Editor’s note: The following article is the second and final installment of a two-part commentary by economist Mazen Soueid on the challenges faced by Lebanese banks.
A conglomeration of regional factors and domestic conditions, and especially serious policy failures from the part of the new government that was formed in 2011, caused growth rates to decline from an average of 8.5 percent in the period 2007-2010 to around 1.5 percent in the period 2011-2013. This has pressured government revenues while expenditures ballooned due to the irresponsible fiscal policy and the weakened state of the public infrastructure, especially the power sector. Meanwhile, the deterioration of confidence caused by the near collapse of law, order and security weakened the capital inflows and reduced the growth rates of banking sector deposits.
Worryingly, the twin deficit of the fiscal primary balance and the balance of payments re-emerged. Banks started reducing rather than increasing their overall exposure to the government by bidding less and less for the treasury bills in auctions.
With the impossible trinity (of fixed exchange rate, free movement of capital flows, and complete flexibility in interest-rate setting) in mind, one would have expected the local interest rate structure to have shifted up in order to maintain the stability of the exchange rate peg in the context of declining growth, higher deficits, and lower capital inflows. But the reality is that interest rate on deposits as well as on treasury bills remained stable. The reason is that the Central Bank stepped up its purchases of treasury bills and funded itself by issuing Certificates of Deposit to the local banks at a higher rate. Earning the higher rate, the banks managed to keep the deposit rates at fairly attractive levels so as to ensure continued capital inflows and deposit growth, albeit both at a slower rate.
Lebanon, despite the total absence and the rather distortive policies of the government, managed, with the help of the Central Bank, to maintain the stability of the overall system. Of course over the last few years, the international monetary conditions were also favorable not just to Lebanon but to all emerging markets. Unprecedented easy monetary policy in the U.S. marked by aggressive quantitative easing has guaranteed negative real interest rates in the U.S. (to support the recovery) and encouraged strong flows of capital and “carry trades” into emerging markets.
But this is about to change: just the talk of “tapering,” or reversing this monetary policy in the U.S. has caused massive capital outflows out of emerging markets, and as a result, countries that were hailed as new “economic superpowers” over the last years such as Brazil, South Africa, Turkey, India and Indonesia, to name just a few, saw their currencies collapse in a few weeks, prompting panic and elevating the “health of emerging markets” to the top concern of the global community, making it even more of a priority than the European debt problems.
If financial history has taught us something since the collapse of the Bretton-Woods monetary system in the late 1970s, it is the fact that crisis in emerging markets, manifested by a combination of reserves losses, high interest rates and depreciating currencies, are always associated with periods of higher interest rates in the U.S. The reason is simple, being the reserve currency of the world, the interest rate you earn on your U.S. dollar holding (say the rate on the U.S.-issued treasury bills) represents a floor on global interest rates. The higher the floor is, the higher the entire global rate structure is. Which brings us back to the impossible trinity: If you are a country that is linking its currency to the dollar, and you want to allow capital to flow freely in and out of your financial system, then you will have to sacrifice the total freedom to set your local rates to your liking. Local interest rates, be it on deposits or on locally issued treasury bills will not be determined solely by domestic factors such as the level of your debt or your need to reduce your fiscal deficit, but also, and more importantly, by the international interest rates, especially on the U.S. dollar.
The biggest challenge facing the Central Bank is how to accommodate these conflicting factors. The domestic economic conditions and the high indebtedness of both the government and increasingly the private (and the retail) sector necessitate maintaining domestic interest rates stable even if the Central Bank incurs the loss itself. But the changing international conditions and the “tapering” of the U.S. quantitative easing, combined with regional and domestic political conditions may call for higher rates which would be detrimental to the Lebanese economy and may even endanger the stability of the exchange rate peg.
Such a challenge cannot be faced by the Central Bank alone. In the absence of a responsible government and in light of weak overall economic and fiscal policies, the Central Bank has been carrying the torch alone, resorting sometime to unorthodox policies that were even beyond its mandate. But that was OK because that was happening all over the world. But now the world is changing, and so are the given factors to the point that the Central Bank will find itself running out of options.
The bottom line is that a government is urgently needed, but one that explains to the people the challenges ahead and conducts an overall macroeconomic policy that is well aware of regional as well as international circumstances. And in particular, a government that puts together a fiscal policy with a priority of safeguarding the stability of the overall financial system, and bear the weight with the Central Bank to protect Lebanon from the coming regional and international storms.
If such a government is not quickly formed, and if no appropriate economic and fiscal policies are put in place to reverse the state of the economy, then we are all going to a very difficult place. Except this time there will be no Paris IV to help. The world is too busy, and in fact too tired of us.