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.
1. The Iraqi authorities would like to express their deep appreciation for the Fund’s Executive Board, Management, and Staff, for their ongoing support under difficult circumstances. They are particularly grateful for staff’s continued contributions to the formulation of sound economic policies in Iraq. The excellent advice and technical assistance delivered under the framework of the Stand-By Arrangement (SBA) continue to afford a coherent context for the elaboration of a consistent set of policies, aimed at rebuilding the foundations for macroeconomic stability and promoting economic development. The authorities remain strongly committed to the program, whose objectives they view as clearly beneficial to Iraq.
2. Improvement on security remains, however, a prerequisite for the ability of the Iraqi government to effectively implement its policies. The marked deterioration in the security situation in 2006 has unfortunately undermined the prospects of continued economic improvement, notably with regard to two fundamental indicators of macroeconomic stability: growth and inflation. Indeed, the violent conflict severely hampered the implementation of budgeted investment projects, particularly in the oil sector, thereby slowing down growth. Moreover, the shortages of key commodities gave rise to the sharp rise in inflation.
3. Notwithstanding the security situation and severe capacity constraints—exacerbated by the emigration of professionals and skilled labor—the authorities have achieved major strides in enhancing their economic policies while advancing their structural agenda. They have adopted decisive policy measures to bring down inflation and have raised fuel prices to regional levels. And to the extent possible, they have also introduced vigorous steps to increase public investment. At the same time, bold measures have been taken to advance structural reforms in the monetary and fiscal areas, while negotiations on a new legal framework to develop a competitive and transparent hydrocarbon sector are ongoing. In an effort to enhance transparency and fight corruption in the oil sector, the authorities are also committed to joining the Extractive Industries Transparency Initiative. They have initiated a rehabilitation program for viable public enterprises and are striving at developing an operational framework for the recently adopted investment law. Iraq has also made significant progress in the process of WTO accession. Notwithstanding these favorable developments, the authorities are well aware of the challenges facing the reconstruction of a sustainable macroeconomic environment over the medium-term. Accordingly, they stand ready to take any additional measures that will enhance economic growth prospects and help in further reducing inflationary pressures.
Fiscal Sector Policies and Reforms
4. Oil production and export volumes in 2006 have been lower than anticipated under the program, due to the inability to expand capacity. Higher oil prices however more than compensated for the lower output, resulting in oil revenues slightly above the budgeted levels, and triggering a slight overperformance in overall revenue. Expenditures, on the other hand, have been substantially lower than planned, essentially due to much lower than anticipated investment spending related to the deteriorating security conditions. The fiscal outturn in 2006 was therefore very strong and contributed to a sharp increase in the accumulation of foreign exchange resources in the Development Fund for Iraq.
5. The authorities are aware that medium-term growth prospects hinge on the capacity to increase investment in infrastructure, notably in the oil sector, which is key to generating sufficient revenues to maintain fiscal sustainability. The implementation of the 2007 budget is therefore geared toward the need to increase investment, mainly in the oil sector. The authorities have also adopted a series of measures to increase the implementation rate of investment projects, including accelerating the approval of large investment projects and reducing the procurement period. However, considering the effect of a further dinar appreciation on oil revenues, the authorities are well aware that they need to further control current expenditures going forward, to be able to fund the needed infrastructure investments as well as to follow through on their commitments relating to security and the social sector. Current spending this year will therefore be kept within the 2007 budget limits, without the need for a supplementary budget. The authorities will continue resisting undue pressures on the wage bill.
6. The government has continued to pursue the process of realigning domestic fuel prices with regional levels, in line with the program. Except for a small subsidy for kerosene, direct subsidies on fuel products will therefore be avoided in 2007. At this stage, the authorities are willing to consider developing a rule–based mechanism for setting domestic fuel prices in the future, and will seek technical assistance in this regard. The authorities have also adopted measures to reduce fuel shortages by promoting the implementation of the 2006 law authorizing the private import of petroleum products. Private sector imports have so far been limited to the Kurdish region due to the security conditions prevailing in the rest of the country. So far, the authorities have issued about 20 licenses to private importers and will take further steps to encourage private sector imports, including making storage facilities and pump stations available to private operators.
7. Considerable effort is being devoted to advancing fiscal reforms. The government is making every effort to ensure that amendments to the new pension law are enacted by the Council of Representatives as soon as possible. The amendments provide for a gradual reduction of replacement rates to fiscally sustainable levels and zero indexation in 2007, in line with earlier understanding with Fund staff. Envisaged changes would allow the pension outlays to stay within the budgeted envelope for 2007. 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 has made progress in implementing the new Social Safety Net. More than 1 million poor families have received in 2006 cash payments under the program, and the coverage is expected to increase to 1.5 million families this year. At the same time, efforts to rationalize the Public Distribution System are ongoing, starting with a narrowing of the eligibility criteria.
8. A medium-term tax reform strategy aimed at modernizing the tax system to enhance non-oil revenue collection has been initiated. The authorities are considering introducing a sales-tax as a precursor to a value added tax, and aim at strengthening the tax and customs administration. Further efforts to improve public financial management are under way, including completion of the remaining steps needed to conform the chart of accounts and budget classification with the GFSM 2001. At the same time, coverage of the recently operationalized Financial Management Information System is being expanded to new spending units.
Monetary and Financial Sector Policies and Reforms
9. Decisive and mutually reinforcing policy measures have, since November 2007, contributed to curbing inflation. The Central Bank of Iraq (CBI) has tightened its monetary stance by raising its policy interest rate in two steps to 20 percent. It has also allowed the exchange rate to appreciate by some 14 percent. These measures, alongside the increases in domestic fuel prices, efforts to reduce fuel shortages, and continued fiscal restraint, succeeded in containing inflationary pressures. Annual consumer price inflation declined to 46 percent in June 2007 after having peaked at about 66 percent in January 2007, while the annual core inflation rate has dropped to 19 percent in June, compared to 32 percent at end-2006. At the same time, cash dollarization declined and the demand for dinars picked-up, pointing to increased confidence in the monetary stance of the CBI. This is evidenced by the expansion in the dinar currency in circulation and the noticeable substitution, at the daily foreign exchange auctions, in favor of transfers within the banking system instead of cash sales of dollars.
10. The authorities acknowledge that inflation needs to be further reduced and are committed to further monetary tightening if needed. However, as discussed at previous occasions, inflation is essentially supply-driven, as it is intrinsically linked to the security situation and to the resulting shortage of key commodities. Without a clear improvement on this front, it would be difficult to see significant progress in disinflation. Nevertheless, to signal its firm commitment to reducing inflation, the CBI is planning to allow the exchange rate to gradually appreciate by 1 percent per month until end-2007, while closely monitoring the effects of this policy. While the exchange rate is the main policy instrument for the CBI to bring down inflation, it stands ready to consider further increasing the policy interest rate, if needed.
11. The CBI continues to address concerns raised in the interim safeguards assessment report and the 2005 audit of CBI. The CBI Board has recently adopted a timetable for full implementation of International Financial Reporting System as the CBI’s financial reporting framework by end-2009. Moreover, the capital of the CBI was increased to the statutory level of ID 100 billion in February 2007. The CBI is also taking steps to improve the quality of its accounting records and control procedures, and in establishing adequate control procedures for reserves management. Important progress was achieved in terms of payment systems reforms and the CBI is now in the process of expanding the coverage of the real time gross settlement payment system and the automated clearing house.
12. The effectiveness of monetary policy in Iraq continues to be hampered by the weakness of the monetary transmission channels due to an inefficient banking sector. A restructuring of the sector is therefore a major objective of the authorities and should play an important role in the development of the Iraqi economy. Important steps have been taken towards the restructuring of the two largest state-owned banks, Rafidain and Rasheed. The economic committee of the Council of Ministers approved in March 2007 the memoranda of understanding for the operational restructuring of both state-owned banks, and a financial restructuring of Rasheed bank. An international auditor has been selected to conduct these audits, which are expected to be completed by early 2008. Later this year, the authorities intend to initiate, in consultation with the IMF and the World Bank, the restructuring of the other four smaller state-owned banks, in line with the approach adopted with regard to Rasheed and Rafidain banks.
Debt Restructuring
13. The authorities are making best efforts in trying to reach agreements with remaining official creditors, including Gulf countries and China, and the technical process of debt negotiation and reconciliation is ongoing. A Special Purpose Vehicle (SPV) has been established to securitize the debt held by private and public creditors, which would help create liquidity for Iraqi debt. The authorities hope that the SPV for debt securitization would facilitate the negotiations with other official creditors. Most of the remaining claims of private creditors are in the process of reconciliation with claims that are being settled as part of the liquidation of the London branch of Rafidain Bank. The authorities expect the liquidation to be completed by end-2007, enabling them to complete the resolution of all private claims.
Performance Under the SBA
14. Despite the adverse circumstances, Iraq continues to make clear progress in implementing the SBA. While the persistently unsettled security situation has caused delays in the implementation of some structural performance criteria (PC) under the SBA, all quantitative PCs set for end-March 2007 were met. On the basis of corrective actions being undertaken as specified in the Supplementary Memorandum of Economic and Financial Policies (SMEFP) for 2007, the authorities would like to request waivers for the nonobservance of these performance criteria, and completion of the fifth review under the SBA. They also request a waiver of applicability of end-June quantitative performance criteria and establishment of the quantitative performance criteria proposed in the SMEFP for end-September 2007, as well as the rescheduling and redefinition of the missed performance criterion on completion of the census of all public service employees, as described in the SMEFP. In order to ensure continuity in the policy framework during discussions for an envisaged successor arrangement, they also request an extension of the current SBA by three months to December 28, 2007. They intend to continue to treat 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. Moreover, the SBA-supported program will continue to provide the macroeconomic framework for the International Compact with Iraq, which was initiated with the help of the United Nations and formally endorsed by the international community in May 2007, with an aim at putting in place a medium-term framework for political, security and economic reforms.