Once Again, Lebanon Is on a Financial Tightrope

Ordered by the CEDRE conference to reform their economy, Lebanese leaders settle for cosmetic and superficial changes likely to lead to a major crisis.

Paris, 6 April 2018. — Jean-Yves le Drian, French Minister for Europe and Foreign Affairs, opens the CEDRE conference, in the presence of Saad Hariri, President of the Lebanese Council of Ministers.

The Lebanese Parliament finally voted on the 2019 budget in July, when the year was already half over. In the Land of the Cedars, no one is surprised by this flagrant violation of the Constitution. Normally, the ministers should now be working on the 2020 budget, meant to be tabled in October. But neglect of the basic rules of democracy doesn’t stop there. The country has lived without a budget for almost twelve years, proof of the lack of public policy. A model of financial management which worked for years “in defiance of the laws of gravity” to quote the director of the World Bank, now clearly reveals its limitations. For want of any genuine reforms, Lebanon is running the risk of a painful devaluation, a banking crisis and a default on the sovereign debt which represents 150% of its GNP, one of the world’s highest figures.

Unbearable imbalances

It was because they claimed to be aware of the unbearable nature of these imbalances and wished to preserve the stability of that tiny buffer state between Israel and Syria which hosts over a million refugees (i.e. 25% of its population) that a large number of donor states expressed their willingness to provide Lebanon with financial support at the CEDRE1 conference on 6 April 2018.

In the view of French President Emmanuel Macron, what was also at stake was to provide a boost for the policies of Premier Saad Hariri whom he helped rescue from the clutches of Crown Prince Mohamed Ben Salman in November 2017 during an incredible episode of hostage taking in Riyadh. The donors’ demonstration of solidarity on 6 May 2018, just one month before the legislative election, helped Hariri to keep his job despite his weakened position, financially and politically, and to pursue his partnership with Michel Aoun, elected President of the Republic on 31 October 2016 after a 29-month vacancy at the head of the State.

Some 11 billion US dollars of financial aid were announced at that conference, the fourth of its kind to be held in the French capital. But because after the previous conferences—“Paris I,” II and III—, the Lebanese authorities never implemented the necessary reforms, this time the donors were much more cautious and demanded a number of hard commitments even though they do not have the power to impose actual conditions like the obligatory programs of the International Monetary Fund (IMF).

Electricity: the symbol of a bankrupt state

The area of electricity production is the most flagrant example of this complacency. Although the sector is a public monopoly, it costs the State nearly two billion dollars (1.6 billion pounds sterling) per annum and represented 20% of the public debt in 2018. Years of negligence have led to the construction of gas-fired power plants with no gas, power-cuts lasting several hours every day which consumers are obliged to make up for by hiring generators—a business in the hands of a regular mafia. Poor maintenance and theft from the transmission and distribution networks represent a record loss of 40% on each kWh produced, etc.

Logically enough, the reform of the electrical sector is therefore one of the first commitments demanded by the CEDRE conference and the first task the government has assigned itself even prior to proposing a budget for 2019. But there is one hitch. Even to the most well-intentioned friends of Lebanon, it is obvious that the efforts to restore a minimal amount of transparency and fair competitiveness regarding public tenders are deliberately obfuscated, while an insistence on the participation of the private sector served for months as a marketing argument.

Thus the first step in this plan, for example, was to grant a contract worth several hundred million dollars for a period of twenty years by mutual agreement and with no competition to a private company the name of which was never officially divulged, even though people in the know were aware that it was owned by “politically exposed persons” in the hallowed phrase used by international organisations. And the first decision of the government is to transmit to Parliament, under the pretext of urgency in the electricity sector, a law exceptionally granting the Council of Ministers power to award public contracts for hundreds of millions of dollars in defiance of all legal and regulatory constraints. A handful of MPs rebelled against this carte blanche which was also a blank cheque and managed to have the law partially nullified by the Constitutional Council, but everything remains to be done to create an acceptable procedure for public tenders.

Billions spent with no oversight

In other words, it would mean a revolution in a country where the appropriation of public funds by a political elite which is past master in the art of cutting the cake to their advantage has made it possible to spend billions of dollars without any real oversight since the end of the civil war: for lack of any budget, the National Treasury has been functioning for years on the basis of “advances” granted itself in the absence of any authorisation of expenditure or tax collection which is supposed to be the chief role of Parliament. Nor have the MPs passed a single discharge bill since 2003: and yet parliamentary endorsement is a constitutional obligation prior to the adoption of a new budget. Consequently, stories of misused funds, rigged markets, nepotism and clientelism are legion, although these are never prosecuted since the judiciary is one of the main victims of the system.

This model of appropriation has functioned year after year thanks to a particular type of windfall. For want of any natural resources, Lebanon is financed by the influx of capital from an increasingly numerous diaspora. To the millions of Lebanese long since departed to the four corners of the earth have been added 600,000 more who emigrated following the war of 1975–1990. The size of their transfers is reflected in the dimensions of the Lebanese banking sector whose assets are four times greater than the national economy (440% of the GDP), comparable to that of Switzerland. But though Lebanon is often compared with the Alpine country because of a law on bank secrecy dating from 1956, the Lebanese financial system is built on very shifting sands. So much so that the analogy with the Ponzi scheme2 is regularly referred to among specialists.

At issue is the allocation of these resources to an economy which is less and less productive and deeper and deeper in debt. Financed locally to an overwhelming extent (international investors hold some 10% of the foreign currency debt which represents only 38% of the overall debt), the government debt is only the tip of the iceberg. Because actually it is the way the whole economy is financed which is near breaking point. It involves two strategies.. The first consists in offering an attractive rate of remuneration to attract foreign currency into Lebanese banks. The second consists in offering an even better rate to anyone who’ll convert their currency into Lebanese pounds.

This well-oiled mechanism rests on three pillars: the banks offer both personalised service and a guarantee of confidentiality, very low taxes (interest is taxed at 7% and the 2019 budget raises this rate to 10% without any progressivity) and a relative degree of security based on a fixed rate of exchange which is the top priority of the Central Bank since the beginning of the nineties. The banks themselves derive considerable benefits in passing. This evolution merely reflects economic and social policies which are as unproductive as they are inegalitarian. According to a study by Lydia Assouad for the World Inequality Lab, the richest 1% of the Lebanese population trusts 23% of the national revenue and holds 30% of the country’s wealth, which makes Lebanon one of the most inegalitarian countries in the world.

However, these huge wealth gaps remain hidden by the artificial inflation of purchasing power due to the policy of a fixed exchange rate, maintained for nearly 25 years now in spite of the structural deficits of the trade balance and the current account, respectively 30.4% and 27% in 2018.

15% yields on bank deposits

The problem is that this policy of a fixed rate of exchange, the corner-stone of the whole system, is becoming increasingly difficult to maintain and Lebanon is experiencing a latent crisis in its balance of payments which threatens to explode at any moment. The country’s deficit reached 3,304 billion dollars (2,600 billion pounds sterling) by the middle of this year, the equivalent of 68.5% of the total 2018 deficit. The red light is flashing.

But the governor of the Central Bank is doing his best to imagine arrangements that will attract greenbacks. But in the end his “swaps”3 aroused indignation among even the closest financial circles so scandalous was the profitability of these operations. Banks were bailed out with no consideration in the form of an acquisition in the stake of their capital, while the management of these same companies pocketed record bonuses.

Among the lucrative bailouts conceived by the Bank of Lebanon was an arrangement by which each 100 dollars brought it by a bank produces a direct yield of 7% per annum and confers entitlement to a loan of the equivalent of 125 dollars in Lebanese pounds taken out at 2% which is immediately deposited again with the Central Bank at 10% per annum. In other words, the real per annum yield of bank deposits in dollars with the Bank of Lebanon is at least 15%. By way of comparison, the comparable American rate is 2,066% while the FED pays 2.5% for facilities in dollars.

In other words, Lebanese banks deploy all their talents to convince depositors to trust them with their dollars. However, the economy needs such a volume of financing that these strategies are no longer sufficient. For want of fresh foreign currency, the Central Bank is forced to delve into its own reserves in order to finance the State directly. At the end of the first semester 2019 it had paid into the Treasury a total of 2,152 billion dollars (1724 pounds sterling) in order for it to honour its foreign currency liabilities. And another due date for 1.7 billion dollars (16 billion pounds sterling) is coming up in November. In the absence of any structural reform, one of the chief measures aimed at a stabilisation of expenditures in the 2019 budget concerns the stabilisation of the servicing of the debt (which absorbs half of the national revenue) through the issuance of 11,000 billion Lebanese pounds (equivalent to 7.3 billion dollars or 5.9 billion pounds sterling) at a reduced rate of 1%, whereas the base rate on the Lebanese market place is 9.72% on the dollar and 13.38% on the pound.

In spite of all the promises, this budget bill does not signify any change, of course, or the sincerity of its projections and bears no scrutiny whatsoever. No serious observer believes it is possible to reduce the deficit to 7.5% of the GDP in the six months remaining, when this ratio was, at best, 11.5% of the GDP in 2018.

The growing scepticism as to the capacity of the Lebanese authorities to put into practice their vows of austerity, together with the increase of regional tensions due to the power struggle between Donald Trump and Iran, can only increase the febrility of the international markets. Even though the volumes involved are quite small compared with the size of the Lebanese debt, the sharp rise in the average yields demanded by investors to hang on to their Lebanese debt securities fuels the fear of a major financial shock and gives the impression that more than ever before the country is skating on very thin ice.

1Conférence économique pour le développement par les réformes et avec les entreprises.

2Editor’s note. A Ponzi scheme is a form of fraud that lures investors and pays profits to earlier investors with funds from more recent investors. The scheme leads victims to believe that profits are coming from product sales or other means, and they remain unaware that other investors are the source of funds. The scheme is named after Charles Ponzi who became notorious for using the technique in the 1920s in Boston. (Wikipedia)

3Editor’s note: A swap is a derivative in which two counterparts exchange cash flows of one party’s financial instrument for those of the other party’s financial instrument. It generally takes place between banks or financial institutions.