Would Lebanon gain by abandoning the lira?

While some are calling on officials to issue larger denominations of lira banknotes, others believe such a measure would have no practical effect on the depreciation of the national currency.

On the parallel market, the largest denomination of lira banknotes, LL100,000 is now worth approximately $1— the smallest US dollar bill.

Lebanon’s national currency has lost more than 98 percent of its value since the economic crisis began in 2019.

Wallets packed full of lira are worth the equivalent of a few dozen dollars. As a result, Lebanese people are forced to carry larger amounts in envelopes, purses, or even bags, while card payments are rarely accepted.

Faced with this situation, calls for the issuance of new denominations — LL200,000, LL500,000 or even LL1 million — are multiplying. While this measure would temporarily solve the problem of carrying around bundles of bills, “it would not address the heart of the problem,” said Siham Rizkallah, an associate professor specializing in monetary policy at the Faculty of Economics at St. Joseph University (USJ) in Beirut.

Rizkallah said she believes the problem lies in the lack of confidence in the national currency, which has been abandoned in favor of the US dollar.

A currency board?

Given the significant fluctuations of the lira and the fact that it has lost its role as a store of value, “Lebanon does not have much choice,” said Rizkallah.

“Sooner or later, it will have to abandon its lira and adopt a hard peg exchange rate policy, in the hope for a sustainable economic recovery.”

She said Lebanon has two options: a currency board or full official dollarization.

Both of these policies restrict the government’s ability to print money indefinitely and therefore use this means, which creates inflation, to adjust its monetary policy.

Jean-François Ponsot, a professor at Université Grenoble Alpes, who, along with Rizkallah, participated in the Dollarization in Lebanon seminar organized by the Laboratory of Economics, Finance, Management and Innovation (LEFMI) in early March, also agrees.

But Ponsot said he believes the currency board should be advocated first, “although neither of these two solutions is optimal.”

In this case, it is a matter of issuing a new national currency and organizing the printing of bills around Lebanon’s foreign reserves. This would prevent the central bank from issuing bills at will and plunging the country into a vicious inflationary cycle, as is currently the case.

“A new currency linked to clear issuance-related rules and to a new political project could restore confidence, and therefore be adopted, without necessarily having to go through dollarization,” said Ponsot. “Of course, this would be complicated, but this solution would avoid the adoption of the dollar as the official currency, which would be irrevocable and should therefore only be adopted as a last resort.”

Full dollarization?

Despite the advantages of full dollarization, the move involves significant risks.

“It would require Lebanon to secure a stable and significant flow of foreign currency so that its economy does not collapse,” said Ponsot.

This is not guaranteed while the Lebanese balance of payments — the main indicator of this variable — has been in deficit since 2011, with the exception of the 2016 fiscal year.

In addition, dollarization would increase the country’s vulnerability to economic shocks, as the authorities would lose their fiscal and monetary leeway to mitigate the impact of such crises, notably by losing the ability to print new bills.

The central bank would lose its role as a lender of last resort. This argument was put forth by defenders of dollarization, who believe it would impose budgetary discipline and realign public finances. The state would consequently be obliged to adjust its expenditures according to its revenues, as it will no longer be able to finance its budgetary deficits by printing money.

Dollarization could also restore confidence in the national economy, which would likely attract foreign investment.

But for Rizkallah, there is no longer a choice. She said Lebanon must now act on dollarization without going through a currency board model, which she believes would only “delay the inevitable.”

Adopting a currency board policy “would act against the transition that is already taking place naturally towards the dollar. It would only complicate the situation,” added Michel Santi, an economist and financial market specialist.

“Whether we like it or not, we now find ourselves in a de facto dollarized economy where almost everything is calculated or paid in dollars, with the exception of government revenues, which affects the salaries of civil servants and the pensions of retirees,” said Rizkallah. “This increases social inequalities and favors the dollarized at the expense of the non-dollarized, contributing to further tensions in the country.”

“Rescuing the nation is more important than rescuing the currency of a nation that could disappear,” she added.

The unofficial dollarization of the Lebanese economy is not new but in fact dates back to the 1975-1990 Civil War. During this period, the lira depreciated dramatically from LL2.2 lira to the dollar in April 1975 to LL870.4 to the dollar by October 1990, as people preferred to convert their money into dollars to avoid the losses incurred by saving and holding lira.

This habit persisted during the three decades that followed the end of the war, despite the many positive signals that could have led to a progressive “de-dollarization” of the economy.

According to a World Bank report published at the end of 2022, the reason for this disenchantment is the high debt level, large twin deficits (budget and current account), an oversized banking sector and a highly dollarized pegged economy.

Since the lira was officially pegged LL1,500 to the dollar in 1997 and despite some favorable macroeconomic conditions, the dollarization ratio of bank deposits — the main indicator of the population’s confidence in the national currency — has always been high, meaning confidence in the lira has always been low.

The ratio has never fallen below 61 percent, a level reached in 1999. In the wake of the 2019 economic crisis, the dollarization rate of deposits even rose to more than 80 percent.

Ecuador, Argentina and ... Lebanon?

Other countries in a similar situation have had to adopt a “hard peg” monetary regime.

Experts look to Ecuador, which adopted the US dollar as its legal tender in January 2000, to be the most revealing.

Twenty years later, economists from the French Development Agency (AFD) noted that “adopting official dollarization offered a ‘magic’ solution to rapidly restore the economy to normal.”

According to the AFD, dollarization “did indeed help to quickly stabilize the monetary and financial conditions. The shift towards full dollarization finally ended the dual currency system, put a floor on depreciation of the real exchange rate and eased liquidity pressures.”

The AFPO also noted in their report that full dollarization of the economy had been an undeniable short-term success in defeating hyperinflation and stabilizing prices, and had restored confidence in the banking sector.

However, the picture is mixed. These economists noted that dollarization did not systematically stimulate economic growth or led to greater fiscal discipline during this period.

The picture is also mixed for countries that have adopted a currency board to deal with economic crises. While the Bulgarian experience, which officially began in 1999, was quite positive, the experience of Argentina in 1991 was only positive in the short term, with much greater negative effects in the long term.

“The success of the currency board depends largely on the economic policies announced and put in place, as well as on the confidence that those in charge will have to inspire,” said Ponsot.

‘No magic solution’

Lebanon is a “special case where such a decision could have important geopolitical repercussions,” Ponsot added. On the one hand, one must take into account the fact that several political and economic actors are subject to US financial sanctions.

On the other hand, and unlike countries that have adopted the currency of a foreign country (for example, the US dollar for Ecuador and Panama, or the euro for Kosovo and Montenegro), Lebanon has no geographical proximity to the United States.

Whatever the nature of the monetary policy adopted; the experts are all unanimous on one point: There is no magic solution.

“In the absence of the implementation of new reforms and a new political compromise to restore confidence, all this would be useless,” Santi pointed out.

This is the fundamental part of the problem.

This article was originally published in French in L'Orient-Le Jour. Translation by Joelle El Khoury.