Will dinar exchange rate impact Iraqi financial crisis?

Will dinar exchange rate impact Iraqi financial crisis?

Posted 12-12-2015

In light of the suffocating financial crisis plaguing the Iraqi economy following the sharp decline in oil prices, experts and concerned parties are discussing the most appropriate option to fix the exchange rate.

Summary⎙ Print In light of the decreasing oil prices that led to an economic crisis in Iraq, the Iraqi government has been discussing options to reduce the dinar-dollar exchange rate.

The Iraqi Parliament had discussed the possibility of reducing the dinar-dollar exchange rate by 10% to reach 1,300 dinars per dollar to supply the general budget with 5 trillion dinars ($4.2 billion), or by 20% to reach 1,400 dinars per dollar to supply it with 9 trillion dinars (about $8 billion).

There is no doubt that a reduction of the dinar exchange rate would provide additional resources for the general budget. It will increase the quantity of Iraqi dinars obtained by the Ministry of Finance in return for converting into the dinar its oil revenues or foreign loans it received through the Central Bank of Iraq in dollars.

However, this method increases government resources at the expense of citizens. The losing parties are ordinary citizens, especially those with limited incomes. The purchasing power of their income will drop, especially with the rise in prices of imported goods. The creditors in local currency will also be affected, including those holding Iraqi treasury bonds.

Moreover, Iraq’s almost total reliance on oil revenues, its poor resources such as goods and services other than oil, the existence of financial investments abroad and large foreign reserves and the high cost of external borrowing all indicate a lack of available options to address the current shortage of government foreign-exchange resources. This means that the only solutions are cutting spending, trying to increase some types of direct taxes and fees and issuing treasury bonds in the local market.

The Iraqi dinar’s exchange rate was equal to $3.3 before the outbreak of the Iran-Iraq War. Then $1 became equivalent to 3,000 dinars during the economic blockade from 1990 to 2003. Anyone who has followed the dinar will realize that the problem lies in the difference between the dollar’s supply and demand and the dinar’s supply and demand. It is a simple equation that controls not only the currency prices, but also the prices of all kinds of goods and services. So, for the state to control one side of the equation, it has to control the other side to ensure that the exchange rate will be stable.

When Iraq’s oil resources were limited before OPEC first raised prices in 1973, the country relied on the currency law, a remnant of the gold standard. This law necessitated that 70% of exported currency be backed with gold and foreign currencies to control the dinar supply through government spending. After the Iran-Iraq War, the currency law was abolished, disturbing the balance between the supply and demand of foreign currency with increased military and civilian government spending.

The government allowed the private sector to directly import goods from producers and sell them at prices that were not subject to its control. Thus, there were two exchange rates: an official rate that maintained the $3.3 price and was used for official expenses, and a parallel rate determined by the supply and demand of foreign currency. The difference between the two rates widened in the wake of the economic embargo on Iraq in 1990. As a result, the parallel exchange rate rose to 3,000 dinars at points.

After the occupation and after the export of Iraqi oil was allowed again and deposits were unfrozen, Iraq was expected to undergo monetary reform, whereby surplus banknotes would be withdrawn from circulation. However, it used the daily currency auction, in which specific amounts of dollars are sold to the banks and the private sector to meet the domestic demand for foreign currency, especially for the purposes of importation. The steady increase in oil revenues led to a gradual improvement in the exchange rate until it reached 1,220 dinars to the dollar.

Many politicians and analysts believe that the daily currency auction is a way to smuggle the dollar through private banks under the pretext of importation, and their criticism has increased in light of the current financial crisis.

The question asked by those concerned in Iraq is: Does the daily currency auction have to continue despite the claims made about it? Or should we abandon it and turn to other means so that the process of buying and selling the dollar is free, without restrictions, as some suggest?

Choosing the appropriate exchange rate for any state is a critical scientific process that depends on the state’s economic and financial situation as well as its economic ideology. The states that choose a free floating exchange rate for its currency and make its buying and selling a free process without restrictions are usually powerful, developed economies that have important and multiple foreign currency sources and currencies of importance in international trade and investment flows, as well as large reserves of international currencies.

To preserve the exchange rate, a country that pegged its currencies to a foreign currency such as the dollar or to a currency basket has two options. The first is to have large foreign currency and gold reserves to support the pegged exchange rate when necessary, as the GCC countries do. The second is to maintain the exchange rate through the management of the monetary authority, which influences the factors determining the demand for foreign currency. This is what Iraq was doing prior to the first oil boom.

Presently in Iraq, the government does not have an official Iraqi dinar to dollar exchange rate, or a currency basket. The $3.3 exchange rate is no longer used for any currency, although it has not been officially canceled.

Accordingly, in light of the limited foreign currency resources and difficulty to go beyond oil resources, it is imperative that the state manages the current exchange rate through the development of a foreign exchange budget by the Central Bank, which will determine the allocation of imported goods, services and transfers without charges.

This way, it is possible to maintain the current exchange rate’s stability and to limit expenditures in foreign currency to the available resources until the circumstances are favorable for monetary reform and the adoption of an appropriate official exchange rate.

al-monitor.com