By Ghassan Karam, Special To Ya Libnan
There is hardly an opportunity given to individuals connected to the Ministry of finance, the Central Bank or the commercial banking system where they do not stress the substantial volume of funds that has been flowing into the country. The implication being that these capital flows are a vote of confidence in the stability, dynamism and confidence in the Lebanese economy. What they conveniently forget to declare is that capital flows are ultimately determined by a thorough analysis of the relative safety of the country in question relative to the risk premium that it is willing to pay. Very simply stated this means that any level of risk becomes attractive at a certain price.
Lebanon has had no problem of attracting capital flows into the country for the very simple reason that the Lebanese banks are paying an interest rate that is above the world interest rate. So the question should be why is Lebanon condoning this misguided policy of in essence subsidizing the deposits that are willing to flow into Lebanon and what is more important is the question of whether such a policy is sustainable. Can tiny Lebanon afford to pay a rate that is above the world rate in order to attract funds that it does not need.
It appears to this observer that the Lebanese commercial banks are willing to pay above that of the rest of the world simply because it is profitable for them. How can that be so if they are not in need of these funds? The surprising answer to this quandary is the Lebanese central bank that is willing to absorb from its member banks their excess liquidity by issuing CD’s at a high interest rate. Such a policy is not sustainable in the long run and is actually damaging to the health of the Lebanese economy in the long run. The current policy attracts funds that are not needed by paying these funds a premium that makes such transactions inefficient. So why does Lebanon engage in these policies that wind up in inflicting pain on the Lebanese economy? Again the answer is rather simple. The Lebanese governments’ continued need for more and more sovereign debt dictates growing the economy. But unfortunately whenever a country decides to have a fixed exchange rate system coupled with perfectly mobile capital flows then its monetary policy option becomes totally ineffective. In such a case the government will have no choice but to apply the expansionary fiscal option delivered through deficit spending. But why does the government feel the need to use deficit finance when it already suffers from one of the highest debt/GDP ratios in the world? You guessed it; the government needs to grow the economy so that it might borrow some more in order to service its sovereign debt. Under normal circumstances the above policy will eventually get the economy back to equilibrium but only once it adopts the world interest rate. And this is the rub. If Lebanon is to adopt the world interest rate then the flow of funds into the country will be greatly diminished.
A quick review of the theoretical four available options should help us get a clear understanding of this problem. Given that capital flows are perfectly mobile then Lebanon must choose from among the following policy options:
……………………………….Fixed Exchange Rates………………….. Flexible Exchange Rates
Fiscal Policy……… Effective if Fiscal is deficit finance Totally Ineffective ………………………+ Monetary growth at world rates
Monetary policy ……Totally Ineffective Effective if used with Fiscal based on X
X: Exports due to lower exchange Rate
Based on the theoretical options as described in the above matrix Lebanon should consider moving away from the Fixed Exchange system currently in force and should move towards a flexible system. That will make repayment of the current sovereign debt easier .will give more power to the monetary authorities and will rationalize capital flows into the country.