ABSTRACT
Theory predicts that the optimal foreign exchange
rate policy of a central bank, in the presence of perfect capital mobility, and
a persistent expansionary fiscal policy, is to fix this rate. Since these
fundamentals apply to Lebanon, the Lebanese central bank has judiciously
followed the policy of pegging the foreign exchange rate since the end of 1998.
However, the actual policy led to a frantic quest for foreign exchange more
than the level required or optimal. The behavioral model estimated in this
paper worked endogenously from 1994 to 1998, and was actively operated upon
afterwards. The model, based on financial engineering concepts, relates the
change in the foreign exchange reserves of the central bank to the change in
foreign exchange reserves of the banking system, and to the change in the
foreign public debt. This model assumes that the central bank swaps government
debt, denominated in Lebanese pounds, for a debt in foreign currency, thereby
increasing its reserves, and improving the balance of payments. Moreover, the
model is based upon the notion that the central bank is able to persuade banks
to sell their excess foreign funds abroad for floating notes issued by the
central bank, thereby increasing its reserves and improving the balance of
payments. Although the central bank has announced publicly that it carried out
the financial engineering embodied in the behavioral model discretely, and at
specific periods, the paper finds that the same policy was continuously and
incessantly undertaken and implemented, but at smaller scales. The crucial
evidence comes about from the empirical finding that the change in the net
foreign reserves of banks is positively, proportionately and significantly
related to the central bank change in foreign exchange reserves. Moreover, part
of the increase in foreign debt is funneled to a positive, and significant,
relation with the change in foreign reserves of the central bank.