1. Rand Conference Arlington, DC - May 31, 2013 The Oil Curse and Iraqi Balance of Payments Robert Looney Naval Postgraduate School relooney@nps.edu

2. Key Questions Issues involving the oil curse and balance of payments: How have natural resources had negative impacts to trade, inflation and currency stability in other countries? How might Iraq be affected by these macroeconomic stability problems? In which ways does Iraq appear to be falling into the normal oil curse pitfalls? Will Iraq experience labor force transitions as experienced in other “oil curse” countries? Will Iraq experience high inflationary and purchasing power reductions as a result of its growing hydrocarbons revenue? Are there limits to importing and petrodollar recycling Will Iraq begin “dollarizing” its economy or are there no limits to the private and government sectors’ ability to import goods? 2

3. Oil Curse Overview Several generalizations are possible concerning the oil or resource curse Economic performance among those with oil, mineral or agricultural resources Tends to be no better than among those without, And often worse Long run patterns suggest that more often than not when fuels, ores and metals exports increase as a proportion of merchandise exports, GDP growth declines This pattern is not inevitable, with many countries finding oil/resources to be a blessing rather than a curse. A good analogy is the lottery winner. In the past Iraq had many symptoms of the oil curse – not inevitable that this phenomenon will characterize the future. 3

4. The Iraqi Oil Curse

5. Patterns of Long-Run Growth 5

6. Channels of the Oil Curse At least four main channels through which the resource curse has harmed an economy. Iraq has at one time or another experienced each: Pro-cyclical fiscal and monetary policies Crowding out of manufacturing High volatility of commodity prices Deterioration of governance and supporting institutions All or combinations of these factors can lead to: Unsustainable growth – bubble economy Wasteful public investment programs An over expansion of the public sector Destruction of the agricultural sector Lack of competitiveness outside the oil sector Underdevelopment of the private sector High levels of chronic unemployment 6

7. Variants of the Oil Curse Main element separating the oil curse and oil blessing countries is the relative level of governance Many aspects of the oil curse are captured in the Legatum Institute’s Prosperity index which has eight dimensions Two of these dimensions separate the oil countries into three separate environments: Economy Five year growth rate (2000) Confidence in financial institutions (% yes) Satisfaction with living standards (% yes) Governance Confidence in the government (% yes) Confidence in the judiciary (% yes) Government Effectiveness (World Bank) 7

8. Diversity of Oil Economies 8

9. Oil Economies: Patterns of Governance 9

10. Revenue Watch 2013 Resource Governance Index 10

11. Oil Economies/Iraq: Vicious Circle 11

12. Balance of Payments Assumptions Iraq is not broken out of its vicious circle of poor governance, limited private sector development, and oil dependency – Still, overall economic performance should be good Oil export Revenues Oil revenues increased from about 30 billion $US in 2004-05 to about 50 billion a year between 2008-10 to nearly 90 billion in 2012. Expected to surpass 100 billion by 2014 By end of decade the IEA estimates Iraq’s annual revenue from oil exports will increase to about 200 billion dollars per year (all in fixed prices of 2011) This gradual growth is forecasted to continue into the next decade Oil Price Forecast – close to $100 per barrel through 2017 Iraqi Economic Growth 7%-8% 2013-2016, then 4%-5%. 12

13. Iraqi Vulnerabilities 13

14. Iraq: Balance of Payments 14

15. Oil Economies: Patterns of Inflation 15

16. Iraq: Trade Several generalizations regarding Iraqi international trade – all related to the oil curse: Trade flows are far below potential as broad-based commercial activity is still suppressed While average tariffs are low, numerous non-tariff barriers add to cost of trade Iraq open to foreign investment in principle, but bureaucratic inertia, policy uncertainty and security concerns deter investment growth. Dysfunctional financial system, limits trade financing. 16

17. Oil Economies: Diversification 17

18. Dutch Disease in Iraq? The Dutch Disease usually occurs during a commodity boom: A real appreciation of the currency A rise in government spending A rise in non-traded goods prices A resultant shift of resources out of non-export commodity traded goods Sometimes a current account deficit While the Iraqi Dinar exchange rate is higher than it would likely be in the absence of oil, difficult to say the country is experiencing a true Dutch Disease phenomenon The problem could develop quickly however if The independence of the central bank is compromised Pubic sector wages rise rapidly The government can not manage its revenues in a countercyclical manner 18

19. Oil Economies: Real Effective Exchange Rate 19

20. Oil Economies, Exchange Rate Volatility 20

21. Assessment I Several tentative conclusions can be drawn from these patterns: Because of oil alone, Iraqi economic activity should continue to expand strongly despite political uncertainties – 7%-8% This has allowed the Al-Maliki government to focus on control rather than institution building/governance reforms As a result Iraq is in a vicious circle of limited private sector activity/ job creation – unemployment is likely to remain very high indefinitely On the other hand relatively weak domestic demand will contain inflation at rates less than 3% per annum Still the country is very vulnerable to a fall in oil revenues – the economy is not resilient, nor does it have the institutions for sustained non-oil growth Any major shock would thrust the country the oil curse category with all of its resulting economic effects 21

22. Assessment II Because the country will most likely run large current account surpluses: It can maintain a relatively fixed exchange rate similar to the GCC countries However this exchange rate may currently be considerably overvalued (cheap imports – inflation ceiling), thus penalizing attempts at economic diversification While the country lacks the political will and ability to set up a sophisticated sovereign wealth fund, there is no reason excess hydrocarbon revenues can not be placed in the international bond markets, or simply held as reserves – no limits to petrodollar recycling As long as the Central Bank maintains its independence, and inflation is kept under control, no reason to believe the domestic economy will become dollarized 22