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.

Sovereign Wealth Fund Options1

A. Introduction

1. Oil revenues boosted Iraq’s sovereign reserves during the past ten years. Iraq’s monetary reserves (held by the Central Bank of Iraq, CBI) and fiscal reserves (maintained in the Development Fund for Iraq, DFI) grew strongly over the past ten years, reaching $18 and $70 billion respectively by the end of 2012. Reserves are financed almost exclusively from oil revenues which account for over 90 percent of both export receipts and government income. Since Iraqi law prohibits government borrowing from the CBI, official international reserves play no role in financing the government.

uA03fig01

Central Bank Reserves and Development Fund of Iraq

(In billions of U.S. dollars)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A003

Source: Iraqi authorities.

2. The rapid growth of Iraq’s sovereign reserves has prompted discussions within Iraqi policy circles about their appropriate level and how best to manage them. This note addresses these questions, drawing on the experience of other natural-resource rich countries.

B. The Current Set-Up for the Management of Iraq’s International Reserves

3. Post-2003, Iraq set up a two-tier architecture to manage its international reserves. Monetary reserves are managed by the CBI and kept in highly liquid assets or cash, following the investment guidelines developed with the help of the Fund. Fiscal reserves are held in the DFI, which was established in 2003 by the UN Security Council Resolution 1483 as a way of accumulating Saddam-era frozen assets, monitoring its oil revenues and ensuring the payment of war compensations to Kuwait. Also, to enhance the protection of Iraqi assets from debtors and other claims, the resolution gave multilateral immunity to the DFI, which expired in 2011 (Iraqi assets are protected by general U.S. immunities on sovereign assets, and by special immunities granted by the U.S. in 2003).

4. The DFI has been the most successful fiscal institution in Iraq. The DFI is an account held by the CBI at the Federal Reserve Bank of New York on behalf of the Iraqi Finance Ministry. All Iraqi oil export receipts are deposited directly by the buyers into the Oil Proceeds Receipt Account (OPRA). After an automatic 5 percent deduction for Kuwait war compensations mandated by the UN is applied, revenues are transferred to the DFI. Payments out of the DFI are carried out against checks signed by the Minister of Finance and the Prime Minister of Iraq, including for financing government imports and other foreign expenditure. Over the past years, the Iraqi government has directed investment partners to credit the account with other types of payment, such as oil contract signature bonuses or mobile phone license fees.

5. The DFI is designed to maximize transparency. From its creation, the DFI was subject to robust international oversight, which was later transferred to the Iraqi authorities on June 30, 2011 when the original DFI structure created under the UN mandate expired. The authorities decided to maintain the DFI essentially unchanged. The account is audited twice a year by an international audit firm selected by a supervisory board, previously co-chaired by the UN and the Iraqi Government and now chaired by the Iraqi Board of Supreme Audit. The audit results are published on a dedicated website (www.cofe-iq.net/pages/e_home.htm).

6. The DFI has helped Iraq absorb negative oil price shocks. While originally conceived as a transit account, the DFI has been operating as a de facto stabilization fund, allowing the government to accumulate reserves through strong fiscal performance in boom years, and financing spending when oil revenues fall short. Thus, the government drew resources from the DFI to avoid slashing spending, especially on current expenditure, following the 2008 oil price shock. As a result, the DFI was almost depleted in the course of 2009, declining from $27 billion in August 2008 to $7.7 billion in June 2009.

7. Oil revenues feed the DFI and are partly transferred to the CBI reserves through government spending. Oil revenues which accumulate at the DFI as fiscal reserves become international reserves of the CBI when the government repatriates the foreign exchange and sells it to the CBI to finance domestic spending. The foreign currency amount adds to the international reserves of the CBI, and domestic currency spent by the government increases domestic currency liquidity in the economy, which in turn creates demand for foreign exchange. Given the high dollarization of the economy, the size of the additional demand for foreign currency (the rate of transformation of the DFI reserves into CBI foreign assets) is estimated by staff at about 40-50 percent of domestic government spending assuming that (a) a large share of goods consumed by households is imported, (b) durable consumption goods and real estate are paid in dollars, and (c) most savings, except for small working balances, are converted into dollars or directly transferred abroad given the lack of confidence in the banking system and the limited investment opportunities.2

uA03fig02

DFI and CBI: Flows and Stocks of Iraq’s Oil Revenues in 2012

(In billions of U.S. dollars and trillions of Iraqi dinars)

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A003

Source: Iraqi authorities and IMF calculations.

C. Adequacy of Reserves

8. Central bank international reserves are adequate. The level of reserves meets with large margins standard measures of adequacy (months of imports, ratio of short-term foreign currency obligations, and coverage of monetary aggregates).3 Maintaining extra buffers compared to the standard thresholds for these metrics is justified in light of the exceptional political and security risks in the country and in the region and the dependence on a single source of balance of payments revenues. Over the medium term, as Iraq’s difficult situation and oil sector dominance is likely to continue, maintaining these buffers would require rising absolute levels of international reserves that broadly keep the metrics at their current range.

9. But, 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 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) without 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 severely limits Iraq’s earnings in foreign currency. Staff projections show that building adequate buffers would only be possible over the medium term. As a result, excess reserves, i.e., reserves over and beyond the level of fiscal buffers, would not be accumulated in the foreseeable future.

10. The need for high fiscal buffers—separate from CBI international reserves—is heightened in Iraq by the government’s lack of access to international capital markets and central bank lending. These financing sources would allow absorbing fiscal shocks, but currently they are not an option for the government. In particular, Iraq’s legal framework forbids central bank lending to the government (and therefore, use of international reserves) to buttress central bank independence, which is particularly important to avoid fiscal dominance given Iraq’s weak governance and low administrative capacity.

D. Investing Excess Reserves Through Sovereign Wealth Funds

11. The current reserve management set-up prioritizes liquidity and is appropriate for CBI reserves and DFI buffers. The main criterion for managing monetary reserves and countercyclical fiscal buffers is liquidity, rather than profitability. The current set-up, which conservatively allocates these assets in high quality sovereign instruments meets this criteria, and is supported in the CBI by investment guidelines developed with the help of Fund technical assistance.

12. A Sovereign Wealth Fund (SWF) could help manage excess fiscal reserves more aggressively. SWFs can be defined as “pools of government-owned or controlled assets that include some international assets (Truman 2011). In many resource-rich countries, SWFs have emerged as the main vehicle for managing reserves, especially fiscal reserves, with the purpose of generating long term income and providing for future generations. Emerging resource exporters also use SWFs to generate returns abroad which cannot be productively invested at home. In addition, SWFs absorb excess liquidity and reduce inflationary pressure, which are typical macroeconomic challenges in natural resource-rich countries due to the size of export revenues (Das et al. 2010).

uA03fig03

Estimated assets of major sovereign wealth funds, 2007 and 2008

US$ billion

Citation: IMF Staff Country Reports 2013, 218; 10.5089/9781484339206.002.A003

Source: Truman (2011).

13. SWFs represent a broad category that encompasses a variety of different types of financial vehicles. There are over 51 SWFs in 44 countries today, with $3.3 trillion of assets under management. Over 86 percent of SWF resources are held in foreign assets. With the exception of the five SWF in Asia, SWFs assets (over 70 percent of the total) are financed from natural resource revenues (Truman 2011).

14. International examples can be useful for the case of Iraq. SWFs differ along several dimensions:

  • Objectives (stabilization vs. long term growth and income): Over 65 percent of SWF assets are managed in savings and stabilization funds, where the main objective is to insulate the economy from the volatility of commodity markets. Examples of savings and stabilization funds are Norway’s SWF, which was initially structured similarly to the DFI, and the Russian Reserve Fund. In the remaining SWFs, assets are managed with the objective of generating long term income. Income could be generated either for the benefit of the government, as with the Kuwait or Azerbaijan SWF, or for the benefit of the central bank, as in the Korean and Singapore SWFs.

  • Funding and withdrawal rules (discretionary vs. automatic). Funding modalities for SWFs differ widely. The China Investment Corporation was initially funded by a one-off purchase of government bonds by the central bank. Other SWFs are funded through a fiscal rule setting a discrete allocation, such as in Kuwait and Azerbaijan. Norway, Malaysia and Australia automatically fund their SWF with the proceeds from realized budget surpluses. The funding modality of the DFI is similar, since oil revenues are immediately deposited in the DFI account abroad. Withdrawals from SWFs could be automatic, for example when automatically triggered by budget or balance of payment shortfalls, or scheduled based on expected future expenditures, such as pension liabilities as in the example of Norway and Kuwait.

  • Investment policies (liquidity vs. long term income): Investment guidelines for SWFs are normally tailored for their specific objectives. Saving and stabilization funds tend to emphasize liquidity as opposed to income, concentrating on ‘safe’ fixed income assets. Reserves held for long term income pursue a more diverse portfolio allocation with varying weights given to asset classes along an increasing scale of risk and return starting with fixed income instruments and ending with commodities. SWF have usually established procedures for the adoption, evaluation and review of investment policies to ensure rigor and transparency (IWG 2008a). The Santiago Principles adopted in 2008 by the International Working Group on SWF (IWG 2008b), are a voluntary code of conduct governing investment policies, disclosure rules and other parameters of SWF activity.

E. Conclusions and Implications for Iraq

15. Iraq’s sovereign reserves are high, but should be increased further. Based on several metrics, the level of international reserves held by the CBI appears adequate. Additional fiscal reserves are, however, needed, in order to maintain adequate buffers, especially given the lack of market access and the prohibition of central bank lending to the government. Furthermore, liquidity should be the main priority in managing CBI and DFI reserves.

16. The current two-tier architecture is appropriate for the foreseeable future. CBI reserves should continue to be managed prudently, following the CBI investment guidelines. The existing typology of SWFs shows that the DFI is already a de facto SWF which carries out mainly stabilization and, to a lesser extent, savings functions. Compared to other SWFs of this type, the DFI has characteristics which make it particularly suited for Iraq’s needs. First, it offers a simple and transparent revenue account. Second, by eschewing dedicated funding and withdrawal rules, it preserves the integrity of the budget process. Third, the DFI has greater political sustainability than a separate SWF would, thanks to its low profile/visibility and relatively long history, and is less likely to attract rent-seeking attention than a dedicated vehicle with a specific spending agenda. At the same time, the DFI—in its present form of stabilization fund—could be further strengthened through new features such as investment policies and guidelines, as Iraq’s capacities in these areas evolve.

17. Relatively marginal modifications to the DFI should be sufficient to manage excess reserves. Should excess reserves be accumulated beyond an adequate level of fiscal buffers, modifications along the lines of other SWFs could be considered to increase the rate of return on excess reserves. Achieving this objective should be possible by modifying the current framework without changing its main features, for example, by adding a high-return subaccount appropriately ring-fenced from the fiscal buffers.

References

  • Das, Udaibir S., Adnan Mazarei, Han van der Horn, 2010, Economics of Sovereign Wealth Funds: Issues for Policy Makers (Washington, DC: IMF).

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  • Ghosh, Atish R., Jonathan D. Ostry, Charalambos G. Tsangarides, 2012, “Shifting Motives: Explaining the Buildup in Official Reserves in Emerging Markets Since the 1980s,IMF Working Paper No. 12/34 (Washington: International Monetary Fund). Available at http://www.imf.org/external/pubs/ft/wp/2012/wp1234.pdf.

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  • International Working Group, Sovereign Wealth Funds, 2008a, “Current Institutional and Operational Practices.Available at http://www.iwg-swf.org/pubs/eng/swfsurvey.pdf

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  • International Working Group, Sovereign Wealth Funds, 2008b, Santiago Principles (Chile: Santiago de Chile). Available at http://www.iwg-swf.org/.

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  • International Working Group, Sovereign Wealth Funds, 2009, International Forum of Sovereign Wealth Funds. Available at http://www.ifswf.org/.

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  • Truman, Edwin, 2011, “Sovereign Wealth Funds: Is Asia Different?PIIE Working Paper Series (Washington: Peterson Institute for International Economics).

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1

Prepared by Yahia Said.

2

Government imports of goods and services and other foreign payments, such as debt service, are financed directly through the DFI.

3

See External sector analysis in Appendix I of the 2013 Article IV Staff Report.

Iraq: Selected Issues
Author: International Monetary Fund. Middle East and Central Asia Dept.
  • View in gallery

    Central Bank Reserves and Development Fund of Iraq

    (In billions of U.S. dollars)

  • View in gallery

    DFI and CBI: Flows and Stocks of Iraq’s Oil Revenues in 2012

    (In billions of U.S. dollars and trillions of Iraqi dinars)

  • View in gallery

    Estimated assets of major sovereign wealth funds, 2007 and 2008

    US$ billion