1. Notwithstanding extremely challenging security conditions, Iraq has made good progress under the Fund-supported Stand-By Arrangement (SBA) in adjusting to the shocks arising from the ISIS attacks and the sharp drop in global oil prices. In particular, the outlook improved since the SBA approval because of higher oil production and prices, the fiscal deficit and the non-oil primary deficit were sharply reduced, and the balance of payments deficit was narrowed. Moreover, inflation remained in the low single digits. Despite persistent capacity constraints—which were compounded by the ISIS attacks—structural reforms progressed in several key areas. These areas include fiscal transparency, public financial management, as well as integration within the international financial system. In support of Iraq’s efforts, the international community, convened by the United States, pledged U.S.$2.1 billion to United Nations’ agencies last July to help the country progress in the humanitarian, de-mining, stabilization, and longer-term recovery areas.
2. Despite these positive developments, the Iraqi economy continues to face daunting challenges and risks, notably a further decline in oil prices, political and security instability, and considerable constraints in administrative capacity.
Economic Policies and Reforms for the Remainder in 2017-19
3. In order to preserve macroeconomic stability and achieve debt sustainability, the authorities will pursue their fiscal consolidation effort to bring spending in line with available resources. They are keen on minimizing the impact of fiscal consolidation on the population given the large number of internally displaced people and refugees, as well as the expected increase in humanitarian and reconstruction needs as ISIS-occupied territories are liberated. To that effect, they will continue to protect social spending, which includes health and education, transfers in support of the social safety net, and assistance for internally displaced persons and refugees.
4. The revised fiscal program in 2016 and the draft budget in 2017 are closely aligned with the SBA. In 2016, the government is implementing a fiscal program that is significantly more restrictive than programmed because of shortfalls in domestic and external financing. In the 2017 budget, non-oil revenue will go up mainly on account of an increase of the contribution levy to the war effort and the internally displaced people from 3.0 to 4.8 percent of all government employee wages and pensions, which is expected to yield ID 1.2 trillion. At the same time, the wage bill and pension payments will be reduced through natural attrition and the enforcement of existing rules in the case of the latter, while public investment in the oil and non-oil sectors will increase, with a prioritization of projects that have already started in the non-oil sector.
5. In 2017-19, the authorities will design and implement deeper revenue and expenditure reforms in order to continue to contain the non-oil primary deficit and maintain debt sustainability. They will conduct diagnostics of the tax and customs codes and tax and customs administrations with Fund technical assistance in order to increase non-oil tax revenue; reduce the wage bill by natural attrition; complete the audits of the wage earner and pensioner payrolls to first identify, and then cancel payments to non-legitimate wage and pension recipients; reform the contributory public pension system, in coordination with the World Bank; as well as reform the electricity sector and state-owned non-financial enterprises.
6. Public financial management reforms rank high on the authorities’ agenda. In this regard, the authorities will focus in the next six months on completing the inventory of arrears and their audit by the Board of Supreme Audit. Future reforms will include gradually moving to a Treasury Single Account, designing and implementing a commitment control system for budget execution as well as an Integrated Financial Management Information System, implementing Public Investment Management reform, and strengthening Debt Management with technical assistance support from the Japanese International Cooperation Agency.
7. Notwithstanding the envisaged consolidation efforts, large fiscal deficits would remain in 2016-17, reflecting continued spending pressures that cannot be further compressed in the current difficult environment. These deficits will be financed mainly by recourse to domestic financing and external financing catalyzed by the SBA. The authorities are keen to avoid excessive indirect central bank financing of the government deficit. Accordingly, if oil exports revenue is higher than programmed, they commit to commensurately reduce the indirect monetary financing of the budget deficit by the Central Bank of Iraq (CBI).
8. The authorities remain committed to maintaining the peg to the U.S. dollar as the stability of the exchange rate continues to provide a key nominal anchor to the economy in an uncertain environment. They are also working actively on rapidly removing remaining exchange restrictions and a multiple currency practice, in close cooperation with IMF staff.
9. The authorities are taking measures to enhance the stability of the banking sector. The audit of the 2014 financial statements by international auditors of the two largest state-owned banks Rasheed and Rafidain is expected to be completed in February 2017. Based on these audits, the Ministry of Finance will prepare a plan to restructure the two banks. At the same time, the government is strengthening the legal framework of the CBI to provide for independent oversight, building on the 2016 IMF safeguards assessment. The authorities will continue to implement reforms to strengthen the anti-money laundering and combating the financing of terrorism framework. In this connection, the government adopted in October a by-law to set up a mechanism to comply with the relevant United Nations Security Council resolutions related to terrorism and terrorism financing and Recommendation 6 of the Financial Action Task Force on Money Laundering and Terrorism Financing.
Performance under the SBA
10. The Iraqi authorities remain committed to the program’s objectives notwithstanding exceptionally difficult circumstances that hamper adequate implementation. They met all the prior actions for the first review, including the circular concerning the 2016 budget that had not been met at the time of the circulation of the staff report. They also met two performance criteria (PCs), the floor on gross international reserves and the ceiling on net domestic assets, at end-September based on preliminary unaudited data. Moreover, they met three out of five performance criteria (PCs) at end-June 2016. They request waivers of applicability for the four performance criteria at end-September for which no information is available yet and for which there is no evidence that these were not observed. The authorities missed the continuous zero ceiling on new external arrears during July 1-November 2, 2016 because a debt service payment to Italy of CHF 0.4 million could not go through for technical reasons. This temporary new external arrear was paid subsequently and the authorities request a waiver for the non-observance of this PC.
11. In the face of extreme political instability following the SBA approval, including the departure of three Ministers from the Government, the Prime Minister decided to reverse the tax increase for senior civil servants that the Council of Ministers had approved as a prior action before the approval of the SBA request. It is well to note that this measure was replaced by an increase of the contribution levy to the war effort and the internally displaced people from 3.0 to 4.8 in the context of the 2017 budget, as discussed above. This is a very courageous and much more comprehensive measure that includes all civil servants, among which military forces, and yields significant revenue.
12. The authorities met three out of six structural benchmarks (SBs) for the first review. These include the compilation of fiscal reporting tables in line with the 2014 IMF Government Finance Statistics Manual presentation, the approval of a draft Financial Management Law according to World Bank and IMF recommendations, and the adoption of a by-law to set up a mechanism to comply with the relevant UN Security Council resolution on terrorism and terrorism financing. They also made good progress to meet the remaining SBs. The SB on the inventory of domestic arrears was only partly implemented because many spending units were under heavy work pressure, and the audit of the civil service wage payroll was incomplete given the very wide scope of the task—it is now proposed to limit it to central government employees. The authorities appreciate staffs recognition that the aforementioned SBs, as well as the SB on the audit of the pensioner payroll require more time than anticipated; they support their postponement to the second and third reviews.
13. The authorities request a rephasing of the program to move from quarterly to semiannual reviews. This will provide them more time to garner support for difficult reforms and prepare data for program monitoring. In order to facilitate program implementation, the authorities will set up a unit in the Prime Minister’s office to strengthen the monitoring of commitments under the SBA and coordinate among various government agencies.
14. Iraq continues to face a particularly difficult time and its economy remains under severe stress. In light of the information provided above, the authorities request completion of the first review under the SBA and request purchase of the second tranche. They see the SBA as providing them with needed financial support and a valuable anchor during a period of considerable uncertainty. They are fully committed to the implementation of the SBA, although stable security conditions remain a prerequisite for the success of their policies. They would like to express their deep appreciation for the international community, the Fund’s Executive Board, and Management, for their continued support. They particularly appreciate staffs hard work and constructive engagement, as well as the valuable technical assistance they are receiving in support of their stabilization and reform efforts.