Dollarization in Lebanon

WP/94/129-EA
Dollarization in Lebanon by Johannes Mueller

Lebanon's 15-year-long civil war had a devastating effect on the
economy. Over time, because of large-scale inflation and currency
depreciation, Lebanese households and enterprises increasingly resorted to
using foreign currency for transaction, store-of-value and unit-of-account
purposes. This reliance on foreign currency persisted even after the end of
the civil war, a normalization of the political and economic situation, and
a significant reflow of funds from abroad.

This paper analyzes the determinants of the use of foreign currency in
the Lebanese economy during the last two decades and--going beyond the
conventional literature on the dollarization phenomenon--explicitly
addresses the persistence in its use. The two econometric models developed
in the paper model the persistence through the inclusion of a ratchet
variable, thus implying an asymmetric substitution process between domestic
and foreign currency. The paper experiments with two different definitions
of the dollarization ratio and of the ratchet variable and also estimates
the likely length of the ratchet effect in Lebanon.

The existence of the ratchet effect is attributed to prolonged periods
of financial innovation and the related fixed costs of developing, learning,
and applying these new money management techniques to beat inflation.
Once these fixed costs are overcome, households and enterprises have little
incentive to switch back to domestic currency after the period of
instability ends. As a result, the effect on the relative demand for
foreign and domestic currency money is more long-lasting. In addition to
the costs, the extent of credibility of the authorities' stabilization
efforts as well as the design of and changes to the institutional and
regulatory framework may influence the duration and strength of the ratchet
effect.

The estimation results suggest that the ratchet variable is significant
in the case of Lebanon. The ratchet effect is particularly pronounced and
unambiguous when defined as the past-peak dollarization ratio and is likely
to last for at least 4 1/2 to 4 3/4 years. Moreover, and in line with the
conventional literature on currency substitution and dollarization, the
expected depreciation does have an impact on households' holding of foreign
currency deposits. The interest rate differential is insignificant if only
domestically held foreign currency deposits are considered in the
dollarization ratio but is likely to be significant when cross-border
deposits are included. Most of the adjustment in households' portfolios
takes place after a certain lag, as indicated by the high significance of an
included stock adjustment variable. Taken together, these findings suggest
that there is only limited scope for the Lebanese authorities to actively
promote a fast de-dollarization of the economy.