May 12 was the last day of trading for Mosul Bank (BMFI) ahead of its proposed merger with Union Bank (BUOI). The stock closed up 7% bringing its year-to-date gain to 29%. BUOI ended the day unchanged and is up only 12% year-to-date.

While the deal is being described as a merger, it would in fact amount to a take-over of BUOI by BMFI. (Either way, it’s a first for the Iraq Stock Exchange.) Both have the same share capital but BMFI is much larger in terms of number of branches, depost base, and the size of its loan book. (There’s more on the two banks here.)

BMFI’s strong performance relative to BUOI might thus strike one as odd. Typically, things go the other way round—if anything, the acquiree’s stock is supposed to outperform the acquirer’s. This reflects the fact that acquirers often pay too much.

There are a number of reasons for this. Acquirers may expect to realize greater synergies than are actually achievable or may underestimate the costs of integrating the merged entity. Managers may expect to benefit personally from an acquisition even though it destroys value for shareholders. Or they may simply succumb to their own hubris.

None of these things seem particularly likely in a case like the BMFI-BUOI deal. There aren’t really any synergies to consider when the target has only a few branches, nor is there much doubt about what the costs will be. Controlling shareholders, rather than managers, are calling the shots, which means that the perverse incentives facing the mangers of larger companies aren’t present. Similarly, the risk that people will be mastered by pride is a lot less when their own money is on the line.

The recent price action in the two companies, while not typical of most take-over situations, is thus not surprising. There’s really no reason to expect BMFI, or any other Iraqi bank in a comparable situation, to overpay.

By the end of next month, the Central Bank of Iraq (CBI) is requiring all private-sector banks to increase capital to IQD 100 bn. The banks were originally supposed to have reached this target by the end of last year but so few could have managed it that the CBI had to give them an additional six months.

With this deadline now fast approaching, 15 out of the 21 ISX-listed banks, accounting for 46% of total ISX bank-sector market cap, are still shy of the mark. (See table.) Of these, eight have announced rights/bonus issues and are already suspended from trading. Another two—BMFI and BUOI—are considering a merger. (See my last post.) The remaining five, so far as I know, have yet to announce anything.

In many of these cases, satisfying the CBI shouldn’t be too difficult. To the extent that there are retained earnings to be capitalized, capital increases don’t even require any new money. And five of these names—Economy, Mansour, Dar Es Salam, Commercial, and National—are partly owned by foreign institutions that will presumably be able to come up with the needed funds.

The interesting question, however, is what’s going to be done about banks that have insufficient retained earnings, lack deep-pocketed controlling shareholders, and have no real prospect of attracting new investors. While the CBI might like them to merge into larger entities, there does not appear to be anything in the Banking Law allowing the central bank to require this. Cancelling their licenses is an option, of course, but then does the CBI really have the administrative capacity to wind them up?

The easy way out, of course, would be to let them slide again—either by formally extending the deadline, say for another six months, or simply doing nothing once it has passed. That’s what happened last time. Will this time be different?

Fans of the “rockumentary” This is Spinal Tap will recall the scene where the band’s guitarist explains that his amplifiers are louder because their volume knobs “go to eleven.” When asked why this is different from having ten as the highest setting, he simply repeats “these go to eleven.”

Most of us have no trouble understanding that changing the units used to measure something does not change the character of the thing being measured. A day doesn’t get longer if you keep track of time in minutes instead of hours, four quarts isn’t more than one gallon, and paying for something in pennies instead of dollars doesn’t make it more expensive.

Yet somehow people continue to claim that a redenomination of the Iraqi currency will have important economic effects. (See this story.) Replacing all the dinars currently in circulation with new ones at a rate of 1,000 to one, thereby “knocking off three zeros,” is supposed to reduce the money supply, for example. Instead of the commercial banks holding 27 trillion dinars as central bank reserves, they will “only” have 27 billion. People won’t have to carry as much money once all the thousand dinar bills have been replaced by one dinar bills. And so on.

It would obviously be ridiculous to insist that an amp that “only” goes to ten would be softer than one that “goes to eleven.” Isn’t the claim that it matters how many zeros there are on a bank note an example of the same fallacy?

On March 11, Rabee Securities came out with the first-ever sector report on ISX-listed companies. The report, which could be thought of as something of a milestone for the Iraqi market, is on the banks—the most heavily weighted sector in terms of both trading volume and market cap.

For me the main takeaway was that the sector is not particularly cheap on a valuation basis. While the analyst does not make this point explicitly, it’s hard to come to any other conclusion on the basis of the data presented. Market-cap-weighted average price/book value for the sector works out to 2.6 times, or 1.8 times if you take out HSBC subsidiary Dar Es Salaam Bank (BDSI). Weighted (historic) P/E comes to 66.0 times, or a still-demanding 17.4 times ex BDSI. And while high PE’s can sometimes be justified on the basis of high earnings growth, it doesn’t look like this is the case here. For the top seven banks (not including Warka), cap-weighted average earnings grew only 16% in 2010.

It’s not clear, however, that historic valuations are particularly relevant in this case. As most of the Iraqi banks are still at a very early stage in their development, current book value and prior-year earnings are a poor guide to what these companies will eventually become. Their real value comes from what their franchises will be worth once they have developed regular commercial banking businesses—something that is still basically unquantifiable.

BDSI is a case in point. Annualized net earnings for the first nine months of last year fell 87%, putting it on a P/E of 333 times. Price/book is 7.2. Does this make the stock a sell? Not necessarily. It all depends on what HSBC, which holds a 70% stake, is planning to do with the company.

Unlike most brokerage research of this type, the Rabee report does not include any buy or sell recommendations. It’s easy to see why. Based on the banks’ historical financial information alone, most of them might be sells. But given the potential for growth in a country where year-end ’09 bank-sector credit to GDP was a mere 4.1%, most might be buys.

What’s an analyst to do?

By Tariq Abdell, Iraq’s political risk analyst, and Founder & CEO of Mesopotamia Insight.

The opinions expressed here are those of the author, and do not necessarily reflect the views of Iraq Business News.

In light of ongoing socio-political changes in MENA region, Iraq’s massive protests, from Zakho to al-Faw, accentuate the political astuteness and the frustration of the Iraqi people with their elected officials. Disenfranchised Shiites, Sunnis, Kurdish, Arabs, and Christians are all demanding the same: an end to ethno-sectarian quota-sharing system, corruption, and, most importantly, universal access to basic services such as potable water, electricity, housing, education, healthcare, and jobs.

Nonetheless, given the legitimacy and urgency of the protestors’ demands, the government nebulous responses (halving of some officials’ salaries, 100-day ultimatum to incumbent ministers, boosting food ration with extra cash, etc…) are mere cosmetic measures to allay people’s frustration and anger. Unarguably, the cumulative effects, hitherto, of the elected officials’ ineptitude and schism are protracting decades of erroneous policies and, subsequently, the people’s tribulations. Impelling the majority of the Iraqi people to question the legitimacy of their government and the effectiveness of its institutions, a dangerous threshold that could hastily throw the country back into its darkest years of sectarian violence and lawlessness.

Notwithstanding Iraq’s colossal energy resources, billions of oil and natural gas reserves, Iraq fragile democracy and ineffectual institutions, in a restive region, are the breeding ground for societal and political upheavals and foreign interventions. In fact, Iraq’s daunting and intricate challenges are both internal and regional:

Internal challenges:

• Lack of basic services, e.g., six million people with no access to clean water -UNICEF.
• 20 to 25 percent of Iraqis still live below the country’s poverty line.
• Unemployment rates hover around %18, notably among military-age male population.
• Higher illiteracy rates, exacerbated with massive brain drain, are eroding Iraq’s skilled and professionally literate workforce.
• Rampant corruption and nepotism undermine the efficiency of the State institutions.
• Inequitable distribution and mismanagement of oil’s revenues – no hydrocarbon law.
• Parliament still faces a backlog of sensitive issues.

Regional challenges:

• Given the region new geopolitical developments, heightened tensions between Iran and Saudi, Iraq could easily turn into a sectarian proxy war battleground – Shiite Vs. Sunnis.
• The fallouts of Iran’s nuclear standoff with the West could easily spillover to Iraq’s already contentious politics and further undermining its stability.
• Given Kirkuk’s enormous oil reserves and ethnic diversity (Arabs, Kurds, and Turkmen), it’s protracted dispute is a timed bomb, which could expeditiously reignite Iraq’s civil war.
• Turkey’s recurrent incursion into Northern Iraq in the pursuit of the Kurdish workers party (PKK) elements and PKK assiduous attacks on the northern oil pipelines are a major threat to the country’s resources and sovereignty.
• Given the hostile intentions of some neighboring counties, the U.S. planned troops withdrawal, by the end of the year, could further jeopardise Iraq’s defense capabilities.

Thus, given the enormity and complexity of the aforementioned challenges, Iraq only viable mean to fend off political instability and chaos is to renounce its sectarian-based policies and espouse an inclusive and genuine democratic system that heads to the people aspirations and protects their rights (UN Universal Declaration of Human Rights). Furthermore, both the government and opposition ought to consolidate their efforts to bolster accountability, eradicate corruption and, subsequently, strengthen the State institutions, an essential prerequisite for a rapid socio-economic recovery. To this end, the new government’s long-term vision should entail an action plan that reflects the country strategic and pressing priorities, namely:

• Genuine national reconciliation to overcome sectarian and political schism and violence.
• Overhauling of State institutions to rein in corruption and enhance efficiency.
• Merit-based appointments to promote efficiency and accountability.
• Providing access to basic services (e.g., potable water, electricity, running sewer, etc)
• Equitable distribution of oil revenues.
• Investing in human capital through education and training.
• Job creation to fend off societal and political unrest (Organized crime, for instance).
• Advancing the principles of human rights and rule of law.
• Diversifying and reviving of Iraq’ strategic industries to curb its dependence on a single commodity – fossil fuel.

Conversely, in the absence of a comprehensive and inclusive socio-economic development strategy, aiming at strengthening State institutions, eradicating corruption, and addressing the aspirations of the Iraqi people, regardless of their political and religious believes, Iraq may revert to its darkest years of sectarian violence and lawlessness (05-07), giving regional players (Iran, Saudi, Turkey, Syria) a free hand in Iraq’s affairs – exploiting Iraq’s vulnerabilities (Shiite-Sunni strife, for instance)- to further their national interests and, subsequently, turning Iraq into a prime battleground for proxy wars, or worse, a pariah State. Simply put, “a house divided against itself cannot stand” Abraham Lincoln.

The opinions expressed here are those of the author, and do not necessarily reflect the views of Iraq Business News.

The author, Tariq Abdell, Iraq’s political risk analyst, and Founder & CEO of Mesopotamia Insight

He can be contacted at: atariq2000@hotmail.com

or

Followed on twitter: http://www.twitter.com/atariqx

By Tariq Abdell, Iraq’s political risk analyst,  and Founder & CEO of  Mesopotamia Insight.

The opinions expressed here are those of the author, and do not necessarily reflect the views of Iraq Business News.

 As Iraq-business news celebrates its one year anniversary, MENA region is witnessing a fundamental political upheavals and changes,  costing Mubarak of Egypt and Ben Ali of Tunisia their presidencies, as result of decades of unpopular and undemocratic policies and, most importantly,  for injudiciously disenfranchising  a crucial segment of their societies: their younger constituents.

  Unarguably, Iraq is undergoing major socio- economic changes, among them, the formation of a new and inclusive government, following months of political horse-trading, improved security conditions due to a strong and nonsectarian Army, and surge of foreign companies and investors’ interest in Iraq’s potentials. However, Iraq’s severely languished infrastructure,  lack of basic services, impoverished and disgruntle  population  – decades of wars and despair-  could easily jeopardize its hard-earned achievements.

 According to the Iraqi Institute for economic reforms, Iraq’s agricultural output had fallen from 8% to 3.5%, industrial output  from 7% to 1.5%,  estimated poverty rate  of almost 23%, unemployment still hover above 18%,  the appropriation of credit to the economy  as % of GDP is 3.37 % in 2008,  current power output at 6,5000 megawatts  is less than half of Iraq’s needs, national debt amounts to $33 billion.

 Given the aforementioned challenges, it’s an absolute imperative for the Iraqi government to devise a comprehensive and inclusive post-conflict reconstruction strategy, taking into account the aspirations of its people and current  budget constraints, which estimates overall expenditure at $81.86 billion and income at $68.56 billion, leaving a shortfall of $13.3 billion.  Drawing on past experiences (BRIC countries, for instance) and the support of the international agencies (IMF and WB, for instance), Such a strategy ought to:

• Create a conducive and transparent business environment, compatible with Iraq’s new constitution,  that is legally and politically permissive (adoption of a new investment law, for instance),  and susceptible to attract foreign capital, foster Iraq’s political capital, and reinvigorate the efficiency of its institutions .  According to the world bank, Iraq ranks 166 on the ease of doing business -next to Afghanistan.
• Institute an independent and inclusive  Petroleum Council — reflecting  the geographic distribution of Iraq’s energy resources — that is responsible for formulating oil strategies (hydrocarbon law, for instance), deflecting the politicization of the oil sector, enforcing transparency and accountability as bulwarks against corruption , and robust enough to reign in SOC, NOC, and IOCs.
• Set a mechanism that will allow for an equitable distribution of the oil revenues and avoid the resource-rich nations’ deleterious disease, the resource war. Historically, the bulk of Iraq’s oil revenues are distributed along ethno-sectarian, political, and tribal allegiances, as opposed to inclusive and growth-oriented economic policies.
• Foster strategic partnership with the private sector and academia. For instance,  GOI could seek foreign companies’ expertise to help revamp its oil sector by introducing technological know-how, the industry best practices, and foster a professionally literate workforce. With such perspicacious initiative, Iraqi government will definitely enhance its oil sector efficiency, boost production, and, eventually, spur economic recovery.
• Revive Iraq’s strategic industries(Petrochemicals, for instance) to curtail its dependence on a single commodity, fossil fuel, and, consequently,  avoiding its hasty depletion. Furthermore, given Iraq’s acute electricity and water crisis, direct solar energy is by far the most abundant renewable energy source in Iraq which can be used for power generation for domestic and international markets , and seawater desalination to help alleviate southern regions water shortage.

 Conversely, in the absence of a concerted and inclusive national development strategy that reflects the needs of the Iraqi people (e.g.,  more jobs, better wages,  universal access to basic services, health care, and education) and help resuscitate the country’s weakened economy, Iraq may risk reverting to its years of lawlessness, sectarianism,  and chaos, which is far worse than Egypt and Tunisia combined. Irrefutably, “A nation’ s strength ultimately consists in what it can do on its own, and not in what it can borrow from others.” Indira Gandhi

 The opinions expressed here are those of the author, and do not necessarily reflect the views of Iraq Business News.

The author, Tariq Abdell, is an Iraq’s political risk analyst, and Founder & CEO of Mesopotamia Insight

He can be contacted at: atariq2000@hotmail.com

or

Followed on twitter: http://www.twitter.com/atariqx

With a year-to-date return of 14.6% as of February 7, the Rabee Securities RSISX index is the region’s second best performer so far this year. Only Iran’s TEPIX index, up 16.4%, did better.

Regional stock markets have generally mirrored the lackluster performance of the Morgan Stanley global emerging markets index, which is down 1.8% year-to-date. The main headwinds, both in the region and around the world, are coming from the threat of rising inflation and higher interest rates. For all the talk of political uncertainty following the protests in Egypt, these have had little impact so far. Markets like Saudi Arabia and Jordan initially took big hits on the Egypt news, but most of those losses have since been made up.

While Iran and Iraq have had similar returns so far, the two countries face dissimilar macroeconomic situations. The Iranian economy is hampered by international sanctions and declining oil production, while year-on-year food price inflation reached 18.9% in December (the last reported month). This compares to the situation in Iraq, where foreign investment is growing rapidly, oil output is expected to double or triple over the next decade and December CPI was only 3.3%.

The two stock markets are quite different as well. The Tehran Stock Exchange has been operating since 1967, has a market capitalization of about US$ 90 bn and 420 listed companies. The history of the Iraq stock exchange only goes back to the mid-1990s. So far there are fewer than 100 listed companies with a combined market cap of around US$ 2 bn.

And the Iranian market has already been rising for quite a while. It was up 68% in 2010. The ISX ended last year basically flat. Its bull market has only just begun.

It shouldn’t be hard for Iraq to take over the top spot.

Last week the federal supreme court ruled in favor of the government’s request to have the Central Bank of Iraq (CBI), along with the Independent High Electoral Commission, the Integrity Commission, and the High Commission for Human Rights, put under the supervision of the cabinet. This is bad news for the central bank.

Up to now, the CBI has been under the supervision of the parliament, as stipulated by the constitution. There is a good reason for this. Under the parliament, the central bank is not answerable to any single politician. Under the cabinet, it could potentially be directly controlled by one man.

A dangerous opportunity has been created for the government to increase the money supply arbitrarily. Saddam Hussein tried this during the 1990s. The result was hyperinflation.

Iraq’s US$ 50 billion in forex reserves are also at risk. There will be a big temptation to use these for local patronage projects with foreign currency-denominated expenses. If this happens, the CBI could be saddled with significant losses. It could even end up having to be recapitalized.

The court’s ruling is great news for anyone who might some day be in a position to “wet his beak” at the CBI’s expense. Bad news for everyone else.