x Abu Dhabi, UAESunday 21 January 2018

Opportunity for piece of Iraq in our time

Mark A DeWeaver: Cold investment wisdom states one should buy when there is turmoil in the streets. Iraq's bloodiest phase seems over and the business climate is inviting.

Many fund management companies are marketing the war-torn country to clients.
Many fund management companies are marketing the war-torn country to clients.

It is easy to understand why Iraqi stocks are not on the radar screens of most foreign fund managers at the moment. While the third Baron Rothschild advised buying "when there's blood in the streets", no one wants that blood to be their own.

And Baghdad, which is home to the stock exchange and most of Iraq's brokers and listed companies, remains a scary place to visit. But conditions of travel for the investor are not really the best indicator of when it is safe to invest. A more relevant signal is the fall in the number of Iraqi civilian deaths caused by violence. At the height of the insurgency from mid-2006 to mid-2007, Iraq Body Count put the death toll at between 2,500 and 3,000 a month. So far this year, the monthly toll has been between 200 and 300.

While no one would argue that this is an acceptable state of affairs, it tends to be during such transitions from the absolutely appalling to the awful that the big money in emerging markets gets made. Naturally, things could get worse again. But this seems unlikely for the simple reason that restarting the sectarian civil war is not really in anyone's interest. The Sunni insurgents effectively lost in 2007 and have no reason to expect a different outcome today. The Shia have found that political power is more likely to stem from the ballot box than the barrel of a gun, turning chairman Mao's famous dictum on its head.

And the Kurds are clearly better off as part of a unified Iraq than as citizens of an independent state that neither their neighbours, nor presumably the US, would recognise. The threat from al Qa'eda-linked extremists seems to be receding as well. They no longer appear to have the capability to stage monthly mass-casualty bombings. Recently their attacks have occurred only every other month. And the deaths of the leaders of al Qa'eda and the Islamic State of Iraq at the hands of Iraqi and US forces last month may well emerge as a turning point in the government's "war on terror".

Equally important for stock market investors has been the drop in the Iraqi inflation rate, from 65 per cent in 2007 to 6.8 per cent last year. Year-on-year core inflation for February was just 3.35 per cent. The currency has strengthened significantly as well - from 2,354 Iraqi dinars to the US dollar in April 2003, in the middle of the invasion, to 1,170 today. This made it possible for the central bank of Iraq to lower its benchmark overnight rate from 20 per cent in 2007 to 7 per cent by the end of last year. Effective as of April 1, this rate was cut again, to 6 per cent, while at the same time the required reserve ratio was reduced from 25 to 20 per cent.

This is a percentage of deposits that commercial banks are required to hold as reserves at the central bank. Cuts in the central bank's benchmark interest rate are particularly significant because cash, rather than loans, continues to be the biggest asset of the Iraqi banks. Their main operating businesses consist of charging fees for services such as wire transfers. Since there is little lending, either inter-bank or to non-financial companies and individuals, reserves held at the central bank are the banks' main source of interest income. Lowering the benchmark rate reduces this income, thereby forcing them to lend more to maintain their income from interest.

While much of the rest of the world continues to deleverage, in Iraq the trend is to the opposite direction - from a state of practically zero leverage to one where the banks play their normal role as financial intermediaries. This is clearly positive for the stock market because a general increase in the supply of credit naturally means more funds will be available for local investors to buy shares - either because they buy with borrowed money or because taking out loans frees up their existing cash holdings.

Iraq is sitting on vast reserves of low-cost oil, which after three decades of war and sanctions remain largely unexploited. Since June of last year, international oil companies have won bids to develop more than 10 million barrels per day (bpd) in additional capacity. Added to production of 2.6 million bpd last year, this new supply would allow Iraq to surpass Saudi Arabia as the world's biggest producer.

While the oil ministry is hoping to get to this point in six years, many believe such a timetable is unrealistic. It does not, for example, allow enough time to build the pipelines and other facilities needed to transport such an enormous amount of oil. But even a doubling of Iraq's oil output would still lead to a boom not unlike those experienced by the OPEC countries (including Iraq itself) in the 1970s.

The resulting fiscal surplus would quickly make its way into the economy through tax cuts, subsidies, and an increase in investment and salaries at state-owned enterprises, which account for the lion's share of Iraqi employment. The effect on the stock market would be explosive. Rising oil exports would have a direct impact on the supply of funds available to speculators as repatriated US dollar revenues were converted into local currency.

At the same time, listed company profits and dividends would rise rapidly as Iraq began a dramatic ascent from poverty to affluence. The combination of reduced violence, increased leverage and an impending oil windfall would seem to be ideal for Iraqi stocks. So far the market remains becalmed: the index is still at 2007 levels, recent daily trading values have been only about US$1 million (Dh3.6m). But things could easily pick up long before the banks start lending or the new oil begins to flow.

Already a number of fund management companies are said to have started marketing the Iraq story to potential clients. It is an easy story to tell - a crisis is ending and an export boom is beginning. And while there is no way of knowing how much they will raise, in a pool of liquidity as small as the Iraq Stock Exchange, even a relatively small inflow will seem like a surge. Mark A DeWeaver manages Quantrarian Asia Hedge, a hedge fund.