Iraq
First Review Under the Stand-By Arrangement and Financing Assurances Review 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:
15 Sep 2008
eISBN:
9781451819168
Language:
English
Keywords:
ISCR; CR; authority; government; Iraq's Stand-By Arrangement; budget; financial management system; government import; State oil; debt forgiveness; oil revenue; CBI bill; Budget planning and preparation
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The First Review under the Stand-By Arrangement (SBA) discusses policies focused on measures to accelerate the reconstruction of the Iraqi economy while maintaining macroeconomic stability. Inflation has slowed down, and monetary and exchange rate policies have been adjusted. The Central Bank of Iraq (CBI) will increase the pace of appreciation of the dinar and keep the policy interest rate positive in real terms to keep inflation under control. Restructuring plans for the two largest state-owned banks will be developed on the basis of their finalized financial and operational audits.

Abstract

The First Review under the Stand-By Arrangement (SBA) discusses policies focused on measures to accelerate the reconstruction of the Iraqi economy while maintaining macroeconomic stability. Inflation has slowed down, and monetary and exchange rate policies have been adjusted. The Central Bank of Iraq (CBI) will increase the pace of appreciation of the dinar and keep the policy interest rate positive in real terms to keep inflation under control. Restructuring plans for the two largest state-owned banks will be developed on the basis of their finalized financial and operational audits.

I. Introduction

1. The current SBA for Iraq was approved in December 2007 in support of the authorities’ economic program for 2008. The main objectives of the program are to maintain macroeconomic stability, facilitate higher investment and growth, and move forward with key structural reforms. The arrangement runs through March 18, 2009.

2. The security situation has improved, but is still precarious and full political reconciliation within the government remains to be achieved. Despite a reduction in violence since early 2007, periodic flare-ups continue to hamper the pace of economic recovery. During March/April 2008, an offensive was launched by Iraqi security forces against the Mahdi Army (loyal to Shia cleric Muqtada Al-Sadr), followed by a campaign against Al-Qaeda in Mosul. In this period, there were also two bomb attacks on southern pipelines, temporarily interrupting oil exports. The various offensives appear to have ended in May. Since April 2007, ministers from the (secular) Iraqi National List, the (Sunni) National Accord Front, and the Al-Sadr block have withdrawn from the government. In mid–July 2008, the National Accord Front rejoined the government.

Figure 1:
Figure 1:

Violence Indicators, June 2003–June 2008

(casualties and oil sector attacks per month)

Citation: IMF Staff Country Reports 2008, 303; 10.5089/9781451819168.002.A001

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

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 comprising a 30 percent debt reduction in NPV terms, went into effect in November 2004 and in December 2005 (following approval of the first SBA), respectively. The final stage will comprise an additional 20 percent debt reduction, and depends on completion by end-December 2008 of the second and last review under the current SBA.

4. The first annual review conference of the International Compact with Iraq (ICI) was held in Stockholm on May 29, 2008. The international community affirmed its support for Iraq’s political, security, and economic reform program. The Fund’s main contribution to the ICI consists of the medium-term macroeconomic policy framework of the SBA-supported program.

II. Recent Economic Developments

5. Economic activity remained subdued in 2007 but growth prospects have improved in 2008, underpinned by increasing oil production and exports. Real GDP growth is estimated to have been only about 1½ percent in 2007, reflecting a decline in agricultural and industrial production. However, crude oil exports began to pick up in the second half of the year, benefiting from better security and improved maintenance, and the resumption of exports through the northern pipeline to Turkey. In January–May 2008, crude oil production averaged 2.3 million barrels per day (mbpd), compared to just above 2.0 mbpd in 2007. There are also indications of a pick-up in non-oil activity in the latter part of 2007 and in early 2008, except for agriculture which is being hit by drought.

6. Inflation was brought down to 5 percent during 2007, from 65 percent at end-2006. The overall consumer price level in June fell by some 6 percent relative to a year earlier, reflecting better availability of fuel products and lower black-market fuel prices. Core inflation (excluding fuel and transportation costs) remained at about 12½ percent in June, year-on-year, in part because of increasing food prices.1

7. Higher oil revenues and below-budget investment spending resulted in an overall budget surplus of 13½ percent of GDP in 2007 (the program projected a surplus of 1.5 percent of GDP). The balance of the Development Fund for Iraq (DFI) grew to $12.6 billion at end-2007. In the first six months of 2008, higher oil exports increased the balance of the DFI by a further $4.6 billion. There are indications that the measures to improve investment execution have begun to bear fruit.

8. Monetary and exchange rate policies have been adjusted in response to the slowdown in inflation. The policy interest rate was reduced in three steps from 20 percent at end-2007 to 16 percent as of July 1, 2008, but remained positive in real terms (defined as the policy rate minus core inflation). The appreciation of the dinar has slowed from about ½ percent per month in the second half of 2007, to about ¼ percent per month during January–June 2008. The appreciation helped to bring inflation down and to reduce cash dollarization. The real demand for dinar currency in circulation expanded by 23 percent in 2007. Gross international reserves increased to $38.3 billion at end-April 2008, equivalent to about 10 months of imports of goods and services.

Figure 2.
Figure 2.

Iraq: Output and Inflation

Citation: IMF Staff Country Reports 2008, 303; 10.5089/9781451819168.002.A001

Source: Iraqi authorities and Fund staff calculations.
Figure 3.
Figure 3.

Iraq: External and Fiscal Indicators

Citation: IMF Staff Country Reports 2008, 303; 10.5089/9781451819168.002.A001

Source: Iraqi authorities and Fund staff calculations.

9. Iraq has continued to make progress toward resolving outstanding external claims (Box 1). The authorities are continuing their efforts to restructure Iraq’s debt with non-Paris Club creditors. The United Arab Emirates has announced the full cancellation of its claims against Iraq in early July. Also, good faith efforts are underway to reach agreement with the remaining commercial creditors on terms comparable with the 2004 Paris Club debt agreement.

10. Progress has been made in structural reforms. The amendments to the pension law have been enacted and the external audits of the CBI net international reserves data at end–2007 and of the CBI 2007 financial statement have been completed as planned. Progress has also been made in modernizing the government’s financial management system, banking reform, and in strengthening the statistical database, but with respect to the implementation of the recommendations of the IMF’s safeguards assessment report (SAR) the results are mixed. While the external audits of the CBI’s 2007 financial statements and of its net international reserves at end-2007 were completed on time and steps have been taken to improve the reconciliation of local banks’ current accounts, progress in some other areas has been slow.

III. Policy Discussions

11. The discussions on the first review focused on measures to accelerate the reconstruction of the Iraqi economy while maintaining macroeconomic stability. The authorities and staff agreed that the reduced level of violence and long-awaited expansion of oil production/exports, together with the surge in world market oil prices, have created a window of opportunity. At the same time, spending pressures are mounting with the much higher Iraqi oil export prices projected for 2008 than the budget/program reference price ($98 per barrel compared to $57 per barrel), and the resulting stronger fiscal and external positions. The discussions focused on the supplementary budget for 2008 that the government was preparing, the appropriate monetary and exchange rate policy stance, and on implementation of the authorities’ structural reform agenda.

12. The authorities remain strongly committed to the program supported by the SBA. The attached Supplementary Memorandum of Economic and Financial Policies (SMEFP) outlines their plans for the remainder of the program period.

A. Macroeconomic Outlook and Risks

13. Real GDP growth is projected to increase to 9 percent in 2008, driven by the ongoing expansion of oil output. Provided the recent reduction in violence takes hold, crude oil production is expected to reach on average at least 2.3 mbpd and exports 1.8 mbpd, both higher than projected at the outset of the program. Although agricultural output in 2008 is likely to be affected by drought, other non-oil economic activities are expected to recover. The annual inflation objective has been increased to 14 percent, slightly above the original program target, to take into account the pass-through of higher international food prices. Assuming no further declines in black-market fuel prices, the gap between headline and core would likely be reduced.

Recent Developments in Iraq’s Debt Restructuring Process

Iraq has made important progress to resolve its outstanding external debt, and has already benefited from substantial debt reduction from official and private creditors.

Bilateral agreements with all of Iraq’s 18 Paris Club creditors have been signed.1/ The latest agreement was signed with Russia on February 11, 2008 and granted a debt reduction of 60 percent as of end-2005 on a reduced stock of debt of $4.5 billion.

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Source: Iraqi Authorities and IMF staff estimatesNote: Amounts do not include capitalized interests as in the DSA tables.
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Source: Iraqi Authorities and IMF staff estimates

The cash settlement involves a payment of $614 million in 2008.

Estimated debt reduction following Paris Club terms (two stages, each of 30 percent NPV debt reduction).

Iraq has signed agreements to reschedule debt with 11 non-Paris Club creditors on terms comparable to those of the Paris Club. 2/ The latest agreement was signed with the countries of the former Yugoslavia on January 21, 2008. Negotiations are under way with 11 other non-Paris Club creditor countries, representing an estimated stock of debt of about $16 billion. A memorandum of understanding has been signed with China (debt stock estimated at $8.5 billion). On July 7, 2008 the United Arab Emirates has announced the full cancellation of Iraq’s debt; debt negotiations with other Gulf countries remain ongoing.

Iraq has resolved the bulk of private creditor claims. Outstanding claims from the previous debt and cash restructuring exchanges constitute only about 4 percent of total original private claims. On January 30, 2008 Iraq reopened its commercial debt-restructuring program. The offer seems to have been successful and final results are expected to be published shortly. On April 3, 2008, the British High Court sanctioned the liquidation plan for the London branch of Rafidain Bank, clearing the path for the settlement of the related outstanding commercial claims.

1/ Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Italy, Japan, Netherlands, Republic of Korea, Russian Federation, Spain, Sweden, Switzerland, United Kingdom, and the United States.2/ Bulgaria, Cyprus, Czech Republic, Hungary, Indonesia, Malaysia, Malta, Slovak Republic, South Africa, Romania, and the former Yugoslavia.

14. The economic outlook remains subject to considerable risks. A reversal of the still fragile security gains and/or political instability could hamper economic growth, add to inflationary pressures, and obstruct timely implementation of the structural reform agenda.

B. Fiscal Policy and Related Measures

15. A sizable increase in wages and allowances for the civil service was signed into law in early May 2008 (SMEFP, ¶12). The salary increase, which was not envisaged under the program, would expand the civil service wage bill by some 57 percent compared to the original budget and add roughly 9 percent of non-oil GDP to consumption demand. Staff agreed with the authorities that a wage increase is justified in light of the significant decline in (average) real wages during 2005–07, when consumer prices almost tripled. However, in order to limit the impact of the salary increase on inflation, and taking into account the considerable import content of private consumption, the government has decided to phase in the salary increase gradually by limiting the effective salary increase in 2008 to 40 percent; the remainder will be paid in 2009. 2

Iraq: Wages and Employment, 2004-08

(In billion Iraqi dinar unless otherwise indicated)

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Evaluated at mid-year employment level. The average wage index is, to some extent, biased downwards as new hirings most likely took place at lower grade levels.

16. The draft supplementary budget for 2008, which is expected to be passed by the Council of Representatives in August, provides for significant increases in current and capital spending, while preserving a sustainable fiscal stance overall (SMEFP, ¶13). In light of the improved security and much higher-than-expected oil revenues, the supplementary budget enables the government to step up investment, partly repair the severe real wage erosion, and accommodate the impact of higher world food prices and war reparations to Kuwait. The inflationary impact of the fiscal impulse is expected to be modest in view of the high import content of the additional outlays. About half of the total expenditure increase provided for in the supplementary budget is allocated to higher public investment in priority sectors, including in the oil sector and at the provincial level. The main increases in current spending, in addition to the civil service wage hike, are for security; the in-kind Public Distribution System (PDS; food imports); transfers to the electricity sector (fuel imports) and public enterprises (wage increase); and war reparations to Kuwait (due to higher oil revenues). To prepare a reform of the PDS as of early 2009, the authorities intend to request technical assistance from the Fund and the World Bank.

17. On this basis, and taking account of the higher oil revenues, an overall budget surplus of about 2¾ percent of GDP is projected for 2008 (versus a programmed deficit of 8½ percent). As a result, the balance of the DFI would increase to almost $16.5 billion by end-2008 (the program target is $5.1 billion).

18. The government increased the official retail prices of jet fuel and LPG in June and July 2008, respectively, and plans to adjust gasoline and diesel prices in early 2009. There are no direct subsidies on fuel products, except for a small subsidy on imported kerosene. However, due to higher international oil prices, the indirect subsidy on fuel products resulting from underpricing of crude oil used for domestic consumption is projected to increase to 6½ percent of GDP in 2008, from 5 percent in 2007. The authorities agreed that the surge in world fuel prices necessitates a further adjustment of domestic prices, but preferred to wait until after the provincial elections due later this year. The authorities remain committed to develop, in consultation with the Fund, an automatic fuel price adjustment mechanism that can be implemented early next year.

Figure 4:
Figure 4:

Official Fuel Prices in Iraq, 2004–08

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

Citation: IMF Staff Country Reports 2008, 303; 10.5089/9781451819168.002.A001

Sources: Iraqi authorities and Fund staff calculations.

19. Iraq is actively engaging with the Fund, the World Bank, and other international partners to improve public financial management (PFM; SMEFP, ¶15). Recent Fund technical assistance has focused on the areas of budget execution, cash management, commitment control, the accounting framework, and fiscal reporting. The authorities are working with the World Bank on a new capacity building project covering budget preparation, public procurement, and fiscal reporting. Progress is also being made, in cooperation with USAID, to install the Iraq Financial Management Information System (IFMIS) before year-end. Efforts are underway, in consultation with the Fund and the World Bank, to adopt a comprehensive PFM action plan. To enhance the transparency of the budget implementation process, the final fiscal accounts for 2005 have been and those for 2006 are being audited by the Board of Supreme Audit (BSA); the Ministry of Finance will submit soon the final accounts of the Federal Budget for 2007 to the BSA. The census of public service employees is underway, but its completion is delayed to end-September due to technical and security-related problems and difficulties with data collection (SMEFP, ¶16).

C. Monetary and Exchange Rate Policy

20. The CBI recognizes that the planned fiscal expansion poses a challenge to keep inflation under control and requires a tightening of its policy stance (SMEFP, ¶17). The upcoming wage increase and the government’s efforts to increase investment spending will intensify price pressures, despite the high import content of both consumption and investment spending. In response, the CBI will increase the pace of appreciation of the dinar to ½ percent per month during the second half of 2008. This would be consistent with a more appreciated equilibrium real exchange rate than was expected at the time the program was approved, as a result of the continued improvement in Iraq’s terms of trade since end-2007 and the expansion of domestic demand. The CBI also agreed to keep the policy interest rate positive in real terms to signal its commitment to fight inflation.

Figure 5:
Figure 5:

Real and Nominal Exchange Rates, January 2004-March 2008

(Index, Jan 2004=100)

Citation: IMF Staff Country Reports 2008, 303; 10.5089/9781451819168.002.A001

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

21. The authorities are committed to implementing the recommendations of the IMF SAR that was finalized in March 2008 (SMEFP, ¶18). The external audit of the CBI net international reserves at December 31, 2007 and the external audit of the CBI 2007 financial statements have been completed as planned, despite the fire that largely destroyed the CBI headquarters in January. Progress has been made with strengthening the accounting and reporting framework of the CBI with better and more frequent reconciliation of accounts, except for the accounts of the two CBI branches in the Kurdish region. Work is underway, with technical assistance from the Fund, towards adoption of new reserves management guidelines. Finally, the authorities remain committed to maintaining a liberal exchange system (SMEFP, ¶19).

D. Other Structural Issues

22. The authorities are continuing their efforts to improve governance, especially in the oil sector (SMEFP, ¶20). Progress is being made with oil-metering. Iraq has joined the Extractive Industries Transparency Initiative (EITI) and the authorities have begun to publish oil export data on the Internet on a monthly basis. Discussions on a new legislative framework for the hydrocarbon sector are continuing.

23. Commercial bank restructuring has progressed in close collaboration with the Fund and the World Bank (SMEFP, ¶21). The financial and operational audits of Rasheed and Rafidain banks based on their 2006 financial accounts have been completed despite the insecurity and curfews that limited on-site visits. Although the audits were affected by the loss of information on branch loans and credit files during the war and by limited access to documentation from branches outside Baghdad, the reports provide a good basis for developing restructuring plans for both banks. The CBI has set up a task force to develop a comprehensive set of prudential regulations for commercial banks, for which the Fund has been providing technical assistance. Almost half of the regulations have been prepared—including key regulations on licensing, capital adequacy, credit risk, large exposures, and liquidity—while the remaining regulations are expected to be completed soon (SMEFP, ¶22).

24. The government intends to rehabilitate the electricity sector. The supplementary budget for 2008 provides ID 1,439 billion to cover for unpaid electricity supplies via a netting out operation between the electricity sector, oil companies, and the ministry of finance. The reform plan envisages increasing the supply of electricity, followed by measures to improve payment collection and gradual increases in tariffs toward cost recovery levels.

25. Progress continues to be made in addressing the weaknesses in Iraq’s statistical database (SMEFP, ¶24). The compilation of national accounts data has improved, with technical assistance from the Fund, and the publication of monetary and balance of payments statistics in the IMF’s International Financial Statistics started in March and July 2008, respectively. The 2007 household expenditure survey was completed and on this basis new weights are being incorporated in the CPI. The updated CPI will be published soon, after completion of a robustness test.

IV. Program Monitoring and Financing Assurances

26. Iraq has met all quantitative performance criteria set for end-March 2008, except for the one on government imports of petroleum products, and all structural performance criteria were met as well. Government imports of petroleum products exceeded the program ceiling by a small margin due to higher-than-expected import prices for kerosene. Staff will inform the IMF Executive Board on compliance with end-June quantitative performance criteria and the end-July structural benchmarks before Board consideration of the first review.

27. The program will continue to be monitored through quarterly quantitative performance criteria and indicative targets, and structural benchmarks. Additional quantitative performance criteria have been set for end-September and end-December 2008, as specified in Table 8. A financing assurances review will be undertaken before the last scheduled disbursement date if any arrears on Iraq’s debt remain at that time. A prior action for completing the first review has also been set (Table 9).

Table 1.

Iraq: Selected Economic and Financial Indicators, 2005–09

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Sources: Iraqi authorities and Fund staff estimates and projections.

2008 at end-June.

Reserve money growth in 2007 reflects the impact of the increase in the required reserves ratio on government deposits from 25 percent to 75 percent per September 2007.

2008 as of July 1.

Table 2.

Iraq: Fiscal and Oil Sector Accounts, 2005–09

(In billions of ID; unless otherwise indicated)

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

For 2008 and 2009, includes $3.125 and $0.625 billion mobile operator license fees, respectively.

The 2008 wage bill includes an allocation of ID216 billion for salaries of provincial councils and personnel contingent upon the enactment of the draft Provinces Law.

Include goods and services financed by donors, including overhead costs for reconstruction projects.

Includes security spending associated with the implementation of reconstruction projects.

2008 data excludes an amount of ID1,436 billion included in the Supplementary Budget to settle arrears of the electricity sector to the state-owned oil companies; this cross-settlement is expected to have no net impact on the budget.

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 the 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.

Table 3.

Iraq: Fiscal and Oil Sector Accounts, 2005–09

(In percent of GDP)

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Sources: Iraqi authorities and Fund staff estimates and projections.

For 2008 and 2009, includes $3.125 and $0.625 billion mobile operator license fees, respectively.

The 2008 wage bill includes an allocation of ID216 billion for salaries of provincial councils and personnel contingent upon the enactment of the draft Provinces Law.

Include goods and services financed by donors, including overhead costs for reconstruction projects.

Includes security spending associated with the implementation of reconstruction projects.

2008 data excludes an amount of ID1,436 billion included in the Supplementary Budget to settle arrears of the electricity sector to the state-owned oil companies; this cross-settlement is expected to have no net impact on the budget.

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 the 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.

Table 4.

Iraq: Central Bank Balance Sheet 2005–09

(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.

This mainly represents the ID and US$ overnight standing deposit facilities and CBI bills.

Reserve money growth in 2007 reflects the impact of the increase in the required reserves ratio on government deposits from 25 percent to 75 percent per September 2007.

Table 5.

Iraq: Summary Balance Sheet of Deposit Money Banks, 2005–09

(In billions of Iraqi dinars, unless otherwise indicated)

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Sources: Iraqi Authorities and Fund staff estimates.