Iraq: Staff Report for the 2005 Article IV Consultation

Iraq’s 2005 Article IV Consultation reports that there has been a marked deterioration in Iraq’s human development indicators over the last twenty years. There is relatively little firm data on the balance of payments other than on oil exports, government imports of goods and services, and external reserves. There have been large current account deficits in 2004 and 2005, reflecting high levels of imports related to reconstruction and recovery. The Iraqi government has begun to engage with official creditors in line with the Paris Club agreement.

Abstract

Iraq’s 2005 Article IV Consultation reports that there has been a marked deterioration in Iraq’s human development indicators over the last twenty years. There is relatively little firm data on the balance of payments other than on oil exports, government imports of goods and services, and external reserves. There have been large current account deficits in 2004 and 2005, reflecting high levels of imports related to reconstruction and recovery. The Iraqi government has begun to engage with official creditors in line with the Paris Club agreement.

I. Introduction

1. The last (1979) Article IV Consultation with Iraq was concluded on February 29, 1980. A staff report for the 1983 Article IV consultation was issued to the Executive Board on August 5, 1983, but there was no Board meeting.1

2. On September 29, 2004, the Executive Board approved a request by the Government of Iraq for a purchase in an amount equivalent to SDR 297.1 million (25 percent of quota) under the Fund’s policy on Emergency Post Conflict Assistance (EPCA).2 In addition to facilitating negotiations with the Paris Club on debt relief, the approval of EPCA was intended to help Iraq meet some of its urgent balance of payments needs. In their request for EPCA, the authorities indicated that they planned to seek further financial support from the Fund in the form of an upper credit tranche stand-by arrangement in 2005, on the assumption that sufficient progress had been made in strengthening administrative and institutional capacity under the program.

3. Upon the approval of EPCA, Directors welcomed the authorities’ commitment to a comprehensive economic and financial program. Directors commended the authorities’ strategy of caution in projecting oil revenues in 2005, but stressed that it was important for the authorities to adhere to their commitment to prioritize any windfall oil revenues in favor of additional reconstruction investment, and/or help meet budgetary needs in 2006 and beyond. Directors also welcomed the commitment of the authorities to begin to increase the domestic price of petroleum products. Directors urged the authorities to make monetary policy more adaptable by widening the menu of instruments for managing liquidity conditions. Directors further emphasized the need for the authorities to focus their structural reform efforts in areas including tax administration, payments and settlements systems, state-owned enterprise restructuring, and governance and transparency of the oil sector.

II. Background

A. Social and Human Development Indicators

4. There has been a marked deterioration in Iraq’s human development indicators over the last twenty years. In 1990, Iraq was ranked 50th on the United Nations Development Program’s (UNDP) Human Development Index; just over a decade later it was ranked 126th. Moreover, compared to other countries in the Middle East, Iraq now scores low relative to the UN Millennium Development Goals (Box 1).

Iraq and the Millennium Development Goals

A survey of living conditions was conducted in the second half of 2004 by the UNDP, in collaboration with the Iraqi Ministry of Planning and Development. This survey found that the policies of the former regime, the three military conflicts since 1980, and the long period of sanctions, have taken a significant toll on the welfare of Iraq’s people, on the provision of basic services, and on infrastructure.

Goal 1. Eradicate extreme poverty and hunger. Reliable data on household income is limited. However, the UNDP survey reports that, using subjective measures of poverty, about 7 percent of households are considered poor. Moreover, about 96 percent of households receive monthly food rations. Malnutrition is widespread: 23 percent of children aged between six months and five years suffer from chronic malnutrition, 12 percent suffer from general malnutrition, and 8 percent suffer from acute malnutrition.

Goal 2. Universal primary education. Net primary school enrollment in Iraq is 79 percent, compared to 93 percent in Jordan and 96 percent in Syria. Overall, 22 percent of the adult population in Iraq have never attended school and 15 percent have not completed primary school. The youth (15–24 years) literacy rate is 74 percent, and the adult literacy rate is 65 percent.

Goal 3. Gender equality. Presently, girls have a significantly lower enrollment rate in primary schools than boys: 40 percent of girls in rural areas are not enrolled in primary education, compared to 20 percent in urban areas. The number of women aged 25–34 years who have not completed elementary school is now 36 percent. The ratio of literate females to males is 50 percent, compared to 60 percent in Yemen and 100 percent in Jordan.

Goal 4. Reduce child mortality. Under five years mortality is estimated at 115 (compared to 33 in Jordan and 107 in Yemen). Infant mortality is currently estimated at 102 per 1,000 live births, compared 105 in sub–Saharan Africa.

Goal 5.Improve maternal health. Maternal mortality is relatively high at 193 per 100,000 births (compared to 41 in Jordan but below 350 in Yemen). The level of postnatal care is low, with 58 percent of women not receiving any health checks in the 40 days following delivery.

Goal 6. Combat HIV/AIDS, malaria and other diseases. Typhoid, cholera, and malaria are endemic. The reported incidence of tuberculosis (at 132 per 100,000 people) is very high relative to neighboring countries. Iraq is categorized as highly vulnerable to HIV/AIDS, but the number of cases remains low.

Goal 7. Environmental sustainability. Major risks include the lack of appropriate sanitary landfills; open burning of solid waste, lack of working sewage infrastructure, oil fires, and excessive car emissions.

5. Unemployment remains very high in Iraq. There are a number of different estimates of unemployment in Iraq. The UNDP survey of living conditions in Iraq in 2004 estimates unemployment—calculated on the basis of the International Labor Organization (ILO) methodology—at about 10.5 percent.3,4 Of particular concern is the UNDP report’s estimate of 37 percent unemployment among the educated young (including discouraged workers). A much higher unemployment rate is suggested by estimates produced by the ministry of planning (28 percent); the Coalition Provisional Authority (30 percent); the Brookings Institution (30–45 percent); and Baghdad University (70 percent).

6. The coverage of public services has improved, but reliability remains a serious problem. According to the UNDP survey, 98 percent of households are connected to the electricity grid, although three-quarters of households report their electricity supply to be extremely unreliable; 78 percent of homes have access to piped water, and 37 percent of all homes are connected to the sewage system, but two-thirds of households report poor reliability in the provision of safe water and sewage services.

B. Political and Security Environment

7. The political process has proceeded more gradually than originally envisaged. Parliamentary elections for the new Transitional National Assembly (TNA) were held on January 30, 2005, but negotiations toward forming a government were protracted. Eventually, on April 4, the TNA elected its leadership, including Jalal Talabani as Iraq’s President. On April 7, the Presidential Council nominated Ibrahim al–Jaafari as Prime Minister, who was subsequently ratified by the TNA. On April 28, the TNA approved the cabinet submitted by the prime minister. The new government was sworn in on May 3, 2005.

8. A TNA committee (comprising 55 members) is assigned to work on drafting a permanent constitution for Iraq (as envisaged under the Transitional Administrative Law (TAL)). The draft constitution, which is expected to be finalized and approved by August 15, 2005, would be submitted to public referendum by October 15, 2005. If approved, elections for a new government under the constitution should be held by December 31, 2005.5

9. Persistent violence continues to hamper economic and social recovery. Although attacks on coalition forces have diminished to some extent, attacks on Iraqi civilians and security and police forces have escalated. The violence has deterred trade and investment flows.6 The lack of a secure environment has also impeded the effectiveness of reconstruction spending, with contractors and donors reporting security and insurance outlays in the range of 30–50 percent of total costs.

C. Institutional and Administrative Capacity

10. Iraq lacks a fully functional statistical framework. The statistical information that the Iraqi authorities are able to provide to the Fund is only just adequate for surveillance purposes. While data on the oil sector, which comprises three-quarters of Iraqi GDP, is generally good and timely, there is very little information on non-oil economic activity or on the balance of payments. Consumer price data are available with relatively short lags, but the data do not cover the Kurdish region.

11. Timely and accurate assessments of the fiscal and monetary stance in 2004 and early 2005 has been problematic. This reflects a lack of progress in establishing proper financial management mechanisms and in developing adequate data reporting frameworks. Fiscal monitoring has suffered from long reporting lags and coverage gaps in data concerning transactions and balances of the Development Fund for Iraq (DFI), expenditure financed by letters of credit issued under the UN oil-for-food program (OFFP), current and capital spending financed by donors, and government balances in the banking system. In the monetary area, a full-fledged monetary survey (including deposit corporations) has yet to be completed. In the meantime, the Central Bank of Iraq (CBI) has had to assess monetary developments chiefly on the basis of its own balance sheet, which has not yet been prepared in line with internationally accepted accounting standards or audited in line with International Standards on Auditing (ISA).

12. The International Advisory and Monitoring Board (IAMB) was established on October 21, 2003, pursuant to United Nations Security Council Resolution 1483, for the purposes of overseeing audits of the operations of the DFI and oil export sales. Membership of the IAMB was expanded in June 2004 to include a member designated by the Government of Iraq. In its most recent review (May 2005), the IAMB has noted the audit report findings of evidence of major weaknesses in the administration of DFI resources and oil operations.7

13. The Fund continues to implement its off-site technical assistance work program for Iraq toward improving Iraq’s administrative capacity. Over the past year, and in coordination with the World Bank and bilateral donors, Fund staff has provided advice on fiscal federalism issues, tax regimes for the oil sector, budget classification, public expenditure management, banking supervision, payment systems, macroeconomic statistics, and macroeconomic policy training (see Appendix I).

D. Recent Economic Developments

14. Gross domestic product (GDP) is estimated to have rebounded by nearly 50 percent in 2004, driven mainly by the recovery of the oil sector (Table 2).8 Oil production expanded by 74 percent from 1.2 million barrels per day (mbpd) on average in 2003 to 2.0 mbpd in 2004 (although this is still below the pre-war production level of 2.5 mbpd and slightly below EPCA program projections). Non-oil GDP is estimated to have expanded more moderately in 2004, as lack of security, electricity shortages, and poor communications hampered the recovery in private sector activity. Some state-owned enterprises (mainly in construction and petro-chemicals) have reactivated production.

15. Consumer price inflation in the year to December 2004 reached 31.7 percent, compared with a projected 7 percent under the EPCA program.9 During the first half of 2004 prices were broadly stable, but inflation picked up sharply in August and remained high for the remainder of the year. This surge in prices appears to have been related primarily to supply shortages of key goods (gasoline and food) consequent upon the intensification of violence in the run up to the elections in January, 2005. After another large jump in January, prices fell from February through May as the supply of goods improved, and the cumulative increase for the first five months of 2005 was reduced to 4.7 percent. Year-on-year inflation in May 2005 was nonetheless still quite high at 33.9 percent, and well above the EPCA program objective of 15 percent for end 2005.

16. The fiscal deficit for 2004 was slightly larger than envisaged under the EPCA program (Tables 3 and 4). Oil export prices averaged $31.6 per barrel in 2004, compared to $30.5 per barrel assumed under the EPCA program, while oil export volumes were close to target, resulting in an additional ID1 trillion in oil export revenues in 2004 relative to the amount of ID25.3 trillion assumed in the program. While wage and pension outlays were slightly lower than budgeted for 2004, spending on goods and services was higher than under the budget (reflecting in part contractual commitments made by the Coalition Provisional Authority (CPA) prior to its dissolution and not included in the budget).

Table 1.

Iraq: Social Indicators

(Most recent estimate-latest year available, 1998–2004)

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Sources: UNDP and World Bank estimates.
Table 2.

Iraq: Selected Economic and Financial Indicators, 2004–10

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Sources: Iraqi authorities and staff estimates and projections.

In the EPCA, differential to WEO oil export prices were calculated to reflect assumed budget prices.

Residual in 2004 could be explained advances currently classified as expenditure.

Debt service paid (not accrued), excluding repayment of arrears.

Table 3.

Iraq: Fiscal and Oil Sector Accounts, 2004–10

(In billions of ID; unless otherwise indicated)

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Sources: Iraqi authorities and staff estimates and projections.

Revised projections for 2005 are based on the 2005 budget, expenditures committed by the Coalition Provisional Authorities, information on revenues and expenditures of oil-related state-owned, enterprises, indicative information on donors’ activities, and information on oil-for-food program, but excludes possible spending or revenues from a supplementary budget.

Medium-term projections do not include possible revenue measures or additional spending (e.g. on transfers) to be discussed by the cabinet.

Projections for 2005 are based on average oil price ($36 per barrel) and volume (1.4 mbpd) for the first five months of 2005.

Projections are based on the fact that no formal agreement has yet been reached on increasing domestic price of light petroleum products, but do not represent the staff’s recommendations.

EPCA (2004 and 2005) data, and estimates for 2004, do not include wages and salaries for the Kurdish area, which are included in other transfers. 2004 estimates for wages include ID2.2 trillion in advances to be reclassified.

Includes spending by the U.S. from seized and vested assets in 2004.

Overhead costs associated with donor-financed reconstruction are believed to be spent mostly outside of Iraq. No firm figures were received from donors to date.

Other goods and services financed by donors include security spending associated with the implementation of reconstruction projects. No firm figures were received from donors to date.

2005 figures are from the budget. It is assumed that the private sector will import an increasing share of light petroleum products starting in 2005.

2004 and 2005 EPCA data and estimates for 2004 include wages and goods for the Kurdish area.

Calculated as 5 percent of oil exports as per UN Security Council Resolution 1483 to finance war reparations to Kuwait. The 2005 data is from the budget. 5 percent of any additional revenue recorded in 2005 should be paid as war reparation.

Projections for 2005 include ID1.4 trillion reportedly committed by the Coalition Provisional Authorities, to be paid by the U.S. out of a special subaccount of the DFI, and unrecorded in the budget, projects in the north previously classified as transfers, and ID1.9 trillion in maintenance expenditure previously classified as goods.

Estimates for 2005 are based on reported balances of Development Fund for Iraq (DFI) managed by the Iraqi authorities, and balances on the DFI subaccount managed by the U.S.

Includes financing from letters of credit previously issued under the UN oil-for-food program.

Residual in 2004 could be explained advances currently classified as expenditure.

Table 4.

Iraq: Fiscal and Oil Sector Accounts, 2004–10

(In percent of GDP)

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Sources: Iraqi authorities and staff estimates and projections.

Revised projections for 2005 are based on the 2005 budget, expenditures committed by the Coalition Provisional Authorities, information on revenues and expenditures of oil-related state-owned, enterprises, indicative information on donors’ activities, and information on oil-for-food program, but exclude possible spending or revenues from a supplementary budget.

Medium-term projections do not include possible revenue measures or additional spending (e.g. on transfers) to be discussed by the cabinet.

Projections for 2005 are based on average oil price ($36 per barrel) and volume (1.4 mbpd) for the first five months of 2005.

Projections are based on the fact that no formal agreement has yet been reached on increasing domestic price of light petroleum products, but do not represent the staff’s recommendations.

EPCA (2004 and 2005) data, and estimates for 2004, do not include wages and salaries for the Kurdish area, which are included in other transfers. 2004 estimates for wages include ID2.2 trillion in advances to be reclassified.

Includes spending by the US from seized and vested assets in 2004.

Overhead costs associated with donor-financed reconstruction are believed to be spent mostly outside of Iraq. No firm figures were received from donors to date.

Other goods and services financed by donors include security spending associated with the implementation of reconstruction projects. No firm figures were received from donors to date.

2005 figures are from the budget. It is assumed that the private sector will import an increasing share of light petroleum products starting in 2005.

2004 and 2005 EPCA data and estimates for 2004 include wages and goods for the Kurdish area.

Calculated as 5 percent of oil exports as per UN Security Council Resolution 1483 to finance war reparations to Kuwait. The 2005 data is from the budget. 5 percent of any additional revenue recorded in 2005 should be paid as war reparation.

Projections for 2005 include ID1.4 trillion reportedly committed by the Coalition Provisional Authorities, to be paid by the US out of a special subaccount of the DFI, and unrecorded in the budget, projects in the North previously classified as transfers, and ID1.9 trillion in maintenance expenditure previously classified as goods.

Estimates for 2005 are based on reported balances of Development Fund for Iraq (DFI) managed by the Iraqi authorities, and balances on the DFI subaccount managed by the U.S.

Includes financing from letters of credit previously issued under the UN oil-for-food program.

Residual in 2004 could be explained advances currently classified as expenditure.

17. Investment overall was in line with the budget, but grant-financed (non-oil) reconstruction expenditure in 2004 fell short. Donors to the International Reconstruction Fund Facility for Iraq (IRFFI)—a two–window trust fund facility administered by the World Bank and the UN—deposited about US$1 billion into this facility. Most of these funds have already been committed to reconstruction projects. Disbursements under these large projects will take place over a number of years, but in 2004 (the launch year) only about $103 million was actually disbursed to finance projects. Moreover, the largest direct bilateral donor (the United States) reportedly spent about $2.2 billion in 2004, but only two-thirds of these funds are estimated to have been spent in the domestic economy (and up to one-half of this was on security). By contrast, investment in the oil industry (mainly financed out of the Iraq’s own resources) was slightly higher than programmed.

18. The 2005 budget was based on a cautious oil revenue projection. Oil prices in 2005 were assumed to be only $26 per barrel, significantly below what might have been expected based on the prevailing WEO projection when the program was designed (September 2004). Oil exports were projected to increase from 1.4 mbpd in 2004 to 1.8 mbpd. The budget also assumed that a start would have been made in reducing the domestic petroleum subsidy by the beginning of the year. Spending plans were constrained so as to ensure that the budget would be fully financed from revenues and available balances abroad (in the DFI and from the winding up of the OFFP).

19. Oil export revenues in the first five months of 2005 were broadly in line with the program, but only because lower oil export volumes were offset by higher oil prices. Oil export volumes in the first five months of 2005 remained at an average of 1.4 mbpd (the same as the average outturn in 2004 and well below the program target), while average oil export prices rose to $36.4 per barrel. The increase in Iraqi oil prices during this period was significantly less than the increase in oil prices generally, reflecting a substantial widening of the price differential on Iraqi oil relative to world market prices. The differential relative to the WEO benchmark oil price (an average of Brent, West Texas, and Dubai) increased from $6.4 per barrel on average in 2004, to $13.4 per barrel in the first quarter of 2005, before narrowing to $8.6 per barrel in April–May 2005. The reasons for these movements in the differential are not well understood. The authorities were able to provide an explanation for part of the change in the differential, but not for all of it.10

20. Implementation of the EPCA commitment to increase domestic prices of refined oil products has yet to occur. Under the EPCA timeline, the authorities were supposed to have begun the adjustment of domestic prices by the end of 2004 (see Box 2). Gasoline prices in the black market have risen to very high levels recently, but the authorities continue to supply gasoline locally at heavily subsidized prices (about 1.3 US cents per liter of regular gasoline), including by importing these products at international prices (private imports of petroleum products are not permitted).

Iraq: Subsidies on Petroleum Products

Official prices for refined petroleum products sold in Iraq are set well below international prices. In addition to subsidizing sales from domestic production, the government imports petroleum products ($3.2 billion in 2004) for sale domestically at subsidized prices. This results in a substantial loss of revenues for the budget, equivalent to nearly $8 billion (or some 30 percent of 2004 GDP).

Iraq: Domestic Petroleum Product Sales Valued at Domestic and International Prices

(volumes as of 2004, prices as of June 2005)

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Based on 2004 figures.

As of June 2005. Comparable prices for a liter of regular gasoline (including tax) for countries in the region include 10 US cents (Iran), 50 US cents (Jordan), 145 US cents (Lebanon), and 46 US cents (Syria).

Using an exchange rate of ID1500/dollar.

21. The growth in reserve money supply in 2004 was rapid, but largely mirrored by the expansion in the CBI’s external reserves. Reserve money in 2004 grew by 117 percent, exactly in line with the EPCA projection (Table 5). With the CBI prohibited from lending to the government, almost all the increase in reserve money derived from higher external reserves, reflecting dollar purchases from the government net of auction sales of dollars to the market. Currency in circulation increased at a slower rate (at 75 percent for the year, compared with the EPCA projection of 118 percent). The difference in the growth of the two measures of money was reflected in a large build up in banks’ free reserves with the CBI.

Table 5.

Iraq: Central Bank Survey, 2003–05

(In billions of Iraqi dinars, unless otherwise indicated)

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Sources: Iraqi authorities; staff estimates and projections; CPA; CBI; and CSO.

Valued at market exchange rates.

Valued at historic or market price, whichever is lower.

This mainly represents the ID and US$ overnight standing deposit facilities.