Starting September 1, the Central Bank of Iraq (CBI) has announced it will be reducing the required reserve rate (RRR) from 20% to 15%. As this move frees up an additional 5% of deposits for the banks to lend out, you might think it would be positive for loan growth and stimulative for the economy as a whole. In fact, however, from a macro point of view it is likely to be a non-event.

At the moment, the required reserve ratio simply isn’t a binding constraint on bank lending. As of the end of March (the last reported month for this data), the system-wide excess reserves to deposits ratio came to 57%. (See chart. Data is from the CBI website–www.cbi.iq.) Unless this percentage has fallen dramatically since then, the banks are sitting on more cash than they know what to do with, which means that the only effect of the RRR cut will be to reclassify a portion of their reserves from ‘required’ to ‘excess’.

This reclassification itself, however, is positive for bank earnings because excess reserves earn interest at a rate of 4% (2 percentage points below the CBI policy rate) while required reserves are unremunerated. From the point of view of the banks, it’s as if their loan books grew overnight by an amount equal to 5% of (reservable) deposits, with a spread of 4 percentage points on the new loans. (The spread is the difference between a bank’s deposit and lending rates. As the “new loans” in this case increase interest revenue without increasing interest expense, it’s as if they were funded with non-interest-bearing deposits.)

The RRR cut is thus neutral for the economy—it won’t lead to an increase in lending—but a plus for the banks, who are effectively getting a stealth capital injection from the CBI.

On August 8, the Iraq Securities Commission (ISC) announced that a total of 18 companies would be suspended for failing to submit their 2009 financials. Of these, 6 had already been suspended for never having submitted 2008 financials. (See the table for a complete list of the companies.) As of August 25, only four of the eighteen—HSBC subsidiary Dar Es Salaam Bank (BDSI), Gulf Commercial Bank (BGUC), Al Kindi for Veterinary Medicines (IKLV), and Al Qum’a for Financial Investment (VQUF)—had resumed trading.

There was more bad news for minority shareholders on August 18, when three of the companies that failed to submit 2008 financials—Iraqi for Bottling and Canning (IIBC), Messan Food Industries (IMFI), and Amusement Town (SAMT)—were delisted for not renewing their registration with the Iraqi Depository Center and failing to submit shareholders lists. A fourth company, National for Food Industries (INFF), was also delisted. In addition to the two violations cited for the other three companies, the reasons for INFF’s delisting also included an “inadequate” board of directors report that “does not support the continuance of the company’s business,” “continued losses, even after an infusion of additional capital,” and “cumulative losses exceeding total shareholders’ equity.”

Most of the 11 companies that remain suspended are likely to resume trading in the not too distant future. Indeed, it is not unusual for Iraqi companies to submit their year-end financials late, even though they get five months to prepare them and are allowed an additional two-month grace period after that. Evidently they find the ISC to be something of a paper tiger. And no wonder, as suspension from trading doesn’t really penalize anyone but the minority shareholder.

Even the ultimate penalty of delisting may make little difference to a company’s managers when it is heading for bankruptcy to begin with. Consider the case of INFF, for example, which was suspended in September of 2009 in advance of a rights issue in November and never subsequently resumed trading. This worked out fine for management—they got to go on paying themselves salaries with whatever money was raised. Once again it’s the outside investors, particularly those unlucky enough to have subscribed for the rights, that end up taking the fall.

On August 11, the Iraqi paper Addustour (Constitution) reported that the government would be providing six hotels with a total of US$ 300 milion to upgrade their facilities in preparation for the Arab League summit, which is scheduled to be held in Baghdad next March. The six—the ISX-listed Palestine (HPAL), Babylon (HBAY), Baghdad (HBAG), Mansour (HMAN), and Ishtar Sheraton (HISH) hotels, and the unlisted Rashid Hotel—will receive 75% of the new funding as interest-free loans, the remaining 25% as equity injections.

While the division of the $300 million among the hotels was not reported, it seems reasonable to suppose that most of it will go to the listed companies. If each gets a sixth of the total, their share will come to $250 million, a sum almost equal to their combined market capitalization of $253 million (as of August 14).

So far, however, market participants seem unimpressed by this news. (See chart.) While HBAG, HBAY, and HPAL all closed up 10% on August 11, as of August 17, HPAL and HBAY were up only 6% and 5% from their respective August 10 closing prices. (HMAN and HISH have been suspended from trading since July 6 and August 8, respectively.) HBAG, which rose on a mere ID 19,800 worth of trading on the 11th, hasn’t traded at all since then.

At the end of June, Al Ahli United Bank (AUB) announced that it was seeking to raise its stake in Commercial Bank of Iraq (BCOI) from 49% to 60% by purchasing 6.6 billion BCOI shares in the Iraq Stock Exchange (ISX).  The purchases are to take place over a two-month period starting July 4, with the Bahrain-based lender paying ID 1.36 per share.

While this scheme might be thought of as a tender offer, it is actually something much simpler.  Normally the acquirer would be buying directly from the existing shareholders rather than in the market and would make its acquisition subject to a minimum number of shares being tendered.  In this case, AUB is effectively just giving the ISX-member brokers collectively a 6.6 billion-share buy order, which they may or may not completely fill.

The obvious reason for doing things this way is that Iraq’s existing securities law makes no provision for tender offers.  Conventional tender offer bids will presumably have to wait until the passage of the new “Law Regarding Securities,” which covers this subject in Article 35 of the draft version (available on the Iraq Securities Commission website, www.isc-iq.org).

If this law were already in force, it is interesting to note that AUB would be required to bid for all of the shares it does not already own.  Article 35 requires that “Any Person who acquires more than 50% of the voting power of the Publicly Held Securities of an Issuer…shall be obliged to offer to purchase all of the remaining outstanding voting Securities of the Issuer.”

So far, AUB’s acquisition appears to be off to a slow start.  From July 4 to August 5, total foreign buying on days when BCOI traded at ID 1.36 came to 2.2 billion shares.  Assuming that AUB accounted for this entire amount, half way through its two-month acquisition period it is only a third of the way to its target.  (See chart.)

Perhaps this is not entirely surprising given that ID 1.36 is below BCOI’s ID 1.38 average closing price for the thirty trading days before AUB put in its bid.

So far two subscription periods for Warka Bank’s ID 150 bn rights issue have come and gone without any official announcement of the results.  The last date for existing shareholders to subscribe was May 16.  As most of them did not take up their rights, there was a subsequent public offering open to everyone except those eligible to participate in the first round.  These subscribers (if any) had until July 2 to get their money in.

Apparently the chairman, who holds about 60% of the shares, did not take up his own rights, which would naturally lead you to conclude that he must have had new investors lined up to invest in the public offering.  (Otherwise what would have been the point in doing such a huge capital increase in the first place?)  But if that had been the case, it seems that there should have been an announcement by now confirming that the second round shares had been taken up and revealing the identity of the new owners.

But no such announcement has been forthcoming and it now appears that the public offering is going to a final sixty-day third round.  As the stock must be suspended until the new shares are either taken up or cancelled, this would mean that BWAI would not resume trading until some time in September at the earliest.

In the meantime, however, the Iraq Securities Commission has further complicated the process by requiring the bank to reaudit its 2009 financials.  In an announcement dated June 6 (and posted on the ISX website on June 9), the ISC claimed to have found “abnormal figures” in the accounts and requested the company to replace the auditor and redo them.

All this leaves the minority shareholder with nothing but unanswered questions:  Did the chairman actually have any investors to take up the second round shares?  Will they subscribe during the third round?  Did they ever exist in the first place?  Did the ISC’s report scare them away?  Was the timing of ISC announcement, right in the midst of a public offering, a coincidence?  What will the bank’s new auditor conclude? 

And when, if ever, will the shares resume trading?

It’s always been a bit of a mystery why anyone should care about bonus share issues.  Since a company’s retained earnings are already owned by the shareholders, you would think that converting these earnings into shares shouldn’t have any effect on an investor’s returns.  Following a bonus, the share price should logically fall by an amount just sufficient to leave the market value of your position unchanged.

Surprisingly, however, the ex-bonus price often falls by less than you’d expect, leaving the shareholder with a profit.  In some cases, these gains may even exceed the amount the company would have been able to pay out as a dividend, making the new shares a better deal than a cash payment.

With a number of ISX-listed banks now likely to issue bonus shares to meet the central bank’s new minimum capital requirement, you might therefore expect to make some easy money holding Iraqi bank shares.  So far, however, the first two banks to resume trading following bonus issues have been disappointments.  (See my June 2 and June 29 posts for more on the central bank’s new policy and bank share suspensions.) 

This month, Middle East Investment Bank (BIME) and Bank of Baghdad (BBOB) closed their first ex-bonus trading days down 2.9% (on 7/15) and 4.3% (on 7/21), respectively.  These were significant underperformances whether measured against the ISX index, the Rabee Securities RSISX index (available online at http://rabeesecurities.com), or the returns on the four most liquid bank stocks to trade continuously during the BBOB and BIME suspension periods.  (Please click on the above table for more details.)

On July 6, the website of Kurdistan’s Peyamner News Agency reported that Iraq’s second stock exchange had “opened” in the Kurdish city of Erbil.  It wasn’t clear what was meant by opening, however.  The Erbil Stock Exchange (ESX) was licensed in February and trading is not due to start until later this year.  I believe the only real news this month was the appointment of board members.  (Hopefully, there will soon be more information available on the ESX website, http://erbil-sx.com/, but at the moment it is still “under construction.”)

Erbil could potentially play an important role in attracting overseas investment into Iraqi capital markets, a role in some ways analogous to that of Hong Kong as ‘gateway’ to China.  By listing companies from all over Iraq (starting with secondary listings for ISX-listed companies), the ESX could promote itself as a place for local brokers and listed company representatives to meet foreign investors, who would naturally prefer this alternative to visiting Baghdad.  Eventually, the city might even become something of a financial center, with all manner of service providers setting up shop there as well.

Unfortunately, however, this doesn’t seem to be what the promoters have in mind.  The secretary of the high economic council of the Kurdistan Regional Government, Izzat Mullah, told Peyamner that the purpose of the exchange was to facilitate trading in “shares in the local companies of Kurdistan.”  While he added that “it will be a secure place for the foreign investors to keep their money,” without listings from elsewhere in the country the ESX won’t be a gateway to anywhere but the Kurdish region itself.

The Iraqi paper Addustour (Constitution) has reported that recent attacks on financial institutions have led some savers to withdraw cash from their bank deposits and keep it hidden at home.  At first glance, it might seem that such a trend could potentially lead to runs on the banks or even a breakdown in the payments system—events with economic consequences much more serious than the robberies and bombings that triggered the initial withdrawals.

In fact, however, there is surprisingly little to worry about.  Iraq’s banks are better able to meet depositors’ demands for cash than their counterparts almost anywhere else in the world because they do so little lending.  Over half of deposits are held as central bank reserves, which are readily available to fund withdrawals.  The absence of lending also means there is relatively little danger of a liquidity crisis.  After all, banks can’t call in loans they haven’t made.

It also seems doubtful that the attacks seen so far will have much of an effect on the aggregate level of bank deposits.  Since getting as high as 1.9 times in May, 2007, the ratio of cash in circulation to deposits has been trending steadily downward, falling below 1.0 last September and reaching a post-invasion low of 0.85 in February.  (See Chart.  Data is from the Central Bank of Iraq and Iraq Body Count.)  And while this ratio climbed sharply from October, 2006 to May, 2007, a period when Iraq’s banks were losing an average of US$ 1 million a month to robberies, it is not clear that holdups were the main reason for this switch to cash.  A more likely explanation is that the level of violence during those months simply made it too dangerous for many people to go to the bank.

As the central bank’s statistics don’t go beyond March, it remains to be seen whether there has been an uptick in the cash/deposits ratio in the last few weeks.  But it seems to me that things would have to get a lot worse before there was any real cause for alarm.

Over the last three months, stocks accounting for over half the turnover on the Iraq Stock Exchange (ISX) in the first quarter of this year have been suspended from trading.  (See chart.  Trading values for the quarter were computed from statistics available in the Rabee Securities Weekly Bulletin, online at http://rabeesecurities.com)  Of the first quarter’s ten most actively traded bank stocks, only four (BBAY, BCOI, BGUC, and BMNS) are still trading.  Baghdad Soft Drinks, which contributed 27% of first quarter trading, was suspended on June 11.

These suspensions are in part an unintended consequence of the Central Bank of Iraq’s new capital requirements for the commercial banks.  (See my June 2 post for more on this.)  With the exception of North Bank, which has already met this year’s ID 100 billion requirement, all the other listed banks will need to issue new shares, generally through bonus issues (to the extent that they can capitalize existing retained earnings), rights issues (when retained earnings are insufficient), or some combination of the two.  And North Bank is increasing capital as well, in a bid to meet next year’s ID 150 billion capital requirement ahead of time.

The problem for investors is that the ISX generally suspends companies for several weeks prior to their shareholder meetings (e.g. those required to approve capital increases) and for periods ranging from weeks to months subsequently.  These suspensions seem to be motivated partly by a desire to control insider trading—if no one can trade at all, the insider’s informational advantage becomes moot.  But this is not an entirely convincing explanation.  After all, once a capital increase is approved, there isn’t anything left for the insider to trade on.  Why must the stocks remain in limbo for long periods after that?

So far, there has been no obvious decline in ISX volume, but a reduction in the sort of large block trades I described in my last post seems unavoidable.  The eight names that accounted for the biggest volume spikes in the first half of this year included the already suspended North Bank and Baghdad Soft Drinks as well as four other banks (Iraqi Islamic Bank, United Bank, Bank of Baghdad, and Gulf Commercial Bank) that must inevitably be halted as well.

As of June 17, year-to-date average daily turnover on the Iraq Stock Exchange (ISX) has remained subdued at just ID 2.2 billion (US$ 1.9 million).  Surprisingly, however, large block trades on just 16 days (8 days in May, 4 in March, and 4 in January) accounted for 48% of YTD total trading.  An easy way to see what the big money has been up to this year is simply to look at what those trades were and who made them.

One thing worth noting is that they were predominantly done by either locals or foreigners trading through local accounts.  Local transactions accounted for 73% of the big trades on those 16 days and involved six names: North Bank (40% of the local transactions), Baghdad Soft Drinks (25%), Iraqi Islamic Bank (23%), Al Mansour Hotel (8%), United Bank (3%), and Babylon Hotel (1%).  About a third of these trades involved locals selling to foreigners, the remaining two-thirds were done with Iraqis on both the buy and the sell side.

Foreign trading accounted for only 27% of the big trades on those 16 days and involved just four stocks:  North Bank (65% of the foreign buying), Bank of Baghdad (27%), Baghdad Soft Drinks (5%), and Gulf Commercial Bank (3%).  These names seem like good candidates for the buy list of anyone hoping to front-run future inflows of institutional investor money.  With the exception of the Gulf Commercial Bank trade, where both the buyer and the seller were foreign, the foreigners were buying in all cases.  This stands to reason as most of the market is owned by Iraqis.  Foreign banks with long term strategic holdings in ISX-listed subsidiaries and affiliates are the only significant non-Iraqi shareholders and they are unlikely to be selling.

Trading in North Bank, which had the largest share of both the local and foreign trading, came to ID 55 bn—23% of YTD total turnover for the entire market.  Foreigners accumulated an 11% stake, leading to a significant diversification of the company’s shareholder base in just a few days of trading.

Iraqi GDP growth remains at the mercy of the oil markets, with the economy growing 10.3% in 2008, slowing to 4.3% last year in the wake of the crash, and now expected to rebound to 7% this year as prices have recovered (according to the central bank’s latest forecast).  This state of affairs has led some Iraqi economists to call for the government to make more of an effort to diversify the economy.

Perhaps diversification is not an unreasonable goal.  While oil accounts for as much as 50% of GDP in some of Iraq’s fellow Arab OPEC members, in others the share is as low as  25%.  (See chart; shares are from the CIA’s World Factbook .)

But unlike these countries, Iraq has enormous reserves of oil that have yet to be tapped and an ambitious development plan to bring them online.  Current production of something like 2 million barrels per day is expected to reach 4.5 million b/d by 2014 and eventually peak at 12 million b/d (if the Oil Ministry is to be believed).  This makes diversifying away from oil a practical impossibility for the foreseeable future.

Reaching the 4.5 million b/d target on schedule would result in average annualized oil production growth of 18% from now until 2014.  Include the contribution of oil-related infrastructure investment to GDP during this period and the growth rate for the sector will certainly exceed 20%.  The non-oil sector would have to be growing even faster than this for its share to increase, and so, consequently, would the economy as a whole.

It’s clearly much too early to be talking about diversification.

Last month, on the occasion of Rafidain Bank’s 69^th anniversary celebration, the chairman reported that the bank was looking forward to implementing its new IT system “as soon as possible.”  The system, which includes the Mysis products “Bankmaster” and “Branchpower,” is supposed to increase efficiency and reduce operational risk by bringing together information throughout the bank onto a single automated platform.

While the chairman didn’t mention it, this project seems to have fallen a bit behind schedule.  In January, 2009, it was reported that the bank would be bringing its 167 domestic branches online at a rate of three per week, which would have meant that the entire network should have been operational by the first quarter of this year.

And there’s evidently not a minute to lose.  No sooner was the anniversary celebration concluded than three Rafidain branches were found to be involved in a scam to funnel bank funds to private businesses.  The resulting loss came to a staggering US$ 350 million—the biggest theft in the bank’s history.  This is exactly the type of operational risk failure that the new IT system might have detected.

Unfortunately, however, corruption at Iraq’s state-owned banks is likely to require more than just a technological fix.  The problem is that IT systems are relatively ineffective in preventing fraud when there is collusion among staff, particularly if upper-level management is involved.  These systems work best when you’re dealing with a single individual acting in secret—the typical perpetrator of insider frauds at the internationally active banks.  Sooner or later a colleague is likely to notice irregularities in the system’s automatically generated activity reports.

But if the colleague, her supervisor, or even the branch manager is involved as well, those reports are only going to end up in the paper shredder.

On March 10, the Central Bank of Iraq (CBI) announced that the privately-owned Iraqi banks will be required to increase capital to ID 250 bn (USD 213 mn) over the next three years.  Each bank will have to reach an initial capital target of ID 100 bn by the end of the first year and get to ID 150 bn by the end of the second.

Warka Bank for Investment (BWAI), the largest of the listed banks by assets, was the first to respond to the new policy.  The bank capitalized retained earnings through a bonus share issue (one new share for every three old), thereby increasing its existing ID 75 bn in share capital to the CBI’s initial ID 100 bn target.  In addition to this, it also announced a rights issue, with 1.5 new shares offered at ID 1.00 for each post-bonus share.  If fully subscribed, this offering would immediately take the bank’s capital to the CBI’s three-year ID 250 bn target.  The subscription period ended on May 16.

At ID 150 bn (USD 128 mn), this was easily the biggest rights issue in the history of the Iraqi market.  It was equivalent to approximately 5% of total market capitalization and something like half a year’s worth of trading for an exchange that typically only sees the equivalent of about USD 1 mn in daily turnover.

The chairman held 60% of the existing shares and presumably had buyers lined up for any rights shares he didn’t want to subscribe for personally.  That left only ID 60 bn (USD 51 mn) to be raised directly from minority shareholders.  Even this, however, may have been more than the market could absorb.  While there has yet to be an official announcement of the results, rumor has it that most of the minority shareholder rights were not taken up.

Perhaps an even bigger problem than the sheer size of the offering was the US$ 360 million embezzlement case that came to light at Rafidain Bank just as the subscription period was ending.  (Rafidain is Iraq’s largest state-owned bank.)  Three Rafidain managers and the manager of Basra Bank were arrested and, according to the Iraqi paper The Citizen (Al Mowaten), there were also rumors that Warka was involved.  These rumors now appear to have been false—possibly fabrications by the bank’s rivals (as the chairman has alleged).  But as far as the rights issue is concerned the damage may have already been done.

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.