Iraq implements austerity policies as oil price falls

Iraq is likely to adopt extraordinary measures to balance its budget, which could see the government raid its foreign currency reserves and renegotiate contracts with oil companies.

Years of corruption and mismanagement have given rise to ever expanding budgets and Baghdad is now faced with plummeting oil prices and the burdens of a costly war.

Having passed in late January the financial plan for the coming year the politicians and technocrats are now faced with trying to square the circle.

“There are some smart leaders in Iraq who understand their spending patterns are unsustainable and the economy one dimensional, but there are just so many political, military and financial constraints to reversing this,” said Ben Van Heuvelen, managing editor, Iraq Oil Report.

There is no Plan B. Iraq’s financial plans, A, B, C and D are all dependent on oil revenue

After considerable wrangling the MPs finally agreed on a budget worth 119 trillion dinars ($105 billion) with 85 percent of the revenue to come from oil, based on the sale of 3.3 million barrels per day (bpd) at $56 per barrel.

Even after making considerable cuts in spending there is still a projected deficit of 25 trillion dinars (approximately $21 billion)... and this is a best case scenario.

The price of oil has dropped below $50, where it could doggedly remain, and Iraq has to factor in a cut of around $5 to cover the difference in the quality of its crude.

"I don't know if they are deceiving themselves or the Iraqi people by saying the price of oil is $56," MP Kadhim al-Saidi told reporters before voting on the budget.

The amount of oil actually coming out of the ground is also considerably below the projected volumes further denting the amount of money flowing into the government’s coffers.

To finance the deficit the government intends to indirectly borrow from the country’s foreign currency reserves in a scheme outlined by the governor of the Central Bank of iraq (CBI) Ali al-Alaq.

Raiding the piggy bank

According to a recent study by Iraq Oil Report foreign currency reserves already fell by over $10 billion over the course of 2014 to around $65 billion, mainly due to large arms imports.

The decision by the authorities in Baghdad to turn to these reserves comes with a risk.

"If Iraq falls back on if foreign reserves this will create a fiscal and monetary problem as it will devalue the Dinar, so they need to be very careful," warned Luay al Khateeb, Executive Director, Iraq Energy Institute (IEI) and Nonresident Fellow, Brookings Institution.

For the average Iraqi this would translate into higher costs of living as the prices of all imported good rise.

The commercial banks would be the preferred choice of lender for the government but they simply don’t have the assets in the vaults to start buying up huge amounts of government debt.

So under the proposed arrangement in steps the central bank to pump money into the commercial banks.

The CBI is banned from lending direct to the government by its own law but that is affectively what they intend to due under the scheme announced by al-Alaq.

Iraq’s commercial banks will buy government bonds, essentially IOUs, which they will then sell onto to the CBI on secondary markets.

With the current amount of foreign currency reserves this may work in the short run but in the long run its a risky gamble.

“There is no Plan B. Definitely not. Iraq’s financial plans, A, B, C and D are all dependent on oil revenue,” said Iraq Oil Report’s Van Heuvelen.

If oil revenues fail to increase significantly, or spending drastically cut, then the government and central bank could be tempted to repeatedly revert to the foreign currency reserves.

A fundamental renegotiation

The drastic drop in oil prices this past year has also pushed the Iraqi government to take the major step of trying to renegotiate the contracts they have agreed with the International Oil Companies (IOCs).

Under the current circumstances, the government is in a weak position of negotiation, however, it has no option but to renegotiate

Iraq Oil Report recently quoted Thamir Ghadhban, the former oil minister who is now a senior economic advisor to the prime minister and western officials in the country as saying that Deputy Oil Minister Feyadh Nema has opened discussions with top level officials over the contracts.

The technical service contracts in place are particularly vulnerable to drops in oil prices and the IOCs are becoming concerned that delays in payment could undermine existing projects and those in the pipeline.

“It’s a known fact that service contracts under low-oil prices scenario is Rentier-States’ worst nightmare,” said the Iraq Energy Institute’s Luay al-Khateeb.

Baghdad will be hoping to escape having to pay billions of dollars upfront to the IOCs by  redrawing the contracts but, once again, it comes with risk.

“Under current circumstances, the government is in a weak position of negotiation, however, it has no option but to renegotiate,” added Khateeb.

Castles made of sand

The government budgets have grown so wildly over the years because they have been exploited as tools of patronage and self-aggrandizement.

The easiest budgets to pass have consistently been the biggest as that would enable enough pockets to be lined to buy loyalty.

With revenues squeezed and the country fracturing under the weight of an unconventional war the status quo is evidently unsustainable.

“This is the smallest, politically feasible, budget they could have passed,” said Van Heveulen, “Prime Minister Abadi has scored a number of tactical victories and changed the tone of political dialogue in Baghdad, but all steps for real reform so far have been minor.”

The 2015 budget was passed out of necessity and on the back of an agreement between Baghdad and the Kurds in the north but still no party was really happy with what they secured. 

Iraq's economy is not so much hostage to its finances but more to the management of those finances. 

The oil curse and the politics of patronage are as rampant as ever.

"The legacy lives on," concluded al-Khateeb.