The government should aim at restoring confidence through economic sustainability and balanced growth.
by Marwan Mikhael -Source: Annahar
A gas station pump is closed during a protest against tight supply of dollars from the central bank in Beirut, Lebanon, Thursday, Nov. 28, 2019. (AP Photo)
There is one question on everyone’s mind: Is there still a way out of the current crisis or are we going to fall into an abyss with an intense deterioration of all economic indicators that could lead to dire consequences? A summary of the current economic situation will help us analyze its sustainability. Then we can try to find a way out of the crisis with the least damage to the economy.
The protests accelerated what was already a deteriorating economic and financial environment. The protests on the street accentuated panic among the population, with the resignation of Prime Minister Saad Hariri being the cherry on the top. When banks opened following 14 days of closure, people rushed to withdraw and/or transfer their deposits into dollars or outside the country.
Banks were obliged to adopt further restrictions in order to maintain financial stability for the longest possible time. No banking system in the world could survive an unchecked rush on banks. When depositors place their money in a Lebanese bank, the bank, in turn, uses these funds to loan to other customers or to buy government bonds or Certificates of Deposit from Banque du Liban (BDL), Lebanon’s central bank. Such uses are standard practice world over, and so long as depositors are content to keep their money in banks and do not en masse try to withdraw their deposits, the banking system remains stable and functional. In Lebanon, the liquidity issues of banks were also exacerbated as the banking system had already lost part of its foreign assets starting in 2011, with the balance of payments (BOP) in the red for more than eight years. Moreover, the BOP deficit had accelerated over the past two years.
The current economic and financial situation can only be transitory as its downfall has been accelerated by the protests, making the economic and financial situation unsustainable. The restrictive measures adopted by banks will make it less likely for capital to flow into the economy as investors will become worried about the risk of being unable to withdraw money from the system. It will, therefore, become more and more difficult to attract money and the economy will have to rely on its own existing stock of foreign assets to finance its imports of goods and services. Imports will decline as a result yet will continue to constitute the major drain on foreign assets.
Another source of draining deposit is cash withdrawals from banks. People are withdrawing as much cash as they can, in both currencies (Lebanese lira and US dollars), to counter the restrictive policies of banks. Then, being unable to transfer cash outside the country, this money is kept in safe boxes at homes. Estimates based on the balance sheets of BDL find that the amount of cash withdrawn from banks in October and November has amounted to more than $2.5 billion.
Taking a longer view, successive governments since 1990 were never able to restore investors’ confidence level to where it was before the war started. The dollarization rate never went below 50 percent and most of the time interest rates on lira were much higher than on dollars. During the episodes of shocks like in 1995, interest rates went up to 38 percent, while in 2005, 2006, 2008, and more recently, the price of credit default swaps (CDS)—these are an insurance against the risk of default of the Lebanese government—increased to more than 2400 basis points, meaning that there is a greater risk of default. Theoretically, the five years CDS should be equal to the difference between five years Lebanese Eurobonds and five years US bonds, which has crossed 1000 basis points.
As demonstrations continue, the restrictive policies of banks will remain in place and the repercussions of both on economic growth are substantial. Analysis of various sources including the Purchasing Managers’ Index, finds that companies’ turnovers fell by more than 50 percent in October, depending on the sector. The impact in November is anticipated to be larger than the previous month as banks froze their facilities for individuals as well as for companies, and reduced credit card limits. Consumption and imports are de facto declining and traders are feeling the heat.
The result is an economic recession combined with a liquidity drought that is unsustainable beyond the short term. Either a government is formed and the country is put on the right track of reforms or the restrictive policies will increase and the parallel exchange market will see a larger depreciation of the Lebanese lira. The cash economy will flourish as depositors will avoid putting money at banks.
So the million-dollar question remains: If a government is formed, is there a way out without a haircut on deposits, a restructuring of government debt, and devaluation? The most urgent issue is to restore investors’ confidence in order to be able to levy the restrictive measures of commercial banks and for capital to start flowing in again. A way out can be found without a haircut on deposits and devaluation, but a restructuring of government debt, at the least the debt in Lebanese lira, is preferable in order to reduce the burden on public finances.
The first step before getting into any future economic plan is to form a government. This government has to be formed quickly and, according to the Lebanese constitution, it has to get the support of the majority of parliamentarians. Beyond parliamentary approval, the government has to gain the confidence of people on the streets, but, most importantly it has to get international recognition as trustworthy and cooperative. Debating the composition of the new government is like debating the sex of angels. Be it technocratic, techno-political, or purely political, the most important thing— besides being approved by the international community—is for the government to be coherent, to have an economic and financial plan for the upcoming three to four years, and to be responsible for its actions, in order to be productive and immediately start to tackle the current economic and financial crisis.
If a government with international support is formed, then resolving the current economic woes will become easier. An inflow of deposits from the GCC governments of $7 billion to $10 billion as deposits at BDL will also be very vital to support confidence, as BDL will then be able to pump dollars in the market, and banks will relax capital controls in few months’ time. Of course, this will be conditional on the new government adopting an ambitious yet credible comprehensive economic reforms plan for the upcoming three to four years.
As capital controls will be maintained in the near term, the banking system has to move into reducing interest rates in order to limit the increase in its foreign currency exposure. A drastic reduction in interest rates is advisable on both dollar and lira deposits. The interest rate differential will have to decline to a quarter or half a percentage point as it is the case in economies with pegged currencies. This step will lead to a reduction in the cost of funds for banks, especially in dollars, at a time where capital inflows have been reduced to negligent levels. Banks will then move to reduce interest on corporate debt and start to provide loans again to businesses.
In order to accelerate the recovery process, it would be advisable for the new government to reach an agreement with the International Monetary Fund (IMF) as soon as possible. The importance of an IMF program is that it will act as a catalyst for capital inflows. The IMF will agree with the government on three years Extended Fund Facility (EFF) that will consist of an economic program agreed with the government including a timeline with quarterly evaluation by the IMF. It will also entail a package that could go up to a few billion dollars with quarterly disbursements if the review by the IMF mission is positive on the implementation of the reform program. Once the IMF gives a green light for the disbursement, international donors will do the same. Hence the IMF will act as a leverage to attract capital from abroad. If the IMF program will disburse $3 billion over three years, it is expected that this money will attract more than $10 billion over the same period. It is important to note that citizens will need to sacrifice in the short term, while gradually getting better public services over the medium term.
Having covered the pressing issues of the current situation, let us then look more specifically at the economic reality that Lebanon finds itself in and the measures that need to be undertaken in the immediate and the long term to put the country on a path toward recovery.
The government should aim at restoring confidence through economic sustainability and balanced growth. The strategy should be founded on three pillars:
- Macroeconomic stabilization along with poverty reduction. This includes Large reduction of the fiscal deficit over the coming three and a half years (from the second half of 2020 till the end of 2023) through an effort to mobilize revenue that will generate 3-4 percentage points of GDP in gross additional tax revenue by end 2023 (it will be 1-2 percent on a net basis due to the privatization of telecoms in 2021), and a strategy for cost recovery in Electricité du Liban (EDL); monetary policy that will continue to aim at preserving the exchange rate peg for the moment, as it is an anchor for confidence and the negative impact from floating the lira outweighs its positive impact on competitiveness and on the reduction of the current account deficit; monetary policy that will try to reach an inflation objective of 4 percent or less in order to help in shoring up confidence; and increasing social and development spending to protect the most vulnerable.
- Structural reforms with improved transparency and governance to strengthen public enterprises and institutions, and to foster higher economic growth. This will include: improving public financial management through better collection and better control of tax evasion to achieve more fiscal discipline and greater budgetary transparency; reforming EDL and the tariff structure to ensure a balanced budget for the energy sector and better services; modernizing and corporatizing all the enterprises owned by the government in order to prepare them for privatization; strengthening anti-corruption agencies such as the central inspection authority and the court of audit; and improving the regulatory framework of investment and job creation.
- Adequate new financing from the international community to support Lebanon. If such a program is adopted, the government will be able to catalyze new external financing from governments and multilateral institutions, which will help close the financing gap and allow reforms to work.
Public debt restructuring is essential if Lebanon wants to get out of the vicious cycle of debt and deficit and put the debt to GDP ratio on a sustainable path. However, it should not include a haircut on the principal of the debt. Restructuring the debt does not mean a haircut on the debt as it will de facto lead to a haircut on deposits, even if it is the one held by the central bank only. The idea of BDL writing off its holding of government debt in order to substantially reduce the stock of debt—BDL holds close to $38 billion of Treasury Bills and Eurobonds—is not a viable option. Any decline of this magnitude in BDL assets will have to lead to a decline in its liabilities, meaning a haircut on banks deposits at BDL, which will result in banks having to do a haircut on their customers’ deposits.
Restructuring of government debt has to entail lengthening the maturity of government debt, while drastically reducing interest rates on the debt for the coming three years. Of course, this decline will hit the banking system profits for the upcoming few years. However, it is the least painful compared to any other measure that can help with getting out of the current crisis. In our scenario, we considered a decline in the effective interest rate on government debt to 1 percent in 2020, 2 percent in 2021, and 3 percent in 2022 and 2023. Interest rates will go back to market-rate starting 2024. This decline in debt service will help the government reduce the total deficit at a time when tax measures and expenditure tightening will help boosting the primary surplus. In our scenario, public debt to GDP ratio will decline from 154.7 percent at the end of 2019 to 113.7 percent at the end of 2023.
The government has to initiate the privatization process of telecom companies. The Higher Council for Privatization and PPP (HCP) will have to coordinate with the Telecom Regulatory Authority (TRA), which has to be appointed as soon as possible, in order to prepare for the privatization of the two telecom companies.
The best privatization strategy will have to bring in both citizens and strategic investors along with the government. It will serve three purposes: to develop capital markets, to give ordinary people a stake in the company to be privatized, and to ensure better management and higher future profits by bringing in a strategic investor. This strategy is based on the fact that the government will do an initial public offering (IPO) for a certain percentage of the company, open to the public. People will get a share of the profits while the strategic investor and the government will divide the remaining share. The government will continue to collect the taxes on the sector and will keep a share in the company; however, it will be a minority share.
Saying that the government should not privatize companies that are providing large profits to the Treasury is not an accurate statement. The privatization of the telecom companies will help reduce government debt by more than $6 billion in one shot (in our scenario, the privatization of the two mobile companies will take place in 2021), in addition to the fact that it will enhance the management and will reduce political interference. Services will improve and prices may decline while key performance indicators will be set for the companies to implement government strategy, mentioned above, in the telecom sector.
Marwan Mikhael is an economist and lecturer at Saint-Joseph University (USJ).