Iraq: From Guns to Budgets

Iraq’s new government must push reconstruction forward, pull in new foreign investment and produce results for a battered population. Its time is limited.

A portable generator in the Iraqi city of Basra beside blast barriers.

This past January, Iraq’s Council of Representatives passed one of the republic’s largest spending plans since the fall of Saddam Hussein. At around $112 billion, the budget stoked optimism that the new government of Prime Minister Adel Abdul Mahdi can tackle the country’s dilapidated infrastructure and redouble its reconstruction initiatives.

A closer look yields scant evidence the government will make serious headway on either front. A significant slice of the budget represents continuing government operating costs and salaries, making this year’s estimate by the World Bank of 6.2% GDP growth look ambitious to some analysts.

It is six months since the 77-year-old Abdul Mahdi began his four-year term as prime minister, a period coinciding with an improvement in the country’s security. December marked the lowest level of violence in six years in Iraq, says the UN. The calm, of course, is tenuous. Large swathes north and west of Baghdad remain hazardous and a significant risk to foreign businesses. The Shia-Sunni divide continues to overshadow Iraqi politics.

Corruption remains rife among much of the political class, posing an early test of Abdul Mahdi’s promise of good governance. Iraq languishes in 168th position out of 180 countries in Transparency International’s 2018 Corruption Perceptions Index, and risk-management company Healix International estimates corruption has cost the economy $320 billion since 2003.

Abdul Mahdi’s ability to administer effectively is also hamstrung by opposition over key cabinet appointments. Institutional decision-making remains painfully slow, says Kirk Sowell, principal at consultancy Utica Risk Services. “The government has no coalition at all and is struggling to do much of anything.”

More worrisome than sectarian violence at this point, government inertia could dash renewed investor interest in Iraq’s energy infrastructure, which desperately needs repair. Last year, protests erupted in Basra over the government’s failure to ensure adequate ongoing electricity supply; the country relies on imports from Iran, whose energy trade is hampered by US sanctions.

“It is pretty much a countdown at this point,” says Sowell. “If summer highs hit, and there is no appreciable improvement in the supply of electricity, that could be a real problem.”

Iraq needs international support to rebuild critical infrastructure, but its success is mixed. Last fall, General Electric signed a five-year, $15 billion deal to upgrade existing power generation plants and build new ones, delivering an additional 14 gigawatts of power, including 1.5 GW as early as this summer. The deal was thrown into doubt recently, however, when Iraq Electricity Minister Luay Al-Khatteeb said he did not possess the financial resources for the project. GE competitor Siemens earlier agreed to a nonbinding plan to supply 11 GW of power generation; but the project, brokered under the previous government, is also subject to review by Al-Khatteeb.

Some important projects appear to be enjoying a smoother ride. UK Export Finance is providing $1.02 billion to GE to build two new power stations and restore several electricity substations. In February, Shell Iraq announced that Basrah Gas Company—a public-private joint venture in which Shell holds 44% and Japan’s Mitsubishi 5%—would expand capacity by 40%, capturing flared gas from three major oilfields and converting it into dry gas for domestic power generation and liquids for export. The 2019 budget increased funds to the Kurdistan Regional Government in a bid to improve relations between the capital and an oil-producing province that is vital to the national budget.

Business is further complicated by the red tape and the often-confusing lines of demarcation between Iraq’s federal and provincial governments. Bureaucracy and a propensity for waste saw Iraq place 171 out of 190 countries in the World Bank’s 2019 Doing Business rankings.

Still, some institutions are finding success. Trade Bank of Iraq carved out a major slice of the trade finance market, a sector that is likely to mushroom as reconstruction efforts accelerate. The bank claims to control approximately 80% of the trade finance business in Iraq and is ranked first among Arab banks by cost-to-income ratio. In December, Fitch Ratings gave TBI a B-/stable outlook, noting its “very strong” Basel I capital adequacy ratio and “important trade finance role.”

Better Banking

Financial institutions considering entering Iraq will face considerable difficulty. “Over 80% of Iraqis do not have a bank account,” says Ben Abboudi, regional threat analyst for MENA at Healix International. “Those who do are often unwilling to deposit their money into local financial institutions, owing to the risk of bankruptcy and a lack of protection for their assets.”

While the Central Bank of Iraq said it will take steps to create a more favorable operating environment, including commitments to tackle corruption and money laundering, many ordinary Iraqis still prefer to keep their cash at home. This is unlikely to change in the short term. “Iraqi authorities have embarked on a modernization program of the banking sector in an attempt to improve supervisory and regulatory authority,” Abboudi notes, but “this has been a prolonged and unproductive process.”

Iraq did not allow private banks until after the 1991 Gulf War, and state-owned institutions dominate Iraq’s financial markets—managing 97% of banking assets as of 2013, according to the US State Department. Unfortunately, those state banks frequently have inaccurate balance sheets and are seen as facilitating corruption. Yet private-sector banks face skepticism too. Government banks are guaranteed and considered more secure by Iraqis. Government agencies and state-owned businesses are also not allowed to borrow from private sector banks, reducing profits for new entrants. The complex operating environment and limited scope for profit has been the main obstacle to foreign financial institutions entering Iraq’s financial sector.

Further complicating Iraq’s business environment is the long reach of US sanctions on Iran. Banks operating in Iraq must avoid dollar-denominated transactions connected to the Islamic Republic. Washington granted Iraq a temporary sanctions waiver for electricity and natural gas imports, but such relief may end. Despite the search for alternative sources, Iraq relies on Iran for much of its energy; any disruption could jeopardize a fragile security situation, something Washington will be keen to avoid.

Reconstruction remains Iraq’s most urgent task, however; and it is still too early to gauge whether the new budget can shift the country’s economic trajectory. The balance of probability suggests it will be a bumpy ride. The IMF predicts 6.5% GDP growth this year, and 3.2% in 2020.

According to the Iraq Initiative at the Atlantic Council, the budget is based on two major assumptions: that oil exports will reach at least 3.88 million barrels per day and that crude prices will not sink significantly below $56 per barrel. Both depend on exogenous forces, and a negative move in either output or price could damage the economy.

Iraq is now the second largest producer in OPEC+. One concern is that Iraq’s desire to increase exports could put it at odds with cutbacks recently agreed upon by oil producers. “Increasing production beyond agreed levels will clash with commitments to OPEC+, but it can happen if Iraq reduces its compliance level,” says Saadallah Al-Fathi, a nonexecutive director of Canada’s Zenith Energy and former head of the energy studies department at OPEC. However, he notes, “If this action reflects badly on the price, then Iraq stands to gain nothing.”