While Iraq’s war against terror is far from over, the conclusion of the Mosul offensive should mark the high point in the cost of war, and its gradual de-escalation has positive implications for the economy that will be explored here.
But first a quick look at the dynamics of Iraq’s economy. The economy is driven by the state, which derives over 90% of its revenues from oil exports, while its spending dominates all aspects of the economy. It employs over 50% of the work force and is the largest player in the non-oil economy with its orders/contracts driving multiple industries.
The double whammy of the Da’esh invasion of the third of the country and the collapse of oil prices in 2014 had a devastating effect on the economy as government finances were crushed by soaring expenses and plummeting revenues.
The diversion of resources to a war footing with escalating military spending, escalating spending on IDPs[i] at over 10% of the population while maintaining basic services forced the government into dramatic cutbacks that had knock-on effects on the economy. Exasperating the economic contraction was the fact the economy started a slow-down in early 2014 due to the uncertainties and violence ahead of the elections in April 2014.
The government’s response to the crisis can be seen over three distinct phases almost mirroring the military progress to date: Mid 2014-late 2015 was dominated by shock treatment in response to the severity of the crisis; late 2015-late 2016 saw the emergence of economic strategies to address the crisis, and early 2017 onwards builds on the economic strategies and plans for post-conflict reconstruction and rebuilding.
The table below shows the three phases over the four-year period.
Moreover, the responses were felt over three different categories of government spending: salaries and pensions, oil & non-oil investment spending and military capital spending (military and security salaries included in overall salaries).
The government maintained overall spending on salaries and pensions, yet the composition shifted significantly towards military and security spending starting in 2014 with the re-allocation of human resources towards the war effort and later on by the incorporation of the Popular Mobilization Units (PMU) into the state.
The effect, while necessary, had a negative consequence on consumer spending, as the process was far from smooth and involved significant delays in the payment of salaries and pensions and the imposition of a levy on salaries, initially 3% increasing to 4.8%, as a contribution for the war effort and IDPs. Moreover, the government introduced new and increased existing consumption taxes on a large number of consumables while it also increased utility prices further denting consumer purchasing power.
Non-oil investments bore the brunt of the cuts as the government sharply curtailed all capital spending and investments, as the table above shows, with 2016 non-oil spending at 12% of peak spending in 2013. The process involved non-payment of finished and ongoing contracts/projects with the government accumulating significant arrears in the process (estimated in 2016 at USD 4 billion or 2.4% of GDP) and cancelling planned spending/investments.
The effects were disastrous for the private sector businesses at the receiving end of the cuts whose finances deteriorated which in turn affected the quality of bank loans as these businesses dominated bank lending. An unintended consequence of the declining quality of loans was the inability of a number of illiquid banks to honor consumer withdrawal of deposits further hurting consumer purchasing power.
Although oil investment spending declined meaningfully in 2015 and 2016, oil production/exports experienced significant growth of 20%/30% and 21%/12% respectively in 2015 and 2016 which came at the cost of accumulating significant arrears to International Oil Companies (IOCs). While these arrears are being paid, constraints on government finances will affect future production growth.
Looking forward, a combination of revival in non-oil investment spending in 2017[ii] and the benefits following the peak of the war effort should be a positive economic driver for the non-oil economy in the immediate term. The effects of the conclusion of the Mosul campaign are a mixture of cuts in military expenses and a pick-up in reconstruction activities with their associated multiplier effects. While, each on its own might be small yet the whole of the parts will be greater than the sum of the parts as they will re-enforce each other.
The immediate effect of the peak in military activities will be the sharp cuts in spending on weapons and ammunition, estimated annually at USD 2.5 billion[iii] or 1.5% of GDP, but likely to be higher given the intensity of the Mosul campaign. A similar peak would be in the number of IDPs and the costs of aid provisions for them. Concurrent with the peak in military spending should be a multi-month reduction in the number of the Popular Mobilization Units (PMUs) as its members would seek a return to civilian life (annual bill estimated at USD 2.5 billion[iv] or 1.5% of GDP).
These cuts in expenses will be accompanied by the efforts to stabilize the liberated areas starting with clearing the wreckage of war, re-installing basic services, repairing and rebuilding of homes, businesses re-opening and all efforts at return to normality, which crucially is coupled with an accelerated and unprecedented foreign aid led by the UN.
The immediate-term benefits should be felt over the next few months as the economy is gradually liquefied, while in the medium-long term the country will benefit from the expansionary effects of the reversal of the forces that crushed it over the last three years. The economic revival would gradually build momentum until the major post-conflict reconstruction process starts.
Disclaimer: Ahmed Tabaqchali’s comments, opinions and analyses are personal views and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any fund or security or to adopt any investment strategy. It does not constitute legal or tax or investment advice. The information provided in this material is compiled from sources that are believed to be reliable, but no guarantee is made of its correctness, is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding Iraq, the region, market or investment.
[i] Internally displaced Persons (IDPs). Data on IDPs from UNHCR, the UN Refugee Agency.
[ii] While it was planned for 2017 as a whole, it will likely unfold over the second half of 2017. Such capital spending will take time to move from the planning stage to the implementation stage given the chronic structural and institutional challenges that Iraq suffers from while at the same time all resources were focused on the battle to liberate Mosul.
[iii] The figure of USD 2.5bn was provided during a presentation by Iraqi government advisors in a recent conference. Data from the Stockholm International Peace Research Institute (SIPRI) for 2016 shows total military equipment spending at USD 6.2 bn but notes that data is highly uncertain.
[iv] As above the figure of USD 2.5 billion was provided during a presentation by Iraqi government advisors in a recent conference.
Note: All economic data is from the IMF through the Iraq country report and WEO and REO databases.
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Additional disclosure: The AFC Iraq Fund is invested in Iraq.