Lebanon: Political gridlock persists while economy suffers from multiple shocks
Four crises simultaneously affecting Lebanon
Lebanon is simultaneously dealing with four crises: (i) Since October 2019, a drop in investor confidence has shaken the Lebanese financial system, effectively leading to the adoption of informal capital controls by the banking sector and the development of a parallel exchange rate. (ii) In March 2020, Lebanon’s government defaulted on its public external commercial debt and subsequently announced a restructuring of its debt. (iii) An explosion whipped away Lebanon’s largest port and damaged a large part of the capital, Beirut. (iv) The current covid-19 crisis is further affecting the Lebanese economy.
Behind this negative economic trend lies a political gridlock that finds its roots in the sectarian politics that marks Lebanon and that has inhibited reforms for years. Currently, it is impeding the formation of a government that could push forward a reform programme. While Prime Minister Hassan Diab started with a clear plan to implement reforms at the beginning of the year and an IMF programme seemed within reach, it stalled in June. On top of that, in August, came the explosion that whipped away Lebanon’s port, damaged a large part of the capital and led to the resignation of Hassan Diab’s government.
Macroeconomic imbalances at the root of the crisis
For years, Lebanon has been running large external imbalances and large fiscal deficits. The current account deficit averaged 23% over the last ten years and the fiscal deficit averaged 8.4% over the same period. Amid these large twin deficits, the Central Bank, in coordination with the local banking sector, reverted to so-called ‘financial engineering’ in order to preserve financial stability. The mechanism consisted of attracting USD deposits from abroad by offering very high interest rates. These inflows of USD thus served to fund the current account deficit and the fiscal deficit. Uncertainty over the sustainability of that policy raised worries among investors, which heightened the concerns over the sustainability of the peg and the sustainability of the public finances in 2019.
Towards the end of 2019, a full-blown confidence crisis erupted. As a result, a parallel exchange rate developed and informal capital controls were imposed by the Lebanese banking association. These capital controls effectively blocked access to US dollars that had been deposited in Lebanese bank accounts before mid-October. Additionally the Central Bank restricted access to dollars at the official exchange rate as they decided to provide them only for essential imports of wheat, fuel and medicines. By the beginning of March 2020, the government defaulted on its external commercial debt. Thereby they acknowledged that debt levels had reached unsustainable levels as gross public debt reached more than 170% of GDP by the end of 2019 and the government was spending half of total public revenue to service the interest payments.
Political gridlock underlying the negative trend
Behind this negative economic trend lies a political gridlock that finds its roots in the sectarian politics that marks Lebanon and that has inhibited reforms for years. When the economic situation grew increasingly dire in October 2019, large protests ensued. While triggered by a tax proposal on WhatsApp, protests targeted the rampant corruption and mismanagement of the country. This led to the resignation of the government headed by Saad Hariri in October 2019 that yet tried to push through the economic reforms that would have made available the funds promised by donors at the CEDRE conference in 2018. Even though the country was going through an unprecedented crisis, a new government, headed by Hassan Diab, was formed in January 2020. While initially working ambitiously on a reform programme, political gridlock remained as no agreement over the needed economic reforms was found among the different factions. Energy subsidy reforms, the restructuring of the banking sector and the Central Bank and a new anti-corruption law remained key sources of disagreement. For example, disagreement between the government and the Central Bank over the size of the banking sector and Central Bank’s losses led to a breakdown of talks with the IMF towards the end of June 2020.
On top of this deteriorating political situation came the port explosion on 4 August 2020. 2750 tons of highly explosive ammonium nitrate had been stored in a simple warehouse in the port since their confiscation in 2013. Negligence and corruption are at the root of this catastrophe. In light of the port explosion, Hassan Diab resigned less than 8 months after he took the Prime Minister job. Since then, Lebanon has been without government.
French initiative to end the political standstill failed
In the aftermath of the explosion, the French president took on the initiative in trying to end the political gridlock. In the weeks after the explosion, he travelled twice to Lebanon and called on the political elite to implement a government of technocrats to push through urgently needed reforms. While the main parliamentary blocks agreed relatively quickly on the designation of a new Prime Minister, Muhammad Abid resigned on 26 September as he failed to form a government. The political stalemate has thereby become complete and the economic consequences are dire. The formation of a new government is expected to take time. A timeline of 6 weeks is currently put forward. A key issue seems to be that Hezbollah wants to remain in control of key ministries, such as the finance ministry, something opposed by the other factions. These kinds of disagreements show that even when a government will be in place, finding agreement over the reforms will be very difficult. The failure of Hassan Diab shows that agreeing on reforms was not possible even though the country went through an unprecedented crisis.
Donor support will be essential to solve the current crisis, however conditional on significant reforms. It has been 2 years already since USD 11 bn in funds were h made available after the CEDRE conference. Nevertheless, those funds (mostly concessional loans) were never released as the reforms were not implemented. This stance is unlikely to change.
The overall economic impact of the crisis is huge. Before the port explosion, the Lebanese economy was expected to contract by 12% in 2020. In light of the explosion, the contraction is likely to be much deeper. Additionally we are seeing a steep rise in inflation as imports become increasingly expensive. While inflation was already 120% before the explosion, due to a depreciation of the Lebanese pound on the black market, it is likely to rise further given that the cost of imports will rise. Thereby Lebanon enters hyperinflation territory. It is evident that the adverse economic conditions is leading to a sharp rise in bankruptcies in the country. As a result, importers remain unable to obtain hard currency through the Central Bank (except for essential imports). Instead, they need to rely on the black market where the Lebanese pound trades at 8300 LBP to the dollar (compared to the official rate of 1513.04 LBP). At the same time, no official devaluation has taken place and officially the peg remains in place. Additionally dollars deposited in Lebanese bank accounts before October remain inaccessible, although for these deposits it is reported that conversion to LBP is possible at the black market rate. As a result of this deteriorating economic outlook combined with the political gridlock, Credendo has decided to downgrade the short-term political risk classification of Lebanon to category 7.
Analyst: Jan-Pieter Laleman – firstname.lastname@example.org