Iraq
2007 Article IV Consultation, Fifth Review Under the Stand-By Arrangement, Financing Assurances Review, and Requests for Extension of the Arrangement, Waiver of Applicability, and Waivers for Nonobservance of Performance Criteria: Staff Report; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iraq

This 2007 Article IV Consultation highlights that Iraq’s economic growth has been slower than expected at the time of the last Article IV Consultation, mainly because the expected expansion of oil production has not materialized. Following a decline in oil production and real GDP in 2005, economic growth is estimated at 6¼ percent in 2006. Progress in implementing the structural reforms has been made. Official fuel prices have been increased to levels in other oil-exporting countries in the region, and private sector importation of fuel products has been liberalized.

Abstract

This 2007 Article IV Consultation highlights that Iraq’s economic growth has been slower than expected at the time of the last Article IV Consultation, mainly because the expected expansion of oil production has not materialized. Following a decline in oil production and real GDP in 2005, economic growth is estimated at 6¼ percent in 2006. Progress in implementing the structural reforms has been made. Official fuel prices have been increased to levels in other oil-exporting countries in the region, and private sector importation of fuel products has been liberalized.

I. Introduction

1. Iraq’s last Article IV consultation was concluded on August 1, 2005, the first Article IV consultation in 25 years. The authorities indicated that they have drawn in their policy making on the Fund’s advice, in particular with regard to the need to containing inflation and phasing out government subsidies on petroleum products.

2. A Stand-By Arrangement (SBA) for Iraq was approved on December 23, 2005 in an amount equivalent to 40 percent of quota (SDR 475.4 million). The arrangement originally ran through March 22, 2007, but was extended on March 12, 2007 to September 28, 2007. The first and second reviews of the arrangement were completed on August 2, 2006, and the third and fourth reviews were concluded on March 12, 2007. The SBA supported a program aimed at maintaining macroeconomic stability, paving the way for sustainable growth, and achieving external debt sustainability. Iraq continues to treat the SBA as precautionary.

3. The Paris Club agreed on November 21, 2004 to a debt reduction for Iraq, equivalent to 80 percent in net present value (NPV) terms, to be achieved in three stages. The first and second stages each comprised a 30 percent debt reduction in NPV terms and went into effect in November 2004 and in December 2005 (following approval of the SBA), respectively. The final stage will comprise an additional 20 percent debt reduction, and depends on completion by end-December 2008 of the final review of the third year of one or more upper credit tranche arrangements with the Fund.

4. The International Compact with Iraq (ICI) was formally endorsed by the international community on May 3, 2007, in Sharm el-Sheikh, Egypt. The ICI aims to put in place a medium-term framework for political, security and economic reforms. The Fund’s main contribution to the ICI is through preparation of the medium-term macroeconomic framework of the SBA-supported program.

II. Background

A. Political and Security Environment

5. Iraq’s first constitutional government since the fall of the Saddam Hussein regime was approved by the Council of Representatives (COR) on May 20, 2006, following elections on December 15, 2005. While there have been political tensions within the coalition government, the prime minister and key ministers have kept their positions. The political consensus was, however, undermined by the resignation of six ministers from the Al-Sadr movement in April 2007.

6. The security situation deteriorated in 2006. Despite the implementation of a new security plan in 2007, Iraq continues to suffer serious security problems. This has further worsened living conditions, adversely affected economic activity, and induced the emigration of professionals and skilled labor.

Figure 1:
Figure 1:

Violence Indicators, June 2003–May 2007

(casualties and oil sector attacks per month)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Source: Iraq Pipeline Watch and Iraq Body Count.

B. Social and Human Development

7. Living conditions in Iraq have further deteriorated in recent years. The 2004 United Nations Development Program survey of living conditions shows Iraq’s poor scores on the Millennium Development Goals, and reports widespread malnutrition, low primary school enrollment, and high child mortality. Although the survey has not since been updated, the results from the 2007 Iraq Poll provide indications of further deterioration in living conditions (Box 1).

8. Large numbers of people have been displaced. The United Nations’ refugee agency estimates that over 4 million Iraqis are displaced, including some 1.9 million inside Iraq and over 2 million in neighboring countries. The economic and social costs are significant, with many professionals leaving the country. 1 The large numbers of refugees are putting a strain on Iraq’s neighboring countries (Syria has 1.2 million refugees, and Jordan about 750,000 refugees), where the inflows are causing supply bottlenecks and rising real estate prices.

C. Institutional and Administrative Capacity

9. Iraq has made progress with data provision, but weaknesses remain. The data on the oil sector is generally adequate and timely, but there is little information on non-oil economic activity and on the balance of payments. The CBI balance sheet and consumer price data are available with relatively short lags but do not cover the Kurdish region. Recently, the CBI started producing a monetary survey, which also excludes the Kurdish region. Incomplete data on letters of credit issued by the Trade Bank of Iraq to finance government imports hampers the assessment of the fiscal stance.

Quality of Life

The quality of life in Iraq has deteriorated in the last two years. When asked to indicate “how things are going in their lives these days?” 60 percent of respondents in the 2007 Iraq Poll answered “very bad” or “quite bad”, compared to 29 percent in 2004 and 2005 1. More than three quarters of Iraqis say that jobs are hard to find, which supports the official under-employment estimates ranging from 30 to 50 percent. The availability of clean water, medical care, and basic goods and services have, after some improvement in 2005, all deteriorated. Three out of five Iraqis consider the conditions of local schools to be bad, more than twice as many as in 2004.

The worsening security situation is perceived as the driving factor behind the deteriorating living conditions. When asked about the “biggest single problem facing Iraq” more than half of the respondents to the 2007 Iraq Poll mentioned security, followed by political and military issues (26 percent), social issues (12 percent), and economic issues (9 percent).

uA01bx01fig01

Quality of Life Indicators in Iraq, 2004-05, and 2007

(Percentage of respondents indicating the availability or condition was “very bad” or “quite bad”)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Source: Iraq Poll 2007, BBC News.
1/ The 2007 survey was commissioned by a consortium of international media outlets and 2,000 people across all 18 provinces in Iraq were questioned in February/March 2007 by an independent opinion research company. The same survey was conducted in 2004 and 2005.

10. The International Advisory and Monitoring Board (IAMB) mandate to audit and oversee the Development Fund for Iraq (DFI; Box 2) was extended through December 2007.2 Meanwhile, the Council of Ministers approved the establishment of the Committee of Financial Experts (COFE) in October 2006, to be chaired by the president of the Board of Supreme Audit. The newly established COFE is working in parallel with the IAMB to smooth the transition of responsibilities from the IAMB to COFE once the IAMB’s mandate expires.

The Development Fund for Iraq

The DFI was established in May 2003 pursuant to UN Security Council Resolution 1483. The DFI was tasked with holding the proceeds of Iraq’s oil exports, as well as the remaining balances from the UN Oil-for-Food Program and other frozen Iraqi funds. Disbursements from the DFI must be used for the benefit of the Iraqi people. The DFI consists of bank accounts held at the Federal Reserve Bank of New York and the CBI. On May 18, 2007, the U.S. President continued for one year the protections against claims available to the DFI in the U.S..

According to UN Security Council Resolution 1483, the IAMB is to act as an audit and oversight body for the DFI. UN Security Council Resolution 1723 extended the IAMB mandate until end-December 2007. The formal transfer of functions from the IAMB to the COFE is expected to take place at UN headquarters in December 2007.

Oil exports receipts are the main inflow in the DFI (over 95 percent of total). Other amounts accruing to the DFI are from returned Letters of Credit and interest earned on overnight deposits and U.S. T- Bill holdings, as well as surplus funds from the UN Oil For Food Program and transfers by UN member states of previously frozen funds of the Iraqi government.

The DFI is the main source for budgetary financing. For import financing, revenues from the DFI are channeled through the Trade Bank of Iraq. To finance domestic spending, the Ministry of Finance credits the CBI’s dollar account from the DFI (thereby increasing the CBI’s gross reserves), while receiving dinars in its account at the CBI in Baghdad.

11. Despite the adverse security situation, progress was made in the delivery of technical assistance (TA). In the monetary and banking area, Fund TA has resulted in: (i) the production of a monetary survey; (ii) replacing an obsolete paper-based system with modern electronic payment systems; (iii) improving banking supervision; and (iv) initiating the restructuring of the two largest state-owned banks. On the fiscal side, Fund TA has helped to design a Chart of Accounts and implement the financial management information system (FMIS). Fund TA in statistics, mostly in the form of training, has significantly improved the quality and coverage of fiscal, monetary and balance of payments data.

III. Recent Economic Developments

12. The economy has not grown as fast as was expected at the time of the last Article IV consultation, although progress has been made in strengthening macroeconomic management and in implementing structural reforms. The prevailing insecurity has seriously hampered reconstruction and investment, which resulted in lower-than-foreseen oil production and hence slower economic growth. 3 It has also worsened shortages of key commodities, contributing to rising inflation in 2006. The low implementation rate of the government’s investment program resulted in large fiscal and external surpluses, with the balance in the DFI standing at $8.6 billion at end-2006. The CBI gross international reserves increased to $18.7 billion at end-2006 (almost 6 months of import cover).

13. Following a decline in oil production and real GDP in 2005, economic growth is estimated at 6¼ percent in 2006. Oil production increased slightly to 2 million barrels per day (mbpd) in 2006, but remained well below the 2.3 mbpd target for the year. Although crude oil production recovered to 2.1 mbpd in March/April 2007, it averaged only 1.9 mbpd during the first four months of the year. Based on indicators for cement, fertilizers, and electricity production, real non-oil GDP is estimated to have increased by 7½ percent in 2006. Non-oil investment is also being adversely affected by the prevailing security situation.

Figure 2:
Figure 2:

Crude Oil Production, January 2005–March 2007

(In million barrels per day)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Source: Iraqi authorities.

14. Inflation reached worrisome levels in 2006, but came down markedly during February through June. Annual consumer price inflation increased to 66½ percent in January 2007 from 31½ percent at end-2005, reflecting shortages of key commodities, primarily fuel. Core inflation (excluding fuel and transportation) remained high at about 32 percent. The growth of the dinar money supply (currency in circulation) was, however, well below the rate of inflation in 2006. The increase in inflation appears instead to have been accommodated by the pervasive cash dollarization. Following an intensified policy effort to bring inflation under control, the annual inflation rate declined to 38 percent in May 2007; core inflation decreased to 21 percent in May. Fuel shortages reportedly declined somewhat in the first months of the year, contributing to the narrowing of the gap between headline and core inflation. In June, however, fuel shortages worsened again and headline inflation increased to 46 percent; core inflation continued to decline to 19 percent.

Figure 3:
Figure 3:

Annual Consumer Price Inflation, August 2004–June 2007

(In percent)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Source: Iraqi authorities.

15. Between mid-November 2006 and end-January 2007, the CBI raised its policy interest rate in two steps to 20 percent and allowed the exchange rate to appreciate by 12½ percent. The exchange rate has since continued to appreciate gradually by a further 2½ percent through end-June. The objective was to counter dollarization and enhance the CBI’s control over monetary conditions, as well as to reduce imported inflation. These policies have had some success in lowering inflation, de-dollarizing the economy, and increasing the demand for dinars. Dinar currency in circulation expanded by 20½ percent between November 2006 and April 2007, while the CPI increased by only 13 percent over the same period. Also, cash sales of dollars at the foreign exchange auction dropped considerably in December, and have remained well below 2006 levels since then. 4

Figure 4:
Figure 4:

Daily Forex Sales and Nominal Exchange Rate May 2006–June 2007

(In thousands of U.S. dollars and ID/$)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Sources: Iraqi authoritiesand Fund staff

16. Following a fiscal surplus of 11 percent of GDP in 2005, the fiscal outturn for 2006 showed yet another sizable surplus of almost 12 percent of GDP, largely due to underspending. 5 The surplus resulted in an accumulation of balances in the DFI of $2.4 billion and of government deposits at the CBI of ID 755 billion, while almost ID 950 billion of outstanding Treasury bills were redeemed. Preliminary information for the first quarter of 2007 indicates continued underspending resulting in a fiscal surplus, due to a shortfall in investment and partly also to the late adoption of the budget. However, budget execution is reported to have accelerated in April/May.

Figure 5:
Figure 5:

Fiscal Developments, 2004–07

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Sources: Iraqi authorities; and Fund staff estimates.

17. Progress in structural reforms has been made, despite the lack of security and capacity constraints:

  • Important steps have been taken toward reducing subsidies, with several rounds of price increases for domestic petroleum products bringing these prices in line with those in other oil-exporting countries in the region. A recently promulgated law permitting the private importation of fuel products is expected to improve the domestic supply of these products and help reduce black market fuel prices. However, negotiations are still ongoing on a new legal framework for the oil sector.

  • The government is also working to modernize public financial management, and the chart of accounts and budget classification are being brought in line with the GFSM 2001 within a cash accounting framework. On the other hand, the new pension law has yet to be amended in order to make it fiscally sustainable. The census of public service employees has started but will likely not be completed by the end of the year.

  • The CBI is now using a modern real time gross settlement system and an automatic clearing house. Preparations for the restructuring of the two largest state-owned banks are underway. An audit of the CBI end-2006 net international reserves and the interim audit report of its 2006 financial statements have been completed. Also, the CBI’s capital was raised to the statutory level.

18. Iraq has resolved most of its debt to Paris Club creditors, but progress in resolving debt to non-Paris Club official creditors has been limited. The authorities have signed bilateral agreements with all Paris Club creditors, except Russia, and nine (out of more than 30) non-Paris Club creditors. Six of these nine creditors (Czech Republic, Hungary, Indonesia, Malaysia, Romania, and South Africa) provided debt reduction comparable to the terms of the Paris Club agreement, while three others (Cyprus, Malta, and Slovak Republic) provided 100 percent reduction. 6 In addition, the authorities have received confirmations from 20 countries that they do not have any claims on Iraq.

19. A Special Purpose Vehicle (SPV) was established in March 2007 to provide single securitization of restructured debt to official creditors. The SPV would issue U.S. dollar-denominated notes in exchange for, and secured by, rights under bilateral agreements between one or more sovereign creditors and Iraq. The Paris Club has indicated that the establishment of the SPV does not raise any issue in terms of comparability of treatment among creditors. The scheme of the SPV does not preclude individual Paris Club member countries to participate as long as the Paris Club concurs.

20. Iraq has resolved most private creditors’ claims through debt and cash exchanges. By mid-2007, Iraq had settled more than $19.7 billion claims submitted by private creditors. Almost two-third of the remaining claims were withdrawn or cancelled during the process of reconciliation and settlement. Most of the unresolved claims (about 4 percent of total claims) are being reconciled with claims that are being settled as part of the liquidation of the London branch of Rafidain Bank.

IV. Policy Discussions

21. The discussions were characterized by broad agreement between the authorities and staff on the key economic challenges facing Iraq and the policies needed to address them. The authorities agreed that decisive actions are required to: (i) increase investment, especially in the oil sector; (ii) bring inflation down further; and (iii) move ahead with priority structural reforms.

22. The authorities remain strongly committed to the program supported by the SBA. In the attached third Supplementary Memorandum of Economic and Financial Policies (SMEFP-3) they outline their plans for the remainder of the program period.

A. Macroeconomic Outlook and Risks

23. Iraq’s economic prospects for 2007 and beyond depend critically on the security situation. The authorities acknowledged that present circumstances constrain their ability to increase the rate of implementation of their investment program, including importantly in the oil sector. As a result, oil production would increase only gradually over the next few years. For 2007, oil production could reach close to 2.1 mbpd. With non-oil output continuing to grow moderately, real GDP growth is projected at about 6 percent in 2007. Over the medium term, output growth is projected to average some 6¾ percent in 2008–09; assuming progress is made in resolving the security problems, economic growth could increase to about 10 percent thereafter. Inflation is targeted to come down to about 30 percent by end-2007, reflecting the combined effects of the policy actions taken by the CBI, the strict control of government current spending, and the start of private imports of fuel products. The increase in government investments should only have a limited impact on inflation, given its high import content. From 2009 on, inflation is expected to gradually fall to single digit levels.

Iraq: Medium Term Outlook

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Sources: Iraqi authorities and Fund staff projections.

24. The fiscal situation remains vulnerable to declines in oil prices. With the current favorable world oil price outlook and assuming a gradual increase in oil production and export volumes, the overall fiscal position would be sustainable. The government will need to continue to restrain current spending in order to allow for sufficient investment and security outlays, especially in view of the expected reduction in foreign grants starting in 2008 and sizable amortization payments of the rescheduled debt beginning in 2011. The balance of the DFI is projected to fall to a very low level during 2007–11 to absorb the projected fiscal deficits, leaving no room for fiscal slippage.

25. Iraq’s medium-term balance of payments and debt outlook remain heavily dependent on crude oil exports. The current account balance is expected to deteriorate in 2007 and remain in sizable deficit through 2009, as oil exports would increase only slightly, and because of somewhat higher investment-related imports and lower inflows of foreign grants. With more rapidly increasing oil exports from 2010, the external current account balance would improve again over the medium term. Gross international reserves are expected to gradually increase to a level equivalent to eight months of import cover.

Figure 6.
Figure 6.

Current Account Balance, External Debt and International Reserves, 2004–12

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

26. The unsettled security situation and possible terms of trade shocks continue to pose serious risks to the outlook. The economy remains extremely vulnerable to the country’s security problems, which impede investment, inhibit private economic activity, and hamper implementation of the structural reform agenda. In the event that investment and production in the oil sector cannot be increased as projected, lower oil revenue would result in higher fiscal deficits and sizable financing gaps from 2008. Absent access to significant external borrowing, spending cuts would be necessary and unavoidable. The debt sustainability analysis indicates that Iraq’s external debt remains also vulnerable to negative oil price and production shocks (Appendix I).

B. Fiscal Policy and Related Measures

27. The 2007 budget allows for an ambitious investment program, while maintaining overall fiscal sustainability (SMEFP-3,¶8–10). The authorities indicated that they have already taken a number of administrative measures to increase the execution rate of investment projects, including accelerating cabinet approval of large projects and shortening the procurement period. However, they considered that, given the gestation period of new projects and the unsettled security situation, the impact of these measures in the short term will be limited. At the same time, they were determined to keep current spending, notably on wages and pensions, within budget to make room for public investment and security outlays, and to avoid putting excessive demand pressures on Iraq’s small non-oil economy. Taking account of the effect of a further appreciation on oil revenues, the overall fiscal deficit would be kept below 10 percent of GDP in 2007.

28. The authorities were committed to continue the phased adjustment of official fuel prices (SMEFP-3, ¶13 and Box 3). Domestic fuel prices were raised on July 1, broadly in line with the program. The increase should avoid the emergence of explicit budgetary subsidies, except for a small subsidy on kerosene. With fuel prices now equal to or above regional averages, the authorities indicated that they will consider developing a rule-based mechanism for setting domestic fuel prices in the future.

29. To reduce fuel shortages, the authorities have issued about 20 licenses to private importers (SMEFP-3, ¶12). They indicated that private imports in the Kurdish region have begun, but that the security situation in other parts of the country remains a deterrent for private sector involvement. The authorities also pointed out that they will take further steps to facilitate private sector imports of petroleum products, including by making storage facilities and pump stations available to private operators. The government will continue to put at the disposal of the State Oil Marketing Organization (SOMO) a revolving credit with a ceiling of ID 400 billion to finance its imports of fuel products.

30. The government has begun to develop a medium-term tax reform strategy with technical assistance from international partners, including the Fund (SMEFP-3, ¶18). The authorities explained that they aim to modernize the tax system to improve revenue collection without placing undue burdens on the economy. They are considering the introduction of a sales-tax as a precursor to a value-added tax, and aim to strengthen the tax and customs administration.

Iraq: Official Fuel Price Adjustments

Despite initial political resistance, Iraq has made significant adjustments to official fuel prices in the past 18 months. Before the first adjustments, in December 2005, fuel prices were extremely low, even by regional standards, with regular gasoline selling in Baghdad for about 3 U.S. dollar cents per liter, and less than half of that outside the capital. In March and June 2007, the prices of regular and premium gasoline and diesel were increased to a level exceeding the regional average. Prices for regular gasoline are now 32 U.S. dollar cents per liter, while prices for premium gasoline largely reflect the actual import cost. With a view to reduce smuggling, the price differentials of premium gasoline between Iraq and its direct neighbors Iran and Kuwait were eliminated, while the price differentials with Syria and Jordan were reduced from more than ninety to less than fifty percent.

The fiscal gains of the fuel price adjustments are substantial. The main objective of the price adjustments is to gradually eliminate budgetary subsidies, and shift resources towards much needed investments in the oil sector, healthcare, education, and security spending. In 2004, the net budget subsidy for fuel imports was ID 4.8 billion (12¾ percent of GDP). By 2006, the price adjustments had reduced this subsidy to ID 3.2 billion (4½ percent of GDP). In the 2007 budget, explicit subsidies for fuel imports have been eliminated, except for a small subsidy for kerosene imports, mostly used by the poor for cooking. These developments were largely in line with the Fund staff recommendations at the time of the previous Article IV consultation and the target set under the SBA.

uA01bx03fig01

Official Fuel Prices in Iraq, 2004–07

(In percent of average fuel prices in other oil-exporting countries in the Middle East and North Africa region) 1/

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Sources: Iraqi authorities and Fund staff calculations.1/ Assumes no price increase in benchmark countries in 2007; June 2007 is projection.

Budget Revenues and Expenditure of Oil Related State Owned Enterprices

(in billion ID)

article image

Excluding government imports of oil derivative products for which a budget subsidy will nog longer be provided in 2007.

31. The authorities underlined that they attach high priority to improving public financial management. They were determined to complete the remaining steps needed to conform the chart of accounts and budget classification with the GFSM 2001, within a cash accounting framework, shortly (SMEFP-3, ¶14). The authorities also indicated that they have started using the Financial Management Information System (FMIS) on a trial basis since January 2007. Staff agreed that the existing legacy system should continue to be used by spending agencies in parallel until the FMIS is fully operational and tested. At the same time, the coverage of the FMIS is being expanded to spending units not yet connected.

32. The authorities explained that the census of public service employees turned out to be more time-consuming than initially foreseen (SMEFP-3, ¶16). They pointed out that the census is linked to the preparations for setting up a computerized payroll to better control the wage bill, and that the security situation has resulted in unexpected delays. However, the preparations for the census have been completed and the census questionnaires have been sent to most relevant government agencies. The data collection phase of the census is expected to be completed by end-November.

33. The authorities indicated that they are actively seeking to have the amendments to the new pension law enacted by the CoR as soon as possible (SMEFP-3, ¶15). The new pension law that was passed in November 2005 is fiscally unsustainable over the medium term. The amendments, once enacted, will provide for a gradual reduction of replacement rates to sustainable levels and zero indexation in 2007, in line with earlier understandings with Fund staff. The authorities also indicated that progress is being made in streamlining the social safety net (SMEFP-3, ¶17).

C. Monetary and Exchange Rate Policy

34. The CBI will continue to manage the exchange rate with a view to reducing inflation and reversing dollarization, and monetary policy will be further tightened, if the inflation situation required this (SMEFP-3, ¶11). While the recent appreciation of the dinar has been successful in helping to reverse dollarization and contain inflationary pressures, the authorities agreed that inflation needs to be further reduced. To this end, they are committed to allow the exchange rate to appreciate gradually in the coming months, while closely monitoring the effects of this policy and adjusting the pace of appreciation as needed.

35. The authorities intend to maintain the link of the dinar to the dollar. In the absence of an effective monetary transmission mechanism and indirect monetary policy instruments, the CBI will continue relying on the exchange rate as the principal nominal anchor for the economy. While the exchange rate will remain the main policy instrument, it will be backed up, as needed, by adjustments in the policy interest rate.

36. Due to data limitations and many structural changes in the economy, it is not possible to estimate the equilibrium real exchange rate. Also, since Iraq is an oil economy, it is difficult to interpret real exchange rate developments based on simple intervention analysis and developments in Iraq’s current account data. However, the improvements in the terms of trade over the past three years and higher current government spending in 2006 have most likely resulted in an appreciation of the equilibrium real exchange rate. With the nominal exchange rate fixed to the dollar for most of the past two years, the adjustment of the real exchange rate to its new equilibrium was reflected in persistent high core inflation. With the policy of allowing the exchange rate to appreciate and the subsequent drop in inflation, the undervaluation of the exchange rate has been significantly reduced. Nevertheless, the real exchange rate likely remains somewhat undervalued as core inflation is still high. Therefore, the authorities agreed that the nominal exchange rate should appreciate further, which should also help to contain inflationary expectations. This policy of gradual appreciation is believed to have a minimal impact on competitiveness, given that Iraq’s main export commodity is oil, and that to achieve lasting gains in competitiveness it is essential to improve security and implement productivity enhancing structural reforms.

Figure 7:
Figure 7:

Real Exchange Rate, Nominal Exchange Rate, and Terms of Trade, January 2004–May 2007

(Index, Jan 2004=100)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Sources: The Iraqi Authorities and Fund staff calculations.1/ Increase denotes appreciation.

37. Iraq continues to maintain a liberal exchange regime. The authorities confirmed that in practice there are no restrictions on current and capital transactions as long as underlying transactions are supported by valid documentation. However, it remains unclear whether Iraq maintains exchange restrictions subject to Fund jurisdiction as the review of exchange regulations by staff is ongoing. As part of this review, the authorities have submitted exchange regulations and recently provided clarifications requested by staff.

38. The CBI’s external audit firm, Ernst and Young (E&Y), has issued in July an interim audit report of the CBI 2006 financial statements summarizing control weaknesses and recommending remedial measures (SMEFP-3, ¶19). The CBI has indicated its commitment to addressing all of E&Y’s audit observations during the course of this year, so that improvements as far as possible would be reflected in the 2007 financial accounts.

39. The CBI has made some progress in addressing the concerns raised by staff and E&Y in the interim safeguards assessment report (ISAR) and the audit of 2005 CBI financial accounts (SMEFP-3,¶20). The CBI Board has adopted a timetable that envisages full implementation of International Financial Reporting System (IFRS) as the CBI’s financial reporting framework by end-2009, and the capital of the CBI was increased to the statutory level of ID 100 billion in February 2007. Furthermore, the CBI indicated to staff that work is underway in addressing the lack of proper accounting records maintained by the CBI, and in establishing adequate control procedures for reserves management.

D. Financial Sector Reform

40. The authorities indicated that they continue to expand the coverage of the new payment system (SMEFP-3,¶21). The CBI will continue to encourage banks to connect to the real time gross settlement payment system and the automated clearing house, and expected to cover most banks by end-2007.

41. The Memoranda of Understanding (MoUs) signed in December 2006 between the CBI and the ministry of finance for the restructuring of the two largest state-owned banks are being implemented (SMEFP-3,¶22). As a first step, an international auditor has been selected to conduct operational and financial audits of both banks that are expected to be completed by early 2008. The restructuring of the remaining state-owned banks will be initiated later this year, in line with the approach adopted with Rasheed and Rafidain banks.

Banking Sector

Iraq’s banking sector comprises seven state-owned banks (SOBs) and 22 private banks as of end-2006. Their consolidated assets totaled about $26 billion (or 51 percent of GDP). The SOBs account for 90 percent of the banking sector total assets (70 percent for Rafidain and Rasheed banks alone). The credit culture is poor with very little extension of credit to the private sector and an asset composition heavily tilted toward government securities. Very few banks offer loans with more than one year maturity as most banks lack the expertise to offer appropriate credit facilities or assess risks.

Financial intermediation in Iraq is weak. The total loans portfolio of the banks was only $2.2 billion (4 percent of GDP) at end-2006, mostly in the form of overdrafts, despite the fact that credit to the private sector more than doubled in 2006. Total deposits in the banking sector were $12.9 billion (26 percent of GDP). Compared to some other countries in the region the deposit base and loan portfolio of Iraqi banks is small.

uA01bx04fig01

Financial Intermediation in Iraq and Selected Regional Comparators, 2006

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 301; 10.5089/9781451819144.002.A001

Sources: IMF International Financial Statistics, Iraqi authorities and Fund staff calculations.

Banking supervision, which involves both on-site (security permitting) and off-site supervision, has improved over the past two years, including as a result of the technical assistance provided by the Fund, which has encouraged the CBI to move from a rule-based to a risk-based system.

42. The CBI issued implementing regulations for the 2004 Anti- Money Laundering (AML) law in September 2006. A new AML office was set up within the CBI to implement these new regulations.

E. Other Structural Issues

43. Negotiations on a new legal framework for the oil sector are ongoing (SMEFP-3, ¶23). The authorities emphasized their commitment to develop a competitive and transparent hydrocarbon sector. The envisaged legal framework is provided by four draft laws, which in addition to the draft hydrocarbon law, include three accompanying draft laws pertaining to reestablishing the Iraq National Oil Company, reorganizing the ministry of oil, and setting the parameters for revenue distribution and intragovernmental fiscal relations.

44. The authorities attached great importance to enhancing transparency and fighting corruption in the oil sector (SMEFP-3,¶24). Oil meters at the Basra export terminal have become operational for the most part. However, the work on the implementation of a comprehensive country-wide metering system is still underway. The authorities intend to join the Extractive Industries Transparency Initiative. As a first step, the ministry of oil will start, during the second half of the year, to publish oil-related data on its website.

45. The authorities are in the process of rehabilitating commercially viable state-owned enterprises (SMEFP-3,¶25). They indicated that so far about 21 public enterprises have been selected, notably in the cement, textile, pharmaceutical, and petrochemical sectors. These enterprises have submitted a business plan to Rasheed and Rafidain banks to obtain financing for starting operations.

46. The new investment law still needs an operational framework (SMEFP-3,¶26 and Box 5). The authorities indicated that they are working to set up the National Investment Commission, which would develop and monitor the implementation of investment policies and regulations to attract investments. They are also seeking to establish national and regional one-stop agencies that would be in charge of issuing investment licenses.

The New Investment Law

In November 2006, the Presidential Council issued a new investment law, which covers all areas of investment except those in banking, insurance, and the extraction and production of oil and gas, which are covered by separate laws. The new law promotes equal treatment for investors regardless of nationality and stipulates the establishment of national and regional investment commissions. The commissions will develop and monitor the implementation of investment policies and regulations, and establish one-stop agencies at the national and regional levels to approve investments. The law also specifies the rights (e.g., leasing the land up to 50 years renewable), benefits, and obligations for investors.

The new investment law provides various tax holidays to promote investment. For example, an investment project may be exempted from taxes for a period of 10 years after the commercial operation starts. Also, imported assets for the project would be exempted from customs duties, provided that they are brought into Iraq within three years from the date of granting the investment license.

47. Iraq continues to maintain an open trade regime and has made significant progress in the process of WTO accession. The authorities intended to maintain the 5 percent custom duty (reconstruction levy) on imports, while reducing its numerous exemptions. However, the security situation and capacity constraints have hampered effective customs administration. The Working Party on Iraq’s WTO accession met for the first time in Geneva in May 2007, and started the process of accession negotiations. Subsequently, the Iraqi delegation met bilaterally with representatives of more than ten WTO members, and has been invited to submit initial offers to advance their market access negotiations on goods and services.

48. The authorities reiterated their commitment to resolving the remaining external claims (SMEFP-3,¶28). Official contacts have been established with key creditor countries in the Gulf region and China, and the process of debt negotiation and reconciliation is ongoing. The authorities hoped that the SPV for debt securitization would facilitate the negotiations with other official creditors. They also expected that the liquidation of the London branch of Rafidain Bank could be completed by end-2007, enabling them to complete the resolution of all private claims.

V. Program Monitoring and Financing Assurances

49. All quantitative performance criteria set for end-March 2007 were met, but there have been slippages in structural conditionality (Tables 7 and 8). The measures set as structural performance criteria for end-May and end-June are expected to be implemented partially or with delay. As a result, waivers are sought for the following performance criteria (LOI, ¶4):

Table 1.

Iraq: Selected Economic and Financial Indicators, 2004–12

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Sources: Iraqi authorities and Fund staff estimates and projections.

For 2007, the average is for January–June.

For 2007, as of January 7.

Table 2.

Iraq: Fiscal and Oil Sector Accounts, 2004–12

(In billions of ID; unless otherwise indicated)

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Sources: Iraqi authorities, and Fund staff estimates and projections.

Projections for 2008-12 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.

Overhead costs associated with donor-financed reconstruction.

Other goods and services financed by donors include security spending associated with the implementation of reconstruction projects.

2006 data includes ID270 billion allocated toward government's share of capital in new regional commercial banks. ID1,500 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 financing from LCs previously issued under the UN oil-for-food program.

Table 3.

Iraq: Fiscal and Oil Sector Accounts, 2004–12

(In percent of GDP)

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Sources: Iraqi authorities and Fund staff estimates and projections.

Projections for 2008–12 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.

Overhead costs associated with donor-financed reconstruction.

Other goods and services financed by donors include security spending associated with the implementation of reconstruction projects.

2006 data includes ID 270 billion allocated toward government's share of capital in new regional commercial banks. ID1,500 formerly recorded under this item were re-classified as non-oil investment expenditures in 2006 budget presentation. Finally, ID 265 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 financing from LCs previously issued under the UN oil-for-food program.

Table 4.

Iraq: Central Bank Survey, 2004–08

(In billions of Iraqi dinars, unless otherwise indicated)

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Sources: Iraqi authorities, and Fund staff estimates and projections.

Valued at market exchange rates.

For 2005, valued at market prices.

This includes both SDR holdings and the reserve tranche position.

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.