Iraq and Algeria Navigate Political Transition, Deflated Oil Demand and Decreased Revenues
The world’s current struggle against the coronavirus pandemic is not only the story of a virus that crippled the global economy and tested health systems throughout the world; it has also offered a glimpse into the future of energy. Since the Organization of Petroleum Exporting Countries (OPEC) was established in 1960, oil producers have been able to control the global oil supply and ensure high revenues for governments. The sharp drop in oil demand caused by the pandemic has brought forward the uncertainty around oil consumption levels. Oil demand will certainly recover but as countries will continue to reduce their reliance on fossil fuels its future is uncertain. Today, many producers in the Middle East and North Africa (MENA) have the opportunity to use the dramatic events of the coronavirus to rethink their economies and even reshape their social contracts.
The oil-dependent countries in the MENA region are now facing a quadruple shock. First, they are addressing the health epidemic—Iran alone accounts for 31 percent of the cases in MENA followed by Saudi Arabia, and countries like Iraq and Libya have exhausted already weak and overcrowded health structures. Second, they are suffering a large contraction in general economic activities, due to the pandemic’s resultant lockdowns. Third, they are facing a significant drop in oil revenues, due to a global oil price crash. Fourth, they will likely continue to face oil revenue contraction in the future, due to OPEC members’ recent agreement to cut oil production until April 2022.
Algeria and Iraq are two among the countries in the region that have been severely impacted by these shocks. The International Monetary Foundation (IMF) projects that Algeria’s economy will contract by 5.2 percent and Iraq’s by 4.2 percent. Both face risk of further decline due to the uncertainty of the global pandemic and its resultant economic impacts. These countries are also experiencing mounting social pressures with young people primarily demanding jobs and better access to public services.
Real growth (as a percentage, 2019 to 2020)
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Source: IMF, REO, 15 April 2020
Iraq, which has the world’s fifth-largest proven oil reserves, has been struggling with corruption and decades of terrorism and foreign military intervention. Iraq, too, experienced civil unrest over the past year, with protestors calling for an end to the sectarian political system that has governed the country since the U.S.-led invasion.
Both Algeria and Iraq were already in places of great transition and turmoil when confronted by the coronavirus pandemic. They are similar in their reliance on oil and gas revenues, as well as the discontentedness of their populations and their lack of crisis preparedness at the onset of the pandemic.
How are the governments of Algeria and Iraq facing the challenges the coronavirus pandemic poses? While both countries have taken some measures in response to the oil price drop and the spread of the coronavirus, questions remain. What will these measures achieve? And, will they be sufficient to avoid a resurgence of social discontent once the pandemic has eased?
Fiscal breakeven oil price (USD per barrel)
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Source: IMF, REO, 15 April 2020
Algeria
At $157 per barrel, Algeria, has the second-highest fiscal oil breakeven price (minimum price per barrel that the country needs to reach in order to meet its expected spending needs while balancing its budget) in the region. The $157 breakeven price is more than four times current oil prices.While most countries have been spending more during the coronavirus pandemic to protect their already sluggish economies, Algeria was forced to cut its spending because it had no savings left in its oil stabilization fund (its sovereign wealth fund). As oil prices fell, Algeria’s government announced cuts in operational spending; it mainly cut spending on goods and services while leaving wages, pensions, health- and education-related spending untouched. However, these measures will generate minimal savings because wages and social transfers comprise the majority of the budget. The government has also announced that it will postpone all investment projects that are in the pipeline. The government codified its spending cuts in reducing total expenditures by 6 percent, with current expenditures down by 3 percent and capital expenditures by 11 percent.
However, not all legislative changes have produced budget cuts. The government has also introduced spending to mitigate the impact of the coronavirus pandemic. It has made an allocation of AD 70 billion ($0.5 billion or 1 percent of total expenditures) for health-related spending and to compensate for individuals and businesses directly affected by the crisis. This legislation also postpones tax payments for small- and medium-sized enterprises (SMEs) and cuts income and corporate taxes in half for individuals and businesses residing in the southern hydrocarbon-rich region. It further includes other business incentive measures targeting access to finance for start-ups. The Bank of Algeria has provided liquidity by lowering its reserve requirement and has reduced its main policy rate. Further, it has eased financial regulation and has extended loan repayment periods.
Algeria’s lack of savings and its accelerated draw-down on international reserves have prompted the government to take additional measures to preserve the foreign currency drain. Sonatrach, Algeria’s national oil company (NOC), will halve its operational and capital expenditures and shrink its import bill.
The Algerian government budgeted for oil to bring a third of 2020 revenues but now, they only expect half to materialize due to low oil prices. Non-oil revenue loss will further compound this budget shortfall. At its current level, spending will consume more than 90 percent of the revenue, which leaves virtually no resources for a recovery stimulus measure. Unfortunately, Algeria would have difficulty cutting its current spending because it mostly includes its public wage bill, pensions and social transfers.
Iraq
At $60 per barrel, Iraq’s fiscal breakeven price is nearly double the current global oil price. Like Algeria, Iraq has no immediate fiscal room to respond to the crisis and will ultimately have to cut spending at a time when most countries are spending more to counteract the coronavirus pandemic’s economic impacts.Prior to 7 May 2020, Iraq operated under a caretaker government, which rendered it far less prepared than Algeria to take policy action to face the current health and economic crisis. In the absence of available additional budget financing, the Central Bank of Iraq (CBI) established a donation fund to support the Ministry of Health in its efforts to fight the pandemic. Initial grants from the CBI and the Trade Bank of Iraq amounted to $25 million.
The government announced that they will cut spending for non-essentials, specifically reducing capital spending and recurrent spending on supplies and services other than health-related. They also introduced a cash transfer scheme targeting 10 million private sector workers that have lost their salaries during the lockdown. The country’s significant informal employment sector might impede its implementation, which could prove insufficient as compared to the social safety net provided through the public wage bill. The cash transfer will cost IQD 600 billion ($ 0.5 billion) for two months, which represents a mere 0.3 percent of the bloated public wage bill.
To lessen the financial impact of the coronavirus pandemic on businesses and individuals, the CBI announced a moratorium on interest and principal payments on its direct SME lending portfolio and asked banks to extend maturities of loans for clients impacted by the lockdown. However, with loans to SMEs representing only 1 percent of gross domestic product (GDP), SMEs remain largely unbanked and are therefore unlikely to benefit from these measures.
With low oil prices at $25 per barrel, Iraq’s budget revenues will shrink by 40 percent and could go lower if the country cuts production. At this level of revenue, Iraq can only cover 62 percent of its operational budget. It will likely be able to cover wages and pensions but will have to either make spending cuts or take on significant debt to pay for goods and services, maintenance and investment expenditures. These potential cuts would further deteriorate already poor infrastructure and inefficient public services. It will likely also halt or cause delays in resuming budget transfers to the Kurdistan autonomous region, which have previously been subject to dispute.
The coronavirus crisis and the decline in oil price have made already existing social and economic problems more acute. Both Algeria and Iraq are currently suffering the consequences of a previous lack of fiscal responsibility from an earlier time when they did not amass sufficient savings during periods of high oil prices and instead spent revenues mostly on recurrent expenditures rather than domestic investment. High youth unemployment—caused by fewer public sector jobs as the main provider for employment, including inefficiencies and over-staffing in state-owned enterprises, and the inability of the private sector to create decent job opportunities—is likely to worsen.
Policy recommendations
As Iraq and Algeria plan their paths to recovery, their new governments should commit to addressing joblessness and other root causes of their populations’ discontent. While many of the current short-term policy efforts are targeted at scaling up health spending and social safety nets, both governments should use this period of transition and rebuilding to put forward long-overdue policy reforms. To that end, Algeria and Iraq should consider a mix of front-loaded and medium-term policy measures.1. Reprioritize expenditure and rationalize the payroll bill. The coronavirus pandemic has shed light on the need for efficient and reliable health systems. Iraq and Algeria suffer from understaffing in the health sector, despite having a substantial public sector wage bill (46 percent and 34 percent of their budgets, respectively). They should prioritize scaling up their health- and social-protection spending by reallocating current expenditures, while also reducing the burden of the payroll bill on public finance. They should revise and reduce compensation schemes and allowances across the whole public sector that are neither linked to performance nor provide a social safety net.
2. Create a fiscal buffer. Iraq and Algeria should implement a fiscal rule that provides a buffer during periods of oil-price decline and limits wasteful and unsustainable spending, including the costly and inefficient subsidies that typically arise during good economic times. A buffer would reduce the need for abrupt expenditure cuts during downturns, thus avoiding disruption to public services and making budgets more predictable over the medium term.
3. Enhance non-oil revenues to diversify away from oil. At 3.5 percent of GDP, Iraq’s non-oil revenues are some of the region’s lowest, representing only 10 percent of its expenditure bill. Recent budgets tried to ameliorate this by introducing new taxes, but they had little impact because of a narrow tax base and weak administration. Enlarging the tax base, improving tax-policy design features and strengthening tax administration could yield substantial revenues. At 14 percent of GDP, tax revenues in Algeria are higher than other oil-exporting countries in the region but lower than Tunisia and Morocco. It could potentially generate more revenue by strengthening tax administration and widening the tax base, through for example, the revision of costly tax exemptions.
4. Reduce energy subsidies. Energy subsidies estimated in 2019 at around 7.9 percent of GDP in Algeria and 3.3 percent of GDP in Iraq carry large fiscal costs. Interestingly, the low oil price environment and the economic activity slowdown are likely to generate savings for both countries due to lower energy subsidy levels. In that respect, Iraq and Algeria may see an opportunity to lock in these savings and plan for a smooth phase-out of energy subsidies over the longer term.
5. Raise external borrowing to finance domestic investment. As spending pressures increase and oil prices remain low, Iraq and Algeria could rapidly deplete their foreign-currency reserve buffers. In that case, they should consider requesting concessional loans for investment and economic recovery programs from regional development banks as well as multilateral institutions, such as the IMF and the World Bank, and additionally seek financing opportunities through capital markets. Algeria may have already reached the point at which it should consider borrowing: with external debt of less than 2 percent of its GDP, external borrowing could finance a pick-up in growth. With debt at 32 percent of GDP, Iraq has higher exposure to external debt than does Algeria, but is still well below other countries in the MENA region. Iraq relies heavily on domestic borrowing, which means there is less left to private-sector financing. Borrowing externally could help rebalance that.
Total external debt as percent of GDP
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Source: IMF - MCD REO statistics - data updated 15 April 2020
6. Enhance transparency and fight corruption. Amid the crisis, corruption, which is already deeply rooted in Iraq and Algeria, may worsen. Increased government spending on health may lead to inflated procurement. In the absence of a social targeting system that can be transparently managed by the public administration, the scaling up of social safety-net spending will be directed to politically affiliated individuals, rather than the most in need. In addition, shortage in foreign currencies and basic goods may lead to the resurgence of black markets. To that end, Algeria and Iraq should prioritize reforms to improve public financial management and governance. As the countries try to recover, their governments should communicate transparently about their policy strategies and follow-up regularly to address any shortcomings.
Nadine Aboukhaled is a senior economist/lead at Inventis. The views expressed in this piece are solely her own and do not reflect the views and the official position or policy of Inventis or NRGI.
