Fitch Affirms Iraq at 'B-'; Outlook Negative
KEY RATING DRIVERS
Political risk and insecurity in Iraq are among the highest faced by any sovereign rated by Fitch. Progress has been made in pushing back the Islamic State (IS), but the military campaign brings in its wake major reconstruction and humanitarian challenges. Sectarian and ethnic tensions continue to undermine political stability, relations with the Kurdish Regional Government are volatile and Iraq scores the worst of all Fitch-rated sovereigns on the composite World Bank governance indicator. This reflects not only insecurity and political instability but also corruption, government ineffectiveness and weak institutions.
The bulk of oil production facilities and export infrastructure are located away from areas of insecurity. After expanding strongly in 2015, oil output in the south has stabilised so far in 2016 at 3.5m b/d on average, given lower budgeted government payments to international oil companies, which has constrained investment. Including output from the north, which incorporates Kurdish fields, total oil production totalled 4.6m b/d in July, according to the Ministry of Oil. Given low oil prices we expect the government to budget a similar amount for oil investment in 2017 and we forecast oil production and exports (at 3.3m b/d) to plateau.
Lower oil prices are driving significant deterioration in Iraq's financial position. Commodity dependence is among the highest of all Fitch-rated sovereigns. Oil accounts for more than 50% of GDP and over 90% of fiscal and current external receipts. The budget deficit in 2015 ballooned to IQD26.4trn (USD22.3bn) or 13.9% of GDP. This was financed by a mixture of T-bill issuance to banks refinanced to a large degree by the CBI (indirect monetary financing), accumulation of domestic and external arrears and multilateral financing.
Iraq and the IMF agreed a stand-by arrangement (SBA) in July 2016, which entails USD5.34bn of funding over three years. The funding is front-loaded, providing USD1.9bn between July and end-2016. Performance criteria under the SBA seem broadly realistic, but implementing earmarked structural reforms is likely to prove more difficult. Risks attached to the programme are high, but the Iraqi government has a strong incentive to adhere to the SBA.
In 2016 the IMF programmes for a deficit of IQD26trn (USD22bn) for Iraq. The majority of financing, USD17bn, will come from T-bills and bonds, USD10.7bn of which will be refinanced by the CBI and USD4bn is from government deposits in the banks. The banking sector itself is not strong enough to be a source of much financing. External financing from the IMF, World Bank, US loans and other bilateral loans will make up most of the remainder.
Government debt is rising sharply on the back of these deficits and we forecast it will average 73% of GDP in 2015-17. However, this includes USD41bn of debt lent to Iraq by GCC countries during the 1980-1988 Iran-Iraq war, which the authorities do not face any pressure to repay or service. If this debt were restructured on the same terms as Paris Club debt was restructured, government debt/GDP would average 52% in 2015-17, closer to the 'B' median of 41%.
International reserves are declining, but remain large and support Iraq's currency peg. Fitch forecasts an average current account deficit of close to 9% of GDP in 2016-17 because of low oil prices. This will contribute to further declines in international reserves, which we project to slip to USD45bn this year and USD41bn at end-2017 from USD54bn at end-2015. This would still equate to almost eight months of current external payments (CXP) in 2017. We assume the authorities will maintain the dinar's peg to the US dollar, although this could come under pressure.
The banking sector is under-developed and fundamentally weak. Private sector credit to GDP is one of the lowest of any Fitch-rated sovereign. The two large state-owned banks Al-Rafidain and Al-Rasheed, which have high non-performing loans and exceptionally low capital adequacy, dominate the sector. There has been no progress in restructuring these banks, although the government has appointed auditors as required by the IMF. Fitch assumes that restructuring will require recapitalisation by the government.
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 IDR scale.
In accordance with its rating criteria, Fitch's sovereign rating committee decided not to adopt the score indicated by the SRM as the starting point for its analysis because the SRM output has migrated from 'B' to 'B-', but in our view this is potentially a temporary deterioration.
Assuming an SRM output of 'B', Fitch's sovereign rating committee adjusted the output to arrive at the final Long-Term IDR by applying its QO, relative to rated peers, as follows:
- Structural features: -2 notches, to reflect political and security risks which are not sufficiently captured by the governance indicators in the SRM and because of the exceptionally weak banking sector.
- External finances: +1 notch, to reflect the benefits of the IMF programme, which is boosting Iraq's financing options, and to adjust for the legacy debt to GCC countries which the authorities do not face any pressure to repay or service.
The main factors that could, individually or collectively, lead to a downgrade are:
-Evidence of stress in financing fiscal shortfalls.
-Further deterioration in the country's security, particularly if insecurity spreads to new geographical areas or hinders oil production or exports.
The main factors that could, individually or collectively, lead to positive rating action are:
-A sustained period of oil prices higher than our current forecasts, particularly if combined with higher oil production and exports and leading to an improvement in Iraq's public and external finances.
-A fundamental improvement in the country's security that allows for stronger non-oil economic development.
Fitch forecasts Brent crude to average USD42/b in 2016, USD45/b in 2017 and USD55/b in 2018. We assume that Iraqi oil sells at a consistent discount to Brent. Fitch forecasts Iraqi oil exports (excluding exports from the Kurdish region) to average 3.3m b/d in 2016-17.
Fitch does not incorporate into its fiscal numbers an oil-sharing agreement between the central government and the Kurdish Regional Government, given the patchy track record for implementing this agreement.