Iraq: First and Second Reviews Under the Stand-By Arrangement, Financing Assurances Review, and Request for Waiver of Nonobservance and Applicability of Performance Criteria—Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iraq
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International Monetary Fund
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Publication Date:
09 Aug 2006
eISBN:
9781451819113
Language:
English
Keywords:
ISCR; CR; government; policy; agreement; amount; crude oil production; debt; reform program; commitment to the program; debt forgiveness; spending power; rate of inflation; Oil; gas and mining taxes
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The government of Iraq is committed to reform the pension law before it goes into effect. Good progress has been made in setting up a payments system. The Central Bank of Iraq (CBI) and ministry of finance are coordinating their strategy toward restructuring the state-owned banks. The government expects to initiate negotiations on resolving non-Paris Club official claims very soon. Iraq’s medium-term economic prospects look reasonably favorable, but are subject to considerable risk. The new government has taken important and decisive measures to bring the program back on track.

Abstract

The government of Iraq is committed to reform the pension law before it goes into effect. Good progress has been made in setting up a payments system. The Central Bank of Iraq (CBI) and ministry of finance are coordinating their strategy toward restructuring the state-owned banks. The government expects to initiate negotiations on resolving non-Paris Club official claims very soon. Iraq’s medium-term economic prospects look reasonably favorable, but are subject to considerable risk. The new government has taken important and decisive measures to bring the program back on track.

I. Introduction

1. The 15-month Stand-By Arrangement (SBA) for Iraq in an amount equivalent to SDR 475.4 million, or 40 percent of quota, was approved on December 23, 2005. The authorities continue to treat the arrangement as precautionary and have not made any purchase. Discussions on the first and second reviews were held with representatives of the new Iraqi government in Amman during June 7-11, 2006.

2. Approval of the SBA unlocked the second stage of the Paris Club debt reduction agreement. The first stage of the agreement (effective in November 2004) involved a 30 percent debt reduction. The second stage (effective December 2005) involved a further 30 percent debt reduction. The final stage, involving 20 percent debt reduction, depends upon the successful conclusion of the final review of the third year of (one or more successive) upper credit tranche arrangements, expected by end-December 2008.

3. The first review of the SBA was delayed because the formation of the new Iraqi government, following elections in December 2005, took much longer than anticipated. The first review was scheduled to be completed on or after February 27, 2006. The new government was not approved by the Council of Representatives (successor to the National Assembly) until May 20, 2006. This was after the scheduled date for the second review (May 14, 2006), so the first and second reviews are being conducted together.

4. The new government has affirmed its commitment to the program supported by the SBA. The new government, which has a four year mandate under the constitution, replaces the transitional government that agreed to the SBA. The government has sought to bring those elements of the program (mainly structural) that were off-track back on track.

II. Political and Economic Background

5. Iraq’s constitutional government is now in place. The government is headed by President Jalal Talibani (as before), with Tariq al Hashami and Adil Abd al Mahdi (who remains in his post) as deputies. The cabinet is led by prime minister Nuri Maliki, with Barham Salih (former minister of planning) and Salam Zaubai as deputies. The minister of finance is Baqir Jabr al Zubaydi (former minister of interior), and the minister of oil is Hussain al Shahristani. The governor of the Central Bank of Iraq (CBI), Sinan Shabibi, remains in his position.

6. The security situation remains very difficult. The political hiatus during the first five months of 2006 was exploited by insurgents, who continued to attack Iraqi and coalition forces, as well as holy sites in an effort to incite further sectarian violence. The death of the major terrorist Zarqawi raised hopes that the insurgency could be brought under control, but the violence has unfortunately continued.

7. Economic growth continues to be below target. Overall economic growth in 2005 is estimated to have slowed to around 4 percent, from nearly 50 percent in 2004. Economic growth in 2006 is also expected to be around 4 percent (Table 1). In both 2005 and 2006, the source of growth is expected to derive from non-oil economic activity, with oil production remaining flat at an average of 2.0 million barrels per day (mbpd).1 The lack of progress in raising oil output reflects a combination of low investment (with project implementation impeded, inter alia, by the continuing violence), and technical problems with the existing infrastructure.

Table 1.

Iraq: Selected Economic and Financial Indicators

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Sources: Iraqi authorities and staff estimates and projections.

8. Inflation has recently begun to accelerate. The twelve-month rate of inflation ended 2005 at 31.7 percent, largely unchanged from end-2004 and higher than the 20 percent targeted under the SBA. Inflation has since accelerated, with twelve-month inflation reaching 58 percent by May 2006. The factors driving inflation have been changing over the past two years (Box 1), but the ongoing insurgency, and the resulting acute shortages of certain goods (especially gasoline and other fuel products), continues to play a major role. It is also possible that rising international crude oil prices and growing spending power in the economy are pushing up Iraq’s equilibrium real exchange rate. With the nominal exchange rate fixed, the real exchange rate adjustment is reflected in a rising domestic price level.

9. The fiscal balance remains in surplus (Tables 2 and 3). Mainly due to lower investment and higher than expected oil revenues, the fiscal balance ended 2005 in a surplus equivalent to 10 percent of GDP, against a programmed deficit of 10 percent of GDP. A part of this surplus was used to place deposits toward letters of credit (equivalent to 5.8 percent of GDP). Resources available in the Development Fund for Iraq (DFI) ended the year at $5.4 billion, substantially higher than programmed. The fiscal balance remained in surplus in the first quarter. Oil export volumes averaged 1.4 mbpd in the first five months of 2006, below the program assumption of 1.65 mbpd, but this was offset by higher than programmed oil export prices. As before, investment continued below budgeted levels.

Table 2.

Iraq: Fiscal and Oil Sector Accounts, 2004–06

(In billions of ID; unless otherwise indicated)

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2006 projections assume WEO crude oil price less the quality differencial of $10.6/barrel for H1, but WEO less quality differential of $10.6/barrel and less a $4.5/barrel discount for H2.

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.

2006 data includes ID270 billion allocated toward government’s share of capital in new regional commercial banks. ID I,500 formerly recorded under this item were re-classified as non-oil investment expenditures in 2006 budget presentation. Finally, ID265 billion were re-classified as debt repayment.

Calculated as 5 percent of oil exports as per UN Security Council Resolution 1483 to finance war reparations to Kuwait.

LCs in the Trade Bank of Iraq, for which 100 percent down-payment is customarily required.

Includes balances on the DFI sub-account (PCO), which are assumed constant throughout 2006.

Table 3.

Iraq: Fiscal and Oil Sector Accounts, 2004–06

(In percent of GDP)

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2006 projections assume WEO crude oil price less the quality differencial of $10.6/barrel for H1, but WEO less quality differential of $10.6/barrel and less a $4.5/barrel discount for H2.

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.

2006 data includes ID270 billion allocated toward government’s share of capital in new regional commercial banks. ID I,500 formerly recorded under this item were re-classified as non-oil investment expenditures in 2006 budget presentation. Finally, ID265 billion were re-classified as debt repayment.

Calculated as 5 percent of oil exports as per UN Security Council Resolution 1483 to finance war reparations to Kuwait.

LCs in the Trade Bank of Iraq, for which 100 percent down-payment is customarily required.

10. The exchange rate remains stable and reserves continue to grow. The exchange of the Iraqi dinar to the US dollar has remained close to 1,475 at the daily auctions, which have been conducted free of any restrictions. The (net) international reserves of the CBI, which reached $11.5 billion at end-2005, grew further to $12.7 billion by end-April, above projected levels under the SBA and comfortably above the program floor (performance criterion) of $7.5 billion. Currency in circulation grew by 27.9 percent in 2005, and by a further 6.1 percent in the first quarter of 2006 (Table 4). The economy remains predominantly cash-based, with cash comprising nearly two thirds of total broad money, which is growing more slowly (Table 5).

Table 4.

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.

The balance sheet is valued using the program exchange rate; memorandum items are valued using the end-of-period exchange rate.

Table 5.

Iraq: Depository Corporations (Monetary) Survey, 2004–05 1/

(In billions of Iraqi dinars)

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Source: Central Bank of Iraq.

The Depository Corporations Survey is a consolidation of the asset and liability positions of the depository corporations relative to all other economic Manual, depository corporations comprise all institutions that issue liabilities included in

Includes part of the external debt of Iraq nominally attributed to Rafidain and Rasheed banks.

Claims relating to Development Fund for Iraq and Oil-for-Food program accounts. These refer to deposits, including at the Federal Reserve Bank of New sheet of the CBI. Counterpart domestic liabilities are included in CBI liabilities to government (DFI/OFF), with some elements in other net claims on central sheet in Table 7.

Inflation in Iraq

Price stability in Iraq has been one important area where the aspirations of the government’s economic program have not yet been met. To a large extent, this reflects the ongoing insurgency, which has caused acute shortages of certain goods (especially gasoline) and slowed the growth of the non-oil sector, impeding its ability to satisfy the rise in spending power in the economy. In 2004, the main contribution to the rate of inflation was from rents (whose end-2003 effective weight was 31 percent), which explained nearly all the increase during the year (Table 1). This reflects the recovery in purchasing power, including as a result of aid flows. Spending power has continued to grow. In 2005, the wage and pensions bill doubled, and is projected to rise by a further 50 percent in the 2006 budget. This is putting rising pressure on the relatively small non-oil economy, which is not believed to have grown as fast. In 2005, inflation increasingly derived from a combination of price hikes in food, fuel and electricity, and transportation and communications (with end-2004 effective weights of 29, 13, and 4 percent respectively), reflecting growing shortages in these commodities and the knock on effects on services. By 2006, these factors (especially fuel and electricity) explain over two thirds of inflation. Most of the increase in prices of fuel and electricity, and of the majority of the other inflation components, occurred early in 2006 (Table 2). However, upward pressure on prices appears now to be fanning out to all items. The year on year change in the different components was subject to wide variation in 2004, but became more consistent in 2005. By May 2006, prices of all items were growing in the range of 15-30 percent, although fuel and electricity prices were still growing much faster, resulting in a year on year increase of 58 percent (Table 3).

Table 1:

Iraq -- Consumer Price Index / Cumulative Contributions

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Table 2:

Iraq -- Consumer Price Index / Cumulative Percentage Change

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Table 3:

Iraq -- Consumer Price Index, Year-Over-Year Percentage Change

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11. Structural reform has been slowed by the delay in forming a government. High profile actions, such as adjustments in oil product prices, were delayed because the caretaker government had insufficient authority to implement controversial measures. Two structural performance criteria (adoption of budget classification and chart of accounts, and the finalization of the audit of the CBI) missed their target dates, as did two structural benchmarks (establishment of an audit oversight committee for the DFI, and a census of public service employees). On the other hand, progress toward developing a payments system (three structural benchmarks) is running ahead of schedule.

III. Policy Discussions

12. The discussions focused on the measures needed to bring the program back on track. The key issues discussed concerned the resumption of domestic fuel price adjustments, the liberalization of private imports of gasoline, the containment of budgetary pressures (especially from pensions), the control of inflation and dollarization, and the resolution of external claims (especially non-Paris Club and Gulf countries). The authorities acknowledged that the delay in forming a government had slowed the reform process, but committed to promptly get to grips with all these issues. Broad agreement was reached on budgetary prospects and priorities for 2006, as well as on the implementation of related measures. In addition, there was a consensus that action needed to be taken to tackle inflation, including through monetary tightening, and allowing the exchange rate to strengthen (as conditions permit).

A. Fiscal Policy and Related Measures

13. The government intends to keep to the approved budget for 2006. The authorities are of the view that the introduction of a supplementary budget would risk a flood of requests for additional spending. With crude oil export revenues projected to be slightly higher than assumed in the budget, it should be possible to implement the existing spending allocations within the existing fiscal deficit target.2 The minister committed to resist calls for an increase in the wage bill (from additional hiring), and will resist the practice of granting large Eid bonuses.3 The greatest threat to the budget, however, derives from the pension law.4 The need to contain recurrent spending has taken on added importance in view of the persistence of inflation, and the possibility that at least some of this derives from the small non-oil economy being overwhelmed by domestic demand.5

14. The government is committed to reform the pension law before it goes into effect. The new pension law that was passed in November 2005 (against the wishes of the then minister of finance) and gazetted in January 2006, was not accommodated in the 2006 budget and is unsustainable over the medium term. The full year effect at the outset is estimated to likely add some ID 2 trillion (about 3 percent of GDP) to the pension bill). This could be expected to grow over the medium term. The government intends to continue to delay implementation of the law, and develop (in consultation with the World Bank) an amended version prior to its implementation.6 The revised law will need to be approved by the Council of Ministers and then by the Council of Representatives. A target date of end-September 2006 has been set for the reform of the law as a (new) structural benchmark.

15. The authorities agreed to restore domestic fuel price adjustments according to schedule.7 On June 17, 2006, the price of kerosene was raised from ID 25 to ID 75 per liter, and the price of diesel was raised to ID 125 from ID 90 per liter. These are in line with the price levels expected for end-June under the SBA (Table 7). The price of liquefied petroleum gas (LPG) was raised to ID 1000 per cylinder (the level projected for end-December). On July 1, the price of regular (octane 82) gasoline was raised from ID 100 to ID 175 per liter (the price scheduled for end-September), and of premium (octane 92) gasoline from ID 250 to ID 350 per liter (the price scheduled for end-June). Blended gasoline (octane 87), a roughly equal mixture of regular and premium gasoline, will sell at ID 250 per liter (compared to ID 150 per liter before). The authorities intend to continue adjusting prices so as to reach targeted levels either at or ahead of schedule over the remainder of the year.

Table 6.

Iraq: Balance of Payments, 2004–06 1/

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Iraqi authorities and staff estimates and projections.

Excludes U.S. military spending in Iraq.

EPCA figures for imports of do not fully account for the cost of freight and insurance, which have been added under services for other estimates and projections.

Includes interest accrued, deferred, and capitalized.

Includes the use/accumulation of the DFI ressources and the UN Oil for Food letters of credit.

Includes the estimates of cash payments to settle the debt owed to small private creditors through cash exchange in 2005 and 2006.

Based on Paris Club agreement, the payments of principal and most interest during 2005–10 are deferred and capitalized.

Reflects advance transfers for the execution of letter of credit (L/C).

Estimates of accrued interest on existing stock of debt prior to Paris Club agreement.

Includes debt forgiveness and clearance of arrears on multilateral debt and arrears related to fuel imports from Turkey.

The notional debt forgiveness reflects: (i) the first stage of debt reduction (30 percent) at end 2004; (ii) the second stage reduction (30 percent) at end-2005; and (iii) the settlement of debt owed to private creditors through cash and debt exchanges. Assumes debt reduction comparable to the Paris Club agreement on other debt to official creditors.

Table 7.

Iraq: Oil Product Prices (SBA)

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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, and as committed in the Stand-by Arrangement.

Indicative.

Exchange rate $1 = ID 1500.

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.

16. Private imports of gasoline will be liberalized as soon as possible. A law designed to liberalize private imports of gasoline was submitted to the National Assembly in November 2005, but was not passed. The draft law contained some elements that need to be removed (specifically, those which subject the resale of such imports to price controls). The Council of Ministers has agreed the necessary amendments to the law, and will (by July 21) have submitted to the Council of Representatives the proposed amendments, and will urge the Council of Representatives to approve the amended law as soon as possible. The law will retain an exemption for such imports from the reconstruction levy, but only for two years. The law should help alleviate domestic fuel shortages and eventually reduce black market prices to international levels. A target date of end-September 2006 has been set for the liberalization of private imports of gasoline as a (new) structural benchmark.

17. The new social protection program is moving forward. In addition to the existing Public Distribution System (which supplies monthly packages of basic goods to all Iraqis), the government introduced (at the end of 2005) a separate means tested program of cash support for poor Iraqi families (those earning less than about $2 per day). By June, some 430,000 families were covered. The aim is to cover 1 million of the poorest families in Iraq by end-2006.8

18. The ministry of finance will resume bi-weekly treasury bill auctions. The last auction was held in April 2006. The ministry of finance had been reluctant to continue with the auctions because it was already very liquid (reflecting the budget surplus in 2005). However, the ministry accepts the importance of keeping the treasury bill market alive in order to (i) maintain a potential market for new borrowing in case circumstances change (e.g., if oil revenues were to fall), and (ii) preserve a market reference point for interest rates.

B. Monetary and Exchange Rate Policy

19. In view of the persistence of inflation, the CBI has raised interest rates further. The CBI’s policy rate was raised from 7.0 to 8.0 percent in April, following this with parallel adjustments in lending rates (but not the deposit rate) in early May. At the moment, the only effective rate is the deposit rate, reflecting the banks’ high level of liquidity. Banks held ID 2.5 trillion in the CBI’s dinar deposit facility as of end-March 2006. These deposits do not count toward satisfying reserve requirements. The CBI raised its policy rate further to 10.0 percent on July 4, with parallel movements in its other rates, and will move rates up to 12.0 percent in July if inflationary trends warrant further tightening. In future, deposit rates will be expected to adjust automatically in line with changes in the policy rate. The monetary transmission mechanism, however, is weak. The effectiveness of interest rate changes in influencing inflation is thus very limited.9 Economic activity is dominated by cash transactions, and the banking system is largely inert. Few loans are extended and the deposit base is not very active. Raising interest rates will nonetheless signal the authorities’ determination to deal with inflation.

C. Other Structural Issues

20. Implementing the Financial Management Information System (FMIS) is proceeding slowly. As a result the assessment of the software is overdue. The authorities confirmed their interest in FAD technical assistance to review the operations of the FMIS jointly with ministry of finance staff and consultants. FAD has been reviewing draft budget classifications and chart of accounts submitted by the ministry of finance. FAD will field a mission later in the year to review the new budget classification, chart of accounts and the FMIS. The related performance criterion has been postponed to December 2006.

21. The ministry of oil is focusing its efforts on combating corruption.10 The new minister of oil reported that he had already cancelled some suspicious contracts related to the transportation of fuel products, and intended to follow up on other leads. The minister noted that corruption related to the production and distribution of refined fuel products was rampant, but he doubted that there was any large scale smuggling of crude oil. Oil metering projects are underway, but the repair of metering systems at the Basra oil export terminal has suffered from delays in receiving parts. International oil companies are advising on installing metering systems for upstream and downstream production, but it will be some time before such systems are operational.

22. Progress is being made in setting up a successor to the International Advisory and Monitoring Board (IAMB). The IAMB, whose mandate expires at the end of 2006, has oversight over external audits of Iraq’s oil revenues deposited in the Development Fund for Iraq. The IAMB met with representatives of the Iraqi government during May 30-31, 2006, to discuss successor arrangements for an independent, competent and professional body to ensure continued oversight of Iraq’s oil revenue accounts. IAMB recommendations for such an oversight body were sent on June 9, 2006 to Prime Minister Maliki for his consideration.

23. Good progress has been made in setting up a payments system in Iraq. The Real Time Gross Settlement System between the CBI and headquarters of commercial banks should be operational very soon and well ahead of schedule. Development of a payments clearing system through the Automatic Clearing House (with a target date of completion of November 2006) looks likely to be also completed ahead of schedule. Payments system regulations (targeted for end-June) have already been adopted.

24. The CBI has established a committee to address the shortcomings in its accounting arrangements that were identified in Ernst and Young’s 2004 audit report. Ernst & Young completed the audit of the 2005 financial statements on July 13, 2006. As expected at this stage, the auditors were not able to confirm the reliability of the balances reported in the financial statements due to accounting weaknesses and inadequate or incomplete information on some balance sheet items.11 Detailed areas for improvement have been flagged in the audit report. The CBI plans to retain Ernst and Young as auditor for its 2006 financial statement.

25. The CBI and ministry of finance are coordinating their strategy toward restructuring the state-owned banks. The CBI has established a bank restructuring unit, tasked with advising on bank restructuring plans. The ministry of finance intends to appoint an international auditor to conduct a financial and operational audit of the banks. The ministry aims to have devised a comprehensive restructuring plan by the end of 2006.

26. The government expects to initiate negotiations on resolving non-Paris Club official claims very soon. While most Paris Club official creditors have now signed bilateral agreements, progress has been slow in resolving non-Paris Club official claims, especially those of Gulf countries. This has been held up by the delay in forming the constitutionally-based government. Now that the new government is in place, negotiations can begin with a view to resolving these claims in a timely manner. Contacts have already been made with Saudi Arabia at the ministerial level regarding the resolution of these claims, and a technical working committee is being set up to begin the process of reconciliation.

27. The authorities continue to make good faith efforts to resolve the remaining arrears to private creditors. By May 2006, Iraq had resolved almost $18 billion of claims submitted by private creditors through debt and cash exchanges, and submitted almost $1 billion of claims arbitration.12 While the process of debt reconciliation is ongoing, the authorities will continue the current strategy of resolving the remaining arrears of about $2 billion through debt or cash exchange offers, including the arbitration process, through July 2006. The authorities plan to develop a follow-up strategy regarding commercial claims still outstanding after July 2006. Since the amount of the remaining private arrears is relatively small, about 4 percent of the total external debt in 2006, they are unlikely to pose significant risk to the program.

IV. Program Monitoring and Fund Relations

28. Some performance criteria have been missed. Iraq met all quantitative performance criteria set for end-March, except for that applying to revenue of oil related state-owned enterprises which was slightly below target, reflecting lower than expected oil production and interruptions of refinery operations. Three other performance criteria were also missed: (i) payments arrears arose with Turkey in December 2005 (but these have since been regularized); (ii) the budget classification in line with GFSM 2001 was not adopted on June 30, 2006; (iii) the audit report of the Central Bank of Iraq’s (CBI) 2005 financial statement, was not finalized by mid-May (but instead on July 13, 2006).

29. The authorities are seeking waivers for the missed performance criteria. In view of the relatively small size of the deviation and in light of the change in the underlying production assumptions, the authorities request a waiver for the missed performance criterion on revenue of oil related state-owned enterprises. On the basis of corrective actions specified in the attached Supplementary Memorandum of Economic and Financial Policies (SMEFP), the authorities request waivers for the three other missed performance criteria noted in paragraph 29. As the IMF Executive Board will be considering the First and Second Review of the SBA after end-June, 2006, but before the outcome for end-June quantitative performance criteria will be known, the authorities request that the applicability of these performance criteria be waived. Staff have no reason to believe that any of these performance criteria would have been missed on the basis of preliminary data.

30. The authorities also request establishment of the quantitative performance criteria proposed in the SMEFP for end-September and end-December 2006. The performance criteria for the second half of the program period are the same as the indicative targets set for this period in the SBA, except that (i) revenues of oil-related state-owned enterprises have been adjusted down to reflect lower projected crude and refined oil production13, and (ii) the ceiling on contracting external debt with a grant element less than 50 percent now provides a window for loans with a grant element exceeding 35 percent (to accommodate pending loans from the Japanese government which are to finance projects designed to improve Iraq’s productive capacity). Staff do not believe that these loans would risk Iraq’s debt sustainability. The SBA currently defines lending as concessional lending if it has a grant element greater than 50 percent.

31. Staff aim to finalize an interim safeguards assessment for Iraq by the time of the next review taking into account the results of the recent audit of the CBI by Ernst & Young. A safeguards assessment should normally be completed before the completion of the first review of the program. However, the security situation in Iraq did not allow this to be done. As explained to the Board at the time of the approval of the SBA, a phased approach has been adopted for the safeguards assessment, similar to that for post-conflict cases, where the security situation or the state of development of the central bank does not allow a full on-site assessment.

V. Vulnerabilities and Risks

32. Iraq’s medium term economic prospects look reasonably favorable, but are subject to considerable risk. A medium term scenario is presented in the Appendix. This scenario updates the projections made in the staff report for the SBA in light of higher oil prices and a slower than expected recovery in oil production. As before, it is assumed that security improves sufficiently to allow the authorities to implement the investment program needed to generate growth. The scenario shows that, provided Iraq exercises due restraint on recurrent spending, the budget should be able to accommodate Iraq’s investment needs without generating financing gaps (and thereby large scale borrowing needs). However, this prognosis depends heavily on the assumption that the wage and pension bill can be kept under control, which in turn makes it imperative that the new pension plan that is expected to go into effect later this year is sustainable and that inflation is contained before triggering a wage price spiral. The scenario is also vulnerable to declines in oil prices relative to present projections, as well as to lower than programmed oil production. The economy remains extremely vulnerable to the country’s ongoing security problems, which impede investment and inhibit private economic activity, and to corruption, which damages Iraq’s ability to manage its oil resources effectively and siphons off much needed wealth to improper ends.

VI. Staff Appraisal

33. The new government has taken important and decisive measures to bring the program back on track. The adjustment of fuel prices in line with the original schedule, within weeks of the new government’s installation, provides strong evidence of the new government’s commitment to the program. The determination to contain recurrent spending, and particularly wages and pensions, to the original budget allocations, is an important signal of the government’s respect for fiscal discipline.

34. The momentum of action and reform must be strengthened. It is essential that the government reform the pension plan to make it a fiscally sustainable system, before it goes into effect. The government must also secure early passage of the law liberalizing private imports of gasoline, if it is to succeed in bringing to an end the acute shortages of fuel products in Iraq.

35. The impact of reform on the poor should be kept in sharp focus. The government is strongly encouraged to pursue it social protection programs, in parallel with the reduction of subsidies, and seek ways to better target support toward the poor.

36. Institution building remains a cornerstone of the reconstruction process. It is encouraging that preparations for establishing an operational payments system are well advanced. This will support reform in many other areas, including by introducing better transparency in the government’s payroll, in redirecting financial transactions away from cash and back into the banking system, and in laying the groundwork for a successor to the PDS.

37. Inflation remains a serious source of concern. The ongoing insurgency and shortages of goods, as well as supply disruptions generally in the non-oil economy, will continue to put upward pressure on prices. But it remains important that the CBI take decisive measures to contain it before inflationary expectations become entrenched, either by an effective tightening of monetary conditions and/or by exchange rate action. The CBI will need to tighten monetary conditions further if inflation does not start to come down soon. The government can help by keeping public sector wages and pensions in line with the absorptive capacity of the small, albeit growing, non-oil economy, and by making every effort to prevent supply bottlenecks (especially in the petroleum product market) from destabilizing prices further.

38. For the program to be implemented effectively, corruption must be tackled and security brought under control. Corruption is damaging the credibility of the government’s reform program, and undermining its effectiveness, especially in the petroleum and petroleum product sector. The continuing lack of security meanwhile remains Iraq’s biggest obstacle to its recovery and reconstruction program, and presents the greatest risk of all to its future prosperity.

39. The staff recommends that the first and second reviews under the SBA be completed. In view of the government’s commitment to the program, and in light of the policies and measures described in their SMEFP, the staff believe that the program is on track. The staff recommend approval of the waivers requested by the authorities for the missed performance criteria, and of the applicability of end-June targets. Based on the authorities’ intentions to accelerate its efforts to address its arrears to non-Paris Club creditors, and on the staff’s judgment that their strategy to resolve the remaining arrears to private creditors remains consistent with the Fund’s policy on lending into arrears, staff also supports the completion of financing assurances review.

Table 8.

Iraq: 2005–06 Quantitative Performance Criteria and Indicative Targets Under the Stand-By Arrangement (SBA) 1/

(In billions of Iraqi dinars, unless otherwise indicated)

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See Appendix I, Technical Memorandum of Understanding for precise definitions of all performance variables.

Estimated.

Rolling over t-bills does not constitute new lending.

Flows for 12/31/05 are cumulative for 2005. Flows for 2006 are cumulative starting 1/1/2006.

Excluding salaries paid by minitires of defense and interior (see Technical Memorandum of Understanding for precise definition).

This will be monitored on a continuous basis.

This ceiling excludes loans with grant element of 35 percent or more of up to Yen 200 billions for reconstruction projects to be contracted with the government of Japan in 2006.

Table 9.

Iraq: Prior Actions, Structural Performance Criteria, and Structural Benchmarks Under the Stand-By Arrangement

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The budget classification and chart of accounts will be deemed in line with the IMF GFSM 2001 if it is consistent with the methodology and high level classification defined in the technical assistance report of the IMF’s Fiscal Affairs Department entitled “Iraq Budget Classification Reform” (July 2005).

Table 10.

Iraq: Proposed Availability of Purchases Under the Stand-by Arrangement, 2005–07

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Source: Fund staff projections.
Table 11.

Iraq: Indicators of Fund Credit, 2004–11 1/

(In millions of SDRs, unless otherwise indicated)

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Sources: Fund staff estimates and projections.

Including the hypothetical purchases under the precautionary SBA, not shown in the balance of payments projections.

Appendix—Iraq: Medium-Term Prospects and External Debt Outlook

1. Iraq’s medium term prospects have improved since the Stand-By Arrangement (SBA) was approved in December 2005, mainly on account of higher oil prices (see Appendix, Table 1-4). Staff projections suggest that, on current WEO forecasts for oil prices, Iraq should be able to meet its first major amortization payment (in 2011) on its rescheduled debt without difficulty. These projections incorporate a downward “risk” discount of one standard deviation in oil prices ($4.5 per barrel) to the existing forecast, in addition to the usual quality differential for Iraqi oil. Nevertheless, the simulations below show that Iraq remains vulnerable to further downward shocks to oil prices and/or to a renewed stalling of oil production. This suggests that Iraq has little room for fiscal expansion beyond what is projected in these scenarios, and that the government would be wise to retain positive precautionary balances in the Development Fund for Iraq (or its future equivalent) throughout the scenario (rather than run balances to zero in 2007).

Table 1.

Iraq: Selected Economic and Financial Indicators

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Sources: Iraqi authorities and staff estimates and projections.
Table 2.

Iraq: Fiscal and Oil Sector Accounts, 2004–11

(In billions of ID; unless otherwise indicated)

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Sources: Iraqi authorities, and staff estimates and projections.

Projections for 2007-2011 assume that the private sector will start importing petroleum products, thereby increasing substantially the base for import duties.

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.

2006 data ncludes ID270 billion allocated toward government’s share of capital in new regional commercial banks. ID I,500 formerly recorded under this item were re-classified as non-oil investment expenditures in 2006 budget presentation. Finally, ID265 billion were reclassified as debt repayment.

Calculated as 5 percent of oil exports as per UN Security Council Resolution 1483 to finance war reparations to Kuwait.

LCs in the Trade Bank of Iraq, for which 100 percent down-payment is customarily required.

Includes financing from LCs previously issued under the UN oil-for-food program.

Table 3.

Iraq: Fiscal and Oil Sector Accounts, 2004–11

(In percent of GDP)

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Sources: Iraqi authorities and staff estimates and projections.

Projections for 2007-2011 assume that the private sector will start importing petroleum products, thereby increasing substantially the base for import duties.

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.

2006 data ncludes ID270 billion allocated toward government’s share of capital in new regional commercial banks. ID I,500 formerly recorded under this item were reclassified as non-oil investment expenditures in 2006 budget presentation. Finally, ID265 billion were reclassified as debt repayment.

Calculated as 5 percent of oil exports as per UN Security Council Resolution 1483 to finance war reparations to Kuwait.

LCs in the Trade Bank of Iraq, for which 100 percent down-payment is customarily required.

Includes financing from LCs previously issued under the UN oil-for-food program.

Table 4.

Iraq: Balance of Payments, 2004–11 1/

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Iraqi authorities and staff estimates and projections.

Excludes U.S. military spending in Iraq.

EPCA figures for imports of do not fully account for the cost of freight and insurance, which have been added under services for other estimates and projections.

Includes interest accrued, deferred, and capitalized.

Includes the use/accumulation of the DFI ressources and the UN Oil for Food letters of credit.

Includes the estimates of cash payments to settle the debt owed to small private creditors through cash exchange offer in 2005 and 2006.

Based on Paris Club agreement, the payments of principal and most interest during 2005–10 are deferred and capitalized.

Reflects advance transfers for the execution of letter of credit (L/C).

Estimates of accrued interest on existing stock of debt prior to Paris Club agreement.

Includes debt forgiveness and clearance of arrears on multilateral debt and arrears related to fuel imports from Turkey.

The notional debt forgiveness reflects: (i) the first stage of debt reduction (30 percent) at end 2004; (ii) the second stage reduction (30 percent) at end-2005; and (iii) the settlement of debt owed to private creditors through cash and debt exchanges. Assumes debt reduction comparable to the Paris Club agreement on other debt to official creditors.

2. Iraq has made significant progress in resolving claims of private creditors through cash and debt exchange offers. Through the cash-exchanges in August 2005, September 2005, and March 2006, Iraq settled about $3.5 billion of claims submitted by small private creditors. In January 2006, Iraq converted claims of large private creditors totaling almost $14 billion into $2.66 billion dollar denominated bonds and $0.18 billion multicurrency loans.

3. 1 The bonds have been traded in the market since January 23, 2006. By May 2006, Iraq has settled almost $18 billion of the total claims of about $21 billion submitted by private creditors. Most of the remaining claims are being reconciled or have been submitted to the arbitration process.

4. Despite the substantial debt reduction received from Paris Club and private creditors, however, the amount of external debt remains large. By end-2005, Iraq had received 60 percent debt reduction from the Paris Club creditors. In addition, by May 2006 Iraq had settled about 85 percent of debt to private creditors, and received overall (private) debt reduction of more than 80 percent. The latest estimates of external debt indicate that the stock of debt was $63 billion (183 percent of GDP) at end 2005, and is expected to decline to about $48 billion (102 percent of GDP) by end 2006. Without the third stage of debt reduction, external debt would increase to about $57 billion (about 57 percent of GDP) by 2011. The third stage reduction (expected in 2008) would further reduce Iraq’s external debt to about $33 billion (33 percent of GDP) by 2011 (see Appendix, Table 5).2 3

Table 5.

Iraq: Estimated External Debt Stock, 2004–11

(In billions of U.S. dollars) 1/

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Sources: The Paris Club and staff estimates.

The assumptions made in this table are for purposes of illustration and discussion only. While the process of Iraq’s debt reconciliation is ongoing, the IMF has had to base its analysis on information that may include as yet unreconciled data. Such use of data by the IMF does not amount to a recognition or denial of any particular claims. The estimates of the debt stock are different from those in IMF Country Report No. 06/15 to incorporate the latest results of debt reconciliation and the settlements of debt to private creditors.

Assumes debt reduction comparable to the Paris Club agreement in 2004.

Assumes that by end 2006 all debt to private creditors would be settled by debt and cash exchanges, and the total amount new bonds and loans issued may be less than projected if the reconciliation rate is less than 100 percent.

Includes new debt and arrears related to fuel imports from Turkey.

Debt service is actual amount paid, including repayment of arrears to Turkey.

Assumes precautionary SBA during 2005–08.

5. Iraq’s external debt also remains vulnerable to a negative oil shock, particularly in 2011 when Iraq will start repaying the debt to official creditors. Based on the Paris Club agreement in 2004, the repayment of the remaining debt stock would start in 2011, while the interest payments accrued during 2005-2010 are mostly capitalized. The debt service would be relatively small until 2010 before it increased to about 5 percent of GDP in 2011. Simulations for two oil shocks—a production shock that keeps oil production constant at 2.7 mbpd over 2008-11, and a price shock that lowers oil export price by $4.5 per barrel (equivalent to one standard deviation) during 2007–11—show that Iraq would require significant borrowing from the international markets to close the financing gaps (see Appendix, Table 6).

Table 6.

Iraq: External Debt Sustainability Framework, 2004–11

(In percent of GDP, unless otherwise indicated)

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Source: Fund staff estimates.

Includes net FDI, other net private sector inflows (all assumed to be equity), and use of official assets held abroad.

Derived as [r - g - ρ(l+ g) + εα(1+r)]/(1+g + ρ + gρ) times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDP deflator in US dollar terms, g = real GDP growth rate, e = nominal apprecia (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ (1+g) + εα(l+r)]/(1+g+ρ+g ρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

Debt service is total accrued amount.

Balance that stabilizes the debt ratio at its previous year’s level, given assumptions on real GDP growth, nominal interest rate, dollar deflator growth, and

Assumes that oil production reaches its peak by 2008 at 2.7 mbpd.

Assumes that oil price in 2007–11 is US$4.5 lower than in the baseline, equivalent to one standard-deviation shock.

Baghdad, July 15, 2006

Mr. Rodrigo de Rato

Managing Director

International Monetary Fund

Washington, D.C. 20431

U.S.A.

Dear Mr. de Rato:

1. The Board of the IMF approved a request for a Stand-By Arrangement (SBA) for Iraq on December 23, 2005, in support of an economic program for 2006. Despite the challenging security and political environment, good progress has been made in implementing this program, and macroeconomic stability has been broadly secured so far. We would like to confirm that the new government, which assumed power on May 20, 2006, remains committed to the program, and to the goals of the SBA. We will take whatever steps are necessary to ensure that the program remains on track.

2. Iraq has met all quantitative performance criteria set for end-March, except for that applying to revenue of oil related state-owned enterprises which was slightly below target, reflecting lower than expected oil production and interruptions of refinery operations. Three other performance criteria were also missed: (i) payments arrears arose with Turkey in December 2005 (but these have since been regularized); (ii) the budget classification in line with GFSM 2001 was not adopted on June 30, 2006; (iii) the audit report of the Central Bank of Iraq’s (CBI) 2005 financial statement, was not finalized by mid-May (but instead on July 13, 2006).

3. In light of the change in the underlying production assumptions, we would like to request a waiver for the missed performance criterion on revenue of oil related state-owned enterprises. On the basis of corrective actions specified in the attached Supplementary Memorandum of Economic and Financial Policies (SMEFP), we would also like to request waivers for the three other missed performance criteria noted in paragraph 2. As the IMF Executive Board will be considering the First and Second Review of the SBA after end-June, 2006, but before the outcome for end-June quantitative performance criteria will be known, we request that the applicability of these performance criteria be waived. We also request establishment of the quantitative performance criteria proposed in the SMEFP for end-September and end-December 2006.

4. Looking forward, we shall strive to continue to maintain macroeconomic stability, in particular to lower inflation, maintain a prudent fiscal stance, and continue reforms that put Iraq on a path of sustainable growth. A cornerstone of this strategy continues to be the reduction of subsidies on oil derivative products. The program of adjusting prices of oil derivative products was resumed in June, in line with our commitments under the program. We will continue our strategy of gradual price adjustments in the remainder of the program. By July 21, 2006, we will have submitted to the National Assembly proposed amendments of the draft law to allow private sector imports of petroleum products for domestic resale at market prices, and will urge the Assembly to approve the amended law as soon as possible.

Sincerely yours,

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IRAQ: Supplementary Memorandum on Economic and Financial Policies for 2006

July 15, 2006

I. Introduction

1. This memorandum supplements our Memorandum on Economic and Financial Policies for 2005-06 (MEFP) annexed to our letter dated December 6, 2005. It describes additional economic objectives and policies agreed in the context of the first and second reviews under the Stand-By Arrangement (SBA). Policies and unfulfilled commitments specified in the original MEFP continue to be part of the program.

2. A new Government of Iraq (GoI) was approved by the Council of Representatives on May 20, 2006. The GoI is committed to adhere to the program that was approved by its predecessor, the Transitional Government, and which forms the basis for the SBA.

II. Recent Developments Under the Stand By Arrangement

3. Macroeconomic stability was preserved, despite political uncertainty and difficult security conditions. The GoI has been able to resist unwarranted spending pressures, maintain a stable exchange rate, while enabling continued economic growth. Inflation, however, remains high and volatile. Twelve month consumer price inflation was 58 percent in May.

4. The growth of real GDP is projected to be 4 percent in 2006. This is lower than the 10.6 percent projected at the outset of the program, because oil production has not increased as expected. Oil production has been constrained mainly by exportation problems, mostly of a technical nature, and by difficulties in undertaking the necessary investment. Non-oil activity is projected to grow 10 percent this year.

5. Fiscal policy has remained on track. The fiscal outturn for 2005 showed a large fiscal surplus, reflecting higher than expected oil revenues and lower than programmed investment. A small fiscal surplus was also recorded in the first quarter of 2006, which allowed the GoI to continue to build up financial reserves in the Development Fund for Iraq (DFI). Revenues overall were broadly as budgeted in the first quarter, as lower oil export volumes were offset by higher than expected oil prices. Recurrent spending was also in line with the budget. Investment expenditure was below budget, mainly due to continuing security problems affecting implementation as well as the delay in forming a government, which hindered approval of investment projects.

6. The GoI has used monetary policy to maintain a fixed rate of exchange of the Iraqi dinar. Daily auctions of foreign exchange were held at rates close to ID 1,475 per U.S. dollar. Net international reserves continued to grow to $12.2 billion at end April 2006. The Central Bank of Iraq (CBI) raised its policy interest rate to 8 percent on April 18, 2006.

7. All but one of the quantitative performance criteria set for end-March were met. Revenue of oil related state-owned enterprises was slightly below the target, reflecting lower than expected oil production (and therefore compensation for associated costs), and interruptions to refinery operations (and lower sales of domestic fuel products). The GoI has regularized the arrears to Turkey (subject to a continuous performance criterion) which arose in December. A copy of the memorandum of understanding with Turkey has been submitted to IMF staff. The new budget classification in line with the IMF’s Government Financial Statistics Manual 2001 (GFSM 2001) has not yet been adopted (a structural performance criterion for end June 2006). The Ernst and Young audit report of the CBI’s 2005 financial statement, due by mid-May (performance criterion), was finalized on July 13, 2006.

III. Economic and Financial Policies in 2006

8. For the remainder of 2006 the GoI’s main macroeconomic policy objective will be maintain fiscal sustainability, lower inflation and continue reforms that put Iraq on a path to sustainable growth.

9. The main parameters of the 2006 budget remain in place. Higher international oil prices will compensate most of the losses from lower production and exports. Revenues of oil related enterprises (a performance criterion 1) will be slightly lower than previously programmed due to lower oil production and lower domestic sales of refined products. Indirect taxes will turn out lower that budgeted due to a delay in the increase of the reconstruction levy from 5 to 10 percent. The draft law to increase the reconstruction levy has been prepared and is scheduled to be discussed by cabinet and submitted to the Council of Representatives by September, 2006.

10. The GoI intends to keep spending within current allocations. Unbudgeted new hiring and unplanned bonuses will be resisted. Minor budget overruns might also be possible for the new social protection program under which we aim to have enrolled one million families by year-end. The Public Distribution System will remain in place, but will not be expanded.

11. These policies should contain the overall government deficit to 6.3 percent of (revised) GDP. The primary deficit for 2006 will continue to be subject to a performance criterion measured in ID billion as envisaged at the time of the SBA approval. By the end of 2006, we aim to hold the equivalent of at least ID 3.3 trillion in assets in the DFI. To keep the option of domestic financing open and to maintain a market indicator for interest rates, we will continue the regular bi-weekly issuance of treasury bills.

12. The GoI is committed to reforming the new pension law prior to its implementation. Law 27/2005 will be reformed to make it fiscally sustainable in the medium term. We will aim to have the law reformed by end-September, 2006 (as a structural benchmark).

13. The GoI remains committed to adjust fuel prices to close to the level of neighboring countries. Oil derivative products will be adjusted gradually to reach the targets specified under the program. In June we increased prices to reach the program targets for end-June.2 We will continue this policy of gradual price adjustment in the coming months to reach price levels slated for September either by, or ahead of schedule. Popular understanding of the price adjustments will be supported by providing sufficient supply of premium gasoline where it is sold, although the premium product will not be available at all gas stations.

14. The GoI will continue to push forward legislation to liberalize private gasoline imports. Liberalizing private gasoline imports is a key element of our policy to contain domestic price inflation and improve the sustainability and quality of the budget. The Council of Ministers has approved the revised draft law for the liberalization of private gasoline imports after removing articles 7 and 8. The revised draft law will be sent to the Council of Representatives by July 21, 2006 (as a prior action for the first and second review). We will continue to push for consideration of the amended law by the Council of Representatives and aim to have it passed by September, 2006 (as a structural benchmark).

15. To help fight inflation the Central Bank of Iraq (CBI) will strengthen monetary policy. The CBI’s policy interest rate was raised on July 4 to 10 percent, and CBI lending and deposit rates will be adjusted in line with the policy rate. The policy rate will be adjusted further to 12 percent by mid-July, if inflationary trends warrant further tightening.

16. The CBI approved the Ernst and Young audit of the CBI’s 2005 financial statement on July 13, 2006. The GoI is committed to develop plans for the restructuring of the state-owned banking sector. The GoI will keep the IMF closely informed, and its plans for the state-owned banks will be subject to IMF review.

17. The GoI is in the process of finalizing the modalities for the formation of a successor oversight board, in light of the expected expiration of the IAMB mandate in December 2006.

18. The GoI will step-up its efforts to negotiate a debt settlement with non-Paris Club official creditors and continue to resolve the remaining claims of private creditors. Contacts have been made at the ministerial level with Saudi Arabia, and agreement was reached to hold technical meetings at the level of deputy ministers. Arrangements for these meetings are well underway. Iraq recently signed agreements with Czech Republic and Hungary, and the negotiations with other non-Gulf countries continue. Iraq has resolved about $18 billion claims submitted by private creditors and submitted almost $1 billion claims to the panel arbitration. The process of reconciliation and resolution of the remaining claims of about $2 billion is ongoing.

19. The GoI remains committed to enhance the effectiveness and transparency of budgetary management. We will step-up our efforts to implement a Financial Management Information System (FMIS) in time for the 2007 budget, which will also help improve the timeliness of budget reporting. An assessment of the Free Balance software will be completed by end-September 2006, and by end-December a report on any changes necessary to adapt it adequately to the needs of Iraq. The GoI will adopt a budget classification in line with the IMF’s GFSM 2001 as soon as possible, but no later than end-December 2006.

20. Development of a market oriented and transparent oil sector remains one of the top priorities of the GoI. We will prepare a draft petroleum law by end-December 2006. In this regard, we intend to take advantage of IMF technical expertise to ensure that the law is consistent with international best practices. The GoI will combat corruption vigorously. We will closely monitor the quality assessments of crude oil and continue to work with the PCO contractor to install a metering system by end-2006.

IV. Program Monitoring

21. Monitoring of the program will remain unchanged and indicative targets specified for end-September and end-December 2006 in the MEFP will be converted into performance criteria except for those applicable to revenue of oil related enterprises and the contracting of external debt. Two structural benchmarks and a structural performance criterion will be rescheduled 3. The performance criterion on revenue from oil enterprises for end-September and end-December 2006 will be adjusted downward from the specified indicative targets in the MEFP to reflect lower projected oil production and lower domestic sales of refined products in 2006. The performance criterion on non-concessional external debt will be modified to accommodate loans with a grant element of 35 percent or more of up to Yen 200 billion from the government of Japan. A census of all public service employees (including military personnel) will be completed by end-December (structural benchmark). Establishment of an audit oversight committee to oversee and audit the Development Fund of Iraq will be based on a proposal that the GoI has received from the IAMB and be completed by end-September 2006 (structural benchmark). A budget classification and chart of accounts in line with GFSM 2001 will be adopted by end-December 2006. In addition, reform of the pension law in line with a sustainable pension system will be completed by end-September, 2006 (new structural benchmark), and the effective liberalization of private gasoline imports shall also be completed by end-September, 2006 (new structural benchmark). The formulation of the 2007 budget will be the focus of the third review, in addition to further adjustments of fuel prices.

22. The Technical Memorandum of Understanding is modified in the manner described in the attached Addendum.

Table 1.

Iraq: 2005–06 Quantitative Performance Criteria and Indicative Targets Under the Stand-By Arrangement (SBA) 1/

(In billions of Iraqi dinars, unless otherwise indicated)

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See Appendix I, Technical Memorandum of Understanding for precise definitions of all performance variables.

Estimated.

Rolling over t-bills does not constitute new lending.

Flows for 12/31/05 are cumulative for 2005. Flows for 2006 are cumulative starting 1/1/2006.

Excluding salaries paid by minitires of defense and interior (see Technical Memorandum of Understanding for precise definition).

This will be monitored on a continuous basis.

This ceiling excludes loans with grant element of 35 percent or more of up to Yen 200 billions for reconstruction projects to be contracted with the government of Japan in 2006.

Table 2.

Iraq: Indicative Quantitative Benchmarks Under the Stand-By Arrangement (SBA)

(In Iraqi dinars per liter, unless otherwise indicated)

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Table 3.

Iraq: Prior Actions, Structural Performance Criteria, and Structural Benchmarks Under the Stand-By Arrangement

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The budget classification and chart of accounts will be deemed in line with the IMF GFSM 2001 if it is consistent with the methodology and high level classification defined in the technical assistance report of the IMF’s Fiscal Affairs Department entitled “Iraq Budget Classification Reform” (July 2005).

IRAQ: Addendum to the Technical Memorandum of Understanding

July 15, 2006

1. This Addendum describes changes to the Technical Memorandum of Understanding (TMU) of December 6, 2005.

2. The limits on medium- and long-term external debt (specified in paragraph 14 of the TMU) excludes loans with grant element of 35 percent or more of up to Yen 200 billions for reconstruction projects to be contracted with the government of Japan in 2006.

3. To facilitate regular monitoring under the SBA the following items are added to the list of information to be provided to the Fund (paragraph 18 of the TMU):

  • The balance sheet of the Trade Bank of Iraq (TBI), with no more than 8 weeks lag.

  • The amount of loans contracted from the Japanese government, and grant element, on a quarterly basis, with no more than eight weeks lag.

4. Review of the structural reforms (paragraph 19 of the TMU) refers to reforms specified in the memorandum of economic and financial policies and its supplement.
1

Non-oil economic activity is estimated have increased by 12 percent in 2005, based on economic indicators (e.g., cement production, electricity output), and is projected to grow by 10 percent in 2006.

2

Projected crude oil export volumes for 2006 were revised down from 1.65 mbpd to 1.5, while the average Iraqi oil export price was revised up from $46.6 to $53.3 per barrel. This revised projection was based on the latest WEO oil price forecast, less a $10.6 quality differential (as in the SBA) and an additional $4.5 risk discount for the second half of the year (as in the SBA, in case the WEO projection may turn out too high).

3

The government remains interested in conducting a census of public employees, but the delay in getting this going has required a postponement of the target date for the census to end-2006.

4

The delay in forming a government has delayed the process in preparing a budget for 2007. The outline of the 2007 budget will be a focus of the third review, scheduled after August 14, 2006. The reconstruction levy was supposed to increase to 10 from 5 percent in April 2006, but this did not happen. The government intends to effect this change later this year and in time for the 2007 budget.

5

The size of the non-oil economy remains very hard to measure, but is estimated at around 30 percent of total GDP in 2006. But the wage and pension bill, which is projected to increase by nearly 50 percent in 2006, is equivalent to around two thirds of estimated non-oil GDP in 2006.

6

Under the plan in the current version of the law, employees can retire at age 50 with 25 years of service. The first 15 years of service earns a pension equal to 50 percent of the final salary, increasing by 1.75 percent per annum up to a maximum of 80 percent of final salary. Neither pensions nor contributions are taxable in Iraq.

7

The last increase in domestic fuel prices was on December 18, 2005, as a prior action for the Board’s approval of the SBA. A second stage of increases was scheduled for end-March, 2006, but did not take place.

8

It is possible that the budgetary allocation for social protection programs could be exceeded, but this can be met out of the contingency allowance. The new program has been allocated ID 500 billion. The authorities intend to reform the more expensive Public Distribution System over the medium term (with the help of the World Bank). Savings under this scheme are already been sought through better procurement programs.

9

The ability of the CBI to influence monetary conditions will be enhanced when it is able to conduct open market operations, allowing the CBI to reduce the money supply other than by selling dollars at auction. However, progress in establishing marketable instruments and developing a secondary market remains slow.

10

In addition to comments in the press, allegations of corruption have been made in the quarterly report to the U.S. Congress of the Special Inspector General for Iraq Reconstruction, as well as in the report of the Iraqi Oil Ministry’s Inspector general. Hard evidence is, however, difficult to come by. In April, the Iraqi authorities broke up a smuggling operation that involved a convoy of 1,200 trucks attempting to carry a total of about 500,000 barrels (equivalent) of semi-refined heavy fuel oil across the Syrian border. Iraq’s oil facilities produce an excess of heavy fuel oil, much of which is pumped back into the ground.

11

This does not affect program monitoring, as the relevant data used for this purpose are derived from elements of the balance sheet that are not in question.

12

In June 2006, the authorities reported the conclusion of the arbitration process of unreconciled claims of large creditors, resulting in an issuance of additional dollar-denominated bonds and multicurrency loans of $143 million. The arbitration process of small creditors’ unreconciled claims is ongoing.

13

Lower crude oil production implies lower compensation (revenue) for the expense (also lower) of lifting oil from the ground, while lower refinery output means lower sales revenue. The target applies to gross revenues.

1

The bond was exchanged at a ratio of 20 percent. The bonds will mature in 2028 and pay a fixed rate of 5.8 percent semi-annually starting July 2006. The multicurrency loan has the terms that closely replicate the financial terms of the Paris Club agreement, and was exchanged at a ratio of 40 percent. Consistent with the terms of Iraq’s Paris Club agreement, upon the completion of the final review of a three-year implementation of one (or more) upper credit tranche arrangement(s) with the Fund, the outstanding principal of the loan will at that time be reduced by a further 50 percent (resulting in a final exchange ratio of about 20 percent).

2

The third stage of debt reduction would be contingent on Iraq completing the final review of the third year of upper credit tranche arrangements.

3

The medium term projections assume that new debt disbursement is mostly from multilateral creditors and Japan.

1

See Table 1 for (revised) performance criteria under the SBA.

2

Table 2 shows the indicative path proposed for oil derivative prices during 2006.

3

See Table 1 for the modified quantitative performance criteria under the SBA and Table 3 for the modified structural performance criteria and benchmarks.

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Cover IMF Staff Country Reports
Iraq: First and Second Reviews Under the Stand-By Arrangement, Financing Assurances Review, and Request for Waiver of Nonobservance and Applicability of Performance Criteria—Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iraq
Author:
International Monetary Fund
Volume/Issue:
Volume 2006: Issue 301
Publisher:
International Monetary Fund
ISBN:
9781451819113
ISSN:
1934-7685
Pages:
53
DOI:
https://doi.org/10.5089/9781451819113.002