The Impossible Trinity Demands Quick Solution


New Model Needed?

Deposits have been fleeing the Lebanese system for more than 3 years; not in the same speed foreign investors exited the Asian economies causing the 1997 crash, but Lebanese residents and non-residents steadily increased their outflow activity, careless about increased interest rates.

To recall the impossible trinity by the Mundell-Fleming model (, a country has to choose two out of three economic policies: fixed exchange rate, free capital movement and an independent monetary policy. Lebanon chose the first two in 1992, making monetary policy unable to adjust interest rates in an effective way to fight economic recession or inflation.

Lebanon has been suffering from an 8 year recession due to the impact of the neighboring Syrian war, and interest rates have been going up due to the loss of confidence in the ability of the political class to bring real economic growth, which crippled the monetary choices. The central bank engaged in a sterilized quantitative easing by selectively compensating large depositors to attract new dollars to the reserves (called locally “financial engineering”), but no billions were enough to stop the inevitable pressure on the trinity.

To control the cost of funding of the government and the negative carry on the balance sheet of the central bank, and to keep what’s left of the central bank reserves; Lebanon effectively entered in capital control mode, although not officially, trying to keep the exchange rate fixed. Any devaluation would cause a lot of poverty and that’s why the upcoming macro-fiscal efforts of the awaited new government are crucial to bring back confidence, fight corruption, and resolve chronic causes of fiscal deficits such as the electricity sector. 

Parallel rates develop when some form of capital controls are in place; it has recently touched 2100LL/USD, or 40% devaluation; this premium can widen to multiple times but cannot persist for years like other countries have witnessed in the past. When parallel rates are instituted officially, they usually target the capital account to reduce the incentive for outflows; in this case the original rate remains for the current account in order to reduce the impact on the purchasing power of the consumers. Lebanon imports 80% of its consumption and is a 75% dollarized economy, hence the capital account can only be protected through official controls and the current account will keep the pressure on central bank reserves to fuel the economy, which will lead to the increased unofficial devaluation and hence imported inflation. 

Cash transactions constituted 2% of total commercial transactions before the beginning of the parallel market, and are now increasing in frequency as banks continue to intermittently close for extended periods, and as they continue to ration dollars when they’re open. A prolonged formation of a government that takes immediate policy measures will lead to a vast widening of the parallel exchange rate forcing an eventual unification, leading to poverty and social unrest, a sad Déjà vu of the massive devaluation in 1987.

The accumulation of corruption and ineffective policies has led both the people to the streets, and has led the parallel currency to develop. Going forward, the fate of both depends on the speed of going back to a normal and effective policy making environment, free of corruption. 

The original choice Lebanon made in the trinity can be preserved if the new government brings enough confidence to reduce interest rates, pressure on outflows, and to keep the peg. Otherwise, the model will be forced to change into a very painful alternative. The clock is ticking.