How Lebanon crashed into chaos

What’s happened?

On 4 August, a huge explosion devastated the port area of Beirut, the capital of Lebanon. It was caused by 2,750 tonnes of ammonium nitrate, an agricultural fertiliser and a mining explosive, which customs authorities had left stocked in a quayside warehouse for six years. The explosion killed at least 171 people and left 300,000 homeless. The disaster may cost up to $15bn, one quarter of Lebanon’s GDP.

What are the political repercussions?

Angry protests forced the technocratic prime minister Hassan Diab to resign on 10 August. He is the second Lebanese prime minister to be ousted in less than a year amid a worsening economic crisis. The explosion has become a symbol of government incompetence and corruption in a city where rubbish often goes uncollected, traffic lights do not work and daily power cuts are a fact of life.

How bad is the economy?

Awful. The Institute of International Finance says that the Lebanese economy is on course to shrink by 24% this year. Unemployment has reached 35%. The Lebanese pound has lost 80% of its value against the US dollar since last October. Lebanon is one of two places in the world experiencing hyperinflation (the other is Venezuela), with prices rising at an annualised pace of almost 90% in June and food prices up 246.6%. The country imports more than 80% of its food.

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How has that affected everyday life?

Some citizens have resorted to bargaining, with Facebook advertisements offering swaps of clothes for cooking oil and foodstuffs. Banks are dealing with a dollar shortage by imposing strict withdrawal limits – depositors are limited to accessing as little as $200 per fortnight of their own money. Rapidly changing and unpredictable prices are another hallmark of hyperinflation and can lead to absurdity. Beirut resident Lina Mounzer writes in The Economist that when a friend’s mother went to buy nuts and inquired “how much?”, the shopkeeper replied “I don’t know madame… How much do you think is fair?”

What caused the hyperinflation?

The root cause of hyperinflation is always the same: central banks using the printing presses to finance government deficits. Yet in Lebanon the story comes with a local twist. The Lebanese pound is officially pegged to the dollar at a rate that has become ludicrously overvalued (1,500 LBP/dollar, compared with about 8,500 LBP/dollar in the black market). Lebanon’s heavily import-dependent economy suffers from a structurally weak balance of payments, meaning dollars tend to flow out of the country. Instead of devaluing, in 2016 the Banque du Liban, the central bank, chose another approach, ominously dubbed “financial engineering”. The bank would offer generous interest rates – as high as 11% – to commercial banks as part of complex swap operations for government debt and US dollars. The financial-engineering swaps often offered bonuses and other extra sweeteners on top of headline interest rates to commercial banks.

Did it work?

No. The high interest rates attracted new greenbacks into the banking system from foreigners in the Lebanese diaspora and the Gulf. Bankers were more than happy to collect generous risk-free returns and the government, through the Banque du Liban, secured the dollars it needed to finance its external debts. The problem is that the central bank was running out of cash to pay the usurious rates it had imposed on itself, leading it to borrow even more dollars from the banks. Economists have dubbed the resulting dynamic a “Ponzi scheme”. The International Monetary Fund (IMF) thinks the Bank has lost $49bn. High interest rates also diverted banks’ money away from loans to businesses in the real economy and towards the central bank’s financially engineered returns.

What about government debt?

In March, the Lebanese government defaulted on its debt for the first time ever. With a debt-to-GDP ratio of 170%, Lebanon is the third most indebted country in the world. Much government spending is wasted. The political class are, as David Gardner puts it in the Financial Times, largely “superannuated warlords and dynasts of the country’s 18 religious sects” who survived the 1975-1990 civil war. The peace deal that ended the conflict was based on a system of “confessionalism”, which ensured that the country’s Christian, Sunni and Shia communities would enjoy political representation. The one-time warlords have carved out new fiefdoms for themselves and their cronies in the public sector. As Toufic Gaspard notes for Middle East Transparent, the percentage of public-sector jobs has leapt from 10% before the civil war to more than 25% today.

How can this the mess be fixed?

International partners have pledged $300m in aid to Lebanon, but that is only a drop in the ocean. World leaders fear that more substantial help will only line the pockets of corrupt politicians. In another sign of the dysfunction in Beirut, the IMF has so far been unable to offer an emergency credit line as politicians cannot even agree on how big the banking system’s losses are. Further defaults are not a panacea: the “financial engineering” trick left Lebanon’s banks holding about two-thirds of government debt. Figures from IHS Markit show that a “haircut” of only 18% would leave local banks insolvent, reports The Economist. Enacting economic reform and sharing the financial losses fairly between banks, depositors and the state would require the sort of political will and broad-based legitimacy that the Lebanese leadership does not have. Instead, for the time being, political and financial elites have opted to impose the losses on ordinary people through the printing presses.