Publications & Resources

July-August 2017

The National Currency and Soundness of the Banking Sector

(Published by Lebanon Opportunities)
Original text edited in Arabic
Reading or listening to what certain experts or journalists were recently saying, the country would seem to be on the brink of disaster regarding its currency, banks, and Treasury. Public opinion will surely not be misled by these statements. Citizens have enough awareness and experience to make them immune to these extremely pessimistic views. Those making these statements, although well-educated and well-informed, are reluctant to objectively tackle the available statistics, data, and developments. In the game of numbers, to name just one example, it is claimed that the gold and foreign currency reserves of the Central Bank (BDL) record a deficit of over $1 billion notwithstanding the banks' deposits of foreign currencies at BDL. This computation ignores BDL’s portfolio of Sovereign Eurobonds on the international markets. If this portfolio is taken into account, the deficit will turn into a $5 billion-$6billion surplus. Just a reminder, BDL in its capacity as the State’s bank, settled financial obligations in foreign currencies on the State’s behalf which reached nearly $10 billion by the end of June 2017. Factoring in all this data, without accounting for the value of the gold reserves, results in a balance between BDL assets and liabilities in foreign currencies. Gold reserves stood at $11.5 billion at that time. It makes sense to include the Eurobonds in these calculations since BDL acts as a ‘Market Maker’ regarding securities issued by the State on global markets. It intervenes by purchasing these bonds to prevent their prices from collapsing. As for the $10 billion disbursed on behalf of the State, especially the cost of fuel for Electricité du Liban (EDL), it is essential to ensure an energy supply to the economy and the country. This payment is made according to a government decision. It would have been better to shed light on the system of corruption that results in the wasting of public money rather than to blame BDL for its intervention in preventing the downfall of government bonds and to shield the economy and the interests of the people from collapse. Exposing the corrupt system might help to safeguard the country’s national interest from profiteers. This could result in recovering public money and State properties that are being wasted or stolen, which would significantly narrow the public deficit.

One recent study claims that “the banks are no more playing the role of the intermediary in the economic activity whereas their main function is to be engaged in financial intermediation with the private sector.” The writer bases his argument on the fact that lending to the economy accounts for just 25 percent of the banks’ total assets, while the banks place nearly 60 percent in the public sector, including BDL and the Treasury. This narrow interpretation of placements made by banks requires three basic remarks. First and foremost, bank credit, according the International Monetary Fund (IMF), is measured in relation to the size of the economy not the size of the banks’ balance sheets. This ratio, in Lebanon, exceeds 110 percent! And it is consistent with similar ratios in most countries and regions worldwide. Charts for 2016 published by The World Bank show that the average ratio for the Arab world is 58 percent. The regional rate sits at 46 percent for the Middle East and North Africa (MENA) region which includes Lebanon. The average is 49 percent for Latin America and the Caribbean region. The lending-to-GDP ratio reaches 89 percent in the Eurozone and 95 percent in the European Union as a whole (98 percent in France). The second remark concerns the insufficiency of bank lending to the economy is that the capacity of the corporate sector to borrow relative to its capital is near saturation. In this case and in light of the concentration of credit, it is advisable that large corporations seek financing through listing on the Beirut Stock Exchange by increasing their shares or by issuing bonds. A move by companies to seek funding through shares and bonds would be considered a healthy and welcome diversification of financing resources. The shares and bonds offered for direct public subscription would be less costly than borrowing from banks since the companies pay dividends to shareholders when they make a profit while they pay a fixed return to bondholders. Economists and researchers should encourage development of the capital markets in Lebanon in order to compete with the banks in terms of financing the economy instead of always blaming the banks when they do finance. The third remark pertains to the claim that the banks are not doing their job as financial intermediaries between economic agents. Facts do not line up with this claim. The banks efficiently attract savings and surpluses from some of their clients and lend them at the best conditions to households, individuals, and institutions with financial needs. The banks have also set up a very broad network of branches (1,078 branches), at the rate of one branch for every 4,174 citizens, which is similar to the averages of the countries that are members of the Organization for Economic Co-operation and Development (OECD). In addition, the banks have a large number Automatic Teller Machines (ATMs) totaling 1,800 across the territory. The banks boast a state-of-the-art payment system of more than 2.8 million credit and payment cards and easy and inexpensive financial transfers as well. Lebanese banks are also present regionally and globally in 30 countries and 82 cities. Banks provide a broad network of correspondence relationships with 183 banks across the world which allows expatriates to transfer their savings to their homeland. This network also allows local residents to transfer their payments overseas. The total assets of the banking system (including commercial banks and business banks) have reached $220 billion. The consolidated assets total $254 billion when including $34 billion in assets of foreign networks of local banks. Banks are playing the role of financial intermediary perfectly well, which is their main mission. For this role to be successful it should be founded on a solid national currency and on a monetary policy that ensures monetary stability, that’s what we will be expounding on in the second part of this article.

Currency and banks are like Siamese twins, they are inseparable. A sound banking sector relies on a strong currency, and the resilience of banks is the bedrock of monetary stability. Money supply is no longer confined to paper money which accounts for a tiny percentage of the M3 money supply in modern economies (M3 is the total amount of local and foreign money supply). The lira in circulation represents 2.2 percent of the overall money supply: LL4,544 billion (around $3 billion), over LL208,050 billion (around $138 billion )as at the end of July 2017! The remaining 97.8 percent of the money supply consists of people’s deposits in the banking sector. This means that the payment systems are managed by banks, alongside their obligation to safeguard national savings, and to finance the economy. The BDL is in charge legally of the welfare of the banking sector which is entrusted with the national savings, payment transactions, and in financing economic activities. The monetary policy followed by BDL is decided by its Central Council, not by the Governor alone. Besides the Governor, the other members of the Central Council are the four Vice-Governors and the general directors of the ministries of finance and economy. The Central Council also decides on the means to ensure monetary and banking stability including interest rates and financial engineering policies and on ways to support the economy or to back any bank that needs assistance. This is done for the higher national interest, all of which is founded on monetary stability. The monetary stability that people have become used to, and are enjoying, did not come out of the blue, and has not persisted over 25 years by pure chance. This stability needed, and still needs, a consistent monetary policy with interest rate control as its main instrument after the State, in all its constitutional institutions (Parliament and the various cabinets), has decided to fix the exchange rate of the lira and has assigned this task to BDL. BDL will be accountable if monetary stability is shaken. It is hard, or rather impossible, for BDL to carry out such tasks without an inevitably high interest rate structure. These tasks consist of ensuring the stability of the lira exchange rate and the soundness of the banking sector which are two sides of the same coin. What is amazing is not that interest rates are high, but rather that they are moderate, and in no way excessive. This is due to many reasons that is detailed below and supported by documented evidence.

The main issue when assessing the level of interest rates lies in the benchmark used to qualify interest rates as high, low, or average. Objectivity compels us to evaluate the level of interest rates relative to the country’s risk. International market ratings are published by credit rating agencies such as Moody’s, Standard & Poor's (S&P), and Fitch IBCA. To simplify and to avoid comparing the methodologies that each of these agencies uses in their evaluation systems, I use S&P as an example. I will apply the interest rates published by the Work Bank, as they are, most probably, based on a cohesive methodology. The aim is also to avoid the complexities involved in the computation of debit and credit interest rates that are prevalent in a number of countries with risks that are similar to Lebanon (or better!). Obviously, every time risk goes up, the interest rates and margins rise in the concerned country. To illustrate this gradual rise in interest rates on the currency markets, a list of countries, including Lebanon, was prepared by the World Bank. We have arranged these countries from the best rated to the worst rated one. The result is as follows:

  Risk level Debit interest
Credit interest (Percentage) Interest margin (Percentage)
Chile A+ 5.6 3.82 1.78
Malaysia A- 4.5 3.03 1.47
Indonesia BBB 11.9 7.17 4.73
Russia BB+ 12.6 6.97 5.63
Brazil* BB 52.1 12.47 39.65
Turkey BB 14.61 - -
Jordan BB- 8.1 3.3 4.8
Argentina B 31.12 24.28 6.84
Nigeria B 16.9 7.5 9.4
Armenia B 17.4 11.62 5.78
Egypt B- 13.6 7.86 5.74
Ukraine B- 19.2 11.49 7.71
Lebanon B- 8.4 5.93 2.47

*Abnormal numbers due to rate of inflation

The data clearly shows that the levels of debit and credit interest rates in Lebanon, as well as the interest margins, are moderate compared with countries with similar risk ratings. The interest margins in Lebanon are even much lower than those prevalent in countries that enjoy a better risk rating. Some people might say that the differences in interest and margins are due to differences in inflation rates between Lebanon and many countries listed in the table. This is true, since inflation rates remained constrained in Lebanon, which continues to uphold the purchasing power of low-income people, especially those whose earnings are in lira. Most of the credit for reining in inflation rates, at an average of less than two percent in the last five years, goes to the monetary policy adopted by BDL. So, why all the fuss? The strength of the lira is a standard of living guarantee and safeguards savings of the middle class that is in the process of being reconstituted after they were impoverished and displaced by the war.

The local interest structure, when compared with other countries, reveals that the banks’ financing of the economy in lira, relative to the country’s risk, is at a moderate and acceptable interest rate (8.4 percent). The share of financing in lira is nearly one third of overall financing. Credit to the private sector in foreign currencies is done at a cost of nearly 7.25 percent as of July 2017, which is less than the cost of borrowing in lira! Financing the economy would not be possible at this cost amid the prevailing country risks if it weren’t for the monetary stability that allows banks to attract deposits, and the monetary policy that fits the country’s circumstances and its sovereign risks. The Central Bank bears part of the cost of financing the country through the interest rate that it pays on the banks’ deposits in lira at BDL at an average rate of 6.1 percent. This means that banks have a margin of 54 basis points in the lira market before taking into consideration the cost of investment or the profit. BDL pays on average 4.19 percent interest rate on foreign currency assets of banks. When compared with the cost of deposits, amounting to 3.64 percent, the banks’ margin is once again basically the same, 55 basis points. This average should be compared to the cost of borrowing from abroad in foreign currencies in countries that have similar risk profiles. Egypt, for instance, whose risk rating is B-, recently launched an issue of $3 billion which included $1 billion with tenure of ten years at a yield of 6.65 percent. Jordan, whose risk rating (BB-) is better than Lebanon, issued $500 million at a yield of 5.8 percent. Turkey, whose rating is better than Lebanon, Jordan, and Egypt, has issued $2 billion in debt for ten years with a return of 6.15 percent. Lebanon’s overall debt in foreign currencies, amounts to $29.7 billion (the share of the banks in it is 55 percent or over $16 billion), generates an average yield of 6.13 percent, according to the June 2017 bulletin of the Ministry of Finance. This return is less than the yields paid by such countries as Mexico (6.85 percent) with a credit rating of BBB+, Brazil (9.88 percent) with a rating of BB, or even India (6.49 percent) with a rating of BBB-. The problem possibly lies in the financial engineering operations performed by Banque du Liban amid very tough, precarious circumstances. Evaluating these operations should only be done by taking into consideration the context of the time when they were carried out. The data above shows that the interest margins of banks with BDL are very low, at nearly 55 basis points. So where is the generosity?

Everyone agrees that widening annual deficits in State finances, and the ensuing rise in public debt, constitute both a real, and a national problem. If it continues to worsen, it will carry risks to the country, society, and the banks, which, with time, will threaten financial stability. This means that it will be hard to finance these deficits at acceptable conditions. Public debt has reached over $76.4 billion, or more than 145 percent of GDP as at the end of June 2017. Nearly 61 percent of the debt is in lira, and 39 percent is in foreign currencies, mainly US dollars. Banks hold in their balance sheets part of the public debt amounting to 47.5 percent, BDL holds a share of 32.3 percent, and public institutions (the National Institute for the Guarantee of Deposits and the National Social Security Fund) hold a share of 7.7 percent. Bilateral and multilateral loans provided by states and international institutions account for around three percent. This means that more than 90 percent of public debt is provided by the institutional and public sides and that less than ten percent is held in the portfolios of individuals and private institutions, whether residents or not. These two features of the State’s debt – more than 90 percent held by institutional lenders and equally over 90 percent held by residents, give this debt a quality of stability which is separate from the volatile aspect of the public debt of many emerging and developing countries.

As clarified above, banks held a $34.6 billion share of public debt as at the end of July 2017, which is roughly divided equally between a debt denominated in liras and in foreign currencies. This debt generates returns to banks of an average of 6.68 percent, which is considered moderate, or rather low, relative to the country’s sovereign risks. It should also be noted that the Treasury holds in its accounts at the Central Bank deposits of LL23,391 billion ($15.5 billion) as at the end of June 2017 against payments settled by BDL on behalf of the Treasury in foreign currencies valued at LL14,588 billion ($9.7 billion) for the same period. This results in a credit balance of the Treasury at BDL of LL8,803 billion ($5.85 billion). This balance is considered on one hand, as a contribution from the Ministry of Finance to the cost of monetary stability. On the other hand, this balance is considered as a reserve that the ministry can use if it becomes hard for it to obtain financing at acceptable conditions at a specific period of time and until lending conditions improve.

The three members of the equation bear the cost of financial stability, with each carrying a different burden. Banks come in the first place through a structure of low interest rates and low margins relative to the country’s risks. The Central Bank comes in second place through the interest rates paid on the deposits of banks at BDL as it is legally mandated to protect monetary stability. In third place comes the Treasury through its lira deposits at BDL. These are the prerequisites for, not the dangers to, financial stability!

The economy consists of production and consumption. The country consumes more than its production or income allows. In other words, national savings, including all transfers and financial inflows from outside, are no longer enough to balance the current national payments. The saving-expenditure gap is reflected as a steady deficit in the country’s current balances. The IMF expects this gap to remain at no less than 15 percent of GDP or $7 billion-$8 billion per year. How could we finance this gap in the coming years? In previous years, the banking system (both BDL and the commercial banks) bridged the gap despite the vilification they were subjected to. It has become hard, however, to continue in this direction unless the authorities come regain power along with all its rights, including collecting taxes from all taxpayers and from all regions. Solutions cannot be found unless the numerous reforms promised by the new Presidency are applied, as the proof in the pudding. Until then, there is no need to destroy the temple on the heads of its people, both residents and expatriates. Rather, what is required, is to manage risks wisely, amid the storms and shifts that engulf our country and its people.