The Iraqi Economy I: Overview History and Key Issues

1. The Iraqi Economy I: OverviewHistory and Key Issues NS3041 Comparative Economic Systems August 2009 Dr. Robert E. Looney relooney@nps.edu

2. Outline I • Introduction • Importance of Understanding the Iraqi Economy • The Pre-War Iraqi Economy • Saddam’s Legacy • The Post-War Economy -- Overview • Defining Iraq's Post-war Economy • Post-War Economic Strategy • Post-War Strategy Dynamics • Difficulties encountered in Initial Economic Strategy • Key Questions in Iraq’s Economic Transition • Key Factors for Successful Economic Transition • Economic Obstacles Posed by Oil

3. Outline II • Economic Progress • Difficulties in Evaluating Economic Performance • Overview of the Economy – Strengths and Weaknesses • Composition of Output • Trends in Output • Key Sectors • The Oil Sector • Agriculture/Public Distribution System • Problem Areas • Inflation • Unemployment • Brain Drain • Debt

4. Outline III • Questions? -- Break • Progress in Reforms • Economic Reforms • State-Owned Enterprises • Governance Issues • Combating Corruption • Consequences of Poor Governance • Reconstruction Experience • Reconstruction Progress • Current Concerns • Summing Up

5. Outline IV • The Future • Key Variables • Virtuous Circles • Critical Intangibles • Contrasting Iraqi Views

6. Introduction • Understanding the Iraqi economy is central to: • Explaining the staying power of the insurgency/militias/gangs • Designing efficient reconstruction strategies • Identifying projects and investments at the local level • Creating the foundation for a viable self-sustaining economy • Incorporating the country’s diverse populations into a modern nation-state • With time, economic factors likely to be more important in determining the eventual outcome in Iraq – need for jobs and a better life key to the country’s future

7. Pre-War Iraqi Economy • In the 1970s, Iraq was set to dominate the Middle East, with oil, industrialization, agriculture, and a large population • However, by 2000, after several wars and sanctions: • The oil sector made up at least 75% of GDP; much of the agricultural sector had been destroyed and the industrial sector was in decline. • There was a distorted pricing system, widespread inefficiency and waste, and a stagnant agricultural sector • 50% of the population was under 24 years of age. • There was widespread unemployment -- up to 50% • 60% of the population depended on food rations • There were macroeconomic imbalances, such as high inflation • The shadow economy made up at least 35% of GDP, with a large criminal economy and rampant corruption

8. Saddam’s Legacy • Saddam bought loyalty using oil money to heavily subsidize necessities • Fuel prices were set at 13 cents a gallon • The Public Distribution System (PDS) provided almost free food baskets • Electricity was provided at a very low cost • Water, medical care and education were free • These programs helped bankrupt Iraq • They were inefficient and a massive drain on the budget • They starved the private sector of funding and resources • They ruined a dynamic agricultural sector • The subsidies and controlled prices facilitated massive corruption/black markets

9. Overview of the Economy • Economic Strengths: • Iraq is believed to have second-largest oil and third-largest gas reserve in the world • Technical expertise in oil extraction should result in large increases in production as and when security improves • Economic Weaknesses (in addition to Saddam's Legacy): • Oil rents create an allocation state rather than a production state, leading to conflicts over access to and control of the money • Government employees have little experience with an open economy and technical expertise is limited • Uncertainty surrounds political transition to a unitary state. • The non-oil sector is starved for skilled workers • Infrastructure is in a state of decay • The exchange rate may be too strong to facilitate diversification

10. Defining Iraq's Post-war Economy Iraq's post-war economy was a complicated mix of different models, each of which required a different policy remedy

11. Post-War Economic Strategy I • US post-war economic strategy in Iraq was initially based largely on only the Transition Economy/Shock Therapy model: • This model is an extreme version of shock therapy focus on long-term efficiency • Its goal was to wipe the slate clean and start the economy anew • The strategy aimed to create an open economy with low taxes to promote foreign private investment • Its emphasis was on creating macroeconomic stability and an independent central bank, with government remaining largely passive in dealing with economy • It aimed for high job creation through rapid private sector investment and expanded output, with foreign direct investment (FDI) and profitable imbalances from massive reconstruction projects as its key ingredients--an unbalanced development strategy

12. Post-war Economic Strategy II • The post-war economic strategy assumed that the government must reduce its role in the economy, expand the play of market forces, and undertake key reforms: • Liberalizing economic activity, prices and market operations • Establishing political accountability for economic performance, as well as public responsiveness to private sector economic needs • Developing indirect, market-oriented Instruments for macroeconomic stabilization • Using these instruments to increase market-based employment opportunities for Iraqis • Achieving effective enterprise management and economic efficiency, usually through privatization • Second-stage -- establishing an institutional framework to secure property rights, rule of law, and transparent market-entry regulations.

13. Post-War Strategy Dynamics • Iraq’s post-war strategy was intended to create Porter-type mechanisms of private-sector-induced reforms

14. Flaws in Initial Economic Strategy • With time, it became apparent that initial economic strategy was unsuited to Iraqi reality. It created an environment more favorable to criminals and extremists than to private investors intent on rebuilding the economy • The economic plan shut large numbers of Iraqis with no skills or capital out of the economic process and fueled widespread anger • It was impossible to attract the private investment on which the strategy depended in the face of political and economic uncertainty • The inability to produce sustainable short-run economic gains made economic reforms an easy target for extremist groups • US-led initial reforms did not lead to second stage of Iraqi-led institutional reforms but, instead, created a vacuum that was filled by existing organized religious and criminal groups • The incomplete reforms and inadequate price controls created profitable Black Market opportunities

15. Iraq’s Economic Transition I • Given Iraq’s continued commitment to an open free-market economy, there are a number of key questions surrounding Iraq’s future economic development: • Can the movement to free markets be accomplished without creating another layer of angry, marginalized Iraqis? • Will a new market economy benefit some groups and regions at the expense of others? If so, are there satisfactory solutions, or will there be an equity/growth tradeoff? • Will there be broad-based popular support for market liberalization, or will the movement to markets be perceived as promoting outside interests to the detriment of Iraqis? • To what extent will the US/IMF affect the nature and speed of economic reforms? Will reform be accomplished by consensus- building or through conditionality of financial support? • What factors may limit the economy from fulfilling its potential in contributing to state formation?

16. Iraq’s Economic Transition II • To achieve a successful transition in Iraq, experience to date suggests it is necessary to: • Separate government from natural resources • Ensure that petroleum benefits the people and avoid “curse of resources” or “paradox of plenty” problems • Diversify, following the example of countries like Mexico that succeeded in reducing dependence on oil revenues by encouraging other industries and non-oil exports • Attract back many of the four million highly trained and skilled expatriate Iraqis who have have experience with democracy and the workings of free markets • Attempt to develop an environment of economic accountability on the part of both the state and the private sector, with each placing pressure on the other for improvements. • Main issue: what level of success is possible if some or all of these conditions are not met?

17. Oil as an Economic Obstacle • Oil not only generates income, it creates its own set of forces that undermine the foundations of a strong, self-sustaining economy: • The availability of oil rents reduces the government’s need to extract money from society and, thus, earn citizen support by providing valued services and effective economic management • This lack of a rigorous tax system impedes the emergence of a strong state that legitimately represents its citizens. • Oil creates an implicit social contract in which state-provided welfare is substituted for political rights • Oil revenues encourage patrimonial loyalties, instead of participatory democracy • Exchange rate appreciation hurts rest of export economy (Dutch Disease).

18. The Oil Curse • There is a general tendency in developing countries like Iraq for oil to create and perpetuate conflict: • Natural resources volatile – booms and busts. • Politics = control of natural resource revenues. • Typically oil only found in certain regions of country. • Revenue source for insurgent groups, criminal gangs and or their sponsors. • Resource wealth detaches government from electorate. • Revenues create opportunity for broad-based corruption. • Perhaps because of the above factors, resource rich countries tend to have authoritarian governments.

19. Evaluating Economic Performance I • Evaluating Iraq’s economic performance is difficult due to: • Lack of accurate economic data • Little effort was made in pre-war Iraq to compile accurate economic data • Much of the data that existed was destroyed after the war • Limited manpower hindered systematic post-war data collection • Large amounts of Iraq’s economic activity occur in the underground, or shadow, economy • Lack of objective reporting • Many accounts are impressionistic, rather than based on verified facts • Lack of reliable surveys • Insurgency limits fieldwork • Many surveys suffer from systematic biases

20. Evaluating Economic Performance II • Even if macroeconomic data show that revenues and government expenditures are up, it would still be unclear whether the living standards of average Iraqis have improved. • The current data does not reflect: • Income distribution • Regional and local differences • Important sectarian and ethnic differences • Finally, data on government spending is hard to interpret because the productivity of that spending is not measured.

21. National Income • Oil dominates the Iraqi economy • It provides about 75% of GDP and 95% of foreign exchange earnings and government revenues • The non-oil economy consists of: • Agriculture, which makes up 7% and 25% of national employment • Wheat, barley, rice, vegetables, dates, cotton , cattle sheep and poultry – country used to be major agricultural exporter • Industry makes up 67% and 10% of total employment, with only 2 percent employed in petroleum • Services make up 26% and 65% of employment, with government the largest employer. • Shadow economy • May be as high as 40% of GDP and 50% of the labor force

22. Post-War Economic Performance • Growth in real Gross Domestic Product (GDP) • 2003: -33.1%; 2004: 23.0%; 2005: 3.3%; 2006: 6.2%; 2007: 1.5%; 2008: 7.8%; 2009: 6.1 (proj); 2010: 6.0 (proj). • For non-oil GDP 2005: 12%; 2006: 7.5%; 2007: -2.0; 2008: 3.0% 2009: 5.0% (proj). • Per capita national income • At cost of living (PPP), income per capita was approximately $3,537 in 2007 • This figure affords a standard of living comparable to that of residents of Bolivia, Honduras, and Pakistan

23. Iraq: Trend in Income

24. Iraqi GDP: Regional Comparisons

25. Iraqi GDP Per Capita: Regional Comparisons

26. Economic Progress

27. Productive Sector Trends

28. Service Sector Trends

29. Perceptions of Progress

30. Electricity Constraints • Restoring the electrical infrastructure is critical to reviving the Iraqi economy and ensuring the productivity of the oil sector. • Demand has grown substantially and continues to outstrip supply • In 2008 supply met around 52 percent of demand even with increased generation. • The Iraqi Ministry of Electricity estimated in its 2006-2015 plan that it would need $27 billion over the next 6-10 years to provide reliable electricity across Iraq by 2015. • U.S. Government estimates the true cost may be twice as large • The GAO found: inadequate operating and maintenance practices as well as the lack of skilled technicians, inhibit an effective electrical infrastructure.

31. The Electricity Gap

32. Regional Power Availability

33. Economic and Security Linkages

34. Questions? -- Break • Questions? • Next: • The Main Economic Sectors – Oil, Agriculture • The Problem Areas – Unemployment, Inflation, Brain Drain, and National Debt.

35. Oil Sector Production: History • Oil dominates the economy but underperforms • The UN ban on oil exports caused a steep fall in production, from 3.5 mbd in July 1990 to 300,000 b/d in 1991 • Output recovered beginning in 1997, with the Oil for Food Program eventually approaching pre-sanctions levels • Underinvestment in the 1990s has taken a toll on output • Because of sabotage, output in the second half of 2003 was only at 1 mbd, with exports at 400,000 b/d • By February 2004 output up to 2.3 mbd, equal to the first quarter of 2003 • Sabotage and underinvestment reduced 2005 output to 1.8 mbd • 2006 output recovered to 1.9 mbd, 2007 to 2.1mbd and continued to expand marginally to 2.4 mbd in 2008, and should reach 2.6 mbd (2009) – may have missed window of high oil prices

36. Oil Sector: Future Expansion • Despite being critical to the country’s future prosperity and stability, the oil sector has been neglected: • Oil production and exports account for about 90% of Iraqi revenue. • The Iraqi government’s ability to fund reconstruction efforts and provide for its citizens depends, in part, on increasing oil production and exports. • Presently, investment in Iraq’s oil sector is below the minimum required to sustain current production: additional foreign and private investments are needed. • The Ministry of Oil has estimated that investments between $25 billion and $475 billion are needed to achieve its production target of 6 mbpd by 2015. • In 2008 the Ministry of Oil spend $421 million, or 19 percent of its investment budget for the year.

37. Oil Sector: Problems • Smuggling and sabotage are on-going problems for Iraq’s oil industry • Despite a 14,000 member Iraqi force to protect pipelines and ports, sabotage and smuggling persists • The Iraq Study Group estimated 150,000-200,000 mbd are lost to smuggling and or poor monitoring • Smuggling of refined products has become a major business with strong political links • In December 2005, the Iraqi government reduced fuel subsidies in an effort to combat smuggling • In 2007, the private import and sale of refined products was legalized • Legal uncertainty and security problems have hurt investment in equipment rehabilitation and development of new fields.

38. Oil: Future Issues • Iraq’s oil sector has great potential for expansion • Iraq has 115 billion barrels of proven reserves, the third highest in world • As of 20 years ago. only 10% of the country’s reserves had been properly explored • There is speculation that the country may have another 100 billion barrels, with reserve possibly even in Western Desert • Iraq needs foreign investment and technology to increase oil exploration and production

39. Oil Policy Critics • Iraqi oil policy has come under harsh criticism. Recurring themes stress: • The Ministry of Oil/Government have no petroleum strategy or business plan. • The nation has not realized the seriousness of not establishing an Oil Law. • The capabilities of the Oil Ministry’s operators, SOC, NOC and Misan oil Company (MOC) are below expectation • International oil companies (IOCs) are still worried about business in Iraq. • A large portion of the associated gas is being flared and oils is being used as feedstock to power generation • Production and export facilities have major bottlenecks. • Conflicts between the Kurdistan Regional Government (KRG) and the federal government are getting worse.

40. Draft Oil Law • Upgrading oil production is hindered by Iraq's inability to pass the Draft Oil Law due to two main areas of disagreement • The first concerns division of control between Baghdad and the regions. • The Kurdish Regional Government (KRG) wants stronger regional decision making. • Sunnis prefer greater central control. • The second involves the role of international oil companies • KRG feels foreign investment is the quickest way to increase production and reduce the control of the central government • Other parties are concerned over the terms of the contracts, and consensus building has proved difficult.

41. Role of International Oil Companies (IOCs) • Despite much talk, there are only limited developments in resolving the role of IOCs in developing Iraq’s oil • The first attempt to bring in foreign expertise through two-year service contracts collapsed in 2008. • The second attempt involves a series of 20-year service and investment deals. • Contracts are not of the production sharing type common elsewhere. The winning bidder will not take over the operations entirely. Instead it will establish a joint venture with whichever Iraqi state company is responsible for the field. • A portion of investment will come from the IOC and a portion from the Iraqi company. Assuming success, and production improved in line with targets agreed at the outset the IOC will recover its costs and receive a fee. In February 2009 the contractor’s stake raised from 49 to 75 percent and the production targets determined by Iraq have also been lowered. • Not as attractive as most contracts elsewhere in the world.

42. Future Oil Prices I • Developments in the oil sector will be greatly affected by future oil prices. Extremely difficult to forecast. • Concensus forecasts for 2009 are in the range of $US35-55 with dips to US$25 a possibility – below the costs of much new production. • The assumption is that world-wide demand destruction will outstrip supply cuts and production delays. • Demand destruction will be quite significant in the OECD and even emerging economies like China which provided the bulk of incremental demand in recent years. • Given the sluggish growth expected for global economy in 2010, oil demand growth could be slow to return to trend but will offset some of the production declines to push price to US$60 range. • Optimists contend that decrease in investment triggered by lower demand, lower prices, and the difficulty of access to credit might create oil supply shortages in the 3-5 year horizon. As a result, prices might begin a steep upward trend.

43. Future Oil Prices II • While many analysts expect oil demand to rebound sharply once the world economy recovers, not everyone agrees that prices are necessarily going to soar at that point. • One distinct pattern is that oil demand has grown slower after each energy crisis. Based on historical patterns, oil demand may only increase one percent once economic recovery sets in. • As OPEC trims output in the face of falling demand it automatically raises the amount of spare production capacity. • The market now has at least 5 million barrels a day of untapped output potential – that could increase to as high as 8 million barrels by the end of 2009. • The last spare capacity was in that range prices stayed low for years. • Many feel the current market looks like it did in the 1980s.

44. Agriculture • Iraq was once self-sufficient in food and agriculture was its second largest sector, but it has been on the decline for years: • Agriculture employs about 25% of workforce but only 8% of overall economic output. • Production dropped dramatically around 1997 following the shift to cheap imports associated with the Oil for Food Program. • It suffers from infrastructure neglect, soil salinity, and the lowering of water table • Prices for inputs and outputs are still largely government controlled. • The overthrow of Saddam had little effect on the agricultural sector, since the Public Distribution System continues to import food.

45. Public Distribution System I • The Public Distribution System (PDS) is the primary (and in many parts of Iraq, the sole) welfare program • It is a recent program, originally begun in 1996 as part of the Oil for Food Program and managed by Ministry of Trade (MoT) • The PDS provides a monthly “basket” of twelve foods and supplies to each Iraqi family • PDS subsidies cost $3 billion, or 9% of the total government of Iraq (GOI) budget • The Iraqi government has proposed phasing it out but there is broad based popular support for the program.

46. Pubic Distribution System II • Due to mismanagement and corruption, the PDS fails to provide sufficient food access to the Iraqi poor, damages domestic agriculture, and distorts prices • The GOI imports food but forbids food exports • Resale of PDS foods keeps market prices down • The GOI pays below-market purchase price of wheat ($180/ton for 1st grade, $130/ton for 4th grade) • Due to excessive administration costs, a PDS basket costs about 3 times more than the value of the food and supplies • The PDS uses budget funds that could be used for targeted aid, education, public health, etc. • The PDS encourages corruption, smuggling, and black market food sales, and loaded trucks regularly go missing.

47. Agriculture: Current Problems • Al-Maliki has started a $200 million initiative to revive agriculture to diversify economy away from oil. However: • Shortage of electricity and fuel that blocks farmers from pumping water out of wells. • Poor systems to deliver water from Euphrates and Tigris rivers to farms. Canals have deteriorated and need continual maintenance • Depleted seed and livestock supplies that were hindered first by Iran-Iraq war in the 1980s, the UN sanctions in the 1990s – for just about every crop grown in Iraq, there are better verities that could be used. • The country is experiencing a major drought that has crippled production in rain-fed wheat and barley areas. Prompted UN to name Iraq one of 32 countries requiring external aid in food supplies in 2009. • Shortage of border security agents to prevent Syrian, Iranian and Turkish imports from flooding agricultural markets.

48. Wheat and Barley Production: Impact of Drought

49. Inflation I • Inflation has been a problem in Iraq the past few years but may be improving • Inflation rates: 2003: -- 36.3%; 2004: -- 31.7%; 2005: -- 31.6; 2006: 53.2% • In 2007, inflation was 30.7%, but fell below 5% at the end of the year • The fall in inflation was assisted by the policy-induced increased strength of the Iraqi Dinar, together with the higher interest rates and controlled government expenditures that were part of the IMF program. • The inflation outlook is uncertain, but it should continue to fall assuming global non-oil commodity prices increase less strongly • Projected 2008 inflation was 15.2% -- but likely lower. • Inflation is projected at 5.4% for 2009 and 7.0 for 2010.

50. Inflation II • Inflation impacts the Iraqi economy in several ways: • Combined with the strengthening of the Iraqi dinar, exports are more expensive, while foreign imports are cheaper • Inflation creates an arbitrary redistribution of income and injures creditors and those on fixed incomes, such as those pensioners • Inflation complicates the planning process, since it is impossible to predict future costs • Makes it difficult to develop deep and efficient financial markets • Creates incentives for speculative investment – real estate, rather than productive investment