3. Macroeconomic Overview and Review of Earlier Findings

The results from the 1996 study show that the macroeconomic impact of sanctions have persisted with little change since 1991. In order to understand the impact of sanctions, it is important to remember how dependent the Iraqi economy is on oil. When evaluated at the market exchange rate, oil exports equalled 75% of Iraqi GDP in 1990.⁶ This overstates the importance of oil since the official exchange rate was maintained at an appreciated level compared with market rates, but even if we measure GDP using the official exchange rate, dollar oil revenues were 15% of GDP in 1990.⁷ The importance of oil in the economy would have fallen somewhere between these two levels.

These oil revenues formed the basis for Iraq's economic structure and policies. Most importantly, while fiscal accounts have not been made public, it is clear that the government was highly reliant on oil for its revenues. There are few taxes in Iraq, so the main part of revenues apparently came from oil and profit transfers from non-oil state enterprises. Iraq's oil production is managed by several large state companies, and these in turn are directly controlled by the government.

The oil revenues had been used to finance a range of investments, expenditures and subsidies. The government hired a large public service and military. Throughout the 1980s large scale military imports and soldier's salaries were financed with oil revenues.

In addition, during the 1970s and early 1980s the government built up state industry and agriculture by introducing sizeable direct and indirect subsidies. This ensured rapid growth of domestic agriculture and industry, but since it grew with the aid of subsidies and inexpensive foreign exchange, it was, in effect, highly dependent on oil revenues.

A third use of funds was to construct a broad ranging social welfare system. This included consumer subsidies for a range of food items, a state safety net and pension system, as well as substantial investment in education and public health. By the late 1980s Iraq had one of the best educational and health systems in the region.

In short, the state was a key player in all areas of the economy: production, employment, private consumption and the provisioning of public goods. Although the main factor behind this economic structure had been the state's access to substantial revenue by the export of oil, it is worth noting that this structure was preserved when, during the war with Iran, foreign debt emerged as an important supplement to oil revenues as the means of financing imports.⁸

3.1. The Impact of Sanctions on Oil Revenues

The impact of sanctions was to abruptly end revenues from oil exports, and also to cut Iraq off from other sources of finance such as foreign borrowing. The effect on imports was dramatic. As shown in Table 1, total estimated Iraqi imports fell from .3 billion in 1988 to just {content}.4 billion by 1991.

The magnitude of this shift can be illustrated using some international comparisons. Table 2 gives estimates of the dollar value of imports per person for various groups of countries. Controlling for factors such as the size of an economy and the diversity of its structure, per capita import values are positively correlated with per capita national income. Before the sanctions Iraq's imports per person were close to the average of the countries ranked as High Middle Income in the World Development Tables of the World Bank. By 1996 they were only around one third the average level for the poorest countries in the world, and one-eighth the level of Low Income Arab countries. Current import levels fall well below levels in countries such as Zaire (1 in 1991), Sudan ( in 1991) and India ( in 1991).⁹

We can use these data to examine the likely macro implications of the food-for-oil (FFO) agreement between Iraq and the United Nations Security Council. Under this agreement, which was signed in May 1996 (but held in abeyance until the end of November 1996) Iraq will be allowed to export up to one billion dollars worth of oil every ninety days. Out of this amount a total of 0 million could be spent on the import of food, medicines, medical equipment and goods specifically for humanitarian purposes. FFO implies imports of 0 per person. Together with existing average import values of per person, this would take Iraq's total imports to 0 per person per year -- still well short of the figure for the three poorest Arab states (Mauritania, Yemen and Egypt).

It can be argued that the figures presented above seriously under-estimate Iraq's ability to import, because they do not take into account possible breaches of the sanctions. In particular, if Iraq is somehow able to export more oil than is allowed under the sanctions, its ability to pay for imports would be consequently higher. This issue is examined in some detail in Appendix 1. There we argue that apart from logistic and political difficulties in hiding oil exports, Iraq's production data, independent estimates of production by OPEC, and evidence from neighbouring countries also confirm that any cheating on oil exports was probably small.

3.2. Impact on Government Finances

The most striking evidence of the effectiveness of sanctions comes from changes in the macroeconomy. The collapse of oil revenues (and other foreign exchange flows) lead to two immediate problems: First, government revenues fell causing a fiscal crisis. Second, and most importantly, a severe shortage of foreign exchange and imports caused the relative price of tradable goods (including food and medicines) to rise. We deal with the fiscal crisis and its effects on the economy in this section. The impact of the foreign exchange crisis is considered in section 3.3 below.

While there is no data available on the fiscal gap, it is clear that the immediate impact of lower oil revenues was to cause a large fiscal deficit. The government responded by limiting nominal expenditures, while issuing money to finance the budget deficit. With more and more money being issued, inflation rose and the dinar depreciated.

Figure 1 shows the movement in the market exchange rate of the Iraqi dinar against the US dollar from 1990 till the middle of 1996.¹⁰ Before Iraq's invasion of Kuwait one dollar exchanged for around 4 dinars. By the middle of 1991 a dollar bought 8 dinars, and by December 1995 it was possible to purchase 3,000 Iraqi dinars for one dollar. This high inflation was driven by the government's need to print money in order to finance expenditures.

One of the important results of sanctions is that the government has sharply curtailed producer and some consumer subsidies. For example, it can be seen from Figure 2 that in 1990 the wheatflour price and the food price index rose much more sharply than the price of a US$ in IDs. This was due entirely to the removal of two sets of subsidies on wheatflour, which accounted around a third of the food price index. Before the sanctions, the import and marketing of wheatflour and some other staples was largely a state monopoly. These imports were valued not at the market exchange rate but at the over-valued official rate, which was equivalent to a subsidy to consumers. In addition to this there was also a direct price subsidy on wheatflour. Soon after the imposition of sanctions the government withdrew these general subsidies and replaced them with a subsidized ration system (on this see section 4.2 and section 6). The private sector began to play an active role in the import and marketing of all food items including wheatflour.

Two distinct types of price movement are noticeable. Firstly, the initial adjustment which involved the removal of subsidies caused substantial relative price movements -- in particular the price of the basic staples relative to wages (or the price of labour) rose sharply. Secondly, as the government resorted to issuing money as a way of financing expenditures, the overall price level also increased and there prevailed a situation of chronic high inflation.

This distinction is worth bearing in mind, because the two types of price movements have different potential implications. The change of relative prices has had a serious adverse effect on the purchasing power of Iraqi households. This change was felt most dramatically in the first year of the sanctions. The second type of price change -- i.e. the general rise in the price level -- became noticeable after the initial period of macroeconomic shock, as the government struggled to keep up with its spending priorities in the absence of any significant sources of revenue.¹¹

Although public finance data were not available, it can be safely assumed that the main items of expenditure are salaries of government employees and consumer subsidies, notably through the ration system.¹² It is clear that under its new and severe fiscal constraints Iraq could no longer afford to maintain its large public sector of old. All the evidence suggests that the government has maintained its fiscal commitment to subsidize the ration, and has preserved employment levels in the public sector at the expense of the purchasing power of public sector salaries, by not adjusting them with the rise in prices.

Although attempts have been made at regular intervals to raise public sector salaries -- the first such pay rise taking place in September 1991 -- since these were financed by monetary expansion, their effects were quickly neutralised as prices rose in response. Indeed, a serious consequence of systematically financing pay rises by printing more money is that the economy could enter a spiralling cycle of inflation.

It can be argued that Iraq was on the verge of such a cycle in late 1995, when the salary and price rises were reversed by a stabilization programme. This stabilization programme coincided with Iraq's announcement that it was willing to enter negotiations for a food-for-oil deal. This announcement contributed to the stabilization programme as it led to an appreciation in the market exchange rate of the Iraqi dinar, and a decline in the relative price of imported goods. The stabilization programme was successful to the extent that it checked the spiralling cycle and brought prices and wages down. Nevertheless, by 1996 public sector workers commonly earned - per month compared to their pre-sanctions salaries of 0-0.

3.3. Foreign Exchange Crisis

The most important impact of the decline in oil revenues was a severe tightening of the available funds for imports. With reduced supply of imported goods, the price of these was bid up relative to domestic goods and particularly labour.

This shift in the relative price of foreign exchange has striking effects on the measure of dollar GDP. The World Bank reports that GDP per capita was 40 in 1989. Our current estimates place it at roughly 0.¹³ Since real GDP has probably fallen on the order of 50%, the remaining decline would have to be explained by changes in the relative price of foreign exchange. Based on these estimates, we can then roughly decompose the overall decline in dollar GDP from 40 to 0 into two components: it fell by half due to loss in real production, and then fell by a factor of seven due to a sharp rise in the price of foreign exchange due to scarcity.

In our surveys of domestic markets and enterprises, we generally found that domestic prices for imported goods were not very different from prices in Jordan adjusting for the exchange rate. This implies that enterprises and households did not have to pay a premium (above transport costs) for imported goods. A premium would be charged whenever import restrictions were highly effective, so that importers earned a reward for the risks they take in attempting to break the restrictions. Given this observation, we believe the greatest impact of sanctions has come through the oil export restrictions - with reduced purchasing power people are simply unable to buy the goods they used to purchase.

The importance of the exchange rate to household purchasing power is shown in Figure 2. The plot shows changes in the price of wheat flour, which is the main staple food item in Iraq, an index of food prices, and the exchange rate (the price of a US$ in IDs).¹⁴ Except in the first year of the sanctions, the three price indexes have tended to move in tandem, corroborating the observation during the 1991 visit that the market prices of staples closely tracked the exchange rate. This shows the strong link between the open markets for staples and the foreign exchange market. It is the imported supplies at the margin which determine the price.

The scarcity of foreign exchange has had direct impacts on production. The enterprises we visited noted that purchasing power had fallen sharply, and the cost of imported goods was prohibitively high.¹⁵ They curtailed production as a result, so that many firms reported declines of the order of 70% to 90%. We did not get the impression that shortages of inputs restricted production, rather it was limits on market demand associated with reduced incomes.

The one sector which did not face decline was agriculture. Since the shortage of foreign exchange induced a sharp relative rise in the price of food, and since food demand has been maintained even with the fall in incomes, it has become highly profitable to be in the agricultural sector. While agricultural production appeared to fall immediately after sanctions were introduced, there was substantial evidence that production was returning or surpassing pre-war levels for many products.¹⁶ This was particularly true of dates where production has grown very sharply.

3.4. A Nation on Hold

The impact of these shocks at the household level varied depending on which sectors households were employed in, whether they were in the private or state sector, and their opportunities to find alternative source of income. Broadly, while the public sector adjusted to the sanctions by mainly reducing wages, the private sector responded more by cutting employment and less by reducing wages. Whether unemployed or earning low wages, the most common means to gain additional income was to find self-employment or casual labour.

Thus, as a result of lost oil revenues, the main macroeconomic impact of sanctions has been to reverse the economic change that began with higher oil revenues in the early seventies. Agricultural production has become highly profitable, inducing greater production and specialization in basic, non-import intensive food production. And employment has shifted from capital intensive sectors to services.

But there is one important difference from this simple view. Instead of causing permanent change, there were clear signs that sanctions have put the economy "on hold" while households, government and enterprises wait for a return of oil revenues. We found that public servants usually maintained their government jobs while searching for additional employment to supplement income. Likewise enterprises reduced production but maintained their full capacity and structure waiting for a return to a period of higher demand.

This impression of temporary change was most visible in terms of the exchange rate movement. Whenever there were signs that the sanctions might be relaxed, the Iraqi Dinar appreciated sharply. This makes complete sense since higher oil revenues would reduce the governments need to print money, and raise the relative supply of foreign exchange - both causing an appreciation of the exchange rate. The exchange rates movements also lead to immediate similar changes in food prices, so that basic goods such as flour and eggs also rose and fell with the Dinar.

These factors were vividly demonstrated in the exchange rate and price movements that took place from around December 1995 onwards. The event that marked the decline in prices and the stabilisation of the exchange rate was a government announcement of an austerity drive coupled with the announcement that after having rejected its terms for five years, Iraq was now willing to enter negotiations on the food-for-oil deal. This deal, as outlined above, allows Iraq to import some humanitarian supplies in return for the sale of a limited value of oil exports. The austerity drive involved wide ranging public sector pay cuts, as well as the announcement of new taxes.¹⁷

The impression this gave was that production and wages could sharply increase once oil exports were restored, and things could return substantially towards pre-war conditions - albeit with a population which has been subjected to extreme hardships in the interim. But an examination of the magnitudes makes it clear that the current programme of food-for-oil will only have a modest impact on economic recovery. The implied exports from this programme will raise oil revenues to 1/3 their pre-war levels, but keep total imports at levels associated with the poorest (non-oil producing) Arab countries. Even with this programme, we can expect the Iraqi economy to remain "on hold" so long as oil revenues do not rise substantially further.