| ERBIL, Iraq
ERBIL, Iraq Iraq's Kurdistan region is in danger of being drowned by an economic "tsunami" as global oil prices plunge, its deputy prime minister said, warning it could undermine the war effort against Islamic State.
Four months in arrears and deeply in debt, the Kurdistan Regional Government (KRG), which depends on oil revenue to survive, has been hit hard by oil's slump below $30 per barrel this week from over $100 a barrel two years ago.
Even before oil's most recent losses, the autonomous region was unable to meet a bloated public payroll including the salaries of its own armed forces, the peshmerga, which are on the front line against Islamic State.
"The world is focused on the war against ISIS but nobody wins a war bankrupt," Qubad Talabani said in the interview on Thursday, using an acronym for Islamic State. "I think this is something the coalition against ISIS really do need to factor into the equation."
The peshmerga have emerged as a key component of the U.S.-led coalition's strategy to "degrade and destroy" the radical Sunni militants, driving them back in northern Iraq with the help of air strikes.
But Talabani said the economic crisis threatened progress on the battlefield: "The most dangerous impact it can have is on morale. We are getting desertions. People are leaving their posts -- it will increase."
The oil price crash has compounded Kurdistan's economic woes, which began in early 2014 when Baghdad slashed funding to the region to punish it for exporting crude on its own terms in pursuit of economic independence from Iraq.
Then Islamic State overran a third of Iraq, driving more than one million refugees into the region of five million and scaring off foreign investors.
In an effort to tackle the crisis, Kurdistan ramped up independent oil exports last year to more than 600,000 barrels per day (bpd), but at current prices the region is still left with a monthly deficit of 380-400 billion Iraqi dinars ($717 million).
Asked whether the KRG was calculating it might be better off resuming oil exports under Baghdad's auspices in return for a slice of the revenue from their combined exports of more than 3.8 million bpd, Talabani said it would make little difference.
"I don't think this is a calculation we're thinking of or they're thinking of because it doesn't actually change the equation for anyone."
"At this oil price, a couple of hundred thousand barrels here or there is not going to fix Baghdad's problems and it's not going to fix ours. We have to think of another formula to fix our economic problems".
A deal last year whereby the KRG agreed to export 550,000 bpd of crude through Iraq's state oil marketing firm SOMO in exchange for the reinstatement of its budget share was never properly implemented.
The same arrangement is embedded in Iraq's 2016 budget, but Talabani indicated the KRG did not intend to implement it.
"The fact that the control continues to lie 100 percent with the central government and the lack of clarity with our share of the budget and how it's calculated would restrict us from going along with what's written in the 2016 budget," Talabani said.
"We don't want to rule out a deal, but we want a deal that's fair," he said, adding that it need not entail the KRG exporting oil via SOMO.
After the oil-fueled economic boom it enjoyed in the wake of the U.S.-led invasion of Iraq in 2003, the Kurdistan region faces spending cuts and economic reform, and is also looking efforts to raise non-oil revenue.
In December, the KRG cut the allowances of ministers and other officials by as much as 50 percent and eliminated perks enjoyed by senior civil servants, and Talabani said bigger changes were on the way.
"We're not bankrupt yet but if we don't enact structural and actual reforms the current situation is not sustainable," Talabani said.
The reforms will target three main areas: fuel subsidies, the power sector and the public payroll, which costs the region 875 billion Iraqi dinars ($804 million) per month.
The KRG has already opened up the fuel market to private companies and will consider selling parts of the electricity sector, Talabani said.
"This is a tsunami. Either we react and respond to it or get dragged under. The initial step is to stop the ship from sinking".
The region, which has racked up between $15-$18 billion of debt, is also considering ways of raising money abroad such as soft loans, bailouts, pre-payment agreements and monetizing assets, including oil infrastructure, Talabani said.
Plans to issue a $500 million Eurobond were derailed last year by falling oil prices and rising political tensions but could be revived in the future: "We certainly haven't scrapped that idea but it's shelved for now."
NO SIGNS OF RECONCILIATION
Despite recent gains on the battlefield, Talabani said he did not expect an offensive to retake the northern city of Mosul this year: "I don't think the Iraqi armed forces are ready".
The peshmerga will play a role in the offensive whenever it happens, but the Iraqi army must take the lead, he said.
In the meantime, more needs to be done to find a political solution. "I don't see any traction on political reconciliation in Iraq," Talabani said. Compared with a year ago, Sunni disenfranchisement was now deeper and Shi'ite mistrust of Sunni intentions greater, he said.
"All of these are factors that are going to slow down our progress in the war to degrade and ultimately destroy ISIS".
(Editing by Dominic Evans)