The Coalition’s decision to print a fresh batch of Saddam dinar notes this June drove home the urgent need to select the currency and monetary institutions for post-Saddam Iraq. The decision to introduce a new dinar rather than to dollarize or create a currency board was the right one.
The immediate advantages of introducing new dinars are clear. Saddam’s face won’t be on them. Moreover, the “Saddam” dinar only comes in two sizes. The 10,000 dinar note (worth a bit more than five dollars) is tainted by rumors of counterfeiting and is too large for everyday transactions. In contrast, the 250 dinar note (worth between a dime and a quarter) has not only continued to circulate, it has also appreciated in value relative to both the dollar and the 10,000 note. There is simply no practical alternative to small dinar notes in an economy where many people live on less than a dollar a day. With many payments being made in dollars, more dollars were chasing the same set of dinars. But even in an economy where $50 a month is a good salary, it is not terribly practical to pay salaries in dimes and quarters. New bills in a wider range of denominations should make day to day life in Iraq easier.
The long-term advantages of a new currency backed by a respected central bank are potentially even more important. The Saddam dinar was never a viable candidate for Iraq’s future currency. The only real question was how quickly it would be replaced, and with what. But there were a range of possible replacements other than a new currency and an independent central bank. The Saddam dinar could have been replaced with the dollar, the pound or the euro or a new dinar that was permanently tied to the dollar (or another anchor currency) through a currency board. A currency board effectively would put an Iraqi face on the dollar while locking Iraq’s into following the U.S. monetary policy. In a currency board, monetary policy is committed solely toward the maintenance of a fixed parity between the local currency and the anchor currency. Dollarization requires the immediate commitment to spend scare funds to buy back existing dinar, and a currency board requires an equal commitment of reserves to back a new dinar.
Advantages Over Dollarization
However, there are good reasons to think that neither outright dollarization nor a currency board would be superior in the long-run to an independent Iraqi currency that can float against the dollar. Why? The simple answer is that it makes little sense for an economy that relies heavily on oil exports to adopt the currency of an oil importer. For example, tying Iraq’s monetary policy to that of the United States is a problem when an oil supply shock drives up the world price for oil, slowing the economies of major oil importers while putting additional cash in the pockets of oil exporters. Right now the stagnant U.S. needs relatively low interest rates, while most oil producers are flush (Iraq excepted, given its limited current oil production) and need relatively high interest rates.
A currency that is tightly linked to the dollar would also make it harder for the government of Iraq to manage its dependence on oil revenues. The dollar revenue from oil sales is highly volatile, so the government would have trouble paying the same dollar salary when oil is at $10 a barrel and when oil is at $30 a barrel. Rather than matching expenses and revenues by paying dollar salaries that vary in line with global oil prices, it is far easier to pay salaries in a local currency and let the value of the local currency fluctuate against the dollar. Since the currency of commodity exporters tends to rise and fall with commodity prices, a fixed local currency salary has a smaller dollar value when oil prices are low (150,000 dinars might be worth $100 when oil is high, but only say $75 when oil is low), and this is exactly what the economy needs.
Managing Oil Revenue Volatility
The difficulties volatility in oil revenues creates for the government are also found in the overall economy. If the currency is tied to the dollar, prices and wages need to be very flexible since the economy’s dollar earnings will fluctuate in line with global oil prices. Wages have to fall when the oil price falls to avoid unemployment. One major oil exporter— Ecuador— has adopted the dollar, but that country’s dollarization has yet to be tested by a period of low oil prices that requires domestic wages and prices to fall. Far better to look to the example provided by major commodity producers like Canada, Australia, Norway, Mexico and Russia who let their currencies float. Changes in the currency’s external value help cushion against falls in local prices and wages when lower commodity prices require economic adjustment. There are other ways to smooth out volatility in oil export earnings, including putting money into an oil stabilization fund when prices are high to support the economy–and the currency— when oil prices are low. But a managed float that allows for some exchange rate flexibility could be part of a set of policies that helps Iraq manage the economic risks associated with oil dependence.
In the near term, however, the focus is likely to be on the set of obstacles that need to be overcome to have a successful currency reform rather than on the long-term advantages of an independent currency. These include:
- Completing the proposed currency reform. The exchange will run from mid October to mid December, with Saddam dinars exchanged at one to one for new dinars, and the Swiss dinars that circulate in the Kurdish north exchanged for 150 new dinars. The risk that this swap will fail are minimal. A government that pays salaries, collects taxes and buys goods in the new currency can directly influence the type of currency that people want to use. Moreover, the broader range of notes should flat out make the new dinar more useful than the Saddam dinar.
- Broadening the use of the dinar and reducing the use of dollars. After getting Saddam’s face off the currency, the U.S. also should consider the advantages of taking George Washington’s face off Iraq’s daily commerce. Iraq would gain in the long-run if the dinar, not the dollar, is an accepted store of financial value and the unit of account in the financial system, not just the currency used for small everyday transactions. Paying government employees in dinar is a good place to start. Emerging economies can live with some informal dollarization, but heavy reliance on the dollar in the domestic financial system complicates economic management. For example, informal dollarization makes it difficult for the government to act as a lender of last resort to the banking system and harder for exchange rate adjustment to help buffer against commodity shocks.
- Managing monetary policy. The new Iraqi government is unlikely to be in a position for some time to issue dinar debt that can be bought and sold to help regulate the money supply. Managing bank balances and buying and selling foreign currency will be the dominant monetary policy instruments for a while. And since most of the economy’s hard currency earnings are coming from the sale of oil by the government, the transfer of frozen assets to the government and international aid, the state will play a much larger role in the foreign exchange market than is typical in advanced economies.
There are significant technical challenges associated with managing monetary policy in a financially underdeveloped economy. The U.S. should not skimp on technical assistance, nor should it hesitate to draw on the IMF and World Bank’s on-the-ground experience in poor and underdeveloped economies. Above all, the United States should not look to an independent central bank to minimize the cost of reconstruction or to fill gaps in the budget. Even a floating currency needs substantial reserve backing and the new dinar won’t hold its value if the central bank starts printing dinars to make up for a shortage of grant aid or oil revenue in the budget. It is impossible to build the foundation for financial stability on the cheap.
A stable currency alone won’t create jobs for unemployed former soldiers, create jobs for employees of Iraqi businesses that cannot compete effectively with imports now that sanctions have been lifted, repair existing oil infrastructure or provide the $100 billion plus in new investment that Iraq may need to return to its 1990 living standards. Yet a sound currency is a precondition for near term economic stabilization and, over time, the introduction of a new currency should help create the foundation for an economy that can use monetary policy as a buffer against the risks stemming from its inherent dependence on oil. More on the Iraqi Dinar.
Brad Setser is an International Affairs Fellow at the Council on Foreign Relations in New York.