Lebanon’s economic crisis is, at its core, a governance crisis emanating from a dysfunctional system that hindered rational policy-making and permitted a culture of corruption and waste. The country, led by the public sector, lived beyond its means. Decades of pursuing this model left the economy with high debt and a banking sector that is both bloated and vulnerable. Inevitably, the debt increase resulted in an expanding debt-servicing burden, rendering the country vulnerable to external and regional shocks. Ultimately, the large external flows on which the whole system depended dried up.

Where are we now?

This situation leaves the country with three simultaneous crises.

The first is a balance of payments crisis

The economy is facing a large gap between the supply and demand of dollars. For 2020, we estimate the gap at $8 billion. If not filled, the multiple negative consequences of this gap will intensify: difficulties servicing debt; shortages of goods; devaluation; and economic contraction.

The second crisis is that of public finance

Beginning with a 10% of GDP deficit in 2019, government revenues are now collapsing under the weight of the recession and the banking crisis. Inflation-adjusted spending is also crumbling. We estimate a $3 billion primary budget deficit (excluding interest payments) for 2020.

The third crisis is that of the banking system

With almost half of banks’ assets invested in Lebanese sovereign risk, including with the Banque du Liban, and another quarter representing risky private sector claims, banks are effectively insolvent and illiquid. Despite the loose and inefficient capital and banking controls recently put in place, the sector is experiencing a classic ‘bank run’. The central bank, is constrained by its limited dollar reserves and concern that an oversupply of Lebanese pounds would lead to further weakening of the currency.

So where do we go from here?

Below, we sketch a comprehensive three-year programme that seeks to ensure equitable burden-sharing in addressing the fallout of this crisis and protection of its most vulnerable, while setting the country on a high-productivity path. The ten concrete steps included in this programme should be implemented in parallel and designed in a way to avoid extreme economic pain.

Establish an empowered steering committee to come up with an economic emergency plan

In parallel, create participatory mechanisms to discuss with civil society groups the policy package and to empower citizens to monitor its implementation.

Replace the ad hoc and self-administered capital and banking controls

Controls are likely needed for an extended period even in the best of scenarios. But they need to be run in a fair and transparent fashion, and be backed by proper legislation.

Deal decisively with public sector debt

Immediately announce a moratorium on debt payments (external and domestic), hire legal counsel, and convene a creditor’s committee, offer creditors a menu of approaches, including lower principal, and reduced interest rates. The restructuring should target a debt stock that Lebanon’s growth potential can afford, which we estimate at 60-80% of GDP.

Embark on a credible fiscal reform

Public spending, currently inefficient, wasteful and vulnerable to corruption, must be transformed. The electricity sector is but one example. A wholesale governance and regulatory reform programme is needed to curb the rent-seeking culture. Cutting waste, along with the savings accruing from lower debt servicing, should allow for increased spending on social sectors and infrastructure.

Second, a broad reform effort is needed, to address a regressive and porous state revenue structure.

Third, we strongly recommend the adoption of a ‘fiscal rule’ to constrain unreasonable deficit financing.

Deal with private sector debt

The private sector is facing a severe crisis. A creditor/debtor roundtable must be convened to discuss a collective approach that produces a menu of financial relief steps aiming to safeguard viable firms while allowing orderly liquidation of those that are not viable. The existing draft Bankruptcy and Restructuring Law should be promptly passed.

Repair the Banque du Liban’s balance sheet

The Banque du Liban is a large lender to the government and has an estimated $30 billion negative net foreign exchange position, rendering it vulnerable to devaluations. Until this is dealt with, it is tough to see confidence in the Lebanese pound returning.

Bring the banking sector back to health as a prerequisite to reinvigorating the economy

Public debt restructuring and mounting non-performing loans will render many banks insolvent. Complicating matters, banks are highly exposed to the Banque du Liban, whose own balance sheet is impaired. Current bank equity is far from sufficient to cover these hits. Current shareholders need to assume the losses and be required to bring in fresh capital.

This may also necessitate a reduction in the number of banks. In parallel, foreign loans and state assets could conceivably be used to recapitalise the sector. As the above is not likely to be enough, there is a near certain need for reducing portions of large deposits and swapping them into bank equity.

Preserve social peace through a focus on social justice

This involves a distribution of losses that is concentrated on the richest in society while sparing small bank depositors. Foreign funding should be used to blunt the pain of adjustment. A safety net must be put in place to fight poverty and support health and education. Workers should be helped to make the transition out of decaying sectors into those that benefit from the devaluation.

Rethink the foreign exchange/monetary policy mix.

The fixed (and overvalued) exchange rate regime has contributed to large current account deficits, hurt export-oriented sectors and forced the Banque du Liban to maintain elevated interest rates. Looking forward, we recommend a more flexible exchange rate arrangement centred on a weaker currency. But until confidence in the Lebanese pound returns, it will be dangerous to allow the currency to float freely. Some form of currency management will have to maintained for the medium term.

Secure a multi-year Stabilisation and Structural Reform Facility

We estimate that a three-year $25 billion fund is needed. This facility should be used to shore up the Banque du Liban’s net reserves, help to fund the immediate government budgetary needs, finance badly needed social spending and contribute to bank recapitalisation.

Conclusion

The economic programme recommended above can garner international support, including from the World Bank, the European Union and the Gulf Cooperation Council. But it will realistically require an International Monetary Fund programme as an umbrella.

We also think there is scope partly to fund this facility with state assets and possibly hoped-for oil and gas revenues. We cannot overstate the importance of good governance, transparency and accountability in this regard.

The consequences of delays in initiating a comprehensive reform effort will only increase dislocation, exponentially magnify the needed adjustment and place the burden on those least able to shoulder it.

A better option is available. It will not be easy, may at times prove painful and will certainly require a new social contract. But we sincerely believe this approach will pave the way to a better and prosperous future.

This is a summary of a longer ‘Manifesto’ by a group of Lebanese financial and development experts, published in Lebanon on 7 January 2020. It has been influential in shaping up the government’s response to the crisis.

The signatories (in their personal capacities) are: Firas Abi Nassif, Edward Asseily, Bilal Bazzy, Hala Bejani, Amer Bisat, Henri Chaoul, Ishac Diwan, Haneen el Sayed, Ali El Reda Youssef, Saeb el Zein, Nabil Fahed, Philippe Jabr, Sami Nader, May Nasrallah, Paul Raphael, Jean Riachi, Nisreen Salti, Nasser Saidi, Kamal Shehadi, Maha Yahya, Bassam Yammine and Gerard Zouein.