Monday 21, May 2018 by Jessica Combes

Darkest before dawn?


For many years, Iraqi citizens have felt that the only way is up—and analysts are finally starting to agree 

Oil is both Iraq’s biggest strength and weakness. It has been the lifeblood of the economy since the country’s first productive well was drilled in 1927, and there has been little diversification since.

According to the BP Statistical Review of World Energy, Iraq’s proven oil reserves were 153 billion barrels, the fifth-largest in the world, equivalent to nine per cent of global proven reserves at the end of 2016. Moody’s says that oil accounts for about 50 per cent of nominal GDP, nearly 100 per cent of exports, and around 90 per cent of government revenues.

However, because oil extraction is a capital-intensive industry it has done little to boost employment and spread wealth among the citizens of Iraq; it accounts for only one per cent of total employment. Hence, lower oil prices have ravaged Iraq’s finances. Black gold has traditionally provided approximately 95 per cent of foreign exchange earnings, so when prices halved in 2014 Iraq’s Government found itself staring into a void.

With skyrocketing security bills and higher humanitarian outlays, the fiscal and external balances in the Federal Government of Iraq and the Kurdistan Regional Government have been deteriorating since 2014. Moody’s estimates that Iraq has moderate fiscal fundamentals, with a debt burden that is expected to stabilise at around 60 per cent of GDP. The IMF anticipates a very large nine-percentage point deficit reduction in 2017. However, both scenarios are almost entirely dependent on oil revenue increases.

Government non-oil investment has declined by two-thirds, starving the agriculture, manufacturing and construction sectors of vital funds. While strong oil production picked up the slack in 2016, the World Bank predicts that the OPEC agreement to cut production until March 2018 is expected to lead to a contraction. According to Moody’s, developments in the oil industry put a brake on growth in 2017 when GDP growth contracted 0.4 per cent. This is a dramatic fall from 2016 when GDP growth surged 11 per cent on the back of improved oil production.

Looking ahead, the rating agency predicts that growth between now and 2022 is likely to slow. After a growth rebound of 2.9 per cent for 2018, the IMF is forecasting that real GDP growth will be between 1.7 per cent and 2.1 per cent through 2022.

While this may paint a fairly pessimistic picture, analysts are quick to point out that it isn’t all bad. Iraq still holds substantial resources and plenty of potential for growth and development. GDP growth held up surprisingly well in the face of an expensive military campaign against Isis, and the government has very significant reserves that total around $40 billion. Growth is set to accelerate in 2018 by virtue of higher oil production and generous international financing.

The World Bank expects that improved security and reconstruction efforts will sustain non-oil growth in 2018. In fact, non-oil growth is predicted to turn positive after a three-year decline, despite the ongoing fiscal consolidation. This is thanks to construction and services on the supply side, and pickup in government consumption and investments on the demand side. The government’s reform effort—but not reconstruction—is supported by a large financing package courtesy of a deal with the International Monetary Fund (IMF). The deal is a result of the Stand-By Arrangement (SBA) and, according to the IMF, Iraq is delivering on its side of the bargain. In the fiscal area, the authorities are implementing a sizable fiscal adjustment, mostly through retrenchment of inefficient capital expenditure while protecting social spending.

The peg of the Iraqi dinar to the US dollar continues to provide a key anchor to the economy. However, the IMF admits that performance under the SBA has been weak in some key areas. According to Moody’s, performance has been mixed under the arrangement and this raises broader questions about governance and policy effectiveness. Further fiscal adjustment will be required to keep the programme on track, the rating agency said. However, the IMF argues that understandings have been reached on sufficient corrective actions to keep the programme ticking along.

“The composition of the fiscal adjustment should be improved over time by increasing non-oil revenue and reducing current expenditure,” the IMF said in a report. “In addition, reforming the electricity sector and state-owned enterprises will make room for larger and more effective investment expenditure that supports growth and job creation.”

Significantly improving public financial management will be important, the IMF warned. Arrears need to be assessed and paid, and expenditure commitment and cash management should be strengthened to prevent the accumulation of new arrears. This isn’t easy when Iraq has some of the weakest Worldwide Governance Indicator scores in Moody’s rated universe, according to the rating agency. Corruption is endemic and contributes to deep-seated dissatisfaction with the government and, ultimately, undermines the country’s political stability and hence policy effectiveness.

Policy effectiveness is accordingly mixed. According to the 2004 Central Bank of Iraq (CBI) law, the central bankThe CBI’s primary objectives are domestic price stability and a stable and competitive market-based financial system. The CBI has ostensibly been successful in reducing inflation rates to low levels in recent years. Moody’s notes that public financial management is a particular area of weakness for Iraq and is, therefore, a key component of the SBA targets. Iraqi data also have significant shortcomings. While detailed monthly oil sector data are available, the analysis of the non-oil sector is hampered by the lack of high-frequency activity indicators and quarterly expenditure-side national accounts data.

Quarterly balance of payments data is only available with very significant lags. is independent from the government.  Iraq’s banks are also among the least developed in the Middle East. According to World Bank data, a mere 11 per cent of the country’s population has a bank account. It is hardly surprising that Iraq’s long-suffering citizens feel that their money is safer under a mattress than in the hands of a banker.

Unfortunately, this means Iraq’s plans to plug a hole in its finance by introducing an elaborate tax regime will be nearly impossible to implement. The new tax policy is the result of Iraq’s 2015 agreement for a $5.4 billion loan with the IMF. The deal includes a reform of public finances to collect $1.8 billion under the 2018 budget through taxes. In the fourth draft of the 2018 budget bill, a 10 per cent tax on sales at commercial centres, restaurants and barbershops was proposed. However, because cash remains king in Iraq, it will be easy for businesses to continue to evade tax, and for collectors to line their own pockets rather than the Government’s purse. IFC, a member of the World Bank Group, and the Central Bank of Iraq have been collaborating to raise corporate governance standards in Iraqi banks and strengthen the country’s banking sector.

IFC’s advisory services team have agreed to support the Central Bank in implementing its new mandatory corporate governance banking guidelines. IFC will initially train all key managers in the Central Bank and then roll out workshops to board members from all the country’s banks. Aly Al Alaq, Governor of the Central bank said, “Helping banks implement sound corporate governance practices will increase the sector’s resilience and sustainability and make them more investment-friendly, enabling banks to not only boost efficiency, but also increase profit.”

The initiatives are part of IFC’s strategy to spur private sector growth in Iraq and scale up support for fragile and conflict-affected states, where private sector investment is key. For companies operating in conflictaffected environments, strong corporate governance can be vital for sustainability. “Our aim is to foster a positive corporate governance culture within which banks in Iraq can operate, to strengthen the sector and drive growth,” said Ziad Badr IFC Principal Country Officer in Iraq. “Improved practices help attract direct investments and ultimately stimulate social welfare and economic growth.”

Other measures to bolster financial sector stability include strengthening the legal framework of the Central Bank of Iraq, restructuring state-owned banks, and eliminating an exchange restriction and a multi-currency practice. Measures to prevent moneylaundering, counter terrorist financing and strengthen the anti-corruption legislation are also on the cards.

There is also optimism surrounding the budget-sharing agreement with the Kurdistan Regional Government, which would put both the federal Government and the Kurdistan Regional Government in a better position to soothe shocks to the Iraqi economy. Economic relations between the Iraqi Central Government and the Iraqi Kurdistan region appear to be gradually returning to normal, according to FARAS.

The UAE think-tank says that there has been a positive shift in economic exchange between the two sides, after relations were badly shaken by the landmark referendum on independence in September 2017. It is imperative that both sides restore minimal relations. The Kurdistan Government undoubtedly needs financial support through the annual budget allocations to Kurdistan. Kurdistan’s oil exports fell more than 50 per cent due to tensions with Baghdad triggered by the referendum, which put more financial pressure on the region’s government.

Analysts are certainly heartened by recent developments. Last summer, international credit rating agencies Standard & Poor’s, Fitch and Moody’s all upgraded the country’s outlook to stable. However, they all issued the same dire warnings. While the country has a relatively large economy endowed with substantial oil wealth, it suffers from highly volatile growth due to its lack of economic diversification. Political and security risks are very high, driven by underlying ethnic and sectarian tensions, and by Iraq’s location within an unstable region.

Moody’s notes that even if dissolution or disintegration of the country is unlikely, the combination of domestic and geopolitical risks affects the Government’s capacity to service its debt. Iraq’s recent positive developments must be weighed against the fragility of the country’s overall political, economic, and fiscal position. Oil has indeed been a mixed blessing for Iraq. While oil has brought Iraq untold riches, it has left the country with an empty chest at a time when Iraq needs all the financial ammunition it can muster.