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IMF Staff Country Reports
Iraq : Selected Issues
Author/Editor:
International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
July 26, 2019
Electronic Access:
Free Full Text. Use the free Adobe Acrobat Reader to view this PDF file
Summary: Selected Issues
Series: Country Report No. 19/249
English
Publication Date: July 26, 2019
ISBN/ISSN: 9781513508917/1934-7685
Stock No: 1IRQEA2019002
Price: $18.00 (Academic Rate:$18.00)
Format: Paper
Pages: 48
Please address any questions about this title to [You must be registered and logged in to see this link.]
...
IMF Country Report No. 19/249
July 2019
IMF Country Report No. 19/249
IRAQ
SELECTED ISSUES
This Selected Issues paper on Iraq was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on July 3, 2019.
Copies of this report are available to the public from
International Monetary Fund • Publication Services
PO Box 92780 • Washington, D.C. 20090
Telephone: (202) 623-7430 • Fax: (202) 623-7201
E-mail: [You must be registered and logged in to see this link.] Web: [You must be registered and logged in to see this link.]
Price: $18.00 per printed copy
...
IRAQ SELECTED ISSUES
July 3, 2019
Approved By
Prepared by Gazi Shbaikat, Salim Dehmej, and
Middle East and Central Asia Amgad Hegazy. Alexander de Keyserling, Jawed Sakhi,
Department Cecilia Pineda, and Laila Azoor provided research and
editorial support.
CONTENTS
A RISK AND RULES-BASED APPROACH TO FISCAL POLICY ___________________________ 3
A. Context _________________________________________________________________________________ 3
B. Fiscal Policy in Iraq: What Is the Challenge? ____________________________________________ 4
C. A Proposed Fiscal Policy Framework to Address These Challenges ____________________ 6
D. Fiscal Rules ___________________________________________________________________ 10
E. Conclusions _____________________________________________________________
26 References _________________________________________________________________ 32
BOXES
1. Which Fiscal Indicators to Target and Monitor _________________________________________ 9
2. Fiscal Buffers _________________________________________________________________ 25
FIGURES
1. Vulnerability to Oil Prices, 1990–2022 __________________________________________________ 5
2. Selected Resource-Rich Countries: Fiscal Rules, 2000–15 ____________________________ 11
3. Convergence to the Buffer Target, 2019–29 __________________________________________ 24
ANNEX
I. Fiscal Rules in Selected Resource-Rich Countries _____________________________________ 27
FINANCIAL DEVELOPMENT AND FINANCIAL INCLUSION __________________________ 33
A. Context ____________________________________________________________________ 33
B. Financial Development and Inclusion: Stylized Facts _________________________________ 34
C. Obstacles to Financial Development and Inclusion in Iraq ___________________________ 39
D. Benefits for Iraq of Financial Development and Inclusion ____________________________ 42
E. Policies to Strengthen Financial Development and Inclusion in Iraq _________________ 43
References ________________________________________________________________ 46
FIGURES
1. Banking Sector ____________________________________________________________________ 34
2. Selected Banking Sector Indicators, 2006–18_________________________________________ 35
3. Household Financial Inclusion Indicators _____________________________________________ 36
4. SME Density and Share of Private Employment ______________________________________ 38
5. SME Financial Inclusion _______________________________________________________________ 39
6. Bank Performance in a Competitive Setting __________________________________________ 41
7. Growth and Employment Benefits from SME Financial Inclusion _____________________ 43
…
E. Conclusions
43. A strong policy framework can help Iraq manage the challenges arising from its heavy dependence on volatile oil revenues. The procyclicality of fiscal policy has led to short-term economic volatility and hindered long term development. Important fiscal institutions such as fiscal rules, stabilization funds, and fiscal responsibility laws that exist in many resource-rich countries are lacking in Iraq. The authorities need to move away from formulating fiscal policy in the context of the annual budget to multi-year fiscal planning, underpinned by robust budget processes and PFM systems. This will help Iraq delink expenditure from oil revenue, scale up and protect capital expenditure to support reconstruction, and safeguard long-term fiscal sustainability.
44. Moving to a risk- and rules-based approach can be part of the new policy framework and would be timely. The two main building blocks of this approach involve anchoring fiscal policy on maintaining adequate fiscal buffers, and introducing operational fiscal rules designed to achieve this target for buffers and protect capital expenditure. A well-designed and communicated fiscal rule can help manage public expectations and resist spending pressures as oil price recover from the sharp decline in 2014–16. Fiscal rules would also help lock-in the consolidation achieved during that period.
45. The choice and design of a fiscal rule is guided by a set of desirable features which should be assessed against Iraq’s specific circumstances including policy priorities and capacity limitations. A rule on current expenditure of the central government is proposed for Iraq on the basis of its simplicity, operational guidance, ease of monitoring and control, and the support it would provide to protecting public investment. Allowing adjustment of the rule ceiling to durable increases in non-oil revenue would help encourage revenue diversification.
46. Calibration of the rule shows that Iraq should set a ceiling consistent with current expenditure growth of between 1.8–2.5 percent annually over the medium term (the upper limit is consistent with the 2 percent growth in primary current spending—excluding one-off factors—recommended in the attached staff report). This would strike a reasonable balance between mitigating risks and creating space to scale up capital expenditure in the coming years. Controlling current expenditure in this range would allow Iraq to cover about half of post-ISIS reconstruction spending over the medium term and would enable the authorities to gradually build fiscal buffers equivalent to 12 percent of GDP, sufficient to withstand one year revenue loss from a permanent oil price shock.
…
B. Financial Development and Inclusion: Stylized Facts
Financial Development
6. Iraq’s financial sector is small, underdeveloped, and dominated by public banks. The private banking sector comprises 63 generally small banks that together account for a modest share of assets, and play a minor role in financial intermediation (Figure 1).5 This reflects the dominant role of the larger public banks, which continue to account for the lion’s share of banking system assets, lending and deposits (Figure 2).
5 Until recently, private banks derived considerable profits by purchasing FX from the Central Bank, and reselling to the private sector at a sizable spread, and they largely abstained from traditional lending operations. As FX spreads have narrowed over the past year, the profitability of such transactions has fallen sharply.
7. Public banks are fragile after years of on-lending to the government. The two largest public banks—Rafidain and Rasheed—have lent directly to the government and undertaken numerous quasi-fiscal operations, while also still carrying legacy assets from the Saddam Hussein era. This has undermined their liquidity, solvency and profitability, and increased risks to financial stability (Figure 3). Repeated efforts to cleanse the balance sheets of Rafidain and Rasheed have yet to be successfully concluded, and restructuring efforts have been delayed, partly due to the lack of accurate data about their financial position.
8. Financial depth is shallow in Iraq. Private sector credit is only 9 percent of GDP, by far the lowest in the MENAP region (Figure 2), and Iraq scores “zero” on the depth of credit information index.6 In 2011, almost half of firms identified access to finance as a major constraint on their operations.7 The loan-to-deposit ratio in Iraq—measured as banks’ credit to deposits—is the second lowest among MENAP countries (at 40 percent), and around half the level in the GCC.
Financial Inclusion of Households
9. Access to financial services in Iraq is underdeveloped (Figure 3):
Account ownership. Only a quarter of adults have opened accounts at a financial institution, the lowest ratio in the region.8 According to surveys, this is largely because branches are too far away and financial services are seen as too expensive, but respondents also said they had
6 According to the World Bank World Development Indicators.
7 Global Financial Development Database, World Bank.
8 The aggregate figures also mask gender disparity since the ratio is only 20 percent for females against 26 percent for males (World Bank FINDEX Database).
insufficient funds to open an account or did not trust financial institutions. A further factor is the underdevelopment of mobile/e-banking that would allow access to all services, including online payment and transfers from phones.
Branch network. There are only four branches in Iraq per 100,000 adults, which is well below the MENAP average (around 12 branches).9.
There are also only three automated teller machines (ATM) per 100,000 adults, much lower than the MENAP average (32 machines per 100,000) and especially the GCC (50 machines per 100,000).
10. A range of indicators highlight the low utilization of financial services:
Only 6 percent of adults with an account at a financial institution said they had made an ATM withdrawal within a 12-month period, far below the regional average.
Likewise, fewer than 30 percent of Iraqis received any deposits into their account in the previous 12 months, half the MENAP average.12
On the credit side, very few Iraqis (less than 3 percent) have borrowed from a financial institution in the previous 12 months.11
The usage of credit and debit cards as a means of payment is much lower than in other countries in the region; only 2 percent of adults possess a credit card,12 a reflection of the dominant role of cash in Iraq.
Moreover, the share of adults using digital technology to make payments (e.g., through mobile money, mobile phones or the internet to pay bills, make purchases or transfers) remains lower in Iraq than peer countries, despite some increase over time.
Another indicator of the usage of financial services—the share of employees whose wages were paid into an account at a financial institution—remains low at 15 percent.
Financial Inclusion of Small- and Medium-Sized Enterprises (SMEs)
11. SMEs are underdeveloped in Iraq. Even though they contribute almost 90 percent to private sector employment in Iraq, the micro, small and medium size enterprise (MSMEs) density—
9 Branch network and ATM figures are obtained through the IMF Financial Access Survey Database.
10 Deposits measured under this indicator include cash, electronic deposits or other money transfers.
11 The highest ratio in the region was in Iran, where 24 percent of adults had borrowed from a bank or other financial institution.
12 Credit card ownership is much higher in the most advanced financial markets in the region, such as 45 percent in UAE.
measured by the number of MSMEs per 1,000 people—is substantially lower than both the MENA region and emerging and developing countries (Figure 4).
12. Iraqi firms, especially SMEs, suffer from lack of access to finance. This is a regional phenomenon: lending to SMEs accounts for only 9 percent of bank loans in 2017, both in Iraq and on average in MENAP countries, one of the lowest ratios in the world (IMF, 2019), and a third of firms in MENAP identify access to credit as a major constraint.13 In Iraq, only 2.7 percent of firms have financed investment projects through banks loans compared with an average of 23.7 percent in MENA (excluding high income countries).14 Lending standards are stringent, with banks generally demanding collateral of more than 150 percent of the loan value.15 This explains why Iraq’s weakest score in the World Bank Doing Business report (2019) relates to “getting credit,”16 and also helps explain why Iraq lags behind the MENA average in business environment rankings.
13. A composite index of SME financial inclusion illustrates the key trends. It captures both SMEs’ access to financial services (loans, saving or checking accounts) as well as their usage (IMF, 2019). It is calculated using principal component analysis and firm-level data from the World Bank Enterprise Surveys. In line with the indicators discussed above, Iraq has the second lowest score for SME financial inclusion in the MENAP and CCA region after Afghanistan (Figure 5).
13 This compares with a global average of 26 percent, according to the World Bank Enterprise Survey.
14 According to the World Bank’s Enterprise Survey, the ratio was 2.7 percent in 2011, which is the latest available data. The ratio for other countries is much higher: 14.6 percent in Egypt (2016), 34.8 percent in Morocco (2013),
46.8 percent in Jordan (2013), and 53.1 percent in Lebanon (2013). The average for this ratio is 23.7 percent for MENA (excluding high income countries). Even for low income countries the ratio is higher (16.9 percent). This is also consistent with the low level of households borrowing from financial institutions, estimated at 3 percent in 2017 (FINDEX Database).
15 Latest data available (2011), according to the World Bank’s Global Financial Development Database.
16 Iraq’s score for getting credit is zero, while the regional average is 36 (on a scale from 0 to 100).
C. Obstacles to Financial Development and Inclusion in Iraq
14. The scale and frequency of conflicts, most recently with ISIS in 2014–17, is a major factor behind the lack of financial development. Conflicts have undermined the business environment and confidence in the economy, weakened the infrastructure, and negatively affected bank asset quality either directly—e.g., through misappropriated assets—or indirectly because clients’ financial difficulties led to a worsening of bank soundness.
15. A wide range of interrelated factors further explain the underdevelopment of the financial sector, which can be divided into structural and financial sector factors. While demand factors play a role, it is hard to disentangle them from supply factors. Moreover, while some of these factors highlight the lack of resources available for lending to the private sector, others suggest that banks are reluctant to lend, especially for riskier projects.
Structural Factors
The structure of the economy. The government accounts for a large share of economic activity, and mainly re-distributes oil wealth rather than providing an enabling environment for private enterprise. The size of the government (including SOEs) has impaired private sector development, especially SMEs, through crowding out as well as preferential financial terms exacerbated by the dominant role of public banks.
Oil price shocks. A decline in oil prices may weaken the financial system and depress government revenues, forcing cuts in public investment which depress growth. This normally leads to the government withdrawing deposits at commercial banks and accumulating arrears, impacting suppliers that have borrowed from banks (IMF, 2016).
Weak legal and institutional frameworks related to property rights, the protection of shareholder rights, contract enforcement, insolvency regimes, governance and corruption undermine the business climate. These factors make it difficult for banks to undertake proper risk management, and complicate asset recovery proceedings in the event of insolvency/default.
Informational asymmetries discourage banks from lending to SMEs and households given the perceived risks arising from the private sector’s informality, poor financial reporting standards and lack of credit history (credit registries/bureau). Lending to SMEs tends to be at higher risk premia and high collateral requirements, which would crowd out safer projects/investors. Banks complain that there is a lack of viable projects.
High collateral requirements represent a serious hurdle to SMEs financing, especially when compounded by the lack of acceptable collateral. Whereas banks typically seek fixed assets as collateral, such as land and real estate, private firms mainly possess movable assets such as equipment and inventories (Love, Martinez Peria, and Singh, 2016); banks use also checks as collateral since they are easier and faster to enforce.
Financial Sector Factors
Weak financial architecture. A number of factors may undermine confidence in the financial system, including undercapitalization of several banks, poor corporate governance of the banks, the lack of independence of the public banks, deviations of certain prudential practices from international standards (e.g., classification of NPLs and provisioning), the lack of comprehensive published audits, and lack of an operational deposit insurance scheme may undermine confidence in the financial system depressing deposit collection and lending capacity.
Imperfect risk management systems, which are not completely digitized, inhibit effective screening and monitoring of borrowers and increase operational costs.
Bank competition is subpar. This is explained by the dominance of public banks, despite the large number of private banks. Indeed, Rafidain and Rasheed together hold about 71 percent of banks’ deposits (86 percent held in total by public banks) and extend 54 percent of credit (80 percent extended in total by public banks).
Large public banks suffer from erosion of the deposit base. Iraq has the lowest deposits-to-GDP ratio in the region (at 23 percent for 2016).17 The same applies to the size of financial system deposits-to-GDP in Iraq.18 This reflects a lack of confidence in the banking system, as well as the dominant role of cash in Iraq.
17 The ratio exceeds 100 percent in Jordan, Lebanon, and even in a number of oil exporters in the GCC.
18 24 percent for Iraq, compared to a range of 90–100 percent for Jordan, Kuwait, Morocco, Qatar, and UAE.
[/size]
High non-performing loan (NPLs) ratio. The official ratio—around 37 percent for private commercial banks—is three times above the MENAP average. Public banks show lower NPLs, around 13 percent, although this may understate the true picture, because a material share of loans are not being fully serviced, yet not shown as non-performing because of (uncalled) government guarantees.
High interest rate spread.19 Iraq has the highest interest rate spread in the MENAP region, at about 7 percentage points, implying high funding costs for the private sector. This may reflect the inefficiency in banks (higher operating costs translating into higher lending rates to customers), lack of competition among banks (higher mark-ups), or simply elevated risk perceptions. In turn, higher interest spreads may exclude households and SMEs, and also be a factor behind elevated NPLs since only the riskiest projects seek bank funding.
D. Benefits for Irq of Financial Development and Inclusion
...
IMF Staff Country Reports
Iraq : Selected Issues
Author/Editor:
International Monetary Fund. Middle East and Central Asia Dept.
Publication Date:
July 26, 2019
Electronic Access:
Free Full Text. Use the free Adobe Acrobat Reader to view this PDF file
Summary: Selected Issues
Series: Country Report No. 19/249
English
Publication Date: July 26, 2019
ISBN/ISSN: 9781513508917/1934-7685
Stock No: 1IRQEA2019002
Price: $18.00 (Academic Rate:$18.00)
Format: Paper
Pages: 48
Please address any questions about this title to [You must be registered and logged in to see this link.]
...
IMF Country Report No. 19/249
July 2019
IMF Country Report No. 19/249
IRAQ
SELECTED ISSUES
This Selected Issues paper on Iraq was prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. It is based on the information available at the time it was completed on July 3, 2019.
Copies of this report are available to the public from
International Monetary Fund • Publication Services
PO Box 92780 • Washington, D.C. 20090
Telephone: (202) 623-7430 • Fax: (202) 623-7201
E-mail: [You must be registered and logged in to see this link.] Web: [You must be registered and logged in to see this link.]
Price: $18.00 per printed copy
...
IRAQ SELECTED ISSUES
July 3, 2019
Approved By
Prepared by Gazi Shbaikat, Salim Dehmej, and
Middle East and Central Asia Amgad Hegazy. Alexander de Keyserling, Jawed Sakhi,
Department Cecilia Pineda, and Laila Azoor provided research and
editorial support.
CONTENTS
A RISK AND RULES-BASED APPROACH TO FISCAL POLICY ___________________________ 3
A. Context _________________________________________________________________________________ 3
B. Fiscal Policy in Iraq: What Is the Challenge? ____________________________________________ 4
C. A Proposed Fiscal Policy Framework to Address These Challenges ____________________ 6
D. Fiscal Rules ___________________________________________________________________ 10
E. Conclusions _____________________________________________________________
26 References _________________________________________________________________ 32
BOXES
1. Which Fiscal Indicators to Target and Monitor _________________________________________ 9
2. Fiscal Buffers _________________________________________________________________ 25
FIGURES
1. Vulnerability to Oil Prices, 1990–2022 __________________________________________________ 5
2. Selected Resource-Rich Countries: Fiscal Rules, 2000–15 ____________________________ 11
3. Convergence to the Buffer Target, 2019–29 __________________________________________ 24
ANNEX
I. Fiscal Rules in Selected Resource-Rich Countries _____________________________________ 27
FINANCIAL DEVELOPMENT AND FINANCIAL INCLUSION __________________________ 33
A. Context ____________________________________________________________________ 33
B. Financial Development and Inclusion: Stylized Facts _________________________________ 34
C. Obstacles to Financial Development and Inclusion in Iraq ___________________________ 39
D. Benefits for Iraq of Financial Development and Inclusion ____________________________ 42
E. Policies to Strengthen Financial Development and Inclusion in Iraq _________________ 43
References ________________________________________________________________ 46
FIGURES
1. Banking Sector ____________________________________________________________________ 34
2. Selected Banking Sector Indicators, 2006–18_________________________________________ 35
3. Household Financial Inclusion Indicators _____________________________________________ 36
4. SME Density and Share of Private Employment ______________________________________ 38
5. SME Financial Inclusion _______________________________________________________________ 39
6. Bank Performance in a Competitive Setting __________________________________________ 41
7. Growth and Employment Benefits from SME Financial Inclusion _____________________ 43
…
E. Conclusions
43. A strong policy framework can help Iraq manage the challenges arising from its heavy dependence on volatile oil revenues. The procyclicality of fiscal policy has led to short-term economic volatility and hindered long term development. Important fiscal institutions such as fiscal rules, stabilization funds, and fiscal responsibility laws that exist in many resource-rich countries are lacking in Iraq. The authorities need to move away from formulating fiscal policy in the context of the annual budget to multi-year fiscal planning, underpinned by robust budget processes and PFM systems. This will help Iraq delink expenditure from oil revenue, scale up and protect capital expenditure to support reconstruction, and safeguard long-term fiscal sustainability.
44. Moving to a risk- and rules-based approach can be part of the new policy framework and would be timely. The two main building blocks of this approach involve anchoring fiscal policy on maintaining adequate fiscal buffers, and introducing operational fiscal rules designed to achieve this target for buffers and protect capital expenditure. A well-designed and communicated fiscal rule can help manage public expectations and resist spending pressures as oil price recover from the sharp decline in 2014–16. Fiscal rules would also help lock-in the consolidation achieved during that period.
45. The choice and design of a fiscal rule is guided by a set of desirable features which should be assessed against Iraq’s specific circumstances including policy priorities and capacity limitations. A rule on current expenditure of the central government is proposed for Iraq on the basis of its simplicity, operational guidance, ease of monitoring and control, and the support it would provide to protecting public investment. Allowing adjustment of the rule ceiling to durable increases in non-oil revenue would help encourage revenue diversification.
46. Calibration of the rule shows that Iraq should set a ceiling consistent with current expenditure growth of between 1.8–2.5 percent annually over the medium term (the upper limit is consistent with the 2 percent growth in primary current spending—excluding one-off factors—recommended in the attached staff report). This would strike a reasonable balance between mitigating risks and creating space to scale up capital expenditure in the coming years. Controlling current expenditure in this range would allow Iraq to cover about half of post-ISIS reconstruction spending over the medium term and would enable the authorities to gradually build fiscal buffers equivalent to 12 percent of GDP, sufficient to withstand one year revenue loss from a permanent oil price shock.
…
B. Financial Development and Inclusion: Stylized Facts
Financial Development
6. Iraq’s financial sector is small, underdeveloped, and dominated by public banks. The private banking sector comprises 63 generally small banks that together account for a modest share of assets, and play a minor role in financial intermediation (Figure 1).5 This reflects the dominant role of the larger public banks, which continue to account for the lion’s share of banking system assets, lending and deposits (Figure 2).
5 Until recently, private banks derived considerable profits by purchasing FX from the Central Bank, and reselling to the private sector at a sizable spread, and they largely abstained from traditional lending operations. As FX spreads have narrowed over the past year, the profitability of such transactions has fallen sharply.
7. Public banks are fragile after years of on-lending to the government. The two largest public banks—Rafidain and Rasheed—have lent directly to the government and undertaken numerous quasi-fiscal operations, while also still carrying legacy assets from the Saddam Hussein era. This has undermined their liquidity, solvency and profitability, and increased risks to financial stability (Figure 3). Repeated efforts to cleanse the balance sheets of Rafidain and Rasheed have yet to be successfully concluded, and restructuring efforts have been delayed, partly due to the lack of accurate data about their financial position.
8. Financial depth is shallow in Iraq. Private sector credit is only 9 percent of GDP, by far the lowest in the MENAP region (Figure 2), and Iraq scores “zero” on the depth of credit information index.6 In 2011, almost half of firms identified access to finance as a major constraint on their operations.7 The loan-to-deposit ratio in Iraq—measured as banks’ credit to deposits—is the second lowest among MENAP countries (at 40 percent), and around half the level in the GCC.
Financial Inclusion of Households
9. Access to financial services in Iraq is underdeveloped (Figure 3):
Account ownership. Only a quarter of adults have opened accounts at a financial institution, the lowest ratio in the region.8 According to surveys, this is largely because branches are too far away and financial services are seen as too expensive, but respondents also said they had
6 According to the World Bank World Development Indicators.
7 Global Financial Development Database, World Bank.
8 The aggregate figures also mask gender disparity since the ratio is only 20 percent for females against 26 percent for males (World Bank FINDEX Database).
insufficient funds to open an account or did not trust financial institutions. A further factor is the underdevelopment of mobile/e-banking that would allow access to all services, including online payment and transfers from phones.
Branch network. There are only four branches in Iraq per 100,000 adults, which is well below the MENAP average (around 12 branches).9.
There are also only three automated teller machines (ATM) per 100,000 adults, much lower than the MENAP average (32 machines per 100,000) and especially the GCC (50 machines per 100,000).
10. A range of indicators highlight the low utilization of financial services:
Only 6 percent of adults with an account at a financial institution said they had made an ATM withdrawal within a 12-month period, far below the regional average.
Likewise, fewer than 30 percent of Iraqis received any deposits into their account in the previous 12 months, half the MENAP average.12
On the credit side, very few Iraqis (less than 3 percent) have borrowed from a financial institution in the previous 12 months.11
The usage of credit and debit cards as a means of payment is much lower than in other countries in the region; only 2 percent of adults possess a credit card,12 a reflection of the dominant role of cash in Iraq.
Moreover, the share of adults using digital technology to make payments (e.g., through mobile money, mobile phones or the internet to pay bills, make purchases or transfers) remains lower in Iraq than peer countries, despite some increase over time.
Another indicator of the usage of financial services—the share of employees whose wages were paid into an account at a financial institution—remains low at 15 percent.
Financial Inclusion of Small- and Medium-Sized Enterprises (SMEs)
11. SMEs are underdeveloped in Iraq. Even though they contribute almost 90 percent to private sector employment in Iraq, the micro, small and medium size enterprise (MSMEs) density—
9 Branch network and ATM figures are obtained through the IMF Financial Access Survey Database.
10 Deposits measured under this indicator include cash, electronic deposits or other money transfers.
11 The highest ratio in the region was in Iran, where 24 percent of adults had borrowed from a bank or other financial institution.
12 Credit card ownership is much higher in the most advanced financial markets in the region, such as 45 percent in UAE.
measured by the number of MSMEs per 1,000 people—is substantially lower than both the MENA region and emerging and developing countries (Figure 4).
12. Iraqi firms, especially SMEs, suffer from lack of access to finance. This is a regional phenomenon: lending to SMEs accounts for only 9 percent of bank loans in 2017, both in Iraq and on average in MENAP countries, one of the lowest ratios in the world (IMF, 2019), and a third of firms in MENAP identify access to credit as a major constraint.13 In Iraq, only 2.7 percent of firms have financed investment projects through banks loans compared with an average of 23.7 percent in MENA (excluding high income countries).14 Lending standards are stringent, with banks generally demanding collateral of more than 150 percent of the loan value.15 This explains why Iraq’s weakest score in the World Bank Doing Business report (2019) relates to “getting credit,”16 and also helps explain why Iraq lags behind the MENA average in business environment rankings.
13. A composite index of SME financial inclusion illustrates the key trends. It captures both SMEs’ access to financial services (loans, saving or checking accounts) as well as their usage (IMF, 2019). It is calculated using principal component analysis and firm-level data from the World Bank Enterprise Surveys. In line with the indicators discussed above, Iraq has the second lowest score for SME financial inclusion in the MENAP and CCA region after Afghanistan (Figure 5).
13 This compares with a global average of 26 percent, according to the World Bank Enterprise Survey.
14 According to the World Bank’s Enterprise Survey, the ratio was 2.7 percent in 2011, which is the latest available data. The ratio for other countries is much higher: 14.6 percent in Egypt (2016), 34.8 percent in Morocco (2013),
46.8 percent in Jordan (2013), and 53.1 percent in Lebanon (2013). The average for this ratio is 23.7 percent for MENA (excluding high income countries). Even for low income countries the ratio is higher (16.9 percent). This is also consistent with the low level of households borrowing from financial institutions, estimated at 3 percent in 2017 (FINDEX Database).
15 Latest data available (2011), according to the World Bank’s Global Financial Development Database.
16 Iraq’s score for getting credit is zero, while the regional average is 36 (on a scale from 0 to 100).
C. Obstacles to Financial Development and Inclusion in Iraq
14. The scale and frequency of conflicts, most recently with ISIS in 2014–17, is a major factor behind the lack of financial development. Conflicts have undermined the business environment and confidence in the economy, weakened the infrastructure, and negatively affected bank asset quality either directly—e.g., through misappropriated assets—or indirectly because clients’ financial difficulties led to a worsening of bank soundness.
15. A wide range of interrelated factors further explain the underdevelopment of the financial sector, which can be divided into structural and financial sector factors. While demand factors play a role, it is hard to disentangle them from supply factors. Moreover, while some of these factors highlight the lack of resources available for lending to the private sector, others suggest that banks are reluctant to lend, especially for riskier projects.
Structural Factors
The structure of the economy. The government accounts for a large share of economic activity, and mainly re-distributes oil wealth rather than providing an enabling environment for private enterprise. The size of the government (including SOEs) has impaired private sector development, especially SMEs, through crowding out as well as preferential financial terms exacerbated by the dominant role of public banks.
Oil price shocks. A decline in oil prices may weaken the financial system and depress government revenues, forcing cuts in public investment which depress growth. This normally leads to the government withdrawing deposits at commercial banks and accumulating arrears, impacting suppliers that have borrowed from banks (IMF, 2016).
Weak legal and institutional frameworks related to property rights, the protection of shareholder rights, contract enforcement, insolvency regimes, governance and corruption undermine the business climate. These factors make it difficult for banks to undertake proper risk management, and complicate asset recovery proceedings in the event of insolvency/default.
Informational asymmetries discourage banks from lending to SMEs and households given the perceived risks arising from the private sector’s informality, poor financial reporting standards and lack of credit history (credit registries/bureau). Lending to SMEs tends to be at higher risk premia and high collateral requirements, which would crowd out safer projects/investors. Banks complain that there is a lack of viable projects.
High collateral requirements represent a serious hurdle to SMEs financing, especially when compounded by the lack of acceptable collateral. Whereas banks typically seek fixed assets as collateral, such as land and real estate, private firms mainly possess movable assets such as equipment and inventories (Love, Martinez Peria, and Singh, 2016); banks use also checks as collateral since they are easier and faster to enforce.
Financial Sector Factors
Weak financial architecture. A number of factors may undermine confidence in the financial system, including undercapitalization of several banks, poor corporate governance of the banks, the lack of independence of the public banks, deviations of certain prudential practices from international standards (e.g., classification of NPLs and provisioning), the lack of comprehensive published audits, and lack of an operational deposit insurance scheme may undermine confidence in the financial system depressing deposit collection and lending capacity.
Imperfect risk management systems, which are not completely digitized, inhibit effective screening and monitoring of borrowers and increase operational costs.
Bank competition is subpar. This is explained by the dominance of public banks, despite the large number of private banks. Indeed, Rafidain and Rasheed together hold about 71 percent of banks’ deposits (86 percent held in total by public banks) and extend 54 percent of credit (80 percent extended in total by public banks).
Large public banks suffer from erosion of the deposit base. Iraq has the lowest deposits-to-GDP ratio in the region (at 23 percent for 2016).17 The same applies to the size of financial system deposits-to-GDP in Iraq.18 This reflects a lack of confidence in the banking system, as well as the dominant role of cash in Iraq.
17 The ratio exceeds 100 percent in Jordan, Lebanon, and even in a number of oil exporters in the GCC.
18 24 percent for Iraq, compared to a range of 90–100 percent for Jordan, Kuwait, Morocco, Qatar, and UAE.
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High non-performing loan (NPLs) ratio. The official ratio—around 37 percent for private commercial banks—is three times above the MENAP average. Public banks show lower NPLs, around 13 percent, although this may understate the true picture, because a material share of loans are not being fully serviced, yet not shown as non-performing because of (uncalled) government guarantees.
High interest rate spread.19 Iraq has the highest interest rate spread in the MENAP region, at about 7 percentage points, implying high funding costs for the private sector. This may reflect the inefficiency in banks (higher operating costs translating into higher lending rates to customers), lack of competition among banks (higher mark-ups), or simply elevated risk perceptions. In turn, higher interest spreads may exclude households and SMEs, and also be a factor behind elevated NPLs since only the riskiest projects seek bank funding.
D. Benefits for Irq of Financial Development and Inclusion
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