1. The Iraqi authorities would like to convey, once again, their deep appreciation for the steady support they have received from the Fund’s Executive Board, Management, and in particular Staff, over the last few years, under very difficult circumstances. The excellent advice and technical assistance delivered under the framework of the Stand-By Arrangement (SBA), and of the Emergency Post-Conflict Assistance (EPCA) before it, have enabled the Iraqi authorities to establish a new institutional structure for economic governance. Such a structure is a prerequisite to the enactment of sound macroeconomic policies and reforms in general, and to the implementation of the objectives of the SBA in particular, to which the Iraqi government remains strongly committed.

2. Another prerequisite for the successful achievement of the economic objectives remains unfortunately elusive, and relates to the overall security situation. Indeed, Iraq’s economic performance continues to depend critically on a most unsatisfactory security situation that undermines both the implementation of policies and the ability of the private sector to take advantage of the great opportunities that the economy could offer. In this respect, as well, the government is fully committed to engage all its available resources to try to bring the situation under control. Against this background, it is no surprise that two fundamental indicators of macroeconomic stability--growth and inflation--have been somewhat disappointing, notwithstanding the best efforts of the authorities. Indeed, the violent conflict is the major reason behind both the inability of the government to expand the oil sector capacity, thus limiting the economy’s growth potential, and the shortages of key commodities underlying the rise in inflation. It is, nonetheless, well to note that despite the unabating violence, the non-oil sector grew at a robust rate of around 7.5 percent, attesting to the potential dynamism of the Iraqi economy. The resolve to keep pressing with the reform process, despite the overall political situation, is strong, and the authorities are ready to take any additional measures that will help achieve their inflation and economic growth targets.

3. The recent approval by Iraq’s cabinet of the draft Hydrocarbon law represents an economic and political breakthrough, in view of the vital importance of the sector and the complex political considerations taken into account in a balanced compromise. After months of arduous discussions, an agreement was reached on the pooling and redistribution of oil resources across regions. Furthermore, the agreement specifies the process that will allow regional authorities to award contracts for exploration and exploitation of hydrocarbon resources. The contracts will be subjected to a review by the high energy commission to ensure that the terms are in line with an agreed-upon set of commercial criteria. The draft law will need to be ratified by Parliament, and the authorities are committed to enact it in a timely manner. The law should open the way for much needed foreign investment, and will be an important foundation for the enhancement of the governance of the oil sector. Several complementary initiatives will contribute to that effect: The government is committed to join the Extractive Industries Transparency Initiative to further enhance the transparency of the sector. It has launched an anti-corruption strategy, including action taken by the Ministry of Oil (MoO) against suspicious fuel import contracts and its review of procurement practices with technical assistance from the World Bank. The MoO is also working with international companies for the implementation of the metering system in upstream and downstream activities and has installed a metering system in Basrah. Finally, the extension of the International Advisory and Monitoring Board¹ (IAMB) mandate by an additional year to end-2007 will allow the newly established Iraqi oversight Board to get the adequate interaction and exposure through its close collaboration with the IAMB in the year ahead.

4. The progress on realigning domestic fuel prices with regional levels has been remarkable given the magnitude of the price adjustments since 2004, and the sensitivity of the issue. However, the government is determined to further increase domestic prices of fuel products in line with the level specified in the supplementary Memorandum of Economic and Financial Policies (MEFP), notwithstanding its concerns regarding possible political backlash in a period of ongoing new security initiatives. While an implicit subsidy will remain on domestic fuel products, direct and explicit budget subsidies will be terminated for all fuel products except Kerosene. Even though the law authorizing the private import of petroleum products was enacted in September 2006, and regulation issued the following month, the government will still need to continue direct imports to avoid shortages, as security concerns have prevented private sector imports. These imports will be financed from the domestic sales of fuel products. The authorities are planning to further encourage the private sector in this activity and will make storage facilities and pump stations available to assist private firms. They will also convene a conference to promote the import of petroleum products.

5. While oil production and export volumes have been lower than anticipated under the program--due to the inability to expand capacity—higher oil prices in 2006 more than compensated for the lower output, resulting in oil revenues slightly above the budgeted levels. Non-oil revenues were also above target resulting in overall revenue overperformance. Expenditures, on the other hand, have been substantially lower than planned, essentially due to much lower than anticipated investment spending. While some capacity and technical constraints have contributed, security has remained the main barrier to the execution of infrastructural and capacity expansion projects. The fiscal outturn in 2006 was therefore very strong and contributed to a sharp increase in the accumulation of resources in the Development Fund for Iraq. The authorities are expecting a better security situation in 2007, and therefore hope that they will be able to undertake their ambitious investment program. The development of both oil and non-oil productive capacity is critical for the sustainability of the fiscal stance. In this regard, a committee in the office of the prime minister will be set up to help improve the implementation of large infrastructural projects, and the investment allocation for 2007 is set at twice the 2006 outturn. However, with the dinar value of oil revenues shrinking due to the appreciation of the currency, the authorities are well aware that they need to further control current expenditures going forward, to be able to fund the needed public investments as well as to follow through on their commitments relating to security and the social sector.

6. The amendments to the pension law, which include a zero indexation in 2007 and the gradual reduction of replacement rates that ensure the fiscal sustainability of the pension system, have been submitted to Parliament. The government will do its utmost to have the amendments enacted as soon as possible. An extra-budgetary fund will be created to pay all new pensioners and collect all contributions, whereas existing pensioners will be paid from the budget directly. The budgetary cost will decline over time. The extrabudgetary pension fund will be managed transparently in line with best practices, and the authorities will seek technical assistance from the Fund and the World Bank in this respect. Furthermore, the government is pushing ahead with the reform of the social safety net. About one million poor families have received monthly cash support and the coverage is expected to increase further, while efforts to rationalize the Public Distribution System are ongoing, starting with a narrowing of the eligibility criteria.

7. While a strong fiscal stance has accompanied an increasingly tight monetary policy, inflation still reached disturbingly high levels (about 66 percent yoy in January 2007). The Central Bank of Iraq (CBI) stands ready to steadily tighten its policy stance, using all the instruments at its disposal, as long as the situation warrants it. In an effort to counter the inflationary pressures the CBI raised its policy rates four percentage points to 16 percent in November 2006 and similarly to 20 percent in early January. To complement this effort, the CBI undertook a bold measure, initiating a gradual and steady appreciation of the dinar since mid-November, in order to both combat inflation and help reverse dollarization. By early March, the nominal exchange rate had appreciated by more than 13 percent. However, it is clear that inflation, as discussed many times before, is intrinsically linked to the security situation and to the resulting shortage of key commodities, and is therefore essentially supply-driven. Without a clear improvement on this front, it would be difficult to see significant progress in disinflation. Nevertheless, to contain the pressures as much as possible and to signal its resolve, the CBI is determined to sustain such a tightening stance until the underlying conditions change.

8. The effectiveness of monetary policy in Iraq is hampered by the weakness of the monetary transmission channels due to an ineffectual banking sector. A restructuring of the sector is a major objective of the authorities and should play an important role in the development of the Iraqi economy. An important step towards the restructuring of the sector was the signature of a Memorandum of Understanding between the CBI and the Ministry of Finance for the operational restructuring of the two largest and state-owned banks Rafidain and Rasheed, and the financial restructuring of the latter. An international firm will be appointed to conduct an audit of the banks in April 2007. The authorities agree with staffs advice to restructure the four remaining state-owned banks and intend to initiate the restructuring in the second half of the year in consultation with the Fund and the World Bank. As staff notes, great strides in modernizing the payment system were accomplished, with operations starting ahead of the target dates, and the CBI currently expanding the coverage to all commercial banks.

9. The CBI will be recapitalized in 2007 and the authorities are committed to follow through on the recommendations of the Interim Safeguard Assessment Report recently completed by the Fund, as well as those of the Ernst and Young (E&Y) 2005 audit. E&Y has been retained for the 2006 audit, and by end-May 2007 the audit of net international reserves reporting to the Fund and an interim report on the 2006 audit are expected to be completed.

10. The authorities are making best efforts in trying to reach agreements with remaining official creditors, including Gulf countries. Negotiations are moving at a slow pace in some instances given the complexity of the circumstances surrounding the claims. The authorities are also trying to settle in good faith some of the remaining arrears with private creditors, which represent about 4 percent of the original private sector debt.

11. Despite the adverse circumstances, Iraq continues to make clear progress in implementing the SBA, which remains broadly on track. Combining the two reviews has allowed the government to implement corrective measures, meet all end-September and end-December quantitative performance criteria, and fulfill both prior actions required for completion of the reviews. Moreover, four out of the six structural benchmarks were met, with progress being made on the remaining two. Correctives actions are also being undertaken to make the budget classification and chart of accounts consistent with the Fund’s GFSM 2001. The authorities request, therefore, a waiver for the non-observance of the related structural performance criterion. They also request the Board’s approval for an extension of the SBA by six months (to September 28, 2007), and a rescheduling of the fifth and final review to May 2007, so as to allow for the necessary time to achieve the objectives of the program. For this purpose, they have agreed on additional quantitative and structural PCs and structural benchmarks for end-March 2007 and end-June 2007, and intend to continue treating the SBA as precautionary. The Iraqi authorities remain fully committed to the implementation of the arrangement, which has served Iraq well, providing cohesion to the policy framework while anchoring and furthering progress towards macroeconomic stability. The SBA will, moreover, provide the macroeconomic framework for the International Compact for Iraq initiated with the help of the United Nations to develop a comprehensive political, security and economic medium-term reform agenda.