JANUARY 11, 2015 PUBLISHED BY THE FOREIGN POLICY RESEARCH INSTITUTE
By Frank R. Gunter
The flow of dinars and dollars within Iraq is critical to dealing with
the ongoing crisis and yet little understood even within the country.
The figure below illustrates the pattern of these flows.
As is well known, the primary source of government revenues – over 95% –
is from oil exports. For over a decade, the dollars earned from these
exports have been paid into the Development Fund for Iraq (DFI), which
is held by the Federal Reserve Bank of New York.
The primary reason for having oil export payments paid to the DFI
rather than directly to Iraq’s Ministry of Finance (MoF) is to avoid
confiscation of these funds by foreign courts in settlement of
Saddam-era lawsuits.
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Upon request, dollars from Iraq’s oil exports are transferred from the
DFI to the MoF. At this point, a divergence occurs. Over half – about
60% in 2013 – of the dollars flow out again to the rest of the world as
payments for government imports, debt service, and miscellaneous
transactions.
The remaining dollars are sold to the Central Bank of Iraq (CBI) for dinars at a rate of 1166 Iraqi Dinars per US Dollar.
The MoF then uses these dinars to pay for the Government of Iraq (GoI)
expenditures in the Iraq economy such as salaries, pensions, social
safety net, security, etc. The dollars accumulated by the CBI through
these dinar sales are, of course, the nation’s international reserves.
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However, many of these dollars immediately flow out again.
The CBI holds daily auctions to provide dollars to the Iraq economy.
Financial institutions buy dollars from the CBI in order to provide
them to individuals and organizations that want dollars as a more secure
savings asset, to facilitate domestic transactions, to purchase legal
and illegal imports, and for capital flight.
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This demand for dollars is quite large. For example, during the first
14 auction days of December 2014, CBI dollar sales totaled $2.25
billion.
Those
Iraq individuals or organizations that are forbidden by the CBI to
directly access the currency auction must purchase dollars at a premium
in the parallel currency market.
On December 18, 2014, the exchange rate in the parallel market was 1199
Iraqi Dinars per US Dollar – about 3% higher than at the CBI auction.
In every year but one over the last decade, the inflow of dollars to
the CBI from the MoF exceeded the outflow of dollars through currency
auctions resulting in an increase in the country’s international
reserves.
For
example, in 2013 the MoF sold about $55 billion to the CBI while about
$53 billion flowed out again through the currency auctions resulting in
about a $2 billion increase in international reserves.
The large increase in international reserves since 2004 has been the
major support for the country’s enviable exchange rate stability.
However, the results for 2014 were grim.
Because of political disputes, Iraq never passed a 2014 budget.
Instead, government expenditures in 2014 were based on an arguably
unconstitutional extrapolation of the 2013 budget.
And the Government of Iraq (GoI) has continuously delayed even a partial accounting of 2014 revenues and expenditures.
However, recent data from the International Monetary Fund support the
view that Iraq’s fiscal and monetary situation is deteriorating. At the
same time that oil export earnings are declining, GoI security-related
dollar imports have increased dramatically.
One effect has been on fiscal reserves held at the DFI, which have
fallen from almost $18 billion at the end of 2012, and $6.5 billion at
the end of 2013, to about $4 billion at the end of November 2014 (IMF
Press Release 14/560, 9 December 2014). Equally worrisome is the drop in
the country’s international reserves.
From $77 billion at the end of 2013, the international reserves held by
the CBI fell to about $67 billion at the end of November 2014. This is
only the second year-over-year fall in international reserves in the
last decade. In the absence of reliable data from the GoI, there are two
possibilities.
Either there has been a decrease in MoF sales of dollars to the CBI
and/or a substantial increase in dollar auction sales to financial
institutions. However, through November 2014, auction sales of dollars
by the CBI have totaled about $47.4 billion, which is roughly in line
with 2013 dollar sales.
Therefore, the cause of the drop in Iraq’s international reserves is
more likely a result of the collapse in oil export revenues combined
with increasing security-related dollar expenditures by the Iraqi
government and, possibly, accelerating capital flight.
Thus in 2015, Iraq not only faces a fiscal crisis from falling oil
export revenues but also a monetary crisis because of the loss of
international reserves. The fiscal crisis might be best understood by
distinguishing between the “break even” price of oil and the “crisis”
price of oil.
Break Even and Crisis Prices
Despite the fact that the country’s 2015 fiscal year starts this month,
the crucial assumptions underlying the budget are uncertain.
Over the last several months, no sooner has the GoI announced a
planning price for oil for the 2015 budget then world prices have fallen
below this level.
The most recent announcement on December 25th was for a $102.5 billion
budget based on an annual average oil price of $60 per barrel resulting
in a large deficit (Gulf Research Center, December 25, 2014).
Expenditures of $102.5 billion in 2015 means that the GoI expects to
spend almost $22 billion less than its actual expenditures in 2013!
Where will the cuts occur?
The drop in oil prices to similar levels in 2009 provides insight into
both the reactions of the GoI and the effects on the Iraqi economy.
In 2009, as total revenues decreased by about 33%, salary and pension
expenditures increased by about the same percentage. This necessitated
sharp cuts in the other major expenditure categories, safety net
transfers and public investment, in order to reduce expenditures.
The remaining deficit was financed through the sale of GoI treasury
bills and the MoF “clawing back” unspent government funds from the state
owned banks.
The
economic effects of the draconian cuts in public investment were severe
and long-lasting. Since public investment accounts for over 90% of
Iraq’s fixed capital formation, the cuts in the investment budget caused
most economic development activities to grind to a stop.
Work on improving roads, increasing electricity generation, opening
schools and clinics, increasing access to clean water, and so on was
abandoned until oil prices finally recovered in 2010.
And when the projects were eventually restarted, it was often
discovered that previous work had to be completely redone due to
looting, vandalism, environmental damage, or planned revisions.
By some estimates, it was not until 2011 that public investment returned to the levels achieved at the end of 2008.
Of course, if 2015 oil prices turn out to be higher than expected, the
GoI might be able to restore some of the cuts. However, rather than have
the reader chase daily changes in oil price predictions, it might be
more useful to consider the implications of two oil prices: the
break-even price and the crisis price.
Assuming oil exports of about 3.3 million barrels per day, Iraq needs
an oil price of about $80 a barrel in order to break-even and to be able
to pay for its sharply reduced 2015 expenditures without running a
budget deficit.
An oil price this high would provide sufficient revenues to pay not
only for current expenditures and security costs but also for essential
infrastructure investment.
Since world oil prices are already less than $60, it is extremely
unlikely that Iraq will be able to break-even in 2015. But at what price
of oil will the required reductions in GoI expenditures become
politically destabilizing?
That depends on the crisis price of oil. The crisis price is the lowest
oil price that will allow the GoI to pay salaries and pensions,
purchase the necessary supplies for the police and army, maintain a
minimum social safety net, pay interest on its debts, pay war
reparations, and continue the absolute minimum infrastructure
maintenance and construction to allow a steady increase in the volume of
oil exports.
If
the world price of oil falls below the crisis price for an extended
period of time and other revenue sources are not available, then the
necessary expenditure cuts can be expected to be politically
destabilizing. In 2009, this crisis price was an estimated $50 a barrel.
Therefore, while the world price of oil in 2009 was below Iraq’s break-even price, it was above the crisis price.
However, in 2015, the crisis price of oil is expected to be much
higher. Not only has there been a steady increase in government salaries
and pensions since 2009, but also the GoI expects to sharply increase
its security expenditures to fight ISIS.
As a result, the 2015 crisis price of oil is an estimated $70 a barrel.
Since world oil prices are expected to remain below the crisis price in
2015, the GoI faces a difficult challenge – either find another source
of revenue, borrow the needed funds, or make politically unacceptable
cuts in salaries or pensions.
The latter option can be expected to lead to widespread political
protests by government employees and retirees as well as threats of a
government shutdown.
If world oil prices average $60 per barrel in 2015, then the GoI needs
at least an additional $12 billion to fund its minimal crisis budget and
an additional $12 billion – $24 billion in total – to rise to the break
even point.
While
its international and domestic options to raise these funds are
limited, the GoI has a high probability of funding its crisis budget.
However, the GoI faces a much lower probability of being able to fund
its 2015 break-even budget.
Options for international lending are limited. Government to government
loans from the United States and other countries involved in the
current war on ISIS are likely to face strong opposition in Washington
and other world capitals.
It will be argued – with an element of truth – that Iraq’s budget
problems are mostly self-inflicted, the result of GoI mismanagement and
corruption.
In
addition, it will be pointed out that the U.S. and other states have
already forgiven 80% or more of their Iraqi debt and that these
countries have spending needs at home.
Iraq’s regional neighbors such as the UAE and Kuwait – who generally
did not participate in the loan forgiveness program – are facing their
own budget challenges resulting from the collapse in oil prices.
However, it is likely that the GoI will be able to borrow several
billion dollars. In addition, it appears that Kuwait has agreed to a
one-year suspension of war reparations.
These reparations were imposed under an agreement with the UN, where
Iraq agreed to pay Kuwait 5% of its gross earnings from oil exports to
compensate for the damages incurred during the Iraq invasion of Kuwait
in 1990.
With a world price of $60 a barrel, a one-years suspension will free up about $3.6 billion.
There are at least five other sources of funds to meet the fiscal deficit.
First, the GoI can readily access the funds held at the Development
Fund on Iraq that were an estimated $4 billion at the end of November
2014.
Second, in
2009, the GoI was able to transfer about $7.7 billion from state-owned
banks back to the MoF. These funds represented amounts that had been
budgeted but not yet spent.
In view of the constraints on spending in 2014, it is unlikely that
more than several billion can be clawed back from state-owned banks in
2015.
Third, the
GoI could attempt to borrow domestically although the amount raised
would probably be less than $1 billion. While there have been several
bond issues since 2003, demand for such instruments is limited
especially since there is no liquid secondary market for government
debt.
Fourth,
although the country has an income tax system, tax revenues in previous
years have been de minimis. It is unlikely that increasing the tax rate
will raise substantial revenues in 2015.
Finally, and most controversially, it has been proposed that the MoF
obtain part of the country’s $67 billion in international reserves by
encouraging/forcing the CBI to buy dollar denominated bonds from the
MoF.
Until a few
years ago, it was believed that the CBI could resist such GoI pressure
to monetize its debt, but former Prime Minister Nouri al-Maliki was able
to remove the head of the CBI without the approval of the National
Council of Representatives and replace him with a Maliki loyalist.
This event severely undermined the perceived independence of the CBI.
Adding together these various sources of funds, the GoI should be able
to raise or borrow enough to pay not only for its crisis budget in 2015
but also move part of the way towards its break-even budget.
However, if sub-$60 per barrel oil prices continue into 2016, then the
GoI will face an even wider budget gap while having exhausted its
borrowing options.
It may be impossible for the GoI to even pay for its crisis budget in
2016. But a more immediate challenge than the future price of oil is the
increasing stress in early 2015 on the Iraqi exchange rate.
Exchange Rate Options
A great source of pride for the CBI has been its ability to maintain a
relatively stable exchange rate despite intense conflict in 2006-7.
In fact, the CBI actually allowed a 20% appreciation of the dinar
during this period. However, as discussed above, CBI reserves are
falling as a result of lower dollar sales to the CBI by the MoF combined
with large auctions of dollars by the CBI to financial institutions.
In addition, there is the possibility that the GoI will attempt to
relieve its current fiscal crisis by encouraging or forcing the CBI to
buy GoI dollar denominated bonds.
This would replace liquid assets in the CBI accounts with illiquid
assets, GoI bonds. If either or both of these events occur, then there
will be a loss of confidence in the ability of the CBI to maintain the
current exchange rate of 1166 Iraqi Dinars per US Dollar.
Anticipating a depreciation of the dinar, speculation against this
currency can be expected to increase. The CBI and GoI have few options
to curb this speculation and prevent a loss of the nominal anchor of the
Iraqi economy – its stable exchange rate.
One possibility is to further restrict access to the daily currency
auctions. This was the primary policy response when the exchange rate
came under attack in February 2012.
Buyers of dollars were required to be registered and provide
documentation for the precise purpose of the dollar purchases. Further
restricting access can be expected to lead to a widening gap between the
official exchange rate of 1166 Iraqi Dinars per US Dollar and the rate
in the parallel currency market.
An expansion of a dual exchange rate system can be expected to
increase corruption as institutions use their political influence to
gain access to the more favorable currency auction rates.
In addition, by restricting access to dollars for less favored groups –
primarily in the private sector – it can be expected that there will be
a further slowdown in the growth of the country’s non-oil economy,
exacerbating the economic crisis.
A more cynical or possibly realistic policy response to the loss of the
country’s international reserves would be a sharp pre-emptive
depreciation of the Iraqi dinar.
This would not only lead to an increase in import prices and a
decrease in the prices of non-oil exports boosting domestic production
but also reduce – at least temporarily – speculative pressure on the
dinar.
The
experience of countries in similar situations over the last several
decades show that if the depreciation option is chosen, then it is
better is to depreciate sooner rather than later and by a larger rather
than smaller amount.
One view is that the GoI should immediately announce a return to the
pre-2006 exchange rate of about 1470 Iraqi Dinars per US Dollar –
roughly a 25% depreciation.
However, with a new government, it is unlikely that there will be an
aggressive dinar depreciation. Typically, governments wait until a
crisis brought about by a substantial loss of reserves occurs before
depreciating their currency. And there is the fear that without
fundamental changes in the Iraqi economy, any depreciation will only be
the first of many.
A more long-term solution to the country’s loss of reserves and
accompanying exchange rate crisis would be a return to using a currency
board such as the one that provided Iraq with a stable exchange rate
during the tumultuous period of 1930-49.
Unlike the CBI, the former Iraq currency board guaranteed full dollar
convertibility of dinar notes and coins only. This immunized the
currency board from the speculative attacks that are often the downfall
of fixed exchange rates such as Iraq’s.
However, the adoption of an orthodox currency board can be expected to
face serious political opposition since it would reduce the GoI’s
ability to divert financial resources in order to favor particular
economic sectors or to benefit friends of government officials.
About Frank Gunter :
http://www4.lehigh.edu/business/faculty/facultyprofile.aspx?Channel=%2FChannels%2FBusiness&WorkflowItemID=67079708-61e6-4a4d-9b4f-4df8d968840f http://www.eurasiareview.com/11012015-isis-oil-iraqs-perfect-storm-analysis/
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