A Primer on the Financial Crisis in Lebanon : A Historical and Cross-Country Perspective

The current financial crisis affecting all sectors of the Lebanese economy became visible in a dollar liquidity shortage in the summer of 2019 that has since become acute with a political crisis since 17 October 2019. However, while the crystallization of the crisis is recent, the fragile funding scheme of the economy has developed over a long period of time. In common with previous countries and crises, the balance sheets of each of the government, the banking system, the central bank and the private sector are overextended and mismatched — currency and maturity mismatch. Also in common with many previous crises, a fixed exchange rate regime is vulnerable to speculative attack, especially in light of the overvaluation of the real exchange rate that has developed over more than a decade. What is unique to the Lebanon case is that the balance sheets of all 4 sectors of the economy are so exposed to each other through claims and cross-claims. Other countries relied on foreign investors for funding (such as dispersed foreign banks) and were therefore prone to volatile inflows and reversals. In contrast, dedicated non-volatile depositors supported most of Lebanon's funding for many years until their sudden stop. In this sense, Lebanon has been a victim of its own luck in having a dedicated resident, expatriate, and regional depositor base. This: i) allowed the debt and the imbalances in the balance sheets to build up even further than in previous crises and ii) now complicates the recovery. It complicates the recovery because a sudden stop in the source domestic depositor funding has quickly spread through all balance sheets, contributing to the systemic liquidity freeze and now causing second-round adverse feedback loops to the economy. There is no easy solution. But to arrest this downward spiral, I propose that a key first step in any effective policy response is to separate the government debt problem from the liquidity problem affecting the banking system and real economy. Borrowing from the lessons of the global financial crisis successfully applied by the Federal Reserve and the European Central Bank, external liquidity support (such as collateralized dollar credit lines) should be targeted directly to the banking system to restore depositor confidence and unfreeze the economy. Then the government debt problem, via restructuring and reform should be addressed separately in a democratic political process with citizen (meaning depositor) agreement