The long-running budget dispute between Iraq’s federal government and the Kurdistan Regional Government (KRG) is rooted in incompatible approaches to federalism in the post-Ba’athist state. Over the past decade, Baghdad’s centralizing efforts have clashed with Erbil’s desire for stronger regional control over its own affairs, especially with regard to oil and gas. The result is a series of failed budget deals that have ill-served residents across the country.
The economies of both federal Iraq and the Kurdistan Region are dependent on oil and gas, with non-hydrocarbon revenues contributing less than ten percent of the public budget. As a result, how each side interprets their respective rights and responsibilities related to management of the energy industry and sharing revenues is the central challenge when it comes time to write an annual budget.
“These are structural issues based on the nature of the corrupt hybrid political system and the undiversified rentier economy,” Zeinab Shuker, a sociology professor at Sam Houston University, told the Red Line.
“Both of these undermine the state’s capacity to respond to issues and problem-solve and limit the political will of those in a position of power to engage in any real political and economic change,” Shuker added.
The result is a profound impasse that slows Iraq’s development and inhibits the authorities’ ability to deliver services to residents. Moreover, in the Kurdistan Region, when serious disputes with Baghdad arise, public sector salaries go unpaid and services deteriorate, which destabilizes faith in the ruling parties and empowers populist opposition groups.
While revenue from oil and gas is the specific issue over which the two capitals grapple, most analysts identify a deeper disagreement.
Ahmed Tabaqchali, a visiting fellow at the London School of Economics’ Middle East Centre, told the Red Line that “the differences are fundamental and go to the nature of the federation as envisaged in the 2005 constitution.”
“Unless that is addressed through a common understanding…I cannot see it ever being resolved,” he added.
Questions about federalism underly the budget disagreement between Baghdad and Erbil, but this is given voice in specific sections of Iraq’s 2005 Constitution.
Articles 116 and 117 established the Kurdistan Region as a decentralized authority, with Article 121 endowing it with a wide range of legal powers.
Nevertheless, the Kurdistan Region exists within the federal framework, which comes with both rights and responsibilities. On the one hand, Erbil is entitled to receive a share of the federal budget, but on the other it is expected to contribute funds to the public treasury to be distributed country-wide according to annual legislation.
Over the past decade, Baghdad and Erbil have been unable to agree how to balance this dynamic in a way that each side feels is fair.
Articles 111 and 112, which govern the development of Iraq’s oil and gas resources, also play a role. There is significant ambiguity in the wording of these articles, which enables both sides to interpret them in a way that advances their financial and political purposes.
The most commonly proffered solution is for the Council of Representatives to pass a national oil and gas law to codify constitutional principles. Without it, Baghdad and Erbil are left to renegotiate terms year after year.
Passing a hydrocarbons law “is both legally and technically doable…it’s a matter of political will,” Bilal Wahab, the Wagner fellow at The Washington Institute for Near East Studies, told the Red Line.
While politicians in both capitals routinely say that they want to solve their disagreements on the basis of the constitution, resentments on both sides over real and perceived failures to uphold previous agreements have eroded trust and empowered spoilers to influence the negotiation process. This renders the process unpredictable and dependent on political circumstances.
Undoing this knot will require “a paradigm shift, where oil is not seen as a political tool, but an economic asset. But, unfortunately, honestly, I just don’t see that happening,” Wahab added.
The start of the problem
In the period following the adoption of the Iraqi constitution in 2005, disagreements over federalism and oil were largely managed through negotiation, but these procedures began to unravel by 2009 as attitudes in Baghdad shifted.
The sectarian war between the Shia and the Sunnis that raged in the aftermath of the US invasion in 2003 until 2008 resulted in a strategic victory for the Shia. Once that primacy was established, their leaders began to advocate greater central control of the entire country.
“In the eyes of Baghdad, federalism basically means some token rights that Baghdad bestows or gifts to the KRG,” said Wahab.
In the mind of the KRG what “is really meant is something practically more than federalism, something like confederalism,” he added.
This gap in interpretation deepened over the next several years. The KRG signed contracts with international oil companies, including ExxonMobil, Total, and Chevron, and began work on a pipeline to Turkey that would eventually enable exports outside federal control.
For some Kurdish officials, particularly within the Kurdistan Democratic Party (KDP), these relationships and the pipeline were a prerequisite not only of securing greater autonomy within Iraq but setting the stage for full independence. They would stage a referendum on secession in 2017.
Through 2013, however, the relationship remained relatively intact and the federal government made regular budget transfers to the KRG, which received a 17 percent share of the total budget. In the Kurdistan Region, this proved quite lucrative, enabling Erbil, Duhok, and Sulaymaniyah to engage in rapid economic development and boost its profile as “the other Iraq.”
This dynamic was not to last. The incompatible political visions held by Baghdad and Erbil came to a head in 2014 when then-Iraqi prime minister Nouri al-Maliki followed through on a threat to cut off budget payments to the KRG when it began exporting oil via the Turkish pipeline.
The suspension of payments caused a major economic crisis in the Kurdistan Region, with the government unable to make payroll.
Wahab identified Maliki’s decision to cut off payments as a significant turning point, which reflected of the changing attitudes of the Shia elite in Baghdad. Once made, there was no reason for them to turn back and assent to Kurdish political and economic demands.
Wahab told the Red Line that it is significant that “no prime minister since Maliki…has said ‘no, we need to undo everything that Maliki did.’”
“Every other prime minister that came after him all agree that the KRG cannot have its cake and eat it too.”
War and referendum
In June 2014, the northern city of Mosul fell to the Islamic State (ISIS) militant group. The ensuing war, which would last until 2017, extensively damaged the economies of both federal Iraq and the Kurdistan Region, the latter which experienced a major influx of refugees and internally displaced persons (IDPs). Both were buoyed, however, by a significant injection of funding from abroad in the form of military and humanitarian aid.
As the Iraqi army retreated south in the initial stages of the war, KRG was also able to take control the vast Kirkuk oil fields, which theoretically would become the key to its economic future.
While the two governments cooperated on the battlefield against ISIS, their dispute over the budget continued and Baghdad maintained its refusal to make cash transfers to Erbil.
As the Kurdistan Region’s economic struggles continued, the KRG introduced a salary withholding program for government employees, including to the Peshmerga military fighters.
Under the scheme, the finance ministry kept as much as half of workers’ monthly paychecks with the promise that it would eventually pay them back. This promise has not yet been honored.
Despite these challenges, Kurdish authorities believed that the time was ripe to attempt an independence referendum on September 25, 2017. Although 92.73 percent of those who voted supported secession from Iraq, it was strongly opposed by Baghdad and the KRG international partners. By mid-October, Iraqi forces had retaken Kirkuk and its oil fields. In the end, the referendum proved a disastrous miscalculation.
As the ISIS war wound down and Iraq’s political system reset after the Kurdistan Region’s independence referendum, Baghdad-Erbil dynamics entered their current phase, during which the federal government mostly resumed payments to the KRG. Typically, negotiations about the budget law for the upcoming year begin in the summer, with draft legislation presented by the government to the legislature in the winter. The Iraqi parliament, known formally as the Council of Representatives, then debates the law with the aim of passing it in January.
Since 2018, the three budget laws passed by the Council of Representatives have run along the same broad terms: in return for 12.67 percent share of the federal budget, Erbil is required to submit 250,000 barrels of oil per day (or its monetary equivalent) to Baghdad.
There has been a lack of implementation of budget laws in two ways. First, the Council of Representatives failed to pass budgets in both 2020 and 2022. Second, the KRG failed to live up to its responsibilities under the laws that did pass, which led to retaliation by the federal government.
The 2018 budget law saw spending increase by 3.5 percent to $ 71.4 billion. Critically, it also lowered the allocation to the Kurdistan Region from 17 percent to 12.67 percent, with the condition that the KRG export 250,000 barrels of oil per day via Baghdad.
Baghdad held up its end, but Erbil did not. It was the first time that the federal government sent regular budget payments to the KRG since 2014.
Following elections and government formation in 2018, the Council of Representatives passed a new $111.8 billion budget law in January 2019, which increased spending by a massive 45 percent. The Region’s share remained at the 12.67 percent set in the previous year’s budget.
Addressing concerns that previous disagreements over the budget had inhibited the KRG’s ability to pay public sector salaries and benefits, lawmakers wrote a provision into the law (Article 10) that required the federal government to continue sending enough money for Erbil to pay salaries even in the event of a dispute. In return, the KRG was supposed to send 250,000 barrels of oil per day to federal oil marketer SOMO.
Despite high hopes that this compromise would enable the two governments to at least manage their disagreements, the law was never fully implemented. When the KRG refused to transfer oil to SOMO, the federal government retaliated by cutting cash transfers.
While the larger aims of the budget law were not realized and Erbil certainly lost out on a significant source of funding, the transfers to pay public sector salaries buoyed the KRG’s balance sheets and enabled Nechirvan Barzani, who at the time was KRG prime minister, to end the withholding scheme in March 2019.
Tishreen and COVID-19
In the summer of 2019, negotiators from both sides began talks to craft the 2020 budget, with an eye to further addressing the dispute. This process was thrown into disarray by the Tishreen protests that began in October 2019.
Under immense pressure from the protesters, Iraqi Prime Minister Adil Abdul-Mahdi announced his resignation in November, leaving the country with a caretaker administration endowed with only limited powers to submit draft legislation to the Council of Representatives. This prevented the cabinet from presenting a 2020 budget law and parliament from passing one. As a result, spending for 2020 was automatically set at the levels set in the 2019 budget law.
The arrival of the COVID-19 pandemic in early 2020 sent oil prices crashing due to oversupply and declining demand during the lockdowns. At one point on March 30, Brent crude was trading at $22.58 per barrel, an 18-year low. This caused a massive budget shortfall amid spending levels that conservatively assumed that oil would be at $56 per barrel.
One of Baghdad’s responses — and one of Abdul Mahdi’s last acts as prime minister before turning over the reins to his successor, Mustafa al-Kadhimi — was to order the suspension of all cash transfers to the KRG, ending an 18-month period where payments had continued despite Erbil’s refusal to submit oil to SOMO.
The result of the suspension was a major financial crisis in the Kurdistan Region. Between March 2020 and June 2021, it could not meet public sector payroll, missing five months of salary payments for government employees entirely and cutting the other months by around 20 percent. It also delayed payments to international oil companies.
Public servants across the Kurdistan Region launched protests against the KRG’s pay cuts, but in Erbil and Duhok governorates these were quickly put down amid arrests of journalists and activists. Populist opposition groups used the situation to heavily criticize the Region’s ruling parties, the KDP and the Sulaymaniyah-based Patriotic Union of Kurdistan (PUK).
The law required the KRG to either submit 250,000 barrels of crude oil per day to SOMO or pay the financial equivalent of that amount at the price set by Baghdad for oil sold in the south. Notably, the KRG would be able to use money from its independent sales above that level to pay international oil companies, whereas it was previously required to make payments out of its budget share.
While the deal raised hopes that the budget law would be implemented by both sides, Erbil again refused to meet its obligations and did not pay Baghdad the equivalent of 250,000 barrels per day. Baghdad retaliated by not resuming payments to Erbil from the budget. With improving oil prices, the KRG’s financial health recovered to a sufficient degree that it was able to resume paying full salaries for public servants.
Ahead of early federal parliamentary election, Iraqi Prime Minister Mustafa al-Kadhimi and KRG Prime Minister Masrour Barzani reached an extra-budgetary agreement in July 2021 where Baghdad would resume limited payments of 200 billion Iraqi dinars ($137 million) per month to Erbil in order to pay salaries. The agreement largely held through the fall, but Baghdad began missing payments again in 2022.
A Federal Supreme Court ruling on February 15, 2022 that found the KRG’s oil and gas law unconstitutional further complicated relations between the Shia parties and the Kurdish ruling parties. So far, its primary effect has been to deter international oil companies from doing business with the KRG, with Baghdad threatening to blacklist those who do so. The ruling adds yet another layer of complexity to the budget negotiations and empowered hardliners on both sides.
Due to the extended disagreement over government formation following the October 2021 parliamentary elections, the Council of Representative’s again failed to pass a full budget for 2022. Spending levels were capped at those set out in the 2021 budget, despite much high oil prices. Unable to legally spend at greater levels, Iraq’s foreign currency reserves have soared above $85 billion. Flush with cash, but without a budget law, Iraqi authorities have been unable to invest in critical development and infrastructure projects.
Iraqi and Kurdish negotiators are set to hold talks over the 2023 budget law in the coming weeks, but the fundamental dynamics that have governed the past five years — or, arguably, the entire post-2003 period — remain unchanged.
Tabaqchali argued that unless the fundamental issue of federalism is addressed, any deals over oil or the budget “are going to be temporary measures because they are going to be full of contradictions.”
Baghdad, and particularly the Shia parties, appear intent on increasing federal control of the Kurdistan Region’s energy industry, while the ruling Kurdish parties are eager to fend off those attempts. Officials say that they will work to pass the long-delayed national hydrocarbons law, but there is little certainty that the effort will succeed.
“The short-term solution is that both governments must realize that they need the resources from each other to operate functionally,” Shuker said.
In the longer-term, however, it is necessary to address deeper structural issues associated with federalism and an economy that is dependent on oil.
“In a hybrid rentier state, where we have states within the state,…political actors are only concerned with personal and group loyalties and interests,” Shuker added.
“This task seems almost impossible without some radical structural changes, which cannot be done without the political will and institutional tools.”