Brewing public disenchantment with rampant corruption and long-addressed inequalities have bubbled over in Beirut, as protests rage on for their second week; Lebanon is at a critical juncture.
For the eighth consecutive day, thousands of Lebanese citizens occupy the streets of nearly all major Lebanese cities. Protests started on Thursday, October 17th when protesters took to the streets in frustration over government corruption, inequality, and sectarianism. What ultimately broke the camel’s back on October 17th was the government’s decision to levy several new taxes, including a $6 per month WhatsApp tax, but the roots of the population’s discontent are in fact much deeper; years of mismanagement of an increasing public debt, questionable financial manoeuvres to keep an import-based economy afloat, and political apathy have left the country on the brink of economic meltdown.
A Domestic Banks Sector Dependent on Public Debt
In 1975, a civil war erupted in Lebanon. For 15 years, the country endured severe human and material losses. The priority for the post-war government, fittingly, was to reconstruct post-war Lebanon sparing no expenses. A costly necessity funded through borrowing large amounts of funds, leading to today’s astronomical public debt. Lebanon’s borrowing in the 1990s had two features worth noting: first, the terms of lending made investments unnecessarily expensive, and, second, the government mainly borrowed from commercial banks.
In the 1990s to 2000s, Lebanese treasury bills had an exceptionally high-risk premium, meaning that the significant risk taken by lenders was compensated by high-interest rates. Today, the highest yielding government bonds in the world barely match the rates offered by Lebanese bonds in the 1990s. According to Banque du Liban’s available data, discounts on Treasury bills were around 15-20%, and yields went up to 36% on several occasions.  These conditions made interest payments unsustainable, leading to a systematic, ever-increasing fiscal deficit. Intense post-war investment and bewildering interest rates meant the debt grew exponentially before stabilizing around 2006 at a sturdy 20% annual rate. By 2006, however, the debt had already reached 40 billion dollars, a staggering 183% debt to GDP-ratio.
As the country was seeing public debt sky-rocket, the Lebanese commercial banking sector was blooming. The government had chosen to exclusively borrow from its domestic market and issue bonds in Lebanese Lira. At the time, the war had left many Lebanese with scarce savings which meant that only commercial banks could afford the bonds and enjoy their yields. For banks, these ever-growing rents turned into sustained profits: in 2017 BLOM Bank declared $731 million profits, an equivalent amount to the profits of the sixth highest-earning bank in the UK. Another example, BankMed, a bank held by Saad Hariri’s family, was valued at $1.27 billion when Ayman Hariri, the prime minister’s brother, sold his 42.24% stake for $535 million in 2017.  Nisreen Salti, an economist at the American University of Beirut, suggests those figures conceal an idle and burdened banking sector heavily dependent on the national debt.  Salt also argues that the exceptional yields on Lebanese Treasury bills exceeded interest rates on deposit accounts, leaving no incentives for banks to investigate riskier investments. Consequently, banks were no longer serving as intermediaries between monetary savings and the private sector, but purchased the lucrative treasury bills in such amounts that, in the late 1990s, banks held 2/3 of the public debt with government-issued bonds constituting ¼ of bank’s total assets on average.  In the following decades, as public indebtedness increased, the Lebanese banking industry became overly dependent on the national debt.
Twin Deficits and Pegged Rates
In the aftermath of the civil war, Lebanon lacked domestic capital as a result of years of underinvestment, destruction and regional tensions. As a result, Lebanon imports vast amounts of goods and services that it cannot produce itself today: an estimated 80% of Lebanon’s food consumption today is imported. Other essential goods are imported en masse, too. According to Georges Sili, president of the Lebanese Order of Pharmacists, 90% of Lebanon’s drug consumption is imported.  The massive consumption of imports relative to what Lebanon exports meant that the country’s current account to GDP averaged -19.09 per cent from 1980 until 2018, reaching an all-time high of 37.80 per cent in 1982 and a record low of -57.50 per cent in 1991. To finance the vast amounts of import, the Lebanese economy needs USD dollars. Lebanon holds a substantial reserve of US dollars to defend a pegged exchange rate of 1500LL/USD. Introduced in December 1997, the peg was initially a response to hyperinflation during the 1980s and dollarization of the deposits, estimated at 86.2% in 1987. The peg gives Lebanese an artificially high-power purchase to the benefit of the 25% of Lebanese who live under the poverty line, allowing them to purchase essential imported food items as a result.
A fixed exchange rate is essential to maintaining Lebanon’s macroeconomic stability. The peg fixes uncertainties regarding the volatility of the exchange rate and avoids periods of high inflation by pegging the currency to a country’s currency with low inflation. Pegging gains are especially high for Lebanon; as trade consists of a large fraction of Lebanon’s GDP, currency instability could come at high costs. For example, exchange rate swings might damage foreign investors’ confidence, and an appreciation of the currency could harm export competitiveness while depreciation could render crucial imports unaffordable. The peg’s main drawback, however, is the loss of independent monetary policy in times of economic uncertainty or recession. Still, the peg has acted as the main pillar of economic stability for Lebanon, and maintaining its credibility has been of the highest priority for the Banque du Liban, the country’s central bank.
The Lebanese Miracle Comes Undone
In 2006, Lebanon’s debt to GDP reached 183%, a rate defying warnings of defaults, a balance of payment crisis and a collapse of the currency. Thanks to generous cash transfers from foreign nationals, savvy central bankers and regional aid, Lebanon managed to defy the exorbitantly high rate of debt to GDP for the past 15 years – an ability to stay afloat named by many observers as ‘The Lebanese Miracle’.
Considerable cash transfers from foreign nationals are the main reason why the Lebanese economy did not crash. Many Lebanese foreign nationals kept depositing foreign money in domestic banks in Lebanon. Wealthy foreigners did so to benefit from high remunerations on deposits as well as the prevalence of bank secrecy in Lebanon. In turn, their deposits have contributed to the country’s dollar reserves, instrumental to financing the debt. Specifically, thanks to convertibility of US Dollars to Lira, domestic banks can easily buy government bonds issued in Lebanese Lira, which in turn, yield high returns easily converted to US dollars, a safer currency. This system proved to be a bonanza for the foreign nationals and their intermediaries, the banks. Still, providing crucial dollars to the Lebanese economy and alleviating the short-term debt burden came at the cost of increasing future debt.
The large cash flow from foreign nationals was complemented by international aid coming mainly from France and Saudi Arabia. In 2002, when Lebanon’s financial system came under serious strains, the Saudi government gave $700 million, and France pledged $500 million. Later, when a sequence of political crises threatened financial stability, notably the July 2006 war, Saudi Arabia and Kuwait deposited $1.5 billion in Lebanon’s central bank to back the economy.
However, recent regional economic difficulties, including the economic slowdown in the Gulf region, have affected this precarious equilibrium. Indeed, regional economic turmoil led to the reduction of foreign deposits, severely hurting Lebanon’s dollar reserves. In fact, an estimated 60 per cent of remittances came from Gulf countries.  In 2016, the International Monetary Fund (IMF) expressed concerns over Lebanon’s $4.7 billion deficit in net foreign exchange reserves, a record revealing Lebanon’s external vulnerability. 
In response to the increasingly dire economic situation, the central bank, Banque du Liban, attempted to buy the country time to implement structural reforms through creative financial manoeuvring. Between May and October 2016, the central bank-led three parallel transactions to strengthen domestic banks’ balance sheet and to increase Banque du Liban’s US dollars reserves. Firstly, the Central Bank swapped Lebanese Lira Treasury bills held in its portfolio for newly issued US dollars Treasury Bills. Thanks to this first mechanism, Banque du Liban converted part of its assets from Lebanese Lira to US dollars, and Lebanon’s government alleviated its debt burden by increasing US dollar liabilities which held lower interest rate than Lebanese Lira liabilities. Second, these US dollars Treasury bills gave the central bank a dollar inflow which the bank used to issue US dollars Certificate of Deposits (CDs), a financial product sold to commercial banks and its most wealthy clients. This mechanism helped the central bank increase its dollar reserves in exchange for a high-risk premium.
In the short run, new US dollar reserves conferred the central bank a buffer to defend the Lebanese Lira against an increasing current account deficit. Third, the central bank offered to buy back its Lebanese Lira Treasury bills to commercial banks before their full maturity with a 0% discount, while also paying upfront half the interest the bank would have earned had they kept the financial product. This last operation was equivalent to an injection of capital, in the form of Lebanese Lira, into commercial banks.
The cost of this operation, however, is estimated at $5 billion, an aberration according to Toufic Gaspard, a French economist, who argued Banque du Liban’s operation was unjustified, shrouded in secrecy and not procedural. Toufic Gaspard has said that interest rates on US dollar deposits have been unnecessarily generous to commercial banks.  However, one could refute Toufic’s argument by invoking Lebanon’s sovereign credit risk rating. As a matter of fact, both Fitch and Standard&Poor, eminent rating agencies, both graded Lebanon’s sovereign credit as B- in 2017, an equivalent rate to Egypt’s credit rating – although Egypt has significantly higher interest rates on Treasury Bills.
Ultimately, these unconventional financial operations strengthened Lebanese foreign-currency reserves which reached a record high of $43 billion at the end of the operation. In its 2016 consultation, the IMF “commended the Banque du Liban for maintaining adequate international reserves”. However, while foreign nationals’ remittances, international aid and qualified central bankers delayed a full-fledged economic crisis, they did so by extending the cycle of ever-increasing public debt and commercial banks’ exposure to sovereign debt. The extra time they bought Lebanon was wasted politically as no structural reforms to address the underlying problems were implemented.
As the economic environment deteriorates further, Banque du Liban will not be able to continue this course of innovative financial tools to sustain foreign currency reserves and defend the peg. For the last decade, the budget deficit has been continuously rising because of the increasing cost of government expenditures.  Indeed, interest payments now exceed 9% of GDP, vast sums of money are engulfed in Electricité du Liban, the national power provider, and civil servants’ salaries make up 42% of government expenditures. Furthermore, the external imbalance continued to rise in 2018 due to low export growth, expensive fuel imports and decreasing remittances from the foreign nationals.
These indicators suggest Lebanon is heading towards a severe financial crisis which would take the form of a currency depreciation and a destabilization of the banking sector. A drastic cut of households’ wealth, dramatic unemployment and lack of imported essential products would follow.
Despite having done little to break the gridlock himself in past years, Saad Hariri resigned as Prime Minister on October 28th saying his government had reached a political “dead end”. As of now, newspaper articles speaking of a meltdown, a black market for US dollars is emerging, convenience stores provide random exchange rates, and it is impossible to withdraw US dollars from ATMs as banks suck in dollars to maintain the peg. These days Lebanon is at a critical juncture. The scale of the coming crisis can either bring the Lebanese together towards a common goal of rebuilding a tattered economy – an unlikely outcome unlikely thanks to the segmented and clientelist Lebanese political system – or spiral down into economic crisis and years of economic and political instability.
 Primary Market Rates on Treasury Bills. Last updated September 2019. Source Banque du Liban. http://www.bdl.gov.lb/webroot/statistics/table.php?name=t5271-3
 “Ayman Hariri sells stake in GroupMed holding for $535 million”, Forbes Middle East, 13th June 2017. https://www.forbesmiddleeast.com/pdf/ayman-hariri-sells-stake-in-groupmed-holding-for-535-million?download=pdf
 SALTI Nisreen, « No country for old men : How Lebanon’s debt has exacerbated inequality », Carnegie Middle East Center, 17th september 2019. https://carnegie-mec.org/2019/09/17/no-country-for-poor-men-how-lebanon-s-debt-has-exacerbated-inequality-pub-79852
 Peters, David & Raad, Elias & Sinkey, Joseph. The Performance of Banks in Post-war Lebanon. International Journal of Business. 2004.
 YAN Victoria, “Local drug manufacturers want boost”, The Daily Star (Lebanon), 28th February 2017.
 “Lebanon secures $4,400 million in Paris”, MEED, 29th November 2002. https://www.meed.com/lebanon-secures-4400-million-in-paris/
 BAUMANN Hannes, “Lebanon’s economic dependence on Saudi Arabia is dangerous”, Washington Post, 7th December 2017. https://www.washingtonpost.com/news/monkey-cage/wp/2017/12/07/hariri-is-back-as-lebanons-prime-minister-heres-how-saudi-economic-influence-still-shapes-lebanese-politics/
 TOUFIC Gaspard, “Financial crisis in Lebanon”, Konrad Adenauer Stifung and Maison du future, Policy paper n°12 august 2017.
“Banque Du Liban’s Financial Engineering: Background, Objectives and Impact”, Banque du Liban, November 2016.
 ”Citizen budget 2018”, Republic of Lebanon Ministry of Finance, annual budget document and process. http://www.finance.gov.lb/en-us/Finance/BI/ABDP
Featured image: flickr@polifaf