The roots of Lebanon's financial crisis
The dire economic and social crisis that the country finds itself in can largely be traced back to the 1975-1990 civil war and its destructive consequences.
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The explosion of August 4, 2020, came at a bad time. When Beirut was rocked by a massive ammonium nitrate blast that left more than 200 dead, Lebanon received its latest in a string of crises that had already seen it battling Covid and an economic catastrophe. Whereas the pandemic emerged suddenly to shock the world in early 2020, Lebanon’s economic and financial situation had been slowly unravelling for years.
It came into the spotlight in October 2019, when tens of thousands of Lebanese took to the streets to protest against rising living costs and the endemic corruption of the country’s political class. Though the immediate spark was a proposed tax on WhatsApp calls – in a country where regular phone service is expensive – Lebanon had already endured decades of economic mismanagement by the elite of its sectarian political system. The comprehensive protest against this multi-confessional elite, encapsulated by the popular refrain “All of them means all of them”, reveals the Lebanese people’s weariness of a system they perceive to have failed them.
And failed them it surely has. According to the World Inequality Database, the top 1 per cent of income earners enjoyed 23.4 per cent of national income in 2019, while the bottom 50 earned 10.7 per cent – a stunning indictment of Lebanon’s endemic income inequality. Moreover, this uneven pie just keeps shrinking. A World Bank assessment published last fall projected real GDP growth to sink to -19.2 per cent for the year 2020, partly due to the shock of Covid-19 to Lebanon’s important tourism sector.
The plight of ordinary Lebanese is exacerbated by the country’s uncontrollable inflation. After a government default on $1.2 billion of foreign debt in March 2020, the drastic loss of confidence in Lebanon’s economy undermined the value of its currency, the Lebanese lira (LL). The lira is officially pegged to the US dollar at a rate of LL 1,507.5 per dollar yet encounters a wildly fluctuating exchange rate on the black market, reaching nearly LL 10,000 per dollar in early July. The rising price of imports, on which Lebanon is vitally dependent, sent inflation skyrocketing. By October, it had hit a peak of 136.8 per cent.
The situation is clearly dire – but how did Lebanon get here? Arguably, many of Lebanon’s current economic troubles can be traced back to the civil war of 1975-1990, a brutal and multifaceted conflict that turned this old cosmopolitan centre of trade and finance into a warzone.
Switzerland by the Sea
Lebanon’s economy before 1975 was widely described as a “miracle”. Indeed, according to economist Nasser Saidi, the Lebanese economy was “expanding at a relatively rapid pace and across a broad spectrum of activities” prior to the war, powered by a high rate of investment, a young and educated population, and a low-wage immigrant labour force.
Lebanon also presented a favourable investment environment, maintained by the country’s relative political stability in the region and banking secrecy laws that enabled wealthy Gulf elites to manage their wealth in privacy. It was thanks to this financial pre-eminence that Lebanon was christened the “Switzerland of the Middle East” in the 1960s.
As a result, economic performance was robust. According to Saidi, real GDP growth averaged 5.8 per cent from 1965 to 1975, while inflation averaged a modest 3.6 per cent. Moreover, the regional demand for Lebanese services kept the balance of payments positive, meaning there was a net influx of foreign currency into the country. As a result, the lira remained strong, even appreciating by 2.8 per cent against the US dollar during this period. This could not be in starker contrast to the wartime economy.
War in the Confessional State
The conflict of 1975-90 can trace its roots at least partially to Lebanon’s political system of various religious groups contending for power. The country contains more than a dozen recognised religious sects, the most prominent of them being the Sunni Muslims, the Shia Muslims and the Maronite Christians.
Some Maronites were aligned closely to Israel, including the right-wing, Maronite-majority Phalange party. In contrast, much of the Muslim population supported the Palestine Liberation Organisation, newly arrived after its expulsion from Jordan in 1970. These tensions, often of a sectarian nature, erupted on April 13, 1975, when a leading Phalangist was shot dead by unidentified assailants in a passing car. The Phalangists, assuming the culprit, reacted in kind by machine-gunning a busload of Palestinians and their supporters, killing twenty-seven. Thus began a cycle of violence that culminated in fifteen years of civil war.
The conflict devastated Lebanon’s economy. Economist Atif Kubursi highlights the “profuse brain drain” on Lebanese society, with at least a million emigrants fleeing the war across its duration, significant numbers of them carrying technical qualifications. Moreover, there was “extensive and massive destruction of buildings, bridges, power stations, schools, refineries and factories [so] that the capital stock stood at less than 45 percent its 1974 level.”
Public finances also suffered as traditional sources of government revenue, such as customs duties, were hijacked by sectarian militias who now controlled infrastructure such as the ports. Declining revenues compelled the government to borrow heavily from commercial banks and forced Lebanon’s central bank, Banque du Liban (BDL), to engage in government bond purchases. The purchase of government debt by the central bank, however, increases the money supply in the economy, and this, coupled with “currency speculation [and] declines in domestic production”, led to rampant inflation.
According to data from the International Monetary Fund (IMF), inflation averaged 94 per cent from 1980 to 1990, hitting a record high of 487 per cent in 1987. Economic growth also tumbled, such that across this period the economy actually shrank to 56 per cent of its 1980 level. Worrying too was the depreciation of the lira, which fell from LL 2.23 per dollar in April 1975 to LL 685 per dollar by the end of the war in October 1990, then again to a low of LL 2,420 per dollar in September 1992, according to BDL data. In late 1992, the new government of Prime Minister Rafik Hariri endeavoured to stabilise the exchange rate, eventually pegging it at LL 1,507.50 per dollar in December 1997.
Defending this exchange rate peg, which would bring stability to the Lebanese economy, thus became the main focus of the central bank. As economist Toufic Gaspard observes, “Banque du Liban … would necessarily have one dominant central objective: to accumulate a substantial cushion of foreign exchange (FX) reserves … to defend the fixed exchange rate”. In other words, BDL required a sufficient supply of US dollars to ensure that the price of one dollar did not rise above LL 1,507.50. This would turn out to be a very consequential policy indeed.
Defending the Peg
Sami Halabi and Jacob Boswall, of the Triangle think tank in Beirut, posit three reasons for maintaining a constant inflow of dollars into Lebanon: to “cover interest payments on the public debt (issued by the state and BDL), maintain the peg, and cover the need for imports [of] vital goods such as fuel, medication and wheat, which must be purchased in foreign currency”. Lebanon’s import dependence renders the latter an absolute imperative.
Meanwhile, public debt has consistently topped 130 per cent of GDP for the last two decades, with the World Bank predicting a rise to 194 per cent by the end of 2020. Indeed, the IMF estimates that in 2018, interest payments on debt comprised no less than 30 per cent of government expenditure, and 9.6 per cent of GDP, more than three times the amount spent on Lebanon’s main electricity utility and more than six times what was dedicated to capital expenditure. The lion’s share of this public debt, moreover, is owed to Lebanese commercial banks, not foreign lenders. Some of it is denominated in lira, which BDL can print, but the majority is denominated in US dollars, which it cannot. In fact, BDL claims that by the end of December 2019, 76 per cent of commercial banks’ deposits and 69 per cent of their private sector loans were denominated in dollars. In other words, BDL needs dollars to pay off its debts.
But how did public debt get so high in the first place? Atif Kubursi points to the Hariri government’s ambitious reconstruction program after the war, when “the government coffers were almost empty [meaning that] there was no choice but to borrow”. However, political scientist Hannes Baumann contends that “the main debt-creation engine was not the cost of reconstructing physical infrastructure, but currency stabilization”. The problem was that in order to attract enough dollars to maintain the fixed exchange rate, BDL had to offer high interest rates.
“The main problem”, as Toufic Gaspard argues, “is not in that [exchange rate] policy per se but in the unnecessarily generous interest rates that BDL has been paying local banks for their $-deposits at the central bank”. He also notes that these high rates have incentivised commercial banks to forgo depositing their dollars abroad in favour of placing them at BDL, such that by mid-2017, they were re-depositing half their dollar deposits at the central bank. The result is that “the balance sheets and financial situation of the commercial banks have become increasingly interlocked with those of BDL”. In other words, financial difficulties at BDL would translate into a crisis of the banking system as a whole, a crisis made all the more likely by the difficulty of paying off Lebanon’s high-interest public debt.
Moreover, this strategy of attracting dollars by offering high interest was spurred by the fact that the country was haemorrhaging more foreign currency through paying for imports than it gained through export revenue and remittances. It had to compensate for this “current account deficit”, which averaged 22 percent of GDP from 1990-2020 (IMF data), by borrowing - hence the evidently unstable regime of high interest rates. But how long could it last?
The River Runs Dry
By late 2019, Lebanon was in the midst of a full-fledged dollar shortage, with hospitals unable to secure medical supplies and petrol stations facing closure for lack of fuel. Investors had lost confidence in BDL’s high-interest regime, which, in its assumption of new debt to pay off old debt, had come to resemble a government-level Ponzi scheme. Even the Arab Gulf states, which had previously committed emergency dollar injections to prop up the lira, now become reluctant in the face of the influence in Lebanon of Iran-supported Hezbollah.
The arbitrary tax on WhatsApp calls, which revealed the government’s dire situation, ignited a financial panic. Lebanese formed long queues at banks to reclaim their dollars as the de facto value of the lira tumbled, only to come up against withdrawal limits and restrictions on transfers abroad that sparked further protests. The banks could save their dollars, but only at the cost of fuelling the political crisis that continues to erase confidence in Lebanon’s economy.
Poverty has become severe, with the World Bank estimating that total poverty “reached 45 percent of the population in 2019, up from about a third in 2018 and from 27.4 percent in 2011-2012”, predicting it to surpass 50 per cent in 2021. Meanwhile, such hardships spare the slim crust of society that has benefited from the financial sector’s generous high-interest policy, with 1 per cent of all deposit accounts holding about half of total deposits in 2017.
Thus, the explosion of August 4th and the coronavirus pandemic merely built upon an ongoing financial, economic and political crisis. However, while Lebanon’s finances have proved fragile, the same could not be said of its people, who have withstood trial and hardship like few others. It is a resilience much needed in these turbulent times.