Iraq Through Investors' Eyes

October 03, 2010


Companies expect the improvements in security to come from non-military sources, now that US forces have ceased formal combat operations. Companies cite job creation through investment as
among the factors that could bring stability and thereby improve security.
While security remains an overriding concern, investors are also focused on other factors of the business environment, including general governance and management of corruption.
Several of our interview partners commented that security risks should be placed in perspective.

Zaab Sethna, head of the Baghdad office at Northern Gulf Partners, a US investment advisory firm focusing on Iraq, says that security is top of a list of obstacles, but that ‘’security is a manageable risk”. This sentiment is shared by Kyle McEneaney, manager of the Middle East practice at Ergo, a US-based consultancy: ‘’Security matters. Whether the risk is real or perceived, it constrains business.” Mr McEneaney believes that security risks can be mitigated, but that the costs remain high “and Iraq is an information-poor environment”. And as Alessandro Varelli, general director for International Project Development at Technital, an engineering firm based in Italy that has won a contract to develop the al-Fao peninsula into Iraq’s biggest port, points out: “There is a tremendous market; we only expect
security problems in the short term.”

“Iraq is a difficult place to do business. It’s important to keep in mind that it’s undergoing three simultaneous transitions: from conflict to postconflict; from a centralised
economy to a free market; and from the strictest sanctions ever imposed to free
--Zaab Sethna, Northern Gulf Partners

Iraq’s slow and cumbersome bureaucracy is a legacy from decades of totalitarian rule, which used the bureaucracy to ensure tight control of the population. This has meant multiple layers of procedures—for example, requirements for sign-off from several government departments for the same permit—which in turn has also produced overstaffing. On top of this, Iraq has suffered unprecedented disruptions in recent years. Many experienced civil servants have been killed, displaced or removed from office because of their perceived connections with the former Ba’athist regime. Records and equipment have been destroyed, lost or stolen. Ongoing power blackouts and security threats continue to inhibit operations. Frequent changes of ministers and high turnover of senior civil servants in the post-war period, and poor governance capacity in general, have exacerbated the situation.

The Iraqi government has recognised that excessive bureaucracy can hinder investment. The National Investment Commission (NIC), with support from the OECD, has therefore been developing a “one-stop shop” service that aims to “streamline the investing process by clarifying legislation, and improving service quality in registration, licensing, permitting and land allocation”. Whether the current reality of the NIC meets its stated remit has been called into question. Luay al-Khatteeb, the executive director of the Iraq Energy Institute based in the UK, believes “the NIC should have executive authority, but this has been curbed. It has been relegated to promotional activities”.

Investors certainly recognise the problems with bureaucracy, with almost one-third of current investors listing this among the top three risks to business operations. Mr Sethna of Northern Gulf Partners comments: “It is extremely difficult, for example, to form a company in Iraq. It needs the approval of several ministries, including the interior ministry, which takes a long time and is cumbersome. The government can take some basic steps to help streamline rules and regulations; for example, it can relax visa requirements, which are now a big impediment.”

Credit risk and financing
Credit risk is viewed as among the three top risks in Iraq by 31% of the companies to our survey, making it their fourth most significant concern (after security, corruption and poor infrastructure). Current investors are even more concerned with non-payment than prospective investors, with 37% citing it as a major risk, pushing it to third place in their concerns, ahead of infrastructure risk. None of our interviewees, however, mentioned that they themselves had faced non-payment problems, and in fact Technital, one of the companies with the longest involvement in Iraq, specifically stated that it had not faced any problems with payment. Mr Horgan of Petrel did recognise this as a potential problem. “There doesn’t seem to be an understanding that contractors need to be paid,” he explains. “Instead, they are always seen as the villain. It is a legacy of resource nationalism.” The concerns of investors in the survey may therefore be more a result of uncertainty about the political environment than specific experiences. There is probably also an issue with the timeliness of payment as a corollary of Iraq’s poor bureaucracy.

Interestingly, credit risk was also one of the major concerns for investors back in 1961, and an Economist Intelligence Unit study at the time (see Appendix) found that virtually all companies “complain of some payment difficulties…but most agree that delays are due not so much to ill-will as to inefficiency and a fear [among officials] of taking financial responsibility.”

Companies found then that applying pressure higher up the chain generally resulted in eventual payment. It is likely that a similar situation pertains today, with considerable variance depending on which government ministries and departments are the counterparties.

Separately, problems in obtaining financing remain an issue. France’s ambassador to Iraq, Boris Boillon, says “the need ’for continuous improvement in the banking sector is huge’’, as ‘’the lack of financing and the reluctance of foreign banking institutions deter companies from investing in some projects”. His government is trying to overcome the problems associated with a weak Iraqi banking sector, and thus encourage French companies to invest in Iraq, by underwriting short- and medium term credit. Mr Sethna of Northern Gulf Partners believes that many of the 36 privately owned banks currently operating in the country are heavily under-capitalised. For Iraqi businesses, the lack of credit history or credit records will also serve as a barrier to accessing finance.

Despite its favourable security situation, Mr Sethna of Northern Gulf Partners favours investment outside the Kurdish north of the country. “Our firm currently focuses on Central and Southern Iraq, as these are where we see the true opportunities. The KRG has less impediments currently, but the best opportunities have already been picked over and there is a much smaller market there (only 15% of the population, and incidentally, 15% of the natural resource base). Baghdad and Basra are where the riches lie and both are eager to attract business.”

...We expect Iraq’s real economic growth to average around 6% per year for the remainder of the decade, as government revenue, and hence expenditure, grows on the back of rising oil production, and as a growing population, with rising average incomes, supports an expansion of domestic demand. FDI inflows are also likely to surge in the coming years, as work on several large oil and infrastructure projects comes to fruition. Mr Sethna of Northern Gulf Partners agrees. “The situation will certainly improve in the medium term, and can even do so in the short term. The economic indicators point to this, FDI is up, inflation is low and manageable. However, political paralysis can adversely affect the business environment.”

Construction companies may also receive a boost from an upturn in tourism, once the country returns to stability. For example, Mr Sethna of Northern Gulf Partners highlighted the promise of the
religious tourism industry in the south, noting that “Najaf and Karbala alone need 500 new hotels immediately to cater to the current influx of pilgrims”. He added that the number of pilgrims from Iran is expected to rise to 3m per year “within the next few years”. A number of Kuwaiti firms are already investing in hotels and other tourism infrastructure.

Iraq currently has 36 privately owned banks, many of which are small and under-capitalised. According to Mr Sethna of Northern Gulf Partners, “There is no real culture or history of lending in Iraq. Many of the companies we speak to tell us they have no debt on their books.” This, however, is expected to change in the medium to long term. Having been almost entirely ostracised from the international community for over a decade, Iraq’s banks are not starting to offer services that are taken for granted elsewhere. The Central Bank of Iraq, for its part, has taken measures to improve the performance of the sector, and on September 1st this year cut commercial banks’ reserve requirement from 20% to 15% in its efforts to spur lending. This follows an earlier decision by the bank to increase the minimum capital requirement to ID250bn (US213m) within three years, up from ID50bn (US$43m), to force undercapitalised banks to merge into stronger entities.

Mr McEneaney of Ergo believes that ‘’knowledge of the local landscape, and havingthe right local partner to navigate it, can go a long way towards ensuring success’’. Mr McEneaney also highlights the importance of having some appetite for risk, as well as access to capital (given the weakness of the domestic financial institutions).

These sentiments were echoed by Mr Sethna of Northern Gulf Partners, who points out that “picking the right partner is key to success in Iraq”, and that “the best ‘risk mitigator’ in Iraq is information”.

Mr Sethna agrees: “It is important to pick a partner with local knowledge and, vitally, contacts, and a presence on the ground. Companies need a partner that can adhere to their standards of compliance.”