The Iraqi Economy I: Overview History and Key Issues

1. The Iraqi Economy I: OverviewHistory and Key Issues NS3040 December 2008 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 • Business Climate • 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 has so far has been 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 • The initial economic strategy was unsuited to Iraqi reality and 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 • There are a number of key questions surrounding Iraq’s economic development over the next several years: • 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

17. Oil as an Economic Obstacle • Oil not only generates income, it creates its own set of economic problems in Iraq: • Oil rents create an allocation state rather than a production state, leading to conflicts over access to and control of the money • 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 the 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 • Oil-associated corruption undermines state formation

18. 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

19. Evaluating Economic Performance II • While macroeconomic data show that revenues and government expenditures are up, it is unclear whether the living standards of average Iraqis have improved. • The current data does not reflect: • Income distribution • The distinction between oil export revenues and revenues from general economic development • Regional and local differences • Important sectarian and ethnic differences • Data on government spending is meaningless unless the productivity of that spending is also measured.

20. 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

21. Post-War Economic Performance • Growth in real Gross Domestic Product (GDP) • 2003: -33.1%; 2004: 23.0%; 2005: -0.7%; 2006: 6.2%; 2007: 1.5%; 2008: 9.0% (proj); 2009: 7.3 (proj). • For non-oil GDP 2005: 12%; 2006: 7.5%; 2007: -2.0; 2008: 3.0% (proj); 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

22. Iraq: Trend in Income

23. Economic Progress

24. Productive Sector Trends

25. Service Sector Trends

26. Perceptions of Progress

27. The Electricity Gap

28. Economic and Security Linkages

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

30. Oil Sector Production I • 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 is expected to continue increasing marginally to 2.4 mbd (2008), and 2.5 mbd (2009)

31. Oil Production and GDP Growth IMF, Iraq: First Review Under the Stand-By Arrangement – Staff Report, September 2008, p. 7

32. Oil Sector Production II • 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.

33. 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

34. 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.

35. 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 • It suffers from infrastructure neglect, soil salinity, and the lowering of water table • Prices for inputs and outputs are largely government controlled. • Production dropped dramatically around 1997 following the shift to cheap imports associated with the Oil for Food Program. • The overthrow of Saddam had little effect on the agricultural sector, since the Public Distribution System continues to import food

36. Public Distribution System I • The Public Distribution System (PDS) is the primary (and in many parts of Iraq, the sole) welfare program • 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 • It is a recent program, originally begun in 1996 as part of the Oil for Food Program and managed by Ministry of Trade (MoT)

37. 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.

38. 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 is 15.2% -- may actually be below 10%.

39. Inflation and the Dinar Exchange Rate

40. Inflation II • Inflation impacts the Iraqi economy in several ways: • Iraq 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

41. Causes of Inflation • Iraq experienced rapid inflation in 2006 • Cost-push inflation occurred as a result of fuel liberalization in December 2005 • The price of premium benzene/gasoline increased 500%, from 50 NID/liter to 250 NID/liter • This, in turn, resulted in a 227% increase in the fuel and light group of the CPI basket • Demand-pull inflation resulted from excess demand, created especially by grants that increased GOI revenues and expenditures by 32% • Inflation figures were probably underestimated as a result of bias downwards in figures, since numerous shortages forced many consumers to pay higher black market prices

42. Iraq: Official Fuel Prices IMF, First Review Under the Stand-By Arrangement – Staff Report, September 2008, p.12

43. Unemployment I • Reported unemployment rates are very high • Nationwide unemployment is between 40% - 70% • Iraqi Ministry of Social Affairs estimates that it is 48% • ILO estimates 50% - 60% • Some reported city rates are even higher, e.g. Samarra 70% • Definitional issues • Unemployment/Underemployment • Discouraged worker • Formal/Informal economies

44. Unemployment II • The perceived high unemployment rate: • Is cited as proof of GOI/USG policy failure and lack of compassion • Is widely believed to drive young males to support the insurgency • Suggests that the focus should be on immediate employment programs (possibly make-work) for young males instead of on other programs

45. Unemployment Data: Biases • Iraq unemployment surveys are biased upwards because • People lie about their personal situation to avoid extortion or loss of benefits • There is a tendency to think of a “real” job as one with reliable wage and benefits, so people in informal economy think of themselves as unemployed • Provinces and cities exaggerate unemployment to qualify for more aid • There is evidence from reconstruction projects that skilled labor is in short supply • GOI/USG projects must be phased because of labor shortages • New projects lead to sharp wage increases even for unskilled labor

46. Brain Drain • Violence has resulted in 2 million refugees fleeing Iraq and displaced 1.4 million within the country. • External migration began in 2003, with the moneyed and upper middle classes transferring business operations to Arab states such as Jordan, Syria, UAE, Egypt and Yemen • Thereafter many middle class professionals--doctors, lawyers, engineers, architects, nurses and teachers--left the country. • Many in this group that stayed were either killed or kidnapped. • New waves of emigration are seeing less affluent Iraqis leaving in search of safer environments, mainly in Jordan and Syria. • While it is difficult to put a cost on the brain drain, it is no doubt in the billions in terms of lost potential income.

47. Movement of Iraqi Refugees

48. Debt Resolution • At the time of Saddam’s ouster, Iraq’s external debt was estimated at $125 billion • Paris Club bilateral = $37.15 billion; non-Paris club bilateral $67.4 billion; Commercial debt $20 billion; Multilateral debt = $0.5 billion • Reducing debt to a sustainable level has been a U.S. priority • Since 2003, debt relief negotiations have led to the cancellation of a significant amount of Iraqi debt, including an 80% reduction in Paris club debt • Iraq is expected to receive no more than 80% cancellation from all its creditors • Since 2003, Congress has provided over $45 billion in aid to Iraq, $10 billion which remains to be obligated

49. Questions? -- Break • Questions? • Next: The Policy Areas -- Economic Reforms and Attempts at Improved Governance

50. Economic Reforms I Main Problem – Many reforms begun but not completed. • Business Environment • Some progress has been made in establishing an investment- friendly business environment, with the main constraints being security and stability • Trade Liberalization • A low flat tariff was established, but non-tariff trade obstacles persist, including significant delays in customs, as well as some import and export bans. • Government Size • Government spending, including consumption and transfer payments, is extremely high, estimated at about 90 percent of GDP