Iran Pulse No. 92

No. 92                                              May 19, 2019

Iran Attempts to Make Iraq a Cornerstone of its Strategy for Economic Survival

Micha’el Tanchum*

While attention focused on the enormous political significance of Iranian President Hassan Rouhani's landmark, three-day visit to Iraq in March 2019, capped off by the powerful symbolism of Rouhani's meeting with Grand  Ayatollah Ali Sistani in the Shiʻi holy city of Najaf, the economic agreements signed between Tehran and Baghdad demonstrated the crucial strategic significance of Iran's relationship with Iraq as Tehran struggles to cope with the U.S. re-imposition of sanctions.

Critical advances concerning Iran's sale of natural gas and electricity to Iraq as well as the effort to create a commercial transit corridor via a new Iran-Iraq rail link were further consolidated during Iraqi Prime Minister Adel Abdul Mahdi's two-day visit to Iran in early April 2019. With Iran's economy reeling from sanctions, Tehran has made Iraq a cornerstone in its strategy for overcoming the sanctions' crippling effects.

Iran's Rapidly Weakening Economy

As a result of U.S. sanctions, the Iranian economy contracted 3.9 percent in 2018 according the International Monetary Fund (IMF), which forecasts the economy to shrink by 6 percent in 2019. The forecast is likely an underestimate as it was calculated prior to the announcement by the United States that it would not extend waivers on oil purchases that it had granted to eight nations. In 2018, Iran's total exports fell by $3.7 billion, being under sanctions for only two months of the year, and with Iran's top oil buyers having received waivers.

The IMF predicts that Iran's exports in 2019 will plummet by $31 billion, dropping to

$74.8 billion from the 2018 total of $105.9 billion. Already in 2018, the Iranian rial lost 60 percent of its value and is trading at over 140,000 rials to the dollar on the unofficial market at the time of writing. According to Iran's own statistical reporting, the 2018 general inflation rate was 37 percent, while the inflation rate on food items such as milk and red meat stood at 57 percent.

Iran's Economic Leverage over Iraq: Electricity Dependency and Debt

Despite its oil wealth, Iraq is starved for electricity, and imports approximately 42 million cubic meters of Iranian natural gas per day to fuel its power stations. Electricity generated from Iranian gas as well as the direct sale of electricity from Iran account for one-third of Iraq's power generation. Iraq's dependency on Iran for its power generation combined with Iraq's mounting debt to Iran for natural gas imports, provides Tehran inordinate leverage over Baghdad.

The large, violent 2018 protests in the southern Iraqi city of Basra were precipitated in part by black-outs and the cessation of vital municipal services as a consequence of Iran's halting gas transmission to Iraq in the wake of the Baghdad's failure to meet its payments to Iran. Although Iran restarted gas transmission to Iraq, Baghdad is still caught in the same debt trap.

Shortly after Iran restored the flow of gas to Iraq, Iran announced on September 1, 2018 that Baghdad had agreed to cease using the U.S. dollar as a currency of transaction for its bilateral trade with Iran, opting either for the Euro or the local currencies for its $12 billion bilateral trade with Iran. At the conclusion of his March 2019 state visit to Iraq, Rouhani announced the goal of raising Iran-Iraq bilateral trade to $20 billion, partially through expanded gas and electricity sales to Iraq, further deepening Baghdad's dependence on Tehran.

Iraq's Trade Debt May Help INSTEX

Iraq constitutes one of Iran's top trading partners from year to year, and consistently is the leading purchaser of Iran's non-oil exports, importing 38 percent of Iran's non-oil export products. In 2018, Iran's export of non-oil commodities to Iraq surpassed the volume of Turkey's total exports to Iraq. However, the trade balance between Iraq and Iran is heavily lopsided in Tehran's favour by approximately 75 percent.

Iraq's debt to Iran may also become a key to the successful functioning of the alternative payments channel, the Instrument for Supporting Trade Exchanges (INSTEX), created by France, Germany, and the U.K., the so-called E-3 nations, to enable European businesses operating in these countries to conduct financial transactions with Iran without U.S. scrutiny and thereby evade sanctions.

The system, whose details have not been made public, involves parallel payments within a particular EU state and within Iran. How INSTEX will reconcile payment imbalances between the E-3 nations and Iran remains unclear. Iraq's debt to Iran may help to solve the problem of payments from Iran to the E-3 nations, should these countries increase their oil imports from Iraq. Revenue earned by Baghdad through sales to the E-3 nations could possibly then be used to settle Iran's payments to the E-3. On February 6, 2019, the governors of the central banks of Iraq and Iran signed an agreement to create a payment channel to facilitate the payment of Iraq's debt to Iranian exporters.

Commercial Transit Corridor and Special Economic Zones

Among the agreements signed between Tehran and Baghdad, during Rouhani's high-profile visit, was an agreement to create a rail link between Shalamcheh, a border town in Iran's Khuzestan province and the Iraqi oil port city of Basra. Although only 32 km in length, the Shalamcheh-Basra railway provides the necessary rail connection for Iran to develop a commercial transit route to the Mediterranean.

The project also entails the construction of 700-meter bridge over the Shatt al- Arab/Arvand Rud river that forms the border between Iraq and Iran, where the river empties into the Persian gulf. The larger strategic ambition of the Shalamcheh-Basra cross-border rail link was made clear by Iran's First Vice President, Eshaq Jahangiri, who declared, "We will connect the Persian Gulf from Iraq to Syria and the Mediterranean."

As a more immediate objective to help relieve the effect of sanctions, Iran hopes to economically link the two million plus inhabitants of the Basra region with south-western Iran. In the short term, Tehran hopes that the rail link combined with the elimination of visa fees will attract Iraqi tourist shopping due to the depreciated value of the rial. Beyond this, Iran