Background

1. Notwithstanding the vastly improved but still difficult security and political conditions that prevailed in the first months of 2008, the authorities have made significant progress in implementing their economic program under the Fund-supported Stand-By Arrangement (SBA). Oil production and exports have considerably increased compared to previous years and to program projections, strongly enhancing growth prospects. Moreover, the execution rate of the investment budget has improved in the first quarter of 2008, as a result of measures to speed-up implementation of projects. The authorities have also succeeded in bringing down inflation dramatically from 65 percent at end–2006 to about 12 percent at the present time, 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 severe capacity constraints, the authorities have advanced their structural agenda in several key areas, including the pension law, the audits of the Central Bank of Iraq (CBI), the government’s financial management system, the banking reform, and the statistical database. They also continued to make best efforts to reach bilateral agreements on arrears to official non-Paris Club creditors and have been negotiating in good faith to resolve the remaining arrears to private creditors.

Economic Policies and Reforms for the Remainder of 2008

2. The authorities see the improvement in security conditions and the related recovery of oil production and exports, which have resulted in strong fiscal and external positions, as a window of opportunity to move toward a path of high and sustainable growth, in the context of continued macroeconomic stability.

3. The authorities’ fiscal strategy aims at rebuilding Iraq’s economy and institutions, restoring adequate public services, and enhancing the standard of living of the population, while maintaining fiscal sustainability. Higher oil revenues and below-budget investment spending resulted in a budget surplus of 13 ½ percent of GDP in 2007 (versus 1 ½ percent projected in the program). Against this background, and to respond to pressing social and infrastructural needs, the authorities have prepared a supplementary budget providing for higher public investment in key sectors and additional current spending in priority areas. The latter includes notably an expansion in civil service wages and allowances to compensate for the significant decline in average real wages during 2005–07. The authorities concur with staff that the overall domestic demand impact of the revised 2008 budget will be manageable, especially that they have decided to implement the salary increase gradually in order to limit the potential adverse effects on inflation.

4. The government increased the official retail prices of jet fuel and LPG in June and July 2008, respectively, and plan to adjust gasoline and diesel prices early next year. There are presently virtually no direct subsidies on fuel products. Nonetheless, the authorities remain committed to develop, in consultation with the Fund, an automatic fuel price adjustment mechanism to help reduce the still sizable indirect fuel subsidies.

5. Considerable effort is being devoted to advancing fiscal reforms. The authorities have launched an ambitious program to modernize public financial management. They are also making progress in putting in place the renewed Iraq Financial Management Information System, which is expected to be fully operational starting with the 2009 budget. Notwithstanding the progress made with the data collection for the census of public service employees, completion of the project was delayed until end-September, due to technical and security-related impediments and the high labor-intensity of the work. The authorities plan on adopting an action plan to eliminate ghost workers and computerize the payroll before year-end, as a first step for a comprehensive civil service reform. Rationalizing the Public Distribution System, with technical assistance from the Fund and the World Bank, also ranks high on the authorities’ agenda.

6. The CBI is fully aware of the challenges to monetary policy that could result from an expansionary fiscal stance, notwithstanding the high import content of both consumption and investment spending. It intends to increase the rate of appreciation of the dinar to about ½ percent per month during the second half of the year, and to keep the policy interest rate positive in real terms to signal its firm commitment to containing inflation.

7. The CBI remains committed to implementing the recommendations of the IMF safeguards assessment report. 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 of this year. Progress has been made with strengthening the accounting and reporting framework of the CBI and work is underway, with technical assistance from the Fund, towards adoption of new reserves management guidelines.

8. Other structural issues. Increased transparency and good governance in the oil sector continue to rank high on the authorities’ agenda. In this connection, the Iraqi Committee of Financial Experts will fully take over the responsibilities of the International Advisory and Monitoring Board as the audit and oversight body for the Development Fund for Iraq by year-end. Furthermore, important progress has been achieved in installing and operationalizing oil-metering systems. In an effort to enhance transparency and fight corruption in the oil sector, the authorities have also joined the Extractive Industries Transparency Initiative. Finally, discussions on a new legislative framework for the hydrocarbon sector are ongoing.

9. Important steps continue to be taken towards the restructuring of the two largest state-owned banks, in close collaboration with the Fund and the World Bank. The financial and operational audits of the Rasheed and Rafidain banks have been completed, providing a good basis for developing restructuring plans for both banks. At the same time, the CBI has set up a task force to develop a comprehensive set of prudential regulations for commercial banks. Key regulations on licensing, capital adequacy, credit risk, and large exposures have been completed.

Performance Under the SBA and Financing Assurances

10. As is clear from the staff report, the Iraqi authorities have demonstrated a strong commitment to undertaking significant macroeconomic policies and structural reforms, which has enabled them to meet various quantitative and structural criteria under the program, except for the performance criterion on the government wage and pension bill. They also continue to make best efforts to reach bilateral agreements on arrears to official non-Paris Club creditors and have been negotiating in good faith to resolve the remaining arrears to private creditors, consistent with the Fund’s policy on lending into arrears. Against this background, the authorities request a waiver for the non-observance of the performance criterion on the government wage and pension bill, the completion of the first review under the SBA, the establishment of performance criteria for end-September and end-December 2008, and the completion of the financing assurances review. The Iraqi authorities remain fully committed to thxe objectives of the arrangement, which provides cohesion to their policy framework while anchoring progress towards macroeconomic stability and structural reforms.

11. The Iraqi authorities are grateful for the valuable policy advice and technical assistance they are receiving from staff in support of their stabilization and reform efforts, as well as for the continued support provided by the Fund and its membership.