Saturday, September 03, 2005

Iraq's currency solution: the importance of adding oil to the equation

Well-functioning monetary arrangements are as important as other aspects of the infrastructure in putting Iraq back on the road of economic development. After the unification of the two kinds of dinars that have been circulating, the next order of business will be to decide what should determine the value of the currency. What exchange rate regime is appropriate for Iraq, at this key juncture in its history?

WHAT'S WRONG WITH PROPOSALS TO PEG TO THE DOLLAR OR EURO?

Given instability in the region and the absence of credible institutions, the Iraqi dinar requires an anchor of substantial credibility. Some have proposed a rigid peg to the dollar, as via a currency board or outright dollarization (see Steve H. Hanke, "An Iraq Currency Game Plan," in the previous issue of TIE). But this idea has major drawbacks. That it would mean giving up the ability to set monetary policy independently is not such a big cost, as few governments have been able to use such discretionary policy well anyway. But there are other big disadvantages.

One big drawback of a fixed exchange rate is that it means giving up the automatic depreciation that a floating currency would experience during periods when the world market for the country's exports are weak. In the case of Iraq, the major export is of course oil. Large fluctuations in the world price of oil have wrought havoc on the economies of other major oil-producing debtors such as Indonesia, Nigeria, and Venezuela, often entailing a serious currency crisis before a change in the terms of trade is accommodated. A second major drawback of fixing the dinar to the dollar would be the introduction of gratuitous volatility when the dollar fluctuates against other major currencies. Argentina's version of the currency board notoriously collapsed two years ago, not just because the straitjacket was so rigid, but because the rigid link was to a currency, the dollar, that had appreciated strongly against the euro and other trading partner currencies during the second half of the 1990s, imposing a huge loss in competitiveness on Argentine exports at a time when world market conditions were already weak. A third drawback is that to impose the dollar on Iraq might tend to play into widespread fears of U.S. imperialism. The politics would get even worse if the arrangement came to tears as it did in Argentina, for example, as a consequence of a future increase in U.S. interest rates.

Read on here.

Regards Marcel.