Will Iraq Devalue Dinar ?

Iraq - Exchange Rate Policy - Nov 10 2011

BMI View: There is a strong case to be made in support of the argument for a devaluation of the Iraqi dinar, including improved fiscal dynamics, greater reserve accumulation, and export competitiveness. However, we believe political and other considerations in support of the current peg of IQD1,170/US$, including inflation and social stability, will prevail over the medium term.

We do not foresee a major change in the country's exchange rate policy going forward (apart from a potential redenomination - see our online service, April 15, 'Redenomination Of Dinar Will Have Negligible Impact). Local media sources reported that the Central Bank of Iraq (CBI) had sold US$205mn on October 31, above the prior week's sale of US$154mn, whilst it had consistently sold similar sums in recent quarters.

This peg, which is being set at an artificially high level, is costing the country billions of dollars per year in foreign exchange and reducing the government's revenues in local terms. However, it appears that Baghdad has continued this policy in order to limit imported inflationary pressures and to promote economic stability in the country, and we believe the policy will continue over the medium term.

The Case For Devaluation

Devaluation of the dinar would bring several benefits, most notably related to fiscal revenues. The government relies heavily on oil exports for its revenues, and a weaker dinar would allow each dollar of hydrocarbon receipts to go further in paying dinar-denominated expenses. Baghdad has been eager to invest in capital projects, particularly those related to electricity, energy, and housing, and also increased current expenditures on items such as subsidies and a larger payroll. A devalued dinar would go a long way towards setting the country on a path towards greater fiscal stability (see accompanying chart).

Depreciation Would Improve Fiscal Accounts Dramatically

Iraq - Budget Balance Under Two Scenarios

Source: BMI

A weaker local currency would also allow the government to accumulate reserves at a faster rate. As stated earlier, the current peg is causing the CBI to sell millions of dollars every week, and those funds could instead be used to build up foreign reserves even more. While Iraq's reserves, which amounted to US$55.2bn at the end of September, are far from being depleted, continued sales of foreign exchange may not be sustainable over the long term.

Cashing In On Higher Energy Prices

Iraq - Net Foreign Reserves, US$bn

Iraq - Net Foreign Reserves, US$bn

Similar to many countries across the Middle East, Iraq is seeking to diversify its economy away from oil, and a devaluation would make its exports more competitive in the global marketplace. With hydrocarbons making up over 90% of all exports and over half of GDP, along with double-digit rates of unemployment, a competitive export sector would facilitate greater investment in sectors other than energy and, in turn, create more employment opportunities.

Sticking With The Status Quo

While the aforementioned arguments suggest strong economic cases for a devaluation, we believe other factors will outweigh them over the medium term. Iraq is a major importer of food items, being among the world's top ten importers of wheat. Food also takes up a large portion of Iraqis' disposable income (as evidenced by the fact that food makes up over 60% of the consumer price basket). Thus, the importance of maintaining low food prices cannot be discounted, particularly at a time when price shocks have sparked large-scale unrest across the region.

Stronger Exchange Rate Has Contributed To Lower Inflation

Iraq - IQD/US$ Exchange Rate (LHS) And Inflation, % chg y-o-y (RHS)

Source: BMI, Bloomberg, COSIT

Higher food prices due to a devaluation would not only have an impact on the country's political risk profile, they would also force higher government spending. Baghdad currently runs a costly Public Distribution System, which provides a ten-item food basket to the large majority of households every month. This programme is intended to limit the impact of food prices rises on the public, and the government has allocated US$3.4bn of its 2011 budget (approximately 6%) to paying for all the goods. Thus, while a devaluation would make every petrodollar more valuable in local currency terms, there may be unintended consequences such as a larger food bill.

Projecting a sense of stability is a major goal of the government, as it would increase investor appetite for foreign direct investment (FDI), and the current peg to the dollar gives the impression of contributing to macroeconomic stability in our view. By relegating monetary policy to the management of the Federal Reserve, Baghdad is allaying investor fears that a mistake in monetary policy could send the economy crashing in the medium term. As a result, while export competitiveness is a major consideration, we believe the aim of building investor sentiment by linking Iraqi monetary policy to that of the US is an even more decisive factor and will continue to be over the medium term.

IRAQ - EXCHANGE RATE
	2008	2009	2010	2011		2012		2013		2014		2015		2016
Exchange rate IQD/US$, ave ¹	1,193.18	1,169.07	1,169.00	1,170.00	f	1,170.00	f	1,170.00	f	1,170.00	f	1,170.00	f	1,170.00	f
IQD/US$, ave % change y-o-y ¹	-4.9	-2.0	-0.0	0.1	f	0.0	f	0.0	f	0.0	f	0.0	f	0.0	f
Exchange rate IQD/EUR, ave ¹	1,746.36	1,638.00	1,551.96	1,673.10	f	1,614.60	f	1,521.00	f	1,462.50	f	1,462.50	f	1,462.50	f
IQD/GBP, ave ¹	2,200.53	1,813.50	1,813.50	1,907.10	f	1,942.20	f	1,989.00	f	2,047.50	f	2,047.50	f	2,047.50	f
IQD/AUD, ave ¹	1,012.37	928.23	1,075.23	1,224.99	f	1,053.00	f	877.50	f	877.50	f	877.50	f	877.50	f
JPY/IQD, ave ¹	0.08	0.08	0.07	0.07	f	0.07	f	0.08	f	0.08	f	0.08	f	0.09	f
IQD/CNY, ave ¹	171.04	171.32	172.31	180.69	f	182.96	f	184.81	f	188.58	f	192.43	f	196.36	f
Notes: ^f BMI forecasts. Sources: ¹ BMI.