Middle East Economic Survey

VOL. XLVII

No 44

1-November-2004

Exchange Rate Regime, Speculation And Price Stability In Iraq

By Ali Merza

The following article was written for MEES by Dr Merza who has worked for the Iraqi ministries of oil and planning and for the UN Department of Economics and Social Affairs.

Nominally, the Central Bank of Iraq (CBI) is following a flexible-exchange-rate regime. The main reason usually advanced for flexibility is the possible, and usually probable, fluctuation in the oil revenues (the so-called terms-of-trade shocks).

More flexible-rate regimes are usually recommended to counter terms-of-trade fluctuations, and are prescribed for oil producing countries facing external imbalances in need of international financing. Such countries as Algeria and Indonesia are following this course (in the form of managed floating, IMF 2000). One would not differ, in this respect, on the merits of this recommendation, but a discussion of other factors, issues, indicators, or criteria for choice of exchange regimes could further illuminate possible benefits and limitations.

Factors or indicators used to choose an exchange regime cannot be solely reduced to terms-of-trade shocks, vital as they are; others are just as important. The set of factors/ indicators to consider may include the following:

(1)        Initial and prevailing conditions.

(2)        Set-up and credibility of the monetary authority and system.

(3)        Price stability.

(4)        Existing stock of money (currency) and possible speculation.

(5)        Economic environment.

(6)        Specter of the Dutch Disease.

(7)        Terms-of-trade shocks (mainly the fall in oil prices and revenues) and   exposure to fluctuations among major currencies.

I will touch on these issues below.

Initial And Prevailing Conditions

The initial conditions governing the performance and credibility of the monetary authority (and system in general) must have had an important bearing on the exchange regime which this authority (the CBI) deemed suitable in the second half of 2003. Just emerging from a devastating violent history and wars the CBI was tied by its limited monetary tools, the incomplete and underdeveloped exchange market institutions, low foreign exchange reserves and ruined infrastructure. These circumstances must have obligated this authority to choose/accept a ‘flexible-rate’, largely set by the market, at least during the four-month period of October 2003 to January 2004.¹

The Monetary Authority

Long before the collapse of the old regime private dealers/operators had developed growing power and experience in the (parallel) foreign exchange market. However, since their inception in October 2003, the CBI has been intervening, through daily auctions, to regain experience and authority to set the rate. The ‘market’ with all its manipulative powers, it seems, has been following the lead of the CBI. Gradually, hence, the setting and determination of the rate have become more transparent, through these auctions. The success of this process has squarely hinged on the size of the CBI’s reserves of foreign exchange. The following table summarizes auctions activities during the first seven months of this year:

CBI’s Foreign Exchange Auctions 2004

Source: Calculated from CBI: http://www.cbiraq.org/CBI%20FX%20auction%20table_website.xls, the figures are rounded.

Band Width: The range of fluctuations measured by the standard deviation of daily rates divided by their average.

The next 18-36 months can be considered a transition period for the monetary authority to feel its way:

(i)    To accelerate the process of rehabilitating and streamlining the banking and financial system,

(ii)    To consolidate and enhance its role in the exchange market,

(iii)   To identify the major operators,

(iv)   To find out the rate suitable to the balance of payments (and hence to CBI’s reserves) and competitiveness of the economy.

Price Stability

As set by its governing law, the primary objective for the CBI is to achieve price stability.³ In present circumstances, however, flexibility of the exchange rate and price stability may seem incompatible. If the exchange rate is left really to the market then the CBI should choose another anchor (other than the exchange rate) to realize price stability – say a monetary aggregate (or price) target that can be maintained through effective monetary policy (see also Mussa et al 2000, Section III). With the current state of the economy/security and the underdeveloped money market it seems that the CBI is opting, instead, to stabilize prices through the stabilization of the rate of exchange. Since January 2004, the flexibility of the rate has been restricted to a very narrow band of about 2.6%. In other words, using its managed-floating interventions, during the last seven months, the CBI has been maintaining a virtual fixed-rate regime (above table).

The close association of changes in (and hence stability of) consumer prices and market rate of exchange has long been observed, in Iraq, as shown in the following table:

Consumer Prices and Rate of Exchange

(Rate of Change %)

Sources:    1990-2002, Merza (2004), Table (6).

                    July 2003-June 2004, Central Bank of Iraq: Annual Bulletin 2003 & Bulletin for the First Half of 2004.

                   The rates of change are calculated using semi-log trend function.

* Figures in this column measure the appreciation (+) or depreciation (-) in the value of the $ against the ID.

When the reconstruction boom sets in, however, price stability could be disturbed because of demand pressures, largely in the non-tradable sectors. In this case an exchange rate policy on its own would not be sufficient to preserve stability. Demand management through fiscal policy becomes important (as monetary policy is less effective in fixed-rate regimes, see footnote 7, below).

On the other hand, although stable during the last seven months, the average exchange rate (of the ID against the $) actually appreciated by about 34% on its 2003 level. With existing money stocks this could have instigated some speculative demand on foreign exchange. It was not that visible, though –  maybe due to growing reserves on the one hand and slower than expected economic activity on the other (or, indeed, speculators are awaiting larger appreciations!). See next.

Existing Stock Of Money (Currency)

The existing stock of money (currency) is composed of the new currency which has replaced the old ‘printed’ money, previously used in the middle and south of the country, and the ‘Swiss’ money in the north. The stock is largely used for transaction purposes. However, there is an important part, which is held inside and outside the country waiting for the ‘right’ moment to claim its ‘appreciated’ value.

Initially, adopting a flexible-rate regime does avert the potentially damaging role of the speculative dormant balances. But free flexibility (usually resulting in fluctuations) heightens uncertainty and only postpones the speculative effect to such times when the dinar begins to appreciate in value. Then, it will result in more fluctuations and uncertainty. At the end of January 2004 the stock of money amounted to NID6.2 trillion.⁴ By mid-year it had risen to NID7.0 trillion (of which NID6.5 trillion with public). This is a huge stock that could assume a serious destabilizing role once the rate of the dinar starts to appreciate.

In this respect it would be possible to neutralize the speculative effect of the existing stock of money by preserving the ongoing market rate of exchange, in a kind of fixed-rate type arrangement. Official currency-board or even hard-peg may not be needed; it is the arrangement that matters. As long as it remains independent, concentrating on its primary objective, the CBI could effect such arrangement, using its reserves.  

Economic Environment

Improvements in the security situation and increasing inflow of oil revenues and aid (together with the resolution of debt/reparations issues) are conducive to attracting foreign investment and expatriate Iraqi capital. There is a high possibility, though, that this could lead to the appreciation of the dinar. Moreover, the reconstruction boom, when it comes, will, most likely, replicate that of the 1970s (mainly a flourishing non-tradable sector). With no concerted policy to intervene, in order to keep the exchange rate from appreciating, the Dutch Disease symptoms would set in, thus frustrating long-term efforts for economic diversification. Unlike the 1970s, however, a free flexible regime does not hinder the appreciation; rather, it facilitates it (the rate may even overshoot). This is one reason for the monetary authority to step in to prevent such an outcome, but how? If free flexibility is to be preserved the CBI and/or ministry of finance has to resort to monetary (lower interest rate)⁵ /fiscal (budgetary) expansion leading to a cheaper dinar, therefore, risking a higher inflation in the process. Alternatively the CBI can abandon flexibility in favor of a devaluation of the rate, thus shifting to a peg.⁶ A soft peg (but not currency-board type arrangement, which is a hard peg) regime may well result in similar fluctuations.

Fluctuations and exchange policy reversals are detrimental to stable economic environment in general and to attracting foreign and expatriate Iraqi capital in particular. Steady rates are necessary for investors to calculate their costs and returns with some certainty. A fluctuating rate, inherently a characteristic of free flexible regimes (especially with weak monetary institutions and tools), is a hurdle in this respect.

Terms-Of-Trade Shocks (The Fall In Oil Revenues)

Since the time of the monarchy, and like many Gulf oil producing countries, Iraq has long followed a pegged-rate regime with intermittent adjustments. Up to 1980 the rate was, more or less, reflecting the state of virtually unrestrained current account (of the balance of payments). Although the exchange system and trade were heavily controlled and regulated, parallel markets, the major sign of imbalances, were either marginal or non-existent. Following the onset of the Iraq/Iran war, and the ensuing shortfall of oil revenues, the parallel markets started to develop and flourish. After 1991 the story is well known: apart from the ration system and other items within the UN Oil-For-Food program the exchange system management was largely relegated to the parallel market. It has, thus, become a de facto free flexible-rate regime, accommodating well the fluctuations in oil revenues. After the fall of the old regime, continuing with a flexible system may suit the conditions in Iraq, but during more normal times.⁷  At that time, flexible regimes could be superior to fixed-rate ones, especially since a single-currency peg also exposes the economy to the wide fluctuations among major currencies (Mussa et al, 2000).

However, a mitigating tool for fluctuations in oil revenues is to use the resources of a stabilization fund (Looney, 2003, Merza 2004) in order to make good part of the shortfall in revenues, and hence in foreign exchange consequent on their use to preserve the fixed-rate. But this is still a partial solution.

Conclusion

The initial and prevailing conditions in the form of incomplete and underdeveloped exchange market institutions and monetary tools coupled with low foreign exchange reserves might all have obligated the CBI to choose a ‘flexible-exchange-rate’ regime, during October 2003-January 2004. The rate was mainly set by the market, in that period. Since then, however, the monetary authority has assumed an increasing role, through its daily auctions, and established somewhat transparent rules for the market.

On weighing advantages and disadvantages of free flexible versus fixed-rate type regimes the confluence of factors points to the preference of the latter during the next two-to-three years. Furthermore, a kind of virtual fixed-rate regime has already been followed by the CBI in the last seven months, due mainly to considerations of price stability (and fear of possible speculation). Giving up this arrangement, especially when security improves and construction accelerates, would endanger stability and most likely lead to the appreciation of the value of the NID. This will almost certainly invite speculative runs and consequent depletion of foreign exchange reserves.

However, when monetary institutions and tools develop further, price stability could be achieved by more effective and active monetary policy, during which time the exchange regime becomes more flexible. Speculative runs continue to be a threat when the ID appreciates, but then the economy would have grown in size and the CBI tools in sophistication to handle this effect.

The following matrix summarizes markings for each of three possible exchange-rate regimes:

Assumptions:

1. World inflation is low.

2. A stabilisation fund is set up.

3. No controls on foreign exchange dealings or cross-border transfers.

Notes

1.    Notwithstanding the manipulative factors in this market and given the existing stock of money, relative prices and wage rates had been adjusting, in the past, in a way that has rendered the market rate an equilibrium rate.

2.    A CBI’s Excel spreadsheet, on Foreign Exchange Auctions, indicates a $14.1bn transaction for 3 May 2004. This is out of line of daily transactions, reported in the same spreadsheet. A typing mistake, it seems, could have exaggerated the figure 1,000 times. A corroboration of this view can be inferred from the CPA Administrator’s Weekly Report (Economy) 1-7 May 2004, stating: “The amount of dollars sold at the auction varied over the week from $4.0 - $14.mn”, P1, CPA website.

3.    Article 3 of CBI Law, issued on 6 March 2004, states: 'the primary objectives of the CBI shall be to achieve and maintain domestic price stability and to foster and maintain a stable and competitive market-based financial system. Subject to these objectives, the CBI shall also promote sustainable growth, employment, and prosperity in Iraq’.

4.    This is the currency issued to date, which divides into NID5.3 Trillion with the public and the remainder with the commercial banks, see CBI: Bulletin for the First Half of 2004.

5.    Under such flexible regimes as ‘floating’ or ‘managed floating’ monetary policy could resort to ‘easy money’ in order to effect a depreciation in the value of the dinar. For its success this, of course, requires well-developed money market and financial system. In the currency-board regime the monetary policy, however, losses its independence; this is a consequence of the so-called ‘Impossible Trinity’ where the following three cannot be realised jointly: (1) fixed exchange rate, (2) free capital movement, and (3) independent monetary policy. See Fisher (2001). 

6     It is pertinent here to raise questions about how free the exchange system can be. The argument in the text assumes full freedom of exchange and transfers across borders. Such situation may not be sustainable in the light of the possible strong influence of the speculative elements in the market. Other more financially developed countries were exposed at times to such strong influence and were forced to impose controls on the transfers of capital, especially short-term capital, eg Malaysia (1998-99).

7.    ‘Normal times’ refers here to the period following the highly critical three-to-four years, ahead.

8.    The currency-board /Dutch-Disease marking in the matrix: as the exchange rate is fixed then the forces leading to the appreciation of the nominal exchange rate would be stalled (neutral effect). However, higher prices and wage rates (in the non-tradable sectors) may result in higher relative domestic to world prices. This leads to the appreciation of the real exchange rate (bad effect). The confluence of these effects ‘could be bad’. But then such developments in the non-tradable sectors may occur in all other exchange arrangements.

References

Canales-Kriljenko, J, R Guimares, S Ishii, and C Karacada¢g, Riding the Tiger: How Central Banks in Developing Countries Can Best Intervene in Volatile Foreign Exchange Markets, Finance and Development, September 2003.

Enoch, C and A Gulde, Are Currency Boards a Cure for All Monetary Problems?  Finance and Development, December 1998.

Fischer S,  Exchange Rate Regimes, Is the Bipolar View Correct, Distinguished Lecture Delivered at the Meeting of the American Economic Association, New Orleans, 6 January 2001.

IMF, International Financial Statistics, Yearbook 2000 (includes exchange-rate arrangements of all member countries, PP 14, 15).

Looney, R, A Monetary/Exchange Rate Strategy for the Reconstruction of Iraq, Strategic Center for Contemporary Conflict (SCCC).  1 May 2003.

Merza, Ali, Reconstruction of Iraq: Debt, Construction Boom and Economic Diversification? The Middle East Economic Survey (MEES) 12 July 2004:

http://www.mees.com/postedarticles/oped/a47n28d01.htm .

Mussa, M, P Masson, A Swoboda, E Jadresic, P Mauro, and A Berg, Exchange Rate Regimes in an Increasingly Integrated World Economy, Occasional Paper 193, IMF, 2000.

Spiegel, M, What Monetary Regime for Post-War Iraq? The Federal Reserve Bank of San Francisco, May 2003.