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Debt reduction by way of inflation: The case of Lebanon

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Debt reduction by way of inflation: The case of Lebanon

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DEBT REDUCTION BY WAY OF INFLATION: THE CASE OF LEBANON
by
Sheikh Shahnawaz
Copyright 1998
A Thesis Presented to the
FACULTY OF THE GRADUATE SCHOOL
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fu lfillm ent of the
Requirements for the Degree
MASTER OF ARTS
(Economics)
August 1998
Sheikh Shahnawaz
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UMI Number: 1393187
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U N IV ER SITY O F S O U T H E R N C A L IF O R N IA
T H E G R A D U A T E S C H O O L
U N IV E R S IT Y P A R K
LO S A N G E L E S . C A L IF O R N IA 8 0 0 0 7
This thesis, written by
Sheikh Shahnawaz
under the direction of k — i.S...T kesis Committee,
and approved by all its members, has been pre
sented to and accepted by the Dean of The
Graduate School, in partial fulfillm ent of the
requirements for the degree of
M a s t er o f A r ts ^
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To my parents and Faisal
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ACKNOWLEDGEMENTS
I would like to thank all the members on my committee for their guidance without
which this thesis would not have been possible. I would also like to thank Mr. Samar
Younes at the Banque du Liban for his help in providing the relevant data.
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iv
TABLE OF CONTENTS
Acknowledgements
1 11
List of Tables
.v
CHAPTER
1 Debt and Inflation
1
The Problem and the Proposed Solution
Economic Policy and the Policy Environment
Financial Factors in Economic Development
Domestic Public Debt and Inflation: A Brief Introduction
The Role and Influence of Exchange Rates in the Economy
The Political Economy of Government Debt
Literature and Sources
Organization
2 An Overview of the Lebanese Economy...............................................................27
The Pre-Civil War Period
The Economy Since the Civil War
3 Financial Policy in Lebanon..................................................................................55
Budgetary Performance and the Civil War
Exchange Rate and Balance of Payments
Currency Substitution and Dollarization
The Organization of the Banque du Liban
The Role and Function of the Banque du Liban
4 Inflation and Exchange Rates................................................................................79
Exchange Rate Developments
Inflation
Changes in Inflation with Exchange Rate Movements: The Long Term
Changes in Inflation with Exchange Rate Movements: The Short Term
5 Using Inflation for Debt-Reduction in Lebanon.................................................. 94
Public Debt Management
The Effect of Debt on Credibility
Debt Management Episodes: Six Experiences
Implications for Lebanon’s Domestic Debt
Conclusion
Bibliography.......................................................................................................... 132
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V
LIST OF TABLES
TABLE
2-1 Changes in NNP, Per Capita Real Income, GDP, and GNP,
1950-1974............................................................................................... 30
2-2 Growth Rates by Period of 5 Years, 1950-1974................................................ 32
2-3 Distribution of Men in Each Sector by Religion, 1957-1958...........................33
2-4 Percentage Share in Net National Product by Sector.........................................34
2-5 External Trade and Trade Deficit of Lebanon—Selected Years......................39
2-6 Distribution of Men in Each Sector by Religion, 1979-1980...........................41
2-7 Trends in GDP and Exchange Rates...................................................................45
2-8 Percentage Share of GDP by Economic Sector.................................................48
2-9 Trend in Foreign Trade, 1976-1993................................. 51
3-1 Standard Deviation of Monthly Minimum and Maximum Exchange
Rates, and Monthly Average Exchange Rates, and Coefficient
of Variation, 1950-1970........................................................................ 60
3-2 Changes in the International Reserves of the Monetary Authorities
and in the Foreign Assets of the Banking System, 1951-1975...........62
3-3 Summary of the Balance of Payments............. } ................................................65
3-4 Currency Substitution.......................................................................................... 66
4-1 Exchange Rates and Inflation..............................................................................84
4-2 Regressions of the Differential Between Lebanese and US Inflation
Rates on Changes in the LL/USS Exchange Rate..............................87
4-3 Regressions of Changes in the LL/USS Exchange Rate on the
Differential Between Lebanese and US Inflation Rates..................... 89
4-4 Inflation and Exchange Rate Movements in the Short Term...........................90
4-5 Regressions of the Differential Between Lebanese and US
Inflation Rates on Changes in the LL/USS Exchange Rate
and an Error-Correction Term..............................................................91
5-1 German World War I Expenditures.................................................................. 102
5-2 Revenue and Expenditure of the Reich: 1920-1923........................................104
5-3 Factors Reducing the US Debt-GNP Ratio, 1945-1974................................. 107
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Vi
5-4 Summary of Public Sector Operations............................................................. 122
5-5 Lebanon’s Domestic Debt and Debt-GDP Ratios, 1993-1997........................123
FIGURE
Banque du Liban Organizational Chart.............................................................71
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1
Chapter 1: Debt and Inflation
The white Rabbit put on his spectacles.
"Where shall I begin, please your Majesty?"
he asked.
"Begin at the beginning," the King said
gravely, "and go on till you come to the end:
then stop."
- Alice in Wonderland
It can be safely asserted that Lebanon’s economy is quite unlike that of any other
developing country. Lebanon has a relatively limited endowment of natural resources.
Out of a total area of 10,400 square kilometers, an estimated one-third is cultivable.1
Agriculture plays only a small role in the Lebanese economy. The most crucial sector is
that of trade and services. The most distinguishing feature of the economy is its
openness, with a simple and liberal exchange system based on a flexible exchange rate.
Prior to 1975 and the outbreak of the civil war in Lebanon, the country boasted
impressive figures for relevant macroeconomic variables with low inflation and high
growth rates. Limited regulations made the country an attractive center of commerce in
comparison to its counterparts in the region. The overall healthy outlook of the economy
made it an important regional economic intermediary between the West and the Middle
East. But the situation changed swiftly with the start of the civil war in 1975. Lebanon
suffered in both human and material terms. The country’s public finances took a turn for
the worse as government authority dwindled making it difficult to collect revenues. The
banking system provided much-needed relief to the government by financing fiscal
deficits. However, this increase in liquidity resulted in a depreciation of currency, rising
inflation, and high levels of currency substitution. The most significant blow to the
1 Makdisi, Samir A., Financial Policy and Economic Growth: The Lebanese Experience, New York:
Columbia University Press, 1979, p. 24.
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2
economic setup came in the form of a much weakened banking system which adversely
affected Lebanon’s role as a regional intermediary.
Since the end of the civil war in 1990, Lebanon has been striving to regain its
prewar position in the world economic framework. Signs hinting toward a desired
recovery are prevalent but Lebanon still has to tread a long and tortuous road leading to
stable economic growth. The war nearly obliterated the country’s infrastructure and its
institutional framework. In response to the Bosnian civil war, Lebanese Prime Minister
Rafik Hariri was quoted in Time magazine of January 15, 1996, as saying: “I wanted to
take them downtown and show them our ruins— and the effort it takes to restore them. I’d
tell them 'This is the result of war.’” The Lebanese now realize that civil war does not
end in triumph but in poverty and exhaustion and that someone has to pay for the cities
that were destroyed facing the wrath of the various militiamen. Lebanon’s civil-war costs
are estimated at $25 billion plus a loss of more than 150,000 lives, together with
immeasurable suffering. The government’s participation in the reconstruction and
rehabilitation process has been exceptionally large and, though it is responsible for much
of the country’s recent good fortune, it has also contributed to a new and emerging set of
problems. The most worrisome among these is Lebanon’s soaring domestic debt which
has increased from about 44 percent of GDP in 1993 to an intimidating 83 percent in
1997. This huge increase is easier to digest if we bring to bear the fact that the rebuilding
of Beirut’s city center, which is by far the largest of the reconstruction projects, is
comparable to the resurrection of the cities of post-Worid War II Europe and Japan.
Sadly, the costs incurred so far do not even include financial commitments that have to be
made to urgently needed public schools, low-income housing, and health programs.
This chapter is in nine parts. The first part delineates the problem the thesis
wishes to address and how it is going to be dealt with. Part two briefly talks about
economic policy and the policy environment. The third part outlines the financial factors
in economic development. It covers topics like budget deficits and inflation, and their
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causes and effects. Part four introduces the main issue this thesis deals with and that is
public debt and its reduction through inflation creation. This discussion is followed up
by parts five and six which consist of topics like the role and influence of exchange rates
in the economy. After a brief overview of the political economy of government debt in
part seven and a literature review in part eight, the chapter concludes with an overview of
the organization of this study.
The Problem and the Proposed Solution
The main issue that this thesis addresses is the reduction of the Lebanese domestic
public debt. At present, only 16.5 percent of Lebanon’s total debt is external while the
rest is domestic debt. The preceding paragraphs sketch a clear picture of the postwar
challenges that Lebanon faces. Debt financing of budget deficits during the civil war and
the increased role of government in postwar development have inflated the Lebanese
debt. Lebanon cannot afford to sustain this burden for long and to carry it into the next
century due to its potential destabilizing effect. The conventional remedy of undertaking
tax and fiscal reform to ameliorate revenue structure in such situations, however, require
concerted effort with significant investments of time and resources. But Lebanon has
already invested huge sums in its reconstruction and rehabilitation drive with vital social
sectors still demanding attention. These initial efforts alone have significantly raised the
country’s domestic debt-GDP ratio which currently stands at around 83 percent. Thus,
Lebanon needs to treat this matter as an exigency and attempt to control this problem of
rising domestic debt before it becomes acute and unmanageable and the authorities are
left without options to successfully tackle the situation.
An alternative way of dealing with this problem is surprise inflation. Lebanon’s
continued recourse to the monetization of its deficits during and after the war has left the
public accustomed to the consequences of such a policy. Consequently, inflationary
expectations of people in response to monetization have attained near-perfection
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rendering any inflation created through this strategy useless for debt-reduction purposes.
It is for this reason that this thesis suggests a relatively more unconventional path for
creating the desired inflation and that is to exploit the relationship between inflation and
exchange rate movements. Hence, the study establishes a relationship between these two
variables using historical data from Lebanon to further the objective. Lebanon’s flexible
exchange rate regime makes it possible to realistically estimate such a relationship. Past
situations with other nations and their domestic debt problems are also invoked to draw
upon the lessons these experiences impart. It is argued that manufacturing inflation by
manipulating the exchange rate has a greater possibility of taking the public by surprise.
An important aspect of this strategy that has to be taken into account, however, is that it
loses its effectiveness after the first time and, therefore, the authorities have to use this
tool in a manner that it achieves its goal in a single operation. In other words, enough
inflation has to be created so that a sizable reduction in debt is effected.
Economic Policy and the Policy Environment
All governments practice some sort of economic policy at all times. What
governments do affects economic performance. Whereas good policies help enhance
growth, poor policies not only slow growth down but, in worst case scenarios, can set
development back by decades.
The basic objectives of economic policy are prosperity, equity, and the twin
objectives of stability and continuity. These objectives have to be achieved in particular
institutional settings. These include the presence or absence of property rights, and
provisions that determine the interaction of individuals and the state. A favorable
institutional setting boasts:
• Well-defined property rights;
• Competition accepted as the basic rule in markets (both within and across
borders); and
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5
• Equity promoted by the government (through an appropriate tax system and by
investment in education and health).
These, then, are the principles which guide microeconomic and macroeconomic policies
to create a favorable climate for economic activity.
From the perspective of the open economy, the efficacy of microeconomic
policies is greatest in the areas of trade and foreign investment. On the other hand,
macroeconomic policy focuses on controlling inflation, maintaining a stable and
competitive real exchange rate, practicing fiscal prudence, and operating efficient capital
markets.
Financial Factors in Economic Development
Financial factors are of strategic importance in economic development
Associated with them are two sides:
1. The role of savings and investment, and
2. The role of inflationary finance, i.e., using deficits to enhance growth and,
consequently, the relationship between high and unstable inflation and poor economic
performance.
Budget Deficits and Inflation.
Inflation represents the interaction of four factors. These are:
1. Deficit finance (which affects the growth of the money supply);
2. Financial institutions (which determine the demand for money);
3. Shocks to the budget; and
4. The ability to react to these shocks by corrective fiscal measures.
It is the combination of these four factors that determines the level of inflation.
Developing countries in Asia and Latin America provide a useful case study in
inflation policy. The countries belonging to the former group are characterized by
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6
deficits which tend to be lim ited to the government’s ability to finance them in a non-
inflationary m anner. This is in sharp contrast to the case of Latin American nations
which have been plagued by chronic deficits and inflation. Adding to this difference is
the relatively equal income distribution in Asian countries while their counterparts in
Latin America suffer extreme inequalities in this sphere. This factor, although not the
only one, has great influence on the ability to achieve rapid adjustment of fiscal and real
exchange rate positions which are needed to avoid bottlenecks.
A point that deserves attention here is that differences in economic performance
do not stem from the widely dissimilar fiscal disciplines. The example of Korea can be
invoked to argue this point. Korea experienced external shocks and debt service
problems in 1981.2 These problems were not very different from those that run rampant
in Latin American nations. The difference is how the adjustment to these shocks takes
place. Korea’s startlingly rapid adjustment process contrasts sharply with the case of,
say, Brazil which is still suffering the consequences of hyperinflation.
We can consider a simple model of the aforementioned adjustment problem. This
model3 is going to delineate the extent to which a government offsets or dampens an
inflationary shock. We start by specifying a loss function, L, which the government then
has to minimize:
L = ( i t - i t ') 2 +AA2 / 2.
Here, it signifies the actual rate of inflation while it' signifies its historical rate; X
denotes the marginal political cost of adjustment while A is the adjustment effort. The
actual inflation, it, which depends in part on the adjustment effort that the government
2 Dombusch, Rudiger, and Alejandro Reynoso, "Financial Factors in Economic Development" in
Rudiger Dombusch, ed., Poliq/makmg in the Open-eccmomy, Washington: Oxford University Press,
1993.
3 This model was adopted from Dombusch, 1993, p. 74.
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7
expends to counter the effects of an inflationary shock and is, therefore, directly affected
by government actions, is defined as:
7 T = 7r‘ + A - Q A /2
where A is the shock (these are discussed below) and 0 is a constant. Then the inflation
under the optimal adjustment effort will be:
n = n + aA. a = A/(A + 0 2 / 2)
This definition of a would differ across countries. If the marginal political cost of
adjustment (A) is high and if adjustment is not very effective in reducing the inflationary
impact of shocks, i.e., 0 is small, the adjustment effort expended is going to be small
which would therefore mean that the rate of inflation will be high. Thus, inflation would
rise over time which would cause the inflation performance of different countries to
differ over time.
The shocks and the media through which they thrust inflationary pressures are
now discussed. There are two characteristics of the high-inflation process.
1. Money Creation: This involves the creation of money to finance the deficit. However,
when high deficits exist, a slight increase in the deficit results in a significant rise in the
inflation rate needed to finance the budget. Also, a higher inflation rate is associated with
a given deficit the more sophisticated the financial structure of the country. Thus
inflationary finance becomes a plausible choice under repressed financial systems.
Lastly, growth dampens the impact of inflationary finance. This means that a drop in real
income growth can therefore lead to higher inflation. These ideas are formalized in
model form by Dombusch and Reynoso (1993) as follows:
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lL = P g (< P + VX),
8
where q > and 7 7 are parameters of the velocity equation, P is the fraction of the deficit
financed by money creation, and the budget deficit, g, is a fraction of real income. Here,
jj. is the growth rate of high-powered money. In steady state, the inflation rate is defined
as:
* = C P < pg - y ) /(i - P&8).
Here, y is the growth rate of output and we take the income elasticity to be unitary.
2. Indexation Arrangements: These increase the inflation rate as the periodicity of
adjustment becomes short. An inflationary shock such as a devaluation often prompts a
response involving a shortening of the indexation interval.
Some Causes o f High Inflation.
The most obvious impetus of high inflation is a lack of fiscal discipline.
However, the problem is further compounded by three other factors which, if they occur
concurrently, have the capability to significantly add to the gravity of the situation.
These are:
1. Debt Service Shock: This is most damaging in the case of countries where inflationary
finance is the rule. In the 1980s, many debtor countries experienced a break in the flow
of lending. This compelled them to discontinue their policy of financing their debts by
borrowing new money and financing at least part of the debt domestically. One option to
circumvent unpopular policies such as bringing about changes in taxes and current
spending was to finance the deficit by money creation. The outcome of this, however,
was high inflation.
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9
An additional consequence is the increase in real value o f external debt service in
terms of the tax base. This is due to the real depreciation that is needed to produce a
trade surplus. Basically what this means is that more tax dollars are required to offset the
cost of a dollar of interest payment
2. Financial Liberalization: This factor poses a no-win situation for the country. As
inflation rises, demands for liberalization also increase since a repressed financial system
only makes the social costs of inflation worse. However, liberalizing the system could
very well reduce the government’s revenue from money creation which implies that the
inflation rate would continue to explode. If this step is not undertaken, phenomena such
as capital flight could occur and further deteriorate the situation.
3. Exchange Losses and Quasi-Fiscal Deficits: Expanding fiscal deficits caused by
“exchange losses on exchange rate guarantees or exchange rate operations”4 of the central
bank as well as from the interaction of inflation and financial subsidies also contribute to
soaring inflation. Quasi-fiscal deficits are extremely inflationary because the printing of
money which nobody wants to hold is employed to finance them. This is further put into
perspective by taking into account the sheer size of quasi-fiscal deficits. Also, they are a
misallocation of resources.
Deficits and High and Unstable Inflation: The Effects.
Economic development is significantly influenced by the financing of large
budget deficits by high and unstable inflation. One of the most prominent of these is the
decrease in the number of resources available to the private sector as more and more of
these resources are appropriated by the government. Latin America, in the 1980s, was an
active user of inflationary finance. However, its experience suggested only a limited
scope of this approach while, at the same time, brought to the forefront the costs
associated with it when it goes wrong. Uncertainty triggers capital flight and the
4 Ibid., p. 79.
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10
misallocation of resources, both of which are largely responsible for giving rise to these
costs.
• Capital Flight and Dollarization:
Countries which experience high inflation and have a repressed financial system
lead to attempts by the asset holders to protect themselves by holding dollar-denominated
assets or simply moving their assets abroad. Capital flight is often a result of continued
negative returns on assets in past periods. In addition, an obvious overvaluation of the
exchange rate can also work as a trigger for capital flight.
To prevent this inevitable shift of assets, the banking system can offer dollar-
denominated (or dollar-indexed) deposits. Although there is substantial inertia associated
with asset holdings which prevents instantaneous dollarization following faulty policy, it
is difficult to effect a reversal once people’s assets are shifted into dollar denominated
deposits. Thus, even an inflation rate which has been brought under control does not
engender a reflow into local currency assets.
In the absence of the dollar-deposit option and in an atmosphere characterized by
economic and political instability, domestic asset holders resort to transferring their
holdings to real and financial assets abroad or transforming them into foreign currency
assets.
Governments encountering the risk of capital flight have several options to
prevent or dampen it.
1. Increasing interest rates on domestic assets;
2. Creating dollar-linked domestic assets; or
3. Using controls to contain capital flight.
The efficacy of (3) has often been subject to skepticism. The need for external capital
assumes a less pressing role if capital flight can indeed be prevented. This implies that
more resources are available for domestic absorption. Therefore, although there are risks
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11
associated with them, domestic dollarization and high interest rates can be plausible
alternatives. Thus, the inflationary effect of a given deficit becomes pronounced as these
alternatives substitute for assets that yield seigniorage.
Deficit financing could become an increasingly trying experience also as a
consequence of a rising interest rate. In such a situation, the governments have to
analyze and conclude whether capital flight or domestic dollarization has a lower
reduction in seigniorage associated with them. Capital flight is often favored over
dollarization as a policy option for governments since the large transaction costs involved
in the former could prevent some capital loss. This view is further buttressed by the
consideration of a tendency toward overvaluation of the exchange rate in the case of
domestic dollarization. This could occur as a result of preventive measures for banks
boasting large dollar deposits since a major devaluation would be no less than a serious
affliction for these financial institutions. In addition, high interest rates only temporarily
relieve governments by delaying the consequences of a continued large budget deficit. A
funding crisis becomes inevitable as the government loses its ability to roll over the debt.
• The Misallocation of Resources:
It is only natural to expect pervasive distortions in the economy as a result of
policies in response to accelerated inflation and due to the air of uncertainty that the issue
of inflation itself creates. Productive factors are utilized more for exploiting financial
opportunities instead of being directed toward effecting advances in production or trade.
Firms become compelled to contract their p lanning horizons. This is also accompanied
by reduced investment in productive assets in the corporate sector due to the increased
riskiness of such ventures. This results in firms holding more paper assets which become
a source of trade surpluses that finance capital flight or debt reduction.
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12
Domestic Public Debt and Inflation: A B rief Introduction
Rising debt levels around the world are a matter of increasing concern. Not only
do these have important implications for stabilization policy but, in the case of countries
bearing external debt liabilities, they also have the potential to create considerable
problems in dealing with foreign debt concerns. This does not imply that the debt
problem is confined to only developing countries. During the 1980s, the debt issue
moved to the forefront in many European countries since “debts were reaching perilous
levels.”s In 1989, Belgium, Ireland, and Italy all had debt-GDP ratios of close to or over
100 percent.
There are three main reasons that account for this general increase in
indebtedness. First, a noticeable increase in real interest rates which meant a rise in the
burden of interest payments to be financed either by larger non-interest surpluses or by
more debt. This was accompanied by lower growth rates in comparison to those attained
in previous decades. Finally, it took some time before countries were able to adjust their
budgets and to subsequendy direct surpluses to stop the further growth of debt
There are two main reasons for rising concern about the growth of domestic debt.
First, due to the growth of domestic debt, debt-service payments have increased sharply.
In countries that are already heavily externally indebted, this has meant a further
weakening in the government’s ability to service its external debt. Although Lebanon’s
external debt is relatively lower at present, its soaring domestic debt could discourage
much-needed external funds that the country requires to effect economic as well as
political reform. Higher debt-service requirements, for both domestic and external debts,
also increase the pressure on public sector investment. Although the Lebanese authorities
have successfully rehabilitated the basic infrastructure, they still have to address the
country’s pressing social requirements by investing in projects like public education and
5 Dombusch, Rudiger and Mario Draghi, Public Debt Management: Theory and History, Cambridge:
Cambridge University Press, 1990, p. 1.
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13
health services among others. This makes it essential for the government to resist any
adverse pressures on its ability for investment in the near future. Therefore, the need to
restore the waning confidence of creditors is absolutely necessary to safeguard the
government’s ability to continue to procure funds, both internally and externally, in the
future. Since growing debt is a huge source of this lack of confidence, it becomes
imperative that this issue be addressed as soon as possible.
In general, a second major reason for concern about the growth of domestic debt
is the sharp increase in the inflation rate which is a concomitant of higher debt burdens.
During the 1980s, many of the heavily indebted external countries experienced annual
inflation rates averaging over 200 percent. The rate o f inflation for the four largest debtor
countries (i.e., Argentina, Brazil, Mexico, and Venezuela) increased from an average of
3.9 percent per month during 1975-1981 to 9 percent per month during 1982-1988.
These are equal to annual rates of 65 percent and 235 percent respectively.6 In addition,
the variability of the average inflation rate also increased. The worsening performance of
inflation led to more uncertainty which further adversely affected investment and
growth.7 Due to high inflation, holding of non-interest-bearing assets also decreased
resulting in significant demonetization in some countries. In addition, there was also an
associated loss in welfare due to higher transaction costs. Also, many governments
suffered a fall in real value of tax revenues caused by collection lags.
These reasons also highlight the inimical nature of increased debt in the case of
Lebanon. If relatively moderate inflation is not used for debt reduction now, high
inflation with no debt-reducing effects would soon become a reality. The last chapter
also discusses how extremely high inflation would entrap Lebanon in a vicious cycle of
rising debt and inflation and pose a threat to both the social and economic stability of the
6 Guidotti, Pablo E. and Manmohan S. Kumar, Domestic Public Debt of Externally Indebted Countries,
Washington, D.C.: International Monetary Fund, 1991, pp. 5 ,7 .
7 Kormendi, Roger, and Phillip Meguire, "Macroeconomic Determinants of Growth: Cross-
Country Evidence," Journal of Monetary Economics, September, 1985, pp. 141-163.
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14
country. Also, the currently less important matter (in the Lebanese context) of falling
real tax revenues due to collection lags would also become more crucial if budgetary and
institutional reform is effected prior to dealing with the debt problem since more
dependency on tax revenues would increase the adverse impact of inflationary shocks
making it extremely difficult for the government to function effectively.
Large also debts have the quality of making creditors shy away which means that
the government has to make concessions in order to be able to borrow further. These
concessions could include a shortening of maturities. However, shorter maturities are
associated with the risk of a funding crisis. Although higher interest rates overcome this
problem in principle (since they compensate the lender for the risk from the present in the
future), they speed up the growth of the debt itself. According to Dombusch and Draghi
(1990), this leads to insolvency sooner or later, increasing the possibility of the market
simply drying up. Ultimately, as the government becomes unable to sell debt, it is forced
to resort to inflationary finance.
Wariness among creditors translates into an absence of credit given that the
perception of risk is really acute. The public starts to put a high probability on future
inflation. Thus, large debts are viewed as harbingers of inflation hikes. As the debt
grows, the government keeps on running out of options to deal with it and is eventually
left with inflation as the only plausible method of alleviating indebtedness. In present-
day Lebanon, expectations of high inflation would discourage lenders and reduce the
country’s chances of obtaining foreign aid. In case of probable instability, any foreign
financial assistance would, most likely, serve the purpose of stabilizing the economy
which would not necessarily mean that the funds would contribute to Lebanon’s
development The destabilizing effect of large debts is evident from the Israeli case of
the 1970s and 1980s where huge debts were accompanied by extreme inflation and
massive unemployment. Any policy, or its lack thereof, that could bring Lebanon to the
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15
brink of instability has to be checked immediately in order to avoid disturbing the
existing fragile social balance.
A less extreme possibility is that of large debts becoming an impediment in the
way of effective monetary policy. As interest rates rise, debt expands since interest adds
to the debt making monetary restraint difficult to be exercised.
Another issue, that of similar total debt-GDP ratios in many developing and
industrial countries, is now discussed. Despite comparable debt-GDP ratios, only the
developing countries were faced with debt crises in the recent past An explanation for
this could be that future expected primary surpluses are larger in industrial countries. It
has been argued that the ability of the industrial countries to raise additional revenues is
higher than that of developing countries. This is imputed to more effective tax collection
in industrial countries and differences in structural factors between the industrial and
developing countries.8 Thus, higher debt in developing countries automatically becomes
more perilous due to such factors. It also underscores the importance of reducing and
controlling the growth of debt in Lebanon prior to the implementation of structural
reforms in the public sector since the above argument suggests that such reforms in a
developing country could have a significant impact on the public sector’s
creditworthiness. Although this would facilitate in borrowing funds, it would continue to
raise the debt and higher debt, due to its implications discussed earlier, would soon lead
to a drying up of these funds. It is, therefore, necessary to address the debt issue first to
ensure that the ability to borrow is maintained in the long term.
Inflation can be used to reduce the real value of nominal government debt. In a
country like Lebanon, where the contribution of direct taxation in government revenues is
low and tax evasion is rampant, the likelihood of inflation being used as an instrument for
debt reduction becomes even higher. However, inflation is effective only if it takes the
8 Reisen, Helmut, "Public Debt, North and South," in Dealing with the Debt Crisis, ed. by Ishrat
Hussain and Ishac Diwan, Washington, D.C: The World Bank, 1989, pp. 116-127.
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16
public by surprise. This is because if inflation is expected, a nominal return will be
required by the bondholders so that their expected capital loss due to the decrease in the
real value of nominal debt can be made up. A simple rise in the nominal interest rate in
response to anticipated inflation does this job. This reduces the effectiveness of inflation
to a m inim um with regard to its objective o f debt reduction since the real return actually
paid on the public debt will be the same as it would have been in the absence of the new
inflation. Thus, for it to have an effect, inflation has to reduce the real rate of return to a
level below what is available in international financial markets. In an ideal case,
inflation would create a negative real rate of interest. An attractive feature of an
inflationary approach to debt reduction is that, in the short-run, policymakers get the
luxury of avoiding tax-rate increases or reductions in expenditure.
It should be noted, however, that large stocks of nominal public debt are
destabilizing precisely because of this temptation to manufacture inflation to get rid of or
at least to shave off part of the public debt. The problem assumes grave proportions if the
government’s ability to successfully implement a stabilization program is in doubt. In
such a case, the public anticipates inflation which causes the nominal interest rates to rise.
However, this increase in the interest rates only makes the debt even larger which further
fuels fears of inflation. But inflation as a tool for debt reduction becomes even more
costly to the economy and society at this point. Thus, undertaking the inflationary
approach to debt reduction is more feasible in the earlier stages and before the debt
spirals out of control and thrusts the economy toward destabilization.
The Role and Influence of Exchange Rates in the Economy
A key linkage between a small, open economy and the rest of the world are
exchange rates. These can be thought of as the price of foreign currency in terms of
domestic currency. Linkages exist at both the micro- and macro-economic levels.
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Macroeconomic linkages between a country and the rest of the world occur in two
ways. The first are linkages established between domestic prices and the given prices in
the rest of the world. This implies that the higher the exchange rate and other things
being equal, the price of foreign goods would be higher in domestic currency. While this
makes foreign goods less competitive domestically, it has the influence of increasing the
competitiveness of local goods abroad. The linkage has been expressed by Dombusch
(1993, p. 92) as follows:
R = P / eP£.
Here, R is the real exchange rate and is the ratio of domestic prices (in, say, Lebanese
pounds) to foreign prices (also in Lebanese pounds), P is the domestic price level (again
in Lebanese pounds), e is the exchange rate (e.g., Lebanese pounds/dollar), and P£ is
the foreign price level (in dollars). This is essentially a measure of competitiveness since
it shows the number of units of foreign goods required to buy one unit of domestic goods.
This implies that, with a real appreciation, there is a loss in competitiveness while a real
depreciation suggests a rise in competitiveness. Similarly, a decline in the real exchange
rate we get a real depreciation which makes the domestic economy more competitive.
This is due to the fewer number of units of foreign goods that are required to buy one unit
of domestic goods.
It is interesting to note that R would appreciate in the case where a country is
pursuing an inflation policy with fixed exchange rates. Competitiveness decreases and
governments are faced with the problem of financing a growing trade deficit. This
analysis suggests that an overvaluation should be avoided.
Another issue is that a depreciation of exchange rates often leads to rising
domestic price levels which means it has inflationary consequences. The direct effect
here is a price increase of foreign goods in domestic currency. Moreover, a tendency
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18
exists amongst domestic firms to increase their prices as the competition raises the prices
of its products. Another indirect effect is the possibility of demands for higher wages by
workers which could result from higher import prices raising the cost of living. This
intimates toward a strong relationship between exchange rate movements and inflation
policy.
In the case where the government buys foreign exchange at a high price from
exporters and sells it at a low price to importers, the result is a budget deficit. Two
options available to finance this budget deficit would be higher taxes or inflationary
money creation. This impact on the budget further strengthens the assertion that a
significant relationship between exchange rate regimes and inflation exists.
Regarding the asset market, domestic wealth holders have to decide how to hold
their wealth. The choices range from holding real assets or claim s on real assets to
holding domestic financial assets which include deposits at banks and government bonds.
They also have the option of holding a plethora of foreign assets which, in the case of,
say, Lebanon, could be deposits in banks in Switzerland or holding US Treasury bills.
This choice would depend on the effective risk and return considerations. For example, if
foreign assets yield a higher return in domestic currency than do domestic assets without
having extra risk associated with them, many domestic assets will eventually transfer into
foreign assets.
On the other side, microeconomic linkages of exchange rates are concerned with
resource allocation. When exchange rates make the economy highly competitive, exports
rise and imports fall as more resources enter the tradable goods sector. A reallocation of
resources also takes place in the factor markets. In short, when the real exchange rate is
highly competitive, both the trade-orientation of the economy as well as the employment
of capital and labor in the export and import-competing sectors rise. The case is quite the
opposite when the real exchange rate is highly uncompetitive.
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Deficits, the Current Account, and the Real Exchange Rate.
To look at the relationship between fiscal deficits and the current account we
assume net private savings a given and consider the following equation.9
D, = (If- Sf ) = (Sf — If) + CAt.
Here, (If - S f ) represents public deficits, (Sf - If) are surpluses from the private
sector, and CAt is the current account deficit
The type of effects of large public deficits on the macroeconomy are determined
by the adjustment process which the components of the equation undergo. This
adjustment is dependent upon the “scope for domestic and foreign financing, the degree
of diversification of financial markets (which determines to some extent the choice
between money or bond financing), and the composition of the deficit.” 1 0 Furthermore,
the transmission of fiscal deficits is also influenced by expectations about future
government policies.
A strong correlation between fiscal deficits and current account deficits may exist
in a case where there is limited opportunity to borrow internally. This implies that a
limited opportunity of external financing necessitates either fiscal adjustment or a rise in
inflation or seigniorage revenue. This occurred in several developing countries following
the debt crisis.
A formulation linking fiscal deficits, external deficits, and the real exchange rate
was put forward by Carlos Rodriguez (1991). The real exchange rate is determined by
the external deficit that is in line with the clearing of the market for non-traded goods.
Such models incorporate the feature that the effect of deficits (or fiscal policy) on the
9 Agenor, Pierre-Richard, and Peter J. M ontiel, Development Macroeconomics, Princeton, NJ:
Princeton University Press, 1996.
1 0 Ibid., p. 126.
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current account and the real exchange rate is influenced by both the level and the
composition of public expenditure.
Recent studies have postulated a positive relationship between large fiscal deficits
and large external imbalances. One of these studies was conducted by Khan and Kumar
(1994) which analyzed the role of public deficits, in conjunction with other domestic and
external variables, in the determination of the current account for non-oil developing
countries. Data for forty two countries over the 1970s and 1980s was used. The authors
concluded that the budget effect of fiscal deficits on current accounts is highly
significant. This effect was greatest for African and Middle Eastern nations. The
relationship was also strong for countries with the most diversified export base.
Therefore, these studies suggest that fiscal policies are often connected with a worsening
in the current account of the balance of payments.
The Political Economy of Government Debt
Public debt policies not only vary from one country to another but also differ
within a country in different periods of time. In a democratic nation, fiscal policy is
chosen directly by the voters under majority rule. However, the political majority lacks
stability over time and the precise nature of political instability is responsible for giving
shape to equilibrium debt policy.
Different political majorities differ in their desired level of government
consumption. Thus, in a case where the current majority issues public debt, it can
provide the future majority “incentives to bring public consumption in the direction the
current majority prefers.” 1 1 Therefore, the relationship between the alternating majorities
defines the equilibrium public debt policy. In a case where the majorities differ in their
desired composition of government consumption and given that the current majority can
1 1 Persson, Torsten, and Guido Tabellini, Macroeconomic Policy, Credibility and Politics, Chur,
Switzerland: Harwood Academic Publishers, 1990, p. 154.
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21
be replaced by another in the future, the current majority would favor budget deficits.
This implies that in a country marred by political instability, a phenomenon labeled
“collective myopia” by Persson and Tabellini (1990) would occur despite the fact that
each voter is a rational decision-maker.
Budget Deficits and Budget Institutions.
The last thirty years have seen many OECD countries accumulating large public
debts. A notable concomitant of these accumulations has been a conspicuous
transformation in the composition of government outlays. This is in contrast with twenty
years ago when purchases of goods and services accounted for most of the governments’
expenditure. Now, however, transfer payments constitute a growing percentage of total
government spending. This makes fiscal adjustments in the face of high debts
particularly difficult since transfers are hard to cut.
“Budgeting institutions are all rules and regulations according to which budgets
are drafted, approved and implemented.” 1 2 As mentioned earlier, institutions vary across
countries as well as over time. There is a strong proclivity to remain with the existing
institutions since it is very costly and complex to change them. Therefore, it is usually
only in the long run that institutional change takes place.
Institutions are divided into two types: laws that impose numerical targets on the
budget, and procedural rules.
• Balanced Budget Laws:
These are the most popular form. However, research suggests that a balanced
budget law would not be optimal. One argument which supports this view is the tax
smoothing theory of budget deficits (Barro (1979), Lucas and Stokey (1983)). This
1 2 Alesina, Alberto, and Roberto Perotti, "Budget Deficits and Budget Institutions," National
Bureau of Economic Research, Working Paper 5556, May 1996, p. 3.
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theory proposes the use of budget deficits and surpluses to “smooth” the distortionary
cost of taxation. Thus deficits should be allowed in times of exceptionally and
temporarily high spending. This could be during wars, natural calamities, emergencies,
etc. The same approach is advised when revenues are temporarily low as in times of
recession.
It is clear now that a law requiring a balanced budget in every year would limit
the gainful use of budget deficits and surpluses. A solution to this problem could be
escape clauses to permit, for example, a certain amount of tax smoothing. However, any
rules that are appended have to be simple since complicated rules invite highly distorted
policy-making which results due to attempts made to circumvent the rules.
Alesina and Perotti (1996) argue that balanced budget laws at the national level
are neither necessary nor sufficient to insure fiscal discipline. They add that although
appropriate procedures may allow for flexibility on the budget front without jeopardizing
fiscal discipline, numerical targets for these procedures may be wholly unnecessary.
• Procedural Rules:
The budget process generally consists of three stages:
1. The formulation of a budget proposal (executive branch);
2. The approval of the budget (legislature); and
3. Implementation of the budget (bureaucracy).
An important issue related to these stages is the voting procedure(s) which leads
to the formulation and approval of the budget. This is important because these
procedures determine who (and when) has an influence on the final budget outcome.
This issue is related to the degree of transparency of the budget. Even the most stringent
voting procedures can be side-stepped using “creative budgeting.”
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We can characterize two types of institutions. These are:
1. Hierarchical: The democratic accountability of the budget process is limited. For
example, strong prerogatives could be attributed to the Prime Minister (or the Finance or
Treasury Minister) to overrule other spending ministers on the formulation of the budget.
In addition, the legislature has limited power to change the budget proposed by the
government. Although these type of institutions are less respectful of minority rights
they are more successful in enforcing fiscal restraint, in avoiding large and persistent
deficits, and in implementing fiscal adjustments more promptly. A country with a high
debt-GNP ratio is, therefore, often advised to employ hierarchical institutions when
planning institutional reforms.
2. Collegial: The emphasis here is on the democratic rule. These include prerogatives of
spending ministers and the legislature, and the rights of the minority opposition in the
legislature.
Central Bank Independence.
Until fairly recently, Central Banks were considered to be an integral part of the
Government’s central policy-making machine and often times were under the direct
leadership of the Prime Minister. This picture, however, is changing. Not only have
countries like South Africa and New Zealand granted their Central Banks formal
constitutional independence from the executive branch but the phenomenon has caught
on even in South America where Venezuela and Chile have followed suit. Historically,
Germany and Switzerland have had Central Banks which have enjoyed immense amount
of independence and much of Europe is now moving toward the same degree of
constitutional independence. The purpose is, of course, the improvement of economic
performance.
During the 1970s and 1980s, governments used monetary policy as a medium
term instrument to control inflation while using fiscal stabilizers, or supply side
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measures. The consequences of this strategy were mixed as inflation came down but
only at a severe short-term cost in terms of higher unemployment. This was indirectly
attributed to the short time-horizons of the politicians who could use a reverse strategy
especially in times before elections. Thus, the solution posed for such a problem was to
establish an independent body which would have a longer time-horizon as well as posses
the technical expertise to conduct medium-term counter-inflationary policy. The easiest
way to meet this end was to propose the granting of independence to Central Banks. It
should be noted that by independence, it was not always implied that the Central Bank
would be independent in pursuing any objective— it could be tied down by well-defined
objectives but would have autonomy over the powers needed to achieve those objectives.
An added bonus of this strategy was that such an institution would be more
democratically accountable than a subservient Central Bank. Econometric results bear
witness to the fact that autonomous Central Banks are generally more likely in effecting
lower inflation rates. This is especially true in the case of Germany and similar signs are
apparent in the cases of Chile and New Zealand, countries which have made the
transition to independent Central Banks fairly recently.
As was the case with budget institutions, autonomous Central Banks also need a
certain amount of flexibility in the policy objectives proposed for them. This is because
rules that are drawn too tightly can become unacceptable in the face of unforeseen
contingencies. However, Central Bank independence would have a constraint imposed
upon it in the form of override powers which the government would retain. These
powers would usually be intended to be used only in emergencies. In general, the
constraint would manifest itself in the need for the Central Bank to maintain at least a
sufficient degree of political support to maintain its autonomy.
One policy instrument which most governments are loath to give up, the degree of
the independence of their Central Bank notwithstanding, is the right to take strategic
decisions on the exchange rate regime. In the US, matters concerning exchange rates are
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25
decided by the Secretary of the Treasury and not the Chairman of the Fed. This leaves
only interest rate decisions in the hands of the Central Bank. This makes it almost
impossible to address two objectives simultaneously, e.g., exchange rate objectives
(external) and price stability objectives (internal). This has led to many small open
economies (e.g., Luxembourg) with Central Banks that have focused their attention on
external rather than internal objectives. Central Banks can be further constrained if the
country’s politicians agree to the establishment of an exchange rate regime.
In a democratic setup, what really matters are the priorities, perceptions, and
beliefs of the general public. Central Bank independence may be a viable option
assum ing that it would influence those same priorities and perceptions more significantly
than an institution controlled by politicians.
This study briefly delineates the organization and structure of the Banque du
Liban, which is the Lebanese central bank, in the thrid chapter.
Literature and Sources
This study benefited from articles and studies appearing in specialized as well as
popular journals like The Middle East, Middle East Report, The Middle East Journal, and
The Economist. In addition, various IMF staff papers provided crucial support. Most of
the relevant data was derived from IMF Financial Statistics and Banque du Liban’s
Quarterly and Monthly reports.
Scholarly work in the form of books relating to the subject also provided
extensive sources in addition to reports of international agencies and web pages of
pertinent institutions.
Organization
In chapters two and three, I study the structure and performance of the Lebanese
economic system. Chapter three also focuses upon the organization and structure of the
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Banque du Liban, which is the Lebanese central bank. Chapter four is dedicated to
quantifying the relationship between inflation and exchange rate movements. Finally,
chapter five discusses the use of inflation for debt reduction with an application to
Lebanon.
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Chapter 2: An O verview o f the Lebanese Economy
For a whole year
The regiment didn't turn up.
A t the War Ministry
It was reported lost.
The search was abandoned
When suddenly one morning
It appeared in the square,
The Colonel still at its head.
- La Chanson du Colonel
To m ake the theory presented in the previous chapter cognizant in the
context of Lebanon, it is im perative to grasp the basic characteristics of the
Lebanese econom y. Thus, this chapter seeks to outline th e economic
structure of Lebanon and its developm ent since 1950. This outline is in two
parts. The first p a rt covers the pre-civil w ar years (1950-1974) while the
second p a rt addresses the changes to the econom ic structure since the civil
w ar.
H ow ever, before addressing these issues, a brief introduction to the
general character of the Lebanese society w ould be salient. Lebanon, a sm all
country w ith an area of approxim ately 4,000 square m iles, gained
independence from France after W orld W ar n . A lthough the state's
sym pathies gravitate tow ard the A rab w orld and it is A rab in its fundam ental
cultural bases, it is different from other Arab countries in several respects.
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L ebanon's m ost distinguishing characteristic is its significant Christian
population. In addition, its exposure to w estern culture, especially French
culture, has spanned centuries an d French serves as a second language for
m ost educated people. The country is prim arily a commercial nation w ith
the economic life of the country being higly dependent on the outisde w orld.
Religion plays an im portant p a rt in Lebanese society and directly
influences econom ic, political, and educational activities. C hristians,
M uslim s, and D ruzes are the m ajor religious groups in Lebanon. A lthough
according to the last census, w hich w as conducted in 1932,53 percent of the
population w as C hristian, 39 percent M uslim , and 8 percent others (m ainly
Druzes), m ore recent estim ates p u t the M uslim percentage at over half of the
total population, w ith the C hristians accounting for about 40 percent, w ith 6
percent belonging to other faiths. In 1997, these estimates stood at an
overw helm ing 70 percent M uslim s (including the Druze) and 30 percent
C hristian .1
The president, w ho has to be a M aronite Christian by law , had the m ost
pow er over the affairs of the state until 1991. N ot only did he enjoy executive
and legislative pow ers, b u t had also been responsible for the appointm ent of
Cabinet m em bers, of the Prim e M inister, the negotiation of treaties, and the
initiation of law s and constitutional revisions. How ever, the post-civil w ar
order curbed these pow ers granting m ore authority to the state's prim e
m inister w ho, by law , has to be from the Sunni M uslim com m unity.
Lebanon has been a refuge for num erous and different groups
throughout history. As a result, it has suffered from political disunity and
1 Central Intelligence A gency, CIA World Fact Book.
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29
internal strife m ainly in religious, ethnic, and economic forms. The citizens
of the country have rarely suscribed to feelings of of loyalty to a Lebanese
nation. Instead, loyalties to a group o r sect take precedence over nationalistic
sentim ents. Thus, in 1975, civil w ar broke out as a result of a w idespread
feeling of dissatisfaction and hatered betw een com m unities due to a sense of
unfairness and unequal distribution of resources of the country.
After W orld W ar II, Lebanese leaders reached an understanding
know n as the N ational Pact. A lthough this brought about stability in the
short run, it also m ade possibilities of an eventual crisis quite real. This w as
because the Pact m ade sectarianism into a political system w hich finally broke
dow n in 1975. The N ational Pact im plicitly believed th at the C hristians as a
m inority in the broader picture of the w hole Arab w orld needed special
political rights and privileges to protect their positions and interests. Thus, in
the absence of the requisite political ideology, the breakdow n in 1975 was only
an im pending disaster.
Due to the sectarian nature of Lebanese politics, every com m unity
leader was expected to su p p o rt his com m unities interests. Thus, the
M aronite President w as expected to cham pion M aronite interests w hile the
M uslim Prim e M inister w as expected to do the sam e for M uslim interests
sow ing the seeds of perennial conflicts. This further eroded any sense in
Lebanese citizens of belonging to the nation and strengthened loyalties to
their ow n groups. C orruption and string-pulling (zvasta) thus becam e a norm
in every sphere, be it econom ics or politics.2 Keeping this social context in
2 El Jisr, Basim, ad-Dimogratiya fi Lubnan (Democracy in Lebanon), A1 Misri Press, 1978, p. 94.
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30
m ind w hile review ing any situation in Lebanon is beneficial to a better
u nderstanding of the country.
The Pre-Civil War Period: (1950-1974)
The pre-civil w ar era w as characterized by a healthy rate of grow th.
This rate w as 5.9 percent for the 1950-1960 period while a higher average
grow th rate of 6 .8 percent w as m aintained betw een 1950-1974.3 Table 2-1
below presents changes in N N P, per capita real income, GDP, and GNP
betw een 1950-1974.
T able 2-1
Changes in N N P, Per C apita Real Incom e, GDP, and GNP, 1950-1974
_________________ (M illion LL = Lebanese Pounds)_________________
Year N N P Per C apita
Real Incom e
GDP GNP
1950 1042 781 — —
1951 1086 644 — —
1952 1115 692 — —
1953 1168 800 — —
1954 1256 915 — —
1955 1374 971 — —
1956 1417 933 — —
1957 1503 951 — —
1958 1325 810 — —
3 M allat, Raymond, Fiscal Policy for Social Justice and Economic Development in Lebanon,
Beirut: A leph, 1980, pp. 81, 85. These growth rates are for the N et National Product (NNP)
at current prices. The average annual growth rate w as 4.9 percent betw een 1960-70 in terms
of GDP.
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Table 2-1 (continued)
Year N N P Per C apita
Real Incom e
GDP GNP
1959 1500 887 — —
1960 1800 1059 — —
1961 2 0 0 0 1136
— —
1962 2120 1 2 1 0
— —
1963 2247 1215
— —
1964 2861 1481 3200 3055
1965 3154 1577 3523 3368
196 6 3460 1642 3867 3695
1967 3443 1525 3820 3694
1968 3862 1684 4273 4125
1969 4112 1661 4565 4383
1970 4411 1683 4866 4686
1971 4854 1778 5398 5183
1972 5436 1840 6365 6106
1973 6062 1888 7100 6788
1974 6959 1912 - 8137
Source: M akdisi, Samir, Financial Policy and Economic Growth: The Lebanese
Experience, New York: Colum bia U niversity Press, 1979, p. 143; M allat,
R aym ond, Fiscal Policy for Social Justice and Economic Development in Lebanon,
Beirut: A leph, 1980, pp. 82-3.
Table 2-2 below helps glean a m ore general view of Lebanese economic
grow th.
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Table 2-2
G row th Rates by Period of Five years, 1950-1974
Period % Average G row th Rate
of NNP a t C onstant
Prices
% A verage Increase per
C apita Real Income
1950-1955 7.4 4.9
1955-1960 4.4 1 .8
1960-1965 13.7 9.8
1965-1970 4.1 1.3
1970-1974 6.3 3.6
Source: M allat, Raym ond, Fiscal Policy fo r Social Justice and Economic
Development in Lebanon, Beirut: Aleph, 1980, p. 84; D ahi, Naji Jaw dat, The
Tertiarization of the Lebanese Economy: The Transition from Feudalism to Capitalism
and European Commodity Export, Ph.D. D issertation, D epartm ent of Political
Science, U niversity of Southern California, 1994, p. 22.
m
From the table, w e can see that the highest grow th in N N P and increase in
real per capita income w as achieved d u rin g the 1960-1965 period. However,
since the percentage increase in per capita income cannot be used to m easure
income distribution, the Gini coefficient index is considered here. A lthough
Lebanon w as ranked am ong the m iddle income countries w ith $454 per
capita, it w as also categorized as being am ong the high income inequality
countries w ith a Gini coefficient index of 0.52.4
A t this point, it w ould be appropriate to discuss the m ake up of the
various sectors of the econom y based on religious origin. M ore specifically,
data is provided about the religious origins of business leaders in the major
* A hluwalia, Montek, "Dimensions of the Problem," in H. Chenery, D uloy, and Jolly, eds.,
Redistribution with Growth: An Approach to Policy, W ashington, D.C.: IBRD, 1973.
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33
sectors. Data is adopted from a 1957-1958 study conducted by the Economic
Research Institute at the Am erican U niversity in Beirut. This study included
207 business leaders, all of w hom w ere innovators in their respective fields.
Table 2-3 below presents the results.
Table 2-3
D istribution of M en in Each Sector by Religion, 1957-1958
Sector Total N um ber R eligion
A griculture 16 10 Christians
6 M uslim s
Industry 130 105 C hristians
21 M uslim s
3 Jews
1 D ruze
Finance 14 11 Christians
2 M uslim s
1 Jew
Services 47 40 C hristians
5 M uslim s
2 Druzes
Total 207 166 C hristians
36 M uslim s
4 Jews
3 D ruzes
Source: Asraoui, Fadi, Social and Political Factors in the Lebanese Economy, MA
Thesis, D epartm ent of Economics, U niversity of Southern California, 1985, p.
61.
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34
The results underscore the discrepancy betw een this distribution an d
the population as a w hole. W hile only half the population belonged to the
C hristian faith in 1957-1958, four fifths of the respondents w ere C hristian.
Equally striking are sim ilar figures for the M uslim s. A lthough 44 percent of
the population was M uslim , only one sixth belonged to the entrepreneurial
group. For the Druze, the figures stood at 1.5 percent of the respondents and
5.6 percent of the population. The Jew s, w ho w ere a m ere 0.1 percent of the
population accounted for 1.9 percent of the business leaders. The change in
this com position after the civil w ar and its effects are discussed under the
section covering the Lebanese econom y since th e civil war.
The structure of the Lebanese econom y is characterized by a m uch
higher rate of developm ent of the service sector (which includes trade, real
estate, finance, transport, and governm ent) th a n of the agricultural an d
industrial sectors, both of w hich are considered to be part of the "production"
sector. As an example, w e can consider the sectoral share of income earn ed by
the trade sector which w as 28.8 percent in 1950, the highest of any sector in
Lebanon, com pared to figures ranging betw een 8 and 18 percent for the sam e
sector in m ost other countries. Table 2-4 below provides a clearer picture of
sectoral shares in the economy.
Table 2-4
Percentage Share in N et N ational Product by Sector
1950 1954 1957 1964 1968 1970 1974
A griculture 19.7 18.0 15.8 1 1 .8 1 0 .2 9.1 9.4
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35
Table 2-4 (continued)
1950 1954 1957 1964 1968 1970 1974
Ind u stry 13.5 13.2 12.5 1 2 .8 12.9 13.6 14.1
C o nstruction 4.1 4.7 2.7 5.6 4.5 4.5 4.4
TOTAL
PRODUCTION
SECTOR
37.3 35.9 31.0 30.2 27.6 27.2 27.9
T rade 28.8 29.3 31.2 32.0 31.8 31.4 32.0
Real Estate 9.2 8 .8 9.2 7.9 7.8 8 .8 9.1
T ran sp o rt 4.1 4.7 5.3 8 .1 8.9 8.3 7.4
F inance 3.8 4.5 6 .0 3.4 3.9 3.4 3.1
Services 9.6 10 .6 9.8 10.7 1 1 .6 1 2 .2 13.4
G o v e rn m e n t 6.9 5.8 7.2 7.7 8.4 8.7 7.1
TOTAL
SERVICE
SECTOR
62.4 63.7 68.7 69.8 72.4 72.8 72.1
AGGREGATES 99.7 99.6 99.7 100 100 1 00 100
Source: M allat, Raymond, Fiscal Policy for Social Justice and Economic
Development in Lebanon, Beirut: A leph, 1980, p. 74-8; D ahi, Naji Jaw dat, The
Tertiarization of the Lebanese Economy: The Transition from Feudalism to Capitalism
and European Commodity Export, Ph.D. D issertation, D epartm ent of Political
Science, U niversity of Southern California, 1994, p. 24.
From the table, we can see that betw een 1950 and 1974, the share of the
agricultural sector in N N P fell from 19.7 percent to 9.4 percent. The industrial
sector, o n the other hand, m aintained a m ore or less steady share by recording
only a sm all increase of 0.6 percent betw een 1950 and 1974.
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36
The service sector experienced a steady increase in its share of the NNP
and reached its apogee in 1970 w hen it accounted for 72.8 percent of NN P
w hich w as m uch higher than the 1965 average of 46 percent of N N P in
m iddle-incom e econom ies .5 L ebanon's specialization in services allow ed it to
take advantage of it unique position in the region. It should be noted,
how ever, that these high figures attributed to the service sector w ere not a
result of domestic needs and dem ands. Instead, Lebanon's role as a regional
interm ediary and external dem and for such activities account for these
figures. Indeed the prim acy of Lebanon's service sector is evident from the
fact that, in 1965, an estim ated " 6 8 percent of the value added in the service
sector w as sold to foreign custom ers," w hich was equivalent to roughly 32
percent of GDP. Also, during 1964-1972, Lebanon's current account deficit
averaged only 5.5 percent although its trade deficit h ad averaged 25.4 percent
over the sam e period. It was this feature of the Lebanese econom y that held
the share of agriculture and industry dow n at 30 percent of GDP.6 Between
the years 1950 and 1974, the share of the productive sector w ent dow n from
37.3 percent to 27.9 percent w hile the service sector increased their share by 9.7
percent during the sam e period.
A lthough the direct contribution of the financial sector to GDP m ay not
have been large— it stood at 3.4 percent in 1970— it was exceedingly im portant
d ue to its part in channeling large flows of foreign capital into the country.
5 Bisat, Amer and Mohamad L. Hammour, "Economic Prospects for a Postwar Lebanon," in
Stanley Fischer, Dani Rodrik, and Elias Tuma, eds., The Economics of Middle East Peace:
Views from the Region, Cambridge, MA and London: The MIT Press, 1993, p. 159.
6 Nasr, Salim, "The Crisis of Lebanese Capitalism," MERIP Reports 8, no. 10, December,
1978, p. 3.
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37
D uring the 1964-1972 period, n et capital inflow s averaged 11.2 percent of GDP
and indirectly financed m ore th an half of dom estic investm ent. Figures for
gross private dom estic investm ent to GDP du rin g this period w ere 20.6
percent.7 Funds usually came from the oil econom ies of the region,
Lebanon's politically unstable neighbors, as w ell as from Lebanese em igrants.
The extent of financialization of the econom y can be gauged from the total
deposits to GNP ratio w hich w as 101 percent in 1974.8
C om plem enting this dom inance of the service sector w as the crucial
role of the banking sector. Before the civil w ar, Beirut w as the unparalleled
center for banking in the M iddle East w ith its free exchange system , secrecy
laws, and strong currency. All of this attracted a w ide variety of financial
institutions and custom ers. The ability of the local banks to fulfil the specific
needs of regional businessm en only raised the sector's popularity. It w as the
banking sector that provided resources for trading and other activities not
classified as being p a rt of the "production" sector. The m ounting im portance
of the banking sector can be gathered from the rise in real bank deposits
w hich increased from LL 216 m illion in 1950 to m ore th an one billion in 1960,
and reached LL 7,307 m illion in 1974. As a percentage of national incom e,
nom inal deposits rose from 20 percent in 1950 to more th an 104 percent in
1971.9 These figures, w hich are higher than th at for any other developing
7 Bisat and Hammour, pp. 161,176.
8 Haseeb, Khair El-Din, and Samir M akdisi, eds., Arab Monetary Integration: Issues and
Prerequisites, London: Croom Helm, 1980, p. 128.
9 Dahi, Naji Jawdat, The Tertiarization of the Lebanese Economy: The Transition from
Feudalism to Capitalism and European Commodity Export, Ph.D. D issertation, Departm ent of
Political Science, U niversity of Southern California, 1994, p. 26; author's calculations.
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38
country, testify to L ebanon's im portance as an interm ediary betw een the
developed an d the Arab countries.
D uring this period, b ank credits in Lebanon w ere distributed in favor of
trade w ith agriculture an d in d u stry receiving relatively little attention. W e
can consider th e year 1972 as an exam ple. Credit to the service sector in the
econom y accounted for roughly tw ice as m uch as d id the productive sectors.
A staggering 54.1 percent of credit w as aw arded to the trade sector com pared to
only 20.7 percent to both agriculture and industry com bined .1 0 In addition, 60
percent of all credits w ere given by foreign banks in 1972. These banks had 57
percent of all deposits. Lebanon's banking landscape was defined by the
presence of 84 W estern banking institutions at a tim e when the total num ber
of banking institutions in the country stood at 114.1 1 Supplem enting the
figures m entioned above is the fact th a t Lebanon w as an unrivalled transit
route handling 60 percent of the Syrian im ports, 45 percent of the Iraqi
im ports, and alm ost all of Jordan's trad e .1 2
The role of the W estern dom inated financial institutions w as key to
the rapid developm ent of the trade sector w hich helped the transfer of
com m odities from the W est to the A rab w orld. Lebanon's role as a transit
center was in addition to its ow n m arket for W estern goods.
The grow ing im portance of external trade in the Lebanese econom y is
evident from table 2-5 below . The table show s a trade deficit w hich increased
over the years from LL 223 m illion in 1951 to LL 2,124 million in 1974. It
1 0 Makdisi, Samir, Financial Policy and Economic Growth: The Lebanese Experience, New York:
Columbia U niversity Press, 1979, p. 146.
1 1 Dahi, p. 29.
1 2 Toksoz, Mina, The Lebanon Conflict: Political Shifts, Regional Impact and Economic Outlook,
London: Economist Publications, 1986, p. 30.
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39
should be m entioned, how ever, that the trade deficit to N N P ratio decreased
from a high of 54 percent in 1960 to 29 percent in 1973.
Table 2-5
External T rade and T rade Deficit of Lebanon— Selected Years
(M illion LL)
Year Im ports*
(M)
Exports*
(X)
Deficit
(D)
X /M
%
M /N N P
%
X /N N P
%
D /N N P
%
1951 321 98 223 30 30 9 21
1955 529 121 408 23 37 8 29
1960 1 1 1 2 144 968 13 62 8 54
1961 1272 156 1116 12 64 8 56
1962 1366 192 1174 14 64 9 55
1963 1314 196 1118 15 59 9 50
1964 1573 216 1357 14 55 8 47
1965 1683 324 1359 19 53 10 43
1966 1914 369 1545 19 55 11 45
1967 1770 453 1317 26 51 13 38
1968 1865 510 1355 37 48 13 35
1969 2006 554 1452 27 49 13 35
1970 2251 650 1601 29 51 15 34
1971 2452 815 1637 33 50 17 34
1972 2902 1168 1734 40 53 2 2 32
1973 3511 1776 1735 51 58 29 29
1974 4224 2 1 0 0 2124 50 61 30 31
♦These figures are for total im ports and exports, i.e., goods plu s all services.
Source: Dahi, Naji Jaw dat, The Tertiarization of the Lebanese Economy: The
Transition from Feudalism to Capitalism and European Commodity Export, Ph.D.
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40
D issertation, D epartm ent of Political Science, U niversity of Southern
California, 1994, p. 32.
The table also highlights the low exports to N N P ratio and the high ratio of
im ports to NNP. O n average, the ratio of exports to N N P hovered around
the 15 percent m ark while the im ports to N N P ratio experienced a grow th
from 30 percent in 1951 to 61 percent in 1974. D eterioration in the balance of
trade can be seen betw een 1951 and 1960 from a falling exports to im ports ratio
w hich ended up at 13 percent from its previous 30 percent. The situation
im proved later, however, as the ratio reached the 50 percent m ark by 1974.
This increasing trade deficit w as covered b y several sources, prim ary am ong
w hich w ere transit and re-export trade, em igrants' rem ittances, and capital
transfers .1 3 It w as because of this that Lebanon boasted a balance of paym ent
surplus over the years since 1950. Between 1951-57,1960-69, and 1970-74,
Lebanon show ed an average annual surplus of LL 35.4 m illion, LL 74.3
m illion, and LL 302.5 m illion respectively .1 4
Thus, the Lebanese economy, despite its fairly high grow th rate of 7.5
percent during the 1950-57 period and 6.0-6.5 percent during the 1964-74
period ,1 5 experienced abnorm al grow th in the sense that the service sector
accounted for m ore than two thirds of the N N P w hile the "production" sector
contributed less than one third to the national product. Trade alone
am ounted to one third of the national p roduct w hile other activities like real
estate, transport, finance, services, and governm ent figured for 30 to 40
1 3 Emigrants' remittances were 3.4 percent and 3.7 percent of GDP in 1965 and 1970
respectively (Daher, M as'ud, The Socio-Economic Changes and the Civil War in Lebanon,
Tokyo: Institute of Developing Economies, 1992, p. 85).
1 4 M allat, p. 122.
1 5 M akdisi, p. 34.
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41
percent of NNP. This explains the trade dependency of the Lebanese
econom y an d its role as an interm ediary betw een the W est a n d the Arab
w orld. A nd it was this role that engendered a W estern dom inated banking
sector th at financed trade activities using Lebanon as both a tran sit station as
w ell as a destination.
The Economy Since the Civil War
Before addressing other issues, it w ould be expedient to continue the
discussion of the m ake up of the various sectors in the econom y based on
religious origin w hich w as started in the previous section a n d w hich has
already covered the situation in this context prior to the o utbreak of civil war.
Table 2-6 below presents results of a later study conducted b y the Economic
D epartm ent at the A m erican U niversity of Beirut in 1979-1980. The study
included 150 business leaders w ho were chosen, as previously, in the capacity
o f being innovators in their respective fields.
Table 2-6
D istribution of M en in Each Sector by Religion, 1979-1980
Sector T otal N um ber R eligion
A griculture 10 6 C hristians
4 M uslim s
Industry 60 55 C hristians
3 M uslim s
2 D ruzes
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42
Table 2-6 (continued)
Sector Total N um ber R eligion
F inance 20 15 Christians
3 Muslims
2 Druzes
Sevices 60 52 Christians
6 Muslims
2 Druzes
T otal 150 128 Christians
16 Muslims
6 Druzes
Source: A sraoui, Fadi, Social and Political Factors in the Lebanese Economy, MA
Thesis, D epartm ent of Economics, U niversity of Southern California, 1985, p.
63.
In 1979-1980, although the Christians constituted less than half of the
Lebanese population, they continued to account for about four fifths of the
respondents. Sim ilarly, the Muslims, who constituted about 55 percent of the
population at this point, continued to account for about one sixth of the
entrepreneurial group. The only siginificant difference betw een these results
and those that w ere obtained in the 1957 study w as the absence of the Jews
who departed in the 1960s and early 1970s d u e to "the absence of political
stability needed for econom ic mobility and g row th ." 1 6 A sraoui (1985) makes
another observation regarding the level of schooling of the Christian and
M uslim groups. C hristians w ere found to be b etter educated than the M uslim
1 6 Asraoui, p. 62.
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43
group. The proprtion of M uslim respondents w as higher at the low er level of
schooling b u t low er at the higher level, than th at of Christians.
W hile the Jew s left the country, the D ruze w ere absent from the
agricultural sector in this study. M uslim s had a greater share of the
agricultural sector and a slightly greater share of industry relative to w hat
they had in finance and services. E ntrepreneurial institutions have been
built around these sectors w ith a long tardition of necessary business contacts.
It is, therefore, interesting to see the Lebanese civil w ar in this new light. The
Christian dom ination of all the m ajor sectors could easily have given rise to
frustration am ong the other religious com m unities at finding m uch of the
opportunity siezed by their C hristian counterparts. Im plications of this
dom ination on entrepreneurial institutions and their m echanics could have
aggaravated the situation further especially in view of the fact that the loyalty
of a Lebanese citizen is "first to his o w n group o r sect and only secondly to his
governm ent and country. A nd if he m u st choose betw een the tw o, he will
choose his ow n group at the expense of his country ." 1 7
Several explanations have been p u t forw ard for this inequality in
distribution. The Christians argued that, as a m inority in the A rab world,
they needed special privileges to com pete w ith the M uslim majority. Prior to
1991, w hen the role of the President, w ho has to be from the M aronite
Christian com m unity by law, w as redefined to curtail his com plete and sole
pow er over the affairs of the state, an overw helm ing am ount of resources
and facilities w ere m ade available to the C hristian business leaders. Also, the
1 7 Ibid., p. 78.
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44
C hristian entrepreneurs, as p art of special interest groups, were helped by
these groups to prom ote and m arket their products and services.
The uneven distribution of resources led to dissatisfaction am ong
m any com m unities and m anifested itself in three m ain forms. First, there
w as an exodus of some of these dissatisfied m em bers. The cases of the Jews
before the civil w ar as well as of the countless Lebanese who currently live
abroad come under this heading. The second form w as vocal objections to
the existing state of affairs. The Sunnis w ere involved in this w ith protests
against the status quo. The last form w as w h at led to the civil w ar in 1975.
The Shi'ites and the Druzes, w ho accounted for a great num ber of the poor
and unem ployed in the Lebanese society, expressed their dissatisfaction by
taking up arm s. In response and to protect its interests, the ruling group, i.e.,
the M aronites, also took up arms. It sh ould be added, however, that the
Shi'ites and the Druzes resorted to this option after vocal objections ceased to
have any hope to bear fruit.
Civil w ar in Lebanon broke o u t in 1975 and continued in various
form s until late 1990. Between 1975 and 1976, the m ost significant setback w as
experienced by the economy in the form of its center of the service sector,
Beirut, being largely destroyed. E verything from the old souks to the Beirut
port to banks in dow ntow n Beirut to hotels, suffered the consequences.
N asser Sa'idi, the Banque du L iban's d eputy governor, puts the dam age
caused to the country's physical capital— roads, ports, power plants, schools,
hospitals— at "well in excess of $15 billion ." 1 8 Just betw een March 14 and M ay
10, 1989, the dam age was estim ated a t $400 m illion. This included the
1 8 The Economist, Survey Lebanon, February 24th, 1996, p. 12.
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destruction of 170 factories in East Beirut.1 9 The collapse of the governm ent's
authority rendered its tax collection system incapable of raising revenue.
Instead, various m ilitias becam e the recipients of these tax paym ents.
Table 2-7 below presents the grow th of G D P during the civil w ar. The
GDP is listed in Lebanese pounds (both nom inal and real w here real GDP is
m easured at constant 1974 prices), as w ell as in US dollars.
Table 2-7
Trends in GDP and Exchange Rates (Billion LL and Billion $)
Year GDP
(LL)
%
change
R eal
GDP
(1974
prices)
%
change
GDP
(US$)
%
change
Exchange
Rate (LL
to US $)
1974 8 .1 8 .1 3.5 2.3
1975 7.5 -9.3 6 .8 -16.1 3.1 -11.4 2.4
1976 4.1 -45.3 2.9 -57.4 1.4 -54.8 2.9
1977 8 .2 1 0 0 .0 4.9 70.0 2.7 92.9 3.0
1978 8 .8 7.3 4.7 -4.1 3.0 1 1 .1 3.0
1979 1 1 .2 27.3 4.8 2 .1 3.4 13.3 3.3
1980 14.0 25.0 4.9 2.1 3.8 1 1 .8 3.7
1981 16.8 2 0 .0 4.9 0 .6 3.7 -2 .6 4.6
1982 1 2 .6 -25.0 3.1 -36.7 3.3 - 1 0 .8 3.8
1983 16.6 31.8 3.8 2 2 .6 3.0 -9.1 5.5
1984 28.2 69.9 5.5 44.7 3.2 6.7 8.9
1 9 George, Alan, "Lebanon: Economy," in The Middle East and North Africa, London: Europa
Publications, 1993, pp. 637, 640.
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46
Table 2-7 (continued)
Year GDP
(LL)
o/
/o
change
R eal
GDP
(1974
prices)
%
change
GDP
(US$)
o/
/o
change
Exchange
Rate (LL
to US $)
1985 59.3 110.3 6.9 25.5 3.3 3.1 18.1
1986 108.1 82.3 6.4 -7.3 1 .2 -63.6 87.0
1987 740.7 585.2 7.5 17.2 1 .6 33.3 455.0
1988 1356.0 83.1 5.4 -28.0 2 .6 62.5 530.0
1989 1350.0 -0.4 3.1 -42.6 2.7 3.9 505.0
1990 1973.0 46.2 2.7 -12.9 2.3 -14.8 842.0
1991 4132.0 109.4 3.7 37.0 4.7 104.3 879.0
1992 9499.0 129.9 3.9 5.4 5.2 1 0 .6 1838.0
1993 13122.
0
38.1 4.2 7.7 7.7 48.1 1711.0
Source: Sena Eken, et al., Economic Dislocation and Recovery in Lebanon,
W ashington, D.C.: International M onetary Fund, 1995, p. 4; A uthor's
calculations.
A decline in grow th is evident if w e consider GDP m easured in real
term s. It presents figures w hich show little increase in grow th since 1982. In
fact, any significant grow th that does appear in that colum n is usually
preceded by an equally high and often higher negative figure for grow th rate
(e.g., 1977,1983, and 1991). It should be pointed out that the year 1982 w as
m arked by the Israeli invasion of Lebanon. The figures also show that grow th
deteriorated further after 1985 w hen central state authority cam e to an end
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47
and gave w ay to an escalation in violence. A sim ilar pattern is reflected by
GDP m easured in US dollars .2 0 Positive signs in grow th have been noted
since the end of the civil w ar in 1991 and the reassertion of state authority and
the return to relative normalcy. IMF figures p u t Lebanon's real grow th rate
for the years 1994,1995,1996, and 1997 at 8.0%, 6.5%, 4.0%, and 4.0%
respectively.
D uring the civil w ar period, there w as also a sharp decline in the value
of the Lebanese pound against all foreign currencies. A n exam ple of this is its
falling value against the US dollar as can be noted from the last colum n of the
table. The Lebanese pound slid by 48 percent in the first six years of the w ar.
This factor led to a high degree of dollarization and effectively m oved the
private sector beyond the central bank's control since the Banque d u Liban
controlled only a fraction of the m oney supply.
The m ost significant occurrence during the civil w ar period w as the
loss of Lebanon's im portance as an interm ediary and as a service provider for
the Arab region. U nderstanding the im portance of this developm ent
becom es easier w hen w e consider the fact th at betw een 27 and 36 percent of
grow th in GDP betw een 1960-1965 was a result of regional dem and .2 1 The
detrim ental effect on Lebanon's traditional role w as caused by both the civil
w ar and the devastation it caused within Lebanon as w ell as by developm ents
taking place outside Lebanon. These included changes in the structures of
2 0 This analysis gains further credence if alternatives for sources used to report data in table
2-7 are em ployed. For example, figures reported in N asser Sa'idi's "Economic Consequences
of the War in Lebanon" (Oxford, Centre for Lebanese Studies, 1986), Economist Intelligence
U nit's Country Profile for Lebanon and Cyprus for the years 1992-93, and Salim Nasr's study
in "Politics and the Economy in Lebanon" in Nadim Shehadi and Bridget Ham ey, eds.,
Oxford: Centre for Lebanese Studies, 1989, all paint a much bleaker picture of the situation
under discussion.
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48
regional Arab econom ies w hich w ere crucial m arkets for Lebanon's services
and for sustaining the banking sector. Am ong these changes w ere
im provem ents in infrastructure and additions to educational and training
facilities. Transit of com m odities also m oved to the Gulf and Red Sea ports
via the Suez Canal.
A lthough L ebanon lost its role as an interm ediary, the sectoral
distribution of GDP did not undergo any significant change. For 1977-1987,
the service and "production" sector continued to account for roughly two-
third an d one-third of GDP respectively. The contribution of agriculture
dropped below its pre-civil w ar level of 9.4 percent. Industry, on the other
hand, boasted a share of m ore than 18 percent b u t this was only a result of the
inclusion of electricity and w ater production as p arts of the industrial sector.
Industry's share exclusive of electricity and w ater w as lower than its 16.4
percent in 1973 an d recorded a contribution to GDP of around 13 percent in
1980-1982. Table 2-8 below sum s up these figures.
Table 2-8
Percentage Share of GDP by Economic Sector
Sector 1973 1977 1980 1982 1987 1988-92
A griculture 9.4 8.5 9.2 8.5 8.7 1 2 .6
Industry 16.3 18.4 17.3 18.5 15.5 18.5
C onstruction 4.4 3.4 3.2 3.4 4.7 1 0 .0
TOTAL
PRODUCTION
SECTOR
30.1 30.3 29.7 30.4 28.9 41.1
2 1 World Bank, World Development Report, W ashington, D.C.: Oxford University Press, 1990,
p. 195.
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49
Table 2-8 (continued)
Sector 1973 1977 1980 1982 1987 1988-92
Trade 32.4 28.3 28.6 28.3 34.1 28.1
Services 30.4 31.1 31.4 31.1 31.6 25.5
G o v e rn m e n t 7.1 10 .2 10.3 1 0 .2 5.4 5.3
TOTAL
SERVICE
SECTOR
69.9 69.6 70.3 69.6 71.1 58.9
AGGREGATE 100 100 100 1 00 100 100
Source: The M iddle East and N orth Africa, Statistical Survey, London: Europa
Publications, 1992, p. 648; Econom ist Intelligence Unit, Lebanon, Cyprus
Country Profile 1992-93, London: Business International, 1992, p.17.
The civil w ar caused the service sector to either experience some
contraction or a reorientation in n ew directions. The financial sector, for
exam ple, seem ed unaffected in the first seven years of the w ar and sustained
its previous grow th rate. H ow ever, on closer scrutiny, a significant
reorientation h ad taken place. This m anifested itself in the form of the
sector's m ain activity becom ing a channeling of political m oney and
rem ittances w hich w as different from its prior dom inant function of
channeling investm ent funds. A financial crisis did ensue eventually in the
post-1982 period as a substantial reduction in these flows together w ith other
financial difficulties engendered a gradual contraction in m ost banks. W ith
the crisis becom ing acute, banks shifted to holding a large p a rt of their balance
sheet in A m erican dollars. M any banks expanded overseas in order to
survive. The com pounding of the problem in th e 1980s m arked by the
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50
liquidation of several Lebanese subsidiary banks in Europe forced the Banque
du Liban in 1992 to require of the banks to raise their capital and lim it their
hard currency loan exposure. In addition, a law w as also p assed to facilitate
m ergers am ong banks .2 2
Furtherm ore, Lebanon's decline as an interm ediary led to the sale of
m any foreign banks to Lebanese and Saudi businessm en. A lternative
banking centers sprung up in Bahrain and Egypt. Lebanon's banking sector
increasingly attained a dom estic flavor after the governm ent lifted its
m oratorium on the licensing of new banks in 1977. Thus, in 1987, 60 percent
of all bank deposits w ere controlled by Lebanese banks w hile Arab and non-
Arab foreign banks controlled 6 and 16 percent of the deposits respectively .2 3
These changes in the m ake-up of the Lebanese banking sector,
how ever, did not bring about a change in the pre-civil w ar tren d of favoring
the trade and service sectors for credit over the "production" sector. O n
average, the service sector continued to receive alm ost double the credit
extended to the "production" sector, a trend that w as also prevalent in the
pre-civil w ar era. The agricultural sector, in fact, became m arginalized as
lending to it actually declined in the period 1966-1989.2 4 O ne of the ways the
destruction of the industrial sector m anifested itself was the decline of
lending to this sector after 1982, the year of the Israeli invasion.
As w as m entioned earlier, trade and services m aintained their prim acy
contributing 34.1 percent and 31.6 percent to GDP respectively. In addition,
the trade sector continued to account for almost half of all credits extended by
2 2 Arab Banking Corporation, The Arab Economies: Structure and Outlook, 1994.
2 3 Dahi, p. 44.
2 4 Banque du Liban, Yearly Report, 1989,1986, 1983; Makdisi, Financial Policy.
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51
commercial banks. T rade also played a vital role during the civil w ar as
im ports rose and exports fell due to the devastation of the industrial sector.
Foreign trade figures are sum m ed in table 2-9 below. H igh trade deficits
rem ain to be its m ost conspicuous feature. H ow ever, Lebanon is a tiny
country and m uch o f the trade imbalance is caused by im ports of m achinery
about to be p u t to productive use.2 5 The deficit had an annual average of
$1,219 m illion d u rin g the 1976-1980 period, $2,291 m illion during the 1981-
1985 period, $1,728 m illion during the 1986-1990 period, and $3,449 m illion
during the 1991-1993 period. Furthermore, the deficit to GDP ratio rem ained
extrem ely high soaring to 136 percent in 1986.
Table 2-9
T rend in Foreign Trade 1976-1993 (M illion $)
Year Im ports*
(M)
Exports*
(X)
Deficit
P )
X /M
%
M /G D P
%
X/GDP
%
D/GDP
%
1976 567.6 497.0 70.6 88 41 36 5
1977 1410.6 683.9 726.1 49 52 25 27
1978 1753.7 743.3 1010.4 42 59 25 34
1979 2533.4 783.1 1750.3 31 75 23 52
1980 3415.9 877.4 2538.5 26 90 23 67
1981 3250.5 839.1 2411.4 26 88 23 65
1982 3169.1 734.0 2435.1 23 96 22 74
1983 3587.0 738.0 2849.0 21 120 25 95
1984 2898.8 609.8 2289.0 21 91 19 72
2 5 International Monetary Fund, Direction of Trade Statistics, 1989-1992.
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52
Table 2-9 (continued)
Year Im ports*
(M)
Exports*
(X)
Deficit
(D)
X/M
%
M /G D P
%
X/GDP
%
D /G D P
%
1985 2031.4 560.2 1471.2 28 62 17 45
1986 2054.7 419.2 1635.5 20 171 35 136
1987 1837.3 473.0 1364.3 26 115 30 85
1988 2407.8 628.5 1779.3 26 93 24 68
1989 2263.1 484.3 1778.8 21 84 18 66
1990 2578.1 496.0 2082.1 19 112 22 91
1991 3784.4 490.2 3258.2 13 81 10 69
1992 4083.4 532.0 3551.4 13 79 10 68
1993 4222.0 686.0 3536.0 16 55 9 46
* The igures are for total im ports and exports, i.e., goods p u s all services.
Source: Econom ist Intelligence Unit, Lebanon, Cyprus Country Profile, 1994-95,
1992-93, 1990-91, (London: Business International, 1994,1992,1990), pp. 33, 32,
34; Sena Eken, et al, Economic Dislocation and Recovery in Lebanon, W ashington,
D.C.: International M onetary Fund, 1995; Econom ist Intelligence Unit,
Regional Review: The Middle East and North Africa, 1985,1984, (London: The
Economist Publications, 1985, 1984).
From the table, it can also be seen that the export to im port ratio, w hich
had increased to 50 percent by 1974, reflected the consequences of the civil w ar
as it experienced a largely continuous fall. A lthough it has show n som e signs
of im provem ent, the situation rem ains troublesom e even after the end of the
civil w ar.
A n interesting point to be noted here is th at despite the rising trade
deficit over the w ar years, it did not show up in the balance of paym ents until
1983. This w as due to an increase in rem ittances from Lebanese m igrant
w orkers w ho w en t to the G ulf countries betw een 1977-1981. The num ber of
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53
Lebanese w orkers in the G ulf in 1970 w as 50,000. This figure rose considerably
in just ten years becom ing 210,000 by 1980. The increase in the num ber of
w orkers translated into higher rem ittances to Lebanon and increased from
$250 m illion to $2,254 million. In 1981, rem ittances from the Gulf countries
accounted for roughly 53 percent of the GDP.2 6 The first balance of paym ents
deficit w as recorded in 1983 and am ounted to $933 million. This was due, in
part, to falling rem ittances from the Gulf d u e to falling oil prices.
Remittances fell drastically from their 1980 level of $2,524 m illion in 1980 to
only $460 m illion in 1983. An additional cause of the deficit w as the
departure of the PLO from Lebanon and the exodus it generated of m uch of
the m ale Palestinian workforce. This deprived Lebanon of m ore than $400
m illion in an n u al spending. At its height, Palestinian spending in Lebanon
form ed 15 percent of the GDP and accounted for 10 percent of the em ployed
w ork force.2 7 The balance of paym ents recorded a deficit of $1.35 billion in
1984 and $205 m illion in 1986, and a surplus of $403 m illion in 1985 and $197
m illion in 1987.2 8 A t present, capital is flow ing from em igre Lebanese and
other A rabs and as long as peace lasts and the econom y stays on course, the
horizon looks reasonably rosy.
Since Prim e M inister Rafik H ariri's takeover in October 1992, the
Lebanese p o u n d has risen by 25% and stabilized at around 1,600 to the dollar.
Inflation has d ro p p ed from a crippling 120% in 1992 to around 10%,2 9 and a
2 6 Nasr, Salim , "The Political Economy of the Lebanese Conflict," in Politics and the Economy
in Lebanon, ed., Nadim Shehadi and Bridget Hamey, (Oxford: Centre for Lebanese Studies,
1989), p. 44.
2 7 Nasr, "Political Economy," p. 44, 47; Dahi, p. 48.
2 8 Economist Intelligence Unit, Lebanon, Cyprus Country Profile 1992-93, p. 34.
2 9 The Economist, Survey Lebanon, p. 13.
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start has been m ade tow ard rebuilding the country's shattered infrastructure.
In addition, projects such as a sophisticated conference complex are going to
be taken up in order to attract international business and compete w ith
Singapore and H ong Kong. Also, long-term planning is going to be
undertaken to re-establish Beirut as a service center for the region. The total
cost to the public sector is estim ated to be around $18 billion.3 0
The above analysis show s an unchanged econom ic structure in
Lebanon even after the advent of the civil w ar. The econom y continued its
heavy dependence on the service sector w ith trade m aintaining its lead role
as the m ost prolific of all sectors in the generation of GDP. The credit system
contributed to the central role of trade in the econom y even after Lebanon's
dim inished role as a center of regional finance, commerce, and services.
Ibid.
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55
C hapter 3: Financial Policy in Lebanon
Many, many are the branches.
Many so many on the grey oak
But the grey oak does not have a golden little crown;
Many, many are the relations, the tribe
Many so many of the princess soul.
But the princess soul lacks her native mother:
there is someone to thank,
But no one to arm.
- Russian wedding song
The Lebanese econom y is highly m onetized and has traditionally h ad a
thriving banking sector. Lebanon is unique am ongst other developing
economies because it has been open to the w orld econom y via the
m aintenance of a liberal exchange rate system , based on a flexible exchange
rate. This is in contrast w ith other developing econom ies that m aintained
exchange restrictions, a fixed exchange rate, and a public sector w ith a
dom inant role in economic developm ent. This chapter relates the trend in
the sphere of financial policy and its consequences in Lebanon. Special
attention is accorded to exchange rate developm ent and policy. Finally, the
chapter looks at the Banque du Liban's organization and activities.
Budgetary Perform ance and the Civil W ar
The G overnm ent of Lebanon played only a sm all role in the econom y
and adopted conservative policies in the pre-civil w ar period. The 1974-1975
fiscal year can be considered as an example. As w as m entioned in the
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56
previous chapter, b u d g et surpluses w ere the norm which, according to
M akdisi (1979), reflected lags in capital expenditure. In addition, 15-20 percent
of the GDP consisted of revenues w hile governm ent expenditure accounted
for less than 15 percent of GDP.1 Tax and non-tax revenue held alm ost the
sam e importance. Indirect taxes such as custom s duties w ere the m ost prolific
source of tax revenue. Tax revenues am ounted to about 11 to 12 percent of
GN P and total governm ent revenue to about 14 to 15 percent. The heavy
reliance on indirect taxes is evident from their (approxim ately) 60 percent
share in total tax revenue. Direct taxes w ere responsible for a little less than a
quarter of the total.2 G overnm ent expenditure was m ainly m ade up of wages
and salaries paid to governm ent em ployees. In addition, investm ent w as also
p art of expenditure.3
Lebanon's civil w ar not only deprived the governm ent of m ost of its
revenue base but also w itnessed a relative rise in governm ent expenditure.
Total expenditure rose to 39 percent of GDP during 1989-90 from its 1974 level
of 15 percent. The Lebanese central bank (Banque du Liban) attem pted to
alleviate the resulting deterioration w hich led to higher inflation rates,
exchange rate depreciations, and dollarization. These factors m ade the
traditionally active private sector take the back seat while the governm ent
gained prom inence in the econom y both during and after the w ar. Domestic
interest paym ents, in particular, accounted for a m uch greater share of total
1 Eken, Sena, et al. Economic Dislocation and Recovery in Lebanon, Washington, D.C.:
International Monetary Fund, 1995, p. 11.
2 Makdisi, Samir A., Financial Policy and Economic Growth: The Lebanese Experience, New
York: Columbia University Press, 1979, p. 37.
3 Total investment expenditure accounted for a little less than 30 percent of total public
sector expenditure.
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57
governm ent expenditure as debt financing of budget deficits became m ore
prevalent. Lebanon's budgetary capital expenditure w itnessed a decline as
well from 6 percent of GDP in 1980 to 2 percent in 1990. This led to a decline
in the stock of public capital. H ow ever, the situation after the w ar has been
m arked by im provem ents as is evident from the fact that the budget deficit
had declined from its 1990 level of 33 percent of GDP to reach a figure of less
than 9 percent in 1993. G overnm ent revenues increased fourfold to 13
percent of GDP after the reassertion of governm ent authority over revenue
resources.4 This w as especially true w ith regard to non-tax revenue. Another
contributing factor w as the hiring freeze im plem ented by the Lebanese
governm ent w hich caused a relative decline in total expenditure.
In 1992, revenues doubled as a result of increases in both tax and non
tax revenues w hich constituted 48 percent and 44 percent of total revenue
respectively. These figures w ere com parable to the ones achieved in 1975.5
Despite the fact that revenues experienced a sm all decline to 11 percent of
GDP, restrictions on current expenditures helped in reducing the total
expenditure which in turn low ered the budget deficit to 12 percent of GDP.
Debt issuance was used to finance m ost of this deficit. This pattern of
im provem ent continued on into 1993 as civil authority becam e m ore
pervasive. N ew low er tax rates and a lower num ber of tax brackets were
m ade effective as of 1994. In addition, a custom s tariff reform law was m ade
active w hich low ered the num ber and level of duty rates and im posed a
m inim um duty on m ost im ports. (Gold, silver, and currency w ere excluded
4 Eken, p. 13.
5 Ibid. p. 14.
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58
from this list of im ports). Since 1992, expenditure on dom estic interest
paym ents has increased betraying greater reliance on dom estic financing
through the issuance of governm ent debt.
The figures above, how ever, do not reveal som e im portant weaknesses
in Lebanon's budgetary structure. O n the revenue side, these include a
narrow revenue base, a heavy reliance on indirect taxes (e.g., custom s duties),
non-tax revenues, and lim ited tax enforcem ent capabilities. The
overem phasis of non-tax revenue m anifests itself in the form of various fees,
charges, fines, and m iscellaneous property and enterprise income. The
situation is further aggravated by the central role the public sector is playing
in the reconstruction process which inflates the expenditure side. Although
the total expenditure has been successfully lowered in real term s compared to
w hat it was at the beginning of the postw ar years, it rem ains higher than w hat
it was prior to the outbreak of the civil war. Thus, the governm ent sector
continues to consum e a greater share of domestic resources. Lebanon did see
an im provem ent in non-tax revenues starting in 1989-90 due to a rise in real
estate prices and an ad valorem registration fee applied to real estate
transactions. This was com plem ented by higher profits of the Banque du
Liban which w ere engendered by the Bank's increased treasury bill holdings.6
These highlight the im portance of indirect taxes and non-tax revenues in the
com position of total revenue.
6 Historically, the Banque du Liban's treasury bill holdings had been limited especially in
the pre-civil war period. At the end of June, 1978, the outstanding short-term treasury bills
(i.e., treasury bills with maturity of one or less years) totaled to around LL 860 million. The
long-term treasury bills with maturity of two to three years amounted to about LL 170
million. All of these bills were taken up by commercial banks (Samir Makdisi, pp. 196-197).
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59
Since the governm ent is expected to continue w ith its ambitious
reconstruction program in the coming years, expecting a m ajor increase in
capital outlays is n o t unjustified. The authorities are also expected to pu rsu e
a policy of financing budget deficits through debt creation. This would m ost
likely increasingly encum ber the budget w ith dom estic interest paym ents. In
addition, foreign loans to finance large reconstruction projects w ould raise
the level of foreign indebtedness and foreign debt service considerably in the
com ing years. A recent survey of M iddle Eastern countries concluded that
Lebanon and Egypt devote sizable and rising shares of their expenditure to
servicing their debt com m itm ents w hich decreases the flexibility available to
the authorities to conduct fiscal policy and respond to unforeseen shocks to
the econom y. IMF estim ates p u t Lebanese interest paym ents at 26.5 percent of
total governm ent expenditure in 1993 up from 17.2 percent just two years
earlier (in 1991).
Exchange Rate and Balance of Paym ents
Lebanon is one of the few countries w hich have m aintained a flexible
exchange rate policy. The period before the civil w ar (1950-1974) was
characterized by a stable exchange rate w hich seldom recorded short-term
(monthly) fluctuations. Table 3-1 below presents standard deviations of the
m onthly average, m axim um , and m inim um exchange rates7 for the period
1950-70. Excluding the first 4 years (1950-53), the coefficient of variation of
both the average and m axim um rates ranged from less than 0.5 percent to less
7 Exchange rates of the Lebanese pound are in terms of the US dollar.
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60
than 2 percent. The coefficient of variation for m inim um rates ranged from
less than 0.5 percent to about 1.5 percent betw een 1956-70.
Table 3-1
Standard D eviation of M onthly M inim um and M aximum Exchange
Rates, and M onthly A verage Exchange Rates, and Coefficient of Variation,
1950-1970
M in im u m Rates M ax im u m Rates A verage Rates
Year Standard Coefficient S tandard Coefficient Standard Coefficient
D eviation of
V ariation
D eviation of
V ariatio n
D eviation of
V ariatio n
1950 0.2956 8.81 0.2352 6.64 0.2094 6.06
1951 0.1277 3.47 0.1455 3.82 0.0669 2.04
1952 0.1456 4.02 0.1704 4.62 0.1117 3.06
1953 0.1832 5.42 0.1782 5.15 0.1089 3.19
1954 0.2017 6.32 0.0565 1.74 0.0591 1.83
1955 0.2018 6.24 0.0101 0.31 0.0084 0.26
1956 0.0180 0.56 0.0111 0.35 0.0252 0.78
1957 0.0285 0.89 0.0149 0.47 0.0279 0.87
1958 0.0155 0.49 0.0502 1.57 0.0173 0.54
1959 0.0094 0.29 0.1031 3.27 0.0173 0.55
1960 0.0160 0.50 0.0167 0.52 0.0284 0.89
1961 0.0459 1.49 0.0365 1.17 0.0463 1.51
1962 0.0147 0.49 0.0294 0.95 0.0270 0.89
1963 0.0227 0.74 0.0234 0.75 0.0284 0.92
1964 0.0170 0.56 0.0193 0.62 0.0209 0.68
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61
Table 3-1 (continued)
M in im u m Rates M axim um Rates A verage Rates
Year Standard Coefficient Standard Coefficient Standard Coefficient
D eviation of D eviation of D eviation of
V ariation V ariation V ariation
1965 0.0722 2.36 0.0081 0.26 0.0250 0.81
1966 0.0308 0.99 0.0464 1.47 0.0402 1.28
1967 0.0372 1.16 0.0239 0.74 0.0317 0.99
1968 0.0417 1.32 0.0101 0.32 0.0202 0.64
1969 0.0295 0.91 0.0369 1.13 0.0203 0.62
1970 0.0166 0.51 0.0169 0.51 — —
Source: M akdisi, Sam ir, Financial Policy and Economic Growth: The Lebanese
Experience, New York: Colum bia University Press, 1979, pp. 152,153,155.
In principle, a m arket-determ ined exchange rate tends to elim inate any
potential deficit or surplus. This takes place by m ovements in the rate itself.
Although the rate of the Lebanese pound has largely been determ ined by
m arket forces, it has not been totally free of intervention, w ith the Central
Bank intervening to influence its level. The surplus or deficit in the
Lebanese balance of paym ents is m easured here as the change in the net
foreign assets of the banking system . Table 3-2 below presents the data.
From the table we can see that the balance of paym ents incurred
continuous overall surpluses from 1951-1961. A n overall appreciation of the
pound of about 19 percent occurred despite the fact that the m onetary
authorities made foreign exchange purchases. A part from 1967, bigger yearly
surpluses were recorded in the period 1962-1967. Although the pound tended
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62
to fluctuate in this period, the overall tendency w as to depreciate. The post-
1967 period w as characterized by even larger an d rising (until 1974) surpluses.
The accum ulation of foreign exchange reserves by the authorities helped
prevent the appreciation of the pound. H ow ever, the pound appreciated
significantly after 1971 despite this official intervention.
Table 3-2
Changes in the International Reserves of the M onetary Authorities and in
___________the Foreign Assets of the Banking System, 1951-1975__________
Year Changes in the International
Reserves of the M onetary
A uthorities (US $ million)
Change in the Foreign Assets
of the Banking System* (LL
m illion)
(- increase)
1951 1.8 -4.0
1952 2.7 -10.0
1953 13.0 -44.0
1954 20.9 -70.0
1955 10.4 -33.0
1956 1.2 -4.0
1957 11.2 -33.0
1958 8.1 -30.0
1959 17.9 -58.0
1960 12.1 -39.0
1961 22.8 -67.0
1962 45.3 -137.0
1963 -0.1 -1.0
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63
Table 3-2 (contdnued)
Year C hanges in the International
Reserves of the M onetary
A uthorities (US $ million)
Change in th e Foreign Assets
of the Banking System* (LL
m illio n )
(- increase)
1964 26.3 -86.0
1965 18.6 -281.0
1966 30.7 -165.0
1967 -0.6 63.0
1968 50.8 -121.0
1969 15.4 -187.0
1970 38.2 -484.0
1971 161.4 -921.0
1972 128.0 -765.0
1973 186.7 -217.0
1974 812.1 -1,493.0
1975 -94.2 -350.0
Source: M akdisi, Samir, Financial Policy and Economic Growth: The Lebanese
Experience, N ew York: Colum bia University Press, 1979, pp. 156-7.
* Gross for the pre-1964 data and net for the post-1964 data. The two series are
thus not strictly com parable though the foreign liabilities of the banking
system prior to 1964 w ere relatively small. H ow ever, the pre-1964 data suffer
from im portant inadequacies, e.g., commercial banks reported on their
foreign holdings only partially.
Thus, prior to the civil w ar, the emergence of overall su rp lu s accounts
(i.e., the accum ulation of official reserves due to Banque d u L iban's purchase
of foreign exchange) and a relatively stable pound w ere the prevailing trends.
Official reserves continued their grow th on until 1977 despite the civil war.
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64
W ith the outbreak of the civil w ar in the mid-1970s, the budgetary
situation started to w orsen and led to rising credit creation. This uncertain
political environm ent along w ith accelerating inflation caused increased
currency substitution in private portfolios and to speculative behavior. Thus,
the LL/US$ and nom inal effective exchange rates depreciated steadily
betw een 1975-1982 and exchange rate volatility increased significantly. D uring
1975-1982, the Lebanese p o u n d underw ent a depreciation of about 50 percent
against the US dollar w hile the nom inal effective exchange rate experienced
alm ost a 40 percent depreciation. In addition, the m axim um increase and
decrease in the m onthly LL/U S$ rate increased to 8 percent and 11 percent,
respectively.8
The situation deteriorated later on in the 1980s with the escalation of
the civil war. Inflation soared, the external position of the econom y becam e
weaker, rapid dollarization occurred, and significant dow nw ard pressure w as
p u t on the Lebanese pound. A t the sam e time, shifting expectations increased
the volatility of the Lebanese pound. The m axim um increase and decrease in
the m onthly LL/US$ rate rose to 43 percent and 20 percent, respectively.
More stability has been achieved since the term ination of hostilities
and the end of the civil w ar in 1991. Stabilization m easures to reduce the
fiscal deficit and credit creation have been adopted. The resulting confidence,
attractive interest rates on Lebanese securities, and favorable prospects in the
real estate and construction sectors generated a rise in capital inflows. This
p u t upw ard pressure on the exchange rate. Despite official intervention at
this point, the Lebanese p o u n d appreciated by about 30 percent against the US
8 Eken, p. 32.
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65
dollar betw een O ctober 1992 and M arch 1994. Since 1993, there has been a
substantial decline in exchange rate volatility.
Although credible data on the balance of paym ents is difficult to come
by for the civil w ar years, estim ates of figures from 1989-97 are presented in
Table 3-3 below. From the table w e can see that balance of paym ents has
incurred continuous overall surpluses from 1991 onw ards and this coincides
precisely w ith the tim e of the return of stability to Lebanon in the form of the
end of. the civil w ar and the reassertion of authority by the governm ent.
Table 3-3
Sum m ary of the Balance of Paym ents
1989 1990 1991 1992 1993 1994 1995 1996 1997
C urrent
A ccount
-785 -1,351 -2,935 -3,053 -3,417
Capital
A ccount
476 920 4,009 3,107 4,587 — — — —
O verall
Balance
-309 -431 1,074 54 1,170 1,131 256 786 420
N et Foreign
Reserves
(-increase)
309 431 -1,074 -54 -1,170 -1,131 -256 -786 -420
Source: Banque d u Liban; IMF, Direction of Trade Statistics and International
Finance Statistics.
C urrency S u b stitu tio n and D ollarization
After the outbreak of civil w ar in 1975, the public resorted to switching
portfolios to liquid assets. The political situation and the prevailing high
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66
inflation led to a further sw itch from the Lebanese p ound to the US dollar
and dollar-denom inated deposits. Large scale capital flight occurred as the
situation continued to w orsen in the 1980s. The situation has show n little
signs of reversing even after the end of the civil w ar and no substantial
increase in desire by the Lebanese to hold pound-denom inated assets has been
observed. Table 3-4 below presents the relevant data.
Table 3-4
C urrency Substitution
Year Money (M l) D em and
Deposits
Currency
in
C irculation
Ratio LL
Deposits to
Total Deposits
A nnualized
Change in
LL/US$
(In M illions Of Lebanese Pounds) (In Percent)
1969 1657.30 787.00 870.30 79.33 3.10
1970 1676.50 830.00 846.50 78.38 0.44
1971 2001.50 1080.00 921.50 77.86 -1.26
1972 2274.70 1239.30 1035.40 79.97 -5.48
1973 2618.90 1389.90 1229.00 76.37 -14.43
1974 2998.20 1642.30 1356.00 76.99 -10.83
1975 3835.90 1587.70 2248.20 75.15 -1.11
1976 4904.80 1803.60 3101.20 78.02 24.74
1977 5061.50 2299.60 2716.90 77.65 6.87
1978 6174.60 2838.00 3309.80 80.63 -3.70
1979 6683.80 3151.70 3532.10 69.43 9.72
1980 7666.60 3668.40 3998.30 63.76 5.96
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67
Table 3-4 (continued)
Year M oney (M l) D em and
Deposits
Currency
in
C irculation
Ratio LL
Deposits to
Total Deposits
A nnualized
Change in
LL/USS
(In M illions O f Lebanese Pounds) (In Percent)
1981 9005.10 4359.70 4645.40 58.64 25.55
1982 11069.80 5467.80 5602.00 73.29 9.96
1983 12945.00 5867.70 7077.30 73.65 -4.54
1984 13783.60 6089.00 7694.60 68.94 43.79
1985 20154.20 9852.00 10302.20 64.90 152.14
1986 30325.60 15557.40 14768.20 29.04 133.72
1987 68890.00 29541.00 39349.00 8.08 485.34
1988 182862.00 65810.00 117052.00 20.87 82.21
1989 287186.00 92526.00 194660.00 33.07 21.37
1990 449923.00 115271.00 334652.00 26.68 39.94
1991 689405.00 202007.00 487398.00 32.42 33.54
1992 1199399.00 393537.00 805862.00 31.86 84.52
1993 1213887.00 498918.00 714969.00 32.34 1.67
1994 1436800.00 498086.00 938763.00 — -3.54
1995 1560600.00 514411.00 1046200 — -3.50
1996 1753400.00 592679.00 1160705 — -3.09
1997 1929400.00 719300.00 1210000 — -2.02
Source: Banque d u Liban; International M onetary
Statistics.
:u n d , International Financial
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68
Since 1986, the Lebanese economy has been operating w ith extremely
high levels of both foreign currency in circulation and foreign deposits in the
dom estic banking system. It should be added, how ever, that it is extremely
difficult to speculate accurately about the substitutability betw een Lebanese
pounds and US dollars due to a lack of data— only the data for bank deposits
denom inated in these two currencies and for Lebanese pound currency
holdings is available. The impossibility of being able to observe dollar
currency in circulation in Lebanon makes the task of gauging the
substitutability impracticable.
The use of foreign currencies in any given econom y is positively
related to high and variable domestic inflation and any uncertainty over
dom estic economic policies. In other w ords, these factors low er the dem and
of dom estic fiat money. Dollarization here is defined as the use of US dollars
as the unit of account and the use of dollar-denom inated assets as a store of
v alu e.9 The trend of the extent of dollarization, w hich can be m easured as
the ratio of foreign currency deposits (FCD) to total deposits (TD), and the
ratio of Lebanese pound currency holdings to Lebanese pound deposits
(LL/LLDEP), over 1964-1993, is as follows: the LL/LLDEP ratio went up from
about 25 percent in 1965 to close to 39 percent betw een 1967 and 1969 in the
wake of the Lebanese banking crisis of 1967-1968; the ratio increased to about
49 percent in 1975 and 1976 in response to the early days of the civil w ar but
w ent dow n to 15 percent in 1985; it was 34 percent and 36 percent in 1987 and
1990 respectively; a rapid decline took place thereafter and the ratio declined
9 Calvo, G.A., and C. Vegh, "Currency Substitution in Developing Countries: An
Introduction/' Revista de Analisis Economico, Vol. 7, June 1992, pp. 3-27.
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69
from around 15 percent in 1993 to about 12 percent in 1994 and has been
hovering around 9 percent since 1996.1 0
Patterns leading to sim ilar conclusions exist in the case of the FC D /TD
ratio. The hostile environm ent, increasing dom estic inflation, and exchange
rate devaluation m ade dollar-denom inated deposits a m ore attractive option
and thus these serve(d) as the store of value. From a m ere 19 percent betw een
1978-1979, the FCD/TD ratio rose to 42 percent in 1981, and soared to a high of
92 percent in 1987 following a sm all drop from its previous peak level.
A lthough it has gone dow n since then, it m aintained its level at about 67
percent betw een 1991-1993. Sena Eken et al im pute this phenom enon to the
prevailing fiscal deficits and the increasing dom estic debt both of which raise
the expectancy of future deficit m onetization, inflation, and depreciation. It
should be added that a close relationship betw een dollarization and exchange
rate movem ents exists in Lebanon with the trend of the changes in both
following each other.
As might be expected, capital flight also played a role in this dram a. As
uncertainty regarding the stability of the Lebanese banking system rose in the
early 1980s, capital flight occurred and w ealth was transferred to cross-border
dollar deposits. After experiencing jumps due to the w ar shocks in 1981-1982
and 1986-1987, these deposits peaked in 1990 and have been declining since
then. A difference betw een the Lebanese and the South American capital
flight of the 1980s is w orth m entioning here. The key difference was that
while the South Americans only moved their capital off-shore, the Lebanese
capital flight was accom panied by an exodus of labor. The situation has been
1 0 The ratio was about 9.2% in January 1998 (Eken, p. 19, and author's calculations).
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70
reversed in the 1990s as Lebanon continues to experience a n et im m igration
along w ith a return of capital on a scale seldom observed in South America.1 1
D espite this return of capital, how ever, the share of foreign currency deposits
in total deposits and the use of the US dollar as a m eans of exchange have
experienced little impact.
The Organization of the Banque du Lib an
The Lebanese Central Bank or the Banque d u Liban started it's
operations on April 1,1964. It is a legal entity of public law and is
autonom ous in financial and adm inistrative regards. In addition, it is not
subject to adm inistrative regulations and supervision applicable to the public
sector. The Banque du Liban alone is the custodian of public funds. Its other
responsibilities include the supervision and regulation of the banking system
and the charge of issuing the national currency. A brief description and
organizational chart of the Bank are provided below.
The Governing Body. The C entral Council makes up the governing body. The
Council implements policies concerning the m oney supply, credit, and
discount and interest rates on loans. It is largely in charge of deciding all
issues concerning the Banque d u Liban and in m atters relating to its real
estate, mortgages, privileges, and rights. It also governs the banking and
financial sectors.
1 1 Available IMF estimates show that real cross-border deposits (in constant 1985 US
dollars) peaked in 1982 to around $11,500 million following the Israeli invasion. They have
been continuously declining since 1990 and stood at close to $9,000 million in 1993.
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Banque du Liban Organizational Chart
1st Vice
G overnor
Treasury
D epartm ent
Inform ation
Technology
D epartm ent
Financial
M arkets
D epartm ent
Statistics and
Economic
Research
D epartm ent
2nd Vice
G overnor
Banking
D epartm ent
Legal
D epartm ent
G overnor
3rd Vice
G overnor
Branches
D epartm ent
Financial
Operations
D epartm ent
Foreign Stdies
D epartm ent
4th Vice
G overnor
Accounting
Departm ent
C urrent
Operation
Departm ent
Purchase and
M aintenance
D epartm ent
Personnel
D epartm ent
Foreign
Exchenge &
International
Operations
D epartm ent
Inspection
and Audit
D epartm ent
Real Estate
and
Financial
D epartm ent
D evelopm ent
and Training
D epartm ent
G overnorate
Office
Source: http://w w w .bdl.gov.lb/bdl/hist/org.gif
72
The Council is structured as follows:
• the G overnor as chairm an: (S)he is the legal representative of
the Banque d u Liban, has authority over its m anagem ent,
and is charged w ith im plem enting relevant codes and
C entral C ouncil resolutions. The length of h is /h e r term
is 6 years long and is renewable. The appointm ent is
m ade by decree from the Council of M inisters upon the
recom m endation of the Minister of Finance. The position
is currently held by Mr. Riad Salameh w ho is a Sunni
M uslim .
• four Vice-Governors: They are also appointed in the sam e
fashion as the G overnor except that the G overnor is
consulted before the appointm ents are m ade. Also, the
term for a Vice-Governor lasts five years and is
renewable. In addition to their duties as m em bers of the
Central C ouncil they also fulfill supervisory functions
assigned to them by the Governor. C urrently, the position
of First Vice-Governor is held by Dr. N asser Saidi and that
of the Second Vice-Governor is filled by Mr. Fahim
M o'dad. There is a vacancy for the position of the Third
Vice-Governor w hile Mr. H aroutiun Sam uelian w ho is
A rm enian fills the position of the Fourth Vice-Governor.
• the General D irector of the Ministry of Finance. This position
is presently held by Dr. Habib Abou Sakr.
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73
• the General Director of the M inistry of Economy an d Trade.
Mr. M oham ed Al-Am in currently holds this office.
Management. The Banque du Liban has 18 departm ents for the m anagem ent
of its affairs. These are:
1. The Accounting Departm ent: This has two divisions. The first is the
Central accounting division in charge of keeping the books of the
Banque du Liban, controlling and recording the current operations
betw een the Bank branches and its head office as well as the Bank's
accounts with its correspondents, and organizing the accounts for both
the head office and the branches. The Budget division controls the
Bank's expenditure and the im plem entation of the Bank's budget.
2. The Banking departm ent: handles all issues related to banks.
3. The Branches D epartm ent: is responsible for the adm inistration of
the Bank's various branches.
4. The Current O peration Departm ent: adm inisters the accounts of
banks, financial institutions, and public institutions, and im plem ents
the interest rates on accounts in accordance w ith m anagem ent
decisions.
5. The Financial M arkets D epartm ent: m onitors non-bank financial
institutions and m oney dealers, and developm ents in the financial
m arkets.
6. The Financial O perations D epartm ent: is responsible for m anaging
dom estic debt issues, and exam ining loan applications of the public
sector, among other things.
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74
7. The Foreign Studies D epartm ent: studies the relationship between
the Bank w ith local and foreign institutions.
8. The Foreign Exchange and International O perations Departm ent: is
in charge of handling the Bank's relations w ith central banks and
financial institutions abroad. It also takes care of gold and foreign
exchange operations, bo th in dom estic and foreign m arkets, as well as
of docum entary credit.
9. The G ovem orate Office D epartm ent: basically w orks for the
G overnor and is involved in activities like handling all
correspondences of the Governor.
10. The Inform ation Technology D epartm ent: handles all IT related
issues.
11. The Inspection and A udit D epartm ent: is in charge of the audits of
the records, operations, assets, and accounts of the Bank head office and
its branches.
12. The Legal D epartm ent: handles the Bank's legal m atters.
13. The Personnel D epartm ent: deals w ith staff issues.
14. The Personnel D evelopm ent and Training D epartm ent: is in charge
of conferences, sem inars and training program s concerning the Bank's
operations. It also handles entering exams to the Bank as well as
prom otions.
15. The Real Estate and Financial Assets D epartm ent: m anages the
Bank's real estate holdings and its financial portfolio.
16. The Purchase and M aintenance D epartm ent: is responsible for office
supplies, furniture, equipm ent, and building m anagem ent.
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75
17. The Statistics and Economic Research D epartm ent: prepares
statistics concerning economic and financial activities, and is in charge
of the Bank's publications. It also conducts research on relevant issues.
18. The Treasury D epartm ent: is responsible for issuing currency as
well as counter related operations and the safekeeping of gold and
other valuables.
r-
Bodies Established at the Banque du Liban. The first of these is the Higher
Banking Com m ittee w hich sets adm inistrative penalties on banks, financial
institutions, m oney dealers, and brokerage firm s that violate the provisions
of the entity's status, m easures im posed by the Bank, etc. The Committee is
com posed of the G overnor of the Banque du Liban as chairm an, one of the
Vice-Governors selected by the C entral Council, the General Director of the
M inistry of Finance, a judge w ith m inim um 10 years of experience appointed
by decree after the approval of the Higher Judicial Council, a member of the
Banking Control Com m ission proposed by the Lebanese Banks Association,1 2
and the Chairm an of the N ational Deposit G uarantee Institution (NDGI).U
The Banking C ontrol Com m ission is an adm inistratively independent
body which consists of five m em bers. These m em bers are appointed by
decree from the Council of M inisters and upon the recom m endation of the
1 2 The Lebanese Banks Association is a professional association with several objectives.
These include encouraging collaboration and ties among its members which consist of bank
representatives, preserving common rights and interests related to the profession, upgrading
the level of operations, ensuring a collective defense of its members, undertaking reform of
rules and regulations, and increasing collaboration with foreign banks. Any bank registered
with the Banque du Liban is eligible to become a member of the Association. Its
management is elected by its General Assembly.
1 3 The NDGI is a cooperative joint stock company with the capital divided equally between
banks and the government. Its objective is to protect smaller depositors.
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76
M inister of Finance for a period of five years. The chairm an is an expert in
banking and finance (or a university professor). One m em ber each is
proposed by the Lebanese Banks Association and the NDGI. The choice of the
rem aining two m em bers is unconstrained. The m ain function of this
commission is to uphold the Bank Secrecy Law.1 4
Finally, the C onsultative Com m ittee (currently n o t operational)
advises the G overnor on m atters that concern the Bank. These include
m onetary and credit policy issues, and general and particular economic
situations in a given region or sector.
The Government Commissariat. This is m anaged by a Com m issioner w ho is
directly in touch w ith the Finance Minister. Responsibilities include the
setting of an annual control program and cooperation betw een the Bank and
public entities.
Commissions Created at the Banque du Liban. Two com m issions have to be
m entioned. One is the Com m ission for the D evelopm ent and
M odernization of Financial and Banking Laws. This com m ission was created
by the Banque d u Liban in conjunction w ith the M inistry of Justice to revise
and establish laws and provide a viable institutional, legal, and regulatory
fram ework for efficient financial m arkets in Lebanon. In addition to revising
the laws relating to the banking and financial sector, the Commission also
1 4 The Bank Secrecy Law requires bank personnel exposed to bank activities to not reveal any
information regarding their "clients' names, assets, or holdings to any party whatsoever."
The only exception is when written permission is granted by the client or his/her heirs in
case of bankruptcy or in case of any litigation between the bank and the client.
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77
updates the prevailing norm s and standards in order to bring them at par
w ith international ones. Also, its objectives include the protection of
investors, the m aintenance of m arket liquidity and transparency, the
regulation of financial m arkets in the country, and the incorporation of new
instrum ents and products that reflect the creation of new m arkets.
The other com m ission is the C om m ission for Banking Technologies.
The Banque d u Liban established this com m ission in conjunction w ith the
Lebanese Banks Association w ith the goal of im proving the efficiency of the
banking system in Lebanon and standardizing its activities by introducing
new banking technologies. In this regard the Com m ission studies the
application of new banking technologies, new techniques in the field of
financial and secondary m arkets, innovations in the Exchange and Paym ent
Systems in Lebanon (e.g., credit cards, ATMs, etc.), and methods for the
establishm ent of a com m unications netw ork linking all banks in Lebanon.
A n additional function is the preparation of training program s for the
em ployees w ho are involved in new projects.
The Com m ission is m ade up of the first Vice-Governor as President
and the fourth Vice-Governor as Vice-President. Its members include the
Director of the Legal Affairs departm ent, the D irector of the Inform ation
Technology departm ent, and the General Secretary of the Lebanese Banks
Association together w ith two representatives of the Association.
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78
The Role and Functions of the Banque du Liban
The Banque du Liban's major concern is the "safeguarding of the
currency in order to ensure a basis for sustained social and economic
grow th."1 5 To m eet this end, the Bank is responsible for:
• safeguarding the currency;
• m aintaining economic stability;
• m aintaining and safeguarding the soundness of the banking system;
• developing the m oney and financial m arkets.
The Banque du Liban cooperates w ith the governm ent in order to m aintain
exchange rate stability, control liquidity, im pose credit restrictions, and issue
banking regulations. The Banque du Liban ensures exchange rate stability by
using any m easures it deem s appropriate. These include intervention in the
m arket to buy or sell currencies.
1 5 Banque du Liban, "The Code of Money and Credit— Article 70."
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79
Chapter 4: Inflation and Exchange Rates
You can work it out by Fractions or by simple Rule of Three,
But the way pfTweedle-dum is not the way qfTweedle-dee,
You can twist it, you can turn it, you can plait it till you drop.
But the way ofPilly-Winky’ s not the way ofWinkie-Pop!
The Jungle Book
This chapter includes sections on exchange rate developments and empirical
studies of the relationship between movements in the exchange rate and inflation. These
empirical studies attempt to establish these relationships both in the short and the long
term.
Exchange Rate Developments
From the previous chapter, it would be recalled that Lebanon has maintained a
flexible exchange rate since 1948 and has experienced only limited intervention from the
authorities. The early 1970s were characterized by a strong macroeconomic position
with high growth rates, low inflation, and overall balance of payment surpluses. The
high rates of growth were not accompanied by a general price increase since inflation
rates were kept low and ranged from 2 to 3 percent.1 A liberal economic system and
surpluses (or small fiscal deficits) were reflected by this performance.
The situation took a turn for the worse after the onset of the civil war in 1975.
Although the overall balance of payments remained positive until the early 1980s, the
unpredictable political situation and rising inflation prompted increased currency
substitution in private portfolios and gave rise to speculative behavior. Not only did
exchange rate movements become more pronounced between 1975-1982 but the LL/US$
1 An explanation for this phenomenon is restrictive monetary policy, relative stability or even moderate
appreciation of the Lebanese pound vis-&-vis major currencies, and confidence in the Lebanese economy
due mainly to the relative political stability that the country was enjoying in the region (Chami, Saade N.,
“Economic Performance in a War-Economy: The Case of Lebanon,” Canadian Journal of Development
Studies, Vol. XHI, No. 3,1992, p. 326).
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80
and nominal effective exchange rates depreciated steadily as well. More specifically, the
pound depreciated by about 50 percent against the US dollar while the nominal effective
exchange rate recorded a depreciation of almost 40 percent.2
However, relative to the years that followed, the pound withstood extreme
pressure for devaluation and maintained its relative strength between 1975 and 1982.
The year 1982 proved to be the turning point for the exchange rate. The escalation of the
war led to a deteriorating macroeconomic condition. Starting in 1983, Lebanon
experienced balance of payments deficits and increasing uncertainty about the future. As
there was no solution to the Lebanese problem in sight, expectations began to worsen.
This could account for at least the beginning of the depreciation which later became
worse due to rising speculation and pessimism. An additional explanation is the
phenomenal increase in military expenditures in 1982-83, the purpose of which was to
rehabilitate the Lebanese army and increase its size. In addition, expenditures on non
productive projects increased considerably.
Nasser Saidi provides another explanation in this regard.3 He claims that the
exchange rate behavior is similar to that of stock prices in the sense that, if there is
consensus about a stock price between the participants in the market, then only a small
volume of trading effects a change in the price of this stock and vice versa; similarly if
most foreign exchange traders believe that the pound will depreciate, then only a small
volume of trading suffices to bring about a substantial depreciation. The behavior of the
Lebanese market which often experienced currency depreciations of up to 50 percent in a
few days in times of very low trading, lends credibility to Saidi’s view. More often,
however, this was a result of speculation and negative expectations created by harrowing
incidents, the deteriorating security situation, or the less than sanguine attitude of the
2 Eken, Sena, et al., Economic Dislocation and Recovery in Lebanon, International Monetary Fund,
Washington, DC, 1995, p32.
3 Saidi, Nasser, Economic Consequences of the War in Lebanon, Oxford: Centre for Lebanese Studies,
1986.
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81
public regarding the future due to political deadlocks. These factors contribute to
uniformity in expectations be they positive or negative. Chami (1992) calls this a unique
characteristic of economies operating in wars. With shifting expectations, the Lebanese
pound depreciated by almost 100 percent vis-a-vis the US dollar and in nominal effective
terms in the 1983-1990 period.4
The Ta’if Agreement provided the Lebanese government with a framework to
settle the dispute and the Government initiated a stabilization program in 1991. Although
the central bank did not attempt to fix the exchange rate at this time, it effectively linked
the pound to the dollar while not committing itself to maintaining a fixed exchange rate.
The Government’s renewed efforts to put its house in order brought about significant
fiscal adjustment and the fiscal deficit dropped from its level of 84 percent of total
expenditures in 1990 to 56 percent in 1991. But a subsequent increase in wages in
December 1991 led to an erosion of confidence in the Government’s fiscal position and
caused a run on treasury bills. The following flight from government paper, capital
outflows, and substitution from Lebanese pounds into foreign currencies in private sector
portfolios exerted intense pressure on the exchange rate in the first few months of 1992.
This is evident from the average exchange rate which depreciated from LL 879 per US$ 1
in January 1992 to a whopping LL 2,527.8 per US$ lby September 1992.5 Inflation also
soared in this period.
To counter these phenomena, the Government adopted new stabilization measures
starting in the last quarter of 1992. These measures were aimed at reducing the fiscal
deficit and credit creation and to make the elusive financial stability a reality. These
measures brought about an increase in confidence as well as attractive interest rates on
Lebanese government securities and made prospects in the real estate and construction
sectors more favorable. The result was an increase in capital inflows and, consequently,
4 Eken, p. 32.
5 Ibid., p. 33.
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82
upward pressure on the exchange rate. The authorities intervened at this point to prevent
further appreciation of the pound and to increase official foreign exchange reserves.
However, the pound appreciated even in the face of this intervention by about 30 percent
to the US dollar between October 1992 and march 1994.6 This made up for the
depreciation that the pound experienced in late 1992. Predictably enough, the volatility
of the exchange rate declined starting in 1993.
The movements in inflation and the exchange rate have caused noticeable swings
in the real effective exchange rate of the Lebanese pound. Changes in the real effective
exchange rate had remained minute between 1964-1981.7 By contrast, it depreciated by
57 percent between 1983 and 1988 and appreciated by about 70 percent between 1989
and 1993. Although these movements are large, it should be noted that the real effective
exchange rate was only about 32 percent more appreciated than its 1974 level.
Inflation
Inflation in Lebanon had remained low and, sometimes, even negative even in the
face of a fast growing economy. However, this changed after the outbreak of civil war
and the country experienced not only double-digit but also triple-digit inflation. Inflation
rose from around 10 percent in 1975 to close to an imposing 500 percent in 1987.®
Although there has been considerable volatility in inflation rates, they have clearly risen
overall during the period 1975-1990. The ever changing inflationary expectations and
loss of confidence in the domestic currency partly explain this volatility.
Although the devastation brought on by the war was widespread throughout the
economy, exchange rates and inflation were two of the most badly hit variables. The
6 See Chapter 3.
7 In 1981, the real effective exchange rate was only about 4 percent more depreciated than its 1964 level
(Eken, p. 34).
International Monetary Fund, International Financial Statistics.
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83
ensuing situation has engendered negative expectations and speculations and has had a
strong impact on market psychology. Significant inflationary pressure comes from the
government’s fiscal deficit and the consequent domestic financing requirements. The
resulting increase in money stock is not met by a substantial rise in money demand
leaving the public with an excess supply of money in their hands. In cases where the
public attempts to adjust by spending on domestically- and foreign-produced goods and
services and by investing in foreign assets, an upward pressure is put on the rate of
inflation either directly or indirectly through the change in the exchange rate. This holds
true for Lebanon.
Another factor affecting the rate of inflation is profit. Up until 1982 firms and
small businesses were making a “normal” level of profit. But the exchange rate started to
depreciate from 1982 which eroded the purchasing power of the Lebanese pound.
However, the prices, especially those of imported goods, could not adjust fully and
instantaneously and thus this sharp decline in the value of the pound was not reflected in
them. With the gradual rise in prices, demand for higher wages also increased. Both the
public and the private sector heeded to these demands and the resulting higher wages
provided an incentive for further price hikes and spiraling high wages. Thus the whole
process involved below “normal” profits in the early stages of the depreciation followed
by attempts by businesses to again achieve their “normal” level of profit in the wake of
the wage increases.
Changes in Inflation with Exchange Rate Movements; The Long Term
Exchange rates are an important factor that influence inflation especially in a very
open economy like Lebanon. In addition, purchasing power parity implies a two way
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84
causation running both from prices to exchange rates and from exchange rates to prices.9
This gains substantial relevance in the case of Lebanon which is not only a very open
economy but also quite a small country. Also, Lebanon relies heavily on imports which
makes the response of domestic prices to exchange rate depreciation very quick and
sensitive.
Table 4-1 below presents the data on inflation and the LL/US$ exchange rate.
Table 4-1
Year LLTUSS
(Period
Average)
CPI
Inflation
(Lebanon)
CPI
Inflation
(US)
Inflation
Differential
(Absolute
Value)
Percentage
Change in
LL/US$
(Absolute
Value)
INFDIFF* Aef*
1950 3.74 1.3 ... ... ... ...
1951 3.80 9.52 7.9 1.62 1.60 0.4824 0.4727
1952 3.57
2.59t
2.2 0.39 6.05 -0.9416 1.8000
1953 3.19 -4.35 0.8 5.15 10.64 1.6390 2.3650
1954 3.24 -4.55 0.5 5.05 1.57 1.6194 0.4494
1955 3.25 O .llf -0.4 0.29 0.31 -1.2379 -1.1756
1956 3.20 4.76 1.5 3.26 1.54 1.1817 0.4308
1957 3.18 9.09 3.6 5.49 0.63 1.7029 -0.4700
1958 3.19 4.17 2.7 1.47 0.32 0.3853 -1.1569
1959 3.16 4.00 0.8 3.2 0.63 1.1632 -0.4669
1960 3.17 3.85 1.7 2.15 0.32 0.7655 -1.1505
1961 3.08 0.081 1.0 0.92 2.84 -0.0834 1.0435
9 Isard, Peter, “Lessons from Empirical Models of Exchange Rates,” Staff papers. International Monetary
Fund, 1987.
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85
Table 4-1 (continued)
Year LL/USS
(Period
Average)
CPI
Inflation
(Lebanon)
CPI
Inflation
(US)
Inflation
Differential
(Absolute
Value)
Percentage
Change in
LL/USS
(Absolute
Value)
INFDIFF* Aet*
1962 3.01 -3.70 1.1 4.80 2.27 1.5686 0.8210
1963 3.10 3.85 1.2 2.65 2.99 0.9746 1.0953
1964 3.07 3.70 1.3 2.4 0.97 0.8755 -0.0328
1965 3.08 3.57 1.6 1.97 0.33 0.6780 -1.1217
1966 3.13
3.5 I t
2.9 0.61 1.62 -0.4943 0.4845
1967 3.20 3.45 2.9 0.55 2.24 -0.5978 0.8049
1968 3.16 5.06f 4.2 0.86 1.25 -0.1508 0.2231
1969 3.25 6.67 5.4 1.27 2.85 0.2390 1.0467
1970 3.27 6.46tt 5.7 0.76 0.62 -0.2744 -0.4855
1971 3.23
6.46ft
4.4 2.06 1.22 0.7227 0.2015
1972 3.05 6.25 3.2 3.05 5.57 1.1151 1.7179
1973 2.61 5.88 6.2 0.32 14.43 -1.1394 2.6690
1974 2.33 11.11 11.0 0.11 10.73 -2.2073 2.3729
1975 2.30 10.00 9.1 0.90 1.29 -0.1054 0.2527
1976 2.87 27.27 5.8 21.47 24.78 3.0667 3.2101
1977 3.07 19.64 6.5 13.14 6.97 2.5757 1.9414
1978 2.96 10.45 7.6 2.85 3.58 1.0473 1.2762
1979 3.24 22.97 11.3 11.67 9.46 2.4570 2.2470
1980 3.44 24.18 13.5 10.68 6.17 2.3684 1.8202
1981 4.31 19.47 10.3 9.17 25.29 2.2159 3.2304
1982 4.74 18.52 6.2 12.32 9.98 2.5112 2.3002
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86
Table 4-1 (continued)
Year LL/USS
(Period
Average)
CPI
Inflation
(Lebanon)
CPI
Inflation
(US)
Inflation
Differential
(Absolute
Value)
Percentage
Change in
LL/USS
(Absolute
Value)
1NFD1FF* Aet*
1983 4.53 6.88 3.2 3.68 4.43 1.3029 1.4885
1984 6.51 18.13 4.3 13.83 43.71 2.6268 3.7776
1985 16.42 69.31 3.6 65.71 152.23 4.1853 5.0254
1986 38.37 95.32 1.9 93.42 133.68 4.5371 4.8954
1987 224.60 487.13 3.6 483.53 485.35 6.1811 6.1849
1988 409.23 154.97 4.1 150.87 82.20 5.0164 4.4092
1989 496.69 72.20 4.8 67.4 21.37 4.2107 3.0621
1990 695.09 68.82 5.4 63.42 39.94 4.1498 3.6875
1991 928.23 51.46 4.2 47.26 25.12 3.8557 3.2235
1992 1712.79 119.99 3.0 116.99 84.52 4.7621 4.4370
1993 1741.36 29.11 3.0 26.11 1.67 3.2623 0.5117
1994 1679.74 8.00 2.6 5.40 3.54 1.6864 1.2637
1995 1620.94 10.60 2.8 7.80 3.50 2.0541 1.2529
1996 1570.94 8.90 3.0 5.90 3.09 1.7750 1.1264
Source: International Monetary Fund, International Financial Statistics; Banque du
Liban; US Department of Commerce, Bureau of the Census, Statistical Abstracts o f the
United States, 1971, 1997; author’s calculations.
♦Values are in natural logarithms.
tAverage of the preceding and following years’ values.
f t Average of the inflation values for the years 1969 and 1972.
To establish the relationship between exchange rate and inflation rate
movements, a simple regression equation estimated by Sena Eken et al was used. The
data in this study, however, is revised and extended to include the most recent periods
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87
possible. The equation relates the differential between the US and Lebanese inflation
rates to changes in the LL/USS exchange rate.
INFDIFFt =cc0+ celAet + ut ,
where INFDIFFt is the differential between Lebanese and US inflation rates, et is the
LL/USS exchange rate, and ut is an error term. All variables are in logarithms. This
equation was used to estimate the said relationship for the periods before and after the
start of the civil war. Results are presented in Table 4-2 below.
Table 4-2
Regressions of the Differential Between Lebanese and US Inflation Rates on Changes in
the LL/USS Exchange Rate°
Independent
Variable
Overall Sample
1951-1996
Before Civil War
1951-1974
Since Civil War
1975-1996
Intercept 0.44 0.44 0.77
(1.69) (1-91) (2.30)
Change in LL/USS 0.74 -0.22 0.80
exchange rate (6.77) (1.17)
(7.57)
R-square 0.51 0.06 0.74
Adjusted R-square 0.50 0.02 0.73
DW Statistic 0.99 1.81 1.21
° The numbers in parentheses are t-statistics.
The results show that the relationship between the Lebanese-US inflation
differential and exchange rate movements was positive but not statistically significant
before the civil war but has been both positive and strongly significant since 1975.
Although the relationship for the overall period, i.e., for 1951-1996, also turns out to be
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88
positive, it is not as strongly significant as it is for the period after the outbreak of the
civil war. In addition, except for the overall case (which has only a marginal role in the
purpose of this study), the DW statistics for the estimations lie within an acceptable range
which does not pose a threat to the credibility of the existing model. In other words, the
values suggest that the chances of the existence of an autocorrelation in the existing
model are remote. This holds especially true when the periods before and since the start
of the civil war are treated separately. Chances of an autocorrelation problem are greater
for the estimation for the overall period but still low enough to be ignored without
seriously jeopardizing the credibility of the model.
To gain further insight into the relationship between inflation and exchange rate
movements, it would be appropriate to estimate an equation where the inflation
differential serves as the independent variable. Therefore, an equation of the following
form was estimated:
Aef = SQ+ 8,INFDIFFt + u,.
This alternate relationship becomes even more important in understanding the inflation-
exchange rate mechanism in our case when we recall our model of the adjustment
problem in Chapter 1. Here, the government has an objective function for minimizing
losses. Government losses depend on inflation while inflation, in turn, is dependent upon
the government’s adjustment effort. This capability to affect the inflation rate
exogenously, therefore, makes it imperative to study the effects of inflation rate
movements on the exchange rate.
Using the data in table 4-1, the said relationship was estimated for the period from
1951-1996, and the periods before and since the start of the civil war, i.e., for 1951-1974
and 1975-1996 respectively. Results are presented in table 4-3 below.
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Table 4-3
Regressions of Changes in the LL/USS Exchange Rate on the Differential Between
Lebanese and US Inflation Rates0
Independent
Variable
Overall Sample
1951-96
Before Civil War
1951-74
Since Civil War
1975-96
Intercept 0.47 0.58 -0.002
(1-91)
(2.40) (0.004)
Lebanese-US 0.69 -0.27 0.92
Inflation Rate (6.77) (1.17)
(7.57)
Differential
R-square 0.51 0.06 0.74
Adjusted R-square 0.50 0.02 0.73
DW Statistic 1.08 1.27 1.42
° The numbers in parentheses are t-statistics.
Comparing the results presented in tables 4-2 and 4-3, it is easy to see that the
relationship between inflation and exchange rate movements is almost equally strong
both ways. Coefficients for the inflation differential in all three periods are comparable
to those of changes in exchange rate when the exchange rate was treated as the
independent variable. The R-square and the adjusted R-square values remain unchanged
while the DW statistics show only little difference from their previous values. Thus, the
effect of inflation rate movements on movements in the exchange rate is almost equally
significant as the effect of the latter variable on the former.
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90
Changes In Inflation with Exchange Rate Movements: The Short Term
The method used to establish the desired relationship between inflation and
exchange rate movements is inspired in part by the method of Engle and Granger (1987).
The following error-correction equation was estimated:
i n f d m = A > + A A e r + P iE C , ~ i + W r .
where ECt_{ is the error-correction term representing the difference between the actual
value of the inflation differential and the value predicted for the previous period from the
equation estimated for the long-term for the period since the outbreak of the civil war;1 0
wt is the error term while inf dijft and Aet are defined as they were before in the case of
the long-term relationship. Again, all variables are in natural logarithms..
Table 4-4 below presents the data used to run the regression. The figures used are
from the period since the end of the civil war (1991-1997).
Table 4-4
Year infdiff, Ae, Predicted Inflation
Differential
(Period t-1)
ECt. x
1991 3.8557 3.2235 3.7370 0.1187
1992 4.7621 4.4370 3.3642 1.3979
1993 3.2623 0.5117 4.3391 -1.0768
1 0 The estimation for the period since the start of the civil war is preferred here over the estimation for the
overall period since Lebanon is still on the road to recovery and has, by no means, reached the level of
normalcy that would justify the use of the estimation for the overall case. The estimation used resembles
the current situation more closely by incorporating peculiarities characterizing the Lebanese situation.
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Table 4-4 (continued)
Year
inf djff, Ac,
Predicted Inflation
Differential
(Period t-1)
EC,.,
1994 1.6864 1.2637 1.1855 0.5009
1995 2.0541 1.2529 1.7897 0.2644
1996 1.7750 1.1264 1.7810 -0.0060
1997 1.9601 2.0185 1.6794 0.2807
° All Variables are in natural logarithms.
Table 4-5 below presents the results obtained upon running a regression using the
data above.
Table 4-5
Regressions of the Differential Between Lebanese and US Inflation Rates on Changes in
the LL/USS Exchange Rate and an Error-Correction Term°
Independent Variable Time Period (1991-1997)
Intercept 0.75
(1.35)
Change in LL/USS exchange rate 1.15
(3.92)
Error-Correction term (Difference between -1.21
actual and predicted inflation differential) (2.18)
R-square 0.81
Adjusted R-square 0.71
DW Statistic 1.12
° The numbers in parentheses are t-statistics.
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92
The results show that the impact of exchange rate movements on inflation has been
significant since the end of the civil war and the extension of government authority over
Lebanon. A negative coefficient for the error-correction term, ECt_x , means that, in any
one period, any movement of the inflation rate which is away from the level determined
by our longer-term relationship between the inflation differential and the exchange rate,
will get corrected in the following period. Thus it can be concluded that, in Lebanon,
sharp movements in the exchange rate could give rise to high inflation. These
movements in the exchange rate could either be planned or be due to political events and
capital flows. The R-square and adjusted R-square figures and the DW statistic again
take on values which lend support to the credibility of this model.
Looking at the results of the above regressions, it can be seen that a conspicuous
distinction in the strength of the relationship between the inflation differential and
exchange rate movements exists in the period before and since the start of the civil war.
The relationship has been notably strong in the period since the outbreak of the civil war
while it was negligible during 1951-1974. This can be attributed to the uncertainty that
has plagued the political environment since the mid-1970s. Although the situation is
much improved following the cessation of hostilities and the drive to implement a
stabilization plan in 1991, Lebanon is still in the process of shedding off its civil-war
legacies and re-establishing itself as a dynamic regional economy. The fragile political
environment and rising inflation during the civil war led to speculative behavior. Thus,
exchange rate volatility increased considerably during 1975-1982. The macroeconomic
situation deteriorated further after 1982 with inflation continuing its rise while shifting
expectations contributed to increasing volatility of exchange rates. Thus, the traditional
exchange rate stability that Lebanon enjoyed prior to the civil war was shattered. This
increase in exchange rate volatility could partially account for the strong relationship
between the inflation differential and exchange rate movements since the start of the civil
war.
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93
Also, exchange rate data for the pre-civil war period conveys the fact that the
Lebanese pound appreciated by about 35 percent between 1957 and 1974. Therefore, a
stronger inflation-exchange rate relationship could also, in part, be imputed to the
argument that appreciations in the exchange rate are not passed through to prices as fully
as depreciations, which prevailed after 1975. In addition, the protracted civil war altered
the way in which the public operated in the economy and this change in outlook has
carried over into the post-civil war period. Thus, the continuing strong relationship
between inflation and exchange rate movements even after the end of the civil war could
also be attributed to this fundamental change in the economic outlook of the public.
The exercises conducted in this chapter show that the relationship between price
level and exchange rate movements are the strongest for the period following the end of
the civil war. This relationship is fairly weak if data for the period prior to the outbreak
of the war is treated exclusively. However, all other regressions point toward a
reasonably strong relationship between these two variables. This bodes well since the
next chapter studies the scope of debt reduction through inflation in Lebanon partly in
light of this relationship.
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94
Chapter 5: Using Inflation for Deht-Reduction in Lebanon
Impute it not a crime
To me or my swift passage that I slide
O’ er sixteen years and leave the growth untried
Of that wide gap, since it is in my power
To o 'erthrow law and in one self-bom hour
To plant and o 'erwhelm custom.
- The Winter’s Tale
As was described in Chapter 3, Lebanon experienced a deterioration in its fiscal
position after the outbreak of the civil war. Although the situation has improved since the
termination of hostilities in 1990, real postwar revenues remain below the levels achieved
in prewar years. Also, real postwar expenditures remain at high levels especially in
comparison to those of war years.
Weaknesses include a narrow revenue base, a needlessly complex revenue
structure, and a limited capacity for tax enforcement. Contributing to the growing
government expenditure is the central role of the public sector in the reconstruction
process. Lebanon’s debt and deficits contribute to the popular perception of instability
plaguing both the economic and political environment. This final chapter suggests short
term steps that could be taken to relieve Lebanon of its debt burden, inject the
environment with stability and optimism, and thus put Lebanon back on the road to
recovery and growth.
Public Debt Management
Debt crises are pervasive and affect a wide range of activities. Joblessness due to
resulting recessions and plunging literacy rates due to cuts in education budgets are but a
few of the consequences. In Latin America, for example, since the eruption of the debt
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95
crisis in 1982, per capita GDP had gone down by almost 1 percent per year up until 1991.
At the end of 1989, the average GDP per capita was more than 8 percent below its 1980
level.1 It is for this reason that the 1980s were labeled the lost decade. Also, investment
in physical capital declined in the wake of increasing concerns about Latin American
solvency. The event is especially relevant to the Lebanese reconstruction drive since the
government’s ever increasing role in this program is merely expanding the debt which,
consequently, discourages investors from participation. Ricardo Faini (1994) confirms
this crowding- out-of-investment effect in the face of rising government current
expenditure. This, in turn, leads to short-term benefits on output of an expansionary
fiscal policy being outweighed by its long-term negative impact on growth. This is
especially true in light of declining investment and demand in the industrial and
construction sectors.
All of this again supports the requirement for fiscal discipline. The Lebanese
authorities have already successfully established the basic infrastructure. Recent trends
in the industrial and construction sectors attest to this fact. During 1997, investment,
demand, and production in the manufacturing sector were on a downturn. Imports of
industrial machinery have stabilized. In the construction sector, both a decline in
construction permits and cement deliveries occurred in 1997. At present, there are
120,000 apartments in reconstructed Beirut that are waiting to be rented or sold.2 Also,
the level of imports deteriorated in 1997 by 6.5 percent.3 Many of the projects that the
government is engaged in at this point are highly unnecessary and are serving only to
expand its debt further. According to the Banque du Liban, during the fourth quarter of
1997, there was a quarterly increase of 12 percent in net domestic debt. In the past,
overdoing projects such as the rebuilding of the Beirut air port, which is designed to
1 Cardoso, Eliana, and Ann Helwege, Latin America’ s Economy: Diversity, Trends, and Conflicts,
Cambridge, MA: The MIT Press, 1992, pp. 110-111.
: Ahmad, Eqbal, Dawn, July 19, 1998.
3 Banque du Liban, Quarterly Bulletin, 41 " Quarter, 1997.
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96
handle 6 million passengers annually, a number it may never attain, have led to
significant and unnecessary increases in debt. Therefore, the government should check
its existing spending pattern and turn its attention toward the provision of social
necessities while encouraging private investors to undertake the more ambitious projects
such as the proposed underground fiber optic network in Beirut.
Large public debts also have the potential to threaten the exercise of sound
monetary policy. A high interest rate triggers a snowball effect adding interest to debt.
This attaches an unwanted side-effect to monetary restraint making it difficult to pursue
this policy vigorously. Modem governments have often employed price rises engineered
through appropriate monetary policies to cancel the real value of their debt. Thus, large
debts make a sizable inflation designed to reduce the debt a tempting option. In such
cases, the objective of maintaining price stability is rendered impossible. This issue is
extremely relevant to the case of Lebanon, where the government is gradually
overcoming the inflation problem on the one hand but simultaneously amassing a
substantial debt on the other. It is for this reason that this study recommends the use of
inflation to reduce debt at the current stage and pursue a policy of price stability later
thereby removing a major source of uncertainty and economic malaise which might
threaten future prosperity.
The European Commission, regarding its concern for debt in the context of fiscal
policy, states: “The failure to realize greater progress in budgetary consolidation sustains,
in many cases, a situation where fiscal policy is severely constrained by a high and rising
burden of interest payments; it also undermines price and exchange rate stability,
increases uncertainty about the course of fiscal policy, and erodes the credibility of
policies.”4
4 Dombusch, Rudiger, Debt and Monetary Policy: The Policy Issues, NBER Working Paper 5573,
Cambridge, MA: National Bureau of Economic Research, 1996, pp. 3-4.
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97
Extreme or hyperinflation wipes out debt. Chapter 1 related the case of Germany
after World War I to illustrate this point. An unexpected increase, more precisely,
eliminates long-term debt. With regard to the short term debt, if it were rolled over with
inflationary expectations perfect, the effect of higher interest rates would neutralize the
inflationary erosion. The consummate elimination of the German debt means either that
the authorities resorted to money creation to pay off the debt or that the extreme inflation
was an ongoing surprise. Dombusch (1996) considers the latter a plausible assumption in
explaining the wiping out of the German war debt.
Further, the following debt dynamics equation5 can be used to study the reduction
in US debt-GDP ratio in the postwar period:
b' = (r - y)b - d .
Here, b' is the rate of increase in the debt ratio, r is the real interest rate, y is the growth
rate, and d is the primary budget surplus as a share of GDP. This is the mechanism that
is used to account for the reduction in the US debt-GDP ratio that took place between
1948 to 1980. Although part of the process is attributed to the presence of long term debt
in an environment of rising inflation, low (and at times, negative) realized real interest
rates also played a role. The overexpansion in the late 1960s led to inflation in the US
and this phenomenon was further strengthened by oil shocks and a declining dollar.
However, ambiguity regarding a shift in the monetary regime prevailed until the mid-
1970s and this helped reduce the debt.6 Once this ambiguity was eliminated, the
possibility of inflationary debt erosion also ended. In fact, in the 1980s, the US had real
interest rates that exceeded the growth rate which fueled debt accumulation relative to
GDP.
5 Ibid., p. 11.
* This debt reduction occurred at a time when debt was really not an issue in public debate.
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98
The Effect of Debt on Credibility
Large debts have the potential to affect the integrity of monetary policy. They
can be dealt with by employing either taxation, repudiation, or inflation. Keynes (1923)
asserts that society prefers inflation. In agreement with this view is Colin Clark (1945)
who sees a general price rise as an alternative to excessive taxation. Clark believes that
policy makers and politicians are more willing to resort to price engineering when faced
with a situation they believe would lead to excessive taxation. This goes on until the
burden of the budget is less onerous. Both Clark and Keynes support a policy of debt
erosion through surprise inflation.7
Despite what the authorities might claim, high debts automatically create the
presumption of inflation. In addition, the problem gets compounded by the practice of a
tight monetary policy.8 A tight monetary policy causes real interest rates to rise which
translate into higher debt service charges which eventually leads to the rapid growth of
debt. Also, increasing real interest rates slow down the growth rate of the economy
which means that the rise in the debt-GDP ratio accelerates. The primary surplus also
suffers in the face of reduced tax and increased unemployment compensation. Most clear
of all the effects of a tighter monetary policy is the reduction in seigniorage which leads
to a larger portion of the deficit being financed by resorting to higher debt.
If the analysis by Sargent and Wallace (1986) is invoked here, the efficacy of
monetary policy in high-debt economies simply becomes suspect. When governments,
such as those which are in the position of the government of Lebanon, take recourse to a
rising debt in order to establish their credibility, they effectively add to the problem faced
7 A similar view is held by Sargent and Wallace (1986) who advocate a policy of seigniorage for deficit
finance to retard debt accumulation.
8 This view is held by many economists including Dombusch (1996), Razin and Sadka (1993), and Guidotti
and Kumar (1991). It should be noted, however, that research in rational expectations has led to some
pessimism regarding this possibility.
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99
by the monetary authorities of continuing on with a tight monetary policy. This means
that the possibility of the monetary authorities sticking with their policy of restraint when
faced with a future shock dwindles considerably. All of the above implies that Lebanon
should address the issue of its rising debt at the earliest possible date and much before
this problem becomes acute and increasingly difficult to handle. The Lebanese debt is
fast on the rise and fifteen years of civil strife have conditioned the public to anticipate
(often accurately) government policies and their economic implications much in advance.
If monetary action is postponed, the authorities would have to take steps which would
inevitably be viewed as contributing to a major social problem. The only choice the
authorities have is to either take the initiative now or postpone the unavoidable to a later
date when socially undesirable consequences would result on a much wider scale.
Another consequence of delay would be to undermine the image of the country’s
economic state at a time when it (most probably) would have overcome its civil war
legacies of unpredictable turbulence and instability. However, the situation could
deteriorate even before reaching that stage if funding crises - the possibility of which is
quite real in Lebanon— are to occur.
Debt Management Episodes: Six Experiences
Awareness about a country’s financial difficulties makes competitive bond
holders less anxious to buy new debt to help the country overcome its existing problems.
Moreover, the cost of servicing the debt leads to depressed living standards,
hyperinflation, sharply reduced investment, and almost invariably reduced growth rates.
These consequences clearly manifested themselves in the case of the Latin American
economies in the 1980s. Rising debt also discourages increases in capital from new
investors due to prior claim of the existing debt. In addition, existing debt makes direct
investment less attractive because of the prospect of low yields on new investment.
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100
Inflation, though it has many negatives associated with it, can work to ease the
situation for governments if employed wisely. The most important task that controlled
inflation achieves is to provide enough space so as to avoid the raising of real interest
rates. Price stability translates into higher demand for local currency in real terms. The
return of stability means positive real interest rates which create a sizable burden in the
presence of a large public debt. Taking the monetization route, however, leaves the
authorities with doubts about the extent of their policy that is necessary to attain the
desired result. Being too conservative leaves room for high real interest rates and an
overzealous approach fuels inflation while giving rise to speculation due to low interest
rates. Exploiting the exchange rate-inflation relationship established in Chapter 4 ,
therefore, provides a viable alternative for debt elimination/reduction.
What follows are debt management experiences of six different countries, all of
which provide useful insight into the problem of a fast-expanding debt and which have
useful implications for the situation currently faced by Lebanon.
The German World War I Experience. Probably the most useful to the Lebanese
situation is the study of the German experience. The total German public debt reached a
peak in 1918 representing a debt financed war. In index terms, a value of 1 for total
public was assumed in 1910 and this reached 16.9 in 1918. By 1924, after stabilization,
the level was 0.00027.9
Germany’s phenomenal rise to the rank of an industrial power came to a sudden
halt in 1914. Germany fought the war in the absence of outside economic or financial
help. In addition, it faced a blockade of its shores. At the time the war broke out,
Germany was totally unprepared economically and had to face bitter consequences later
9 Dombusch, Rudiger, “Debt and Monetary Policy: The Policy Issues,” National Bureau of Economic
Research, Working Paper 5573, 1996, p. 5.
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101
on. The Germans had not expected to engage in a lasting war and, thus, did not factor in
steps like a blockade taken by their adversaries into their war plans.
In the aftermath of the forty-eight hour ultimatum that was served by the Austro-
Hungarian government to the Serbian leadership, the Reichsbank (central bank) lost in
excess of 100 million marks in gold with the gold reserves falling from 1357 to 1253
million.1 0 The war scare manifested itself in people’s actions - gold hoarding and runs to
convert bank deposits into bank notes. The situation forced the Reichsbank to
discontinue redeeming bank notes in gold, an action that was against its legal obligations.
This step was more than an attempt to guard against panics. In fact, the policy was
enacted in order to allow the Reich government to finance the war.
Germany further enacted four financial laws which were meant to finance its war
effort. These were as follows:
• The moratorium on banknote redemption was to be maintained indefinitely.
• “The tax on all note circulation in excess of 550 million marks over and above the gold
coverage was abolished.
• Loan Banks1 1 were to be organized.
• The Reichsbank was empowered to include in its note coverage the three-month
treasury bills issued by the Reich, and in its “ready money coverage” (Bardeckung), the
notes of the Loan Banks.”1 2
While the first of these was simply a defensive policy against gold hoarding, the
last three led to inflation in the future, although it is doubtful that the German authorities
were aware of it at that time. The Loan Banks were responsible for procuring credits for
1 1 1 Ringer, Fritz K., ed.. The German Inflation of 1923, New York: Oxford University Press, 1969, p. 64.
1 1 The Loan Banks were essentially an emergency organization and were initially used during the Franco-
Prussian war of 1870-1871. Their purpose was to procure credit for business requirements. The task of
these banks was the same in 1914 and they performed these tasks up to the end of the inflation period in
1924. In addition to granting credit to businesses, their major task was to serve as supplementary agencies
of the Reichsbank. In this role, these banks were not confined by various legal regulations that restricted
the Reichsbank itself. Thus, the Loan Banks were allowed to grant credit on collateral that did not qualify
for Reichsbank loans. They also gave credit to federal and state municipalities and to new war
corporations.
1 2 Ibid.. p. 65.
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102
business needs. They also served as supplementary agencies of the Reichsbank without
having to work within the regulations that limited the Reichsbank itself. What opened
the gates for unrestrained inflation, however, was the clause granting the Reichsbank the
authority to rediscount unlimited amounts of short-term Treasury bills against bank notes.
Thus, it is clear that the Germans employed the printing press to finance the governments
immediate war needs as well as to satisfy the increased credit requirements of private
businesses.
Table 5-1 below, presents data pertaining to Germany’s war expenditure. The
erratic rise in expenditures from 1916 to 1917 and 1918 could, in part, be attributed to
fast-rising prices.
Table 5-1
German World War I Expenditures
April 1 to March 31 Millions of Marks
1914-1915 6,936
1915-1916 23,909
1916-1917 24,739
1917-1918 42,188
1918-1919 33,928
Accounted After 1918 32,599
TOTAL 164,300
Source: Ringer, Fritz K., ed., The German Inflation o f 1923, New York: Oxford
University Press, 1969, p. 67.
The most important means of war financing in Germany were war loans. In large
part, the war loans were issued in the form of 5 percent perpetual bonds though a portion
was also issued in the form of 4.5 to 5 percent Treasury certificates with different
maturities. These loans were issued in half-yearly intervals for a total of nine times. The
first eight saw a rising trend with the first netting 4,492 million marks while the eighth
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103
getting 15,126 million. The ninth loan showed a little decline. The total amount
procured by the German authorities through these loans was 96,929 million marks.1 3
Ironically, despite the enormous amounts that the German government had been
able to procure, the sum covered hardly 60 percent of the total expenditures. To cover
the rest, the government, therefore, had to resort to increased taxation and extension of
short-term credits by institutions other than banks of issue. Thus, by the end of the war,
the amount of Treasury bills held outside the Reichsbank stood at 29,300 million marks.1 4
Table 5-2 shows the revenues and expenditures of the Reich between 1920 and
1923. Revenues did not rise either in gold mark values or in the purchasing power of
paper marks. Tax reforms were implemented in 1919-1920 and these had produced their
maximum effect by the middle of 1921. However, this still did not satisfy the
requirements of the German government and further tax reforms were needed. This came
about in the spring of 1922 leading to an ephemeral rise in tax revenues which lasted for
about a month. Unfortunately, these steps were too little too late. Although exchange
rates, prices, and governmental expenses were on the rise, tax revenues, which increased
in paper mark totals, failed to keep up with the increase in these other variables. In late
1923, only 1-2% of expenditures were covered by taxes and many taxes did not yield the
cost of collection.1 5
The table also presents a clearer picture of the government’s debt obligations. The
floating debt continued its uninterrupted rise from the end of the war till the currency
reform in November 1923. Also, the ratio of the monthly increment in floating debt to
state revenue from all other sources continued its rise. Taxes covered a negligible portion
of the expenditures in the last half-year of inflation. For all practical purposes, the
government was not collecting ordinary taxes and was wholly dependent on the issue of
1 3 Ibid.. p. 68.
1 4 Ibid.
1 5 Graham, Frank D., Exchange, Prices, and Production in Hyperinflation: Germany, 1920-1923,
Princeton, NJ: Princeton University Press, 1930, p. 39.
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Table 5-2
Revenue and Expenditure of the Reich: 1920-1923
(Millions of gold marks)
Table 5-2A (Revenue)
Fiscal
Year
Revenue
Taxes Floating Debt Sundries Total
1920 3,497 6,092 108 9,697
1921 3,924 4,939 73 8,936
1922 2,255 3,953 36 6,244
1923*
1,100 8,431 144 9,675
Table 5-2B (Expenditure)
Fiscal Expenditure
Year Repayment Interest on Contribution Execution of Other Total
of Funded Floating to Reichsbahn the Versailles Expenditures
Debt Debt Treaty
1920 717 — — — - - 9,697
1921 804 617 847 —
6,668 8,936
1922 51 221 1,037 2,292 2,643 6,244
1923*
— 647 2,614 — — 9,675
* Figures for 1923 are for 9 months.
Source: Graham, Frank D., Exchange, Prices, and Production in Hyperinflation:
Germany, 1920-1923, Princeton, NJ: Princeton University Press, 1930, pp. 40-41.
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105
fiat money. This is a classic example of using inflation as a concealed method of
taxation. Economists of the time have argued that the German government would
probably have been better off if it had ceased the collection of ordinary taxes altogether.1 6
As was stated in the previous paragraph, in many instances, tax collection was costing
more than revenues from taxation. This is especially pertinent to the Lebanese case due
to limited direct taxation in Lebanon, a heavy reliance on non-tax revenues, and a limited
capacity for tax enforcement. Corrections required here demand a focused effort and a
significant time investment on the part of the Lebanese authorities and are, therefore,
beyond the scope of any short-term strategy aimed at raising the level of revenues. Thus,
Lebanon would be better off utilizing its strength in collection from the non-tax- and
indirect tax-revenue spheres, at least in the short-term, for the strategy being proposed in
this study.
The extent of the issues of fiat money in World War I Germany can be gleaned
from the fact that from a level of 24 billion marks in January 1919, these reached an
awesome and staggering level of 496, 507,424,800 billion marks December 1923.1 7 It
should be noted, however, that this increase in the issues of fiat money does not reflect
the Reich’s financing requirements fulfilled through these issues alone as the figures also
incorporate the depreciation of the currency. The depreciation of currency, therefore, had
a twofold effect. First, it wiped out the pre-inflation federal budget debt. In addition, it
constantly kept on reducing the debt burden of the large amounts of current borrowings.
Peter Reinhold (1928) sketched a vivid picture of the dramatic fiat money issues of the
Reich. If a thousand-mark notes were to be taken and piled tightly together one on top of
the other to equal the government’s borrowing from the Reichsbank, we would have a
pillar twenty-five billion times as high as the world’s tallest mountain.1 8
1 6 This is because doing away with the ordinary taxation mechanism would have reduced the issues of hat
money.
1 7 Graham, p. 46.
1 8 Reinhold, Peter P., Germany Since the War, New Haven: Institute of Politics Publications, Yale
University Press, 1928, p. 53.
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Preceding paragraphs give enough credibility to the view that the German
inflation was not a postwar phenomenon but had started with the war. In fact, by the end
of the war, Germany was experiencing unusually high levels of inflation. During the
war, the German stock exchanges remained closed and no quotations of foreign
exchanges were published. This made it difficult for the people to accurately gauge the
level and effects of the ongoing inflation. In Lebanon, this much-needed element of
surprise apropos the inflation rate would have to be effected in a different way. Since the
government liberally took recourse to the printing of money during the civil war to
finance its deficits, much of the Lebanese population is well aware of the effects of this
policy. Consequently, almost perfect inflationary expectations prevail in episodes of
money creation. This is the main reason why this study recommends the manipulation of
the exchange rate-inflation relationship to create desired inflation. Not only does this
minimize the accuracy of the inflationary expectations formed by the public due to the
lack of acquaintance they have with this inflation-creating strategy, it also has a higher
likelihood of catching the economic agents off-guard since official intervention in
exchange-rate markets would be a negation of Banque du Liban’s traditional role of non
interference.
The United States and the World War II Debt Experience. The United States has had
positive experiences with inflation as far as debt reduction through inflation is concerned.
In the aftermath of the Revolutionary War, inflation was responsible for reducing the debt
by 32 percent between 1789-18001 9 and again by 30 percent by the end of 1815 following
the War of 1812. However, inflation accounts for a sizable reduction in the debt-GNP
ratio even in recent history. For that we look toward the World War II debt experience of
the United States.
1 9 Brown, E. Cary, “Episodes in the Public Debt History of the United States," in Public Debt Management:
Theory and History, ed. by Rudiger Dombusch and Mario Draghi, Cambridge, England and New York:
Cambridge University Press, 1990, p. 230.
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107
By the end of the war the US debt exceeded its GNP. The debt could easily be
imputed to the immense build-up in expenditure. President Truman, in an attempt to
reduce the nominal debt, adopted tight fiscal policies in the postwar period.
Subsequently, prices soared in 1946 and 1947 after the premature elimination of price
and other controls. Brown (1990) ascribes virtually all reduction in debt beyond that
point to inflation. He further states that the government did not intend to reduce its debt
through a policy of inflation. However, the early elimination of the excess-profits tax in
1945 rendered the wartime stabilization program impossible and doomed the continuation
of wartime price and wage controls. Victory over Japan had brought about a significant
change in policies. President Roosevelt had received no-strike and no-lockout pledges
which were valid for the duration of the war only. Thus, in August, 1945, President
Truman issued an executive order which removed direct wage controls. It was a
combination of these forces that worked together to end price and wage controls.
Table 5-3 below shows the relative weight of output growth, net real debt
repayment, and inflationary changes in real debt for three postwar periods.
Table 5-3
Factors Reducing the US Debt/GNP Ratio, 1945-74 (%)
Debt/GNP Ratio, 1945 110
Terminal Year 1955 1965 1974
Real Growth to -10 -39 -55
Net Real Debt Repayment to -3 +3 +10
Net Price Changes to -42 -38 -41
Total Change -55 -74 -86
Debt/GNP Ratio, Terminal Years 56 37 23
Source: Brown, E. Cary, “Episodes in the Public Debt History of the United States,” in
Public Debt Management: Theory and History, ed. by Rudiger Dombusch and Mario
Draghi, Cambridge, England and New York: Cambridge University Press, 1990, p. 240.
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From the table we can see that the debt-GNP ratio continued to fall over time. In
the first decade, the role of inflation in the reduction of the debt-GNP ratio was by far the
more significant as compared to growth and debt repayment. The two-decade postwar
period had inflation and growth almost equal in their contribution to the reduction of the
debt-GNP ratio while growth led the way in the three-decade period which ended in an
oil shock. Except for 1949, some inflation has always played a part in the reduction of
the US debt-GNP ratio.
A point that has to be emphasized here is the fact that this inflation in the US was
unanticipated and an ongoing surprise. Fluctuations in inflation were considerable,
diverging almost 10 to 20 points away from the mean. These divergences, at times, were
retained for years at a time. Until the mid-1960s at least, nominal interest rates were
virtually unchanged rarely diverging from their normal values by more than 1 or 2
points.. Real interest rates were very low in the 1940s and 1950s and even consistently
negative. It was this negative level of the real interest rates that eased the way for the US
to lower its debt-GNP ratio so dramatically following World War II. In fact, inflation
wiped out more than a third of the real debt in the two years of 1946-47.2 0 This debt
reduction due to extremely low real interest rates is also easy to comprehend in the
context of the debt dynamics equation presented earlier in this chapter.
The US example shows the effectiveness of moderate inflation to shave off part of
the debt. What becomes apparent here is that it is possible to liquidate a significant
portion of the debt provided that it is done as a sideshow with enough ambiguity
surrounding the regime in place such that the existence of inflation as a normal fact of life
only slowly gets to be expected. This strategy has to be complemented by fiscal
moderation. Although this encourages the adoption of an inflation policy for debt relief
in Lebanon, there are certain key differences that have to be considered and which in turn
2 0 Another example of post-World War II debt reduction through inflation is that of Italy. Italy’s debt
plunged from a whopping 91 percent of GDP to only 24 percent between 1945 and 1947 mainly due to the
doubling of prices (Gaimpaolo Galli, 1990).
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make the Lebanese case distinct from that of the US. In the forefront is the fact that
although the Lebanese authorities will be well advised to practice fiscal moderation, it is
unreasonable to expect them to adhere to this policy of moderation in a way such that it
has to be depended upon to play a significant role in the debt-reduction operation. This
holds especially true given the massive reconstruction effort that Lebanon requires. Also
important is the consideration that since the mid-1960s and after the postwar debt-
reduction experiences of countries like the US and Italy, the market no longer appears
content with relatively stable nominal interest rates. Investor perceptions and behavior
have changed and inflationary expectations have come to play a major role. For this
reason, a protracted effort using inflation to gradually decrease the debt-GDP ratio seems
less than effective in achieving its objective. Thus, the advice of the Conliffe
Commission in 1928-if you must do it, do enough of it-becomes all the more pertinent to
the Lebanese case.
The Case o f Italy in the 1980s. Italy reached the 1980s with a short and rapidly declining
maturity of public debt. Italy faced an average maturity on its whole debt outstanding of
less than one and a half years and almost all of it was nominal domestic debt.2 1 During
the late 1970s, mounting inflation and high nominal interest rates had inflicted capital
losses on investors which made them reluctant to hold long-term fixed-interest nominal
debt.
The Italian case is interesting because the authorities needed to lengthen the
maturity of public debt. To do this, they had to choose between foreign currency debt,
debt indexed to the price level, or debt indexed to some short term nominal interest rate.
Another option was fixed nominal interest debt which took a backseat because of a very
high premium against the inflation risk. This case becomes relevant for Lebanon because
2 1 Alesina, Alberto, Alessandro Prati, and Guido Tabellini, “Public Confidence and Debt Management: A
Model and a Case Study of Italy,” in Public Debt Management: Theory and History, ed. by Rudiger
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110
the Italian authorities adopted the third option (i.e., debt indexed to short-term nominal
interest rate) and decided not to bear the risk of inflation. Thus, Italy considerably
increased its net issues of Treasury Credit Certificates (CCT) between 1982 and 1987.
These were basically medium-term notes whose coupons were indexed to the returns on
6-months or 1-year Treasury Bills (TBs). This extended the average maturity of
government debt from a minimum of 14 months in 1982 to a maximum of nearly 4 years
in 1 9 8 7 Concern for inflation was so high that the choice of financial indexation was
preferred over price-level indexation on the grounds that the latter would have decreased
the Treasury’s incentives for fiscal adjustment which would have negatively influenced
the credibility of their anti-inflationary policy.
This choice of policy, however, brought with it some negative effects. Most
significant of these was the higher susceptibility of the government budget to monetary
policy. Even a small increase in the short-term interest rate automatically magnified the
interest payments on a large portion of the government debt. Thus, one of the objectives
of lengthening the debt maturity was rendered unattainable.
Another problem that arose due to the choice of financial indexation was that of
time-inconsistency. In such a situation, there is the possibility that the authorities would
keep the parameter high when the debt is issued at first and then reduce it once the
private sector’s decision to invest becomes irrevocable. This would make the investors
suffer a capital loss. This, postulate Alesina, Prati, and Tabellini (1990), is what
happened in Italy after 1985 as the authorities succumbed to this temptation. The rate of
return on the 1-year TBs remained lower than not only that on the shorter-term TBs but,
generally, also that on medium-term government bonds. This happened after 1985 until
Italy was hit by its debt crisis in the summer of 1987. Although there were other factors
Dombusch and Mario Draghi, Cambridge, England and New York: Cambridge University Press, 1990, p.
95.
2 2 Ibid., p. 96.
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Ill
that account for the debt crisis of 1987 as well, the perception of this time-inconsistency
was surely a major contributor to the debt crisis of 1987.
In the end, the Italian strategy of financial indexing failed and deficit financing by
issuing CCTs had to be discontinued. By 1988, the government resorted to issuing large
amounts of short-term TBs signaling a fall in the average maturity of debt. This was
supplemented by the issue of large amounts of medium-term fixed nominal interest debt
of a high interest rate. However, there were clear signs that the market was unwilling to
hold medium-long-term debt without compensation. Such situations open up doors to
fears of a financial crisis which could not only be initiated by a government default on its
debt but, in greater likelihood, be triggered by the reluctance of investors to roll over
debt. Any occurrence like this only increases the chances of a default or consolidation
since these become the only available options for the government. A run on government
debt could become self-fulfilling just by the realization that in case of a crisis the
government would have to default which would then actually trigger the crisis.
Clearly, a situation like this would be difficult to stave off for any country. The
Italian case is interesting because the authorities tried their utmost to avoid tampering
with the prices in view of the adverse effect they carry politically (and economically), but
eventually reached a stage where a default on debt became increasingly likely. This put
the government face to face with the possibility of incurring very high political costs
through the disruption that would have been caused in the system of financial
intermediation and an arbitrary redistribution of wealth.
The Italian case highlights the risk posed by a high and mounting debt. The
prospects of successfully dealing with large debts become increasingly dim as the size of
the debt grows. Options available to face the debt problem invariably have adverse side-
effects. As the Italian example clearly delineates, financial indexing brought the country
to the brink of a major political disaster. It is not difficult to see that Lebanon can hardly
afford any threats to its political stability. In this context, the use of inflation to handle
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112
the debt problem in Lebanon becomes even more viable since it avoids confidence crises
in addition to realistically paving the path to future economic and political stability. A
delay in the use of these tactics would only diminish the efficacy of this policy as both
the associated political and economic costs would be much higher later on.
The Ottoman Situation in the 19th Century. Imbalances between government revenues
and expenditures led to large public debts in the Ottoman empire. It was only well into
the 19th century, however, that the Ottoman government incurred a regular and permanent
debt.. In the early stages, the problem was dealt with by issuing Treasury bonds (in the
1840s) but the government had to later resort to borrowing from abroad, an action it had
considered but fiercely resisted before 1854. Although government revenue rose from
the equivalent of TL 2,250,000 in 1809 to about TL 3,000,000 in 1830, TL 6,200,000 in
1840, and TL 9,000,000 in 1855,2 3 the climb in expenditures was even faster. Armed
forces, the bureaucracy, the court, and debt servicing accounted for most of the rise in
expenditures with debt servicing increasingly becoming a significant part.
There were two ways in which the Ottoman government dealt with the shortfall of
revenues as compared to expenditures. Money was either borrowed locally (and paid
back from the following year’s revenues) or the currency was depreciated. Currency
depreciation was the main element that pushed up prices.
Like most of the other nations discussed here, the Ottomans also incurred huge
costs of engaging in numerous wars. Estimates for direct costs of the Crimean War
(1853-1856) alone range between TL 11.2 million and TL 13 million. Added to the costs
of war are opportunity costs of the mobilization of farmers and other workers whose
numbers ranged in hundreds of thousands. These were also times of sharp inflation, a
fact that is confirmed by noting that even the consuls asked for salary increases. Matters
2 3 Issawi, Charles, The Economic History of Turkey, 1800-1914, Chicago: The University of Chicago Press,
1980, p. 324.
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113
did improve between 1878 and 1911 which was a relatively peaceful period. Between
1887 and 1911, debt servicing went down from 30 percent of total expenditure to 19
percent while investment increased from 2.2 percent to 7.6 percent.2 4 Following the
adjustment for territorial losses, government revenue rose rapidly (at least until World
War I when expenditure caught up with this increase). These almost doubled from their
1963 level of TL 15 million, reaching TL 29.2 million by 1913.2 5
What the Ottoman experience teaches us is that accumulating a huge public debt
does not automatically translate into pervasive benefits and usually only contributes to
uncertainty and instability. During the period from 1854 to 1914, figures for gross
amount borrowed stand at TL 399.5 million. Thirty-four percent of this represents
commissions and the difference between nominal and issue price, 45 percent was used for
debt servicing, 6 percent for m ilitary expenditure, 5 percent to finance budget deficits,
and around 5 percent more was invested. The remaining amount was put to
miscellaneous uses.2 6 This only goes to show the little benefit that the Ottomans achieved
from their huge public debt. A positive implication for Lebanon of the Ottoman case is
that although currency depreciation adversely affected direct trading in Turkey,
Lebanon’s primary importance as a financial center and a trading thoroughfare have the
potential to largely extricate it from any problems that could directly affect it which
would, therefore, minimize the damage.
The Newly Independent Eritrea. Useful insight into Lebanon’s problems can also be
obtained by looking at smaller countries. One such nation is the recently independent
Eritrea. Like Lebanon, Eritrea suffered from a long and protracted civil war during the
course of which the country’s industrial infrastructure, transport and communications,
power and energy, water and sewage system as well as the agricultural sector, were
2 4 Ibid.
2 5 Ibid., p. 325.
“ Ibid., p. 363.
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114
severely damaged and effectively disrupted. Eritrea, like Lebanon, is strategically
located in northeast Africa on the Red Sea. Thus, it has the potential to play a crucial and
effective role in its economic links and trade relationships with its immediate neighbors.
A population of more than 75 million resides in Djibouti, Ethiopia, Somalia, and Sudan,
countries which are Eritrea’s immediate neighbors.2 7 The centrality of Eritrea’s location
makes it an ideal distribution center. It also has the potential to play host to regional
headquarters of multinational companies which, at present, are concentrated in Nairobi in
East Africa. This again provides a parallel with Lebanon which has a similar role further
north in the Middle East region. The Eritrean service sector is dominant in its
contribution to GDP2 8 accounting for over half of the total in 1995. However, its
financial sector remains underdeveloped which is reflected by its less than 2 percent
share in GDP in 1995.2 9 Within the service sector, trade, transport, and public
administration are the most vital with transit trade destined for Ethiopia being an
important activity.
Shortly after its independence from Ethiopia in 1991, Eritrea obtained substantial
foreign aid without which it would have been almost impossible to rehabilitate many
sectors of the economy. War destruction adversely affected the country’s mainstay, the
agricultural sector. This has left food production below sufficient levels to satisfy
domestic requirements and has necessitated significant food aid and commercial imports.
Although the government’s role in the rehabilitation and reconstruction operation has
been inevitably central, the authorities have not neglected the need to encourage private
investors to share this burden. The Eritrean Investment Center, a one-stop autonomous
body, ensures a liberal environment for private investment in all sectors of the economy.
Low income taxes are coupled with minimal tax rates for raw materials and intermediate
2 7 Tesfagiorgis, Gebre H., ed.. Emergent Eritrea: Challenges of Economic Development, Trenton, N J: Red
Sea Press, 1993, p. 3.
2 8 IMF estimates put Eritrea’s GDP at Br 3904.8 million in 1995.
2 9 IMF Staff Country Report, Eritrea— Recent Economic Developments, Washington, D.C.: International
Monetary Fund, 1996, p. 7.
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inputs. Duties and taxes on inputs and other raw materials are rebated. Additional
incentives are provided if a project is expected to benefit a large community or improve
the environment The Investment Center reported a remarkable increase in the volume of
investment between 1993 and 1995 with the number of licensed projects jumping from
only 24 in 1993 to an awe-inspiring 144 in 1995.
The surge in the expenditure pressure faced by the government from
reconstruction together with other needs (e.g., demobilization and reintegration of
refugees, severance payments for civil service restructuring) has, on the whole, led to
expansionary fiscal policies. Consequently, by 1995, deficits had steadily increased with
inflation rising from 5.2 percent in 1993 to 24.7 percent in 1995.3 0 The government had
resorted to government bank deposits and external financing through 1994 to finance its
deficits but undertook substantial domestic bank borrowing in 1995. Thus, net domestic
financing stood at Br 672.2 million in 1995 which was 14.4 percent of GNP.3 1 Net claims
on the Central Government at the end of 1995 were Br 759.7 million which is about 19.5
percent of GDP.3 2 Eritrea is, therefore, uniquely placed in comparison to the G-15
countries3 3 which are highly indebted both internally as well as externally. The Eritrean
government has only just started to incur domestic debt at a time when basic
rehabilitation problems have been either eliminated successfully or adequately addressed
(with the help of external financing) and further development is being undertaken, in
large part, by the private sector with the government itself playing a supporting role.
This approach has employed external financing wisely by directing it toward the most
pressing and cosdy needs leaving projects that are financially less demanding to be
undertaken with the aid of domestic financing. These include the provision of basic
social services like education and public health. With the basic infrastructure already in
3 0 Ibid., p. 50. The overall deficit went up from 2.7 percent of GNP in 1992 to 17.5 percent in 1995.
3 1 Ibid., pp. 53,54.
3 2 Ibid., p. 59 and author’s calculation.
3 3 These are Argentina, Bolivia, Brazil, Chile, Colombia, Cote dTvorie, Ecuador, Mexico, Morocco,
Nigeria, Peru, the Philippines, Uruguay, Venezuela, and Yugoslavia.
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116
place, it is reasonable to assume that any domestic debt is going to be short-lived or, at
the very least, manageable as productivity rises and the economy expands.
Despite the Eritrean government’s commitment to rehabilitation and to
reconstruction projects, its role has not been as ambitious as that of its Lebanese
counterpart. The Eritrean government played an active part in the rehabilitation drive in
the period immediately following the country’s independence but it curtailed its role once
the basic infrastructure was re-established. Currently, it limits its commitment to
promoting and assisting in the rehabilitation process. One way in which it strives to
achieve this objective is by assisting private domestic and foreign investors by
undertaking complementary investment in economic and social infrastructure and
initiating investment jointly with the private sector. Many local projects have been
undertaken with the involvement of local communities with the Government providing
resources in the form of machinery, materials, and transport. Transport, communication,
and construction are among the sectors where capital spending surged by almost 100
percent in 1995.3 4
Eritrea provides useful lessons for Lebanon regarding tax policy. While it would
be pmdent for Lebanon to revise its tax structure and tax laws in the near future and to
improve its capability of procuring revenue through direct taxation, Eritrea’s policies
apropos indirect taxes could be useful in the very short term of a possible debt reduction
exercise. Regarding customs duties, Eritrea levied minimum duties on capital goods and
intermediate inputs and discouraged the conspicuous consumption of luxury items. It
also eliminated taxes on exports. The latter can be especially useful for Lebanon
considering that not a considerable amount of revenue is collected through taxation.
Eritrea inherited a highly regulated external sector from Ethiopia but gradually
liberalized its exchange and trade system significantly in 1991-1994. The currency has
been devalued steadily and stood at Br 6.32 per US$1 at the end of March, 1996, in
3 4 IMF Staff Country Report, p. 14.
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contrast to Br 2.07 per US$1 in October, 1992.3 5 Between 1992 and 1994, Eritrea
maintained a fairly strong external position as the overall balance of payments surplus
averaged about US $ 105 million a year.3 6 Exports almost doubled in value every year
while imports also increased reflecting a higher demand for both capital and consumer
goods in the wake of the strong economic recovery and the ongoing rehabilitation
process. This occurred in the face of rising inflation which had increased from 4.8
percent between June 1992 and June 1993 to 14.6 percent between June 1993 and June
1994.3 7 This provides some insight into the devaluation and inflation mechanisms in a
small recovering economy with regard to the external sector. Between 1992 and 1994,
the Eritrean government itself was engaged in a massive reconstruction drive and import
requirements for fulfilling the needs of these rehabilitation projects were at their peak.
As a result of a significant devaluation of the currency and despite a substantial rise in
inflation, Eritrea enjoyed sizable balance of payments surpluses over this period.
Therefore, this experience dissipates much of the concern that could be voiced regarding
the detrimental effect of these variables (i.e., higher inflation and a devalued exchange
rate) in Lebanese debt reduction. Also, as in Eritrea, the rise in exports in the previous
year since the end of the civil war can be imputed to a recovering Lebanese economy and
the government’s rehabilitation drive.
Israel in the 1970s and 1980s. Another relevant case from within the small economies
diaspora is that of Israel. Israel is comparable to Lebanon in its economic orientation
which is characterized by a flourishing private sector and advanced Western-type market
mechanisms with extensive openness to world markets. Israel’s experience following the
Yom Kippur War in October 1973 is of special interest Prewar annual output growth
rates of around 10 percent slowed down in the postwar period to levels below those of the
3 5 Ibid., pp. 24, 36.
3 6 Ibid., p. 24.
3 7 Ibid., 50.
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118
industrialized countries of the West.3 8 This period was also peculiar for its high inflation
and balance of payments crises.
Israel is a small economy and not very rich in resources, except human capital.
Thus, it has always relied heavily on international trade. The exchange rate has,
therefore, been an important policy instrument. With the economy being open to
international capital flows, the exchange rate policy is interrelated with monetary and
inflation policies. After independence in 1948, Israel practiced a policy of a fixed
exchange rate. The period was largely characterized by infrequent devaluations which
were made necessary by the minor differential inflation between Israel and its trading
partners. In 1975, following the Yom Kippur War, however, the authorities resorted to a
policy of crawling peg in the face of accelerating inflation. This was later changed to a
managed float as foreign exchange controls were increasingly relaxed in the late 1970s.
The annual inflation rate moved into triple digits at this time in response to the monetary
expansion which was engendered by growing public deficits. This monetary expansion
and the consequent rise in domestic interest rates pulled massive flows of financial
capital into the country. The Israeli currency appreciated substantially in real terms. In
Lebanon, any inflation that is created would eventually lead to rising interest rates once
the public becomes aware of and adjusts for inflation. However, with a reduced debt,
Lebanon would be better able to afford this rise in interest rates which, as in the case of
Israel, could attract substantial capital inflows and effect currency appreciation.
Another consequence of the spiraling Israeli inflation was a drastic fall in tax
receipts of around 8.5 percent of 1984 GNP. This decline resulted in an increase in the
budget deficit which hovered around 12 percent of GNP between 1980 and 1984.3 9 It
was this budget deficit which further fueled inflation rendering it out of control. This
also supports the idea of inflation now as opposed to later in Lebanon. The reason is that
3 8 Razin, Assaf, and Efraim Sadka, The Economy of Israel: Malaise and Promise, Chicago and London:
The University of Chicago Press, 1993, pp. 1-2.
3 9 Ibid., p. 20.
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119
the Government’s dependency on revenues from taxation is very limited at present and
any attempt toward reform would inevitably include improvements in the tax structure
making the authorities more susceptible to potential shocks from a deterioration in tax
revenues. Also, as the debt continues to rise, it would give birth to fears of either a
government default or the imposition of heavy taxes which would trigger capital flight
and retard any development efforts. Therefore, delaying the debt issue would force the
government into employing inflation later when this policy instrument would be much
more costly. Not only would it widen budget deficits but also fuel inflation further, thus,
entrapping the economy in a vicious cycle which would culminate in hyperinflation and
inflict massive damage on the economy and society.
Israel’s economic policies prior to 1985 were designed more for the short-term
rather than long-term which led to frequent sharp policy changes. Between the period
since the Yom Kippur War and 1985, Israel’s policies had been very inconsistent and, by
the mid-1980s, had pushed the economy into the jaws of intolerably high inflation rates
and debt levels, which became an ominous threat to the country’s socio-economic fabric.
It was only in 1985 that the government took the bold step of implementing a new
economic policy (of fiscal and monetary restraint) which was harsher in the short-run but
has achieved its goal of stabilization in the long-term. A little scrutiny of the present
Lebanese situation makes it amply clear that the government’s current policies are, in a
sense, relatively myopic. Although the current level of inflation is under control, it
threatens to explode in the future as the public debt continues its uninterrupted ascent.
The situation in Lebanon could, thus, become alarmingly similar to that of Israel in the
mid-1980s with high levels of both inflation and debt. The only way to extricate
Lebanon out of such a situation would be to resort to measures similar to those taken by
Israel. It should be noted that Israel’s stabilization program was an arduous and
protracted exercise with features like the country’s growth rate dipping to only 2 percent
in 1989 and an unemployment rate that increased from its level of 6 percent in 1985 to
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120
peak at 9.3 percent in 1989-1990.4 0 Israel’s trade deficit also deteriorated from US$3795
million in 1985 to US$10,776 million in 1991.4 1
The most pressing problem for the Israeli economy and society in the early part of
the 1990s remained the record high levels of unemployment.4 2 Several government
programs to encourage investment and create jobs between 1990-1992 remained
ineffective. Government measures to reduce unemployment (which included government
loan guarantees and grants in substantial amounts for new investments, reduction of
payroll taxes, etc.), in fact, adversely affected productivity by generating low-yield
investments. As a result, output per capita growth had been small and sustainable
economic growth had not been achieved. This was the situation after almost eight years
since the Israeli government took corrective measures to address its inflation and debt
problems. Needless to say that the costs of implementing such a stabilization program in
Lebanon once the country is faced with extreme economic difficulty are going to be
immeasurably high and could well test the resilience of both the economy and the people.
Lebanon can ill-afford any such tests that threaten to disturb the delicate social and
political balance that is currently maintained in the country.
Implications for Lebanon’s Domestic Debt
Just prior to the cessation of hostilities, the Lebanese government had increasingly
resorted to debt financing of budget deficits. However, money creation remained the
primary method of budget financing with the issuance of treasury bills also playing a
small role. The share of foreign financing was insignificant. As mentioned earlier,
money creation led to high inflation (which was useless for debt reduction purposes)
since the public had become conditioned to this policy and its consequences. Thus, the
government sector simply started to account for an increasingly large share of domestic
4 0 Ibid., pp. 16,34-35.
4 1 Ibid., p. 245. The figures are in 1990 dollars.
4 2 Unemployment rate in 1991 had increased further to 10.6 percent (Razin and Sadka, 1993, p. 232).
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121
resources. Total domestic debt, which stood at LL 31 billion in 1984, had reached LL
982 billion in 1989. In 1989, fuel subsidies accounted for 19 percent while the
Government’s wage bill for 7 percent of the total government expenditure. In 1990, the
government’s wage bill was 11 percent o f GDP while its share in total government
expenditure had increased to 27 percent.4 3
The situation changed somewhat in 1991 following the gradual reassertion of
government authority. Government revenues increased to 13 percent of GDP as revenue
collection improved especially with respect to customs duties and non-tax revenue.
Fiscal restraint brought the total expenditure down to 29 percent of GDP while, at the
same time, interest payments on domestic debt went down as a result of increased
monetary financing. The fuel subsidy plunged below 1 percent of GDP and other current
expenditure stood at 10 percent of GDP. The main increase occurred in capital
expenditure which rose fivefold to 4 percent of GDP. This was a result of the
government’s drive to restore basic public services and to rebuild public infrastructure.
Overall, however, the deficit went down from 33 percent of GDP in 1990 to 16 percent of
GDP in 1991.4 4
The process of fiscal adjustment continued on into 1992 with revenues doubling
although their ratio to GDP declined to 11 percent. With current expenditure being
successfully restrained, total expenditure declined to 23 percent of GDP. As a result, the
budget deficit was reduced to 12 percent of GDP or to 52 percent of total expenditure. At
this point, it was being financed largely through debt issuance. This is portrayed in table
5-4 below. As a result of treasury bills being used increasingly as a means of financing,
domestic interest rate payments doubled reaching 20 percent of total expenditure.
4 3 Eken, Sena et al., Economic Dislocation and Recovery in Lebanon, Washington, D.C., International
Monetary Fund, 1995, pp. 12-13.
4 4 This was 56 percent of total expenditure.
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122
Table 5-4
Summary of Public Sector Operations
Prewar Years Some War Years Post- War Years
1974 1975 1976 1980 1988 1989 1990 1991 1992 1993
REV 100 100 100 100 100 100 100 100 100 100
ENUE
Tax 56 49 55 53 39 29 32 42 48 53
Direct 13 7 5 14 33 23 29 17 4 9
Indirect 44 42 51 39 6 6 3 25 44 43
Non-tax 44 51 45 47 61 71 68 58 52 47
EXPEN 100 100 100 100 100 100 100 100 100 100
DITURE
Current ... ... ... 83 93 94 96 87 93 93
Wages ... 56 80 23 23 18 27 31 30 22
Domestic ... ... 4 30 29 27 17 23 ' 27
Interest
Foreign ... ... 4 30 29 26 17 20 25
Interest
Fuel Subs ... ... ...
— — — 1 — 3 1
Other ... ... ... 55 24 28 35 35 34 39
Develop ... ... 17 7 6 4 13 7 7
ment
Source: Eken, Sena, et al., Economic Dislocation ana
D.C.: International Monetary Fund, 1995, p. 14.
Recovery in Lebanon, Washington,
In 1992, the outstanding stock of treasury bills had reached LL 4,754 billion, increasing
from its 1991 level of LL 2,333 billion. But due to high inflation and, therefore, the rapid
growth in nominal GDP, the ratio of the nominal stock of treasury bills to GDP decreased
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123
to reach 50 percent in 1992.4 5 The trend of financing the budget through debt issuance
continued unabated into 1993 as expenditure on domestic interest payments rose to 25
percent of total expenditure and 6 percent of GDP.4 6
The increase in the domestic debt stock underscores the problem of the
sustainability of budget deficits in the long term. Table 5-5 below presents figures for
Lebanon’s domestic debt and its debt-GDP ratio from 1993 to 1997. The rising trend in
the debt-GDP ratio is evident from the figures in the last column.
Table 5-5
Lebanon’s Domestic Debt and Debt-GDP Ratios: 1993-1997
Year Domestic Debtf
(billions of LL)
GDP
(billions of LL)
Debt/GDP
1993 5,803.7 13,122 0.4423
1994 9,347.5 15,305 0.6197
1995 11,997.2 18,028 0.6655
1996 17,228.8 20,552 0.8383
1997 19,787.1 23,840 0.8300
t End-of-period figures.
Sources: International Monetary Fund, International Financial Statistics; Bank of
Lebanon; and author’s calculations.
Lebanon’s domestic debt, by January 1998, had increased to LL 20,182 billion while its
foreign public debt remained stable at its former level of US$ 2,418 million.4 7
The preceding figures illustrate the stark reality of Lebanon’s constantly rising
debt and the problems that are the concomitant of this phenomenon. The Lebanese
authorities have been engaged in the process of fiscal adjustment for sometime but are
4 5 Ibid., p. 14.
4 6 Ibid., p. 15.
4 7 Banque du Liban, Banque du Liban Monthly Bulletin, January 1998. At the end of December 1997, the
share of external debt in total debt was 16.5%.
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124
bound by the country’s prevailing economic and social conditions from taking drastic
steps in this regard. This lends further importance to the use of inflation as a tool for debt
reduction. To show the extent of the method’s usefulness, consider the following
situation. Let us say that a once-for-all and unanticipated increase in the price level is
undertaken. Suppose that this increase is of 10 percent with a stock of nominal debt of 83
percent of GDP (as in the Lebanese case). According to Guidotti and Kumar (1991), this
increase is going to bring about a fall in the real value of domestic debt of 7.6 percent of
GDP (i.e., 83 x (0.1/1.1)). This is tantamount to the fall in the real value of domestic debt
which would be effected by a primary fiscal improvement of 3.1 percent per year over a
five-year period. The one-time increase in the price level causes a reduction in the real
value of stock debt of 7.6 percent of GDP. This is equal to the present discounted value
of the primary surplus of 3.1 percent of GDP per year which is computed over a period of
five years and using the prevailing Lebanese discount rate of 30.00 percent per year.4 8
With the stock of nominal public debt becoming greater, the public starts
expecting inflation to occur. This causes nominal interest rates to rise. However, an
increase in interest rates would simply aggravate the debt situation by expanding the debt
further. The more the debt grows out of reach of policies like tax increases and fiscal
tightening, the higher the probability that the government would eventually resort to
inflationary methods although, by that time, not only the effectiveness of an inflationary
policy would have dwindled considerably, it would also entail much larger costs for both
the economy and society.
In Chapter 4, we established a relationship between movements in inflation and
exchange rates in Lebanon since the end of the civil war. The estimated equation was of
the following form:
4 8 Guidotti, Pablo E., and Manmohan S. Kumar, Domestic Public Debt of Externally Indebted Countries,
Washington, D.C.: International Monetary Fund, 1991. It should be noted that interest rates might well
jump with the rise in inflation. However, as we are concerned with surprise inflation, it is not likely that
interest rates would adjust, at least not proportionally. This adjustment would occur only after the public
becomes aware of the rise in inflation by which time the manufactured inflation should have achieved its
objective.
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125
inf diff, = 0.75 + 1.15A *?, - 1.21ECf_,.
This equation provides the basis for the extent of manipulation of the exchange rates that
is needed to bring about the desired change in inflation. In order to avoid raising
inflation rates to extremely high levels and inadvertently plunging the economy in the
abyss of hyperinflation, it is going to be judicious to remind ourselves of the operational
definition of hyperinflation proposed by Cagan (1956). Cagan sets the benchmark at a
monthly inflation rate of 50 percent which is equivalent to an annual inflation rate of
12,875 percent. He states this as follows: “The term hyperinflation must be properly
defined. I define hyperinflation as beginning in the month the rise in process exceeds 50
percent and as ending in the month before the monthly rise in prices drops below that
amount and stays below for at least a year. The definition does not rule out a rise in
prices at a rate below 50 percent per month for the intervening months, and many of these
months have rates below that figure.”4 9
Lebanon is currendy experiencing single-digit inflation. Since printing money
will render the inflation created useless due to inflationary expectations on the part of the
public in response to monetization, exchange rates should be used to raise the inflation
rate. An important feature of the method of creating inflation by manipulating exchange
rates is that it has the “built-in” capacity to counter future use or abuse. This is because a
one-time use of this method is going to drastically reduce its efficacy by depriving it of
the much-needed surprise element since the public is going to slowly but surely perfect
its inflationary expectations with regard to changes in the exchange rate. It is also
reasonable to think that this method will safeguard against extreme inflation due to the
4 9 Cagan, Phillip, “The Monetary Dynamics of Hyperinflation,” in Milton Friedman, ed., Studies in the
Quantity Theory of Money, Chicago: University of Chicago Press, 1956.
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126
direct effect that devalued currency will have on the terms of trade and, thus, restrict the
magnitude of devaluation to manageable limits.
The arguments presented in the preceding part of this chapter regarding the
lessons disseminated by the experiences of other countries also hold relevance. The most
important of these are the German case, which in some ways is similar to the postwar
situation faced by Lebanon, and the American experience due to the insight it provides
regarding the dynamics of debt. Both situations underscore the requirement of
unanticipated and surprise inflation. Also, Eritrea and Israel provide useful lessons as
small economies.
Eritrea’s approach to post-independence and post-civil war development has been
unique due to the manner in which the Eritrean government chose to employ the debt in
its rehabilitation and reconstruction process. The strategy of channeling foreign funds to
address infrastructure needs and relying on domestic borrowing for development past the
basic requirements promises prolific payoffs in the future in the form of an expanding
and revitalized economy, and maintaining the government’s capability to deal
successfully with both its domestic and external debt. The role of the Eritrean
government in the rehabilitation process at this point also presents its Lebanese
counterpart with a way in which to pragmatically limit its part in its country’s
reconstruction drive without becoming completely absent from that scene. In addition,
Eritrea’s tax structure gives important hints to Lebanon to implement tax reforms that
could be productive in both the short and long runs. These reforms could allow Lebanon
to adequately address the issue of equity that arises out of the suggested debt-reduction
policy. Although higher inflation would tax everyone, the effect would be most
pronounced for the working class of Lebanon which, although it is small, would feel the
impact of this policy most strongly. However, the hardship should be only temporary and
once the policy achieves its objective, Lebanon would have to undertake sweeping
budgetary reform especially on the revenue side. Improvements in direct taxation and a
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127
reduction in the reliance on indirect taxes and non-tax revenues would have to be
effected. The authorities would have to focus on the wealthy and the large middle class
of the country for this purpose. More breaks for the working class could be provided
which, by this time, would also hopefully be able to reap the benefits of reforms and a
redirected government orientation in the form of pervasive social services including
health and education programs. In the meantime, the government could resort to steps
such as progressive taxation on luxury items which does not exist at present.
The Israeli case also makes significant contributions to this reservoir of lessons.
Israel’s domestic public sector debt underwent a reduction falling from 112 percent of
GDP in 1985 to 90 percent of GDP in 1989.5 0 Inflation went down from 305 percent to a
much lower 20 percent within the same period.5 1 The role of seigniorage in inflation or
disinflation here was, at best, marginal. In fact, Bufman and Leiderman (1995) found
that the behavior of inflation was more closely associated with fluctuations in public debt
ratios than with government seigniorage. Also, the stabilization program that was carried
out in Israel beginning in 1985 and its consequences serve to draw attention to issues
such as the ability of Lebanon, both as an economy and as a society, to sustain the
stability it currently enjoys and that eluded the nation for fifteen devastating years, if
Lebanon continues to tread its current path and continues to ignore its rising debt
commitments.
Further support for the proposed policy can be garnered by studying the episode
in Bolivian stabilization. Hyperinflation in Bolivia in the 1980s considerably developed
its financial sector. This phenomenon of financial sector development is common to all
high-inflation experiences. This engendered the allocation of savings to investment and,
therefore, played a critical part in the country’s growth process. In addition, it became a
5 0 Bufman, Gil, and Leonardo Leiderman, “Israel’s Stabilization: Some Important Policy Lessons,” in
Rudiger Dombusch and Sebastian Edwards, eds.. Reform, Recovery, and Growth: Latin America and the
Middle East, Chicago and London: The University of Chicago Press, 1995, p. 181.
5 1 Dombusch, Rudiger, Stabilization, Debt and Reform: Policy Analysis for Developing Countries,
Englewood Cliffs, NJ: Prentice-Hall Inc., 1993, p. 17.
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128
hedge against high inflation. The phenomenon has certainly played a part in Lebanon as
well. During the years immediately after the end of the civil war which were
characterized by triple-figure inflation, a legislation was passed concerning the merging
of banking institutions. Bank mergers were still continuing up until 1997 in the aftermath
of reforms that were undertaken when inflation was still high.5 2 The significance of the
Lebanese financial sector to the country’s economy is no secret. Therefore, the potential
for further development of this sector of the economy would be more than welcome. Not
only would this provide fresh impetus to Lebanese development and growth by making
the effects pervasive throughout the economy, it would also aid in the stabilization
process that inevitably has to follow by serving as a hedge against high inflation.
Further, like in the Bolivian case, high-inflation could muster political support for further
fiscal reform. It is these two effects of inflation that provide for the possibility of durable
stability in the future. If strict fiscal balance is sacrificed, hyperinflation would occur
immediately with a highly dollarized financial sector. For this reason, fiscal austerity has
become politically feasible in Bolivia. All of these effects, due to their potency in the
reform, stabilization, and development game, make surprise inflation the lowest cost
means of reducing Lebanon’s domestic debt to more manageable proportions.
Conclusion
In recent years, there has been increasing concern about the growth of domestic
public debt in developing countries. One such nation is Lebanon. One of the most
dynamic economies in the Middle East prior to the outbreak of the Lebanese civil war, it
boasted low inflation, impressive economic growth rates, sizable balance of payments
surpluses, small fiscal deficits, and a floating, stable, and fully convertible domestic
currency. With limited regulations and a stable macroeconomic environment, it had an
5 2 Three banks merged in 1997 reducing the number of banks operating in Lebanon at the end of 1997 to
72. This is in comparison to 114 banks that were operating in Lebanon during the early part of the war
years.
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129
important role as the key economic intermediary between Europe’s developed economies
and the developing economies of the Middle East. These factors supplied Lebanon with
a strong comparative advantage in the services sector, especially in banking and finance,
tourism, insurance, and trade.
The situation, however, took a nasty turn in 1975, when the 15-year long civil war
enveloped the country. Not only did Lebanon suffer in human and material terms, but its
economy also underwent fundamental changes. The wartime infrastructure and industrial
facilities were destroyed while, at the same time, the environment discouraged further
investment. Capital flight occurred and Lebanon was denied the previous level of access
it had to flows of foreign capital. Also during this period, public finances deteriorated
due to crumbling central government authority and its resulting inability to collect
revenues. The banking system primarily financed large fiscal deficits raising the level of
liquidity while economic activity remained dormant. This exerted continuous pressure on
the Lebanese pound in the exchange market, raised pressure on inflation, and culminated
in high levels of currency substitution. Since the civil war had weakened the banking
system significandy, Lebanon experienced a diminished role as a regional intermediary.
In 1990, the Ta’if Accord effected an end to hostilities and restored government
authority. At this time, the authorities set out to bring about economic stabilization
together with the task of reconstruction and development of the war-ravaged economy.
This work got a boost with the election and subsequent installation of the new
government of Prime Minister Rafik Hariri in 1992. Thus, the year 1993 was marked by
favorable macroeconomic developments like increasing real GDP, falling inflation, a
stable exchange rate, and the strengthening of the foreign exchange reserve. But the
latter half of the 1990s has brought with it the realization that inadequate infrastructure,
debilitated institutions, and human-capital shortage are constraining economic recovery.
The government’s strategy of strengthening the infrastructure has not paid the expected
dividends as the extent of the rehabilitation and reconstruction is restricted by the
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130
government’s limited ability to finance these activities. The government has increasingly
taken recourse to debt financing of these activities which has left it with a bloated
domestic public debt currently standing at around 83 percent of GDP.
This study proposes a strategy of debt-reduction through inflation. Several
reasons are put forward to support the proposal. In the forefront is the fact that Lebanon
has not yet been able to shrug off its civil-war legacy and although the authorities have
been able to significantly alter the perception of a Lebanon suffering from innumerable
maladies, this change at present can largely be categorized as only a pacification and a
reduction in fears regarding the country’s economic and political health. These
perceptions fall well short of the view Lebanon commanded in the pre-civil war era. It is,
therefore, wise to undertake the task of debt reduction at the earliest and thereby remove
a crucial destabilizing factor. Due to the time and resources that alternative methods of
debt reduction like an improvement in the revenue collection machinery or fiscal reform
demand, it is suggested that inflation be used to carry out the job. And since the
economic and social costs that any potential inflationary episode in Lebanon would entail
can be m inim ized by conducting the process at the earliest possible time, it is
recommended that the operation be carried out as soon as possible.
During the civil-war period, the Banque du Liban served as a popular source of
financing. Although this fueled inflation, the overuse of this manner of financing trained
the public to adjust their inflationary expectations until they zeroed in on to almost
perfect expectations. The country studies presented in this study make the importance of
the element of surprise in inflation for debt reduction amply clear. In post-World War I
Germany, it was the lack of information available to the public that made it very close to
impossible to estimate inflation. The example of the United States, however, goes
farthest in explaining the absolute indispensability of this prerequisite since the debt
dynamics equation can be invoked here. The extremely low and sometimes even
negative real interest rates that prevailed in the US following World War II highlight the
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131
fact that unanticipated inflation is an absolute imperative if this policy to bring about a
reduction in debt is to succeed. For primarily this reason, the study advises the cessation
of the printing of money to create inflation and the manipulation of the relationship
between inflation and exchange rates instead. Not only does this have a higher likelihood
of catching the public off-guard but also has the quality of making inflation less tempting
in the future since its one-time use is going to bring this at par with money creation in the
sense that both methods would be rendered bereft of the absolutely-essential element of
surprise. In addition to the proposed inflation’s primary purpose, several desirable side-
effects of the phenomenon also occur. These include the possibility of lower inflation
with a falling debt as well as the chance for the further development of the financial
sector. It could also activate and gather political will for future fiscal reform.
The judicious use of this policy, therefore, has the potential to relieve the
Lebanese authorities of a significant part of their behemoth domestic public debt. The
faster this debt is liquidated and the sooner the government is able to redefine its role in
future Lebanese development, the sooner new investment can be brought into the country
and directed toward reconstruction and rehabilitation and other productive and growth-
inducing activities. This would put Lebanon on the path to recovery and growth and
reduce the time it needs to achieve its past status of a world-class financial center.
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132
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Asset Metadata

Creator Shahnawaz, Sheikh (author)

Core Title Debt reduction by way of inflation: The case of Lebanon

School Graduate School

Degree Master of Arts

Degree Program Economics

Publisher University of Southern California (original), University of Southern California. Libraries (digital)

Tag Economics, Finance,Economics, General,OAI-PMH Harvest

Language English

Contributor Digitized by ProQuest (provenance)

Advisor [illegible] (committee chair), [illegible] (committee member)

Permanent Link (DOI) https://doi.org/10.25549/usctheses-c16-27569

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Legacy Identifier 1393187.pdf

Dmrecord 27569

Document Type Thesis

Rights Shahnawaz, Sheikh

Type texts

Source University of Southern California (contributing entity), University of Southern California Dissertations and Theses (collection)

Access Conditions The author retains rights to his/her dissertation, thesis or other graduate work according to U.S. copyright law. Electronic access is being provided by the USC Libraries in agreement with the au...

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