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 2005 Postwar Iraq's Financial System: Building from Scratch Looney, Robert Middle East Policy, Vol. XII, No. 1, Spring 2005. http://hdl.handle.net/10945/40861 MIDDLE EAST POLICY, VOL. XII, NO. 1, SPRING 2005 POSTWAR IRAQ’S FINANCIAL SYSTEM: BUILDING FROM SCRATCH Robert Looney Dr. Looney is a professor at the Naval Postgraduate School. If I am permitted to dream, Iraq will develop into the Japan of the Middle East.1 – Talib al-Tabatie, chairman, Iraq Stock Exchange The best thing is to overhaul the whole financial system. It’s like when you have a house infested with termites. It’s much easier to knock it down and rebuild than to keep spraying for termites and fixing the holes.2 – Rubar S. Sandi, head, U.S.-Iraq Business Council n the midst of daily reports of suicide Significantly, a large proportion of bombings, insurgents, coalition interim Prime Minister Iyad Allawi’s initial casualties and the relentless toll of address focused on the economic issues Icivilian dead and wounded, any confronting Iraq. Allawi, a Baathist who appraisal of Iraq’s economy has seemed served in the Iraqi intelligence services irrelevant when set against the greater until falling out with the regime and leaving military and security concerns. Yet the Iraq in 1971, cited inflation, unemployment long-run health of the economy will be and weak purchasing power as the main crucial in determining whether Iraq will be economic problems. He indicated that the able to make the transition to a stable government planned to stabilize the dinar’s democracy. exchange rate, improve living conditions Many authorities on post-conflict and boost oil output. While he offered no reconstruction feel that the interim specific plan for addressing these issues, government’s most significant challenge he did at least acknowledge that, a year will be delivering measurable improvements after the fall of Baghdad, the country’s to the Iraqi people. The importance of this economy is at a watershed. goal was summed up by Amatzia Baram, If the security situation does not senior fellow at the U.S. Institute of Peace: improve considerably, efforts to rebuild the “I think the new government will gain economy will be fruitless. Yet improve- legitimacy in the eyes of the people on one ments in the economy are critical for condition: if it delivers on security, infra- dampening the insurgency. In testifying structure and employment. If [Iraq’s before the Senate Foreign Relations leaders] manage to deliver, even on the Committee, senior Iraqis have stressed latter two, it will make a major difference. repeatedly that a key reason Iraqis have If not, the whole thing will fall apart.” not cooperated with the coalition against 134 LOONEY: BUILDING POSTWAR IRAQ’S FINANCIAL SYSTEM the insurgency has been resentment over financial system since the fall of Saddam the lack of progress in improving conditions Hussein. In particular: (a) What was the and solving unemployment. condition of the banking system before The interim government’s economic March 2003? (b) What are the key institu- strategy to date is a continuation of the tional structures that have been put in place basic approach3 laid down by the Coalition over the last year? (c) Are these institu- Provisional Authority (CPA). Briefly, the tional structures consistent with the plan encompasses the creation of (a) country’s basic economic structure and openness and transparency of Iraq’s position in the world economy? (d) What institutions, (b) strong incentives for are the key indicators to watch in assessing private-sector development, (c) close progress made at various points in the economic and financial integration with the future? international community, (d) international standards and best practices, and (e) a ECONOMIC LEGACY OF THE CPA social safety net that addresses the needs In the fall of 2003, with Iraq’s of all Iraqis.4 economy still shattered and little recovered While many factors within this frame- following the ouster of Hussein, the CPA work will play a key role in the economy’s initiated a package of free-market reforms recovery, emphasis on free markets and reminiscent of the “shock therapy” pro- private-sector investment suggest that the grams6 carried out in the early to mid- creation of a viable, efficient financial 1990s in many of the transition economies system will be the key to the country’s of Central and Eastern Europe.7 Overnight economic recovery. In this regard, a recent Iraq became the most open economy in the UN needs assessment notes: Arab world.8 While there had been persistent rumors With a dysfunctional financial system that major free-market reforms were featuring a poorly organized regula- contemplated, most observers were tory framework and ineffective surprised at the extent to which they institutions, the task of rebuilding a embodied key elements of the neoliberal sound and safe modern financial agenda. As The Economist noted9 : “If sector in Iraq is daunting. It should carried through, the measures will repre- start with the banking sector which is currently the essential component of sent the kind of wish list that foreign the financial system and should cover investors and donor agencies dream of for the sector’s legal and regulatory developing markets.” The main thrust of aspects as well as its main institutions. the neoliberal reforms centered around five This would be a long-term process key provisions:10 that will require significant resources, technical as well as financial.5 1. Investors (except for all-important oil production and refining) would be To gauge the progress made to date in allowed 100-percent ownership of Iraqi laying the foundation for the country’s assets, full repatriation of profits and equal economic recovery, the sections below legal standing with local firms. examine the main developments in the Iraqi 2. Foreign banks would be welcome to 135 MIDDLE EAST POLICY, VOL. XII, NO. 1, SPRING 2005 establish operations immediately or to THE BANKING SYSTEM purchase equity shares in existing Iraqi The banking sector in Iraq dates back financial institutions. to the mid-1930s, when branches of foreign 3. Income and corporate taxes would banks and private Iraqi banks were be capped at 15 percent. opened. These grew as the economy 4. Tariffs would be reduced to a expanded. However, in 1964, Iraq consoli- universal 5-percent rate, with none im- dated and nationalized private banks into posed on food, drugs, books or other what is now the Rafidain Bank, the humanitarian imports. country’s largest state-owned bank. In the 5. Although no precise timetable was 1980s, the Rafidain Bank and, later, a set, Iraq’s state-owned enterprises (SOEs), second state bank, the Rashid Bank, were excepting the oil sector, were to be priva- profitable largely through financing the tized (although the method of privatization government’s budget deficits. This prosper- was not specified). ity ended when U.N. economic sanctions were imposed in 1990. From then until the The tax treatment, in particular, is a ouster of Saddam’s regime, most of the classic application of supply-side econom- state bank’s business was directed towards ics similar to the programs introduced in simply underwriting the Iraqi military and the United States in the early 1980s.11 As then the ruling party. The government explained by Iraqi Finance Minister Kamel opened its banking sector to local private al-Gailani, low tax rates will help create banks in the early 1990s to spur business strong incentives for future investment and and help offset the impact of sanctions.14 employment and limit the size of the public By March 2003, the sanctions, two sector, simplify in order to minimize the wars and several decades of Baathist rule administrative costs of tax collection, had left the Iraqi banking sector in com- create transparency to minimize tax plete decay. Greatly compounding the evasion and corruption, and promote situation was the devastation inflicted on fairness to ensure that all sectors pay the system during the immediate post-war reasonable shares of future taxes.12 period. At that time, the Ministry of The CPA reforms were also comple- Finance, the Central Bank, the Baghdad mented by a series of measures designed Stock Exchange and the two key state to strengthen institutions critical for the banks, Rafidain and Rashid, were system- establishment of a free-market economy. atically looted, as were a number of the 21 Most important in this regard were initia- smaller state-owned and private banks. tives designed to establish a viable banking The situation was so serious that, even a sector. The CPA’s Order Number 40, year later, there was no proper banking issued on September 19, 2003 (and updated sector to speak of. Iraq was still almost in a slightly modified form13 under Order entirely a cash economy. No. 94, issued in June 2004), defines the In reconstructing the banking system, rules establishing and governing the new the CPA was confronted with a structure Iraqi banking system and, in so doing, unlike that in many neighboring countries. provides a foundation for Iraq’s future In contrast to most banks in the Gulf economic growth and development. Cooperation Council (GCC) states, recov- 136 LOONEY: BUILDING POSTWAR IRAQ’S FINANCIAL SYSTEM ering Iraqi banks could not count on THE CENTRAL BANK OF IRAQ liquidity-driven profits. Very little liquidity As a necessary step in developing a existed. In addition, Iraqi interest rates dynamic commercial banking system, much were set high (17 percent) by the Central of the CPA’s initial focus was on strength- Bank.