By Timour Azhari

BAGHDAD, Aug 16 (Reuters) - Iraq has made strides implementing U.S. dollar supply restrictions targeting Iran but faces an uphill battle with a banking system unaccustomed to strict oversight and persistent currency smugglers, central bank governor Ali al-Allaq said.

"It is really a battle, because the people benefiting from this situation and those harmed (by the new measures) will try in various ways to continue their illegal activities," Allaq said in an interview with Reuters.

Allaq did not mention Iran by name and said he did not have data on how much of Iraq's dollars been smuggled to Iran or other neighbouring countries, including Turkey and Syria, before the United States tightened regulations in November.

The U.S. measures that aim to enforce sanctions on Iran are a sensitive matter in a country that has often been a front line in the rivalry between Washington and Tehran.

Iraq's government is reliant on Washington's continued goodwill to ensure oil revenues and finances do not face U.S. censure, but it came to power with the support of powerful, Tehran-backed groups and so cannot afford to alienate Iran.

The latter groups have accused the U.S. of meddling in Iraq's internal affairs and creating a currency crisis, as businesses either struggling or unwilling to abide by the new measures sourced dollars from exchange shops, driving down the value of the Iraqi dinar.

Iraq has more than $100 billion dollars in reserves, Allaq said, but could not freely intervene in the market to bring the rate down due to the restrictions.

Last month, the U.S. Treasury Department and the Fed barred 14 Iraqi banks from conducting dollar transactions as part of a wider crackdown on dollar smuggling to Iran via the Iraqi banking system, U.S. officials said.

Allaq said that action related to transfers from 2022, before a new platform that aimed to improve transparency went live. He said the central bank was undertaking a review of the banking sector and introducing new regulations that he said would likely see some banks close.

"It would be very normal in the coming period to see a reduction in the (number of private banks)," he said.

"There are always side-effects, but at the same time we have a responsibility to protect the country's interests by trying to find the necessary means for monitoring and oversight so as not to expose the country to any issues on this front," he said.

'TRANSFORMATION'

The U.S. measures have targeted Iraq's so-called dollar auction, where the central bank requests dollars from the U.S. Federal Reserve before selling them to commercial banks, which in turn sell the funds to businesses in the highly import-dependent economy.

U.S. and Iraqi officials have said the auction allowed large sums of money to be illegitimately acquired by groups who would provide fake invoices and then either transfer or physically smuggle the funds to neighbouring countries, chiefly Iran.

A feature of a highly informal economy, the system was also used by thousands of small businesses that are not registered with the state, Allaq said, a widespread phenomenon in Iraq that allows them to dodge taxes and customs fees.

Since January the central bank has asked banks to provide detailed information on senders and recipients of transfers via an online platform.

When companies began trying to use the platform in January, less than 20% of requests were approved by U.S authorities, Allaq said. That number had now risen to around 85 percent, signalling growing ease with the new regulations, he said.

Allaq said that tighter regulations along with government plans to promote digital payment were forcing a wider shift in the Iraq economy in a country where cash remains king and the majority of adults do not have bank accounts.

"It is not just an electronic platform, it will lead to a total reorganisation of trade and the movement of money, and control on a lot of avenues for suspicious activity."

Reporting by Timour Azhari; Editing by Angus MacSwan