Understanding Lebanon’s economic free fall

2 Oct 20

Muhammad Afnan Alam takes an in-depth look at the economic crisis that has engulfed Lebanon, that predates the Beirut explosion and even Covid-19.

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Beirut explosion

©2020, European Union (photographer: Bernard Khalil)

By any count, the year 2020 is proving to be an economic disaster for Lebanon. The country is suffering from a triple whammy: an exchange rate crisis, a banking crisis, and a debt crisis, with no end in sight, in the short term at least. Most analysts agree that it was the debt crisis, coupled with a sluggishly performing public sector, that had sparked the two other concerns.

But, surprisingly, the debt crisis has receded in relative significance these days. This is partly because it is not as juicy as the other two (banking and exchange rate), but mostly because domestic debt, which constitutes close to 64% of total debt (with total debt reaching $93.74bn in July 2020 and recording an annual 9% increase) is losing its real value with rising inflation.

An economic, fiscal and monetary crisis had accelerated in Lebanon since March when the government defaulted on a debt payment for the first time in its history. Month-on-month inflation surged to 56.5% in May, poverty and unemployment are soaring, and many Lebanese believe the country’s bankers — and its politicians — are to blame. The government also disclosed that the foreign exchange reserves held by Banque du Liban (BdL), the Lebanese central bank, were experiencing a “rapid downward trend.”

The $29bn foreign exchange reserves as of January 2020 were too low to sustain the Lebanese economy facing immense debt. The government claimed that $22bn of these reserves consisted of liquid assets. Meanwhile, given the opacity of the BdL’s foreign exchange disclosure, some question the actual size of liquid foreign-currency assets.


In April, the government said its economy was in “free fall”


A September report from ratings agency Moody’s affirmed Lebanon’s credit rating to C as downgraded on 27 July, with no outlook assigned. Noting that C is the lowest rating on Moody’s rating scale, the country’s debt-to-GDP ratio was 151% as of 2018, one of the highest in the world. The government estimates that the ratio surged to 178% of GDP at end-2019. Meanwhile, Lebanon faces $20bn in debt amortisation in 2020, and even more in coming years

The accumulating massive debt and the outflows of US dollar deposits also led to a severe depreciation of the domestic currency. The country has committed itself to a fixed exchange rate, pegging the Lebanese Pound (LBP) at 1,507.5 to the US dollar since 1997. This was a critical policy to stabilise the financial market back then. In 1992, before the introduction of the fixed-rate, the LBP saw a severe depreciation by more than two-thirds against the USD and inflation rose above 100%.

However, the fixed exchange rate meant to stabilise the financial market has led to a parallel market with an official rate and a black-market rate. There is a vast discrepancy between them.  As of 24 September, the unofficial currency rate on the black market has depreciated by 79.9% compared to the official fixed exchange rate. Furthermore, as Lebanon imports 80% of its food needs, the rapid de-facto currency depreciation is significantly affecting households.

In April, the government said its economy was in “free fall” and projected that its 2020 GDP would plummet by 13.8%. It expects annual inflation to rise from 2.9% in 2019 to 27.1% in 2020. Meanwhile, the monthly inflation rate has risen as high as 57%. It was 190% for food and non-alcoholic beverages.

Following the default on Eurobond maturity on 9 March, and the subsequent nonpayment of foreign currency debt service, the government presented a restructuring plan on 28 April. Unfortunately, the lack of a unified position and the resignation of the government following the Beirut port blast have further delayed negotiations with bondholders and with the IMF on proceeding with a debt restructuring along with external funding support packages.

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Beirut

A government building in Beirut

After the default, the Lebanese government began to work with the International Monetary Fund to restructure its debt and negotiate a support program. On 30 April, the government proposed an initial financial recovery plan to the fund.

Though the rescue plan backed by consulting firm Lazard was useful to kick off the negotiations, the government and central bank do not seem to agree on the estimates of actual losses. The unconfirmed losses for the private sector have also been wrecking the negotiations.

Furthermore, a few have questioned the feasibility of the restructuring plan, which largely depends on tourism. While the government hopes to double the number of tourists from two million to four million over a five-to-seven-year period, the outbreak of Covid-19, the global economic downturn, and the explosion in Beirut may keep tourists away from visiting Lebanon.

Meanwhile, in assessing the losses and available foreign exchange reserves, the BdL’s balance sheet and its accounting are under scrutiny. Governor Riad Salame, who has been in charge of the BdL for 27 years, is said to have been relying on discretionary accounting practices, concealing the actual amount of risky liabilities on the central bank’s balance sheet. These accounting practices may have burgeoned the BdL’s assets by $6bn.

Indeed, there is no dominant generally accepted accounting framework for central banks; some adopt common accounting standards such as IFRS. In contrast, others use home-grown frameworks embedded in the central bank or other laws. However, recording expected seigniorage, the profit made from printing money, as an asset, apparently a common practice in the BdL, is somewhat unconventional. Most central banks record seigniorage as an income stream.

The lack of fiscal space and the political impasse has made it difficult for the government to provide support to the most vulnerable people in Lebanon. The proposed IMF support of about $10bn could ease some of the pressure; however, the progress of negotiations has been sluggish, and it is uncertain when the government and the IMF could reach an agreement. Furthermore, structural reforms requested by the IMF will be painful and would be subject to local opposition.

Further international support could come from other multinational organisations, such as the Gulf Cooperation Council.  Lebanon could also unlock the $10.8bn in aid that France and 47 other countries and institutions pledged in 2018. In April 2018, France, led by president Emmanuel Macron, hosted an international conference aimed to support Lebanon’s development and reforms.

Two important conclusions can be obtained from the discussion, as mentioned earlier.  First, with close to two-thirds of the debt in domestic debt that is losing its real value, the debt crisis is perhaps becoming increasingly less of a crisis. That is not to say that debt shouldn’t be taken seriously; it should, especially when it comes to restructuring foreign debt payments. But what should be taken most seriously are the recurring budget deficits, which reflect a structural problem in Lebanese public finances that has less to do with fiscal matters and more to do with governance.

So, fundamentally, what should underlie budgetary reforms in Lebanon are governance reforms that aim at reducing waste, corruption, nepotism, and at increasing efficiency, in public administrations and enterprises.

Second, governance reforms in the public sector take time, and they are usually a medium-to-long-term project. Therefore, the short-term priority should be to enact measures that restore confidence in the banking system and the exchange rate regime. In this context, it is wise to recall that, based on various country experiences, exchange rate crises do not necessarily lead to banking crises. Still, all banking crises lead to exchange rate crises. Reforming and fixing the banking system should be the first order of business which can then also help in lessening the exchange rate problem.

  • Muhammad Afnan Alam

    Muhammad is a career federal government civil servant from Pakistan

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