Sunday 06, August 2017 by Georgina Enzer

Moody's assigns Caa1 issuer rating to the Government of Iraq; outlook stable

Moody's Investors Service, ("Moody's") has assigned a Caa1 long-term issuer rating to the Government of Iraq; the outlook is stable.

Moody's has also assigned a (P)Caa1 senior unsecured rating to the country's bond issuance.

The rating was initiated by Moody's Investors Service and was not requested by the rated entity.

Concurrently, Moody's has assigned B3 long-term local currency and foreign currency bond ceilings. It has also assigned Caa2 long-term local currency and foreign currency deposit ceilings.

RATINGS RATIONALE

The Caa1rating is driven by four key factors:

1. Iraq has a relatively large economy that is endowed with very substantial oil wealth, but which suffers from highly volatile growth due to its lack of economic diversification.

2. The country's institutional strength is very low, as reflected in its weak governance indicators and transparency.

3. It has moderate fiscal fundamentals, with a debt burden that is expected to stabilise at around 60 per cent of GDP, but with an overwhelming dependence on oil revenues.

4. Iraq's susceptibility to event risk is very high, against the backdrop of some of the highest political risks in Moody's rated universe.

The stable outlook balances the positive security developments and the support from the international community against the still-fragile political situation and fiscal consolidation challenges that the government faces.

MODERATE ECONOMIC STRENGTH

Iraq is oil rich and has significant potential for economic development and growth. According to the BP Statistical Review of World Energy, Iraq's proven oil reserves were 153 billion barrels, the fifth-largest in the world, equivalent to 9.0 per cent of global proven reserves at the end of 2016.

According to the latest data, oil accounts for about 50 per cent of nominal GDP, nearly 100 per cent of exports, and around 90 per cent of government revenues. However, because oil extraction is a capital-intensive industry, it is not particularly important for employment, with only one per cent of total employment in the sector.

Real GDP growth is highly volatile and is likely to be weaker going forward than it has been in the past. It has remained quite strong in spite of the war with Da'esh and the government's fiscal consolidation efforts that caused non-oil GDP to contract by one per cent year-on-year in the first half. Robust oil production was able to pick up the slack, and the IMF has reported real GDP growth of 11 per cent for 2016.

However, developments in the oil industry as well as base effects have caused a sharp slowdown in growth in 2017, and we are currently forecasting a 0.4 per cent contraction in growth in the economy.

And looking ahead, growth between now and 2022 is likely to slow. After a growth rebound of 2.9 per cent for 2018, the IMF is forecasting that real GDP growth will be between 1.7 per cent and 2.1 per cent through 2022.

VERY LOW INSTITUTIONAL STRENGTH

Iraq has some of the weakest Worldwide Governance Indicator scores in Moody's rated universe. Corruption is endemic and contributes to deep-seated dissatisfaction with the government and, ultimately, undermines the country's political stability and hence policy effectiveness.

Policy effectiveness is accordingly mixed. According to the 2004 Central Bank of Iraq (CBI) law, the central bank is independent from the government. The CBI's primary objectives are domestic price stability and a stable and competitive market-based financial system. The CBI has ostensibly been successful in reducing inflation rates to low levels in recent years.

However, performance under the Stand-by Arrangement (SBA) with the IMF has been mixed, raising broader questions about governance and policy effectiveness. Further fiscal adjustment will be required to keep the programme on track. Public financial management is a particular area of weakness for Iraq and is, therefore, a key component of the SBA targets.

Iraqi data also have significant shortcomings relative to what we see in other rated sovereigns. While detailed monthly oil sector data are available, the analysis of the non-oil sector is hampered by the lack of high-frequency activity indicators and quarterly expenditure-side national accounts data. Quarterly balance of payments data is only available with very significant lags.

MODERATE FISCAL STRENGTH

The decline in oil prices in recent years caused a very material deterioration in Iraq's fiscal position. The government faces funding constraints even with the SBA. The deficit for 2016 as a whole was much larger than targeted—14.1 per cent of GDP versus a 10.9 per cent of GDP target. The IMF anticipates a very large nine percentage point deficit reduction in 2017 that is almost entirely dependent on oil revenue increases.

Set against that, the government has very significant reserves that total around $40 billion, which provide it with a fiscal buffer for when other sources of funding are constrained.

Headline fiscal numbers may not fully capture the country's true vulnerabilities. The large state-owned sector implies the potential for sizeable contingent liabilities to crystallise on the government's balance sheet, though a detailed quantification is challenging due to data availability constraints.

VERY HIGH SUSCEPTIBILITY TO EVENT RISK

Political and security risks are very high, driven by underlying ethnic and sectarian tensions, and by Iraq's location within an unstable region. Even if dissolution or disintegration of the country is unlikely, the combination of domestic and geopolitical risks affects the government's capacity to service its debt, which weights very heavily on Iraq's rating.

Notwithstanding the Iraqi army's recent successes in the campaign against Da'esh, Iraq still faces very significant domestic and geopolitical challenges that stand in the way of a lasting and significant improvement in the security situation. Moreover, we expect regional tensions within Iraq, particularly with regard to the Kurdish region, to be an ongoing source of domestic political risk.

While political event risks dominate Moody's assessment, the banking sector, which is dominated by weak state-owned banks, poses a further source of contingent liabilities.

RATIONALE FOR THE STABLE OUTLOOK

The stable outlook reflects that balance between recent positive developments and the fragility of the country's overall political, economic, and fiscal position. On the positive side, security developments have reduced political risks somewhat, though they still remain very significant. Moreover, the support from the international community gives Iraq an opportunity to bolster the country's macroeconomic, institutional, fiscal, and balance of payments position.

Nevertheless, the political situation remains fragile and will do so for some time.

Moreover, the government faces significant fiscal consolidation challenges that are a notable focus of the SBA.

WHAT COULD MOVE THE RATING UP/DOWN

The rating could move up should political and geopolitical tensions reduce significantly in a way that is likely to be sustainable over the medium term. Positive rating pressure would also build with successful implementation of the SBA, particularly with regard to fiscal targets.

Over the longer term, greater economic and fiscal diversification that reduces the government's and the economy's dependence on oil would also be credit positive.

Conversely, a further intensification of domestic political tensions or increase in violence would put downward pressure on the rating.

The rating would also come under negative pressure should budget deficits and government debt fail to decrease in line with our current expectations.

GDP per capita (PPP basis, $): 17,721 (2016 Actual) (also known as Per Capita Income)

Real GDP growth (per cent change): 10.1 per cent (2016 Estimate) (also known as GDP Growth)

Inflation Rate (CPI, per cent change Dec/Dec): -1 per cent (2016 Actual)

Gen. Gov. Financial Balance/GDP: -8.3 per cent (2016 Actual) (also known as Fiscal Balance)

Current Account Balance/GDP: -7.2 per cent (2016 Actual) (also known as External Balance)

External debt/GDP: 58.5 per cent (2016 Actual)

Level of economic development: Moderate level of economic resilience

Default history: At least one default event (on bonds and/or loans) has been recorded since 1983.

On 02 August 2017, a rating committee was called to discuss the rating of the Iraq, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have materially decreased.

The issuer's institutional strength/ framework, have not materially changed. The issuer has become increasingly susceptible to event risks.

The principal methodology used in these ratings was Sovereign Bond Ratings published in December 2016.

Features & Analyses