VZCZCXRO1221
RR RUEHBC RUEHDA RUEHDE RUEHIHL RUEHKUK
DE RUEHGB #4059/01 3471815
ZNR UUUUU ZZH
R 131815Z DEC 07
FM AMEMBASSY BAGHDAD
TO RUEHC/SECSTATE WASHDC 4837
INFO RUCNRAQ/IRAQ COLLECTIVE

UNCLAS SECTION 01 OF 03 BAGHDAD 004059 
 
SIPDIS 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: ECON EFIN IZ
SUBJECT: WHAT IS DRIVING IRAQ'S DECLINING INFLATION RATE 
 
REF: BAGHDAD 004058 
 
¶1. (SBU) SUMMARY: Inflation in Iraq is on a downward trend, 
reflecting improved security, supply and targeted monetary 
policy.  A close examination of the country's inflationary 
trend revealed poor security compounded by increasing 
demand--especially for fuel--to be the major inflationary 
pressures.  Tight monetary policy enacted by the Central Bank 
of Iraq helped curb inflation with the dinar appreciating 
approximately 17 percent against the dollar since September 
¶2006.  Declining inflation is helping the average Iraqi and 
increasing domestic confidence in the government's economic 
policies.  At the same time, however, banking and other 
economic reforms need to be moved forward to capitalize on 
lower inflation and create sustainable private sector jobs in 
Iraq's oil-based economy. END SUMMARY. 
 
--------------------------------- 
Recent Decline in Inflation Trend 
--------------------------------- 
 
¶2. (SBU) Inflation in Iraq is trending downwards, with the 
consumer price index (CPI) reaching just 15.5 percent 
year-on-year (y-o-y) in November 2007, due largely to the 
increase in all the prices of commodities and services 
groups, especially foodstuffs, fuels, transportation, and 
communications.  This is encouraging when compared to a spike 
in inflation from 22.3 percent in January 2006 y-o-y to 41.9 
percent y-o-y in February 2006 following the Samarra mosque 
bombing, which was then followed by an all-time post war high 
of 76.6 percent y-o-y for CPI in August 2006.  Inflationary 
growth hovered in the 50 percent range for almost all of 
2006, and finally began easing in the spring of this year, 
with a substantial drop in February 2007 to 37.1 percent 
y-o-y. 
 
¶3. (SBU) Core inflation's trend mimics CPI for the most part, 
albeit at a lower level.  Iraq's core inflation is defined as 
the rate of change of CPI calculated by excluding three fuel 
derivatives items of kerosene, LPG, and gasoline.  Core 
inflation was 30.7 percent y-o-y in February 2006, climbed to 
38.1 percent y-o-y in July 2006 and reached just 14.4 percent 
y-o-y this November. 
 
--------------------------------- 
How Inflation is Measured in Iraq 
--------------------------------- 
 
¶4. (SBU) Inflation in Iraq is measured by the Ministry of 
Planning and Development Cooperation's Central Office for 
Statistics and Information Technology (COSIT).  Although 
understaffed and under-resourced, COSIT is working to update 
its methodology and further refine its measurements.  A 
senior USAID consultant to COSIT told Econoff during a 
meeting on November 22 that COSIT is making steady progress 
to increase the efficiency of it data collection, and the 
statistics produced on a monthly basis are accurate.  For 
example, data collection experts sample three black market 
fuel providers located in the vicinity of official gas 
stations to calculate the price for fuel. 
 
¶5. (SBU) The current base year COSIT uses is 1993.  The base 
does not include the Kurdish provinces, and measures only 446 
items in 60 markets.  However, CPI will soon be calculated 
using the a new market basket as established by the new Iraq 
Household Social and Economic Survey run from November 1, 
2006 until October 31 2007.  The survey includes all 18 Iraqi 
provinces and measures 1,616 items as purchased by 18,144 
households.  Some initial findings of changes in income 
expenditure between 1993 and 2006 include: food expenditure 
dropped from 63.2 percent of income to 28 percent; fuel 
expenditure increased from 2.1 percent of income to 31 
percent (although the 2007 formula includes housing and 
utilities expenditures); and the amount spent on 
transportation went from 4.9 percent to 10 percent. 
 
--------------------------------------------- -- 
High Demand, Constrained Supply Drive Inflation 
--------------------------------------------- -- 
 
¶6. (SBU) A close examination of Iraq's inflationary trend 
since 2004 revealed poor security compounded by increasing 
demand as the major inflationary pressure.  Inflation 
remained high between February 2006 and summer 2007, but as 
the military surge lowered levels of violence, the 
inflationary rate declined in tandem, and in particular in 
Baghdad.  The USAID consultant raised a particularly striking 
example: modern Baghdad's infrastructure was originally 
planned to accommodate 500,000 vehicles, with an attendant 
number of gasoline stations and other supply infrastructure 
to support that number.  After 2003 demand soared for 
personal automobiles, which now total more than 1.5 million. 
 
BAGHDAD 00004059  002 OF 003 
 
 
Demand has similarly risen for other new purchases that 
require fuel, such as air conditioners and power generators. 
While this surge in demand was growing, the flow of goods and 
services was under severe strain due to dangerous 
transportation networks, attacks against refineries, and a 
shortage of supplies in the market exacerbated by official 
prices previously below regional levels.  These factors led 
strongly to the high supply-driven inflation. 
 
¶7. (SBU) Another factor fostering inflationary pressure is 
supply inelasticity due not only to poor infrastructure, but 
also linkages between regional markets. A senior US military 
officer noticed in summer 2007 visits throughout Iraq that 
the price of dates varied by a factor of 5 over a 75-mile 
highway distance.  The price of tomatoes varied by 25 percent 
over a similar distance and each of the two markets are 
supplied primarily by different countries--Syria and 
Iran--and not Basra province where they are in excess supply. 
(COMMENT: Econoff has encouraged in economic briefings to new 
PRT officers to seek to identify ways of capitalizing on 
regional trading relationships for their provinces, both 
inside and outside of Iraq, to ease these market 
inefficiencies that have very real consequences on the 
ground. END COMMENT) 
 
¶8. (SBU) COMMENT: What is surprising is how quickly inflation 
responded when fuel supply shortages eased at the end of the 
summer and early into the fall.  Although there is no one 
concrete factor, Econoff's meetings with numerous Iraqi 
government advisors and Iraqis themselves point to increased 
fuel availability at a reasonable, and in most cases 
official, price due to improvements in security.  This is not 
just physical security, but the removal of sectarian actors 
who controlled fuel sales and enforcing delivery to major 
official gas stations.  Combined with the official gasoline 
price rising to market levels to reduce smuggling incentives, 
this appears to be making a substantial difference in 
Baghdad.  Even Minister for Oil Hussein Al-Shahristani told 
the press at the end to November that "decreasing violence 
has allowed his ministry to reopen gas stations across the 
city.  At those stations, where drivers last year sometimes 
waited for days to fill up, waits are now usually less than 
15 minutes, decreasing demand for black-market gas". END 
COMMENT 
 
------------------------------------- 
But Tight Monetary Policy Helped Too 
------------------------------------- 
 
¶9. (SBU) Although supply-side issues have shaped Iraq's 
inflationary pattern in the past few years, tighter monetary 
policy enacted by the Central Bank of Iraq (CBI) has helped 
to dampen additional inflationary pressures.  Alarmed by the 
steady climb of inflation in 2005 and the sharp increase in 
2006, the CBI curbed liquidity by gradually appreciating the 
dinar approximately 17 percent against the dollar starting in 
September 2006 through December 2007.  The International 
Monetary Fund (IMF) in a report yet to be released noted the 
appreciation of the exchange rate has succeeded in increasing 
the demand for dinars and contributed significantly to the 
drop in inflation.  The IMF (in the same report) also is 
recommending the CBI continue dinar appreciation until core 
inflation comes down to near single-digit levels, which is 
important to continue to de-dollarize Iraq's oil-based 
economy. 
 
¶10. (SBU) A senior TF-BSO consultant to the CBI met with 
econoff on November 28 and provided unique first-hand insight 
into how the CBI formulates and implements monetary policy 
through volume control.  The auction price for the dinar at 
its foreign exchange auction often is set on an almost daily 
basis before the currency auctions by polling the nearby 
money traders.  In August 2007 the CBI increased its required 
reserve ratio on government deposits from 25 to 75 percent in 
order to draw up excess liquidity from government deposits in 
commercial banks.  Finally, the CBI also sells its own 
treasury bills directly. 
 
-------------------- 
Why this All Matters 
-------------------- 
 
¶11. (SBU) COMMENT: Current inflationary trends are helping 
provide breathing space opened by the improving security 
situation to translate into improvements in the quality of 
life for the average Iraqi.  Previously inflation was 
underestimated and post-war Iraqis felt the full brunt of 
Saddam Hussein's distorted economic policies, remnants of 
which still exist, such as the free basic goods provided 
monthly in the Public Distribution System.  However, the 
clear trend of a decreasing rate of inflation is a success 
story and can further improvements in supply elasticity.  We 
 
BAGHDAD 00004059  003 OF 003 
 
 
will highlight via septel how a strong increase in demand for 
dinars is a vote of confidence by Iraqis in their domestic 
economy and their government's economic policies. 
 
¶12. (SBU) On the cautionary side--maintaining tight monetary 
policy to curb inflation can restrict growth and limit 
lending capital for small and medium sized enterprises.  In 
order to capitalize on the improving security situation,  a 
more even playing field for private and commercial banks 
needs to be fostered against the state-owned and supported 
Rafidain, Rasheed, and Trade Bank of Iraq.  Moving in this 
direction will help the private sector development that will 
assist tangible, sustainable job creation in Iraq's oil-based 
economy. END COMMENT 
BUTENIS