Wednesday, December 28, 2005

The End of Iraq's Gasoline Subsidies

As my friend Hassan wrote on his blog, the outgoing Iraqi government had a little post-election surprise for the electorate: a 800% hike in gasoline prices. Iraqis were outraged, protests were held, some areas in Iraq refused to implement the new pricing scheme, and in other areas, Sadr's militia took over gas stations to make them keep selling at the old price.

I am quite sure the timing of these gas price hikes was no accident - the outgoing government knew they'd be highly unpopular and if they did it before the election, it would have cost them dearly at the ballot box.

Iraq's fuel price hikes may be painful, but they are a necessary step in ensuring Iraq's long-term financial viability. For decades, Iraqis have gotten used to paying rock-bottom prices for gasoline - perhaps the lowest prices in the world. These low prices have fueled a thriving black market in gasoline - both for local consumption as well as for export. A few months ago, Christian Science Monitor published a very informative piece on how this black market works:

Typically, a truck driver will pick up a load of fuel at a refinery. Rather than delivering it to a gas station, he will take it to a place like White Gold. Oil ministry officials are paid to look the other way, the gas station owner is paid off for not receiving his shipment, and the driver makes a profit when he sells it.

"The employees at the gas stations these days are like emperors," says Hassan. "The guy in charge of cleaning the station has a brand-new car. Everyone knows this. It's not a secret anymore." On the highway, he says, "If you notice, you will see six or seven trucks guarded by the Americans. This is not for protection. It's to prevent corruption."

The Christian Science Monitor piece also describes how low fuel prices, "can entice people like factory workers or fishermen to sell their ration to smugglers and even forge documents to get more rations. Smugglers can then resell the fuel in neighboring countries at much higher prices."

Back in June, I wrote a blog post titled Iraqi Fuel Shortages: the real cause where I discussed Iraq's chronic fuel shortage problem, and how the problem stems directly from the heavy subsidies and the artificial demand created by them. The elimination of these subsidies, while painful, is the only real cure.

As I wrote in my earlier post:

Another problem with subsidized fuel is that it artificially inflates demand, and can allow demand to reach unsustainable levels. Prior to the Iraq war, Iraqi demand for gasoline was 15 million litres per day. Today, thanks to an influx of automobiles and electrical generators, the demand is 23 million litres per day. And, many of these consumers are driving cars they could not afford to maintain if fuel was selling at market prices.

Unfortunately, the basic nature of subsidies does not provide much of an incentive for the Iraqi government to fix the supply situation, since every gallon of subsidized gasoline they sell is another dollar of government money down the toilet.

In addition to causing supply-chain problems, Iraq's gasoline subsidies cost the Iraqi government over $3 billion per year to sustain. Think about that number: THREE BILLION DOLLARS. That's a lot of money. That kind of money could go a long way to buying medical supplies, fixing hospitals, buying school books, patching up the nation's woefully unstable electrical grid, or adding new electrical generating capacity. Instead, it is being wasted.

The gasoline price hike that Iraq just implemented is probably only a first step: taking the gas price from a measly 5 cents per gallon to 40 cents per gallon. While this is eight times higher than the old price, it is still heavily subsidized: here in the US we spend about $2 per gallon of gasoline, while in other Persian Gulf countries, the average gas price is just under a dollar. According to a Washington Post article today, these price hikes will not be the last:

The price increase brought the cost of a gallon of gasoline to the equivalent of about 40 cents from less than 5 cents. It is meant to be the first in series of jumps over the next year designed to raise the price of fuel to the average in Persian Gulf states, which a U.S. official said Tuesday was about 93 cents per gallon.

When the price reaches 93 cents per gallon, it will be at fair market value with respect to the rest of the region, and I would expect Iraq's fuel supply headaches will be completely gone. The black market will disappear, since the fuel is no longer being sold below-cost, and supplies will become more free-flowing from neighbors as Iraqis will no longer be dependent on government imports.

Interestingly, some officials in the outgoing Iraqi government blamed the price hikes on former prime minister Iyyad Alawi. Of course, this is a fallacy. Iraq recently struck a deal with the International Monetary Fund (IMF) to forgive up to 80% of Iraq's foreign debt, which required Iraq to phase out its fuel subsidies as a precondition. The real blame for the price hikes should be levied at Saddam, who instituted these heavy subsidies in the first place.

While Iraqis may find the price hikes in gasoline painful, this step is necessary to ensure stability of the gasoline supply-chain in Iraq, to eliminate the black market, to encourage Iraqis to use fuel responsibly, and to free up tax dollars for better uses.