Statement by Mr. Hazem Beblawi, Executive Director for Iraq and Ms. Maya Choueiri, Senior Advisor to the Executive Director, July 7, 2016

This paper discusses Iraq's First and Second Reviews of the Staff-Monitored Program (SMP) and Request for a Three-Year Stand-By Arrangement. The oil price decline has resulted in a massive reduction in Iraq's budget revenue, pushing the fiscal deficit to an unsustainable level. The authorities are responding to the crisis with a mix of necessary fiscal adjustment and financing, maintaining their commitment to the exchange rate peg. The authorities started an SMP in November 2015 to establish a track record of policy credibility and pave the way to a possible IMF financing arrangement. Their performance under the SMP has been broadly satisfactory.

Abstract

This paper discusses Iraq's First and Second Reviews of the Staff-Monitored Program (SMP) and Request for a Three-Year Stand-By Arrangement. The oil price decline has resulted in a massive reduction in Iraq's budget revenue, pushing the fiscal deficit to an unsustainable level. The authorities are responding to the crisis with a mix of necessary fiscal adjustment and financing, maintaining their commitment to the exchange rate peg. The authorities started an SMP in November 2015 to establish a track record of policy credibility and pave the way to a possible IMF financing arrangement. Their performance under the SMP has been broadly satisfactory.

1. Since mid-2014, the Iraqi economy has been severely hit by two shocks, the attacks by the so-called Islamic State in Iraq and Syria (ISIS) and the sharp decline in global oil prices. The ISIS attacks have created a humanitarian tragedy, resulting in the loss of thousands of lives and causing about four million people to be displaced internally and 27 percent of the country’s population—including about 250,000 Syrian refugees—to be in need of humanitarian assistance. The violence has also resulted in a marked deterioration in living conditions across the country and has caused extensive damage to infrastructure and assets. As a result of the two shocks, real GDP contracted in 2015, notwithstanding a large increase in oil production, and wide fiscal and balance of payments deficits emerged.

2. In view of these developments, the authorities have initiated a large fiscal adjustment program since early 2015. Building on wide-ranging reforms announced by the Prime Minister in August 2015, they also adopted a comprehensive plan mainly focused on enhancing security and reconstruction, promoting integrity and transparency, and activating lending for housing, manufacturing and agricultural projects. They engaged in a Staff-Monitored Program (SMP) with the Fund in support of their reforms plan in November 2015, and performed satisfactorily under the SMP despite challenging conditions. In light of the continued conflict with ISIS and drop in oil prices since the start of the SMP, as well as the resulting worsening economic outlook, the authorities are seeking support from the Fund under a three-year Stand-By Arrangement (SBA). The main objective of the program is to maintain macroeconomic stability during a period of high economic and political uncertainty, while protecting social spending to maintain social cohesion. The program will help manage external pressures, implement fiscal consolidation and achieve debt sustainability, strengthen public financial management, and preserve financial sector stability.

Performance under the SMP

3. Despite the rapid fall in oil prices and the challenging security environment, program performance under the SMP was broadly satisfactory, as mentioned above, with three out of the five indicative targets met at both end-December 2015 and end-March 2016. Moreover, the target on social spending was missed by only a small margin in December 2015. While the target on zero accumulation of external arrears was missed due to the government’s severe cash constraint, it is now the subject of two performance criteria under the requested SBA.

4. All three structural benchmarks for the SMP’s first review were met. The structural benchmark for the second review, consisting in the approval of a draft financial management law by the Minister of Finance, has not been met. It will be a structural benchmark for the first review under the requested SBA, and work toward achieving it is currently carried out with Fund technical assistance.

Economic and Financial Policies and Reforms in 2016–19

5. The authorities are committed to gradually bringing expenditures down in line with the new lower level of oil revenues and to strengthening revenues in order to achieve debt sustainability. Following the large fiscal consolidation undertaken in 2015, the government will implement in 2016 a fiscal program that is significantly more restrictive than the budget approved by parliament. Lower-than-budgeted execution is authorized under the country’s public financial management laws when revenue is less than what is assumed in the budget.

6. In order to reach their fiscal target, the authorities will broaden the tax base on wages for non-military personnel, reduce the wage bill (through natural attrition, delaying hiring of new staff and reducing discretionary benefits, among other measures) and reduce pension payments by enforcing existing rules. The authorities are fully aware that a large portion of the fiscal adjustment will have to be achieved by temporarily reducing non-oil investment. In this regard, they will follow a rigorous prioritization process to ensure that essential projects do not get delayed. In order to minimize the impact of the fiscal consolidation on the poor, the government will protect social spending and commits to maintain such spending above a given floor during the SBA. This includes spending on health and education, food and agricultural subsidies, and transfers to internally displaced people and refugees. Investment in the oil sector will be preserved at the budgeted level in order to secure the oil revenue needed to finance public expenditure.

7. Notwithstanding the envisaged consolidation efforts, a large fiscal deficit would remain in 2016, reflecting continued acute spending pressures that cannot be further compressed in the current difficult environment. This deficit will be financed mainly by recourse to domestic financing and external financing catalyzed by the SBA. The authorities are keen to avoid excessive indirect central bank financing of the government. Accordingly, in case oil revenue or external financing are higher than programmed, they commit to commensurately reduce the indirect monetary financing of the budget deficit by the CBI.

8. Fiscal consolidation is front-loaded and half the fiscal adjustment envisaged over 2016–19 will be achieved in 2016–17. Starting in 2017, the government intends to implement deeper fiscal reforms in order to achieve debt sustainability. These include reviewing the tax and customs codes and administrations with the aim of increasing non-oil revenue, implementing a hiring freeze in sectors other than security, health, and education, and having the Board of Supreme Audit audit the wage and pension recipients’ payrolls to eliminate ghost users. The government will also reform the public pension system and enhance the efficiency of state transfers to the poor, in coordination with the World Bank. It will also gradually reform the electricity sector and state-owned non-financial enterprises.

9. Considerable effort is being devoted to advancing fiscal structural reforms. In this regard, the authorities are strengthening their public financial management procedures to support fiscal discipline and efficient use of oil resources. With support from the Fund and the World Bank, they will approve a new draft of the Financial Management law, report fiscal tables in compliance with the IMF Government Finance Statistics, survey, audit and pay domestic arrears, take steps to move to a Treasury Single Account, design and implement a commitment control system for budget execution as well as an Integrated Financial Management Information System, implement Public Investment Management reform, and strengthen Debt Management with technical assistance support from the Japanese International Cooperation Agency. Importantly, the government will also strengthen the legislation aimed at combating corruption.

10. The stability of the exchange rate provides a key nominal anchor to the economy in an uncertain environment. The authorities are therefore committed to maintaining the peg to the U.S. dollar despite the deteriorating external position. The government will gradually remove remaining exchange restrictions and multiple currency practice with a view to eliminating exchange rate distortions. In this connection, the authorities will remove the limitation on transfer of investment proceeds that gives rise to an exchange restriction. Moreover, the CBI will increase the sale of foreign exchange for valid current exchange transactions on the official market in order to reduce the spread between the official and parallel exchange rates.

11. Safeguarding financial sector stability ranks high on the authorities’ agenda. International auditors have been appointed to conduct the audits of the two largest state-owned banks, Rafidain and Rasheed, and the results of the audits will inform a restructuring plan for the two banks. At the same time, the government is intent on strengthening the CBI’s legal framework, building on the recommendations of the Fund’s safeguards assessment of December 2015. The government will also implement reforms to strengthen the anti-money laundering and combating the financing of terrorism framework. This will help improve the integration of the domestic financial system into the global economy, lower transaction costs, strengthen governance, reduce the size of the informal sector, and disrupt ISIS funding.

12. The authorities are committed to improve the timeliness, coverage, and accuracy of macroeconomic statistics, despite serious capacity constraints. To optimize the delivery of data to the Fund, the authorities will call on external auditors to report data on three out of the six performance criteria under the requested program. They will also continue to rely on Fund technical assistance in order to strengthen fiscal reporting.

Conclusion

13. Iraq is facing a particularly difficult time in its history, and its economy is under extreme stress. The authorities have demonstrated their commitment to undertaking macroeconomic policies and implementing economic reforms under the SMP. They are fully committed to the implementation of the SBA, although stable security conditions remain a prerequisite for the success of their policies. They would like to express their deep appreciation for the Fund’s Executive Board, Management, and staff, for their continued support under difficult circumstances. They particularly appreciate the engagement and constructive discussions with the team, and the valuable technical assistance they are receiving in support of their stabilization and reform effort.