From the late 1940s up until October 2019, including the 15-year war period, Lebanon was known for its unique free foreign exchange system and the freedom to carry out transactions domestically in either the national currency or foreign currencies. Indeed, the major portion of bank deposits has long been held in US dollars.

But on 17 October 2019, increasing withdrawals of dollar deposits led to a sudden and strict clampdown by banks on such withdrawals as well as transfers abroad. Interestingly the imposed restrictions were not announced officially by the central bank: instead, with its tacit approval, their implementation was left to the commercial banks. Lebanon entered a new phase of unaccustomed capital and exchange controls.

The announced objective of these measures was to slow down the depletion of central bank foreign exchange reserves, which, the authorities argued, were needed to maintain a stable foreign exchange rate (the Lebanese pound is linked to the US dollar).

It should be mentioned that the central bank had in recent years resorted to so-called financial engineering intended to induce commercial banks to deposit with it, at very attractive interest rates, sizeable portions of their own free foreign exchange reserves in the form of medium-term maturities. And the banks did.

But this shouldering of the central bank’s own foreign exchange reserves was insufficient to allow it to continue defending the official exchange rate as before. Restricting its accommodation at the official rate to purchases of select import necessities, a parallel exchange market has since emerged where the pound has been trading at a much-depreciated level vis-à-vis the dollar with a consequent rise in prices.

Unsurprisingly the October measures have generated a great loss of confidence in Lebanon’s banking system and the ability of the authorities to cope with the emerging situation, a loss that will continue to reverberate at the national political, economic and financial levels for a long time to come.

In attempting to fathom the underlying causes that led to the October outcome and the required policies for a potential recovery, I submit that we should first have a close look at the historic roots of the problem, namely, the fiscal policy of the post-civil war period specifically after 1992. Basically, with few exceptions, it reflects faulty fiscal governance and policy whose distortions, over time, led to parallel distortions in monetary and other policies.

Briefly, after 1992, successive Lebanese governments failed to restrain growing budget deficits, a few attempts at containing it notwithstanding: by the end of 2019, the public debt came to stand at about 155% of GDP. This failure in fiscal control with its multifaceted manifestations, including outright fiscal corruption, was, it should be clearly noted, part and parcel of a highly defective political governance from which Lebanon has suffered despite certain efforts at reform that were not permitted to materialise.

Equally, the growing fiscal deficits eventually led to increasing accommodation by the central bank, which, in turn, as noted above, resorted to the commercial banks for the required financing (which the banks willingly accepted), thereby diverting their resources towards an unproductive project.

Thus, whatever aspects of success might be ascribed to central bank policy in the post-war period, it suffered from a major fault, namely not imposing limits on its accommodation of budgetary deficits with its consequent distortionary effects on banking practices. (Why the central bank did not impose limits or the banking system seriously attempted to push in this direction is a separate matter, which I do not take up in this note.)

The present government (formed on 22 January 2020 and comprising mostly technocrats) plans to implement measures aimed at stabilising the financial situation or at least preventing its further deterioration as a prelude to a hoped-for recovery. But the magnitude of the financial problem is such that in the absence (so far) of substantial aid from oil-rich Arab countries, the government may not be able to achieve its objectives without recourse to assistance from the International Monetary Fund (IMF), which would also pave the way to other donor aid.

Admittedly this course of action has its staunch opponents, most prominently Hizbollah, one of the parties supporting the government. But given the increasing gravity of Lebanon’s financial situation, it now seems open to Lebanon seeking IMF assistance, though on condition that this would not lead to what Hizbollah considers unacceptable terms of lending.

If the government does seek negotiations with the Fund, any potential aid would of course be forthcoming in the context of the well-known IMF approach to conditional loans. Clearly, the Lebanese authorities will have to be fully prepared for these negotiations on the basis of a well thought out national recovery plan. And the question that immediately follows is: what should be the central focus of such a plan?

I submit that Lebanon’s fiscal record post-1992 is the appropriate guide: the plan should focus on fiscal measures that address the major faults of Lebanese fiscal governance and policy since 1992. This would in turn permit the authorities to address successfully the major faults of monetary policy and banking practices, especially in recent years.

In this brief note, I cannot go into the details of the required fiscal action except to say it should include, above all, measures that would effectively control widespread fiscal corruption in the public sector, estimated at several billion dollars annually of lost Treasury revenue. This would pose a great challenge for the new government, but then fighting corruption was the raison d’être for its formation following sustained popular demonstrations that led to the fall of the preceding government.

Alternatively, choosing the easy way out such as resorting to a ‘haircut’ on bank deposits (proposed by certain policy-makers) could leave permanent damage not only on the reputation of Lebanon’s banking sector and financial system, but more importantly on incentive to keep genuine national savings in Lebanon.

A proposed policy of targeting only so-called big, or very rich, depositors may not prove fruitful on three counts:

• First, unless the threshold is really sufficiently high – for example, say above $2 million – then the burden of the cut will basically be shouldered by the middle class (professionals, retirees, various middle range businesses etc.) rather than the very rich. This would add to the middle class burden on account of rising prices and diminishing work opportunities, which it shares with the poorer classes, a burden that hardly affects the welfare of the richer classes.
• Second, if the richer classes are the target, then the proper method of making them share equitably in the cost of financing is through progressive income taxation rather than via arbitrary levies on deposits that determine the flow of credit to the national economy.
• Third, gains accumulated by profiteers, whatever the circumstances of their profits, that the government wishes to capture, via a haircut, to finance its programmes have in all probability been already converted into investments other than bank deposits in Lebanon. In any case, profiteering is a loathsome activity that extends beyond the banking system, reaching the very core of public sector operations. It would need to be addressed as part of overall national reform.

Briefly, whatever the faults of monetary policy and banking practices – and there have been major faults – the focus of the government’s plan should be on fiscal governance and policy measures that constitute the bedrock for reforms in other areas of economic policy.

A final observation: the reform measures that the IMF may initially postulate as a condition for extending assistance will not necessarily be engraved in gold. If the Lebanese authorities are well prepared, there will be room for satisfying negotiations and a mutually agreed rescue programme.

The author wishes to acknowledge helpful comments by Noha El-Mikawy on an earlier version of this Note.