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Analysis: 5 key takeaways from Iraq’s 2015 draft budget: By Patrick Osgood, Ben Van Heuvel

PM Abadi’s draft budget seeks to balance the competing interests of a fractured polity while contending with a devastating drop in oil prices and a crippling legacy of fiscal mismanagement

ERBIL – Prime Minister Haider al-Abadi’s Cabinet is trying to pull off a difficult balancing act – attempting to fund a war, reconstruct a country, and corral a fractured body politic, despite a devastating collapse in oil revenues.

The 2015 budget bill is now with Parliament, which gave it a first reading on Dec. 25 and will hold a session on it next week, though a final vote is unlikely until later in January.

The draft, obtained by Iraq Oil Report, makes several attempts to remedy past budgeting blunders that have made the country so vulnerable to the recent drop in oil prices. The new budget makes swingeing cuts to Iraq’s bloated public payroll; it also increases borrowing, increases taxes, and for the first time includes provisions aimed at improving Iraq’s weak fiscal management.

The Cabinet has also aimed to placate the autonomous Kurdistan Regional Government (KRG) and the country’s fractious provinces. The KRG will secure a deal that will restore their budget payments, and the provinces will get increased control over investment spending and contracting, with a doubling of the petrodollar payment for oil-producing provinces.

Between approving the draft budget and passing it to Parliament, a committee headed by Deputy Prime Minister Baha al-Araji tweaked some of the headline figures, which are all slightly higher than previously reported. Total spending is now 125.2 trillion Iraqi dinars ($104.3 billion), and total revenue is now 99.8 trillion dinars ($83.2 billion), leaving a planned 20 percent deficit of 25.4 trillion dinars ($21.2 billion).

The most important aspects of the budget, however, are embedded in the details. These provisions will shape the political landscape of Iraq and determine whether the country will start repairing the economic and fiscal governance structures that have buckled in this current time of crisis.

1. Iraq remains vulnerable to oil price volatility

More than 90 percent of Iraq’s federal revenue will come from oil exports in 2015, with an assumption that Iraq will export an average of 3.3 million barrels per day (bpd) at an average sale price of $60 per barrel, raising a total of 86 trillion dinars ($72 billion).

While these figures are technically achievable, they also depend on an optimistic assumption that several things will go right.

First, it is hardly assured that the price of oil will rise. Iraq is currently selling oil at a discount to Oman and Dubai benchmarks, which have now fallen below $56 per barrel. In light of that price weakness, $60 per barrel does not look like a conservative figure.

Second, these export and revenue numbers depend on the ongoing cooperation of staunch political rivals in Baghdad and Erbil. The budget’s expected 3.3 million bpd of exports include contributions from the KRG, which has agreed to hand over 250,000 bpd of Kurdish production to be sold by the federal State Oil Marketing Organization (SOMO), and to facilitate the export of another 300,000 bpd of federal production from Kirkuk.

Leaders in Baghdad and the KRG have established a brief track record of cooperation, having negotiated short-term political deals in November and December that re-started Kurdistan’s contributions to federal export sales for the first time since 2013. But there is an even longer track record of political strife: under the auspices of similar export and revenue agreements, past budgets have anticipated hundreds of thousands of barrels per day of KRG exports, but those figures have never been realized.

A third element of uncertainty comes from the oil sector in Basra. Southern exports hovered around 2.5 million bpd in 2014, yet the budget assumes they will average 2.75 million bpd through the upcoming year, implying that they will rise well above that figure. Although production and exports are indeed trending upward, southern oil sales have been hampered due to delays in building onshore storage and pumping facilities, and critical bottlenecks are likely to remain for years.

Abadi acknowledged Iraq’s ongoing financial vulnerability in a meeting with provincial officials in Basra on Monday, saying the government may hold back spending in reserve for the second half of 2015 if the oil price outlook continues to decline.

“Next year’s budget was completed for submission to Parliament on the basis of $60 oil, but after that submission, oil prices dropped below $60, which makes it imperative for Iraq to have a reserve from the budget in the first six months of next year, to a avert a serious deficit in the second six months,” Adabi said.

The budget bill itself also appears to anticipate a potential revenue shortfall. It contains a provision authorizing the Prime Minister to make transfers from Iraq’s treasury, or to issue secured debt to oil companies in payment for production, up to a cumulative total of $12 billion.

The draft also seeks non-oil revenue sources. The budget includes indirect taxes on cellphone credit sales (20 percent), new car sales (15 percent) and travel tickets (15 percent). Together with customs revenue, the Cabinet expects these taxes to take in over 15.5 trillion dinars ($12.9 billion) in 2015. If realized, these tax revenues would represent an initial attempt to reduce the country’s dependence on oil, which has historically provided more than 95 percent of state income.

Yet these projections are uncertain at best. Iraq’s economy was already structurally fragile, and has been further weakened by war and oil price declines – all of which discourages consumption and reduces the potential to generate state revenue by taxing it. The IMF, in a Dec. 9 statement, projected a modest rebound to around 2 percent annualized growth in 2015 caused by higher oil production.

2. Provinces get more autonomy and spending power – but not as much as they would like

Abadi has pledged to focus on delivering economic development to the provinces, and to let local governments take the lead.

Accordingly, the 2015 budget bill earmarks 3.5 trillion dinars ($2.9 billion) of funds for reconstruction and development to be distributed to the provinces, including in Kurdistan. To access the money, provincial governors will have to submit plans to the Ministry of Planning; upon approval, the projects will be implemented by the governor, under the supervision of their provincial council.

Abadi has also expanded the petrodollar program, under which an oil-producing province receives a premium for each barrel of oil produced or refined and for every 150 cubic meters of natural gas produced within its borders. The petrodollar has been a fixture of federal budgets since 2010, when Maliki introduced it at a rate of $1 per barrel to placate oil producing provinces vexed by underinvestment.

The Cabinet’s current budget pegs the petrodollar payment at $2 per barrel – a drastic increase, but far less than many provinces have demanded. Their expectations were raised in 2013, when the Iraqi Parliament passed an amendment to the 2008 Provincial Powers Law, including a provision to increase the petrodollar to $5 per barrel. Maliki’s administration petitioned the High Court to invalidate that law, and in the meantime the government has not honored the $5 per barrel provision.

Abadi has pledged to drop that lawsuit, but he has also signaled his reluctance to follow the Provincial Powers Law’s budget guidance. Not only does the draft budget fall short of the $5 petrodollar mark, but Abadi has also said he thinks the Provincial Powers Law should again be revised to become more fiscally prudent.

The petrodollar provision is a high-profile political issue that could complicate passage of the budget. Galvanized largely by perceived slights in the 2015 budget, leaders in Basra have begun a serious push to create a region that would have autonomous powers similar to the KRG. Provincial leaders in Missan and Kirkuk have voiced sympathy for the autonomy movement, and have also called for a full $5 petrodollar.

Even if the budget fails to meet all provincial demands, it does contain other provisions that devolve power from Baghdad.

The budget specifies that Iraq’s ministries have to coordinate in advance with provincial governments when awarding projects, and to award projects equitably among the provinces, according to population distribution – a move likely aimed at allaying fears from majority-Sunni provinces that they will continue to be economically marginalized.

Provinces can also take over the “advertisement, transfer and implementation” of projects under 10 billion dinars ($8.3 million) in value from most ministries, other than the Oil Ministry and the security ministries.

3. The KRG export-revenue deal is embedded in the budget – with problematic ambiguity

The budget bill implements the terms of the Dec. 2 agreement struck between Abadi and KRG Prime Minister Nechirvan Barzani, which is supposed to pave the way for 550,000 bpd – nearly 17 percent – of Iraq’s federal oil sales. In exchange, the KRG is supposed to receive a fair share of the country’s largesse.

Key details of that cooperation were left unresolved in the Dec. 2 deal, and the budget draft clarifies some – but far from all – of the important points.

First, the budget makes clear that the KRG’s 17 percent share of federal spending will be calculated after subtracting the operating costs of the government from the overall budget. In past years, the deduction of these so-called “sovereign expenses” has sparked bitter complaints from Kurdish leaders, who have accused Baghdad of engaging in accounting tricks designed to reduce the KRG’s portion of state money.

Those concerns have been allayed in part because, for the first time, the 2015 draft budget includes a provision to pay the KRG’s Peshmerga military forces a proportionate share – likely 17 percent – of the total spending on federal land forces in the Ministry of Defense budget.

The budget also partially answers the question of how much oil the KRG must deliver to SOMO. When the Dec. 2 deal was announced, Abadi’s office released a statement saying the KRG would export “at least” 250,000 bpd of its own production – a semantic distinction that appeared to imply that Kurdish output above that level might also have to be sold through federal channels. By contrast, KRG leaders said they were responsible for delivering exactly that number, but not more.

The Cabinet’s budget draft appears to confirm the KRG’s expectation of a fixed export contribution. It anticipates revenues according to an “exportation level of 3.3 million bpd, including 250,000 bpd of Kurdistan’s production of crude oil, and 300,000 bpd of Kirkuk’s production of crude oil.”

Many consequential ambiguities still remain.

Article 10 of the draft says that a “Federal Financial Observer, in coordination with KRG’s Financial Observer” should account for “federal revenues” that the KRG accrues over the year. Either the KRG must pay these revenues to the Iraqi treasury, or the KRG’s budget transfers from the federal treasury will offset by the same amount.

That provision could be problematic because leaders in Baghdad and Erbil have tended to reach vastly different numbers when tallying their debts. Central authorities argue the Kurds have withheld billions of dollars of oil revenue that should have flowed to the national treasury, while Kurdish leaders have stated their intention to recover arrears owed from 2014 through future independent oil sales. They have also claimed they are owed hundreds of billions of dollars’ worth of reparations, in compensation for atrocities committed by previous regimes dating back to the 1960s.

Moreover, past attempts at oil export cooperation have been derailed by the mere attempt to audit the KRG’s finances: federal authorities have accused the Kurds of obstruction, while the Kurds have complained that Baghdad has made unreasonable demands designed to render cooperation all but impossible.

These accounting disputes could be compounded by the country’s unresolved territorial disputes. The KRG now controls two oil assets – the Bai Hassan field and Avana Dome – which were, prior to June 2014, managed by federal authorities, and which are producing around 150,000 bpd.

The budget draft does not specify which fields the KRG’s production contribution must come from. Given public statements by leaders in Baghdad and Erbil, there appears to be every likelihood that federal authorities expect Bai Hassan and Avana to count as “Kirkuk production,” while the Kurds could consider it part of their 250,000 bpd contribution.

The budget itself says that the agreement will become void if either side reneges on its obligations – a particularly ominous provision, given that the legislation also leaves room for each side to interpret its obligations differently. Thus, even though it has been enshrined in the budget, the oil-for-revenue deal is still likely to fail without an unprecedented effort on both sides to sustain an atmosphere of good will.

4. Even after spending cuts, Iraq faces big deficits

The budget calls for total spending of 125.2 trillion dinars ($104.3 billion), a decrease of around 25 percent from spending levels in the 2014 draft budget, which was never passed due to political disputes.

The biggest reductions appear to come from cuts to the budgets of Iraq’s ministries. Iraq’s state employees also stand to take an across-the-board pay cut totaling 2 trillion dinars ($1.6 billion). Planned operational spending totals 80 trillion dinars ($66.7 billion), around 63 percent of total spending – a reduced proportion compared to recent budgets.

Investment spending has also been cut, and totals 45.2 trillion dinars ($37.7 billion).

Yet spending is still slated to outpace revenue: the budget anticipates a deficit of over 25.4 trillion dinars ($21.2 billion), around 20 percent of total spending for 2015.

Despite years of high oil prices and rising production, Iraq has no rainy-day fund. The country’s oil proceeds flow to the Development Fund for Iraq (DFI) – an account at the Federal Reserve Bank of New York – which in the past has held tens of billions of dollars. But the Maliki administration financed its bloated deficit spending largely by dipping into these savings: even before the rise of the IS militant group and the fall in oil prices, the account was regularly dipping below the $4 billion mark, which IMF officials say is near the minimum needed for day-to-day operating cash flow.

Iraq has also burned through $10 billion of foreign currency reserves, leaving $67 billion at the start of December, according to an IMF statement. As a petro-state, Iraq’s central bank requires large dollar reserves to protect the stability of the Iraqi dinar. Further drawdowns could weaken the dinar and increase Iraq’s sovereign debt costs.

Without other options for bridging the deficit gap, the 2015 budget plans for several forms of financing: the government plans to issue 6 trillion dinars ($4 billion) of government bonds, and the treasury will tap Iraq’s state banks for 17 trillion dinars ($14.2 billion) in transfers and loans. The government also plans to recover 3 trillion Iraq dinars ($2.5 billion) of unspent money from ministries, which tend to lack the institutional capacity to fully execute their budgets.

5. Iraq is trying to strengthen fiscal management

For the first time, the budget contains several provisions aimed at curbing Iraq’s profligacy and waste, and for improving basic controls over money allocated to ministries by empowering the Ministry of Finance to act as a centralized ledger of revenue and spending.

Several provisions freeze new state sector job hires, or regulate them more strictly. The budget requires that state companies refrain from new hiring.

The Ministry of Finance will retain stricter controls over money allocated to ministries, and the bill calls for ministries, historically operating as black holes for central spending, to record and report all revenues and expenditures back to the ministry.

Some of the articles that devolve spending power to local governments also aim to improve accountability. The Ministry of Finance is obliged to stop funding ministry projects that are less than half done by July 1, and ministries have to include strict work timetables in project contracts, which will be subject to greater oversight by the Ministry of Planning.

Patrick Osgood reported from Erbil. Ben Van Heuvelen contributed from the United States. Iraqi staff reporting from Nassiriya are anonymous for their security.


Source: Iraq Oil Report, Published Thursday, January 1st, 2015


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