23 years of a pegged regime on the verge of termination

Policy Analysis by Gaelle Nohra and Rhea Haddad, Staff Writers

May 30th, 2020

Exchange regimes are key factors of how daily international economic operations proceed, therefore they consist a radical part of how economic growth could either run smoothly or be drastically disrupted. The 23 years aging dollar peg in Lebanon has long been accused of inducing, or at least, bolstering the freezing state of the economy. Aside from the need for the IMF financial intervention, current Finance Minister, Ghazi Wazni, has claimed that a shift towards a floating exchange regime requires time, confidence restoring, as well as an economically rigid environment.

This policy analysis presents a concise, yet comprehensive, historical overview of the Peg journey in Lebanon ever since its implementation in 1997. But first, and in order to render the read less complicated, a brief explanation regarding a fixed and a floating exchange regime will be introduced.

Fixed Vs Floating exchange regime

Under a fixed or pegged exchange regime, the country’s currency is fixed against a foreign currency (the U.S. dollar in the Lebanese case). Maintaining the peg occurs through the Central Bank’s monetary policies consisting of buying and selling its own currency. The main advantage of this regime lies in the fact that it arguably promotes stability and prevents the central bank from increasing money supply contextually to the events of the country or other factors. Yet, drawbacks are not absent and can be summarized by recessions occurring whenever monetary authorities are constraint to preserve the peg at the expense of short-term employment and price stability.

In contrast, a floating exchange rate is market-determined through fluctuations in supply and demand in foreign exchange markets. For instance, a high demand for the currency will result in decreasing its value and vice-versa.

Advantages of this regime could be summarized by, first the fact that it is “self-correcting” and differences in supply and demand are automatically translated by a change in the exchange rate. Second, it frees up some reserves as under this regime there is no peg. Most importantly, this system is characterized by its flexibility, it places no particular pressure on the Central Bank to maintain the peg by implementing ‘unfavorable’ measures such as deflationary policies.

That said, a floating regime suffers uncertainty, the exchange rate could be easily subject to change and manipulation from policy regulators, which could also render foreign investors more reluctant to start-up businesses in the domestic country

Historical Overview

On September 2nd 2019, Lebanon declared an economic emergency following a downgrade from two major credit rating agencies in addition to a 0% GDP growth, raising concern over the country’s ability to maintain one of its arguably most successful monetary policies: the fixed exchange rate between the Lebanese Pound and the US Dollar.

In 1980, the exchange rate was so that about 3 Lebanese pounds to 1 dollar. In less than a decade, this rose to over 2,500 pounds, deterring investors inevitably. This economic turmoil was largely due to the 1975 Lebanese Civil War and the political events and leadership that followed thereafter. By the mid-1990s, the conflict was toning down and reconstruction became the priority of the State and of the State leadership.

However, due to the currency inflation, the government struggled to attract investors and worked on establishing a currency peg, fixing 1,507.5 pounds at 1 dollar by 1997. Banque du Liban became responsible for maintaining the peg through the use of its foreign currency reserves, buying government debt, and setting high interest rates to allow people to deposit their money in the country. However, this allowed local banks to make money from attractive interest rates and buy up government debt rather than investing in productive industries.

Currently, the reserves - excluding gold and other assets - are declining. According to Fitch, the reserves have dropped nearly $3 billion since the end of 2018, leaving $29.1 billion in 2019, and are expected to decline $3 billion annually in 2020 and 2021 without proper reforms. Additionally, accumulating political issues has further swallowed confidence leading foreign investment and remittances to fall off.

In a country suffering trade deficit, capital inflows are a main route for Lebanon to equalize its balance of payments, keeping its reserves high. Lebanese citizens, victims of a vulnerable economy, reduced their local deposit by converting them to dollars.

However, back in 2016, Banque du Liban engaged in a new maneuver of creating money entitled “financial engineering”. First, the strategy consisted of exchanging Lebanese Pound treasury bills with equivalent Eurobonds issued by the Ministry of Finance. Second, selling these Eurobonds to commercial banks against newly-swapped USD treasuries; Customers’ USD are now theoretically held at BDL at an attractive interest rate. Third, in order to get commercial banks to participate in this financial engineering exercise, BDL resorted to discounting at 0% an amount equivalent to the previous transaction (Eurobonds and USD CDs) of LBP denominated debt held by commercial banks in their portfolio. This transaction was subject to voluntary 50% haircut on interest in favor of BDL. Thus, financial engineering was indeed a pivotal path taken by BDL, as expressed on November 11th 2019 by Riad Salameh, Central Bank Governor, “Financial engineering allowed us to accumulated reserves which backed the Lebanese pound…”.

Today, something similar could be implemented such as cutting the gap between government spending and revenues through reforms, yet Lebanon would first need to secure capital inflows.

Less than a month ago, Prime Minister Hassan Diab has published a financial recovery plan, which, in addition to structural reforms and changes to the entire banking system, includes changes allowing the Lebanese Pound to adapt to market rates, estimated to be 3,500 pounds to 1 dollar.

“The peg to the US dollar that has been maintained over decades is now impossible to restore and must be revamped […] For years, the lack of competitiveness of the Lebanese companies has prevented the emergence of a productive and diversified economic base in Lebanon and encouraged the consumption of imported goods through artificially inflated purchasing power” says the Lebanese Prime Minister Hasan Diab. While Banque du Liban continues using the official rate of 1,507.5 pounds to import fuel, medicine, and basic foodstuffs, around 70% of transactions are now at a parallel rate of around 4,100 pounds, fluctuating every hour. In Lebanon, basic goods have risen by 50% in price since October 2019.

“The float has indirectly happened as 70% of economic transactions are at the parallel rate”, says Garbis Iradian, chief economist for MENA at the Institute of International Finance (IIF). Currently, the authorities aim at unifying the dual or rather various exchange rates after an agreement with the IMF. One of the key issues to explain what happened is the overvalued exchange rate. Imports rose sharply and exports remained stagnant, resulting in persistent large current account deficits, depletion of foreign exchange reserves, and increased debt.

Analysts believe that the government will not be able to unify the multiple exchange rates into a determined single-market currency until it secures some form of foreign creditor support from the IMF, because if not, “the rate will go up to 10,000 or 20,000 pounds”, says Iradian.