In the ten years prior to 1975, the Lebanese economy was one of the most dynamic in the Middle East region. It was characterized by low inflation, high rates of economic growth, large balance of payments surpluses, small fiscal deficits, and a floating, stable, and fully convertible domestic currency. Regulations impinging on the functioning of markets for goods and services, labor, capital, and trade were limited, and tax burdens were light in comparison with other countries at a similar stage of development. Furthermore, Lebanon had an important role as the key economic intermediary between the developed economies of Europe and the developing economies of the Middle East. Because of this combination of a stable macro-economic environment, liberal economics, and its role as regional intermediary, Lebanon enjoyed a strong comparative advantage in the services sector of its economy, particularly in banking and finance, tourism, insurance, and trade-related services.
Lebanon's civil war, which started in 1975 and spanned 15 years, exacted a heavy toll in human and material terms and caused fundamental changes in the economy. The economy suffered from the destruction of infrastructure and industrial facilities, while the reluctance to invest resulted in the obsolescence of remaining production capacity. Moreover, the flow of goods and factors of production in Lebanon was disrupted as a result of the fragmentation of the country. There was mass emigration, with an accompanying loss in professional and entrepreneurial skills. The emigration of workers was accompanied by a flight of capital, and Lebanon's access to flows of foreign capital was much reduced. Meanwhile, Lebanon's public finances deteriorated significantly owing to the lack of central government authority in the country and the consequent inability of the authorities to collect revenues while continuing to provide a minimum of public services. Large fiscal deficits were financed primarily through the banking system. The consequent rapid growth in liquidity compared with economic activity, and the erosion of private sector confidence, led to continuous pressures on the Lebanese pound in the exchange market, heightened inflationary pressures, and resulted in high levels of currency substitution. Furthermore, during the war years the banking system was weakened considerably and Lebanon's role as a regional intermediary was greatly reduced. Nevertheless, Lebanon continued to maintain an exchange and trade system that was almost entirely free of restrictions on payments and transfers for current and capital transactions.
The basis for a peaceful settlement to the civil war was provided by the 1989 Taif Accord for National Reconciliation, negotiated under the aegis of the Arab League. Following the accord, government authority was gradually restored, and hostilities came to an end in 1990. Subsequently, the authorities began the difficult task of simultaneous economic stabilization and confidence building on the one hand, and postwar reconstruction and development on the other, to ensure a sustainable recovery of the dislocated Lebanese economy. Confidence was restored in the last quarter of 1992 following the completion of parliamentary elections, the first in twenty years, and the installation of the new government.
In 1993, improved political stability, increased confidence, and an effective adjustment effort spurred favorable macroeconomic developments. Real GDP picked up, inflation decelerated sharply, foreign exchange reserves were built up to a comfortable level, and the exchange rate was stabilized. However, the lack of adequate infrastructure, a weak institutional framework, and shortages of human capital continued to constrain overall economic recovery. In the circumstances, the authorities aim at accelerating the reconstruction and rehabilitation program in the period ahead while strengthening the macroeconomic stance.
This paper provides background information on the Lebanese economy, based on an analysis of the economic consequences of the war, and discusses several issues that will be central to Lebanon's prospects for recovery. The analysis is based, for the most part, on economic developments through the end of 1993. The second section of the paper examines the economic costs of the war and the effects of the drastic war-induced shrinkage of real output on the potential growth path of the economy. The third section reviews the impact of the civil war on Lebanon's government finances, highlighting the initial collapse in revenue, and discusses the authorities' postwar efforts to rein in the run of war-induced deficits. The fourth section analyzes the reasons for and consequences of the largescale dollarization in Lebanon, the rationale for capital flight and the consequences of its return, and appropriate policies to de-dollarize the economy. The fifth section of the paper presents estimates of money demand in Lebanon, in an effort to determine which monetary aggregate gives the authorities the best scope for influencing future macroeconomic developments. The sixth section reviews historical developments in the Lebanese exchange rate system and examines the strength of the empirical relationship between movements in the exchange rate and the rate of Lebanese inflation during 1951–93.