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

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

March 14, 2017 in Construction & Engineering In Iraq
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-‘. The Country Ceiling has been affirmed at ‘B-‘ and the Short-Term Foreign-Currency IDR at ‘B’.
KEY RATING DRIVERS
The revision of the Outlook reflects the following key rating drivers:
Iraq’s fiscal position has improved relative to 2015 and 1H16 because of higher than expected oil prices and reduced government spending. We estimate that the budget deficit narrowed to IQD16.5trn or 8.1% of GDP in 2016, from 12.3% of GDP in 2015. The IMF programme agreed in July 2016 is providing a useful policy framework and has helped Iraq’s financing options. However, progress has been slow in a number of areas including surveying arrears, in part due to capacity constraints.
In 2017 we forecast that the deficit will narrow further, to 5.1% of GDP, with higher average oil prices driving strong revenue growth. We incorporate non-oil revenue of IQD8trn (the IMF assumes IQD10.5trn). On the spending side, we forecast 12.1% growth in expenditure after three years of substantial spending declines.
Financing needs will therefore be lower in 2017 and the authorities expect to rely less on indirect monetary financing by the CBI. External financing will play a more dominant role, with funds from the IMF, World Bank, bilateral project loans, a USD1bn Eurobond (with a 100% US guarantee) issued in January and another planned for later in 2017 (without a guarantee). For 2018, Iraq still needs to identify sources of funding to plug the financing gap calculated by the IMF and will likely again focus on external financing.
Identified arrears totalled IQD12.5trn (USD10.6bn or 6.1% of 2016 GDP) at end-June 2016. In October the IMF expected around IQD6.5trn of these arrears to be repaid in 2016 (including most external arrears) and these are included in 2016 spending estimates. The remaining identified domestic arrears are to be repaid in 2017-19 after they have been audited.

It remains uncertain what level of unidentified arrears there might be that are not yet accounted for as there are still ministries that have not been surveyed. Since June 2016 Iraq is likely to have built up arrears at a much slower rate, given the higher oil price. In 2H16 the Iraqi oil price averaged USD41/b compared with USD25/b in 1Q16
Government debt/GDP projections have improved because of smaller fiscal deficits, higher oil prices and the statistical office’s upward revisions to nominal GDP (by 2.8% in 2014 and 13.6% in 2015) which have been broadly accepted by the IMF. We estimate the government debt/GDP ratio rose to 62.7% in 2016, compared with a ‘B’ peer median of 54.9%, and forecast it to average 61% in 2017-18. We previously expected government debt/GDP at 75% in 2018. This incorporates identified arrears. The potential for more arrears coming to light presents the risk of higher debt numbers.
Iraq’s total debt stock includes an estimated USD41bn (21% of forecast 2017 nominal GDP) 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, government debt/GDP would be 43% in 2016, lower than the ‘B’ peer median. The vast majority of remaining external debt is owed to the Paris Club and multilateral and bilateral institutions.
Iraq’s ‘B-‘ IDR also reflects the following key rating drivers:
Political risk and insecurity in Iraq are among the highest faced by any sovereign rated by Fitch. Substantial 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.

Oil prices have increased since 1Q16, but Iraq’s public and external finances remain highly vulnerable to any renewed slump in the oil price. Commodity dependence is among the highest of all Fitch-rated sovereigns. Oil accounts for more than 50% of GDP and around 90% of fiscal revenue.
The bulk of oil production facilities and export infrastructure are located away from areas of insecurity. After strong growth in recent years, oil output in the south was largely stable in 2016 at 3.5m b/d on average, given lower budgeted government payments to international oil companies, which has constrained investment. We expect production and exports to plateau in 2017 given similar amounts budgeted by the government for IOC payments this year. The majority of exports from the north are being sold independently by the KRG.
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. The government has appointed auditors as required by the IMF, but it remains unclear how the banks will be restructured or what this might cost in terms of 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 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.
– External finances: +1 notch, to adjust for the legacy debt to GCC countries which the authorities do not face any pressure to repay or service and to reflect financial support from the international community, including multilateral organisations and the US guarantee for Iraq’s January bond issue.

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 negative rating action are:
– Failure to secure adequate fiscal financing in 2017-18.
– Deterioration in the country’s security, particularly if insecurity hinders oil production and exports.
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.
KEY ASSUMPTIONS
Fitch forecasts Brent crude to average USD52.5/b in 2017 and USD55/b in 2018 (up from USD45.1/b in 2016). 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 2017-18.
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.