Features : Total Rebuild: Reconstructing Iraq’s Banking System Starts from Scratch
Before Iraq’s economy can even begin to recover from the war, its banking system


The ruins in Baghdad of the Central Bank of Iraq, its marble-clad walls collapsed, are symbolic of the condition of the entire Iraqi banking sector. A majority of the country’s banks were bombed, torched and looted during the war. Six months after the United States declared an end to major combat operations, only a few banks are open for business.
Late in 2002, even before war in Iraq was certain, high-level US treasury officials began drawing up plans for financial reconstruction. They knew that reopening the banks after the fall of Saddam Hussein’s regime would be essential to get the country running again.
They were right. And the widespread devastation left economic planners with a clean slate on which to design a new banking and financial system. What has emerged is a radical proposal to transform a centrally planned economy based on Eastern European communism into a free-market model for the Arab world.
The occupation government of Iraq has decreed a sweeping liberalization that would privatize most state-run industries except oil and gas, roll out the red carpet for foreign investors and put much of the banking system in foreign hands. It is a plan that many analysts and economists say is bound to fail in a country that lacks basic institutions and laws vital to the functioning of a free-market economy.
“You can’t take a Bundesbank and plunk it down in Baghdad and expect it to work,” says Steve H. Hanke, professor of applied economics at Johns Hopkins University in Baltimore, Maryland, and a senior fellow at the Cato Institute, a Washington, DC-based public-policy research foundation. “All of this liberalization talk is just ‘Washington-speak.’ It’s stuff grabbed out of the air,” he says. “We don’t know how the dust will settle. These are just decrees that could be overturned by an elected government.”

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Steve H. Hanke

Banks Must Be Recapitalized
Without a functioning money market, it will be impossible for the central bank to operate using monetary-policy instruments such as repurchase agreements, Hanke says. The central bank and all of the commercial banks are insolvent, since their balance sheets are dominated by claims on the now-defunct Hussein government. Hanke says the banking sector will have to be recapitalized and restructured to operate in a market economy.
The existing banking system centers on two large state-owned banks, Al Rasheed and Rafidain, as well as the central bank, which Saddam treated as his personal bank account. The former Iraqi leader sent his younger son Qusai to take nearly $1 billion from the central bank in the middle of the night shortly before the US began bombing Baghdad.
“Simply restoring the economy to what it was before Saddam will be a tremendous improvement in the well-being of the Iraqi people,” according to John B. Taylor, US undersecretary of the treasury for international affairs. In 1979 Iraq’s gross domestic product was $128 billion, but by 2001 it had declined to $40 billion. “Strengthening and modernizing the banking sector is central to achieving overall economic progress in Iraq,” Taylor told a US Senate committee following the fall of the Hussein regime.
Under Saddam, Iraqi banks were oriented much more toward the fulfillment of Baath Party political objectives than toward financial intermediation, Taylor said. Banks under the former regime were not permitted to make loans based on commercial viability and a borrower’s ability to repay. The country, therefore, lacks a commercial banking culture and technical skills.
The US-led Coalition Provisional Authority issued a Request for Information in August to get ideas about how to restructure Rasheed and Rafidain banks to operate successfully in a market economy. According to the CPA, these two banks are likely to play key roles in Iraq’s economic reconstruction due to their longstanding presence in Iraq, their substantial shares of assets and deposits and their extensive customer base and branch networks.
Meanwhile, the CPA named a 13-bank consortium led by JPMorgan Chase to operate the newly created Trade Bank of Iraq, which will support Iraqi imports of equipment and commodities funded through the Development Fund for Iraq. The CPA-administered fund receives most of the proceeds from Iraqi oil exports. JPMorgan Chase was selected over five competitors, including groups led by Bank of America, Bank One, Citigroup and Wachovia, as well as UK-based HSBC, which applied as a single bank.
The trade bank is scheduled to operate for 12 months, with the option to remain open for an additional two years, after which the job of issuing and confirming letters of credit will be turned over to local banks. Members of the consortium are being urged to transfer trade-finance and other international banking skills to Iraqi institutions.

US Banks May Hold Back
The national origins of the members of the trade-bank consortium closely mirror that of the coalition. However, this does not necessarily mean that American and other Western banks will dominate the Iraqi banking system in the future, says Richard Stewart, counsel in the London office of lawyers Bryan Cave. The US-based firm maintains offices in Kuwait, Riyadh, Dubai and Abu Dhabi.
“I would be surprised if US banks rush into the Iraqi banking business,” says Stewart, who specializes in Islamic finance. “The legal vacuum in Iraq is a problem. You need to have security on the money you lend. And I have to wonder if the retail banking business will be all that profitable,” he says. Banks involved in Eastern Europe could have an advantage in Iraq because of their experience with transition economies, he says.
Getting a banking license in Iraq could prove to be difficult, Stewart adds. “There are 170 other small private banks in the country, although some of these are likely to merge, as happened in Eastern Europe,” he says.
“Iraq is a relatively secular country, but its people would prefer to deal with Islamic institutions,” Stewart says. US treasury department officials say they endorse the objective of Iraqis having access to financial products and services based on Islamic principles.
Most of the international banks seeking to play a role in Iraq have Islamic windows or separate organizations that offer Shari’a-compliant products. Australia and New Zealand Banking, a member of the trade-bank consortium, established a Global Islamic Finance unit in London in 1989 to handle cross-border Islamic financing. Over the past decade, Islamic finance has developed into a mainstream source of funding for development projects. ANZ says terms of its involvement with the Trade Bank of Iraq are confidential, but that there will be no risk to the bank’s staff, because there will be no on-the-ground presence in Iraq.
“None of the participating banks are commenting on the operations of the Trade Bank of Iraq,” a spokesperson for JPMorgan Chase says. The New York-based bank adds that it is too early to make a decision about opening any branches in Iraq.
Other US banks are similarly coy. “Obviously we would like to help in any way we could,” William Rhodes, senior vice chairman of Citigroup, said at an extraordinary meeting of the World Economic Forum in Shuneh, Jordan, in June. “There are discussions for Citigroup to do something in Iraq,” Rhodes said. “I think it’s fair to say we are interested in helping, and leave it at that.”

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Richard Stewart

No Boundaries
Iraq’s new finance minister, Kamel al-Gailani, created a stir at the annual meeting of the World Bank and International Monetary Fund in Dubai in late September. He announced a series of new laws to create a “free and open market economy” in Iraq that he said would be unprecedented in the Arab world.
The measures, approved by the CPA and the Iraqi Governing Council, would allow up to 100% foreign ownership in all sectors except natural resources and provide for national treatment of all foreign firms. International banks will be permitted to enter Iraq as branches, subsidiaries, representative offices or through joint ventures with local banks. Six foreign banks will be allowed to purchase up to 100% of local banks within the next five years, after which there will be no limitation on foreign-bank entry.
There will be a 'fast-track entry' process for the first two of these six banks, which will be selected in part on their commitment to make prompt and substantial lending, according to the finance minister. There will be a $25 million capital requirement for foreign majority-owned subsidiaries, but no specific capital requirements for branches. An unlimited number of foreign banks will be allowed to purchase up to 50% of local banks.
Al-Gailani’s plan to throw open the country’s doors to foreign competitors was greeted with howls of protest from Iraqi business leaders. “Clearly the situation in Iraq remains in flux and is subject to both international law and US law that is constantly changing,” says Pieter Bekker, an attorney in the New York offices of White & Case.
While a new Iraqi government would have the right to alter CPA orders opening up the economy, it is unlikely to do so, given that the country needs foreign investment to successfully rebuild, Bekker says.
“Capital is a coward,” US treasury secretary John Snow said at the IMF meeting in Dubai. “It doesn’t go places where it feels threatened.” He warned that the restoration of security in Iraq is an essential prerequisite for economic recovery.
One concern of US officials was that the war and its aftermath could result in a massive depreciation of the Saddam dinar. The US strategy called for paying workers and pensioners in US dollars on an interim basis to help create stability.
Hanke of Johns Hopkins University says the transitional authorities should either adopt the classic British currency-board model or simply ‘dollarize’ the Iraqi economy. “The euro has some advantage politically over the US dollar, although the dollar would work just as well,” he says.
There is historical precedent for such a move, Hanke says. After the territory of Iraq was captured by British forces in 1916 and removed from the Ottoman Empire, the British made the Indian rupee the official currency in place of the Ottoman pound.
While it would take years to create a functioning central banking system, a currency board could be constructed quickly, Hanke says. “The proof of the pudding is in Bosnia,” he says. “The successful establishment of a currency board in Bosnia and Herzegovina after its bloody civil war argues in favor of such a monetary system for Iraq.”
On October 15 Iraqis began exchanging their dinars for new banknotes without the image of Saddam Hussein. The new currency bears the designs of the old Iraqi—or 'Swiss'—dinar that circulates in the north of the country. About 2,200 tons of the new currency was shipped to Iraq from printing facilities in the UK, Spain and other countries. Coalition officials selected De La Rue, the official printer of UK banknotes, to lead the work.
Iraq’s economic makeover is beginning to happen. If all goes as planned, the US administration envisions a world-class exchange in Baghdad within a year for trading the shares of newly privatized companies. It remains to be seen, however, what the Iraqi people will have to say about all of this.

Members of the Consortium Selected to Operate the Trade Bank of Iraq
JPMorgan Chase—Leader (US)
Australia and New Zealand Banking (Australia)
Standard Chartered (UK)
National Bank of Kuwait (Kuwait)
Bank Millennium (Poland)
Mitsubishi Tokyo Financial (Japan)
Sanpaolo IMI (Italy)
Royal Bank of Canada (Canada)
Credit Lyonnais (France)
Caja de Ahorros y Pensiones de Barcelona (Spain)
Standard Bank (South Africa)
Akbank (Turkey)
Banco Comercial Português (Portugal)
Source: Coalition Provisional Authority

Financial Reconstruction Timeline
March 20, 2003:
US launches a series of air strikes on Baghdad. President Bush vests $1.7 billion of frozen Iraqi assets and places them in an account at the Federal Reserve Bank of New York.

April 13, 2003:
First shipment of US dollars to pay Iraqi workers and pensioners is flown from Andrews Air Force Base in Maryland to Kuwait for distribution in Iraq.

May 1, 2002:
US declares an end to major combat operations.

May 22, 2003:
United Nations lifts most economic sanctions on Iraq.

July 7, 2003:
The US-led Coalition Provisional Authority announces measures to ensure the independence of the Central Bank of Iraq and says a new currency will be introduced in October.

July 13, 2003:
The CPA establishes the Governing Council of Iraq as the principal body of the interim administration.

July 15, 2003:
US State Department lifts restrictions on the use of US passports for travel to Iraq. However, the security situation remains dangerous.

August 19, 2003:
Explosion rocks UN headquarters at the Canal Hotel in Baghdad. The International Monetary Fund and World Bank pull their staffs out of Iraq.

August 29, 2003:
JPMorgan Chase is selected to run the operating consortium for the Trade Bank of Iraq.

September 21, 2003:
Iraqi finance minister announces a series of economic and financial reforms, allowing the entry of foreign banks.

October 15, 2003:
New Iraqi dinars begin to be introduced. Exchange period runs through January 15, 2004.


Gordon Platt
 

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