Saturday, April 24, 2010

Can Lebanon Afford its Current Fixed Exchange System?

There is hardly an opportunity given to individuals connected to the Ministry of finance, the Central Bank or the commercial banking system where they do not stress the substantial volume of funds that has been flowing into the country. The implication being that these capital flows are a vote of confidence in the stability, dynamism and confidence in the Lebanese economy. What they conveniently forget to declare is that capital flows are ultimately determined by a thorough analysis of the relative safety of the country in question relative to the risk premium that it is willing to pay. Very simply stated this means that any level of risk becomes attractive at a certain price.

Lebanon has had no problem of attracting capital flows into the country for the very simple reason that the Lebanese banks are paying an interest rate that is above the world interest rate. So the question should be why is Lebanon condoning this misguided policy of in essence subsidizing the deposits that are willing to flow into Lebanon and what is more important is the question of whether such a policy is sustainable. Can tiny Lebanon afford to pay a rate that is above the world rate in order to attract funds that it does not need.

It appears to this observer that the Lebanese commercial banks are willing to pay above that of the rest of the world simply because it is profitable for them. How can that be so if they are not in need of these funds? The surprising answer to this quandary is the Lebanese central bank that is willing to absorb from its member banks their excess liquidity by issuing CD’s at a high interest rate. Such a policy is not sustainable in the long run and is actually damaging to the health of the Lebanese economy in the long run. The current policy attracts funds that are not needed by paying these funds a premium that makes such transactions inefficient. So why does Lebanon engage in these policies that wind up in inflicting pain on the Lebanese economy? Again the answer is rather simple. The Lebanese governments’ continued need for more and more sovereign debt dictates growing the economy. But unfortunately whenever a country decides to have a fixed exchange rate system coupled with perfectly mobile capital flows then its monetary policy option becomes totally ineffective. In such a case the government will have no choice but to apply the expansionary fiscal option delivered through deficit spending. But why does the government feel the need to use deficit finance when it already suffers from one of the highest debt/GDP ratios in the world? You guessed it; the government needs to grow the economy so that it might borrow some more in order to service its sovereign debt. Under normal circumstances the above policy will eventually get the economy back to equilibrium but only once it adopts the world interest rate. And this is the rub. If Lebanon is to adopt the world interest rate then the flow of funds into the country will be greatly diminished.

A quick review of the theoretical four available options should help us get a clear understanding of this problem. Given that capital flows are perfectly mobile then Lebanon must choose from among the following policy options:

…………………………………………………..Fixed Exchange Rates…………………………..Flexible Exchange Rates
Fiscal Policy……………………Effective if Fiscal is deficit finance…………………………Totally Ineffective
……………………………………. + Monetary growth at world rates
Monetary policy……………………….Totally Ineffective………………………Effective if used with Fiscal based on X
X: Exports due to lower exchange Rate

Based on the theoretical options as described in the above matrix Lebanon should consider moving away from the Fixed Exchange system currently in force and should move towards a flexible system. That will make repayment of the current sovereign debt easier .will give more power to the monetary authorities and will rationalize capital flows into the country.


Anonymous said...

Lebanon has to stop using a fixed exchange system no matter what the cost of the change. Artificial rates are simply wrong.

Anonymous said...

I do not think that many Lebanese understand the difference between fixed and flexible exchange rates . They can care less and that is a fact.

rayan said...

Hi Ghassan,

I am not questioning the validity of your reasoning but I would like to understand it better, so I would appreciate it if you could clarify a couple of points for me. This may be a bit long but I am not an economist and so I have plenty of questions :)

From what I understood, you say that the Lebanese banks can pay high interest to attract depositors since their liquidity is then given to the central bank at (also) high rates (meaning the banks get to turn a profit). You then state that 1- this approach is not sustainable , 2- the funds being attracted are not needed, 3- the transactions are inefficient.

So my first question is: could you clarify these 3 points?

Second, you state that the solution to this apparent paradox is that the Lebanese government's need for more and more debt (why is there such a need) dictates growing the economy (I would have thought that growing the economy in Lebanon's case dictates more debt - at least that seems to be the official line).

From there you move to tie this to the exchange rate. My (limited) understanding of your point is that if the currency is allowed to fluctuate then repaying the debt should be easier (why? isn't the debt in foreign currency and doesn't that depend on whether the Lira appreciates or depreciates).

As you can see, I am no expert, so any explanation would be much appreciated

ghassan karam said...

It is OK to question the validity of my arguments:-)
The answer to your first point:
Capital funds usually flow into a country as investments. In the case of Lebanon a large portion of these capital flows are liquid funds in various bank deposits. They are not attracted to Lebanon except by the high interest rate. Lebanon cannot keep paying these interest rates that are above the world market. As soon as the interest rates drop to world level, in all likelihood a lot of these deposits will leave the country to better and safer pastures.

The answer to your second point: The sovereign debt in Lebanon is very high as a proportion of the GDP (147%) ans so servicing this debt requires a huge portion of the Lebanese government budget. If the debt is to be serviced then it has to grow bsince the current resources are not large enough to service it and yet fulfill some domestic obligations of the government like spend on education, healthcare, police etc... As a result the Lebanese government finds itself in the unenviable position of not being able to reduce its debt and yet its need for larger expenditures. As a result deficit finance buys them time. Their hope is that the economy will grow at a faster rate than the debt and so the debt as a proportion of the GDP will decrease. So as you can see government needs to borrow in order to meet its obligations but in order to increase its revenue stream it needs to run a deficit which means more borrowing.

Under a flexible exchange mechanism then the exchange rate would depreciate for a while but that should cause an improvement in the current account which would bring back the rates to their initial position.

You are right when you say that a lower exchange rate would increase the burden of the foreign portion of the sovereign debt that is denominated in dollars. That is one reason why I have always arguesd against sovereign debt that is not in the local currency. As the dollar strengthens against other currencies then the Lebanese economy compared to these other economies becomes less competitive anyway. But under a flexible exchange mechanism if the Lebanese currency initially weakens but then strengthens then the weakness will be only transitory.

In theory A fiscal expansion under fixed exchange rate would lead to the same result as a monetary expansion under flexible exchange rates. But for the above to be so then the interest rate that attracts the foreign capital cannot be above the world rate.

Lebanon has to lower its sovereign debt if it is ever to be able to feel as if it is in contro; of its destiny. To do that through artificial high interst rates that merely attract capital flows to banks is a temporary fix at best. A flexible exchange rate will introduce some market discipline but for best results Lebanon has to seek major restructuring of its debt, preferably through write offs/grants/moratoriums. But if that does not work then restructuring is a must.

rayan said...

Hi Ghassan,

Thanks for the clarification! In essence, I guess you are describing the system as a Ponzi scheme. In some sense, you borrow to both pay debt and grow the economy - so that you can stop borrowing and pay the debt. But then your debt grows at pace with (or faster than) your economy and you are stuck. The reason for that is you have to offer high interest to attract investors to a shitty economy. On the other hand, you can't realistically hope for the value of the debt to magically decrease due to currency fluctuations since your currency is pegged to a major lending foreign currency.

Sorry for the summary :) I just want to make sure I get your reasoning right.

I recall from a previous post (+ comments) on this blog that: Numbers on Lebanese economic growth in past years have coincided with Hariri governments (when positive) and with Hoss/Karami goverments (when negative). The latter two were more conservative in terms of borrowing and more frugal in terms of public spending (arguably, an equally bad policy). On the other hand, that led to economic stagnation and thus the economy was not better positioned to grow faster than the debt.
One could argue that they did not lead for long and that did not give enough time for the necessary recovery.

Any thoughts?

As a side note: You wouldn't happen to know what proportion of the Lebanese budget goes to debt servicing would you?

ghassan karam said...

The last question you raise is the easiest to answer: $0$ of the Lebanese budget is earmarked for debt service. This is huge. Many other countries with large debts allocate only a fraction of what Lebanon does for debt service because they pay much lower interst rates and because they their sovereign debt accounts to less than 147% of their GDP. A good example is the US whose public debt has ballooned to over 93$ of the GDP but whose interest accounts for under 7% of the budget. Some are viewing with alarm the possibility that interest on the public debt could become 20 %of the budget over the next decade if nothing is done to stop it.

It is true that the economy might have turned a better performance under Hariri than the others. I do not argue that Mr. Hariri should not have borrowed. I do not like labels but if I were to use one I would be essentially a keynesian . That means that I favour debt as an active policy of the Government. That is not the issue. What is important is what you do with the debt and how you finance it. Lebanon has exceeded its carrying capacity a long time ago. That if a fact that we choose to ignore at our peril. Why did we exceed our capacity? I would argue that it is a combination of inefficient management a misguided policy objectives. But what is most important currently is noit to convert the debt into foreign denominated currencies , to lower the level of interest rate and to transform all of these huge deposits into investments if possible. Lebanon should learn from what is happening to Greece. Greece could have extended the pain over a number of years but by biting the bullet this year and nest they will be a better country eventually. Lebanon is playing the odds and the odds are not in our favour. Lebanon needs for everything to turn its way if it is to avoid a crisis. How likely is that in the Middle East? I would not bet on it.


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