Background

Notwithstanding extremely difficult security and political conditions, Iraq has continued to make progress in rebuilding its economy and achieving macroeconomic stability over the past few years. Under three successfully completed Fund-supported programs, the authorities reduced inflation to single digits from 65 percent in 2006, while significantly adjusting domestic fuel prices. In addition, they strengthened the international reserves position and implemented significant structural reforms—including to the pension system, and the audit and capitalization of the Central Bank of Iraq (CBI). These accomplishments were made possible by timely adjustments in monetary and exchange rate policies, as well as continued fiscal discipline.

Notwithstanding these developments, the Iraqi economy continues to face daunting challenges, which were exacerbated by the large drop in oil prices in 2009. With both the balance of payments and the government budget largely reliant on oil revenues, the lower oil receipts have given rise to sizeable, although temporary, balance of payments and fiscal deficits. In 2009, the authorities were able to absorb much of the adverse impact of the external shocks by using the financial buffers built up in recent years.

The balance of payments is likely to remain under pressure in 2010 and 2011 and a substantial fiscal deficit will be recorded in 2010 before receding sharply in 2011. Financing these deficits, even after mobilizing substantial domestic financing, could exhaust the government’s remaining financial balances. It could also severely constrain government spending at a time when Iraq’s developmental and security-related needs remain high, poverty and unemployment are widespread, and the security situation remains fragile. The authorities are also concerned that a drastic fiscal contraction at this juncture would undermine hard-won macroeconomic stability, and could contribute to a deterioration of the security situation.

In view of these developments, the authorities have adopted an economic adjustment program for 2010–11 for which they are seeking support from the Fund under a new two-year Stand-By Arrangement (SBA), as well as financial assistance from other international institutions and countries. The main objective of the program is to maintain macroeconomic stability during a period of high economic and political uncertainties. The program also aims at advancing the authorities’ structural reform agenda, notably in the areas of public financial management and financial sector development, in close coordination with a prospective Development Policy Loan provided by the World Bank. The Bank Board is scheduled to consider this loan on February 25, 2010.

The program will provide the authorities with access to Fund financing, if needed. With international oil prices and domestic oil production forecast to increase in the coming years, Iraq’s financing needs are expected to be temporary. In this connection, the authorities intend to treat the SBA as precautionary if, at the time of the first and second program review, futures prices for Iraqi oil average US$73 per barrel or higher. With these prices, Iraq would no longer expect to have a financing need, provided that it is able to sustain an oil export volume of 2.1 million barrels per day in 2010.

Similarly, the authorities would also treat the SBA as precautionary if investment remains significantly below budgeted amounts—specifically, if at the time of the second review, the rate of execution of the capital budget for the year as a whole were expected to remain below 93 percent. Disbursements of capital spending in 2009 indeed fell short of budgeted amounts, due in part to severe disruptions of administrative capacity as a result of the bombings of the Ministry of Finance in August and December. Investment remains a key priority, and the authorities are striving to restore and expand administrative capacity, including with the assistance of the World Bank, to ensure that implementation quality is not compromised.

The authorities would use Fund resources to finance the budget deficit, which would directly address the country’s balance of payments needs given the very close linkages between the balance of payments and the government budget. At the same time, given the constraints on other sources of external and domestic financing, the additional fiscal space offered by the use of Fund resources would allow the government to avoid an economic contraction. It would also allow the authorities to preserve CBI independence and avoid central bank financing of the government.

Economic and Financial Policies and Reforms in 2010–11

The fiscal strategy aims primarily at containing current spending in order to gradually reduce the deficit and create room for higher investment outlays. A moderate decline in the budget deficit to 19 percent of GDP in 2010 is projected, followed by a marked decline to 6 percent of GDP in 2011, and a return to a surplus in 2012 as oil revenues increase.

To this end, current spending will be kept broadly unchanged in nominal terms beyond 2010. This would ensure a decline in current spending by about 30 percentage points of GDP by 2012. To obtain this target, it is intended to reduce non-priority expenditures immediately. To this end, the authorities will: (i) contain the wage bill by refraining from raising wages and limiting hiring; (ii) complete the census of government civil servants; (iii) improve the targeting of social spending by enhancing the in-kind Public Distribution System initially, and replacing it over time with a well-targeted cash-based safety net; (iv) reduce transfers to state-owned enterprises; and (v) avoid the reemergence of direct fuel subsidies while gradually reducing indirect subsidies.

Considerable effort is being devoted to advancing fiscal reforms. In addition to the reform commitments indicated above, the authorities intend to modernize their public financial management system over the next two years. In this regard, they adopted in October 2008, in consultation with the IMF and the World Bank, a three-year action plan identifying priority measures in the areas of budget preparation, execution and reporting; cash management; public procurement; and the accounting framework, as detailed in the Memorandum of Economic and Financial Policies. They have also made progress in developing a medium-term tax reform strategy with the objective of streamlining the tax system, broadening and diversifying the tax base, and increasing revenue collection. They plan to introduce a sales tax in the coming years as a precursor for a value-added tax, and are also considering reducing the number of income tax brackets. They intend to seek technical assistance from the Fund and other international partners to support their tax reform effort.

Investment remains a key priority, as evidenced in the increase in investment spending in the budget for 2010. Investment will focus on improving the delivery of key public services, including electricity, water, health, and education. It will also aim at further rehabilitating and expanding the oil sector infrastructure given its critical role in maintaining fiscal and external sustainability.

The CBI intends to maintain its present monetary and exchange rate policies, which are aimed at keeping inflation in the single digits and further reducing dollarization in order to enhance the CBI’s control over monetary conditions. Up until late 2008, the CBI had allowed the dinar to appreciate gradually to bring down core inflation to near single digit levels. Once the inflation target was achieved, the CBI returned to its earlier policy of maintaining a stable exchange rate as the nominal anchor ?as specified in the last SBA. The CBI also intends to keep the policy interest rate positive in real terms.

The structural agenda in the monetary area includes further enhancement of the CBI’s reserve management practices. The authorities have prepared prudential regulations for commercial banks, including those related to minimum capital requirements, liquidity risk, and anti-money laundering, and will begin the implementation phase shortly. Further improvements in banking supervision will be sought following the assessment that is currently underway with foreign assistance. Moreover, control procedures and manuals are being developed to help strengthen the accounting and reporting framework, as well as the internal audit function of the CBI.

The Iraqi authorities are committed to strengthening the stability of the financial system. They developed, in coordination with the World Bank and other international agencies including the Fund, a banking sector reform strategy aimed primarily at undertaking the operational and financial restructuring of the two largest state banks. The operational restructuring entails introducing a new organizational structure, including the establishment of business units, risk management units, as well as governance, control and support units. The financial restructuring will consist of cleaning-up the banks’ balance sheets from the legacy of bad debts and recapitalizing them.

Increasing transparency and good governance in the oil sector continues to rank high on the authorities’ agenda. In this connection, they will maintain a single account for all oil export proceeds and will continue to adhere to the strict transparency and accountability rules that currently govern the Development Fund for Iraq. This account will continue to be audited by a reputable external auditor and overseen by the independent Iraqi Committee of Financial Experts, which would take over the audit oversight role currently performed by the International Advisory and Monitoring Board. In an effort to enhance transparency and fight corruption in the oil sector, the authorities will complete the process of becoming a candidate for membership in the Extractive Industries Transparency Initiative by March 2010.

The authorities are committed to further improve the timeliness, coverage, and accuracy of macroeconomic statistics, despite serious capacity constraints. This will take time. Monetary and balance of payments data are now being published in the IMF’s International Financial Statistics regularly, annual national accounts data have been compiled up to 2007, and the quality of the national accounts has improved in the last year. A new CPI using the latest Socio-Economic Household Survey is being developed. Iraq began participating in the General Data Dissemination System in December 2009, and comprehensive information on Iraq’s statistical production and dissemination practices now appears on the IMF’s Dissemination Standards Bulletin Board.

The Iraqi authorities will continue their good faith efforts to resolve outstanding external claims under terms that are consistent with the 2004 Paris Club agreement. With twelve non-Paris Club official creditor claims already signed and currently being implemented, they will focus their efforts on resolving the still outstanding non-Paris Club claims. Regarding private creditors, most of the commercial debt has been restructured, and is being serviced as agreed.

Conclusion

The Iraqi authorities have demonstrated their commitment to undertaking strong macroeconomic policies and implementing economic reforms under three successive Fund-supported programs, including two SBAs. These arrangements have served Iraq well, providing cohesion to the policy framework while anchoring and furthering progress towards macroeconomic stability and economic reforms. The road ahead is still very challenging. The Iraqi authorities are fully committed to the implementation of the new arrangement, although stable security conditions remain a prerequisite for the success of 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.