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Consequences of KRG’s dollarization

Militants belonging to the so-called Islamic State (IS) have taken over several key areas in Iraq, including the country’s second largest city Mosul on June 10th.

Consequently, the political, social and economic shockwaves throughout the country has had severe consequences on the already unstable Iraq. Some of the changes include the increased controversy surrounding oil sales revenue in Kurdistan Region, and Baghdad’s refusal to pay Kurdistan Regional Government (KRG) constitutional share of the annual budget.

As a result of Baghdad’s withdrawal of the annual budget, KRG has announced that civil servants will be paid in dollars starting next month due to a lack of sufficient liquidity of the Iraqi currency (IQD) in the region’s banks.

What is dollarization?

Currency substitution occurs in instances where citizens of a country officially or unofficially use a foreign country’s currency, in this case, US dollars as a legal tender for conducting transactions. One of the primary reasons for currency substitution is due to the greater value of a foreign currency over domestic currency. Several countries have officially adopted the US dollar as a legal tender, including Panama (1904), Ecuador (2000) and El Salvador (2001). Countries that substitute national currencies with a foreign currency hope to achieve economic stability and growth.

Central Bank of Iraq and its USD currency asset

The Central Bank of Iraq (CBI) is the highest authority in charge of implementing monetary policy throughout the country.

In 2012, CBI changed some its rules and relations pertaining to USD selling auctions, and it has been operating as a de facto dual exchange system since. The rate has been fixed at IQD 1,166: USD 1.00. While the unofficial exchange rate of the dinar has ranged from 1,194 to 1,292, with two major episodes of depreciation in mid-2012 and mid-2013.

The majority of market transactions are made in USD both within KRG and Iraq while IQD is used for relatively small daily transactions, alongside the local currency. To illustrate this by way of example, real estates and car prices are all in USD and not IQD. It is important to distinguish between two reasons for the demand of USD current assets in Iraq.

Currency substitution — USD assets are used as money, essentially as a means of payment and unit of accounts, and this typically arises under conditions of high inflation.

Asset substitution — Direct result of risk and return considerations about domestic, as well as foreign assets, which is more applicable to the current situation in Iraq.

Historically, foreign currency-denominated assets have provided the opportunity of insuring against macroeconomic risks, such as price instability and prolonged depressions in many developing countries.

Consequently, it is reasonable to conclude that Iraq as a whole has established an informal dollarized economy. However, full-dollarization requires more than this. Full dollarization necessitates the official use of foreign currency in all transactions and governmental balance sheets. If KRG pays its civil servants with USD, this can amount to the semi-official initiation of dollarization with some uniqueness.

It is important to keep in mind that Kurdistan is still part of Iraqi mainland and does not have power over the monetary system which is controlled by CBI in Baghdad. Furthermore, this will lead to additional USD transactions in the economy, and as a result with distort the CBI monetary policy.

The usage of USD in large amounts will lead to ambitious changes in the CBI targeted formal exchange rate, and it will make it increasingly difficult for CBI to control the exchange rate.

KRG still has the option of buying IQD in regional banks to fill the liquidity shortage, and thereby avoid a potential fight with Baghdad.

The current tensions throughout the country leave KRG with limited options. Civil servants need to be paid, and because the amounts of IQD in Kurdistan’s state banks are not sufficient to meet the demand, it has no choice but to use USD. The main attraction of dollarization being the elimination of a sudden devaluation of the country’s exchange rate. This could also allow the region to reduce the risk of premium attached to its international borrowing.

Evaluating the advantages and disadvantage of full dollarization

It is increasingly hard to evaluate the pros and cons of full dollarization, and this is primarily due to the lack of historical cases that can be used for the purposes of analysis. Panama is the only sizeable country with a history of using a foreign currency (USD) as a legal tender, and it is fairly small, with very close historical, political and economic ties to the United States.

Pre-independence scenario

KRG has to pay public employees and the best short-term option is to use oil exports revenue as a median of payment. Dollarizing will act as a temporary survival policy to tackle liquidity shortage of IQD. Salaries payment will prevent potential depression driven instances from the possible lack of aggregate demand. In terms of Kurdistan’s bid for independence, currency substitution allows them to become independent economically.

The Iraqi government is likely to continue to challenge Kurdistan’s oil exports but this is within the constitutional rights of KRG given that the Iraqi government has withheld KRG’s share of its annual budget. However, CBI could potentially declare an exchange rate war with KRG by devaluing the USD, and thereby cutting the purchasing power of Kurdistan’s civil servants. This scenario is a lose-lose situation for both CBI and KRG, and it is unlikely that CBI could afford to impose this in the long-run because it will also affect Iraq’s oil export sale value.

Post-independence scenario

If Kurdistan declares independence — Central Bank of Kurdistan (CBK) is expected to have its own currency issued. In the short-term, dollarization might be necessary to keep the economy functioning and to avoid liquidity shortage. An immediate benefit from eliminating the risk of devaluation is reducing Kurdistan’s risk premium on foreign borrowing and obtaining lower interest rates for the government, as well as private investors.

Implementation steps and concerns

Kurdistan’s dollarization must waon the completion of complementary reforms in Kurdistan’s economy, in order to work smoothly and yield more benefits than costs. Pre-dollarization reforms that should be made include a consolidate bundle of labor market reform, fiscal reform, and financial sector reforms. To ensure the smooth transition, coordination among all of the Ministry of Finance and Economics in Kurdistan, academic institutions, private and public banks, and Legislature of Kurdistan in order to guarantee a sustainable Macroeconomic performance and stability.

Recommendation

A policy agenda for dollarisation necessitates considerable research and assessment on its short-term as well as long-term consequences. It requires a three-pillar approach

  1. Ensuring that regulation encourages or, at least does not penalise intermediation in domestic currency.
  2. The use of local currency, or at least indexed instruments should be promoted.
  3. The institutional set-up of the central bank as well as its monetary policy strategy should be geared towards reducing uncertainty about the value of the local currency (IQD) throughout the transition process.

Some academics argue that it is not necessary to wait for these pre-dollarization reforms to initiate dollarization. They argue the very act of dollarization with produce the necessary changes needed to smoothen the operation of the new regime. Those who stand by this viewpoint believe an independent monitor policy will necessarily accelerate the pace of reforms.

Ismael Ismael is a master’s student of financial economics at Kent State University-Ohio. He has previously worked as a senior finance assistant at United Nations High Commissioner for refugees, and as a graduate assistant at the University of Duhok. 

3 Comments on Consequences of KRG’s dollarization

  1. Thank you for a really interesting piece! I would like to discuss this topic further if you are still available. Just email me.
    Many thanks,

  2. Ismael Ismael // August 16, 2014 at 9:51 pm // Reply

    Thank you for your Comment. We are looking forward to translate it soon

  3. This piece need to be translated into Kurdish. It is really very well explained and the recommendations are very practical. This work need to be submitted to the KRG’s ministry of finance and explain to them that dollarization has good and bad sides. I don’t think they really understand it as it has been explain here by you. Please, send it to KRG’s ministry of Finance in Kurdish.

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