One would imagine that, of all the countries in the Middle East, Lebanon would be among the hardest hit by the global financial crisis. Famous for its weak central state and ferociously capitalist private sector, Lebanon has the closest thing to a free market in the region. It has a dollar-based economy that is highly integrated into global markets and is heavily dependent on the remittances of expatriates in the rich countries where the crisis came first. And the origins of the downturn in high finance would seem to augur especially poorly for Lebanon: The banking and financial sectors are the cornerstone of the country’s economy, and the banking sector relies on foreign and non-resident depositors. Since the global downturn emerged from a crisis in the banking sector — resulting from a poorly regulated mortgage market in the United States — Lebanon might have been quite vulnerable to its impact. Indeed, the crisis was exported first from the US to financial markets, through securitized mortgages that were transformed into “toxic assets” first in Europe and then on the balance sheets of banks and financial institutions throughout the world. As the crisis became a contagion, there was every reason to expect that the Lebanese financial sector would face the same profit losses experienced in the West and the Gulf.
Yet World Bank and International Monetary Fund reports on the global recession show resilience in Lebanon’s economic indices. Real gross domestic product growth exceeded 8 percent in 2008. Inflation dropped to 4 percent in January 2009, down from the double digits briefly reached the previous summer as a result of soaring international food and fuel prices. Even the debt-to-GDP ratio declined by six percentage points, showing a net decrease in debt as a percentage of GDP. In light of these remarkable statistics, the question that emerges is: How has Lebanon, at least thus far, been able to weather the storm?
Of the most common explanations advanced, three stand out. It has often been remarked that contrary to the erstwhile conventional wisdom, the countries that are most insulated from globalization are those faring best amidst the financial crisis.  “Closed-market” countries like Syria, Libya and Iran are expected to experience gains, on some accounts, as compared to economies more exposed to the banking contagion from the West. One conceivable corollary of this argument is that Lebanon, ironically, has benefited from its involuntary integration with the Syrian economy, with Syria’s relative isolation from global trends offering a buffer. Syria legalized private banking only in 2001, and its licensed private banks were allowed to conduct business in foreign currency only in 2005. Its exposure to risky international investments has been minimal.
This explanation is not convincing. First, the interdependence of Lebanese and Syrian markets has much more to do with the “real” economy than with the financial sector. Lebanon is an important destination for Syrian goods and manual labor, as well as capital fleeing severe financial restrictions, while Syria serves as a market for Lebanese services. Second, to the extent that the two countries are interdependent in high finance, it is Syrian banks that are dominated by Lebanese banks — not the other way around. Far from the Syrian economy sheltering Lebanon, the Lebanese banking sector, with its history of global integration and autonomy, would have infected the Syrian sector with risk had it been exposed. The interesting question, to which there is no “Syrian” answer, is why the Lebanese banking sector did not dissolve in the global meltdown.
A second explanation has been a story of capital flight from the West of which Lebanon is the beneficiary. This argument contends that while Lebanon has suffered from the financial crisis as acutely as other globalized economies in the region, the pain was ameliorated by the country’s long-standing role as default banker to the Gulf. Historically, Lebanon’s stable and open economy, and strict laws regarding secrecy in banking, had made Beirut an attractive destination for deposits. When the financial crisis began in the West, some have argued that Gulf Arab capital fled American and European banks and came back to the Arab world, chiefly Lebanon.  This explanation, too, is fairly weak for two reasons. First, Lebanon is no longer the region’s principal banking destination. When the Gulf wants to invest its money in the Arab world, it now invests in the Gulf. The banking sector of the United Arab Emirates — in particular, Dubai — has eclipsed Lebanon’s over the last decade. Of course, the financial crisis has afflicted Dubai more severely than any other Gulf country, but capital has not so much fled the UAE as it has evaporated. If Lebanon has reaped a small dividend, the question that remains unanswered is why Lebanon’s financial sector was able to survive the risk associated with mortgage-backed securities, and to continue to offer strong returns, while some of the largest banks in the West were not.
The third and most compelling argument focuses on the role of Lebanon’s central bank, Banque du Liban, in regulating the financial sector. In particular, the strict limits on lending and cautious investment rules during the global boom of 2003-2008 served Lebanon well in avoiding the worst effects of the ensuing bust. Beyond this episode, however, it is the role that Banque du Liban has played since the 1990 end of Lebanon’s civil war that has enabled the Lebanese banking sector to survive, outperforming the more capital-rich Gulf sector against all odds.
Unlike in neighboring Syria, the Lebanese state has never seriously threatened to commandeer the laissez-faire spirit. Throughout the 1960s and 1970s, Lebanon enjoyed an influx of oil rents from the Gulf, capital fleeing state-controlled economies in Egypt, Syria and Iraq, and remittances from the Lebanese diaspora. One of the central objectives of the recovery plan in the post-civil war period was to regain Lebanon’s financial position in the Middle East.
Banque du Liban was an instrumental player in the post-war recovery, for instance, in stabilizing the nominal exchange rate, the price in foreign currency of one Lebanese pound. Exchange rate stabilization required abundant foreign reserves for what at times was sustained intervention in the foreign exchange market. Once the decision was taken to stabilize the currency in 1992, Banque du Liban was able to sustain it (see graph) even through times of fiscal and political crisis. The central bank also played a key role in the general recovery of the banking sector, which had $7 billion in assets in the early 1990s and bounced back to $91 billion in 2009.
The success of Banque du Liban is attributed to both its substantial independence and to the political consensus surrounding its policies amidst the country’s notorious feuds. Its autonomy can be traced back to its inception in 1964, during the modernizing regime of Fu’ad Shihab, the first administration in post-independence Lebanon to prioritize planning, development and the building of state capacity and institutions. At the time, the Lebanese Banks’ Association was able to wield its considerable influence to curb the extent of government intervention in Banque du Liban’s conduct, and the pressure from the Association has enhanced the bank’s independence since then. The Association’s substantial political clout derived from the concentration of wealth and connections embodied in the prominent bank owners who made up its board of directors. Because the Association was able to serve as a buffer between the Banque du Liban and the state, the temptation to politicize central bank policy was avoided.
The regulatory framework governing the banking sector involves high reserve requirements, a cap on lending (70 percent of deposits) and a floor for the share of deposits to be held as treasury bills. Since 2004, Banque du Liban has imposed still more specific rules despite resistance from the banking sector, including a cap on loan-to-value ratios of 60 percent for real estate loans and 50 percent for equity loans, and a ban on investing in structured products and derivatives. These rules constrained Lebanese banks to maintain conservative practices in issuing, holding and trading financial instruments since instruments had to be properly collateralized and their degree and structure of risk generally understood. The regulatory framework has also made the banking system compliant with the Basel II regulations — the international standard for best practices governing capital reserve requirements. While Western banks lent and lent, irrespective of the borrower’s ability to pay, Lebanese banks did it the old-fashioned way, taking the regulations seriously.
Since the beginning of the global financial crisis, the discipline shown by Banque du Liban has been rewarded with a steady rise in capital invested in Lebanese banks. A closer look at the data shows sustained growth in time deposits — fixed-term investment accounts, such as certificates of deposit — in both Lebanese pounds and foreign currencies for much of the period since 2004 (see graph). During this same period, demand deposits — such as checking and savings accounts — remain roughly unchanged. The period since November 2007 in particular has seen an accelerated growth in time deposits in pounds, which in April 2009 stood at 2,181 billion pounds, 32 percent more than its value 18 months prior. Time deposits in foreign currencies also exhibit an upward sloping trend in the long run but show more fluctuation since early 2008. This variance is partly due to the interest rates offered on domestic currency deposits and treasury bills, which hover around 6 percent and 9 percent respectively in 2009. Because the fixed terms on time deposits reduce their liquidity, the rising trend in such deposits in both Lebanese pounds and foreign currencies is an indication of growing confidence in the banking sector and in monetary stability more generally, and a perceived reduction in sovereign risk of failure or collapse. In other words, investors’ behavior suggests confidence that Lebanon is less likely to experience the bank failures or sudden currency devaluations that are occurring elsewhere under the pressure of the financial crisis.
Looking at only non-resident private sector deposits, there is an upward trend over the last 36 months, with a more accelerated growth rate since the beginning of 2008. These deposits are probably held primarily by expatriate Lebanese, though some proportion may also be held by other non-Lebanese Arab investors. Non-resident deposits in the financial sector have also increased over the last four years, but more slowly.
The inflow of capital into the Lebanese banking sector since 2007, coupled with the persistence of relatively high interest rates on commercial loans and treasury bills, has meant that Lebanese commercial banks have reported exceptionally high profits at a time when the global banking industry is flailing.
Lebanon has escaped the onset of the global financial crisis relatively unscathed, due in large measure to the regulatory environment created by Banque du Liban, but it is unlikely to evade the crisis going forward. Quite simply, the country cannot remain impervious to the effects of the financial crisis on the real economy—no matter how well the banks perform.
Real estate, which boomed over the last decade, now faces stagnation. In addition, Lebanon’s dollar-denominated economy places it at a disadvantage. As the dollar continues to rise, the prices of Lebanese exports — including paper products, precious stones and metals, and fruits and vegetables — have risen as well, triggering a decline in demand for goods and services exported to industrial countries and emerging markets. Reduced demand for exports has contributed to deceleration in business activity, which can be measured in the slight decline in commercial registrations over the first six months of 2008.
Then there are the secondary effects of regional and international financial decline, from which Lebanon’s good banking practices do not offer immunity. One of the fears going forward is that the downturn in the region, primarily in the Gulf, will eventually cost Lebanese expatriates their jobs and compel them to come home. The World Bank estimated remittances in Lebanon to be around $5.2 billion in 2006, close to 26 percent of GDP, and 45 percent of which come from the Gulf. Remittances increased in 2007 and continued to increase in 2008. The figures for 2007 and 2008 are believed to be $5.77 and $6 billion, respectively. In 2008, Lebanon was the eighteenth-largest recipient of remittances in the world. Remittances account for 27 percent of current account receipts, the highest rate in the region, the closest rival being Jordan at 19 percent.  One can only speculate about why remittances have remained high despite the financial crisis in Europe and the Gulf. It may be that the principal sectors employing Lebanese expatriate labor have been less hard hit or that the remittance figures are also capturing the redirection of Lebanese non-resident capital more generally away from investment in Western and Gulf markets, back to Lebanon. Similarly, more Lebanese are leaving the country than returning (see graph), suggesting the absence of a serious returnee problem. Lebanese politics, ever unpredictable, has lately been stable enough that the country is enjoying the best summer tourist season in over 20 years. The relative political stability makes the decrease in net returnees especially striking. Overall remittances to the Middle East and North Africa are expected to drop in 2009, however. The World Bank projects a decline of 6.7 percent — 13.2 percent in the worst-case scenario.
Another area of concern is the reconstruction effort following the 2006 war with Israel. Lebanon made sizable commitments to infrastructure development, with international assistance. Significant international aid commitments were made at a 2007 donors’ conference, commonly known as Paris III. The likely loss of some of this assistance due to the worldwide contraction represents another anticipated blow. In addition, the crisis is expected to yield reduced capital flow — particularly due to the destruction of Gulf capital — further depressing projections for investment in Lebanon. Finally, other forms of regional aid that regularly flow to Lebanon, such as assistance from Iran, can also be expected to contract.
The combined effect of the loss of grant monies and foreign direct investment will certainly exacerbate the effects of the global slowdown on Lebanon’s real economy. It may also force the government to compensate with large-scale additional borrowing — as many other governments have — to support the economy and finance a growing deficit at a time when interest on government debt will likely increase. While there are a number of short-term measures that Banque du Liban can take to offset the damage, the tool kit available to Lebanon’s central bankers is no better than those available to regulators the world over. But while these measures may help, they likely will not forestall the recessionary impact of the lost exports, remittances, foreign direct investment and international assistance on Lebanon’s near-term horizon.
 See, for example, Shana Marshall, “Syria and the Global Financial Crisis: Insulated or Isolated?” Syrian Studies Association Newsletter (2008), available online at: https://ojcs.siue.edu/ojs/index.php/ssa/article/viewFile/13/53.
 Los Angeles Times, October 20, 2008.
 Daily Star, April 9, 2009.