Infrastructure report

Industry Forecast

Construction And Infrastructure Forecast Scenario

BMI View: Despite significant ongoing political and security risks, our outlook for the Iraqi government to be nearing a fiscal strength to prioritise reconstruction efforts remains unchanged, if significantly impacted by downside risks.

Latest Updates

• 
  We maintain our construction sector forecasts, both for 2017 and over the next five years, as the fundamental factors underpinning our outlook remain - we forecast tepid growth of 1.25% in 2017, followed by an annual average of 6.7% over 2018-2022.
  

• 
  While conflict against Islamic State (IS) is dissipating, there has been a significant increase in tensions between Baghdad and the Kurdistan Region following an independence referendum. Downside risks are growing and growth will largely relate to base effects, as opposed to any genuine improvement in the investment environment.
  

• 
  Iraq's weak but improving fiscal position will ensure that the country remains reliable on donor funding for the foreseeable future. In this vein, it was announced in July that the World Bank will support post- Mosul reconstruction efforts with a USD350mn financial assistance package targeting basic infrastructure.
  

• 
  Although Iraq needs investment across the infrastructure spectrum, we expect that the economic importance of the oil sector will ensure that oil-related infrastructure remains a focal point. Illustrating this trend, it was announced in May 2017 that Iraq's oil ministry had authorized the construction of a refinery in Kirkuk at a cost of USD5bn.
  

Table: Construction And Infrastructure Industry Data (Iraq 2016-2026)

Construction industry	2016e 13,251	2017f 13,735	2018f 15,459	2019f 17,386	2020f 19,335	2021f 21,470	2022f 23,637	2023f 25,897	2024f 28,276	2025f 30,880	2026f 33,733
value, IQDbn
Construction Industry Value, Real Growth, % y-o-y	-4.40	1.25	8.75	7.47	6.21	6.04	5.10	4.56	4.19	4.21	4.24
Construction Industry Value, % of GDP	6.6	6.3	6.6	6.7	6.7	6.8	6.9	6.9	7.0	7.0	7.1

e/f = BMI estimate/forecast. Source: National sources, BMI

Structural Trends

2017-2021: Better But Not Good

We are cautiously optimistic that Iraq's construction market will emerge from a period of volatility following years of conflict and return to broad-based, diversified growth. We project that construction sector value will expand by an annualised average of 5.9% out to 2021, as Iraq's improving fiscal position allows the state to invest in reconstruction projects spanning the country's infrastructure spectrum. Having said that, we caution that our outlook is predicated upon the maintenance of relative stability in Iraq, and though we do not anticipate a return to large-scale sectarian conflict in the near future, the volatile nature of Iraq's political and security situation ensures that risks are established firmly to the downside.

Not least of which is growing tension between Baghdad and Erbil, the capital of the Kurdistan Region, a key component of Iraq's overall oil production. In late September, people in northern Iraq (Kurds and non- Kurds) voted in favour of independence for the Kurdistan Region in a referendum, which was not recognised by Baghdad. Following failed negotiations between the Iraqi central government and the Kurdistan Regional Government (KRG), the Iraqi Security Forces (ISF) launched a military operation in Kirkuk (not part of the Kurdistan Region, but governed from Erbil after Kurdish Peshmerga forces ousted the ISF) to retake oil facilities and federal installations on Sunday October 15. A few hours after the start of the operation, various reports announced that the ISF had retaken the headquarters of the North Oil Company and the K1 military base in the surroundings of Kirkuk, and that some Iraqi troops had entered the city. While we believe that the operation will not necessarily translate into a full-scale conflict between the two entities, we do note that the risks of such a scenario playing out have dramatically risen (see Rising Risks Of Prolonged Conflict In Iraqi Kurdistan, October 16).
Meanwhile, an ongoing but gradually dissipating risk will come from Islamic militants, who continue to pose a security threat, but we believe that it will be limited to sporadic terror attacks. As a result of the central government taking back control of this territory, the displaced population (3mn Iraqis out of 33 million) will return home. This will create an environment more conducive to private consumption - it will be easier for public servants to receive their salaries for example - and we therefore expect to see household spending increase over the coming quarters.
Clearer upside risks to investment driven growth stem from global oil prices recovering durably in 2017 to average USD53.5bbl (compared to USD45bbl in 2016), Iraq and the IMF signing a USD5.3bn stand-by agreement in July 2016, the country increasing gas capturing for power and exports, and seeking to expand oil production through smaller fields to reduce reliance on large fields and their operators.


Steady Growth Ahead Following Years Of Volatility

Construction Industry Value, IQDbn & Real Growth, % y-o-y
75 30,000

50

20,000

25

0

2006


2007


2008


2009


2010


2011


2012


2013


2014


2015e


2016e

-25

10,000

2017f


2018f


2019f


2020f


2021f

0

Construction industry value, IQDbn

Construction Industry Value, Real Growth, % y-o-y


e/f = BMI estimate/forecast. Source: National sources, BMI

External Factors Underpinning Construction Growth

Iraq's growing ability to finance a variety of infrastructure projects will rest upon a gradually improving fiscal position, though the pace of improvement will be hindered by lower-for-longer oil prices. While conversely, spending cuts will prove politically difficult to implement, with the need to rebuild infrastructure after years of conflict a significant pressure on the country's deficit. In this context, we have revised our forecasts for Iraq's budget deficit to 8.1% in 2017 and 8.2% in 2018, from 7.8% and 6.5% previously.(see chart below).

Nevertheless, a steadily reducing deficit will be positive for infrastructure investment and driven by:

• 
  Rising Oil Prices: Our Oil and Gas team forecasts that the price of Brent will rise steadily to USD72 per barrel by 2021; concurrently, we expect Iraq's production of crude to grow to 5.1mn barrels per day over the same time period, up from 4.5mn in 2017. With oil accounting for well over 90% of federal revenue in 2014, the combination of higher volumes at higher prices will provide a significant financial windfall for the government.
  

Rising Oil Price Lifts Fiscal Outlook

Iraq - Budget Balance, % Of GDP & Brent Prices, USD
125 10
5

100
0

75

-5
50

-10

2010


2011


2012


2013


2014


2015e


2016e


2017f


2018f


2019f


2020f


2021f

25 -15
Budget balance, % of GDP (RHS) Brent, USD/bbl (LHS)


e/f = BMI estimate/forecast. Source: IMF, BMI

• 
  Donor Funding: Iraq remains heavily reliant upon inflows of donor funding to finance its budget deficit
  

- given the country's perceived importance to the stability of the broader region, we expect donor aid from a variety of stakeholders to continue to flow for the foreseeable future. We have previously highlighted a bilateral USD10bn loan extended by the British government expressly for the purpose of investing in infrastructure, with the stipulation that contracts be awarded to British firms (see, 'British Firms Major Beneficiaries Of Bilateral Infrastructure Loan,' March 7 2017). On a multi-lateral level, we note that the International Monetary Fund (IMF) approved a USD5.3bn loan in July 2016, which will be disbursed over the following three years.


External Assistance To Fill Part Of The Gap

Iraq - International Financial Contribution Pledges, USDbn
5,000

4,000

3,000

2,000

1,000

0

2017 2018 2019

^IMF ^World^Bank	^USA	Germany	Japan	France	UK
^Italy ^Canada	EU

Source: IMF, BMI

Infrastructure Growth To Be Broad-Based

Iraq's improving fiscal situation will afford the central government - the main financier in the country's infrastructure space - the necessary breathing room to accelerate the reconstruction of the country's infrastructure, which has suffered significantly in terms of disruption and underinvestment following the 2003 invasion of Iraq. Although the scale of Iraq's investment needs across infrastructure segments will ensure that various sectors stand to benefit, we expect that short-term growth will be concentrated in:

• 
  Industrial Construction: A series of high profile investments relating to Iraq's vital oil and gas sector will drive value creation in the country's industrial building segment, as the country seeks to ramp up production in the coming years. In this context, we highlight ongoing construction associated with the USD6bn Karbala Oil Refinery and the USD879mn Badra Gas Separation Plant Project. We note also that in light of a recent government decision to explore new contract models that would make hydrocarbon- related investments more attractive to outside investors, risks to our outlook in the industrial construction sphere are skewed to the upside. On a regional basis, we expect that private, oil-sector investment will in large part flow to the relatively stable Shiite south, as security and political headwinds continue to weigh on Kurdistan's attractiveness as a competing investment destination.
  

Urbanising Population Fueling Structural Infrastructure Demand

Population, mn & Urban Population, % Of Total
100 80

77.5

75
75

50

72.5

25

70

0

2005 2010 2015e 2020f 2025f 2030f 2035f 2040f 2045f 2050f

^{Population, mn (LHS) Urban population, % of total (RHS)}
67.5

e/f = BMI estimate/forecast. Source: National Sources, BMI

• 
  Energy & Utilities: Reconstruction efforts will boost growth in Iraq's energy and utilities sector in the short-term, particularly with regard to gas-fired power plants, with projects like the USD2.5bn plant at Rumaila, a USD1bn plant in Al Anbar, and the USD550mn plant in Diyala Governate all currently under construction. Over the long term, Iraq's young and growing urban population will stoke demand for additional infrastructure investment. Accordingly, there are a variety of high-profile projects currently in the planning phase of the construction pipeline as the government seeks to address long-term demand, including the USD10bn Common Seawater Supply Facility Project and the USD3bn Bismayah Combined Cycle Power Plant Project in Baghdad.
  

Long-Term View: Unpredictable Variables Means Growth Not Assured

Our seemingly healthy forecast is in the context of growth recovering from a negative base and the extent of reconstruction and upgrading required throughout the country, which, if growth were to be maximised, would exceed this figure easily for a decade. But our cautious and flat growth view is underpinned by the uncertainty surrounding the future trajectory of the country.

Long-term investment commitments will be required, but will be difficult to secure in such a volatile environment. Should the security situation improve in earnest, physical, financial and governmental

infrastructure will remain inadequate for some time. After three years of economic recession, we expect Iraq's real GDP growth to turn positive in 2017. Yet the country still suffers from major structural issues that will prevent a boom in economic expansion. Indeed, we have decreased our forecast for real GDP growth in 2017 from 2.3% to 1.4%, and in 2018 from 4.4% to 3.1%, due largely to risks relating to rising tensions between Baghdad and the Kurdistan Region since the independence referendum in September that saw 93% of voters seeking Kurdish secession and the subsequent military action by the ISF in Kirkuk.

Furthermore, the status of Iraq as a single entity is by no means assured, which will deter investors from striking deals with institutions which may not be valid in a few years. BMI's core scenario, following a protracted period of conflict, is for the emergence of a fragile Iraq that will be federalised along sectarian lines, with a majority Sunni entity in the north, a majority Shi'a entity in the south, and a Kurdish region in the north east. Although the formal unity of the country will be maintained, levels of violence will remain elevated for several years and the governance of the north will remain a major problem. A significant risk remains, however, that the country will disintegrate entirely, resulting in the emergence of three new states.

Kurdistan's Shine To Dull

After more than a decade of boom, we believe that Iraqi Kurdistan has entered a protracted period of slower economic growth. Low oil prices, substantial political tensions within the KRG and between the KRG and Baghdad, widespread corruption, and elevated insecurity will drag on economic activity and prevent the implementation of necessary reforms to diversify the Kurdish economy away from oil and the public sector.

For some time, owing to the relative peace and prosperity comparative to the rest of Iraq, the Kurdish north east has been a safe haven. Kurdistan, seen as a stable, investor-friendly region without many of the risks affecting the rest of Iraq, has subsequently witnessed a boom in the residential and non-residential construction sector - particularly for hotels and commercial real estate. Tourism has also been a key driver of this growth, attracting many visitors from Iran and Turkey, as well as Europeans and Americans.

However, the Iraqi Kurdistan's economy has been substantially impacted by the slump in oil prices since the summer of 2014. Growth in Iraqi Kurdistan is fuelled by spending from the regional government - the public sector employs more than 50% of the region's labour force, and public spending accounted for more than 50% of nominal GDP in 2015 - which is funded by revenues from oil sales. The lower oil price environment will prevent KRG revenues from making a significant recovery and the regional government

will be compelled to push ahead with austerity measures in order to reduce large fiscal shortfalls. These will be limited, given that Erbil's previous measures have significantly increased discontent in the region.
Since 2015, Erbil has postponed investment projects, let payments to contractors and public servants fall in arrears, and cut public servant salaries by up to 75%. These measures have severely impacted household and corporate earnings (including international oil companies), and triggered widespread protests in the region, without significantly improving the KRG's fiscal situation. Between February and October 2016, the Kurdish government netted on average USD370mn per month from oil sales, while its monthly spending requirements averaged USD1bn.
The impact of the worsening business environment on foreign investment is clearest in the hydrocarbon sector, with international oil companies increasingly relinquishing exploration blocks in the region. Since early 2015, ExxonMobil, DNO, Petroceltic, Hess, Chevron, Genel and Gulf Keystone have all pulled out of investments in Iraqi Kurdistan.
Additionally, political instability, within the KRG and in its relationship with Iraqi central government, will worsen the economic outlook and the investment environment. Indeed, the independence referendum and military action by Baghdad in September-October only serves to deepen the negative outlook. Furthermore, despite the 2017 budget stating, favourably for Kurdistan, that the KRG would send 550,000 barrels of oil a day to Iraq's State Organization for the Marketing of Oil (SOMO), in return for federal funds to pay for 650,000 Kurdish civil servant salaries, it will not last even if implemented, as the KRG and Baghdad enter a period of increasing tensions. The oil-rich city and region of Kirkuk, which Iraqi Kurds have controlled since early 2014, is at the centre of tensions, with ISF gaining ground from Peshmerga held oil and military instillations in the region in October.
Additionally, relations between the Iraqi central government and the KRG will worsen as the KRG looks to international capital markets to issue debt. As Erbil pushes for financial independence from Baghdad, we expect the constitutional deal between the central government and the Kurds - under which the KRG is required to export 550,000 barrels-a-day in exchange for 17% of the nationwide budget - to come close to collapsing. In addition, The Kurdish government will become more and more assertive in its territorial disputes with Baghdad, and this will increase sectarian tensions in Iraq.
Following a much-debated law in the Kurdish Parliament passed in early June 2015 - without approval from Baghdad - the KRG will seek to raise up to USD5bn from international capital markets under the condition that the money be used to fund infrastructure projects. We expect the Kurdish borrowing rate to be significantly higher than Iraq's, as several factors increase the risk premium. In particular, the limited

economic data available for the region, which does not have a credit rating, and the reliance of the KRG on Baghdad for its budget -the Kurds would only meet 50% of their budget needs if they exported at their pipeline's full capacity - will deter foreign investors.

With uncertainty over the future status of Kurdistan at an all-time high, we expect investment to be slow, with foreign direct investment (FDI) inflows to remain restrained over the coming quarters, despite the country implementing a new investment law aimed at encouraging FDI flows. Over the longer term, the security situation will remain uncertain, hindering interest from foreign companies. However, the Kurdish region will continue to outperform the rest of Iraq and, despite the KRG's move towards greater financial independence, our core scenario is not for the country to be partitioned in future. The Kurdish strength stems from regional and international support, and its sponsors oppose an independent Kurdistan. In particular, the US - the KRG's main military ally - and Turkey, through which Kurdish oil is sold, both consider the unity of Iraq as an uninfringeable political necessity. There is little support from any regional power to redraw borders, particularly given the presence of significant Kurdish minorities in Iraq's neighbouring countries.