Background

1. Notwithstanding the improved but still fragile security and political environment that continued to prevail in 2008, the Iraqi authorities have made considerable 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, strongly enhancing growth prospects. The fiscal balance through July 2008 was in surplus, while capital expenditures have doubled in January–July 2008 compared to the same period last year, as a result of measures to enhance investment execution rates. Inflation has been kept under control at around 7½ percent for October, through effective exchange rate policy and by reducing fuel shortages, with little impact from the wage increases introduced in the 2008 Supplementary budget. Notwithstanding continued capacity constraints, the authorities have advanced their structural agenda in several key areas, including the approval of the central bank’s new reserves management guidelines, and the adoption of an action plan for modernizing the government’s public financial management system. They have also continued to make progress toward reaching bilateral agreements on arrears to official non-Paris Club creditors, and toward resolving the remaining arrears to private creditors.

Economic Policies and Reforms for the Remainder of 2008 and for 2009

2. 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. They acknowledge, however, the challenge for their public finances and balance of payments stemming from the sharp decline in oil prices in recent months.

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. In this regard, the draft 2009 budget provides for an increase in security and capital spending, while strictly containing other current outlays. It comprises a 14 percent of GDP reduction in the government’s initial spending plans in response to declining oil revenues. In particular, the 2008 civil service salary increase will be fully funded, no additional wage increases will be granted nor will there be net hiring of non-security personnel in 2009. A reform of the in-kind Public Distribution System, aimed at restricting eligibility of well-off beneficiaries as of mid-2009, has also been initiated. Moreover, other transfers, including to state-owned enterprises, will be strictly limited and the practice of carrying over unspent investment allocations from the previous year will be discontinued. Although a fiscal deficit of about 17 percent of GDP is foreseen for 2009, such deficit would be eliminated over the next three years. More importantly, while the budget is based on an average oil price of $62.50 for 2009, the authorities stand ready to prepare a supplementary budget to further cut current spending and adjust investment in line with future oil price developments, should declining oil prices put fiscal sustainability at risk.

4. Further to increases in the official retail prices of jet fuel and LPG last June and July, the government is considering raising official fuel prices for regular and blended gasoline, diesel, and kerosene in the first part of 2009, to help reduce the still sizable indirect subsidies and to counter smuggling. It will continue to work on the development of a periodic adjustment mechanism for fuel prices, based on the recommendations of a recent Fund technical assistance mission.

5. Considerable effort is being devoted to advancing fiscal reforms. The authorities have made progress in developing a medium-term tax reform strategy with the objective of streamlining the tax system while broadening the tax base and increasing revenue collection. They have prepared a draft law on import tariffs, which they plan to discuss with staff before submitting it to the Council of Ministers. They are working on the development of a sales tax as a precursor for a value-added tax. The authorities have also adopted, in consultation with the Fund and the World Bank, a three-year action plan that identifies priority measures to modernize public financial management. Notwithstanding the progress made with the data collection for the census of public service employees, completion of the project was delayed until end-January 2009, due to technical reasons. Once the project is completed, the authorities plan on adopting an action plan to eliminate ghost workers and computerize the payroll, as a first step for a comprehensive civil service reform.

6. The Central Bank of Iraq (CBI) is committed to maintaining its tight monetary stance, including through its exchange rate policy, with a view to keeping inflation under control. The CBI intends to maintain the gradual appreciation of the dinar until core inflation has come down from 13½ percent to near single digit levels, and to keep the policy interest rate positive in real terms to signal its firm commitment to containing inflation.

7. The CBI has made progress in implementing the outstanding recommendations of the IMF safeguards assessment report. It has appointed a control committee for establishing a modern internal audit function. It has also set up an independent audit committee, including one external expert, to make recommendations regarding external and internal audit oversight, financial reporting, and controls. In addition, the CBI has started implementing the new reserves management guidelines that were adopted last August.

8. Other structural issues. Increased transparency and good governance in the oil sector continue to rank high on the authorities’ agenda. Important progress has been achieved in installing and operationalizing oil-metering systems. Moreover, since joining the Extractive Industries Transparency Initiative, implementation procedures are underway, especially with regards to informing the public about oil production, exports, and domestic consumption. Finally, discussions on a new legislative framework for the hydrocarbon sector are ongoing.

9. Bank restructuring will pave the way to strengthening financial intermediation. In close collaboration with the World Bank, the authorities have made good progress in the development of a restructuring plan for the two largest state-owned banks, Rafidain and Rasheed, based on their financial and operational audits. Moreover, while significant progress was achieved in finalizing key prudential regulations for commercial banks, the authorities are committed to completing the remaining regulations, and to further improve the accounting and reporting framework of the CBI.

Performance Under the SBA and Financing Assurances

10. The Iraqi authorities have demonstrated a strong commitment to undertaking significant macroeconomic policies and structural reforms, which has enabled them to meet the program’s quantitative and structural criteria. 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 the completion of the second review under the SBA and the financing assurances review. They remain fully committed to the objectives of the program, 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.