Tuesday, 25 August 2015

Unpleasant fiscal artihmetics in Iraq

The Iraqi government is struggling to finance its increasing deficit.

Things used to be simple in the Iraqi economy. The government received large revenues from oil exports. The revenue trickled down to the rest of the population through salaries to the large number of unproductive (and sometimes non-existent) civil servants employed by the government, with corruption taking a slice of the revenue as it moved down the pyramid.

But the world changed in June 2014 as the war with ISIS intensified and oil prices tumbled almost simultaneously. The government’s oil revenue fell by more than a half, and a significant chunk of the reduced income had to be spent on financing the war with ISIS. 

The new reality manifests itself most strikingly through the 2015 budget, where the government is struggling to finance an increasing deficit.

The initial budget law stipulated a deficit of around 26tn dinar ($22bn). But things have not exactly gone according to plan. Lower oil export volumes and delayed introduction of non-oil taxes mean that revenues are likely to fall short of their budgetary target. Expenditure is higher than anticipated as a $10bn payment to international oil companies was not adequately included in the budget. But the government plans to make up for this by cutting investment spending. As a result, the deficit is now likely to reach 42tn dinar, or around 20% of GDP. 

How is the government going to finance this deficit? It intends to raise around 8tn dinar through external borrowing. This includes borrowing from the International Monetary Fund and the World Bank, but also involves plans to issue bonds in international markets. Iraq has recently managed to obtain a credit rating from Fitch for the first time (hint: not a good one), which could facilitate its attempts to tap international bond markets.

But nearly half of the deficit (19tn dinar) is expected to be indirectly financed by the Central Bank of Iraq (CBI). This works as follows: commercial banks would lend the government by buying its T-bills, then sell these loans to the central bank and receive newly-printed money in exchange.

Getting the central bank to finance the government’s deficit is dangerous and could have painful implications for inflation and the value of the Iraqi dinar. And even with this, the government still admits a financing gap equivalent to a third of its deficit (13tn dinar) which it hopes to fill with unidentified “domestic and foreign sources”. 

The two shocks (oil prices and the war with ISIS) are creating a messy reality in Iraq. And with oil prices remaining low for longer, and the war with ISIS unlikely to end anytime soon, the shocks may turn out to be less transitory than first anticipated. The urgency of the situation could force a major overhaul in policy. But this remains more of a hope than an expectation.

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