In the Midst of a Meltdown – Bank Deposit Crisis

Given Lebanon’s recent experience with long periods of political stalemate, power vacuums and drawn-out government formations, three months may appear to be a reasonable time frame for the transition from one government to the next.

Unlike before, however, Lebanon this time faced the immediate prospect of an exploding fiscal and economic crisis that was threatening, and continues to threaten, the livelihood of swathes of the population.

The mid-March shutdown of the already struggling economy in response to the COVID-19 crisis could well turn disaster into catastrophe for many people. Severe pressure on broad strata of society, including people who consider themselves middle-class, may create new tensions that could turn violent. In that scenario, it is unclear how long the security apparatus would be able to keep control.

Lebanese leaders had acknowledged before the protests that the fiscal and economic system was in dire straits.

At the root of the problem lies an unsustainable model whereby Lebanon imports far more than it exports, while the Lebanese state spends way more than it receives in revenue. Funding the resulting chronic current account and state budget deficits while keeping a fixed exchange rate has required a constant inflow of funds. This money arrives in the form of remittances from the Lebanese diaspora, external assistance, foreign direct investment and bank deposits, to a large extent also from Lebanese living abroad.

Starting in 2016, the Central Bank (the Banque du Liban) engaged in a string of complex debt swapping operations it termed “financial engineering”.

These schemes amounted to extracting dollar liquidity from Lebanese commercial banks – some 65 per cent of bank deposits were denominated in U.S. dollars at the time – by offering exceptionally attractive interest rates and discounts for exchanging dollars for Lebanese lira. As a result of these operations, Lebanese banks deposited most of their liquid dollar assets with the Central Bank, which now owes these banks in excess of $100 billion, almost five times the size of its remaining foreign reserves ($22 billion). Lebanese economists argue that since the Central Bank is a public body, this negative balance should be added to the nearly $90 billion in official public debt, equal to more than 170 per cent of GDP, the third highest ratio worldwide after Japan and Greece.

The Central Bank, in turn, spent most of the hard currency thus collected to defend the fixed exchange rate and fund imports. As the ratings for Lebanese sovereign debt continued to descend into junk territory and the government’s access to international financial markets deteriorated, the Central Bank increasingly had to compensate for the perennial budget deficit as well.

Lebanese economists have long argued that these fiscal and monetary practices had a debilitating impact on the economy. They blame the constantly rising cost of debt servicing, as well as graft and the politically motivated bloating of the public sector, for the state’s inability to invest in dilapidated infrastructure and underperforming public services that hamstring economic activity. They also see the Central Bank’s strategy to attract depositors by offering high interest rates as a major reason behind the private sector’s sluggish growth, as available capital has gravitated toward the higher and ostensibly safer returns of bank deposits rather than to investments in productive ventures other than the highly speculative real estate sector. Failing services and stagnating growth while the financial sector’s profits skyrocketed further increased inequality and unemployment, preparing the ground for the popular explosion of 17 October.

As some observers had pointed out well before the current crisis, a system that relied on exceptionally high interest rates to guarantee a constant inflow of fresh money to pay off previous investors, while not generating enough revenue to pay for the constantly increasing cost of the interest, suspiciously resembled a state-backed Ponzi scheme that was bound to collapse sooner or later.

During 2019, warnings of an impending liquidity crunch in the banking sector grew steadily, and by October, foreign media reported an increasing dollar shortage. During the second half of October, banks along with public institutions and many private enterprises remained shuttered, as road closures often prevented employees from reaching work. Yet in the case of the banks, the closure further undermined confidence, as did persistent warnings about an impending financial meltdown from government ministers and opposition activists alike. Fear spread that, once they reopened, a run on the banks would ensue that could precipitate a complete financial collapse.

When banks finally reopened for business in early November, withdrawals from dollar accounts, which amount to more than 70 per cent of deposits, were initially restricted to $1,000 a week at most banks and for most accounts, following an informal advisory by the Association of Banks in Lebanon. Money transfers outside the country were restricted to “urgent personal matters”, such as supporting children studying abroad and paying for life-saving medical care.

Banks have continued to tighten these limits since, and by early April many had stopped dispensing cash dollars altogether.

Customers were allowed much higher withdrawals if they accepted to receive the counter value of their dollars in Lebanese lira at the official exchange rate of 1,507 lira to the dollar, but many were deterred by the widening gap between the official rate and the lira’s real value. As access to dollars declined, the dollar’s lira price started to rise, reflecting the mismatch between supply and demand. By early April, the exchange rate in the black market, the only source of real, cash dollars, was approaching 3,000 lira. Withdrawing dollars in lira at the official rate therefore implied an effective loss of 45 per cent of their nominal value.

The Central Bank responded to pressure on the currency by gradually allowing banks to pay out holders of dollar deposits limited amounts at a higher lira rate, initially 2,600, then 3,000 then 3,900 to the dollar. As many of those who took advantage of the improved rates promptly sought to buy cash dollars with the lira they withdrew to protect themselves from further devaluation, the currency weakened even further, hitting 4,300 lira to the dollar on 27 April.

These restrictions, the general lack of liquidity they created and the devaluation that followed have wreaked havoc on the daily lives of most Lebanese, and on much of the economy as well. Until November 2019, the lira was used interchangeably with the dollar at the official rate, and the majority of transactions not involving the public sector were conducted and denoted in dollars. Since banks no longer pay out dollars, most Lebanese who have to meet dollar obligations (for example, to pay rent and school fees or to cover expenses outside Lebanon) have no choice but to buy the hard currency from money changers at the black-market rate, often for lira they had taken out of their dollar deposits at the official rate.

The April rate adjustments initially reduced the losses that depositors incurred this way, yet the low ceiling for withdrawals at many banks limited the effect to small expenses, while the gap between the newly introduced rates and the black-market price of cash dollars quickly widened again. Those who accept payment in lira instead of dollars often apply the black-market rate or one between it and the official rate.

The banking sector’s lack of dollar liquidity has also drastically reduced importers’ access to letters of credit, prompting many to resort to direct transfers and insist to be paid in cash dollars by the retailers they supply, forcing the latter to convert the lira they receive from customers into dollars at the black-market rate.

As a result, by April the currency devaluation had pushed up lira prices by more than 50 per cent across the board.

This increase reflects the rising black-market rate at which importers have to obtain the dollars they need to import new merchandise. Lira salaries, on the other hand, have remained the same, meaning that those who receive them have lost nearly half their purchasing power.

Moreover, the dramatic reduction in purchasing power resulting from the de facto devaluation, in addition to the disappearance of consumer credit, has depressed demand and slowed economic activity to a halt in many sectors. The CEO of a major vehicle importer said:

Plummeting demand, which has led to an average contraction of turnover of around 70 per cent for more than 90 per cent of all business owners, has prompted a massive wave of lay-offs.

By late January, one third of businesses had laid off employees, at an average rate of 60 per cent, while another 12 per cent had laid off all employees, ie, closed down, at least temporarily.

Based on these figures, 220,000 employees may have lost their jobs already then with a prediction to that the number would reach 300,000 by the end of the first quarter of 2020, equivalent to roughly one fifth of the active labour force.

With the lockdown imposed in response to the COVID-19 pandemic, many businesses, in particular in the hospitality sector, are now closed and have furloughed their staff, often without pay, and with uncertain prospects of reopening once restrictions are lifted, making it appear likely that the number will surge even higher.

The economic downturn has also led to a dramatic decrease in state revenue, already down by around 40 per cent in the last quarter of 2019, a trend that the lockdown is also certain to amplify, auguring an even larger budget deficit in 2020. In the absence of external support, the state will have to resort to the printing press to pay salaries, further fuelling inflation and currency depreciation, and reducing the real value of lira salaries.