Iraq on track for a much-needed IMF loan

Iraq could secure a loan from the IMF before the end of the year.

The International Monetary Fund (IMF) completed the first review of its staff-monitored programme with Iraq last week. The programme is an agreement to monitor the implementation of the Iraqi government’s economic agenda and does not involve any financial assistance. But four reasons suggest that it may well be converted to a full-fledged loan even before it expires at the end of this year.

1. Iraq has large financing needs. The fall in oil prices has reduced the government’s revenue leading to a large budget deficit, forecast by the IMF to be 10% of GDP in 2016. Lower oil prices have also reduced export revenue, leading to a large external deficit of around 6% of GDP in 2016 (see chart).

2. Iraq has limited options for financing. The attempt to borrow from financial markets last year fell through due to weak investor appetite.  Reserves can finance the external deficit for roughly three years, but at the risk of depletion and potential devaluation. Indeed, the central bank has been using its reserves to finance nearly half of the deficit. This left the government with little choice but to accumulate significant arrears to finance some of the other half.

3. Iraq is making some progress in meeting the IMF’s targets. The review has shown that three out of the five quantitative targets were met, with a fourth narrowly missed. The only failure was the inability of the government to avoid arrears. The programme had also structural targets related to surveying and measuring the exact size of accumulated arrears and to look into the financial health of state-owned banks. Good progress has been made on these targets according to the IMF, although only one of them was met.

4. The IMF is likely to be lenient with Iraq. Any decision may well involve a bias to help Iraq at this difficult moment, especially given its war with the Islamic State in Iraq and Syria (ISIS). 

So a full-fledged IMF programme involving a loan may materialise before the end of the year, perhaps even as early as June, barring a complete political collapse in Iraq. The programme could mobilise as much as $15bn over three years from the IMF as well as other institutions and governments. In return, it would require the government to cut spending further, which may prove painful. But it could also help the country avoid devaluation, given that the IMF still views the exchange rate peg to the dollar as the only constant in an otherwise messy and highly uncertain environment.

Have oil prices bottomed out?

Signs that rebalancing in the oil market is underway.

Oil prices had fallen from the $100-plus level sustained over 2011-13. The reasons for the decline are also well-known: large new supply from US shale producers; OPEC’s refusal to lower production; and weak global demand in 2014. These have made the oil market over-supplied and led to a large build-up of inventories. But oil markets, like any other market, have a tendency to rebalance themselves. Incoming data confirm that the adjustment is indeed underway and could be behind the recent mini-recovery in oil prices to around $40 per barrel.

When markets are over-supplied, they tend to adjust in two ways. First, low prices push some producers out of the market as they become unable to cover their costs. This leads to a decline in supply, which should help the rebalancing. We are seeing evidence of this among the high-cost producers in the oil market, namely shale producers in the US. Production in the US has been in decline since it peaked in April 2015. And The Economist reports that further declines by more than 1 million barrels per day are expected in 2016-17.

The second adjustment mechanism is through higher demand. Low oil prices encourage people to increase their energy consumption by, for example, driving more and buying bigger cars. They also make the switch to oil from other energy sources more attractive. Again, the data support that demand is picking up. Last year saw the largest increase in global oil demand since 2010, which is impressive given that the world witnessed its slowest economic expansion over the same period. The boost to demand was purely due to lower prices.

So there are signs in the market that oil prices might have bottomed out. But two caveats apply. First, the adjustment is likely to progress only slowly given the large build-up of stocks that need to be cleared. Second, while some US shale oil producers are being pushed out, they have changed the landscape of the oil market. Unlike conventional producers, the response of shale companies to price swings is rather quick. If oil prices recover to around $50-60, shale could become profitable again, and production could soon increase as a result. This means that a world with $100 oil price might well be a thing of the past, and that oil producers should expect prices in the range of $50-60, at the very best.

Is devaluation in Egypt inevitable?

By defending an overvalued currency, the Central Bank of Egypt is merely delaying the inevitable.

Egypt’s currency crisis is intensifying. The price of the US dollar reached 9.8 Egyptian pounds last week, 27% higher than the official rate. Despite this, the central bank is still resistant to any devaluation of the currency. Its resistance could prove ultimately successful only if it is supported by economic fundamentals. But these point to an official exchange rate which is well above its fair value.

The starting point for estimating the fair value of any currency is the theory that prices of identical goods must be the same everywhere. Suppose that the price of a can of Pepsi is $1 in the US and 2 pounds in Egypt. Then the theory stipulates that the exchange rate must be 2 pounds for each dollar to ensure that the price of Pepsi is the same in the two countries. If the exchange rate was instead 1 pound for each dollar, investors would find it profitable to buy the whole supply of Pepsi in the US (where it is cheaper) and sell it in Egypt (where it is more expensive), which is obviously not a sustainable situation. This theory is called Purchasing Power Parity (PPP).

But PPP needs to be modified before it can be used for obtaining a fair value of a currency. Lower labour, rent and transportation costs typically result in cheaper Pepsi in Egypt compared to the US, after taking the exchange rate into account. Consequently, the Egyptian pound has traded below the PPP-prescribed value. But deviations from PPP have been stable over time. Since 1988, the pound has tended to fluctuate around 21% of its PPP value.  We can use this historical average (21% of PPP) as a measure for the fair value of the pound.

What is the current fair value of the pound according to this method? Using the International Monetary Fund’s estimates for PPP, the method suggests that the fair value of the exchange rate is 11.9 pounds for each US dollar. This is 35% above the official exchange rate of 7.73 pounds for the dollar. The prevailing overvaluation is the largest since 1988 (see chart). No wonder there is intense market pressure to devalue the currency.

How can this situation be resolved? A gradual devaluation of the currency (say 10% each year) could allow a convergence to its fair value within a few years without causing an abrupt disruption. But irrespective of its speed, an adjustment is likely to start at some point in the near future. Resistance to devaluation runs against economic fundamentals. By defending an overvalued currency, the Central Bank of Egypt is merely delaying the inevitable.

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 Central Bank of Egypt’s misdiagnosis of a crisis

The dismal performance of exports, not excessive spending on imports, is behind Egypt’s currency woes.

Correct diagnosis is key to successful treatment. On 21 February, the governor of the Central Bank of Egypt, Tarek Amer, gave a TV interview outlining his diagnosis to the country’s ongoing struggle with a currency crisis, which has led to intense speculations about a possible devaluation of the Egyptian pound. Below are a few remarks on the interview.

1.  What is the central bank’s diagnosis of the problem? The governor was clear in his assessment: the excessive increase in imports over the last few years is to blame for the crisis. This has led to a large demand for the US dollar, which reduced its availability and led to pressures on the Egyptian pound.

2. Is the central bank correct in its diagnosis? No. It is natural for spending on imports to increase with the rise in income. It would only be considered excessive if its growth far exceeded that of national income, which has not been the case in Egypt. Imports grew at an annual rate of 4.7% between 2010 and 2014, lagging the 7.0% annual growth in Egypt’s nominal gross domestic product (GDP), a measure of income for the country. There is nothing excessive about this. In fact, the share of imports in GDP fell from 31% in 2010 to 28% in 2014.

3. If imports are not the root cause of Egypt’s currency crisis, what is? The answer is exports. In 2010, Egypt’s exports were valued at $49bn. In 2014, this number fell to $47bn. As a share of GDP, exports fell from 23% in 2010 to 17% in 2014. The fall in exports meant that Egypt earned fewer US dollars than it did in the past, which led to a shortage of foreign currency.

4. What explains the decline in exports? The main reason is that Egypt lost market share in its export destinations, despite the overall growth of exports to these markets. For example, Egyptian exports accounted for 1.5% of total exports to Saudi Arabia in 2010. But this share fell to 1.2% in 2014. Among the largest 43 trade partners of Egypt, the share of its exports declined in 31 countries between 2010 and 2014.

5. What could explain the dismal performance of Egyptian exports over the last few years? Potential explanations include: First, Egyptian exports may have become less appealing because they have become more expensive, either because inflation has pushed up domestic costs or because the Egyptian currency has appreciated against competitors’ currencies. Second, demand for Egyptian exports could have declined due to either security concerns (affecting tourism), the slowdown in global trade (impacting traffic in the Suez Canal) or the quality of Egyptian exports. Third, the capacity of Egypt to produce exports may have been constrained due to power cuts in factories, the shortage of foreign currency required to buy intermediate goods for production or the destruction of the gas pipeline in Sinai, which reduced exports to Jordan.

The oil production freeze is no game changer

The agreement to freeze oil production will do little to rebalance the market.

Russia, Saudi Arabia, Qatar and Venezuela agreed on 16 February to freeze oil production at January levels, if other countries join in. Despite the publicity, the move does not change the dynamics of the oil market in any significant way. Its impact is likely to be limited for three reasons:

1. The quartet alone have limited potential to increase production anyway. Annual oil production in Qatar and Venezuela is expected to decline in 2016, according to forecasts from Goldman Sachs. And while output in Russia and Saudi Arabia is expected to rise this year, some of this might have already been realised in January. Total production from the quartet is expected to increase by only 270 thousand barrels per day (k b/d), not enough to rebalance the market in a meaningful way.

2. The main growth countries (Iran and Iraq) are unlikely to join the freeze. Iran can convincingly argue that it needs to make up for the lost production during the years of economic sanctions. It currently produces around 0.7m b/d below its 2012 peak. Meanwhile, Iraq is struggling with revenue shortages and a large budget deficit and is unlikely to commit to any cap to its oil production. Indeed, the statement issued after oil ministers from the two countries met with their Qatari and Venezuelan counterparts was polite but lacked any enthusiasm to join the deal.

3. The output freeze is unlikely to be a precursor to a future production cut agreement. OPEC’s strategy to increase production, defend market share and squeeze US shale oil firms out of the market is finally bearing fruit. US oil production is expected to decline by 492k b/d this year as US oil firms are unable to recover their costs under current oil prices. A production cut from OPEC could give these firms a lifeline to come back into the market and fill the gap vacated by OPEC.

In addition, OPEC will probably face internal disagreements on how to allocate any production cut among member countries. Even if these disagreements were resolved, temptations would be high for individual countries to deviate and produce more.

So despite initial market enthusiasm, the production freeze agreement is unlikely to be a game changer.

The McKinsey blueprint for Saudi Arabia

McKinsey makes sensible high-level recommendations but falls short on the implementation details.

A few weeks ago, the deputy crown prince of Saudi Arabia, Muhammad bin Salman, gave an interview to The Economist. The interview created headlines because it outlined the young prince’s ambition to transform the Saudi economy. Bin Salman’s vision was clearly influenced by a recently-published report from McKinsey, a management consulting firm. In fact, the prince, who is an avid reader of consultants’ reports, mentioned the McKinsey report during the interview. Understanding this report therefore sheds light on the advice Saudi policymakers are getting.

What is McKinsey saying? It says that Saudi Arabia can increase the income of its citizens by developing its non-oil sectors. Some of the discussion on the potential of certain sectors to grow is insightful, as in the case of the automotive industry. McKinsey argues that Saudi Arabia has the ingredients to develop this industry given the size of its domestic market, the growth in neighbouring countries and the lack of manufacturing hubs in the region. But in other cases, the imagined potential is unrealistic. For example, McKinsey claims that Saudi Arabia can increase the number of religious tourists five-fold to 50m by 2030 by sustaining all year round the number of pilgrims seen during the Hajj season. And I want to have Christmas every day, please.

That said, the overall case for the potential of the economy to grow is convincing. The question then is how to do it. Economies grow by either increasing the number of people working, or by making working people more productive. McKinsey suggests that the former can be achieved by encouraging more Saudis to participate in the labour market. The participation of women, in particular, is very low. Only 18% of working-age Saudi women participate in the workforce compared with 51% in Indonesia, 44% in Malaysia and 29% in Turkey. McKinsey also suggests that productivity can be boosted by allowing more competition (which would push firms to perform better in order to survive), reducing restrictions on foreign labour to move between jobs, and increasing the productivity of workers through education and training.

But this is where the report falls short. It is all good recommending increased competition in the product market or more flexibility for foreign workers, but the current state of affairs is in place because there are vested interests benefiting from it. Likewise, it is easy to recommend boosting productivity through education and training but Saudi Arabia already spends a quarter of its budget on education with meagre results. Saudi students underperform their international peers in standardised tests, and the university dropout rate is close to 50%.

I would have expected more practical recommendations from a firm like McKinsey given its global reach, its work across different sectors and its “micro-to-macro” approach to economics. I would have expected them to provide insights and lessons from success and failure stories where countries tried to overcome vested interests, increase competition or boost productivity through education and training. The insights on how to achieve these objective are unfortunately lacking in the report.

So overall, the report makes all the sensible high-level recommendations but falls short when it comes to practical implementation.