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Gradual Appreciation Expected As Anti-Inflationary Tool
May 2008 | Currency Forecast
BMI IRAQ CURRENCY FORECASTS
Short-Term Outlook
We expect the Central Bank of Iraq (CBI) to maintain its strategy of allowing gradual appreciation of the dinar, while keeping interest rates generally stable, in order to ensure inflation remains well below the double-digit levels seen during 2007. Indeed this policy has already proved extremely effective at curbing inflation, which came in around 5.6% y-o-y in March down from 36.6% y-o-y in March 2007 although continued fiscal restraint and a swift hike in interest rates also contributed to slowing inflation. However, currency appreciation remains the CBI's principal anti-inflationary policy instrument and we therefore expect the dinar to appreciate around 2% over the rest of this year to hit IQD 1,180/US$ by end-08 and around 7% in 2009 to hit IQD 1,100/US$ by the end of the year.
Core View
With inflation now well below the level it was at during 2007 - the CPI averaged 5.0% y-o-y over Q108 compared to 46.7% in Q107 - the government has tentatively started to cut rates. The policy rate was cut to 19% in February and then to 17% in March. However, we see these adjustments in interest rates as minor changes designed to back up the CBI's exchange rate policy, and not the primary instrument of the CBI's monetary strategy. Indeed with the economy still primarily cash-based, more weight is being given to the CBI's currency policy and with the banking system still recovering from 2003's US-led invasion and subsequent war, interest rate movements remain relatively impotent in the current economic climate.
However, other macroeconomic factors will to help drive the dinar's appreciation over the coming years. Indeed with oil prices currently at record highs and Iraq's oil production continuing to creep higher, the government has been able to amass reserves suggesting upside pressure on the dinar. Reserves grew by almost 70% in 2007 to hit estimated US$31.4bn and we expect foreign reserves to rise to US$32.9bn in 2010. A large part of this will be from oil revenues as we expect the oil price to stay high in the medium term - we are forecasting Brent crude to average US$100.00/bbl and US$85.00/bbl in 2008 and 2009 respectively - and Iraq's oil production to continue to push higher to hit 2.70bn b/d in 2010 up from an estimated 2.08bn b/d in 2007. On top of this strong real GDP growth - which we expect to average 8.5% over the next five years - and increasing foreign investment as the security situation improves will also support dinar strength.
In light of the success of the inflation-targeting overall strategy, Finance Minister Bayan Jabr has mooted (mooted... think about carefully; weigh) a possible rebasing of the dinar, however we think this is unlikely to happen over the coming years, as the crawling peg is continuing to serve the Iraqi economy well. In addition, in December 2007 rumours spread that the government was planning to rebase the currency and remove the last three zeros to achieve 1:1 parity with the dollar, something that the CBI quickly denied. The central bank said it was not currently considering such an option and the rumour had been spread by speculators wishing to take advantage of currency inflows. That said, the CBI remains committed to developing Iraq's currency regime and diversifying the range of policy instruments at its disposal. It has said that it will lend support to a liquid secondary market of tradable instruments by selling the treasury bills it receives from the Finance Ministry and a central depository system is also planned. Furthermore, by reforming the banking sector, it is expected that a secondary market will start to emerge over the time providing the CBI with another avenue within which to conduct market operations.
Risks To Outlook
The key risk to our outlook comes from a marked fall in oil prices, which would likely lead to slower dinar appreciation or currency weakness depending on the extent of the drop. Indeed a significant slowdown in the US and other developed countries could dampen global demand for oil, which would feed into lower oil revenues and slower growth (although this is far from our core scenario). Alternatively, an escalation of violence or sectarian clashes could lead to a crisis of confidence in the currency, which remains another risk to the downside. That said, we expect the price of oil to stay high over the medium term, given strong demand from emerging markets, and with coalition forces pledging to stay in Iraq until they have 'finished the job', we are hopeful that Iraq can avoid a return to the widespread violence seen in previous years.
Finally... something written in real english.
