VZCZCXRO3218
PP RUEHBC RUEHDA RUEHDE RUEHIHL RUEHKUK
DE RUEHGB #2431/01 2180337
ZNR UUUUU ZZH
P 050337Z AUG 08
FM AMEMBASSY BAGHDAD
TO RUEHC/SECSTATE WASHDC PRIORITY 8655
INFO RUCNRAQ/IRAQ COLLECTIVE

UNCLAS SECTION 01 OF 02 BAGHDAD 002431 
 
SENSITIVE 
SIPDIS 
 
E.O. 12958: N/A 
TAGS: EFIN ECON PGOV IZ
SUBJECT: NO SUB-PRIME CRISIS HERE: CONSTRAINTS ON 
COMMERCIAL LENDING IN IRAQ 
 
¶1. (SBU) Summary: The GOI wants the Central Bank of Iraq 
(CBI) to loosen its monetary policy to promote economic 
growth.  But cuts in the CBI's interest rates or reserve 
requirements will not deliver the growth boost GOI officials 
seem to expect.  Iraqi banks already have plenty of money to 
lend, so expanding the money supply will not mean more loans 
for businesses and households.  Iraqi banks lack the credit 
infrastructure needed for lending that expands output and 
creates jobs.  Rather than press the CBI to print more money, 
the GOI should take steps to build a money market that gives 
banks tools to measure and manage risks.  End summary. 
 
Leaning on the CBI 
 
¶2. (SBU) Senior CBI officials report in private that the GOI 
is exerting "intense pressure" for changes in monetary 
policy.  It is a commonly held view in Iraq that banks do not 
lend because the CBI sets interest rates too high and 
requires state-owned banks to hold unusually high levels of 
reserves.  GOI ministers have reportedly threatened to revoke 
the CBI's statutory independence if it did not loosen 
monetary policy.  Partly as a result of such pressure, the 
CBI cut its policy rate from 20 percent to 16 percent over 
the first half of the year. 
 
¶3. (U) When GOI leaders look to the CBI to facilitate 
lending, they may be thinking of how Iraq's economy used to 
be organized.  When state-owned enterprises, government 
plans, and international sanctions defined Iraq's economy, 
the central bank served as little more than a cash dispenser. 
 Price stability was not in its mission statement.  From 1993 
through 2002, Iraq's average annual rate of inflation 
exceeded 100 percent. 
 
¶4. (U) Iraq is building a new economy, but a good deal of the 
old machinery remains in place.  The GOI payroll still 
accounts for the bulk of salaried employment.  Vestiges of 
controlled prices, intra-enterprise barter, and the planning 
apparatus still cause significant economic distortions. 
Habits learned in the bad old days still guide the economic 
policy instincts of leading politicians and senior 
bureaucrats. 
 
A Banking System Awash in Money 
 
¶5. (U) Iraq's financial plumbing, however, is brand new. 
Risk management and profit maximization now drive bank 
lending, not orders from the top.  As a result of decades of 
directed lending, most of the state-owned banks carry a 
crushing burden of non-performing assets.  The two largest 
banks, Rafidain and Rashid, are technically insolvent and 
unable to take on new risks.  Over the past year, the loan 
portfolio of state-owned banks grew by less than 10 percent, 
mainly through non-commercial, GOI-subsidized programs.  Over 
the same period, lending by private banks grew by nearly 50 
percent. 
 
¶6. (U) The role of the central bank is also radically new. 
The CBI takes seriously its statutory responsibility to 
achieve price stability.  And it has performed admirably on 
that score under extremely difficult conditions.  The CBI's 
most effective policy tool is intervention in the 
foreign-exchange market.  By auctioning dollars at ever lower 
prices, the CBI takes a large volume of dinars out of 
circulation, restraining growth of the money supply.  The 
increasing value of the dinar also makes imported goods more 
affordable, further blunting inflationary pressures.  Iraq's 
core price level (excluding volatile food and fuel 
components) is now increasing at an annual rate of between 10 
and 15 percent, less than half as fast as in 2006. 
 
¶7. (U) Even though the CBI has curbed inflation through a 
restrictive monetary policy, the banks have more than enough 
money to support more commercial lending activities.  In 
addition to cash reserves mandated by CBI regulations, all 
banks in Iraq maintain remarkably high levels of excess 
reserves, on which they earn no financial return.  On 
average, Iraqi banks hold excess reserves equivalent to about 
6 percent of total assets, a ratio more than 10 times higher 
than in the developed world.  This holds even for the private 
banks, which lend far more actively than the moribund 
state-owned banks. 
 
Infrastructure, Not Interest Rates 
 
¶8. (U) With so much liquidity available, banks need not 
borrow to fund new loans.  Some observers note that banks 
earn interest on their deposits with the CBI, so the high 
policy rate gives them a riskless investment alternative that 
discourages lending.  But the CBI enforces a limit on banks' 
access to its interest-bearing deposit facility.  Funds in 
 
BAGHDAD 00002431  002 OF 002 
 
 
excess of this limit remain with the banks as idle balances, 
immediately available to fund new loans.  Under these 
conditions, cuts in the CBI's policy rate or required reserve 
ratios have no effect on the supply of credit. 
 
¶9. (U) So if Iraqi banks have money, why don't they lend more 
of it?  The answer lies in the first rule of banking: Don't 
lend money you don't expect to be repaid.  Under present 
conditions, the supply of loanable funds in the banking 
system exceeds the supply of acceptable lending risks. 
Meanwhile, banks earn reasonable profits from no-risk 
services like currency exchange, letters of credit, and 
performance guarantees.  As the private banks grow and 
competition intensifies, the fee-for-service model will 
become less profitable and banks will put more emphasis on 
lending. 
 
¶10. (U) How quickly the banking system makes the transition 
to profitable intermediation depends on the development of 
financial infrastructure Iraq still lacks.  In order to 
deploy their excess reserves profitably, Iraqi banks must be 
able to measure and compare the risks of alternative lending 
opportunities.  They need to be able to enforce claims on 
collateral.  And they need a money market where banks and 
businesses trade financial claims for cash.  To promote 
growth, the GOI should work to build the financial 
infrastructure that provides these capabilities, not lean on 
the CBI to loosen monetary policy. 
 
What the USG is Doing 
 
¶11. (U) USG programs already bridge some gaps in Iraq's 
financial infrastructure, at least on a small scale.  Lending 
programs supported by USAID provide modest financing where 
banks fear to tread, mainly for small enterprises.  For 
larger enterprises, OPIC has made financing available through 
the Iraq Middle Market Development Foundation.  Treasury and 
Defense have introduced electronic funds transfer to the 
banking system, significantly lowering transaction costs.  At 
the local level, Provicial Reconstruction Teams work with 
small businesses to develop entrepreneurial skills, design 
business plans, and locate sources of financing.  These 
initiatives help move Iraq's economy forward by reducing the 
costs and risks associated with lending. 
CROCKER