1. Today marks another defining moment in the relationship between Iraq and the Fund: the resumption, after a quarter century of interruption of the Board’s review of an Article IV consultation for Iraq. The authorities would like to thank the Fund’s board, management and particularly the staff, for their ongoing commitment in assisting Iraq through a long and arduous road and in furthering the normalization of the country’s standing in the international community. Moreover, I would like to convey the authorities’ continued commitment to sound policies and to needed structural reforms, that will contribute to rebuilding the economy and its institutions, and recover the prosperous position it once held in the not too distant past.

Background

2. The economic situation—particularly in Iraq—needs to be assessed in its larger social and political context, given its tremendous bearing on economic developments. It is easy to overlook that the establishment and maintenance of relative macroeconomic stability in the midst of violence and a security chaos is an achievement in itself. It required strong and continuous efforts on the part of the authorities, along with firm assistance from the international community and in particular the Fund. Indeed, the staff’s advice and technical assistance have strongly contributed to the identification of priorities, the assessment of capabilities and the formulation of desired policies in this difficult context.

3. The implementation of policies in Iraq, and especially their pace, is severely constrained by the new and fragile institutional setting in which it is formulated, the limited administrative capacity and the precarious social, political and security situation. Large segments of the Iraqi population continue to live in hardship, with an unemployment rate estimated by the Ministry of Planning to be around 28 percent, probably an underestimate. The recent UNDP survey portrays some of the daunting social challenges, including widespread chronic children malnutrition and endemic diseases. Moreover, basic household needs, such as reliable access to water, sewage services and electricity are poorly provided for, and further underscore the urgency of assisting the population to cope with the ongoing conflict. In light of these large social needs, the politically charged atmosphere and the security breakdown, the timing of the introduction of major reforms such as that of the petroleum subsidy—to which the authorities are firmly committed—is critical. Tangible improvements in daily life and compensatory measures to alleviate the burden on the population would be crucial to ensure the feasibility of introducing politically contentious reforms. An acceleration of disbursements of the donor’s commitments to Iraq—which has received only a small fraction of the pledges made so far—would go a long way in creating a policy space for the authorities and allow a more vigorous pace of economic restructuring.

Recent Developments

4. Political reforms have advanced substantially even if the process appeared protracted at some junctures. Successful parliamentary elections were held in January 2005 for the Transitional National Assembly, which was followed by the election of the president of the republic followed by the formation of a new cabinet in April of this year. Moreover, a committee from the Assembly has been set up and has started its deliberations to draft a new constitution for the country. A public referendum on the constitution will follow shortly after.

5. In parallel with this active and eventful political dynamics, the economic process also moved along with resolve, even if in an uneven way. The rebuilding of the economic institutions has been pursued relentlessly in order to create a vibrant market based economy and increase the efficiency of the use of its natural resources. GDP growth in 2004 has been close to 50 percent (albeit from a low level), reflecting increases in oil production to about 2 mbpd—as a result of public investment in the oil sector—and sustained growth in the non-oil sector. While violence and insecurity have limited the further expansion of oil production this year so far, it is expected that it would rebound in 2006 with a strong prospect for real GDP growth to be in the double digits again. Iraq’ s proven oil reserves, estimated at around 115 billion barrels, are the world’s third largest. The potential development of the oil sector is considerable given that a large portion of the country remains unexplored. Oil production could expand to 2.4 mbpd in 2006 and to a further 3.5 mbpd by 2010, pending improvements in general security as well as decreased sabotage to northern pipelines.

Monetary Policy

6. High inflation has accompanied the high growth rate in 2004, essentially due to violence-related shortages of essential goods. Prices have, however, stabilized relatively in 2005, but will nonetheless imply a higher than expected rate for the year, requiring an adjustment of the EPCA target to 20 percent for end-2005. The Central Bank of Iraq (CBI) has recently introduced separate dinar and dollar deposit facilities in an effort to reduce liquidity and help stem price pressures. In early July, the CBI increased the remuneration on the dinar’s overnight rate from 4 to 5 percent annually, and introduced 14 and 30-day deposit facilities, with a 6 and 7 percent interest rate respectively, signaling a tightening of monetary conditions. These facilities widened the range of monetary policy instruments of the CBI and additional instrument are under consideration. The monetary tightening was reflected in the CBI treasury bills’ rates which have increased from 4 percent in 2004 to 7 percent in June 2005.

7. The rate increases should help ease some of the pressures on the exchange rate that were witnessed earlier this year. The authorities note that only on few occasions was the supply of dollars rationed and they understand the importance of satisfying the demand for foreign exchange. While the authorities have considered moving to a flexible exchange regime to alleviate the pressure on reserves in trying to achieve price stability, they recognize the need for a nominal anchor for monetary policy and agree that the peg to the dollar has been relatively effective in this respect. The rapid buildup of international reserves at the CBI beyond the EPCA target, almost reaching US$9 billion in May provides a safety cushion for the continued support of the peg. The authorities fully recognize that prudent monetary and fiscal policies are needed to support the peg.

Fiscal Sector

8. The fiscal deficit in 2004 was slightly higher than the EPCA’s target. Higher oil revenues and lower than expected wage and pension outlays helped contain the net effect of an increase in spending in goods and services, the latter being, to a large degree, due to unbudgeted commitments by the Coalition Provisional Authority the year before. Investment spending was also lower, reflecting a weak disbursement in donor-financed non-oil reconstruction projects. On the other hand, the Iraqi investment spending on the oil sector was close to target.

9. While further oil price increases are keeping oil revenue targets in line with the program so far in 2005, thus compensating for the lower-than-programmed oil export volumes, the authorities are aware of the volatility of oil prices and the risk it entails for the fiscal outlook. Moreover, with a doubling of the differential between the price of Iraqi oil exports and world prices this year, Iraq is not reaping the full benefits of stronger prices. The authorities are looking into the matter to explain the origin of the differential and hope to be able to take any measure they can to narrow this differential, and thus increase revenues. The major fiscal issue, however, as staff points out, remains the foregone revenues of the petroleum product subsidy. The authorities are aware of the importance of this measure for the medium and long term sustainability of the fiscal stance. As we noted earlier, they are subject to stringent political constraints in this regard, but are committed to start reducing significantly the subsidy as soon as feasible. They, moreover, emphasize the need for a good communication and education strategy to be developed in this regard.

10. The authorities agree that in view of the delay in implementing the reduction of subsidies and the pressures to increase spending including on security, a financing gap might emerge for 2005 and 2006. They further agree that in the event that the gap is not closed by higher oil revenues, additional measures may have to be undertaken in the context of a supplementary budget and that any additional spending commitment would have to be funded from government revenues and the sale of assets held abroad. The accumulation of arrears will continue to be avoided as has been the case so far.

Structural Reforms

11. Budgetary management has improved in 2005 with the reporting on budget outturns in line ministries, albeit with a significant delay. To deal with the fragmentation of fiscal operations and off budget operations, the MOF is committed to approve additional spending only in the context of a supplementary budget. The authorities will work on strengthening further governance and budget management, including through the preparation of consolidated government accounts. They intend to follow up on the recommendation of the International Advisory and Monitoring Board regarding the Development Fund for Iraq and the audit of the oil sector, and inspections and verification of oil exports is already taking place. Further measures to increase savings and enhance revenue will be undertaken, including scrutinizing procurement practices while strengthening and diversifying the sources of revenues. The authorities are considering the conversion of the levy on imports into a permanent import duty and the strengthening of customs collection and administration in order to increase the relatively low levels of revenues from this source. Other taxes and surcharges, including on profits in the cell phone sector, are also being contemplated.

12. The CBI is intent on the reform and modernization of the financial sector in general and the banking sector in particular, especially in view of the low financial sector intermediation and the prevalence of cash transactions in the economy. Modern central bank, commercial bank, and AML laws are being adopted. Moreover, a modern payment system, including a real time gross settlement system and an automated check-clearing system, and its accompanying regulation, is being developed. With a modernized payment infrastructure and regulation the promotion of a competitive financial sector will be sought next. This will include the restructuring of existing banks and inviting foreign participation in the commercial banks. It is important to note in this regard that the security situation has slowed the development of the banking sector as none of the international banks granted a license to operate in Iraq has established a presence there yet. In due time, the authorities will consider the creation of a deposit insurance scheme after the supervisory framework has been well established, and intend to apply international auditing and accounting standards in the sector. The CBI has proceeded with the request for tenders for an international auditor to audit its own operations according to the International Standards on Auditing, which the authorities understand is a requirement for its safeguard assessment process, a pre-condition for an SBA with the Fund. The audit could take place shortly after the end-July deadline for the tender. Other material necessary for the safeguard assessment is being provided as well.

Debt Restructuring

13. The Paris Club agreement in November 2004 paved the way for a major restructuring of Iraqi’s external debt towards a sustainable position. Iraq has made good progress with official Paris Club creditors in reconciling debt claims, and has engaged non-Paris Club creditors, including the Gulf countries, in discussions with the aim of securing similar debt restructuring terms. Iraq is also engaging in good faith commercial creditors while clarifying the essential principle of Paris Club comparability in settling claims. The Iraqi authorities have met with the private creditors in Dubai in May of this year, and have subsequently made an offer to settle such claims in a press release on July 26. Further details on this offer will be communicated to the Board shortly. Given the structure of the Paris-Club agreement and the conditioning of further debt relief on an arrangement with the Fund, the authorities are seeking to enter into a stand-by arrangement with the Fund towards the end of the year.

Conclusion

14. The authorities are very well aware of the daunting challenges facing Iraq and of the major risks to the economic outlook looking forward, given the many political and security obstacles facing the country. They also understand the necessity of sweeping reforms in the fiscal, monetary, and oil sectors as well as the importance to attend to the large social and humanitarian needs of the population. The authorities remain confident that with the continuous support of the international community, their commitment to political, economic, and social reforms will allow the resumption of a sustainable growth and an improvement in living standards commensurate with the aspirations of the Iraqi citizens.