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Backgrounder #1633 on Iraq

March 5, 2003

The Road to Economic Prosperity for a Post-Saddam Iraq

By , and

As the Bush Administration and Iraqi opposition groups plan the future of a post-Saddam Hussein Iraq without its menacing arsenal of weapons of mass destruction (WMD), economic issues loom large. Iraq's economy has been grossly mismanaged for 40 years, and its people desperately need an alternative strategy to supplant the failed policies of its dictator. Sound economics are needed to help them rebuild their lives and their country after two decades of wars and four decades of repression under the current regime.

Saddam Hussein's regime has succeeded in bankrupting the country even though it boasts 112 billion barrels of oil in reserves--the world's second largest after Saudi Arabia's.1 According to some experts, Iraqi reserves can be as large as 220 billion barrels--equal to those of Saudi Arabia.2 Gross domestic product (GDP) for 2001, at the market exchange rate, however, is estimated to be only about one-third the level in 1989.3 Iraq also is hobbled by its $140 billion foreign debt.4

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.5 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 country's 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).

THE TOUGH ECONOMIC ROAD AHEAD

Iraq's Lifeblood: Oil
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.6 The economic sanctions imposed by the U.N. in the past decade in an effort to force Saddam to give up his weapons of mass destruction not only have not worked, but also have helped to depress foreign trade.

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According to the U.S. General Accounting Office, however, oil smuggling and illegal surcharges of 25 cents to 50 cents a barrel on legal oil purchases under the U.N. oil-for-food program bolster Saddam's regime. These illegal activities from 1996-2002 have provided unaccounted revenues of at least $6.6 billion,7 which Saddam has been free to spend to develop WMD and support terrorism.8

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.9

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.10

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.

Taxing Imports, But Not Smugglers
The Economist Intelligence Unit notes that direct taxation has never been a preferred means of raising revenue in Iraq.11 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."12 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.

Tough Investment Environment
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 ranged from 60 percent to 70 percent.13

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.

AFTER SADDAM: THE OUTLOOK FOR IRAQ AND WORLD ENERGY MARKETS

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 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.14 Together with repaying the Iraqi foreign debt (estimated at from $60 billion-$140 billion) and compensation costs to Kuwait and other countries (over $20 billion), the more realistic figure is $200 billion.15 However, as long as structural economic reforms are undertaken, Iraq's vast oil reserves and rebuilt economy, including the revamped oil sector, are likely to provide the funds needed to rebuild and boost economic growth.

Thus, the United States and the people of Iraq have the same interest at heart: maximize Iraq's economic performance. Without private ownership, however, oil will remain politicized and mismanaged. A group of Iraqi-born oil experts stated in December 2002, after a conference on the future of the Iraqi oil sector sponsored by the U.S. State Department, that

The aspiration of the group is a rehabilitated, globally connected oil and gas sector.... Oil will remain the primary source of revenue and will play a pivotal role in the country's economic reconstruction. The group recognized the need to establish a favorable investment climate and attract international and inward capital in the reconstruction and growth of the industry. It saw the importance of introducing modern technology, know-how and management skills.16

Thus, the exiles fell short of calling for post-Saddam privatization of the Iraqi economy.

Secretary of State Colin Powell has said that "The oil of Iraq belongs to the Iraqi people.... [I]t will be held for and used for the people of Iraq. It will not be exploited for the United States' own purpose...." But this does not preclude the United States from offering its guidance to the future government of Iraq on establishing sound economic and trade policies to stimulate growth and recovery.17 It would be counterproductive to empower either U.N. bureaucrats or Iraqi officials loyal to the Ba'ath party and Saddam to run the Iraqi oil industry.

The Bush Administration, through its executive directors at such IFIs as the IMF and World Bank, as well as other international governmental and non-governmental organizations, should begin to advise the future leaders of Iraq's next government 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.18 (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 Organization 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 incentives for Iraq to leave the OPEC cartel down the road, which would have long-term, positive implications for global oil supply.

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Potential Benefits of Leaving the OPEC Regime
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.19 Estimates by Iraqi oil officials are even higher: According to Oil Minister Amir Muhammad Rashad20 and Senior Deputy Oil Minister Taha Hmud, the reserves could be as high as 270 billion to 300 billion barrels, making them equal to Saudi Arabia's.21

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.22 (See Chart 4.)

Such a surge in production may be opposed by OPEC countries, which would like to keep its quota around the current 2.8 million barrels per day, while historic market share is taken by the Kingdom of Saudi Arabia, which currently is pumping close to 8 million barrels per day.23 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.

PRIVATIZATION: LEARNING FROM THE PAST

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.

Several lessons from other countries' privatization experiences are particularly relevant to Iraq's situation. Specifically:

LESSON #1: Privatization works everywhere
Between 1988 and 1993, 2,700 state-owned businesses in 95 countries were sold to private investors.24 In 1991 alone, $48 billion in state assets were privatized worldwide.25 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 again demonstrate why privatization is good for the economy as a whole, no matter where it is implemented.26

LESSON #2: Privatization works best when it is part of a larger structural reform program
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.27 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.

LESSON #3: Privatization of large enterprises requires preparation
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.28

LESSON #4: Transparency and the rule of law are critical
Opaque privatization and allegations of corruption and cronyism provide political ammunition to the opponents of market-based policies. To eliminate these 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.29

LESSON #5: A minimal safety net is necessary to support laid-off workers and prevent social unrest
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.

LESSON #6: Privatization is taking place in the Middle East
Privatization is no longer limited to 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.30 A number of Middle Eastern states, including Iraq's neighbors Turkey31 and Kuwait,32 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.33

Lessons from Oil and Gas Privatizations

Oil privatization remains a politically painful issue in many countries. Economic nationalists claim oil is a "national patrimony,"34 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:

ENERGY SECTOR LESSON #1: First "entitize," then privatize
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.35 The partial privatization effort has led to friction between state-controlled entities and the privatized-publicly held companies over pipeline access.

ENERGY SECTOR LESSON #2: Oil privatization generates high economic efficiency and market capitalization
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.

ENERGY SECTOR LESSON #3: Keep it clean, and keep it profitable
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.36 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.

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