US embassy cable - 05BAGHDAD3876

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, Reconstruction, Parliament 
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