Sali Mahdy & Nussaibah Younis

There is little to envy in the life of embattled Iraqi Prime Minister Haider al-Abadi, who is struggling to finance a war against ISIS even as the collapse of oil prices has crippled the Iraqi economy. As the Iraqi parliament deliberates over the proposed budget for next year, Iraq’s escalating financial woes and the significant challenges that lay ahead make clear that lawmakers will have to reconsider Iraq’s budget strategy and elicit significant support from international actors to sustain its economic (and political) health in 2016.Iraq’s 2015 so-called austerity budget, which slashed spending by 16 percent and introduced sales taxes on vehicles, airline tickets, cellphone credit, alcohol and cigarettes, has failed to keep to the $22 billion deficit specified by the budget. One analyst forecasts that Iraq’s budget deficit for 2015 could reach an astonishing $35 billion – around 20 percent of Iraq’s GDP. The 2015 budget assumed an oil price of $56 a barrel, an assumption that was out of date almost immediately. By the time the budget came into operation in January 2015, the Iraqi government exported oil at an average price of $41 per barrel.

The 2015 budget also forecast that Iraq would export 3.3 million barrels of oil a day, including 550,000 barrels a day from territory administered by the Kurdistan Regional Government. But the much-celebrated agreement between the Abadi government and the KRG reached in December 2014 quickly unraveled, leaving a substantial hole in Iraqi government oil exports.

The agreement between the KRG and the Abadi government allowed the KRG to receive 17 percent of the federal Iraqi budget in return for marketing 550,000 bpd through the Iraqi state oil marketing company SOMO. But the KRG failed to transfer the 550,000 barrels, stating that it would take them time to build their oil production capabilities to this level. At the same time, the KRG independently exported a portion of its oil, eliciting the ire of Baghdad. Suffering an acute cash flow problem, Baghdad failed to pay the KRG anything close to the mandated 17 percent of the federal budget and, rather than admitting their financial straits, declared the KRG responsible for this underpayment because of its shortfalls in the delivery of oil.

The dispute reached its climax in June, when the KRG reduced the amount of oil it marketed through SOMO and increased its independent oil exports. Since then, the KRG has continued to increase its independent oil exports while funneling a small proportion of its production to SOMO in exchange for small payments from Baghdad.

Among the most troubling elements of the proposed 2016 budget currently under review by parliament is that it assumes that the 550,000 bpd for 17 percent of the federal budget deal is still in place, when it has clearly collapsed. The deputy head of the Oil and Gas Committee in the Kurdish parliament explicitly said to the Turkish Anadolu Agency that he did “not believe that the central government will implement the budget act of 2016 and send Kurdistan's $11 billion share.” There has been no indication that this deal, having failed so dramatically this year, has any better chances of succeeding in 2016 – and the 2016 budget must be modified to reflect that if it hopes to be a document fit for purpose.

The 2016 budget does attempt to address the need for substantial government borrowing in the face of continued shortfalls. In July, the International Monetary Fund approved $1.24 billion in financial assistance for Iraq under the Rapid Financing Instrument, which offers a low interest rate and no conditionality. The World Bank signed a $350 million loan agreement in July to fund emergency reconstruction in towns recaptured from ISIS and has started devising a separate $1 billion loan, which should be finalized next month to help Baghdad deal with its budget deficit. Iraq plans to borrow a further $2.02 billion from the Islamic Bank, the Qatar National Bank and the Japanese government in an attempt to raise an ambitious $6 billion from the international bond market. Baghdad launched an investor roadshow last week to market a series of sovereign U.S. dollar bond sales, but is unlikely to reach its target of $6 billion, not least because Standard and Poor’s has given Iraq a below-investment-grade B minus rating.

But what is most worrying about Iraq’s 2016 budget is its intent to finance the budget deficit through indirect loans from the Central Bank of Iraq. Although Central Bank’s laws prohibit the bank from lending directly to the government, the government has come up with a work-around that will involve the Central Bank buying government bonds from commercial banks. But this tactic would require the Central Bank to use its foreign reserves, which are crucial for enabling the Central Bank to back the Iraqi dinar. If the Central Bank loses its ability to stabilize the value of the Iraqi dinar, it could risk destabilizing the Iraqi economy. To prevent such a scenario, the Central Bank would need to articulate a clear cap on the amount of money available to the government, even if that money cannot cover the budget deficit. If the Central Bank fails to stick to such a cap, it would have to print Iraqi dinars in exchange for foreign currency, thereby introducing inflationary pressure into the Iraqi economy and further destabilizing Iraq’s currency.

In the face of these myriad factors, it seems unlikely that the 2016 budget has found adequate sources of finance for its projected spending, exposing Iraq to the real risk of a financial crisis in the coming year. Abadi inherited a broken society, a brutal insurgency and a collapsing economy when he assumed office in September 2014. Political disputes meant that Iraq had to operate without a budget for the whole of 2014. Endemic corruption has bled an estimated $350 billion from government coffers since 2003. Economic growth in Iraq fell from 13.9 percent in 2012 to a projected 0.5 percent in 2015. An estimated $49 billion worth of economic activity has stalled due to the deteriorating economic conditions. Popular unrest has spread across Iraq and adds pressure on the Abadi government to improve Iraq’s crumbling infrastructure and long-neglected public services at a time when the Iraqi government needs to retrench. The Abadi government would not likely survive 2016 without substantial financial and political support from its international partners.