Iraq’s Fiscal Outperformance May Not Last Amid Political Volatility

Fitch Ratings- Hong Kong-20 July 2022: Iraq’s government debt is set to fall steeply as a share of GDP in 2022, bringing it to pre-Covid-19 pandemic levels, says Fitch Ratings. This is positive for the sovereign’s creditworthiness, but the decline may not be sustainable, as it partly reflects political tensions that have constrained public spending and reflect the high political risk captured in Iraq’s ‘B-’ rating.

We expect debt/GDP to drop as higher oil prices – which we estimate will average at USD105/barrel (bbl) in 2022 and USD85/bbl in 2023 – and production boost government revenue and nominal GDP. Our forecast fall in Iraq’s government debt/GDP ratio in 2022, to around 47% of GDP, from 66% in 2021, is the largest for any sovereign in the Middle East and north African region, bringing the country below the median for ‘B’ rated sovereigns.

In our January 2022 affirmation of Iraq’s rating we stated that positive rating action could result from a sustained period of elevated oil prices, particularly if combined with higher oil production and exports, leading to a downward trend in government debt/GDP and larger foreign reserves. Nonetheless, there is still significant uncertainty about public finance trends and the oil price outlook.

Iraq’s falling debt ratio also reflects its failure to form a government and pass a budget since its October 2021 elections. This constrained spending to 2021 levels until parliament passed an emergency funding bill on 6 June to allocate USD17 billion, or 7% of GDP, for food and energy subsidies and salaries. Subsidy programmes, which remain unreformed, were in danger of running out of money due to the rise in global commodity prices.

Our forecast of a 17% of GDP fiscal surplus in 2022 assumes a 6% of GDP boost in spending, broadly consistent with the emergency funding. However, risks to our spending forecasts are on the upside, as any new budget is likely to entail higher spending in light of Iraq’s pressing social and economic development needs. We still forecast some nominal reduction of debt in 2022 if a new budget passes, in particular of accumulated central bank claims on the government, which had risen to about 13% of GDP in 2021. However, accelerated spending could impair the sustainability of public debt reduction. This could track a similar path as in 2018, also following elections, when public spending was slow to accelerate after oil prices rose, leading debt to fall to a degree, but spending eventually rose strongly.

Fitch Ratings- Hong Kong-20 July 2022: Iraq’s government debt is set to fall steeply as a share of GDP in 2022, bringing it to pre-Covid-19 pandemic levels, says Fitch Ratings. This is positive for the sovereign’s creditworthiness, but the decline may not be sustainable, as it partly reflects political tensions that have constrained public spending and reflect the high political risk captured in Iraq’s ‘B-’ rating.

We expect debt/GDP to drop as higher oil prices – which we estimate will average at USD105/barrel (bbl) in 2022 and USD85/bbl in 2023 – and production boost government revenue and nominal GDP. Our forecast fall in Iraq’s government debt/GDP ratio in 2022, to around 47% of GDP, from 66% in 2021, is the largest for any sovereign in the Middle East and north African region, bringing the country below the median for ‘B’ rated sovereigns.

In our January 2022 affirmation of Iraq’s rating we stated that positive rating action could result from a sustained period of elevated oil prices, particularly if combined with higher oil production and exports, leading to a downward trend in government debt/GDP and larger foreign reserves. Nonetheless, there is still significant uncertainty about public finance trends and the oil price outlook.

Iraq’s falling debt ratio also reflects its failure to form a government and pass a budget since its October 2021 elections. This constrained spending to 2021 levels until parliament passed an emergency funding bill on 6 June to allocate USD17 billion, or 7% of GDP, for food and energy subsidies and salaries. Subsidy programmes, which remain unreformed, were in danger of running out of money due to the rise in global commodity prices.

Our forecast of a 17% of GDP fiscal surplus in 2022 assumes a 6% of GDP boost in spending, broadly consistent with the emergency funding. However, risks to our spending forecasts are on the upside, as any new budget is likely to entail higher spending in light of Iraq’s pressing social and economic development needs. We still forecast some nominal reduction of debt in 2022 if a new budget passes, in particular of accumulated central bank claims on the government, which had risen to about 13% of GDP in 2021. However, accelerated spending could impair the sustainability of public debt reduction. This could track a similar path as in 2018, also following elections, when public spending was slow to accelerate after oil prices rose, leading debt to fall to a degree, but spending eventually rose strongly.

It remains unclear whether an incoming government will execute reforms put forward in a whitepaper under the previous administration in October 2020, even if Prime Minister Al Kadhimi is re-appointed. Parliament took out proposals for income tax reform from the 2021 budget, while other reforms, such as the removal of fuel subsidies for electricity generation, were approved, but not implemented.

The political outlook remains volatile. The largest parliamentary faction, led by Shia cleric Muqtada al-Sadr with 73 of the 329 members, resigned collectively on 12 June, having failed to form a coalition excluding the rival Iran-backed Shia Coordination Framework. The reordering of forces in parliament may enable government formation. However, Sadr retains considerable influence outside parliament and the underlying tensions that have hobbled Iraq’s politics will persist, including over Iranian influence and Kurdish oil autonomy.

Public grievances could boil over into broader social instability, as they did in 2019-2020, with protests ultimately leading to early elections. Iraq scores poorly across the World Bank’s governance indicators, reflecting insecurity and political instability, corruption, government ineffectiveness and weak institutions. We expect persistently high levels of political risk and weak governance will continue to weigh on the sovereign rating.