Identifier
Created
Classification
Origin
05BAGHDAD3876
2005-09-19 15:28:00
CONFIDENTIAL
Embassy Baghdad
Cable title:  

THE IRAQI BUDGET DILEMMA - TOUGH CHOICES

Tags:  EFIN ECON ENRG EPET MOPS MARR PGOV PINR IZ 
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C O N F I D E N T I A L SECTION 01 OF 03 BAGHDAD 003876 

SIPDIS

E.O. 12958: DECL: 09/19/2015
TAGS: EFIN ECON ENRG EPET MOPS MARR PGOV PINR IZ
SUBJECT: THE IRAQI BUDGET DILEMMA - TOUGH CHOICES

REF: BAGHDAD 3805

Classified By: CHARGE D'AFFAIRES DAVID M. SATTERFIELD FOR REASONS 1.4 (
b) AND (d).

C O N F I D E N T I A L SECTION 01 OF 03 BAGHDAD 003876

SIPDIS

E.O. 12958: DECL: 09/19/2015
TAGS: EFIN ECON ENRG EPET MOPS MARR PGOV PINR IZ
SUBJECT: THE IRAQI BUDGET DILEMMA - TOUGH CHOICES

REF: BAGHDAD 3805

Classified By: CHARGE D'AFFAIRES DAVID M. SATTERFIELD FOR REASONS 1.4 (
b) AND (d).


1. (C) Summary: Iraq faces hard choices on its budget, with
difficult policy considerations for the USG. Iraqi ability
to meet expenditure needs for normal functions,
reconstruction, and security are severely constrained.
Funding estimates for security needs have risen
substantially, with "high estimates" largely linked to
sustainment costs, not weapons procurement. The ability to
ramp up energy output, hence revenues, is hindered by attacks
on infrastructure and a limited ability by the GOI to proceed
with capital investment projects. Subsidy reform is on the
table, but only modest (at best) alterations appear likely,
absent political will from the GOI, lack of administrative
preparation, and no public education on the subject.
Finally, political concessions in the draft Constitution to
regional interests have muddied the waters regarding revenue
sharing. The Iraqis will need to address this last point
themselves. We are prepared to engage them on these issues.
End summary.

--------------
An Exploding Security Budget
--------------


2. (C) Minister of Finance Allawi is beginning to understand
that his politically difficult 2006 budget intention to
reduce food and fuel price subsidies by 25 percent next year
-- in hopes of achieving a $2 billion savings in order to
increase by nearly 50 percent Iraqi MoD/MoI expenditures,
from $2.5 billion to $3.6 billion -- will not be met. We
have informed him that we believe that 2006 budget security
costs will range between $7 billion and $11 billion,
depending on GOI sustainment costs. Another wildcard is that
the current ministers of defense and interior have expressed
interest in expanding their respective force levels, the
Ministry of Defense (MoD) modestly and the Ministry of

Interior (MoI) significantly. These issues have not entered
into the Iraqi political debate; nor is it clear that that
they will before the December elections. It should be
emphasized that neither "high" nor "low" security budget
projections include significant new weapons systems.


3. (C) Informally, Allawi has told us that under an
optimistic assumption of sustained high oil export revenues,
the GOI could possibly find an extra $3.4 billion for the $7
billion-plus security package. He remains skeptical that
either MoI or MoD can absorb the demands that this extra
money would place on them. In addition, he remains committed
to avoiding security budget leakage, such as resulted in an
apparent $1 billion shortfall in defense accounts in
2004-2005, a scandal now coming to light that seems to
implicate the previous government.

--------------
Tough Economic Reforms Without a Net
--------------


4. (C) Allawi strongly believes that some kind of social
safety net must accompany implementation of subsidy reforms
to provide political credibility. Previously, he favored
limiting the food basket to essential items only (i.e.
ridding it of soap, for example),regardless of his larger
reform plan. The Ministry of Labor and Social Affairs
(MOLSA) also is interested in establishing a safety net
program, albeit with a poverty-reduction focus. Common to
both proposals is a desire to mitigate the situation of the
most vulnerable members of Iraqi society. USAID contractors
have begun to do some work for MOLSA in this area and suggest
that some kind of safety net can be developed to protect the
poorest sector of Iraqi society by either 2007 or 2008 at a
cost of about $333 million. (Note: We have not seen anything
in Allawi's proposed 2006 budget that would allocate money
for a safety net. End note).

--------------
Changing the Form is Not Reducing the Subsidy
--------------


5. (C) Allawi told us just before his departure for IMF
discussions that he is contemplating a scheme by which a
reduction of the food and fuel subsidies would be offset by a
stipend of $200 given to each Iraqi citizen (the "Alaska
model"). (Comment. Although this proposal serves a GOI
political imperative, it does not address the GOI's
fundamental budget imbalance. Furthermore, Iraq is hardly in
a position to issue its citizens a dividend, no matter the
form, when it is in such dire fiscal straits. End comment.)

-------------- --------------
MO's Ability to Increase Oil Output in 2006 in Doubt
-------------- --------------


6. (C) The Ministry of Oil's (MO) ability to increase oil
revenue in 2006 will be directly affected by world oil
prices. Benefits gained from increased oil revenue must be
weighed, however, against the MO's failure to maintain,
modernize, or protect its critical infrastructure. Its
failure to do so invites a repeat of the situation in summer
2005, when failures in domestic production and refining
caused an unanticipated increase in fuel imports from Turkey.
While the MoF recently paid Iraq's arrears to Turkish oil
companies that had accrued during the first half of 2005, the
MO and MoF agreed in August that projected import expenses of
roughly $1.2-$1.6 billion for the remainder of the year would
be covered from the virtually unused $3 billion MO capital
budget.


7. (C) The MO has left largely untouched its 2005 capital
budget due to an apparent procedural misunderstanding of how
the funds would be released: the MO is waiting for the funds
to be transferred to its account before drafting proposals,
while the MoF is awaiting submission of MO projects approved
by the inter-ministerial committee on budget expenditures
before providing funding. Although the procedure was
clarified in May, the MO acknowledged that it was too late in
the year to develop a full slate of sound and responsible
projects. The MoF subsequently authorized the MO to spend
$1.8 billion on infrastructure security (including funding
for the first four Strategic Infrastructure Battalions or
SIBs),as well as on a small number of capital projects.
Given the few months remaining in calendar 2005 and the
Ministry's weak capacity to draft tender documents and
arrange letters of credit, it is highly unlikely that the MO
will succeed in spending the entire sum of $1.8 billion
remaining in this account.


8. (C) The MO's inability to make best use of its capital
budget is especially troubling, given that the rate of
pipeline failures has kept pace with the already considerable
rate of insurgent interdictions. The Kirkuk-Bayji 40" line,
for example, has suffered a series of failures that have kept
it off-line for over two weeks. Although the incidents
remain under investigation, the Chief of the Infrastructure
Coordination Cell reported to DPM Chalabi September 12 that
his investigation indicated that the initial breach in early
September had been due to a poorly-implemented repair. The
insurgency appears to have caused yet another break in the
line on September 19. This latest break starves the
already-depleted Bayji refinery of crude oil, putting the
plant out of service for no less than a week as it is now
necessary to conduct a "cold start." Although a second 40"
pipeline is expected to come into service in the first
quarter of 2006, without substantial additional investments
in security, this line too is likely to be rapidly and
prematurely weakened by repeated insurgent attacks.

--------------
Oil and the Constitution
--------------


9. (C) The Constitution, in its most recent draft, creates
budgetary ambiguity while it attempts to solve the
regional/sectarian-based conundrums of resource sharing. The
document addresses Iraq's petroleum resources on three
distinct levels: ownership, management, and disbursement of
funds. Regarding ownership, Article 108 (109 in a previous
draft) reaffirms TAL language that "oil and gas are owned by
all the people of Iraq in all the regions and
governorates."


10. (C) According to article 109 (110 in a previous draft),
the federal government is charged with distributing revenue
fairly, in proportion to the population distribution in Iraq,
and setting aside for a defined period of time special
allotments for "damaged regions that were unjustly deprived
(of such revenue) by the former regime, and the regions that
were damaged afterward in a way that ensures balanced
development in different areas of the country." This
language is ambiguous, but may imply distribution to
subnational units based on their proportion of the total
population. The special allotment for damaged regions may
mean temporary special disbursements for the Kurdish and Shia
areas. Ultimately, the constitution merely postpones a
decision until the next national assembly by stipulating that
the assembly shall pass a law on how such revenue sharing is
to be accomplished. The assembly may set a permanent formula
(we can imagine the Kurds seeking this) or may determine a
one-time allocation of a fixed amount (Iraqi federalists
would likely prefer this option).


11. (C) Article 109 also stipulates that "(the federal
government, with the producing governorates and regional
governments, shall undertake the management of oil and gas
extracted from present fields..." By referring only to
present oil fields, this provision implicitly distinguishes
between the management of existing fields, in which the
federal government takes the primary role, and the undefined
management rights over still to be discovered fields. The
central government is charged with developing a policy for
future oil and gas resources, together with the regional and
governorate authorities. However, it is possible that a
contest between the regions and the center for control could
develop, despite the constitution's goal of compelling the
central government and the regions to seek a political
approach that will include some form of revenue sharing. The
regions and governorates could also take this provision as
encouragement, to put their resources into developing new
fields, where they may have more influence, to the detriment
of re-working existing fields. Similar difficulties may arise
where fields are not clearly in any one region's control.


12. (C) Finally, because the draft constitution contemplates
that some elements of the oil and gas sector will be subject
to shared authority, special provisions govern when conflict
between federal and non-federal regulation arises. Should a
dispute emerge between the federal government and a
governorate, for example, over an issue in which power is
shared, Article 111 states that priority will be given to the
regional law. Article 117(2) seemingly makes similar
in-roads on federal authority, providing "in the case of a
contradiction between regional and national legislation in
respect to a matter outside the exclusive powers of the
federal government, the regional authority shall have the
right to amend the application of the national legislation
within that region." Nevertheless, the oil and gas
provisions in the constitution still establish substantive
standards, i.e., fair distribution, balanced development,
highest benefit to the Iraqi people, that are presumably
applicable to whichever governmental entity is regulating.


13. (C) Clearly, there are budgetary implications here with
which Iraqis have yet to grapple. Moreover, given that these
issues remain highly controversial, they ultimately may land
at the federal Supreme Court, whose authority includes
issuing decisions on disputes between regions and between
regions and the central government. The Embassy is entering
into broad interagency discussions to better define any
potential pitfalls in the economic sphere further down the
road. In the months following the Constitutional referendum
and election, we will engage the Iraqis on the points
outlined above.
Satterfield