After equitably allocating the losses, policymakers must eliminate the roots of our financial crisis.
A substantial part of those roots is the partial dollarization of deposits.
Dollar deposits in Lebanon currently constitute 74 percent of total deposits at commercial banks.
A substantial part of those roots is the partial dollarization of deposits.
Dollar deposits in Lebanon currently constitute 74 percent of total deposits at commercial banks.
The problem with partial dollarization is that it leaves the banking system vulnerable to currency mismatches on its balance sheet, creating a dollar hole. If banks’ dollar assets don’t cover its dollar liabilities, solvency risk amplifies.
Allowing for dollarization is a double edged sword. In part, this incentivises dollar inflows which the central bank can use to fund the country’s external needs. Additionally, it creates massive dollar liability costs.
Optimally, dollar liabilities must be matched by liquid dollar assets that entail a higher return. In Lebanon, dollar deposits are allocated among four key assets: eurobonds, deposits at BdL, deposits at custodian banks, and private sector loans.
However, the guarantee that local dollar assets, the majority, are received in dollars entirely depends on the central bank and its ability to exchange the local currency for dollars in several ways.
First, if the central bank does not have adequate foreign currency reserves, then banks cannot withdraw their $ deposits, rendering them illiquid (or inexistent). BdL has around $30bn in reserves while banks’ deposits there are ~ $70bn.
Second, the government has insignificant dollar income so its ability to pay in USD depends on the central bank to exchange its Liras for dollars. Given the peg, this transaction requires BdL to deplete its foreign currency reserves.
Third, if the private sector mostly gets paid in LBP, as most domestic income is in LBP, then it will have to pay back its loans by first converting its LBP into USD. Given the peg, this transaction also requires BdL to use its foreign currency reserves.
Notice that the second and third points exacerbate BdL’s dollar hole in its balance sheet (its net reserves position), making it more difficult for banks’ dollar deposits at BdL, their largest asset, to be realised in dollars.
Banks’ dollar assets are also exposed to sovereign risk (eurobond default) and credit risk (private sector default). The currency crisis we are presently in amplifies banks’ solvency risks by increasing its borrowers’ costs of acquiring dollars.
Clearly, a currency mismatch on BdL’s and banks’ balance sheets is a reality which, as previously discussed, will result in a from of haircut. Policy should tackle partial dollarization (move towards lirafication) in the future to avoid falling into the same trap.
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