Iraq's Next Challenge: A New Currency

Iraq is planning to revalue its currency, the dinar, cutting three zeros from its notes. The purchasing power of the dinar will remain unchanged if the government adopts the correct measures, writes Thaka’ Mokhless al-Khalidi. The author argues that this will lower the level of dollarization of the Iraqi economy.

al-monitor A man leaves a currency exchange shop in Baghdad, January 30, 2012. Photo by REUTERS/Saad Shalash.

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Feb 28, 2012

A few weeks ago, a source at the Iraqi Central Bank announced the government’s plan to [re-denominate] the [Iraqi] currency by cutting three zero from all notes, effectively dividing these notes by 1000. 1000 dinar notes would be changed to one dinar notes and 5000 [old dinars] would equal five new dinars.

The new currency will be introduced in 2012. The process will take up to two years, at the end of which the old currency will ultimately be void. However, banks will continue to accept [the old notes] for another 10 years - for exchange against new notes, not for circulation.

The source added that the purchasing power of the new currency would remain unchanged. For example, a product that currently costs 1000 dinars, would be worth one dinar of the new currency. A product that currently costs one million dinars would be worth 1000 dinars.

Two questions must be asked, for this is an issue of great importance and there are several misconceptions surrounding it - for example, some believe that they will be able to profit from buying [old] dinars now and selling them later. First, what does the government hope to accomplish with this change? Second, how will the government, or more precisely, how will the monetary authorities be able to guarantee the exchange rate between the two currencies, and make sure that the process harms no one?

In response to the first question: Until 1981, the Iraqi dinar was backed by gold reserves, foreign currencies (up to 70%) and in part by Iraqi treasury bills given that Iraq still adhered to the gold standard at the time. In order to [guarantee the value of the Iraqi currency], successive governments linked Iraq’s current and investment expenditures to their foreign assets, oil revenues and their gold reserves.

To ensure [that a balance was struck between the Iraqi dinar’s value and the country’s gold holdings], administrative restrictions were applied to foreign transfers - both in the trade of goods and services - and capital movements. Moreover, conservative monetary and fiscal policies were enforced. Consequently, the Iraqi dinar’s stability was preserved and its official exchange rate of 3.2 dollars to the dinar did not change. The Iraqi dinar was considered a safe investment inside Iraq and in the region, especially in neighboring markets. However, following the Iraq-Iran war, and given the high cost of this war, the government abandoned this currency law and started spending with no quantitative restrictions. The Iraq dinar consequently suffered from a continuous decline in both its exchange rate and purchasing power.

The economic blockade imposed on Iraq in 1990 made matters worse. Even though the Iraqi Government maintained the public exchange rate of 3.2 dollars to dinar for official transactions, a black market ruled by [the real forces of] supply and demand emerged. On this market, the value of the dinar fell to 3000 dinars to the dollar. After the [US invasion] and occupation of Iraq, the ban on Iraqi oil exports and Iraq’s reserves in foreign countries was lifted and the dinar’s value rose to around 1125 dinars to the dollar.

The Iran-Iraq War and the subsequent economic blockade weakened the Iraqi dinar. This deprived it from its status as a safe investment and [medium of exchange and store of value], forcing most of those conducting financial transactions [in Iraq] to turn to the dollar. As a result, the Iraqi economy suffered from [wide] dollarization. The first effect of the decision to [revalue] the currency would be a return to the dinar, and the widespread circulation of dinar notes of even the smallest denomination. The Iraqi economy would become less dollarized and the Iraqi dinar would take on an exclusive role [in day-to-day transactions].

Now, for the second, more important question. For the exchange rate between the two currencies to be guaranteed will require the monetary authority to issue the following orders:

Iraqi Government expenses - including employee salaries - should also be divided by 1000. An employee who currently receives a monthly salary of 1.5 million dinars would receive 1500 in new dinars. What’s more, the prices of all goods and services [must] also be divided by 1000 - products currently priced at 1000 dinars would have to be priced at one new dinar. The [proper authorities will have to] monitor the implementation of this process.

In addition, all personal, public, corporate and banking debts should be divided by 1000. A one million dinars loan would be worth 1000 dinars in the new currency. All courts and judicial entities will have to take note of this when dealing with certain complaints. However, were the loan made in dollars it would not change; it would have to be paid back in dollars just the same. Moreover, all bank deposits will have to be divided by 1000.

However, the monetary authority would still face the tough mission of determining the Iraqi dinar’s exchange rate. Will it peg the dinar to the dollar, or to a basket of currencies? Or will the authority employ [floating exchange rates] - the current system - leaving the dinar’s value to be determined by market forces, albeit limited to acceptable margins enforced by the government. The best solution for a developing country like Iraq is to peg the dinar to the dollar or a basket of currencies. However, the chosen exchange rate must reflect [economic realities], for the previous official rate of 3.2 dollars to the dinar was exaggerated. Therefore, if the current unofficial exchange rate of 1125 dinars to the dollar is divided by 1000, this will give us a rate of 1.125 dinars to the dollar, which might be reasonable. 

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