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April 03, 2020
Lebanon's Financial Crisis: Where Did the Money Go?

 
An interview with Mike Azar, finance professional
 
Although people have not been able to access their deposits, the Central Bank Governor and the President of the Banking Association have repeatedly reassured people that their deposits are safe.
 
 
Why can't people access their deposits?
 
People have limited access to their deposits because banks have no dollar liquidity. The banks’ dollars are tied up in impaired assets, which are assets that have lost a significant amount of their value, such as deposits with Banque du Liban (BdL), as well as loans to the Lebanese government and to the private sector. Analysis by myself and economist Andy Khalil indicates that the gap between the total amount of dollar deposits—resident and non-resident customer deposits—and dollars remaining in the system is currently between 70 and 80%. In other words, dollar depositors, in the aggregate, are facing losses of more than 70% of their funds. This is a dynamic calculation that is likely to increase over time as BdL’s reserves are drawn down to fund imports, among other factors.
 
People are also unable to retrieve their Lebanese pound (LBP) deposits because, if they were given unrestricted access, many would run to the exchange houses and sell them for dollars, further weakening the LBP. As a result, when dollar withdrawals were restricted, LBP withdrawals were also restricted to avoid a collapse in the LBP/dollar exchange rate.
 
 
What have the deposits been used for?
 
Using the consolidated balance sheet of Lebanese banks, we can estimate that the banks’ total dollar assets (approximately $126 billion) are tied up as follows:
 
1.  BdL: Approximately $70 billion (56%) have been deposited at BdL, though this figure is likely greater than $80 billion today
2. Government Eurobonds: $12.7 billion (10%) are Lebanese government dollar debt
3. Resident private sector: $28.7 billion (23%) are loans to individuals and business in Lebanon, referred to as claims against the resident private sector
 
As indicated above, approximately 66% of the banks’ foreign assets are in the form of claims against the “Sovereign”, which are BdL and the government. This is essentially where most of depositors’ dollars went.
 
Most of the money deposited at BdL was spent to maintain the LBP/dollar exchange rate and, to a lesser extent, to finance the government’s fiscal deficit through the direct purchase of Eurobonds. To put it simply, BdL “sold” most of these dollars (i.e., banks’ deposits at BdL and, by extension, depositor’s deposits in banks) at a rate of LBP 1,500 per $1, to fund imports into the country.
 
Looking into data from the Lebanese Customs administration, Central Administration of Statistics, and BdL suggests that, since 2010, approximately $55 billion has left the country in the form of “transfers and remittances” (such as non-Lebanese employees in Lebanon sending money to their home country, parents paying for their children’s college tuition abroad, other personal transfers abroad, among others), $45 billion on petroleum products (such as fuel for Electricité du Liban and for the transportation sector), $40 billion on personal travel, $30 billion on various food imports, and $18 billion on vehicles imports. These alone comprise approximately $188 billion spent from 2010 to 2018, partly funded using the Lebanese diaspora’s dollar deposits, remittances, foreign currency debt issued by the Lebanese government (Eurobonds), and Lebanon’s modest export receipts and foreign direct investment.
 
Minister of Finance Ghazi Wazni recently announced that BdL has $22 billion left in liquid reserves (1),  which are needed to fund imports into the country until another source of dollar funding is found. It is therefore highly unlikely that BdL will be able to repay the banks their deposits.
 
The banks also hold approximately $12.7 billion of government debt which are held in dollars. These funds were used to finance the government’s fiscal deficit, a large proportion related to Electricité du Liban’s fuel costs. The government recently announced its intention to restructure its Eurobond debt, which will result in further losses to the banks. Though it would be more accurate to describe this as the realization of existing losses as the repayment of Eurobonds is made from the same $22 billion of BdL’s foreign currency reserves. As a result, every dollar paid to repurchase a Eurobond is a dollar that is not available to return the banks’ deposits with BdL.
 
About 23% ($28.7 billion) of the banks’ dollar assets are loans to the resident private sector. A growing number of these loans will be classified as “non-performing” as the economy contracts, unemployment increases, and the private sector struggles to keep businesses going, adding another significant strain on the banks’ dollar liquidity and ability to meet depositors’ demands. Banks will face even greater liquidity problems if two things continue to happen: (i) the repayment of dollar loans in LBP, which would mean that the dollar assets that banks would have used to meet their dollar deposit liabilities will be converted to LBP assets; and (ii) conversion of consumers’ LBP deposits into dollars, which would result in growth in banks’ dollar liabilities without a corresponding new dollar asset.
 
 
Who is responsible for their mismanagement?
 
In any society, responsibility ultimately lies with political decisionmakers who are responsible for managing the economy. The Lebanese political system precludes accountability and, as a result, reforms were never implemented. International bailouts since the 1990s—and a large, relatively wealthy diaspora that is emotionally connected to its home country—enabled the system to limp on without reforms.
 
For example, the inability of the political leadership to reform the electricity sector over the last several decades has had catastrophic consequences. More recently, delays in facing the current crisis in a transparent and effective manner may yet prove to be extremely costly.
 
In 2008, during the height of the global financial crisis, billions of dollars flowed into Lebanon, considered to be a safe-haven at the time. The country had a remarkable opportunity to reform its electricity sector, develop its economy, build an export industry, and remove the LBP/dollar exchange rate peg. This artificially strong exchange rate made the Lebanon’s goods and services too expensive compared to foreign goods, and therefore, uncompetitive. As a result, the country does not have a serious export industry. Instead, poor economic policy resulted in having these inflows channeled into excess import consumption, unproductive real estate projects, and wasteful government spending.
 
The responsibility also lies with BdL’s decisionmakers for their mismanagement of the country’s monetary policy, their lack of transparency and data availability, and their willingness to oversee the hallowing out of the Lebanese economy by refusing to publicly raise the alarm bells about the excessive costs of maintaining the exchange rate peg. The “financial engineering” operations over the last five years were simply an attempt to kick the can down the road at tremendous cost. BdL offered exorbitant interest rates on new dollar deposits, even though it had very little dollar earnings itself and, therefore, incurring huge losses on these deposits. The interest paid on dollar deposits was thus paid by attracting new dollar deposits at even higher interest rates, resulting in an explosion in the size and scale of the problem. This was carried out with little transparency to the Lebanese people.
 
The responsibility also lies with certain bank executives and shareholders who made tremendous profits from the unsustainable financial and economic system at the expense of depositors and taxpayers. The banks attracted depositor dollars by offering exorbitant interest rates and depositing such funds with BdL, without disclosing to customers the risks involved. At the same time, banks and their executives made outsized profits. They were in a position to blow the whistle, but most of them did not. Today, the same banks are attempting to make-up their losses at the expense of depositors by convincing customers to freeze their deposits or to subordinate their position by converting their dollar deposits into bank capital (which almost certainly has no value and is, in any case, subordinate to deposits in the event of an insolvency).
 
The responsibility also lies with any person in a position of authority or influence who could have blown the whistle on corruption, mismanagement, and the unsustainable financial and economic system over the last many decades but chose to remain silent.
 
How can deposits be made available again?
 
It is unlikely that unrestricted withdrawals will be available again for quite some time. The “dollar gap” (the difference between resident private sector deposits in dollars and the net foreign assets of banks and BdL) is estimated by economist Andy Khalil using BdL data to be greater than $80 billion, without taking into account several other areas of potential dollar loss (non-performing loans, further dollarization, repayment of existing dollars loans in LBP, etc.). This means that there is a need to recapitalize the banking sector, including BdL, which is the source of a majority of the loss. It is unclear yet how this gap will be filled and/or the banks and BdL restructured.
In general, there are three ways to execute such a restructuring. Banks’ liabilities are mostly the deposits that customers keep with them and interest on such deposits. Banks meet those liabilities using their assets (e.g., loans to the private sector or government, other investments). In Lebanon’s case, the banks’ assets are impaired and, as a result, the banks are no longer able to meet their liabilities. So how is such a banking crisis resolved so that depositors can withdraw their money again?

1. Raise capital: Raise fresh capital by selling equity shares or other financial instruments or assets. By raising fresh capital, banks would benefit from an increase in good, liquid assets with which to meet their liabilities. Last November, BdL instructed banks to undertake a 20% capital raise. It is unclear whether most of the banks will be able to raise such capital (particularly given the current global economic climate in light of the COVID-19 pandemic) and, in any case, the amounts are insufficient relative to the scale of the banks’ losses. Given the size of the existing losses and the high possibility of a depositor bail-in (described in point 4 below), there is little incentive for bank shareholders to raise new capital at this time as they would, in effect, be putting new money into a bank that is on the cusp of insolvency, in which case this new capital would be wiped out.
 
2. Replace bad assets with good assets. During the global financial crisis, the US Federal Reserve purchased US banks’ bad assets: It gave them good assets/cash in exchange for their bad mortgages, which allowed banks to then meet their liabilities (i.e., customer deposits). Neither the Lebanese government nor BdL, however, have sufficient dollars to purchase Lebanese banks’ bad assets or to provide dollar injections. In fact, most of the banks’ bad assets are loans to the government and BdL in the first place.
 
3. Lirafication. Convert BdL/banks’ dollar liabilities into LBP, which BdL/the government has the ability to fund as it can simply create more of the local currency. In other words, convert dollar deposits into LBP deposits, which can then be created by BdL. This could have catastrophic consequences on domestic price inflation if lirafication is done so extensively that the money supply grows rapidly relative to the size of the economy. Therefore, under such an approach, it is likely that strict capital controls on LBP withdrawals will have to be maintained for a long period of time to limit the impact on the LBP exchange rate and price inflation.
 
4. Reduce banks’ liabilities. Banks’ liabilities can be reduced, generally speaking, in two ways: Using bail-ins (converting deposits into bank equity) or by freezing deposits for a long period of time so that banks don’t have to meet such liabilities for a while.
 
As we have heard recently from Prime Minister Hassan Diab and Minister of Finance Ghazi Wazni, the Lebanese government is studying the third and fourth approaches. The prime minister had indicated that the government will work on protecting at least 90% of depositors. Aside from these general statements from government officials, no other details have been provided around the cabinet’s plan. We may yet see a combination of the third and fourth approaches. The first and second approaches are, unfortunately, the only ones that allow depositors to avoid taking a loss.
 
Given the size of the “dollar gap” identified at the beginning of this article (i.e., the scale of the losses being estimated to be greater than 70-80% of total deposits and growing), it is unclear how the government will be able to protected 90% of depositors. In either case, LBP depositors will likely see a loss in the real value of their deposits as a result of the depreciation of the LBP against the dollar and rising price inflation even if they are not directly implicated in the bank restructuring. In fact, this would affect all Lebanese, whether or not they have banks accounts. This is why it is critical that the bank recapitalization be undertaken with a view toward limiting the impact on most Lebanese people, whether or not they have dollar bank accounts.

Regardless of the form of bank recapitalization, the economy is in dire need of fresh dollar liquidity or it will contract even more severely than it otherwise would. Lebanon is a small, open, and import-dependent economy. A dollar shortage means reduced economic activity and fewer imports—even “productive” imports such as capital investments, which are necessary for future economic growth. The result will be catastrophic for our ability to recover in the long term, as some of the potential consequences, such a brain drain from the country and reduced capital investment will cut the country’s future economic potential.
 

(1) This is based on Minister of Finance Ghazi Wazni’s appearance on a show on LBC. See: "Vision 2030 - Episode 26," LBC, March 9, 2020, https://www.lbcgroup.tv/watch/49727/episode-26-after-the-9th-of-march/en










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