Lebanon’s Economic Recovery Plan Part 4: Capital Controls
Analysis by Sandro Joseph Azzam, Staff Writer
July 17th, 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”, “Part 2: Banking” and “Part 3: Monetary Policy”, prior to reading this article.
At the moment the crisis started, Governor of BDL, Riad Salame faced the cameras and said point-blank that capital controls were off the cards and that a Lebanese default and a devaluation of the local currency were also not going to happen anytime soon. Many put their full faith in his credibility, having run the financial institution ‘impeccably’ for almost three decades.
Yet Lebanese banks took it upon themselves to lock depositors out of their own accounts, essentially imposing illegitimate capital controls right under the nose of a central bank that has not budged to put an end to this banking malpractice. They might have decided upon this good cop/bad cop decision together with BDL to save the Lebanese banking sector from collapsing due to “The Impossible Trinity”.
To put it simply, it is an international economic concept which states the impossible coexistence of what we can find behind three doors. Behind door #1 you will find a fixed exchange rate. Behind door #2, free capital mobility and behind the last door, independent monetary policy. This trilemma basically means that you cannot open more than two doors at once and if you try opening the 3rd, one of the other doors slams shut.
By announcing that he would be lowering interest rates, Salame chose independent monetary policy and keeping the currency peg in place implied a fixed exchange rate regime. Simply, he chose doors #1 and #3, thereby informally announcing capital controls. He needed to bring down the cost of borrowing so that the entrepreneur who wanted to start a productive business would be able to do so, even if he didn’t have access to Daddy’s multi-million-dollar accounts. Remember the impossible trinity? When lowering interest rates, depositors find Lebanon’s banking sector less attractive as returns on deposits are lower, thereby prompting them to send their money elsewhere. “Sending money elsewhere”, aka capital mobility, would drain the central bank’s FX reserves, thereby threatening the currency peg. Lebanon’s depositors were thus locked out of foreign capital markets in order to preserve the currency peg and lower interest rates were set to alleviate the recession.
The central bank essentially made depositors choose: you can either have a portion of your money now or the rest of your money will be worthless in the future. Lebanon’s deposits are highly dollarized, meaning a vast majority of depositors have dollar denominated accounts. These are called Eurodollars. Similarly to what we call Eurobonds, the prefix ‘euro’ means foreign, hence, a Eurodollar is nothing more than a US Dollar held outside of the United States. The same thing can be said for other currencies, hence the existence of Euro-pounds, Euro-yen and euro-euros, or as some call them, euro2.
At least 30% of the banking sector was saved through this operation. Had the banks (or the central bank for that matter, whoever you think was playing bad cop in this scenario) allowed transfers of money abroad, Lebanon’s foreign exchange (FX) reserves – currently standing at about 30 billion dollars – would have run dry, eliminating the FX on the central bank’s balance sheet, opposite their liabilities, aka money in circulation. The mismatch would have led to an official devaluation. If you had 1 million LBP in the bank, they would become worthless. By allowing capital to take flight, not a single dollar would have remained in the economy, leading all lira-denominated deposits to be no more than computer entries with practically no real value, a scenario much worse than today’s reality. Inflation would then skyrocket following a sudden shock in money supply due to the high dollarization rate. If you had $100, then instead of being worth 150.000LBP, it could be worth 1 million times that.
An example of such a situation would be Zimbabwe, whose currency at one point was literally not worth the paper it was printed on. $1 was equivalent to the staggering sum of ZWD2.621.984.228 with inflation reaching 89.7 sextillion percent year-on-year in mid-November 2008. To try and put that number into perspective, write down 89 on a piece of paper. Start writing down 0s after it and keep going. More. More. Keep on writing down 0s. You should have written down 21 zeros by the end of this exercise.
By locking depositors out of their accounts, what banks have done is buy time. The impossible trinity allows for capital mobility and a fixed exchange rate, as was the case before the Lebanese uprisings. In this case, the problem faced is high interest rates. These high interest rates make the cost of a mortgage, launching a startup and getting a student loan extremely high. If a depositor with $1 million could earn 10% interest in the bank without having to invest in, say, a tech startup, the real Lebanese economy is damaged as this money is not being injected into local business and is rather used to fund the currency peg and gaping government deficits.
In the long run, once Lebanon’s productivity and industry pick up their pace and the local economy starts to flourish (ideally after strong anti-corruption reforms and the implementation of the solutions given in Parts 1, 2 and 3), then the central bank will revert back to its decision of choosing doors #1 and #2. This is conditioned upon Lebanese residents and international actors regaining confidence in the local banking sector and can only be achieved through transparent banking, strong monitoring of capital markets and banks not lending to a government which is not creditworthy.
This article concludes Lebanon’s Economic Recovery Plan. A summary article of all aforementioned solutions and reforms will be published shortly.