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Iraq Financial Crisis Prompts Emergency Action

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Iraqi Prime Minister Haider al-Abadi addresses the session ‘A Vision for Iraq’ at the World Economic Forum in Davos, Switzerland, on Jan. 23, 2015.

Iraq is pursuing a series of emergency measures to finance its 2015 budget, following years of poor governance and unchecked spending that led to a financial crisis now made worse by low oil prices and high military spending demands.

The government is planning to indirectly borrow from the country’s foreign currency reserves, in a plan described Wednesday in Baghdad by Central Bank Governor Ali al-Alaq. The move could create a risk to the credibility of the Central Bank of Iraq (CBI) and the stability of Iraq’s currency, according to international economists who have long monitored Iraq’s finances.

The Oil Ministry is also trying to negotiate with international oil companies (IOCs) to reduce its immediate payment obligations, according to Thamir Ghadhban, the former oil minister who is now a senior economic advisor to the prime minister. The negotiations apparently have the potential to alter the basic structure of IOC contracts.

“There are serious and constructive dialogues with [IOCs] to connect what is paid with the price of a barrel of oil, whether it decreases or increases,” Ghadhban said.

The extraordinary measures underscore the severity of Iraq’s financial crisis, which was created by years of unsustainable budgeting practices and poor fiscal management during former Prime Minister Nouri al-Maliki’s administration. The oil price collapse and the rise of the so-called Islamic State (IS) group have aggravated those pre-existing problems and made them more difficult to solve, despite the efforts of Prime Minister Haider al-Abadi’s new government.

“The issue of the budget is fundamentally linked to the massive dysfunction of the government,” said former Iraqi Finance Minister Ali Allawi. “We’ve had people in charge of a boat that was barely seaworthy, and they don’t know anything about navigation.”

Iraq’s 2015 budget, which passed Parliament at the end of January, authorizes more than 119 trillion Iraqi dinars (more than $99 billion) in spending. Eighty-five percent of revenue (nearly 79 trillion dinars, or nearly $66 billion) is to come from oil exports, based on an assumption that an average of 3.3 million barrels per day (bpd) will be sold at $56 per barrel. Although such rates are technically feasible, Iraq is falling short so far this year.

Even if those oil sales are achieved, there will still be a deficit. After making politically difficult spending cuts and efforts to raise non-oil revenues, the government is still anticipating a deficit of more than 25 trillion dinars (nearly $21 billion), most of which is supposed to be financed by borrowing.

Those plans are not realistic, according to several western officials involved in Iraq’s financial sector. They spoke on the condition of anonymity because of the sensitivity of the topic.

For example, they said, Iraqi commercial banks simply do not have enough capital to lend the amounts called for in the budget; all told, the government’s actual ability to borrow could fall more than $10 billion short of the budget’s assumptions.

“These [borrowing] numbers are way too big,” said one official. “The idea [for much of the financing] is to sell bonds to the banks. But the banks essentially don’t have any money left.”

In previous years, Iraq has had a financial backstop in the form of the Development Fund for Iraq (DFI), an Iraqi-controlled account at the Federal Reserve Bank of New York that collects the country’s oil revenue and has functioned as something of a national savings account.

At the beginning of 2013, the DFI held $18 billion, according to the International Monetary Fund (IMF). But government spending was so high that, even with the price of oil above $100, the budget deficit was large. Rather than make cuts or seek financing, Iraq used about $12 billion of its savings to pay the bills that year; at the same time, the Maliki administration allowed a World Bank program to lapse that could have helped provide financing and make structural reforms.

“Basically, the budget is put together without any coherence, without any understanding as to its implications and significance on macroeconomic policy,” Allawi said. “It is just an accounting mechanism for the government to distribute its largesse. Things got out of control because of this underlying illusion that this revenue stream is continuously on the upswing. The facts of history have not really borne that out.”

The DFI fell to just $6 billion by the end of 2013, according to the IMF and other experts intimately monitoring Iraq’s finances, and has continued to be drawn down.

In the current atmosphere of crisis, Iraq has been living week-to-week, with virtually no rainy-day fund; now the DFI has dipped to $1 billion, according to two officials with access to the data.

Raiding the foreign currency reserves

The CBI’s lending plan appears to be a response to these constraints. Under the policy outlined by Alaq on Wednesday, Iraqi commercial banks will buy government bonds and then sell them to the CBI on secondary markets. The cash infusion from the CBI will then allow the banks to give more cash to the government, in exchange for more bonds.

“The CBI, according to its law, is not able to give the government any loan,” Alaq said. “But if we can buy the bonds issued by the government to the other banks… then those banks will have the liquidity to support the budget.”

One western financial expert characterized the plan as a “triangle scheme” that was functionally equivalent to a direct loan from the CBI to the government.

“They’re hoping to make it less obvious that what they’re doing is using their foreign currency reserves to finance their budget, but everyone knows that’s what they’re doing,” said another official familiar with Iraq’s financial situation.

Central banks typically avoid using their foreign currency reserves to directly support government spending because they are needed to support the sovereign currency. Iraqi dinars have value largely because the CBI will accept them in exchange for dollars; if the CBI’s reserves shrink too much, it would risk losing the ability to make the large currency transactions required to stabilize the dinar’s value, which has barely fluctuated since 2007.

Iraq’s foreign currency reserves dropped from $77 billion at the end of 2013, according to the IMF, to about $65 billion at the end of 2014, according to several officials with access to the data. The officials said the reduction was a result of ballooning imports, mainly weapons: because many big purchases were made abroad, that currency was never brought into Iraq, which meant the CBI was taking in fewer dollars than it was using to buy dinars. The falling reserves were a byproduct of the government’s changing spending patterns.

By contrast, the new CBI bond-buying plan is a large step closer to using currency reserves to actively support government spending.

The $65 billion in currency reserves is a level that many international economists consider healthy. For now, the CBI can likely absorb a further hit to its reserves without much impact on the broader economy.

“If you were to contain it to a one-off operation, the risks would be limited,” said one western financial expert. “The danger is that such an operation could undermine the credibility of the central bank. You do it once, why shouldn’t you do it twice or three times? Then the reserves will go down to such a level that you can no longer protect the dinar.”

Iraqi and western financial experts worry that such CBI intervention will be repeated partly because some Iraqi leaders do not understand the possible consequences.

“Some people think the Central Bank’s reserves are government savings,” Allawi said. “There is very, very poor – catastrophically poor – economic understanding on the part of government, Parliament, policymakers. You would be shocked how poor it is.”

Even so, Iraq might not have a choice. The 2015 budget is already 16 percent smaller than the 2013 budget, which also governed state spending for 2014 due to political disputes that prevented passage of last year’s budget.

The government needs to fund a massive military effort against a well resourced insurgency and provide for millions of displaced people and refugees. It also must contend with a legacy of fuel, food and electricity subsidies, a bloated public-sector payroll, and growing distributions of money to fractious local governments – all of which are impossible to reverse without risking political upheaval and broad instability.

“Cutting more is not a good solution. Borrowing from the CBI is not a good solution,” one of the western financial experts said. “They only have bad solutions.”

Negotiating with oil companies

Oil executives have begun to worry that Iraq’s cash flow problems will cause payment delays, which have the potential to undermine the financial models that the projects are based on and render them uneconomical.

“The way the contract is structured, you invest money and then get paid back the following quarter,” said one IOC executive. “This [contract model] was all about, ‘We pay you a small margin but you get cost recovery quickly.'”

Iraq’s technical service contracts appear to be especially vulnerable to the collapse in oil price. They require Iraq to quickly turn around payments, which are linked to the level of production rather than overall project revenue. As a result, even though Iraq’s oil proceeds have fallen, its dues to oil companies have actually risen slightly along with production.

“As the oil price goes down they have to give us more and more cargoes,” said an official from an IOC working in Iraq. “Costs won’t go down. Production isn’t magically going to ramp up; in order to make that happen, they have to pay IOCs the costs, at least.”

This has prompted Deputy Oil Minister Fayadh Nema and other top oil officials to open discussions to renegotiate contracts with oil companies, according to both Ghadhban and a western official familiar with the talks.

“When the price of oil changes, whether it decreases or increases, the payment would change, too,” Ghadhban said.

Yet any changes that link IOC payments to revenues – rather than a flat fee for production – has the potential to significantly change the contract.

“If they want to delay payment and alter how the risk-reward structure goes, I think the companies would be up for it,” the IOC executive said. “But that’s a big negotiation… it’s a very fundamental negotiation.”

The 2015 budget also authorizes the prime minister to borrow $12 billion that could be used to pay IOCs. But even if the government can secure such loans, the underlying practices of fiscal management are hardly sustainable.

No easy solutions

Iraq is no stranger to financial shocks. When the price of oil crashed in 2009, revenues dropped and the government was forced to spend far less.

But when prices began to recover, the Maliki administration raised spending to match. In Iraq’s atmosphere of perpetual crisis, there have always been urgent justifications to delay painful reforms.

“No one knows what the economic policy of Iraq is,” Allawi said. “As much as the budget is central to it, there is no idea of what the priorities are. It just becomes an arithmetic game of adding the demands of various ministries and seeing who has the ear of the prime minister.”

As a result, Iraq has descended into a cycle of poor governance, one-dimensional economic activity, and corruption that is characteristic of the so-called “resource curse,” a phenomenon documented by economists in which great resource wealth functions to stymie a country’s development.

In Iraq, revenues from rising exports and record oil prices and were not set aside in a sovereign wealth fund. Rather than create a diversified economy, the government continued to grow its payroll, enabling citizens to indirectly live off state oil proceeds.

“This huge expansion of the operational budget, the current expenditures, salaries, wages and pensions and so on – they are used generally, at the margin, to basically buy off people, elements of the population that may need to be bought off,” Allawi said.

In this patronage system, there is great opportunity for corruption.

“The heavy dependence on oil… means that the authorities face little or no incentive to build strong budgetary institutions and transparency, encouraging instead a top-down fiscal policy where public scrutiny of expenditure and accountability is weak,” said a 2014 World Bank report on Iraq’s public expenditures.

These factors reinforce one another in a vicious cycle, which has now been compounded by not only falling oil prices but also the rise of the IS militant group.

Abadi’s government appears to be making some serious efforts. Iraq’s 2015 budget of $99 billion is vastly more realistic than the 2014 draft budget, which slated expenditures at $140 billion.

Likewise, the predicted oil exports are more realistic than in 2014, when the draft budget anticipated 3.4 million bpd of oil exports – nearly 900,000 bpd more than Iraq actually achieved. By contrast, the 2015 budget goal of of 3.3 million bpd is lofty but technically feasible, due to development of oil fields and a cooperative oil and revenue deal between the federal government and the autonomous Kurdistan region.

The new budget also benefited from a cut of unnecessary spending on multi-billion defense purchases, though some of the funds were redirected to refugees and to fund the Shia militias that have been at the forefront of the fight against IS militants. Kuwait also agreed to defer more than $4 billion in Saddam Hussein-era reparations payments due this year.

In addition, Ghadhban said, next week Iraq will begin to publicly outline steps to selling off state-owned enterprises, many of which are staffed but unprofitable if not inoperable.

These tactical maneuvers appear to be helping Iraq avoid insolvency, but the country’s unrealistic deficits are ultimately the symptom of a deeper problem.

“What’s most concerning here is not so much the fact that they can’t balance the budget,” said one of the western officials involved in the Iraqi financial sector. “What’s most concerning is that they are unable to manage their budget process. That’s a sign of the complete dominance of the internal Iraqi politics over how to administer their resources. That’s what’s really worrying.”