Currency board for Lebanon
Executive Magazine- Hanke | March 2, 2021
The Lebanese are currently subjected to depreciation, with the ever-rising prices of goods and services, self-imposed limits on withdrawals by banks at a rate of LBP 3,900 to the dollar, and a local currency estimated at LBP 9,600 to the dollar as at March 1st 2021. Rampant inflation was estimated at 84.8 percent for the full year 2020 according to the Central Statistics Department, with end-of-year inflation from December 2019 to December 2020 estimated at 14.8 percent. Additionally, any release of controls for withdrawals in LBP would result in added inflation due to an expansion of the monetary mass and a rush to buy USD currency at black market rates. The depreciation of the currency reflects, in part, a loss of confidence in the national currency, and a flight to safer cash currencies on the black market. In light of this situation, some financial experts have recommended the establishment of a currency board (CB) in Lebanon to help tackle inflation.
Broadly defined, a currency board is an authority in charge of managing the money supply and the exchange rate of a country’s currency, in lieu of the central bank. Its tasks are set by law, and no printing of the currency can occur without it being 100 percent backed by another foreign currency, in most cases the US dollar as the worldwide preferred medium of exchange. Unlike a typical central bank, it is not a last-resort lender and is not legally allowed to print currency and lend to the government under any circumstance.
Under a CB management, the exchange rate and the monetary level are determined independently by the board, who is ruled by law and, due to its direct task, is less likely to be under political pressure. CBs often have a 100 percent reserve requirement, therefore a specific unit of foreign currency must back every unit of currency printed. For someone to obtain a fixed amount of LBP, they must ask their bank to convert dollars at the CB. Thanks to a stable foreign-currency-backed fixed exchange rate, CBs allow fighting inflation more effectively.
Overall, more than 70 countries have adopted currency boards, most notably Hong Kong, Estonia, Bulgaria, and Denmark amongst others. In the case of Estonia, the institution of a currency board in 1992 helped end hyperinflation, with monthly inflation falling from 80 percent in early 1992 to only 3.3 percent in December of the same year.
Determining a fixed exchange rate
The question is: How would this be implemented? In an exclusive interview for executive Magazine, Professor Steve Hanke, the main proponent of the CB for Lebanon, recommended freezing all printing of Lebanese currency for a month, in order to lower the supply of LBP, which would drive down the price of the USD in the black market, a recommendation echoed by Dr. Patrick Mardini, head of the Lebanese Institute for Market Studies. In this situation, market forces would determine the rate.
This new fixed rate, unlike a currency peg, would not rely on the trust and credibility of a central bank in managing the money supply, as it would be 100 percent backed by reserves. “Developing countries don’t have the proper institutional framework to protect the Central Bank from government interference,” says Dr. Mardini. According to him, in a CB system, the currency in circulation grows in the presence of capital inflows, and if a person wishes to send their money abroad they would have to give their LBP to the CB, which would take them out of circulation, in exchange for providing an amount of USD in reserves. Such a CB would only require a law to be implemented to modify the Lebanese Code of Money and Credit, noting that such model-laws do exist, including one that has been drafted by Professor Hanke.
This is in contrast to the opinion of Jean Riachi, Chairman and Chief Executive Officer at FFA Private Bank. In his opinion, the problem with the peg is its inability to adjust to external conditions, deeming the fixed rate of the CB as similar to that of the dollar peg at LBP 1,500. “It’s just another peg, which has cost the Lebanese economy a lot,” he says. Indeed, fluctuations of currencies permit adjustments to changing economic conditions: for example, deficits in trade balances result in devaluations in order to limit imports and favor exports of goods and services. Riachi believes that “we were pegged when we needed more flexibility to export and produce,” as the LBP peg to the dollar was deemed to be overvalued and therefore made Lebanon expensive, causing it to lose any competitive edge.
Impact on inflation
The implementation of CBs has been deemed by many economists a success in fighting inflation. Imposing a 100 percent foreign reserves guarantee for local currencies succeeded in ending hyperinflation entirely in some countries: in 1997, Bulgaria’s CB ended hyperinflation in just one month.
Nevertheless, this requires effective governance and trust in institutions. “You need very strong governance to sustain it; you need fiscal discipline,” says Riachi. On the other hand, the opinion of economists supporting such an implementation is that the framework, which is backed by law, is enough to support trust in such a system, as the CB would not be allowed to print any amount of local currency if it doesn’t have the equivalent amount in USD in its reserves.The CB would be free from political interference and, for example, would not be allowed to lend the government to finance its budget deficits (this would be done either through taxes or through issuing debt on the financial markets).
In principle, implementing a CB would result in added foreign investments and therefore reserves: currently, the Central Bank of Lebanon (BDL) holds around USD 17.5 million in reserves, while it has around LBP 55 trillion in bank deposits and LBP 30 trillion in currency in circulation. At this level, the foreign currency reserves would serve as an anchor in order to cover such amounts in LBP. Any additional surplus from abroad in USD would allow for an expansion of the monetary base without any inflation, as it would be backed by USD reserves. It is worth noting that implementing a CB in Bulgaria quadrupled foreign reserves in a matter of 12 months between 1997 and 1998 thanks to an influx of foreign investments (wishing to take advantage of arbitrage possibilities, which will be addressed below).
As a consequence, inflation levels would drop dramatically. It should be noted though, that in the case of Bulgaria, Estonia, and others in the former Soviet bloc, the CB has been adopted in the aftermath of Soviet management. In the case of Lebanon, this would occur after a long tradition of laissez-faire economics that had been aggravated by corruption and infective governance: while for the former soviet republic countries, the adoption of a CB was perceived internationally as a sign of willingness to engage in reforms, in the case of Lebanon it could appear as one last attempt to stall the necessary reforms by solving one issue only, which is inflation; it is therefore less certain that this would result in additional trust in Lebanon’s economic governance.
Impact on public finances
A CB is forbidden by law to loan the central government and/or to cover its deficits by printing money. Nevertheless, outflows of USD dollars would result in a lesser amount of LBP and therefore might impact the public sector: the government would have to revise its budget, which would result in a contraction of the economy. According to Riachi, the timing is wrong, “I don’t think we can have a balanced budget on the short to medium term”. Indeed, the current state of the economic crisis in Lebanon, with GDP projected to contract heavily, makes it difficult for the Lebanese government to balance its budget. On the other hand, should an inflow of foreign capital occur, the money supply in Lebanon would expend and therefore allow for the government to meet its expenditures as government revenue from taxes will increase due to inflows allowing for more bank lending and would therefore stimulate the economy. The questions remain nevertheless: why would this currency stability result in massive inflows of foreign capital?
Impact on foreign investments: arbitrage solution
The idea of arbitrage entails that a fixed rate in Lebanon would result in lower interest rates, in principle, as the currency would be interchangeable at the CB with US dollars. Nevertheless, the LBP interest rate would still be higher than its USD counterpart as interest rates incorporate political risk, sovereign debt risk, and others, which are higher than those of the United States. Therefore, due to low interest rates offered on the USD in international markets, holders of dollars would want to deposit money in LBP to take advantage of higher interest rates. Unlike the practices of the last years in Lebanon, the LBP would be fully backed by the dollar.
According to Mardini, USD interest rates would be lower than in past years but higher than overseas ones, therefore investors would be interested in taking advantage of this by depositing their dollars in Lebanon and exchanging them for LBPs.
Because of this, banks would be able to lend money in LBP and this would jumpstart the private sector thanks to lower rates and more liquidity in the Lebanese economy. Still, political factors in Lebanon, including geopolitical risk and lack of reforms, and limited trust in political institutions, could dissuade some from investing their money. According to Riachi, “reality bites when it comes to confidence,” as confidence remains the main motor to attract long-term investments, and the main issue with the peg remains its lack of flexibility in adjusting to shocks, “being solid is an illusion, you need flexibility,” he says. In the case of Lebanon, a floating currency would adjust to economic shocks, whereas a peg would not).
Indeed, though the fixed rate thanks to a CB would be lower than the current official LBP 1,500 to the dollar rate, and could therefore stimulate exports, it would still remain fixed and therefore would not change according to laws of supply and demand. In addition, lack of trust in the Lebanese economic sector, especially after a year of inaction on the part of the political class, could result in outflows, which would impact the interest rates and result in higher rates, therefore there could be little impact on resuming lending. Indeed, were the CB able to attract capital at a lower rate than typical Lebanese rates, the private sector would profit from a boost thanks to lower lending rates. If interest rates were to remain the same, additional inflows would have little impact on re-boosting the private sector.
Impact on the private sector
Should a CB be successfully implemented, lower rates than the typical rates of 8 to 9 percent on USD lending would be lowered, and this would in principle serve as a boost to the private sector. Business executives in Lebanon have long complained that high interest rates have had a negative impact on economic lending as it has discouraged investments due to the inability of businesses to make returns that would be high enough for them to service their debt. Lower interest would then permit more private sector lending.
In addition, this would result in banks getting back to diversifying their lending portfolio more in favor of private enterprise and allow for returns. The trade deficit would therefore be reduced as a fixed rate would be lower than the current peg and therefore favor exports. On the other hand, should this result in outflows from Lebanese willing to exchange their LBP notes to dollars, a consequence would be more pressure on the governmental budget due to difficulties in levying taxes: less activity would result in less profit and therefore less tax revenue for the state.
A limited solution?
Overall, the implementation of a CB would, in theory, help end the threat of hyperinflation in Lebanon, and attract foreign capital that would allow banks to lend to the productive economy. This would be accompanied by larger investments, and with a rate lower than LBP 1,500 to the dollar, promote Lebanese exports.
International investors would, again in theory, also be interested in acquisitions due to a productive and now cheaper (due to the devaluation) workforce. But this solution would seem in principle limited to the extent that it would solve hyperinflation alone, and reforms would still need to be implemented to help restructure the sovereign debt and the banking sector, and also help improve transparency and limit corruption. After years of eroding the confidence of the populace in their government and political class, Lebanon, indeed, does not suffer only from enormous inflation, but also from public deficits, an ever-growing public sector resulting in more currency printing and inflation, budget deficits, perception of extreme corruption, and a dearth of trust in the state.
With regards to the banking sector losses, an inflow of foreign capital would allow banks, in the long run, to lend again in LBP and therefore to stimulate the economy and make profits again. This would in theory help reduce the losses of the banking sector, though Mardini believes that it is only a stepping-stone that would provide stability, not excluding other necessary reforms. “Bankers can become bankers again,” says Mardini, “that’s how the CB solved the banking crisis in Bulgaria.” In the case of Bulgaria, banks were deemed insolvent but were able to repay their losses once they started making money.
Though controversial, the issue of instituting a CB in Lebanon is gaining ground. For example, Member of Parliament Paula Yacoubian has submitted, in June of 2020, a draft-law in parliament that would allow for the establishment of a CB.
Still, it is not deemed to be a miracle solution that would rid Lebanon of its economic difficulties. Even if it were successfully implemented and hyperinflation thus avoided, and with investment inflows pouring in, Lebanon’s government will still have to institute the necessary reforms that have been a key demand of civil society groups, non-governmental organizations, and international financial institutions. Lebanon still suffers from a lack of trust in institutions, lack of transparency in governance, and massive corruption.
The implementation of a CB in Lebanon could occur, but overall, there is doubt as to its attractiveness due to the lack of effective and transparent governance in Lebanese institutions, which may deter foreign investments even if the CB’s institutional framework could in principle be effective and transparent. Another risk is the implementation of a CB in name only as was the case in Argentina from 1991 to 2002: though called a CB, it had the authority to use its reserves in a discretionary manner and to lend the state, which resulted in an economic crisis and the suspension of the convertibility of Pesos to USD.
Overall, Lebanon appears short on viable alternatives, given that already much time has been wasted where the exchange rate problem and inflation pressures have been allowed to fester. A floating peg, whereby the Central Bank or the treasury reassesses the value of the peg periodically and then changes the peg rate accordingly, has also been on the table, though it remains difficult to assess whether this will require a hike in interest rates in order to stabilize it . Digitization of the dollars held in banks has been discussed but has been deemed a limited option, as it would not be a freely transferable currency. Reforms would take time and there is a sense of urgency with regards to tackling Lebanon’s woes, which call for solutions that would be implemented quickly. The final lacking element is simple: trust, and whether or not a CB would help restore trust from a monetary perspective is still subject to debate.