Iraq: Request for Stand-By Arrangement

This paper discusses Iraq’s request for Stand-By Arrangement for 15 months from December 2005 through March 2007, which they intend to treat as precautionary. The authorities’ policies have succeeded in promoting overall macroeconomic stability despite the extremely difficult security environment. Economic growth in 2005 is estimated at 2.6 percent, following the rebound of almost 50 percent recorded in 2004. Inflation pressures have moderated in 2005, though prices remain volatile. The medium-term outlook for Iraq is favorable, but subject to many risks.

Abstract

This paper discusses Iraq’s request for Stand-By Arrangement for 15 months from December 2005 through March 2007, which they intend to treat as precautionary. The authorities’ policies have succeeded in promoting overall macroeconomic stability despite the extremely difficult security environment. Economic growth in 2005 is estimated at 2.6 percent, following the rebound of almost 50 percent recorded in 2004. Inflation pressures have moderated in 2005, though prices remain volatile. The medium-term outlook for Iraq is favorable, but subject to many risks.

Executive Summary

The authorities have requested a Stand-By Arrangement (SBA) for 15 months from December 2005 through March 2007, which they intend to treat as precautionary. Access for the proposed arrangement is SDR 475.4 million (40 percent of quota). The SBA is intended to support the program for 2006, following the program for 2005 that was supported by Emergency Post Conflict Assistance (EPCA).

Policy efforts and developments in 2005

  • The authorities’ policies have succeeded in promoting overall macroeconomic stability despite the extremely difficult security environment. Economic growth in 2005 is estimated at 2.6 percent, following the rebound of almost 50 percent recorded in 2004. Inflationary pressures have moderated in 2005, though prices remain volatile.

  • The projected fiscal deficit in 2005 is much lower than expected under the EPCA-supported program, mainly due to higher than projected export prices for crude oil. The exchange rate has remained stable, and the central bank’s international reserves have continued to increase.

  • The implementation of structural benchmarks specified in the EPCA-supported program was slower than scheduled. The commitment to increase domestic fuel prices of refined oil products was not implemented.

The Program for 2006

  • The authorities’ program for 2006 aims to strengthen administrative capacity, allocate resources towards the planned expansion of the oil sector, and to redirect expenditures away from general subsidies towards providing improved public services. The program seeks an acceleration in the growth rate of GDP to 10 percent in 2006, a reduction of inflation from 20 percent in 2005 to 15 percent in 2006, and an increase in net international reserves by $1.7 billion.

  • The authorities plan to increase prices of all refined oil products as a prior action for the SBA. In addition, the audit of the Central Bank of Iraq needs to be at an advanced stage by the time of Executive Board consideration of the SBA.

  • The medium term outlook for Iraq is favorable, but subject to many risks. Program implementation may suffer if there are continued security problems. Moreover, Iraq would remain vulnerable to external shocks, particularly if oil production does not expand as projected, or oil export prices decline substantially.

  • Approval of the SBA should trigger the second stage (30 percent) of debt reduction, according to the terms of the Paris Club arrangement.

I.Introduction

1. On September 29, 2004, the Executive Board approved a purchase by Iraq of SDR 297.1 million (25 percent of quota) under the Fund’s policy on Emergency Post Conflict Assistance (EPCA). The main objectives of the EPCA-supported program were to (i) begin the process of improving economic conditions in Iraq, and (ii) facilitate debt relief negotiations with Iraq’s Paris Club creditors. The program included a quantified policy framework for 2005 and was designed, inter alia, to help build Iraq’s capacity to implement a follow-up program of sufficient strength to merit support through an upper credit tranche arrangement.

2. Following the approval of EPCA, Paris Club creditors (plus Korea) agreed on November 21, 2004, to reduce their claims on Iraq by 80 percent in net present value terms. Under this agreement, debt reduction would take place in three stages: (i) 30 percent upon signing the debt agreement; (ii) 30 percent upon approval by the IMF Executive Board of an upper-credit tranche arrangement (expected by December 31, 2005); and (iii) 20 percent upon the successful conclusion of the last review under the third year of (one or more successive) upper credit tranche arrangements, expected by December 31, 2008.

3. In their request for EPCA, the Iraqi authorities noted their intention to seek further financial support from the Fund in the form of a Stand-By Arrangement (SBA). In the summing up of the 2005 Article IV Consultation with Iraq, Directors noted that progression to a SBA would help underpin a sound macroeconomic framework for the continuation of Iraq’s reconstruction and recovery, as well as pave the way for Iraq to move forward to a sustainable external debt situation under the terms of the Paris Club agreement. To prepare the ground for a SBA, Directors urged the authorities to build on their track record of policy implementation under the EPCA-supported program, and to strengthen the quality and timeliness of economic data needed for program monitoring.1

4. Despite serious security problems, which hindered implementation, and institutional limitations, the authorities have demonstrated a clear ability to execute policies during 2005, and made good progress in improving data compilation. The EPCA-supported program has achieved a surprising degree of macroeconomic stability in very difficult circumstances. Progress was initially slow in pushing forward reforms. However, a number of important measures have recently been implemented, and more such actions are planned in the coming weeks. Data quality and timeliness has meanwhile been brought to a standard that would enable program monitoring under an upper credit tranche arrangement. The authorities now propose to follow the 2005 EPCA-supported program with a more ambitious program for 2006.

5. In the attached letter to the Managing Director, the iraqi authorities request a SBA in support of their program outlined in the accompanying Memorandum of Economic and Financial Policies (MEFP - Appendix I). The arrangement is intended to cover the program for calendar year 2006, and is therefore expected to run for fifteen months through March 2007. The Iraqi authorities intend to treat the arrangement as precautionary.

II.Political and Economic Developments

A. The Political and Security Situation

6. A profound transformation of Iraq’s political landscape is underway. Following the installation of the Iraqi interim government on June 28, 2004, parliamentary elections for a new Transitional National Assembly (TNA) were held on January 30, 2005. A new Iraqi transitional government (ITG) was sworn in on May 3, and began working on a permanent constitution (to replace the Transitional Administrative Law put in place by the Governing Council in March 2004). The draft constitution was approved by public referendum on October 15, 2005. The approved constitution envisages the possibility that changes could be made to it by the first Assembly elected under it. Elections for the first Assembly under the constitution are scheduled to take place on December 15, 2005. A constitutional government with a four-year term will then be formed.

7. The security situation remains dangerous, and continues to hamper economic recovery and program implementation. The lack of a secure environment has impeded reconstruction, and sharply increased security and insurance costs. In addition, there have been allegations of large misappropriations of funds in the security area by officials of the (former) interim government.

B. Developments under the EPCA-supported Program

8.Reflecting, in part, the difficult security situation and the long political transition process, performance in 2005 was mixed when compared to expectations under the EPCA program:

  • Gross domestic product is estimated to have increased by only 2.6 percent in 2005, below the EPCA projection of 16.7 percent, though this followed a rebound of nearly 50 percent in 2004 (Table 1). Oil production expanded by 74 percent to 2.0 million barrels per day (mbpd) in 2004, but is projected to have stabilized at this level during 2005 due to delays in implementing oil investment projects and continued sabotage to Northern oil export pipelines. Non-oil GDP is estimated to have expanded only moderately in 2005, as continuing security problems, electricity shortages, and political uncertainties have hampered the recovery of private sector activity.

    Table 1.

    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 reflect assumed budget prices.

    In the EPCA columns, data for income net, current account, and the overall balance do not include interest accrued and deferred in 2004 and 2005. Consistent with the BOP table in this report, corresponding data for the 2005 outcome include interest accrued and deferred in 2004 and 2005. Consequently, the EPCA data are not directly comparable.

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

  • Inflation in the year to December 2004 reached 31.7 percent, compared with a projected 7 percent under the EPCA program. A surge in prices in late 2004 and early 2005 appears to have been related primarily to supply shortages of key goods (gasoline and food) because of the intensification of violence in the run-up to the elections in January 2005. Inflationary pressures have since moderated, though prices remain volatile, reflecting periodic shortages of certain goods in the market and strong seasonal effects and Ramadan. Cumulative inflation for the first 9 months of 2005 was 15.5 percent, in line with a revised program objective of 20 percent for end 2005.2

  • The exchange rate of the dinar has been relatively stable throughout 2005 at about ID 1460-1480 to the U.S. dollar. Foreign exchange sales volumes at the daily CBI auctions increased from around $30-35 million in the first half of the year to around $45-55 million in the second half. However, government sales of dollars to the Central Bank of Iraq (CBI) also rose, reflecting higher government spending in dinars (and higher oil revenues). Foreign exchange reserves are estimated to have reached around $8.5 billion at end-September 2005, well above the EPCA projected floor for end-September of $4.75 billion (Table 2).

    Table 2.

    Iraq: Quantitative Indicators, 2004-05, Under Emergency Post-Conflict Assistance Policy

    (In billions of Iraqi dinars, unless otherwise indicated)

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    Sources: Iraqi authorities and staff estimates and projections.

    Stocks at end-of-test period.

    Net foreign assets. See Appendix I (technical Memorandum of Understanding) for definition.

    Net reserve assets, defined as net foreign assets less CBI foreign currency liabilities to resident banks (comprising US dollar required reserve deposits and other US dollar deposits).

    Target exceeded due to an overdraft to cover a timing discrepancy in late-December 2004. Amount overdrawn was repaid in early January 2005.

    Reflects interest due on CBI claims on the Ministry of Finance (MoF) for 2004 and capitalized in January 2005, pending the restructuring agreement between the CBI and the MoF.

    Flows from January 1, 2004, for test date of end-2004; and cumulative flows from January 1, 2005 for test dates in 2005.

    This will be monitored on a continuous basis.

  • Currency issued, which grew rapidly during 2004, decelerated sharply during the first 8 months of 2005 to 13.9 percent (below program projections). Reserve money increased only by 6.9 percent for the same period (as a result of the introduction of CBI deposit facilities which reduced banks’ free reserves).3 Interest rates increased at recent treasury bill auctions, reaching 9.5 percent in early September and staying around this level through November. The CBI increased the interest rate on the overnight dinar deposit facility from 4 to 5 percent per annum in early July, and introduced 14-day and 30-day deposit facilities paying 6 percent and 7 percent, respectively. In October, the CBI also introduced two (30- and 90-day) term facilities for dollars, alongside the existing overnight dollar facility. As of end-September, banks had outstanding dinar deposits with the CBI of ID 2.4 trillion and dollar deposits of $646 million.

  • While the fiscal deficit for 2004 was somewhat larger (in dinars) than envisaged under the EPCA-supported program, the fiscal position in 2005 has turned out to be more comfortable than expected because of higher oil prices, as well as lower expenditures in certain areas (partly reflecting implementation difficulties associated with the lack of security). The overall fiscal deficit in 2005 is expected to be around ID 5.3 trillion, well below the ID 10.1 trillion deficit projected under the EPCA-supported program. As a result, the year should end with a positive balance in the Development Fund for Iraq (DFI) of some ID 5.8 trillion ($3.9 billion) compared to ID 0.8 trillion envisaged under the EPCA-supported program and a balance of zero projected at the time of the Article IV Consultation. Disbursements of grants have also accelerated, and are now projected at ID 11.3 trillion ($7.7 billion) in 2005, compared to ID 6.4 trillion ($4.2 billion) projected under the EPCA-supported program.

9. Implementation of structural reforms and key policy measures was much slower than expected in the EPcA-supported program (Table 3). This reflected both the difficult security situation, and overestimation of the government’s administrative and institutional capacity. However, progress was made in a number of areas. Some of the implementing regulations for the financial management law were issued on September 1, 2005, and agreements were negotiated with neighboring countries to facilitate the collection of customs revenues. In the financial area, draft payment system regulations were prepared (with technical assistance from MFD), and a contract was signed with Ernst and Young to conduct an audit of the CBI. In September, the government initiated the reform of domestic petroleum product subsidies by unifying the official price of regular gasoline in Baghdad (from ID 20 per liter) with the official price of premium gasoline (ID 50 per liter), and began selling premium gasoline in Baghdad from government-owned gas tankers for ID 100 per liter.

Table 3.

Iraq: Structural Benchmarks and Key Policy Measures Under Emergency Post Conflict Assistance

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10. The government has stepped up efforts to improve governance. It has established (i) a cabinet-level committee for the purpose of reviewing all tenders greater than $3 million, and (ii) an integrity commission to investigate alleged corruption practices throughout the government. Finally, the ministry of finance has taken steps to ensure that the disbursement of all funds are made strictly on the basis of budget appropriations.

11. Data reporting has also improved substantially. Monthly fiscal data is now being reported with a lag of 9-10 weeks, monthly data on the CBI’s balance sheet is reported with a lag of about seven weeks, and a preliminary depository corporations survey (monetary survey) for 2005 (through August) has just been compiled. STA has also conducted a number of technical assistance missions, aimed at improving national accounts and price statistics and balance of payments data.

12. Following the Paris Club agreement, progress has been made towards securing bilateral debt agreements with official creditors. So far five bilateral agreements on Paris Club terms have been signed with Paris Club creditors (U.S.A., Belgium, Canada, Italy, and Japan), and the authorities are optimistic that they will have nearly all 18 Paris Club bilateral agreements signed by end-2005.4 The process of debt reconciliation with the 26 non-Paris Club official creditors has been slower.5 Firm progress is yet to be made toward reconciling claims of Gulf country creditors, but there are indications that these creditors would be willing to provide debt relief on terms at least as favorable as those of the Paris Club.

13. Progress has also been made toward resolving claims of small private creditors.On July 26, 2005, Iraq announced a program to settle commercial claims. The program has two components: a cash buy-back of 10.25 cents on the dollar for small creditors with claims of $35 million or less, and a debt-for-debt exchange for larger creditors.6 The Paris Club has concluded that the offers made to Iraq’s private creditors, both large and small, are on broadly comparable terms to the Paris Club agreement. Iraq successfully concluded the first two cash offers that were launched on August 8, and September 26, 2005. Of approximately $1.6 billion commercial claims eligible for settlement in the first two cash offers, the holders of 72.5 percent of claims accepted the offer, holders of 20.8 percent of claims deferred decision, and holders of 6.7 percent rejected it (or failed to respond in time).

14. The process of dealing with large private creditors is proceeding. Contacts between financial and legal advisors of the Iraqi authorities and large private financial and suppliers creditors took place in the period leading to the Annual Meetings. This followed correspondence between the Iraqi authorities and some of the larger creditors, raising issues regarding the terms of settlement and requesting more frequent face-to-face meetings. The minister of finance also met with the largest financial creditor of Iraq during the Annual Meetings. On October 21, the Iraqi advisors met with a group of large financial creditors to hear their suggestions for making the planned debt-to-debt exchange offer more attractive to creditors. Some of these suggestions were incorporated in the debt-to-debt exchange offer made on November 16, 2005.7,8 Korean supplier creditors have indicated, however, that they are not willing to accept settlement on the terms of the Paris Club. The Iraqi authorities, with their advisers, will be holding a meeting with private creditors in Singapore on December 7 for a presentation on Iraq’s economic and political conditions.

III.The Economic Program for 2006

15. The main objective of the authorities’ program for 2006 is to maintain macroeconomic and financial stability, while undertaking sufficient investment to secure the basis for sustainable growth over the medium term. The program seeks, inter alia, to strengthen administrative capacity, and to prioritize resources toward regenerating the oil sector and rebuilding Iraq’s infrastructure, and away from general subsidies (especially for domestic petroleum products) toward more targeted social support. Providing social services (including in health, education, security and the provision of reliable electricity) is an important objective of the program.

A. Overview of the Macroframework

16. The program envisages an increase in economic growth in 2006, while maintaining the deceleration of inflation. After stalling at 2.0 mbpd in 2005, oil production is projected to resume its expansion in 2006 to around 2.3 mbpd (Table 1). With non-oil economic growth assumed to be around 8 percent, overall GDP growth is projected to rise from 2.6 percent in 2005 to 10.4 percent in 2006. The inflation rate is expected to fall to 15 percent by end-2006.

17. The fiscal stance in the near term will be driven by the reconstruction program, subject to a financing constraint. The primary fiscal deficit in 2006 is projected to be 8.2 percent of GDP, following a deficit of 10.8 percent of GDP in 2005.9 Over the medium term, as reconstruction needs subside, the government’s fiscal deficit should gradually decline to zero.

18. The monetary program is based on the continuation of the de facto peg of the Iraqi dinar to the U.S. dollar. With no net domestic credit creation, net international reserves of the CBI should continue to increase by some $1.7 billion to $10.6 billion by end-2006.

B. Fiscal Policy in 2006

19. The 2006 budget combines the government’s competing expenditure requirements with revenues and available financing, with little room for slippage. The government is seeking to contain recurrent (non-military) spending pressures, while allowing room for growing security responsibilities, and at the same time providing for investment in both the oil and non-oil sectors. The government’s oil revenues—which comprise almost 90 percent of its total revenue (excluding grants)—are based on an assumed recovery in oil production and thereby oil exports. This in turn depends on the government’s program of investment. The fiscal deficit for 2006 will be financed from remaining resources in the DFI and some modest amounts of project financing (Tables 4 and 5). Off-budget expenditures will not be allowed, and any additional spending will be integrated into a supplementary budget. Spending allocations from the contingency allowance will only be made after consulting with IMF staff and in light of a review of spending and revenue developments. In the event of revenue shortfalls, cuts in non-priority spending may also need to be made. The 2006 budget was passed by the TNA on December 4, 2005, in line with the program understandings.

Table 4.

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.

Projections for 2006-2010 assume that the private sector will start importing petroleum products, thereby increasing substantially the base for import duties.

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. Projections for 2006 include a one-off compensation for military personnel who retired in 2003 (of ID1,484 billion).

Include goods and services financed by donors, including overhead costs for reconstruction projects which are believed to be spent mostly outside of Iraq.

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.

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.

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.

The amount in 2006 relates to transfers to banks for the procurement of capital goods to be received in future years.

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

Table 5.

Iraq: Fiscal and Oil Sector Accounts, 2004-10

(In percent of GDP)

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Sources: Iraqi authorities and staff estimates and projections.

Projections for 2006-2010 assume that the private sector will start importing petroleum products, thereby increasing substantially the base for import duties.

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. Projections for 2006 include a one-off compensation for military personnel who retired in 2003 (of ID1,484 billion).

Include goods and services financed by donors, including overhead costs for reconstruction projects which are believed to be spent mostly outside of Iraq.

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.

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.

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.

The amount in 2006 relates to transfers to banks for the procurement of capital goods to be received in future years.

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

20. oil revenues in 2006 assume continued stability in oil prices, as well as rising production. The budgeted oil price projection for 2006 is based on WEO (futures market) benchmark price projections, less a $4.5 discount (to build in some downside risk to the oil market), and a further additional quality differential of $10.6 per barrel.10 These assumptions generate an average assumed export price for Iraqi oil of $46.6 per barrel in 2006. Oil exports are projected to increase from 1.4 mbpd in 2005 to 1.65 mbpd in 2006. This assumes some limited restoration (of about 50,000 barrels per day on average) of oil exports through the North (this route has been badly affected in the past by the insurgency).

21. The authorities are looking to raise ID 1.5 trillion in 2006 by reducing the subsidy on domestic consumption of oil derivatives. The staff urged the authorities to seek the alignment of petroleum product prices to at least the average prices of similar products in other Gulf countries by 2007, according to an announced format. The authorities agreed to establish a schedule of price changes, but were reluctant to link this to a formula or automatic adjustment mechanism ahead of the formation of the new government at the end of the year. Under the authorities’ strategy—and as a prior action to the SBA in December 2005—there would be sharp nationwide increases in prices of petroleum products. Premium gasoline would be raised from ID 50 to ID 250 per liter, while regular gasoline would go up from ID 20 per liter (ID 50 per liter in Baghdad) to ID 100 per liter nationwide. Diesel would go up from ID 10 to ID 90 per liter, and kerosene would go up from ID 5 to ID 25 per liter. Liquefied petroleum gas (LPG) would be increased from ID 250 to ID 600 per cylinder. Prices for all oil products would be raised again in (quarterly) stages during 2006. The cabinet has approved this path for price increases through September 2006. The private sector will be permitted to import premium gasoline in 2006 (according to a law submitted to the TNA in November 2005). Progress in adjusting petroleum product prices will be assessed in the context of the program’s (quarterly) reviews, while the resulting revenues will be subject to a performance criterion. Revenues of state-owned oil related enterprises, which derive from domestic sales of oil and oil products (and which are used to finance domestic recurrent operations) will be subject to a floor. Part of these revenues will be remitted to the budget.11

22. Total non-oil revenues in 2006 are projected to increase from 2.7 percent of GDP in 2005 to 3.0 percent of GDP. Tax revenue rises from 2.4 percent of non-oil GDP in 2005 to 4.2 percent of non-oil GDP in 2006. This mainly reflects the expected conversion of the reconstruction levy (5 percent) into a uniform import duty of 10 percent (effective in April 2006), as well as enhanced customs revenue collection through arrangements with neighboring countries, customs revenues on (new) private imports of premium gasoline, and the introduction of a tax on mobile phone companies. The introduction of new levies should also help achieve an increase of 21 percent in non-tax revenues in 2006.

23. External grants are expected to remain at a high level in 2006, before winding down sharply in 2007. Most of these grants (including $8 billion from the U.S.) are directly linked to donor projects and therefore have a neutral net effect on the overall budget balance.

24. Government operating expenditures in 2006 are projected to increase by over 24 percent compared to 2005, reflecting upward pressure from wages and pensions (mostly in the security and defense sector), and from increasing security spending on goods and services. The wage and pension bill increase from 17.7 percent of GDP in 2005 to 20.6 percent in 2006 includes an increase (equivalent to 1.5 percent of GDP) in the security and defense wage bill and a one-off compensation payment (worth 2.4 percent of GDP) for military personnel retired in 2003. Non-security/defense wages and pensions increase more modestly and actually fall as a ratio to GDP in 2006, after increasing sharply in 2005. Nevertheless, it remains important for the government to keep non-security/defense wages and pensions under firm control hereon. In an effort to contain the growth of civil service wages, the authorities have therefore agreed to put a ceiling (as a performance criterion under the SBA) on the non-security/defense wage bill. Potential future spending pressures arising from increases in pensions have been averted (for the moment) by the decision to withdraw from the National Assembly a proposal to set pensions at 80 percent of final salary. Security-related spending is now projected at ID 8 trillion (about $5.3 billion) in 2006, compared with ID 3.4 trillion in 2005, reflecting the rising cost of security and the transfer of responsibility for security from the US to the Iraqi budget. In 2007, it is expected that spending on goods and services, excluding security, will fall sharply, as donor disbursements (a large part of which are spent outside Iraq) decline, and government imports of refined petroleum come to an end.

25. The program includes some new initiatives on the social safety net. The authorities are determined to seek savings on the public distribution system (PDS), mainly through tighter control over procurement and efforts to reduce waste and corruption without sacrificing the quantity or quality of the distributed goods. With this in mind, the PDS budget for 2006 is set at the same amount as the estimated outturn for 2005, itself 25 percent below the budgeted amount in 2005.12 However, the budget also makes provision for an additional ID 500 billion to improve on a new targeted social safety net for the poor, which should help mitigate some of the effects of the proposed increase in oil product prices. This program will be implemented in the course of 2006 and will benefit around 1 million of the poorest households in Iraq.13 In addition, a voucher scheme has been introduced in Baghdad ensuring that residents get at least one liter of kerosene and one canister of LPG per month.

26. The program allows for a significant increase in public investment in 2006. Overall public investment is projected to increase by ID 3.4 trillion to ID 15.9 trillion in 2006 (25 percent of GDP). However, half of this increase reflects an increase in the budget allocation for the oil sector. Some of this oil investment will be reflected in physical investment in 2006, and some in investment which will materialize in later years and underpin the continued recovery in oil production over the medium term. Non-oil investment is projected to increase more moderately, reflecting higher disbursement of donor financing. Although security-related investment is budgeted to increase sharply, overall domestically financed non-oil investment (reconstruction) in 2006 is projected to be similar to 2005 (including investment financed by the oil-for-food-program), and in line with projected non-oil GDP growth.

27. The overall budget deficit in 2006 is projected at ID 5.6 trillion. With an estimated ID 5.8 trillion expected to be outstanding in the DFI at end-2005, and a possible World Bank IDA loan disbursement equivalent to ID 0.4 trillion, the deficit should be covered (although it will largely exhaust the DFI). The budget includes a contingency allowance of ID 2.4 trillion.14

C. Monetary and Exchange Rate Policy

28. Monetary policy will continue to be based on the framework of a de facto exchange rate peg. The exchange rate peg has proved a valuable anchor of stability for Iraq. Although inflation has been volatile (mainly reflecting periodic supply shortages), it has been on a downward trend. Apart from temporary pressures in the spring and early summer of 2005, moreover, the peg has not been seriously tested, and the CBI has been able to maintain it while still accumulating international reserves. In part, this is because of the prohibition on net lending to the government, which ensures that the money supply can only increase through increases in international reserves. The program includes a ceiling (performance criterion) in 2006 of zero new claims by the CBI on either the government or private sector.15

29. Demand for dinars should pick up during 2006 as the economy resumes its expansion. Demand for currency issued (and thereby supply) is projected to expand by about 24 percent during 2006, in line with nominal (non-oil) GDP and consistent with a modest increase in NIR of $1.7 billion (Table 7). The demand for dinars should be additionally supported by a recent decision of coalition forces in Iraq to switch payment to local contractors to dinars from dollars, in a move designed to help arrest dollarization in Iraq.

Table 6.

Iraq: Oil Product Prices

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Sources: Iraqi authorities and MCD database.

Priced at ID per 12 kg cylinder.

ID 50 in Baghdad.

Approved by cabinet decree.

As of June 2005, average prices for Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates. Prices for regular gasoline in the Gulf are typically for octane levels of at least 87, whereas current octane for regular gasoline sold in Iraq is about 82, and it is of significantly lower quality.

Table 7.

Iraq: Central Bank Survey, 2003-06

(In billions of Iraqi dinars, unless otherwise indicated)

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Sources: Iraqi authorities, and staff estimates and projections.

Valued at market exchange rates.

For 2005, valued at market prices.

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