Iraq Economic News And Points To Ponder Thursday Afternoon 6-12-25
The Resilience Of Fiscal Adjustment Over The Flexibility Of Monetary Adjustment. Mechanisms For Repaying Domestic Public Debt.
On the flexibility of monetary adjustment Mechanisms for repaying domestic public debt Resilience of financial adjustment
Soft Monetary Hegemony:
Over the past few years, the Iraqi economy has witnessed extensive overlap between fiscal and monetary policy, with the Central Bank assuming direct financial roles—from financing the deficit to stabilizing the market—which has led to ambiguity in roles and weakened some aspects of the effectiveness of monetary policy tools at different points in time.
In rentier economies, where natural resources—primarily oil—dominate the structure of public revenues, the problem of the imbalance between the resilience of fiscal adjustment in maximizing non-oil revenues and the flexibility of monetary adjustment emerges, such as the ability to finance inflation or practice a cheap money policy in indirectly financing public budget operations (inflationary finance) by generating cash at the lowest cost, particularly through bond discounting mechanisms and government transfers.
Fiscal policy is often constrained by the requirements of inflated public spending, weak revenue diversification, and high social and political obligations.
This makes them less adaptable to cyclical shocks or sudden shifts in oil prices and the intensification of oil asset cycles.
Alternatively, monetary policy—represented by the central bank—is left alone to confront the repercussions of these shocks, and is required to respond quickly through exchange rate instruments, liquidity injections, or currency market intervention, despite the limited room for maneuver available to it.
This is one of the most severe examples of overlap, interaction, or conflict between fiscal and monetary policies simultaneously.
The Iraqi economy is currently witnessing a qualitative shift in the balance of power between fiscal and monetary policies.
This may represent a potential gradual shift (from strong fiscal dominance to soft monetary dominance), meaning that monetary dominance is neither absolute nor severe, but rather occurs in a flexible and gradual manner, with a degree of coordination with fiscal policy.
However, monetary policy does not completely lose its independence, given the legal or broad independence of monetary policy covered by Law No. 56 of 2004.
After years of financial dominance, which relied heavily on government spending financed by oil revenues, a new phase began to take shape, with the central bank's role as a key player in controlling macroeconomic balances, particularly through monetary policy tools.
The central bank maintained its independence with degrees of control over inflation and exchange rate management, interspersed with flexible and thoughtful coordination with the fiscal authorities to ensure market stability, ward off the specter of recession, and meet the necessary financing needs of public finances without threatening monetary control.
This shift is evident in the disciplined independence of the Central Bank in formulating its policies, its regulation of financing the fiscal deficit through monetary expansion, and the adoption of sometimes stricter and sometimes more flexible measures to control public liquidity and inflation, even if this conflicts with the expansionary objectives of public finance.
2 This shift in soft monetary dominance reflects a trend toward enhancing monetary stability. However, it also poses significant challenges for decision-makers in reconciling the imperatives of monetary discipline with the requirements of economic stimulus and sustainable development, in an economy that remains rentier and largely dependent on public spending for its overall activity.
(Hard Fiscal Dominance) B- On the other hand, this problem has clearly emerged between public finances, in which they attempt to close aspects of their financing levers to reduce the effectiveness of the central bank’s independent decisions, and (Hard Monetary Dominance).
It is highly complex and manifests itself in broad and strict independence, after monetary policy demonstrated levels of tolerance for the emergence of "soft monetary hegemony." Monetary policy is fully independent while simultaneously taking into account the circumstances of fiscal policy during severe economic crises, particularly cycles of declining oil assets and rentier economic obligations.
Despite the Central Bank's attempts to implement more flexible and independent monetary policies that fluctuate between two directions, the structural rigidity of public finances, whether in the form of fixed current spending or recurring deficits, has remained an obstacle to building a balanced and stable economic model.
This imbalanced dynamic has often burdened monetary policy beyond its natural function, leading to monetary imbalances, such as inflationary expectations, exchange rate fluctuations, and unstable growth in public liquidity.
C- Addressing this structural imbalance necessitated reassessing the relationship between fiscal and monetary adjustment, ensuring harmonious flexibility between monetary and fiscal policies. This would achieve a balance capable of absorbing shocks and supporting sustainable development in a highly volatile economic environment exposed to pressures from oil asset cycles.
Thus, the expected effects will continue to reduce inflationary pressures, protect the country's foreign currency reserves, and enhance the credibility of the Central Bank domestically and internationally, in addition to paving the way for the issuance of stable domestic debt instruments and sustainable development.
The problem of financing public expenditures with oil resources between monetary and financial adjustment:
The relationship between financing public expenditures and oil revenues is one of the most prominent structural problems facing the Iraqi economy. Under the dominance of oil revenues, the state has relied for decades on a single source to finance its budgets, leaving it vulnerable to sharp fluctuations in global energy markets. This reality has posed dual challenges in terms of fiscal and monetary adjustment.
At the fiscal adjustment level, fiscal policies failed to build a sustainable, diversified non-oil revenue base or restructure public spending in line with long-term development goals. Public spending was often expansionary during periods of oil abundance and contractionary and harsh during periods of oil recession, without flexible mechanisms to adjust the economic cycle or absorb shocks.
3 Regarding monetary adjustment, the Central Bank found itself in a defensive position, sometimes forced to use monetary tools that were not geared toward achieving macro-stability as much as they were to respond to financing pressures resulting from the fiscal deficit, whether by stabilizing the exchange rate or injecting liquidity to cover government obligations. This often led to monetary inflation and imbalances in the currency market.
Continued reliance on oil resources to finance expenditures without structural reforms at the fiscal and monetary levels will deepen the fragility of the economy and prevent the development of an integrated fiscal and monetary adjustment system capable of absorbing shocks and achieving stability and growth in the long term.
Based on the above, there are two basic mechanisms that monetary and fiscal policies have become accustomed to exchanging roles between them.
Monetary Adjustment - Reducing the external value of money (First mechanism:
Any devaluation of the exchange rate, as it often leads to providing leverage for public finances with low purchasing power for government expenditures, and (helps sustain nominal operating expenditures such as salaries, wages, pensions, and social welfare), but (does not help sustain external payments such as debt service, imports, and government external payments) as long as there is a stagnation in expanding the non-oil revenue base (it is simply buying a cheaper dinar financed by the same oil revenues exchanged from the central bank), which means that the fiscal adjustment will become derived from the monetary adjustment, nothing more!!
The second mechanism: in the event of enhancing the external value of money
The second mechanism: In the event of a monetary adjustment to counter inflationary pressures and expectations, meaning there is a nominal adjustment, public finances will increase the purchasing power of their public expenditures in exchange for a decrease in budget revenues in the nominal dinar.
This will be achieved by using fiscal mandates again to maximize non-oil resources.
Public finances will be forced to borrow from the government banking market, particularly the largest financial market in our country.
Given the phenomenon of external liquidity leakage according to the country's overall monetary equation, this mechanism will force monetary policy to accept the discounting of government bonds and expand the monetary base through open market operations, as long as foreign currency has been obtained through highly flexible monetary adjustment.
This is achieved by the budget bearing a financial deficit financed through the ability of monetary policy levers to provide sufficient liquidity to the government in an ongoing process.
This process now absorbs approximately 50% of the domestic public debt, which is an additional monetary issuance due to financial dominance.
4 Domestic public debt repayment and joint policy adjustment: A view of the interaction of the external monetary equation and its equivalents:
A- Monetary policy has been able in recent years, through its high foreign reserve capacity, to convert domestic quasi-external money into effective external money for the benefit of public finances.
This has been achieved as long as it has the ability to cover the national currency issued by discounting domestic debt instruments held by commercial banks and through open market operations.
This coverage rate exceeds 75% for these discounted debt instrument issues covered by foreign exchange reserves, without prejudice to Article 26 of the Central Bank of Iraq Law No. 56 of 2004, which prohibits lending to the government but allows the sale and purchase of foreign currency through open market operations.
This means the regeneration of foreign currency, known as MOM, amidst positive factors provided by optimism in the current account of the balance of payments and its impact on the provision of a government borrowing lever from the banking system, which the public finances considered a convenient lever to finance the deficit for the purpose of expanding public spending.
Most of this borrowing came from the purchase of treasury transfers to the government banking system.
B- On the other hand, the foreign currency issued and operating outside the banking system in our economy is primarily idle cash balances operating outside the banking system.
However, it has not constituted a source of disruption to monetary policy or macroeconomic stability, despite the fact that 90% of the monetary issuance is mostly outside the banking system.
5 Noting that idle cash balances outside banks (which are cash held by individuals or institutions and not deposited in the banking system) include liquid cash, money held by economic units in homes, offices, or any other place away from banks.
The reasons for keeping cash outside banks, as is well known in our economy, stem from inherited characteristics, including limited trust in the banking system. Some prefer to keep their money in cash due to fears of financial crises at opaque institutions, which are little known.
This is in addition to the lack of appropriate banking services, especially in rural areas or those lacking banking infrastructure, or the lack of easy access to the funds held in the grey market or their immediate use when needed.
The grey market still accounts for approximately 70% of total market transactions.
It is no secret that, in light of the dominance of the grey market, the informal economy has become, in the case of using cash outside banks, merely a tool for avoiding taxes or recording transactions.
Despite this, inherited cultural and social reasons favor keeping cash as a traditional method for storing wealth, even today, within the components of the overall monetary economy.
These inherited cultural complexes will be transformed by electronic payment methods into inert money, but this time within the banking system, unless they are invested.
C- Based on the above, it can be said that semi-external money, which is created by the domestic public debt and amounts to more than 85 trillion dinars (which is one of the factors of monetary issuance and a component of basic money), does not generate any inflationary pressures as long as it is covered by foreign currency, which automatically transforms it into completely external money, rather than being semi-external money. This automatic transformation from semi-external money to external money is governed by two factors:
First: Automatic High Coverage of Semi-External Money
Second: The rational official exchange rate, which allowed domestic borrowing to reach more than 85 trillion dinars without causing disruptions in the growing liquidity sourced from indirect monetary issuance financing, through the trading and discounting of sovereign bonds and treasury transfers, as mentioned above, at the Central Bank of Iraq.
- Hedging against the link between public debt and the money supply issued through domestic borrowing will remain a controversial issue within economic policy circles, both financial and monetary, regarding maintaining economic stability.
This is because the availability of cash balances outside or within the banking system will remain uninvested or unused for a long period of time.
This money is often stored in homes, in current bank accounts, or in funds without generating any returns or interest. This is not ideal from an economic perspective, as it leads to the loss of investment opportunities.
Therefore, these balances can be invested in projects that generate profits or benefit the national economy.
This money is also affected by inflation. The purchasing power of this money may decline over time due to long-term inflation rates, as well as weak economic efficiency, which means that there are uninvested funds that are difficult to utilize as financial resources.
However, the question remains: Is there a break-even point for measuring the relationship between the accumulation of domestic public debt held by the monetary authority and foreign reserves in a rentier economy? This is what we will discuss below.
6 Joint Monetary Adjustment Operations between Monetary and Fiscal Policies...!/Mechanisms and scenarios for extinguishing domestic public debt:
What the national economy and economic policy can bear is monitoring the current account of the balance of payments to the gross domestic product.
This requires fiscal policy to work to extinguish domestic debt whenever there is a positive improvement in that ratio.
This is an automatic process that should be carried out from outside the framework of the Joint Monetary Adjustment Operations (JMAOs), i.e., adjustments between monetary and fiscal policies in the interest of containing domestic public debt within the financial and monetary systems.
As we mentioned, the Central Bank still holds more than 50% of that domestic government debt, which has become the country's monetary basis.
In contrast, the traditional default on the principal of domestic debt requires the adoption of a framework of joint fiscal and monetary policies, one of whose priorities is to avoid, when absolutely necessary, reducing the external value of money (the exchange rate) in the event of a default and its extension into the long term, especially if The country's foreign reserves have not decreased without a decrease in the domestic debt balance or the creation of any national assets that the public finances can exchange from the public domain for that debt, according to the strength of the current account indicators of the balance of payments and the oil asset turnover, as external factors influencing macroeconomic stability.
The current account of the balance of payments to GDP ratio is a monitoring factor for the accumulated unpaid domestic public debt, one of the most important indicators for measuring debt sustainability and its impact on long-term stability, particularly the problems of rising inflation rates.
This is within the framework of a fiscal policy that seeks financial consolidation, i.e., the annual reduction of the general budget deficit and the reduction of the domestic debt stock to achieve the goals of stability and sustainable economic growth.
In this regard, and in order to adopt common principles between monetary and fiscal policies to gradually extinguish the domestic debt, the following solutions can be adopted:
Fiscal Adjustment, which is considered one of the adjustment methods.
The first: Start by extinguishing the accumulated domestic public debt on the bank's balance sheet. The central bank, whenever that debt approaches the value of marginal external money (foreign reserves), converts the marginal portion of the debt to its equivalent in the value of the annual deficit in the current account of the balance of payments divided by the annual GDP (hybrid monetary-fiscal adjustment).
Second: The central bank's acceptance: The monetary authority agrees to waive the annual interest charged on those government financial assets held by the central bank's general budget (i.e., zeroing the annual interest rate) until the general budget situation improves and the deficit gap in the current account of the balance of payments and the general budget, or one of them, is eliminated, and a solid roadmap is initiated to extinguish the public debt held by the monetary authority.
7 The above does not negate the adoption of a policy to extinguish the accumulated domestic public debt balance in the public finances, which currently constitutes the bulk of the central bank's external assets.
Third: Contrary to the second statement above, monetary policy will bear the pressures of the money supply from external currency. If foreign reserves decline, this occurs when the value of issued foreign currency exceeds its equivalent in foreign reserves or assets. This results in two dominant or pressuring trends facing monetary and fiscal policymakers, who face three possible scenarios: First:
Debt Inflation Swap: Devaluation of the currency and repayment of domestic public debt. This is the process of exchanging debt for inflation in order to finance the general budget and extinguish part of the debt.
Monetary Adjustment, also known as monetary adjustment, is often considered one of the worst types of financing, due to the negative price effects it leaves on overall stability.
Scenario Two:
Waiver of the debt amortization share based on a percentage of the Central Bank's annual profits. This is considered good governance of monetary policy, given that the Central Bank's capital is based on allocations from the general budget, and the general budget is responsible for the sustainability of the Central Bank's general budget capital, in accordance with Law No. 56 of 2004.
Scenario Two:
Finally, if the two scenarios above fail to fully repay the accumulated government debt on the Central Bank's balance sheet, the remaining government debt will be exchanged for real assets, which the monetary authority will use as effective assets in supporting monetary stability.
Monetary adjustment (waiver of the Monetary Adjustment aspect) is therefore considered fair for monetary policy to bear the burden of this debt, through annual profits, at a proportionate rate, before fiscal policy is able to waive its real assets for the benefit of the monetary authority's balance sheet to extinguish half of the public finance debt.
Fiscal adjustment (which is an optimal collaboration between monetary and fiscal policies to contain domestic debt sustainability problems) for relatively long periods may constitute a constraint on the sustainability of stability within the framework of achieving monetary and fiscal policy objectives.
This requires adopting the following solution scenarios:
First Solution Scenario: This is the easiest scenario, which requires engaging in high inflationary financing by reducing the external value of money, equivalent to sustaining 75% of operating expenses to extinguish the domestic debt, in exchange for this stability and in the interest of maintaining foreign reserves at the red line.
This is a strong or gradual shock approach.
However, it is a solution that is politically and socially unacceptable in most cases...!
8 The second scenario is the preference for strengthening monetary policy.
This is when public finances abandon their possible fiscal adjustments in favor of more flexible monetary adjustments.
This represents a sharp political shift from fiscal dominance to monetary dominance.
This means that there is a major economic shift in which monetary policy becomes the controlling force over public finances, after fiscal policy had been dominant.
This could indicate an extremism in the independence of the central bank, or a greater reliance on monetary tools to control macroeconomic movements and overall economic activity, rather than relying on government spending due to the rigidity of fiscal adjustment.
This is constitutionally unacceptable, but it is politically unacceptable in a rentier country that relies on oil revenues to finance public expenditures by 90%.
This is especially true when the central bank refuses to finance the fiscal deficit by printing inflationary finance.
The dinar, and adheres to strict monetary measures even if they cause financial distress for the government, represents a shift from financial dominance to monetary dominance.
This scenario entails granting the central bank broader powers to combat inflation and control the currency market through:
a. Establishing a more flexible exchange rate regime.
b. Using open market tools with greater efficiency.
c. Regulating the central bank's intervention in government financing.
The third or final scenario (Dual Adjustment Strategy): This scenario is based on a combined dual adjustment strategy.
This scenario is determined by combining the first and second scenarios, by reducing (financial dominance) and transforming it from a state of complete abolition to a state of accepting partnership with (monetary dominance) at an equilibrium point that is politically, economically, and legally acceptable.
This is a shared will, but it will grant the central bank in a highly rentier country the powers of public finance to protect financial stability and sustainability, and to address the cycles of oil assets.
This comes at the forefront of which is the ownership of real government assets that are immediately converted into financial assets and gradually become components of net wealth on the bank's balance sheet.
The central bank and market partnership mechanisms in the debt-equity swap process.
This is a financial arrangement in which a portion of a state's debt is converted into equity (shares) for assets.
It is often used in common cases of financial restructuring, bailing out public companies, or even settling state debt to extinguish the central bank's holdings of government debt instruments and reduce the burden of domestic public debt.
9 Conclusions and Recommendations:
Although the third scenario for extinguishing domestic public debt remains more politically and administratively challenging, it is the most sustainable, especially in light of the increasing pressures on public finances and the Iraqi economy's need to develop flexible tools to address crises and reduce its dependence on oil fluctuations.
This scenario will achieve a true balance between fiscal and monetary adjustment, leading to prudent management of the economic cycle and providing space for development spending, free from rent-based fragility.
However, this does not preclude the implementation of parallel fiscal and monetary reforms within a comprehensive development framework, through:
Linking spending to a truly effective benchmark oil price.
This prevents excessive spending during periods of high oil prices, reducing the risk of deficits when they fall.
It also provides reserve resources that can be used in times of crisis (price declines or disasters).
It also provides financial consolidation and makes fiscal policy more stable and predictable. Fiscal Consolidation enhances fiscal discipline.
It also requires the importance of establishing a sovereign wealth fund to isolate oil surpluses from current expenditures, as many countries have done, including Norway and other oil-producing countries.
Continued close coordination between the Ministry of Finance and the Central Bank within a professional higher committee for economic policies remains a necessary condition for achieving the goals of stability and sustainable development in our country, achieving financial and economic sustainability within the framework of what is called the country's economic vitality, which is usually expressed optimally by the standard of non-oil primary fiscal balances.
The Non-Oil Primary Fiscal Balance (NOPEF,s) is a financial indicator used to assess fiscal sustainability in oil-producing countries.
It measures the surplus or deficit in the general budget after excluding oil revenues and before calculating debt interest payments.
10 Author: Dr. Mazhar Mohammed Salih: Economic researcher and academic. Advisor to the Prime Minister of Iraq.
Ze) Mazhar Muhammad Salih June 7, 2025 Since 2009 | Phone +9647866296600 | info@iraqieconoists.net |iraqieconomists.net | Copyright Reserved :copyright: 2025
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