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Interview with Åke Lönnberg: IMF draws on postconflict experience to help Iraq with currency and banking reforms

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International Monetary Fund. External Relations Dept.
Published Date:
November 2003
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IMFSurvey: What is the main focus of the IMF’s work in postconflict countries?

LöNNBERG: After a conflict or a breakdown of law and order, it is critical that institutional and administrative capacity be restored or enhanced at an early stage. A framework—underpinned by a simple but realistic policy stance—must be quickly put in place to reestablish macroeconomic stability and lay the ground for a quick resumption of growth. In addition, an early, realistic assessment must be made of external aid flows. Training people is also essential. Once the first bases have been covered—getting the currency roughly right, establishing a functioning payment system, and setting up the key legal foundations—there is a backlog of important things that will still need to be done.

For my department, the major assignment in postconflict economies consists in helping establish or transform central banking functions and the payment and banking systems. We’ve done this in Cambodia (1991-95), Albania (1991-94), Rwanda (1994-99), Bosnia and Herzegovina (since 1996), Kosovo and Timor-Leste (since 1999), and Afghanistan (since 2001), among other places. So Iraq is only the most recent case of the IMF supporting local capacity building by restoring or transforming central banking functions and the payment and banking systems.

IMF Survey: How do you do this?

Lönnberg: We have developed an operational framework for reforming postconflict economies, drawing on practical applications gained in dealing with critical events and milestones reached in our previous work.

Our department’s methodology emphasizes the sequencing of actions within a graduated approach. Key early decisions are the choices of a legal tender and an appropriate exchange rate regime. Setting up and operating a rudimentary payment system on an emergency basis will also be crucial if the established payment system has ceased to function. Preparation of key financial legislation—for example, for central banks, the banking sector, and the country’s currency—is also a high priority. Such legislation should be in line with international best practices but always adapted to local legal traditions. Over time, core central banking functions should be restored and clearly distinguished from commercial banking activities. The financial system is strengthened through the (re-)licensing, regulation, and supervision of banks and the reestablishment of an efficient and sound payment system.

IMF Survey: How flexible are you?

Lönnberg: In many of the postconflict cases, the banking system was subject to a lot of abuse—directed lending or loans for political purposes—while the average citizen had little access to it. The restoration of a functioning banking system is important, but it is a difficult process, and new and unconventional solutions must sometimes be sought.

For example, in Afghanistan, the IMF early in 2002 encouraged the central bank to use hawala, the indigenous informal funds transfer system. This was perhaps unexpected advice, but hawala is an extremely efficient payment system and, traditionally, has been the most vibrant part of the domestic financial infrastructure. Without the hawala system, the complex banknote exchange reform that took place in Afghanistan in the last quarter of 2002 would have failed. Also, without the hawala system, the central bank’s foreign exchange auctions, which have kept inflation under reasonable control, would not have taken place.

It should be noted that the hawala system is virtually unregulated. That is new for the IMF in the sense that we normally would recommend that the authorities use only institutions that are properly licensed, regulated, and supervised. But in this case, tight regulation of hawala would just kill the system or drive it underground, which has occurred in other countries and is not very constructive. Instead, attention is being devoted to fighting money laundering and the financing of terrorism.

Another novel field for the IMF has been the active use of microfinance institutions. In recent years, MFD has supported setting up such institutions in Kosovo and Timor-Leste, and in Afghanistan a microfinance bank was licensed in September 2003. So, we are expanding into areas that five years ago were simply not on the IMF’s horizon.

IMF Survey: Getting the banking and payment systems up and running is the key to restarting the economy?

Lönnberg:: Yes. For example, during serious unrest in Timor-Leste in August-September 1999, all the commercial banks except one were destroyed, and the central bank branch in Dili (the capital) was saved only because of the presence of security forces. As a result, in the immediate postconflict situation, no normal banking and payment operations could take place. Together with the Timorese and the United Nations Transitional Administration in Timor-Leste, work had to start from scratch.

Following the declaration of the U.S. dollar as legal tender in January 2000, cash U.S. currency had to be purchased abroad and brought into Dili. In some cases, the transportation containers were used as storage because of the lack of functioning safes and vaults. The only surviving commercial bank building was taken over and converted into the state-owned Central Payments Office (CPO).

To pay salaries, government employees lined up outside the CPO and initially received their money in plastic sandwich bags handed out by MFD staff and resident experts. The first time that government salaries were disbursed, the CPO ran out of cash in the early afternoon while the lines were still long, and visiting IMF staff had to scrape together some more from travel advances to provide the CPO with a temporary loan. Everything was rather primitive and done manually as the supply of electricity was erratic, but in the end it worked.

The CPO was the rudimentary start of what is today the Banking and Payments Authority of Timor-Leste, a well-functioning institution slated to become the country’s first central bank.

IMF Survey: How important is the currency and exchange rate in the period after a conflict?

Lönnberg: Extremely important, and at least three early decisions must be made, which should be codified into new currency legislation. Regarding cash currency, it must be decided whether to use national banknotes from existing stocks, banknotes of another country, or multiple currencies for a transitional period. On exchange arrangements, a choice should be made between a freely convertible currency or one subject to various controls. Finally, on the exchange rate, a choice of system for exchange rate management must be made—free float, managed float, crawling peg, fixed exchange rate, or currency board.

In Kosovo, the choice was not very difficult because the deutsche mark was already widely used in parallel with the Yugoslav new dinar. Upon the IMF’s recommendation, the United Nations Interim Administration Mission in Kosovo decided to denominate its budget in deutsche mark (and subsequently in euros) and to use that currency for disbursements from the budget. But it was still possible to use Yugoslav new dinars to pay taxes and other public services.

In Timor-Leste, the future currency was an immediate political issue—the Timorese leadership did not want to continue using the Indonesian rupiah. After intensive discussions, it decided to adopt the U.S. dollar as legal tender because the main Timorese export (coffee) was priced in dollars, and future oil revenue will also be invoiced in dollars.

In Afghanistan, the preferred choice was to continue using the national currency in combination with a banknote exchange during the fourth quarter of 2002. In the new series of Afghanis—the legal tender—the security features were much improved, three zeros were dropped, and Afghanistan got its first unified currency since 1996.

IMF SURVEY: What about Iraq?

Lönnberg: Since the early 1980s, Iraq’s economy has suffered from the effects of three wars, political repression, intrusive state ownership and control, and international sanctions. These developments made it difficult to assess the economic situation in Iraq.

An IMF staff mission visited Baghdad in June 2003 to make an initial assessment and explore early priorities for advice and technical assistance. Since then, and despite the bomb attack on the UN headquarters in Baghdad on August 19, in which several IMF staff were injured, the IMF has provided technical assistance on the introduction of new banknotes; central bank legislation and bank licensing; budget execution and public expenditure management; options for tax policy (including a fiscal regime for the oil sector); and the compilation and dissemination of economic statistics. As for macroeconomic policy, the IMF is assisting the authorities to develop a macroeconomic framework—including a fiscal budget for 2004 and a monetary and exchange rate policy regime—to ensure that macroeconomic stability is quickly restored and growth resumes.

IMF Survey: Is Iraq in for a post-Soviet-style period of economic shock?

Lönnberg: There are some similarities but also important differences. The price controls in the Iraqi command economy resemble those of the Soviet system, and the freeing of the price system will no doubt have major effects on the whole economy. This will allow markets to function better and promote an efficient allocation of resources. But the issue of freeing prices cannot be separated from the level of wages and the need for a social safety net for weaker groups. The combination of a targeted safety net and wage increases should protect people from the sharp increase in prices for basic necessities.

A special problem in Iraq is that the economy is already in a state of shock, not so much because of the recent war or the subsequent widespread looting but because of decades of neglect. War and related military activities had priority at the expense of investment in infrastructure, education, health care, and society as a whole. This seems to have gone further in Iraq than in the former Soviet Union. So a tremendous future agenda is before Iraq and the international community.

IMF Survey: What is Iraq’s potential, considering that it has oil and a relatively well-educated population?

Lönnberg: In many ways, the country is potentially very rich. But there are also factors suggesting that it will take longer and be much more costly to fulfill that potential than many may have been expecting. Until around 20 years ago, Iraq could rightly be proud of having one of the better-educated populations in the region. But with the costly wars and the increasing militarization, resources were siphoned away from education, health care, and other productive uses. In addition, the departure of highly skilled Iraqis has had a great impact. This has affected the oil and natural gas sectors, which are in dire need of massive investments. Also, in the prevailing security situation, the road to recovery is likely to be complicated and very demanding for both policymakers and the population.

IMF Survey: What are the main lessons from other postconflict countries that you have been in, in terms of training and advice?

Lönnberg: A key lesson is that local ownership of reforms is absolutely essential for success. Without local counterparts, capacity building will be much slower. IMF advice must be presented in such a way that local staff can use it and develop further without continuous, detailed external assistance. The long-run objective must be to build the foundation for countries to make their own decisions.

Another lesson is that technical assistance in postconflict situations must be closely coordinated among key donors. Working with the authorities and major technical assistance providers, we can bring change for the better in many places. In Iraq, that work has just started and may well be the biggest challenge to date.

A special problem in Iraq is that the economy is already in a state of shock, not so much because of the recent war or the subsequent widespread looting but because of decades of neglect.

—Åke Lönnberg

Åke Lönnberg’s paper “Building a Financial System in Afghanistan” was presented at a symposium in Bonn in June 2003 called “State Reconstruction and International Engagement in Afghanistan,” jointly arranged by the Crisis States Program of the Development Research Center of the London School of Economics and Zentrum für Entwicklungsforschung, Universität Bonn. The paper is available online at http://www.afghanistan-rg.de.vu/arp.

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