How a Currency Crisis in Iraq Risks Fight Against Islamic State

Jack Fairweather Rinat Gaynullin

Any currency crisis usually comes with dire consequences for a country, and the threat of one in Iraq shows how the impact can go beyond the economy and markets.

A foreign-exchange crunch because of a drop in oil prices could force a devaluation of the dinar and risk making the fight against Islamic State militants even tougher. The nation, currently OPEC’s biggest producer after Saudi Arabia, is dependent on oil revenue to fund its operations on the battlefield and quell growing unrest over the economy.

Iraq's Looming Dollar Shortage

Dollar reserves tumbled about 20 percent to $59 billion as of July 23 since the fighting escalated a year before, and the losses are accelerating. In the first 25 days of August, the central bank sold $4.6 billion of currency to keep the dinar at a pegged rate, a daily outflow of about $184 million, data compiled by Bloomberg show.

“Iraq’s perfect storm means the country will continue to lose reserves until the government of Iraq decides to devalue the dinar,” said Frank Gunter, author of “The Political Economy of Iraq.” The currency could weaken as much as 20 percent over the next year, he said.

Global Wave

It raises the prospect of Iraq joining other developing nations in a new wave of devaluations as emerging markets take a hammering this month, led by China. The Iraqi dinar is one of those most at risk in the Middle East from that happening, though the current exchange-rate regime is likely to remain, according to research published on Tuesday by Emirates NBD, the biggest bank in Dubai.

Saudi Arabia’s central bank this week said it’s committed to the riyal’s dollar peg, the Saudi-owned Al Arabiya television reported, amid speculation the country would devalue its currency after the plunge in oil prices.

In Iraq, market forces are complicating Prime Minister Haidar al-Abadi’s efforts to win back territory from Islamic State. Military success has been piecemeal as the government has struggled to enlist support from mainly Sunni communities in parts of the country ravaged by attacks.

The U.S. and its allies have sent arms to the Kurds in northern Iraq and President Barack Obama’s administration plans to spend another $700 million in 2016 on support for the military. The government in Baghdad, though, pays for the bulk of the operations from its budget since the Americans pulled out their troops in 2011.

Selling Dollars

A collapse in the value of the dinar would raise the cost of living for Iraqis already protesting against government corruption, power cuts and water shortages.

“The policy now is to meet the demand for dollars,” Waleed Eedi, a director general at the Central Bank of Iraq, said by telephone on Monday. The reserves won’t be depleted because of oil sales and the dinar won’t devalue, he said.

The Iraqi central bank’s fixes the dinar’s exchange rate at 1,166 per dollar and there’s pressure on the peg. As a result, Iraq’s foreign-currency reserves may drop to about $45 billion by the end of 2016, according to Exotix Partners LLP, a London-based investment firm specializing in frontier markets.

“The authorities will try to hold on to the peg as long as possible, but may be forced to devalue if pressures continue,” said Jakob Christensen, a director at Exotix.

Few Choices

The central bank has so far resisted government pressure to print money to meet anestimated$30 billion budget deficit. It announced plans for a $6 billion bond program last week, which follows about $1.2 billion from the International Monetary Fund, though neither is big enough to plug the shortfall.

That leaves the Finance Ministry with few easy choices. The government is seeking to cut spending and tackle corruption. Other options include borrowing domestically from public banks or even forcing the central bank to buy dollar-denominated bonds from the Finance Ministry, said Gunter.

“Iraq will be able to finance its 2015 deficit, but if the battle against Islamic State and low oil prices continues, Iraq will then hit a wall,” he said.