Background

1. Notwithstanding challenging security and political conditions, Iraq has made good progress in implementing its economic program under the Fund-supported Stand-By Arrangement (SBA). In particular, fiscal performance improved, reflecting reduced government spending and higher than projected oil revenues, which resulted in a budget surplus in the first half of 2010. Nonetheless, both the fiscal balance and current account are projected to remain in deficit the current year and next year. Growth is projected to decline in 2010, on account of low oil production and exports. Inflation remained in the low single digits and the exchange rate remained stable. Despite persistent capacity constraints—which were compounded by repeated attacks on the Ministry of Finance and the Central Bank of Iraq (CBI)—structural reforms progressed in several key areas. These areas include program safeguards, central banking, as well as the oil sector.

2. Notwithstanding these accomplishments, the Iraqi economy continues to face daunting challenges and risks, notably political and security instabilities, constraints in administrative capacity and volatility in oil prices.

Economic Policies and Reforms for the Remainder of 2010 and 2011

3. GDP growth is expected to recover in 2011 as oil production increases. Non-oil GDP is projected to continue to pick-up slowly as security conditions improve.

4. The fiscal strategy continues to aim at containing current spending in order to gradually reduce the deficit and create room for higher investment outlays. A marked decline in the 2010 and 2011 budget deficits is projected, followed by a return to surplus in 2012 as oil revenues increase. Current spending is to be reduced by about 14 percentage points of GDP between 2010 and 2012 mainly by containing the wage bill, further improving the targeting of social spending, and reducing transfers to state-owned enterprises. Investment remains a key priority and the authorities are making every effort to fully execute the 2010 investment budget. They are determined to restore and expand administrative capacity to ensure that implementation quality is not compromised.

5. Considerable effort is being devoted to increasing the pace of fiscal reforms. With regard to the 2011 government budget preparation process, line ministries are now restricted to put a ceiling for their current and capital spending with the objective of substantially reducing the size of the budget deficit in 2011. Further efforts are aimed at strengthening public financial management. A new accounting manual is being finalized to help spending units improve the implementation of the new Chart of Accounts. Moreover, the authorities will review, with World Bank and United Nations assistance, the new Civil Service Law that is currently with the Shura Council to ensure compliance with international best practices.

6. The CBI intends to maintain its present monetary policy, which is aimed at keeping inflation in the single digits. The exchange rate remains the CBI’s main policy instrument, given the very low level of financial intermediation. The authorities agree with staff that a strong and stable currency provides a solid anchor for the public’s expectations in an otherwise highly uncertain environment.

7. Continued progress has been made in monetary reforms and the authorities are working to address the remaining issues that were identified by the IMF’s safeguards assessment of the CBI. The CBI will contract a multi-year co-sourcing agreement with a reputable accounting firm by end-December 2010. This will help review and improve the internal audit function. The CBI Board has also adopted a decision to transform the Internal Control Committee into an Audit Committee that will have a comprehensive mandate for effective oversight.

8. The review of the accounts in the banking system that were classified as central government deposits proved to be more difficult than expected. Nonetheless, the authorities were able to clarify the ownership of a large portion of the accounts. As they had expected, the accounts which did not belong to the central government included mainly the pension fund, state-owned enterprises, and various agencies and funds that operate at arm’s length of the central government. Work to clarify the remaining accounts is ongoing.

9. Little progress was made in the restructuring of the balance sheets of the two largest state-owned banks, Rafidain and Rasheed. With the assistance of the IMF and the World Bank, however, the authorities have developed a plan to address this issue by end-June 2011. They will establish a Bank Reconciliation Unit (BRU) with the participation of all the parties involved. The BRU will work under the supervision of the Restructuring Oversight Committee—which consists of the Minister of Finance, the Governor of the CBI, and the Chairman of the Board of Supreme Audit—to ensure that the restructuring of the banks’ balance sheets has the necessary support.

10. Other structural issues. Increased transparency and good governance in the oil sector continue to rank high on the authorities’ agenda. In this connection, the authorities have submitted an action plan to the UN Security Council to prepare for a post-Development Fund for Iraq mechanism. They reiterate their commitment to maintaining a single oil export revenue account that is subject to the principles of transparency and accountability that apply to the Development Fund for Iraq currently. Iraq became a candidate member of the Extractive Industries Transparency Initiative in February 2010.

Performance Under the SBA

11. The Iraqi authorities have demonstrated a strong commitment to the program’s objectives. They met all the performance criteria for end-March 2010, with the exception of the floor for the CBI’s net international reserves, which was missed by a small margin. They also met all of the performance criteria for end-June 2010 that can already be assessed, with the exception of the floor for the CBI’s net international reserves. They therefore request a waiver of nonobservance for the missed performance criterion for end-June, and a waiver of applicability for the end-June 2010 performance criterion related to the central government current spending bill (for which data is not yet available and for which there is no evidence that it was not observed). Due to the delay in completing the first review, they also request a rephasing of the disbursements under the SBA.

12. The Iraqi authorities are grateful for the valuable policy advice and technical assistance they receive from staff in support of their stabilization and reform efforts, as well as for the continued support provided by the Fund and its membership. They see the arrangement as providing them with needed financial support and a valuable anchor during a period of difficult political transition and considerable global economic uncertainty.