Economic Analysis - Fiscal Slippage, Reconstruction To Limit Pace Of Deficit Reduction - MAR 2018

BMI View: Iraq ' s budget shortfalls wil l decline over the coming years, on the back of rising oil revenues and government efforts to contain the public sector salary bill - a move encouraged by the IMF. That said, the pace of consolidation will be limited by rising capital expenditures in light of the reconstruction process and fiscal slippage in the run-up of the May 2018 elections.

Rising oil revenues and government efforts to contain current spending underpin our view for a reduction of Iraq's budget shortfalls over the coming years. That said, we remain cautious on the government's ability to implement its fiscal plans, especially in the run-up to the 2018 provincial and parliamentary elections, while capital expenditures will increase at a robust pace owing to the tremendous reconstruction needs. As such, we forecast a budget deficit of 6.9% of GDP in 2018 and 3.2% in 2019, down from an estimated 8.5% in 2017.

Higher Oil Prices To Drive Deficit Reduction
Iraq - Budget Balance & Brent Prices
e/f = BMI estimate/forecast. Source: IMF, BMI

Rising Oil Prices To Support Revenues

Recovering oil prices will be the major driver of Iraq's improving fiscal position. Oil accounted for an estimated 88.3% of total revenues in 2017; as such, the government's budget remains overly reliant on oil price movements and output. Rising prices - our Oil & Gas team is forecasting Brent prices to average USD57.0 per barrel (/bbl) in 2018 and USD63.0/bbl in 2019, up from USD54.7/bbl in 2017 - will therefore support government revenues over the coming years. Production growth will remain tempered by the OPEC-stipulated cuts in 2018, before picking up in the following years. Meanwhile, we expect robust growth in non-oil revenue, largely owing to the reintegration of territories previously controlled by Islamic State (IS) and by improvements in the non-oil economy. That said, it will not be sufficient for non-oil revenue to become a much more significant share of the total.

Efforts To Contain Spending Positive...

Government efforts to contain current spending also underpin our view for shrinking budget shortfalls in the years ahead. As part of the USD5.3bn Stand-By Agreement signed with the IMF in July 2016, Baghdad has agreed to implement a number of consolidation measures. In line with this pledge, the 2018 draft budget (which, at the time of writing, had yet to be adopted) includes a freeze on public sector hiring and on civil servants' bonuses. Meanwhile, the budget only includes 122,000 fighters from Shi'a dominated Popular Mobilisation Units - militias which have played a key role in the fight against IS and have now been recognised as state-affiliated entities - compared with an estimated 152,000 fighters officially on the ground. Government attempts to minimise the number of fighters under his oversight can also be seen as a way to limit spending. Lastly, the draft budget also allegedly reduces the Kurdistan Regional Government (KRG)'s share of the national budget from 17.0% to 12.6%. We believe that part of this reduction is linked to plans to eliminate ghost workers from the public sector payroll and to contain the salary bill. However, it can also be seen as a way for Baghdad to put pressure on the KRG following the September 2017 independence referendum.

Efforts To Contain Salaries A Welcomed Step
Iraq - Breakdown Of Government Spending, 2015 (% Total)
Note: Latest data available. Source: IMF, BMI

... But Implementation Constrained By Political Pressures, Reconstruction

That said, we believe that the implementation of these measures will come short of the government's stated plans. Iraq will hold provincial and legislative elections in May 2018, which will likely result in some fiscal slippage. This will be reinforced by the fact that Iraq is one of the most corrupt countries globally - ranking 166th out of 176 countries in Transparency International's Corruption Perceptions Index - which results in the government spending considerable amounts on ghost workers and patronage networks. In addition, Iraq is set to restart war reparations to Kuwait, with amounts gradually increasing through to 2021. Meanwhile, fiscal consolidation plans will also be delayed by the tremendous capital expenditure needed to rebuild the country's damaged infrastructure network. In June 2017, the government unveiled a USD100bn reconstruction plan, set to start in 2018 and stretching over a 10-year period.

Borrowing Conditions Have Improved
Iraq - Yield On USD2028 22Y Bond, %
Source: Bloomberg, BMI

Risk Of Credit Event Now Contained

Despite sizeable fiscal deficits expected over the next two years, the risk of a credit event has significantly declined over the past year and a half, since the government reached a deal with the IMF in July 2016. The agreement enabled the government to unlock other lines of financing, and this strong external support has allowed Baghdad to successfully return to the international debt markets in August 2017, issuing USD1.0bn of eurobonds - the country's first independent issuance since 2006. The Iraqi government is currently benefiting from favourable borrowing conditions - the yield on its USD 2028 22-year bond has fallen from 11.6% in January 2016 to 6.1% at the time of writing. As such, we believe that the government will return to the debt markets in 2018, as suggested by the Central Bank of Iraq's governor Ali Al-Allaq in November 2017. The government will also continue to monetise part of its deficit, by selling treasury bills to state-owned banks Rasheed and Rafidain (accounting for more than 80% of assets at commercial banks), which can later refinance some of these issuances at the discount window of the Central Bank of Iraq.