VZCZCXRO8975
PP RUEHBC RUEHDA RUEHDE RUEHIHL RUEHKUK RUEHMOS
DE RUEHGB #1287/01 1101248
ZNR UUUUU ZZH
P 201248Z APR 06
FM AMEMBASSY BAGHDAD
TO RUEHC/SECSTATE WASHDC PRIORITY 3996
INFO RUCNRAQ/IRAQ COLLECTIVE PRIORITY
RUEATRS/DEPT OF TREASURY WASHDC PRIORITY

UNCLAS SECTION 01 OF 02 BAGHDAD 001287 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN IZ
SUBJECT: UNDERSTANDING RECENT INFLATION IN IRAQ 
 
REF: A. AMMAN 2452 
 
     ¶B. DAMASCUS 1696 
 
¶1. (SBU) SUMMARY: The impact of the December 2005 fuel price 
increases contributed to a one month, one-time inflation 
spike of 13.1 percent in February 2006.  Although inflation 
is undesirable, a one-time inflation increase based on a 
badly-needed economic reform (see reftels for similar 
situations in Jordan and Syria) is preferable to the current 
"built-in," perennial inflation of 30 percent that is driven 
by government spending.  Reducing the current high level of 
inflation will require fiscal measures to control GOI 
spending, including additional subsidy reductions and 
decreased fuel imports.  Classical monetary instruments for 
controlling inflation (such as lowering interest rates, 
decreasing the money supply, and marketing T-bonds) have been 
surprisingly ineffective in Iraq.  END SUMMARY. 
 
¶2. (SBU) The 13.1 percent monthly inflation increase in 
February 2006 was unusual not because of its size but because 
it occurred so early in the year.  In both February 2004 and 
2005, the economy cooled down after January, a month of high 
inflation as the impact of end-of-year government spending 
and private consumer spending was felt.  For example, 
inflation rose 13 percent in January 2005 but then sank to 
negative .3 percent in February 2005.  The same pattern 
occurred in 2004.  After the large February 2006 inflation 
increase, March 2006 inflation was 1.7 percent.  Inflation 
still is running high: it was 21.7 percent in the first 
quarter of 2006, already above the IMF's 2006 objective of 15 
percent.  Most disturbing is that the annual inflation rate 
from March 2005 to March 2006 was 53.4 percent. 
 
----------------------- 
Reform-driven Inflation 
----------------------- 
 
¶3. (SBU) In December 2005, the GOI began a first-ever round 
of IMF-required fuel subsidy reductions. Implementation of 
the reductions was uneven as a number of provinces resisted, 
but eventually most of the country went along and the price 
of regular gasoline increased 500 percent (5 cents to 25 
cents).  (NOTE: The GOI is scheduled to implement four fuel 
price increases this year, but nearly all of them are much 
smaller than the December 2005 increase.  The GOI did not 
implement the increase planned for March 2006; however, key 
GOI officials have told us that they will consolidate the 
March increase into the June increase.  END NOTE.)  For 
reasons unrelated to inflation (problems with domestic 
refining and decreased fuel imports), fuel supply dropped 
precipitously in early 2006.  Fuel shortages became more 
widespread, and Iraqis turned to buying fuel at higher black 
market prices.  As a result, the two consumer price index 
categories most sensitive to fuel prices increased sharply in 
February: "transportation and communications" by 15 percent 
and "fuel and light" by 61 percent.  This was a one-time 
shock, however, since in March "transportation and 
communications" increased only 3.3 percent and "fuel and 
light" decreased 0.1 percent. 
 
¶4. (SBU) The February 2006 inflation rate suggests that, for 
the first time, Iraq experienced reform-driven inflation as 
the gradual removal of subsidies pushed prices towards real 
or market prices.  Other countries experienced similar 
challenges when beginning economic reforms, including Russia 
in the early 1990s.  The difference in Iraq, however, is that 
a high inflation rate (over 30 percent annually since 
liberation) is already built into the economy.  As a result, 
even higher levels of inflation may be expected if the 
government does not accompany subsidy reforms with measures 
to drive down government spending.  The GOI is pursuing a 
mixed policy, however, by increasing government spending; 
plans for 2006 include a 67 percent government workforce 
expansion, a budgeted 150 percent increase in pension 
expenditures, and additional budget transfers to the 
provinces.  Although these measures can soak up unemployment, 
they are inherently inflationary. 
 
--------------------------------------------- ----- 
Managing Inflation: Why Monetary Instruments Don't Work in 
Iraq 
--------------------------------------------- ----- 
 
¶5. (SBU) The GOI's challenge is that it lacks effective 
monetary instruments with which to fight inflation.  Interest 
rates do not work because they are way below the rate of 
inflation (the current commercial lending rate is 12-15 
percent, well below the current 53.4 percent annual inflation 
rate).  The GOI has begun a market for treasury bills, but at 
this point the amounts bought and sold are too small either 
to expand or contract the money supply.  Controlling the 
 
BAGHDAD 00001287  002 OF 002 
 
 
money supply has not worked either: in 2005, inflation 
increased by 31.7 percent while the money supply contracted 
6.1 percent, contradicting textbook economics that printing 
less money decreases inflation. 
 
¶6. (SBU) The reality is that the Central Bank of Iraq (CBI) 
influences money supply but does not control it.  The CBI 
estimates that about 60 percent of Iraq's money supply is 
currency (much in U.S. dollars) that is not saved in banks. 
Many Iraqis had bad experiences with banks under Saddam.  In 
addition, the economy is heavily dollarized.  Although the 
exact amount is unknown, some estimates approximate that 20 
percent of the Iraqi economy is dollarized. 
 
---------------------- 
Exchange Rate Controls 
---------------------- 
 
¶7. (SBU) The one monetary tool that the CBI has used to limit 
inflation is pegging the Iraqi dinar closely to the U.S. 
dollar (at about 1475 dinars).  In 2005, the dinar was 
devalued about 1 percent while the difference between U.S. 
rate of inflation (3.4 percent) and Iraqi inflation (31.6 
percent) was 28.2 percent.  This divergence suggests that in 
2005 the dinar was overvalued by about 27 percent (the 
difference in the two inflations as well as the small dinar 
depreciation).  One reason the CBI can sustain this is that 
it receives oil payments in dollars and can sell lots of 
dollars to soak up dinars.  The problem is that, in the 
long-term, an overvalued dinar encourages imports and hurts 
Iraqis who produce for their domestic markets (keeping Iraqi 
non-oil exports expensive). 
 
------- 
Comment 
------- 
 
¶8. (SBU) Turning inflation around is a process of many 
inter-related steps -- mostly fiscal -- starting with 
controlling government spending and lowering subsidies.  The 
GOI needs to balance its budget but also has to spend its 
money on the right things, beginning with increased security, 
capital investments (particularly in oil), and planning for 
sustainment costs of U.S.-funded projects that will be turned 
over to the GOI.  In the first quarter of 2006, the GOI's 
biggest budget expenditure was on salaries (including 
increased hiring and pay raises) and imported fuel. 
According to the Director General of Budgetary Affairs at the 
Ministry of Finance, nothing was spent on capital investments 
in the first quarter of 2006.  At the same time, much work 
will need to be done by the next GOI to create a modern 
banking system that attracts cash and issues credit based on 
real interest rates (i.e., interest rates not lower than the 
rate of inflation).  Even if the payoff for banking reform is 
less immediate, moving Iraq away from a cash-based, highly 
dollarized economy towards a credit-based economy (with banks 
that can extend home mortgages and make commercial loans 
according to market-based interest rates) will take time. 
KHALILZAD