economic crises can only be solved with meaningful reform, without which it faces a lost decade of mass migration, social and political unrest and violence.

Nasser Saidi

Violence and crises have shattered Lebanon’s pre-1975 civil war standing as the banking and financial centre of the Middle East. The country is currently engulfed in overlapping fiscal, debt, banking, currency and balance of payments crises, resulting in an economic depression and humanitarian crisis, with poverty and food poverty affecting some 50% and 25%, respectively, of the population. The Lebanese pound (LBP) has depreciated by some 80% over the past year; inflation is running at 120%, with hyperinflation a worrying prospect. The horrendous explosion at the Port of Beirut, combined with the Covid-19 lockdown, has created an apocalyptic landscape, aggravating these crises further. The cost of rebuilding, following the explosion, is estimated to exceed $10bn – more than 25% of current gross domestic product (GDP) – which Lebanon is incapable of financing. 

The economic and financial meltdown the country is facing marks the culmination of long-running unsustainable fiscal and monetary policies, combined with an overvalued fixed exchange rate. Persistently large budget deficits (averaging 8.6% of GDP over the past 10 years), structural budget rigidities, an eroding revenue base, wasteful subsidies and government procurement riddled with endemic corruption, have all exacerbated fiscal imbalances.

Meanwhile, a monetary policy geared towards protecting an increasingly overvalued exchange rate has led to growing trade and current account imbalances, and increasingly higher interest rates to attract deposits and capital inflows to shore up dwindling international reserves. Deficits financed current spending, with limited real investment or build-up of real assets, while high real interest rates stifled investment and growth.

The unsustainable twin (current account and fiscal) deficits have inevitably led to a rapid build-up of public debt. This currently stands at $111bn, including $20bn of debt at Banque Du Liban (BdL), the country’s central bank. This figure represents more than 184% of GDP – the second highest ratio in the world behind Japan, according to the International Monetary Fund (IMF). Most of this debt is held by the BdL and domestic banks, with 13% held by foreigners.

Financing government spend

The BdL’s financing of government budget deficits, debt monetisation, large quasi-fiscal operations (such as subsidising real estate investment) and bank bailouts, created an organic link between the balance sheets of the government, the BdL and domestic banks. In effect, depositors’ monies were used by the banks and the BdL to finance budget deficits, contravening Basel III rules and prudent risk management.

BdL policies led to a crowding-out of both the private and public sectors, and to disintermediation: the government could no longer tap markets, so BdL acted as financial intermediary, i.e. paying high rates to the banking system, while allowing the government to borrow at lower rates. The higher rates, in turn, increased the cost of servicing the public debt, with debt service representing some 50% of government revenue in 2019 and over one-third of spending. Creditworthiness rapidly deteriorated, leading to a ‘sudden stop’ in 2019, with expatriate remittances and capital inflows moving into reverse. 

The crisis Lebanon is now experiencing is the dramatic collapse of what economists describe as a Ponzi-like scheme engineered by the BdL, starting in 2016 with a massive bailout of the banks equivalent to about 12.6% of GDP. In a bid to protect an overvalued LBP and finance the workings of government, the BdL started borrowing at ever higher interest rates, through so-called ‘financial engineering’ schemes, which evolved into a vicious cycle of additional borrowing to pay maturing debt and debt service, until confidence evaporated and reserves were exhausted. 

With the BdL unable to honour its foreign currency obligations, Lebanon defaulted on its March 2020 Eurobond – the country’s first ever sovereign default – and is seeking to restructure its domestic and foreign debt. The resulting losses of the BDL exceed $50bn, equivalent to 2019’s national GDP, a historically unprecedented loss by any central bank. 

With the core of the banking system, the BdL, unable to repay banks’ deposits, the banks in turn froze payments to depositors. As a result, the country’s banking and financial system imploded. The bubble burst in the last quarter of 2019, with a rapid depreciation of the LBP continuing into 2020. The BdL’s costly attempt to defy the ‘impossible trinity’ by simultaneously pursuing an independent monetary policy, with fixed exchange rates and free capital mobility, resulted in growing imbalances, a collapse of the exchange rate and an unprecedented financial meltdown. 

Economic disaster

A series of policy errors triggered the banking and financial crisis, starting with the closure of banks in October 2019, ostensibly because of anti-government protests decrying endemic corruption, incompetence and lack of reforms. A predictable run on the banks ensued, followed by informal capital controls, foreign exchange licensing, freezing of deposits, inconvertibility of the LBP and payment restrictions to protect the dwindling reserves of the BdL. These errors precipitated the financial crisis, generating a sharp liquidity and credit squeeze, the sudden stop of remittances and the emergence of a system of multiple exchange rates. 

The squeeze severely curtailed domestic and international trade, and resulted in a loss of confidence in the monetary system and the LBP. With the outbreak of Covid-19 and the subsequent introduction of lockdown measures came a severe drop in tax receipts, resulting in the printing of currency to cover the fiscal deficit, generating a vicious cycle of exchange rate depreciation and inflation. The black market exchange rate touched a high of LBP9800 in early July, before steadying to around LBP7400 in early September (versus the official peg at 1507). In turn, these policy measures led to a severe economic depression, with GDP forecast to decline by 25% in 2020, with unemployment rising to 50%.

In response to the crisis, the government of Hassan Diab prepared a financial recovery plan that comprised fiscal, banking and structural reforms as a basis for negotiations with the IMF. Despite the country’s deep and multiple crises, the government did not undertake any fiscal or monetary reforms. In effect, the Diab government and Riad Salameh, governor of the BdL, deliberately implemented an inflation tax and an illegal ‘lirafication’ – a forced conversion, a spoliation, of foreign currency deposits into LBP – to achieve internal real deflation. The objective is to impose a ‘domestic solution’ and preclude an IMF programme and associated reforms. 

The apocalyptic Port of Beirut explosion on August 4, compounded by official inertia in responding to the calamity, has led to the resignation of the Diab government and the appointment of a new prime minister, Mustapha Adib. Economic activity, consumption and investment are plummeting, unemployment rates are surging, while inflation is accelerating. Confidence in the banking system and in macroeconomic and monetary stability has collapsed. 

Rebuilding the economy

Prospects for an economic recovery in Lebanon are dismal unless there is official recognition of the economy’s large fiscal and monetary gaps, and the immediate introduction of a comprehensive, credible and sustainable reform programme by the new Adib government. Such a programme needs to include immediate confidence-building measures with an appropriate sequencing of reforms. The government must immediately pass a credible capital controls act to help restore confidence and encourage a return flow of remittances and capital inflows. Immediate measures need to be taken to cut the budget deficit, including the removal of fuel and electricity subsidies (which account for a third of budget deficits). The removal of these subsidies is necessary to stop smuggling into neighbouring Syria, which has been a major drain on international currency reserves.

Monetary policy reform is needed to unify the country’s multiple exchange rates, moving to inflation targeting and a flexible exchange rate regime. Multiple rates create market distortions and incentivise more corruption. In addition, the BdL will have to repair and strengthen its balance sheet and stop all quasi-fiscal operations and government lending. Credible reform requires a strong and politically independent regulator and policy-maker. 

There is a need to restructure public domestic and foreign debt (including BdL debt) to reach a sustainable debt to GDP in the range of 80% to 90% over the medium term, implying a write down of some 60% to 70% of the debt. Given the exposure of the banking system to government and BdL debt, such a debt restructuring implies a restructuring of the banking sector whose equity has been wiped out.

A bank recapitalisation and restructuring process should top the list of reforms, including a combination of resolving some banks and merging smaller banks into larger banks. Bank recapitalisation requires a bail-in of the banks and their shareholders (through a cash injection, sale of foreign subsidiaries and assets) of some $25bn to minimise a haircut on deposits. As part of such far-reaching reforms, Lebanon needs a well-targeted social safety net to provide support for the elderly and other vulnerable segments of the population.

Crucially, the new government needs to rapidly implement an agreement with the IMF. Lebanon desperately needs the equivalent of a Marshall Plan, a ‘reconstruction, stabilisation and liquidity fund’ of about $30bn to $35bn, along with policy reform conditionality. 

A comprehensive IMF macroeconomic-fiscal-financial reform programme that includes structural reforms, debt and banking sector restructuring would help restore faith in the economy in the eyes of the Lebanese diaspora, foreign investors/aid providers and help attract multilateral funding from international financial institutions and Cedre conference participants, including the EU and the Gulf Co-operation Council. This would translate into financing for reconstruction, access to liquidity, stabilise and revive private sector economic activity. 

Without such deep and immediate policy reforms, Lebanon is heading for a lost decade, with mass migration, social and political unrest and violence. If the new government fails to act, Lebanon may turn into ‘Libazuela’.

Dr Nasser H Saidi is founder and president of Nasser Saidi & Associates. He was Lebanon’s minister of economy and trade and minister of industry of Lebanon between 1998 and 2000, and also served as vice-governor of the Banque du Liban. He was also chief economist and head of external relations at the Dubai International Financial Centre. This article was published prior to Mustapha Adib's resignation.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter