By Mark DeWeaver
Iraq faces a big downside risk from the European sovereign debt crisis—perhaps an even bigger risk than that of renewed sectarian violence.
While Iraq’s limited financial links to the outside world make it immune to contagion through the banking sector, sustained debt deflation in Europe would result in a big drop in oil prices. This would be bad news for the Iraqi economy, which is crucially dependant on oil to finance a state sector that accounts for the lion’s share of GDP and is the country’s largest employer.
But the dark clouds that have gathered over Europe may yet have a silver lining—they make it much less likely that the Fed will be exiting its ultra-loose monetary policy any time soon. Nor are the odds of sustained European deflation really that high. What’s more likely is that the European Central Bank, faced with the alternative of having countries abandon the euro altogether, will try quantitative easing.
On balance, the effect of the crisis may well be positive for oil. While oil demand growth will obviously be slower than it otherwise would have been, since the end of 2008 oil prices seem to have been driven more by monetary conditions than anything else. (See chart)
This suggests that as long as the central banks continue to flood the world with liquidity the Iraqi economy should enjoy relatively smooth sailing.