By Mark A. DeWeaver, of Quantrarian Asia Hedge
Two good rules for emerging stock market investors have always been: (1) buy crises and (2) buy export booms. The first would have worked well in Sri Lanka in the weeks following the Tamil Tiger suicide attack on the country’s main airport in July, 2001. Had you bought Sri Lankan stocks then and held them until February, 2007 you would have made about six times your money. Another case was Russia in April, 1995 when inflation was running at 229% and the communists seemed to have a good chance of winning the 1996 elections. By September, 1997, the market had gone up eight times as inflation fell to 13% and Yeltsin won another term as president.
As for rule two, consider the Taiwan market during the period from December, 1985 until February, 1990. The index rose about twelve times in local currency terms as exports doubled and the exchange rate strengthened from 40 to 26 New Taiwan dollars to the US dollar. Or more recently, think of the Saudi market, which went up ten times from December, 2000 to February, 2006 while exports tripled on increased oil production and a rise in the price from $30 to $70 a barrel.
Anyone trying to follow these two rules would find little to like about most of the emerging markets that make the headlines today. The crises (e.g. in the Chinese property sector) generally seem to be just beginning rather than nearing resolution while the export booms (e.g. in Brazilian resources) are for the most part old news. Surprisingly, however, one of the world’s least noticed markets not only combines features of all four of the above examples but is also open to foreign investors. Like Sir Lanka after 2001, a civil war is coming to an end; like Russia in the mid-‘90’s, inflation has come down dramatically; and like Taiwan in the late ‘80’s or, even better, Saudi Arabia ten years ago, exports are set to soar.
Yes, I’m talking about the Iraq Stock Exchange.
Blood in the streets
It’s easy to understand why Iraqi stocks aren’t on the radar screen 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 the majority of the brokers and listed companies, remains a scary place to visit.
But conditions of travel for the investor aren’t really the best indicator of when it’s safe to invest. A more relevant signal is the fall in Iraqi civilian deaths from violence. At the height of the insurgency from mid-2006 to mid-2007, Iraq Body Count put the death toll at 2,500 – 3,000 a month. So far this year it’s been in the range of 200 – 300. While no one would argue that this is an acceptable state of affairs, it tends to be during just such transitions from the absolutely appalling to the merely 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 isn’t 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 (contrary to Chairman Mao’s famous dictum). And the Kurds are clearly better off as part of a unified Iraq than as citizens of an independent state that neither their neighbors nor, presumably, the US would recognize.
The threat from Al Qaeda-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 only occurred every other month—and the deaths of the leaders of Al Qaeda in Iraq and the Islamic State of Iraq at the hands of Iraqi and American forces on April 18 may well turn out to be a turning point in the government’s “war on terror.”
From zero to hero
Equally important for stock market investors has been the drop in Iraqi inflation, which fell from 65% in 2007 to 6.8% in 2009. Year-on-year core inflation for February was just 3.35%. 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% in 2007 to 7% by the end of 2009. Effective April 1, this rate was cut again, to 6%, while at the same time the required reserve ratio was reduced from 25% to 20%. (The required reserve ratio 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 nonfinancial companies and individuals, central bank reserves are the banks’ main source of interest income. Lowering the benchmark rate reduces this income stream, thereby forcing them to lend more.
While much of the rest of the world continues to deleverage, in Iraq the trend is thus in 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 that 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.
The coming oil bonanza
As if all this weren’t enough, 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 over 10 million barrels a day in additional capacity. Added to current production of 2.6 million barrels a day in 2009, 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 timeframe is unrealistic—for example, because it doesn’t 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) during the 1970’s. The resulting fiscal surplus would quickly make its way into the economy via tax cuts, subsidies, and an increase in investment and salaries at the 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.
A great story
The combination of reduced violence, increased leverage, and an impending oil windfall would seem to be a ‘perfect storm’ for Iraqi stocks. So far the market remains becalmed: the index is still at 2007 levels, recent daily trading values have been only about a million US dollars. 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 will be an easy story to tell—a crisis is ending and an export boom is beginning. And while there’s 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 storm surge.
The opinions expressed here are those of the author, and do not necessarily reflect the views of Iraq Business News.