David McWilliams: What happens to a country when its money dies?

The road from Beirut to the Roman ruins at Baalbek takes you on the main highway to Damascus, the same route the occupying Syrian army rumbled along, east to west, throughout their 20-year occupation during Lebanon's civil war.

With a certain cruel symmetry, it is the same road trodden west to east by the desperate refugees escaping the horror of Syria's own civil war. Lebanon, a country of around 6.8 million, has absorbed about 1.8 million Syrian refugees.

Passing over the Green Line that separated Beirut’s Christians from its Muslims, passing by the brutalist “egg-cinema”, testimony to a time when this city of the early 1970s played host to all sorts of confident experimental architecture, you can travel down to the port, where the world’s largest non-nuclear explosion ever detonated in August 2020, destroying huge swathes of an already pock-marked city.

Criss-crossing this tiny country involves a crash-course in national, regional and international politics, interests and alliances

Black market traders exchange dollars at the crossroads. A little over a year ago, the Lebanese pound traded at 1,500 to the dollar. Last night it was 21,000. People’s salaries have fallen in real terms by over 90 per cent. Most places would throw in the towel. Not here. Not yet anyway.

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The road that leads up and over Mount Lebanon travels through a patchwork of different ethnic regions. Christian areas, populated by Greeks and Maronites, are followed by a Druze area towards the top of the mountain, before sweeping down to the Sunni of the Bekaa Valley, the Roman Catholics at Zahle (with more shrines to the Virgin Mary than Knock), and on to Shia territory, past the Palestinians, back to the Sunnis and on again to the Shia, Hezbollah-supporting town of Baalbek and its glorious Roman ruins.

Like Belfast, each area, each sectarian zone is distinctly marked by its own flags and posters just in case you need reminding. In Shia areas, Hezbollah's stronghold, giant posters of Iranian military commander Qasem Soleimani, assassinated by the US last year, beam down at you. Yasser Arafat still adorns Palestinian streets, while the head of the Lebanese army, Joseph Aoun, watches over Maronite villages and Sunni regions boast images of MBS of Saudi Arabia. With friends like that, who needs enemies?

Criss-crossing this tiny country involves a crash-course in national, regional and international politics, interests and alliances.

For the past 50 years, Lebanon has been the fulcrum for proxy wars as the main players cynically move their chess pieces about the assorted ethnic board that is this state.

Against this background, the intermittent cedar-adorned flags of the Republic of Lebanon appear more of a vague aspiration than representing any reality. However, the one place where all the Lebanese converge is in the economy, where the plunging currency tells its own story. They share a currency, an inflation rate and economic fate.

The question is, what happens to a country when money dies?

The shorthand of Lebanon’s economic story and its collapse is that it did something like Celtic Tiger Ireland. It bet the house on banking, finance and real estate. But whereas Ireland tried to pull this trick off within the euro zone, the Lebanese tried it with its own currency.

As the banks keep borrowing and lending [...] the country morphs not so much into a state with a banking system, as a banking system with a state grafted on to it

We are talking about two highly leveraged episodes where both banking systems were turned into indebted casinos, soldered onto a roaring property market, seducing in foreign money with the promise of super-normal profits. Bank shares went through the roof and the banks grew, gluttonously, as did the construction sector. Lebanon of course is a much less stable country, dependent on tourism, and even more on the largesse of the Gulf Arabs.

The central bank of Lebanon attracted money into the country with interest rates that were higher than elsewhere and the promise to keep the exchange rate steady. If an investor believed them, and many did, the investor could pick up yield in Lebanon that was disappearing elsewhere. This new foreign money was then converted into Lebanese pounds.

“Converting” means selling foreign currency and buying Lebanese pounds, which initially puts upward pressure on the Lebanese currency and fills the Lebanese central bank with abundant foreign reserves. Everything looks hunky dory. If the central bank keeps interest rates high, the money supply expands. This means that it feels very prosperous.

However, the banks are carrying two risks. The first is they are borrowing in dollars and lending in local currency, implying that they are potentially exposed to an exchange rate risk. Secondly, they are borrowing using short-term instruments such as notes and IOUs that need to be rolled over every couple of years, but they are lending long term to residential real estate that might be in the form of the 30-year mortgage.

In economics, this mismatch is called “lending long and borrowing short” and it means that if the foreigners get windy and call in their loans, the banks have no money to pay these loans back.

As the banks keep borrowing and lending and no one is calling a halt because everything is booming, the country morphs not so much into a state with a banking system, as a banking system with a state grafted on to it.

Sound familiar? For such an economic model to work, nothing – either politically or economically – can go wrong. Everything is finely balanced.

Then Lebanon was hit by five massive shocks. First the war in Syria. Large parts of Shia-Muslim, Hezbollah-controlled Lebanon, sided with the Assad regime. Hezbollah is Shia, as is Iran. It gets its support from Iran and as Iran backed Assad, so Lebanese Hezbollah fighters entered Syria to fight on the ground. Seen as a proxy Iranian Shia army, this angered the rich Sunni Islamic Gulf states and Saudi Arabia. Saudi and Gulf investors retaliated by calling in their loans.

Second, as Isis rampaged just across the border in Syria, the tourism industry in Lebanon, the only significant domestic source of foreign currency, evaporated.

Third, humanitarian Lebanon was forced to take in millions of Syrian refugees without any new tax revenue to pay for these people.

Fourth, the economy shut down during Covid. And on top of all this, a massive explosion in Beirut’s port, destroyed large parts of the city, which now need to be rebuilt.

One of these crises would knock a precarious banking Ponzi-scheme off course; take all five together and you have a disaster.

Foreign currency surged out of Lebanon, leaving the central bank with a choice: deflate the economy commensurate with the pace at which dollars are leaving, or print money.

Who is going to pay the army, teachers, public servants and police if they don't print money?

In theory, there are two other options. The state could have increased taxes and cut spending dramatically, but with an economy in lockdown, groaning with refugees and without tourism, where is any growth going to come from?

Or it could have borrowed to cover the bank losses, but who will lend long-term to such a state that can’t even pay its short-term debts? The Lebanese banks are all bust, owing dollars which they can’t pay.

To keep the country afloat, the central bank prints money and hopes for the best. Who is going to pay the army, teachers, public servants and police if they don’t print money? Remember just how fractious and divided this country is.

Dollars disappear as the crisis mounts, yet the newly printed local currency is everywhere. Savings trapped in the bust banks are wiped out. The currency’s value collapses and the country splits into one more deep division: those with dollars and those without. Lebanon has a huge diaspora. People fortunate enough to have foreign relations get enough remittances to get by; those who don’t have to survive as their incomes fall by 90 per cent.

Where it goes next is anyone’s guess. As the barman Nino, in the Dragonfly bar in downtown Beirut said to me last night: “Don’t ask me how we survive, but we do.”