In numbers

$72bn: Iraq’s budget for 2010

85 per cent: Amount of state income derived by oil exports

$120bn: Value of investments planned by oil companies to increase Iraq’s production

Source: MEED

Baghdad may not have a government in place, but it boasts some impressive macro-economic fundamentals. Gross domestic product (GDP) growth this year is projected at 7 per cent. Inflation has been brought down from 35-40 per cent in 2007 to single digits. Higher oil prices should feed through into a 32 per cent increase in oil receipts this year and billions of dollars worth of foreign direct investment (FDI) is flooding into oil field development.

But dig a little deeper and the Iraqi economy quickly looks less attractive, with myriad challenges facing policymakers looking to improve ordinary Iraqis’ well-being.

Political deadlock

This year, the energy sector is beginning to feel the impact of the investment that oil companies are ploughing into field development contracts. However, delays in forming a new government is stifling decision-making and thwarting momentum on key economic projects. Indecisive elections five months ago produced political deadlock between the incumbent prime minister Nouri al-Maliki and former-prime minister and head of the non-sectarian bloc, Ayad Allawi.

The political impasse creates uncertainty, which has serious economic implications on the ground.

Private investment outside the construction sector is minimal and public housing is the only sector that is seeing a significant boost in spending. 

While Iraq’s 7 per cent GDP growth rate looks impressive compared with the lethargic pace of growth in Western economies, when placed in context, it is growing from a very low base. After more than two decades of war and sanctions, economic life in Iraq had all but ground to a halt when US-led forces ousted Saddam Hussein in 2003.

Delays in forming a government is stifling decision-making and thwarting momentum on key projects

One of biggest challenges facing the new administration is the need to boost revenue creation. “The economy is still over reliant on oil and there’s low potential in private sector investments due to sectarian violence, poor governance and degraded infrastructure and human capital loss,” says John Sfakianakis, chief economist at Banque Saudi Fransi. “Non-oil growth will continue to expand, but way below trend and potential.”

Iraq is not quite there yet … this is because of the political deadlock. Business people are concerned about that

Eric le Blan, MerchantBridge

The continued absence of a stable government is proving the decisive factor in preventing the state from disbursing funds into growth areas of the economy. Delays in forming a government are also hindering the execution of capital budgets.

The political stalemate has a follow-through impact on private consumption levels. Around one-third of Iraqi employees are on the state payroll and an estimated 100,000 civil service positions remain in limbo, while Iraq’s politicians attempt to form a government. This is resulting in lower consumption levels and weaker economic activity.

Electricity outages are another significant challenge. Most firms are unable to access sufficient energy supplies to commit to investing in expansions. “For us, the power bottleneck is a bigger [problem] than security,” says Eric le Blan, chief operating officer at investment firm MerchantBridge, which makes investments across different sectors. “Security is a cost we can manage, but electricity you can’t get at any price.”

Despite a more than 50 per cent increase in planned state spending to $72bn in the 2010 budget over the previous year, Iraq’s fiscal position is mixed. But a conservative forecast on oil prices should at least allow Baghdad to beat its own deficit projection. The budget plans for a deficit of $19.6bn for 2010, based on an average oil price of $60 a barrel. Oil prices have been averaging $75 a barrel for the first six months of 2010.

Oil income

The US Special Inspector General for Iraq Reconstruction (SIGIR) estimates the government will accrue $48.7bn in oil receipts for 2010. This is after assuming export volumes and prices remain the same as in the first half of 2010, which would be $11.5bn more than the equivalent figure for 2009.

On the other hand, the failure to increase oil exports this year could affect income. At present, Iraq exports 1.2 million barrels a day. With at least 85 per cent of state income derived from crude oil exports, the government will still face a financing gap of more than $5bn until the end of 2011, according to the Washington-based International Monetary Fund. It warns that plugging deficits could exhaust the government’s remaining balances and result in the accumulation of arrears.

Even if Baghdad exceeds revenue forecasts and shows a surplus, it may not be for the right reasons. Much of the cause of a surplus could be down to the failure to spend state funds, rather than an increase in revenues.

The large public wage bill has forced the government to commit more state funds for spending, driven by a substantial rise in costs for security forces, including tribal militias.

However, the economy’s lack of absorptive capacity means capital spending has failed to reach the most productive sectors of the economy where investment is most urgently needed. Capital spending was reduced by almost one-third in 2009, compared with 2008. 

Spending constraints

The failure to execute budgets is not for want of trying on the government’s behalf. “There has been a serious effort from the government to spend money,” says Le Blan. “You can see that with the investment in Basra and Umm Qasr ports, the Baghdad metro and in places such as Karbala, they are trying to put infrastructure in place.”

“But though there are good intentions, Iraq is not quite there yet and this is because of the political deadlock. Business people are very concerned about that,” he adds.

The one area of undoubted success has been the containment of inflation by the Central Bank of Iraq (CBI).

Until late 2008, the CBI had allowed the dinar to appreciate gradually to bring down inflation to near single digit levels, more than halving its Iraqi dinar policy interest rate since February 2008 to 6 per cent. Having succeeded in cutting it to 3 per cent in the second quarter of 2010, the CBI has resumed its policy of maintaining a stable dinar.

The CBI has achieved this despite lacking the full range of tools that would allow it to dictate a more constructive monetary policy. Instead, the CBI has managed liquidity through the interbank market and daily currency auctions.

“The exchange rate has stabilised and inflation has come down which is positive for the macro picture,” says Sfakianakis.

“But then there’s very little interest rate transmission mechanism from the banking sector and the conduct of monetary policy is highly constrained. The exchange rate is the only policy instrument to achieve price stability.”

Iraq’s banking sector is still struggling to play a significant role in channelling finance to local companies and the capital market is largely non-existent. Banks have a penetration at less than 5 per cent of the population and most transactions are still cash-based.

The state-owned lenders Rafidain Bank and Rasheed Bank account for 90 per cent of total assets and the 23 private banks in the country have yet to make a real impact.

 “There’s not much banking you can do in an environment where the lack of urban security is a challenge,” says Sfakianakis. “Non-performing loans are very high in the two state banks; the central bank’s lack of bank supervision is an issue, and a cash-based culture is pervasive.”

Crime is a major headache and widespread corruption in the public sector continues to drain the state of needed resources and capacity.

If a government is formed by September – at the best guess – Iraq could be in a position to address its economic challenges.

The interim government presented in June a new five-year national development programme aimed at creating 3.5 million new jobs, cutting unemployment by half from the current 15 per cent official level, and generating a 9 per cent annual average GDP growth rate. 

The programme assumes that Iraq will generate $334bn in revenue between 2010-14, with around half of this – $186bn – required as investment. It envisages the government spending $100bn, with the remaining $86bn coming from the private sector. These funds will be used to support 2,831 projects, mostly construction projects.

If the private sector is to step up to the task and provide this $86bn, Iraq will need a fully functioning banking system and a capital market. These will take time to develop.

Despite the challenges, investors are optimistic that the country is moving in the right direction. Telecoms companies will be forced to list on the Iraqi Stock Exchange in 2011, creating a new sector that could attract significant international investment.

“Telecoms will become a dominant sector on the stock exchange and that is when we will see a strong development of the capital market in Iraq,” says Le Blan, whose firm MerchantBridge has launched a Iraq open-ended listed equity fund, the Mesopotamia Equity Fund.

Energy investments

The oil and gas services sector in particular is expected to boom as international oil companies prepare to spend $120bn to increase production capacity.

These will look for local companies to provide the bulk of the required services and they will have to raise substantial volumes of capital, which in turn will have to come from the capital market. 

“These local companies have the engineers, but they have to have the rigs as well and those are up to $10m for a new one at the moment,” says Le Blan. “I suspect you will see many of these companies coming to the stock exchange to raise capital.”

Iraq has a long way to go before its engineering and contracting firms will be able to tap the local capital market.

There are a number of smaller steps that will be needed to put the economy on the right track before then. Forming a government and executing state spending budgets would be a positive first step.