August 2, 2006

1. The Iraqi authorities would like to thank the Fund’s Executive Board, Management and Staff, for their continued support throughout these momentous times. They appreciate in particular the cooperative spirit of the staff and their useful contributions to the formulation of sound policies in Iraq under difficult circumstances. The current SBA, which has been approved by the Board in December 2005, has played a significant role in anchoring and furthering the progress made in achieving macroeconomic stability under the EPCA that preceded it; As importantly, the program offers a coherent context for the elaboration of a consistent set of policies to establish the basis for a viable open economy. While the unexpected delay in the formation of the new cabinet has caused the postponement of the first review—initially scheduled for February—and led to some elements of the program to go off-track, the new government in place since May has acted swiftly to bring the overall program back in line. In this respect, the authorities would like to express their vigorous commitment to the SBA, whose objectives they view as clearly beneficial to Iraq.

2. The first parliamentary elections under the framework of the new constitution was successfully held on December 15, 2005 with a high voters’ participation rate from across the various segments of the population, resulting in a more representative parliament. Given the desire to establish a well balanced and inclusive cabinet, a protracted and difficult negotiation process for the formation of a new government followed the elections. This resulted in the delayed confirmation of the current government headed by Prime Minister Al-Maliki. However, given its stronger legitimacy and its four year mandate, the new government—the first non-transitional government of Iraq since the onset of the war—has the opportunity to contemplate the possibility of a longer-term horizon in which to formulate its strategic choices and elaborate its policies. In this respect, the authorities look forward to develop further their fruitful collaboration with the Fund.

3. Notwithstanding this improved institutional context, the security situation remains tragically out of control and keeps undermining the prospects of rapid improvements of economic outcomes. With unabating violence affecting the daily lives of Iraqi citizens, the implementation of critical measures often remain subject to the influence of events outside the control of the authorities. Improvement on the security front is a clear prerequisite for the ability of the government to effectively implement its policies and for the private sector to develop its productive capacity. One evident adverse impact of the security situation on economic activity is the inability to implement budgeted investment projects, which are essential for the provision of critical infrastructure, and to increase the export capacity in the oil sector. The latter, still constrained by sabotage activities and the threats to necessary qualified personnel have led to a stagnation of oil production levels at an average of 2.0 mbpd (and export levels at 1.5 mbpd) so far in 2006. Hence, notwithstanding an overall growth of the non-oil economy estimated to around 12 and 10 percent for 2005 and 2006 respectively, overall growth performance is expected to remain at around 4 percent, well below the staff projections in December. The authorities are hopeful, however, that with more focused attention to the security of the pipeline infrastructure especially in the north, export capacity should grow significantly next year and oil production can resume its upward trend.

4. The authorities have made the improvement of security their overarching objective, while being at the same time committed to accelerate the economic agenda. They recognize that the provision of basic services and the improvement in standards of living have a role in reducing social tensions. The new government has consequently been decisive in addressing the daunting economic challenges it faces in this respect. This is evidenced by the measures undertaken in the short time span since taking office, to broadly realign the program. These actions stand in sharp contrast with the expectations that were being formed earlier about the prospects of the new government, such as those related by staff during their informal briefing to Directors in May. The main areas of potential risks were identified as (1) a possible inability of the new government to commit to the schedule of fuel price increases (2) the likely emergence of strong pressures on the wage bill resulting from additional civil service hiring (in particular to reward political groups that supported the government in the elections) (3) the emergence of cost pressures from the new pension law which the then minister of finance was unable to withdraw, (4) and the likely revision of the 2006 budget with a supplementary budget.

5. The new government has responded resolutely to these concerns and ruled out the introduction of a supplementary budget, to avoid encouraging requests for additional spending which they could see arising from many quarters. The authorities have furthermore committed to resist any increase in additional hiring and bonuses and, importantly, to reform the pension law. They agree with staff that in its current form, the pension law—which has already been approved by the previous parliament and would therefore be very difficult to repeal—will have unsustainable fiscal consequences in the medium to long term. Accordingly, they have decided to further delay its implementation to allow an amended version of the pension plan that ensures its sustainability, to be developed in consultation with the World Bank. The approval of the reformed law by the cabinet and Parliament by September 2006 has been set as a new structural benchmark.

6. While the previous caretaker government was unable to carry out the second stage of price increase scheduled for end-March 2006 in the SBA, the new government has moved promptly to restore the original schedule, and even accelerate it for some products. Indeed, prices for some fuels have been brought in line with their end-June targets (kerosene, diesel, premium gasoline) while for others, prices have been increased to the target for end-September (regular gasoline) or even end-December (liquefied petroleum gas). These increases have been accompanied by clearer public communication as to their critical necessity for the welfare of the country. In parallel, improvement in the social protection program that includes a cash support for poor families, has been progressing steadily. More than 40 percent of the one million household objective have been enrolled in the program so far. This program will complement the popular Public Distribution System already in place, which will be rationalized to improve its targeting.

7. Another key measure for the government in the oil sector will be the passing of the law to allow the liberalization of private gasoline imports. The law has been amended to remove the possibility of price interference and has been already sent to Parliament this week, thus satisfying a prior action for the current review. The government is hoping for swift approval of the law, which should have an important impact on alleviating domestic fuel shortages and reduce black market activities. Moreover, the combined effects of removing fuel subsidies and increasing imports will help with efforts to combat corruption, a key issue for the current government’s objective of developing a transparent and open oil sector, and strengthen the credibility of policies in this regard. The government furthermore, plans to enhance significantly its monitoring of oil production and transportation and aims to install an oil metering system by end-2006. Finally the government will follow-up on the recommendations of the IAMB, which is set to dissolve by end-2006, for the creation of a oversight committee to replace it in monitoring and auditing the Development Fund for Iraq (DFI).

8. The reduction of shortages following from the liberalization of gasoline import is expected to contribute to lower inflation, as increasing black market gasoline prices have a major impact on the cost of living indices. The high and increasing rate of inflation, whose dynamics is still quite uncertain as the staff reports, is a key issue for the government. It aims at containing it through structural policies aimed at reducing shortages and monetary policy tightening. Indeed the Central Bank of Iraq (CBI), faced with a surging inflation rate has raised the policy rates by two percentage points to 10 percent at the beginning of July, and by another two percentage points more recently, in an effort to slow the inflationary cycle. While the monetary transmission channel is relatively weak, the CBI agrees with staff that strong moves in interest rate will signal the clear determination of the monetary authorities to control inflation dynamics and prevent the consolidation of inflationary expectations. Furthermore, the authorities aim to strengthen the effectiveness of monetary policy through linking deposit rates to the policy rates in the future. Finally, the CBI will consider the possibility of a gradual appreciation of the Iraqi dinar if needed, which could have a positive effect on both inflation and the process of dedollarization.

9. The measures enacted by the new government so far, attest to their resolve in facing squarely the challenges they face in establishing a functioning economy under very adverse circumstances. The authorities remain committed to a strong implementation of the program. They have met all quantitative performance criteria (PC) except with regard to the transferred revenues from the oil-related state owned enterprises, due to lower-than-projected oil production. They request waivers for this quantitative PC and for the three other missed PC on the basis of the corrective actions specified in the Supplementary Memorandum of Economic and Financial Policies attached to the staff report. They would like also to underscore their appreciation for the Fund’s technical assistance in various areas, which has been critical for enhancing their ability to implement the program and enact their policy initiatives. In this respect, they would like to express their gratitude to the member countries that have provided generous financial support to the Technical Assistance Subaccount for Iraq. The Iraqi authorities hope they can continue to rely on the support of the Board in helping them overcome the difficult challenges ahead.