9

Case Studies

Exchange rate regime choice in a postwar country: Iraq

This case study draws heavily on Moosa (2004a, 2004b). Iraq is a case of
a postwar country that experienced hyperinflation resulting from exces-
sive currency printing. Between 1991 and 1995, the nominal value of
the currency in circulation jumped from 22 billion to 584 billion, giving
rise to an average annual inflation rate of 250 per cent. Monetary reform
in post-Saddam Iraq is an issue that has been dealt with in the academic
literature (for example, Hanke, 2003a; Roubini and Sester, 2003), in the
media (for example, Hanke, 2003b) and in policy documents (for exam-
ple, Sanford, 2003). King (2004) used the case of Iraq to demonstrate
that expectations of future collective decisions can have a major impact
on the value of a currency, irrespective of the policies pursed by the
current government.
One of the major tasks facing any civilian authority in a postwar
situation is to get the economy up and running. Central to this effort
is putting in place stable monetary conditions as a prerequisite for the
success of economic reconstruction. This is particularly the case if the
country in question has been enduring macroeconomic mismanage-
ment and inflationary monetary policy, which were the conditions that
Iraq endured for many years under the regime of Saddam Hussein. The
question that had to crop up, therefore, was the choice of exchange rate
regime, as this choice is a critical component of monetary reform in
Iraq. As expected, the views on this issue diverge between the extremes
of dollarization and free floating.
I argue that the optimal exchange rate regime under the prevailing
conditions is a currency board, while arguing against suggestions for

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I. A. Moosa, Exchange Rate Regimes

© Imad A. Moosa 2005
226 Exchange Rate Regimes

adopting managed floating and other regimes. The basis of the argu-
ment for a currency board and against managed floating is that the
former imposes the discipline that the Central Bank of Iraq (CBI) needs
after years of monetary abuse. It is also argued that while a currency
board is a rather stringent system, it is an extreme measure that is
needed to deal with an extreme situation. There is no better way to curb
the temptation to monetize the deficit than a currency board, whereby
the central bank keeps a full foreign exchange cover at a fixed exchange
rate.
One argument against a currency board for Iraq is that the foreign
currency reserves needed to run the exchange rate arrangement can and
should be used more appropriately for the reconstruction of the coun-
try. Some counter-arguments can be suggested. The first is that this is a
price worth paying to achieve monetary stability and restore confidence
in the currency. The other counter-argument is that the foreign
exchange reserves required for a full cover are rather small relative to
the total cost of reconstruction. Assuming that the monetary base/GDP
ratio is 0.1 and that GDP in 2003 is $25 billion, the initial cover required
is $2.5 billion. This is a small fraction of the $100 billion or so needed to
finance reconstruction. The amount required for this purpose should be
readily available from the frozen Iraqi assets. Moreover, keeping full
reserves at the CBI gives it more credibility at a time when potential
transaction partners associate it with bankruptcy. This is not to mention
that the CBI needs to hold some reserves under other exchange rate
arrangements, albeit smaller amounts.
The arguments against a currency board for Iraq are the following:

. Difficulties of managing external shocks.

. The requirement of a strong fiscal policy in place.
. The possibility of serious consequences if an inappropriate level of the
fixed exchange rate is selected.

While there are no problems with these arguments in a general sense,

I find it unacceptable to put forward propositions that do not take into
account the specifics of the situation in Iraq and its priorities. Hence,
consider the following counter-arguments:

. To start with, the argument about shocks is mostly applicable to a

developed country with a diversified export base, not to a country that
derives 95 per cent of its foreign exchange revenue from a commodity
that is priced in US dollar terms. Iraq will be (for a long time to come)