Fitch Revises Iraq's Outlook to Negative; Affirms at 'B-'

Fitch Ratings has revised the Outlook on Iraq's Long-term foreign currency Issuer Default Rating (IDR) to Negative from Stable 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:

Lower oil prices are driving a significant deterioration of Iraq's financial position. Commodity dependence is among the highest of all rated sovereigns. Oil accounts for more than 50% of GDP and over 90% of fiscal and current external receipts.

The budget deficit widened in 2015 to an estimated 8.2% of GDP, due to sharply lower oil prices. The 2016 budget envisages a larger deficit, but its assumptions of an average oil price of USD45/b and 3.6m b/d of crude exports still look optimistic. Fitch forecasts that Brent crude will average USD35/b in 2016, suggesting an Iraqi price of USD32/b (based on the average discount in 2013-15). Assuming crude exports remain at current levels of around 3.3m b/d and the government enacts modest spending cuts, we project the budget deficit to widen to 15% of GDP in 2016. Fitch expects this to moderate to 7.6% of GDP in 2017 as oil prices rise.

In 2015 the government received USD1.2bn each from the IMF and World Bank and further foreign concessional loans are likely. Iraq and the IMF agreed on a Staff Monitored Program (SMP) in November with the aim of moving to a stand-by arrangement (SBA). Iraq is hoping to revive plans to issue Eurobonds of up to USD2bn this year. Fitch believes this is contingent on securing a SBA with the IMF. Meanwhile, domestic issuance of T-bills has ramped up, with indirect monetary financing by the central bank playing a substantial role. Despite some modest initiatives to introduce new excise and consumption taxes, there is little prospect of substantial revenue diversification in the medium term.

Government debt is forecast to rise sharply on the back of these deficits, averaging more than 70% of GDP in 2016-17, up from 56% of GDP in 2015. However, this debt stock includes funds (and accumulated interest) provided by GCC countries during the 1980-1988 Iran-Iraq war amounting to 24% of estimated 2015 GDP. Iraq faces no pressure to repay or service this debt. Excluding this, Iraq's government debt would be lower than the 'B' median.

Fitch estimates that the current account swung into a large deficit in 2015, with oil export revenue down by more than 40%. Deficits are forecast in 2016-17, averaging 9% of GDP. This will contribute to further declines in international reserves, which we project to slip from USD53bn at end-2015 to less than USD40bn this year, still covering almost eight months of CXP. We assume the authorities will maintain the dinar's peg to the US dollar, although this could come under pressure.

Iraq's 'B-' IDR also reflects the following key rating drivers:

Political risk and insecurity are among the highest faced by any sovereign rated by Fitch. Some progress has been made in pushing back the Islamic State (IS), but IS is expected to retain a significant presence in Iraq, at least in 2016. 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.

The bulk of oil production facilities and infrastructure are away from areas of insecurity. Oil output expanded strongly to 3.5m b/d on average in 2015, from 3.1m b/d in 2014, reaching a high of 3.7m b/d in November-December. Including estimated output from Kurdish fields, end-2015 production was about 4.3m b/d. However, investment is likely to slow in 2016 in the face of lower oil prices with the government budgeting smaller payments to international oil companies.

The banking sector is under-developed and fundamentally weak. Private sector credit to GDP is one of the lowest of any 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. There has been little progress in restructuring these banks; an exercise that Fitch assumes will require recapitalisation by the government.

RATING SENSITIVITIES

The main factors that could, individually or collectively, lead to a downgrade are:

Evidence of stress in financing fiscal shortfalls. Further deterioration in the country's security, particularly if insecurity spreads to new geographical areas or hinders oil production or exports. 

The main factors that could, individually or collectively, lead to positive rating action are:

A sustained 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 fundamental improvement in the country's security that allows for stronger non-oil economic development 

KEY ASSUMPTIONS

Fitch forecasts Brent crude to average USD35/b in 2016 and USD45/b in 2017. Fitch conservatively forecasts Iraqi oil exports (excluding exports from the Kurdish region) to average 3.3m b/d in 2016-17.

Given a patchy track record in 2014-15, Fitch does not incorporate an oil-sharing agreement between the central government and the Kurdish Regional Government.

Fitch assumes ongoing serious security threats, with significant parts of the north east outside of the government's control.