Whither the Lebanese Economy?

by Ali Bolbol, Economic Advisor, BLOMINVEST Bank [1]t

A close, hard look at the Lebanese economy reveals two unfortunate attributes: a long-simmering breakdown of governance in the public sector and the legacy of an outdated economic model. Corruption and inefficiency in the public sector are not new to Lebanon – the country has always fared badly on reputable international standards of transparency and good governance. But they have become increasingly costly – spending more for less and worse services — especially in a slowing economy and a climate of dwindling resources. And they have consistently denied the economy an attractive environment for needed investments, foreign or domestic, making it operate below its potential and holding back its catch-up to a genuine middle-income economy. This situation is sadly compounded by the sorry state of the Lebanese infrastructure, which has not undergone even minor improvements in the past fifteen years.

But what makes this attribute more damaging is its association with an outdated economic model and how this model works or, rather, how it does not work. The model rests on a once-celebrated view of how the Lebanese economy can thrive based on its services sector, especially in banking, tourism, and real estate. Leaving banking aside for the moment, such a view is no longer viable simply because Lebanon has lost its competitive edge in that sector. Tourism and other services are highly sensitive to political and economic risks, and the recurrence of these risks has eroded the country’s advantages. Not only that, new service hubs have emerged in the region — Dubai is perhaps the best example — and is making this model more obsolete by the day.

In the model’s defense, however, it is sometimes argued that the model can remain sustainable given the flexibility of the Lebanese economy and the crucial role of expatriate income. These are interesting arguments, but they are unfortunately not good enough. Economic flexibility refers to the economy’s ability to withstand a case of generalized shocks through price adjustments — goods prices, wages, interest rates, and exchange rates – that if allowed to operate would make the shocks self-correcting. And in the case of specific sectoral shocks, it stands for the economy’s fluidity to move resources away from the shock-laden sector to the shock-free sectors, thus negating any negative effects of the former. But in Lebanon almost all shocks are general in nature, being political or security shocks. In addition, prices are hardly flexible: exchange rates are fixed by the de-facto regime, interest rates are largely set and change by the requirements of deficit financing, and money wages are rigid by contractual arrangements. So how can flexibility come about?

The argument concerning the role of expatriate income is more favorable, but it also suffers from potential drawbacks. At close to $7.5 billion annually, expatriate income and transfers play a commendable role in increasing banks deposits, in shoring consumption and investment, and in ameliorating balance of payments imbalances. However, they seem to have engendered a culture of dependency and inaction, and are looked at as a safety valve that can substitute for serious policy action on how to improve external imbalances and growth prospects. Moreover, they are losing momentum: they have hardly increased in the past five years, and they might not do so in the future given the increasing restrictions on granting Lebanese nationals work permits especially in the Gulf. There are some doubts also about their growth mileage, since most of their investments have been in the real estate sector and, as a result, there has been little transfer of the expatriates’ expertise to the domestic economy.

Notwithstanding the recent public agitation and demonstrations, the issue of inaction and policy freeze is very serious. The passivity of the policy establishment and even the general public in the face of economic debilitation is quite striking. It not only signifies the subservience of economics to politics – and the repeated false starts and missed opportunities that have plagued the economy since at least 2005 — but it also indicates a disturbing attitude among the Lebanese that things will eventually turn the corner, that the economy has been in this rut before but it survived, and that the Lebanese economic model will deliver growth and prosperity once again.

What about banks? The Lebanese banking system played an instrumental role in growth spurts, as it is well-managed, experienced, and conservative. It has repeatedly been considered the protector of the country’s economy and wealth, and for good reasons. The financial system being bank-based, banks are almost the only financiers of both the private and public sectors, and home to safe, rewarding, and modern banking services and products. Their deposit base continues to grow, bolstered by the high confidence and reputation that the system enjoys, though profits have naturally suffered because of the prevailing political turmoil. Despite all of this, Lebanese banks can’t be considered the leading sector in the economy. By their nature, banks are intermediaries that vet investments and provide loans to fund them, but they can’t create these investments. That is what other sectors do; and that is why in spite of all the liquidity that Lebanese banks carry, there is a dearth of productive investments – aside from mainly housing – because of the high risk premiums involved and, more importantly, because the service sectors can no longer deliver and lead. It is of course possible that the Lebanese banking sector can itself have a leading role by being a hub of financial services for the region and beyond – the way Singapore is for South-East Asia – but that is no longer politically viable and, anyhow, Lebanese banks lack the complementary capital markets essential to deepen and widen the functions of a financial center. Even in the very unlikely possibility of attaining such a centrality, Lebanese banks still have to be an integral part of a diversified economy with a host of growing sectors.

And it is this diversification that the Lebanese economy badly needs – in fact, what it needs is a new economic model. The new model should relegate the primacy of the service sector and should build on sectors with putative comparative advantages. If you think that this is an old idea and its execution takes considerable time, you are absolutely right. But it is an idea whose time has sorely come, and since it takes a lot of time to effect such structural changes, it is hence all the more urgent to proceed as quickly as possible. The country is home to an educated, talented, and relatively cheap human capital that is considered the country’s prime advantage, and that should form the basis upon which the new sectors are fostered – for instance, sectors in information and communications technology (ICT), media and fashion, electronics and logistics and, given the new resource advantages, oil and gas.

As important, the new economic model requires a new policy framework and a new supporting environment. Aside from monetary policy, economic policy in Lebanon is largely confined to short-term tinkering with the budget to control public deficits and debt as the remedy to all economic ills. This policy emphasis not only misses the simple fact that a big part of the deficit can be eliminated by withholding subsidies to Electricite du Liban (EdL). But, more fundamentally, it misses that solving the country’s economic problems is a long-term process which entails a patient application of an effective industrial policy designed to nurture the new sectors that the model upholds. That this new approach gives a more complex and essential role to the government is definitely true. And that is why sustainable prosperity in Lebanon depends crucially on proper governance. It provides a conducive environment for government efficiency where policy incentives are translated to sound economic and business decisions; and it represents an important determinant of the country’s competitiveness. Perhaps the best indicator of an economy’s competitiveness is total factor productivity (TFP), which captures the economy’s productivity after accounting for labor and capital inputs. TFP is mostly determined by tangibles like technology and innovation, and by intangibles like the quality of institutions and the efficiency of markets. And for the longest while, TFP growth in the Arab world and Lebanon was negative, implying that market and institutional imperfections were robbing from GDP growth rather than adding to it.

So it is these qualitative improvements in governance and institutions that we should actively seek so as to achieve sectoral structural changes and higher productivity and competitiveness. Needless to say, such improvements will go a long way towards solving other economic ills, like budget deficits, which are actually the symptoms of a weak economy and poor governance and not the cause, since proper reforms of public enterprises, including EdL, will render budget deficits innocuous. And the ensuing prosperity would be reflected most of all by better jobs and higher-productivity wages, which in turn would stop the hollowing-out of the middle class and would bring back the virtues of shared citizenship. Not only that, a prosperous middle class would act as a necessary harbinger for social peace and for democratic politics.

In the end, it is politics that will make or break the viability of the economy and the success of such a new vision for its transformation. It is perhaps ironic that the two enduring characteristics of Lebanon have proven to be both a blessing and a curse — its strategic location and its religiously-diverse population. The country’s geography has placed it at the gateway to the Eastern Mediterranean and Arabia, but has endowed it with powerful and belligerent neighbors who have never shied from exercising their influence and rivalry on its soil. Also, the country’s confessional mosaic should have blessed the country with cultural diversity and the bliss of communal living, yet it has unfortunately acted as a source of discord and political disunity and turned confessional groups as proxies for regional contestants. The combination of these external and internal fissures has been calamitous to the country, and has denied it the stability and determination needed to effect credible economic change and sustained, genuine growth. But the country can’t afford to continue with these divisions and to rent out its future to regional interests, simply because (at the expense of being dramatic!) it may cease to really exist. History is very unkind to small countries with heterogeneous populations, and if their internal political house is not put in order, then they will either disintegrate into meaningless, irrelevant islands of instability or they will be taken over by stronger neighboring countries.

The antidote to either eventuality is a reaffirmation of the shared long-term interests and destiny by the diverse political groups, and finding the political will to reinvent government and undertake structural changes in the real economy. If done well, the outcome of these transformations is an economic virtuous cycle whose inclusive nature will bind the Lebanese people’s lives together and help dissolve any malignant political differences among them. If not done, or done superciliously, then the country will self-destruct into national and regional oblivion. Political fragmentation will drive the various antagonists to fight over a shrinking economic pie, encouraging more corruption, craft, and rent-seeking activities, and causing further economic shrinkage and political decay in the process, like a vanishing “black hole”.

With the recent talk of a possible political settlement and election of a new president in mind, I want to conclude by pointing out a significant historical event that could serve as a useful analogy here. It is common among American political circles to attribute the fall of the Soviet Union to outside pressures exerted by the US. The reality is, however, a lot different and perhaps simpler. First Secretary Gorbachev took a hard and truthful look at the internal workings of his country and saw a bankrupt economy and a stifling political culture. He realized that the system requires fundamental changes, and he courageously went about doing just that, irrespective of what the external pressures really were. The moral of the analogy is quite clear: the Lebanese need to take a similar look and be equally courageous.

[1] Views expressed in the paper are those of the author and not necessarily those of BLOMINVEST Bank. Part of this essay was published in ABL Monthly Bulletin, 11/2014.

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