Rating downgrades propagate the oil price shock

By reducing the funding available to oil-dependent governments, the recent rating downgrades could lead to slower growth than previously expected.

A number of oil-producing countries in the region were subjected to rating downgrades, a re-assessment of their ability to pay back loans or make timely interest payments. Saudi Arabia’s credit rating was cut by Standard and Poor’s (S&P), one of the three major rating agencies, on 17 February. Despite the downgrade, Saudi Arabia still maintains medium/high credit worthiness. The same cannot be said about Bahrain, which was assigned a junk status by both S&P and Moody’s, another major rating agency. This means that Bahrain has a high risk of failing to service its debt. The credit worthiness of Oman, another of the countries downgraded, is somewhere in between its two Gulf neighbours.

Low oil prices are the main reason behind the downgrades. They are leading to budget deficits among the region’s oil producers, increasing the risk attached to each of them.

But not all oil-producers were subjected to rating downgrades. Kuwait, Qatar and the United Arab Emirates maintained their high credit worthiness by S&P. They are assessed to have accumulated significant savings during the last oil boom, especially in relation to the size of their economies. However, they were still put on negative watch by Moody’s with a possible downgrade further down the line. Outside the Gulf, Iraq’s credit rating was also maintained by Fitch, the third major rating agency, although two caveats are in order. First, Iraq was also put on negative watch with a possible downgrade in the future. Second, it had already been assigned a junk status associated with a high risk of default.

Almost all of the region's oil-exporters intend to borrow from investors to finance their deficits, and the downgrades make this task more difficult. Saudi Arabia has plans to borrow $30bn; Oman and Qatar up to $10bn each; and Iraq $2bn. The downgrades would reduce investors’ appetite to lend to these countries. Even if they were willing to lend, investors would charge higher interest rates to compensate for the additional risk.

The recent experience of Bahrain highlights this issue. The downgrade of Bahrain by S&P happened while the country was finalising a deal to borrow $750m from international investors. The downgrade led to a change in the terms of the deal. The amount Bahrain borrowed was lowered to $600m and the interest rates increased by 0.25%. The change in rates was small suggesting that markets were partially expecting the downgrade. But further deterioration in the ratings could worsen the terms of borrowing further.

In summary, the rating downgrades are propagating the oil price shock experienced by oil-producers. Low prices are leading to budget deficits and the downgrades make these deficits harder to finance. If rating downgrades result in reduced resources for the governments to spend, then the impact on growth could be even worse than previously anticipated.

The puzzle of electricity in Iraq

Weak infrastructure, corruption and lack of fuel are behind the chronic power shortage in Iraq.

The ongoing protest movement in Iraq is developing fast and, judging by the list of reforms proposed by Prime Minister Haider Al-Abadi yesterday, is shaking up the political landscape. The movement was triggered by power shortage amid a scorching heatwave that is engulfing the country. It is a puzzle why electricity remains in short supply more than 12 years after the fall of Saddam. Iraq earned large financial windfalls from the oil price boom of recent years, and directed a lot of resources towards investment in the electricity sector. Iraq is also one of the world’s largest and fastest growing oil producers, so it should not have trouble finding energy to operate its power plants. So where is the problem?

A recent study by the World Bank on the electricity sector in Iraq clarifies some aspects of the puzzle. I summarise the main points below.

·         What is the extent of problem?

There is a serious shortage of electricity in Iraq. Demand for power in Iraq was estimated at 13.7 gigawatts in 2010, but supply fell well short at 8.3 gigawatts. This restricted electricity supply to eight hours per day on average. The problem is clearly one of insufficient supply rather than excessive consumption. Iraq’s electricity consumption per capita (1,187 kilowatt hours) is much lower than countries with similar income level such as Serbia (4,359 kilowatt hours) and South Africa (4,581 kilowatt hour).

·         What are the causes of the problem?

1. Weak and inefficient infrastructure. Iraq’s nameplate power generation capacity in 2010 was 15.3 gigawatts, but it has one of the most inefficient generation systems in the region. This meant that the maximum technical capacity was 12.3 gigawatts. Shortage of water and fuel reduced production by 3 gigawatts, and aging by a further 1 gigawatt. Beyond generation issues, the transmission and distribution infrastructure is very weak due to under-investment and depreciation.

2. Widespread corruption. Electricity projects require many signatures and approvals, encouraging bribes and short-cuts at every step of the way. This slows down the investment process, and results in the under-execution of capital budgets. So although large allocations were made to the electricity sector, a big share were returned unspent to the central government at the end of each year. Corruption also comes in another variety: In 2011, the Ministry of Electricity signed contracts for electricity generation with a company that was bankrupt and another that did not even exist!

3. Shortage of fuel feedstock supply. 37 out of 47 power plants operate on natural gas. Former Prime Minister, Nouri al-Maliki, famously complained on TV about importing gas-operated power plants, when Iraq had no gas to supply them with. In reality, Iraq does not lack natural gas: large quantities of associated gas are produced but then flared due to the lack of infrastructure to refine and consume it. The government has therefore resorted to importing natural gas from Iran, but there are issues with the stability of this supply and the logistics required to transport it to the power plants.

·         Is the electricity shortage problem likely to be resolved anytime soon?

The issues here are structural and systematic. The problems of weak infrastructure, inefficient use of resource, red tape and corruption take time to resolve. There have been many false dawns and many broken promises. The World Bank report cites the Ministry of Electricity projections of meeting all demand by 2014, which seems laughable now. Abadi’s reforms include a clause calling for coming up with “a set of measures to end the problems of electricity production, transmission, distribution and tariffs within two weeks”. To say this is unrealistic would be an understatement.

Who is right about the currency auctions in Iraq?

Ahmed Chalabi’s campaign against the currency auctions is based on weak economics.

The currency auctions continue to divide opinions in Iraq. The Central Bank of Iraq (CBI) is appealing before the Supreme Court against the imposition of Article 50 in the budget law. The article, imposed by parliament, prevents the CBI from selling more than $75m a day in the auctions. Meanwhile, Ahmed Chalabi, the chairman of the parliamentary finance committee who is now spear-heading the attack against the auctions, has claimed that they have been a source of corruption, which led to the depletion of the country’s reserves. Undeterred by critics, the CBI has restarted the auctions on 6 April, after a few weeks’ suspension. Its daily sales averaged $133m in the first nine sessions, well above the limit set by parliament. Who is right and who is wrong in this debate?

1. On form alone, it was wrong to include Article 50 in the budget law. The budget law should be about fiscal policy: the government’s expenditure, sources of revenue, new taxes etc. Article 50, however, was about the conduct of monetary policy. It can be debated whether it intrudes into on the CBI’s independence, but the article was certainly out of place in a budget law.

2. Chalabi’s argument that the auctions were a source of corruption and have wasted the country’s reserves might be right. Around a quarter of the dollars sold in the currency auctions in 2013 were not used for their intended purposes, which is funding the private sector imports. But imposing a limit on dollar sales is not the right response.

If Iraq wants to maintain its peg to the dollar and eliminate the black currency market, it has no choice but inject enough dollars to meet demand. Failing that, market prices would decouple from the official price, making the peg redundant.

This is something that was confirmed time and again by Iraq’s recent experience, and is happening now too. Although the CBI no longer publishes data on the market rate, press reports suggest that the price of the dollar has reached 1340 as a result of the suspension of the auctions. This is 15% above the official exchange rate and represents the highest deviation probably since the data became available in 2004.

3. It may be argued that the official exchange rate itself should be revised. Iraq may need to either devalue its currency by choosing a higher price for the dollar or even let its currency float freely. Chalabi has hinted at that in his interview, saying that “the price set by the central bank is its choice and is not based on a particular rule”. This is a debate that could be had, especially against the background of of lower oil prices. But as long as Iraq wants to maintain its current peg and as long as it wants to eliminate the need for an unofficial currency market, the CBI should to be allowed to supply enough dollars without restrictions. 

Are lower oil prices impacting the Iraqi dinar?

Lower oil prices and confusing policies are starting to cause a dollar crunch in Iraq.

1. Iraq gets almost all of its US dollars from the government’s sale of oil. To meet the private sector’s demand for dollars (to pay for imports, travel and medical expenses etc), the Central Bank of Iraq (CBI) holds daily auctions in which it sells dollars to the private sector at the official exchange rate (1,166 Iraqi dinar per 1 US dollar) as long as import receipts are provided.

2. The 2015 budget imposed a new restriction preventing the CBI from selling more than $75m a day in its currency auctions. The imposed limit reduces the volume of dollars available to the private sector by two thirds (daily volumes averaged $204m in 2014). The limit was not in the initial draft of the budget, but was later added by the parliament to prevent the depletion of international reserves as oil prices declined, reducing the availability of dollars in the economy.

3. The restriction on the currency auction brings back memories of the dollar crunch of 2013. Following the sacking of its governor, Sinan al-Shabibi, the CBI significantly reduced the volumes of dollars on offer at the auction. As a result, the market price of the dollar deviated from the official price. At its peak, the dollar was sold at 1,292 dinar in the market, almost 11% above the official price. But even during this episode, the volumes sold at the auction were about double the new $75m limit.

4. Following the approval of the budget, the CBI reduced the volume of the dollars sold in its daily auction to an average of $80m—above the ceiling imposed by the budget, but much lower than the $204m it sold daily in 2014. Unsurprisingly, the market price of the dollar began to deviate from the official price. It reached 1,237 dinar to the dollar on 19 February, 6.1% above the official price.

5. The CBI suspended the daily dollar auction after 19 February, leading to speculations that it would stop selling dollars altogether. The CBI denied these speculations, claiming that it has merely replaced the daily auction with a new mechanism based on direct bank transfers. Meanwhile, reports suggest that the government and the CBI are likely to appeal against the article restricting the CBI sales to $75m a day. Against this backdrop of policy uncertainty, the dinar has continued falling against the dollar. Anecdotes suggest the dollar was trading at 1,264 dinar a few days ago.

6. Why is the currency auction so controversial? Its controversy led to the sacking of a former CBI governor, the imposition of a limit on the auction’s daily sales and, ultimately, its outright suspension. Opponents claim that the CBI was lenient in selling dollars against fake import receipts. The dollars sold were then used for speculation and sometimes smuggled out of the country.

Are these claims right? Probably yes. My estimate of private sector imports of goods of services in 2013 is $41bn, which is below the $54bn sold in the CBI’s auctions in the same year. This suggests that some of the dollar purchases were indeed used for speculation and probably smuggled out of Iraq.

7. But is tightening the supply of dollars the correct response to this? Probably not. As in 2013, supply restrictions will only lead to a decoupling of the market price from the official price—a process that is ongoing now despite the CBI’s insistence that it is only temporary.

The Iraqi budget and oil: First as tragedy, then as farce

Iraq might approach the IMF for help, just like it did in 2009 when oil prices fell

The Iraqi parliament approved the government’s 2015 budget on 29 January. Merely passing a budget is normally an unremarkable event, except in Iraq where it was met with relief and jubilation. After all, the country went through the whole of 2014 without a budget.

How does the new budget fare? Starting with the broad figures: Government revenue is expected to be around 94.0tn Iraqi dinar ($80.7bn); expenditure is budgeted to reach 119.6tn dinar ($102.6bn) resulting in a fiscal deficit of $21.9bn. A portion of the deficit will be financed externally (around $8.3bn) with the rest financed through domestic borrowing and the issuance of bonds. The broad picture hides two problems, at least as far as raising the required $8.3bn of external financing is concerned.

1. The budget stipulates that Iraq would use $1.8bn of its special drawing rights (SDR) to finance the deficit. But according to the latest accounts at the International Monetary Fund (IMF), Iraq’s remaining holdings of SDR amount to only $0.6bn, which is the maximum it can use. It is not clear how the shortfall be explained or bridged.

2. The budget suggests borrowing $4.5bn from the IMF to finance the deficit. Problem: This can probably only happen if Iraq agrees a programme with the IMF. An IMF programme would imply conditionality, most likely starting with cutting government expenditure.

Now we can blame declining oil prices for Iraq’s fiscal predicament, but Iraqi policymakers do not seem to have learnt from past mistakes. Iraq did rush to seek the IMF’s help last time oil prices fell sharply in 2009. That programme was a failure as the subsequent recovery in oil prices weakened the appetite for reform in Iraq.

Rather than learning from this experience by building up reserves during the oil boom years, Iraq has managed to blow most of its savings. Reserves at the Development Fund of Iraq (DFI)—whose role is precisely to accumulate oil surpluses in the boom years to finance deficits in slumps—declined from almost $23bn in March 2013 to an estimated $4bn in November 2014. This drawdown would have been enough to finance most of the deficit this year. Why did the government tap the DFI at a time when oil prices were so high? No one knows. Conveniently, by the way, the DFI has stopped publishing its balances since March 2014!

So after four years of record high oil prices, Iraq remains fragile. All it took was a quick drop in oil prices (which has not even persisted yet) to make Iraq consider seeking the IMF’s help, just like it did in 2009/10. But while 2009 might have been a tragedy, 2015 looks more like a farce. 

Who controls Iraq’s oil?

The conflict in Iraq is unlikely to materially reduce oil production but could lead to a significant slowdown in its growth.

The International Energy Agency has released the full text of its monthly Oil Market Report. The report raises interesting points about the current state of Iraqi oil production, some of which I discuss below.

                                 Source: International Energy Agency

1. Iraqi oil production continues unabated, despite the ongoing violence. Officially, Iraq's daily oil production averaged 3.1 million barrels per day (mb/d) in July. Oil fields in Kirkuk pumped 0.16 mb/d; the Kurdish Regional Government (KRG) produced 0.31 mb/d; with the southern fields responsible for the remainder of production at around 2.65 mb/d. 

2. By capturing Kirkuk, the KRG has doubled the production capacity under its control to around 0.85 mb/d. However, logistical constraints and political/legal disputes with the central government in Baghdad has kept production at half capacity.

3. Logistically, the KRG does not have the infrastructure to refine or export additional oil production. Fighting around Baiji has resulted in the closure of Iraq’s biggest refinery—with 0.3 mb/d capacity. Furthermore, the Kurdish private pipeline, which has been used to transport independent Kurdish exports, can accommodate current Kurdish exports but very little on top of that.

4. The dispute with Baghdad over independent oil exports has made it difficult for the KRG to find international buyers. Of the six KRG cargoes which have left the Turkish port of Ceyhan since May, only one has managed to offload its contents—at the Israeli port of Ashkelon. Another cargo is a subject of a legal dispute before a US court between Baghdad and the Kurds. The rest are still in limbo.

5. The Islamic State of Iraq and al-Sham (ISIS) has added Ain Zahla and Batma to its existing portfolio of oil fields, which consists of Najma, Qayara, Himreen, Ajeel and Balad. This means that ISIS controls 80 thousand barrels of daily oil production in Iraq alone—equivalent to 2.6% of the total official Iraqi output (including the KRG).

6. Oil production and smuggling has been reportedly providing ISIS with $2 million a day. These reports are not backed by hard data but they seem plausible if we assume that ISIS is producing at 50% of capacity (40 kb/d) and selling crude at half price ($50 per barrel). It also means that losing the oil fields could deal a significant blow to ISIS by depriving it from a valuable source of funding.

7. Southern oil accounts for 85% of Iraqi production and all official exports. Southern production and export facilities are quite distant from the conflict zones in the north and west of the country, and have been immune from sabotage. In the short term, violence is likely to have limited impact on Iraq’s ability to pump and export oil.

8. In the medium term, violence could have quite a negative impact on oil production and exports. First, the general deterioration in the country’s security situation could lead to a disruption in foreign investment and missing out on ambitious production targets. Some companies, such as BP and ExxonMobil, have already withdrawn non-essential staff. Second, trade partnerships are likely to be tested, with China and India—the largest importers of Iraqi oil—pre-emptively looking for supply alternatives. 

A bloody June in Iraq

Iraqis left physically unharmed by violence may still have an economic price to pay.

Iraq witnessed its bloodiest month in June since the height of its civil war in the summer of 2007. Preliminary data show that almost 2,000 civilians have died as violence gripped the country. The figure would rise significantly if casualties from the Iraqi security forces were also included. Not only does increased violence threaten the physical safety of Iraqis, it also adversely impacts the economic well-being of those fortunate enough to survive unharmed.

Data on casualties from violence in Iraq come from two main sources. The United Nations Assistance Mission for Iraq (UNAMI) publishes statistics on civilian and security forces casualties based on witness reports as well as evidence from civil leaders, government officials, international organisation, media reports and the UNAMI own network in Iraq. The figures released by UNAMI show that 1,531 civilians and 886 members of the Iraqi Security Forces were killed in June. These numbers exclude deaths in the Anbar province, where the UNAMI estimates further 244 civilian deaths. The figures make June comfortably the bloodiest month since UNAMI started publishing its statistics in January 2008.

The second source is Iraq Body Count, a project to record civilian casualties in Iraq since 2003 based mainly on verifiable media reports. Its preliminary estimate for civilian casualties in June stands at 1,934—the highest number since August 2007, or the heydays of the civil war. The data also show that 2014 is on track to become the most violent year outside 2005-7.

Unsurprisingly, increased level of violence tends to take its toll on economic activity. In recent years, higher levels of violence in Iraq were associated with lower economic growth. As the chart below displays, 2007 was the second most violent year and also the year which witnessed the slowest growth rate. In contrast, the relatively peaceful years of 2009-12 saw some of the highest levels of growth. Only 2006 stands out as an outlier with both high levels of violence and a fast-growing economy.

What does that imply about growth in 2014? If the levels of violence seen in the first half of 2014 were to continue into the second half of the year, 2014 would be the most violent year outside the 2005-7 period. Should the impact of violence on the economy be similar to the one witnessed in recent years, then we should expect real GDP growth of 4.4%.

Alternatively, a more tragic scenario in which the elevated levels of violence in June continued for the rest of the year would result in 18.5 thousand civilian deaths, making 2014 the third most violent year after 2006-7, the peak of the civil war. Under this scenario, real GDP would grow by a mere 3.1%. Given that population is also expected to grow by 3.1%, this would imply stagnant economic conditions for the average Iraqi.

So what are the economic costs of increased violence? The International Monetary Fund had recently forecast real GDP growth of 5.9% in 2014, the recent rise in violence would probably shave off 1.5-2.8% from this year’s real GDP—a significant cost for a country still lagging behind in terms of goods and services provided.

It means that Iraqis who were fortunate enough not to lose their lives or get injured during the recent violence may still have an economic price to pay.

Unpleasant arithmetics at the Central Bank of Iraq

In its conflict with the central bank, the Iraqi government got its economics wrong. Twice.

The last few weeks saw a further decline in the value of the Iraqi dinar. The gap between market and the official exchange rates reached its peak in the second week of May when the dollar was being sold for around 1290 dinars; 10% above the official rate of 1166 dinars to the dollar. This might be surprising since for several years prior to 2012, the Central Bank of Iraq (CBI) managed to maintain a narrow gap between the official and market rates using its daily currency auctions.

The story of how the Iraqi foreign exchange market went from stability to volatility in the space of 18 months can be divided into three episodes.

Episode 1 (Jan 2012 – May 2012): Two explanations for an emerging gap

In early 2012, The CBI and the government offered two different explanations for a newly-emerging gap emerged between official and market exchange rates. Mudher Salih, then the deputy governor of the CBI, attributed the gap to excess demand from the neighbouring Syria and Iran—which were facing foreign currency shortages due to sanctions. Meanwhile, Izzat Al-Shahbandar, an MP and an aide to PM Maliki, blamed the stringent measures of the CBI, which hindered the foreign currency supply, for the emergence of the gap. Shahbandar claimed that prior to 2012, the CBI sold $200 million on average in its daily auctions, but that figure fell to $100 million in 2012.

Contrary to Shahbandar’s claims however, CBI’s data (summarised in the table below) show that the amount of dollars sold had in fact increased in the period from January to May 2012 relative to previous years. The data leaves little doubt which of the two explanations is more plausible - the only question mark is about the source of Shahbandar's figures.

Episode 2 (May 2012 – Oct 2012): The CBI increases supply and gets its governor sacked

To meet the excess demand, the CBI significantly increased its supply of dollars, successfully bringing the market price down to within 3% of the official rate in early October (see the chart below). At that point, an arrest warrant was issued against its governor, Sinan Al-Shabibi, over allegations of “of financial irregularities” related to the currency auctions. A more detailed report by the Board of Supreme Audit (BSA) concluded that the CBI’s loose control over the auctions encouraged smuggling of the dollar out of the country and money laundering.

The change in tone is notable: in October, the CBI was being accused of leniency in running its currency auctions, having been (falsely) accused of stringency in May!

Episode 3 (Oct 2012 – present): The CBI restricts dollar supply

Over this period, volumes in the CBI’s auctions averaged $177 million—a significant drop from the previous episode. This appears to be a deliberate policy as can be inferred from the appointment of the head of the BSA as the interim governor and CBI’s statements on 18 and 24 October 2012.

An unsurprising outcome of restricted supply is the significant rise in the market value of the dollar, which reached a high this month. It is hard to tell what is going to happen next, but the politicians who have been actively involved in the saga now seem concerned with the uncomfortable fall of the dinar.

Epilogue

The last part of the chart shows a sharp pick-up in the auction volumes over the last few days (almost to the levels reached by Shabibi before his dismissal) coupled with a narrowing of the gap between market and official rates. It would be a positive change if this trend continued. Currency smuggling, unnecessary depletion of CBI’s resources and money laundering must be fought of course. But this should be done through a legal and supervisory framework not through the excessively powerful tools of monetary policy. One should not starve the patient to death in order to kill the bacteria.

The IMF programme in Iraq

Iraq was fortunate to avoid an external financing crisis, but failed to deliver on structural reforms.

Arab countries that are seeking help from the International Monetary Fund (IMF) fall into one of two categories: countries which have experienced recent political change such as Yemen, Tunisia and Egypt; and oil-importing ones exposed to high price shocks. It may then seem surprising that Iraq—an oil-exporter with an unchanged prime minister since 2006—has been until recently engaged in a programme with the IMF.

A little historical background may help explain this. Oil prices experienced a large drop in 2009 following the global financial crisis and the economic recession that ensued. The price of an Iraqi barrel of oil fell from $124 in mid-2008 to $35 in early 2009 before picking up later in the year. For an economy where oil accounts for 95% of total exports and 90% of the government’s revenue, this risked creating a hole in the financing of both the government’s budget and imports.

The second column of the table illustrates this by showing the calculations carried out in February 2010 when Iraq applied for help. Assuming an average oil price of $62.5 per barrel and average exporting volume of 2.1 million barrels per day, Iraq would have had a $5 billion gap in financing its transactions with the outside world through 2011. Faced with this risk, Iraqi officials agreed with the IMF on a two-year programme and a $3.7 billion loan was approved on 24 February 2010. 

As it turned out, the risks did not materialise and oil prices recovered from their 2009 lows. My calculations—shown in the third column of the table—suggest that the financing gap was reduced to $3 billion by the end of 2010 as Iraqi oil price averaged $74 per barrel in 2010, more than compensating for the failure to meet the export volume target. By the time the programme had its second assessment in March 2011, the financing gap was all but eliminated under the government’s new conservative assumptions for oil price ($76.5) and export volume (2.2 million barrels per day) as shown in the last column of the table.

At the stage, the programme’s main focus shifted from “covering the balance of payments needs” to providing “a framework for advancing structural reforms”. This included improving accounting, auditing and reporting practices; restructuring and recapitalising the two main state-owned banks; and improving public financial management. However, the programme became a frustrating affair from this point on. Progress slowed down, reviews were delayed and eventually never carried out, and the programme deadline was extended twice, first to July 2012 and then to February 2013, when it finally expired.

In summary, the programme was one of two halves. The first focused on avoiding a balance-of-payments crisis, which Iraq managed to do more by luck than judgement. But higher oil prices, which were the main reason for preventing the crisis, weakened the appetite for change. It is fair to say that the second half of the programme, designed to advance structural reforms, was a complete and utter failure.