When will Iraq Peg the Iraqi Dinar?
A Crude Peg for the Iraqi Dinar
by Jeffrey Frankel
June 13, 2003
Reprinted from the Financial Times
Rebuilding Iraq involves many difficult problems. It may seem that the question of the
exchange rate should be one of the easier ones to solve. The choice of cur-rency
regime - particularly what to anchor the currency to -is perhaps the most widely
studied topic in international monetary economics. Yet this question too turns out to
be difficult; none of the traditional solutions will quite fit.
Given instability in the region and the absence of credible institutions, the Iraqi di-nar
requires an anchor of considerable credibility. Some have proposed a rigid peg to the
dollar, as through a currency board. But this idea has significant drawbacks. That it
would mean giving up the ability to set monetary policy independently is not such a
big cost, as few governments have been able to use such discretionary pol-icy well
anyway. But there are other serious disadvantages.
One big drawback of a fixed exchange rate is that it means giving up the automatic
depreciation that a floating currency would experience at times when the world market
for the country's exports were weak. In the case of Iraq, the most important export is of
course oil. Large fluctuations in the world price of oil have wrought havoc on the
economies of other big oil-producing debtor nations such as Indonesia and
Venezuela, often entailing a serious currency crisis before a change in the terms of
trade is accommodated.
A second big drawback of fixing the dinar to the dollar would be the introduction of
gratuitous volatility when the dollar fluctuates against other leading currencies.
Argentina's currency board collapsed two years ago, not just because the straitjacket
was so rigid but also because the rigid link was to a currency, the dollar, that had
appreciated strongly against the euro and other trading partner currencies during the
second half of the 1990s. That meant Argentine exports suffered a huge loss in
competitiveness at a time when world market conditions were already weak.
Finally, imposing the dollar on Iraq could also feed widespread fears of US
imperialism. The politics would get even trickier if, as in Argentina, the arrangement hit
a crisis - for example, as a consequence of an increase in US interest rates.
An alternative would be to peg the dinar to the euro. But this idea has big draw-backs
as well. The euro has been appreciating against the dollar and might continue to do
so as a result of ever-widening US trade deficits. A peg to the euro would thus risk a
future loss of competitiveness against non-euro trading partners. The problem is that,
as Iraq's trade returns to normal, its trading partners will be so dispersed
geographically that a peg to either currency alone - the dollar or the euro - would
introduce unwanted volatility with respect to the other. Like other countries with
geographically diverse trading partners, Iraq may thus be headed for a basket peg,
with equal weight given to the dollar and euro.
But a basket peg does not solve the problem that, in the event of large future declines
in the world price of oil, the currency of an oil exporter must be able to depreciate in
order to accommodate the adverse shift in the terms of trade and help stabilise export
earnings. Fortunately a proposal designed for small commodity-exporters, which I
have called "peg the export price", addresses precisely this is-sue.
The proposal is for a country to peg its currency to the export commodity. It could be
implemented as follows. The central bank would set the daily price of dinars in terms
of dollars in direct proportion to the daily price of a barrel of oil in terms of dollars. The
result would be to stabilise the price of oil in domestic terms. This approach combines
the best features of both fixed and floating exchange rates. Like fixed exchange rates,
it constitutes a transparent nominal anchor and also helps promote integration into
world markets. And yet, at the same time, it retains a crucial advantage claimed by
floating exchange rates: automatic accommodation of fluctuations in world markets for
the export commodity. In short, it offers the best of both worlds.
To fix the dinar simply to oil alone may be too radical a proposal. While it would
facilitate the recovery and expansion of the oil sector, it might at the same time dis-
courage production of other internationally tradeable goods by shifting the entire
burden of price uncertainty on to them. My proposal for Iraq, therefore, is to add oil to
the basket of currencies to which the dinar is pegged. For simplicity, give equal weight
to all three units. Or, what is almost equivalent, define the value of the dinar as one-
third of a dollar plus one-third of a euro, plus one-hundredth of a barrel of oil.
Unlike other proposals for nominal anchors, this is one that Iraq could live with even if
there are big swings in world exchange rates or oil prices in the future. The country
faces enough challenges without worrying about the risks of a future currency crash.
From the Harvard Business School Article on Price Waterhouse Coopers:
Include Oil in a Basket
To fix the dinar (or other countries' currencies) simply to oil alone may be too radical a
proposal. While it would facilitate the recovery and expansion of the oil sector in Iraq,
it might at the same time discourage production of other internation-ally tradable
goods by shifting the entire burden of price uncertainty onto them.
My proposal for Iraq, therefore, is to add oil to the basket of currencies to which the
dinar is to be pegged.
For simplicity, give equal value weights to all three units. Or, what is almost
equivalent, define the value of the dinar as one-third of a U.S. dollar plus one-third of
a euro, plus one-one-hundredth of a barrel of oil.
Unlike other proposals for nominal anchors, this is one that an oil producer like Iraq
could live with even if there are big swings in international exchange rates or world oil
prices in the future.
From a discussion at Iraqi Wiki:
Most countries use a floating exchange rate. In other words, the value of a currency is
purely decided by supply and demand. Central banks do occasionally intervene to bol-
ster a floating currency, but this is typically a very unusual occurrence.
A peg is essentially a fixed exchange rate that is fixed against a currency or basket of
currencies. The government promises to maintain that specific exchange rate within a
limited band above and below the specified exchange rate.
There are generally two agents that can be used to maintain that rate. The first type
is the central bank. The definition of a central bank is "the lender of last resort," in
other words the entity which facilitates liquidity by lending money to banks when banks
run low on currency and demand deposits (sum of deposits making up a bank's
assets). Not only is a central bank responsible for printing money, but it also conducts
a monetary policy to ensure there is an adequate amount of money in the economy
without trigger-ing significant inflation or deflation.
The second type is the currency board. A currency board is not a central bank. It
does not lend money to banks. The sole responsibility of a currency board is to
maintain the exchange rate between the local currency and the pegged currency. It
must maintain a reserve of 100% of the value of the local currency in the pegged
currency. So say a country has 1 trillion dinars circulating and wants to maintain a 1:1
exchange rate with the US dollar, the currency board must hold $1 trillion in US
currency. In practice, many currency boards do not hold exclusively currency. An
alternative is to hold highly liquid debt securities from the pegged country or countries.
To maintain the exchange rate within a certain trading band, the currency board or
cen-tral bank must be ready to trade quickly. In the case of dinars backed by dollars,
if the dinars begin to depreciate, it must buy dinars with dollars until the exchange rate
comes back into range. In the case where the dinar begins to appreciate, it must buy
dollars in exchange for dinars.
A central bank is not obligated to hold 100% of the value of the local currency in the
pegged currency, but is obligated to exchange those currencies on demand.
Typically, a large amount of pegged currency is held, but other assets can be used to
obtain the pegged currency such as oil.
* Advantage and Drawbacks *
Why does a country use a peg instead of a float? Typically it is done in an
environment that is fairly volatile, politically and economically. In order to attract
foreign investors, it's beneficial for a government to give those investors confidence
that their investments will be stable and not subject to wild swings in the exchange
rate. So the advantage is that the country is able to offer not just a more stable
investment environment, but also able to strengthen its currency beyond what it would
be if the currency were left to float. It does this, though, at the cost of having monetary
policy taken out of the government's hands.
If the pegged currency appreciates, the wealth of the local population grows since for-
eign goods become cheaper to buy if the government can easily maintain the
exchange rate.
The disadvantage comes in when the pegged currency strengthens considerably.
Two things can happen. As the pegged currency gets stronger, so does the local
currency. This leads to a current account deficit (trade deficit) since local goods
become more ex-pensive to buy. Unemployment rises as exports drop. What typically
happens in this case is that the local currency is re-pegged at a lower exchange rate
(devaluation). Each time that happens, though, confidence in the economy goes down.
The second thing that can happen is far worse. The pegged currency can appreciate
beyond the capability of the country to support the exchange rate. Panic sets in
among currency holders that the government will not be able to maintain the
exchange rate. Essentially a "run" happens and hard currency reserves are bled dry
and leaving insuffi-cient local currency available in the economy. Economic chaos is
usually the result as the local currency goes into freefall. Such a thing happened a
few years back with Ar-gentina as their currency board was unable to maintain the
exchange rate.
Depreciation of the pegged currency can help or hurt. A minor depreciation helps by
making local goods cheaper, thus boosting exports and creating additional jobs. It
hurts if depreciation is severe since that essentially destroys the wealth of its citizens
as for-eign goods become too expensive to buy. The latter scenario is not typical
since pegged currencies are usually the strongest of the major industrialized nations:
the United States, the UK, or the Euro, though occasionally pegs are done on the
major trading partners of that country instead.
Pegs on a major trading partner are often helpful. When the currency strengthens,
the now wealthier pegged country often buys more goods, pouring more hard
currency into the country, making everyone wealthier. Since foreign reserves grow,
the country can release more local currency without fear of inflation.
Informed Comments on the Iraqi Currency (portions of )
'[The] statement that “The peg (properly a dirty peg, or trading range) is being run
with reference to the market, maintained with regular Dinar and Dollar auctions.” is
wrong and misleading, see below. Like many others, your correspondent has a
“picture” in mind and assumes that it represents the facts. Would the currency have
collapsed if there were no peg? Probably in theory, yes. But there would have been
and would be under the circumstances no way to implement a “free market” for the
Dinar, see below.
There has certainly been a de facto peg, contrary to Bremer’s original intention and
applicable laws he “enacted” (although they are superficial and incomplete). The IMF
in its recent report acknowledged the fact. The permitted “trading range” has been
1475-1483, with the target 1475. On Sunday, as a greeting to the new government,
for the first time in months, the Central Bank bought a significant amount of Dinars to
achieve the target rate of 1475 for one day. The exchange rate has been held firm at
1477 since then. Each day, between 15 and 22 banks participate in the Central Bank
auctions. At least fifteen of them are state-owned and one, Rashid, when I last saw
figures (six or so months ago) held more than 90% of all bank deposits in Iraq.
Needless to say, the Embassy is beavering “fanatically” to privatize the banking
system, but there is a long way to go even if the new Government were to decide that
it should be privatized, which I doubt that they will.
The peg system can be (and is) maintained because its principal function is to convert
the accounts of the Government’s Ministries from Dollars to Dinars. The Government
receives 90% or more of its revenues from oil exports, priced and paid for in Dollars.
The Central Bank accounts and the transition accounts in the Ministry of Finance are
maintained in Dollars. The Ministries, for salaries and much else, make expenditures
in Dinars. While I cannot prove it with a documentary citation, my belief and
assumption (based upon a knowledgeable reading of the text of the KPMG audit
reports) is that Dollar deposits are made on a Ministry-by-Ministry basis in the
commercial banks and the banks then buy Dinars for the US Dollars deposited on a
daily basis (plus or minus $50 million) to provide the Dinars for next day’s government
expenditures. The “purchased” Dinars are used to fund the Ministries’ expenses. If the
daily amounts are totaled, the annual total is on the order of the size of the
Government’s budget, which you and I have been estimating (recall our earlier
exchanges on that subject; at his last press conference, Prime Minister Jafari said
that, at the end, his budget was $14 billion). As you can see, it is a closed system
(although the banks probably also convert some non-government Dollars). They
could maintain the peg, within limits, at any level they liked. The banks cooperate
because most of them are state-owned.
In administering the peg, “market conditions” may be taken into account, but the data
collection and analysis systems are still far from complete. In any event, “market
conditions” are only “taken into account” in respect of the insignificant variations
within 1475-1483, which has been the range for nearly three years, during which a lot
has happened. Is there a black market? I do not know. If it were substantial, one would
have thought that at least one reporter would have noted the fact.
The inflation rate provides an indication as to what the level of a “freely-floating Dinar”
might be, although care must be taken because there are surely supply problems in
parts of Iraq, including Baghdad, resulting from the security conditions. The most
recent report (yesterday; reported in VOI) from the Ministry of Planning shows inflation
at 48% (down from 53%), but the data are probably not complete and conditions
presumably vary among different parts of Iraq.
The system is “good” (stable) because the money supply is calibrated in effect to oil
exports, ie. Gross Domestic “Production” (not “Consumption”). The aggregate money
supply is firm, because the Central Bank can count (an audit by Ernst & Young is
overdue) the physical Dinars it has issued. There are none of the sophisticated
money market equivalents that we and most other advanced nations have. The entire
system is “primitive.”
The main point is that, so long as the preponderance of aggregate national
macroeconomic income is from oil exports, and so long as the oil industry is state-
owned (which it will be for some time longer than the four-year term of the current
Government), the system in place is the only and best thing that can be done, which
is why the IMF has “endorsed it.” The Central Bank cannot “print money” arbitrarily,
because the money supply is calibrated to oil export revenues. That eliminates one
source of a currency’s collapse. The system is “artificial” (“conservative”) to an extent,
because oil export revenues, and the money supply derived there-from, do not
represent all productive economic activity. Pax to your correspondent, the system has
little (or nothing) to do with currency market supply and demand. I do not know what
determines the insignificant variations within the “trading range.” I have attempted to
rationalize specific movements, but they make no theoretical sense. It could be a
game played by the handful of people who participate in the Central Bank auctions.
(As a footnote, at the time the peg target was established, I recommended that they
pick a low number so that the situation in Japan with trillions would be avoided. They
did not do that, we the 000,000 will abound for a long time.)
While a “currency board peg” is expressly disallowed by the Central Bank Law, the
Bank has been holding substantial amounts in US Dollars, $8 billion the last report I
saw, which was months ago. See process above which involves receiving Dollars for
oil, selling Dinars to the Ministries for Dollars and then holding the Dollars. The
amount should be substantially more than that by now and it is being recommended to
some that Dollars in excess of the amounts required to maintain the peg (relatively
small, given the closed system) be used for major infrastructure projects such as
refineries and electric power plants. It would seem to be a better use for Iraq’s
“national savings.” We shall see.
Both the Central Bank and the IAMB-supervised Government audits as of 31
December are long overdue. Among other things, that is because no one knows
exactly how much oil is being exported in the south (none has been exported from the
north for months) and how much of the proceeds actually arrive at the Central Bank
DFI account, which was and probably still is held at the New York Fed. They will have
to come out with something soon which will give a more current picture.
by Juan Cole
President of the Global Americana Institute
May 24th, 2006
