Lebanon’s Economic Recovery Plan Part 3: Monetary Policy

Analysis by Sandro Joseph Azzam, Staff Writer

July 5th, 2020

This article is part of a more general series discussing Lebanon’s Economic Recovery Plan. Each piece tackles a different aspect of the reality of current events, explains the economic or financial principles behind it and provides the real solutions that Lebanese citizens deserve to see implemented. Readers are strongly encouraged to read “Lebanon’s Economic Recovery Plan Part 1: Exchange rate” and “Part 2: Banking” prior to reading this article.

This article will delve deeper into Lebanon’s massive inflation problem, ways to solve it, and what BDL Governor Riad Salame must be thinking. 

The Central Bank has one key number on its books: foreign reserves. To put it simply, this is how we pay for imports, and we can maintain a currency peg as long as the reserves are large enough. With the Central Bank now bleeding reserves, it desperately needs to increase its net foreign reserves position.

Lebanon’s banking system is characterized by a 70% dollarization rate of deposits. Thus, the largest share of Lebanese depositors’ money is denominated in dollars, a staggering 90 billion dollars to be precise. By implementing a forced currency conversion, the Central Bank’s foreign reserves position would see an unprecedented (and highly urgent) increase. Remember Nabil from Part 2? His $1000 would now need to be converted at the new exchange rate. He would no longer hold a $1000 account but rather a 3 million LBP one. 

The most important thing that lawmakers must remember in this scenario is long-term sustainability. If an American depositor, George Washington, holds an LBP account, what is he going to do when he wants to exit Lebanon? Liras are worthless to him. That’s why the Central Bank should remain ready, willing, and able to exchange LBP to USD in a predefined number of cases for those having no speculative intentions. These would include accounts held by foreign companies, non-resident depositors, and individuals with a demonstrated need for foreign currency: those who need to pay tuition fees abroad, undergo medical procedures, foreign service officers etc.  

Let us remember that currency speculators and exchange desk owners in the USSR were given the death penalty in what was arguably the strictest form of capital controls in modern memory. While I would never advocate for such violent punishment, banks – and most importantly the Central Bank – must replace these exchange desks through transparent operations in order to alleviate the risk of another currency crisis all the while maintaining a fair foreign exchange market in a bid to de-dollarize the economy.

At this point, the inflation alarms must be going off in Riad Salame’s office. A deal must be negotiated with banks on the amount of money that depositors can withdraw in any given time-period. Banks could look at individual customers’ spending habits and adjust that number for inflation to find their weekly “allowance”. Due to the 70% dollarization and 50% depreciation, Lebanon’s money supply – that is the total amount of Lebanese Liras that exists in the world – will jump overnight as $1 which used to be worth 1500LBP is now worth twice as much. The obvious side effect is inflation, and the only way to curb it would be to reduce the true money supply by limiting withdrawals and making sure people don’t have access to all their money so as not to spend all of it, otherwise depositors now have double the wealth and prices would double as well in the short run.  

With a devaluation comes an increase in prices in nominal terms. A 50% devaluation would lead to a 50% increase in prices. Luckily, Lebanon’s 70% dollarization should lead to an alleviation of the price increase if the withdrawal restrictions are implemented. The 50% increase in prices is caused by a devaluation of the Lira as prices are set in dollars (because of Lebanon’s inherent twin deficits). This can be solved by giving the 70% of depositors with dollar deposits the same purchasing power they would have had if they were holding onto a greenback rather than a Lebanese banknote. How? Well, the aforementioned forced currency conversion at the new exchange rate is what does the trick. If you could buy something for 1500LBP (so what used to be $1), and its price has now increased to 3000LBP, it still costs you, a depositor who used to have a USD deposit, $1. This solution would save at least 70% of deposits and an even larger proportion of depositors, as many hold accounts in multiple currencies. 

It goes without saying that the Ministry of Economy and its consumer protection agency should also play their fundamental role in alleviating this crisis. Price caps are an absolute must on basic food and home supplies. In the context of the massive spending spree mentioned in Part 1, subsidies to bakeries and local producers should follow. A better social security net must also be funded, even if it would be costly in the short-term. 

With the Central Bank’s astronomical interest rates, a drop would almost certainly imply an increase in inflation. But interest rate decreases don’t solely have a negative aspect. By decreasing interest rates, borrowing money will become more affordable and people no longer have an incentive to park their money at the bank and earn 10% interest. They’ll be encouraged to find returns elsewhere, by investing in the real economy and opening up a business or purchasing real estate. Thus, Salame and his team must strike the delicate balance between interest rates low enough to spur economic activity but high enough to keep inflation at bay. 

With monetary policy, banking and exchange rate covered so far, the next part in Lebanon’s Economic Recovery Plan is Capital Controls