Now that the U.S. and its allies have fought their way to Baghdad, what are the prospects for Iraq’s economy?

About the surest prediction one can make is that the journey from economic basket case to something resembling a vibrant free-market-style system will be long, tough and uncertain, according to interviews with Wharton faculty and others who follow developments in the Middle East. Oil revenues in recent years have fallen far short of their potential because of the deterioration of production facilities and the absence of exploration. Iraq has no capital markets and is a police state with no functioning impartial judicial system. The country has a huge debt burden, much of it stemming from the 1980-88 war with Iran and the invasion of Kuwait in 1990. Even basic economic data to measure the country’s status are almost impossible to come by.

Iraq’s economic future will depend on many factors, including the kind of government that emerges in Baghdad in the months to come and the ability of the country to strengthen its crippled oil-production infrastructure, say the experts interviewed by Knowledge at Wharton. Indeed, oil has been both a blessing and a curse to Iraq. As in other Middle Eastern countries, oil can provide enormous wealth but can also sap a country’s drive to develop other economic sectors.

“The economy of Iraq depends on its oil – its ability to extract oil and sell it on world markets,” says Raphael Amit, professor of entrepreneurship at Wharton and a native of Israel. Iraq has the world’s second-largest oil reserves, after Saudi Arabia, but under the Saddam Hussein regime there has been an acute shortage of spare parts and a sharp decline in production capability. Iraq has the ability to produce about six million barrels of oil per day, according to published estimates, but is currently producing only half that amount.

Amit says Iraq’s oil sector should be privatized. The government would be involved in taxation and regulation, but multinational oil companies would oversee production on a for-profit basis. “After the war, the number-one focus will have to be on managing the oil industry by international oil companies,” he argues. “That will bring to Iraq an enormous amount of investment that will create jobs and fuel the economy. Iraq doesn’t have too many parameters to play with. It’s oil or nothing.”

Bart Kaminski, a consultant for the World Bank and a professor in the government and politics department at the University of Maryland, agrees that Iraq’s oil facilities should be transferred to the private sector, but with some safeguards. “I would privatize them with a strong provision to make sure that profits are retained within the country with clear rules as to how the money is spent,” says Kaminski, a native of Poland who as a researcher and consultant experienced first-hand the economies in central and eastern Europe during their emergence from the shadow of the Soviet Union in the 1990s.

The Financial Times reported on April 7 that Iraqi oil experts in exile have urged that their country be opened to international oil companies as quickly as possible after the war. The comments came at a meeting of the oil specialists, business consultants and officials of the U.S. State Department. Some people at the meeting said they favored production-sharing agreements (PSAs) with oil companies, according to the FT.

PSAs are controversial. In exchange for an equity stake in oil fields, oil companies are given favorable tax treatment and protected from certain financial losses. An article in the March 24 issue of Newsweek International notes that the major oil companies are the only firms with the wherewithal to boost Iraqi oil production and develop its untapped fields. “To protect the tens of billions they will need to pour into a postwar Iraq, the oil giants are likely to push” for PSAs, the magazine says. So far, oil companies have signed PSAs “mainly in weak states that don’t know better than to give away the store – but never in the big Middle Eastern countries,” the article adds.

$383 Billion in Debt

Iraq has 112 billion barrels of proven oil reserves, but its potential reserves may be far greater since about 90% of the country remains unexplored due to years of war and United Nations sanctions, according to the Energy Information Administration (EIA), part of the U.S. Department of Energy. Iraq’s oil-production costs are among the lowest in the world, which makes its fields highly appealing to potential investors. But only 15 of 73 discovered fields have been developed, and few deep wells have been drilled when compared with those of Iraq’s neighbors, according to the EIA. A revitalized Iraq, an original member of the Organization of Petroleum Exporting Countries, could emerge as a rival to Saudi Arabia.

The Iraqi government has exercised firm control of the oil sector ever since a centralized socialist system was introduced in 1968, according to the Economist Intelligence Unit (EIU). Oil exports were halted under U.N. sanctions imposed after the Gulf War. But under terms of the U.N.’s food-for-oil deal in 1996, Iraq was allowed to resume limited exportation of oil so that it could have funds to buy humanitarian goods for its people. Traditionally, oil has provided 95% of Iraq’s foreign exchange earnings, according to the Central Intelligence Agency’s World Factbook 2002. The Hussein regime has unsuccessfully tried to increase the role of agriculture in the economy. The CIA estimates that Iraq’s GDP declined 5.7% in 2001 due to the global economic slowdown and lower oil prices.

One expert who is not sure about the wisdom of selling ownership interests in Iraqi oil to foreign companies is E. Roger Owen, professor of Middle Eastern history at Harvard University and author of several books, including A History of Middle East Economies in the Twentieth Century. “Nobody’s done it,” Owen says. “In the Middle East, all oil is managed by the government and there’s always a state oil company. That isn’t to say you couldn’t somehow privatize the oil industry [in Iraq], but it’s unclear to me whom you would sell it off to. Iraqis don’t have the money. The only way to possibly sell it is to foreigners, and that would be a recipe for disaster.”

No matter how increased production is achieved, revenues generated by oil will prove pivotal in rebuilding Iraq and tackling its economic problems. One of those problems is debt. According to the Center for Strategic and International Studies (CSIS), a Washington think tank, Iraq’s total financial obligations are estimated to be as much as $383 billion. This is a crushing figure in a country whose gross domestic product in 2000 was estimated by the EIU to be $31.8 billion.

The largest chunk of Iraq’s total obligations, about $199 billion, is in the form of settled and unsettled claims related to the Gulf War, which have been submitted to the U.N. Compensation Commission. The next largest portion of Iraq’s obligations is in the form of foreign debt, which may be as much as $127 billion (or as low as $62 billion), according to CSIS. The uncertainty of this figure stems in part from a disagreement between Iraq and other countries, most of them in the Middle East, over the nature of funds owed for assistance given to Iraq to fight its war with Iran. The remainder of Iraq’s debt, some $57 billion, takes the form of pending contracts with public and private companies in Russia, the Netherlands, Egypt, the United Arab Emirates, China and France, mostly in the energy and telecommunications sectors, according to CSIS.

Noting that Iraq has not been paying down its debt during the period of U.N. sanctions, CSIS has called on the U.N. Security Council to review war-related claims against Iraq and renegotiate its debt. “Even if this figure [the $383 billion] is massively discounted, Iraq would have a debt-to-export ratio that would place it in the World Bank’s most burdened category, far surpassing the average of 3:1 for highly indebted poor countries,” CSIS said in a January 2003 report. The center said the U.S. government “should lead the call for convening a meeting of sovereign claimants and creditors to discuss a speedy and effective debt renegotiation.”

Iraq’s economy was not always in the terrible condition it is in today.

“Iraq was in pretty good shape in 1979, when Saddam took power,” says Daniel Pipes, director of the Middle East Forum, a think tank in Philadelphia, and author of the recently published Militant Islam Reaches America. “It was less dependent on oil revenues than other countries of similar standing. There were some real skills in the country – not terribly impressive by Western standards but by Middle East standards quite advanced. Today, as a result of utterly totalitarian rule and one series of catastrophes after another, the economy is decrepit. Some estimates indicate it’s 10% of where it was 25 years ago. The infrastructure is in terrible shape – the oil industry, roads, education, medicine, electricity grids, you name it. It will require substantial capital investment to get back to where it was.”

“The conventional wisdom is that Iraq should always have been a very happy and prosperous country because it has oil and water and [arable] land – a rare combination in the Middle East,” says Harvard’s Owen. “There was reasonably successful land reform, but like all oil economies the Iraqis weren’t able to develop a vibrant industrial sector for the usual sorts of reasons: It was easier to import stuff than to make it themselves. The most vibrant part of the economy in the 1980s was the construction sector, because money was used to build housing and palaces [for Saddam’s regime].”

Different Government Scenarios

The future of Iraq’s economy will hinge in large measure on the kind of government that is put in place.

“Politics are the key,” Pipes says. He adds that a positive picture could emerge under certain conditions: “If a stable government can succeed the current government, with a federalism that meets the major demands of the three major components of the Iraqi population [the Sunni Muslims, Shiite Muslims and the Kurds]; if Iraq’s neighbors don’t make land grabs; if remnants of Saddam Hussein’s regime don’t make trouble, and if the U.S. is serious about rehabilitating Iraq … At best, Iraq would be a latter day version of Germany or Japan.”

Like Pipes, Owen says Iraq’s economic destiny hinges on its future system of government. “If Iraq ends up with another strongman and a highly centralized government, it will have one set of tendencies. If, by miracle of miracles, it ends up with pluralism and democracy, there will be other tendencies. There are obviously statist tendencies in an oil economy because the money goes to the government. I think the best you can do in those circumstances is have a reasonably clear consensus about what the government does and what the private sector does. The Shah of Iran, for all his faults, got that reasonably right in the 1970s. The government looked after the industrial sector but provided plenty of credit [for the development of medium- and small-sized businesses].

Based on his experience in central and eastern Europe, Kaminski of the World Bank recommends that the new stewards of Iraq “dramatically liberalize the economic regime.” For one thing, he says, Iraq should institute a system of uniform tariff rates so that goods can be easily imported into the country. Another way to ease the flow of goods into Iraq is to ensure that products that are certified as safe for use in highly developed countries, such as the United States and those in the European Union, do not have to go through special procedures before being permitted to enter Iraq. “If products are good enough for the E.U. or American consumers, they would be safe for Iraqi consumers,” says Kaminski.

Another suggestion from Kaminski: “Don’t introduce personal or corporate income tax rates. Anything that may distort markets should not be introduced because there’s always a political danger that you will have a shady group distorting the level of excise taxes. In Bosnia and Herzegovina criminals engaged in smuggling because there were high excise taxes. If you have excise tax rates on cigarettes or alcohol, then you create enormous opportunities [for illegal behavior].”

Navin Valrani, a Wharton alumnus who serves as a director and shareholder in the Al Shirawi Group of Companies, a Dubai-based conglomerate, is optimistic about Iraq’s future. He says the country has long valued education and that it has an entrepreneurial mentality. Before Saddam Hussein became president, he says, “Iraq always operated on free-market forces; the people of Iraq are quite used to the capitalist mentality of the West and, for that matter, in the rest of the Gulf.”

Valrani adds: “As long as the oil income is put back into Iraq, that economy will come back strong pretty quickly. I see minimum U.S. or U.N. intervention needed. I also perceive that the U.S will want to play a role in the rebuilding of Iraq and there will be as great an American influence as there was in Kuwait after the 1991 invasion, where there were streets named after President Bush senior. I see a big American presence in Iraq. I see American firms winning a lot of large reconstruction contracts.”

But Valrani cautions that “the U.S. government has to play its part very tactfully because right now there’s this general mistrust among the Arab person on the street as to what American intentions are behind the current [military] campaign. I’d like to see the government monitor the oil income so that it comes back to Iraq for the Iraqi people. President Bush has alluded to the fact that this will happen.”

For his part, Owen says “it would be nice to see democracy and human rights” take root in Iraq, but he harbors doubts about how easily economic improvement will unfold. “It would also be nice to have a good economy but it’s hard to see what that would consist of. It will be extremely difficult to get the politics right. As in all quasi-colonial situations, at some stage the Americans will have to leave. Then, who knows if any structures or bargains or treaties [put in place] under a puppet American government will continue after the Americans leave?”

Owen says he hopes that the U.S. officials planning to take on a transitional role in governing Iraq will do “as little as possible.” He suggests that they concentrate primarily on using oil revenue to rebuild the infrastructure of the country but leave the rest to Iraqis. “If you go beyond [reconstruction] and [decide] what the relationship should be between the public and private sector and say it should be free enterprise, that is not for the U.S. or any foreign planner to say, really.”

If may take years for Iraq’s economy to reach its potential. But if the economy does change for the better, the benefits could go well beyond Iraq’s borders.

Wharton’s Amit says the biggest potential hurdle to economic development would be failure to “get the oil industry in a state where foreign investors would be willing to put money in to upgrade and maintain and operate professionally the enormous reserves that Iraq has. That is the biggest single thing to worry about.”

But if that obstacle is overcome, he adds, a healthy Iraq will be “good for stability in the Middle East, good for the Arab world. The more stable the region, the less terrorism we will see. It’s not just Americans who are afraid of terrorism. It’s also people in Qatar and the United Arab Emirates. It’s in everyone’s best interest to see a healthy, stable Iraq with a vibrant economy.”