1. Since mid-2014, Iraq has been facing a double shock resulting from the so-called Islamic State of Iraq and Syria (ISIS) conflict and the sharp drop in global oil prices. The double shock compounds very challenging security and political conditions that have been prevailing for several years. The armed conflict has also created a humanitarian tragedy, causing over three million people to be displaced internally, and about 11 million to be in need of humanitarian assistance. Living conditions across the country have markedly deteriorated since the onset of the armed conflict, and the government’s ability to provide basic public goods and services is severely hampered. The violence has also caused extensive damage to infrastructure and productive assets, disrupted internal and external trade, and deteriorated investor confidence.
2. Against this background, in order to restore fiscal and external sustainability, the authorities have taken bold steps to put their public finances on a sustainable footing, while maintaining their commitment to the exchange rate peg, which continues to provide a key nominal anchor in an uncertain environment. They reiterate their appreciation to the international community for supporting their efforts, including through the IMF Stand-By Arrangement (SBA) and generous donor support. Despite very difficult circumstances, the authorities have successfully implemented many of the 2015 Article IV recommendations. Moreover, they have strengthened their performance under the SBA. The performance criteria (PC) at end-December 2016 and one continuous PC were missed because of the spending pressure flowing from the war against ISIS and the ensuing humanitarian crisis. Nonetheless, the authorities have implemented strong corrective measures as prior actions, including adoption by parliament of a supplementary 2017 budget. Moreover, the government has made considerable progress in meeting the structural benchmarks (SBs) under the second review, with ten out of twelve SBs met, while the remaining two are in progress.
3. Despite these persistent efforts and encouraging 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.
Recent Economic Developments
4. Real GDP growth remained strong in 2016, increasing by 11 percent, due to the increase in oil production resulting from past oil investment. Nonetheless, oil production is expected to contract in 2017 in line with the OPEC-agreed production cut. Non-oil GDP continued to contract in 2016 as a result of continued fiscal consolidation and the conflict with ISIS. Oil prices and exports dropped sharply in 2016, resulting in a widening of the balance of payments to 8.7 percent of GDP and a further decline in foreign exchange reserves.
5. In response to the fall in oil revenue, the authorities have implemented a large fiscal effort consolidation in 2014, with the aim to achieve debt sustainability. Further fiscal consolidation was achieved in 2016, but at a slower pace than programmed to allow for some essential non-oil investment expenditure—following drastic cuts in non-oil investment under the SBA—and due to spending pressures stemming from the military campaign against ISIS. Streamlined procedures for access to the Central Bank of Iraq (CBI) foreign exchange window have contributed to a reduction of the spread between the parallel and official rates since the fall of 2016. Moreover, the yield of the 2028 bond has diminished since early 2016 in reaction to the increase in oil prices and progress in fiscal consolidation.
Fiscal Policies and Reforms
6. The authorities will pursue their fiscal consolidation effort to bring spending in line with available resources. They believe that further consolidation must be mindful of the country’s fragile security, political and social situation. The brunt of the adjustment has been achieved so far through cuts in non-oil investment—notwithstanding the country’s vast investment needs—while maintaining wages and pensions in an effort to preserve social stability. The authorities are also keen on continuing 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.
7. Earlier this week, parliament approved a supplementary 2017 budget reducing total spending by 2 percent and introducing a credit allocation for repaying arrears incurred during previous years. In the 2018 budget, the government will prepare measures (to be finalized during the third review) to reduce the non-oil primary deficit on an accrual basis by ID 2.3 trillion (4.4 percent of non-oil GDP) compared to the draft supplementary budget for 2017. The authorities intend to strengthen revenue by (i) auditing the Development Fund for Iraq and Successor Account 300/600 at the CBI to check that all oil revenue reaches the treasury; (ii) preparing and sending to parliament a sales and excise tax law in line with Fund technical assistance (TA) recommendations (proposed SB for the third SBA review); and (iii) introducing changes in the Customs Code in line with Fund TA recommendations (also proposed SB for the third SBA review). The government will also continue ongoing work on reforming state-owned non-financial enterprises and the electricity sector, notably by increasing collection and reducing production costs and capturing flared gas to use it for electricity production.
8. Public financial management reforms continue to rank high on the authorities’ agenda. They have adopted tight procedures for the approval of state guarantees (prior action). They will improve Government Finance Statistics reporting in line with Fund TA recommendations. They will also carry out quarterly surveys of arrears and prepare plans for their orderly payment, following an independent audit of domestic arrears by the Board of Supreme Audit. The government will also design and implement a commitment control system for budget execution, in line with IMF TA recommendations to avoid the emergence of new arrears. Future reforms will include gradually moving to a Treasury Single Account, designing and implementing an Integrated Financial Management Information System, implementing Public Investment Management reform, and strengthening Debt Management with TA support from the Japanese International Cooperation Agency.
Monetary, Exchange Rate and Financial Sector Policies and Reforms
9. 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 working actively on removing remaining exchange restrictions and a multiple currency practice, in close cooperation with Fund staff.
10. The authorities are taking measures to enhance the stability of the banking sector. The audit of the financial statements of the two largest state-owned banks Rasheed and Rafidain will be completed by end-August 2017. Based on these audits, the Ministry of Finance will prepare a plan to restructure the two banks, in cooperation with the World Bank. At the same time, the government is strengthening the legal framework of the CBI to provide for independent oversight, building on the December 2015 IMF safeguards assessment. The authorities will continue to implement reforms to strengthen the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) framework. Following the adoption of an AML/CFT compliance mechanism in October 2016, the CBI and Iraqi Insurance Diwan will issue AML/CFT instructions for exchange and insurance companies, followed by guidance to all reporting entities covered by the AML/CFT Law regarding the implementation of preventive measures.
Performance Under the SBA
11. The government remains fully committed to the objectives of the program, notably gradually bringing expenditure down to a level consistent with the lower level of oil revenues to achieve debt sustainability while maintaining the exchange rate peg, strengthening public financial management and banking supervision, and fighting money laundering, the financing of terrorism, and corruption. The government will also ensure that social spending is protected.
12. As noted above, the PCs at end-December 2016 and one continuous PC under the SBA were missed because of the spending pressure flowing from the war against ISIS and the ensuing humanitarian crisis. These factors resulted in larger spending and lower external arrears payments than programmed for 2016. Considering the temporary nature of these arrears, and the steps to put the program back on track and improve cash management, the authorities request waivers for the non-observance of the continuous PC and one PC at end-June 2017. They also request waivers of applicability for the four PCs at end-June 2017 for which complete information is not available yet. Notwithstanding a difficult environment and severe constraints, the authorities were able to preserve social spending above program floors by a significant margin.
13. Considerable progress was also made in meeting the structural benchmarks for the second review of the SBA, with ten out of twelve SBs met, while the remaining two are in progress. In particular, the authorities have completed essential SBs aimed at improving fiscal transparency, strengthening governance, enhancing debt management, improving cash management and fiscal transparency, strengthening safeguards assessments and the governance of the CBI, and improving the business environment, as detailed in the Memorandum of Economic and Financial Policies. In view of the difficulty to reduce to zero the obligations outstanding for more than three months to international oil companies (because of the lumpy size of oil shipments), the government proposes to raise the floor on these obligations to $500 million, starting in September 2017.
14. In order to facilitate program implementation, the authorities have 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.
15. Iraq continues to face particularly difficult times, and its economy remains under severe stress. In light of the performance under the SBA and the policies laid out in the MEFP, the authorities request the completion of the second review under the SBA and the purchase of the third tranche. The SBA continues to provide them with needed financial support and a valuable anchor during a period of considerable uncertainty. They are fully committed to implementing 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 Fund’s Executive Board, management and staff, for their continued support. They particularly appreciate staff’s hard work and constructive engagement, as well as the valuable TA they are receiving in support of their stabilization and reform efforts.