cfr - iraq currency regime

8/14/2019 CFR - Iraq Currency Regime

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Should Iraq dollarize, adopt a currency board or let its currency float?A policy analysis1

Nouriel Roubini

Stern School of BusinessNew York University

and

Brad SetserCouncil on Foreign Relations

May 15, 2003

1 The authors emails are: [email protected] and [email protected].
mailto:[email protected]:[email protected]:[email protected]:[email protected]


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The United States is reportedly shipping large quantities of small denomination dollar bills toIraq. It needs to pay Iraqs civil servants, and small denomination bills are necessary in acountry where monthly salaries are often well under $50.

Iraqi civil servants are soon to receive

an interim payment of $20.2 News reports also suggest that U.S. troops discovered substantialhidden stashes of hard currency in Baghdad $600 million in $100 dollar notes in one place.

These dollars, if they are real, also could conceivably be put into use in some way.

There may be more pressing immediate needs in Iraq than deciding on a new currency andexchange rate regime. At the same time, some decisions cannot be put off for long. Steps takento solve immediate, pressing problems like the need to pay those Iraqis who show up for work will strongly shape the choices that Iraq will subsequently be able to make. Facts on the groundhave a way of becoming permanent. Once the interim authority starts paying people in dollars,the use of the dollar as a means of exchange is likely to increase rapidly. The supply of dollarbills and twenty dollar bills circulating inside Iraq is set to grow dramatically. If the interimauthority starts contracting for services in dollars, the dollar will also become a standard unit ofaccount in financial contracts. U.S. contractors hired to make immediate improvements in Iraqs

infrastructure are being paid by the U.S. government in dollars, and likely will want to signcontracts with their subcontractors that are denominated in dollars. The dollar has been used inIraq for some time, no doubt, and the dollar circulates along side the local currency in manyemerging economies. But informal dollarization has its own costs: it renders monetary policyless effective and makes it more difficult for borrowers to service their hard currency debts whenthe exchange rate depreciates. Consequently, it is increasingly urgent to start thinking about theright currency regime for a new Iraq, and how decisions made now will or wont limit Iraqsfuture policy options.

Iraqs transitional government in principle could decide to dollarize, to euroize, to Swissdinarize, to adopt a currency board, to introduce a new currency that is pegged to the dollar, or tointroduce a new currency that floats.3 In the near term, paying people in dollars is likely to be fareasier than introducing a new currency. Indeed, Iraqs interim authority is likely to have theopposite problem of most emerging market governments. Most emerging markets can print theirown currency to solve immediate problems, but cannot print dollars. In contrast, Iraqstransitional government initially will not be able to print the local currency but will have readyaccess to dollars. It may not be able to print dollars, but it should be able to borrow them fromthe Fed, using future aid receipts, frozen Iraqi bank accounts or oil revenue as collateral.

Yet there is good reason to think that the dollar or the euro, for that matter is not an idealcurrency for a major oil exporter. Dollarization, euroization or a strict currency board thateliminates any monetary policy autonomy can make sense when the country that dollarizes oradopts the currency board is subject to the same shocks as the anchor currency. Iraq, a major oilexporter, is likely to be subject to different shocks than net oil importers like the United States orthe Euro zone. In particular, an oil supply shock would help Iraq but hurt oil importers.Dollarization or a rigid currency board also complicates the process of adjusting to volatility in

2 Bob Davis, Cummins and Kerr (2003). See also Slevin (2003).3 Some commentators, namely Hanke (2003), are in favor of Iraq giving up an independent monetary policy andeither euroizing or adopting a strict currency board; the Wall Street Journal editorial board, while generallysympathetic to euroization/dollarization, advocated a tight currency board.


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oil revenues: the real depreciation needed in the face of a negative oil price shock would requirea often painful fall in domestic wages and prices since the dinar/ dollar or dinar/euroexchange rate could not change. Iraqs government, like the governments of most oil states, islikely to be more dependent on oil than the overall economy, and a rigid currency regime wouldmake it more, not less, difficult for the government to maintain its fiscal stability in the face of

volatility in oil revenues. Even informal or liability dollarization using the dollar todenominate local bank deposits and local financial contracts would carry important costs,because it complicates the real exchange rate adjustment needed in the face of major oil priceshocks.

Consequently, a core policy objective should be to avoid the temptation to use dollars to solve allimmediate problems and to take steps that preserve the option of eventually moving to a freelyfloating currency. This likely requires two things:

Moving relatively quickly to introduce a new currency. In the very near term, there maybe no choice but to use dollars to make some payments. But as soon as possible, the

government should start to make payments in a local currency. The new currencyinitially could be loosely linked to the dollar to establish its underlying value. But it is notnecessary to have a formal currency board to assure its stability.4 So long as thegovernment avoids excessive monetary creation and government spending does notexceed the revenues that the government obtains from donor grants and oil sales, the newcurrency should retain its value. The physical circulation of a new currency and theability to pay salaries in this currency would help to prevent the widespread use of thedollar as a means of settling domestic bills.5

Limiting the use of the dollar in financial contracts. To the extent possible contracts forlocal goods and services should be denominated in an Iraqi currency rather than dollars.One of the lessons to be learned from recent crises in emerging market economies is that

informal dollarization can make it much more difficult to respond to external shocks.

It needs to be noted that the absence of full dollarization or a currency board does not imply thatIraqs currency will float freely, without any government intervention. A managed float is morelikely. Most emerging markets do intervene in the currency markets on occasion. Moreover, theIraqi government almost necessarily will be the largest player in the foreign exchange market, asa large share of the revenue from Iraqs oil exports will be intermediated through the

4 In a currency board, every dinar in circulation is fully backed by a dollar or other reserve asset. The need forfull reserve backing completely constrains monetary autonomy.5 It is possible for the symbols and faces on the new currency to evolve over time without a major currency reform.

Old notes can be withdrawn from circulation and replaced with new notes. The easiest way to introduce the newcurrency is to start using it to pay government salaries. But there will also be a need to replace the existingSaddam dinars still in circulation through a currency exchange. Right now so-called Swiss dinars circulate inthe Kurdish areas in the north and Saddam dinars circulate in the areas formerly under the control of the regime.Ideally, these two different currencies would be unified, and a new dinar would replace both the Saddam and theSwiss dinar. But, for a while, one could also continue using the Swiss or Saddam dinar issuing new amountsof either one as needed to satisfy the demand for currency as economic activity recovers. In practice, since theSaddam dinar is discredited for political reasons (i.e. it is undesirable to print new notes with the face of Saddamon it) and its value is way down and swinging sharply, issuing newly printed Swiss dinars may do the job while anew credible currency is being designed and created.


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government. If the government draws on its hard currency savings to cushion the impact of lowoil prices, the net effect will be to supply hard currency to the foreign exchange market.

This analysis will focus on the economic arguments associated with various possible currencyarrangements. A common currency is an important symbol of national sovereignty and is part of

the political glue that helps to hold many countries together. However, the political value of acurrency is not central to this analysis. Rather, this analysis will focus on the reasons why thelong-term use of the dollar or the adoption of a strict currency board would complicate theeconomic management of a major oil exporter.

Managing oil dependence

With the worlds second largest proven oil reserves and a relatively small population (though notas small as many Gulf states), Iraqs future economy will be dominated by the production of oiland the consumption of oil rents. Over time, its oil production is likely to rise according toenergy analysts from 2.5 million barrels a day to around 6 million barrels a day, only a bit less

than Saudi Arabia. Consequently, oil exports will account for the lions share probably wellover 75% of Iraqs exports and a very significant share of Iraqs GDP. Petroleum accounts for90% of Saudi Arabias exports and almost half of Saudi Arabias GDP. Petroluem accounts for80% of Venezuelas exports and about a third of its GDP. Russias economy is much morediversified than Iraq, and oil and gas still account for over 50% of Russias exports and a fifth ofRussias GDP.6 The core economic policy challenge for an oil state like Iraq is managing therisks associated with heavy dependence on a single commodity whose world market price hasbeen quite volatile.

While there is a range of possible currency regimes, it makes sense to focus on three inparticular.

Dollarization. Dollarization is the outright adoption of another countrys currency asthe basic unit of account. The currency that is actually selected need not be the dollar. Itwould also be possible to Euroize. Conceptually, Iraq could also adopt the currency ofa net oil exporter, though there is not an obvious candidate. Venezuelan bolivarization isnot an attractive option.

A currency board. In a currency board, the national currency is backed one for one withreserves, so that for every dinar in circulation, the central bank holds an equal amountof reserves. A currency board makes the adoption of the dollar or euro morepolitically palatable by putting an Iraqi face on the currency. Economically, however, itis similar to dollarization, as the government gives up the ability to devalue or revalue the

currency and instead promises to automatically tighten monetary policy in the face ofpressure to devalue.

A managed float. The currencys value relative to major currencies is set in the market,with occasional intervention to smooth excessive currency movements. The governmentdoes not commit to maintain a given exchange rate. Many important commodity

6 Weafer (2003) provides data on Russias oil production. Additional data fromwww.cia.gov/cia/publications/factbook/geos.


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exporters including Canada, Australia, South Africa and Russia have currencies thatfloat against the dollar.

In principle, a soft peg a peg that lacks the institutional backing of a currency board and thatcan be adjusted provides a fourth option. However, recent experience in emerging economies

had demonstrated the weaknesses of such soft pegs. These weaknesses are large enough that asoft peg does not offer, in our judgment, a viable long-range option though a soft peg could bepart of a transitional arrangement.

In our view, a managed float offers three significant advantages over a more rigid currency boardor outright dollarization.7

The monetary policy autonomy made possible by floating would help Iraq adjust to an oilsupply shock, which would create divergent economic conditions in oil exporting and oilimporting countries.

Floating facilitates the real adjustment that can be needed in the face of oil pricevolatility. It is easier for the exchange rate to adjust than for domestic prices to adjust.

Floating helps the government manage the mismatch between its volatile oil revenues andits fixed domestic costs, and thus can help assure the governments fiscal stability.

Responding to oil supply shocks

Dollarization or a dollar-based currency board means adopting the monetary policy of the UnitedStates. Euroization or a euro-based currency board means adopting the monetary policy of theEuropean Central Bank. Economic theory indicates that if the shocks hitting a common currencyarea are common to all the economies in the area, rather than being idiosyncratic national shocks,the monetary policy of the anchor country is likely to be appropriate for the dollarized

economy as well. The degree of synchronization of the business cycle, in turn depends on factorssuch as the degree of trade integration and the similarity in production structures. Two countriesthat produce the same good are more likely to be exposed to similar shocks, as are two countriesthat trade extensively with each other. Since Iraq will export basically one commodity, oil pricesand oil supply/demand cycles will determine the degree of synchronization of the business cyclebetween Iraq and the home country of its anchor currency far more than the degree of tradeintegration.

The viable anchor currencies for Iraq the dollar and the euro are both currencies of net oilimporters. Is the monetary policy of an oil importer likely to correspond with the monetarypolicy an oil exporter needs? The basic answer is yes during oil demand shocks, but no during

oil supply shocks. If strong global demand for oil is pushing oil prices up, economic conditionsin an oil exporting country are likely to coincide with economic conditions in major oilimporting countries. A recession in either the U.S. or Europe similarly will push oil demand andoil prices lower, given the size of both economic blocks. However, the opposite is true if asupply disruption leads to a spike in the price of oil. A disruption in supply outside of Iraq willincrease Iraqs real income while slowing real growth in the U.S. or Europe. Booming Iraq risks

7 See Roubini (2001) for a more detailed analysis of the criteria to assess whether a country is ready fordollarization.


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overheating and needs tight money, while slumping oil importers need loose money. Of course,protracted oil supply shocks eventually tend to produce a global slowdown, a fall in demand foroil and ultimately a fall in the oil price that brings the economic cycles of oil exporters and oilimporters back into synch, but this convergence occurs slowly. It seems likely thatgeopolitical oil supply shocks will continue to buffet the global economy as they have over the

past thirty years (1973-1974 Yom Kippur War; 1979 Iranian Revolution; 1990-1991 Iraqiinvasion of Kuwait; 2003 Iraq and Venezuela). Consequently, one cost of dollarization oreuroization is that it would lock Iraq into a pro-cyclical monetary policy during oil supplyshocks.8

It is worth noting that the ability of many emerging market economies to pursue counter-cyclicalmonetary policies the key theoretical benefit of floating remains a subject of debate. Studieshave suggested that some small open economies with a history of high inflation and highexchange rate volatility often are unable to use monetary policy in a counter-cyclical way. Acombination of informal dollarization, lack of policy credibility and wage indexation may rendermonetary policy ineffective. Worse, it has been argued that in some countries monetary policy

may be pro-cyclical rather than counter-cyclical. Negative external shocks be it an oil priceshock and a reduction in the availability of international financing for emerging economies may force monetary authorities to tighten monetary policy during a recession. The gains fromexchange rate flexibility would be reduced and dollarization or a currency board would become amore attractive option if Iraq proves unable to use monetary policy to provide counter-cyclicaloutput stabilization. But there is no reason to believe that the new Iraqi government should befundamentally incapable of creating the credible economic institutions needed to pursue acounter-cyclical monetary policy.

Facilitating adjustment to oil prices shocks (terms of trade shocks)

Countries whose exports are concentrated in a narrow range of goods, often primarycommodities like oil, are vulnerable to terms of trade shocks. If the country is small and a pricetaker in export and import markets, no currency regime can protect the country from thisstructural vulnerability. If the price of the countrys primary export say oil falls, and theglobal price of the basket of goods the country wants to import is fixed, the country will be ableto buy fewer imports. If Iraq can buy four bushels of wheat for every barrel of oil it exportswhen oil is at $20 a barrel, Iraq can only buy two bushels of wheat when oil is at $10 a barrel.No matter how you cut it, falling oil prices reduce Iraqs real income. The key question for aneconomy exposed to large terms of trade shocks is whether a given currency regime dollarization, a currency board or a managed float can help the country adjust to unavoidableterms of trade shocks.

A country can adjust to a fall in its terms of trade in many different ways. First, it can sell moreof its exported good (oil) at home, as foreign demand declines. However, in the near term,

8 This analysis assumes that an oil exporter such as Iraq is small enough to be a price taker in global markets. Thismay not be exactly true as Iraq has the second largest known reserves of oil and Iraq, like Saudi Arabia, couldpotentially use its oil production to help shape global oil prices and indeed to try to dampen volatility in oil prices.But if Iraq were to strategically use its market power to affect oil prices (either up or down) the correlation betweenIraqs business cycle and the business cycles of major oil importers would be even further reduced.


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demand for oil in Iraq is likely to be fixed, so this is not a practical strategy. In any case, manyoil producers keep domestic prices below the world market price. Second, the level of oilproduction could adjust. Classic economic theory suggests that a fall in the relative price of oilwould tend to discourage its production. This is no doubt true at a global level. But it may not betrue for a low cost oil producer with substantial market power. A low cost producer like Iraq still

can make money at low oil prices it just earns smaller economic rents on each barrel of oil. Itcould respond to lower prices by increasing production to try to increase its income. But thisstrategy only works if other members of the oil cartel dont pursue the same strategy.Alternatively, a member of a cartel of oil exporters could respond to a fall in the price of oil bycutting production to try to stabilize the price.9 Third, a country can try to limit its need to adjustto a temporary shock in terms of trade by borrowing or drawing down reserves to allow it tocontinue to import at the higher level. Fourth, an increase in the relative price of imports in theexample above, a bushel of wheat costs a barrel of oil when the oil prices falls instead of ofa barrel of oil can lead to a shift in demand toward domestic goods, both domestic goods thatcompete with imports and non-traded goods.

It is worth walking through the economic processes that bring about this adjustment in relativeprices in different currency regimes. A fall in the price of oil will reduce the export earningsand the dollar GDP of a country like Iraq. Since the price of a small countrys imports is set inthe global market, the dollar price of imports does not change following a fall in the countrysoil income. The country either has to import less, or use more of its income to buy the samequantity of imports. In a dollarized economy, a fall in the countrys real income leads topressure on the domestic price of non-tradeables. The local barber realizes that the local oil-man now has to spend more of his oil revenue buying imported wheat, and has less to spend on ahaircut. The oilman can either buy fewer haircuts, or the local barber can reduce his prices. Thisimplies an absolute fall in local wages and prices deflation as nominal and real wages need tofall to maintain full employment in the face of the real income shock.

The fall in local prices needed to adjust to a fall in oil prices, however, may triggerunemployment and otherwise reduce real income and output more than necessary if there arerigidities in the economy. These rigidities could take the form of sticky nominal wages, stickydomestic prices or the costs of transferring sector specific factors such as labor and capital fromthe traded sector to the non-traded sector (following the fall in the relative price of tradedgoods).10 The simplest case that leads to avoidable unemployment is the case of rigid nominalwages. As the international price of the traded exportable good falls, nominal wages should fallin the export sector to avoid a fall in demand for labor that would create unemployment.Otherwise, the fall in the international price of the exported good will reduce demand for labor asnominal stickiness increases real wages in the exportsector. Similarly, if nominal wages aresticky, real wages in the non-tradedsector would also remain too high to sustain fullemployment, since full employment requires a fall in real wages following a shock to the

9 See Krugman (1999) for a model of the oil market based on earlier work by Cremer and Salehi-Isfahani that allowsfor perverse supply responses and multiple equilibriums.10 Traded good sector could be defined to include those employed spending oil rents as well as those directlyemployed in the production of oil. In many Gulf states where production costs are low, relatively few people aredirectly employed in the production of oil, while many more are employed spending the countrys oil rents. Oftenthese oil rents are captured by the state, and maybe state employees whose salaries are paid for by the profits fromoil are effectively employed in the tradeable or oil sector.


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countrys real income. Without adjustment in wages, the fall in labor demand in both sectorscauses unemployment.

The adjustment process can occur somewhat differently if the currency is allowed to float. A fallin the price of oil will tend to lead the currency to depreciate, and the currency depreciation will

lead automatically to a reduction of the real wage in the traded exportable sector and the non-traded sector so long as nominal wages stay constant.11 The countrys real income still falls inthe face of an adverse terms of trade shock: a barrel of oil still buys less wheat. But the fall in thevalue of a dinar both increases the price of imported goods and reduces domestic real wages,making domestic non-traded goods more competitive with imports and supporting employmentin the export sector. Consequently, a nominal depreciation of the currency can help to avoidunemployment if domestic wages are sticky. Nominal exchange rate flexibility can also preventthe emergence of unemployment if there are other domestic price rigidities or difficultiestransferring economic resources from one sector to the other.12

Empirically, there is little doubt that diversified economies that are also large commodity

exporters such as Canada, Australia, New Zealand, South Africa and more recently Chile andRussia have successfully used a flexible currency to adjust to external terms of trade shocks.When commodity prices fall (either due to a fall in global demand or a glut in supply) thecurrencies of these countries tend to depreciate, helping to absorb the effect of the shock on thedomestic economy. These economies produce many of the goods that they import, so they canrespond to a fall in the world price of their commodity exports by, generally speaking, buyingmore domestic goods and fewer imports. Several of these countries notably Mexico andCanada are quite closely integrated into the U.S. economy and thus score well on thetraditional criteria for dollarization, yet they have opted for a floating currency. Indeed, it is thesmall Central American countries (El Salvador, Panama) that lack natural resource wealth andthe associated vulnerability to terms of trade shock that have tended to adopt the dollar.

It is true that there are fewer opportunities for a shift in relative prices to lead to a substitution ofdomestic production for imports in less diversified economies. However, even undiversifiedeconomies could still benefit from exchange rate flexibility if it facilitates the needed adjustmentbetween the relative prices of imports and locally produced non-tradeable goods and moregenerally limits the impact of wage and price rigidities. This may be the reason why most smalloil producers with little market power have not dollarized, euroized or adopted currency boards.For example, Norway has remained outside the Eurozone. Only Ecuador, among oil exporters,has dollarized and the jury on this economic experiment is still out.

A managed float would differentiate Iraq from a number of other regional oil states, since mostmajor oil exporters in the Middle East notably Saudi Arabia, Kuwait, Libya and the Emirates have pegged their currency to a basket of other major currencies rather than adopted a floating or

11 Import prices necessarily increase, both relative to exports and relative to local production, so constant nominalwages implies a falling real wage.12 Broda (2001) found that flexible exchange rates were associated with immediate large real depreciations andsmaller output losses than fixed exchange rate regimes in the face of terms of trade shocks in a sample of emergingmarket economies.


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a managed float.13 But there are good reasons why Iraq should not follow the example of otheroil states in the region. Libya is a command economy. The economy of Saudi Arabia has beenstagnant, with significant unemployment. Saudi Arabia is rumored to have borrowedsignificantly and perhaps unsustainably during periods of low oil prices. It may face financialdifficulties should oil prices fall after the windfall created by Iraqs withdrawal from the world

market comes to an end.

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Iran, which has indicated that it plans to move toward a managedfloat, may provide a more useful model.

Helping the government manage its fiscal dependence on oil

In most oil states, the government is even more dependent on oil revenue than the overalleconomy. The government usually finances itself by capturing a large share of the gap betweenproduction costs and the world market price, and government spending is the primary means fordistributing the countrys oil rent to the countrys population. Since oil often accounts for 75%or more of the revenue of an oil states government, the volatility in the governments revenue islarger than the volatility in overall economic activity associated with oil price shocks.

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The governments exposure to terms of trade shocks can create fiscal problems since governmentspending typically is not as volatile as oil revenue. 16 The army, police, judiciary and healthservice all need to be paid when oil prices are low. Government employees are typically paidfixed salaries, not a salary linked to the price of oil. Government investment in roads, ports, andother infrastructure can be reduced when government revenues fall, but such pro-cyclicaladjustment in capital spending tends to augment the downturn associated with an oil price shock.In more technical terms, there is a mismatch between an oil states highly volatile revenue streamfrom oil, and its need to cover the stable fixed costs associated with operating a government.

There are lots of ways of trying to manage this mismatch. The government can build up fiscalreserves, though in practice this requires resisting democratic pressure to increase spendingduring good times.17 The government can borrow to sustain spending in bad times. Thegovernment could engage in various hedging strategies long-term sales contracts, forward sales that would limit the volatility in its oil revenues. The government could, in theory, indexgovernment salaries to the price of oil.

13 It is worth noting that pegging to a basket of currencies does allow for some exchange rate adjustment since abasket peg will depreciate against the dollar and appreciate against the euro when the dollar rises against the euro.14 Saudi Arabia increased production during the Gulf War to offset the fall in Iraqs production. More generally,geopolitical risks have contributed to recent high oil prices during a time of relatively weak global demand,

providing a windfall to the Saudis.15 Oil accounted for 90% of the Government of Angolas revenue, over 75% of the revenue of the governments ofOman, Nigeria, Saudi Arabia, Qatar, Algeria and Yemen, and over 60% of the revenue of the governments of theUnited Arab Emirates, Bahrain, Iran, Gabon, Libya and Kuwait. See Daniel (2001). Barnett and Ossowski, (2002)offer a more detailed analysis of the operational aspects of fiscal policy in oil-producing countries. They note thatfor every $1 change in the world price of oil the revenue of Venezuelas public sector is reduced by roughly 1% ofVenezuelas GDP; public sector revenues from oil fell from 27% of GDP in 1996 to 12.5% of GDP in 1998.16 Oil can be produced in some Gulf states for less than $5 a barrel and the gap between the low production cost andthe world market price produces large economic rents.17 See Fasano (2000) for a review of the mixed experience with oil stabilization funds.


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Letting the exchange rate float also helps the government manage this mismatch. Thegovernment of an oil state wants the real price of the non-traded goods it buys to fall when thereal value of its oil export revenues falls. This tends to happen if the country has a flexibleexchange rate regime. In the face of a negative oil price shock, the nominal and real exchangerate will tend to depreciate. This tends to improve the fiscal balance of a government, as a quick

real depreciation allows the government to buy more domestic non-traded goods and services foreach barrel of oil the country exports even as the external purchasing power of each barrel of oilfalls. For example, if the governments revenues from oil fall from $20 a barrel to $10 and thedinar also falls from 1 to 2, the governments dinar earnings stay constant. One barrel of oil buys20 dinars before and after the oil price falls. This makes it easier for the government to sustainfixed domestic salaries. The government earns fewer dollars per barrel of oil, but each dollar canbuy more at home. Of course, constant salaries in dinar and higher import prices make it harderfor a government employee with a fixed dinar salary to afford imported goods. There is still aneed for a real adjustment.

The needed adjustments occur with more difficulty in a country that has dollarized or adopted a

close proxy for dollarization such as a currency board. As the governments dollar revenuesfrom oil fall, it must reduce its spending. That means fewer policemen and hospital workers ifpolice and hospital salaries are fixed, or lower salaries and the same number of workers. Ifsalaries fall, the fall in domestic prices provides the same real adjustment (a fall in the price ofnon-traded goods) that would happen with a floating exchange rate regime, but the adjustmentcomes about through the fall in nominal salaries rather than the fall in the nominal exchange rate.Adjusting nominal salaries takes longer than letting the nominal exchange fall. Indeed, thedifficulties associated with adjusting expenditure and cutting salaries is one reason why many oilstates have encountered fiscal difficulties.

In practice, it may not be optimal for the government to adjust fully to a temporary oil priceshock. Building up an oil stabilization fund to act as a buffer against temporary oil shocks canmake more sense than constant adjustments. When oil prices are temporarily high thegovernment should run surpluses and accumulate assets; when oil prices are temporarily low thegovernment should run deficits and run down its assets. This helps insulate both the governmentand the overall economy from volatility in the price of oil. However, oil stabilization funds havebeen hard for many countries to implement. There is a temptation to fail to set enough aside ingood times, leaving too small a cushion against bad times. Alternatively, a government couldalso use its capacity to borrow internationally to help smooth out volatility in oil revenues. Butthis too has its practical difficulties. There is a tendency to borrow in bad times but not to paydown debt in good times, which eventually leads to debt problems. Moreover, an oil exportersaccess to financing tends to be correlated with the price of oil. When prices are high, financingis available at a low price. When oil prices are low, financing is both less available and moreexpensive. It may not be possible to rely entirely on fiscal reserves and government borrowingto smooth oil price shocks. Consequently, exchange rate flexibility may provide a useful andpractical way to help the government manage its own exposure to oil price volatility.

Potential objections to a floating Iraqi currency


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There are a number of potential objections to the idea of a floating national currency for Iraq thatare worth exploring.

First, some argue that a country with a poor record of policy credibility needs a fixed exchangerate to discipline monetary and fiscal policy and to assure that the currency serves as a stable

store of value. It is true that the new transitional government will not inherit monetary policycredibility. But it also will not inherit Saddams record of monetary mismanagement. Given theclear break in regime and policies, Iraqs new institutions will start with a clean slate. The pasthistory of the country should matter less, and the record of the new government will matter more.There is no reason that the creation of an independent central bank and a sound fiscal policycould not provide Iraq with a chance to earn policy credibility quickly.

Indeed, Iraqs new institutions potentially start with two important advantages. First, Iraq shouldinherit significant reserves, whether from frozen Iraqi assets, from funds recovered fromSaddams personal accounts or from funds in the UNs Oil for Food escrow account. 18 Second,Iraq also will start with a relatively low level of liability dollarization (the use of the dollar rather

than the local currency in local financial contracts). While the use of the dollar could increaserapidly if the U.S. or the transitional government use the dollar to pay salaries for an extendedperiod of time, Iraqs recent economic isolation seems to have limited the use of the dollar as abasic means of payments, store of value and unit of account by ordinary Iraqis.19 A low level ofliability dollarization makes it easier to float, as the stimulus to domestic activity from a realdepreciation is not partially offset by an increase in the real burden of dollar denominated debts.

There is nothing in principle that prevents a national currency and a managed float to succeed ifappropriate monetary and fiscal policies are in place. And if such policies are not in place,dollarization or a currency board cannot provide monetary or fiscal policy discipline per se.Argentina demonstrates that a rigid currency regime does not guarantee fiscal discipline, andhow the fiscal and financial difficulties can lead to the creation of quasi-currencies thateventually undermine monetary discipline as well.

Second, some argue that Ecuadors experience indicates that dollarization can succeed even incountries that fail to meet the traditional criteria for dollarization, including business cyclecorrelation, labor market flexibility and a history of sound fiscal policy. They would also pointout that Ecuador is an oil exporter, just like Iraq. However, in our judgment, the experience ofEcuador neither strengthens the case for dollarization nor suggests that oil exporters are optimaldollarizers. For one thing, it is somewhat premature to declare Ecuador a success. Its fiscaland debt problems are still severe, the sovereign spread of 14% suggests a continued high risk ofdefault, the banking system is severely undercapitalized and it is still vulnerable to a run.Moreover, Ecuadors dollarization has not been really tested by a major oil price shock oneanalogous to the 1998 oil shock that contributed to Ecuadors 1999 crisis. Oil prices generallyhave remained high following Ecuadors decision to dollarize. Ecuador also dollarized at a veryundervalued exchange rate, which provided a large initial competitiveness buffer that has

18 Iraq will also inherit substantial debts, which will need to be renegotiated. However, in the near term, there is noneed to draw on Iraqs existing assets to resume payments on its debts.19 Regime insiders obviously had large hoards of foreign currency.


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mitigated the impact of subsequent real appreciation. Finally, the country is still on IMF lifesupport and it is likely to remain on such intensive care for a long time.

It is not far fetched to think that one day Ecuador may de-dollarize if it is unable to clean itsfiscal house. A creeping de-dollarization could occur if Ecuador need to raise money at a time

when it has lost access to domestic financing. It might then start issuing a quasi-money zero-interest bonded debt something like Argentinas Patacones or more appropriately Sucretones to pay public employee salaries and to finance other spending. If issuance of such Sucretoneswere to become widespread, an new currency trading below par with the dollar will be created.Eventually creeping de-dollarization will turn into full-scale formal de-dollarization. It is alsoquite easy to see how the need to issue Sucretones would be correlated with an oil price shockthat both reduced government revenue and required domestic deflation.20

Third, many post-conflict countries have either adopted a currency board or dollarized/euroized, often with some success. Bosnia and Kosovo adopted currency boards, East Timordollarized and Montenegro euroized. Iraq does not superficially look very different from such

post-conflict entities. However, the superficial similarities mask substantial differences. Aboveall else, these countries/entities are not major oil exporters and our analysis suggests that it is notoptimal for major oil exporters to dollarize. But there are other differences as well. Most post-conflict states emerged following the break-up of larger national states and lacked many of thebasic institutions of a nation-state, including a national currency of their own or a central bank.Many of these economies hope to join the European Union and eventually EMU, and expect toexit from the currency board by joining the Euro. In contrast, it has been difficult to successfullyexit from a currency board to a float. It also should be noted that many of these countries remainon the semi-permanent dole of the international community, and rely on the sustained transfer oflarge amounts of aid to maintain a minimum standard of living.

Iraq should be different. It should not need permanent aid or transfers from abroad given itsfuture oil wealth. It is not a rump state that is emerging from the breakup of a bigger state. It hashad its own national currency (however demeaned). It is not liability dollarized at least not yet.It is not on its way to becoming a member of the EU or the 51

ststate of the United States of

America. There is no reason to believe that all post-conflict countries should dollarize or adopt acurrency board. The example of Serbia is instructive. It too is a post-conflict state and like Iraq, italso inherited significant debts. But it got substantial though not total debt relief, and it nowhas its own stable currency. It has been phasing out its capital controls and generallyflexibilizing its exchange rate regime.

Finally, some may argue that the absence of a banking system, let alone a well functioningfinancial system, limits effective capital mobility and this makes exchange rate flexibility rathermeaningless. Money changers on the street are not quite the same as a real foreign exchangemarket. But this argument strengthens the case for a national currency and an eventual managedfloat. If Iraq maintains fiscal discipline and avoids excessive and inflationary monetary creation(i.e. abusive seignorage taxation), it should be able to maintain a stable currency. If, as seemslikely, Iraq finances new investment in infrastructure and the rehabilitation of its oil production

20 To date, Ecuadors domestic prices have increased more rapidly than U.S. prices, resulting in continued realappreciation.


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capacity with some combination of current oil revenue, grant aid and borrowing from the officialsector, it will have little immediate need for large inflows of private capital. Early pressures onthe currency should be limited. As the institutions needed for effective capital mobility develop,a managed float could be able to absorb domestic and external shocks without being subject toexcessive volatility.

Conclusions

Ultimately, the Iraqi government itself must determine what currency regime would best serveIraqs interest. Our analysis suggests that Iraq should keep a national currency rather thaneuroize/dollarize or lock itself into the straitjacket of a currency board. In the face of an oilsupply shock, an oil exporter would want a different monetary policy than an oil importer. Afloating exchange rate also makes it easier to adjust to negative terms of trade shocks, as theneeded real exchange rate adjustment could come about more easily through a fall in the nominalexchange rate than through a fall in domestic wages and prices. The introduction of a newcurrency might be easier if the new currency is temporarily pegged to the dollar, though this is

not strictly speaking necessary. But the goal should be to move quickly to a managed float andto ensure monetary stability with sound fiscal management and some form of inflation targeting.

In the short-run, the dollar offers a convenient solution to many of the immediate problems thatthe transitional government is likely to face. However, a core policy objective should be to findways of solving immediate problems without locking Iraq into a suboptimal monetaryarrangement, since a managed float exchange rate regime would be preferable to outrightdollarization or a currency board over the medium term. The more payments the U.S., othermembers of the coalition and the interim government make in dollars, the more difficult it willbe to de-dollarize the domestic economy at a later stage. The more contracts that are signed indollars now, the greater the chance that the dollar will be used in subsequent financial contractsas well.

Introducing a new currency relatively quickly would make it easier to establish this currency,rather than the dollar, as the basic means of exchange. It also makes sense for Iraq not to followthe example of post-conflict countries that have relied on a currency board to assure currencystability. There are ways of providing a sound currency that do not require a permanentcommitment to devote monetary policy to the maintenance of a fixed parity with an anchorcurrency.


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References:

Barnett, Steven A. and Rolando J. Ossowski, (2002) Operational Aspects of Fiscal Policy inOil-Producing Countries, IMF Working Paper No. 02/177.

Broda, Christian (2001) Coping with Terms of Trade Shocks: Pegs versus Floats, AmericanEconomic Review, Volume 91, no 2 (May 2001).

Celasun, Oya (2003) Exchange Rate Regime Considerations in an Oil Economy: The Case ofthe Islamic Republic of Iran, IMF Working Paper WP/03/26.

Daniel, James (2001) Hedging Government Oil Price Risk, IMF Working Paper WP/01/185.

Davis, Bob, Chip Cummins and Simeon Kerr (2003) U.S. Dollars Are Sent to Iraq to ReplaceDiscredited Dinar, Wall Street Journal, April 16, 2003.

Fasano, Ugo (2000) Review of the Experience with Oil Stabilization and Savings Funds inSelected Countries, IMF Working Paper No. 00/112.

Hanke, Steve (2003) The euro could help Iraq's economic recovery, Financial Times, April 17

2003.

Krugman, Paul (1999) The Energy Crisis Revisited, unpublished,MIT January (http://web.mit.edu/krugman/www/opec.html).

Roubini, Nouriel (2001) Factors to be Considered in Assessing a Countrys Readiness forDollarization, Stern School of Business, New York University, November.(http://pages.stern.nyu.edu/~nroubini/dollarization.pdf)

Slevin, Peter (2003) A Few Kinks in the U.S. Money Pipeline, Washington Post, April 24,2003.

Weafer, Chris (2003) Too Much Oil Could Be Bad for Russias Health, Financial Times, April28, 2003.
http://web.mit.edu/krugman/www/opec.htmlhttp://pages.stern.nyu.edu/~nroubini/dollarization.pdfhttp://pages.stern.nyu.edu/~nroubini/dollarization.pdfhttp://web.mit.edu/krugman/www/opec.html

cfr - iraq currency regime

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