Lebanon is facing such a severe financial collapse that the World Bank has called it one of the worst since the mid-19th century. The country is quickly sinking into a dangerous state of state failure marked by violent riots, escalating power outages and sky-high increases in fuel prices.
According to Rami Hajjar, portfolio manager at Allan Gray, the Lebanese crisis shows how badly things can turn out when mismanagement of public policies and corruption are the order of the day.
“While South Africa is in a very different position from Lebanon, the events there are a valuable lesson in understanding how quickly things fall apart if there is a lack of sound economic policy, fiscal discipline and no strong and independent institutions to keep the economic and financial system functioning, ”Hajjar said.
He added that too often the root of a crisis lies in a country constantly spending beyond its means.
Looking at the unfolding crisis in Lebanon, Hajjar discusses the main flags that warn of a country’s near financial collapse.
1. Getting stuck in a debt spiral
According to Hajjar, the Lebanese crisis arose from the financial and economic policies he undertook to attract significant foreign flows to finance the reconstruction of the country. To do this, the currency was pegged (giving confidence in the monetary system), high interest rates were provided and capital movements were fully liberalized.
“While the economy was out of the ordinary and the tax base was tiny, the budget was funded by a large debt. The government has resorted to domestic borrowing, raised in local currency, to meet its overall financing need. Most of them carried very high interest rates, given the risk premium demanded by investors to finance a country in ruins. With high borrowing costs, the overall budget deficit widened rapidly. “
Between 1993 and 2019, the government generated cumulative revenue of about $ 170 billion and spent about $ 260 billion, resulting in a deficit of $ 90 billion. This compares to a cumulative interest payment estimated at $ 87 billion, meaning that interest was responsible for the entire cumulative deficit.
“It only takes a few years of reckless spending to get stuck in a spiral of debt distress. “
2. Embezzlement of public money by nepotism
Hajjar said the reconstruction project involved a massive embezzlement of public funds through nepotism in the awarding of contracts, an overt transfer of wealth from public entities to private entities, and tenders far in excess of the costs of the project.
“Some estimates place the amount of waste at over 50% of the total cost of reconstruction,” he said. “In 2019, Lebanon had one of the highest debt-to-GDP ratios in the world. As a result, interest payments consumed around 50% of government revenue by 2019. ”
3. Expenses for an inflated bill from the public sector and broken state entities
“Most public spending did not generate economic value. The two main sources of primary spending were public sector salaries (a very bloated public sector that served sectarian patronage) and subsidies to the bankrupt state-owned Electricité du Liban (EDL), where deeply entrenched vested interests blocked any reform, ”Hajjar said. .
4. A country consumes more than it produces and is too dependent on imports
Lebanon consumes more than it produces and depends heavily on imports.
“The export base is tiny due to the long-standing neglect of productive sectors at the expense of the service sector, an overvalued exchange rate and a commitment to open trade without policies to protect domestic industries. “
He said that the link between the budget deficit and the current account deficit is important.
“Budgetary expenditure comprised three main items: interest expense, salaries and subsidies to EDL. Almost half of the interest expense was in US dollars and most of the EDL costs were in foreign currency. As for wages, even if they were paid in local currency, consumer spending would automatically lead to outflows of US dollars as the country depended on imports to cover 85% of its daily needs.
5. Excessive reliance on remittances
In the case of Lebanon, the main source of finance was not export, which is a sustainable means by which countries generally finance capital outflows. Instead, the country has relied on the constant influx of remittances from the Lebanese diaspora (an estimated 12 million Lebanese live abroad compared to 6.5 million in Lebanon) that have been channeled via a banking sector perceived as solid.
“Remittances are not a sustainable way to finance a huge deficit. They are volatile in nature, as much of it accumulates as liabilities on the banking sector’s balance sheet, making them vulnerable to sudden exits, ”Hajjar said.
6. The (dubious) role of a central bank
“The net reserves figure of Lebanon’s central bank showed a worrying picture,” Hajjar said.
He explains that as Lebanon began to see its inflows decrease, which intensified in 2015, the central bank, the Banque du Liban, underwent a series of operations called “financial engineering”, intended to solve serious problems. : the central bank’s shortage of foreign exchange, the financing of the Treasury’s needs, and the insufficient capital and liquidity of private banks.
“In short, the central bank has paid banks an exorbitant return on dollar deposits to bolster its dollar reserves. This gave a boost to the profits and capital of the banks (in effect an injection of capital financed by money without any equity participation in return – that is, a direct transfer of money from the banks). taxpayers to a few wealthy bankers), ”Hajjar said.
He said that to maximize the benefits of the program, banks were incentivized to attract new inflows of dollars by offering high rates to expatriates (and at the same time a significant reduction in lending to the real economy, compounding the problem).
“The effect of this has been to strengthen the central bank’s gross reserves in the short term.”
The central bank, in turn, used this money to fund both the current account (i.e. the net reserve figure (which takes into account liabilities – and was never released) turned red and continued to grow. widen.
“Basically, a great Ponzi scheme was at play. The central bank was paying very high interest to banks and banks to customers by crediting accounts without generating a return on cash. On the contrary, the central bank was spending money and relying on new money to fund exits, ”Hajjar said.
7. Blind and stubborn trust in the banking system
“The role of crowd psychology in preventing / precipitating crises is fascinating: as long as people didn’t know that a devious plan was unfolding and trust existed, the plan could go on. “
On October 17, 2019, the government’s proposed WhatsApp communications tax sparked large protests that lasted for weeks. The banks (which were in part the target of the protests, accused of generating super profits over the years and failing to pay a fair share to the fiscus) closed their branches for a week.
Confidence was lost. When they reopened, there was a rush on the banks, especially from expats with dollar accounts. The banks could not meet this demand. Informal capital controls were immediately put in place and the system collapsed.
“It only took a few weeks for the Lebanese to realize that the value of the financial system was artificial and that their hard-earned savings were gone. “
He added that in the months leading up to the crisis, most Lebanese with average financial education still held the majority of their savings in a deposit account.
“While they understood that the country’s parameters were worryingly serious, they were complacent about the situation, arguing that it had always been the case and that confidence in the system would continue no matter what. Until it didn’t, and it happened overnight.
“In the end, Lebanon was left with a three-pronged crisis: a balance of payments / currency crisis, a sovereign debt crisis and a banking crisis,” Hajjar said, adding that it is wise to watch for the above red flags in economies that are under pressure.
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