Iraqi Kurdistan is on the verge of a fiscal crisis. Given the autonomous region’s vast and untapped oil reserves, disputes over the right to manage these resources have sparked tension between Baghdad and Erbil. In January, Iraq’s central authority froze transfers to the Kurdistan Regional Government (KRG) representing its share of the national budget. The move came in response to the KRG’s back-channel oil exports. Since the governorate’s operations depend on budget transfers from Baghdad, the freeze has undermined the KRG’s ability to maintain local institutions.

The dispute between Baghdad and Erbil has coincided with a major outbreak of violence in Iraq. As a result of efforts to contain ISIS’s advance, the KRG has gained control of historically disputed territories to the south. Iraqi Kurdistan has also become home to half of Iraq’s 1.8 million internally displaced people, who have fled on-going violence elsewhere in the country.

Without funding and increases in expenditures, the KRG is unable to pay the salaries of government employees. It is also under severe pressure to continue providing public services to the populations under its control. These financial considerations have rekindled the underlying conflict with the central government over the KRG’s political autonomy. Kurdish authorities are pressuring a beleaguered Baghdad for increased independence, by leveraging hydrocarbons resources and recent territorial gains.

If the KRG breaks away from Iraq, it is clear that, fiscally, the Kurdish government would use oil revenues to offset the current annual transfers of $12 billion from Baghdad. In this sense, Kurdistan could be heading toward the same mistakes made by many oil-rich countries in the Middle East: becoming a rentier state dependent on a single revenue source. So far, public discourse in the region has not included discussions of a diversified development strategy beyond the export of oil. Without addressing this issue, however, Iraqi Kurds may achieve a weak and fragile independence.

Oil & Statehood

Should the option be available, any fledgling government would jump at funding public finances through the development of natural resources. For the KRG, oil revenues also provide a short-term solution to the ongoing fiscal crisis (although they are, in many ways, also the cause of this crisis). Since May, the KRG has been transporting oil to Turkey’s Ceyhan seaport for sale at discounted rates to undisclosed buyers. The KRG’s decision to sell oil on its own, instead of through the central government, is a legally dubious one. Baghdad claims that only the Federal Ministry of Oil is the only one entitled to sell the crude and has threatened to take legal action against potential buyers of Kurdish oil. The U.S. government’s seizure of an oil tanker chartered by the KRG near Texas is a clear example of the lengths Iraq’s government is willing to go to ensure that Erbil does not circumvent its authority.

To offset budgetary transfers from Baghdad, oil production levels must reach 450,000 barrels per day, according to estimates made in June of this year. Minimum levels are likely even higher now. Kurdistan lacks the infrastructural capacity to produce or transport oil at such levels. Exacerbating these limitations, development projects in the region are threatened by the on-going violence.

Separate from these logistical problems, Kurdish authorities are pursuing a political vision that is fraught with risks. Years of empirical research have shown the inherent shortcomings of development policies dependent on oil revenues. These include the disruptive impact oil price volatility has on state finances and political stability. Agricultural and manufacturing sectors also become less competitive, as domestically-produced goods tend to experience price hikes in oil-dependent economies. Unproductive rents, like income from oil, also make governments more likely to apply public funds to magnificent infrastructure projects with little use or value to average citizens. Oil rents help sustain and nurture unaccountable governments, which can buy popular allegiance or complacency through cash handouts to citizens.

But vast natural resources do not inherently condemn a country to the resource curse. This negative outcome can be avoided in Kurdistan, if the government prioritizes the quality of its governance mechanisms and carefully thinks through how to use its oil reserves.

Neglected Reforms

Unfortunately, however, it appears Kurdistan is already showing signs of the resource curse. Apart from its oil industry, many economic sectors in the KRG are largely underdeveloped. While real estate development is rapidly increasing in urban areas, this has not been accompanied by public investments in areas critical to economic growth, including transportation, communications, and energy facilities. Financially, the current drop in oil prices has also exhausted both Kurdish and Iraqi coffers. Also, some commentators have already expressed concerns over the democratic environment in Kurdistan, where the government has used oil rents to seek legitimacy and average citizens do not play a role in sustaining the region’s civic and political institutions.

Sustained development requires responsible investment. In many ways, the KRG is trying to build a state without the changes required to put Iraqi Kurdistan on a development track similar to other successful, emerging economies. The institutions that underpin healthy economic growth require governments to diversify public finances, such as through the adoption of an appropriate taxation policy, rather than relying solely on oil revenues. The government must use its revenue sources, whether from oil or taxes, to finance the right kinds of investments.

In particular, financing recurrent expenses, such as public salaries, through finite oil revenues is unsustainable. Instead, these one-off revenue flows should be invested in other forms of capital, such as infrastructure (physical capital) or education (human capital). Developing these assets, in turn, attracts foreign investment, generates income sources, and encourages domestic consumption. By taxing these economic activities, the KRG can generate recurrent, sustainable revenue to relieve reliance on natural resources.

The need to tackle Kurdistan’s outsized public sector has also largely been absent from public debate on the region’s economy. The KRG acts as the largest job creator in the governorate. Public sector salaries reportedly absorb 70% of the budget. Under these circumstances, it is imperative to facilitate private sector growth that can provide employment opportunities to the local population.

A final element that must be tackled is reforming the fossil-fuel subsidy system. These kinds of subsidies are widely seen as regressive and inefficient, diverting public resources from other more productive uses and benefiting rich rather than poor families. They also place a significant burden on the public budget.

While data on Kurdistan is unavailable, the IMF estimates that these subsidies represented 13% of Iraq’s government revenues in 2011. Due to the current fiscal crisis, the KRG has had to implement a temporary decrease in fuel subsidies. More reforms are, however, necessary in order to provide support to those in need, in line with other emerging economies.

No Alternate Approach

The resurgence of violence throughout Iraq along with the fiscal crisis in Kurdistan has provided a window of opportunity for Kurdish authorities to develop strategies to operate as an economically independent region, a necessary step for further self-autonomy. For now, the cornerstone of these strategies is relying on abundant oil resources to sustain public finances. In building toward statehood, KRG officials have yet to propose a development path that promotes economic reforms required to avoid the resource curse. As a result, an autonomous Kurdistan is bound to experience the same development woes faced by Iraq and other oil-rich nations in the region.

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