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Lebanon’s monetary meltdown tests the limits of central banking

Summary:
Patrick Honohan and Adnan Mazarei of Peterson Institute in this paper write about Lebanon economy. In particular, how Lebanon central bank and its banking system managed to keep the economy going despite macroeconomic problems. However, multiple random shocks have exposed the problems and central bank cannot really do much: Lebanon has spent the last 20 years juggling an excessive level of debt and current account deficits. Apparent financial wizardry by the central bank (Banque du Liban) helped keep the exchange rate fixed, inflation low, and debt service flowing until 2020. But these efforts merely postponed the inevitable, at a high cost. Repeated shocks to the Lebanese economy and governance weaknesses pushed the financial contraption over the cliff before the COVID-19 outbreak.

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Patrick Honohan and Adnan Mazarei of Peterson Institute in this paper write about Lebanon economy.

In particular, how Lebanon central bank and its banking system managed to keep the economy going despite macroeconomic problems. However, multiple random shocks have exposed the problems and central bank cannot really do much:

Lebanon has spent the last 20 years juggling an excessive level of debt and current account deficits. Apparent financial wizardry by the central bank (Banque du Liban) helped keep the exchange rate fixed, inflation low, and debt service flowing until 2020. But these efforts merely postponed the inevitable, at a high cost.

Repeated shocks to the Lebanese economy and governance weaknesses pushed the financial contraption over the cliff before the COVID-19 outbreak. The explosion that ripped through the Port of Beirut in early August added to the disarray. The Lebanese pound has crashed, the government has defaulted on some of its debt, and restrictions have been placed on deposit withdrawals and access to foreign exchange.

Lebanon faces an uncertain future of uneven suffering. It will need foreign assistance, but such assistance will not extend to covering the losses of the banking system. How the losses are distributed will set the scene for Lebanon’s future development. Policymakers should aim for fairness, predictability, and stability without overindebtedness.

So should Lebanon have addressed these problems earlier or postponement was the right strategy? What are the lessons?

Lebanon has spent the last 20 years juggling an excessive level of debt and current account deficits. Apparent financial wizardry by the BdL helped keep the
exchange rate fixed, inflation low, and debt service flowing until 2020. But these efforts merely postponed the inevitable, at a high cost. Repeated shocks to the Lebanese economy and governance weaknesses pushed the financial contraption over the cliff before the COVID-19 outbreak, and the Beirut port explosion added to the disarray.

During much of this period, the BdL was seen as the most credible of Lebanon’s official entities. It did what it could to maintain monetary stability and enable the government to service its debts to the banking system and other creditors. Although tactically impressive, this achievement can by questioned at a strategic level. We will never know whether Lebanon would have weathered a debt restructuring better if it had been engineered 20 years ago. The banking
system would have suffered, but might the economy not have performed betterwithout the overhang of an unsustainable debt that necessitated a high cost of
capital? This question is likely to be long disputed.

In any country, the underlying causes of elevated national financial market risk premia, whether they relate to currency risk or credit risk, need to be
addressed sooner rather than later. Even if the market is wrong in its pessimism (and in Lebanon’s case in the end it was not), these premia erode confidence and undermine the incentive for innovation and capital formation. Absent removal of the underlying causes of pessimism, central banking attempts to put off the day of reckoning through financial engineering are doomed to ultimate failure. What starts out as ingenuity all too easily acquires some of the attributes of a Ponzi scheme.

…..

Central banks, especially in emerging markets, that are beginning to use experimental monetary management techniques should bear such lessons in
mind. These techniques can be used safely only in the context of a sustainable long-term prospect for the exchange rate and government debt. Absent such
prospects, collapse may only be postponed, possibly at a much higher cost. 

As was widely said of central banks during the global financial crisis, the BdL came to be thought of as “the only game in town” over the past two
decades. Technical effectiveness is not the only requirement of a central bank when it steps to the center of an economic crisis to that extent. In such times,
the technocratic central bank also needs to maintain its democratic legitimacy through mechanisms of accountability and transparency.

Hmm.. What is wrong will eventually show up in much uglier manner.

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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