Fitch Ratings-Hong Kong-July 30: Fitch Ratings has affirmed Iraq's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'B-' with a Stable Outlook.
A full list of rating actions is at the end of this rating action commentary.
KEY RATING DRIVERS
Iraq's rating is constrained by commodity dependence, weak governance, high political risk, and an undeveloped banking sector, while the rating is supported by GDP per capita, robust FX reserves, a low level of debt service obligations and international financial support.
Higher oil prices helped narrow the budget deficit significantly in 2017, with the IMF estimating that the deficit shrank to 2.3% of GDP from 13.9% in 2016. The government will earn significantly more oil revenue than it assumed in the 2018 budget, and even with an expenditure response, is likely to record a budget surplus, of around 3% of GDP, after five years of deficits. For each USD1 higher oil price, the government receives approximately an extra USD1.2 billion in revenue, assuming stable export volume.
The 2018 budget, which targeted an overall deficit of IQD12 trillion, assumed an oil price of USD46/barrel and exports of 3.9m b/d (including 250,000 b/d from the Kurdistan Regional Government (KRG) and 300,000 b/d from Kirkuk). We assume that the price of Iraqi oil will average USD64/b (Brent crude average of USD70/b) and that federal oil exports flowing into the budget will average 3.45m b/d. This implies an extra IQD19 trillion in revenue.
Iraq's public and external finances remain vulnerable to a renewed slump in the oil price. Commodity dependence is among the highest of all Fitch-rated sovereigns. Oil accounts for 85%-90% of fiscal revenue and almost all export revenue. In 2019-2020, under our assumption that average Brent crude oil prices decline to USD65/b and USD57.5/b, we forecast that a budget deficit (of around 2% of GDP) will re-emerge in 2020. This forecast assumes further modest increases in investment spending, limited by capacity constraints, and in current spending. A ramp up in reconstruction spending could put additional pressure on the budget.
Public debt edged down in nominal terms in 1Q18, with excess oil revenue allowing for some repayment of debt. The government is not planning to issue a Eurobond this year. We forecast government debt/GDP to fall to 49.9% of GDP in 2018 and 48.7% in 2019 on the back of budget surpluses and the uplift to nominal GDP in 2018 from higher oil prices. We forecast government debt/GDP will increase again, to 50.4%, in 2020 as oil prices drop back and a budget deficit re-emerges.
Iraq's total debt stock includes an estimated USD41 billion of debt lent to Iraq by GCC countries during the 1980-1988 Iran-Iraq war, which the authorities do not face pressure to repay or service. If this debt were restructured on the same terms as Paris Club debt was restructured in 2004-06, government debt/GDP would be around 34% in 2018, about half the current 'B' peer median. The majority of remaining external debt is owed to the Paris Club and multilateral and bilateral institutions. Annual external debt service costs are relatively low (forecast at roughly USD2.5-USD3.5 billion in 2018-20), especially given the level of FX reserves.
The Central Bank of Iraq's (CBI) stock of international reserves (including gold) was USD48.9 billion at end-2017, up from USD45.3 billion at end-2016. We forecast that reserves will average USD54 billion in 2018-2019. The increase in reserves is supportive of the exchange rate peg and the gap has narrowed between the auction rate and market rate of the Iraqi dinar.
Iraq's three-year Stand-By Arrangement (SBA) with the IMF is on hold, after one year of mixed implementation. This highlights the difficulty of enacting fiscal and structural reforms in Iraq because of weak governance systems and political constraints. Approval of the third review has been pending since late 2017, held up by disagreement over the 2018 budget in the context of an impending parliamentary election, the dispute between the federal government and the KRG and higher oil prices. The IMF is open to re-engaging with Iraq when a new government is formed. Iraq continues to receive other bilateral and multilateral support.
Political risk and insecurity in Iraq remain among the highest faced by any Fitch-rated sovereign. 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. Nevertheless, the bulk of oil production facilities and export infrastructure are located away from the areas that have presented the highest security risk.
Iraq continues to face pressing political challenges, although security has improved with the recapture of territory in 2017 from the jihadist Islamic State. Government formation is proceeding slowly following the parliamentary election in May. We expect the eventual formation of a broad-based government that will struggle to implement more than piecemeal reforms. Low voter turnout and mounting protests since the election highlight high levels of popular dissatisfaction with the political class. Protests have taken place outside oil facilities, demanding more jobs from the oil sector. Such protests, which have occurred before, have not caused interruptions to oil production or exports and we assume that remains the case.
The banking sector is under-developed and fundamentally weak. It is not in a position to provide much domestic financing to the government. 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. The government has appointed auditors as required by the IMF, but it remains unclear how the banks will be restructured.
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 adjusted the output from the SRM to arrive at the final LT FC 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.
- Public finances: +1 notch to adjust for the legacy debt to GCC countries and to reflect ongoing bilateral and multilateral financial support.
- Macro: -1 notch to reflect the weakness of the policymaking framework, in particular related to reform of the public finances.
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.
RATING SENSITIVITIES
The main factors that could, individually or collectively, lead to positive rating action are:
- A period of oil prices in excess of 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 sustainable improvement in the country's security that allows for stronger non-oil economic development.
- A greater degree of political stability which allows for improvements in policymaking, including reforms of the public finances.
The main factors that could, individually or collectively, lead to negative rating action are:
- Failure to secure adequate fiscal financing.
- Deterioration in the country's security, particularly if insecurity hinders oil production and exports.
KEY ASSUMPTIONS
Fitch forecasts Brent crude to average USD70/b in 2018, USD65/b in 2018 and USD57.5/b in 2019. 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 3.55m b/d in 2018-20.
Fitch does not incorporate into its fiscal numbers a full oil-sharing agreement between the central government and the Kurdish Regional Government, given the patchy track record for implementing this agreement. An agreement may be more likely after a new government is formed.
The full list of rating actions is as follows:
Long-Term Foreign-Currency IDR affirmed at 'B-'; Outlook Stable
Short-Term Foreign-Currency IDR affirmed at 'B'
Country Ceiling affirmed at 'B-'
Issue ratings on long-term senior unsecured foreign-currency bonds affirmed at 'B-'
Contact:
Primary Analyst
Toby Iles
Director
+852 2263 9832
Fitch (Hong Kong) Limited
68 Des Voeux Road Central
Hong Kong
Secondary Analyst
Krisjanis Krustins
Director
+852 2263 9831
Committee Chairperson
James McCormack
Managing Director
+44 20 3530 1286
Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com; Wai-Lun Wan, Hong Kong, Tel: +852 2263 9935, Email: wailun.wan@fitchratings.com.
Additional information is available on
Applicable Criteria
Country Ceilings Criteria (pub. 19 Jul 2018)
Sovereign Rating Criteria (pub. 19 Jul 2018)
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