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Nada Mora, lecturer at the Lebanese University and is an LCPS senior fellow.

July 2020
Policy for Recovery Should Prioritize Growth

After months of an unprecedented financial crisis, the Lebanese government ratified an economic rescue plan on April 30, in which over 100 measures were listed. There are positive elements in it that have been discussed elsewhere.[1] Here, I highlight that the key for recovery, in one word, is growth. The first-best policy response is to rapidly arrange external liquidity support, lift capital controls, and in parallel, gradually reset debt on a sustainable path.[2] However, given lengthy negotiations with the IMF and increasing instability, a second-best response is needed. How can policy achieve the positive confidence-boosting effects of an external liquidity injection if it is delayed or impossible and while temporary capital controls are required to reduce capital flight? Every effort possible should be made to prioritize growth. In this article, I describe how Lebanon can indeed take advantage of a flexible exchange rate in order to achieve that aim, while at the same time implementing policies to insulate households and businesses from the worst consequences of exchange rate volatility.
Why growth?
Growth matters, not only for providing jobs and improving living standards, but also for debt sustainability. In the aftermath of the European sovereign debt crisis, only Ireland managed to reduce its debt-to-GDP ratio from 120% in 2013 to less than 60% by 2019 because it achieved average annual growth of 9.9% during this period versus 1.6% growth in Greece, Italy, Portugal, and Spain.[3] The government plan correctly recognizes that confidence will return after growth-enhancing reforms are implemented and capital controls can then be gradually removed starting 2021. But the missing link is that future growth rates—even by the plan’s projections—are weak: -4.4% is expected for 2021, 1.6% for 2022, and only 3% in subsequent years, on average.
Growth is strongly associated with export growth, and access to finance supports growth.[4] Examples abound, such as the rapid rise in East Asian living standards by the 1980s; the rebound in Mexico’s tradable sector after its 1995 crisis; the increase in Irish exports from 84% to 122% of GDP in the decade after its crisis in 2008. There is a lot of potential for Lebanon’s export sector to grow, in particular in areas for which the country has a comparative advantage such as agro-foods and high tech.[5] After increasing in the early 2000s, the country’s exports of goods and services shrank from 39% of GDP in 2008 to 23% by 2018. So how does Lebanon jump-start growth?
Flexible exchange rate helps growth
One of the main ways that countries grow after a financial crisis is through adjustment in the relative price of domestic to foreign products, causing exports to grow and imports to fall. This adjustment occurs as the weaker lira currency makes Lebanese goods and services (such as agro-foods and tourism) relatively less expensive, encouraging demand, exports, job creation, and dollar inflows. By contrast, adjustment can occur under a fixed currency, but it is slower and more painful because it would entail nominal wage reductions in order to lower production costs. Lessons learned from comparing the recovery of output-per-person after a financial crisis for three different exchange rate regimes (strict pegs, de-peggers, and flexible) were that strict pegs had the worst performance and flexible ones had the best performance. Strict pegs maintained fixed exchange rates for at least two years after the crisis and de-peggers moved from a pegged to flexible exchange rate. By the fourth year following the crisis, output for strict pegs was 4% below its pre-crisis level, while output for de-peggers was 3% above pre-crisis level, but the best performance was for flexible ones with an output of 8% above pre-crisis level.[6]
A flexible exchange rate provides a built-in automatic stabilizer that works through an export-led recovery, even without any other policy. To help recovery, one supporting policy measure is to maintain vital credit flow in the form of credit lines or trade financing to productive businesses. This is where the government has a role to play as South Korea did, by pressuring banks into maintaining their short-term credit lines.[7]
The government’s suggested economic plan proposes other good financing options: Licensing for new development banks, mobilizing public funds as cash collateral for imports of raw materials, negotiating foreign lines of credit with international development banks, as well as export subsidies and quality standards. Another important supporting policy measure is for the government to improve the general provision of public services. These measures benefit all businesses (and individuals), leaving the best businesses to survive and innovate while the inefficient ones close down.[8]
Many have a negative view of exchange rate flexibility because it has coincided with exchange rate volatility and a loss in their real savings. People would be more likely to accept it if policymakers delivered measures to lessen the most adverse effects of exchange rate flexibility and if officials also clearly communicated why flexibility is an opportunity for near-future gains. The alternative would be to maintain a strong currency that will preserve the real value of people’s savings, but would come at the high cost of years of jobless economic stagnation with no new savings.[9]
Protecting households and businesses
There are ways to protect households and businesses from excessive exchange rate volatility. When households queue for dollars, it is not the dollar per se that they are seeking. What they are seeking is a safe asset that will retain its purchasing power. To meet this demand, banks and savings funds could offer a new financial asset such as an “inflation-protected savings account” where the rate of return is linked directly to inflation, as done elsewhere. These accounts should be designed for savings purposes only and subject to limits.[10] To better protect businesses, setting up a “forward foreign exchange market” would allow them to insure against currency risk and support foreign trade transactions. The forward exchange rate is an exchange rate agreed on today for future delivery. Therefore, demand for dollars today would go down if businesses can cover any foreign currency open position in the forward market. While exchange rate volatility will not be eliminated, it will be less connected to the real economy, and stabilizing speculation would take hold over time in a flexible regime, albeit with some conditions.[11] In contrast, speculation is destabilizing when there are multiple quasi-fixed exchange rates and some degree of capital mobility, as people try to arbitrage away differences in rates.
Prioritizing these policies would help address the top two obstacles for Lebanese businesses based on the latest 2019-20 World Bank survey.[12] In it, 36.9% of respondents reported political instability as their top obstacle, and another 28.7% reported access to finance as theirs. While political instability is wide-ranging, part of it is reflected in the negative effects of exchange rate instability and policy uncertainty on business transactions. To reduce instability and uncertainty further, the government should select one or more high-priority public services to tackle, and if it follows through and delivers equitable results, it will gain the confidence of its citizens, thus anchoring exchange rate expectations.
In sum, export-led recovery is central to growth. Moreover, stability will be a natural byproduct of sound policy that delivers growth. This is what will ensure lasting price stability and lower exchange rate volatility.

[1] See recent LCPS analysis by, among others, Karim Daher on reforming the tax system, and Jessica Obeid on electricity reform.
[2] In this and an earlier article, I describe how, in the case of Lebanon, external liquidity would substitute for the role of the central bank as a lender-of-last-resort because it cannot print dollars.
[3] For example, while Greece’s debt ratio decreased by 20% at the time of its debt restructuring in 2012, it worsened the next year to 180% due to the collapse in economic activity and has remained elevated. See Gourinchas, PO, T. Philippon and D. Vayanos. 2017. “The Analytics of the Greek Crisis.” National Bureau of Economic Research Macroeconomics Annual 31(1), 1-81.
[4] See for example, Frankel, J. A. and D. H. Romer. 1999. “Does Trade Cause Growth?” American Economic Review, 89(3), 379-399; and Krugman, P. R., M. J. Melitz, and M. Obstfeld. 2017. “International Trade: Theory and Policy.” A more nuanced argument—but still relying on exports in the longer term—has been made for the temporary protection of infant industries that might not have comparative advantage in world markets initially but become more productive over time through ‘learning-by-doing’ (e.g., see Rodriguez, F. and D. Rodrik. 2000. “Trade Policy and Growth: A Skeptic's Guide to the Cross-National Evidence.” NBER Macroeconomics Annual, 15, 261-325.) In contrast, import-substituting industrial policies—while they are successful in expanding the manufacturing sector and investment—have generally not led to gains in growth and living standards. Therefore, I would caution against the 10-year tax exemption for new investments in new companies set out in the government’s economic plan. A case can be made to temporarily subsidize labor-intensive industries. This is not a desirable policy when employment returns to full-employment but is a way of aiding the recovery without getting the government into the business of picking “winners” that all too often leads to entrenched and inefficient incumbents.
For the review on the role of finance, see Levine, R. 2005. “Finance and Growth: Theory and Evidence.” Handbook of Economic Growth, 1, 865-934. While there are qualifications and reverse causality from growth to finance, there is much support for the view that better developed financial systems lessen financial constraints on firms and are associated with higher future growth.
[5] An additional comparative advantage that Lebanon has is in its skilled and multilingual workforce and its geographic location. Especially in light of disruptions of global supply chains with the pandemic, this can be an advantage for the country to grow its high-tech sector and develop ties with multinationals via foreign direct investment. The figures provided for Lebanon’s exports of goods and services are from the latest World Development Indicators database.
[6] Gourinchas, Philippon and Vayanos. 2017. “The Analytics of the Greek Crisis.” They also show that the performance of Italy, Ireland, Portugal, and Spain was similar to strict pegs, which makes sense as they maintained the euro. Greece fared a lot worse so that its output per capita reached 30% below pre-crisis levels by the fourth year after the onset of the financial crisis. An earlier study also found that having a flexible exchange rate provides a better buffer against negative real shocks (Broda, C. 2001. “Coping with Terms-Of-Trade Shocks: Pegs Versus Floats.” American Economic Review, 91(2), 376-380). For example, a 10% fall in the terms of trade of a country causes real output to fall by 1.7% more in the average peg compared with the average float, which experiences a greater real exchange rate depreciation. Interestingly, Broda finds this effect even when he restricts to a sample of highly dollarized countries.
[7] See Krugman, P. August 11, 2018. “Partying Like It’s 1998.” The New York Times, for ways that governments can pursue short-run heterodox policy until a return to capital mobility and orthodox policy. It is important to avoid self-defeating capital controls that get in the way of providing liquidity to the productive sectors.
[8] Bottlenecks arise from the inadequate provision of public services: These are infrastructure-related (electricity, telecommunications, transportation and shipping logistics, and timeliness) but also arise at the points of interaction between business and government (corruption and bribery, tax and trade regulations). Any of these bottlenecks can distort the field and favor the survival of firms with market power, political connections, or high cash buffers but are not necessarily the most profitable. For example, evidence from Lebanon shows that overall growth and job creation are lower in sectors with more politically connected firms. Truly competitive markets motivate firms to provide products at lower prices and higher quality, also benefiting consumers.
[9] The classic example is 1920s Britain when Winston Churchill decided to return to pre-War parity with gold, against the advice of John Maynard Keynes. As Keynes argued in his 1925 book, The Economic Consequences of Mr Churchill: “It is ill-judged because we are running the risk for no adequate reward if all goes well… It seems wiser and simpler and saner to leave the currency to find its own level for some time longer rather than force a situation where employers are faced with the alternative of closing down or of lowering wages, cost what the struggle may.” Britain remained in recession with high unemployment for the rest of the decade while its trade partners were growing. This discussion sets aside the issue of whether the central bank can even defend fixed exchange rates anymore.
[10] For example, the UK allows banks and building societies to offer inflation-indexed fixed-term deposits (1-5 years, and subject to deposit insurance limits and withdrawal restrictions). Following its financial crisis in 1995, Mexico introduced a CPI-indexed accounting unit, UDI (unidad de inversión), and also allowed dollar loans to be re-denominated in UDIs to lessen the burden on borrowers. The government absorbed the costs of re-denominating loans into UDIs. If we return to the example of the European sovereign debt crisis, by maintaining the euro, savers in Ireland and Greece retained the purchasing power of their existing savings—even as the value of their wages and prices decreased vis-à-vis Germany as needed for external adjustment. 
[11] There will always be speculative activity in currency markets, like in any asset market. However, rational speculators should have a stabilizing influence by buying when the currency price is low and by selling when it is high. Otherwise, speculators lose money. This idea goes back to Friedman, M. 1953. “Essays in Positive Economics.” There are caveats: Irrational speculators, illiquid markets, and imperfect information (noise traders), among others. As part of its stabilization reform program in 1995, Mexico created a forward exchange market to cover exchange rate risk. This together with the implementation of the rest of the stabilization program, led to lower variability in the price of foreign exchange, as discussed in Krueger, A., and A. Tornell. 1999. “The Role of Bank Restructuring in Recovering from Crises: Mexico 1995-98.” (No. 7042). National Bureau of Economic Research.
[12] The World Bank’s enterprise survey was based on 532 firms surveyed between May 2019 and April 2020 (more than half of which were small firms between 5-19 employees).

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