Background

1. Notwithstanding extremely difficult security and political conditions, the Iraqi authorities made good progress in implementing their economic programs for 2006 and 2007 under the Fund-supported Stand-By Arrangement (SBA). In particular, the authorities significantly increased official prices of domestic fuel products, bringing them in line with those in other oil-exporting countries in the region, as called for in the current SBA. They also succeeded in sharply reducing inflation to 20 percent in October 2007 from 65 percent at end-2006, as a result of a timely adjustment in both monetary and exchange rate policies, as well as continued fiscal discipline and the reduction of fuel shortages. Despite the lack of security and capacity constraints—exacerbated by the emigration of professionals and skilled labor—the authorities advanced their structural agenda in several key areas, including the pension system and the audit and capitalization of the Central Bank of Iraq (CBI). They also continued to make progress toward resolving external claims.

2. Notwithstanding this favorable performance, however, the Iraqi economy continues to face daunting challenges. Low investment and stagnating output in the oil sector, largely due to the persistent violence, continue to hamper economic growth. Moreover, further efforts are needed to enhance governance in the oil sector, strengthen public financial management, improve the CBI’s accounting and reporting framework, and move forward the restructuring of the two largest state-owned banks.

3. Against this background, and building on progress achieved under the current SBA, the Iraqi authorities are requesting a new 15-month SBA with the Fund in an amount equivalent to 40 percent of quota, and the cancellation of the current arrangement. They intend to treat the requested arrangement as precautionary. The new SBA would support the implementation of the authorities’ economic program for 2008. The broad objectives of the latter are to maintain macroeconomic stability, facilitate investment and higher output in the oil sector, advance structural reforms to pave the way for higher growth, and strengthen governance and administrative capacity in the public sector. The successful completion of the program will also trigger the third and final stage of debt reduction under the 2004 Paris Club agreement, thereby contributing to fiscal and external sustainability.

Economic and Financial Policies and Reforms in 2008

4. The authorities’ fiscal strategy aims primarily at rebuilding Iraq’s economy and institutions, restoring adequate public services, and enhancing the standard of living of the population, while maintaining fiscal sustainability. They are fully aware that there is little room for fiscal slippages and that increased investment and production in the oil sector remain critical to maintain fiscal and external sustainability. In this context, the draft 2008 budget accords high priority to the investment program, especially in the oil sector, with oil output estimated to increase to 2.2 mbpd. It also maintains essential spending in education, health, and security, while containing other current expenditures, including wages. In this connection, the recent adoption of the amendments to the new pension law will help place the pension system on a fiscally sustainable path.

5. Considerable effort is being devoted to advancing fiscal reforms. The government is conducting a census of public service employees, aimed at enhancing the management of the government wage bill. Moreover, the authorities intend to develop, with technical assistance from the Fund, a periodic adjustment mechanism for fuel prices, so as to further reduce distortions and inefficiencies. In this context, they will continue to facilitate private sector fuel imports. Rationalizing the in-kind Public Distribution System, in line with World Bank recommendations, while expanding the coverage of the new cash-based Social Safety Net, also rank high on the authorities’ agenda. The government has requested Fund technical assistance to help identify priorities for modernizing public financial management and is committed to publish the audited fiscal accounts for 2007. A medium-term tax reform strategy aimed at supporting economic development, while broadening the tax base and increasing revenue collection, has also been initiated.

6. Iraq’s monetary and exchange rate policies aim at reducing inflation and dollarization in order to enhance the CBI’s control over monetary conditions. The CBI is committed to continue the gradual appreciation of the exchange rate, while keeping its policy interest rate unchanged, until annual core inflation declines to near single-digit levels. The CBI is determined to keep a close watch on the effects of this policy on inflation and adjust the pace of appreciation as needed. Once the inflation target has been achieved, the authorities intend to return to their previous policy of maintaining a stable exchange rate as the nominal anchor for the economy. However, further reductions in the inflation rate will require addressing supply bottlenecks and an improvement in the security situation.

7. The structural agenda in the monetary area includes preparatory work to extend the availability of monetary policy instruments to be able to conduct open market operations. The CBI continues to address concerns raised in the interim safeguards assessment report and the 2006 audit report, namely with regard to strengthening its accounting, auditing, and reporting systems.

8. The Iraqi authorities are committed to strengthen the monetary transmission channels by enhancing the efficiency of the banking sector. Important steps continue to be taken towards the restructuring of the two largest state-owned banks whose audits, expected to be completed by end-May 2008, will determine an operational restructuring program for Rafidain Bank, and an operational and financial restructuring program for Rasheed Bank. At the same time, the Supreme Board of Audit has initiated the reconciliation of the foreign debt held by both banks and the cleaning up of their large suspense accounts. The completion of a comprehensive set of prudential regulations for banks and measures to enable the timely issuance of CBI regulations will help strengthen the regulatory and supervisory framework.

9. Increasing transparency and good governance in the oil sector continues to rank high on the authorities’ agenda, as reaffirmed in the Memorandum of Economic and Financial Policies. In this connection, the Iraqi Committee of Financial Experts will fully take over the tasks of the International Advisory and Monitoring Board as an audit oversight body for the Development Fund for Iraq by year-end. In an effort to enhance transparency and fight corruption in the oil sector, the authorities are committed to joining the Extractive Industries Transparency Initiative. Furthermore, negotiations on a new legal framework to develop a competitive and transparent hydrocarbon sector are ongoing, in view of the large future investment needs in the oil sector.

10. The authorities are committed to further improve the timeliness, coverage, and accuracy of macroeconomic statistics, despite serious capacity constraints. Work to improve the consumer price index (CPI) is progressing, and the completion of the 2007 household survey would enable to update the CPI weights by May 2008. The authorities are also pursuing their efforts to extend the geographical coverage of the CPI to the Northern Region, and to incorporate data from the two CBI branches located in the Kurdistan region into the monetary statistics. The authorities plan to start submitting monetary data for the IMF’s International Financial Statistics in the coming months and are working towards participating in the General Data Dissemination System.

11. The Iraqi authorities will continue their good faith efforts to resolve outstanding external claims, in line with the Paris Club agreement. With most of the Paris Club bilateral agreements signed, they will focus their efforts towards resolving the still outstanding non-Paris Club claims. 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.

Conclusion

12. The Iraqi authorities have demonstrated their commitment to undertaking strong macroeconomic policies and implementing economic reforms under the current SBA. The Fund-supported arrangement has served Iraq well, providing cohesion to the policy framework while anchoring and furthering progress towards macroeconomic stability. The Iraqi authorities are fully committed to the implementation of the new arrangement, although improvement in security conditions remains a prerequisite for their ability to effectively implement their policies. They would like to express their deep appreciation for the Fund’s Executive Board, Management, and Staff, for their continued support under difficult circumstances. They are particularly grateful for the valuable policy advice and technical assistance they are receiving from the staff in support of their stabilization and reform efforts.