Fitch Revises Outlook on Iraq to Stable; Affirms at ‘B-‘

Wed 24 Mar, 2021 – 5:00 AM ET

Fitch Ratings – Hong Kong – 24 Mar 2021: Fitch Ratings has revised the Outlook on Iraq’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to Stable from Negative and affirmed the IDR at ‘B-‘.

KEY RATING DRIVERS

The Outlook revision reflects a smaller-than-expected decline in foreign reserves and materially higher oil prices relative to Fitch’s baseline in April 2020, when we assigned the Negative Outlook. Policymaking remains hamstrung by political-economy dynamics, although an 18.5% devaluation of the Iraqi dinar and government approval of a white paper on fiscal and economic reforms indicate some potential for measures to place Iraq’s finances on a more sustainable footing.

Iraq’s rating is constrained by commodity dependence, weak governance, high political risk, and an undeveloped banking sector, while the rating is supported by high FX reserves and low interest costs on government debt.

We forecast a budget deficit equal to about 5% of GDP in 2021, shrinking from an estimated 16.5% of GDP in 2020 because of higher oil prices and the devaluation, which will boost the local-currency value of oil exports by 5% of GDP, ceteris paribus. There is considerable forecasting uncertainty because the 2021 budget is not finalised, amid widely differing proposals. In 2022, we forecast a similar deficit, as higher oil exports offset an oil price decline, while spending increases only marginally after strong growth in 2021.

In 2020, the Ministry of Finance (MoF) relied on 14% of GDP (IQD27 trillion) of indirect monetary financing from the Central Bank of Iraq (CBI) to fund the deficit. Net foreign financing was negative. Given the weak and undeveloped banking sector and domestic debt market, further CBI financing could be required if external financing remains muted.

Oil export revenue will grow by 75% in 2021, based on a 42% improvement in the Iraqi oil price to USD55 per barrel (bbl) (Brent crude at USD58/bbl), the devaluation and slightly higher export volumes. The latter assumes some unwinding of OPEC+ oil production cuts in 2H21. In 2022 we expect average oil production to reach 4.4 million barrels per day (b/d), from 4.1 million b/d in 2021, and federal oil exports to reach 3.3 million b/d, from 3 million b/d in 2021. Iraq’s budget revenue sensitivity to oil price and volume is significant. A USD5/bbl increase in the oil price leads to a 3% of GDP rise in government revenue, and 250,000 b/d of exports equate to 3% of GDP.

Non-oil revenue is likely to increase, but fall short of budget proposals, which included progressive payroll tax reform, a 10% flat tax on pensions and new excise and sales tax on alcohol, tobacco and vehicle sales.

We project spending to rise substantially in 2021, by 28% to IQD113 trillion, approaching the 2019 levels reported by the MoF. The salary and pension bill is set to expand further, related to commitments made by the previous government, while we expect some recovery in other spending lines, including capital spending, following the financing constraints of 2020.

Government debt/GDP increased to 87% in 2020 from 48.5% in 2019, pushed higher by the budget deficit, a 25% decline in nominal GDP and the currency devaluation, which added close to 10pp to the government debt/GDP ratio. Foreign-currency debt includes an estimated USD40 billion of legacy debt stemming from the 1980s, which Iraq faces no pressure to service following its Paris Club agreement of 2004. Excluding this debt, overall government debt/GDP would have been around 60% at end-2020.

Fitch expects government debt/GDP to decline in 2021 to 74%, before increasing gradually towards 80% over the medium term, given a moderation in oil prices and increases in oil output and exports to 4.6 million b/d and 3.45 million b/d, respectively, in 2024. In terms of debt composition, 25% of total debt is held by CBI and a further 12% by state-owned banks. There is ongoing discussion between policymakers about reprofiling this domestic debt to lengthen maturities and lower coupons. We do not assign local-currency ratings to Iraq.

International reserves remain substantial, at USD54 billion, despite declining by USD14 billion in 2020. We forecast reserves to stabilise in 2021 as stronger oil prices and the devaluation narrow the current account deficit (CAD), to 1.5% of GDP from 12.5% of GDP in 2020. However, we expect reserves to decline in 2022 to USD48 billion as lower oil prices and higher imports widen the CAD. Nonetheless, at 7.2 months of current external payments (CXP) in 2022, Iraq’s reserves would remain stronger than the ‘B’ median ratio of 4.3 months of CXP and sizeable in relation to projected government debt amortisation of USD4.7 billion.

The government approved a reform white paper in 2020 and is working on a more detailed implementation plan. This could potentially be the basis of an IMF programme. Public-sector compensation is a key focus of the reform, but sweeping measures will be tough to implement. Failure to curb government spending would raise the risk of further devaluation of the currency over time or erosion of foreign reserves, depending on the course of oil prices.

Political risks, domestic and regional, constrain the rating. Widespread protests, frequent security incidents relating to US-Iran tensions and insurgent activity undermine political stability. Iraq’s persistently low scores across World Bank governance indicators reflect insecurity and political instability, corruption, government ineffectiveness and weak institutions. Nevertheless, the bulk of oil production and export facilities are located away from areas that have presented the highest security risk.

ESG – Governance: Iraq has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns. Theses scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Iraq scores the lowest of all Fitch-rated sovereigns on the WBGI.

RATING SENSITIVITIES

The main factors that could, individually or collectively, lead to positive rating action/upgrade:

– Public Finances: A sustained period of oil prices in excess of our current forecasts, particularly if combined with higher oil production and exports, leading to a downward trend in government debt/GDP and larger foreign reserves.

– Public Finances: Improvements in the cohesion and credibility of economic policymaking, notably reforms of the public finances, for example to reduce the wage and pension bill and to raise non-oil revenue.

– Structural Features: Greater security and social stability together with enhancements to governance and institutional quality that facilitate non-oil economic development.

The main factors that could, individually or collectively, lead to negative rating action/downgrade are:

– Public Finances: Deterioration of external and fiscal finances, for example stemming from a sustained period of low oil prices or uncontrolled government spending, contributing to government financing stress.

– Structural Features: Marked deterioration in the country’s security, particularly if this negatively impacts oil production and exports.

SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)

Fitch’s proprietary SRM assigns Iraq a score equivalent to a rating of ‘B-‘ on the Long-Term Foreign-Currency (LT FC) IDR scale.

Fitch’s sovereign rating committee did not adjust the output from the SRM to arrive at the final LT FC IDR.

Fitch’s rating committee removed a -1 QO notch adjustment assigned to the Structural features analytical pillar as declines in GDP per capita and share in world GDP lowered the overall score for structural features and contributed to the decline in the SRM output to ‘B-‘ from ‘B’ at the previous committee. The removal of this notch does not indicate an improvement in risks relating to politics and weak governance and institutions.

Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

BEST/WORST CASE RATING SCENARIO

International scale credit ratings of Sovereigns, Public Finance and Infrastructure issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of three notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit [https://www.fitchratings.com/site/re/10111579].

KEY ASSUMPTIONS

Fitch has revised its forecasts for the average Brent crude price to USD58/bbl in 2021 and to USD53/bbl in 2022, with the price staying at USD53/bbl in the medium term. We assume that Iraqi oil sells at a discount to Brent of USD3-3.5/bbl in 2021-2022.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

Our assessment of the External Finance position for Iraq is impaired by two data limitations. For the balance of payments data, the IMF highlights various deficiencies, which reduce our confidence in the accuracy of the data. Data on Iraq’s international investment position stops at 2014; thereafter, we derive our own estimates using the available balance of payments data from the IMF. The availability of reliable data on FX reserves mitigates these weaknesses, such that the data are sufficient for maintaining the rating

ESG CONSIDERATIONS

Iraq has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.

Iraq has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch’s SRM and are therefore highly relevant to the rating and are a key rating driver with a high weight.

Iraq has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as the Voice and Accountability pillar of the World Bank Governance Indicators is relevant to the rating and a rating driver.

Iraq has an ESG Relevance Score of 4 for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for all sovereigns.

Except for the matters discussed above, the highest level of ESG credit relevance, if present, is a score of 3. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity(ies), either due to their nature or to the way in which they are being managed by the entity(ies). For more information on Fitch’s ESG Relevance Scores, visit www.fitchratings.com/esg.