Exchange rate arrangements : the Lebanese context -

Abstract

Fifteen years of disturbances have left the pre-war booming Lebanese economy in a much-deteriorated state, and have had highly destructive repercussions. The country embarked on a massive reconstruction plan in the early 1990s, and since then, the Lebanese economy has been caught in a chronic viscous cycle of high indebtedness and recurrent budget deficits. In view of skyrocketing inflation rates, increasing fiscal pressures, high exchange rate volatility, and a severe trend of depreciation, and in order to reestablish confidence in the economy, the central bank has engaged in exchange rate-based stability policies, pegging the Lebanese Lira to the dollar at a rate of LBP 1507.5 per US Dollar, in 1999. With the aim of weighing the benefits of adopting a pegged exchange rate in Lebanon against the costs of defending it, this project starts with an extensive literature review of exchange rate arrangements, detailing their advantages and disadvantages. Emphasis is placed on fixed exchange rate regimes, and how particularly vulnerable they are to currency crises. Along the way, the aim of this study is to assess the sustainability of this established parity, given country-specific circumstances. In this context, we empirically test for the stability of the Lebanese money demand function, which turns out to be highly volatile and susceptible to shocks. The results reveal that the exchange rate peg policy efficiently helps in stabilizing prices, which perfectly matches the ultimate objective of the central bank. However, the strictly high Debt-to-GDP ratio, coupled with persistent fiscal and current account deficits, indicates that such a fixed rate regime cannot be sustained indefinitely, and Lebanon could be heading towards an exchange rate crisis.