A tricky operation

DURING the looting that followed the fall of Baghdad in April last year, the ten-storey headquarters of the Central Bank of Iraq (CBI) was burgled and torched before it collapsed into a pile of soot-stained rubble. Fourteen months later, the charred ruins have been cleared, and the CBI's staff work on American-provided computers in a building nearby.

Rehousing the central bank is one thing. Rebuilding an entire banking system is quite another. Despite the focus on military and political matters, the task has been surprisingly high on the American-led coalition's to-do list: even before George Bush declared that “major combat operations have ended” in May 2003, American advisers were preparing in neighbouring Kuwait. The job is all the more formidable because under Saddam Hussein Iraq had no independent banks to speak of. From the CBI to the lending policies of the six state-owned institutions that controlled most bank assets, the system was under Mr Hussein's thumb. Lending was based on cronyism, not credit quality.

Not surprisingly, inflation and bad loans left the banking system to all intents and purposes insolvent—as far as anyone can tell. Under Mr Hussein, record-keeping was patchy at best. One adviser tells of “madly trying” to reconstruct historical balance sheets at the banks, searching fruitlessly for records of collateral against bad loans, and of the frustrations of wading through opaque financial reports in which accounting “varies from branch to branch and, often, month to month”.

No wonder that most Iraqis chose to stuff their dinars in their pillows rather than in bank accounts—and the habit persisted after the Americans abolished the old currency and printed a new one. With no electronic banking—there are no ATMs or credit cards—most of the Iraqi economy is still based on cash. It works around, not through, the formal banking sector. America's Treasury Department estimates that Iraq's banks' assets amount to just $2 billion, or only 10% of GDP, a “low ratio by any comparison”.

Years of economic isolation, due to sanctions imposed by the United Nations after the first Gulf war in 1991, have also added to the forces keeping banking primitive. Transactions are limited to deposit-taking and infrequent loans—for which banks require collateral worth up to four times the credit. Many bank processes (such as cheque clearing, which can take as little as three days or as long as three weeks) are still done by hand. Electronic links among bank branches, let alone to the outside world, are rare, although this is changing. Until recently, the Coalition Provisional Authority (CPA) paid Iraqi army pensions by (well-armed) courier.

Despite the unpromising conditions, the CPA, which will be dissolved next week to make way for an interim government run by Iraqis, has made some headway. It has drawn up a framework of laws and rules for the new banking system. A law that came into effect in March established the CBI's independence and laid down its procedures for everything from the management of foreign reserves to bank supervision. A new commercial-bank law governs the functioning of Iraq's 17 private banks, which were legalised by Mr Hussein in the early 1990s in response to a cash crunch following UN sanctions.

A huge training effort has been going on. Advisers from America's Treasury and bank regulators have given classes on subjects ranging from the use of Microsoft Word to the basics of Basel 2, a new treaty on bank supervision. “It is a big challenge, a new way of thinking,” says one American adviser. “Banking based on risk and judgment is radically different from bank decisions based on Saddam's say-so.”

A basic currency reform was also necessary. Under Mr Hussein, there were two lots of dinars: one in the Kurdish north, another elsewhere. Because there were only two or three denominations, worth up to at most $5 or so, even basic purchases required thick wads of notes. So the CPA set to work designing a new, unified currency with several denominations. After frenzied printing in factories from Germany to Kenya, 27 Boeing 747s crammed with bank notes flew to Baghdad. Armed convoys delivered the cash to 240 bank branches across Iraq and officials distributed, in all, two billion pieces of paper. The exchange was completed by January this year with virtually no hitches, a remarkable feat given the insurgency already in progress.

The creation of a single currency has permitted the CBI to carry out a basic monetary policy. The central bank carries out daily currency auctions, receiving about a dozen bids a day according to the CPA. The new dinar has appreciated by 25% or so since its launch, and has traded steadily at around 1,450 to the dollar since January. Inflation has been kept in check, no small thing given that hyperinflation often occurs during and after wars.

Encouraging as all this is, it still amounts to little more than the rudiments of monetary policy and a banking system. Without going much further it is hard to see how the Iraqi economy, which currently depends heavily on American grants and subsidies, can be put on a self-sustaining path.

The six state-owned banks, which comprise most of the banking sector, are still in a sorry state. The four smallest of these, which between them hold 5% of Iraq's bank assets, are “without a doubt insolvent”, according to a CPA official. Four-fifths of their loans are non-performing. The two biggest banks, Rafidain and Rashid, which together account for roughly 85% of the system's assets, may be no better off. They are thought to have lost $100m in the looting. Rafidain was the biggest commercial bank in the Arab world before the first Gulf war, with assets of $47 billion. If its estimated $24 billion of off-balance-sheet borrowing from abroad on behalf of Mr Hussein's regime were factored into its books, it would now be bust.

Exacerbating this is the $120 billion Iraq owes to foreigners (not counting reparations from the first Gulf war). While much of this debt may well be written off, no agreement has yet been reached. Until the extent of Iraq's debt is resolved, the state banks cannot do business abroad. Trade is funnelled through the Trade Bank of Iraq, run by a consortium of 13 international banks, which provides letters of credit for everything from medicine to the services of forensic accountants. It is hoped that Iraqi banks will one day take this over.

Perhaps the best hope lies with the 17 private banks, which are unencumbered by the worst of the old regime's cronyism and unburdened by its debts. But they are tiny, holding just 5% of all bank assets, although their share is growing. None of them has a country-wide presence. Bank of Baghdad, the biggest, has 20 branches; currently, Rafidain and Rashid have almost 300 branches open.

This would seem to be a suitable case for foreign investment to bring in the needed know-how and technology. In January, the CBI granted bank licences to three foreign banks: Britain's HSBC and Standard Chartered, and the National Bank of Kuwait. The new commercial-bank law permits other foreign banks to buy up to 49% of existing Iraqi private banks. At least one-third of the private institutions are already in discussions with other Middle Eastern banks.

All well and good. But so far none of the three licensed foreign banks has entered the Iraqi market. Security is an obvious concern, outweighing, for now, the risk that licences may be revoked if branches are not set up within a year.

And who can be sure that what has already been achieved will not be undone? Some observers worry that once the guiding hands of American advisers have gone, the CBI will become politicised and print money to pay off state debts. It is also possible that the new bank laws will one day be overturned altogether, because of nationalistic bias against foreign ownership or their lack of reference to Islamic teaching. And important as the state of the banking system might be, Iraq's economic health is sure to rest, in the final analysis, on political stability. The future, in other words, is still in the balance.