Iraq
Second 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:
29 Dec 2008
eISBN:
9781451819175
Language:
English
Keywords:
ISCR; CR; price; authority; world oil price; Fund.; core inflation; food price inflation; debt forgiveness; public finance; reconstruction expenditure; Oil prices; Oil exports; cash settlement
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The second review under Stand-By Arrangement and the financing assurances review highlight Iraq’s economic activity and robust growth. The authorities continue to see the improvement in security conditions, and the related recovery of oil and non-oil activity, as a window of opportunity to move toward a path of high and sustainable growth, in the context of continued macroeconomic stability. The Central Bank of Iraq (CBI) is committed to maintaining its tight monetary stance, including through its exchange rate policy.

Abstract

The second review under Stand-By Arrangement and the financing assurances review highlight Iraq’s economic activity and robust growth. The authorities continue to see the improvement in security conditions, and the related recovery of oil and non-oil activity, as a window of opportunity to move toward a path of high and sustainable growth, in the context of continued macroeconomic stability. The Central Bank of Iraq (CBI) is committed to maintaining its tight monetary stance, including through its exchange rate policy.

I. Introduction

1. This is the second and final review under Iraq’s second Stand-by Arrangement (SBA). The (precautionary) arrangement expires on March 18, 2009, at which point Iraq will have completed over three years of programs continuously supported by upper credit tranche arrangements with the Fund. Iraq’s first SBA was approved on December 23, 2005, and was extended twice before being cancelled just prior to approval of the present arrangement on December 19, 2007. Completion of this review (by end-December 2008) will trigger the third and final stage of Iraq’s Paris Club debt reduction agreement, for a total debt reduction of 80 percent (in net present value (NPV) terms).1

II. Recent Economic and Political Developments

2. The security situation in Iraq continues to improve and some progress has been made toward political reconciliation. The rejoining of the Cabinet by ministers belonging to Sunni and other political parties in July 2008 has strengthened the position of the government. The provincial elections law was enacted on October 3, allowing the elections to be held in early 2009. A draft agreement on the future status of foreign forces in Iraq has been approved by the Council of Representatives (CoR), ahead of the expiration of the United Nations mandate on December 31, 2008. The turnaround in the security situation achieved in 2007 has been sustained. Indicators of violence show an improving trend in 2008 despite intermittent flare-ups.

Figure 1:
Figure 1:

Violence Indicators, June 2003–September 2008

(casualties and oil sector attacks per month)

Citation: IMF Staff Country Reports 2008, 383; 10.5089/9781451819175.002.A001

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

3. Economic activity has picked up in 2008, underpinned by improving security. Following the reopening of the northern pipeline to Turkey, crude oil production in the first eight months of 2008 rose to 2.3 million barrels per day (mbpd), compared with 1.9 mbpd in the same period of 2007. Oil exports in the first nine months of 2008 were running slightly ahead of the target average for the year of 1.8 mbpd. Preliminary indications, including from the industrial production index, are that non-oil activity also picked up, albeit from a low base. On this basis, real GDP growth is expected to increase to almost 10 percent in 2008 from 1½ percent in 2007.

4. Inflation has been subdued thus far in 2008. Annual consumer price inflation in October was 7½ percent, reflecting declining black-market fuel prices. Core inflation (which excludes fuel and transportation costs) has remained somewhat higher (running at about 13½ percent in the year to October), in part because food price inflation has not yet come down. The 2008 civil service salary increase that came into effect in June has had a limited impact on inflation thus far because of the high import content of consumption spending.2 Inflation for the year as a whole is likely to remain somewhat below the target of 14 percent.

5. The fiscal balance through July 2008 was in surplus, mainly on account of larger-than-expected oil revenues, reflecting both higher export prices and volumes. While still below budget, capital expenditures during the first seven months of 2008 were twice the level recorded for the same period in 2007. The balance in the Development Fund for Iraq (DFI) increased from $12.6 billion at end-2007 to $23.5 billion at end-September 2008, and government deposits in the banking system rose by ID 4½ trillion to ID 18 trillion over the same period. Notwithstanding the recent drop in world oil prices and the increased spending in the supplementary budget for 2008, an overall budget surplus of close to 8 percent of GDP is projected for 2008.

6. Exchange rate policy was adjusted in anticipation of price pressures resulting from the fiscal expansion in 2008. During July–October 2008, the appreciation of the dinar increased to ½ percent per month from ¼ percent per month during the first half of the year. The dinar has appreciated by 20 percent since November 2006, when the CBI started to appreciate the currency to counter dollarization and reduce inflation. Gross international reserves of the CBI increased from $31.5 billion at end-2007 to $44.3 billion at end-September 2008. In light of the subdued price pressures in 2008, the CBI reduced its policy interest rate from 16 percent to 15 percent as of November 3.

Figure 2.
Figure 2.

Iraq: Output and Inflation

Citation: IMF Staff Country Reports 2008, 383; 10.5089/9781451819175.002.A001

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

Iraq: External and Fiscal Indicators

Citation: IMF Staff Country Reports 2008, 383; 10.5089/9781451819175.002.A001

Source: Iraqi authorities; and Fund staff calculations.

7. Iraq has continued to make progress toward resolving outstanding external claims. As at end-October 2008, bilateral debt arrangements with eleven non-Paris Club official creditors had been signed on terms comparable to the Paris Club agreement, restructuring a debt stock of $9.4 billion. Negotiations with Greece, Morocco, Tunisia, and the United Arab Emirates have been concluded, and debt agreements are expected to be signed in the near future; this would bring the resolved share of total non-Paris Club debt (excluding the other Gulf countries) to 46 percent of the initial debt by value. Debt negotiations continue with several other non-Paris Club official creditors, including China and some Gulf countries. In August 2008, a cash settlement was completed with private creditors on terms comparable to the 2004 Paris Club agreement, resulting in a cash payment of $48.3 million and the cancellation of $470 million of outstanding commercial debt.

8. Some progress was made in structural reforms. The CBI Board approved the new reserves management guidelines, the final fiscal accounts for 2007 have been submitted to the Board of Supreme Audit (BSA), and an action plan for modernizing the government’s public financial management system was adopted in November. Some progress was also made in banking reform, but the census of public service employees is still not completed.

III. Policy Discussions

9. The discussions focused on 2009 budget in the context of lower oil prices and revenues, on the conduct of monetary policy, and on the outstanding structural reform agenda. With the average Iraqi oil export price at $95.4 per barrel in the first half of 2008, spending pressures mounted and a supplementary budget was passed that provided for significant increases in current and capital spending. The steep decline in oil prices beginning in September has worsened Iraq’s external outlook for the period ahead. The draft 2009 budget is based on an oil export price of $62.5 per barrel, a third lower than the average price expected for 2008.3 The authorities and staff agreed that the 2009 draft budget needs to allow for adequate security and investment spending, while limiting other current spending to preserve fiscal sustainability. The discussions also covered the authorities’ plans regarding adjustment of official fuel prices next year, the appropriate monetary and exchange rate policy stance, and the implementation of the structural reform agenda.

10. The authorities remain strongly committed to the program supported by the SBA. The attached second Supplementary Memorandum of Economic and Financial Policies (SMEFP-2) outlines their plans for the remainder of the program period through March 2009.

A. Macroeconomic Outlook and Risks

11. The direct impact of the global financial crisis on Iraq has been limited but the decline in oil prices prompted by the global slowdown has adverse implications for Iraq’s budget and balance of payments. Financial spillovers are small because private capital flows and foreign direct investment are low, and Iraq’s banking sector is relatively underdeveloped and primarily focused on the domestic market.

12. Real GDP growth is projected to continue at about 7½ percent in 2009, provided the reduction in violence is sustained. Oil production and exports are projected to increase to 2.5 mbpd and 2.0 mbpd, respectively, and the non-oil sector is expected to further recover as improved security would allow private commerce to expand. Assuming no further declines in black-market fuel prices, the gap between headline and core inflation would likely be reduced; annual inflation is targeted to be contained at 10 percent in 2009. The external current account surplus of 15 percent of GDP in 2008 is projected to disappear in 2009, mainly due to lower oil export revenues. From 2010 onwards, the current account balance is projected to improve again, assuming a continuing rise in oil export volumes and a gradual recovery in oil prices over the medium term.

13. The economic outlook remains subject to considerable risks. A reversal of the still fragile security gains and a resumption of political instability could lower economic growth, add to inflationary pressures, and hamper the timely implementation of the structural reform agenda. A slowing world economy could further depress international oil prices, which would pose a major risk for public finances and the balance of payments.4 Iraq’s external debt situation remains vulnerable to oil shocks, even after the completion of the debt reduction (Appendix).

B. Fiscal Policy and Related Measures

14. The draft 2009 budget provides for an increase in security and capital spending, while strictly containing other current outlays to preserve fiscal sustainability (SMEFP-2, ¶¶ 9 and 10). The draft budget was approved by Cabinet on November 10, 2008. Faced with declining oil revenues, the government significantly reduced its initial spending plans (by 14 percent of GDP) by cutting current spending and bringing investment in line with implementation capacity. Oil revenues are expected to be about a quarter lower than the projected outturn in 2008. The carry-over from the 2008 civil service salary increase will be fully funded but there will be no additional wage increases and zero net hiring of nonsecurity personnel. As a first step to reform the costly and untargeted in-kind Public Distribution System, eligibility of better-off families will be restricted as of mid-2009. Transfers to public enterprises will be contained and include transfers to the electricity sector (fuel imports) and a limited wage increase. Investment spending, including in the oil sector and at the provincial level, will be increased compared to the expected 2008 outturn, but the practice of carrying over unspent investment allocations from previous years will be ended.

15. On this basis, an overall fiscal deficit of about 17 percent of GDP is projected for 2009, which under current policies would turn into a surplus by 2012. The swing in the fiscal balance between 2008 and 2009 is mostly due to the fall in oil revenues and, with expenditures only rising moderately, is unlikely to be inflationary. The deficit will be financed by drawing down part of the balance in the DFI and by using some of the bank deposits accumulated during 2006–08. In the event that oil export revenues are substantially lower than budgeted and fiscal sustainability is at risk, the authorities have stated their readiness to prepare a supplementary budget to reduce government spending.

16. The authorities will consider adjusting official fuel prices after the provincial elections early next year (SMEFP-2, ¶11). Although official retail prices of jet fuel and LPG were increased in mid-2008, the total indirect subsidy on fuel products resulting from underpricing of crude oil used for domestic consumption is projected to increase by ½ percent to 6.3 percent of GDP in 2008 (Box 1). While recognizing that the indirect fuel subsidy remains high, the authorities were hesitant to increase domestic fuel prices now as world oil prices are falling and the indirect subsidy is projected to decline again to about 4 percent of GDP in 2009. They agreed to continue working on developing a periodic adjustment mechanism for fuel prices based on the recommendations of a recent Fund technical assistance mission.

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, 383; 10.5089/9781451819175.002.A001

Sources: Iraqi authorities and Fund staff calculations.

C. Monetary and Exchange Rate Policies

17. The CBI will continue to manage the exchange rate and maintain its tight monetary policy stance with a view to keeping inflation under control (SMEFP-2, ¶15). The fiscal adjustment planned for 2009 should alleviate the burden on the central bank in this regard. In the absence of an effective monetary transmission mechanism, given the weak state of the banking system, the exchange rate remains the CBI’s main policy instrument. It was agreed that the CBI will continue to gradually appreciate the exchange rate of the dinar in the coming months. Once core inflation has come down to near single digit levels, the CBI should return to its previous policy of maintaining a stable exchange rate. The CBI also agreed to keep its policy interest rate positive in real terms (as measured against core inflation), in order to signal its continued commitment to fighting inflation.

Pricing of Fuel Products in Iraq

Prices of domestic fuel products in Iraq have been raised significantly since 2005, but pass-through remains limited. While direct budgetary subsidies were eliminated in 2007 (except for a small subsidy on kerosene which will be abolished in 2009), indirect subsidies remained sizable at almost 6 percent of GDP as domestic refineries receive crude oil for a fraction of the export price (currently $2 per barrel). Indirect fuel subsidies are expected to increase by ½ percent of GDP in 2008, reflecting the significant increase in world market prices in the first part of the year. The indirect fuel subsidies are expected to fall in 2009 because of falling world oil prices.

Iraq: Domestic Fuel Prices

(In U.S. dollars per liter/per cylinder for LPG, end of period)

article image

Q2 prices reported. LPG price was raised on July 1, which is the price reported.

Average import prices for the period January-July, 2008.

uA01fig01

Iraq: Indirect Fuel Subsidies

(as a percent of GDP)

Citation: IMF Staff Country Reports 2008, 383; 10.5089/9781451819175.002.A001

To preserve the cost recovery gains made in 2005–07, the government intends to develop a periodic price adjustment mechanism for fuel prices based on changes in domestic production costs and import costs. To assist the authorities in this undertaking, FAD conducted a seminar on petroleum product prices and sector financial flows in Beirut during August 10–14, 2008.1 Key recommendations of the seminar included to:

  • Gradually move toward export parity pricing whereby domestic fuel prices are based on a pre-determined fraction of the Iraqi export price of crude oil plus a margin for refining and distribution costs;

  • Implement price adjustments on a quarterly or semi-annual basis to avoid large price jumps and discourage hoarding; and

  • Smooth price changes by basing adjustments on a moving average of production and import costs.

1/ The seminar was originally scheduled for May but had to be postponed for security reasons.
Figure 5.
Figure 5.

Real and Nominal Exchange Rates, January 2004–September 2008

(Index, Jan 2004=100)

Citation: IMF Staff Country Reports 2008, 383; 10.5089/9781451819175.002.A001

Sources: Iraqi authorities; and Fund staff calculations.1/ Increase denotes appreciation.

18. Some progress has been made in the implementation of outstanding safeguards measures (SMEFP-2, ¶16). An independent audit committee, including one external expert, has been set up to make recommendations regarding external and internal audit oversight, financial reporting, and controls consistent with the requirements of the central bank law. The CBI has started implementing the new reserves management guidelines that were adopted in early August. Finally, the CBI will appoint an international external auditor before year-end to conduct the audit of the CBI 2008 financial statements.

19. Iraq is making progress to accept the obligations of Article VIII, Sections 2(a), 3, and 4, of the Fund’s Articles of Agreement (SMEFP-2, ¶17). The staff’s review of exchange laws and regulations has almost been completed, and the authorities intend to implement staff’s recommendations in this area to complete the process.

D. Public Finance Reform

20. The authorities continue to give high priority to improving public financial management. The government has adopted an action plan for modernizing its financial management system (Box 2 and SMEFP-2, ¶13), with the assistance of the Fund and the World Bank. The action plan includes a timetable for priority reforms in this area and specifies technical assistance needs.

21. Progress is also being made in other public finance-related areas:

  • While completion of the census of public service employees has been delayed due to technical problems, 25 percent of the data collection was completed by end-October, and half of this work is expected to be achieved by end-November (SMEFP-2, ¶14). The census is now expected to be completed by end-January 2009;

  • The 2005 final fiscal accounts have been audited by the BSA, and the audits of the 2006 and 2007 final accounts are underway (SMEFP-2, ¶13);

  • The Committee of Financial Experts (COFE) has published on its website the audit report covering DFI operations in the first half of 2008 (SMEFP-2, ¶18). The COFE has also presented its first semi-annual report to the Council of Ministers.5

  • Some progress was made in developing a medium-term tax reform strategy. A draft law on import tariffs has been prepared that will be reviewed by the Fund and envisages establishing a transparent and efficient system of tariffs with fewer exemptions (SMEFP-2, ¶12). Efforts to develop a sales tax (as precursor for a VAT) and to reduce the number of brackets for the personal income tax are also underway.

Public Financial Management Reform

The Iraqi authorities have actively engaged with the Fund, the World Bank, and other international partners in recent years with a view to modernizing public financial management (PFM). A new budget classification based on the IMF Government Finance Statistics Manual (GFSM) 2001, within a cash accounting framework, was adopted in 2007. Progress is also being made, in cooperation with USAID, on the Iraq Financial Management Information System (IFMIS), which is expected to become fully operational in 2009.

However, the PFM framework continues to have shortcomings in a number of critical areas. Recent Fund technical assistance has focused on budget execution, cash management, commitment control, and the accounting framework. The authorities are also working with the World Bank on a new project covering budget preparation, public procurement, and fiscal reporting.

To set these efforts in a unified framework, the authorities have adopted—in close consultation with the Fund and the World Bank—a comprehensive PFM action plan. Its main pillars are:

  • budget preparation, including strengthening the link between government policy and resource allocation, achieving a better coordination between the current and capital budgets, and incorporating information on donor-financed projects;

  • budget execution, cash management, and reporting, including introduction of effective cash release and commitment control systems, establishment of additional monthly reporting requirements for spending units, and expansion of the application of the IFMIS; and

  • public procurement, including ratification of the draft Public Procurement Law and introduction of standard bidding documents for all procurement entities.

E. Banking Reform

22. The financial and operational audits of Rafidain and Rasheed banks have been completed, but work on the restructuring plans for both banks has been delayed (Box 3 and SMEFP-2, ¶19). The authorities have requested assistance from the World Bank and other international partners to develop the restructuring plans for Rafidain and Rasheed banks as soon as possible. The BSA will undertake diagnostic reviews for the three smaller specialized state banks in the coming months with a view of developing restructuring plans for them.

23. The authorities completed half of the prudential regulations for commercial banks, including key regulations on licensing, capital adequacy, credit risk, large exposures, and liquidity risk (SMEFP-2, ¶20). Work is ongoing, with Fund technical assistance, to finalize the remaining regulations, including those related to minimum capital requirements, liquidity risk, and anti-money laundering.

F. Other Issues

24. Further efforts are being undertaken to strengthen governance, in particular in the hydrocarbon sector (SMEFP-2, ¶18). Oil-metering systems are being extended to the northern pipeline and export terminals, and all domestic oil sector activities. Work on the implementation procedures under the Extractive Industries Transparency Initiative (EITI) has started, with technical assistance from the World Bank. Discussions on a new legislative framework for the hydrocarbon sector are ongoing.

25. The authorities are continuing their efforts to improve the statistical database (SMEFP-2, ¶22). The publication of monetary and balance of payments data in the IMF’s International Financial Statistics is a welcome development. While the Socio-Economic Household Survey has been completed, the updating of the weights in the CPI, with technical assistance of the World Bank, is still underway. A new national coordinator for the General Data Dissemination System (GDDS) has been appointed and GDDS participation is expected next year.

IV. Program Monitoring, Financing Assurances, and Future Relations

26. Iraq has met the quantitative performance criteria set for end-September on the net international reserves of the CBI and on CBI lending to the government and the private sector (Table 8). Based on the available information, the other end-September quantitative performance criteria are expected to have been met as well. All structural performance criteria have been met. Staff will inform the IMF Executive Board on compliance with the other end-September quantitative performance criteria and on progress made in meeting the structural benchmarks through November before Board consideration of the second review. The program will continue to be monitored through quarterly quantitative performance criteria set for end-December 2008, as specified in Table 8.

Table 1.

Iraq: Selected Economic and Financial Indicators, 2006–13

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

2008 at end-October.

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 November 3.

Table 2.

Iraq: Fiscal and Oil Sector Accounts, 2006–13

(In billions of ID; unless otherwise indicated)

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

For 2008 and 2009-11, includes $1.875 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 ID636 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 reclassified as non-oil investment expenditures in the 2006 budget presentation. Finally, ID265 billion were reclassified 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, 2006–13

(In percent of GDP)

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

For 2008 and 2009-11, includes $1.875 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 ID636 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 reclassified as non-oil investment expenditures in the 2006 budget presentation. Finally, ID265 billion were reclassified 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 2006–13

(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.