The social, security and economic implications of Iraq’s currency devaluation
Interview with Prof Frank R. Gunter :
Q1: As an economist who is familiar with Iraq, what is your view on the currency devaluation? Is it the right step taken at the wrong time? How do you see the overall effects of the devaluation?
FG: I think that the primary motivation for the devaluation was the 2020 budget crisis. With the collapse of oil prices, GoI revenues were insufficient to pay current expenditures – primarily salaries and pensions – even with a sharp cut in investment expenditures. The almost 23% devaluation of the dinar to 1450 ID/$ in December 2020 will result in an estimated 11 trillion increase in government dinar revenues. However, the net increase will be about one-third less due to government expenditures for imported goods that are unaffected by the devaluation. Of course, this devaluation will also have the effect of increasing import prices – fueling an acceleration of inflation – as well as improving the competitiveness of the country’s small amount of non-oil exports.
Q2: How did we get here, and more importantly, what is the way forward?
FG: According to the theory of optimal currency areas, a country whose national income is dominated by foreign trade and where most of that trade is dominated by one foreign currency then this country can maximize its economy by adopting a fixed exchange rate. Iraq is heavily dependent on dollar-denominated oil exports and imports large quantities of agricultural products which also tend to be denominated in US dollars. Shortly after the US-led invasion of Iraq, the GoI fixed the dinar to the US dollar. And the relative stability of the dinar/dollar exchange rate has been one of the great unexpected successes of Iraqi macroeconomic policy. However, this fixed exchange greatly limits Iraqi monetary policy. Or to be more precise, with a fixed exchange rate, monetary and exchange rate policies are the same. This has severely constrained the ability of the Iraqi financial system to facilitate private sector economic growth.
The primary danger of attempting to maintain a fixed dinar/dollar exchange rate is riskless speculation. Declines in the
international reserve holdings of the CBI motivate speculators to borrow dinars and exchange them for dollars in either the daily currency auction or in the secondary market. This speculation leads to a further decline in reserves stimulating more speculation. Eventually, the loss of reserves will force the GoI to further devalue the dinar providing a profit for speculators. The loss of Iraq’s international reserves is also exacerbated by the collapses of the Iranian rial and Syrian pound that have led to large amounts of dollars being smuggled out of the country.
The CBI can try to reduce reserve loss by keeping dinar interest rates high. This will, of course, discourage private sector growth. In addition, the CBI could once again attempt to reduce the rate at which dollars are leaving by restricting access to the daily currency option. Both options are short-term solutions to a long-term problem.
One option that would maintain the advantageous fixed exchange rate while eliminating speculative attacks on the dinar would be for Iraq to return to a currency board such as the one that enabled Iraq to have a stable currency from 1930-1949 despite severe internal conflict and chaos of World War II. In a currency board, the GoI would commit to a fixed exchange rate for paper currency only and maintain 100% reserves. These commitments would eliminate the chance of a successful speculative attack on the dinar and allow lower interest rates for loans to the private sector.
Q3: What are the opportunities and challenges facing Iraq in increasing the competitiveness of local products?
FG: While the December 2020 dinar devaluation should – in theory – make Iraqi exports more competitive, I think that there will be a little real impact. The key problem with the country’s international trade is that Iraq currently suffers from extreme regulatory hostility towards its private sector especially with respect to foreign trade. According to the 2021 World Bank Ease of Doing Business, Iraq ranks 181st out of the 190 countries surveyed. To legally export a product from Iraq is an expensive and complex process. For example, documentary compliance alone requires an estimated 500 hours. The expense of complying with these regulations or paying bribes to avoid them is a high implicit tax on exports. This export tax resulting from the current regulatory hostility towards international trade substantially explains the current low level of non-oil exports such as agricultural products and textiles. On the import side, there is widespread corruption at the border entry points with Iran and Turkey. Combined with extensive smuggling, import tariff collections are de minimus and Iraqi markets are swamped by imported goods that are often cheaper than products produced in Iraq.
Q4: On top of the protesters’ demands for employment opportunities and better access to public services came the currency devaluation: how do you see the social and security implications of this?
FG: Beginning in the 1980s and continuing through about 2014, the government of Iraq has acted as the “employer of first resort”. Each year, government employment was increased in an attempt to create enough new jobs for Iraqis entering the labour market. However, as a result of the 2014 collapse of oil prices combined with the expenses of the anti-ISIS fight, the GoI lacks the needed revenues to create enough new public sector jobs for the estimated 350,000 young Iraqis who enter the labour market each year. While the data is difficult to interpret, I think that about 80% of young Iraqi males are currently unemployed or underemployed. This will be an increasing source of political instability.
The devaluation was a temporary fix that allowed the GoI to maintain its existing employment and pensioner levels. However, with an expected decade of oil prices of $60 a barrel or less, the GoI will not be able to return to massive public sector job creation. As a result, political stability will depend upon job creation in the private sector. Currently, private sector growth is constrained by the associated problems of regulatory hostility and corruption.
Q5: During your recent seminar, you suggested that all the subsidies (such as food, fuel, and farm-support programs) should be removed, even though the devaluation reduced purchasing power for most Iraqis. Given Iraq’s high poverty rate (over 31 % by July 2020), what could be done to support the impoverished segment of the Iraqi population?
FG: Iraq’s heavy subsidies of energy, water, food, education, etc. suffer from four related challenges. First, in a future of low oil prices, Iraq can no longer afford the subsidies. The World Bank estimated that such subsidies amount to about 12% of the country’s GDP. Second, these subsidies severely distort the data necessary to correctly evaluate government programs. For example, subsidized energy, water, etc. make determining the viability of SOEs almost impossible. Four, subsidies that result in zero or very low official prices lead to substantial waste – if something has a zero price, people treat it as if it has a zero cost. When the grid is providing electricity and air conditioners are operating, shop owners leave their doors in hopes that the cool air will encourage customers to enter. Finally, these subsidies lead to corruption. The amount demanded of these products and services is much greater than the amount supplied. Iraqi families are competing against each other to obtain these products/services using political, family, religious connections, or, most commonly, by paying bribes. The subsidies should be eliminated. As implied in the question, this would cause severe hardships for Iraq’s poor. That is why the elimination of subsidies must be accompanied by a direct dinar transfer to Iraqi’s poor. This transfer payment should be sufficient to allow them to purchase essential services, food, etc. at unsubsidized prices. There will be a budget-saving from eliminating subsidies for Iraqis who are not poor. Also, there should be a reduction in petty corruption since the prices should be sufficient to cover the cost of production – officials will not have less of an economic rent that they can sell for bribes. In addition, it will allow poor Iraqis to make their own decisions on spending priorities rather than having a member of the Baghdad bureaucracy decide on what each poor family wants or needs.
Q6: Do you think the Public Food Distribution Program, if properly reformed and limited to low-income citizens, is an efficient mechanism to support the Iraqis who are already living below the poverty line and the IQD devaluation just exacerbated their situation?
FG: No. The PDS is extremely inefficient. The cost of the food basket is a multiple of the value of the food actually provided to the recipient. In addition, the PDS is corrupt. One survey showed that over 80% of the food “baskets” were lacking one or more of the promised items. The Ministry of Trade purchases the needed quantities but, somehow, large quantities are diverted before the baskets reach the recipients. Finally, much of the food is imported rather than obtained from domestic farmers and agricultural businesses. A much-discussed alternative is to replace the PDS with direct dinar transfers to the poor. While this option would probably reduce the problems mentioned above, there is a cultural issue to be dealt with. In traditional families, food is the responsibility of women while men handle money. If the PDS is replaced by direct dinar transfers, this may reduce family food consumption as males uses funds for non-food expenditures.
Q7: Given Iraq’s heavy red-tape procedures and poor enabling business environment, do you think it is realistic to expect any bureaucracy reform to address the impediments?
FG: Reducing the regulatory hostility towards the country’s private sector is a necessity. Although some progress has been made, the further movement towards a rational commercial code faces two challenges. First, the complex and expensive regulatory barriers to private businesses in Iraq are no unloved artefacts from the Saddam era. Rather, each rats’ nest of regulations is carefully preserved and protected by the bureaucracy since the more difficult it is to legally follow a regulation, the greater the bribe that will be offered by a businessman or woman. Second, in a future of low oil prices and rapidly rising numbers of unemployed or underemployed young men, Iraq doesn’t have a decade to gradually reform its commercial code before the country faces another severe period of political instability.
One option would be for Iraq to rapidly adopt the commercial code of another Arab country such as the UAE. While far from perfect, the UAE commercial code is much more favourable to the private sector. While Iraq is ranked 172nd by the World Bank on the overall ease of doing business, the UAE is ranked 16th.
Q8: On the challenges of endemic corruption, do you think this issue can be addressed at the level of the public administration (where it is considered as grand corruption)? or it can be at the level of petty corruption?
FG: An interesting question! Although I think that Saddam and his family and supporters stole more of the country’s wealth,current corruption is doing more damage to Iraq’s economy and society. Under Saddam, corruption was more structured and predictable whereas current corruption is more competitive and uncertain. As a result, while grand corruption – also known as state capture – is a serious problem and gets a great deal of media attention, I think that petty corruption – paying small bribes to an unending queue of officials – is doing more damage to both households and private businesses not only because of the costs of the bribes but also because of increased uncertainty. Even if one pays a bribe for an accommodation from an official, one cannot be confident that the accommodation will actually be provided. What is needed are not new government programs intended to “help” the private sector but for the GoI to get out of the way. In conversations with young Iraqis, I have been surprised that so many of them express their desire to be entrepreneurs, not government employees. If the GoI can give these young people, the space they need to create their own businesses, the resulting job creation should improve political stability. The many failures and few successes of anti-corruption efforts throughout the world have some lessons for Iraq. An anticorruption strategy composed of arrests of a few high-level officials and displaying anti-corruption posters in government offices
will fail. What is needed is a multi-faceted anti-corruption strategy that reflects Iraq’s unique characteristics. It is especially important that the anti-corruption strategy seeks to reduce both the supply of corrupt acts by officials as well as the demand for such acts by private individuals and businesses. Since 2005, Iraq’s efforts have focused on the former with little attention to the latter. Two necessary components of reducing the demand for corrupt acts are to change the culture of corruption in Iraq and rationalize the regulatory environment of the country’s private sector. Education starting at a young age is probably the most straightforward of changing attitudes toward corruption. As an example of the effect of excessive regulation on corruption, consider the 167 days currently required to obtain the necessary permits to build a warehouse. To avoid this delay, a business might be willing to pay a substantial bribe to speed up the approval process. However, if the regulations were rationalized so that a business could obtain permits in 30 days then the business owner will only be willing to pay a smaller bribe or no bribe at all.
Q9: You know how the structural issues and imbalances resulted in the current unemployment crises because of the political economy, before and after the 2003 regime change. Is there any way to address the unemployment crisis apart from a proper and comprehensive private sector development program?
FG: No. Decades of the government of Iraq acting as the “employer of first resort” has led to spending on salaries and pensions crowding out needed essential services and infrastructure spending. It has also corrupted the country’s political culture since ministries are operated primarily as welfare programs for government workers. In addition, it has facilitated the corruption that is the most serious challenge facing Iraq. Iraq could barely afford massive government job creation when oil prices were over $100/barrel, with the expectation of a decade or more of sub $60/barrel oil, further expansion of government employment is impossible. What new programs should the government of Iraq fund to develop the private sector? I think that this is the wrong question. With the current budget crunch, widespread corruption, and limited competency of the bureaucracy; any new program can be expected to be a costly failure that will probably make the situation worst. What is needed is for the government to do less – to allow space for the private sector to create and operate profitable businesses that will increase employment. While the government in its 5-year
plans states that the private sector is critical to Iraq’s further development, the same documents severely constrain the private sector’s operation. As one of many examples, a GoI 2010 plan discusses the severe housing shortage in Iraq and notes that home construction is within the capability of small and medium private firms. But, at the same time, the GoI proposes that certain customers receive priority (civil servants), certain construction materials are used, that homes be built in certain areas, and that a specific complex system of funding is utilized. All of which will require “an expansion of the housing legislative framework” (GoI 2010, National Development Plan: 2010- 2014, pp.124–7). This combination of complexity, uncertainty, and arbitrary bureaucratic decision making seems specifically designed to discourage private-sector home building. It is interesting to note that among the hundreds of persons involved in
developing the National Development Plan: 2010–2014, all or almost all were government officials; representatives of Iraq’s private sector were not at the table when the topic for discussion was increasing the role of the private sector.
What is needed are not new government programs intended to “help” the private sector but for the GoI to get out of the way. In conversations with young Iraqis, I have been surprised that so many of them express their desire to be entrepreneurs, not government employees. If the GoI can give these young people, the space they need to create their own businesses, the resulting job creation should improve political stability.