Misconduct charges against the Central Bank of Iraq (CBI) and banking system, before and after the replacement of the Governor, Sinan al-Shabibi, in October 2012, fall into two categories. The first relates to possible “misuse” of CBI foreign exchange auction sales by banks, favoritism in allocating sales and money laundering. The second includes the failure to monitor the final usage of auction sales (mainly for private importation), capital flight (“smuggling”) and the handling of international reserves. Charges in the second group display a misunderstanding of the nature of central banking in a free foreign exchange regime as well as of the nature, components, obligations and functions of international reserves.
Notwithstanding misconduct charges, the conflict largely transcends them and goes directly to the CBI’s independence and control of international reserves. This paper, examines the origins of the conflict during the last three years. Then, in order to evaluate the CBI’s performance in foreign exchange management, it will look not only into its foreign exchange auctions, which have gained prominence in the charges against the bank, but also touch on some institutional issues of the foreign exchange regime and international reserves before concluding.
ROOTS OF CONFLICT
Three fundamental interrelated factors can be cited as reasons for the conflict between the government and the CBI during the last three years: the independence of the CBI, as stipulated in the constitution and Central Bank law; the governor’s refusal to lend to the government; and the growing size of international reserves. After the collapse of oil prices in 2008-09, the government in 2009 and 2010 attempted without success to secure loans from the CBI to finance a possible deficit in the budget. (Article 26 of the CBI Law prohibits lending to the government.) Since then, efforts to limit the bank’s independence resulted in a decision by the High Federal Court in January 2011 to subordinate the CBI and other independent bodies to the prime minister’s office. Although this decision was not implemented, the attempt to subordinate independent bodies underlined a reality; that despite stipulations to the contrary in the constitution, governments in Iraq are traditionally averse to the existence of bodies out of the reach of the executive branch, especially one with growing international reserves of, reportedly, $67bn.
The government’s objective therefore gradually changed from borrowing from – to control of – the bank, a hypothesis supported by the fact that due to an accumulated budget surplus, deficit financing has not been needed, especially in the past two years. For despite data problems about the size of the accumulated budget surplus, conservative estimates place it between $26bn and $32bn at the end of 2011. Most likely, it is higher. Furthermore, in spite of a planned deficit of $12.7bn in 2012, actual oil revenues for the first eleven months imply that even if all budgeted expenditures materialize, there will be no deficit in 2012.
Two additional factors may have contributed to the hostile relationship, and later to misconduct charges against the bank. One relates to the nature and function of international reserves, which have been erroneously described as stocks that are ‘put aside’ for emergencies only. Such a misconception could have created a misunderstanding on the part of politicians and non-specialists that international reserves can be readily used as free finance. In reality, instead of being ‘put aside’, they are continually subject to additions and withdrawals. For instance, purchases (or receipts) of US dollars by the CBI add to the reserves, while auction sales withdraw from them. Reserves rise when additions outweigh withdrawals and vice versa. Furthermore, international reserves as assets are completely balanced by liabilities (obligations). Therefore, using them independently of obligations results in disequilibrium in the exchange market and the economy as a whole.
The other contributory factor relates to the CBI’s daily foreign exchange auction. Due to the fact that auction sales of US dollars are intended for the private sector through participating banks, it has been mistakenly perceived, somehow, that the CBI meets the demand of the private sector only. The continuation of UN Security Council Chapter VII Sanctions may have contributed to this view. According to the sanctions, oil revenues are not deposited directly in the CBI, but in the Development Fund of Iraq (DFI) at the Federal Reserve Bank of New York. Iraq’s Ministry of Finance (MOF) is the authority which makes decisions concerning oil revenues. Annually, it sells part of the revenues to the CBI in return for dinars. When it requires foreign exchange, however, the MOF usually uses its account at the DFI rather than requesting it from the CBI. It has appeared, therefore, as if the MOF provides rather than demands foreign exchange from the CBI. The perception, however, is at variance with the fact that government accounts in Iraqi dinars (in the CBI and other banks) are one of the main obligations against international reserves. (Other obligations include private sector accounts in dinars and issued currency.) Therefore, if the government (say, the MOF) requests dollars in return for its accounts in dinars the CBI needs to accept.
It should be noted first that despite the use of the term ‘auction,’ Iraq, like most oil exporting countries in the region, has been following a fixed exchange rate arrangement against the US dollar since the beginning of 2009. Furthermore, the auction rate of exchange is referred to as the ‘official’ rate to distinguish it from the ‘market’ rate which is used by banks and money exchangers.
To meet demand, auction dollar sales (henceforth, sales) to participating banks include two types of transactions, international transfers and cash payments. International transfers, which make up the majority of transactions, are intended mainly to finance imports by the private sector. Cash sales serve to meet payments for travel, medical expenses etc. The purpose that these two types of transactions serve define what can be called “auction rules,” which ensure that sales meet ordinary demand. From the widening gap between official and market exchange rates in 2012 (see table) on the one hand, and the enforcement of auction rules, on the other, it can be inferred that sales do not necessarily meet all of bank demand. Consequently, upper limits on daily transactions seem to exist.
The exchange market, however, was in balance throughout 2004-11. Between 2004 and 2010 the percentage difference between the market and official exchange rates (ie gap rate) was only 0.7%, which can be taken to signify equilibrium in the exchange market. After 2010, the gap rate started to increase. In the first half of 2011 it rose to 1.6% (which still indicates a balance) and in the second half to 2.8%. During the first nine months of 2012 the average climbed to 6.4%, obviously indicating an imbalance, reaching 10% on 10 April before falling to 2.9% in October.
During 2012, the gap rate does not seem to have moved in tandem with the inverse change in supply (sales). Average daily sales in the first four months of 2012 were not much different from those in the second half of 2011; yet the gap rate rose rapidly. On the other hand, although average daily sales rose tangibly between May and August, the gap rate did not decline proportionally. The pattern of change in 2012, therefore, points to the possibility of other variables influencing the gap rate. Econometric investigation of daily auction transactions during January 2009-October 2012 has identified what appears to be ‘additional’ demand as one such variable in 2012. Uncertain economic prospects and regional instability could have resulted in higher additional demand for US dollars since November/December 2011.
Furthermore, the investigation indicates that the gap rate responded rather strongly to additional demand and relatively weakly to changes in auction sales. The implication is that in order to restore balance in the market, daily sales should have risen to very high levels, which were not possible according to auction rules, in addition to being politically unacceptable. Hence, during the first nine months of 2012, the actual increase in daily sales was not very effective in restoring balance to the market. What appeared to be a fall in demand at the end of third quarter seems to have been more effective. This hypothesis gains some support from the slow decline in the gap rate between April and August and the faster fall afterwards.
This description points to the balancing mechanism in the market. After the lifting of quantitative restrictions, the main tool at the disposal of the CBI to achieve equilibrium is change in supply to satisfy demand. The apparent resurgence of additional demand since November/December 2011, however, seems to have weakened the effectiveness of supply tuning to return the market to equilibrium, and the imbalance of 2012 raises the important issue of how to deal with similar shocks. The lesson to be learnt is that when the exchange market confronts shocks, it needs more effective tools than only those in possession of the CBI to return to balance. The tools required, however, depend on the type and nature of the shock.
Entrenched habits and long years of familiarity with old regimes of restricted foreign exchange dealings have prompted many politicians and non-specialists to object to the increase of US dollar sales, implying that they facilitate ‘smuggling.’ This could have further limited the effectiveness of supply tuning in achieving balance in the foreign exchange market. In this regard two recently-published official documents which imply charges of ‘smuggling’ and favoritism in auction transactions should be mentioned. The first, by the Board of Supreme Audit (BSA), has concluded that only 18% of auction sales in 2012 were used to finance private imports. The rest of the sales are not detailed beyond mentioning a lack of documentation for some and repeated uses for others. Furthermore, the BSA has referred to the dominance of specific banks and persons in the auction sales. Based on the BSA findings a second report by a parliamentary committee has reiterated similar charges.
EVALUATING POLICY AND INSTITUTIONS
After fluctuations in auction sales in the first four months of 2012 the CBI increased daily sales in May and subsequently by October the market was near balance. However, it is clear that the market was in disequilibrium for the best part of 2012, which requires an explanation. Why had it taken more than 10 months to come close to balance? Was the CBI overwhelmed by the size of ‘additional’ demand in 2012? Why had it not increased auction sales more quickly to narrow the gap? Was it held back by anticipated political opposition or by auction rules? Was the delay in responding the result of institutional and/or managerial problems at the bank?
Until such time as better answers and explanations become available, responsibility for the delay should not be attributed to the CBI. The apparent rise in additional demand during the 10 months before October 2012 required increases in daily sales which could have been unfeasible under auction rules. Furthermore, an entrenched aversion to the workings of freer exchange markets may have further deterred the CBI from providing a proportional increase in sales. The bank was thus facing a dilemma that must have constrained its response. In the end, though, it succeeded in restoring stability in the exchange market.
Unlike budget surpluses, whose size, place of deposit and mode of management are not known exactly, the CBI’s international reserves (balance of payments surpluses) are known in size, places of deposit and mode of management. Furthermore, instead of keeping all reserves in the Federal Reserve Bank of New York, the CBI deposited important portions in other, especially European, central banks. The preservation of the CBI’s independence and sound parliamentary and professional monitoring would also help to prevent misuse of the reserves.
Notwithstanding restrictions relating to money laundering and other lesser offences, the foreign exchange regime in Iraq was characterized at the beginning of 2011 as “generally [having an] unrestricted current account ... and a significantly liberalized capital account.” Although still largely an accurate characterization, auction rules since November/December 2011 have imposed de facto restrictions on private sector transactions in the two accounts, mainly through meeting ordinary rather than all demand. We think that the present foreign exchange regime as described above should be maintained in the future, subject to some provisos. A fixed exchange rate arrangement in a balanced market requires adequate oil revenues and international reserves. If oil prices decline and/or international reserves fall below critical levels, fixed exchange rate arrangements become unsustainable. In that case the CBI may need to revert to a crawling-peg arrangement and to impose stricter controls, largely on the capital account. Furthermore, the CBI’s independence needs to be maintained and political and extralegal interference stopped.
The foreign exchange auction has long outlasted its purpose and an alternative arrangement is needed to serve the foreign exchange demands of both public and private sectors. Depositing all oil revenues in the CBI instead of the DFI will enhance such an arrangement and make the CBI the main provider of foreign exchange to the public sector. The lifting of UN Chapter VII’s Sanctions will facilitate the new role.
The institutional set-up of the exchange market is in need of restructuring, especially in terms of management, procedures, monitoring, documentation and data processing and assimilation. Restructuring can enhance the efficiency of the market and its transparency. The development of tools to swiftly identify imbalances and devise measures to overcome them is necessary. The documentation of imports needs to be streamlined to match actual with reported costs.
Since the replacement of the governor in October 2012, political and official statements have indicated that the government and an important block in the council of representatives question the performance of CBI in foreign exchange auctions and in handling international reserves. Charges relating to the auction have been contained in recently published documents by the BSA and a parliamentary committee. The BSA’s main finding, on volume of imports financed by auction sales, is, however, debatable.
In conclusion, it is feared that, despite the accumulated budget surplus, previous calls for borrowing from the CBI and, since the beginning of 2012, the improper use of international reserves could point at an intention to compromise the independence of the bank.