Iraq
Request for Stand-By Arrangement and Cancellation of Current Arrangement: Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Iraq
Author: International Monetary Fund
Publication Date:
16 Jan 2008
eISBN:
9781451819151
Language:
English
Keywords:
ISCR; CR; Stand-By Arrangement; Iraq; government; core inflation; government import; debt forgiveness; nominal exchange rate; cash deficit; government oil revenue; authorities' intention
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Iraq showed good progress in undertaking strong macroeconomic policies and implementing economic reforms under the Stand-By Arrangement (SBA). Executive Directors welcomed this, and noted that low investment and stagnating output in the oil sector continue to hamper economic growth. They stressed that the new SBA should maintain macroeconomic stability, facilitate higher investment and output in the oil sector, and move forward with key reforms that were initiated under the previous arrangement. They also emphasized for reduction in inflation, increase in international reserves, and implementation of structural reforms.

Abstract

Iraq showed good progress in undertaking strong macroeconomic policies and implementing economic reforms under the Stand-By Arrangement (SBA). Executive Directors welcomed this, and noted that low investment and stagnating output in the oil sector continue to hamper economic growth. They stressed that the new SBA should maintain macroeconomic stability, facilitate higher investment and output in the oil sector, and move forward with key reforms that were initiated under the previous arrangement. They also emphasized for reduction in inflation, increase in international reserves, and implementation of structural reforms.

I. Introduction

1. 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 twice. The first extension to September 28, 2007, was to allow more time to reach program objectives and implement reforms, while the second extension to December 28, 2007, served to keep a policy framework in place during discussions for the requested successor SBA. Reviews for the program were concluded on August 2, 2006 (first and second reviews), March 12, 2007 (third and fourth reviews), and August 1, 2007 (fifth review). This precautionary SBA supported a program aimed at maintaining macroeconomic stability, paving the way for sustainable growth, and achieving external debt sustainability.

2. The Paris Club agreed on November 21, 2004 to reduce Iraq’s debt by 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, respectively. The final stage will comprise an additional 20 percent debt reduction, conditioned 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.

3. The International Compact with Iraq, an initiative of the Government of Iraq for a new partnership with the international community, was formally endorsed on May 3, 2007. The Compact aims to put in place a medium-term framework for comprehensive political, security, and economic reforms. The Fund’s main contribution is through preparation of the medium-term macroeconomic framework of the program supported by the SBA.

4. Despite serious difficulties, the authorities have demonstrated their commitment and ability to implement macroeconomic-policies and advance structural reforms. Under the SBA they used appropriate monetary and exchange rate policies to bring down inflation; implemented fuel price adjustments; contained the wage and pension bill to make budgetary room for investment and priority social spending; and advanced structural reforms in public financial management and central bank operations. However, the macroeconomic situation remains fragile, economic growth has been below target, and many reforms are unfinished. The authorities therefore propose a successor SBA-supported program to consolidate macroeconomic stability and advance their reform agenda.

5. In a letter to the Managing Director, the Iraqi authorities request an SBA in support of their program outlined in their MEFP for 2008, and the cancellation of the current SBA (Attachments I and II). The arrangement, which the Iraqi authorities intend to treat as precautionary, will cover the period from December 2007 through March 2009.

II. Recent Developments

A. Political and Security Situation

6. The political consensus has weakened but the government of Prime Minister Al-Maliki has remained in power. Since April, ministers from the secular Iraqi National List, the (Sunni) National Accord Front, and the Al-Sadr block have withdrawn from government. However, despite the political tensions, key ministers have remained in place, including the ministers of finance and oil.

7. The security situation continues to hamper economic recovery. After a dramatic deterioration in security in 2006, there are signs of improvement this year. The situation, however, remains difficult and the economy continues to suffer from the violence. Although most parts of the government are functioning, the security problems are straining its capacity to develop and implement policy.

Figure 1:
Figure 1:

Violence Indicators, June 2003–October 2007

(casualties, oil sector attacks, and bombings per month)

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

Source: Iraq Pipeline Watch, Iraq Body Count, and Brookings Institution.

8. The number of displaced persons has increased and poverty is worsening. The United Nations’ refugee agency estimates that in September 2007 more than 2.2 million Iraqi’s were internally displaced, up from 1.9 million in April. Another 2.2 million have fled the country, mostly to neighboring Syria (1.2–1.4 million) and Jordan (0.5–0.75 million). The deteriorating living conditions have resulted in the emigration of professionals and skilled labor, hampering economic development and reconstruction efforts. Iraq’s statistical agency estimates that 43 percent of the Iraqi population lives on less than $1 a day, with much of the poverty due to the high rate of unemployment.

9. Corruption remains a serious problem. Transparency International lists Iraq second-lowest among 179 countries surveyed for its 2007 Corruption Perception Index. The authorities are well aware of the problem and have taken up the challenge of fighting corruption, which had become entrenched after decades of authoritarian rule. The Board of Supreme Audit has taken a more active stance in auditing ministries and government agencies, a National Integrity Commission has been set up, and the maximum amount at which procurement decisions can be made at the ministerial level has been lowered significantly from what it was shortly after the war.

B. Developments Under the Current SBA

10. The main objective of Iraq’s first SBA-supported program was to maintain macroeconomic and financial stability, while undertaking sufficient investment to secure the basis for sustainable growth over the medium term and improving governance. Performance under the program was good, especially in light of the unstable political and security situation, although growth has remained below expectations:

  • The very difficult security situation combined with slow implementation continued to impede the pace of investment, thus preventing the envisaged expansion of oil output. Although oil output has reached 2.1 million barrels per day (mbpd) in recent months, average production for 2007 is unlikely to exceed 2 mbpd, broadly unchanged from 2006. Oil exports have increased slightly in recent months, partly on account of resumed shipments through the northern pipeline to Turkey, and are projected to reach 1.6 mbpd this year, compared to 1.5 mbpd in 2006. Overall economic growth reached 6.2 percent in 2006, but is projected to decline to 1 percent this year, with oil production flat and indicators of non-oil activity pointing to a slowdown.

  • The fiscal program was successful in containing current spending and preserving fiscal sustainability, but fell short in implementing the ambitious investment program. The wage bill and other current spending were kept under control, which has helped to contain underlying inflation pressures. The authorities put on hold the implementation of a fiscally unsustainable new pension law until 2008, after corrective amendments that will make the pension system sustainable were adopted in October 2007. Investment spending was below target due to a combination of political, security, and administrative factors, although there has been a pick-up in 2007. On the revenue side, higher crude oil export prices compensated for the shortfall in oil production. These developments combined to generate a budget surplus of 12 percent of GDP in 2006 and a small projected surplus of 1½ percent in 2007 (taking into account the adverse impact of the appreciation of the dinar on oil revenue), while DFI balances grew to $12.1 billion by end-October 2007.

  • Inflation was brought under control with a policy package including exchange rate appreciation, tight monetary policy, and control of current government spending.

Shortfall and Offset in Iraqi Oil Exports

  • Production and export of crude oil have been lower than expected under the SBA-supported program. In December 2005, crude oil production and exports were expected to reach 2.25 and 1.65 mbpd, respectively, in 2006 and 2.7 and 2.1 mbpd in 2007, which was revised to 2.3 and 1.7 mbpd at the time of the third and fourth reviews, in March 2007. These targets have generally not been met, except in recent months, when both production and exports have picked up.

  • The shortfall in oil production has been offset by higher world market prices and a lower discount for Iraqi oil. The average monthly world market price for crude oil (an average of three benchmark prices published in the World Economic Outlook) increased by 20 percent in the period January 2006–August 2007 compared to 2005. The average price of Iraqi oil increased by 27 percent in the same period, partly due to a decline in the discount on Iraqi oil of about $2 per barrel. The lower discount partly reflects a higher share of Iraqi exports to markets in Asia, which pay a higher price for the heavier and more sulfur-rich Iraqi oil than U.S. and European markets.

  • Higher prices offset about two thirds of the production shortfall in 2006, while in 2007 higher prices more than offset for the shortfall. In 2006 higher world market prices and a lower discount combined to compensate $2.4 billion of the $3.7 billion shortfall due to lower than expected production, leaving a cash deficit of $1.3 billion compared to program projections. In 2007 the offsetting factors, in particular higher world market prices, generated $7.1 billion to compensate a production shortfall of $3.1 billion. Without the offset of higher world market prices and a lower discount the production shortfall would have depleted the DFI by the end of 2007. This illustrates how fragile Iraq’s public finances have been in recent years and underscores the urgency to raise oil output.

uA01fig01

Iraq: Crude Oil Production and Exports, January 2005–September 2007

(In million barrels per day)

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

Sources: Iraqi authorities and Platts.
uA01fig02

Iraq: WEO and Iraqi Crude Oil Prices and Discount for Iraqi Oil

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

Source: CBI and Fund staff calculations.Note: WEO crude oil price in brackets. 2007 realization is through August.

Iraq: Shortfall and offset in oil export revenues

(in millions US dollar)

article image

Calculated as the difference between projected and realized export volumes times the projected export price.

Figure 2:
Figure 2:

Fiscal Developments, 2004–07

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

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

Annual inflation jumped from 32 percent at end-2005 to 65 percent by end-2006, mainly because of violence-related fuel shortages. The CBI responded by letting the exchange rate of the dinar to the dollar appreciate by 16 percent since November 2006 to ID 1,232 by end-October 2007, and by raising its policy interest rate in two steps to 20 percent as of January 2007. These policies, together with measures to reduce fuel shortages, helped bring down consumer price inflation to 20 percent, and core inflation (excluding fuel and transportation) to 16 percent by October 2007. Annual inflation is expected to remain below the target of 25 percent by year-end.

Figure 3:
Figure 3:

Annual Consumer Price Inflation, August 2004–October 2007

(In percent)

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

Source: Iraqi authorities.

  • The tight monetary and exchange rate policies also helped to reduce dollarization, while accumulation of net international reserves exceeded expectations. Real demand for dinar currency in circulation expanded by 9 percent between end-November 2006 and end-August 2007, after it had fallen by 37 percent between end-December 2005 and end-November 2006. Also, in 2007, cash sales of dollars at the foreign exchange auction—a key indicator of dollarization—were substantially below 2006 levels. Dollar sales for bank transfers, which largely represent the financing of imports and the increasingly important remittances to Iraqi refugees abroad, recovered quickly in early 2007 and have remained well above 2006 levels since then. This did not signal increased pressure on the exchange rate as increased sales of dollars by the government, reflecting efforts to increase the execution rate of the investment budget, enabled the CBI to accumulate reserves well in excess of program expectations, bringing net international reserves of the CBI to $25.5 billion by end-October 2007. The CBI absorbed excess liquidity by using its standing deposit facilities, issuing CBI-bills, and, in September 2007, increasing the required reserves ratio on government deposits from 25 percent to 75 percent. Despite improved macroeconomic management, considerable reserve accumulation, and lower inflation, Iraq’s internationally traded bond has underperformed, suggesting that investors are pricing in a higher country risk premium.

Figure 4:
Figure 4:

Real and Nominal Exchange Rates, January 2004–August 2007

(Index, Jan 2004=100)

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

Sources: The Iraqi Authorities and Fund staff calculations.1/ Increase denotes appreciation.
Figure 5:
Figure 5:

Daily Foreign Exchange Sales and Nominal Exchange Rate May 2006–September 2007

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

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

Sources: Iraqi authorities and Fund staff estimates.Note: Foreign exchange sales are weekly averages of daily sales.
Figure 6:
Figure 6:

J.P. Morgan EMBI+ Composite and Iraq Bond Indices, January–October 2007

(January 1, 2007=100)

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

Source: Bloomberg

11. All quantitative performance criteria under the SBA through June 2007 were met, but one structural performance criterion was missed. Staff will inform the Executive Board on the outcome of the end-September quantitative performance criteria before Board consideration of the successor SBA. The security situation has caused further delays in conducting the census of public service employees, and the data collection phase of the census was not completed by end-November as planned.

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

  • Prices of domestic fuel products were increased significantly and brought in line with those in other oil-exporting countries in the region. Direct budgetary subsidies, which amounted to almost 13 percent of GDP in 2004, were eliminated in 2007 (with the exception of a small subsidy for kerosene), while the price adjustments also helped to fight smuggling.1

  • Legislation and administrative regulations were enacted to allow importation of fuel products by the private sector, which has begun in 2007, including in the south.

  • Amendments to the new pension law were passed by the Council of Representatives in October 2007. The amendments aim at making the new pension system fiscally sustainable, notably through a gradual reduction of replacement rates to sustainable levels.

  • As part of its efforts to modernize public financial management, the government has brought the chart of accounts and budget classification in line with the GFSM 2001, within a cash accounting framework. However, the work on the FMIS was terminated following the abduction of an external consultant in May 2007, and in light of the difficulties to align the system to the needs of the Iraqi government.

  • An audit of the CBI end-2006 net international reserves and the audit of its 2006 financial statements were finalized, and the CBI has begun to address weaknesses in its accounting and reporting framework. Also, the CBI’s capital was raised to the statutory level.

  • The payment system is being modernized, and an up-to-date real-time gross settlement system and an automatic clearing house are operational. Preparations for the restructuring of the two largest state-owned banks (Rafidain and Rasheed) are underway.

13. Iraq has continued to make progress toward resolving outstanding external claims. Bilateral agreements have been signed with all Paris Club creditors, except Russia. Progress has been much slower with non-Paris Club creditors, where Iraq has announced agreements with ten creditor countries.2 A special purpose vehicle has been established to facilitate official creditors desiring to securitize their claims, while avoiding the emergence of a multiplicity of different securitizations. Iraq has resolved all but about 4 percent of private creditors’ claims.

14. Data provision has been adequate for purposes of program monitoring, but weaknesses remain. Oil sector data are readily available, but there is little information on the non-oil economy. Consumer price data are timely and coverage is adequate (but excludes the Kurdish region), although the basket of goods is outdated. The CBI has recently produced a monetary survey, which also excludes the Kurdish region. Fiscal reporting is adequate to monitor budget execution, but should be more timely.

III. The Authorities’ Program for 2008

15. The requested SBA should help the authorities to consolidate and advance the achievements of the program supported by the current arrangement. In broad terms the program aims to: (i) maintain macroeconomic stability; (ii) facilitate investment and higher output in the oil sector; and (iii) advance priority structural reforms. The program envisages a 2008 budget that makes room for sizable investment while maintaining fiscal sustainability; the continued avoidance of direct fuel subsidies; the strengthening of public financial management and the accounting framework of the CBI; the restructuring of the two largest public banks; and improving governance in the oil sector.

16. The program will have ambitious yet realistic macroeconomic objectives for 2008. Based on the recent upturn in oil production and exports, in particular through the North, and further progress in executing the investment program in the oil sector, the program envisages that oil output will increase to 2.2 mbpd and oil exports to 1.7 mbpd in 2008. With a modest pick-up of non-oil growth, overall GDP growth of 7 percent should be achievable. The program also aims to bring annual consumer price inflation down to 12 percent in 2008. The net international reserves of the CBI are expected to increase to about $34 billion by end-2008.

A. Fiscal Policy and Related Issues

17. The 2008 budget submitted to parliament envisages a further increase in investment and a moderate rise in current spending (¶10).3 The budget is based on a conservative oil export price assumption of $57 per barrel and oil exports of 1.7 mbpd, which would generate oil-revenues slightly higher than the expected 2007 outturn. Receipt of $3.75 billion (5.3 percent of GDP) in fees for auctioned mobile phone operator licenses will provide a one-off boost to revenues. The government intends to limit new hiring, and not to grant any general wage increases. On this basis, the overall fiscal deficit is expected to increase to almost 8½ percent of GDP in 2008, while leaving sufficient resources in the DFI to maintain fiscal sustainability over the medium term.4 In the event that oil revenue in 2008 differs substantially from the budget assumptions, the government will discuss with the Fund on how to proceed in order to attain the program objectives.5

18. An ambitious investment program has been prepared for 2008 (¶12). In the oil sector, the program includes projects to increase production and export capacity in the South and to better secure the northern export pipeline. Measures are also being taken to speed up implementation of reconstruction projects that could not be undertaken in previous years, in particular in the electricity, water and sanitation, health, and education sectors. Total investment spending is planned to more than double in real terms in 2008, provided that the security situation allows full implementation of the investment program. The authorities are aware of the need to ensure the high quality of public investment while taking account of implementation capacity constraints.

19. The government is determined not to provide any direct budget subsidies on fuel products, except for a small subsidy on imported kerosene (¶15). To preserve the cost recovery gains made under the current SBA, the authorities, with technical assistance from the Fund, will develop a periodic adjustment mechanism for fuel prices. The MOO will continue to facilitate private sector fuel imports to further reduce shortages and contain inflationary pressures.

20. The census of public service employees is underway, albeit with delays caused by the complexity of the task and the security situation (¶14). The authorities are endeavoring to complete the census by end-June 2008. This will form a basis for an action plan to be adopted by September 2008, that will aim at eliminating ghost workers and computerizing the payroll and eventually at establishing a bank transfer system for wage payments.

21. Steps are being taken to streamline the social safety net (¶16). In addition to enhanced monitoring and improved procurement procedures, the authorities are considering to limit the rations in the Public Distribution System, and to further limit eligibility of well-off families. The draft 2008 budget provides for an expansion the coverage of the new cash-based Social Safety Net, which presently covers about 800 thousand families.

22. The authorities remain committed to strengthening public financial management (¶17). Following the termination of the FMIS, the government has requested Fund technical assistance to help it identify priorities in this area and to develop a reform plan. To strengthen transparency and accountability, the authorities intend to submit to the BSA, and subsequently to the Council of Representatives and the public, the final accounts of the federal budget for 2007 (as required by the 2004 Financial Management Law).

23. The government is preparing a medium-term tax-reform strategy with assistance from international partners, including the Fund (¶18). Priority reforms are to establish an efficient tax system for the oil sector conducive to private sector activities, and possibly to introduce a sales tax. In the interim period, the corporate income tax will be kept at 15 percent, and the 5 percent customs duty (reconstruction levy) will be maintained while exemptions will be reduced.

B. Monetary and Exchange Rate Policy

24. The CBI intends to maintain its present exchange rate and monetary policy stance, which helps to de-dollarize the economy, until core inflation is firmly under control (¶19–20). Although the lack of data and the many structural changes in the economy preclude an estimation of the equilibrium real exchange rate, it is likely that the improvement in the terms of trade have resulted in an appreciation of the equilibrium real exchange rate. With the nominal exchange rate fixed to the dollar until end-2006, the adjustment of the real exchange rate to its new equilibrium was reflected in persistent high core inflation which was validated by the pervasive cash dollarization. The still high core inflation rate seems to indicate that the nominal appreciation of the dinar since November 2006 has reduced but may not have fully eliminated the undervaluation of the real exchange rate. Therefore, the CBI will continue the gradual appreciation of the dinar until core inflation has come down to near single digit levels. Once this has been achieved, the CBI would return to its previous policy of maintaining a stable exchange rate while continuing to provide the full amount of foreign currency demanded at the cut-off rate at the daily auction. The CBI will also keep its policy interest rate at 20 percent until core inflation is near single digit levels. Provided inflation continues its downward trend, the policy rate could then be reduced gradually, while maintaining a positive real interest rate and taking into account the impact on inflation expectations.

25. The monetary program for 2008 is designed to accommodate the projected accumulation of net international reserves and a growing real demand for dinars (¶20). The floor on net international reserves in the program is set with a sufficient margin to allow the CBI room to maneuver should monetary conditions change. The CBI will continue to absorb excess liquidity by issuing CBI-bills and giving banks unrestricted access to its standing deposit facilities.

26. The CBI is preparing to add new monetary policy instruments to its tool kit (¶21). It intends to continue to support a liquid secondary market of tradable instruments by continuing to sell treasury bills it receives from the MoF as part of the rescheduling of CBI claims. The CBI also plans to develop a central depository system, while the MoF will continue with the regular bi-weekly issuance of treasury bills. Restructuring the presently largely inactive banking system will also help towards developing a secondary market and, over time, give the CBI the option to conduct open market operations.

27. The CBI will continue its efforts to strengthen its accounting, auditing, and reporting systems (¶22). The CBI has made some progress in implementing the recommendations of the Fund’s ISAR, which covered three of the areas of the safeguards framework (external audit, financial reporting, and controls). Work on an update of the ISAR, which will also include the internal audit and legal structure safeguards areas, is substantially complete. The update identified a number of key actions, including maintaining proper accounting records and regular reconciliation of CBI accounts, as well as adopting reserves management guidelines. Also, the external auditor for the audit of the CBI net international reserves at end-2007 and the audit of the CBI 2007 financial statements will be appointed before Board discussion of the proposed arrangement, while completion of the audits will be performance criteria under the program. The authorities also plan to amend the central bank law, with technical assistance from the Fund.

C. Banking Sector Reform

28. The authorities are convinced that development of financial intermediation is critical to accelerate economic growth in Iraq and therefore place bank restructuring high on their reform agenda (¶29). International auditors will soon be appointed to undertake operational and financial audits of Rafidain and Rasheed, the two largest banks, that are scheduled to start in early December 2007 (prior action) and should be completed by end-April 2008. The terms of reference for the audits have been approved by the Restructuring Oversight Committee and agreed with the Fund and the World Bank. Diagnostic audits for the three small remaining state-owned banks will also start in 2008.

29. Comprehensive restructuring programs based on the results of the audits for Rafidain and Rasheed banks will be adopted by end-September 2008. In the meantime, measures to improve the banks’ governance have been taken. Progress is also being achieved in the reconciliation of their foreign debt, and toward the liquidation proceedings for the London branch of Rafidain Bank. The cleaning-up of the books of Rafidain and Rasheed banks is underway, in particular to resolve their very large suspense accounts. Recapitalization of the two banks will be financed with the issuance of government bonds.

30. The authorities are also making efforts to strengthen the financial sector infrastructure (¶30). A set of prudential regulations applicable to all commercial banks will be compiled and applied by end-July 2008, and the switch from domestic accounting standards to International Financial Reporting Standards is under preparation. Progress also continues to be made in expanding the payment system.

D. Other Issues

31. Fighting corruption, notably in the oil sector, and improving transparency in the management of public resources is a high priority for the authorities (¶27). They have made efforts to ensure a smooth transition when the Iraqi COFE takes over the IAMB responsibilities for oversight and monitoring of the DFI by end-2007.6 They intend to implement a number of IAMB recommendations, including for the COFE to continue the IAMB practice of publishing audit reports and making recommendations in semi-annual reports to the Council of Ministers. A metering system in the export terminal of Basra is operational and metering systems in other ports and oil installations are being put in place, in line with IAMB recommendations. The authorities also plan to join the Extractive Industries Transparency Initiative.

32. The authorities are taking steps to revitalize the public enterprise sector (¶31). A program to provide subsidized bank loans—the cost of which will be fully reflected in the budget—to restart the activities of commercially viable public enterprises, has started. In addition, a microfinance scheme has been established. The authorities are committed not to provide any government guarantees on bank loans under these programs. A National Investment Commission has been set up to implement the new investment law (adopted in November 2006) which aims to attract foreign investors.

Recommendations of the IAMB

The IAMB was established by the United Nations Security Council in 2003 and will be in operation until December 2007 to act as an audit oversight body for the DFI.

Several audits mandated by the IAMB concluded that the overall financial system of controls is deficient and that financial management reforms need to be pursued further. The audits noted large un-reconciled differences regarding oil extraction, production and export sales, and found that basic administrative procedures in ministries are outdated and ineffective. Based on these audits the IAMB makes the following key recommendations:1

  • Install comprehensive metering equipment in line with standard oil industry practice;

  • Discontinue the use of barter transactions. If some barter transactions remain necessary, transparently reflect them as sales and purchases so that these transactions become less prone to misappropriation and corruption;

  • Continue to take concrete steps to follow up on all audit findings and implement recommendations, including to improve financial reporting and control systems in key ministries;

  • Seek resolution with the U.S. Government concerning the use of resources of the DFI which might be in contradiction with UNSCR 1483; and

  • Continue the independent oversight work, upon dissolution of the IAMB, by the Government of Iraq’s COFE, with regular reporting to the public and the international community.

1/

These recommendations are listed in a draft report that is scheduled to be issued in December 2007. Fund staff conduct much of the IAMB’s secretariat-related work and are currently finalizing the draft report.

33. The authorities reiterated their commitment to free trade policies and an open exchange system (¶23–24). Negotiations to join the WTO continue, and bilateral meetings on market access for goods and services with a number of members started in 2007. Work toward accepting the obligations of Article VIII, Sections 2(a), 3, and 4, of the IMF’s Articles of Agreement is also ongoing. In the meantime the authorities remain committed to avoiding restrictions on the making of payments and transfers for current international transactions, introducing new or intensifying trade restrictions for balance of payments purposes, or resorting to multiple currency practices.

34. With most of the Paris Club bilateral agreements signed, efforts are now focused towards resolving still outstanding non-Paris Club and commercial external claims. Understandings with China have been reached on part of the debt, and progress is being made with the remainder. Despite Iraq’s good faith efforts, progress has been slow with the Gulf countries and Russia (the only remaining Paris Club creditor). The reconciliation of most of the remaining unresolved claims of private creditors is ongoing as part of the liquidation of the London branch of Rafidain Bank.

35. The authorities will step up their efforts to further improve the timeliness, coverage, and accuracy of macroeconomic statistics. Work to improve the CPI is progressing. The 2007 household survey is expected to be completed by year-end, which will allow the authorities to update the CPI weights by end-May 2008. They are also working to extend overage of the CPI and monetary statistics to the Kurdish region. Work towards GDDS participation is ongoing and it is expected that Iraq will start submitting data for the IMF’s International Financial Statistics shortly.

IV. Program Modalities and Risks

A. Medium Term Outlook and Capacity to Repay the Fund

36. Iraq’s medium-term outlook is favorable, provided there is an improvement in security. The present circumstances constrain the effectiveness of macroeconomic policies and the authorities’ ability to implement reforms. In light of the government’s limited ability to increase the rate of implementation of their oil investment program, oil production is expected to increase only gradually over the next few years, while non-oil output may grow moderately. Inflation is targeted to decline further, reflecting the policy actions taken by the CBI, the continued control of government current spending to avoid excessive demand pressures on Iraq’s small non-oil economy, and the expansion of private imports of fuel products to reduce shortages. The increase in government investment should have only a limited impact on inflation, in view of its high import content and considerable unused capacity in the economy. With the current favorable world oil price outlook and assuming a gradual increase in oil export volumes, the overall fiscal position would be sustainable. However, there is little room for fiscal slippage, in view of the projected fall in the balance of the DFI during 2008–10 to absorb the projected fiscal deficits and the need to finance the sizable amortization payments of the rescheduled debt beginning in 2011. The external current account balance is expected to deteriorate in 2007–08 and improve gradually thereafter, as oil exports would increase only slightly and because of higher investment-related imports and lower inflows of foreign grants. Gross international reserves are expected to gradually increase to a level equivalent to 12½ months of import cover by 2012.

37. The favorable medium term outlook is subject to substantial risk. The threat that the security situation poses to the government’s ability to raise investment and production in the oil sector remains the largest risk to the outlook. Raising oil output is critical to avoid financing gaps, as staff’s alternative scenario shows (see below). A further weakening of the political consensus could derail the government’s structural reform program and jeopardize budgetary discipline. The risk of oil price fluctuations is mitigated by the conservative oil price assumption of $57 per barrel in the 2008 budget. Oil prices in the medium term are projected to be in line with WEO forecasts.

Figure 7.
Figure 7.

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

Citation: IMF Staff Country Reports 2008, 017; 10.5089/9781451819151.002.A001

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

38. If investment and production in the oil sector cannot be increased as projected, lower oil revenue would lead to high fiscal and external deficits, and sizable financing gaps from 2010. In staff’s illustrative alternative scenario oil output remains flat at 2.1 mbpd, causing overall GDP growth to remain low over the medium term. Even with the current favorable oil price outlook this would lead to high fiscal deficits from 2008 and depletion of the DFI by 2009. A negative oil price shock would further deteriorate the outlook. Absent access to significant external borrowing, drastic spending cuts would be unavoidable.

Iraq: Medium Term Outlook - Alternative Scenario

article image
Sources: Iraqi authorities and Fund staff projections.

39. Iraq has received substantial debt reduction from official and private creditors, but further reduction is needed to achieve external debt sustainability (Appendix I). The first two stages of the Paris Club debt rescheduling, rescheduling of some of the non-Paris Club debt, and most of the private sector claims thus far have reduced Iraq’s external debt to $101.5 billion at end-2007 (about 162 percent of GDP). To make the debt sustainable, the third tranche of Paris Club debt rescheduling (worth 20 percent in NPV terms) is needed upon completion of the final review of the proposed SBA, as well as progress in rescheduling the rest of the debt from non-Paris Club creditors at terms comparable with those granted by the Paris Club. This would bring the debt down to $32.7 billion (46 percent of GDP) by end-2008 and secure debt sustainability over the medium term.

40. If purchases were to be made under the precautionary arrangement, Iraq should have the capacity to repay the Fund. Total Fund credit would peak at 1.2 percent of GDP (46 percent of quota) by end 2008, and most of it would be repaid before payments for the rescheduled debt to Paris Club creditors start in 2011, with the entire Fund exposure eliminated by 2012. Total debt service to the Fund in any year would not exceed 0.7 percent of exports of goods and service. Even with only a projected gradual expansion of oil output, Iraq should be in a position to meet its obligations to the Fund. Under the baseline scenario external surpluses would continue throughout the medium term.

B. Proposed Arrangement

41. The successor SBA would be precautionary and cover a 15-month period, ending in March 2009, in support of the authorities’ economic program for 2008 (¶33–34). Access is proposed at SDR 475.36 million (40 percent of quota), with six equal purchases of SDR 79.23 million (6.67 percent of quota) each. Implementation of the program will be monitored through prior actions, quantitative and structural performance criteria, an indicative target, and structural benchmarks, as specified in the MEFP. In addition, the program will be monitored through two (semiannual) reviews. The first review will focus, inter alia, on progress made with developing an action plan to modernize the government’s financial management information system and on the completion of an audit of the CBI’s net international reserves. The second review will focus on progress made with developing an action plan to restructure the two large state owned banks and a periodic adjustment mechanism for fuel prices.

42. If needed, the regular reviews will be combined with financing assurances reviews. The fully financed program and the authorities’ commitment to continue its good faith efforts to reach a debt rescheduling agreement with official and private international creditors, provide assurances that Iraq will be in a position to repay the Fund any purchases it may make under the arrangement.

V. Staff Appraisal

43. Iraq’s performance under the current SBA has overall been good, especially in light of the very difficult security and political circumstances. In particular, the authorities took a major step in increasing domestic fuel prices to regional levels, thereby all but eliminating direct budgetary subsidies on fuel products. They have also successfully mounted a policy response to bring a high rate of inflation sharply down. Fiscal discipline has been maintained throughout the program period. Despite the lack of security and capacity constraints, structural reforms continued.

44. Nevertheless, Iraq still faces enormous challenges and much remains to be done. The ongoing violence has severely reduced the rate of execution of the public investment program, which, combined with attacks on oil installations, kept oil production virtually flat. Non-oil economic activity also suffered. As a result, economic growth was much below target. Reforms to strengthen the financial management of the government and the CBI, as well as to modernize the banking sector are still at an early stage. While the installation of a metering system in the Basra oil-export terminal is an important step forward, further progress is needed to significantly reduce corruption in the oil sector and elsewhere.

45. The proposed SBA will support the authorities’ economic program for 2008 that aims to build on the progress made under the current SBA and address the unfinished agenda. The main objectives of the new program will be to maintain macroeconomic stability, facilitate investment and higher output in the oil sector, and advance priority structural reforms to pave the way for higher economic growth and to strengthen administrative capacity and governance in the public sector.

46. The implementation of the proposed program carries significant risks. The exodus of professionals has weakened the policy implementation capacity of the government, and also harmed the economy as a whole. Although Iraq’s medium-term outlook is favorable, this depends critically on the security situation improving. Continued violence would hamper investment and thereby the expansion of oil output and overall economic activity. This, in turn, would result in uncovered financing gaps and possibly worsen commodity shortages leading to higher inflation. The unsettled political situation could reduce the ability of the government to maintain fiscal discipline and undertake reforms. The lack of strong governance in some areas also remains a concern.

47. Staff welcomes the priority given in the draft 2008 budget to increasing investment while containing current spending and maintaining fiscal sustainability over the medium term. Staff believes that a gradual expansion of oil production is achievable, provided the envisaged investments in the oil sector are realized. The ambitious increase in public investment in 2008 requires sustained efforts to ensure its quality. The government will also need to ensure that the wage and pension bill remains within budget. In this connection, the amendments to the new pension law are a key step to make the pension system sustainable. It is also important to complete the census of public service employees without further delay and to computerize the payroll, in order to put the future management of the wage bill on a sound footing. Staff support the authorities’ intention to further streamline the Public Distribution System, while stressing the need to protect the poor.

48. Staff welcomes the CBI’s commitment to continue the gradual appreciation of the exchange rate and to keep its policy interest rate unchanged until annual core inflation has decreased to close to single digit levels. The CBI should continue to keep a close watch on inflationary developments and adjust its policy stance as needed. It is also important for the government to further reduce shortages, including by supporting private sector fuel imports. If inflation continues to decline, the policy interest rate could be reduced gradually, while seeking to maintain this rate positive in real terms. Once the inflation objective has been reached, it is appropriate for the CBI to return to its previous policy of maintaining a stable exchange rate.

49. Staff underscores the need to accelerate structural fiscal reforms, notably in public financial management. The termination of the FMIS is a setback. Therefore, the authorities should step up their efforts to develop, with Fund technical assistance, a realistic action plan to modernize public financial management, in order to address the most pressing needs. Staff welcomes the commitment of the authorities to publish the audited fiscal accounts for 2007. It is also important to streamline the tax system in order to broaden the tax base and improve incentives for economic activity.

50. Staff welcomes the authorities’ focus on banking reform. To significantly strengthen financial intermediation in Iraq, it is crucial to move ahead with developing and implementing restructuring programs for Rafidain and Rasheed banks, based on the results of their audits. At the same time, it is important for the government to adhere to its commitment to refrain from providing government guarantees on bank loans. The efforts to strengthen banking supervision and expand coverage of the payment system should be stepped up. The CBI should continue to strengthen its accounting, auditing, and reporting systems.

51. It is crucial to push ahead with reforms in the oil sector, notably in light of the need to strengthen governance and fight corruption. The government’s commitment to ensure that the COFE will fully take over the tasks of the IAMB as an audit oversight body for the DFI is welcome. Staff encourages the government to expand metering to all upstream and downstream oil sector activities as soon as possible. In order to ensure that fuel prices continue to cover costs, it will be important to develop a periodic price adjustment mechanism to allow prices to change in line with costs. In view of Iraq’s large future investment needs to increase oil production, efforts should continue to establish a new legislative framework for the hydrocarbon sector.

52. Staff urges the authorities to continue their efforts to conclude debt agreements with the remaining official and private creditors. In light of the good faith efforts undertaken by the authorities, staff hopes that the process of resolving Iraq’s debt to non-Paris Club creditors will accelerate and that an agreement with Russia will be signed soon.

53. Staff underscores the need to further improve the accuracy, coverage, and timeliness of macroeconomic statistics, notably of data on the real sector, public finance, and the balance of payments. It is important to update the weights of the CPI and to continue efforts to extend the coverage of statistics to the Kurdish region.

54. The staff supports the authorities’ request for a precautionary Stand-By Arrangement in an amount of SDR 475.4 million for a period of 15 months. While the implementation of the program is subject to higher than usual risk because of the security situation, the authorities have demonstrated their commitment to undertaking strong macroeconomic policies and implementing economic reforms. The staff therefore believes that their program merits the support of the Fund.

Table 1.

Iraq: Selected Economic and Financial Indicators, 2005–12

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

Iraq: Fiscal and Oil Sector Accounts, 2005–12

(In billions of ID; unless otherwise indicated)

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

Projections assume that the private sector will start importing petroleum products, thereby increasing substantially the base for import duties in 2009–12.

For 2008, includes $3.75 billion mobile phone operator license fees.

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. ID 1,500 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 full 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, 2005–12

(In percent of GDP)

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Sources: Iraqi authorities and Fund staff estimates and projections.

Projections assume that the private sector will start importing petroleum products, thereby increasing substantially the base for import duties in 2009–12.

For 2008, includes $3.75 billion mobile operator license fees.

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 full down-payment is customarily required.

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