Fragile budget erosion in Iraq: from resource abundance to shrinking financing capacity (20202026)

Financial sustainability has in recent decades become a prominent issue in economic literature, particularly in economies that rely heavily on natural resources to finance public budgets. Real income gives governments a broad capacity to expand spending and delay financial reforms, but this capacity remains constantly linked to the flow of real resources, making them vulnerable to fluctuations imposed by global markets and geopolitical variables.

In this context, Yanoush Kornay introduced the concept of Soft Budget Constraint to explain the behavior of economic units that do not fully bear the consequences of their financial decisions, due to their expectation of receiving support or bailout in the face of deficits. Although the concept originated to analyze institutions in socialist economies, its use was later expanded to include governments and rural economies that rely on exceptional resources that provide a continuing ability to finance public commitments.

The economy of Iraq is an appropriate model for analyzing this phenomenon, as oil revenues for the main source contracts for public budget financing formed, while non-oil revenues remained limited. Oil abundance during the years (20212023) has allowed for the expansion of public spending, especially operational spending, and the strengthening of foreign reserves and net foreign assets, providing the government with a wide margin to continue to finance its commitments.

However, developments since 2024 indicate a gradual change in this environment, as oil revenues declined compared to peak years, foreign reserves and net foreign assets declined, while government commitments continued at high levels. This raises questions about the nature of the transformation experienced by Iraq's public finances, not just about the level of individual financial indicators.

This study does not assume the transition of Iraq to a Hard Budget Constraint, because the practical evidence does not support this conclusion, but rather suggests the concept of erosion under fragile budgets, as a transitional stage in which the ability of geographic resources to finance government obligations begins to decline compared to what it was during years of abundance, without this implying a loss of the state's ability to meet its obligations.

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