Cablegate: What Is Driving Iraq's Declining Inflation Rate

DE RUEHGB #4059/01 3471815
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E.O. 12958: N/A


1. (SBU) SUMMARY: Inflation in Iraq is on a downward trend,
reflecting improved security, supply and targeted monetary
policy. A close examination of the country's inflationary
trend revealed poor security compounded by increasing
demand--especially for fuel--to be the major inflationary
pressures. Tight monetary policy enacted by the Central Bank
of Iraq helped curb inflation with the dinar appreciating
approximately 17 percent against the dollar since September
2006. Declining inflation is helping the average Iraqi and
increasing domestic confidence in the government's economic
policies. At the same time, however, banking and other
economic reforms need to be moved forward to capitalize on
lower inflation and create sustainable private sector jobs in
Iraq's oil-based economy. END SUMMARY.

Recent Decline in Inflation Trend

2. (SBU) Inflation in Iraq is trending downwards, with the
consumer price index (CPI) reaching just 15.5 percent
year-on-year (y-o-y) in November 2007, due largely to the
increase in all the prices of commodities and services
groups, especially foodstuffs, fuels, transportation, and
communications. This is encouraging when compared to a spike
in inflation from 22.3 percent in January 2006 y-o-y to 41.9
percent y-o-y in February 2006 following the Samarra mosque
bombing, which was then followed by an all-time post war high
of 76.6 percent y-o-y for CPI in August 2006. Inflationary
growth hovered in the 50 percent range for almost all of
2006, and finally began easing in the spring of this year,
with a substantial drop in February 2007 to 37.1 percent

3. (SBU) Core inflation's trend mimics CPI for the most part,
albeit at a lower level. Iraq's core inflation is defined as
the rate of change of CPI calculated by excluding three fuel
derivatives items of kerosene, LPG, and gasoline. Core
inflation was 30.7 percent y-o-y in February 2006, climbed to
38.1 percent y-o-y in July 2006 and reached just 14.4 percent
y-o-y this November.

How Inflation is Measured in Iraq

4. (SBU) Inflation in Iraq is measured by the Ministry of
Planning and Development Cooperation's Central Office for
Statistics and Information Technology (COSIT). Although
understaffed and under-resourced, COSIT is working to update
its methodology and further refine its measurements. A
senior USAID consultant to COSIT told Econoff during a
meeting on November 22 that COSIT is making steady progress
to increase the efficiency of it data collection, and the
statistics produced on a monthly basis are accurate. For
example, data collection experts sample three black market
fuel providers located in the vicinity of official gas
stations to calculate the price for fuel.

5. (SBU) The current base year COSIT uses is 1993. The base
does not include the Kurdish provinces, and measures only 446
items in 60 markets. However, CPI will soon be calculated
using the a new market basket as established by the new Iraq
Household Social and Economic Survey run from November 1,
2006 until October 31 2007. The survey includes all 18 Iraqi
provinces and measures 1,616 items as purchased by 18,144
households. Some initial findings of changes in income
expenditure between 1993 and 2006 include: food expenditure
dropped from 63.2 percent of income to 28 percent; fuel
expenditure increased from 2.1 percent of income to 31
percent (although the 2007 formula includes housing and
utilities expenditures); and the amount spent on
transportation went from 4.9 percent to 10 percent.

--------------------------------------------- --
High Demand, Constrained Supply Drive Inflation
--------------------------------------------- --

6. (SBU) A close examination of Iraq's inflationary trend
since 2004 revealed poor security compounded by increasing
demand as the major inflationary pressure. Inflation
remained high between February 2006 and summer 2007, but as
the military surge lowered levels of violence, the
inflationary rate declined in tandem, and in particular in
Baghdad. The USAID consultant raised a particularly striking
example: modern Baghdad's infrastructure was originally
planned to accommodate 500,000 vehicles, with an attendant
number of gasoline stations and other supply infrastructure
to support that number. After 2003 demand soared for
personal automobiles, which now total more than 1.5 million.

BAGHDAD 00004059 002 OF 003

Demand has similarly risen for other new purchases that
require fuel, such as air conditioners and power generators.
While this surge in demand was growing, the flow of goods and
services was under severe strain due to dangerous
transportation networks, attacks against refineries, and a
shortage of supplies in the market exacerbated by official
prices previously below regional levels. These factors led
strongly to the high supply-driven inflation.

7. (SBU) Another factor fostering inflationary pressure is
supply inelasticity due not only to poor infrastructure, but
also linkages between regional markets. A senior US military
officer noticed in summer 2007 visits throughout Iraq that
the price of dates varied by a factor of 5 over a 75-mile
highway distance. The price of tomatoes varied by 25 percent
over a similar distance and each of the two markets are
supplied primarily by different countries--Syria and
Iran--and not Basra province where they are in excess supply.
(COMMENT: Econoff has encouraged in economic briefings to new
PRT officers to seek to identify ways of capitalizing on
regional trading relationships for their provinces, both
inside and outside of Iraq, to ease these market
inefficiencies that have very real consequences on the
ground. END COMMENT)

8. (SBU) COMMENT: What is surprising is how quickly inflation
responded when fuel supply shortages eased at the end of the
summer and early into the fall. Although there is no one
concrete factor, Econoff's meetings with numerous Iraqi
government advisors and Iraqis themselves point to increased
fuel availability at a reasonable, and in most cases
official, price due to improvements in security. This is not
just physical security, but the removal of sectarian actors
who controlled fuel sales and enforcing delivery to major
official gas stations. Combined with the official gasoline
price rising to market levels to reduce smuggling incentives,
this appears to be making a substantial difference in
Baghdad. Even Minister for Oil Hussein Al-Shahristani told
the press at the end to November that "decreasing violence
has allowed his ministry to reopen gas stations across the
city. At those stations, where drivers last year sometimes
waited for days to fill up, waits are now usually less than
15 minutes, decreasing demand for black-market gas". END

But Tight Monetary Policy Helped Too

9. (SBU) Although supply-side issues have shaped Iraq's
inflationary pattern in the past few years, tighter monetary
policy enacted by the Central Bank of Iraq (CBI) has helped
to dampen additional inflationary pressures. Alarmed by the
steady climb of inflation in 2005 and the sharp increase in
2006, the CBI curbed liquidity by gradually appreciating the
dinar approximately 17 percent against the dollar starting in
September 2006 through December 2007. The International
Monetary Fund (IMF) in a report yet to be released noted the
appreciation of the exchange rate has succeeded in increasing
the demand for dinars and contributed significantly to the
drop in inflation. The IMF (in the same report) also is
recommending the CBI continue dinar appreciation until core
inflation comes down to near single-digit levels, which is
important to continue to de-dollarize Iraq's oil-based

10. (SBU) A senior TF-BSO consultant to the CBI met with
econoff on November 28 and provided unique first-hand insight
into how the CBI formulates and implements monetary policy
through volume control. The auction price for the dinar at
its foreign exchange auction often is set on an almost daily
basis before the currency auctions by polling the nearby
money traders. In August 2007 the CBI increased its required
reserve ratio on government deposits from 25 to 75 percent in
order to draw up excess liquidity from government deposits in
commercial banks. Finally, the CBI also sells its own
treasury bills directly.

Why this All Matters

11. (SBU) COMMENT: Current inflationary trends are helping
provide breathing space opened by the improving security
situation to translate into improvements in the quality of
life for the average Iraqi. Previously inflation was
underestimated and post-war Iraqis felt the full brunt of
Saddam Hussein's distorted economic policies, remnants of
which still exist, such as the free basic goods provided
monthly in the Public Distribution System. However, the
clear trend of a decreasing rate of inflation is a success
story and can further improvements in supply elasticity. We

BAGHDAD 00004059 003 OF 003

will highlight via septel how a strong increase in demand for
dinars is a vote of confidence by Iraqis in their domestic
economy and their government's economic policies.

12. (SBU) On the cautionary side--maintaining tight monetary
policy to curb inflation can restrict growth and limit
lending capital for small and medium sized enterprises. In
order to capitalize on the improving security situation, a
more even playing field for private and commercial banks
needs to be fostered against the state-owned and supported
Rafidain, Rasheed, and Trade Bank of Iraq. Moving in this
direction will help the private sector development that will
assist tangible, sustainable job creation in Iraq's oil-based
economy. END COMMENT

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