This Selected Issues paper on Iraq discusses medium-term projections for oil production and exports. Constraints to oil export volumes arise from export bottlenecks and technical production issues. Production is held back by technical challenges such as the need for water injection in the southern oil fields and limited supply of electricity, of which the oil industry is one of the main consumers. Export infrastructure has suffered during many years of decay owing to sanctions and wars. The Iraqi crude is priced as an average of a benchmark oil price for 15 or 30 days from the bill of lading.

Abstract

This Selected Issues paper on Iraq discusses medium-term projections for oil production and exports. Constraints to oil export volumes arise from export bottlenecks and technical production issues. Production is held back by technical challenges such as the need for water injection in the southern oil fields and limited supply of electricity, of which the oil industry is one of the main consumers. Export infrastructure has suffered during many years of decay owing to sanctions and wars. The Iraqi crude is priced as an average of a benchmark oil price for 15 or 30 days from the bill of lading.

Fiscal Policy Tools For Iraq1

A. Introduction

1. Iraq faces large fiscal policy challenges following more than 30 years of sanctions and conflict, which have resulted in very large infrastructure and social needs. Iraq needs to transform resource wealth into assets that support sustained reconstruction and development, while adopting mechanisms to avoid the boom-bust cycles that stem from volatility in natural resource revenues. This paper applies tools to assess long-term fiscal sustainability,2 and proposes a fiscal policy framework to improve macroeconomic management of the economy, including a procedural fiscal rule to help delink the budget process from fluctuations in international oil prices.

2. Iraq’s government plays the central role in channeling oil revenues into the domestic economy. The government receives one-hundred percent of Iraq’s oil export revenues, and in turn decides how much to save abroad or channel into the domestic economy via government spending. Thus, the chosen expenditure path has a substantial impact on macroeconomic developments in the non-oil economy, macroeconomic stability, and intergenerational equity.

B. Characteristics of a Fiscal Framework

3. A medium-term fiscal plan for Iraq should ensure solvency. This entails assessing whether the medium-term spending path is consistent with long-term fiscal sustainability, and it is tied to exhaustibility of oil reserves based on Iraq’s oil wealth and its exploitation.

4. Iraq’s ambitious spending plans need to be also balanced against implementation capacity and financing constraints. The authorities aim at boosting non-oil investment as much as possible. For instance, in 2013, the budget authorizes capital spending allocations of 40 percent of non-oil GDP. However, based on past experience, such investment levels may not be possible because of low capacity and economic absorption constraints.

5. A medium-term fiscal framework should address Iraq’s vulnerability to fluctuations in international oil prices. With oil export revenues accounting for more than 90 percent of total government revenues, and fiscal buffers at only about six months of salaries and pensions in 2012, Iraq is highly vulnerable to oil price volatility. Revenue vulnerability is exacerbated by the high degree of concentration of both production and export infrastructure, 70 percent of which is concentrated in the Basra province alone. Moreover, Iraq’s budget structure is skewed towards non-discretionary current expenditure, which would make it difficult to adjust to sustained revenue shocks through expenditure adjustment. This vulnerability has increased over the past few years as the gap between the break-even and budget oil price narrowed considerably, resulting in one of the highest fiscal break-even oil prices in the region at $102 per barrel in 2012.

6. Thus, the dependence of government revenues on a single source of revenue requires high levels of fiscal buffers. For Iraq, useful measures for the level of fiscal buffers are (a) coverage of current spending (e.g., salaries and pensions), which reflects how much of the short term government obligations can be financed in case of a complete shortfall of oil revenues; and (b) coverage in terms of lower oil prices or oil export volumes than projected under the baseline scenario in any given year, which indicates the share of government spending that can be financed by the buffers in case of shocks to oil markets resulting in a fall in oil revenues.

Fiscal Buffers Stress Testing

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Sources: Country authorities and IMF staff calculations.

7. Currently, fiscal buffers are not yet sufficient to withstand large oil revenue shocks. At $18 billion, or 6 months of salaries and pensions at end-2012, Iraq’s current fiscal buffers held in the Development Fund for Iraq (DFI) would be sufficient to absorb a relatively small short term revenue shocks (as laid out in the downside scenario of the 2013 Article IV Staff Report) and help avoid a socially destabilizing disruption to public finances. Buffers are not sufficient, however, to absorb a shock of the magnitude of the 2008 oil price shocks, or a collapse in production or exports that would severely limit Iraq’s earnings in foreign currency.

8. Fiscal policy should be formulated to delink expenditures from volatility of oil revenues. As the government channels oil revenues generated abroad through government spending in the domestic economy, domestic demand is affected. The Non-oil Primary Balance (NOPB) is a good measure to assess this impact, since focusing on the overall balance or expenditure levels as a percent of total GDP would be misleading.5 For instance, following a 40 percent decline in oil prices in 2009, the overall fiscal deficit increased to 13 percent of GDP compared to 1 percent in 2008. Likewise, total expenditures increased by 2 percent of GDP. However, the non-oil primary deficit declined by almost 20 percent of non-oil GDP, mostly because of a 19 percent of non-oil GDP decline in capital spending, showing the true contractionary fiscal stance adopted by the authorities.

uA02fig01

Iraq: Historical Oil Prices and Medium-term Outlook

(In U.S. dollars per barrel)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations
uA02fig02

Break-even oil prices

(Proj. for 2013, in U.S. dollars per barrel)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations.
uA02fig03

Oil Prices, 2009–2013

(In U.S. dollars per barrel)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: Country authorities; and IMF staff calculations.
uA02fig04

Non-oil Fiscal Balance

(In percent of non-oil GDP)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations

C. Application of Permanent Income Hypothesis (PIH) and Modified Permanent Income Hypothesis (MPIH) Models to Assess Long-Term Fiscal Sustainability

9. Various policy analysis tools can help enhance IMF policy advice for Iraq.3 While the estimates of these models are subject to large parametric uncertainty and data weaknesses, they provide a useful framework to look at the impact of fiscal policies on sustainability of government non-oil spending trends.

PIH Model Application

10. The PIH model can help assess long-term fiscal sustainability. Staff used assumptions that are consistent with the baseline scenario laid out in the 2013 Article IV staff report. The scenario is predicated on the implementation of prudent fiscal policies. Key assumptions include:

  • Oil production will rise gradually by about 400-500 thousand barrels per year, reaching 5.7 mbpd by 2018. The non-oil sector will grow by about 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 5.5 percent will be higher than inflation in trading partners.

  • The pace of financial sector reforms will continue to be slow, and real interest rates will remain constant at about 7 percent over the medium-term.

  • 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).

  • The authorities will target fiscal surpluses and target a gradual improvement in the NOPB over the medium term by rationalizing spending.

  • This fiscal path will allow doubling the size of fiscal buffers held at the DFI to 12 months of wages and salaries by end-2018. These buffers would allow Iraq to withstand a negative shock of $36 per barrel in oil prices, the magnitude of the 2008-9 crisis, or a decline in exports by 2 million barrels per day (mbpd), i.e., back to 2012 levels.

  • For the long-term oil export projections, staff assumes an oil-export horizon of 35 years and that oil exports rise steadily from 2011 until the plateau in 2041 at 9.0 mbpd, where they remain constant until the end of the period.

  • Oil prices follow the World Economic Outlook baseline through 2018, and long-term prices are based on International Energy Agency’s projections adjusted for U.S. dollar inflation.

uA02fig05

Non-Oil Primary Fiscal Balance

(In percent of non-oil GDP)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: Country authorities; and IMF staff calculations.

11. The computation of PIH-consistent expenditure levels includes three steps:

  • 1) Computing the present value of the financial wealth (in Iraq’s case held at the DFI) and of future oil export revenues.

  • 2) Computing a constant annuity in terms of non-oil GDP, which is equal to the real rate of return of financial and oil wealth, and the full depletion of financial and oil wealth by the end of 35 years.

  • 3) Setting the NOPB level equal to the constant annuity value.

12. The results suggest that Iraq’s medium-term fiscal policies as outlined in the baseline scenario are broadly consistent with long-term fiscal sustainability. The PIH benchmarks yields constant primary expenditures of about 60 percent of non-oil GDP over the long term, compared to estimated non-oil revenues of 9.5 percent of non-oil GDP, yielding a non-oil primary fiscal deficit of about 50.5 percent of GDP. Iraq’s medium term projected medium-term expenditures are broadly in line with these results. Projected non-oil primary expenditures are significantly higher than the benchmark PIH expenditure levels in 2013-2016, but converge towards the benchmark level by 2017-2018.

uA02fig06

PIH model vs. baseline scenario—primary expenditures

(Percent non-resource GDP)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations.

MPIH Model Application

13. Application of the Modified Permanent Income Hypothesis (MPIH) model can help quantify the potential risks of ‘scaling up’ expenditures. While a ‘scaling up’ of social and infrastructure spending may have growth-enhancing effects, its impact is highly uncertain because of low implementation capacity and a volatile domestic and regional context. The MPIH model, which allows for ‘scaling up’ of spending over the medium term that is followed up by a ‘scaling down’ of spending to preserve long-term wealth, computes the necessary fiscal adjustment if the “scaled-up” spending does not result in higher growth. The need to save in later years could be lessened by a positive growth and tax revenue impact of the additional investment spending upfront, which are conservatively assumed at zero in the model.

uA02fig07

Non-resource primary balance

(Percent non-resource GDP)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations.

14. The MPIH model is useful to look at the long-term impact of front-loading investment. The model allows for front-loading investment in 2013-2018 by an average of 5.5 percent of non-oil GDP, which is the difference in annual spending between the baseline medium-term scenario and the spending levels derived from the PIH simulation, to quantify the ‘scaling up’ scenario. Thus, the MPIH scenario allows for an increase in annual spending equivalent to about 5.6 percent of non-oil GDP on average for 6 years (front loading investment period in accompanying chart). The period of front-loaded spending then needs to be compensated by an annual improvement in the NOPB of 3 percent of non-oil GDP on average smoothed from 2020 until 2031 (MPIH adjustment period in accompanying chart). The model sets the future value in 2032 of the front-loading and adjustment periods equal to preserve long-term wealth. Spending levels return to PIH-consistent levels from 2032 until 2045.

D. Fiscal Rules

15. Fiscal rules could help delink budget formulation from volatility in international oil markets. A procedural rule, outlining steps to be followed during the budget preparation process, would be relatively simple to implement. In addition, since 2004 the authorities set conservative oil price and export volume assumptions in the context of IMF-supported programs.

Procedural Fiscal Rule

16. The authorities could adopt the budgeting procedures based on financial programming that were used during past IMF programs. This approach could include the following steps when determining the medium-term budget envelopes, such as:

  • 1) Setting a clear medium-term fiscal objective, and corresponding NOPB targets. Staff suggests, as outlined above, that Iraq’s overall fiscal medium-term fiscal objective should be to accumulate fiscal buffers, while preserving social and investment spending needs. For instance, under current projections, a fiscal buffer of 12 months of salaries and pensions by 2018 would require a gradual improvement in the NOPB implying overall fiscal surpluses of 3-4 percent of GDP.

  • 2) Establishing a conservative baseline scenario, with realistic oil price and export volume assumptions. The Ministry of Finance does not have a macro-fiscal unit that is capable of making macroeconomic projections. As a consequence, the Budget Directorate of the Ministry of Finance relies on export volumes that are planned by the Ministry of Oil. Over the past few years, these plans tended to over-project oil export volumes. For example, the authorities could replicate the procedure followed under IMF programs to set the budgeted oil price by applying a 10-15 percent uncertainty premium to the year-ahead World Economic Outlook oil price projections. Alternatively, the authorities could consider adopting a simple formula to set oil price assumptions based on a moving average of past and future price (see numerical fiscal rules section below). In the future, Iraq could also benefit from having a politically independent institution set macroeconomic projections.

  • 2) Identifying domestic and external sources of financing. The 2011-13 budgets included overly ambitious external financing projections, and, most importantly, overall spending plans that were not fully financed. The budget also did not fully reflect all sources of domestic financing, such as domestic banks loans and use of government deposits.

  • 3) Identifying non-discretionary spending commitments. The budget should reflect all non-discretionary obligations of the central government, including U.N. compensation payments to Kuwait, and all public sector salaries and pensions (including state-owned enterprises salaries financed with loans from Banks Rafidain and Rasheed).

  • 4) Setting realistic discretionary spending path that include all spending commitments. The 2011 and 2012 budgets did not include all planned spending explicitly in the budget tables, including some large items such as transfers to state-owned enterprises and purchases of military equipment. The inclusion of all spending commitments in the budget would help ensure that all spending is actually funded by planned revenues and sources of finance, and would also help increase transparency.

  • 5) Preparing a statement of fiscal risks. This statement is intended to raise awareness of the vulnerabilities associated surrounding budget outcomes, and to strengthen fiscal discipline by helping to ensure that risks are appropriately identified and managed.

Numerical Fiscal Rules

17. Iraq could, in principle, benefit from adopting a structural primary balance rule based on oil price smoothing. Experience in a number of resource-rich countries suggests that numerical fiscal rules can help maintain sustainability and support macroeconomic stability. Over the medium-term, Iraq could adopt a numerical fiscal rule to help mitigate the impact of oil price volatility on the budget, and build buffers. The first step is to compute the structural oil revenues by forecasting oil revenues by deliberately adopting conservative oil price assumptions. The second step is to target a specific NOPB using the structural revenues projections. This rule would be simple to implement, and easy to communicate to the general public and parliament.

18. However, a numerical rule needs to be calibrated carefully. Simulation of structural balance rules suggest that further work is necessary to calibrate fiscal rules and systematically assess the tradeoff between setting feasible expenditure levels, delinking expenditures from oil price volatility, and building adequate fiscal buffers. Staff simulated structural balance rules targeting a 1 percent of non-oil GDP primary surplus to build fiscal buffers using three different price-smoothing formulas:6

Rule 1: 5-year moving average of the past 5 years. This rule can track changes in prices, but may result in volatile spending envelopes and pro-cyclical fiscal policy (light blue line).

Rule 2: Simple average of past 5 years, the current year, and the future 5 years (as Trinidad and Tobago) (red dotted line).

Rule 3: A 16-year moving average of oil prices (prices for the past 12 years, projected prices for current and next 3 years) (as Mongolia). This rule attaches high weight to past prices and allows a more gradual incorporation of future prices (black line).

19. Simulations of these three rules illustrate the potential challenges in implementing these rules in times of large oil shock (2009) or declining oil prices (2013-2018). The simulation results are affected by the large drop in oil prices in 2009, and the subsequent rebound in 2010-2012. The 2010-2012 price levels get carried over to the oil price formulas in a declining oil-price outlook for 2013-2018. Thus, further work is needed to calibrate an oil-price smoothing formula that is realistic, simple to compute, and projects fiscal outturns consistent with the overall expenditure path envisaged in the medium-term policy scenario of the 2013 Article IV report.

uA02fig08

Real primary expenditure growth

(Percent change, year-on-year)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations.
uA02fig09

Realized Non-Oil Primary Balance

(Percent non-LNG GDP)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations.
uA02fig10

Cumulative financial savings

(USD billion)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A002

Sources: IMF staff calculations.

E. Building Fiscal Institutions

20. International experience suggests that successful implementation of fiscal rules depends on strong fiscal institutions. At present, Iraq’s fiscal institutions are weak. While the Public Financial Management law of 2004 codifies best international practices, it is not fully enforced. Efforts to implement an Integrated Financial Management Information System (IFMIS) that would help improve budgeting, budget execution, spending controls, and fiscal reporting have stalled. Iraq still relies on manual recording of spending, spending controls and reporting has lagged. The authorities have relied on off-budget advances without allocation to fund immediate spending needs, undermining the budget process. The authorities also lack a coherent debt management strategy, and rely on financing from state-owned banks Rafidain and Rasheed to fund state-owned enterprise operations.

21. The authorities have a good window of opportunity to codify key Public Financial Management (PFM) reforms as part of their present process to redraft the Public Financial Management Law. Moreover, the authorities should redouble their efforts in enhancing PFM practices by implementing IFMIS, refraining from off-budget spending, and improving investment planning and execution, debt management, and fiscal reporting.

References

  • Barnett, Steven, and Rolando Ossowski, 2002, “Operational Aspects of Fiscal Policy in Oil-Producing Countries,IMF Working Paper No. 02/177 (Washington: International Monetary Fund).

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  • IMF, 2012a, “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.

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  • IMF, 2012b, “Macroeconomic Policy Frameworks for Resource Rich Developing Countries—Analytic Frameworks and Applications—Supplement 2,IMF Policy paper. Available at http://www.imf.org/external/np/pp/eng/2012/082412b.pdf.

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  • Villafuerte, Mauricio, and Pablo Lopez-Murphy, 2010, “Fiscal Policy in Oil Producing Countries Dureing the Recent Oil Price Cycle,IMF Working Paper No. 10/28 (Washington: International Monetary Fund).

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1

By Francisco Parodi.

5

For a discussion and applications of the NOPB, see Barnett and Ossowski (2002) and Villafuerte and Lopez-Murphy (2010).

6

For more information on the formulas, see IMF (2012b).

Iraq: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.