Unappetizing Dinar

November 7, 2003 • Commentary
This article originally appeared in The Wall Street Journal on November 7, 2003.

On Oct. 15, Iraq began to distribute new dinar bills, graced with the likeness of an ancient Babylonian ruler and a 10th century mathematician. By Jan. 15, 2004, new dinars will replace the two types of notes currently in circulation. Old Saddam dinars will be swapped for new dinars at a one‐​to‐​one rate, and each so‐​called “Swiss” dinar (now circulating in the Kurdish region) will fetch 150 new dinars. Bank accounts and contracts will be converted at the same rates, and Iraqi salaries will be paid in crisp new notes. The new currency will be convertible into foreign currencies at market rates.

Iraq’s currency swap has been heralded with great fanfare in Baghdad and Washington. As President Bush put it, “The new currency symbolizes Iraq’s reviving economy.”

Not so fast. Iraq lacks law and order, let alone the rule of law. Without these, we should not expect the new notes to ignite an Iraqi Wirtschaftswunder.

Why, with everything else it has to do, did the Coalition Provisional Authority (CPA) mandate a made‐​over central bank and a new currency? Because monetary nationalism — the idea that every country should have its own central bank and unique currency — has been the doctrine at the U.S. Treasury since the early 1940s, when Secretary Henry Morgenthau deemed it a clever way to tap into nationalist sentiments. As a result of Treasury’s relentless arm twisting, the number of central banks in the world has ballooned to 162, from only 40 in 1940. However, the fact that monetary nationalism is alive and well at Treasury suggests that U.S. officials have closed their eyes to the shameful performance of most central banks established after 1940. The new Iraqi dinar promises to be another currency debacle, one that will increase the spiraling cost of “reconstructing” Iraq.

To safeguard the stability of the dinar, the Central Bank of Iraq must be able to regulate the price or quantity of money and credit in the economy. One way to accomplish this is with the use of indirect policy instruments. These operate by influencing underlying demand and supply conditions in foreign exchange, money or interbank markets. Because such operations take place voluntarily at market prices, they are termed “market‐​based.”

But institutions do not exist in Iraq for a central bank to operate using indirect monetary policy instruments. There is no primary market in Iraqi government debt at this point, and the small secondary market in debt issued by the Hussein government may very well disappear should a new government decide not to service that debt. There are also no functioning markets for debt or equity securities issued by private Iraqi firms. Hence, there is no formal money market in Iraq as money markets are commonly understood. In addition, there is no interbank market which links banks via a payment and settlement system. Moreover, foreign exchange markets are primitive. Trades against the dinar are not managed electronically, but through the open outcry of the bazaar, making potential central bank interventions sloppy, if not coercive.

Even setting a reference interest rate or adjusting the quantity of base money cannot happen easily in Iraq. Since there is no interbank lending market, there is no market‐​clearing rate of interest that the central bank can hope to influence by setting its own lending rate. Most developing countries have run into similar problems when attempting to regulate the price of money and have chosen instead to regulate the quantity of money. In Iraq, however, the quantity of base money can be affected only by altering the amount of currency in circulation, since there are no efficiently cleared bank reserve accounts to be debited or credited at the central bank. Bundles of notes will have to be distributed physically in return for physical delivery of some asset (most likely foreign notes, given the dearth of marketable financial instruments).

The state of financial markets in Iraq rules out all indirect, “market‐​based” instruments of monetary policy. The central bank will, therefore, be forced to utilize direct instruments that work through involuntary regulations, such as controls on banks’ deposit and lending rates, credit floors and ceilings, rediscount quotas, statutory liquidity ratios, selective credit controls and moral suasion. The new CPA‐​mandated Bank Law of Sept. 16 acknowledges this harsh reality. For example, Art. 15 states that “Each branch of a foreign bank, if so directed by the CBI , shall maintain in Iraq an excess of assets over liabilities to residents of Iraq in such an amount, if any, as the CBI may stipulate.”

Such involuntary restrictions on banks’ balance sheets fly in the face of a “market‐​based” approach to central bank money and credit management. They impose two costs: First, they make it impossible for banks to allocate their portfolios in response to market signals. Second, they destroy competition for deposits because, for example, once a bank’s credit ceiling is reached, extra deposits represent unwanted, idle cash reserves. Therefore, banks stop trying to attract new deposits, or stop providing good service to existing depositors. No wonder direct regulations governing bank balance sheets have been a deterrent to financial development in countries that use them.

If all that were not bad enough for Iraq, data on its economy are, in most cases, nonexistent. The International Monetary Fund does not have any data on even the balance sheets of the central bank or the financial system after 1977, let alone national income accounts (missing since 1993), prices, interest rates or the balance of payments. For the foreseeable future, therefore, the central bank will be improvising.

The central bank’s new governor, Sinan al‐​Shabibi, confounded reporters at the recent IMF meeting in Dubai. When asked about the new dinar’s exchange‐​rate regime, he dismissed the idea of a fixed rate governed by a currency board. He then rejected a floating dinar. He also torpedoed the idea of capital controls and declared that the authorities would intervene to prevent a heavy dinar depreciation — but with what? The central bank has little ammunition for intervention, and a new supply of foreign reserves from some sugar daddy would compromise the central bank’s advertised independence.

Lacking the prerequisites to conduct “market‐​based” monetary policies, including any semblance of the rule of law, what should Iraq do? It should replace the dinar with the euro or the U.S. dollar. Iraq would then return to a regime it used from 1916–31, when the Indian rupee was its legal tender. Iraq has the liquid assets to execute such a currency swap, and if the Iraqi stock falls short, the ECB or the Fed can print the difference and ship it to Baghdad. Adopting an international currency would avoid the pitfalls of Iraqi central banking and immediately provide Iraqis with stable money. And while stable money might not be everything — without it, everything is nothing.

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