This staff report on Iraq’s 2013 Article IV Consultation highlights economic policies and development. Risks to the macroeconomic outlook remain high. The risks can translate into lower oil revenues, deterioration in the fiscal position, pressures to use Central Bank of Iraq reserves for fiscal purposes leading to depreciation pressures, and higher inflation. Policies to mitigate their impact include strengthening fiscal institutions and oil revenue management, improving monetary policy transmission, and reducing the economy’s dependence on the oil sector. The authorities depend solely on fiscal policy to address these vulnerabilities, underscoring the need for the authorities to urgently build up sufficient fiscal buffers, since Iraq’s fiscal and external performance is very sensitive to fluctuations in oil prices.

Abstract

This staff report on Iraq’s 2013 Article IV Consultation highlights economic policies and development. Risks to the macroeconomic outlook remain high. The risks can translate into lower oil revenues, deterioration in the fiscal position, pressures to use Central Bank of Iraq reserves for fiscal purposes leading to depreciation pressures, and higher inflation. Policies to mitigate their impact include strengthening fiscal institutions and oil revenue management, improving monetary policy transmission, and reducing the economy’s dependence on the oil sector. The authorities depend solely on fiscal policy to address these vulnerabilities, underscoring the need for the authorities to urgently build up sufficient fiscal buffers, since Iraq’s fiscal and external performance is very sensitive to fluctuations in oil prices.

Background

A. The Iraqi Economy Today

1. Iraq is exceptionally rich in oil, but its economy suffers from severe structural weaknesses. Iraq’s proven reserves, at approximately 143 billion barrels, are among the highest in the world, with extremely low oil extraction costs. The increase in production since 2003 has contributed to a rise in GDP per capita from $1,300 in 2004 to $6,300 in 2012. 1During this period, Fund program engagement was instrumental in maintaining macroeconomic stability—even though progress on structural reform was mixed (Box 1). Thus, there are still many weaknesses:

Iraq’s Program Relations with the IMF

Fund engagement with Iraq over almost a decade has been instrumental to maintain macroeconomic stability and build institutions. The Fund has been closely working with the Iraqi authorities in the context of post-conflict assistance and Stand-By Arrangements since 2004. In the context of Fund programs, the authorities were able to limit fiscal spending, contain inflation, and successfully restructure Iraq’s external debt. They also reformed the Central Bank of Iraq (CBI) and implemented new laws and regulations in fiscal and financial sectors.

Iraq’s IMF Program Relations

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Of the two-year 2010 SBA of SDR 2.37 billion (200 percent of quota), only about SDR 1 billion was disbursed. Despite two extensions for a total of three years, insufficient progress after the second review in March 2010 precluded completion of the third and fourth reviews before the SBA expired in February 2013:

  • The program was successful in safeguarding CBI reserves from being used for fiscal financing and protecting central bank independence in 2010–11. However, the CBI’s enforcement of exchange restrictions starting in 2011 triggered a multiple currency practice in the foreign exchange market and led to the nonobservance of the two related performance criteria.

  • In the context of higher-than-expected oil revenues, the authorities exceeded overall fiscal balance targets in 2010–11, but spending composition was worse than planned because of continued slippages in current spending and persistent PFM weaknesses. Thus, the authorities missed the end-2010 and 2011 performance criteria on current spending and the continuous performance criterion on external arrears.

  • Progress on structural reforms was mixed. The authorities initiated efforts to strengthen PFM (introduction of the chart of accounts) and transparency (including becoming EITI-compliant in December 2012), bank supervision (co-sourcing with Ernst & Young), international reserve management (introduction of investment guidelines), and central bank safeguards. However, there was little traction on broader reforms, such as state-owned bank restructuring, which required political consensus across ministries.

  • The non-oil sector represents only 46 percent of the economy. Non-oil activity (services, construction, transport, and a small agricultural sector) is highly dependent on government spending, given the limited direct spillovers from the oil sector, which is operated mostly by international oil companies.

  • The economy is dominated by the public sector. Government and state-owned enterprises employ approximately half of the labor force. Most of the population depends on government employment or transfers for its income. Moreover, the population sees the public sector as the main vehicle to distribute oil wealth. Rising government employment and high wages contribute to social stability, but improvements in public service delivery have been scarce.

  • Unemployment is high, and poverty remains pervasive. Unemployment is officially estimated at 11 percent in 2011, although actual levels, particularly among the youth, are likely to be considerably higher. Demographic pressure is strong, with 41 percent of the population under 15 years. The labor force lacks basic skills due to years of war and sanctions, and massive emigration since 2003. Administrative capacity is weak at all levels of government. Poverty is widespread, affecting 22.9 percent of the population according to 2008 data, with 40 percent of poverty in rural areas. Because of low access to services, housing, and education, Iraq occupies the 131st place in the UNDP’s Human Development Index.

  • The business environment is very weak. Poor governance, an inefficient judiciary system, inconsistent regulations, and insufficient security keep Iraq at the bottom of global rankings for doing business. Foreign direct investment, particularly in the non-oil sector, is lower than in other oil-exporters in the region.

Figure 1.
Figure 1.

Largest Proven Oil Reserves

(In billions of barrels)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: EIA; and IMF staff estimates.
Figure 2.
Figure 2.

GDP in 2011: Oil vs. Non-Oil

(In billions of Iraqi dinars)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Iraq Central Statistics Office; and IMF staff calculations.
Figure 3.
Figure 3.

Foreign Direct Investment, 2012

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Country authorities; and IMF staff calculations.

B. Recent Developments

2. The political situation deteriorated steadily since the withdrawal of U.S. troops in December 2011. The government has been plagued by political infighting with increasing sectarian undertones, exacerbated by instability in Syria. Ministers from various parties have been intermittently boycotting the cabinet since early 2012, and parliament has been able to meet only a few times in the course of 2013. Tensions between the semi-autonomous Kurdistan Regional Government (KRG) and the central government remain high due to disagreements about sharing of oil export revenues and territorial disputes. The security situation remained critical in 2013 in parallel to the political crisis, with March recording the highest number of casualties of the past three years.

Figure 4.
Figure 4.

Violence Indicator, January 2008-February 2013

(Documented civilian death from violence per month)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Source: Iraq Body Count.

3. Nevertheless, macroeconomic developments have been broadly positive:

  • Economic growth has accelerated from 5.9 percent in 2010 to over 8.4 percent in 2012, when oil production averaged 3 million barrels per day (mbpd), the highest level reached in the last 30 years. In 2013, staff expects growth to rise to 9 percent as oil production increases to about 3.3 mbpd and activity in non-oil sectors (government services, trade, real estate, construction, and transportation) picks up.

  • Inflation has declined, from about 6 percent at end-2011 to 3.6 percent at end of last year, mostly as a result of lower imported food prices, and is expected to increase only slightly in 2013.

  • Broad money declined sharply in 2012 after strong growth in 2010-11, reflecting increased political tensions which are likely also the cause of the shift from dinar deposits to foreign currency deposits (now 25 percent of the total).2 In large part because of loans to state-owned enterprises, credit growth remained high at over 60 percent in 2012.

  • The real exchange rate has been appreciating over the past three years, and remains broadly in line with fundamentals (Appendix 1).

  • Central Bank of Iraq (CBI) international reserves rose from $61 billion at end-2011 to $70 billion at end-2012 (over nine months of imports, 33 percent of GDP) on the back of rising oil exports, and fiscal reserves held at the Development Fund for Iraq (DFI) have increased from $16.5 billion to $18 billion (six months of salaries and pensions, 8.5 percent of GDP).

  • Fiscal performance has been mixed. Thanks to higher-than-expected oil revenues and the under-execution of the investment budget, fiscal surpluses reached almost 5 percent in 2011 and 4 percent of GDP in 2012. However, fiscal discipline weakened over the past couple of years, with poor budget planning and execution, large off-budget spending (3 percent of GDP in 2012), low investment execution rates, and serious deficiencies in fiscal reporting. The authorities also continued the practice of directing loans from state-owned banks Rasheed and Rafidain to unviable state-owned enterprises (SOEs), mostly to pay for salaries. The total stock of these loans reached 3.5 percent of GDP at end-2012.

Figure 5.
Figure 5.

Foreign Exchange Developments, January 2011—March 2013

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Source: IMF staff calculations.
Figure 6.
Figure 6.

Macroeconomic Indicators

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Iraqi authorities, and IMF staff estimates and projections.

4. The 2013 budget raises risks. In March 2013 parliament approved a final budget that includes large unfunded commitments, which, if fully executed, would imply a deficit of 13 percent of GDP, deplete fiscal reserves, and result in a financing gap of 7 percent of GDP. Draft pension and public-sector wage laws under preparation may also increase fiscal liabilities.

5. The nominal exchange rate in the official market remained stable against the U.S. dollar since 2010, but the rate in the parallel market increased. The CBI pursues a policy of de facto peg to the U.S. dollar, providing a key nominal anchor to the economy. However, in 2011, fiscal expansion and political instability in Iraq and the region led to increase demand for foreign exchange. In late 2011 the CBI started enforcing existing exchange restrictions and introduced new restrictions in response to concerns about money laundering and illegal foreign exchange outflows. As a result, the spread between the official rate and the parallel market rate—which had been up to that point below 2 percent—started to climb, giving rise to a multiple currency practice, and reached over 8 percent in April 2013.

Medium-Term Outlook, Risks, and Spillovers

A. Medium-Term Outlook

6. Over the medium term, Iraq’s macroeconomic outlook will continue to be driven by developments in the oil sector (see accompanying Selected Issues paper). Staff projections assume the implementation of sound macroeconomic policies and gradual progress on structural reform. The authorities broadly agreed with the baseline scenario, but noted that policy implementation will be challenging because of the complex political environment, large spending pressures, and security issues. Staff projects that:

  • Oil production will rise gradually by about 400-500 thousand barrels per day (tbpd) per year, reaching 5.7 mbpd by 2018. The non-oil sector will grow by about 5 6 percent and reach 51 percent of GDP in 2018. Overall, growth will remain above 8 percent over the medium term.

  • Strong oil export revenues will lead to higher nontradable prices and cause an appreciation of the real exchange rate. Domestic inflation at 5-6 percent will be higher than inflation in trading partners.

  • Containment of current spending growth will allow a ramp-up in investment spending and the build-up of fiscal buffers. Fiscal reserves are targeted to double from about six months of salaries and pensions at end-2012 to 12 months by end-2018.

  • Oil exports will support strong current account surpluses over the medium term and boost CBI reserves to $104 billion by end-2018 (eight months of imports).

Figure 7.
Figure 7.

Iraq Oil Production Take-Off in Context

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: International Energy Agency; and IMF staff calculations.

Iraq: Selected Economic Indicators, 2010–18

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Sources: Iraqi authorities; and Fund staff estimates.

B. Risks and Spillovers

7. Risks to the macroeconomic outlook remain high. They include (a) inadequate policy implementation; (b) a deteriorating political and security situation; (c) a larger-than-projected decline in global oil prices; and (d) delays in developing Iraq’s oil fields and oil export capacity. (See Risk Assessment Matrix in Appendix 2). These risks can translate into lower oil revenues, deterioration in the fiscal position, pressures to use CBI reserves for fiscal purposes leading to depreciation pressures, and higher inflation. Policies to mitigate their impact include strengthening fiscal institutions and oil revenue management, improving monetary policy transmission, and reducing the economy’s dependence on the oil sector. At present, the authorities depend solely on fiscal policy to address these vulnerabilities, underscoring the need for the authorities to urgently build up sufficient fiscal buffers, since Iraq’s fiscal and external performance is very sensitive to fluctuations in oil prices. The authorities agreed that building sufficient buffers is essential, but highlighted that containing current spending to achieve this objective will be difficult in the current fragile social context without broad political consensus. Outward spillovers are mostly related to the impact of the oil sector on global markets (Box 2).

The Iraqi Oil Sector: Perspectives and Outward Spillovers

The ramp-up in oil production represents Iraq’s main outward spillover to the global economy.

Medium-term projections of global demand remain subdued due to concerns over developments in Europe and a possible slowdown in China. The IEA expects demand to increase from 90 mbpd in 2012 (of which Iraq met about 3 percent) to about 96 mbpd by 2017.1 However, global capacity is expected to rise to approximately 102 mbpd in 2017, with OPEC producing about 37 mbpd. Iraq is currently the second-largest OPEC oil producer (its OPEC quota is currently suspended) and the third-largest oil exporter in the world after Saudi Arabia and Russia. Staff expects Iraq to contribute over 2.2 mbpd in additional oil production through 2017. This amounts to 20 percent of the expansion in global production capacity and the biggest increase within OPEC. Spillovers related to Iraq’s oil production might play out through two alternative channels:

  • Should global demand turn out weaker than expected, excess production could weaken oil prices.

  • Conversely, delays in developing Iraq’s export capacity could have a sizable impact on international oil markets, putting upward pressure on prices.

At the regional level, the coming on stream of Iraqi exports might affect the pattern of energy trade and consumption. The authorities are planning a pipeline through Jordan to diversify their oil export routes and export markets by becoming a larger regional supplier of oil.

uA01fig01

Oil Exports by Destination

(In thousands of barrels per day)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Iraqi authorities; and IMF staff calculations.
uA01fig02

Projected Change in Total Oil Exports, 2012-2018

(In millions of barrels per day)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Source: IMF staff calculations.
1 Energy Agency, 2012, “Medium-Term Oil Market Report 2012: Market Trends and Projections to 2017.”

8. A low-case scenario modeling a temporary decline in oil prices stemming from a deeper-than-expected slowdown in emerging markets illustrates the economy’s dependency on oil. Staff estimated the impact of the downside emerging markets Global Risk Assessment Matrix (G-RAM) scenario, envisaging a fall in oil prices 15 percent below the World Economic Outlook (WEO) baseline in 2013. Given the lack of other policy instruments, the authorities would respond to the oil price shock in part through the worsening of the fiscal balance (which would require using up fiscal buffers) and in part by tightening spending (mainly investment expenditure, as they did in response to the decline in oil prices in late 2008). Both CBI and DFI reserves would be lower throughout the medium term. Iraq is even more vulnerable to the tail risk of a much larger fall in oil prices—of the magnitude of the 40 percent oil price shock of 2008-09—which would lead to the complete depletion of the fiscal buffers held at the DFI in less than one year, additional tightening (including on current spending), and depreciation pressures following the sudden drop in oil revenues.

Figure 8.
Figure 8.

Oil Price Shock Scenario vs. Baseline

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Iraqi authorities; and IMF staff calculations.

Roles of Policies in Managing Oil Wealth

A. Fiscal Policy

In the past, the fiscal stance was pro-cyclical, as higher oil revenues triggered spending increases. With oil revenues soaring, political pressures to boost current spending will grow, compounded by weaknesses in fiscal management. Discussions focused on (a) setting the appropriate fiscal stance in 2013, (b) addressing volatility in oil revenues through fiscal buffers, and (c) strengthening macroeconomic management and fiscal institutions.

9. Fiscal policy should aim at protecting social and investment spending by containing vulnerabilities to oil revenue shocks. With a breakeven oil price of $102 per barrel in 2012, among the highest in the region, Iraq is very vulnerable to a fall in oil prices. At the same time, the high level of current spending makes it difficult to adjust to external shocks without disproportionately cutting investment spending, as happened during the 2008-9 global crisis. Furthermore, the budget is the main transmission channel of oil market volatility on the domestic economy. In this context, fiscal policy should aim at building up fiscal buffers to insulate priority spending from oil market volatility, and to create space for a countercyclical use of fiscal policy, and increasing fiscal space for social spending and investment by rationalizing low-priority current spending. To build up fiscal buffers, the authorities rely on the DFI as a de facto oil stabilization fund. Given that the current legal framework precludes CBI lending to the government, and that Iraq still does not enjoy access to international capital markets, DFI reserves can be seen as an insurance against the impact of oil price shocks or export volume shortfalls.

Figure 9.
Figure 9.

Break-Even Oil Prices in Context

(In US$ per barrel)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Country authorities; and IMF staff calculations.

Fiscal Buffers Stress Testing

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Sources: Country authorities and IMF staff calculations.

10. In 2013, the authorities plan a limited fiscal consolidation. The authorities saw the unfunded commitments included in the 2013 budget as driven by politics. They explained that the actual execution of the budget would aim at meeting priority social and investment spending and maintaining fiscal buffers. They intend to limit spending growth in subsidies for energy producers, rationalize transfers to state-owned enterprises and the universal Public Distribution System (PDS, in-kind food basket subsidy), and contain the increase in public-sector employment. The authorities agreed that the overall surplus of 1.6 percent of GDP in 2013, as suggested by staff, down from an estimated surplus of 4 percent in 2012, was a reasonable projection. The non-oil balance—a better measure of the fiscal impulse to the economy—would remain broadly constant, posting a deficit of 73 percent of non-oil GDP. This fiscal stance would (a) contain demand pressures on the non-oil economy; (b) maintain the fiscal buffers at the DFI to cover about six months of salaries and pensions (equivalent to a negative shock of $19 in oil prices, or 500 tbpd in export volumes); and (c) allow fully executing investment projects in the oil sector, while keeping non-oil sector capital spending constant in nominal terms, in line with implementation capacity.

Figure 10.
Figure 10.

Non-Oil Primary Fiscal Balance

(In percent of non-oil GDP)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Country authorities; and IMF staff calculations.

11. Over the medium term, the authorities intend to continue rationalizing spending and increasing buffers. Continued streamlining of current spending could result in sustained fiscal surpluses and double the size of fiscal buffers by end-2018 to 12 months of wages and salaries. By the end of the projection horizon, these buffers would allow Iraq to withstand a negative shock of $36 in oil prices, the magnitude of the 2008-9 crisis, or a decline in exports by 2 mbpd, i.e., back to 2012 levels. The suggested fiscal path, if adhered to, would be consistent with long-term fiscal sustainability (Box 3 and accompanying Selected Issues Paper). However, such significant fiscal consolidation would require broad consensus across the government and the population.

Long-Term Fiscal Sustainability

  • The Permanent Income Hypothesis (PIH) model allows evaluation of Iraq’s long-term fiscal sustainability based on its natural resource wealth (see accompanying Selected Issues Paper). The PIH model determines a level of constant Non-Resource Primary Fiscal Balance (NRPB) in terms on non-oil GDP consistent with an annuity derived from Iraq’s accumulated and expected financial wealth resulting from future oil exports.1 While the model estimates are subject to large parametric uncertainty and data weaknesses, they provide a useful framework to assess the sustainability of government non-oil spending trends.

  • The PIH model suggests that Iraq’s medium-term fiscal policies, if implemented as outlined in the baseline scenario, would be broadly consistent with long-term fiscal sustainability. Iraq’s projected non-oil primary expenditures are significantly higher than the benchmark PIH expenditure level in 2013-2016, but converge by 2017-2018. This frontloading—justified by Iraq’s large investment needs—can be better modeled with the Modified Permanent Income Hypothesis (MPIH) model, which allows for a ‘scaled up’ spending period, followed up by a ‘scaling down’ (increase in public-sector savings) to preserve long-term wealth. The need to save in later years could be lessened by the positive growth and tax revenue impact of the additional investment spending upfront, which are conservatively assumed at zero in the model. The results of these tools underline the critical importance of implementing credible spending rationalization policies in public-sector employment, subsidies, and transfers in ensuring long-term fiscal sustainability.

uA01fig03

PIH Model vs. Baseline Scenario - Primary Expenditures

(In percent of non-oil GDP)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Source: IMF staff calculations.
uA01fig04

Non-Resource Primary Balance

(In percent of non-oil GDP)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Source: IMF staff calculations.
1 IMF, 2012, “Macroeconomic Policy Frameworks for Resource Rich Developing Countries—Analytic Frameworks and Applications,” IMF Policy paper. Available at http://www.imf.org/external/pp/longres.aspx?id=4698.
Figure 11.
Figure 11.

Oil Prices, 2009–2013

(In US$ per barrel)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Country authorities; and IMF staff calculations.

12. A procedural rule could help uncouple budget execution from volatility in international oil markets. Since 2004, conservative oil price and export volume assumptions have been set in the context of IMF-supported programs. In the future, the authorities could adopt procedural rules, preferably by law, to help formulate the annual budget by establishing a baseline oil scenario, identifying sources of financing, setting a realistic discretionary spending path, and assessing fiscal risks. In addition, while Iraq does not yet have the capacity to adopt a numerical fiscal rule based on structural balances, the authorities should consider adopting a simple formula to set oil price assumptions based on a moving average of past prices which would help follow a path to build fiscal buffers.

13. Sound fiscal policy implementation requires strong fiscal institutions. A solid institutional framework is needed to ensure that oil revenues are put to productive use in a transparent fashion, and that the fiscal risks are properly addressed, including those arising from contingent liabilities such as possible recapitalization of state-owned banks and enterprises. Iraq has made some progress in adopting a chart of accounts, and has became a full EITI member in December 2012, buttressing oil revenue transparency. The authorities agreed on the importance of strengthening institutions, and confirmed their commitment to adopt a single treasury account, and fully put in place an Integrated Financial Management Information System (IFMIS), which would help improve spending controls, debt management, and fiscal reporting.

B. Monetary, Exchange Rate, and Financial Policies

With a severely underdeveloped financial system, high bank liquidity, and administered interest rates, the usual channels of transmission of monetary policy are largely ineffective. Therefore, the principal instrument available to the CBI is foreign exchange intervention, but its effectiveness has been hampered by CBI regulations. Discussions focused on (a) distortions in the foreign exchange market, (b) exchange rate policy, (c) foreign asset management, and (d) banking system restructuring.

14. The de facto fixed exchange rate has served Iraq well. The authorities agreed that a stable nominal exchange rate provides a valuable anchor for inflation expectations in an uncertain environment, and intend to continue implementing this policy for the foreseeable future. In the medium term, staff encouraged the authorities to consider creating the conditions which would make possible a move to a more flexible exchange rate policy. Such flexibility could allow a predictable and gradual appreciation of the nominal exchange rate, triggered by strong oil revenues and the Balassa-Samuelson effect, to accommodate a possible real exchange rate appreciation while keeping domestic inflation low.

15. However, the authorities have been limiting foreign exchange supply to address concerns related to money laundering and terrorism financing. The CBI has recently taken steps to simplify foreign exchange market regulations, but has not eliminated all existing exchange restrictions and the multiple currency practice.3 The CBI continues to rely on controls to ration the supply of foreign exchange, which have contributed to the increase in the spread between the official auction and parallel market rate. The authorities aim to liberalize the foreign exchange market over the medium term. However, given the limited capacity of the financial sector to implement Anti-Money Laundering and Combating Financing of Terrorism (AML/CFT) preventive measures, they consider restricting the supply of foreign currency necessary to stem illegal outflows triggered by regional developments and increased import demand financed by illegal sources.

16. In contrast, staff recommended liberalizing the foreign exchange market and improving the AML/CFT regime. Staff noted that effectively limiting supply might be inconsistent with a de facto fixed exchange rate regime. The CBI has ample international reserves to maintain the de facto peg. Furthermore, AML/CFT standards do not contemplate ex-ante controls on foreign currency transactions, but focus on customer due diligence and reporting suspicious transactions to an operational and fully independent Financial Intelligence Unit. In staff’s view, accelerating the liberalization of payments for current transactions would therefore be the best approach to eliminating distortions in the foreign exchange market, the exchange rate spread, and the rents it creates. It would also allow removing the exchange restrictions and the multiple currency practice, with a view to accepting the obligations under Article VIII. The improvement of the AML/CFT framework, in line with the MENA-Financial Action Task Force (FATF) recommendations, and FATF standards, together with the ongoing efforts in strengthening AML/CFT supervision by the CBI, would help address money laundering and terrorism financing concerns.

17. The size of Iraq’s foreign assets (both CBI and DFI) is fueling a domestic debate on their most productive use. Staff projections show that, while CBI reserves are broadly appropriate over the forecast period, fiscal buffers will achieve an adequate level only in the medium term. Furthermore, the legal framework and governance arguments do not support pooling of CBI and DFI reserves. Moreover, the low execution rates of public investment, owing to limited administrative capacity and domestic absorptive capacity, suggest that there is little scope for accelerating the spending of foreign assets in the domestic economy. Increasing the returns to sovereign foreign assets might imply adopting some form of sovereign wealth fund (SWF) as exemplified by international experience (see accompanying Selected Issues paper). On balance, in light of the need to preserve the independence of the CBI and maintain a high level of liquid reserves to address possible pressures on the Iraqi dinar, and given Iraq’s weak capacity and governance, it seems appropriate to maintain the current two-tier architecture composed of CBI reserves (invested following prudent guidelines) and fiscal reserves held in the DFI. Should the DFI reserves increase beyond the recommended level of fiscal buffers, it should be possible to modify the DFI structure to allow for a more active management of excess fiscal reserves. The authorities agreed that the management of Iraq’s sovereign assets should continue to be cautious, and that a separate SWF would not be appropriate at this stage.

Figure 12.
Figure 12.

Medium-Term Outlook for International Reserves and DFI

(In billions of U.S. Dollars)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: Iraqi authorities; and IMF staff calculations.

C. Supporting Private-Sector Led Inclusive Growth

With an economy dominated by oil production and public spending, the authorities will need to focus on creating an enabling environment for private-sector development. A stronger financial system, better business environment, and a far-reaching structural reform plan can boost private-sector activity and employment.

Banking System

18. Efforts to modernize the financial system have hinged on the reform of state-owned banks. The restructuring of state-owned bank giants Rasheed and Rafidain has been lagging since its launch in 2006. Recently, the CBI has impressed new momentum to the clean-up of the banks’ balance sheets from pre-2003 assets and large valuation losses. The next step would be a rigorous audit of the balance sheets and the formulation of plans for their recapitalization, which is likely needed. In the long run, plans to put Rasheed and Rafidain on a sustainable commercial basis can be realized only if Rasheed and Rafidain stop lending to the government or on its behalf.

19. Development of the private banking sector requires leveling the playing field with state-owned banks (Box 4). Options include opening up the market for trade finance for government imports and allowing private banks to honor customers’ checks to the government. Moreover, the ongoing operational strengthening of banking supervision centered on better staffing, training and co-sourcing, and extension of the supervisory perimeter to include state-owned banks is essential to promote a sound banking system. In addition, the competitiveness of the private banks depends on the modernization of their operations (many banks still lack a core banking system) and strengthening of their governance structure.

Financial System Development

The financial system in Iraq remains seriously underdeveloped. Total banking assets in Iraq are estimated at 77 percent of GDP, compared to 130 percent in the Middle East and North Africa region, and total credit is about 29 percent of GDP, compared to 55 percent in the region. However, the headline credit figures reflects in large part loans and trade credit extended from state-owned banks to SOEs. Thus, credit to the private sector is estimated at only about 15 percent of GDP.

State-owned banks dominate the financial sector. The 50 private banks are small and focused on trade-related business. Banks Rasheed and Rafidain hold 71 percent of the system’s deposits. Together with the Trade Bank of Iraq, established in 2003, they enjoy a symbiotic relationship with the government, based on extension of credit to the government, the frequent execution of quasi-Treasury operations, the almost complete monopoly over government transactions, and historic lax supervision and shareholder control. While Rasheed and Rafidain are very liquid, they are likely not solvent, even though their net worth has so far been difficult to assess given the lack of transparency and the persistence of pre-2003 items on their balance sheets.

uA01fig05

Financial Deepening Indicators for Selected Countries, 2011

(In percent of GDP)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Source: IMF staff calculations.

Employment

20. Despite the large size of the public sector, unemployment remains high. The oil sector employs only an estimated 80,000 workers out of a total of about 8 million in the labor force. The government absorbs most entrants to the labor market, with about 40 percent of the workforce in the public sector, up from 31 percent in 2007. Job security and a generous pay structure in the public sector set a high reservation wage and crowd out private employment. As a result, total job creation has been weak, averaging around 1 percent a year. Female participation in the labor force, at only 13 percent, is particularly low compared to international and regional standards. Aggregate labor market indicators also mask large geographical disparity, with official unemployment in some provinces at 20 percent.

21. Over the medium term, demographic trends will put pressure on the labor market. The Fund’s labor template, based on conservative assumptions (whole-economy growth projections and average growth-employment elasticity estimates of MENA oil producers), suggests that employment creation in 2013-18 will likely not be strong enough to absorb the 2.1 million total new entrants in the labor force estimated by the International Labor Organization (ILO), leading to a rise in the unemployment rate. These results should be interpreted cautiously given significant data quality issues, but they do underline the need for higher growth or better job-creation strategies to help generate adequate employment.

22. The medium-term projections stress that the current employment model hinging on public-sector employment may soon reach its limits. So far, like other oil-exporting economies in the region, Iraq has relied on the public sector to employ almost half of the labor force, and government hiring has increased at a fast pace (the government hired about 120,000 workers in 2012 alone). Public salaries are in many cases effectively transfers as many employees do not actually work. Moreover, the need to control violence is reflected in the large size of the security forces. The authorities pointed out that the public sector is reaching the limits of absorptive capacity to employ new workers, and that a new model for employment growth is needed. For example, in 2013, the ILO projects about 300,000 new entrants in the labor force, while the authorities expect the public sector to hire about 150,000 new employees, and only 130,000 are projected to be taken in by the private sector.

Figure 13.
Figure 13.

Unemployment Rate Projections, 2012–2018 1/

(In percent)

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Sources: International Labour Organization; and IMF staff calculations.1/ 2011 is the latest year with actual data.

23. Private-sector employment creation is hindered by a very weak business environment. Since 2003, the authorities have not undertaken any major reform to create an enabling environment for the private sector. Apart from security problems, red tape is pervasive and governance is poor. The country ranks 165 out of 183 in the World Bank’s 2012 Doing Business rankings. Iraq fares particularly badly in starting a business, access to credit, trading across borders, enforcement of contracts, and resolving insolvency. The poor state of infrastructure—particularly the provision of electricity—constitutes a major hurdle for the private sector. Moreover, private companies face competition from the large number of state-owned enterprises—operating in agriculture, manufacturing, and trade—that are generously subsidized and staffed, and enjoy favorable treatment in government contracts and access to public bank financing.

Figure 14.
Figure 14.

Iraq: Business Environment and Governance

Citation: IMF Staff Country Reports 2013, 217; 10.5089/9781475538908.002.A001

Economic reform agenda

24. Inclusive growth will need progress on the broad economic structural reform agenda. In many aspects, Iraq is still largely a resource-rich transition economy in which the old central planning structure has only been partly dismantled. Ambitious post-2003 reform efforts—exemplified by the International Compact with Iraq—have been only modestly successful. Without progress on the basic reforms, however, Iraq will not be able to promote employment-creating economic activity outside the oil sector and government. Besides the reform of the financial and fiscal sectors,4 the key areas of the economic agenda include:

  • Energy sector: A hydrocarbon law has been long delayed mainly because of disagreements between the central government and the KRG. Investment in electricity production, restructuring of electricity producers, and imposition of adequate tariffs are needed. Moreover, distortionary fuel subsidies to producers should be removed.

  • State-owned enterprises: SOEs absorb large transfers from the government, and many are completely inactive. The authorities should launch a comprehensive triage of SOEs, leading to the operational restructuring, governance reform, and recapitalization of those that can be rehabilitated and the closure of unviable enterprises.

  • Business environment and governance: Regulation should be streamlined, made more consistent, and focused on assisting, rather than constraining, private-sector operators.

  • Agriculture: A revival of agricultural production (once one of the mainstays of the Iraqi economy) depends on a reform of the PDS, which has contributed to the decline of domestic production through large food imports.

D. Data Issues

25. Macroeconomic statistics are broadly adequate for surveillance. However, there are significant data gaps and lags in publication, mainly due to capacity constraints, security issues, and lack of coordination with sub-national entities. The authorities are committed to strengthening data quality with the help of Fund technical assistance.

Staff Appraisal

26. Despite a difficult security and political environment, the authorities successfully maintained macroeconomic stability over the past two years. The authorities posted fiscal surpluses, increased oil exports, kept inflation low, and accumulated sizable external reserves. However, mainly because of limited advance on structural reform and foreign exchange management, progress under the 2010 SBA has been uneven, and only two reviews could be completed.

27. The Iraqi economy has huge potential thanks to its large oil reserves. The challenge is to use the oil wealth to address the economy’s weaknesses—including a small non-oil sector, bloated public sector, high unemployment, and a weak business environment—and foster high, sustainable growth and create an enabling environment for the private sector to create jobs needed to improve the living standards of its people. Failure to do so could expose the economy to the harmful effects of the natural resource curse—weak governance, rent-seeking behavior, loss of competitiveness, and a stunted non-oil private sector.

28. Fiscal policies must ensure sustainability and address risks related to oil revenue volatility. Starting in 2013 and over the medium-term, continuous rationalization of current spending, including public employment, energy subsidies, the PDS, and transfers to state-owned enterprises will be needed to create fiscal space to finance investment and accumulate buffers. Sound fiscal planning requires reform of public financial management, notably by introducing IFMIS and a single treasury account, eliminating off-budgetary spending and investment rollovers, and shutting down the quasi-fiscal operations of banks Rafidain and Rasheed.

29. Fiscal rules can provide a framework for fiscal policy. In the first instance, the authorities could establish procedural rules to improve budgeting, including a formula to set oil price assumptions in the budget. Over the medium term, they should aim at building the capacity needed to adopt formal numerical fiscal rules that would de-link oil revenues from the budget.

30. Staff welcomes the CBI’s objective to liberalize the foreign exchange market and the recent steps to simplify market regulations. However, staff urges the CBI to take immediate further measures to liberalize fully the supply of foreign exchange, with the objective of lowering the exchange rate spread, removing distortions, eliminating rents, and ultimately complying with Article VIII of the Fund’s Articles of Agreement. Staff also encourages the authorities to refrain from introducing any new regulation that could lead to a breach of obligations under Article VIII. In parallel, the authorities need to strengthen the AML/CFT framework in line with MENA/FATF recommendations and FATF standards, to support their efforts to deter money laundering and financing of terrorism. Against this background, staff does not recommend approval of the exchange restrictions and the multiple currency practice listed in the Informational Annex.

31. The stable exchange rate has provided a valuable anchor in an uncertain environment. This policy remains appropriate for the foreseeable future. In the medium term, the authorities should create the conditions that would facilitate moving to a more flexible exchange rate.

32. The current two-tier architecture resting on prudent management of CBI reserves and the use of the DFI as de-facto oil stabilization fund is appropriate. Given the highly uncertain environment and low administrative capacity, staff recommends maintaining a high level of liquid reserves. The authorities should also continue to rely on the DFI—probably Iraq’s most successful fiscal institution—to provide oil revenue transparency and help stabilize government spending in the face of oil revenue volatility.

33. Staff welcomes progress in banking sector supervision and state-owned bank restructuring. A stable and secure financial sector is a necessary condition for developing of the private sector and diversifying the economy away from oil. Reform of the state-owned banks should be combined with the development of private banks by ensuring a level-playing field for all banks and more rigorous supervision.

34. Iraq needs sustained high and inclusive growth to reduce poverty and provide opportunities for its population. Growth prospects hinge on implementing a prudent policy mix, enhancing service delivery, rebuilding infrastructure—particularly in electricity—and strengthening the business environment. Boosting the activity of the non-oil private sector is crucial as the employment model based on the public sector is reaching its limits.

35. Efforts are needed to improve the quality and timeliness of economic data, as weaknesses hamper analysis and policy formulation.

36. Staff recommends that the next Article IV Consultation with Iraq take place on the standard 12-month cycle.

Table 1.

Iraq: Selected Economic and Financial Indicators, 2010–18

(Quota: SDR 1188.4 million)

(Population: 31.7 million; 2010)

(Poverty rate: 22.9 percent; 2007)

(Main exports: Crude oil)

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

Excluding escrow account held abroad to purchase military equipment.

Assumes a debt reduction in 2013 by non-Paris Club official creditors, comparable to the Paris Club agreement.

Table 2.

Iraq: Central Government Fiscal Accounts, 2010–18

(In trillions of ID; unless otherwise indicated)

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

For 2010-2013, includes off-budget transfers to SOEs financed by Bank Rafidain.

Five percent of oil exports as mandated by U.N. Security Council Resolution 1483 to finance war reparations to Kuwait until 2015.

Includes the $250 million Development Policy Loan from the World Bank and the IMF 2010-11 SBA disbursements.

Table 3.

Iraq: Central Government Fiscal Accounts, 2010–18

(In percent of GDP; unless otherwise indicated)

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

For 2010-2013, includes off-budget transfers to SOEs financed by Bank Rafidain.

Calculated as 5 percent of oil exports as per U.N. Security Council Resolution 1483 to finance war reparations to Kuwait until 2015.

Includes the $250 million Development Policy Loan from the World Bank and the IMF 2010-11 SBA disbursements.

Table 4.

Iraq: Central Bank Balance Sheet, 2010–13

(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.

Table 5.

Iraq: Monetary Survey, 2010–13

(In billions of Iraqi dinars, unless otherwise indicated)

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Sources: Iraqi authorities; and Fund staff estimates and projections.
Table 6.

Iraq: Balance of Payments, 2010–18

(In billions of U.S. dollars; unless otherwise indicated)

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

Includes interest accrued, deferred, and capitalized.

Estimate of accrued interest on existing stock of debt prior to the implementation of the Paris Club agreement.