1. On behalf of the Iraqi authorities, I would like to thank the Fund’s Executive Board, Management and Staff, for the support provided to Iraq throughout these difficult times, in assisting the initiation of the process of overhauling the country’s economic institutions and promoting the transition to a modern market economy. Under very trying conditions, and with the support of the Emergency Post Conflict Assistance (EPCA), Iraq has achieved strong advances in macroeconomic stabilization. However, in order to anchor the progress achieved so far and to support the continuation of economic and institutional reforms, the authorities are requesting a fifteen months Stand-By Arrangement from the Fund. Such an arrangement will also be helpful in ensuring external debt sustainability, as Iraq would face a solvency problem unless its debt is broadly restructured¹. With an SDR 475.4 million (40 percent of quota) access, the program will be treated as precautionary, in view of the authorities’ expectation that they will be able to secure adequate financing for their program within the available resource envelope, barring severe unanticipated shocks. In this regard, I would like to convey the authorities’ continued commitment to sound policies and to the needed structural reforms as outlined in the excellent staff report. I am pleased to confirm that the two prior actions on the audit of the Central Bank of Iraq (CBI), and the increases in the prices of domestic petroleum products, according to the agreed upon schedule, have been met, as the staff supplement states.

2.A major landmark in the political reconstruction of Iraq was reached on December 15, as the first parliamentary elections under the framework of the new constitution—endorsed through a public referendum in October 2005—was successfully held that day. More than 10 million people, representing over two thirds of the registered voters participated, and, importantly, the elections witnessed an active involvement of all major factions of the populations. These elections, which come after more than two years of transitional administration of the country since the onset of the war in 2003, open the way for a representative government with broader legitimacy to take the helm in Iraq. It is hoped that the successful representation of all segments of the population in an active and open political process will contribute to the reduction of violence and to an environment more conducive to economic prosperity.

3.The violent conflict that has marked the difficult and complex restructuring of the political and economic landscape in Iraq since 2003 has been of longer duration and greater intensity than was expected. It is hard to overstate the adverse implications that this open conflict has had on the pace of reconstruction and economic restructuring, and the ability to implement policy and reform measures. Whether directly or indirectly, the conflict has undermined the reform of the public sector, the functioning of institutions, investment in oil capacity and the rebuilding of infrastructure. Clearly, the ability of the government to enact very unpopular reforms, such as the increase in domestic petroleum product prices envisaged in the EPCA, was also curtailed by the risks that an ill-timed move in this respect could have caused.

4.In spite of these difficulties, the authorities have spared no effort to stabilize the economy and create a more hospitable environment. On the macroeconomic front, they have succeeded in putting in place a broad-based stabilization, and established a reasonably advanced framework for policy making. Economic activity rebounded strongly in 2004, and growth was maintained in 2005. At the same time inflation, which reached more than 30 percent at end-2004, essentially due to security-related shortage of basic goods, is declining, but remains somewhat volatile. The CBI has focused its efforts on seeking price stability in the context of an exchange rate peg. To defend the peg, and improve confidence in the system, the CBI has accumulated sizeable foreign currency reserves amounting to about $8.7 billion, well in excess of the EPCA target, which puts it in a relatively comfortable position to address potential pressures on the currency, such as those that occurred in the summer of 2005. On the fiscal level, in 2004, higher than anticipated security-related spending led to a somewhat larger nominal deficit. For 2005 however, the overall balance is expected to be about half the level anticipated under the EPCA, essentially on account of higher oil revenues. Investment outturns have also been significantly lower than planned for 2005, partly reflecting weaker than expected disbursement from donors.

5. Looking forward, the overarching objective of the Iraqi authorities remains to systematically lift the population’s standard of living, to recover the high level it has reached in the recent past. In order to place Iraq on a sustainable path to this objective, the authorities have elaborated a program that will pursue, first, institutional reforms with an emphasis on good governance, second, the development of the oil sector as a strategic focus, and third, the strengthening of macroeconomic stability to encourage the development of a dynamic market economy. Strong emphasis will be accorded, moreover, to the provision of better social and public services and the improvement of the social safety net to protect vulnerable segments of the population.

6.While the broader political institutions of democratic governance are being firmly established, the authorities recognize the need to strengthen economic governance and reduce corruption within the existing public institutions. To this effect, they have established a cabinet-level committee to review tenders above $3 million and created an Integrity Commission to investigate corruption cases throughout the government. These measures will be accompanied by an effort to improve the administrative capacity and transparency in policy making institutions and the implementing agencies. In particular, to enhance the effectiveness and transparency of the budget process, the ministry of finance has taken steps to ensure that the disbursements of all funds are made strictly on the basis of budget appropriations. Moreover, with assistance of the Fund, and the World Bank, a set of measures on budget reporting, projections, financial management, and training, as described in the staff report, will be implemented. Similarly, in order to enhance transparency, and comply with a requirement of the Fund, the CBI has been engaged in an audit of its financial operations and statements, and has appointed Ernst & Young to perform the task. Moreover, the authorities have also agreed to set up an audit oversight committee that will include the participation of independent international experts to carry on the work of the International Advisory and Monitoring Board (IAMB) in overseeing the transparent use of the funds of the DFI and oil export sales.

7.The restructuring of the oil sector will, naturally, be a major focus of the authorities, given that it represents the main source of revenues for the government now and in the foreseeable future. The planned expansion of the oil sector is, therefore, the key ingredient of the program agreed with the Fund. Thus, oil production is projected to expand from 2.0 million bpd in 2005 to 2.3 million bpd in 2006. The government’s approach will involve allocating substantial investments to the sector to upgrade and expand oil production and refining, as well as reforming the institutional and legal framework. In this regard, they will aim at restructuring the oil sector in such a way as to put the oil enterprises on a full commercial basis under the regulatory watch of the ministry of oil. Moreover, they will draft a new petroleum law according to the directives of the new constitution on oil revenue allocations.

8.A cornerstone of the program agreed with the Fund is the reduction of the very large government subsidy of the domestic sale of petroleum products—and hence of smuggling—which will free up oil revenues to fund the major priority needs of the country. The agreed-upon schedule of price increases of petroleum products is very ambitious, but the authorities believe it is achievable. The public is now more aware of the need to do so, and the political situation, it is hoped, is more favorable for action on this front. Following the large price adjustments announced last week that increased gasoline and kerosene fivefold, and diesel ninefold, prices will continue to go up in a gradual manner each quarter and will be, by the end of 2006, relatively close to prices of similar products in the Gulf region. While such significant and sustained increases in prices could provoke inflationary pressures, their impact is expected to be subdued in part due to the already high prices in the black market for these products. As the official market gradually replaces the black market for the provision of petroleum products, large gain in efficiency and the reduction of uncertainty in supply, will also help reduce the overall cost of these measures. These actions will be supplemented by a ceiling on the government’s import of petroleum products, while allowing private companies to import and sell the product at market prices. The revenue gains to the government from these measures are unquestionably critical for the sustainability of public finances and the financing of security, social and infrastructural needs.

9. Given the large, urgent, and competing need for resources from different sectors, the government will seek to put in place a fiscal strategy focused on an adequate prioritization of the allocation of its limited resources. In this regard, the National Assembly has passed a 2006 budget in line with the program objectives. Operating expenditures are projected to increase significantly in 2006 mainly on account of security-related needs, guided by the requirement to maintain and improve public order. However, non-security related public pensions and wages will be tightly controlled. Moreover, the overall balance as a percent of GDP is expected to improve in 2006, due to economic growth and the strengthening of revenues. Indeed, the authorities expect to raise ID1.5 trillion (about $1 billion) in 2006 from the reduction in oil subsidies. Non-oil revenues are also set to increase by more than 15 percent, albeit from a low base. In line with the commitment under the EPCA, the authorities have adopted a uniform 10 percent duty to replace the construction levy, strengthened custom collection and will introduce additional levies at the beginning of 2006.

10. In their allocation strategy, the authorities will strive to preserve the integrity of the budget without compromising priority spending in the social sectors, the provision of basic services and critical infrastructure, which are deemed necessary for the sustainability of the economic recovery, the reconstruction process and social cohesion. In this respect, they plan to allocate large investment outlays to the oil sector, to ensure the expansion of the revenue base. They also intend to finance important projects for the provision of basic services such as electricity, education and health. To protect the low income segment of the population, they have provisioned ID 500 billion in the 2006 budget for a social assistance program to improve the new social safety net, and introduced a voucher system for kerosene and LPG in Baghdad. Additionally, the government aims, with World Bank assistance, to reform the Public Distribution System (PDS) and, through tighter control, reduce waste and abuse of the system. It plans, ultimately to replace the PDS with a more effective cash-based system that will better target the poor. This reform will await the completion of the ongoing improvement of the payment system and the completion of a household survey.

11. The monetary policy framework is centered around the need to support the exchange rate peg, which has served the country well in providing a firm anchor and helping stabilize the macroeconomic situation. The CBI remains committed to defending the currency, and has pursued a policy of foreign reserves accumulation to foster stability and confidence. As part of the program, the CBI has agreed to a floor on net international reserves with a significant margin to allow it the flexibility to respond to the demand for foreign currency. In this respect, the CBI stands ready to supply the full amount of foreign exchange the market demands in the daily auctions, and has agreed to refrain from the use of administrative measures to intervene in that market. The CBI will continue to develop its capacity and broaden the menu of policy instruments at its disposal. It has created separate dinar and dollar overnight deposit facilities, and seven and fourteen days facilities with higher interest rates. Eventually it will conduct open market operations, which will provide it with a much better instrument to manage liquidity apart from the use of foreign exchange transactions. Towards this end, the CBI will seek the establishment of a secondary market for treasury bills, a securities’ depository and a clearing and settlement system. In light of the outcome of the external audit of its operations, the outstanding claims of the CBI on the government will be restructured. However, sufficient treasury bills will be held by the central bank to allow it to conduct open market operations.

12. A major reform that is being implemented is the plan to establish a modern payment system, which will be critical to the development of the financial sector and the expansion of economic activity. It will also facilitate fiscal and financial management, and the reform of the social safety net. The CBI is also developing a restructuring strategy for the banking sector. For the two main banks, Rafidain and Rasheed, an initial assessment is being provided with US technical assistance, while future development of the strategy will be subject to close scrutiny by the Fund. The development of Islamic banking and the restructuring of smaller banks is also being considered.

13. Iraq’s external debt will not be sustainable without the full implementations of the Paris Club restructuring agreement, which sets the benchmark for all other debt resolutions. The negotiations on the restructuring of external debt have advanced steadily as the authorities concluded and signed bilateral agreements with nine of its eighteen Paris Club creditors, and have reached an advanced stage of negotiations with an additional four members. Iraq will continue to seek to engage all remaining Paris Club countries to reconcile claims and sign definitive bilateral agreements. As for non-Paris Club official creditors, from the list of 50 potential countries, only 24 had definitive claims. Of these countries, bilateral agreements have been signed with, Malta and Romania and Iraq hopes to have signed agreements with at least six more non-Paris club creditor countries by the end of January. Negotiations with remaining claimants are being pursued.

14. Progress on commercial debt restructuring has also proceeded rapidly after the announcement of the terms of the commercial debt settlement offer last July, and discussed at the Board meeting on Iraq in August 2005. The offer included a cash buyback component for small claims and a debt exchange component for larger ones. Iraq successfully concluded two rounds under the cash tender offers and expects to make a final round of offers to the remaining smaller commercial claimants early next year. On November 16, the authorities made a debt exchange offer to large commercial claimants with a deadline for responses of December 21. Results are expected soon. The government remains committed to maintain a constructive dialogue with all its private creditors in a manner consistent with the Fund’s lending into arrears policy.

15. Iraq has made, under very difficult circumstances, impressive progress in macroeconomic stabilization and the establishment of a modern framework for policy formulation. The support of the Fund has been a critical element of this success. The challenges ahead remain daunting, and the authorities hope that the Board will support their request for an SBA in view of its importance for domestic and external sustainability. The designed program is strong, and through the prior actions, performance criteria and structural benchmarks, along with the frequency of reviews, its monitoring will be adequate. This close engagement with the Fund will be needed in the medium-term to provide the essential support for Iraq’s efforts to establish a thriving economy.