Low oil prices and the battle against Islamic State (IS) are pushing Iraq toward a financial crisis. Only fundamental reforms, especially decentralization of power, can resolve the challenges facing Iraq today.

Oil exports are by far the most important segment of Iraq’s economy, making up about half of the country’s GDP and 90% of government revenue. Given the state’s reliance on oil, investors pay careful attention to the conditions of the industry. And today those conditions are mixed.

On the positive side, the country appears to be pumping and exporting more oil than expected, almost four million barrels a day, thanks to investments in production. And the government in Baghdad appears to be on better terms with semi-autonomous Kurdistan—neither were upholding the terms of the 2015 budget agreement, with the former paying less money than promised and the latter providing less oil than promised.

But Iraq’s oil industry, and the government’s budget, is being squeezed by low oil prices. As a result, the nation’s finances are being hit hard: the market price is now half that needed to break even, expanding the budget deficit, forecast to return to balance until the rise of IS, to a projected 9% of GDP.

In the past, Iraq’s leaders approved budgets without seriously taking into account a drop in the price of oil. Now the severe revenue shortfall is forcing leaders to cut back on new investments. Russia’s Lukoil, Royal Dutch Shell, and Italy’s ENI are also cutting back, eyeing neighbouring Iran’s pending economic opening as a safer investment.

Despite improving its finances after the US troop withdrawal, the drop in oil prices and the rising costs of battling IS have pushed Iraq’s economy into a state of near-crisis. According to the IMF, the nation’s GDP shrank by 2.7% in 2014 and unemployment is estimated to be over 25%.

The World Bank rated Iraq one of the worst places in the world to do business in 2015: 156th out of 189 countries. The government is in talks with the IMF for a loan worth over $800 million to finance some of the budget shortfall. However, the country requires more fundamental reforms if it is to achieve long-term economic stability.

The link between violence and economic instability

Iraq’s latest economic problems are linked to the increasingly costly battle with IS, now in control of much of Anbar province and Mosul, the nation’s second-largest city. To stop the insurgency, many analysts have called on Iraq’s Shia-dominated government to reach a reconciliation with the Sunni minority. But Sunnis have a long list of grievances, stemming from the atrocities committed during the civil war under US occupation and the intense political conflict after the US withdrawal.

Iraq’s Sunnis claim that they are targeted by security forces as punishment for collusion with insurgents like al-Qaeda in Iraq and IS. Reports of detentions without evidence, the use of de-Baathification laws to keep them out of lucrative government jobs, and forced eviction from their homes may have contributed to IS’s rise. Many Sunnis see the extremist group as preferable to the Shia-led government and current security forces.

But Iraq’s Sunni-Shia divide is a symptom of a more fundamental problem in poor governance. Writing for the Brookings Institution, Luay Al-Khatteeb explains how power in Iraq has been highly concentrated with the executive branch and bureaucrats, who have wide discretion to implement policy without legislative or judicial oversight.

The judiciary, already at a disadvantage after years of irrelevance under Saddam, is subject to executive pressure and does not adequately enforce property rights. Corruption has also worsened after the US withdrawal in 2011.

Rather than being the cause of Iraq’s poverty, persistent violence has become part of a cycle that feeds off the country’s weak institutions, in what Stanford economist, Barry Weingast, calls the “violence trap”.

The key problem is that reducing violence in the long term requires alternative opportunities, and those opportunities tend to require reforms that respect the rule of law, protect property rights, and promote trade. Yet, those reforms rarely arise absent the kinds of opportunities that reduce violence in the first place, and so poorly governed states like Iraq are trapped in a cycle of violence.

Partition: the least bad option?

The long-term threat that violence poses to Iraq’s future is illustrated by the increasing role that Shia militias, often trained and funded by Iran and unconnected to the central government, now play in combating IS. Financial Times correspondent, Borzou Daragahi, argues that the Shia domination of the security services “will have the deepest and most lasting impact on Iraq.”

This deepening sectarianism is convincing some analysts that the best option, or perhaps rather the least bad option, is for Iraq to divide along ethnic or denominational lines. Iraqi Kurdistan is already largely self-governed, and is even planning to issue semi-sovereign bonds to help finance oil industry development and its own fight against IS. Writing for Foreign Affairs, Marina and David Ottoway describe how the Kurdish example is prompting other provinces to seek greater autonomy from Baghdad.

Not all agree, but most arguments against partition do not put enough emphasis on Iraq’s poor governance. In Iraq, imperfect partition or poorly-executed federalism may be preferable to the current regime, despite the fact that conflicts over state finances, especially access to natural resources, would pose huge challenges.

Solving Iraq’s financial crisis requires fundamental reforms to how Iraq is governed, not just the defeat of IS and a sectarian reconciliation. But the slim prospects of reform from within the central government may drive some in Iraq’s periphery to push for more independence from Baghdad.

Frederic Hof, a senior fellow at the Atlantic Council, describes the growing movement for self-government among the victims of Syria’s civil war. It is likely that minorities in neighbouring Iraq, stung by years of corruption and abuse by their leaders, have similar designs.