Implications of Iraq's new currency

Iraq gets a new currency today. The 'new Iraqi dinar' will be unveiled to the public and the mammoth task of exchanging an estimated 4 trillion in old dinar notes will begin. Saddam Hussein's face, which was on most of the old notes, will be replaced by pictures of an ancient Babylonian ruler and a 10th century Iraqi mathematician.

A deadline of January 15 has been set for the complete hand over of all the old notes. Given the lack of a functioning banking system the tight deadline is ambitious but the authorities believe that the transfer of the 2,300 tons of new currency can be done through the banking branches currently operating, post offices and government buildings.

This is more than a PR exercise to remove Saddam's face from circulation. A stable, unified currency system is essential for Iraq's long-run economic prospects.

The current system, by contrast, is chaotic. There are two types of Iraqi currency in use at the moment - the 'old dinar' and the 'swiss dinar', which is predominately used in the Kurdish dominated areas of northern Iraq.

The more limited supply of the latter means that it has retained more value than the 'old dinar'. This has been officially recognised in the exchange rates set for the 'new Iraqi dinar'. One 'old dinar' will be replaced by one 'new dinar' but one 'swiss dinar will be converted into 150 new Iraq dinars. The hope is that these rates should equalise prices across Iraq.

With the fall of the old regime in Baghdad there was a significant risk that the Iraqi dinar would cease to serve as an accepted means of exchange.
The old currency regime been completely discredited by rampant hyperinflation, poor monetary policy and concerns about widespread
counterfeiting.

Saddam had financed government deficits by printing money, for example. Public concerns about fake money has led to any note above 250 dinars (the equivalent of 12 US cents) being treated with suspicion, to such an extent that local press report that the 10,000 dinar note is trading at a 33% discount to the 250 one.

The 'new Iraqi dinar' offers an important fresh start. The new currency should enjoy a new measure of credibility. Counterfeiting should be harder thanks to use of watermarks and metallic inks in the new notes.

The Central Bank's new independence and giving it sole control of the printing press, something that used to be the preserve of the Ministry of
Finance, are also important steps. However maintaining that credibility will depend on implementing an effective monetary policy quickly.

Under the previous regime the primary policy tool was the currency peg to the US dollar. In theory interest rates and/or the money supply were altered in order to maintain the parity of one US dollar to 0.3 dinars. The currency peg acted as a monetary anchor for the economy. This has now been abandoned.

The Iraqi dinar has been effectively floating since March, ranging from 5000 dinars to the US dollar to the current rate closer to 2000. Given the lack of Central Bank reserves, the authorities have no other option but to let the dinar continue to float.

This policy vacuum runs risks for the stability of both the economy and the new currency. An economy needs an anchor, whether it is a currency peg or interest rates. But neither option is available to Iraq at the moment - the current state of the banking system precludes setting meaningful interest rates.

As the economy becomes more open, and heavy government controls over trade, prices and wages are dismantled, it will be more vulnerable to rapid fluctuations in external value of the dinar. This is happening quickly, anecdotal evidence suggests that the level of imports
has already risen sharply.

Baghdad is full of second hand cars from the UAE and Saudi Arabia, for example. To maintain the stability of the new currency, the Central Bank will have to turn to something that has become very unfashionable among economists and Central Bankers - money supply targeting.

This was widely used in the West in the 70s and 80s and then discarded. But it is the only option at the moment for the Iraqi Central Bank. This holds an important wider lesson for the rest of Iraq's reconstruction and US plans to impose a market style economy - the latest economic fashions are sometimes just impractical.