The Iraqi Dinar
By Vedran Vuk, Casey Research
Every few weeks I receive an email inquiring about the investment-worthiness of the Iraqi dinar. Since multiple subscribers are interested in the topic and US withdrawal from Iraq is in the news, this issue is worth mentioning. The Iraqi dinar promoters seem to push two main ideas:

1. With Iraq free of Saddam Hussein, the economy will boom and as a result the currency will strengthen; and

2. The Iraqi government will revalue the currency to pre-war levels. Instead of over a thousand dinars per dollar, the government could even set a one-to-one exchange rate - making holders of the old notes rich.

What's missing from both of these cases is an understanding of monetary policy.

Either the Iraqi dinar promoters are completely ignorant of the basics of currency markets and monetary policy or they're just plain scammers. I'll let you decide.

Let's start with some common sense. If one thinks the US economy is going to boom, would the dollar be a good investment idea? Well, maybe, but it wouldn't be the best idea. Why not invest directly in the DJIA, Nasdaq, or S&P 500? Currencies and the strength of the country's economy are not perfectly correlated. Just think of the US economy in the past few years. The economy has been in a horrible rut, yet the dollar has been all over the place. Furthermore, as the stock market has plunged, the dollar has strengthened - and vice versa. Many other factors affect a currency other than the strength of the economy. If one really believes that Iraq will become a booming economy, don't buy the currency - buy a diversified portfolio of Iraqi stocks. That might be a little troublesome, but if this is really the trade of the decade in your mind, go for it.

One of the most important factors in a currency's strength is its central bank. A nation can have all the economic growth in the world, but if its central bank is printing money like crazy, the currency will still become worthless. In fact, that growth might be the result of a monetary-induced bubble. Ultimately, a bet on any currency is a bet on its central bank. While many readers are likely familiar with the political situation in Iraq, the vast majority probably don't know anything about the country's central bank. And don't think the connection to oil can save the currency either. Just think about the currency controls and over 30% inflation in Venezuela.

The second case for the Iraqi dinar isn't particularly good either. The central bank doesn't possess a magic wand that revalues the currency. This investment thesis assumes that the Iraqi central bank can just legislate a fixed exchange rate. In reality, it's a process where the central bank must contract the money supply and battle forces on the exchange market. Consider the basic logistical problem here. Currently, 1,170.50 dinars trade for a single US dollar. Suppose the central bank sets a one-to-one exchange for the dollar. What's immediately going to happen? Everyone holding dinars will want to trade them for US dollars, but who will exchange the dinars to dollars? Currency markets always require a buyer and a seller. Will major banks say, "Iraq's central bank told us that the dinar is the same as the dollar, so we are going to assume that's true"? Of course not! No one would trade dollars for dinars based on an arbitrary rate.

Is the central bank completely powerless to fix the rate? No; it can try to convince the market of the exchange rate by purchasing Iraqi dinars on the open market. If the Iraqi central bank agrees to exchange one US dollar for each dinar, market participants may believe the new exchange rate, but that's going to take a lot of convincing - meaning a ton of reserve currency from Iraq's central bank. If the central bank wants to return its currency to a one-to-one relationship with the dollar, it will have to spend billions in the currency market buying up dinars. Why the central bank would want to waste this money is extremely puzzling.

To sum this up, this is a monetary issue, yet the dinar promoters love to discuss anything but the central bank of Iraq. They're on some different planet where the strength of currencies has a perfect correlation with economic growth and where exchange rates can be set with the swish of a magic wand.