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Currency conundrum

Feb 20

Currency conundrum

The Lebanese lira and the Dutch disease

Two major topics are keeping economists, politicians, academicians, journalists, and others busy nowadays. The first topic is the real value of the Lebanese lira and if the nominal rate must be de-pegged or moved to a lesser pegged value in order to relieve us from our current monetary, economic, and financial misery.

The other topic is how Lebanon should protect its currency and economy in the future should petroleum profits start flowing, since any petroleum related legislation we draft today will need to protect us from the famous Dutch disease. The issue that most do not realize is that those two topics are very much intertwined, because Lebanon is already suffering from Dutch disease. What we need to do is to escape a worsening of the disease. The solution is definitely not devaluation; we should rather use the lira to build the proper platform for economic growth.

The Dutch disease

The discovery of the elephant natural gas field in Groningen north of Holland in 1959, changed the lives of Dutch citizens forever—massive amount of revenues started flowing into the coffers of the government as well as into the economy. However, in return, the Dutch witnessed a collapse in investments, an unemployment hike, a drop in industrial exports, and a drop in purchasing power, despite the appreciation of the Gilder, its currency at the time. What happened?

The sudden increase in riches caused a sudden increase in spending by both the private sector and the public sector, whose expenditures reached 50 percent of its GDP at the peak, one of the highest in the world. This increase in consumption led to an increased demand for tradable goods and services, as well as non-tradable goods and services.

Tradable goods and services are those that can be purchased and transferred between countries without barriers such as transport costs or trade restrictions, and as a result their prices become global and not easily influenced by the demand or supply of one country. This means any society with sudden increase in wealth would consume more tradables regardless if they are produced locally or internationally. Most tradables are food products, manufactured goods, metals, stones, petroleum products, and some global services, such as commercial travel and corporate financial services.

Nontradables are not economically feasible to consume across borders, are usually retail and wholesale sectors, restaurants, hotels, local transport, warehousing, communications, public utilities, real estate, retail banking, and most personal and commercial services. This means that even if the price of a haircut, an apartment’s rent, a meal, a phone bill, or ATM fees are cheaper in Budapest, it is not economically feasible for a resident in Amsterdam to travel to Budapest every time she needs to get a haircut, eat, make a phone call, withdraw cash, or sleep.

This also means that the increase in demand on those goods raises their prices locally in Holland, while the price of tradables (local and foreign made) remain the same, since their global nature will not be impacted by the increase in demand by the Dutch.

The resulting relative difference in price between tradables and nontradables means two things:

First, the increase in the price of nontradables will lead to more profits in those sectors, and to an increase in the wages of the workers, which will attract capital and labor on the expense of manufacturing and agriculture (the major tradables).

Second, this relative difference in price leads to an appreciation of the real value of the currency, which leads to an increase in the price of exports for the country’s trading partners.

This is what happened to the Netherlands, colloquially known as Holland, as demand increased locally due to petroleum revenues, leading to an appreciation of the Gilder and the collapse of its pride sector, which was manufacturing. Holland realized the challenge, which became known as the Dutch disease, and learned a lot from it. Its experience set the stage for a new pedagogy in economics and revenue management of natural resources. Today, the Netherlands is one of the most successful economies in the world, while petroleum income represents less than 1 percent of the total government revenues.

Dutch disease, therefore, is a disease that is suffered by any economy that relies on foreign currency inflows into the economy, and which is directed toward consumption rather than investment, resulting in an overpriced services sector (electricity, water, restaurants, communication, transportation, real estate), a drop in its exports, and its industries and farmers suffer the most … welcome to Lebanon. The foreign currency inflows can result from the sale of natural resources, but also from remittances or foreign aid—the result is the same.

The Lebanese lira

The Lebanese economy is always characterized as a rentier economy that ignores productive sectors and revolves around real estate and banks. This is true, but it is not only the result of corruption, wrong economic policies, and accumulation of debt over three decades, but is also a disease that has been around for more than half a century, and which has a cure, and that cure is not devaluation.

When Lebanon decided to peg its currency in the early- to mid-1990s, it was a wise choice economically for a small open economy with free movement of capital. The confidence that the peg provides attracts investments and foreign deposits, however, to avoid the curse of those flows, they should have been directed toward investment in industry, agriculture, and infrastructure, and not consumption and real estate. The lira becomes subject to massive pressures such as the ones we are witnessing today, when those accumulated flows start losing confidence in the financial and economic model of Lebanon, and start exiting. It is true that Banque du Liban (BDL), Lebanon’s central bank, has ample ammunition to defend the lira but we need to ask ourselves: How good is our lira if no one wants to exchange goods and services with us? Turning those flows into 20 billion dollars of imports yearly is the problem, not the exchange ratio; instead they need to be directed to become a powerful force in creating economic growth, employment, and reducing poverty.

Restructuring the Lebanese model

The necessary steps to restructure the Lebanese economic and financial model is to restructure the way we handle those large deposits in the banking sector so they can be a blessing and not a curse:

1) Reduce the deficit of the government immediately through the known solutions of reducing corruption and wasteful spending, reforming the electricity sector, and collecting taxes better. The objective is not only to reverse the debt dynamics and create fiscal space to improve public services, but also to reduce credit risk and consequently reduce the cost of borrowing, so the private sector is incentivized to increase the size of its operations, and as a result its exports and the taxes it pays to the government.

2) Urgently invest in infrastructure to support economic growth and with the least amount of borrowing possible. Off-balance sheet concessionary project financing should be available through CEDRE under PPP structures, and increased borrowing by the government should be avoided. Additionally, mutual funds could be structured, so all Lebanese depositors can participate in infrastructure investing and benefit from the resulting returns.

3) Urgent simplification of government procedures with Lebanon ranked at a pathetic 142 in the world in ease of doing business.

4) Master plan to seriously grow the agriculture and industry sectors and hence their exports.

Petroleum Lebanon

Lebanon is not facing the risk of catching the Dutch disease should its petroleum exports begin, but it risks the deterioration of its Dutch disease into something worse. Today the country is characterized by a large financial sector full with lazy deposits, and a public sector filled with corruption that leads to poor government services, which in return leads to low investments, low economic growth, small economy, high unemployment, and high income inequality.

The steps above are necessary to get out of our current failed economic and financial model and to get ready for a petroleum Lebanon or else we will fall into the resource curse where things will get much worse and we will suffer like Nigeria, Angola, Iraq, and Venezuela. Avoiding the resource curse lies in the governance and revenue management of the petroleum sector, where countries such as Botswana, Chile, and Norway turned their diamonds, copper, and oil into an accumulation of wealth.

The best way to manage petroleum revenues is to separate them from current spending, especially in countries with weak governance such as Lebanon, and to turn this newly generated financial wealth into three types of capital: human capital through investment in education and healthcare; infrastructure capital, which serves an economy for decades of economic transformation; and financial capital through diversified savings. This method of investing petroleum wealth benefits both the living and future generations, directly and indirectly. The future generation will have a reservoir of education, health, infrastructure, and cash.

The Lebanese Sovereign Wealth Fund has been designed as such to protect the future income generated from petroleum activities by separating this income from current spending, and instead channel it into human capital and productive sectors, in a conditional and forethought way.

We are now left with the duty of real reform and restructuring of our economy and public sector, before a new disease is named after Lebanon.

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