September 25, 2002 | Backgrounder on Middle East
Saddam Hussein's regime has succeeded in bankrupting the country even though it boasts the world's second largest oil reserves after Saudi Arabia. Gross domestic product (GDP) for 2001, at the market exchange rate, is estimated to be only about one-third the level in 1989.1 Iraq also is hobbled by its $140 billion foreign debt.2 This devastation was wrought by such policies as the nationalization of the country's chief export commodity, oil; extensive central planning of industry and trade; the 1982-1988 war against Iran; and the invasion of Kuwait, which precipitated the 1991 Gulf War. And Saddam still stubbornly refuses to meet the terms for lifting the economic sanctions that the United Nations has imposed on his regime.
Saddam also has succeeded in diverting at least $6.6 billion--primarily in revenues from smuggled oil and kickbacks--to his program to develop nuclear, chemical, and biological weapons and platforms for their delivery. He continues to support terrorist organizations, such as Hamas and the Popular Front for the Liberation of Palestine (PFLP), which the U.S. Department of State includes on its list of state sponsors of terrorism.3 Presumably, a post-war U.S. military presence in Iraq and Iraq's future security forces will ensure that the new Iraqi government does not continue to develop WMD and support terrorism.
The future of Iraq depends not only on the ouster of the repressive regime, but also on the ability of the new Iraqi leaders to reverse the damage through policies that will spur real economic growth. The sooner the threat from Saddam's WMD programs ends and the Iraqi economy recovers, the sooner the United States and the other security forces will be able to depart.
A double strategy of ensuring security and enabling economic growth will need international support. The Bush Administration should help Iraqi opposition leaders to develop an economic reform package for their country. The new post-Saddam federal government should develop a modern legal system that recognizes property rights and is conducive to privatization; create a public information campaign that prepares the people for structural reforms and privatization; hire expatriates and Western-educated Arabic speakers with financial, legal, and business expertise for key economic positions; deregulate prices, including prices in the utility and energy sectors; prepare state assets in the utility, transportation, pipeline, energy, and other sectors for privatization; keep the budget balanced and inflation, taxes, and tariffs low; liberalize and expand trade; and launch an effort to join the World Trade Organization (WTO).
As Chart 1 and Chart 2 show, the Iraqi economy is dominated by the oil sector, which provides more than 60 percent of Iraq's GDP and 95 percent of its hard currency earnings.4 The economic sanctions imposed by the U.N. in the past decade to try to force Saddam to give up his weapons of mass destruction not only have not worked, but have helped to depress foreign trade.
According to the U.S. General Accounting Office (GAO), however, oil smuggling and illegal surcharges of 25 cents to 50 cents a barrel on legal oil purchases bolster Saddam's regime. These illegal activities during 1996-2002 have provided unaccounted revenues of at least $6.6 billion,5 which Saddam has been free to spend to develop WMD and support terrorism.6 How much Saddam is actually spending on his deadly arsenal is hard to tell. The lack of information is so pervasive that the international financial institutions (IFIs), foreign government agencies, and private businesses that provide country economic analysis and data do not publish any official economic statistics or estimates for Iraq.7
This means that no recent data on Iraqi government consumption of GDP are available. In 1993, the most recent year for which data are available, government consumption amounted to 13.9 percent of GDP. According to the Economist Intelligence Unit,
Oil revenue has been the mainstay of government income since the 1950s. In 1968 the oil-based nature of the economy was reinforced by the introduction of a centralized socialist system, with the government regulating all aspects of economic life other than peripheral agriculture, personal services and trade.... Meanwhile, the state's centrality to the economy has increased because the vast majority of imports and foreign exchange have been controlled by the government.8
The socialist Ba'ath government has demonstrated gross mismanagement of the oil sector. During the 1960s, exploration stopped and the sector was nationalized, which bred corruption and mismanagement. Oil production has barely increased since 1980. In 2001, oil production stood at approximately 2.8 million barrels a day. Today, Saddam's regime controls oil exploration, extraction, refining, pipelines, ports, and all utilities, but oil export prices are set by the U.N. sanctions regime.
But Not Smugglers
The Economist Intelligence Unit notes that direct taxation has never been a preferred means of raising revenue in Iraq.9 As the International Monetary Fund (IMF) reports, "imports are restricted by [U.N.] sanctions. All imports subject to import duty are also subject to a customs surcharge.... Imports of commodities are normally handled by the public sector."10 Although the government of Iraq inspects and regulates all imports, a small private sector is involved in considerable smuggling and black market currency exchange activities.
Even though Iraq has permitted some foreign investment in its oil industry and private sector, mainly to help it rebuild from the damage of the Gulf War, it discourages most capital inflows. The legal system does not guarantee contracts. Inflation in Iraq remains high. From 1994 to 2001, Iraq's weighted average annual rate of inflation was 80.4 percent; for 2001-2002, the rate has ranged from 60 percent to 70 percent.11
The government controls almost all prices, and rationing is the norm for items like food. The regime continues to distribute imported goods in what is essentially a highly centralized command economy structure, although it does retain the ability to skew the distribution of food and other items as a way to favor cronies.
There is no application of modern property rights protected by legislation and enforced through the courts. The Revolutionary Command Council (RCC) of Iraq holds all executive, legislative, and judicial authority. The RCC's chairman, Saddam Hussein, appoints a council of ministers who are theoretically vested with executive authority, but in fact they are able only to rubber-stamp the decisions of the RCC and its chairman. The judiciary is not independent; consequently, there is no check on Saddam's power to override any court decision.
One thing is clear: Saddam's regime, obsessed with control and coercion, is destroying the wealth of the Iraqi people. After liberation from this regime, it will be important for the Iraqi people to rebuild their economy, especially the oil sector, increase GDP and improve the standard of living, attract foreign investment, and improve government services through privatization.
The cost of rebuilding the country will be high. If Operation Desert Storm reconstruction costs are used as the basis for estimation, the cost of rebuilding Iraq after Saddam's regime falls will be in the $50 billion to $100 billion range.12 Together with repaying the Iraqi foreign debt, the more realistic figure is $200 billion.13 However, as long as structural economic reforms are undertaken, Iraq's vast oil reserves are more than ample to provide the funds needed to rebuild and boost economic growth.
The United States, through its executive directors at such IFIs as the IMF and World Bank, and other international governmental and non-governmental organizations, should begin to advise the future leaders of Iraq's three primary ethnic groups to establish policies that will lead to a thriving modern economy. These policies should be based on "best practices" developed around the world in the 1990s, when the largest government privatizations in history occurred.
During the Iran-Iraq War and the post-Gulf War sanctions period, Iraqi petroleum production declined significantly. Saudi Arabia filled the void, generating a net profit of $100 billion. The funds it generated represent monies that should have benefited the Iraqi people.14 (See Chart 3.)
Following the demise of Saddam Hussein, it is unlikely that the Saudi kingdom would transfer a fraction of its production quota under the Organisation of Petroleum Exporting Countries (OPEC) regime to Iraq to compensate for those lost profits and facilitate its rebuilding. Iraq will need to ensure cash flow for reconstruction regardless of OPEC supply limitations. Combined with the potential privatization of the oil industry, such measures could provide incentive for Iraq to leave the OPEC cartel down the road, which would have long-term, positive implications for global oil supply.
An Iraq outside of OPEC would find available from its oil trade an ample cash flow for the country's rehabilitation. Its reserves currently stand at 112 billion barrels, but according to the U.S. Energy Information Administration, it may have as much as 200 billion barrels in reserve.15 Iraqi officials estimate even more: According to oil minister Amir Muhammad Rashad16 and Iraqi Senior Deputy Oil Minister Taha Hmud, the reserves can be as high as 270 billion to 300 billion barrels, making them equal to Saudi Arabia's.17
Iraq's 1990 output prior to the beginning of the Gulf War stood at 3.5 million barrels a day, while oil discovery rates on a few new projects in the 1990s were among the highest in the world: between 50 percent and 75 percent. Given Iraq's own output projections, it may be capable of pumping as much as 6 million barrels (by 2010) to 7 million barrels (by 2020) a day, more than doubling current production levels.18 (See Chart 4.)
Depending on the dynamics of global economic growth and world oil output, Iraq's increase in oil production capacity could bring lower oil prices in the long term. An unencumbered flow of Iraqi oil would be likely to provide a more constant supply of oil to the global market, which would dampen price fluctuations, ensuring stable oil prices in the world market in a price range lower than the current $25 to $30 a barrel. Eventually, this will be a win-win game: Iraq will emerge with a more viable oil industry while the world will benefit from a more stable and abundant oil supply.
Boosting oil exports and oil industry privatization by itself still may not be sufficient for growth over the long haul. To rehabilitate and modernize its economy, a post-Saddam government will need to move simultaneously on a number of economic policy fronts, utilizing the experience of privatization campaigns and structural reforms in other countries to develop a comprehensive policy package.
Between 1988 and 1993, 2,700 state-owned businesses in 95 countries were sold to private investors.19 In 1991 alone, $48 billion in state assets were privatized worldwide.20 Privatizations led to higher productivity, faster growth, increased capacity, and cheaper services for consumers.
In one study, the World Bank reviewed 41 firms privatized by public offerings in 15 countries. This review demonstrates that privatization will increase the return on sales, assets, and equity. As privatized firms grow, they often increase their workforces. In another study, the World Bank reviewed 12 privatization efforts in four countries, and its findings also demonstrate why privatization is good for the economy as a whole, no matter where it is implemented.21
Privatization needs to be accompanied by reforms to open markets, removal of price and exchange rate distortions, reductions in barriers to entry, and elimination of monopoly powers. In addition to these policies, governments should enact legislation that protects consumer welfare.22 Such successful structural reform and privatization programs were implemented in the 1990s in Poland, Hungary, the Czech Republic, and the three Baltic States, particularly Estonia.
Successful privatizations of large enterprises may necessitate such advance actions as breaking them into smaller competitive units, recruiting experienced private-sector managers, adopting Generally Accepted Accounting Principles (GAAPs), settling past liabilities, and shedding excess labor.23
Opaque privatization and allegations of corruption and cronyism provide political ammunition to the opponents of market-based policies. To eliminate those problems and be successful in its privatization efforts, the government must adopt competitive bidding procedures, objective criteria for selecting bids, and protocols for hiring independent privatization management firms, and establish a privatization authority with minimal bureaucracy to monitor the overall program.24
Buyouts of the state-owned enterprise's management and labor force, as well as distribution of some of the privatized firm's shares to its management and labor force, can go a long way toward alleviating social tensions that might undermine public support for privatization.
Privatization is no longer an affair of affluent or middle-income countries. From Margaret Thatcher's Great Britain, privatizations of state-owned assets and structural reform policies spread to many countries in Africa, Asia, and Latin America, including the Philippines, Malaysia, Jamaica, and Sri Lanka. An internal study of World Bank managers in the Middle East and North African department found that many were enthusiastic in supporting privatization efforts in their regions.25 A number of Middle Eastern states, including Iraq's neighbors Turkey26 and Kuwait,27 are pursuing privatization of their telecommunications, transportation, utilities, and oil sectors and services, while others, such as Iran and Saudi Arabia, have declared their intentions to privatize assets and are in the policy discussion stage.28
Oil privatization remains a politically painful issue in many countries. Economic nationalists claim oil is a "national patrimony,"29 whereas socialists and radical Islamists call private and foreign ownership of natural resources "imperialist" and other such pejoratives. Such rhetoric has one goal: to keep a precious and profitable resource in the hands of the ruling elite, be it a communist party politburo, a dictator, or a group of mullahs.
In fact, oil is a commodity and should be managed according to the laws of economics and best business practices. Even a country as fiercely nationalist as Russia recognizes this and is undertaking the largest oil sector privatization in history. The lessons from past experience in oil privatizations are also positive. Specifically:
The Conservative government of Margaret Thatcher successfully privatized some British oil assets in the 1980s. In the early 1990s, Russia carved up its state-run oil ministry into regional monopolies. It created joint stock companies, later selling stock to the Russians, first, and then to foreigners. The Ministry of Privatization distributed some stocks to managers and workers in order to smooth the path to privatization. Since privatization, many of these stocks, such as in LUKoil, Tyumen Oil Co. (TNK), and Yukos, have risen in price considerably.
The Russian government did not go all the way, however. For example, it did not privatize Transneft, a company that controls its pipeline infrastructure, or fully privatize some oil companies, such as Slavneft and Zarubezhneft and GAZPROM, the giant natural gas monopoly that boasts the world's largest natural gas reserves and controls a 90,000 km pipeline network.30 The partial privatization effort has led to friction between state-controlled entities and the privatized-publicly held companies over pipeline access.
The results of Russian oil privatization are fascinating: While the privatized Russian oil companies significantly expanded their production and exports and significantly increased market capitalization, GAZPROM did not. The government-controlled pipeline operator also has had difficulty providing adequate pipeline capacity to the quickly developing oil sector.
Meanwhile, privatized Russian companies not only have attracted Western portfolio investment, but also have been more successful than GAZPROM in attracting capital for foreign direct investment. Several leading Russian publicly traded oil companies also transformed their antiquated, Soviet-era accounting practices to the GAAP standard, hired Western managers, and became centers for dissemination of Western management and accounting skills across Russia's industrial sectors. Moreover, Russia's largest oil companies, such as LUKoil and Yukos, are fast becoming major global oil players. LUKoil recently purchased 1,300 Getty gas stations in the United States, and LUKoil and Yukos are selling American Depository Receipts (ADRs) on the New York Stock Exchange.
The major problem with the Russian oil privatization effort has been its relative opacity, especially in the early 1990s. Scandals included the oil-for-shares debacle in which Boris Yeltsin's government took loans from banks in exchange for shares of the oil companies. The government never repaid the loans, and the companies became the property of politically connected banks.31 The insider dealing provoked a political row that discredited privatization in the public's eyes.
Other problems in Russia have been privatization through vouchers and the denial of access to foreigners in early privatization stages in order to assuage nationalists in the parliament. These policies resulted in much lower revenues (by as much as a factor of 10) than the government could have received for the privatized assets.
The Bush Administration should provide leadership and guidance for the future Iraqi government to undertake fundamental structural economic reform. This process should include a massive, orderly, and transparent privatization of state-owned enterprises, especially the restructuring and privatization of the oil sector. These steps would greatly enhance needed access to global capital markets.
U.S. political commitment will be needed to motivate international organizations to provide appropriate expertise and technical assistance. Inter alia, these organizations could include IFIs such as the International Monetary Fund and the World Bank, and would likely encompass such diverse non-governmental organizations (NGOs) as the National Endowment for Democracy, the Center for International Private Enterprise, the American Bar Association, and the AFL-CIO.
In particular, the Bush Administration should convince the future federal government of Iraq to come to an agreement on how oil revenues are taxed and proceeds are distributed to the country's three distinct ethnic regions--Shiite Arabs, the Kurds, and the Sunni Arabs. Successfully privatizing the country's oil fields, refining capacity, and pipeline infrastructure will mean higher efficiencies and higher tax revenues in the oil sector.
The Administration, the IFIs, and other economic decisionmakers should prepare and provide support for a future federal Iraqi government to:
The U.S. government, its allies, and international organizations should be ready to provide technical assistance in the legal, economic policy, and public administration areas. Working cooperatively with the United States, the European Union, and the IFIs, the post-Saddam government of Iraq will need to boost the court system and the rule of law. It will need to provide legislation to allow the use of broad alternative dispute resolution mechanisms outside of Iraq, as the local laws may change too quickly (and the local court system too slowly) for local judges to be able to follow and apply new legislation. Education for judges about the latest legal developments in the economic area will also be important. The courts will have to boost the enforcement of court rulings independent of the executive branch. The central government will need to pay judges and court employees adequate salaries to keep corruption in check.
In particular, the Oil Ministry and regional oil companies should be restructured to transform them into attractive government-owned oil companies as an intermediary stage before initial public offering (IPO). For example, one company may focus its work in the southern portion of the country, another in the central region (around Baghdad) and the Western desert, and the third around Kirkuk in the North. Three more companies may be created, one to operate the pipelines, the second to operate the refineries, and the third to develop natural gas.
Given adequate implementation of each of these stages, the time frame for this privatization effort could be four to five years after the new government is installed by the people of Iraq. During this time, the U.S. government and the IFIs would have to ensure that the political will for privatization remains intact. Management and accounting consultants hired by the new Iraqi government would have to ascertain that the program is transparent and on track.
Moreover, after privatization, Iraq must demonstrate that it is not losing tax revenue and that the government's oil revenue is distributed among the regions equitably and efficiently, allocated to the worthy causes, and not wasted, looted, or abused, which could undermine the entire economic reform program.
For the Iraqi people, structural economic reform and comprehensive privatization of government assets is necessary to stimulate recovery and provide stability after years of disastrous economic policies under Saddam Hussein. The winning strategy of structural reform and privatization also would benefit the industrial world, the United States and its allies, countries of the Middle East, and the developing world.
Iraq's return to global markets would allow for a more abundant and stable energy supply, a higher cash flow for the Iraqi people, and numerous business opportunities for the region and the world. Iraq's restructuring and privatization of its oil and gas sector could become a model for oil industry privatizations in other OPEC states as well, weakening the cartel's influence over global energy markets.
Ariel Cohen, Ph.D., is Research Fellow in Russian and Eurasian Studies in the Kathryn and Shelby Cullom Davis Institute for International Studies, and Gerald P. O'Driscoll, Jr., Ph.D., is Director of the Center for International Trade and Economics, at The Heritage Foundation.
3. U.S. Department of State, Office of the Coordinator for Counterterrorism, "Appendix B: Background Information on Terrorist Groups," Patterns of Global Terrorism-2000, April 30, 2001, at http://www.state.gov/s/ct/rls/pgtrpt/2000/2450.htm.
7. Gerald P. O'Driscoll, Jr., Edwin J. Feulner, and Mary Anastasia O'Grady, "Iraq," in 2003 Index of Economic Freedom (Washington, D.C.: The Heritage Foundation and Dow Jones & Company, Inc., forthcoming).
13. Julian Borger, "Post-Saddam Iraq Will Cost You, U.S. Warned," The Guardian, August 2, 2002, at http://www.guardian.co.uk/bush/story/0,7369,767755,00.html. Lawrence Lindsey, Director of the National Economic Council, is quoted as estimating a cost for the Iraq war of between $100 billion and $200 billion. It is unclear what is included in that figure. See Bob Davis, "Bush Economic Aide Says Cost of Iraq War May Top $100 Billion," The Wall Street Journal, September 16, 2002, p. 1.
14. "Round Table on Declining Oil Prices and Its Political Consequences in the Middle East," Middle East Studies, Vol. 6, No. 1 (Spring 1999), pp. 5-36, at http://www.netiran.com/Htdocs/Clippings/Economy/990322XXFE01.html.
21. World Bank, "Privatization: Eight Lessons of Experience," Policy Views from the Country Economics Department, July 1992, at http://www.worldbank.org/html/prddr/outdeach/or3.htm. For the latest annual update on global privatizations, see Reason Public Policy Institute, "Privatization 2002: Putting the Pieces Together," at www.rppi.org/apr2002.pdf.
27. Dr. Shafiq Ghabra, "The View from Kuwait," The Middle East Forum, March 18, 2000. For more on Kuwait, see U.S. Department of Commerce, "Commercial Overview," at http://www.arabchamber.com/arab-coutnries/Kuwait/commercial_overview.htm. See also International Monetary Fund, "IMF Concludes Article IV Consultation with Kuwait," Public Information Notice No. 00/27, April 4, 2000, at http://www.imf.org/external/np/sec/pn/2000/pn0027.htm.
28. See Energy Information Administration, "Saudi Arabia," January 2002, at http://www.eia.doe.gov/emeu/cabs/saudi.html. On Iran, see "Round Table," Middle East Studies, at http://www.netiran.com/Htdocs/Clpppings/Feconomy/990322XXFE01.html.