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Abstract

This report aims to identify in detail the causes of the collapse of the Lebanese financial system and currency. The report begins with a bit of background on how modern, post-civil war Lebanon’s economy was structured based on the needs of the time and how it progressed. It shows that when starting off after the civil war, Lebanon took on a lot of debt, yet government spending and initiatives translated into economic growth. In parallel, the central bank pegged the domestic currency to the dollar to encourage foreign investment through the promise of stability. Over time, the government invested less into private sector development and construction and more on current expenditures like public salaries and debt repayment, both encouraged by political conflicts of interest.

While the government was amassing an ever-increasing debt load, the central bank was combatting decreasing foreign currency flows due to a negative current account balance by raising the interest rate. It could not continue this remedy further as it would prematurely bankrupt the government. Instead, it pursued unconventional monetary policy means, which did bring more foreign currency that the banking sector had abroad into Lebanon and the central bank in the short run. However, the means in which the central bank attracted these inflows was unsustainable and resembled a traditional ponzi scheme where new inflows covered for losses that accumulated over time, eventually bankrupting the central bank.

The loss of confidence hit the government’s ability to raise more debt and exacerbated the lack of political will to combat the high budget deficit. The government defaulted on its foreign currency debt and pressured the central bank to debase the currency to aid in repaying domestic currency debt and finance short term spending.

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