Groundbreaking advances in the Region’s energy sector and an expanding customer base for its oil and gas exports have marked the beginning of a new chapter in Kurdistan’s economic growth. While these developments promise exciting new opportunities for the Region’s economy, ISIS-led violence and previous budget disputes with Iraq’s federal government serve as reminders that Kurdistan must continue a trend of fortitude and pragmatism to maintain the economic progress that has so far distinguished it from its regional peers.

Striving to Grow

The KRG Ministry of Planning predicts annual economic growth at a rate of 8% for the 2014-2016 period. This year’s growth figures may be negatively impacted by recent ISIS-led violence in the region, however. The IMF predicts that the Iraqi economy as a whole will shrink by around 2.66% this year, a downward revision from original projections of growth somewhere in the region of 5.9%. The extent to which this broader regional downturn will affect the Kurdistan Region’s economy in the near term is unknown. Looking at past GDP data, though, gives a picture of the Region’s long-term growth potential. In 2012, the Region’s GDP grew at a rate of 12%.

In 2013, GDP growth decreased slightly but remained a robust 8%. Figures from 2011, the most recent numbers available, estimate the Region’s total GDP to be in the area of $23.6 billion.

Another testament to the Region’s upward economic trajectory is the progress that has been made in raising standards of living amongst the Kurdish populace. Annual per capita income in the Kurdistan Region is now $7,000, while in 2002 it stood at just $800. Unfortunately, the KRG has been unable to publish inflation figures for the current year that would help paint a more accurate picture of the real improvement in living standards brought about by this impressive rise in income.

Despite these improvements, unemployment figures indicate that more work is needed to close the skills gap in the Kurdistan Region’s changing economy and reflect the strain that prolonged tensions with Baghdad have placed on the regional business climate. By September 2014, the unemployment rate in the Kurdistan Region stood at 10%, having increased from 7% at the end of 2013. Specifically, a lack of available credit, sanctions levied by Baghdad against the KRG, and a shortage of jobs that match the skillset of new entrants into the workforce have been identified as factors hindering reductions in unemployment levels. When contrasted with Iraq’s overall unemployment rate of nearly 46%, however, the relative success of the Kurdistan Region’s economy despite the obstacles it currently faces stands out.

Going forward, the KRG has set its sights on increasing private sector employment, which stands at just 48.9% of the active labor market at the moment. The regional government also aims to close the gender gap in the area’s labor market participation rates and unemployment levels. While 67% of men in Kurdistan are active in the local economy, just 14% of women in the Region participate in its labor force. The disparity also extends to unemployment rates. In 2011, for instance, women who were active in the labor market faced unemployment levels that were over twice as high as their male counterparts.

In the future, the KRG plans to capitalize on a young population (over 50% of the Kurdistan Region’s population is under the age of 20) and build an economy characterized by innovation and equal opportunity for men and women. To do so, the government will focus on legal reforms, skills-building programs, pension and benefits reforms, the development of an unemployment insurance system to make employment in the private sector seem more secure, and initiatives aimed at helping women participate and get ahead in the Region’s labor market.

Fertile Ground for Investment

Kurdistan continues to set itself apart in Iraq and the Middle East as an investment destination. In the past few years, annual capital investment in licensed projects in the Kurdistan Region grew by nearly 400%, rising from $3.1 billion in 2011 to $12.4 billion over the course of 2013. There are currently around 80 planned or ongoing licensed investment projects in the Kurdistan Region representing a value of over $39 billion. To put that amount in context, the total value of licensed investments in Kurdistan over the 2006-2014 period was $41.9 billion. Despite growing investor interest and an expanding portfolio of projects, recent regional turmoil has touched the Kurdistan Region and shaken investor sentiment. Over the first 8 months of 2014, for instance, investment in the Region had reached just $3 billion.

Despite these setbacks, progress has been made in diversifying the regional economy. While the housing sector had previously dominated projects licensed by the Board of Investment (BOI), 2014 saw a continuing trend towards projects in the industrial sector, which has emerged as the primary destination for investment. The BOI froze licenses for projects in the housing sector after around 160 projects had been approved. This was done to focus more on sectors such as industry, tourism, and agriculture. Over the course of the last year, that shift in emphasis has borne fruit. Industrial investment licenses have finally surpassed those in the housing sector and represent around 184 projects valued at a total of $12.8 billion according to data from the KRG’s Ministry of Planning. That number is approaching but still short of the $13.6 billion in capital investments that have gone towards the housing sector in Kurdistan since 2006. The Ministry’s figures reveal that industry and housing together represent nearly two-thirds of capital investments and half of all capital investment licenses in the Kurdistan Region to date.

Over the same period, the tourism sector has seen $6.6 billion (15.7% of total investment) invested in a total of 128 projects, while $5.1 billion (12.1% of total investment) has flowed towards 114 projects in the trading sector. Agriculture and other sectors lag behind, attracting less than $4 billion in combined investment.

Oil & Gas: The Engine of Economic Growth

The oil and gas industry continues to form the bedrock of Kurdistan’s economy, and the past year has been one of great accomplishments for the Region’s energy sector. Independent exports of the Region’s oil resources commenced through a newly completed pipeline to Turkey via the border town of Fishkhabour. The pipeline currently has the capacity to transport 300,000 bpd to Turkey, with a potential capacity of 500,000 bpd in the near future. The current year will also see new records set in oil production in the Kurdistan Region. Aggregate production capacity has risen to 280,000 bpd and is projected to increase further to 400,000 bpd by the end of the year. The KRG has set a production goal of 1 million bpd by the end of 2015 and aims for levels of 2 million bpd in the coming years.

Baghdad has made efforts to thwart independent oil exports from the Kurdistan Region, threatening legal retaliation against those who purchase oil exported outside its control. This has made it more difficult to find buyers for Kurdish crude oil, which is being shipped from the Turkish port of Ceyhan. Despite this, the Kurdistan Region seems to be finding a growing number of buyers around the world. One factor that may complicate matters is the recent slide in world oil prices, which have dipped under $80 a barrel recently. Experts point to an oversupply of oil stemming from sluggish economic growth and lagging demand around the world, along with the glut of new supplies coming online in places like the United States, as sources of the recent slide in prices.

Budgetary Pressures

In January, disputes over oil revenue and control of natural resources between the KRG and the federal government led Baghdad to suspend payment of the entirety of the Kurdistan Region’s share of Iraq’s national budget. This has been especially problematic since over 50% of the Region’s population is employed in the public sector, something which the KRG itself has identified as an unsustainable over-reliance on government jobs. Many workers in the public sector have not been paid in months, further straining the overall economy of Kurdistan and denting consumer confidence. A measure of relief for this situation has come from revenues gained from Kurdistan’s growing number of successful oil sales. In the period through December, the KRG collected $1.7 billion in revenue from independent oil sales.

In 2013, the KRG’s regional budget stood at $13.1 billion. Even before Baghdad cut off federal funds at the beginning of this year, budgetary disputes marred relations between Erbil and Baghdad. The KRG is entitled to a 17% share of Iraq’s overall budget. That money is first distributed across federal agencies in Iraq before it is dispersed to the KRG, so Kurdistan’s actual share of the federal budget has tended to settle more in the area of 11-13%. This system of budget allocation has been characterized by frequent disagreement. In 2013, tensions over revenues and resource rights that would set off the current budget impasse in Iraq were already brewing. A federal budgetary allocation of $646 million to pay oil and gas companies operating in the Kurdistan Region that year greatly undershot a KRG request of $3.5 billion, which Kurdish leaders claimed was needed to cover funds already owed to it by the federal government.

In December, leaders from the KRG and the Iraqi federal government announced a long-term agreement to work collaboratively on oil exports and finally normalize the budgetary situation of the Kurdistan Region. The KRG has promised to supply 550,000 bpd of oil for sale by Baghdad authorities, with revenues to be divided between both sides. In return, Iraqi PM Haider al-Abadi's government has pledged to permanently restore budget payments to the Kurdistan Region that will, for the first time, include funds to pay and outfit the Region's Peshmerga forces.

Laying the Foundations of Future Prosperity

The KRG has outlined bold goals for the Region in its 2013-17 Regional Development Strategy. The Strategy calls for diversification of the Region’s market, a streamlined investment process, and a drive towards exports in order to make the regional economy more competitive and raise standards of living. Its targets include raising tourism expenditure in the Region to $1.5 billion by 2017 (from a level of $320 million in 2009) and developing the Region’s mining sector. To boost competitiveness, the plan aims to reduce construction costs and shorten timelines for project execution to levels that undercut neighboring countries by 2017. It also envisions increasing investment rates to 20% of GDP and expanding GDP growth by 10% each year through 2017, in addition to raising the number of licensed businesses across all sectors of the economy by 15% per annum over the same period.

Finance: Building Trust

Kurdish leaders continue to strive for a modern, dynamic banking sector to complement the Region’s growing economy. Despite this, the Kurdistan Region continues to struggle under cumbersome red tape from banking authorities in the federal government, a lack of integration into international financial networks, and a legacy of distrust among Kurdish citizens.

Opportunities & Obstacles

The Kurdistan Region’s economy remains largely cash based and its banking sector is relatively underdeveloped compared to other countries in the region. While the standard international ratio of bank branches to customers is around 1: 10,000, in Iraq that ratio stands at 1:30,000. In addition to 3 large state-owned banks, there are around 20 homegrown private banks and over 10 foreign private banks operating in the Kurdistan Region. The majority of private international banks working in the Region are from Lebanon and Turkey.

International banks have an increasing presence in the Region, but they tend to cater to businesses from their home countries and are prevented from competing in the same market segments as domestic banks. The past year has seen important steps forward, though. The UK’s Standard Chartered Bank opened a new branch in Erbil, becoming the first major international bank with comprehensive operations in the Region. In another landmark development for the finance sector, the Erbil Stock Exchange prepared to launch at the end of 2014 with the help of 4 local firms that will be going public.

The Kurdistan Region is also home to a burgeoning Islamic banking industry. There are currently six local Islamic banks in operation, along with foreign firms such as Abu Dhabi Islamic Bank and Al Baraka. Among the most successful local Islamic banks is Kurdistan International Bank, which is the only Islamic financial institution among Iraq’s 5 largest banks. The industry is awaiting a regulatory structure from Baghdad authorities that is specifically designed for Islamic banking.

During the reign of Saddam Hussein, banks in Iraqi Kurdistan were frequently looted and depositors often found that their savings had simply vanished, creating what North Bank’s chairman Nawzad Jaff describes as a “deep-seated mistrust in banks.” For residents of the Kurdistan Region today, trust in the regional banking infrastructure continues to be undermined by recurring liquidity crises. Lingering doubts about the safety of their money with local banks have led residents of Iraqi Kurdistan to turn to practices such as hiding savings in their homes or investing in gold as a store of value.

Calls for Reform

The task of creating a truly modern banking sector will require substantial reform in Baghdad. While the KRG has used its political autonomy to fashion a largely business and investment-friendly environment, the banking sector falls entirely under the purview of the Central Bank of Iraq in Baghdad, which has the sole authority to regulate the banking sector and issue licenses for banks to operate in Iraq.

Many analysts point to regulations that seem to be biased in favor of large, state-run Iraqi banks as key impediments to a modern, competitive banking sector in Kurdistan. State-controlled Rafidain Bank and Rasheed Bank, for instance, control nearly 90% of banking business in Iraq. Aside from assured business stemming from federal regulations prohibiting government agencies, government employees, and state-run corporations from dealing with private sector banks, Iraq’s state banks gain an advantage in the minds of customers from the implied guarantee that state funds will back up deposits.

Kurdistan also lacks the regulatory and physical infrastructure for industries that could support a healthy banking sector. The Region’s insurance sector remains very limited, mortgages are virtually non-existent, and a web of confusing regulations and out-of-date technology contribute to inefficiency.

Iraqi authorities have acknowledged the need for reform, yet little in the way of reform legislation has actually been passed. Political turmoil surrounding the rise of ISIS has only contributed to doubts about the Iraqi government’s ability to implement changes in the near-term that will foster a more competitive, modern, and capable banking sector. For its part, the KRG has repeatedly expressed its desire for reform in the banking and finance sectors. The PM Nechirvan Barzani recently added his voice to the chorus of Kurdish leaders calling for change, saying: “I believe the time has come for us to seriously examine international financial practices and carefully consider how modern banking can help families and businesses to manage their wealth.”