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Vikas Shah, Thought Economics, November 2009
Spanning from the north-west end of the Zagros Mountains, to the eastern Syrian and northern Arabian deserts, Iraq has been home to continuous civilisations from the 6th millennium BC, starting with the Sumerian people (the oldest known civilisation) through to the empires of the Assyrians, Babylonians, Hellenistic and Parthian peoples, and more recently, becoming a major part of Roman, Mongol, Ottoman and British empires. It is known, historically, that these civilisations, in Iraq, produced the earliest writing, literature, sciences, mathematics, laws, and philosophies of the world
In stark contrast to the desert landscapes of Western Asia and the Middle East, Iraq has two major rivers (The Tigris and the Euphrates) which flow through the country, providing land which is highly capable (agriculturally) and viable to build successful human settlement (a geography which later revealed incredible natural resources, particularly oil). In European History it was these rivers which led to Iraq being referred to by its Greek eponym ‘Mesopotamia’ (meaning land between two rivers). Iraq’s location is also strategically important from a trade perspective, sharing borders with Jordan, Syria, Turkey, Iran, Kuwait and Saudi Arabia together with 35miles of clear coastline on the Persian Gulf.
The twentieth century has, though, been a tremendously volatile time for Iraq. Following World War I, Iraq passed from the Ottoman to the British Empire who, in 1932, established the Kingdom of Iraq. In the revolution of 1958, the king was deposed, and the Republic of Iraq declared. By 1979, after two coup’s, Saddam Hussein took power of Iraq, and ruled for the remainder of the century, during the Iran-Iraq War of the 1980’s, the Invasion of Kuwait and Gulf War of 1990-91, and the period of sanctions of the 1990’s.
It was the Iran-Iraq war which first laid a rift in Iraqi finances (which are based predominantly on the Oil sector) leaving losses of at least USD 100 billion. After hostilities ended, a combination of low oil prices, repayment of war debts, and reconstruction costs resulted in a financial crisis which many cite as the reason (at least in the short term) for the invasion of Kuwait.
After this invasion, the U.N. Security Council adopted “Resolution 661” which imposed severe economic sanctions on Iraq, placing an embargo on all trade excluding medicine, food and humanitarian items. The effects of these sanctions, and government policies inevitably led to hyperinflation, poverty, and malnutrition. Iraq’s historically generous state welfare disappeared overnight, and the, “large and well-educated middle class that had grown from the years of plenty to form the bedrock of Iraqi society was impoverished”. By 2003, Iraq was, for all intents and purposes, a country suffering from a “profound macroeconomic shock”.
Saddam was eventually removed from power in the 2003 invasion of Iraq, and following one of the most controversial wars of modern times, Iraq is beginning, again, to show signs of improvement (described by the US Department of Defence as ‘significant and fragile gains’). With coalition troops withdrawing, Iraqi forces are starting to take responsibility for their own security, supported by an increasingly effective Iraqi parliament, who are slowly trying to build capacity in areas such as constitutional rights, threat deterrence, energy, economic development, education and other areas.
So what, then, is the future for Iraq?
In this exclusive interview, we speak to Zaab Sethna, Head of the Baghdad Office of Northern Gulf Partners (one of the leading asset managers in Iraq). We discuss the state and stability of Iraq, the future of its economy, and sectors ranging from oil & gas, renewable energy, commodities, utilities, telecommunications, real-estate and infrastructure. We also look at the investment opportunities Iraq offers, together with many of the key issues on rebuilding the nation.
Mr. Sethna has been working closely with Iraq’s leading political parties, business families and entrepreneurs for over ten years. He worked for the worked for the Government of Iraq on financial, trade, and energy policies and since then, has represented a number of international companies involved in Iraqi oil and gas, banking, insurance, aviation, and construction projects among others. He began his career with the United Nations in Brazil and also worked at the Sawyer/Miller Group in New York and the Rendon Group in Washington, DC and London. He is a graduate of Georgetown University and has an MIA from Columbia University.
Q: What is the current situation in Iraq?
[Zaab Sethna] The situation in Iraq is significantly improved by any measurement. Statistically violence has decreased by around 90% in the last two to three years by every metric: number of incidents, number of civilian casualties, number of security force casualties, damage to infrastructure, etc. In fact more people have been killed by violence in Mexico in the last 18 months than in Iraq. Of course there have been some terrible incidents recently and we cannot say that all the terrorists have been defeated but generally speaking the trends are very positive. More important even than the statistics is the mood of optimism you feel in Iraq now. People are certainly much more confident, and of course this kind of confidence is viral (in the sense that as people see optimism and confidence around them they themselves feel it and in turn pass it on). Quality of life indicators are also significantly improved in the last few years. GNP per capita has increased from $1800 under the US-appointed government of Ayad Allawi in 2004 to over $4000 today. Unemployment, inflation and other economic figures are also similarly improved. Corruption has been another factor in Iraq but we see this as declining as well from the high point during the US occupation and the immediate post-occupation period. The Iraqi government has instituted strong anti-corruption measures including Inspectors General in every Ministry as well as a national anti-corruption agency and there is also a parliamentary anti-corruption committee. As a firm we have a strong policy of zero tolerance for any kind of corruption but I am pleased to say we have never encountered any corruption or ever been asked for a bribe in Iraq.
Politically the situation is stabilising and what we see is that almost every group or faction in Iraq, with the exception of Al Qaeda and the Ba’athists, has now agreed to take part in the new system. The parliamentary and constitutional system is almost five years old and is ingrained. There will be free elections next year and we expect to experience a unique event in the Arab world, a peaceful transfer of power from one elected government to another.
Q: Why invest in Iraq?
[Zaab Sethna] Iraq today is an opportunity to pay rock-bottom prices for one of the world's richest countries and one of the world's best economic growth stories. The IMF forecasts Iraq's GDP growth this year at over 4% this year and close to 6% next year which is still higher than almost all others. Although it is currently impoverished, Iraq has the potential to be a very rich country in the medium term. It has water and oil but more important it has excellent human resources. Iraqis are smart, energetic and resourceful. They have an ancient history of urban civilization and commerce. The Iraq opportunity is far more compelling than the GCC and Iraq also has the most liberal economy in the Gulf region. It is easy for companies to register branches or subsidiaries and they are free to compete in any sector (with a few exceptions such as owning real estate or natural resources). There are no restrictions on repatriating capital or revenue, a simple 5% import duty and 15% income tax, a stable and free floating currency, and easy, 'one stop shopping' access through the National Investment Commission. It is a country of about 30 million people, intelligent and capable, enthusiastic about democracy, strong allies of the US and Europe, and ready to rejoin the modern world.
The Central Bank of Iraq has been doing a creditable job of keeping the dinar stable while lowering inflation. Their primary tool is interest rates which were over 20% in 2007 but have slowly been brought down and currently stand at 8.5%. Inflation has been brought under control and is 2.8%. At the same time unemployment is down from 60% to around 18%.
One of the greatest achievements of the US in Iraq has been the successful effort to reduce Iraq's debts. In 2003 Iraq was facing an absolutely massive and crushing debt burden of over $150 billion that had been accrued by the Ba’athists starting in the 1980's. The Bush administration appointed James Baker as the special envoy on Iraqi debt and he went around the world convincing Iraq's creditors to accept a large haircut. Iraq managed to reduce its debt burden with both Paris Club and London Club creditors by 80% which is the highest ever achieved by only a few other indebted countries. In fact only the Arab states have refused to reduce Iraq's debt and Kuwait continues to receive 5% of all Iraq's gross revenues under UN resolutions enforcing reparations for Saddam's invasion almost 20 years ago. It was only by reducing the debt burden that Iraq became economically viable again and also has slowly managed to rebuild its creditworthiness and rejoin the international capital markets. In fact next year Iraq plans a $5 billion bond issue which will be a major milestone. Reducing the debt burden and restoring Iraq to the world financial system might actually turn out to be the single best achievement of the Bush administration in Iraq and it was always mystifying to me why they didn't take any credit for it.
Q: What is the energy and commodities opportunity?
[Zaab Sethna] Iraq is the last place in the world where there are huge hydrocarbon reserves that are relatively easy to develop. The scale of its energy resources is simply astounding- probably the world's greatest reserves, bigger even than Saudi Arabia, at least 80 producible fields including nine 'super-giants' with over 5 billion barrels each, with close to the lowest extraction costs in the world. Iraq is the only producer on the planet that has the capability to quadruple its oil production in the next decade and increase gas production by an even higher factor. Certainly as Iraqi oil comes on stream it will raise issues with OPEC since Iraq has been without an OPEC production quota for the last 11 years. The other countries in the cartel will start to clamour for Iraq to be given a new quota while Iraqi will argue that it has produced far less than its previous quota for many years so should be allowed to make up for this lost time. Nevertheless Iraqi oil will probably have little effect on oil prices as world demand is forecast to grow by a larger margin than Iraqi production expands.
For now there are still few opportunities for investors in the upstream oil sector. Iraq has recently signed service agreements with some of the largest oil companies in the world but we know that international oil companies want production sharing agreements not service contracts. It will be some time before Iraq is ready to sign PSA's. These are still controversial in the country and there is a strong nationalistic feeling among the people when it comes to oil. Nevertheless there are excellent opportunities connected with the energy sector. Oilfield services for example will be a growth sector in Iraq for the foreseeable future as is logistics and equipment supply and maintenance. The government has also liberalised downstream and there are interesting possibilities in everything from refining to service stations. Iraq is also suffering an electricity shortage and this is a priority area for the government. They are encouraging private sector involvement in the power generation and distribution business and in fact the first private power plant in Iraq is already operational and meeting all its financial targets.
Iraq needs to rebuild its infrastructure across the board. From housing to transport to energy, there will be massive construction opportunities as well as huge demand for construction materials. Lafarge has two cement plants in Iraq already and they estimate that demand for cement will grow by over 10% annually for the next several years. If you look at statistics like cement demand per capita you see that Iraq is still very low. Lower even than Egypt let alone the Gulf states so it gives you an idea of the growth potential.
Renewable energy is not a big factor in Iraq. The country does have several hydro power stations along its rivers but they meet only about 5% of total electricity demand. One of the main problems is that Turkey has built large dams upstream and significantly restricted the water flow on the Tigris and Euphrates. That, together with low rainfall in the last few years, has reduced Iraq's hydro capacity and in fact is threatening Iraq's farmers with water shortages. However, there are some interesting uses of micro hydro generators in remote villages of the mountains of northern Iraq that are far from the national grid.
There is also an interesting use of solar power in Iraq. In Baghdad and other cities the lack of electricity meant that street lights were out for most of the night. Not only did the blackout make it easier for terrorists and criminals to plant bombs and move about but the almost total darkness had a very deleterious effect on civilian morale. The Iraqi government decided to install solar powered street lamps, even though they are 7-8 times more expensive then conventional street lighting. Now the lights are on all night and this has served to reduce crime but much more important has given people another shot of confidence.
Of course because of Saddam's weapons programs and the continuing regional fear that another Iraqi regime could revive these programs in the future, I would not imagine that nuclear power will be a factor in Iraq in the foreseeable future.
Q: What is the reconstruction, real-estate and physical infrastructure opportunity?
[Zaab Sethna] Iraq has a huge lack of housing. At least 1.5 million housing units need to be built immediately just to meet current demand. The problem here is finance. There are still no mortgage schemes available to Iraqi citizens so until the government works out a system there will not be large scale housing construction. But real estate will be a huge investment area; my guess is especially for GCC developers. In the last month two Abu Dhabi state-owned developers have finalised multi-billion dollar projects in Iraq and more will certainly follow. Baghdad is a city of 5 million people that is almost completely low-rise, hardly any building rises higher than ten stories. This is a country of almost 30 million that has no modern commercial office space, almost no international standard hotels, only one shopping mall, rudimentary public transit, and so forth. Not to mention the very large pilgrimage traffic to the Shia shrines in Najaf and Karbala. I heard the Minister of Tourism say recently that 500 hotels need to be built in Najaf and Karbala to meet demand from religious tourists which is expected to grow six-fold in the next five years. Financing remains the problem with almost no source of finance within the country and few international lenders willing to take Iraq risk. Some developments in Iraq have actually been financed with 100% cash but this is obviously not a long term solution. The Iraqi government will need to be creative and proactive in coming up with financing options that make sense to lenders and developers. I was pleased to see that the National Investment Commission has hired one of the biggest international accounting firms to provide advice on financing options for the Iraqi housing market.
Q: What is the opportunity in telecommunications and technology?
[Zaab Sethna] Iraq is the fastest growing, most competitive and most lucrative telecom market in the MENA region. There are currently three GSM carriers in Iraq but penetration is still in the range of 60-70% so there is definitely room for growth. Also the service is extremely poor and certainly an operator that was able to offer better service would capture large market share. There is a fourth GSM licence which is held by the state-owned telecom ITPC but they do not have the capital or technical know-how to build and operate a network. They are looking for international operators as JV partners to build a fourth network. There is currently no broadband service in the country but fibre links with neighbouring countries are being established and some private companies are already operating in this sphere. This is an excellent opportunity and the first companies to move into this market will do very well. There is no question that a lack of fibre backbone infrastructure is holding back economic development and I expect a boom of sorts to be set off once the national backbone is completed in the next 12 months. Because of the sanctions of the 1990s Iraq was kept out of global IT and telecom developments but now it is in a position to leapfrog straight to state of the art technologies. It is perfectly positioned geographically to become the regional fibre hub connecting Europe to the Gulf and Asia and that is what will eventually happen.
Q: What is the Agriculture & Water opportunity?
[Zaab Sethna] It is hard to believe that until the 1960s Iraq was a large agricultural exporter. Wheat, rice, barley, tobacco, lentils, fruit and vegetables were all exported from the centre of the so-called 'Fertile Crescent'. Now after two generations of a heavily oil-dependent economy overlaid with socialist planning and then the corruption of the UN Oil For Food programme, Iraq does not export a single agricultural commodity not even the dates for which it is famous. Iraq has become a major food importer. We have seen a number of interesting agribusiness plans in Iraq for things such as dairy plants, poultry farms and even cattle herds. Bottled water is another growth area. Imagine that Iraq currently imports bottled water and other beverages from Saudi Arabia, Kuwait and the UAE- the Biblical 'Land of Two Rivers' forced to bring water from 'The Empty Quarter'.
The revival of agriculture is a priority for the government but as yet they have not taken necessary steps to help farmers. It will require coordinated government action and foreign investment to revive Iraqi agriculture but of course the potential is there. I would not be surprised to see UAE companies investing heavily in Iraqi agriculture as a measure to insure food security in their country. It is possible you could see some kind of production sharing agreements for agriculture between foreign investors and Iraq.
Q: What are the consumer and business services opportunities?
[Zaab Sethna] All services are currently at a low level of development in Iraq. The banking system is primitive, medical care is substandard; there are virtually no distribution or logistics networks. Iraqi consumers have not even begun to scratch the surface of the possibilities that are available in other countries.
We see services as an excellent way to invest in Iraq and take advantage of the future growth. For example we have financed Iraq's best and most modern construction equipment rental company. This is a good way to benefit from the coming infrastructure, construction and oilfield development boom, the same with financial services. Iraq needs modern technologically advanced commercial banks and insurance companies and asset managers. We are involved in all of these areas.
Q: What is the state of banking and investment infrastructure in Iraq? and what is your view on the currency?
[Zaab Sethna] The banking sector is dominated by state-owned banks which are reminiscent of the Soviet Union for their levels of efficiency and customer service. It can take weeks to clear a cheque, there are no ATM's, and most damaging is that the banks do not really lend. For businessmen and entrepreneurs there is essentially no source of financing in the country. A dynamic well-capitalised bank based on technology and customer service will be able to capture significant market share.
The Iraqi dinar has been remarkably stable and is one of the success stories of the last few years. The Central Bank keeps a sort of unofficial peg against the dollar although the dinar is a free floating currency. As the oil sector develops and petrodollars start to flow into Iraq we can imagine that the currency will appreciate.
Q: How do you invest?
[Zaab Sethna] We invest in both public markets and private equity. We have a fund called “Iraq Investment Partners I” that invests in the Iraq Stock Exchange The ISX has no restrictions on foreign ownership and since they moved to electronic trading in the last few months volumes have increased hugely. The ISX was one of the best performers in the world last year which is very impressive since almost every market was significantly down in 2008. Since Jan 08 Iraq is up about 16% while emerging markets equities are down about 22%. It is still a small market with total market cap of around $2.5 billion and extremely low liquidity. But it is an easy way for investors to get long Iraq.
However the more important aspect of our business is direct investments in Iraqi companies that are not listed, including some that we are building ourselves as new ventures. I mentioned the equipment rentals company that we have built and our efforts in financial services. We are also involved in oilfield services, telecoms and construction materials.
Q: How do you manage and measure risk?
[Zaab Sethna] Iraq is a country that is undergoing two transitions at the same time- from centrally planned economy to free market and from war and occupation to post-conflict. Add to that a decade of the strictest sanctions regime ever established by the international community and that certainly makes for a risky environment. Besides the obvious security risks there is still a certain amount of political uncertainty as well as the longer term question of the Kurds' future in Iraq. There are also the standard risks associated with transition and frontier economies- corruption, stifling bureaucracy, weak institutions.
We employ a combination of factors to mitigate risk. We use Iraqi security firms for physical security, we use enhanced due diligence when looking at investments, we use local and international insurance--there is a lot available--for our assets. Most important of all is our local knowledge and presence. Nothing substitutes for local knowledge in emerging markets investing and this is an area where our firm certainly has a competitive advantage. With our office in Baghdad and longstanding links with Iraqis in many different walks of life we have a feel for the place that only comes from years of involvement.
Q: What kind of returns can investors expect from Iraqi markets?
[Zaab Sethna] The biggest mistake potential investors make is to approach Iraq as some kind of Klondike where there are untold riches available with little effort. There has definitely been a gold rush mentality associated with Iraq, especially in the first few years of the US occupation and its successor government when official corruption was rife. We look at Iraq from the standpoint of a long term relationship not a get rich quick scheme. We like projects with a 12-18 month capital payback period and then an IRR in the 30% range. If you have the patience, courage and perseverance to stick it out in Iraq then yes there will be outsized returns, but it will not come easy.
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Regardless of any political rhetoric, we can see, through the commentary of those engaged on the ground in Iraq such as Northern Gulf Partners, the situation is improving.
An important measure of the state of a country is human development, and rights. The Commission for Human Rights, in 2002 condemned President Saddam Hussein's government for its “systematic, widespread and extremely grave violations of human rights and international humanitarian law” demanding that Iraq immediately put an end to its “summary and arbitrary executions... the use of rape as a political tool and all enforced and involuntary disappearances”. During Saddam’s rule, full political participation was restricted to only members of the Arab Ba’ath party (just 8% of the population), citizens were not allowed to assemble unless in support of the government, and the movements of citizens was heavily taxed and monitored. Many hundreds of thousands of people were brutally tortured or killed as ‘punishment’ for violating these arbitrary restrictions, and tactics including forced disappearances, the destruction of food sources, and the widespread use of chemical and biological weapons against non-combatants.
The situation in this regard now is vastly improved, but the facts do remain that we are dealing here with a country which is just emerging from a very serious conflict (which brings ancillary risks), and a country which is still paralysed by a macro-economic shock which has forced its citizens back to subsistence.
From other conflict situations worldwide, we have also seen that economics is not only one of the key drivers for war, but for peace. As countries become economically unviable, for whatever reason it may be (climate change, politics), you see an inevitable propensity for the population to drift into conflict as competition emerges for scarce resources such as food, water and energy, and we revert to anthropological safety behaviours such as grouping (leading to gangs, terrorist groups, extremists). For rogue leaders, economics also gives leverage to control a population, reducing their mobility to a stage where they are fundamentally captive (as you see in North Korea now). A study released by Oxfam in 2009 also supports this view, finding that, "Seventy per cent of Afghans surveyed see poverty and unemployment as the major cause of the conflict in their country"
We have seen first hand in many African nations the power of economic growth to bring peace and opportunity, simply looking at the changes in Nigeria, Zimbabwe and Botswana (for example) shows that as populations become more economically empowered, with the right political infrastructure, economies can grow rapidly, and the sense of conflict decreases as populations, regardless of their political or religious beliefs, begin to fight towards a common economic goal, in which they all participate.
Rebuilding Iraq thus becomes not only an obligation of the international community to the people of Iraq, but a uniquely exciting and humbling opportunity for investors engaged in this reconstruction.
We are fundamentally faced with blank-slate economy, with huge resources (predominantly in the form of oil and potential agriculture) and an educated population who are hungry for change and have waited long enough to get it.
For investors, whether participating in individual sectors (such as energy, telecommunications, real-estate, or infrastructure), participating through exchanges and funds on broader positions, or joint venturing with international agencies engaged in the reconstruction of schools, hospitals and the like, the fundamentals remain attractive. We have a country which will experience (mid to long term) strong, resource backed growth, generating significant national, commercial, and consumer wealth.
When we combine this potential growth with a highly mobile and interconnected global economy, we can see that perhaps the world needs Iraq, as much as Iraq needs the world; and that partnership is the fundamental basis for this opportunity.
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