Unfortunately for the government, very few solutions to the problem present themselves. Increasing the price of oil derivatives would remove the price differential and prevent insurgents from profiteering at the expense of the average Iraqi--but the average Iraqi is likely to interpret any price increase as the government profiteering at his expense. Clamping down on the officials who are selling the products onto the black market should help, but when corruption has become so pervasive it is difficult to imagine that the government will ever be able to stem the tide entirely.

The Kidnapping Industry

Kidnappings have become an institutionalized criminal activity in Iraq. The Iraqi police report that under Saddam Hussein abductions made up 1 percent of their cases, but they now account for 70 percent of reported crime. In early 2004 an average of two people were kidnapped every day in Baghdad, with a typical ransom of about $25,000. Both figures have steadily increased with the development of sophisticated kidnapping gangs--at the end of the year the average had risen to ten kidnappings per day.

While the kidnapping of foreigners receives most of the publicity, hundreds of wealthy Iraqis, especially Iraqi women, have also fallen into the clutches of the kidnapping gangs. The gangs appear to be made up of criminals, unemployed soldiers and former mukhabarat agents with little to lose and much to gain in Iraq's security vacuum. Some go straight to the hostage's family or employers demanding a ransom; others feel that they can achieve a more satisfactory price selling their hostages to militant groups. The highest bidders for foreign hostages are likely to be organizations with a political axe to grind, looking for leverage over foreign governments.

In short, common criminals are working in tandem with insurgents, and the political demands of groups that execute captives in the name of their causes are driving a street-level hostage economy. The two groups appear to be feeding off each other in a variety of ways. Insurgent groups "outsource" the seizures to criminal gangs for money, and gangs independently take hostages when the opportunity arises and then sell them up the chain to the insurgent groups.

Kidnapping is an especially attractive business for the insurgents. It is not only an easy source of revenue to help fund their operations; the activity supports their cause in a more subtle, wide ranging way. It helps to feed popular dissatisfaction both with the government, which appears to be unable to control the country, and with the Americans, perceived as unable to provide effective security.

The economic consequences of terrorist-related criminal activities have been devastating for the development of the economy. By targeting businessmen and professionals such as doctors and university professors, the insurgents have sparked an exodus of Iraq's "human capital"--depleting the key building blocks of the country's formal economy. With little or no growth in the economy, the expansion of the shadow economy is coming directly at the expense of the productive elements needed to rebuild the economy.

The Drug Trade

Until recently, drug trafficking was not viewed as a serious problem. But given Iraq's porous borders, geographical location--situated near one of the major drug routes for opiates from Afghanistan--and an established tradition of smuggling, it is set to rise. Smuggling of heroin, hashish and prescription drugs from Afghanistan, Iran and Syria is making a comeback through transit points such as Samawah--the closest town to the Saudi Arabian border--after being interrupted by a 2000-01 crackdown by Saddam and the subsequent U.S.-led war to oust him.

Drug smuggling proceeds along two main routes--along a northern route from Iran to Turkey and from there into the Balkans pipeline for distribution in western Europe and a southern route to the Iraqi port of Umm Qasr, where it transits alongside illegally tapped oil and looted copper into the Gulf states. Other drug shipments move across the long, unguarded Saudi-Iraqi border.

The flow of drugs into Iraq is associated with the significant increase in Iranian pilgrims visiting Shi'a shrines in Najaf and Karbala. The CPA estimated that 10,000-15,000 Iranians enter Iraq each day, a development that has naturally encouraged Iranian drug smugglers to begin using the pilgrim route as a transshipment artery. Since September 2003 a number of Iranian pilgrims have been apprehended with large consignments of drugs, principally hashish.

Most experts concede that the drug trade in Iraq is increasing. In 2004 the border police seized 323 pounds of drugs, mostly hashish and opium coming in from Iran. The United Nations' International Narcotics Control Board has expressed concern over Iraq emerging as a narcotics route. While numerous incidents have been cited by the board, perhaps the most disturbing came in late May, when six Iranians arrested in Sulaymaniyah were found with a large stash of narcotics and explosive materials.

The extent to which the insurgency is benefiting financially or materially from the drug trade is unclear at this time. It is a fact, however, that under Saddam, Iraq's intelligence services (now key participants in the insurgency) were complicit in drug smuggling.

Money Laundering

The various illegal markets noted above intersect in the hawala-based money laundering market. In its simplest terms, the hawala system works as follows. An individual desiring to transfer money exchanges cash for a hawala note, often coded or secretly marked to foil potential counterfeiters. This note is then transferred to the other party via mail or courier, who in turn presents the note to an associated exchanger in their country, who converts the hawala note back into the appropriate cash specified in the note, minus a handling fee. In modern times, the use of e-mail, faxes and telephones has made these private cash transfers almost instantaneous and nearly impossible to trace or regulate.

The attractiveness of the hawala system to terrorists and criminals is obvious. As with most criminal activities in Iraq, the hawala system was given a great stimulus by the sanctions in the 1990s. The sanctions made it impossible for Iraqis outside the country to legally transfer money to friends and relatives in Iraq. Using this system, informal money-
brokers took money in the United States and other countries and got contacts in Iraq to deliver the equivalent to recipients in Iraq. Other methods included taking cash in person--always risky--or depositing money in a bank in Jordan or Turkey and hiring couriers to take it into Iraq.

At the present time, little is known of the hawala network in Iraq. This stems in part from the fact that the system is essentially an unrecorded, informal arrangement based on trust rather than reliance on formal records of financial transactions. While data on hawala activity are nearly non-existent, there are signs of its importance. Zarqawi activists in Dublin, Ireland, for example, are believed to have moved money to Iraq using the hawala system.

The dilemma for the Iraqi government posed by hawalas is that, while there is clear abuse of the system by Zarqawi and other criminal elements, the vast majority of money transferred by an individual hawaldar is likely to have come from legal sources. A crackdown by authorities at this time might cripple many legitimate transactions that, in the absence of a viable domestic banking system, serve a valuable economic function. Further, as an amorphous collection of independent operators, the hawala system does not depend on a single location of infrastructure. A crackdown would simply drive them underground. No doubt at this point such a crackdown would further alienate many Iraqis, who would view the action as caving in to Western demands at the expense of Muslim tradition. Even the CPA was reluctant, in its many orders setting regulatory standards for the country's financial system, to venture into this area. In particular, its "Order 93" covering money laundering was largely silent on hawala transfers. Understandably, Iraqi politicians have been likewise reluctant to suggest any form of hawala regulation, even along the successful lines pursued by the UAE.

That leaves two ways to deal with this system: intelligence or structural macroeconomic change. The latter is more effective and implies creating an economic climate in which people switch to a formal banking system. At the present time, however, the hawala system is likely to be attractive to many Iraqis because it is less expensive, swifter, more reliable, more convenient and less bureaucratic than the formal financial sector. In Iraq's case the misuse of the formal banks by the old regime resulted in lost trust and confidence among large segments of the population. Bank robberies undertaken by the insurgents and criminal gangs have also led many potential depositors to avoid the formal banking system.

In part these factors have resulted in little postwar progress in developing viable alternatives to the range of informal banking relationships that exist in the country. The semi-official Iraqi Strategic Review Board has acknowledged that Iraq's financial sector still has extremely low capacity and capitalization, with poor credit facilities and a weak system of money transfers. It estimates that the banking sector has only $2 billion in assets, spread among the central bank, six public banks and 18 private ones. Overall, the banking sector is only playing a marginal role in the economy as a provider or absorber of liquidity.