Iraq finally has a new government — and it faces a fiscal crisis with no easy exit. Prime Minister Ali Al Zaidi’s consensus government was sworn in on 14 May, a political breakthrough after nearly six months of deadlock. The new cabinet will need to immediately take on an economic crisis that threatens its survival, with the Strait of Hormuz still shut and oil exports sharply reduced. That has the state treasury drawing down its reserves, and it faces the prospect of missing public-sector payroll within months.

There’s no domestic route out of the hole, and If the strait stays closed, the endgame is a bailout, likely from the IMF. But taking money from the IMF comes with conditions — including demands to cut the public wage bill that a quarter of the country lives on, making it untouchable by every one of Al Zaidi’s predecessors.

The optimism that greeted Al Zaidi was grounded in something real. He’s 40 — Iraq’s youngest PM ever — with business interests spanning banking, logistics, and retail, and no deep ties to the factional blocs that have paralyzed Baghdad for a decade. Standout assets in his portfolio include Dijlah TV and Al-Janoob Islamic Bank, which he chaired until 2019. He’s also behind conglomerates including Al-Watania Holding (involved in agriculture and food wholesale, among other sectors) and Al Oways Group, which helps the government execute its ration-card food subsidy program.

BACKGROUND- Al Zaidi emerged as a consensus alternative to Nouri Al Maliki, Iraq’s former prime minister and a dominant figure in post-2003 Shia politics, after US objections ended his bid. Al Zaidi was not a fixture in Iraq’s most important political movement, the Coordination Framework (CF), until the Shia-dominated group catapulted him into the country’s premiership.

Up against the world

Al Zaidi ended up taking office with an incomplete cabinet despite early expectations that he was heading for a smooth Parliamentary process. Absent from cabinet are ministers for critical security posts including defense and interior.

The new PM has inherited an economy pushed to the brink by a combination of the Iran-US-Israel war in the Gulf, successive oil crises, and decades of paralysis on structural reforms. His government will need to grapple with the disappearance of oil revenues thanks to the closure of Hormuz; sky-high unemployment, especially among youth; a liquidity crisis in the banking industry; and a massively bloated public sector weighing down the country’s budget and, with it, the state’s ability to spend and invest on anything else.

The war has also severed Iraq’s main source of revenue streams: Iraq is painfully dependent on hydrocarbon revenues, which account for about half of the country’s GDP and 90% of its revenue. With Hormuz shut down, Iraq’s oil exports are now at 600k bbl /d, down from around 3.3 mn bbl /d before the conflict. Crude production fell nearly 61%.

The math is stark: “They need about USD 84 a barrel just to balance their budget,” economics professor and Iraq expert Frank Gunter tells EnterpriseAM. The war-fuelled rise in the price of oil isn’t enough to compensate for the drop in crude volumes.

Al Zaidi will also face the challenge of keeping Iraq’s most important geopolitical partners — Iran and the US — happy. “The US will use its financial, diplomatic and security leverage to press for tighter controls on Iran-backed groups, while Iran will seek to preserve the influence of its Iraqi allies across the [Hashd al-Sha'abi] PMF, parliament and patronage networks,” Connor Coleman, senior analyst the Economist Intelligence Unit, tells EnterpriseAM.

That may give him limited room to maneuver: “Although Mr. Zaidi has pledged to rein in Iran-backed groups, he will struggle to meaningfully dismantle their entrenched position. He will probably pursue limited but visible steps to avoid punitive US measures like excluding overtly sanctioned or militia-linked figures from sensitive posts, tightening banking oversight and reaffirming the state’s monopoly over arms — while avoiding direct confrontation,” Coleman adds.

A bloated public service

Iraq’s bloated public sector is a boat anchor for any PM looking to drive reforms: “You have 4 mn government workers for a country of 34 mn people, which is the largest public sector bill in the world,” independent MENA economist Hamzeh Al Gaaod tells EnterpriseAM. “You also have to take into consideration the military, the PMF, and various factions, [are] all funded through the Defense Ministry budget,” he adds.

SOUND SMART- The PMF is a quasi-state militia group that includes dozens of political organizations under its umbrella, many of which have strong ties to Iran.

And there’s a real risk the state treasury may not be able to make payroll, experts tell us, in direct contrast to Governor of Central Bank of Iraq (CBI) Governor Ali Al Alaq’s recent assurances to the public. “Zaidi's government will struggle to meet public sector payroll in the coming months… This could be a huge financial disaster for Iraq and could lead to great domestic unrest,” Hamzeh Hadad, Iraq fellow at the Center for a New American Security, tells us. “Iraq is going to literally draw down on its reserves and sell local assets until it gets to a stage where it can no longer finance its massive wage bill,” Al Gaood says.

Look for cabinet to delay spending on investment as it plays for time, Gunter says. “It's considered political suicide to touch salaries or pensions, so the only thing that gets crushed is the non-oil investment. Now, I'd hate to see that happen right now because Iraq [has been] involved in this incredible effort to diversify its economy,” Gunter says, pointing to massive logistics projects including Al Faw Grand Port and new rail networks.

Al Zaidi is also going to have to reckon with a banking system that’s under significant stress. Despite boasting healthy reserves (around USD 73 bn, excluding gold or USD 97 bn with it), the banking system was stretched thin by liquidity crises driven by low oil prices in 2014 and 2020. “Rafidain and Rasheed, the two largest state-owned banks and the two largest banks in Iraq, are bankrupt. They have a negative net worth. We've known this, and the World Bank has known this, now for almost 20 years. So, there's your first problem,” Gunter says.

How it goes down: “When the government of Iraq tries to finance its needs, it is not doing so through international borrowing — international debt is actually down — but through selling bonds and borrowing money domestically. Rafidain, Rashid, the smaller state-owned banks, and the many very small private banks, are buying this government debt and then immediately turning around and reselling it to the Central Bank of Iraq,” Gunter tells us.

The result: “The assets of the Central Bank of Iraq are gradually replacing very liquid USD assets with very illiquid IQD government debt. This is not a healthy thing,” Gunter adds. As has been the case in Egypt through successive currency devaluations, banks that load up on government paper rarely make an effort to lend to the private sector, “because lending to the government is the safest thing you're going to find for a risk-free investment,” Gunter notes.

Political paralysis = no reforms

Iraq has done little in recent years to drive the type of reforms that put the domestic private sector in the driver’s seat — let alone attract foreign direct investment. “There is zero regulatory landscape. It is impossible to diversify away from oil because there is no legal framework that supports the private sector unless through corruption,” Al Gaood tells us. “Look at wheat,” he says, pointing out that wheat growers haven’t been paid a promised subsidy for a year.

Gunter agrees. “Finance is not the most serious problem the private sector faces in Iraq,” Gunter tells us. “In my opinion, the most serious problem is regulatory hostility... The progress is so slow. You could read the 2005 economic development plan published by the Iraqi government right after the constitution was approved, and the analysis of their problems is almost exactly the same as in the current plan,” he adds. Iraq is ranked last for friendliness to the private sector among 16 upper-middle income countries ranked in the World Bank’s most recent Business Ready survey.

Al Zaidi has a narrow window

Iraq is coming off five years of relative stability that had allowed Al Zaidi’s predecessor to make some progress. “For what Iraq has experienced in the past — war with ISIS, invasion by the US, the Gulf War, Iran-Iraq war — this has been the most stable it has been. And before this regional war with neighbouring Iran, Iraq had half a decade of relative stability,” Haddad tells us.

“I think everyone was very cynical that no progress would be made against corruption,” Gunter notes. “The World Bank does an annual evaluation called the Worldwide Governance Indicators, and last year Iraq had the biggest improvement of any country in the world. It's still not good, but it went from desperately bad to much better. I don't think anyone expected that there would be so much progress against corruption,” he adds.

There was also “some progress toward helping private businesses. Towards the end of the last prime ministership, the one-stop shop established by the Ministry of Trade actually did allow businesses to become more efficient with business registration,” Gunter says.

The war risks ending that momentum: “You need more than just five years of stability to prove yourself to investors, especially since the previous four decades have been very difficult,” Haddad says.

What now

Would Iraq knock the IMF door? If the Hormuz disruptions continue, Iraq needs access to foreign liquidity, not domestic. IMF is one option, but that “simply won't work because that requires complete control of the country as we see in Egypt. Sisi has complete sovereignty over the Egyptian economy. Iraq does not, quite simply,” Al Gaood tells us.

Iraq signed up for a USD 5.3 bn assistance program in July 2016, adding to a 2015 emergency facility, during the Daesh war and oil crash the time.

The IMF could be too costly for Iraq’s political elite. “The IMF is going to have conditions, and those conditions are going to be both at the macro level — that the deficit has to be reduced — and at the micro level—that the government of Iraq has to revise its regulatory system and its commercial code to make it more friendly to the private sector. Politically, it would be seen as a defeat by the government of Iraq to negotiate a new agreement, to have the IMF flying into Baghdad and saying: You will do this and that,” Gunter says.

Is there a compromise? A stabilization program, rather than sweeping reform, could also be an option, Coleman tells us.

Ultimately, if Hormuz remains shut, Gunter thinks the government would fold: “I don't think this new government is immediately going to approach the IMF, but if the strait stays closed, eventually they're going to have to,” Gunter argues. That’s when things will get tricky: Washington to apply pressure for reforms, while Tehran would push factions aligned with it to resist.