Lebanon Economic Monitor – the country is descending further into crisis and the outlook remains dire
Since October 2019, Lebanon has been beset by the most crippling, multi-pronged crisis in its modern history as a result of both an economic and political collapse. The deteriorating economic and financial crisis that started in 2019 was further inflamed by the adverse economic impacts of COVID-19, the Port of Beirut explosion in August 2020 as well as the inundation of Syrian refugees that started in 2013 who now make up over a third of the country’s population. The humanitarian consequences were exacerbated in 2022 by Russia’s invasion of Ukraine given Lebanon’s reliance on wheat imports from the region, compounding the already high inflation and balance of payments crises.
The economy has been destabilized by the deleterious depreciation of the Lebanese Lira, which has lost circa 98% of its value (vis-à-vis the USD) since 2019. This has resulted in triple-digit inflation and a disastrous economic and humanitarian crisis. Basic social protections like water, garbage collection, transport, education, access to medicines and electricity are now all but gone in the former middle-income country. The crisis has marred the aspirations of generations to come and is the biggest risk to Lebanon’s stability since the end of the 1975-90 civil war. According to the World Bank, 80% of the population are now living below the poverty line and they declared that the “economic crisis is within the top three worst in modern history”.
The crisis stems from three decades of mismanagement and successive corruption. Successive governments accumulated excessive debt burdens (which reached 360% of GDP) alongside reckless fiscal policy. The Lebanese central bank for many years essentially underwrote an unsustainable Ponzi style scheme which offered ludicrously high interest rates to attract foreign investors in order to fund the country’s balance of payments as well as the government itself. However, the foreign inflows have now stopped, the banking system has totally collapsed and depositors are resorting to violence to make withdrawals. Lebanon is bankrupt, without a president and has no functioning government.
The country has long been a proxy battlefield for regional agents. For example, the US helps fund the Lebanese military, Saudi funds a major party bloc, Iran funds several political /militia groups and France has always been involved in Lebanon’s affairs. This compounds the complications of the existing sectarian political structure. Whilst the International Monetary Fund (IMF) has offered a life-line via a US$3 billion Extended Fund Facility (EFF), the access to and implementation of it is highly doubtful as the political elite appear unwilling to make the reforms stipulated by the IMF. It is hard to envisage a scenario where the same politicians that caused the crises would be forthcoming in the reform and restructuring process.
Lebanon used to have a renowned banking sector that could attract foreign money, and in fact, prior to the civil war it was known to be the ‘banker of the middle east’, akin to Dubai’s standing today. Lebanon also had banking secrecy like in Switzerland which made it a favored destination, including for many infamous investors, attracted to the privateness of the framework. However, the Lebanese civil war that began in the 1970s devastated the local Lira. Before the war the exchange rate was 3 Lira per USD but by 1992 it was 2,500 Lira per USD. As a result of the increasing trend of FX depreciation, the exchange rate was officially pegged to the USD in 1997 at 1,500 Lira per 1 USD. The central bank maintained this peg until late 2019, when it unofficially allowed the currency to become free floating after the accumulation of tens of billions of dollars in losses. The result was a complete collapse in the Banking system where account holders have been unable to freely access their savings ever since.
In fact, the central bank has been trying to shift losses to retail depositors via a multiple exchange rate system.
Furthermore, on the 9th of March 2020, Lebanon incurred a sovereign debt default for the first time ever as it did not repay a $US 1.2 billion Eurobond (issued in USD). The Prime Minister at the time Hassan Diab outlined how the foreign currency reserves had reached a “critical and dangerous” level and were required to meet the basic needs of Lebanon. Hassan went on to say “how can we pay creditors abroad when the Lebanese cannot get their money from their bank accounts?” and he called for “fair negotiations” with creditors to restructure the debt.
As Mark Baker from Abrdn explained to me, the Banking sector was acutely damaged given they were the largest holders of the sovereign debt, and due to the solvency problems within the public sector, the government is unable to pay back the investments /deposits that the Banks made with them. In fact, both the Banks and the Central Bank itself invested close to 70% of their respective balance sheet assets with the state. The Central Bank was the architect of an unsustainable policy which has since been dubbed a ‘Ponzi scheme’. The proceeds of the Issuance of USD denominated sovereign bonds were used to fund the country’s twin deficits (i.e., the current account and fiscal deficits) as well as the government itself. So how did it all work? The central bank would pay the Banks ludicrously high deposit rates e.g., nearing 10% and the Banks would also then pay international investors (largely via the disparia) ludicrously high rates e.g., at 8%, at a time where US policy rates were close to 1%. For a long time this all worked, however post COVID, a lot of emerging market & frontier countries just didn’t have the room to absorb shocks anymore.
Overall, Lebanon is now said to be a ‘failed state’ but it seems it is really be more accurately described as a ‘failed system’.
How USD strength in 2022 compounded Lebanon’s financial crises woes
Lebanon as we know was already suffering when a confluence of factors caused the USD to surge to its strongest level in several decades throughout 2022. The USD strength became Lebanon’s weakness. These currency movements transpired as the US Federal Reserve went on an aggressive path of front loading interest rate hikes to quell inflation. This combined with a fragile global macroeconomic and geopolitical backdrop saw a ‘flight to safety’ by global investors into USDs. This also hastened the economic pain in Lebanon given it imports about 80% of the goods it consumes now using a weaker Lira (vs the USD). This USD strength in 2022 impacted every currency in the world and led many in the investment community to warn that emerging markets were facing a 1980s style Latin American debt crisis. However, the Lebanese Lira as Mark Baker explained to me is a “special case” because what it boils down to is that for many years the currency was pegged to the USD at 1,500 and that peg could be maintained by attracting offshore investors via the ludicrously high interest rates as aforementioned. However, what happened when the “Ponzi scheme” broke down is that the global community lost confidence in Lebanon & its Banking sector and hence the country could no longer attract USD deposits at any interest rate. This crucially meant there was not enough USDs in the economy to maintain the pegged FX rate. Mark Baker, outlined to me that what usually happens when there is not enough USD in the formal system, is that a ‘parallel market’, otherwise known as a blackmarket, opens up. When there are extreme shortages of USD in a system, as is the case here, the parallel rate declines precipitously. As a case in point, it was initially 20,000 per 1 USD but has since declined to circa 140,000 Lira per 1 USD. So basically, the shortage of USDs has led to a currency crisis / devaluation which was particularly troublesome for Lebanon as it doesn’t really export anything to the rest of the world and hence there are no ‘fresh dollars’ coming in from trade & exports. Initially the central bank was running down their FX reserves to produce sufficient USD.
into the system but they are now left with only circa $US10 billion in FX reserves alongside circa $US15B in Gold. Moreover, although at a critical point in this crisis, Lebanon’s constitution does not allow these reserves to be sold. Hence, there is essentially no dollars left in the system so the Lira has gone into freefall.
Desperate depositors are now holding up banks to access their life savings
Lebanon’s Banks for years now have stopped customers withdrawing money because the country does not have enough FX reserves and the Bank’s fear their customers may transfer the money to foreign institutions. This is all while the rich and powerful political elites transferred circa $US15 billion of their own money out of the country. The people feel the Banks have robbed them! As the Banks are seen as not being held accountable, desperate depositors have resorted to holding up the Banks, commonly with assault rifles and molotov cocktails, in a heartbreaking attempt to simply access just part of their life savings. Army training for bank heists is now being conducted as the government understandably expects repeated incidents.
In response to the Lebanon Lira hitting an all time low in 2023, the central bank set a new rate for withdrawals from dollar deposits. This new rate is 15,000 Lira to 1 USD, effective 1st of February 2023, for withdrawals from Bank deposits denominated in USD, but which can now only be accessed in the local currency. The rate was previously set at 8,000 under the central bank’s framework, which implied a “haircut” of close to 80%. This new official rate is miles lower from the black market rate of 140,000 Lira, and that of which is used for everyday trade, and hence there is consequently a materially larger haircut now incurred by depositors. As part of February’s amendments, the central bank also announced a withdrawal limit of $US1,600 per month equivalent in Lebanese Lira for those depositors, who have been unable to access their money since 2019.
IMF rescue package – what’s involved?
Lebanon signed a staff-level agreement with the International Monetary Fund (IMF) nearly one year ago for a US$3 billion 4-year Extended Fund Facility (EFF) ; however the conditions to secure a full programme, which is seen as crucial for its recovery, have not yet been fully met. The IMF ‘prior actions’ include measures such as:
- A bank restructuring strategy
- A bank by bank audit by a reputable international firm
- A audit of the central bank’s foreign asset position
- A medium term fiscal and debt restructuring strategy
- Capital control and deposit withdrawal law
The power vacuum and non-functioning government has meant all the major institutions needed to get the recovery underway are lacking the necessary power structures needed to get the recovery in play and hence compromising the delivery of the much needed IMF package. The IMF recently warned that “Lebanon was in a very dangerous situation” a year after it committed to reforms it has failed to implement and said “the government must stop borrowing from the central bank”. The lackluster track record of policy inaction over recent years doesn’t leave too much room for optimism.
Lebanon – Is there hope for change?
In my recent discussions with Mark Baker, he compared and contrasted the situation in Sri-Lanka to that of Lebanon. To start with, Sri-lanka has also had a terrible time, for example, the government became bankrupt but is past the worst of its crises now and is slowly getting better. In Sri-lanka you have the political class making the reforms stipulated by the IMF, for example; a boost to fiscal revenue by increases in taxes, a broadening of the tax base and a reduction in wasteful spending (such as fuel and electricity subsidies). As a result of the political class being more forthcoming in making the requisite reforms, we have a way forward with Sri-Lanka. However within Lebanon, the political class seems in many ways to benefit from the situation and hence there are many vested interests. As a case in point, the powerful families here own many of the electricity generators and more alarmingly, the ruling elite own circa 50% of the Banks.
So how to solve the world’s worst economic disaster? Lebanon will need to win back trust and confidence from the international community. This would involve a major governance overhaul so as to build better and more credible institutions. The Lebanese parliament must stop their blame game and act immediately on the various social, financial and governance reforms required to move forward. A complete overhaul and restructuring of the Banking sector is needed in order to restore solvency. There needs to be a major government reform so as to increase the economic consequences to the powerful elites in order to avoid such failures ever occurring again. Fiscal prudence and debt sustainability must become the new status quo! Lebanon’s economy needs to be reformed as it fundamentally doesn’t make money due to the lack of the production of any goods. Importantly, the urgent establishment of a government that is able to implement the necessary reforms to secure an IMF package is crucial.