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Friday, August 6, 2021

Lebanon’s economic crisis: A tragedy in the making

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For the past 18 months, Lebanon has been reeling from a wrenching economic crisis. This essay deciphers the crisis’s origin, describes the current juncture, and reflects on the likely outcomes in the proximate future.

How did we get here?

With hindsight, Lebanon’s economic crisis was predictable. By the time the crisis erupted in October 2019, the economy was facing four extraordinary challenges. First, public sector debt had reached such elevated levels that a default had become a question of when, not if. Second, the banking sector, having lent three-quarters of deposits to the government, had become functionally bankrupt and increasingly illiquid. Third, the productive economy had experienced virtually no growth for an entire decade — a development with acute socio-political implications. Finally, and perhaps most importantly, the country was politically rudderless: there was no president between 2014 and 2016, there were multiple and lengthy delays in cabinet formation, and the 2018 parliamentary elections took place but only after a five-year delay. The Hariri government that was in place when the crisis hit in 2019 became impotent to such an extent that it lacked power to deliver on any of the reforms required as a condition for foreign support.

The crisis

By October 2019, the citizenry had had enough. Sensing a looming crisis and frustrated by the utter lack of action by the political class, hundreds of thousands of people took to the streets demanding radical political change. The cabinet resigned, throwing the country into a political crisis. Unsurprisingly, capital inflows came to a sudden halt. Banks, already insolvent, experienced a sharp liquidity crunch, forcing them to declare a “bank holiday” and institute severe restrictions on bank withdrawals. A foreign exchange black market emerged and the national currency, the lira, sharply depreciated. In turn, inflation soared and people’s real wages and purchasing power collapsed. In addition, as if all these woes were not sufficient, a severe COVID-19 crisis hit the country and, most tragically, a devastating explosion took place on Aug. 4, leveling a third of downtown Beirut.

The confluence of these large negative shocks led to the implosion of the economy: GDP is estimated to have contracted by 25% in 2020, with an additional 10-15% decline forecast for 2021. When measured in USD, the Lebanese economy may end up shrinking from $60bn in 2018 to $15bn in 2021. An extreme form of wealth destruction is taking place with the Lebanese de facto losing the majority of their bank savings. Meanwhile, four out of every ten Lebanese are out of work, and half the population is under the poverty line. 

But what these numbers do not reveal are the structural scars. Human capital is fast eroding due to a massive brain drain of the young and skilled. Equally worrying is the loss of physical productive capacity resulting from widespread business closures. Much more alarming are the security consequences of the economic implosion. Lebanon’s sectarian history is rife with conflict. An economic collapse provides a perfect habitat for a return of violence.

What is being done?

Confronted with these traumatic shocks, the Lebanese political class has been appallingly missing in action. A new government was formed in January 2020 and, to its credit, worked with an international consultant on an emergency economic program and initiated IMF negotiations. The program spelled out the size of the financial losses and called on all stakeholders to share in the burden, starting with creditors and bank shareholders. Unfortunately, the effort quickly proved quixotic. Under concerted attack from a wide-ranging coalition of political and vested interests, the government balked at the required economic and financial measures, which in turn led to a halt in IMF negotiations. In the event, the government became ineffectual and, following the Aug. 4 explosion, tendered its resignation, creating another political vacuum.

What explains the political class’s inaction?

There are three likely explanations. First, an intractable political environment that makes collective decision-making difficult, especially given the size of the losses that need apportioning. Second, Lebanese political parties are “agents and not principals,” effectively acting as messengers of regional and international players who are currently not incentivized to solve the Lebanese crisis. Third, paralysis reflects an active decision by the political class to do nothing: high inflation, exchange rate depreciation, and deposit “lirafication” shift the burden onto the population at large and away from the interests of the oligarchy. Regardless of which of these reasons dominates, policy neglect is creating seismic political shifts that will eventually threaten the survival of the current political class.

Where do we go from here?

Predicting how the crisis evolves from here is difficult, but we can frame the contours of the likely outcomes around three different scenarios.

The worst-case scenario is a continuation of the path of “malign neglect.” While not our baseline, we see the probability of this scenario playing out as reasonably high. This scenario allows for a continuation of the ongoing but extremely insidious process of “auto-adjustment” of macroeconomic imbalances, albeit in a very sub-optimal and regressive manner, and with a long-term negative impact on growth and the social fabric of the country. Left to its own devices, the economy will generate an alarming acceleration of youth and skilled labor emigration, and enterprise closures. The currency will become further un-anchored, hyperinflation will wipe out incomes and wealth, and food and medical shortages will escalate, requiring rising levels of humanitarian support. The security situation will inevitably deteriorate into, at best, a state of lawlessness and, at worst, organized armed conflict of the kind the country has experienced in the past.

The best-case scenario involves a political consensus around a comprehensive economic program, on which basis a credible and independent government with emergency legislative powers is formed. Such a cabinet would start with a short-term stabilization program involving tightening of liquidity, arresting the fiscal implosion, officializing capital controls, and obtaining an urgent bridge loan under the umbrella of an IMF Stand-By agreement. The cabinet would also commit to a three-year program that would restructure the debt, recapitalize the banking sector, streamline the public sector, and enact “real economy” reforms that would put the country on a recovery path.

At this juncture, we assign to this positive scenario a very low probability of coming to fruition. Indeed, such an ambitious program, albeit essential for the long-term survival of the country, will almost certainly be rejected by an entrenched political class and vested interests, who would see it as political suicide.

The most likely scenario lies somewhere in the middle and involves the formation of a “traditional” (as opposed to independent) government, with the backing of all political parties. A shift in regional dynamics (with the promise of an Iran/U.S. rapprochement) may open a space for domestic compromise. Furthermore, the magnitude of the recent economic collapse may have created enough fear among local players regarding their political survival, that they may be willing to implement some difficult measures.

Under this middle scenario, the government would only have limited room for maneuver and will remain hostage to the political class and associated vested interests. It would not have the political muscle (or willingness) to put in place the structural transformation required by the country and would be unlikely to adhere (on an ongoing basis) to the conditions of an IMF program. With elections planned in 2022, political parties would block measures required to put the economy on a sustainable path, including reducing subsidies, restructuring the banking sector with an even distribution of the massive losses across the various segments of the economy and population, and cutting government spending and raising taxes. As such, although this middle-of-the-road scenario may stabilize the situation in the short run (and may even mobilize some limited foreign funding), it has little chance of allowing the country to genuinely turn the corner.

Conclusion

Lebanon is facing an existential moment. Over the short term, the best one can hope for is a “muddle through” scenario (with limited foreign financial support) that arrests the economic collapse. In the medium term, the 2022 parliamentary elections, if they are held on time, and the hoped-for resolution of regional crises may open up a window for the emergence of a new leadership that can finally put the country on the trajectory of prosperity it so deserves.

 

Amer Bisat is Head of Sovereign and Emerging Markets (alpha) at BlackRock and a former IMF economist. Marcel Cassard was the global head of Fixed Income and Economics Research at Deutsche Bank and a former IMF economist. Ishac Diwan is professor of economics at the École Normale Supérieure in Paris and a former Director at the World Bank. The views expressed in this piece are their own.

Photo by JOSEPH EID/AFP via Getty Images

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