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.