Iraq As a Transition Economy

View metadata, citation and similar papers at core.ac.uk brought to you by CORE

provided by Calhoun, Institutional Archive of the Naval Postgraduate School

Calhoun: The NPS Institutional Archive

Faculty and Researcher Publications Faculty and Researcher Publications

2004 Iraq as a Transition Economy

Looney, Robert

http://hdl.handle.net/10945/38464 Iraq as a Transition Economy By Robert Looney

14 The Milken Institute Review ith order yet to be re-established in Iraq as these words are being written, any appraisal of its postwar economic prospects may seem premature. But it is important to begin asking how best to reconstruct the Iraqi econ- Womy – if only because broad-based economic development is one prerequisite to the creation and maintenance of a civil society. By no coincidence, much of the initial address to the nation by the interim prime minister, Iyad Allawi, focused on economic issues. Allawi, a Baathist who served in the Iraqi intelligence services until falling out with the regime in 1971, cited inﬂ ation, unemployment and weak purchasing power as the main economic problems facing the country. While he offered no speciﬁ cs for addressing these issues, he did make the case that, a year after the fall of Baghdad, security and economic progress were inextrica- bly linked. The key reason that Iraqi support for suppressing the insurgency that followed the invasion has been modest has been resentment over poverty and lack of jobs. Many of the most pressing economic decisions touch on the temptation to resort to interventionist policies in an economy

Fourth Quarter 2004 15 iraq • Import tariffs are reduced to a fl at 5 per- currently lacking the infrastructure to sup- cent, with no duties at all imposed on port competitive markets. Washington would food, drugs, books and other humanitarian plainly prefer that Iraq opt for restraint, in imports. part because free markets are more likely • With the exception of oil, Iraq’s state-owned to deliver the goods in the long run and enterprises are to be privatized (though at a in part because Baathist-style intervention time and by a method not specifi ed). would undermine the prospects for democ- The Coalition’s reforms were comple- racy and political pluralism. A third plausible mented by a series of measures designed to option, the establishment of a Saudi-style, strengthen institutions needed in a free-mar- oil-dominated economy in which stability is ket economy. Most important were the bank- maintained by paying off disaffected interest ing initiatives. Order Number 40 defi ned the groups, would hardly be likely to evolve into rules establishing and governing a new Iraqi a prosperous, viable democracy. banking system based on the Western model. It gives the Central Bank of Iraq full legal and the economic legacy of the operational authority over the payments sys- coalition provisional authority tem. More important, it gives private banks In the fall of 2003 with Iraq in ruins, the broad discretion to serve as fi nancial interme- American-led Coalition Provisional Author- diaries, with none of the limitations imposed ity imposed a series of reforms reminiscent of by fundamentalist Islamic interpretations of the shock therapy attempted in the 1990s in lending practices. most of the transition economies of Central In addition, a new Iraqi dinar was intro- and Eastern Europe. Overnight, Iraq became duced, with the central bank given indepen- the most open economy in the Arab world. “If dence in its pursuit of stable monetary and carried through,” The Economist concluded, exchange-rate policy. While many experts “the measures will represent the kind of wish recommended a fi xed exchange rate (or even list that foreign investors and donor agencies a “currency board” arrangement that locked dream of for developing markets.” Five provi- the value of the dinar to major foreign cur- sions were key: rencies), the central bank opted for a man- • With the exception of oil production and aged fl oating-rate regime. refi ning, foreigners are allowed 100 percent The management mechanism is relative- ownership of Iraqi assets, full repatriation ly simple. The central bank exchanges dol- of profi ts, and legal standing equal to local lars for dinars in a daily auction. It can sell fi rms. dinars if it deems the local currency too dear, • Foreign banks are welcome to establish or it can buy them if the dinar depreciates. By operations immediately, or to purchase mid-2004, the central bank had intervened in equity in existing Iraqi fi nancial institu- this manner on several occasions to curtail tions. speculator-driven appreciation. • Income and corporate taxes are capped at With the reduction of tariffs to levels that 15 percent. raise some much-needed revenue without signifi cantly protecting domestic producers, Iraqi producers and consumers face world ROBERT LOONEY is a professor of national security

affairs at the Naval Postgraduate School in Monterey, Calif. price levels. This exposure has already forced ed kashi/corbis previous page:

16 The Milken Institute Review Private banks have broad discretion to serve as financial intermediaries, with none of the limitations imposed by fundamentalist Islamic interpretations of lending practices.

painful adjustments in employment, wages the discovery of vast quantities of natural and prices. What’s more, the shock is likely to gas – is not a trivial problem. Indeed, it part- be reinforced by the recovery of oil produc- ly explains the relatively poor long-term per- tion and the expenditure of foreign donor formance of a host of economies that seem- funds. Both will increase the quantity of for- ingly had the advantage of generous export eign exchange in the hands of Iraqis, putting earnings. upward pressure on the exchange value of the The main advantage of the dinar’s man- dinar and raising the likelihood that domes- aged ﬂ oat is that adjustments to compen- tic goods other than oil will be priced out of sate for the effects of changing oil prices world markets. can be made in the exchange rate, rather The overvaluation of a currency linked to than in wages and prices. However, this will booming exports of raw materials – dubbed not cure Dutch disease if the country is also “Dutch disease” because of the econom- prone to inﬂ ation. Faced with a similar sit-

getty images ic damage suffered by the Netherlands after uation, other oil exporters have established

Fourth Quarter 2004 17 More than half the state-owned companies are not operating at all, and the rest are functioning at a fraction of capacity.

stabilization funds to “sterilize” export rev- defi ned property rights, needed to underpin enues. These accounts segregate part of the free markets, has also been neglected. Perhaps foreign currency earned from oil sales in a the Coalition Authority intended to defer cre- centrally managed fund, thereby reducing ation of the legal architecture to an elected upward pressure on the local currency. The Iraqi government. But unless the interim gov- idea is to accumulate cash in good times and ernment and its elected successors do com- deplete it in bad times, providing a stable plete the reform, most Iraqis will continue to balance-of-payments environment. experience a darker sort of free-market capi- Thus, if current plans go forward, Iraq will talism in which might makes right. develop as a highly open economy. It will also have many of the modern fi nancial institu- the coalition provisional tions needed to operate in the world environ- authority reforms in practice ment. Economic theory suggests that an open The economic-policy challenges facing the economy with modern fi nancial institutions new government are daunting. Among the would be best served by a combination of a most immediate: creating jobs for millions of managed fl oating exchange rate and an oil- dislocated workers, establishing a social safety stabilization fund. But while the former is in net, rehabilitating agriculture, guaranteeing place, the latter is not. stable food supplies – and, of course, funding benjamin lowy/corbis benjamin

The establishment of enforceable, well- all these tasks without triggering unaccept- ©

18 The Milken Institute Review able rates of infl ation. raised about 150 billion dinars (then, $103 Anecdotal accounts suggest that the Coali- million) by selling debt due in three months. tion Authority drew up the shock-therapy The bonds paid interest of between 5 and 8 program with minimal Iraqi consultation. percent – not enough to entice foreign partic- Iraqis, no doubt, will be able to exercise some ipation in light of the risks involved. Instead, control over the details of implementation. the vast majority of buyers were local banks. However, undertaking a full-scale shift in The short maturity of the bonds was development strategy makes little sense until designed to allow the government to prove an elected government is in place. Perhaps its creditworthiness to a skeptical market. for this reason, the interim government has Baghdad plans to issue six-month and one- shown little inclination to deviate from the year bonds later on, hoping to raise as much path laid out by the Coalition Authority. as $1.2 billion by the end of the year. One Arguably the biggest risk associated with ancillary benefi t: the development of a gov- this rigidity is that Iraqi governments will ernment debt market will introduce anoth- not be able to pursue the fi scal policies neces- er constraint on the government – if it over- sary to revitalize the economy. As noted, the spends the way Hussein did, investors will highest income tax bracket is set at 15 per- demand higher interest rates. cent. Other constraints on the government’s In a related move, the interim government fi nances involve treatment of past govern- began implementing a Coalition Authori- ment domestic debt and limits on offi cial ty initiated revamp of the Baghdad Stock borrowing from the central bank. In June Exchange. The new Iraq Stock Exchange, the Coalition Authority’s administrator, Paul which opened in June, is the product of more Bremer, signed the Public Debt Law, requir- than a year’s work by the 12 brokerage fi rms ing the Iraqi government to honor all domes- and banks that jointly own it. And, at least tic debts to Iraq’s commercial banks – debts on paper, it is buttressed by a strong regula- largely contracted by Saddam Hussein. This tory framework stressing transparency and paper is estimated to be around 1.3 trillion accountability. At the proverbial opening bell, dinars (more than $1 billion). The Public the exchange listed 27 companies; a total of Debt Law, therefore, can be seen as a way to 180 to 200 are expected by the end of the year. recapitalize Iraq’s private banks, which would The tea leaves offer positive signs: in fi ve ses- otherwise face insolvency. sions, trading volume nearly quadrupled and The central bank also holds about $2.5 the value of stocks surged. billion in Iraqi government debt. Under the While the old stock exchange contained Bond Market Plan put together by the Coali- only Iraqi companies and traders, the new tion Authority, this debt must be paid as it one will eventually be accessible to foreigners. matures. However, because the central bank The exchange plans to shift to an electronic is now formally independent, the govern- trading system in the near future. With luck, ment cannot force the bank to buy govern- the stock market will begin to lure money ment debt (as Hussein did). from Iraqis living overseas. It should be no surprise, then, that the While it is too early to make fi rm judg- interim government is attempting to devel- ments, the Coalition Authority’s program’s op a domestic bond market as an addition- fi scal and monetary aspects do not appear to al source of fi nance. In July, the central bank place impediments on the Iraqis other than

Fourth Quarter 2004 19 iraq to market forces are generally more effi cient. those found in any sound fi nancial system. Moreover, the sale of the state enterprises The rules and institutions simply represent would both generate needed revenues for the the steps responsible governments must take government and relieve it of the ongoing to lay the foundation for sustainable growth. drain of subsidies to the losers. The Authority’s enthusiasm for privatiza- A closer look, however, suggests that the tion is more controversial. U.S. offi cials see diffi culties owners would face are likely to privatization as part of a broader conserva- dampen interest in the transition for some tive economic agenda. The state still con- time. The State Company for Woolen Indus- trols almost all large businesses; the 61 major tries provides a useful illustration. The com- industries under the Ministry of Industry pany has power generators, which can keep and Minerals account for 90 percent of Iraq’s machinery moving even when Baghdad’s industrial production, including oil, leather electricity supply is down. Nonetheless, its goods and textiles. When the interim govern- fi ve functioning plants are running only one ment assumed power, most state enterprises shift out of three. And while the 3,700 workers are putting in far less than a full week on the job, they are still being paid full salaries. One major source of the fi rm’s diffi culties is the Coalition Authority’s arbitrary doubling of worker salaries after it took over in April 2003 – a move to reduce political unrest. That huge increase in operating costs makes the company’s woolen blankets, tents and clothing much more expensive than imports, which are now enter- ing the country essentially duty-free as a result of the decision to slash tariffs. Compounding the problem, fac- were in dire straits, with only the oil and tory suppliers refuse to deliver materials over cement industries showing a profi t. State-run Iraq’s bandit-ridden roads. enterprises brought in the equivalent of $73 The bottom line: privatization is a non- million in revenue in the fi rst fi ve months starter, at least for the moment. Uncertainty of 2004, but paid out $85 million in salaries over security makes it impossible to arrive at alone – much of it to the two-thirds of their fair-value bids, and the political need to keep employees who were not working. More than underemployed workers on the job makes half the state-owned companies are not oper- restructuring highly problematic. ating at all, and the rest are functioning at a fraction of capacity. the spectre of unemployment On fi rst glance, privatization would appear The U.S.-sponsored reforms have come under to be a plausible start to solving the underuti- intense criticism both inside and outside Iraq.

lization problem; private enterprises subject Much of this criticism has been focused on world photos ap/wide

20 The Milken Institute Review The damage to Iraqi goodwill caused by unaddressed unemployment was all too apparent.

their most immediate consequence – unem- Employment also fell after the war because ployment. of the Coalition Authority’s decision to dis- After the fall of Hussein’s government, band the army, which consisted of about Ambassador Bremer and the Governing 7 percent of the labor force. The coalition Council decreed that the top three levels of would later pay stipends to former soldiers, the Baath party membership could not be on but the decision to put soldiers back on the the government payroll. Estimates vary, but a streets without jobs has been blamed for safe guess is that more than 120,000 people much of the increase in violent resistance to lost their jobs. Some were diehard Saddam the occupation. loyalists. But many were doctors, nurses, uni- In addition, delays in reconstruction have versity professors and other professionals taken a toll on employment. Seven months who probably joined the Baath Party just to after Congress approved an $18.4 billion aid get jobs or to advance their careers. Not only package for Iraq, less than 5 percent had been were their productive services lost, but their spent. By late May of this year, the pace of foregone wages also had a familiar negative expenditure appeared to be picking up. How- multiplier effect on aggregate demand for ever, by then, the damage to Iraqi goodwill consumer goods. Only in April of this year, caused by unaddressed unemployment was after much of the damage was done, did all too apparent. Ambassador Bremer reverse the wholesale de- Reconstruction contracting has also played Baathiﬁ cation policy and make many laid-off a part in slowing the pace of job creation. In

ap/wide world photos ap/wide Baathist teachers eligible for jobs. principle, the system for disbursing the $18

Fourth Quarter 2004 21 iraq that growth and reform will fi t into a virtuous billion should give Iraqi companies a boost. circle, just as they did in the successful transi- They were given priority in subcontracting, tion economies in Eastern Europe. although fi rms from the 69 coalition coun- None of this will happen, however, unless tries could also bid. However, Iraqi compa- Iraq gets the breathing room to shift from nies suffered in competing with foreign fi rms an expenditures/reconstruction mindset to a because they have inadequate working capi- reform/development/growth orientation. tal and could not obtain fi nancing from the Past experience suggests that for oil-based country’s nascent banking system. economies like Iraq’s, increased efforts in As a result, reconstruction projects are four areas appear critical: rule of law, voice not putting much money into the hands of and accountability, banking and fi nance, and Iraqi entrepreneurs. By May 2004, fewer than foreign investment. Interestingly, the most 25,000 Iraqis were working on projects fund- important are the fi rst two, which fall under ed by the United States, a tiny fraction of the the rubric of governance. original projections. Of course, sustaining reform is a daunting As noted above, most Iraqi companies task. As in other transition economies, reform are not able to win reconstruction contracts can take Iraq in one of two directions. Some because they lack access to credit. Yet most countries, including Hungary and the Czech development experts agree that the success Republic, have experienced a sustained eco- of midsize businesses in creating new jobs is nomic revival and have even met the condi- critical for stability. Again, delays in restoring tions for membership in the European Union. the country’s banking system are severely lim- By contrast, some transition economies – for iting the pace of economic recovery. example, Moldova, are still struggling to dereg- In sum, Iraq’s current economic malaise ulate prices, establish institutions to support has its origins in a series of miscalculations competitive markets, rationalize the reach of by the Coalition Provisional Authority. Too government and impose effective rule of law. many decisions were made without examin- Why have some countries succeeded while ing the economic dimension. Once unem- others failed? Recent research links the fail- ployment got out of control, violence and ures to the strength of interest groups that insurgency increased, the economy suffered, benefi t fi nancially from the status quo. One and aid fl ows dried up due to the lack of safe- can already see these groups forming in Iraq ty, creating a vicious cycle that the belated – for example, among workers in the state reforms could not correct. enterprises, whose jobs often amount to sine- cures. Note, too, that many Iraqis who are peering into the future receiving subsidized gasoline, food and the The interim government seems committed like can profi t by selling these goods on the to staying the course, hoping that, with a black market. The more chance these groups number of new construction projects coming have to tighten their grip on the middle levels online, unemployment will be brought under of power, the greater the obstacle they present control – and, with it, the insurgency. One to Iraqi advancement. hopes improved security will bring more cap- To offset the infl uence of these groups, ital from abroad, stimulating reconstruction Iraqi reformers will have to create their own and job creation. Accordingly, it is possible winners – groups with a vested interest in the

22 The Milken Institute Review A good case can be made for temporary import protection to nurture infant industries.

success of the reforms. In Eastern Europe, gy sector, a good case can be made for tem- these groups have often been workers and porary import protection to nurture infant entrepreneurs associated with new small- industries. In addition, the tax system will and medium-sized businesses. And it is in have to be revamped so that the authorities just these categories that most of the new are better able to shift resources in desired jobs will have to be created in Iraq. Thus, one directions and, in the absence of an oil fund, of Iraq’s top economic priorities should be to offset oil price fl uctuations. improving the infrastructure that supports Finding ways to solve technocratic prob- these businesses – everything from depend- lems is easier than fi nding the will. The great- able telecommunications to an effi cient bank- est challenge facing Iraq’s transition to a sta- ing system. ble free-market democracy will be sustaining Although the Coalition Authority reforms support for reform. For, as Ronald Rotun- do not appear to be a major impediment to da, the George Mason University Founda- the economy’s recovery, they are unlikely to tion professor of law, observed, “It seems that perform miracles by themselves. Eventual- many Iraqis do not understand … why a mar- ly, Iraqis will have to implement a develop- ket economy can make the poor people much ment strategy that reduces dependence on oil. better off than they ever were when Saddam While the current low-tariff policy is useful in controlled the oil wealth and doled out perks allowing a clearer identifi cation of the coun- to the Iraqis like a stern parent rewards small thomas jouanneau/corbis sygma thomas jouanneau/corbis

Fourth Quarter 2004 23