LEBANON Time for an ECONOMIC Equitable MONITOR Banking Resolution Fall 2022 EXECUTIVE SUMMARY Recent Economic Developments to depreciate sharply. The Lebanese Pound (LBP) depreciated 137 percent in 2020, by 219 percent in The economy continues to contract, albeit at 2021, and in the first 10 months of 2022 is already a somewhat slower pace. Owing to better-than- down an additional 145 percent (Average Effective expected data, we are revising (upward) our estimated Exchange Rate as estimated by the World Bank).1 The contraction in real GDP for 2021 to a nonetheless steady depreciation is despite BdL’s FX interventions significant 7 percent (from 10.4 percent in the last to attempt to stabilize the banknote rate (BNR)/parallel LEM). Our 21.4 percent estimated contraction in market exchange rate at the expense of dwindling real GDP in 2020 remains unchanged. While tourist reserves. arrivals have risen by 132 percent (yoy) in 12M-2021, The sharp deterioration in the currency up from a Covid-induced low base, the recovery has continues to drive surging inflation, in triple digits not been sufficient to compensate for the persistent since July 2020, impacting the poor and vulner- increase in the current account deficit and the able the most. Inflation averaged 150 percent in substantive drop in private consumption. 2021 and 218 percent (yoy) in the first half of 2022 Public finances improved in 2021, but (reaching a peak of 240 percent (yoy) in January only because spending collapsed faster than 2022). Inflationary pressure was exacerbated by revenue generation. Revenues are estimated to the rise in global food prices since the onset of have declined from an already low 13.1 percent of the Ukraine war. Globally, Lebanon is one of the GDP in 2020 to 6.6 percent of GDP in 2021, among countries most affected by food price inflation owing the lowest rates globally. As the decline in revenue to the destruction of its strategic wheat reserves in was, however, outpaced by an even larger decrease the Beirut port explosion, heavy dependance on in total expenditures (10.5 percentage points (yoy) to Ukrainian and Russian wheat imports and the depre- 5.9 percent of GDP), the 2021 overall fiscal balance ciation of the LBP; food inflation stood at 332 percent is estimated to have reached a surplus (of 0.7 percent of GDP). 1 The Bank-calculated Average Exchange Rate (AER) Testament to the continued atrophy of Leb- methodology is detailed in the Lebanon Economic anon’s economy, the Lebanese Pound continues Monitor, Fall 2020: The Deliberate Depression. ix (yoy) in June 2022. Inflation is a highly regressive tax, depreciation. The increase in the pass-through is also disproportionally affecting the poor and vulnerable, linked to higher levels of dollarization in the economy- especially since basic goods including food items are notably for services that had been previously priced in the primary drivers of overall inflation. LBP at lower than market value exchange rates and Surprisingly, for a country in a pro- have now been dollarized. tracted and deep depression, and in sovereign An unprecedented institutional vacuum default, Lebanon continues to run a sizable cur- will likely further delay any agreement on crisis rent account deficit. The current account deficit resolution and much needed reforms; this includes increased from 2020 to 2021 (from 9.3 to 12.5 per- prior actions as part of the April 2022 IMF staff-level cent of GDP, respectively), and is expected to broaden agreement (SLA). While Lebanon is no stranger to further in 2022. Customs data point to: (i) a higher political paralysis, the price of an institutional vacuum energy import bill (in US$) as lower volumes are offset is at an all-time high, as it impedes decision-making by surging global energy prices, and (ii) a significant and reform ratification, deepening Lebanon’s long- nominal increase in non-energy imports (by 21.1 per- term economic woes and the plight of the Lebanese cent in 2021). The current account deficit continues people. An IMF program remains elusive as the to be financed from the remaining usable gross for- authorities have yet to complete ten reforms up front. eign reserves at the central bank and a pervasive cash A fragmented parliament, coupled with governmental economy, in which importers have also relied on cash and presidential vacuum casts further doubt on the to access credit lines for imports that now require ability to complete prior actions and secure a final 100 percent cash collateral. agreement in the next few months. Outlook and Risks Time for An Equitable Banking Resolution Real GDP is projected to contract by a further 5.4 percent in 2022 assuming continued political Divergent views among key stakeholders on how paralysis and no implementation of a recovery to distribute the financial losses remains the strategy. The BLOM-PMI index has inched up to main bottleneck for reaching an agreement on 48.5 in the first nine months of 2022 and tourist a comprehensive reform agenda. Such discord arrivals have increased by 51.2 percent (yoy) until prevents banking sector resolution which is critical August. However, net exports remained negative, for restoring financial sector stability and economic as imports increased faster (40.7 percent (yoy) in recovery. Global best-practice principles endorse a 7M-2022) than exports (12.7 percent). Part of the financial sector rehabilitation strategy that recognizes increase in imports was driven by industrial goods and addresses the large losses in the sector upfront, imports (42.7 percent).2 Anticipated increases in respects the hierarchy of claims, protects small custom duties and the customs duties exchange rate depositors, and refrains from recourse to public have likely contributed to the substantive increase in resources. Key stakeholders in Lebanon, however, industrial goods imports and have driven the hoarding strongly oppose such a resolution, calling on the of those goods in anticipation of the price adjustment. State to bear responsibility for the ongoing crisis Inflation is expected to average 186 per- and to privatize public assets and/or draw on future cent in 2022, amongst the highest globally, partly government revenues to bail-out the financial sector. due to the shrinking share of imports based on BdL subsidized rates. This surge in the inflation 2 This includes imports of the following categories: Wood, rate arises despite a relative decrease in narrow Rubber and Chemical Products; Non-Metallic Products; money supply growth in 8M-2022, owing to a change Textiles; Capital Goods; and Equipment Other than in the dynamic relationship between inflation and Capital Goods. x LEBANON ECONOMIC MONITOR: TIME FOR AN EQUITABLE BANKING RESOLUTION The size of the balance sheet and associ- one overly dependent on the other, and in the end ated losses make Lebanon’s financial sector, too leading to systemic failure. With the sovereign default big to bail. Financial losses exceed US$72 billion, of March 2020, the erstwhile equilibrium has collapsed. equivalent to more than three times of GDP in 2021. Lebanon must now move to a new sustainable develop- Combined losses stem from a public sector in default, ment model. Delays in the day of reckoning with the a central bank holding the largest negative reserves magnitude and viable distribution of financial losses position in the world, and an oversized and insolvent will only compound human and social capital losses. banking system. Therefore, the magnitude of the As repeatedly called for, Lebanon needs to urgently holes in the intertwined balances sheets of the Central adopt a domestic, equitable, and comprehensive solu- Bank, the banking sector and the Sovereign, dwarfs tion that is predicated on: (i) addressing upfront the the current and future assets that the sovereign could balance sheet impairments, (ii) restoring liquidity, and realistically mobilize for a bailout. State-owned assets (iii) adhering to sound global practices of bail-in solu- and public real estate are worth only a fraction of the tions based on a hierarchy of creditors (starting with estimated financial losses, as are any potential rev- banks’ shareholders) that protects small depositors. enues from oil and gas, which are still indeterminate and in any case years away. Given the uncertain valuation of both assets, any crisis resolution plan that Special Foci relies on these would lack credibility and fail. A bailout of the financial sector by tax- Lebanon’s four-year contraction in real GDP payers would redistribute wealth from poorer to has already wiped out 15 years of economic richer households, as the public would be asked growth and is scarring the country’s potential to compensate bank equity holders and wealthy for recovery. The depth of the cumulative economic depositors. Pre-crisis, 50 percent of deposits in contraction ranks Lebanon’s ongoing crisis among the Lebanon’s banking system were owned by 1 percent worst ever since the 1850s.3 In Special Focus I, we of depositors; with 20 percent of deposits held among assess the severity of Lebanon’s crisis by comparing 0.01 percent of depositors. The heavy concentration it to a select group of Fragile and Conflict States of deposits amongst a few high-net-worth individuals, (FCS). We conclude that Lebanon’s macroeconomic marking one of the most unequal distribution of performance is worse—or—at best—on par, with deposits in history, must serve as a basis for equity those of this specific FCS group (Zimbabwe, Yemen, and fairness considerations. As argued in our Spring Venezuela and Somalia). Strikingly, the contraction to 2021 Lebanon Economic Monitor issue Lebanon date is comparable to that Yemen during the first four Sinking (to the Top 3), not only is a bailout of the years of war. The depth and duration of the Deliberate financial sector unviable, but it is also inconsistent with Depression4 is reducing Lebanon’s potential for the restructuring principles that protect taxpayers and growth as its physical, human, social, institutional, small depositors and foster equitable burden sharing. and environmental capital are rapidly and potentially A bail-in solution, based on a creditors’ irreparably being depleted. hierarchy, along with comprehensive reforms is the In Special Focus II, we analyze dollarization only realistic option for Lebanon to turn the page in Lebanon, and conclude that the current crisis on its flawed development model. A bail-in, makes will likely reinforce high levels of dollarization, large creditors and shareholders bear the main cost even upon recovery. Historically, multiple currency of bank restructuring, by writing down, canceling and/ crises led to hysteresis in dollarization in the country, or converting liabilities into equity; this allows viable banks to regain solvency and ensures the protection of 3 See Lebanon Economic Monitor, Spring 2021: Lebanon small depositors. Lebanon’s post-civil war development Sinking (to the Top 3). model has been characterized by strong interlinkages 4 See Lebanon Economic Monitor, Fall 2020: The between the fiscal-monetary-financial sectors, rendering Deliberate Depression. Executive Summary xi with the extent of dollarization widening over time to reduce or reverse dollarization. Going forward, the for deposits, lending, and public debt. We find that current crisis will further reinforce the hysteresis driver Lebanon’s financial system was not developed of dollarization. The development of capital markets beyond the banking sector, and the lack of a capital remains unattainable under current conditions and market has prevented the development of diversifica- will require macroeconomic stability in the short term tion and hedging instruments that could have helped and new growth model in the long term. xii LEBANON ECONOMIC MONITOR: TIME FOR AN EQUITABLE BANKING RESOLUTION 1818 H Street, NW Washington, DC 20433