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Iraqi economic prospects1

Colin Rowat

11 February 2004
CWC, London

Colin Rowat
Department of Economics
University of Birmingham
Birmingham B15 2TT, UK
c.rowat@bham.ac.uk
+44 121 414 3754

The absence of basic economic data on Iraq, the magnitude of the shocks that it has experienced recently, and the expectation that it will continue to experience large shocks in the near future combine to make Iraq's economic future profoundly unclear. This paper outlines some elements that may aid in thinking about Iraq's economic prospects.

1  A new transition economy?

One of the economic models for Iraq's transition is that of the former Soviet bloc: rapid liberalisation after decades of state planning.
By the time of the USSR's collapse, the comparative economics debate was largely over: market economies clearly generated more wealth. However, the transition to the superior market economy has, to date, been troubled. Figure 1 shows that only six of 25 countries have grown since 1989; as Uzbekistan's official growth figures exceed independent estimates, this can probably be reduced to five.2 This performance comes in spite of international institutional support, through the EBRD, for economic development in the transition economies.


Picture Omitted
Figure 1

Stylized Fact Comments Iraqi relevance
Output Fell Output fell in all countries .... in stark contrast with development in China and Vietnam ... The exact magnitude of the fall is a matter of controversy, inter alia, because of the sizeable informal sectors that quickly emerged. ?
Capital Shrank Capital stocks reduced dramatically ... although the expectation is that efficiency has increase. Looting losses; further investment declines hard?
Labor Moved Labor moved in all senses but the most obvious one: measures of geographical mobility are very low. Yet we observe large changes in labor market status, sectors and occupation. Geographical unlikely: many skilled professionals have already left; rest likely.
Trade Reoriented trade collapsed and was redirected to industrial countries in a very short period of time, with few exceptions (the slow reorientation in BUR is led by Ukraine and Belarus, not Russia). Certainly. Concern: trade with neighbours key; US doesn't like neighbourhood.
Structure Changed The share of value added by industry in GDP declined rapidly. In the CEEB case, this is due almost exclusively to the increase of the services share. In the case of CIS, the reasons for the slower decline are much less clear-cut. Reduced oil role: big investments require more stability? More industry, financial services?
Institutions Collapsed The fall of communism created an enormous institutional vacuum. ... its effects are sizeable and omnipresent. Maybe greater: OPs opposed to previous institutions.
Costs Were High One of the surprises of the transition was the appearance of unexpected costs. The rise of unemployment and income inequality was expected. The rise in mortality rates and the decline in school enrollment rates were not expected. ?
Table 1: Seven stylized facts of transition economies. First two columns from Campos and Coricelli [2002].

A basic conclusion from this literature is that the GDP collapse owed to "lack of coherence in the reform strategies", a likely result of undertaking "political and economic transition simultaneously" [Campos and Coricelli, 2002]. This stands in contrast to rapidly growing economies like China and Vietnam, whose initial conditions (e.g. capital stock, education, legal systems) were not clearly worse.

2  Iraq's debt overhang

Iraq accumulated debt during the 1980s, to finance its war with Iran; after its invasion of Kuwait, the Security Council held it responsible for damages arising from that. Table 2 presents an overview of outstanding obligations; they are consistent with the information gathered by the IMF3. These are at higher levels than they were in 1990, and even more as a share of Iraqi GDP. As debt was already a major impediment to Iraqi development by 1990, it can be expected to be worse now: unless reduced in present value terms, the debt overhang will impede new loans to both the public and private sectors.

Creditor Amount Comments Source
Paris Club $41 - 43 bn $21 bn principal, plus interest www.clubdeparis.org
GCC $55 bn Grants or loans? Exotix, April 2003
private $8 - 10 bn Some likely to have expired Exotix
multilaterals $1.1 bn Exotix, April 2003
other bilateral c. $11 bn
UNCC $30 bn further $84 bn unresolved www.uncc.ch
Table 2: Iraqi financial obligations

On 5 December, US President Bush named James Baker his personal envoy on Iraqi debt. Baker's effort has apparently focussed on convincing Iraq's Paris Club creditors to accept debt reductions. Baker has claimed that Iraq's creditors may be willing to write off two thirds of Iraq's foreign debt. World Bank president James Wolfensohn believes that even a reduction of this magnitude would not leave Iraq `viable'.4 The IMF will deliver its own assessment to the Paris Club in April.
The standard process of debt negotiation involves negotiations between the debtor government, creditor governments, and international financial institutions like the IMF. The `public bad' nature of sovereign debt typically makes these processes very slow: as each creditor gains from concessions made by others, all have incentives to delay.
In Iraq's case, there is a further complication: the usual process of Paris Club negotiations requires the debtor to commit to IMF-mandated reforms. In turn, this requires a sovereign Iraqi government, which Iraq does not have. The Paris Club president thinks that a deal can nevertheless be reached by the end of 2004.5
An important criticism of debt relief programmes is that they allow countries to continue irresponsible policies. Thus Easterly [2001],Easterly [2002] has proposed two necessary conditions:

  1. "there has been a proven change from an irresponsible government to a government with good policies", for which his standard is "a long and convincing record of good behavior"; and

  2. "it is a once-for-all measure that will never be repeated".

The first criterion cannot be met, as stated: a non-existent government cannot have proven itself. In Iraq's case, it may be possible to modify this: significant changes are being effected, and the international community is unlikely to finance another Iraqi war in the near term.
The second criterion is easier to meet: Iraq has experienced unprecedented conditions which, we hope, will not be repeated. Further, the absence of an Iraqi government guards against a concern underlying Easterly's condition, namely that debt relief teaches governments how to seek debt relief.
In addition to negotiated outcomes is the possibility that a future Iraqi government will default on its Saddam-era debt. Unless Iraq's economy is on the road to improvement when a recognised Iraqi government takes power, there may be considerable popular pressure for such action. In addition to the immediate economic attractions, there may be a strong political appeal: such a pro-active strike at Iraq's creditors may be satisfying to Iraqis who have suffered much from the international community.
Historically, "countries with repayment difficulties were charged higher interest rates markets than countries with no repayment difficulty." Further, "recently sovereign borrowers were charged rates as high as the defaulters" [Özler, 1993].
In Iraq's case, default's harm may be limited by the extreme circumstances under which its obligations were incurred. The Wall Street Journal has made this point from its editorial pages: "we wouldn't blame [Iraq's] leaders if they decided that some of those financial obligations are indeed `odious.' And given that this is such an extreme case, international lenders probably wouldn't hold it against them for long."6

3  `Reconstruction' and `needs'

Two of the most widely used words in connection with Iraq's economy and `reconstruction' and `needs'. The analytical utility of the first term is unclear; the second term may actually be harmful.
`Reconstruction' does not have a clear economic interpretation: there is no proposal to return Iraq to some status quo ante. Instead `development' may be a more meaningful term, allowing analytical tools developed by economists to understand poor countries can be applied to Iraq. In spite of its oil reserves, Iraq is a poor country: per capita GDP calculations for 2001 ranged between $237 and $3,312 [Al-Saadi, 2003].

Sector 2004 2004 - 2007
   
Local Administration, Rule of Law, Civil Society 101 313
Education: Primary, Secondary, Higher 1005 4805
Health 500 1600
Employment 375 785
Transport and Telecommunications 1043 3409
Water, Sanitation, Solid Waste 1881 6842
Electricity 2377 12122
Urban Management 110 413
Housing and Land Management 425 1418
Agriculture 1230 3027
State-Owned Enterprises 30 200
Financial Sector 71 81
Investment Climate 44 340
Mine Action 80 234
   
Security and Police 5000 5000
Oil 2000 8000
Culture 140 940
Environment 500 3500
Human Rights 200 800
Foreign Affairs 100 200
Religious Affairs 100 300
Science and Technology 100 400
Youth and Sport 100 300
   
Total UN/WB 9272 35589
Total CPA 8240 19440
Total 17512 55029
   
Table 3: UN, World Bank, CPA needs assessment; 2 October 2003. Recurrent costs omitted.

The second term, `needs', has driven `needs estimates', such as those of the UN, World Bank and CPA. Their findings are presented in Table 3. Needs, however, are not well-defined unless specified in terms of particular goals. Furthermore, even if such goals are defined, the costs of meeting them tend to depend on the incentives facing agents. Analysis of incentives drives much of modern economics; the costs associated with them may dominate the costs of importing hardware.
The contrast that some Iraqis have made between 1991 and the present situation reflects incentive issues:

Within three months we managed to raise our production and export capability to 75% of the pre-Gulf War capacity. ... In the present situation, which is similar to that of 1991, after more than three months, little has been done to rebuild the oil installations and get them functioning again. It would seem that a lack of coordination and planning is hindering my colleagues from providing oil for domestic consumption as well as export to secure the income so vital in setting Iraq on the road to normality. The oil industry personnel are perfectly capable now, as they were then, of planning and executing the necessary repairs if they are given a free hand. There is no need for foreign companies to take control. Iraqi oil revenue should go to Iraqis to employ, where necessary, foreign companies for specific projects and, working together, to set their country to rights. [Sabir-Ali, 2003]

The UN/WB assessment does concede this point somewhat:

xxviii. While the figures in the Assessment reflect the best estimate of the likely needs for the immediate and medium term, the actual disbursement of funds is much harder to predict since it is linked to the security situation, the current capacity in Iraqi institutions, to plan and implement projects, and the state of infrastructure and energy services to to support importation and distribution of physical assets.

Easterly [2001] argues that the focus on `needs' (or `financing gaps') that has pervaded many development circles originates with 1920s Soviet planning procedures. He argues that the insensitivity of these approaches to incentives has had disastrous consequences for development.
In particular, he concludes that the evidence show that aid has not helped economic growth. Examining a dataset of 88 countries' performance over 1965 - 1995, he finds a positive correlation between aid and investment in only 17 of them. Easterly believes that aid recipients used aid income to reduce their own savings by, for example, increasing their purchases of consumption goods.7
In this context, the $18.7 bn in US aid supplied by the supplemental appropriations bill will likely be helpful as a relief effort. It is harder to see it contributing to sustained economic development.

4  State failure

For at least the past decade, the importance of institutions to growth has been recognised as central. Independently of the quality of the policies implemented, strong institutions both reduce uncertainty and regulate social competition between factions.
High levels of uncertainty increase the risk adjusted rate of return that projects must yield. Thus, projects viable under one rate may cease to be under a higher rate. In a related context, Addison and Rahman [2001] claim that investor uncertainty "is more important in explaining whether a country is a HIPC or not than bad policies".
This effect of higher discount rates may also influence government decisions. Projects whose benefits are only experienced in the longer term will be disadvantage relative to those with short term returns. This short-termism may increase uncertainty further.
Strong institutions also regulate social competition between competing factions. The economics literature has been flooded by papers explaining everything from GDP growth [Alesina et al., 2003], fiscal deficits [Woo, 2003] and civil wars [Collier and Hoeffler, 1998,Annett, 2001] in terms of societal fractionalisation. The main measure used assesses the probability that two randomly selected individuals are from different ethnic or linguistic `groups'.

Ethnic Linguistic Religious
Iraq (1983) .369 .369 .484
Belgium (2001) .555 .541 .213
Canada (1991) .712 .577 .696
United States (2000, 2001) .490 .251 .824
Yugoslavia (pre-1991) .809 .405 .550
sample mean .435 .385 .439
Table 4: Fractionalisation measures; sample of 180 - 198 countries. Alesina et al. [2003]

Table 4 presents samples of these measures for Iraq and some comparison countries. While Iraq's scores are not much different from the sample mean, the collapse of institutions may exacerbate tensions. Identity politics seems at risk of metastasizing in Iraq: the Occupying Powers' decision to apply ethnic and religious quotas to the Iraqi Governing Council has reached down through the ministries, pushing professionals aside in favour of nepotism [Khadduri, 2004].
Many Iraqis who began their careers in the 1960s, note ruefully that this is a new development: one is commonly told that Iraqis of that era did not know the religion of their closest friends, until asked to be best man at their weddings, or that of their colleagues until decades later.
On a slightly more hopeful note, the overlapping of ethnic and religious identities (e.g. Arab Shia, Arab Sunni, and Kurdish Sunni) may provide stability.
Independently of ethnicity and language, weak central institutions allow competing power factions to turn government policy into a `commons', each stripping as much out for itself to prevent the other factions doing so first [Tornell and Lane, 1999]. A rapid privatisation of state resources in Iraq could worsen this, spurring oligopolistic `crony capitalism'. The rise in private corruption which began under sanctions seems to be continuing with the further limitations on state authority.
In Iraq's case, the presence of Occupying Powers adds further dimensions to this competition: the responsibilities of the CPA and IGC to each other are not well defined; within Washington, the policy making community is clearly divided.
One set of institutions that may have been strengthened over the 1990s, and which remain strong now, are tribal networks. Much new business in Iraq seems to be flowing through them. Their extra-legal ability to enforce contracts may be particularly valuable in the absence of a strong commercial legal system.

5  The sovereignty dilemma

Modern political economy views policy makers as economists view economic agents: trying to achieve personal goals in the face of constraints. Democracy as an institution seeks to alter those constraints, making it more difficult for the electorate to be ignored.
As Iraq is currently governed by Occupying Powers, the central political economy question for Iraq is that of the extent to which their political systems take into account Iraqi well being. In theory, they are not: Iraqis do not vote in British or American elections. Furthermore, neither country has a large, politically powerful Iraqi community: in the US, the highest profile Iraqis organisations have not raised money from their constituencies to lobby Congress but have, in fact, been funded by Congress.
In practice, these theoretical concerns seem to have been borne out: the US political system has allowed a string of policies harmful to Iraq over the past three decades, dating at least to Kissinger's use of Kurdish aspirations in the 1970s.
The current climate may even exacerbate these concerns: while Saddam Hussein's capture removes from Iraq a strong negative connotation in the US psyche, the violence that has occurred between Iraqis and Americans may increase the perception that Iraqis, as a whole, are enemies.
Not surprisingly, then, there is a widespread view that US policy decisions reflect the wishes of policy makers in Washington more than they do the wishes of Iraqis. Awarding non-competitive contracts to political allies of the Bush administration, non-transparent management of Iraqi revenues8, and policy announcements designed for US consumption (e.g. the 21 September privatisation/investment announcements) are all examples of this. The US' flawed planning and forecasting for the post-Saddam period and its inefficient `parallel chimneys' may also be seen not just as bad luck, but as reflecting the absence of strong incentives to get it right for Iraqis.
This presents a real dilemma: good governance in Iraq likely requires that domestic politicians be held democratically accountable. For their rule to be credible and stable, however, they may require the backing of stronger security forces than Iraq can currently provide domestically. At present, only the Occupying Powers seem able to do this. Hence the dilemma: will a US president place US soldiers at risk to enforce the will of a democratic government whose interests may diverge from his own?

6  Conclusion

Iraq's most obvious advantage is its oil wealth. This, however, has not kept it from trouble in the past - and may even have been a `resource curse'. Thus, confidence in Iraq's future success cannot appeal only to this.
Centrally, economic improvement will depend on Iraq's ability to select accountable leaders committed to its success. Their legitimacy offers the hope of stable rule, in turn facilitating the attraction of foreign investment.
Whether or not this will occur is still to be determined. The White House's 30 June `transition' deadline seems more designed for the US electoral cycle than for Iraqi benefit. Particularly dangerous, it seems designed to allow the White House to disavow responsibility for events in Iraq. Already suggestions that Iraq should be seen as another Yugoslavia - an `artificial' state held together by a dictator - are circulating, an explanation for failure that may prove saleable to the US public.
This signalled desire to `get out', or be less visible, has a number of negative consequences. First, a rapid transition without elections may grant power to Iraqi politicians more accountable to foreign powers - or to themselves - than to Iraqis. This seems a recipe for poor governance, and may be particularly risky during this formative period.
Second, this impatience may encourage violent competition between factions within Iraq whose plans no longer require that they contest the US for power in Iraq, merely other domestic factions.
On a positive note, Iraq's less obvious advantage has been its educated, cosmopolitan population. Contemporary Iraq is unusually scarred, and it is inappropriate to romanticise Iraq's past. Nevertheless, this tradition does provide some cause for hope. Debate in Iraq is more alive than it has been for decades: Iraq's nascent civil society is learning to organise, building allies abroad, and influencing the policy of the Occupying Powers.

References

[Addison and Rahman 2001]
Tony Addison and Aminur Rahman. Resolving the HIPC problem: is good policy enough? Presented at UNU/WIDER debt relief conference, 15 August 2001.
[Al-Saadi 2003]
Sabri Zire Al-Saadi. Oil wealth and poverty in Iraq - statistical adjustment of government GDP estimates (1980 - 2001). Middle East Economic Survey, XLVI (19), 12 May 2003.
[Alesina et al. 2003]
Alberto Alesina, Arnaud Devleeschauwer, William Easterly, Sergio Kurlat, and Romain Wacziarg. Fractionalization. Journal of Economic Growth, 8 (2): 155 - 194, June 2003.
[Annett 2001]
Anthony Annett. Social fractionalization, political instability, and the size of government. IMF Staff Papers, 48 (3): 561 - 592, 2001.
[Campos and Coricelli 2002]
Nauro F. Campos and Fabrizio Coricelli. Growth in transition: What we know, what we don't, and what we should. Journal of Economic Literature, XL (3): 793 - 836, September 2002.
[Collier and Hoeffler 1998]
Paul Collier and Anke Hoeffler. On economic causes of civil war. Oxford Economic Papers, 50 (4): 563 - 573, 1998.
[Easterly 2001]
William Easterly. The Elusive Quest for Growth. MIT Press, 2001.
[Easterly 2002]
William Easterly. How did heavily indebted poor countries become heavily indebted? Reviewing two decades of debt relief. World Development, 30 (10): 1677 - 1696, 2002.
[Khadduri 2004]
Walid Khadduri. Iraq: Critical days ahead. Middle East Economic Survey, XLVII (4), 26 January 2004.
[Özler 1993]
Sule Özler. Have commercial banks ignored history? American Economic Review, 83 (3): 608 - 620, June 1993.
[Sabir-Ali 2003]
Ghazi Sabir-Ali. Rebuilding North Oil Company, Kirkuk in 1991. Middle East Economic Survey, XLVI (35), 1 September 2003.
[Tornell and Lane 1999]
Aarón Tornell and Philip R. Lane. The voracity effect. American Economic Review, 89 (1): 22 - 46, March 1999.
[Woo 2003]
Jaejoon Woo. Economic, political, and institutional determinants of public deficits. Journal of Public Economics, 87: 387 - 426, 2003.

Footnotes:

1This paper has benefitted from the comments of attendees of the 21 October 2003 CWC conference in Geneva.
2Bosnia and Herzegovina and Serbia and Montenegro omitted due to data incomparability.
3"IMF may lend to Iraq by second half of 2004", IMF Survey, 2 February 2004.
4Reuters, DAVOS-World Bank sees two-thirds Iraq debt write off, 22 Jan 2004.
5Reuters, DAVOS-World Bank sees two-thirds Iraq debt write off, 22 Jan 2004.
630 April 2003
7More powerfully, Easterly [2001] only finds a weak connection between foreign investment and growth. He terms the position that insists on this connection `capital fundamentalism'.
8See http://www.iraqrevenuewatch.org for more details.

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