Iraq is confronting an economic crisis as its oil sector collapses due to the war involving Iran, placing immense pressure on an already weak caretaker government struggling to manage the escalating conflict's fallout.

Following the outbreak of hostilities, Iraq's daily oil exports have dropped sharply from 3.4 million barrels to approximately 250,000 barrels. Storage facilities are nearing critical capacity because Iran has effectively blockaded the Strait of Hormuz, severing Iraq's primary maritime route and slashing its oil output by nearly three-quarters.

The responsibility for managing this crisis falls to a caretaker government with limited authority, which remains in office five months after the last general election concluded.

The Iraqi government is also contending with U.S. military strikes, ongoing for over three weeks, targeting Iran-backed Shia militia groups within its borders. Washington is effectively fighting a shadow war against Iran on Iraqi soil. This week, a suspected U.S. attack on a military base resulted in the deaths of seven Iraqi soldiers.

Renad Mansour, Director of the Iraq Initiative at Chatham House, stated, "Iraq is now far more vulnerable than the Gulf states. A divided country can barely function during normal times, but it becomes highly susceptible to shocks during a major conflict."

Economists note that Iraq's failure to modernize and diversify its economy over the past two decades leaves it exposed to "unique" risks in the current conflict.

As one of the world's most oil-dependent nations, crude sales account for roughly 90% of Iraq's state budget. Concurrently, the country relies on imports for 90% of its consumer goods, food, and medicine, most of which transit the Strait of Hormuz. Its power grid is heavily dependent on natural gas imports from Iran, which have declined significantly following Israeli attacks on Iran's largest gas field.

Justin Alexander, Director of Khalij Economics, estimates that Iraq, OPEC's second-largest producer, has already lost approximately $5.4 billion in oil revenue due to the Strait blockade—close to 2% of its projected 2024 GDP.

Iraqi economist Abdul Rahman al-Mashhadani indicated that the state budget is under severe strain, with existing funds sufficient to cover public sector salaries for only the next month or two. A funding crisis could emerge as early as May.

The challenges facing the government are further complicated by attacks from Iran-backed radical Shia militias on various U.S. targets, including the U.S. Embassy in Baghdad, a military base in Erbil, as well as hotels and oil and gas facilities.

Suspected U.S. retaliatory strikes have hit multiple locations across Iraq, including an attack on a residential area in central Baghdad last week.

Mansour added, "In recent years, the government used periods of relative stability to build bridges and roads but failed to simultaneously diversify the economy or establish a unified security apparatus to prevent such attacks."

Baghdad is urgently seeking alternative routes for oil exports, including repairing an existing pipeline and another damaged pipeline in the north. Last week, Baghdad declared force majeure on all oil fields developed by foreign companies.

Al-Mashhadani noted that Iraq aims to increase current daily exports to 500,000 barrels. However, even that level "falls far short of covering basic obligations like social welfare payments, let alone salary disbursements."

Iraq currently can only export about 250,000 barrels per day via a single pipeline running from the semi-autonomous Kurdish region to the Turkish port of Ceyhan. Iraqi officials revealed that this arrangement is fragile, stemming from long-standing disputes between Kurdish authorities and Baghdad, and was only reached under U.S. pressure.

In January, Iraq's Foreign Minister, who also chairs the Economic Committee, stated that the country runs a monthly fiscal deficit largely due to supporting a bloated public sector wage bill. Public sector employment, a key source of political patronage for various parties, accounts for about 40% of Iraq's workforce.

"Besides borrowing directly from the Central Bank and the International Monetary Fund, the government has few options," al-Mashhadani said, pointing out that the Central Bank of Iraq had provided bailouts during previous crises like the COVID-19 pandemic.

The Central Bank of Iraq has claimed it possesses reserves sufficient for 12 months of imports, but most of this liquidity is held in accounts controlled by the U.S. Federal Reserve. Iraqi officials stated that before the war, Washington had threatened Iraq with a dollar shortage if it did not curb militia activities, raising concerns that the U.S. might reactivate such threats.