MOST LIKELY REGIMES AND THEIR PROBABILITIES
18-Month: National Unity Coalition 55% (65%)
Five-Year: National Unity Coalition 45%

 FORECASTS OF RISK TO INTERNATIONAL BUSINESS
 Turmoil  Financial Transfer  Direct Investment Export Market
18-Month:  Very High  B- (C+)  C  C+ (C)
 Five-Year:  High  C+  C  C+
 ( ) Indicates change in rating. *  Indicates forecast of a new regime.

 

KEY ECONOMIC FORECASTS
Years Real GDP Growth % Inflation % Current Account ($bn)
2006-2010(AVG) 4.4 17.4 -0.60
2011(F) 5.2 4.9 -8.10
2012-2016(F) 5.9 5.7 5.90

Implications for Investors

As the “Arab Spring” spread across North Africa and the Middle East, Iraqis took to the streets to voice their frustration over unemployment, soaring food prices, and the still-dismal state of public services more than eight years after the US military invasion that toppled the regime of Saddam Hussein. Having witnessed the fate of autocratic leaders whose hold on power was presumed to be far stronger than his own, Prime Minister Nuri al-Maliki promised that his government would become more accountable, and in late February gave his Cabinet ministers 100 days to produce results or get the sack

The government reshuffle, which was delayed until late July, was notable mostly for its complete lack of boldness; no full ministers were removed or transferred, nor were the vacant security posts (Defense, Interior, and National Security) filled. Maliki’s caution is a reflection of the high potential for controversial personnel moves to upset the careful balance of power that is essential to preserving the coalition of Sunni, Shiite, and Kurdish parties.

The persistent tensions within the coalition and the evident escalation of violence with the approach of the year-end deadline for the withdrawal of remaining US combat troops highlight the continuing risk of damaging political instability and a worsening of security conditions, both of which will create significant impediments to the realization of the country’s economic potential.

Oil earnings in the first five months of 2011 totaled $34 billion, about one-third higher than projected, which will help to ease the fiscal constraints imposed under the government’s two-year agreement with the IMF. However, economic performance in 2011 and 2012 will be determined to a large degree by production and price levels of oil and gas and the delivery of planned investment in hydrocarbons projects, which may be delayed or scaled back if, as appears already to be the case, the withdrawal of US troops is accompanied by an increase in domestic unrest.

Pressure for Increased Accountability

The “Arab Spring” that has triggered popular uprisings throughout North Africa and the Middle East over the past several months did not bypass Iraq completely. Although the country’s democratic (such as it is) political system and the presence of large numbers of US troops afford Prime Minister Nuri al-Maliki’s government a fair measure of protection from mass displays of public discontent, the unrest elsewhere in the region nevertheless inspired Iraqis to take to the streets to voice their frustration over unemployment, soaring food prices, and the still-dismal state of public services more than eight years after the US military invasion that toppled the regime of Saddam Hussein.

Having witnessed the fate of autocratic leaders whose hold on power was presumed to be far stronger than his own, Maliki adopted a posture of conciliation, promising that his government would become more accountable. In late February, Maliki gave his Cabinet ministers 100 days to produce results, warning that those who failed to measure up would get the sack. Few believed that there would be any real improvement by the early June deadline, and any significant reshuffling of the Cabinet would pose a threat to the survival of the unwieldy government of national unity, which includes representatives of the country’s Sunni, Shia, and Kurdish factions.

To no one’s surprise, the 100-day mark came and went without any noteworthy signs of progress. Just as predictably, Maliki proclaimed his satisfaction with the performance of most of his ministers. But with the specter of a popular uprising still hanging in the air, the prime minister called upon his coalition allies to work with him to streamline the 44-member Cabinet by removing ministers judged to have performed poorly and doing away with “unnecessary and honorary posts.”

In doing so, Maliki risked disturbing the delicate balance of power within the coalition that was only achieved after nine months of negotiations. The main danger lay in the possibility that personnel moves could alienate the Iraqi National Movement (al-Iraqiyya), which, as the main representative of Sunni Iraqis, is an essential partner in the national unity coalition, but only reluctantly joined a government headed by Maliki, whose State of Law bloc actually won two less seats than Iraqiyya at the March 2010 elections.

Iyad Allawi, the leader of Iraqiyya, is not even on speaking terms with Maliki, whom he has accused of reneging on his promises to appoint Iraqiyya’s nominee as minister of defense, one of three sensitive security posts that has yet to be filled. However, Allawi has refrained from threatening to pull Iraqiyya out of the coalition, probably because the bloc joined the government over his objections, and there are no guarantees that members would heed his call to move into opposition.

On July 30, Maliki announced the elimination of a total of 17 posts, most of them ministers of state. The prime minister’s State of Law lost three positions, while Iraqiyya lost two. The Sadr Group, the largest faction in the mostly Shiite Iraqi National Alliance (INA), also lost two posts, while the Sadr Group’s allies in the INA surrendered a total of four additional positions. The prime minister has indicated that the reorganization is not finished, as the merger of some ministries is still being considered. In that event, the INA could be assigned responsibility for ministries not currently under its control.

Skeletons

The reshuffle was probably most notable for its complete lack of boldness. No full ministers were removed or transferred, nor were the vacant security posts (Defense, Interior, and National Security) filled. One possible reason for Maliki’s caution, other than concerns about upsetting the delicate balance of power within the coalition, was thrown into sharp relief in early August, when the prime minister fired Electricity Minister Raad Shallal over fraudulent contracts for power projects.

In July, Shallal, a member the Iraqiyya bloc, signed contracts with companies from Canada and Germany to build 15 power stations with a capacity of 100 megawatts each, at a total cost of $1.85 billion. It subsequently came to light that the German firm had declared bankruptcy in January 2011 and that the Canadian company was fictitious. Upon receiving that news in early August, Prime Minister Maliki announced that Shallal had been fired.

Shallal protested that both Maliki and Deputy Prime Minister for Energy Hussain al-Shahristani had seen and approved the contracts, a claim backed up by the Integrity Committee in the Parliament. Insisting that he was being set up, Shallal threatened to make public some suspect contracts concluded by his predecessors at the Ministry of Electricity, a group that includes Shahristani.

At that point, Shahristani called a press conference to announce that Shallal would remain at his post until his dismissal was confirmed by the Parliament. The parliamentary speaker, Osama al-Nujaifi, also a member of Iraqiyya, was reported to be pursuing a compromise that would enable Shallal to keep his job, while other members of Iraqiyya demanded that Shallal come before Parliament for questioning. For their part, members of Maliki’s State of Law began spinning the affair as a misunderstanding, claiming that no one doubted Shallal’s integrity, and that he was being removed based on his performance. (In that regard, it is worth noting that Shallal was singled out for sharp criticism by Maliki during a nationally televised Cabinet meeting held in early June.)

On August 14, Shallal submitted his resignation to the Council of Ministers, which still has the option of rejecting it. He has continued to proclaim his innocence, and Iraqiyya lawmakers have warned that they will push for an extensive probe into all of the financial dealings of the Ministry of Electricity dating back to 2003. That is undoubtedly unwelcome news for Maliki and (especially) Shahristani, who faces the prospect of having to explain the disappearance of large amounts of funds during his tenure at the ministry.

Investment Roadblocks Persist

Beyond the potential for political disputes to lay bare the enormity of the corruption perpetrated by post-Saddam governments, the Shallal episode highlights the potential for power struggles within the coalition to create distractions and standoffs in the Parliament. Through most of his tenure as prime minister, Maliki has claimed at least a paper legislative majority, key reform measures have been held hostage to coalition infighting.

The most important of these is the long-stalled Hydrocarbons Law, which is widely acknowledged to be essential to Iraq’s hopes of exploiting the full economic potential of its massive reserves of oil and gas. Because it will also establish the structure for ensuring the equitable sharing of the wealth generated by sales of oil and gas among the country’s three main regions, the Hydrocarbons Law is also seen as central to the goal of holding Iraq together, which is ostensibly the same goal that motivates political leaders to invest so much time and energy in the effort to form inclusive governments.

The political and legal hurdles have not deterred foreign investors, a fact that has contributed to a lack of urgency among lawmakers. But Iraqis lose when legislative roadblocks and Cabinet battles delay the launch of major development projects.

A case in point is a $17.2 billon deal with Royal Dutch Shell and Mitsubishi to capture, treat, and market the estimated 1 billion cubic feet of gas flared in the oilfields near the southern city of Basra. An initial agreement to form a joint venture with state-owned South Gas Company was reached in 2008, but it took two years to hammer out a final agreement, which was approved by the Cabinet in mid-2010.

Final approval required a review (and revisions) by the Ministry of Oil, a process that was delayed by the objections of some ministry officials to the lack of competitive bidding for the project, among other things. The government’s demand to renegotiate the pricing structure created further delays, as did the escalation of domestic tensions in early 2011, which prompted the government to seek guarantees that domestic gas needs would be met before any of the fuel was exported.

Production is scheduled to get underway in 2013, and exports will only be permitted after domestic needs are met. Shell’s top executive in Iraq has forecast that the country could become a net exporter of liquefied natural gas (LNG) within 12 months of startup. The final deal is expected to receive the required approval of the Cabinet, although the administration’s vulnerability to public pressure means that nothing can be taken for granted.

Elsewhere on the investment front, the government announced in early August that 41 companies had qualified to participate in bidding for 12 new exploration blocks. The auction, which will focus on rights to explore gas reserves, is scheduled to kick off in January 2012.

Significantly, officials confirmed that none of the companies that have signed contracts with the Kurdish Regional Government (KRG) will be permitted to participate. The dispute with the KRG is a direct outgrowth of the failure to implement the Hydrocarbons Law, and the exclusion of companies doing business with the KRG from bidding for federal oil and gas contracts has resulted in weaker competition for federal contracts, the withdrawal of companies from Kurdistan, and heightened tensions between the KRG and the federal government.

The upcoming round of bidding could be further complicated by a dispute between the government and the parliamentary Oil and Energy Committee. In May, the head of the committee called upon both the KRG and the federal government to cease the auctioning of exploration blocs until the Hydrocarbons Law is in place. More recently, the committee has called upon the Parliament to ban the further issuing of licenses, and has raised questions about the validity of previous oil and gas contracts, none of which received parliamentary approval.

At this point, it is hard to predict how far the Parliament might be willing to push the issue, but there is virtually no chance that the Hydrocarbons Law will be in force by the beginning of next year. In fact, government officials have indicated that the immediate focus will be the re-establishment of the National Oil Company (NOC), which is rather optimistically projected to be accomplished by the end of 2011.

Security Strategy Still Uncertain

The bickering in Maliki’s coalition has also contributed to government indecisiveness over what to do about the impending withdrawal of US forces. Under a Status of Forces Agreement (SOFA) concluded in 2008, all US combat troops are to leave Iraq by the end of 2011. Leon Panetta, who replaced Robert Gates as the US secretary of defense in July, indicated that the Iraqi government might request an extension of the deadline for withdrawal, and stated that the US was prepared to honor such a request.

But Baghdad has been unable to make up its mind, pulled in different directions by members of the governing coalition. The militant cleric Moqtada al-Sadr, who is the titular leader of the Sadr Group in the Parliament, has warned that his Mahdi Army militia will take up arms against the US forces if American soldiers remain beyond the original deadline. His political allies have pressed the provincial councils in 10 central and southern provinces to pass resolutions demanding a complete withdrawal. Thus far, only the council in Basra, the southern Sadrist stronghold, has approved a resolution.

Others in the coalition believe that Iraqi forces are not yet capable of handling security on their own, and want at least some US troops to stay in 2012. Given the recent spike in deadly violence, they could still win the argument, Sadr’s threats notwithstanding.

The worst single-day bloodletting in more than a year took place on August 15, when a series of car-bombings in several cities resulted in more than 90 deaths and left some 300 people injured. Most worrisome was an incident in which self-proclaimed members of Al Qaeda in Mesopotamia entered a Sunni mosque and executed seven people they identified as participants in the Awakening Movement, an armed Sunni grouping that has battled Al Qaeda militants on behalf of the government.

US intelligence experts estimate that some 1,000 members of Al Qaeda are presently carrying out terrorist operations in Iraq. But US military leaders contend that Shiite militias supported by Iran are responsible for a large portion of the violence. Although there is not yet evidence of sectarian reprisal killings of the sort that pushed Iraq to the brink of civil war in 2006–2007, the threat is clearly present.

The Iraqi government has launched a major counteroffensive against the escalating violence, an operation that mobilized some 3,000 Iraqi troops and has included a crackdown on illegal weapons smuggling from Iran. The effort came as a relief to US officials, who worried that Maliki might be reluctant to take action that could alienate Sadr and his supporters.

However, Maliki came under sharp criticism from members of the Iraqiyya bloc in the wake of the most recent attacks, which they blamed on the prolonged vacancies in the top security posts. The prime minister responded by naming Sadun al-Dulaimi as acting head of the Ministry of Defense. Unfortunately, the move will only add to tensions within the coalition, as Dulaimi was not among the candidates proposed by Iraqiyya to fill the post.

Stability Key to Achieving Economic Potential

Were Iraq to enjoy an extended period of relative calm, the country’s hydrocarbons sector could become a magnet for foreign direct investment (FDI), which in turn would enable the government to invest in improvements to infrastructure and otherwise create a more hospitable climate for expansion of the private sector, resulting in rapid growth of employment opportunities and rising incomes. Unfortunately, the persistent tensions within the coalition and the recent escalation of violence highlight the continuing risk of damaging political instability and a worsening of security conditions, both of which will create significant impediments to the realization of the country’s economic potential.

Oil sales account for very nearly all of Iraq’s exports and three-quarters of government income. Oil earnings in the first five months of 2011 totaled $34 billion, about one-third higher than projected, which will help to ease the fiscal constraints imposed under the government’s two-year agreement with the IMF. However, economic performance in 2011 and 2012 will be determined to a large degree by production and price levels of oil and gas and the delivery of planned investment in hydrocarbons projects, which may be delayed or scaled back if, as appears already to be the case, the withdrawal of US troops is accompanied by an increase in domestic unrest. On balance, real GDP growth is forecast to remain in the 5%–6% range in the near term.

Economic Forecasts for the Three Alternative Regimes

National Unity Coalition Divided Government Formal Partition
Growth(%) Inflation(%) CACC($bn) Growth(%) Inflation(%) CACC($bn) Growth(%) Inflation(%) CACC($bn)
2011 5.2 4.9 -8.10 4.5 4.6 -11.30 4.1 5.8 -13.80
2012-2016 5.9 5.7 5.90 2.1 13.0 3.80 6.0 7.5 -2.00