Iraq's 'B-/B' ratings affirmed despite lower oil price assumptions
Source: Standard & Poor's Ratings Services , Author: Posted by BI-ME staff
Posted: Sat February 27, 2016 1:35 pm

IRAQ. On Feb. 26, 2016, Standard & Poor's Ratings Services affirmed its 'B-' long-term and 'B' short-term foreign and local currency sovereign credit ratings on the Republic of Iraq. The outlook is stable. The transfer and convertibility (T&C) assessment remains at 'B-'.

RATIONALE

In mid-January 2016, Standard & Poor's lowered its oil price assumptions for Brent by about $20 per barrel (/bbl) over 2016-2019. We now assume $40/bbl in 2016, and an average of $46/bbl in 2016-2019 (see "Related Research" below).

When we last reviewed Iraq in August 2015, we expected Brent oil prices to average $55/bbl in 2016 and $65/bbl in 2016-2019. Current prices for crude oil in spot and futures markets are about 70% below mid-2014 levels, when prices began to slide. Iraqi crude trades at about a $5/bbl discount to Brent.

Our rating on Iraq is constrained by its war with the so-called Islamic State (IS or Daesh), as well as by its political institutions, which are in an early stage of development, and sectarian divisions between the Sunni, Shia, and Kurdish ethnic groups. The rating is also constrained by high fiscal and external deficits and, as a consequence, sharply rising debt. Iraq's rising oil production and massive oil reserves underpin our rating.

Iraq has the world's fifth-largest proven crude oil reserves and is the second-largest oil exporter in the Organization of the Petroleum Exporting Countries (OPEC). Oil dominates the Iraqi economy, contributing over 60% of GDP, 90% of government revenues, and more than 95% of exports.

In recent months, the Iraqi forces and their allies have retaken some territories that IS controls, such as Ramadi (west of Baghdad) and Baiji (the site of Iraq's largest oil refinery). IS previously controlled large areas in the country's north and east. Although it still controls Iraq's second largest city, Mosul, its territorial control of Northwest Iraq has shrunk significantly since our last review.

Crucially, over 85% of Iraq's oil fields and production are located in the south of the country close to Basra, the main port for crude exports. These are Shia-controlled areas at some distance from IS-controlled areas and the conflict. Within our rating, we assume that the federal government will remain in control of these assets. They are the key support for the rating.

In 2014, faced by the then-rising IS threat, Iraq elected a new government. In September of that year, Haider Al-Abadi became prime minister. Mr. Al-Abadi is viewed as more inclusive and secular in his approach than his predecessor, which is easing ethnic tensions and improving relations with the U.S., one of Iraq's key allies. In August 2015, Mr. Al-Abadi announced reform measures, including cuts in the size of government, in response to escalating social protests across the country spurred by electricity blackouts and unsatisfactory social services. Many Iraqis believe that the government reforms have yet to bear fruit.

After a 2.2% contraction in 2014 and estimated 0.3% growth in 2015, real GDP growth will by our projection likely rise to an average of 6% in 2016-2019, assuming the government's expansion of oil production proceeds as planned. In January 2016, Iraq's oil production had already reached 4.1 million barrels per day (bpd), which was the target the government planned to achieve by the end of the 2016.

This compares with targeted exports of 3.6 million bpd in 2016, up from 2.5 million bpd in 2014.

We think that Iraq's oil output could reach 5 million-5.5 million bpd by 2019 (with exports of about 4.5 million-5 million bpd). We think that Iraq's oil output could reach 5 million-5.5 million bpd by 2019 (with exports of about 4.5 million-5 million bpd). We expect domestic demand will remain weak for at least two years, owing to the war against IS, internally displaced populations, and general social uncertainty.

The internal and external shocks--the IS conflict and sharply lower oil revenues--that Iraq has faced since 2014 have hurt public finances. We project the general government fiscal deficit will rise to 18% of GDP in 2015 and 14% of GDP in 2016 from a deficit of 5.5% of GDP in 2014.

The widening deficit will result largely from falling oil revenues and high military and humanitarian expenditures. We think that the IMF's Staff-Monitored Program approved in December 2015, will help restore some order to public finances and pave the way to a possible IMF financing arrangement in 2016, which could include budgetary support.


The drop in oil revenues is hurting the government's debt position. We understand that domestic issuance is the main funding source for the 2016 government financing requirement. We expect most of the debt will be taken up by Iraq's commercial banks, led by the two largest: Raffidain Bank and Rashid Bank. We expect that the banks will fund these purchases by incremental deposit growth and by repurchase operations with the Central Bank of Iraq (CBI).

In addition, the government has indicated it is planning external financing from the IMF, the World Bank, and bilateral creditors, as well as from a possible Eurobond offering. We project that general government debt will average 78% of GDP in 2016-2019, up from about 39% of debt in 2014. Iraq's debt stock has benefited from an 80% haircut that the government negotiated with its Paris Club creditors in 2003-2004.


Iraq's current account has typically run a surplus thanks to the country's large oil exports. However, we expect the current account balance will turn to a deficit and remain in deficit until 2019 because of the sharp drop in the oil prices. We forecast Iraq's current account deficit will average 5% of GDP in 2016-2019, compared with an average surplus of 10% of GDP in 2011-2014. We understand that the current account deficits will be financed by a substantial drawdown of official foreign exchange reserves, as well as external borrowing.

We forecast external debt, net of public and financial sector external assets, at about 8% of current account receipts during 2016-2019, and we estimate average gross external financing needs as a percentage of current account receipts and usable reserves at about 82%.

Inflation currently remains low, with consumer price inflation in the low single digits (approximately 2.2% in 2014). We expect that the CBI will maintain the dinar peg to the U.S. dollar, albeit with minor fluctuations, unless financing conditions are more difficult than we currently expect. While the peg has helped control inflation, it limits the CBI's monetary flexibility.

Moreover, although the liabilities and guarantees of the domestic banks appear high compared with the fair value of their assets, we view financial sector stability as a secondary issue compared with the country's security and the consequences of negative terms of trade.

OUTLOOK

The stable outlook reflects our expectation that Iraq's large fiscal and external deficits will be financeable, and that its conflict with IS will be contained. It also incorporates our forecast of a return to strong growth from 2016 thanks to the increases we project in Iraqi oil production and oil exports.

We could lower our rating on Iraq if the assumptions mentioned above do not hold.

We could raise the rating if Iraq's security situation and its public finances improve substantially.

About Standard & Poor’s Ratings Services

Standard & Poor’s Ratings Services, a part of McGraw Hill Financial (NYSE: MHFI), is the world's leading provider of independent credit risk research and benchmarks. We have approximately 1.2 million credit ratings outstanding on government, corporate, financial sector and structured finance entities and securities.

With nearly 1,400 credit analysts in 26 countries, and more than 150 years' experience of assessing credit risk, we offer a unique combination of global coverage and local insight. Our research and opinions about relative credit risk provide market participants with information and independent benchmarks that help to support the growth of transparent, liquid debt markets worldwide.

 

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