Missing Economic Strategy in Iraq

Missing Economic Strategy in Iraq

Clark Johnson

Summary (2016).  This paper was prepared in early 2010, when it might still have been possible to advance an agenda for a diversified private sector in Iraq.  We missed our opportunity.  US economic strategy passed through stages: first, we encouraged privatization and price liberalization; years later, almost absent-mindedly neglecting private sector development, we shifted efforts to getting the Iraqi government to speed-up spending of oil revenues – an effort that failed with the collapse of oil prices in 2008.

Efforts to build a private sector failed in large part because the Iraqi economy lacked a market-based source of finance. We concentrated on commercial banking – which in fact cannot work without sophisticated infrastructures of financial analysis and regulatory oversight.  Alternative, simpler channels (following international practice) would include some combination among having MOF facilitate letters of credit for small contractors, factoring of receivables, equipment leasing, facilitation of use of civil servants as loan guarantors or even as lenders, and structured commodity finance.  Longer term agricultural and real estate finance would require enhancement of property rights.  Reform-oriented Iraqis wanted US support.

In monetary policy, we should have encouraged Iraq to link its dinar to an outside exchange standard – dollars, euros, perhaps a GCC regional currency.  Monetary isolation in a small economy stunts financial integration and extends reliance on support from international donors.

Missing Economic Strategy in Iraq (Drafted, 2010)

Much of the story of the U.S. and Coalition effort in Iraq from late 2006 has been about discarding one security strategy and then implementing new approaches that have succeeded beyond expectations.  A diplomatic and human disaster was averted, to the point that a less violent and politically stable Iraq has become a realistic prospect.   Nevertheless, the stability is fragile, and Iraq remains “in play.”  Military correspondent Thomas Ricks concluded recently, citing discussions with Ambassador Crocker, that Iraq is likely someday to be remembered for things that have not yet happened.  [For example, the departure of the US in 2011 and the subsequent rise of ISIS.]  Inter-sectarian strife, even civil wars, both of which have occurred recently in Iraq, have high rates of recidivism. 

The military turnaround has not been matched in the economic sphere.  Unemployment and underemployment remain widespread, private sector and agricultural credit are difficult to obtain, and the pace of non-oil foreign investment is anemic.  The role of oil exports as an economic driver is scarcely dented.  Various Iraqis have told me, approximately, that we are “re-patching together Saddam’s old government-dominated economy.”  Certainly there is little evidence of growth in the size of the non-oil economy.

To some extent this reflects inertia on the part of Iraqis, particularly those who have spent much of their lives in state bureaucracies.  But it also reflects an inadequate economic policy on the part of the Coalition.  What follows will illustrate some of the efforts made since 2003, and their limitations.  Different US and international agencies lacked either authority or capacity to devise overall strategies, with the result that policy embraced the most conventional “default” views.  Back in Washington, senior department and agency officials declined to challenge decisions made in the field – or to challenge their absence.  Lack of cogency was reinforced by frequent turnover of personnel.  The good news, nevertheless, is that a more cogent and unified economic strategy could still be introduced in Iraq, and the benefits from it might be considerable. 

Grand Vision Fades

The grand vision in 2003 was to create a market-driven alternative to the oil-based and state-dominated economic model common in the Middle East and in other petroleum exporters such as Iran and Venezuela.  This economic model was offered alongside “democracy” as an alternative to the region’s typically centralized and autocratic political practice. 

In that spirit, the focus from the first few months was to encourage Iraqis to privatize state-owned enterprises.  Iraqis dragged their feet.  One objection to privatization was that it would lead to shuttering enterprises and loss of employment; in this, the Coalition’s privatization effort was seen as parallel to what was viewed as the large mistake of disbanding the Republican Army under Coalition Provisional Authority (CPA) chief Paul Bremer shortly after his arrival in May 2003.  Following the collapse of the Soviet Union a decade earlier, the sale of state-owned enterprises moved forward in part because many of them had protected access to vast raw material resources – hence well-positioned managers and others had an incentive to privatize resources and pocket their rents.  In Iraq, oil resources (the country’s crown jewels) were not to be up for sale, and most other state-owned companies showed limited prospects for profits or capital gains.  For these and other reasons, there was thus little constituency for privatization in Iraq, and the effort flagged.  It suffered further when a CPA lawyer pointed out that an occupying power had no authority under international law to sell state assets.

The effort to privatize in 2003 was conceptually out of sequence.  The economic argument for selling state-owned companies to the private sector is that assets will be redistributed to private owners who are able to make the best use of them.  But where financial markets, including markets for corporate assets, are thin, the judicial system scarcely works, and rules on corporate bankruptcy are weak und untested – it is implausible to expect that state assets can be efficiently distributed.  The difficulties increase if we consider that by the summer Iraq had entered a spiral of civil breakdown.

At the same time, there was an effort to boost the state-owned banks, eventually to be privatized, but within a shorter time frame to enhance intermediation between savers and borrowers.   The state-owned Rafidain and Rashid were an early focus of Coalition advice.   In 2003, the CPA mandated cross-cancellation of state-owned enterprise loans and deposits on bank balance sheets.  We sought ways to remove Saddam-era

liabilities from state-bank balance sheets.  The Trade Bank of Iraq (TBI), a joint effort by the Government of Iraq (GOI) and several large international banks, was set up, initially with a two-year charter, to provide letters of credit (L/C’s) in connection with public sector reconstruction needs.  But neither the state banks nor TBI, itself a quasi-state bank, were equipped to lend to private sector enterprises.  A number of private banks sprung up, but they too have not been a large source of private sector lending.  And the head of one of the private banks told me in early 2008, in a summary that probably applied to Iraqi private banks generally, that most of their credit was extended to “insiders.”  (This practice would be illegal for a Western-regulated bank.)  A Central Bank (CBI) source estimated to me in late 2008 that some 85 percent of private bank lending is for speculative purposes.

As the early vision for privatization and banking reform was frustrated – although never abandoned -- economic strategy floundered.  Coalition military leaders – who have insisted from the beginning that finding jobs for Iraqis was critical to achieving and maintaining stability – looked elsewhere for direction.  Their response was to increase Commander Emergency Response Funds (CERF) and other military-controlled outlays for project-by-project efforts, essentially an extension of the role of Civil Affairs units in immediate post-combat environments.

Urged on by Coalition military leaders, the US Defense Department (DOD) then introduced civilian-led job creation efforts.  A DOD project (Brinkley Group) reversed the emphasis on privatizing state enterprises, for awhile pumping money into or buying equipment for often non-viable firms with the intent of maintaining or boosting employment over short-to-medium horizons.  They also launched efforts to support private banks.  DOD efforts were often led and conducted without coordination with those of State or Treasury, and even in physical isolation from them – although by most accounts communication later improved.  Reflecting typical turf and time-management issues, but perhaps also lack of mission-wide coherence on economic issues, the US Agency for International Development (USAID) and State-directed Provincial Reconstruction Teams set up barriers to access and discussion with representatives and contractors from outside agencies. 

The grand schemes of 2003 gradually faded.  GEN Petraeus, in his April 2008 Congressional testimony, described his objectives as “minimalist”, with a goal of “sustainable security” – without mentioning “democracy.”  This sort of mission scale-back led also to a damping down of economic objectives.  That was unfortunate, as the reasons for introducing democracy are distinct from those for introducing market-based economics.  The national elections of December 2005 contributed to the sectarian divide (in part attributable to use of closed party lists) that brought Iraq to the verge of civil war the following year.  But it is hard to see a “down side” to advancing economic reform.  Even authoritarian governments gain stability and legitimacy from improved economic performance – China, Chile, and Singapore come to mind.  The centralization of economic decision-making typical in oil-driven economies reinforces centralized political power, discourages transparency of information and governance, and puts a brake on moves toward participation in political processes.

As security has improved, the attention of most Iraqis has shifted to their economic prospects.  Discussion during 2008 and 2009 with GOI and private sector officials suggests that a constructive role from the US Embassy or other advisors would be welcome.  An Iraqi banker told me he believes the economic situation will play a much larger role in determining political stability in Iraq than will any results from the March 2010 elections. 

Money, Banking, and the Budget

Monetary policy was similarly inconsistent.  Initially the Iraqi dinar (replaced by the New Iraqi Dinar in late 2003) strengthened from nearly 2000 to the US dollar to the 1400-1500 range.  The Central Bank Law was drafted and adopted, presumably with advice from Coalition and IMF advisors, to prohibit Iraq from adopting a currency board.  Nevertheless, from about February 2004 through September 2006, the Central Bank of Iraq stabilized the dinar against the dollar in upper-middle 1400 range, and introduced daily sales of dollars to meet demand.  The International Monetary Fund (IMF) endorsed the stable dinar policy in its various country reports during that period.  No less an authority on currency boards than Steven Hanke indicated that CBI then effectively operated as a currency board, but without calling it that.

Meanwhile, and potentially in contradiction to the CBI Law, the International Compact with Iraq (ICI), enthusiastically advocated by the US, and formally launched in May of 2007, calls on Iraq “to pursue closer cooperation with and to consider accession to the Gulf Cooperative Council (GCC).”  The stated objectives of the GCC include establishing a currency union.  Monetary cooperation or currency union would facilitate regional financial integration and undermine the independence of Iraqi monetary policy – either by functionally converting CBI into a currency board, or by replacing the Iraqi currency altogether.

The Paris Club debt negotiations brought large write-downs in Iraqi government debt.  To reassure creditors, the write-downs were made conditional on Iraqi acceptance of IMF conditions, the most important of which was gradually to raise prices of refined fuel to approximately regional levels.  Other conditionality required audits of the state banks, greater Ministry of Finance (MOF) transparency, and reform of the tax system.  A result was a greater role for the IMF in setting the tone of policy in the coming years.

The mandated fuel price increases were soon combined with an Iraqi government decision to restrict fuel imports, which led to a sharp increase in market prices, from around 2 US cents/ liter in late 2005 to often over $1/liter at black market stations by the summer of 2006 – well above the international open market price.  A study by the Iraqi Central Statistics Bureau found that more than 40 percent of a typical Iraqi family’s disposable income at that point went to pay for fuel.

The conditions of incipient civil war, fitful decontrol of prices on an array of goods, and rising oil revenues and government-to-government transfers, led to rising domestic prices, usually measured in the 20-30 percent (annually) range during 2003-2005.  In 2006, the fuel price increases led the consumer price index to spike upward by more than 60 percent.  During this period, the dinar was stable against the dollar, and the Central Bank freely supplied dollars to met demand in exchange for dinars -- which were then withdrawn from circulation.  Iraq effectively adopted US monetary policy.  Price inflation was a result of liberalization and of rising oil revenues – not a consequence of slack (easy) monetary policy.

CBI, presumably with IMF approval, then embraced an initiative to counter inflation by appreciating the dinar and sharply raising interest rates.  The rising dinar did have some effect on prices, as it made for cheaper imports (which comprised more than 40 percent of GDP.)  In the process, it favored the interests of government employees over private sector producers, whose profit margins were squeezed.  Higher interest rates affect the price levels by discouraging extension of credit, and the decision to raise the CBI deposit rate gave banks a risk-free alternative to private sector lending.  But as the volume of private sector lending was tiny, the boost in rates had little effect on prices.  The IMF indeed acknowledged in its August 2006 Country Report that “the banking system is largely inert” and that “the effectiveness of interest rate changes in influencing inflation is thus very limited.” 

A perhaps more important motive for raising dinar interest rates, also outlined in IMF reports, was to discourage and reverse dollarization of the Iraqi economy.  This IMF goal was consistent in spirit with the Iraqi CBI Law, which directed independent currency management -- but it opposed the declarations of the ICI, noted above, which embraced regional monetary and financial integration as conducive to private sector development.  

Dollarization reduces the central bank’s control over interest rates and the money supply – hence it must be avoided in a GOI policy mix that has implicitly favored government expansion over nurturing the private sector.  As noted in the IMF Country Report for Iraq of September 2008, “The CBI recognizes that planned fiscal expansion poses a challenge to keep inflation under control and requires a tightening of its policy stance.”  In other words – the private sector will be squeezed to constrain potentially inflationary consequences from having the Ministry of Finance spend its then growing oil revenues.  The results of these decisions at times became almost laughable.  In 2008, as private sector activity was choked by dinar appreciation, GOI budgeted an array of subsidized credits, including lending facilities through the Ministries of Industry and Minerals and of Labor and Social Affairs for $1.5 B -- or more than the net extension to the private sector through the banking system.  Lending by government ministries is no less a boost to demand, and hence potentially to inflation, than is private sector lending.

The Fund also advocated an expanded tax base for increased revenue collection -- a variation on what it recommends for almost all emerging market countries, whether or not they export crude oil.  There are several reasons why this was a bad idea for Iraq.  The most important is that, by a proportion that changes from year to year, usually more than 60 percent of GDP is collected as revenue for oil exports.  The Iraqi government, or almost any government, should be able to meet social, infrastructure, and security obligations using less of the GDP than its oil revenues comprise – without additional taxes on the non-oil private sector!  In fact, whenever GOI revenues increase more than slightly, their first use is usually toward hiring more public employees and raising their salaries -- which is hardly the way to build a market economy.

By late 2007, the security and political situation inside Iraq improved and – causally unrelated -- oil prices and export revenues increased.  GOI dollar account balances in New York swelled to over $70 B.  Coalition opinion coalesced around the view that the way to consolidate security gains was to get the Ministry of Finance to spend money faster.  This was the most unified Coalition position on economic policy since the privatization and banking effort of 2003.  The reasoning was that increased capital expenditure, and even higher outlays for current budgeting, would generate jobs and thereby increase satisfaction with the Iraqi government.  “Budget execution” became a key item in discussion, and in formal directives.  This theme pervaded the State-directed (and non-classified) Economic Annex to the annually-prepared Joint Campaign Plan in the Fall of 2008.

There were, however, seldom-remarked limitations to this approach.  First, it lost sight of the Coalition’s original goals in Iraq, which included creation of an alternative economic model emphasizing a market-based private sector (a goal still cited in official documents), not simply resuscitation of Iraq’s pre-sanction era oil-export-driven economy.  Second, and related, Iraq had two dollar funds in New York: the MOF-controlled Development Fund for Iraq (DFI) which by then consisted mostly of oil revenues; and the CBI reserve fund – which by mid-2008 was at least half-again as large as the DFI. 

Absent a dramatic decision to transfer reserve funds to the DFI, which both CBI and the IMF would (properly) have resisted, CBI reserve resources could not be budgeted.  (As MOF drew down its account, it transferred dollars to the CBI in exchange for dinars.)  The Central Bank’s reserve build-up reflected in part weak demand for imports, and, hence, weak aggregate demand generally.  While stepped-up spending from the smaller DFI would have increased demand, emphasis on it overlooks the more usual way of boosting economic activity, which is accelerated extension of market-based finance and credit (linked to easier monetary policy and more liquidity.)  But any such demand expansion was deliberately constrained by IMF conditionality on exchange and interest rates described above – which conditions were tacitly, and sometimes openly, embraced by the US Treasury and State Departments.

In part because the Coalition was so focused on oil revenue and budget issues, we were caught off-guard when oil prices fell by some 75 percent in the late summer of 2008 – and missed an opportunity.  Oil economy leaderships are most resistant to structural change when oil prices are high and budgets are flush.  When prices and revenues fall, oil-exporting governments generally show more interest in reform, and in developing a market-driven economy.  In the face of a sharp fall in oil revenues, Iraq had little to sustain economic activity.  That would have been the time to advance the sort of financial sector development agenda outlined below.  Reflecting an absence of a reform vision, the potential opportunity seems to have dawned on only a small numbers of advisors.

Reflecting this lack of organizational coherence, the State-drafted Economic Annex to the annual Campaign Plan assembles “bottom up” input from nearly everyone involved in economy-related issues, but offers little “top down” strategic direction.  I identify below several critical areas of economic development that are absent from the Annex.  Treasury has focused on the Iraqi budget process and the banking sector.  But according to accounts of private conversations, senior Treasury officials in Washington in late 2009 (and perhaps also at other times) dismissed development of the private sector in Iraq as not pertinent to US goals.

Recovery and Diversification

We should, much to the contrary, emphasize why market development in Iraq is pertinent.  Iraq has structural weaknesses typical of oil exporting countries.  These include: a rising real exchange rate (especially when oil production or prices increase), which makes most non-oil-related industries uncompetitive in world markets; lack of diversification, leaving economic well-being subject to fluctuations in oil prices; and an underdeveloped private financial sector – a consequence of the habit of depending on the government for provision of credit.  Economics research indicates that what generates growth is not the volume of investment but its efficiency – its effectiveness in creating real economic returns.  Oil rich economies often have high MOF-driven levels of investment, but few of them have developed balanced economies with sustainable non-oil sector growth; indeed, this pattern describes what is alternately called the “resource curse” or the “Dutch Disease.” 

The way forward is to diversify, which means to nurture goods and service industries that can compete in world markets, and/ or to compete inside domestic markets. Government-led attempts to diversify often lead to “white elephant” investments, and to trade barriers set up to protect affiliated workers and products.  Effective diversification requires a market-driven financial sector, one that can gradually allocate resources to where they can earn competitive returns.

Structural and longer-term considerations aside, and more immediately:  in forum after forum, Iraqis in commerce, agriculture and contracting identify the inability to obtain credit as the largest barrier to doing business.  Evidence supports them.   According to IMF data for 2006, Iraqi bank deposits and private sector lending are very limited, smaller relative to GDP than in most neighboring countries, much lower than in Iran or Pakistan, and lower even than in Yemen.  And short- and long-term capital available through other market-based financial channels – factoring, leasing, mortgages, stock market, etc. – has been even more limited.  (Americans might appreciate this by considering that the financial freeze-up in the US during September and October of 2008 created conditions comparable to the ongoing shortage of finance in Iraq.)   

The near-absence of private sector finance parallels another phenomenon, which is that few business initiatives succeed in Iraq without a government contract or subsidies.  (We have implicitly recognized the latter in efforts of USAID to offer supporting finance for large and small start-ups, as well as contingent plans for the US to budget USD 25 M for an "enterprise" fund.  Current Iraqi efforts to encourage a home mortgage market involve interest rate subsidies.)  The essential test for any investment decision lies in whether expected return on capital exceeds the cost of capital.  The inability of most enterprises in Iraq to obtain credit against receivables, equipment, or other collateral, except sometimes at steep rates, mean that the effective cost of working capital is very high.  Meanwhile, economic demand is suppressed by interest and exchange rate policies -- hence expected returns are lowered.  Financial sector deepening can reduce the cost of capital, boost liquidity, and increase prospective returns. 

An empirical pattern is that countries with a high degree of central planning tend to have more corruption; this conclusion fits evidence of most Soviet and former Soviet republics, the bulk of socialist economies, and many whose economies are based on export of oil and other natural resources.  A move toward market-based resource allocation is, accordingly, among the most useful steps we can take to reduce the level of corruption in Iraq.  It would also be self-reinforcing, as less corruption encourages private investment, in a virtuous cycle.

A unifying theme of Coalition advice should be to advance a multi-dimensional effort to create a market-driven financial sector and adopt modern property rights.  Were Iraq to move in this direction, it would become possible to generate sustainable (non MOF-funded) employment.  Three foundations of this policy would be:

• A monetary framework based on a stable dinar and interest rates anchored on regional and international levels, and, hence, conducive to financial sector integration;
• Developing alternatives to domestic bank finance, including foreign banks, factoring of receivables, trade IOU’s, equipment leasing, use of civil servants as guarantors, etc.; and
• Enhancing property rights, which would facilitate issue of mortgages against land, as well as encourage longer-term perspectives on the part of investors and owners. 

Other Coalition-led initiatives have landed in the rocks because they were undertaken without the context of such a strategy.  Two examples involve the Iraqi Stock Exchange (ISX) and the Iraq Foreign Direct Investment Law (FDI Law).  The ISX is kind of initiative that should contribute to building a financial sector.  But an Iraqi banker tells me, “It is a shadow, it is not reality.”  To this point, only a small amount of long-term capital has been raised through new share offerings over the ISX.  It is unlikely that much will change here until other kinds of finance become more available.  Where working capital and medium term loans and leases are scarce, we are unlikely to see significant commitments for long-term capital.  The ISX would also benefit from monetary and currency reforms that would facilitate Iraq’s integration into external financial markets. 

The FDI Law has been criticized as a barrier to investment for lots of reasons, but the most frequently cited is that, as passed in 2006, it did not permit foreign investors to buy land.  A legislative revision to permit non-Iraqi land purchases was recently adopted and broadcast with fanfare at the Iraqi Investment Conference in Washington DC in October 2009.

Subsequently, the revision was declared invalid in an Iraqi court because it was in conflict with other Iraq law that did not permit land purchases.  (Incidentally, it has been a puzzle why the land ownership issue got so much attention; in most emerging market environments, foreign investors are content with long-term leases.)  Disquiet over the land issue reflects deeper confusion over issues of contracts and other authority in Iraq.  Property law in Iraq is not only confusing, it is based on principles different from those in nearby countries.  It will have to be addressed as an area for fundamental reform and revision, not a something where an isolated legislative adjustment can introduce structural change.

A third example might be the “capacity building” efforts now underway in various ministries.  We of course want better government performance -- but the role of government ministries in oil-export economies sometimes has little to do with performance.  Public sector jobs are instead a “benefit”, almost an entitlement, distributed as revenue becomes available.  Only as Iraqis’ expectations about the role of government changes can we expect to see a “performance ethic” take root.   It is likely that our capacity building efforts will bear limited fruit if they are grafted onto the fairly narrow set of development objectives now in place.

Monetary Policy

In early 2009, the IMF and CBI relented in their focus on reducing inflation as the oil price collapse and the international recession took hold.  But for several months in 2007, the central bank paid commercial banks 20 percent or more for risk-free dinar deposits at a time when the dinar was appreciating against the US dollar – and dollar rates were typically in single digits.  Given those risk-free returns, Iraqi banks had even less reason than otherwise to lend to the private sector.  The high rates were also a barrier to generating any sort of non-bank finance, including factoring and leasing, as bank lending costs tend to become standards for other financial transactions.  (It is true that almost nothing was done at the time to encourage such non-bank activity, but that too represents a lack of strategic foresight.)

It is fashionable among economists to advocate that central banks target domestic price stability (“inflation targeting”), which implies monetary policy “independence” in management of a separate currency and, hence, assumes fluctuations in the exchange rate.  This fashion has clearly guided CBI and IMF policy in Iraq.  On its face, an independently managed local currency was a strange policy choice for Iraq.  Most nearby oil-exporter economies linked their currencies to the dollar, and probably none were free-floating.  By what economic logic should an area with the GDP about the size of that of the New York City borough of Queens adopt its own currency and have its own monetary policy?

There are a variety of reasons why developing countries often choose to forego monetary independence in favor of linking their exchange rates to major international currencies.  One is that most developing countries lack forward markets in foreign exchange, which would allow importers and exporters to hedge exchange exposure.  A second is that many governments limit foreign exchange exposure by domestic banks, for valid, prudential reasons -- but doing so prevents banks from being active dealers to stabilize the exchange rate.  Flexible exchange rates are thus perceived by many governments as a cause of instability.  A third reason, especially relevant here, is that most developing countries lack financial markets in their own currencies that can provide access to short- or long-term capital.  Some firms in developing economies are able to access offshore dollars or euros, but doing so in the context of floating exchange rates exposes them to un-hedgeable currency risks. 

Given the strategic emphasis that should go to financial sector development, the third point alone suggests a serious flaw in the inflation targeting rationale.  In the case of Iraq, replacement of inflation-targeting by hard-linking the dinar to an external standard would help Iraqis access well-developed external financial markets, and hence not be limited to the very thin markets inside Iraq.   Considerable evidence indicates that financial deepening in emerging markets – outside of the largest, e.g. China, India, Brazil – is closely linked to dollarization, or other use of international currencies.  Other evidence over dozens of small economies with floating exchange rates shows a pattern of increased reliance on credit from multilateral lenders including the World Bank, IMF, and Asian and African Development Banks, etc., despite the near flood of private sector capital that moved to better integrated economies.  (Manual Hinds, Playing Monopoly with the Devil, Yale, 2007)

Nobelist Robert Mundell told a Fund interviewer in 2006 that he believed the IMF played a “divisive role” by encouraging countries to move to flexible exchange rates, thereby “balkanizing the monetary world into a ridiculously large number of tiny currency areas.”[1] (IMF, Finance and Development; September 2006, Volume 43, Number 3)  Even Milton Friedman, the pied-piper of flexible exchange rates theory, proposed in the 1970s that Yugoslavia, a country with a scarcely-developed financial sector, should fix its currency to the deutschmark.

A strict version of this contrary view advocates that developing country central banks should give way to currency boards, which link domestic monetary policy directly to that of an external key currency.  An even stricter version urges developing countries to replace their domestic currencies with an international currency – usually the dollar or the euro.  In the case of Iraq, either, or, perhaps, both versions of hard-linking would be compatible with a switch later to a GCC-led currency union, a goal in the ICI, and in which the Iraqi dinar would presumably disappear. 

Financial Sector Development

Iraqi commercial banks make few SME (small and medium enterprise) loans, which reflects a variety of structural factors, including lack of capacity to analyze risk, inadequate legal support for secured transactions, and unreliable financial statements.  In part to overcome these obstacles, collateral requirements are often set very high, which further discourages lending.  The state-owned commercial banks Rafidain and Rashid have large deposit bases, but are essentially out of the game as long as concern about foreign attachment of their assets based on Saddam-era claims persists.  Also, the IMF recently estimated that the state banks need injections of about $13 B of additional capital – which hardly seems likely in the current budget environment.

We cannot count on bank lending to increase greatly in the near future – although we should proceed with capacity-building initiatives.  USAID training efforts, as well as support for the Iraqi Bank Guarantee Corp. (an effort to pool bank resources in support of medium-term lending) get good marks in discussion with private sector Iraqi bankers.  Similarly, bankers are hopeful about DOD/ Brinkley Group)-sponsored training efforts.  Constraints include lack of oversight capacity and inadequate prudential regulation -- without which more extensive lending would endanger deposits and potentially invite financial instability.

The late Ronald McKinnon, an international development and macroeconomist at Stanford University, suggested alternative finance channels:

[D]eposit-collecting banks [in transitional and emerging market economies] may have little experience in aggressively seeking out borrowers who can pay ... yields that accurately reflect high social productivity of the investments they are undertaking.  Indeed, the whole process of seeking out small and innovative entrepreneurs in industry and agriculture outside the urban enclaves may be quite foreign to the banking system's previous experience - particularly in the socialist economies...

[I]n the initial stages of the transition to a more open capital market, reliance on nonbank sources of finance and on self-finance might well be preferred... Indeed, large commercial banks may be the wrong institutions for small-scale loans, and an informal credit market that includes rural credit cooperatives, the factoring of ordinary trade credits, and traditional moneylending could well remain important for many years, as in the Taiwanese example.  (The Order of Financial Liberalization; Princeton, 1993)
 

Foreign banks should be encouraged, both for the almost automatic integration they provide with external financial markets, and for the talent and learning opportunities they can bring to the domestic Iraq market.  Yet a difficult legal and regulatory environment awaits them.  Would-be investors are likely to encounter an unfriendly 1983 Company Law (even though a friendlier CPA-era Company Law is “gazetted;” that is, made formally binding), while the CPA-era Central Bank Law lacks implementing regulations.  Appropriate administrative changes to support the CPA-era laws should be adopted with urgency.

In the case of Iraq, there are further alternatives to consider (and this is a process that should involve Iraqis and discover Iraq-specific solutions.)  Banking volumes in Iraq are small – large “flow” items in the Iraqi economy are oil-revenue-linked, which means government contracts and civil servant salaries and pensions.  We should look for ways to use such cash flows to nurture market-based finance.  The regulatory and legal issues in developing such channels are usually simpler than those involved in collateral-based lending and in establishing sound prudential oversight. 

In the near-term, we might encourage MOF to collateralize L/C’s through private banks to facilitate credit in support of GOI contracting – without access to letters of credit, less capitalized contractors cannot bid for any but small contracts.  In one step, MOF action to support L/C’s for contractors could both boost private banks and help small firms begin to build banking relationships. 

We could recommend – as proposed to me by a senior CBI official -- revision of the civil service statute so that government employees would be permitted to engage in commercial activity, and specifically so they may be authorized to guarantee bank loans and other types of credit.  (One USAID lending program has made use of civil servants as loan guarantors, usually on a small scale – but this might serve as a prototype for larger programs in the future.)  This revision would have the added benefit of effectively bringing civil servants, who tend to be relatively well-educated, into the market economy.

Alternatives to traditional bank lending might also include equipment leasing and structured commodity finance.  Equipment leasing can offer access to long-term finance – rarely offered by banks -- by allowing farmers or others to obtain capital equipment.  It is relatively safe and legally uncomplicated for the lessor, as equipment can be reclaimed in the event of non-payment.    For leasing to be a viable option will require change in the Law of Industrial Development, which requires that companies own equipment as a condition for registering.  It may also require a change in the Agricultural Cooperative Law, which has discouraged farms from operating on a for-profit basis.  In some countries, including Pakistan and Uganda, government entities have been set-up or adapted to facilitate leasing.  At some point, it might be profitable for an international equipment manufacturer to provide machinery leases (for example, as a John Deere subsidiary has done in Mexico.)

Business people in Mosul proposed to me in early 2008 that we take steps to establish a grain exchange.  Structured commodity finance – packaging of warehouse receipts, for example – can provide post-harvest finance in agriculture.  An initiative would begin by providing improved storage facilities for newly harvested grain and other commodities; next would come product grade standardization, hence commoditization.  This framework would set the ground for introducing warehouse receipt financing in an economy where other kinds of market-based lending to farmers have been nearly absent.   Such financing, based on collateralizing goods already produced, and then placed in safe warehouses, and standardized, can much increase the competitiveness of producers.  It can also proceed despite general weakness in the banking sector.  In some cases it will be easier to use farm associations – of which I believe there are now more than 200 in Ninewa alone -- as transaction counter-parties, rather than individual farmers.

Factoring of receivables could offer an alternative for short term enterprise finance, first, by simplifying collateral requirements, and, second, by shifting credit risk away from small sellers to larger, better-known buyers.  A 2006 World Bank study concluded that factoring of receivables might “be a powerful tool in providing financing to high-risk informationally opaque borrowers... and particularly important in financial systems with weak commercial laws and enforcement and inefficient bankruptcy systems.”  An

Iraqi lawyer has identified two legal steps that might help to facilitate factoring.  First, recognize factoring as a sale and purchase; second, change the Central Bank Law to permit banks to engage in factoring.  Once the legal framework has been adjusted, GOI might adapt one of a number of state-owned finance entities to serve as a platform for factoring in Iraq.  An effective factor would essentially become the equivalent of a large credit information exchange.

All of the alternative finance channels suggested here are interest-rate-sensitive, and none could have been viable during the period of anti-lending monetary policy.  Relaxing of that stance make the present a good time for financial sector initiatives.  Yet IMF reports and directives neglect mention of such nonbank channels – as do State and Defense Department and USAID planning documents.  None of the suggestions above are included in Campaign Plan Economic Annexes.

The essence of the suggestions above is in using some imagination to find ways to use assets to generate finance.  Iraqis in the private sector, CBI bank, the legislature, and even in the al-Maliki Administration have ideas for generating financial networks.  The importance of the suggestions here is not in the details, but in understanding that US leverage might be used to leverage of reform-seeking and market-oriented Iraqis. 

Property Rights

Property rights are critical to expanding financial opportunities, because land is the most important loan security around, especially for long-term mobilization of capital.  Less than 5 percent of agricultural land in Iraq is held in freehold (or fee simple), which is bankable, that is, acceptable as collateral for lending.  The remaining agricultural land is owned by the state, and is held either in tessaruf (an often tribe-related use right) title, which has modest legal protection, or as leased or distributed government land, which has less.  With rare exceptions, banks do not accept tessaruf or distributed land as security for lending. 

Poorly developed property rights close off at their root many potential opportunities to develop or provide finance.  Land rights gains added importance in oil rich countries, because mobilization of land finance facilitates economic diversification, and can offer a source of wealth independent of the oil sector and of government officials generally.

To be effective, we (and Iraqis) will also have to address complicated patterns of ownership, especially for tessaruf titles.  Even if tessaruf titles were bankable, banks would be uninterested in security with scores or hundreds of owners.  For large ownership blocs, we might convert joint into corporate ownership (as proposed in a State-funded Business Development Zone funded project in 2006.)  Other legal forms could work better for smaller holdings.

Several well-informed Iraqis have told me that establishment of property rights would be taken as concrete evidence that the powers of the government were limited – and that they believe this would create an “extremely important” barrier against a return to authoritarianism.  It would boost GOI’s legitimacy, and, on balance, increase national cohesion.  

To now, little has been accomplished regarding rural and agricultural property rights.  (We have begun to address some urban land rights issues as they might affect housing construction.)  In fact, effective property rights cannot be introduced overnight, and Iraqis must build their own consensus on the best way to proceed.  A Ministry-level Iraqi in Baghdad told me in early 2008 that he considered the agricultural land issue to be pivotal, and wanted to take it up with members of the Council of Representatives, and with the Prime Minister.  But he vented frustration that he had gotten no encouragement from anyone at the US Embassy or elsewhere in the Coalition in support of his efforts – and he insisted that nothing could be accomplished without that support.  As far as potential odds-enhancers in our approach, non-bank finance is “low hanging fruit.” 

Conclusion

Ricks notes in his recent book on Iraq policy during 2006-2008, The Gamble, that the impetus for change in military strategy from conventional war to counterinsurgency came from a retired general officer (Jack Keene), and some interested Washington think-tanks, led by the American Enterprise Institute.  The senior tier of active duty military officers at the Joint Chiefs and the Pentagon continued to back what Ricks and others considered a losing strategy.  Even as GEN Keene’s active duty allies Petraeus and Odierno implemented a strategic turnaround, many ranking officers resisted it.  Ricks may insufficiently credit on-the-ground support for and implementation of counterinsurgency methods among mid-level officers during much of 2005 and 2006; but there could be no strategic success until the approach was endorsed at senior levels, and reinforced with increased manpower.

It is tempting to draw a parallel in economic strategy.  We have on-the-ground advisors, some of whom have spent years in Iraq, who understand the paucity of accomplishment thus far.  Some advisors understand the financial sector, land, agricultural, and monetary issues – but have not been able to impact strategy.  Military officers working on non-combat operations at times have an almost palpable impression that something is missing.  My sense is that we generally do not have the wrong strategy on economic development; rather, what we have is a lot of projects, and almost no strategic direction.

For example, I have been told on a number of occasions that the State Department was actively opposed to raising the visibility of the property rights question.  Then one day in the Autumn of 2007, I heard Ambassador Crocker speak to welcome a conference on agriculture in which he casually commented that Iraq would not reform its agriculture until it sorted out property rights issues.  As it happens, property issues were not even on the agenda for that conference.  And they were not mentioned in subsequent Economic Annexes – which were presumably drafted under the Ambassador’s oversight.

On another occasion I asked a senior USAID official working on private sector and banking issues if his group had given any attention to factoring of receivables as a mechanism for providing short-term finance to small and medium enterprises.  He seemed momentarily taken back, then he said he had not heard anyone mention factoring for the last twenty years.  Factoring is used in much of the developing world for short-term enterprise finance – and it should be included in our strategic thinking in Iraq.

The strategic vacuum is not confined to US agencies.  As an illustration, the World Bank has drafted a large number of papers during the last decade on factoring, leasing, and rural finance.  Yet in my dealings with World Bank officials in Iraq, they appeared to be unaware of this work by others in their own organization, and in any event wanted instead to concentrate on – and limit efforts to -- the long-standing task of restructuring Rafidain and Rashid Banks.

We have for years given lip service to market based finance, building a private sector, and agricultural reform.  But it is not serious to discuss market-driven finance and private sector development without some attention to monetary policy and property rights. 

It is late, but perhaps not too late.  The decisions early in 2009 to reduce CBI administered interest rates and to stabilize the dinar make it possible to plan the next steps, which should include working with GCC countries toward establishing a common currency and monetary policy.  The decision to lower interest rates itself begins to melt away what had been a large obstacle to development of any sort of finance, in or outside of banking channels.

A consequence in part of the Paris Club debt agreements is that US Government agencies, led by the Treasury, came to see their role as that of carrying out IMF mandates – which have thus set the tone for economic policy.  But the Fund tends to emphasize dis-inflation, fiscal constraints, liberalization of controlled prices, and restructuring of state-owned banks and enterprises.  As important as these are, they should be considered within a context of development, or what the World Bank and others have called “second-generation reforms” -- including financial deepening, property rights and a legal environment that would better protect investors’ rights.  Such reforms, nearly absent from Mission plans, are not usually the province of the IMF; someone else should have come forward.  It is time to act on what the US Army would call “lessons learned.”