Ratings On Iraq Affirmed At 'B-/B'; Outlook Stable

  • We understand that Iraq's external balance sheet and fiscal position improved in 2018 owing to relatively high oil prices.
  • We expect that lower oil prices and an expansionary government budget will likely reverse this improvement in 2019.
  • We are therefore affirming our 'B-/B' sovereign credit ratings on Iraq.
  • The outlook is stable.
On Feb. 22, 2019, S&P Global Ratings affirmed its 'B-' long-term and 'B' 
short-term foreign and local currency sovereign credit ratings on Iraq. The 
outlook is stable.

The stable outlook reflects our opinion that risks to Iraq's fiscal 
performance will be contained. The government's extremely expansionary 2019 
budget faces limitations on potential financing lines, as well as conditions 
associated with the possible resumption of Iraq's IMF program.

We could lower the ratings if, contrary to our expectations, the government 
maintains its extremely expansionary fiscal plans and its net debt or debt 
servicing costs were to rise sharply. This could also occur if oil revenues 
fell further than expected and the government was unable to cut expenditure or 
implement countermeasures.

We do not expect to raise the ratings over the next 12 months, but we could if 
Iraq's political and security situation improves meaningfully, along with its 
public finances.

Our ratings on Iraq are constrained by its nascent political institutions and 
domestic political tensions--including divisions between the Sunni, Shia, and 
Kurdish ethnic and sectarian groups--as well as security risks. Our ratings 
are underpinned by the fact that the majority of Iraq's oil output is in areas 
firmly under the control of the federal government. Crucially, more than 85% 
of Iraq's oil fields and oil output are located in the south of the country, 
some distance from the volatile areas formerly held by Islamic State (IS). 
Despite a significant hydrocarbon endowment, Iraq's GDP per capita remains low 
and economic activity weak, in our view. Monetary policy is largely 
constrained by the weakness of the banking system. The country's external 
indebtedness is relatively low, reducing external risks. However, we view 
external liquidity as relatively constrained, partly because we exclude the 
monetary base from our calculation of the Central Bank of Iraq's (CBI's) 
usable reserves, in line with other sovereigns, owing to Iraq maintaining a 
pegged exchange rate. 

Institutional and Economic Profile: A volatile political environment and 
security risks hamper reform prospects
  • Broadly, we expect that Iraq's institutional profile will remain weak, with a divided society and unpredictable policy making.
  • The new prime minister has struggled to appoint a cabinet since his own appointment in October 2018, indicating weak parliamentary support.
  • There are some indications that the security situation is improving, which, along with increased oil production, will help growth.
Iraq's political situation will remain complex and unpredictable, in our view. 
The new prime minister, Adil Abdul-Mahdi, was appointed in October 2018, five 
months after parliamentary elections. A full cabinet has yet to be appointed. 
We view these substantial delays as symptomatic of weak administrative 
capacity. We also view the delay to appoint a full cabinet as a sign of weak 
parliamentary support for the prime minister given that his cabinet 
nominations require the majority support of parliament.

In our opinion, the recently announced 2019 budget highlights the 
unpredictability of Iraq's policy making. The budget incorporates numerous 
concessions to quell the risk of public discontent, following years of 
conflict, and address substantial reconstruction needs. However, it results in 
a significant public spending increase that we estimate will be some 20% above 
2018 levels. Consequently, we no longer expect that the IMF will disburse 
anticipated funds in the near future. Under its three-year standby arrangement 
(SBA), which was approved in July 2016, the IMF has disbursed about $2.1 
billion of a $5.4 billion program, despite Iraq's previous failures to meet 
all of the program's conditions. The IMF program had been an important support 
of Iraq's fiscal situation in that it unlocked further budget financing from 
both official and unofficial creditors. With the program now largely stalled, 
we expect that other bi- and multi-lateral lenders will be less willing to 
lend to Iraq. As a result we expect the magnitude of the government's planned 
fiscal deficit to be contained. 

The threat of domestic conflict remains. The government has thwarted two 
would-be states within its borders in recent years: an IS caliphate and an 
independent Kurdistan. However, risks of further political turmoil from both 
groups persist. In September 2017, the Iraqi Kurdistan independence referendum 
resulted in a 93% vote in favor of independence. However, shortly afterward, 
the Iraqi government took control of territory disputed by the Kurds, 
including the southern Kirkuk oilfields. The Kurdistan Regional Government's 
(KRG's) position has weakened a lot since the referendum, and it is highly 
unlikely to achieve independence. In our opinion, the more probable scenario 
is that its autonomy will be curbed and it will transfer its oil production 
revenues in exchange for fiscal transfers from the federal budget and a 
lifting of sanctions. We note more conciliatory provisions have been made for 
the region in the 2019 budget. In addition, there is a risk that the continued 
influence on Iraqi politics by external parties--including Iran, the U.S., and 
Turkish incursions into northern Iraq to confront the Kurdistan Workers' Party 
(PKK)--could destabilize consensus building. 

We also believe Iraq's political and economic development is hampered by 
widespread corruption. The country ranks among the world's worst in the 
Corruption Perceptions Index and the World Bank's governance indicators. We 
believe that fighting corruption, the lingering presence of IS, and tensions 
with the KRG are Iraq's major political and security challenges in the near 
term. Strengthening governance, accountability, and transparency could help 
unlock Iraq's economic potential.

Iraq has the world's fourth-largest proven crude oil reserves and is the 
second-largest oil exporter in the Organization of Petroleum Exporting 
Countries (OPEC). Oil dominates the Iraqi economy, contributing about 50% of 
GDP, 90% of government revenues, and more than 95% of exports. The industry 
helps to support Iraq's relatively low economic wealth levels, with per capita 
GDP at an estimated $4,900 in 2019.

We estimate real per capita GDP growth at -0.1% as a weighted average over 
2013-2022, with population growth outstripping real GDP growth in our 
projections. This growth rate is below that of peers that have similar wealth 
levels. Notwithstanding this, we expect overall GDP growth to pick up in 2019, 
to 3.5%, based on partial (60%) compliance with planned OPEC production cuts 
and a subsequent ramp up in production over the second-half of the year, so 
that production averages 4.7 million barrels per day (mbpd) compared with an 
average of 4.6 mbpd in 2018. While private consumption will likely be hampered 
by lower oil prices (see "S&P Global Ratings Lowers Brent And WTI Oil Price 
Assumptions For 2019 Through 2020; Natural Gas Price Assumptions Are Unchanged,
" Jan. 3, 2019), its contribution to growth harbors upside potential, which 
could be at least partly unlocked as the government's increased fiscal 
expenditure gives rise to more positive sentiment. We expect that total oil 
production will increase toward 4.9 mbpd by the end of our forecast period.

In our view, administrative shortcomings jeopardize the quality of Iraq's 
national accounts data. For example, output in areas under the jurisdiction of 
the KRG cannot always be directly measured by the federal government.

Flexibility and Performance Profile: Sharp fiscal reversal offsets a stronger 
external position 
  • We expect an average Brent oil price of $55 per barrel (bbl) in 2019 and beyond.
  • We expect a fiscal surplus of 4% of GDP in 2018 will turn to a deficit of 6% in 2019, with little subsequent consolidation.
  • Following a substantial current account surplus in 2018, reserves have increased substantially and Iraq's liquid external assets now exceed its external debt.
We understand that the general government ran a budget surplus of 4% of GDP in 
2018, following much higher oil prices than budgeted and a 25% underspend, 
largely on projects. At the same time, restated 2017 balance of payments data 
show a higher current account surplus in 2017 than previously recorded. Given 
the increase in oil prices over 2018, this results in an estimated surplus of 
nearly 13% of GDP; official foreign exchange reserves increased to $64 billion 
as a result, pushing liquid external assets above external debt and 
potentially weakening the rationale for adhering to a politically difficult 
agreement with the IMF. Higher current account receipts have also improved our 
assessment of Iraq's external liquidity (our estimate of gross external 
financing needs as a percentage of current account receipts [CARs] and usable 
reserves has declined to about 80% over 2019-2022). 

However, in 2019 we expect oil prices will average 24% lower than in 2018 and 
remain $55/bbl over our forecast period. Assuming only slow growth in imports, 
we expect the current account balance to halve in 2019 but to remain in 
surplus over the forecast, averaging around 5% of GDP.

The budget envisages a deficit of around 10% of GDP in 2019, however we expect 
that limited access to bi- and multi-lateral funding lines will moderate 
government spending. We expect that non-adherence to the IMF's SBA will 
complicate access to other official sources of funding and we foresee a budget 
deficit closer to 6% of GDP for 2019. Keeping in mind that the political 
pressures that contributed to this expansionary stance are unlikely to fully 
abate--and that Iraq's reconstruction needs are very significant--we see 
limited prospects for consolidation measures to be implemented without a 
renegotiated IMF program. We expect the government's debt burden to increase 
toward 70% of GDP, and possibly higher if it can secure more funding than we 
currently expect.

The government plans to finance its 2019 deficit through a mixture of 
short-term domestic financing (T-Bills bought by domestic banks), running down 
assets accumulated from the 2018 fiscal surplus, increasing the pension fund's 
holdings of government securities, and tapping official and bilateral funding 
sources, the latter mainly through project finance deals.

The financial stability of domestic banks is uncertain, and we view the risk 
stemming from the financial sector as a moderate contingent liability for the 
government. State-owned banks dominate the banking sector. Financial accounts 
audited to international standards are not available, but we believe that 
Rafidain Bank and Rasheed Bank are severely undercapitalized, with high 
nonperforming loans across the whole sector. 

Reporting on Iraq's external data (balance of payments and international 
investment position) is poor, which reduces the visibility of external risks. 
We believe CBI data significantly under-reports imports since imports into the 
region of Iraqi Kurdistan are not included and imports at other entry points 
into Iraq are not systematically measured. We use IMF data because we believe 
it provides a more accurate representation of Iraq's external position. 

We expect the Iraqi dinar's exchange-rate peg to the U.S. dollar will remain 
in place over the next few years. While the peg has helped control inflation, 
it limits the CBI's monetary flexibility, in our view. We consider CBI foreign 
exchange reserve coverage to be an important factor in maintaining confidence 
in the exchange-rate link. We have therefore deducted the monetary base from 
usable reserves because we regard these reserves as somewhat encumbered by the 
likely need to defend the peg in times of stress. 

We view the monetary policy transmission mechanism as weak. The banking sector 
in Iraq is still burdened by high nonperforming loans, and does not fully 
fulfil the lending functions a banking sector normally would be expected to 
undertake. For this reason, the monetary policy tools that rely on the banking 
sector, such as the reserve requirement and the provision of standing 
facilities, are of limited effectiveness in Iraq.
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