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Iraq: New Money But Dollars, Euros, Or Dinars?

The U.S.-led interim authority in Iraq is embarking on a major reform of the Iraqi economy. Later this month, officials will introduce a new currency, withdrawing old Iraqi dinars currently in circulation. But many questions have yet to be addressed -- should the reform resemble something like the "shock therapy" that was applied in many former Communist countries, or is a slower, more gradual approach better?

Prague, 3 October 2003 (RFE/RL) -- The U.S.-led authority in Iraq on 15 October will begin the process of withdrawing old Iraqi dinars from circulation and replacing them with new notes. The currency change is part of a larger effort to reform the economy and open it to the rest of the world.

Officials say the conversion will take about three months and will mean pulling out of circulation old notes with Saddam Hussein's picture on them. The currency swap will also eliminate even older dinars circulating in the north in areas controlled by the Kurds.

But behind the cosmetic improvements lies the deeper question as to the nature of the reform -- whether the country should move quickly to introduce free market elements or pursue a more gradual course. And part of that question is whether to fix the value of the new dinar to a "hard" currency like the U.S. dollar or to allow it to float.

There is a wide range of economic opinion on the issue.

Steve Hanke, a professor of applied economics at Johns Hopkins University, says the authorities should fix the dinar to the dollar or another hard currency like the euro. Hanke has long experience in helping developing countries set their currency policies, having advised officials in Bosnia-Herzegovina, Montenegro, Kosovo, and Bulgaria, among other countries.

He favors what is called a "currency board" arrangement, under which the new Iraqi money would be backed by foreign-currency reserves and be easily exchanged into dollars or euros. The arrangement, he says, would help to attract outside investment by ensuring that investors could repatriate their profits. He says currency boards have worked in Europe.

"If you look at the former Communist countries that are really ready to enter the European Monetary Union with no problems at all, it's no surprise that Estonia, Lithuania, and Bulgaria are way ahead of everybody else. And the reason why is that they installed a currency board after Communism collapsed. And their currencies are already linked with this currency board arrangement and backed up to 100 percent by euro reserves."

Hanke says Iraq could even go further and give up the dinar altogether, adopting the dollar or euro as legal tender. In 1999, Kosovo and Montenegro introduced the German mark and later the euro. When East Timor split from Indonesia, it started using U.S. dollars. Ecuador got rid of its bad money and completely "dollarized" its economy in 2000.

Hanke's ideas are not universally shared.

During a recent international banking meeting in Dubai, Iraqi Interim Central Bank Governor Sinan al-Shabibi indicated he did not favor fixing the dinar to the dollar or adopting the dollar as Iraq's currency. He said, instead, he would like to see the value of the dinar float within limits -- a so-called managed float.

Werner Becker of Deutsche Bank Research agrees, saying that "dollarizing" Iraq or adopting a currency board would be extreme. He points to Argentina as an example of where instituting a very rigid currency regime backfired.

"There is a huge catch-up process necessary in the Iraqi economy. And therefore, it is problematic to give away from the very beginning the exchange rate as a tool of adjustment. My best guess at the moment is they will have their own currency and not be dependent on all these problems which Argentina, for instance, had with the dollar regime."

Becker says if a country adopts another currency, it loses control over key aspects of its monetary policy -- such as setting interest rates. Central banks typically lower interest rates to stimulate domestic investment by making it cheaper to borrow money. They then raise interest rates to slow an economy in danger of overheating. A "dollarized" Iraq, Becker says, couldn't do this.

"Argentina had to follow a relatively strict interest rate policy in the late 90s, determined by the Federal Reserve [U.S. central bank] in New York. You have no influence on the interest rates policy [if there is no central bank, it cannot decide] whether those interest rates of the dollar area fit your country or not -- there is no room for maneuver."

Central to the debate is the future role of Iraq's central bank -- whether the country will have a strong and independent bank or simply a coordinating body with little real power.

Hanke favors the latter. He says that -- contrary to conventional wisdom -- the idea of a country having an independent, traditional form of central bank that issues and manages the currency has not always proved successful. He says this is especially true in the case of developing countries.

"My prognosis is central banking as it has been designed in Iraq will fail as it has always failed in Iraq. Their experience with central banking is more or less like everybody else's. It's a disaster. This is a time bomb waiting to explode in Iraq if they keep this central bank. This idea of new currencies for individual countries being emitted by central banks is a rather new idea. Really, it's only about 50 years old. But the record has been absolutely terrible in developing countries."

Becker and others say, however, that Iraq would benefit from having a traditional type of central bank, especially at the start of its transformation. Among other things, he says central banks help to coordinate a country's banking sector and facilitate financial transactions between companies.

"[A] central bank has several macro- and microeconomic functions in an economy like Iraq," Becker said. "[A] central bank is responsible for the circulation of money and the conduct of monetary policy. Issuing money -- cash and noncash -- establishing the necessary instruments, establishing the necessary cooperation within the banking sector and then doing the payment transactions domestically and also in international terms. Some other functions can be introduced; [they] are nice to have but not a must."

The U.S.-led authority has indicated, so far at least, that it is pushing for a more rapid economic transformation. It recently said all sectors of the Iraqi economy -- with the exception of oil -- would be open to foreign investment. The degree to which Iraq succeeds with its currency will play a role in whether this investment ever comes.