Our rating on Iraq is constrained by its war with the militant group ISIS, by the sovereign's political institutions, which are in an early stage of development, and by sectarian divisions between the Sunni, Shia, and Kurdish ethnic groups.
Iraq's oil production and massive oil reserves underpin our rating. Iraq has the world's fifth-largest proven crude oil reserves and is the second-largest oil exporter in the Organization of the Petroleum Exporting Countries (OPEC). Oil dominates the Iraqi economy, contributing over 60 per cent of GDP, 90 per cent of government revenues, and more than 95 per cent of exports.
In recent months, the Iraqi forces and their allies have retaken some territories that ISIS had controled, such as Ramadi (west of Baghdad), Baiji (the site of Iraq's largest oil refinery), and more recently Fallujah. All three cities are within 100 miles of Baghdad. ISIS previously controlled large areas along the Tigris and Euphrates Rivers north of Baghdad. ISIS’ territorial control of Northwest Iraq has shrunk significantly since our last review. We understand that the Iraqi army is preparing the ground to retake Mosul--Iraq's second largest city--before year-end.
Crucially, over 85 per cent of Iraq's oil fields and production are located in the south of the country close to Basra, the main port for crude exports. These are Shia-controlled areas at some distance from ISIS-controlled areas and the conflict. With our rating affirmation, we assume that the federal government will remain in control of these assets. They are the key support for the rating.
In 2014, faced by the then-rising ISIS threat, Iraq elected a new government. In September of that year, Haider Al-Abadi became Prime Minister. Mr. Al Abadi is viewed as more inclusive and secular in his approach than his predecessor, which is easing ethnic tensions and improving relations with the U.S., one of Iraq's key allies.
In August 2015, Mr. Al-Abadi announced reform measures, including cuts in the size of government, in response to escalating social protests across the country spurred by electricity blackouts and unsatisfactory social services.
Many Iraqis believe that the government reforms have yet to bear fruit. Also, Iraq faces significant corruption challenges. The country scores among the worst countries on corruption perception and governance indicators in the world. Corruption in Iraq is exacerbated by the ethnic-sectarian divide, lack of experience in public administration, and its weak capacity to manage the influx of aid money. We believe that fighting corruption and Daesh represent Iraq's major political and security challenges in the near term. Combating corruption by strengthening governance, accountability, and transparency and repelling ISIS will help unlock Iraq’s economic potential and lead to improving creditworthiness, in our view.
After an estimated six per cent growth in 2016 because of public investment in the oil sector, we project real GDP growth to fall below two per cent in 2017-2019 owing to the headwinds from fiscal consolidation and weak domestic demand. We think domestic demand will remain weak for at least two years, owing to the war against ISIS, internally displaced populations, and general social and political uncertainty. In 2016, Iraq’s oil production is estimated at 4.2 million barrels per day (mbpd) in comparison with 3.5 mbpd in 2015. We expect oil production to remain close to these levels in 2017-2019 owing to planned fiscal consolidation. Iraqi oil exports are projected at 3.6 mbpd in 2016, up from 3.0 mbpd in 2015 and 2.5 mbpd in 2014.
The internal and external shocks--the ISIS conflict and sharply lower oil
revenues--that Iraq has faced since 2014 have hurt public finances. We project the general government fiscal deficit will rise to 14 per cent of GDP in 2015 and 15 per cent in 2016 from a deficit of six per cent in 2014. Since our last review, the federal government’s fiscal position has become less flexible owing to the disagreements between the federal government and Kurdistan Regional Government (KRG) over their oil revenue sharing agreement. This agreement represents roughly a sixth of the Iraqi general government budget. The KRG, dissatisfied with the size of fiscal transfers from Baghdad, drastically reduced oil supply to the State Oil Marketing Organization (SOMO) and increased its independent sales to finance its expenditure.
Assuming the government enacts fiscal consolidation and freezes nominal spending at the 2015 level, we project budget deficits at eight per cent of GDP on average in 2017-2019. Deficits will result largely from falling oil revenues and high military and humanitarian expenditures. We think that the IMF's Staff-Monitored Program, approved in December 2015, helped restore some order to public finances and paved the way to the $5.4 billion IMF financing agreed in July 2016. Additional external financing of the budget is expected from the World Bank ($3 billion) and other bilateral creditors over 2017-2019.
Domestic issuance remains the main funding source for the 2016 government
financing requirement. We expect most of the debt will be taken up by Iraq's commercial banks, led by the two largest: Raffidain Bank and Rashid Bank. We anticipate that the banks will fund these purchases by incremental deposit growth and by repurchase operations with the Central Bank of Iraq (CBI). In addition, the government has indicated its intention for a possible $2 billion Eurobond offering. We project that general government debt will average 87 per cent of GDP in 2016-2019, up from about 34 per cent of GDP in 2014. Our net general government debt average for the forecast period includes 20 per cent of GDP of fiscal assets, which are mostly deposited with domestic commercial banks. Iraq's debt stock has benefited from an 80 per cent haircut that the government negotiated with its Paris Club creditors in 2003-2004.
Iraq's current account has typically run a surplus thanks to the country's large oil exports. However, we expect the current account balance will turn to a deficit and remain so until 2019 because of the sharp drop in the oil prices. We forecast Iraq's current account deficit will average five per cent of GDP in 2016-2019, compared with an average surplus of 10 per cent of GDP in 2011-2014. We expect that part of the regularization of public finances will entail the Iraqi government clearing approximately $2.6 billion of accounts payable with international oil companies in September 2016. Iraq typically makes these payments in oil. Although the clearing of these arrears will affect the 2016 current account deficit, we believe the payments will induce needed foreign direct investment that otherwise would have been stanched. We expect that the current account deficits will be financed in part by a substantial drawdown of official foreign exchange reserves, and in part by external borrowing and investment.
We forecast external debt, net of public and financial sector external assets, at about 37 per cent of current account receipts (CARs) in 2016, and we estimate gross external financing needs as a percentage of CARs and usable reserves at about 65 per cent.
Inflation is currently staying low, with consumer price inflation in the low single digits (approximately 2.2 per cent in 2014). We expect that the CBI will maintain the dinar peg to the U.S. dollar, albeit with minor fluctuations, unless financing conditions are more difficult than we currently expect. While the peg has helped control inflation, it limits the CBI's monetary flexibility. Net international reserves have fallen from 120 per cent of the monetary base in 2013 to an estimated 109 per cent at year-end 2015, and are projected to reach 83 per cent at year-end 2017. At the same time, the share of repo operations with domestic banks, which we regard as quasi fiscal in nature, is projected to increase substantially to reach 44 per cent at year-end 2017 from 11 per cent in 2015. Moreover, although the liabilities and guarantees of the domestic banks appear high compared with the fair value of their assets, we view financial sector stability as a secondary issue compared with the country's security and the consequences of negative terms of trade.
The stable outlook reflects our expectation that Iraq's large fiscal and external deficits will be financeable, and that its conflict with ISIS will be contained. It also incorporates our forecast of an increase in Iraqi oil production and oil exports to 4.4 mbpd and 3.6 mbpd, respectively, by 2019, while the IMF program leads to gradual fiscal consolidation.
We could lower our rating on Iraq if the assumptions mentioned above do not hold.
We could raise the rating if Iraq's security situation and its public finances improve substantially.
original source: