Fed sees debt, inflation vexing Iraqis

From the Business & Economics Desk Published 5/6/2003 11:11 AM

SAN FRANCISCO, May 5 (<a href=www.upi.com>UPI) -- Iraq's next government will face a daunting economic challenge from past debt and the anticipated cost of rebuilding despite its wealth of oil reserves, the Federal Reserve Bank has said.

Oil will no doubt continue to be the keystone of Iraq's fledging economy once a new regime takes over in Baghdad, however an analysis Monday from the Federal Reserve's San Francisco bank warned that Iraq will return to the oil market saddled with heavy debt and a vulnerability to rampant inflation with even a possibility of total economic collapse down the road.

"The post-war Iraqi situation appears to be one of a heavily indebted oil-exporting country, more similar to Venezuela than to Saudi Arabia or Kuwait," the report from Fed analyst Mark M. Spiegel concluded. "Moreover, the cost of rebuilding Iraq after the war is likely to place further burdens on its public finance."

A decade of war and economic sanctions took a crushing toll on Iraq's infrastructure while at the same time Saddam's Hussein government ran up international debt that the Fed said, citing numerous economists, has been calculated as high as $300 billion.

Although Iraq has the world's second-largest proven crude reserves, the outstanding debt alone could take 35 years to pay off even if half of Iraq's oil revenues were dedicated to the arrears.

The Fed noted that the 50-percent figure would be three times the rate of export income that Germany was obligated to pay in reparations during the disastrous post-World War I period that ended with Adolf Hitler's ascension to power.

"While there has been discussion of possibly reducing this debt burden through moratoria and outright forgiveness, servicing its outstanding debt burden is likely to be a major feature of Iraqi public finance going forward," Spiegel said in his report.

The stage appears set for Iraq's new leadership to be faced with managing a shaky economy over an extended period while at the same time being pressured by the ups and downs of the oil market in a potentially volatile political atmosphere. Many economists see such situations as a recipe for disaster if politics begin to interfere with sound monetary policy.

"The fear that a nation's central bank will give in to pressure and devalue its currency can lead to a loss of confidence...and an increase in a nation's cost of borrowing," the report warned. "This can further exacerbate the government's budgetary problems and lead to an inflationary spiral ending in a collapse of the exchange rate peg."

Iraq's exchange rate indeed will likely be pegged to the dollar, the Euro or a combination of the two, the Fed predicted. The dollar is the currency used in the vast majority of international oil transactions; however, it would also expose Iraq to the perils of currency speculation and a spike in Baghdad's cost of borrowing.

"At worst, the peg could collapse dramatically, leading to financial turmoil," the report said. "Because of the exposure to these difficulties, it would be imperative that a managed exchange rate peg regime be tailored to limit concerns about Iraqi monetary policy."

The United States has developed a comprehensive economic plan for Iraq that includes an unspecified overhaul of Iraq's central bank and stock market. Thus far, the plan appears primarily focused on creating a market-based economy that opens the door to direct foreign investment and the privatization of Iraq state-run industries.

Spiegel said all was not lost in Iraq since the incoming Iraqi government would basically be able to start from scratch and build a monetary system that will best suit Iraq's specific economic needs and keep inflation in check rather than having to adapt an existing system that is no longer effective.

"A critical issue is the determination and management of the country's outstanding liabilities and the costs of financing the rebuilding of the nation," Spiegel said in his report. "No less important is the need to institute a monetary regime that promotes price stability, and the most positive environment in which to meet these other challenges."

(Reported by Hil Anderson in Los Angeles)