Selected Issues

Abstract

Selected Issues

A Risk and Rules-Based Approach to Fiscal Policy1

Building fiscal buffers for precautionary purposes and introducing fiscal rules as part of broader fiscal reforms to strengthen fiscal institutions can help Iraq address the challenges from oil revenue volatility. The paper discusses the choice and design of rules for Iraq, guided by fiscal policy priorities and the country’s institutional capacity. A ceiling on current spending is proposed as a fiscal rule that would be simple and easy to monitor and support efforts to create space for scaling up capital expenditure, build fiscal buffers to reduce fiscal policy procyclicality, and also help secure debt sustainability.

A. Context

1. Iraq’s oil sector has generated substantial revenue since 2003 but institutional weaknesses have hindered effective allocation of these resources. The proceeds from the sale of oil exceeded $850 billion between 2003–18, a period of steadily rising production and generally favorable international prices. However, poor governance, public financial management (PFM) weaknesses, and capacity limitations have diverted these windfalls away from essential investment in human and physical capital towards current spending, notably the public sector wage bill, and little has been saved in financial assets. As a result, Iraq’s development needs remain large, with wide infrastructure gaps, and difficult social conditions, highlighted by unrest last summer over the poor quality of water and electricity, and high unemployment.

uA01fig01

Use of Oil Revenue

(In percent of cumulative oil revenue)

Citation: IMF Staff Country Reports 2019, 249; 10.5089/9781513508917.002.A001

Source: IMF staff calculations.

2. The challenges for fiscal policy are set to increase in the context of highly volatile oil prices. Spending pressures are mounting in the aftermath of the war with ISIS not only due to the large reconstruction needs (an estimated $46 billion of damage to infrastructure and property2) but also demands to expand public employment and the social safety net in war-affected areas. While the recent recovery in oil prices provides some fiscal space, increased oil price volatility and the projected reversal in prices over the medium term—to well below the levels needed to balance the budget—highlight the risks involved in basing expenditure decisions on current revenue levels.

3. Iraq therefore needs a stronger fiscal policy framework to deal with oil price risks and ensure resources are directed towards much needed reconstruction and development spending. Elements of the proposed framework include well identified objectives and risk-based anchors for fiscal policy, robust budget processes and PFM, and multi-year fiscal planning supported by fiscal rules. This paper focuses on the latter aspect, discusses different rules and international experience, and considers how to select and calibrate a fiscal rule that would help mitigate the risks of oil price volatility, reduce procyclicality, and create space for higher capital spending. Establishing and implementing such a framework will also require a strong resolve to overcome potential political objections.

B. Fiscal Policy in Iraq: What Is the Challenge?

4. Iraq has one of the most undiversified revenue bases of oil exporters in the MENA region, and is correspondingly more vulnerable than most to oil price movements (Figure 1). In 2018, oil revenue accounted for about 92 percent of total budget revenue. Rising oil production has magnified this dependence—for instance at current production levels, every dollar change in oil price results in a change in total revenue by 1.1 percent of non-oil GDP ($1.5 billion), compared with 0.6 percent in other oil-exporting countries in the MENA region. On the other hand, the non-oil tax base is narrow and has been eroded by weak compliance; in 2018 non-oil revenue represented less than 5 percent of non-oil GDP.

Figure 1.
Figure 1.

Iraq: Vulnerability to Oil Prices, 1990–2022 1/

Citation: IMF Staff Country Reports 2019, 249; 10.5089/9781513508917.002.A001

Sources: Bloomberg LP; WEO; Market projections; and IMF staff estimates and calculations.1/ The Chicago Board Options Exchange (CBOE) Crude Oil Volatility Index measures the market’s expectation of 30-day volatility of crude oil prices. Deviation of Iraq oil price from international prices equals Iraq export prices minus WEO crude oil prices.

5. Volatility and unpredictability of oil prices have increased in recent years, posing significant challenges to policymakers (Figure 1). Oil price shocks are often large and persistent, with booms and busts involving prices moving by as much as 40–80 percent for as long as a decade. Oil price volatility has increased sharply especially during the 2014–15 commodity price shock, and has shown renewed volatility since the fourth quarter of 2018. Hence, forecasting commodity prices has proved exceptionally difficult in recent years (IMF, 2015 and 2019). An added factor of volatility for Iraq is the differential with international prices, which fluctuated between +1 and -10 since 2004, reflecting security-related changes in the freight cost, mixture of light and heavy crude, and delivery risks.

6. Iraq’s policy frameworks and institutions are ill-equipped to deal with these challenges. Fiscal policy is short-term oriented—largely conducted in the context of the annual budget, while medium to long-term fiscal planning supported by a policy to build adequate buffers has been lacking. Revenue projections generally reflect the oil prices prevailing at the time of budget preparation, while expenditure allocations usually follow a bottom up approach, leading to incremental trends without adequate consideration of changing government priorities or fiscal sustainability. Moreover, weaknesses in the legal framework have allowed spending to be approved outside budget procedures, and inadequate commitment control and cash management processes have undermined the integrity of the annual budget, which has become a poor predictor of fiscal outturns.3

7. These factors have together led to a highly procyclical fiscal policy and unbalanced expenditure structure, adversely affecting growth and development. Government expenditure has been closely associated with oil price changes—the correlation between growth in government spending and oil prices was 0.7 during 2003–18. The adverse impact of expenditure fluctuations on long-term growth is well documented, and is exacerbated by asymmetrical fiscal policy responses to changes in oil prices. Current spending, notably the wage bill, has been ramped up during booms, while abrupt cuts in capital spending and an accumulation of arrears have been the first line of defense when oil prices have declined. This asymmetry has skewed the structure of expenditure towards current spending—non-oil capital expenditure represented only 4 percent of total expenditure in 2018, and led to severe expenditure rigidities and limited buffers. As a result, Iraq has experienced greater economic volatility than comparator countries, and lower investment rates, which have translated over time into lower human and physical capital accumulation (Figure 1).

C. A Proposed Fiscal Policy Framework to Address These Challenges

Defining Fiscal Policy Objectives

8. The long-term goal of fiscal policy in most oil-producing countries is to leverage depleting oil wealth to promote sustainable economic development. This involves making strategic choices about the share of oil revenues to be converted into other forms of assets (real or financial) or consumed, subject to long-term fiscal sustainability and intergenerational equity considerations.4 The choices should reflect the government’s economic and social priorities, its capacity to spend efficiently, as well as the rate of return and risks associated with each form of asset.

9. Iraq’s short- to medium-term objective—which is the focus of this paper—is to meet pressing post-conflict demands and address infrastructure gaps while maintaining macroeconomic stability. The space for investment is constrained by volatile international oil prices and the lack of fiscal buffers, while a modest debt-carrying capacity and imperfect access to capital markets limit the scope for financing spending through borrowing. Fiscal policy should therefore aim at:

  • Creating space within the budget, through tight control on current spending and increasing tax revenue, to scale up the needed infrastructure and social spending, reflecting the availability of significant pledged donor support ($30 billion).

  • Managing oil revenue volatility and avoiding procyclical fiscal policy by building adequate fiscal buffers (which can be used to protect capital expenditure during downturns).

Medium-Term Budget Planning

10. Developing a medium-term orientation to budget planning would help dampen procyclicality and ensure that oil revenues are spent in a sustainable manner. Fiscal planning over a medium-term horizon helps prevent volatile annual revenues from translating into expenditure fluctuations that may destabilize the economy and reduce the quality of spending. Setting and adhering to medium-term spending plans will lower the risk of short-term spending pressures jeopardizing longer-term strategic fiscal objectives. Key components are:

  • Medium-term fiscal framework (MTFF). The budget should be underpinned by an MTFF with forecasts for broad fiscal aggregates for revenues and expenditures, formulated in line with the fiscal anchor.

  • Medium-term budget and expenditure frameworks. Such aggregate expenditure forecasts should be translated into disaggregated expenditure ceilings, including for the investment program. Initially, this would focus only on larger expenditure categories, but over time it would be implemented with greater granularity, based on component programs.

  • Strengthening macroeconomic forecasting. Reliable forecasts are essential for formulating fiscal policy decisions and assessing their impact on the economy. This underscores the importance of a strong analytical capacity supported by proper national accounts, reliable methodologies and well-qualified staff. In many countries, the establishment of a macro-fiscal unit at the Ministry of Finance has supported moves to a medium-term fiscal framework.

11. Iraq could build on the progress already made in preparing medium-term projections. The Ministry of Finance has recently started preparing indicative three-year projections for individual expenditure items as part of its budget submission. To make these targets meaningful, ministries would be expected to commit to these ceilings as part of the budget preparation process and develop medium-term plans on this basis. This can be further supported by a medium-term fiscal framework that sets the overall parameters of fiscal policy and guides the formulation of these projections. Such a medium-term framework is a prerequisite for the authorities’ planned move towards program and performance-based budgeting.

Robust Annual Budget and Supporting Fiscal Institutions

12. The budget process and public financial management frameworks can be significantly improved. Extending the budgeting horizon over multiple years would improve fiscal policy outcomes only if there is a credible annual budget and robust systems to ensure fiscal discipline and spending efficiency at all levels of government. In this regard, the following are priority areas:

  • The budget process needs to be unified and comprehensive, requiring appropriate levels of coverage of government operations and fiscal reporting. Practices or legislation that allow spending to be approved outside budget processes should be eliminated.

  • The budget should be based on the best possible forecasts, which requires a sound understanding of how parameters drive annual expenditure, as well as making repeated comparisons between the adopted budget and the budget execution outturn—both in-year and soon after the end of the fiscal year.

  • Adherence to the expenditure envelope in the adopted budget even if oil prices exceed budget projections; in this regard, while the use of lower than actual/expected oil prices in budget preparations gives policymakers a buffer, using more realistic oil price assumptions would enhance policy planning and budget transparency.

  • Fiscal reporting that reflects international reporting standards, timely and frequent, and includes within-year reporting.

13. Parliament adopted a new General Financial Management Law (GFML) in 2019 that strengthens the legal framework for public financial management. The law defines general government for the first time, establishes the need for a medium-term fiscal framework and enshrines fiscal transparency requirements. It also limits parliament’s capacity to amend the budget, as well as the scope for spending to be authorized outside budget processes. It will be important for the authorities to develop subsidiary legislation and/or adopt decisions at the council of ministers so that the law is implemented, and remaining gaps relating to guarantees and commitment controls are addressed.

14. The medium-term fiscal frameworks can be reinforced by robust fiscal institutions. Fiscal rules, stabilization funds, fiscal responsibility laws, and independent fiscal agencies or fiscal councils are example of such institutions. They seek to increase commitment and accountability of policy makers and set binding boundaries to guide the formulation of medium-term fiscal framework. They all require a strong political commitment and adequate administrative capacities and should be introduced gradually and flexibly in the case of Iraq given the fragilities. This paper focuses on fiscal rules and stabilization buffers as complementary instruments that could help improve fiscal policy outcomes in Iraq—about one quarter of oil-exporting countries have combined fiscal rules with stabilization funds. However, adopting a numeric rule should be seen as a complement to, rather than a substitute for, a strong medium-term budget framework.

Targeting the Right Fiscal Indicators

15. The fiscal framework should include a set of fiscal indicators to help assess the macro-fiscal stance and fiscal sustainability. The overall (primary) fiscal balance is the main conventional indicator for resource and non-resource rich countries, given its direct link to financing needs and public debt. However, changes in the overall balance could be cyclical rather than a reflection of changes in the underlying fiscal position. Many countries, therefore, augment fiscal analysis with measures of structural balances that strip the cyclical components of revenue and expenditure out of the overall balance.

16. As a resource-rich country, Iraq should focus on alternative set of fiscal indicators that exclude (or smooth) the volatile oil revenue. The non-oil primary balance and overall balances that uses smoothed oil prices are often used in countries where natural resource revenues represent a significant part of total revenue. The primary current balance and current expenditure are particularly informative in Iraq’s case, as they help track the use of oil revenue and focus attention on fiscal risks and adequacy of resources for public investment (Box 1). It would be useful for Iraq to provide in the policy frameworks such indicators and report them in the annual budget.

Which Fiscal Indicators to Target and Monitor

Policy makers rely on a range of indicators to assess various features of fiscal policy such as the fiscal stance, fiscal risks and sustainability, and quality of fiscal adjustment. For resource rich countries, the traditional fiscal indicators do not accurately capture these aspects. For instance, the large impact of externally driven changes on the oil prices on the overall balance means that it could mask large fiscal risks and could give misleading signals about the underlying fiscal position. Conventional debt measures also do not adequately capture debt and fiscal sustainability considerations or intergenerational equity, as they exclude other financial and under-the ground resources. However, the traditional indicators remain relevant and serve important objectives—for instance, the overall balance is directly linked to government gross financing requirements and changes in net financial assets, while debt indicators are important to monitor rollover risks and debt service burden. The financing of the overall balance (and its main domestic and external components) can shed light on liquidity constraints and the impact of government demand on private sector credit.

Measures that exclude oil revenue—such as the non-oil primary balance (NOPB)—are more suitable for assessing fiscal risks and long-term sustainability in resource rich countries. They measure the degree of dependency on oil and the fiscal risks involved, and when assessed against long-term benchmarks, can serve as an indicator of long-term sustainability. These measures also indicate the direction of fiscal policy, with an increase in the non-oil primary deficit indicating a loosening of fiscal policy arising either through higher expenditure or a relaxation of non-oil revenue collection. A reduction in the non-oil primary deficit would signal fiscal consolidation. The short-run macroeconomic impact of a loosening/tightening in the NOPB is similar to an externally-financed increase/decrease in the overall deficit in a conventional economy (Medas and others. 2009).

To focus on the underlying fiscal stance and the medium term, the overall balance based on price-smoothing is another useful indicator that excludes cyclical components in the fiscal position. It is usually used as a complement to the non-resource balances in resource-rich countries with long reserve horizons. Oil revenues can be decomposed into a structural and a cyclical component using various approaches, including a price-based smoothing rule. The structural primary balance is equal to the non-resource balance plus the structural component of resource revenues. In this manner, the structural primary balance target could be set to ensure a sustainable fiscal policy framework, and the smoothing rule would delink expenditures from externally-driven volatility in commodity prices. A key decision is the reference price used to calculate structural resource revenues. The reference or benchmark commodity price could be set by using an automatic price smoothing formula such as backward and/or forward looking moving averages of oil prices, or by an independent committee (IMF, 2012).

If the government is focusing on the composition of expenditures and aims at protecting capital expenditure, the primary current balances/spending should feature prominently in the formation of fiscal policy. For Iraq, this is particularly important and would improve the fiscal policy outcome in two ways. First, it will help control the extent to which transitory oil revenue increases lead to permanent increases in current outlays, thus reducing fiscal risks. Second, containing current spending growth would help create space for capital spending. However, changes in aggregate measures of public expenditure should be monitored to assess the impact of fiscal policy on aggregate demand and guard against creative accounting; a practical drawback of focusing on current spending is that it ignores difficulties in classifying current and capital expenditure.

Indicators such as the NOPB should be normalized by non-oil GDP to avoid the fluctuation in the indicators caused by oil price changes and to better reflect the domestic economy.

D. Fiscal Rules

17. Fiscal rules can promote fiscal discipline in three main ways:5 (i) Commitment device, tying the hands of the government and limiting the scope for fiscal discretion; (ii) Signaling effect, by increasing transparency in a context of imperfect information, and revealing the government’s priorities and plans; and (iii) Political function, by imposing numerical limits, rules may serve as a focal point for politicians, facilitating the formation and stability of political coalitions, and enhancing coordination (Eyraud and others, 2018).

18. Fiscal rules can help control expenditure, and limit deficit and procyclicality biases. Economic theory and empirical evidence points to a tendency for government expenditure to rise over time (expenditure creep), whereas taxes tend to grow more slowly, leading to higher deficits and the accumulation of public debt.6 The tendency of procyclical polices is also well documented, as the fiscal position is loosened during good times (when resources are abundant), with contractionary measures to reduce the deficit enacted in the downswing. Fiscal rules help correct these biases by constraining the scope for fiscal discretion (Eyraud and others, 2018).

19. These tendencies are particularly pronounced in Iraq, pointing to the benefits of rules in the short and long terms. As shown in Section B, the high dependence on oil revenue creates high expenditure volatility in Iraq, but there are also a number of structural factors that will continue to exert pressure on spending in the longer term. These include a demographic and labor structure that will exert increasing demand on public employment and public services, a large fiscal burden and contingent liabilities from a large and inefficient SOE sector, as well as inefficiencies in public spending.

International Experience with Fiscal Rules

20. Fiscal rules have become common in resource-rich countries. The number of resource-rich countries with fiscal rules increased from five in 2000 to 18 by 2015, and such countries are increasingly using two rules as a combination. Rules targeting the budget balance are the most common, combined in many countries with a public debt rule. Expenditure rules are gaining popularity among resource-rich countries (Figure 2). In most resource-rich countries, standard fiscal rules are modified to take into account fiscal sustainability and commodity price volatility. While some such countries target traditional fiscal aggregates such as the overall balance and debt (e.g., Canada, Nigeria, Indonesia, and Russia before 2010, and Peru before 2013), non-resource balance and structural balance rules are more common among resource-rich countries.

Figure 2.
Figure 2.
Figure 2.

Selected Resource-Rich Countries: Fiscal Rules, 2000–15 1/

Citation: IMF Staff Country Reports 2019, 249; 10.5089/9781513508917.002.A001

Sources: IMF Fiscal Rules Dataset, 2015; Budina and others (2012); and IMF staff calculations.1/ Resource-rich countries: Botswana, Cameroon, Canada, Chad, Chile, Colombia, Congo, Ecuador, Equatorial Guinea, Gabon, Indonesia, Liberia, Namibia, Niger, Nigeria, Norway, Peru, and Russia.

21. The performance of fiscal rules in resource-rich countries has been mixed owing to design flaws and weak institutional arrangements. Designing and implementing fiscal rules for such countries is challenging for two reasons; the technical difficulties of designing a rule that can withstand large and unpredictable swings in resource prices, and the political difficulties associated with resisting spending pressures during booms. There are a few examples of rules that have been successfully implemented (Botswana, Chile, and Norway); for instance, the presence of the fiscal rule in Chile has reduced the procyclical fiscal bias, increased the credibility of fiscal policy and contributed to a 20 percentage point of GDP reduction in net public debt before the global financial crisis (IMF 2015). In many oil-resource countries rules have been subject to frequent modification and suspension during both down and upswings in resource prices, although rules are more likely to be breached in bad times.

22. International experience highlights a number of lessons for the successful implementation of rules in resource-rich countries:

  • Political commitment, as exemplified by the Chilean and Norwegian cases.

  • Supporting institutions. Robust budget planning and monitoring, adequate PFM capacity and fiscal transparency are examples of institutional frameworks that support rules. Moreover, the creation of institutions such as fiscal responsibility laws and fiscal councils have been instrumental in enforcing and enhancing the credibility of fiscal accounts and mitigated the complexities inherent to certain rules (for example in Chile the fiscal council provides estimates of the structural balance) (IMF, 2015). By contrast, Mongolia’s fiscal rule was undermined by off-budget spending, while excessive revenue earmarking was an adverse factor in Ecuador’s case.

  • Design matters for rule’s effectiveness (see next section), such as incorporating sufficient flexibility and appropriate escape clauses to deal with various shocks. In Norway, temporary deviations from the effect of the automatic non-oil stabilizers are permitted over the nonoil economic cycle, while Chile’s structural balance rule provides room for countercyclical policy.7

  • Timing matters for commitment to the rule and successful implementation, as it is preferable to introduce rules in stable conditions. Evidence has shown that rules have helped countries preserves fiscal consolidation gains when conditions changed and are more credible and successful if introduced following a period of adjustment. Mexico and Spain, for example, adopted fiscal rules toward the end of large fiscal consolidations, using this to lock in the achievements (IMF, 2009). By contrast, Argentina’s attempt in 1999 to introduce fiscal rules in the context of extreme economic volatility was ineffective, with the rules later reversed.

Selecting Fiscal Rules: The Case for an Expenditure Rule for Iraq

23. Effective fiscal rules generally have a number of desirable features. Rules are selected mainly based on their effectiveness in achieving stabilization and/or fiscal sustainability. The choice also depends on a number of operational aspects:

  • Simplicity; the rule should be easily understood by decision makers and the public, and it should be possible to translate the implications of the rule into clear operational guidance in the annual budget process.

  • Controllability; budget aggregates targeted by the rule should be largely under the control of the policymaker.

  • Resilience; a rule should be in place for a sustained period to build credibility, and should not be easily abandoned after a temporary shock.

  • Ease of monitoring and enforcement; it should be easy to verify compliance, and policy makers should be held accountable for deviations from the rule.

  • Flexibility; the rule should be flexible enough that it can be modified in case of permanent economic shocks. Some instruments such as debt brakes and escape clauses can provide adequate flexibility, but they should be introduced with pre-established rules to trigger them, and to the extent possible, understandings about how best to distinguish temporary from permanent shocks.

24. Each type of fiscal rule varies in relation to these properties and the choice should reflect Iraq’s circumstances (see Text Table). No single rule is likely to fulfil all the above criteria simultaneously. For example, rules based on specifying ceilings for the overall balance and debt encourage debt sustainability, but at the cost of incentivizing procyclicality. Rule design could also entail trade-offs between these features. For example, increasing flexibility by including more escape clauses to allow the rule threshold to adjust in specific circumstances could come at the expense of simplicity. Using multiple rules is a global trend that emerged after the financial crisis, as countries sought to address shortcomings and trade-offs involved in single rules (what is referred to as second generation rules). It has a drawback, however, of increasing the complexity of the framework and potential inconsistencies and overlap between the rules (see Eyraud and others, 2018) for further discussion).

Assessment of Fiscal Rules

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25. For Iraq, the following should be taken into account in rule selection:

  • Solvency is not currently the main concern, notwithstanding Iraq’s limited debt carrying capacity, while volatility is a major policy challenge given the high dependency on oil revenue. The latter also makes controllability of the targeted aggregate and flexibility in the design of the rule to allow it to withstand large shocks, key considerations. More importance should, therefore, be assigned to rules that promote stability such as structural balance or rules based on price smoothing, and rules that are under the direct control of the government such as expenditure rules and non-oil balance rules. The incorporation and use of escape clauses should be carefully examined to ensure robustness of the rule.

  • The composition of adjustment should feature highly in rule selection and design. Rules on the overall, non-oil, and structural balances, public debt, or total expenditure are silent on the composition of the fiscal adjustment needed to comply with the rule. This is a crucial issue in Iraq given the recent pattern where capital expenditure has borne the brunt of adjustment and, looking forward, the need to create space for large development spending in the coming years.

  • Capacity limitations call for simplicity in the selection of the rule. The technical and institutional capabilities to adopt more complex rules such as structural, cyclically adjusted rules or rules based on oil price smoothing are lacking in Iraq’s context Fiscal reporting systems are also not in line with international standards, and many key indicators such as the structural and non-resource balances are not publicly used or included in fiscal policy analysis.

26. Based on the above, expenditure rules have a number of features that are particularly appropriate for Iraq. First, they have been shown to be more effective in reducing expenditure volatility (IMF, 2015), which is a policy priority in Iraq. Expenditure is the part of the budget causing procyclicality of fiscal policy (driven by the close link to oil price), and fiscal consolidation episodes in Iraq have historically been expenditure-based.8 Unlike deficit caps, expenditure rules also help create buffers in good times, when revenue windfalls can make spending pressures difficult to resist (Ayuso-i-Casals, 2012). As such, expenditure rules promote stabilization more directly than, for example, structural balance or price smoothing rules, which mitigate but do not fully remove volatility. At the same time, expenditure is the budget component that the government controls most directly, which helps increase the compliance rate with the rule, as shown by empirical studies (Cordes and others, 2015). For Iraq this is a clear advantage over rules targeting both sides of the budget given that revenue movements are almost entirely due to factors outside the government’s control, in particular externally driven changes in oil revenue.

27. Expenditure rules could support efforts to improve the quality of spending and encourage public financial management reform. If well designed, expenditure rules can be instrumental in improving the composition of government expenditure in Iraq and shifting resources away from outlays such as the wage bill to social and productive spending. This can be achieved by excluding certain items from the ceiling, or by breaking down the overall spending ceiling into separate thresholds for each of the main expenditure areas, which in turn provides clear policy guidelines and priorities for policymakers. Moreover, multi-year expenditure ceilings are by definition a top-down approach to budgeting and as such form the basis for well-designed medium-term budgetary frameworks. When translated into procedural spending rules, they can also foster strong spending commitment and control practices by spending units. In this regard, there is strong empirical evidence that expenditure rules have fostered complementary public financial management reforms and strengthened budget procedures, such as the adoption of top-down budgeting, and their introduction has often been accompanied by a strengthening of medium-term fiscal frameworks (Ayuso-i-Casals, 2012 and IMF, 2015).

28. While a rule on the non-resource balance (NRB) shares similar features, for Iraq it would add little value compared with an expenditure rule. A NRB rule includes the non-oil component of revenue, thus has a broader coverage than an expenditure rule. Targeting the non-resource balance would help reduce volatility and facilitate an explicit link to long-term sustainability and intergenerational equity. A rule on the NRB is generally recommended for countries with shorter reserve horizons where issues of exhaustibility should figure more prominently (IMF, 2012). Moreover, non-oil revenue in Iraq is limited (3 percent of GDP in 2018), and thus expenditure is the dominant factor in non-oil balance movements. An expenditure rule would therefore play a similar role to the non-oil balance, but with the added advantages of simplicity and ease of monitoring. Expenditure rules are also more directly linked to absorptive capacity (IMF, 2015), which would support macroeconomic management (e.g., avoiding overheating and large current account deficits) and reduce spending inefficiencies. As the share of non-oil revenue becomes more important in the future and intergenerational equity becomes a policy priority, Iraq could consider moving to a non-oil revenue rule anchored on long-term benchmarks.

29. Expenditure rules have some potential shortcomings that can be addressed in their design and by combining them with other rules. As they cover only one side of the budget, other rules are required to ensure that the overall balance is consistent with macroeconomic stabilization and sustainability. Empirical evidence has shown that combining expenditure rules with other rules is associated with higher primary balances and lower primary spending (IMF, 2015). For example, an expenditure rule combined with a debt rule, a common combination in emerging market economies, would assist policymakers with short to medium-term operational decisions and provide a link to debt sustainability. A number of resource-rich countries have combined expenditure rules with structural balance rules (for example Colombia, Peru, and Mongolia).

Design and Implementation Issues

30. The coverage of the expenditure rule should be determined based on policy priorities. This involves layers of the government and the expenditure categories to be included in the expenditure ceiling. In most countries—and especially in resource-rich countries (Figure 2)—the coverage of the rule is limited to central government for operational feasibility reasons. Many countries also exclude certain expenditure items such as interest payments, cyclically-sensitive expenditure, capital expenditure, and security-related spending. For instance, in the EU countries, expenditure rules coverage ranges between 20 to 80 percent of general government expenditure (Ayuso-i-Casals, 2012). More comprehensive coverage is better from a fiscal sustainability viewpoint, but other considerations such as improving the composition of spending to promote long-term growth or the difficulty of controlling some outlays may argue for excluding certain items.

31. In Iraq’s case, setting the ceiling on current primary spending at the central government level would support efforts to scale up and protect public investment. Excluding capital expenditure from the rule would help allocate adequate resource to rebuild the country after the war and close infrastructure gaps. It would also prevent the buildup of fiscal risks during oil price booms—by controlling the growth of current spending, which is difficult to reverse during shocks. In this regard, more than a third of the resource-rich countries with expenditure rules protect public investment by excluding it from the rule, while some of these countries include capital expenditure but establish limits for capital expenditure growth that are higher than those for current spending (Figure 2). To be effective, a current expenditure rule should be supported by measures to strengthen public expenditure management to ensure efficiency of capital spending and prevent creative accounting (reclassification of spending items) to circumvent the rule. Iraq can expand the rule coverage in the future to general government as capacity to monitor and control other public spending improves, and to include capital expenditure once the country’s capital stock has been built.

32. A multi-year horizon for the expenditure rule seems preferable to a one-year target, and would support efforts to move to a medium-term fiscal framework. A longer horizon supports the management of public expenditure by allowing prioritization, taking into account the future impact of current spending policies over the next years, and setting targets consistent with the expected macroeconomic outlook and sustainability issues. A multi-year horizon would also limit the potential circumvention of the rule by postponing the recording of expenditures or the implementation of structural adjustments. Longer planning, however, may be associated with lower compliance when macroeconomic conditions change, which are frequent in the context of Iraq’s high exposure to large swings in oil prices. Regardless of the time horizon, targets should be adopted before the outset of the annual budget process to ensure that the spending rule guides the preparation and execution of the budget.

33. Setting the rule’s target as a ceiling on expenditure in nominal terms would be easier to implement and more effective in controlling expenditure in Iraq. Targets for expenditure rules could be a ceiling either on (i) nominal expenditure (in levels or growth terms); (ii) growth of expenditure in real terms; or (ii) expenditure as share of GDP (or non-resource GDP in resource rich countries). The latter may be preferred over a longer planning horizon, or if the goal were to control the overall size of the public sector, but it is difficult to control and is associated with lower compliance rates than ceilings on nominal expenditure or expenditure growth (Cordes and others, 2015). For Iraq, oil price-driven fluctuations in nominal GDP would destabilize expenditure if the rule is expressed in relation to GDP, which would result in procyclicality. It could also increase expenditure during oil price booms to unsustainable levels. Therefore, from a stabilization point of view and other considerations including transparency and simplicity, targets expressed in nominal terms would be preferred to those expressed in relation to GDP or non-oil GDP.

34. Developing procedures to adjust the expenditure target to structural changes in non-oil revenue would be useful for Iraq.9 It would create incentives to diversify revenues, and thus reduce vulnerability to oil prices. The additional expenditure would not increase fiscal risks or a deterioration in the non-oil primary balance, making the expenditure rule more closely linked to long-term fiscal sustainability. In this regard, adjustment to the rule should be symmetrical and apply only to permanent increases/decreases in non-oil revenue.

35. The rule should have a clear institutional mechanism to deal with large oil price shocks and correct past deviations from the numerical target. Large oil price drops could result in excessive headline deficits and a sharp rise in public debt. While in the case of a rule on current spending, capital expenditure can be adjusted to absorb the shock, the rule should identify the size of the overall deficit that would trigger adjustment to the current expenditure ceiling. On correcting past deviations, this is important to increase compliance and can be achieved by including in the rule a mechanism that defines under which circumstances past deviations should be corrected and establishes over what period this should be carried out, with an explicit enforcement procedure. This correction mechanism can be applied at the aggregate level or at the spending unit level.

36. The rule could initially be formalized through a cabinet decree, but ultimately needs to be supported by legislation. Most fiscal rules are backed by legal provisions, especially in emerging countries where rules are more commonly supported by fiscal responsibility laws and transparency and accountability features than in advanced countries (Figure 2). However, rules can also be established through political commitments and coalition agreements: in advanced economies, expenditure rules tend to be more closely integrated into Medium-Term Expenditure Frameworks, which are sometimes part of coalition agreements (IMF, 2015). For Iraq, the rule can be introduced as a policy guideline for the medium-term budget framework and later, after building capacity and a successful implementation in a learning period, can be supported by a law.

Calibrating the Rule

This section presents an exercise of how the rule can be put into practice in Iraq. The calibration is carried out in three steps, starting from identifying and calibrating the rule’s anchor—in order to quantify the fiscal objectives—to deriving the operational rule (the ceiling on current expenditure).

Step 1. Identifying and Calibrating the Rule’s Anchor

37. The first step in calibrating the rule is to define and specify a numerical target to anchor the medium-term framework, which in Iraq’s case is best done through a risk-based approach (IMF 2012, 2018).10 Specifically, given oil revenue volatility and uncertainty, this approach entails building fiscal buffers to mitigate the impact of oil price shocks on spending. Most resource-rich countries have established funds for this purpose and specified rules for accumulation and withdrawals from these funds (Box 2). Several methods exist to calculate the level of financial saving that countries should maintain as a precautionary buffer that can be tapped to support spending when resource revenues fall short.

  • For Iraq, maintaining a buffer that covers part of the revenue loss from a potential permanent shock to oil prices could be an appropriate benchmark to help calibrate the expenditure rule. The shock can be estimated based on one standard deviation (SD) of the forecast errors as a proxy for volatility. The potential revenue loss is the sum of the differences between oil revenue under the central forecast of oil prices (Rb) and oil revenue at one SD below the central forecast (Rs). The government’s decision as to how large a buffer it builds to cover such a potential loss depends on its risk tolerance, captured by (δ ) in the following equation:
    FBt*=FBt1+δΣt+1N(RbRs)(1)
  • To illustrate how this rule of thumb would have anchored fiscal policy in the past, a simulation for 2010–18 is applied based on maintaining a buffer equivalent to the one year ahead revenue loss resulting from an oil price shock. It shows that the government could have built a buffer of over $104 billion (45 percent of GDP) by 2014, which would have been sufficient to cover the entirety of the oil price shock in 2015–16 and still remained large by 2018. It would also have supported a more countercyclical fiscal policy compared with actual policy in the 2010–14 upturn as well as the downturn in 2015–17.11

  • Looking ahead, applying the same methodology to WEO oil price projections, a negative oil price shock equivalent to one standard deviation, implies an annual revenue loss of about 28 percent of Iraq oil export proceeds in one year ahead. The loss is much higher in the longer term reaching 40 percent by 2024 as forecast uncertainties rise. The buffer target could be set at a level equivalent to the potential revenue loss in one year ahead (about 12 percent of GDP on average over 2019–24).12

  • Modifying/changing the anchor in the future. In the transition period, the adequacy of the buffer to absorb a larger shock can be increased if (i) oil prices increased above current projections and/or (ii) capital expenditures are underexecuted. If, on the other hand, the oil price shock materializes and turns to be persistent, the government would use this buffer to protect expenditure under the rule. Once Iraq has accumulated large buffers, beyond precautionary levels, the rule’s anchor can be revisited.

uA01fig02

Public Expenditure and Fiscal Buffer

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 249; 10.5089/9781513508917.002.A001

Source: IMF staff calculations.
uA01fig03

Fiscal Buffer Under Different Risk Tolerances

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 249; 10.5089/9781513508917.002.A001

Source: IMF staff calculations.

Step 2. From the Buffer Target to the Overall Fiscal Balance Path

38. The second step is to derive the budget balance consistent with the buffer target identified above (of 12 percent of GDP), taking into account below-the-line financing items. The initial transition period, in which the level of buffer gradually converges to its target, should be determined based on a feasible fiscal adjustment path. The overall balances over this period should lead to a gradual buildup of the buffer and their sum should result in reaching the target by a specific date. In the steady state, the fiscal balance should remain at a level consistent with the buffer target every year. Financing below the line will affect the level of the implied overall balance (OB), derived according to the following accounting identity:

OB*=ΔFiscalBuffer+Δfinancing(2)

39. The build-up of the buffer should not be achieved through excessive or overly expensive borrowing that would put gross debt on an unsustainable path. When feasible, the buffer should be accumulated from actual budget surpluses. However, as part of an asset-liability management, the government may decide to borrow to build the fiscal buffer for a number of reasons.13 Provided that the fiscal positions is not changed, the net debt (debt-buffer) will not be affected, and decline as share of GDP. Excessive recourse to borrowing to accumulate assets could, however, increase gross debt and financing needs to unsustainable levels. Importantly, without controlling for debt, the buffer target would no longer provide a meaningful anchor for the rule and for the adjustment in the fiscal balance. To avoid the risk of circumventing the rule, the medium-term fiscal framework should be formulated with a view to ensuring that debt remains within sustainable levels. The frameworks could explicitly set, within the overall debt limit, restrictions on specific financing items, for example borrowing from the central bank or to allow certain external borrowing such as project financing.

Starting from an initial path for the overall balance (OBi) that is consistent with debt sustainability, the targeted overall balance OB* required to increase the buffer from its initial level (FB0) to a targeted level (FB*), can be derived as follows (lower case indicates percent of GDP):

ob*=(obi)+(fb*ηfb0)(3)whereη=11+gandgisinvariantnominalGDPgrowth.

The second term of Equation 3 is the additional adjustment in the overall balance to achieve the targeted buffer.

40. Convergence to the buffer target could be gradual over the medium term in view of the current outlook. The pace of fiscal adjustment needed to reach the target depends on a number of factors including the distance to the target (from the projected level of 6.7 of GDP in 2019 to the targeted 12 percent of GDP) and macroeconomic projections, especially the projected path for oil prices. Should oil revenue surprise on the upside, convergence can be accelerated. Below is an illustration of different speeds to reaching the buffer target and the corresponding overall balance in each case. Equation 3 can be modified to allow different time horizon for the convergence to the buffer target as follows:

ob*=obi+λ(1+λ)n1[fb*(1+λ)nfb0](4)whereλ=g1+g

Assumptions:

Nominal GDP growth and public debt levels over the medium terms are derived from a proposed adjustment scenario in the accompanying staff report—a debt to GDP ratio of 49.9 percent on average over 2020–24 and nominal GDP growth is 7 percent annually on average. After 2024 the long-term GDP growth is assumed to be 6 percent, and debt to remain at its level in 2024 (49.2 percent of GDP).

1. Achieving the target over the medium term: to achieve the target gradually over five years (by 2024), the overall balance should not exceed -1 percent of GDP during the convergence period (derived as -2.6 percent of GDP as the initial level consistent with the debt path and 1.6 percent of GDP additional adjustment to build the buffer) (Figure 3).

Figure 3.
Figure 3.

Iraq: Convergence to the Buffer Target, 2019–29

Citation: IMF Staff Country Reports 2019, 249; 10.5089/9781513508917.002.A001

Source: IMF staff calculations.

2. Converging over a longer time horizon to allow scaling up of capital expenditure (recommended). The authorities may wish to build the buffer more gradually over the medium term and accelerate it once a desired level of capital spending has been reached (see Step 3). If the time horizon is set at 10 years, the overall balance over the medium term, 2020–24 can be relaxed to -2 percent of GDP, and tightened thereafter to -1.3 percent of GDP over 2025–29 to ensure the buffer targeted is achieved by the end of that period (Figure 3). On current oil price projections, this would strike a reasonable balance between mitigating risks and creating space to scale up capital expenditure in the coming years.

Step 3. From the Overall Fiscal Balance to the Expenditure Ceiling

41. The final step is to calibrate the operational rule for expenditure growth. Projections of the revenue side is needed in this step. Current macroeconomic projections over the medium term (see accompanying staff report) are used. Beyond 2024, oil revenue (roil) is projected to grow by 3 percent (1 percent increase in oil exports and 2 percent increase in oil prices). Non-oil revenue (rnon) grows in line with nominal non-oil GDP growth, which is 8 percent. Using the overall balance level identified in Step 1 and these revenue projections, the expenditure level (e*) consistent with the rule can be calculated as a residual:

  • Creating space for capital expenditure. From the overall expenditure envelope, a ceiling on current expenditure (ce*) can be set to ensure adequate space for capital expenditure (capex*), which would be a target in the rule, ce = e* – capex*. Determining how much and how fast public investment can be scaled up would be challenging given data limitations. One approach is to use benchmarks: for instance, the level of investment and capital stock shows that Iraq’s capital stock is well below those in comparators (125 percent of GDP versus 175 in the GCC region). These estimates (available in the IMF expenditure assessment tool database) follow a uniform approach of accumulating public investments and do not reflect the destruction to infrastructure caused by wars and violence in Iraq over the past decades. More sophisticated general equilibrium models are proposed as an alternative option (IMF, 2012), but they are also very sensitive to parameter calibration.

  • Taking into account capacity limitation. Gradually scaling up investment would give the authorities time to improve absorptive capacity and public investment efficiency and build fiscal buffers to prevent a disruption to investment if there is a negative oil shock (IMF, 2012). Iraq can safely increase the level of non-oil capital expenditure from about 1.4 percent of GDP in 2018 to about 5 percent over the medium term (so total capital expenditure including oil, which is linked to oil production targets, would increase from about to 5.3 percent in 2018 to 9 percent of GDP in 2024). This would help Iraq cover about half of damage caused by latest war with ISIS (estimated by the Work Bank at $88 billion). The nonoil capital expenditure should be a target under the rule but can be adjusted upward once the buffer target is reached, taking into account capacity of implementation. At the same time, the rule should specify that unexecuted capital spending should be saved in the buffer.

  • Choosing the time horizon. The authorities should determine the timetable to achieve the rule’s objectives and, based on that, set a fixed annual ceiling on current spending. As an illustration, to achieve the buffer target of 12 percent of GDP over the medium term and increase capital spending to 4.8 percent by 2024 and remains constant afterwards, the annual growth in current expenditure should not exceed 1.8 percent. A more gradual approach which staff suggests at current oil price projections is to achieve the buffer target over a 10-year horizon, which would allow a higher annual growth in current spending of 2.5 percent (Figure 3).14

E*=(roil+rnon)ob*(5)

42. Adjusting the ceiling upward in case of structural increase in non-oil revenue. Adjustment should take place on an ex-post basis to avoid using overly optimistic revenue projections to relax the rule. One option is to adjust the ceiling by one year lagged change in the moving average of the ratio of non-oil revenue to non-oil GDP (Rnon).

ce=(e*capex*)+Δt1Rnon(6)

This would give more flexibility in the rule without risking long-term sustainability and would not affect the buffer target and its coverage to oil price risks.

Fiscal Buffers

Saving a share of oil resources for precautionary reasons would help Iraq manage oil revenue volatility. Building fiscal buffers during good times that can be tapped when oil revenues fall short is a self-insurance mechanism that would help smooth expenditures and promote countercyclical policy. Most resource-rich countries have established some sort of fund for this purpose,1 ranging from separate institutions with discretion and autonomy, to funds that amount to a little more than a government account. Empirical evidence has shown that such funds can help achieve policy objectives if they are well designed, supported by strong institutions, closely linked to broader policy objectives, and backed by a strong political commitment (IMF, 2015).

Many resource-rich countries have set pre-announced thresholds, above (below) which funds are built up (drawn down). For example, in Mexico, oil revenues in excess of 4.6 percent of GDP are saved in the reserve fund, which can be drawn upon when oil revenues fall below this benchmark. In Russia, when current oil prices are above the benchmark long-term oil price, the resulting savings are deposited in the reserve fund until it reaches 7 percent of GDP; when current oil prices are below the benchmark price, the reserve fund can be tapped. Other resource-rich countries, however, have accumulated buffers without establishing specific rules, relying on discretionary transfers, and net flows into the stabilization fund are a residual of the overall fiscal balance and financing mix decided by the government.

The appropriate size of the fiscal buffer depends on country circumstances. In general, at a certain degree of risk tolerance, precautionary buffers should be larger the more dependent the country is on resource revenues (i.e., the less diversified is the revenue base), and the larger and more persistent is the volatility of resource revenue. Credit-constrained countries need larger buffers to provide more self-insurance against shocks. The optimal size also depends on the strength of the government’s balance sheet, the structure of expenditure, and the costs and speed of adjustment in the event of shocks. For Iraq, these considerations point to the need for sizable buffers, although this should be weighed against the country’s pressing development needs, which would make maintaining very large buffers difficult to justify and achieve.

Iraq does not have formal arrangements to save from oil revenues, but in the past has built buffers during windfalls. These buffers were insufficient to withstand large oil price shocks (Iraq saved only 8 percent of oil revenue on average annually during 2004–18) and they were quickly exhausted. During 2011–14, when oil prices exceeded $100 on average, a very small share—less than 4 percent of oil revenues—was saved. The government has often used conservative oil prices in annual budgets to guard against oil prices declines, but intra-year spending increases through supplementary budgets and off-budget spending has also prevented the buildup of buffers.

Iraq could move gradually towards maintaining a stabilization buffer on a risk-based approach. A pragmatic approach is for the government to target a certain level for the fiscal buffer over the medium term. Including in the budget documents alternative macro-fiscal scenarios showing the implications of changes in key macroeconomic assumptions such as different oil price and production scenarios, could be a basis for determining the size of the precautionary buffers and the space that needs to be created in the budget to achieve the targeted buffer. The existing balances of the government at the central bank would act as a “virtual” stabilization fund. As assets build up to significant levels, the government would then need to establish rules for transparency and management of these assets. At this stage, a formal stabilization fund with fixed rules may prove difficult to design and operate in Iraq.

Several methods have been advanced in the literature to calculate the level of net financial wealth on a risk basis. For instance, IMF (2012) proposes a few options including use of a value-at-risk (VaR) approach or a model-based approach to estimate the minimum buffer that can absorb tail risks in resource revenue volatility, and proposes that the buffer should be large enough that—with a high probability—it is not fully depleted over the forecast horizon and, therefore, expenditure cuts can be avoided. Another approach developed in IMF (2015) calibrates the level of financial savings to ensure that investment returns on financial assets are sufficient to avoid a large fiscal adjustment in the event that commodity prices fall. To illustrate, IMF (2015) computes, for three major oil exporters, the level of financial assets that would generate sufficient investment returns to cover half the lost revenue over five years with 75–90 percent probability.

1/ Countries that have or have had resource fund are Algeria, Azerbaijan, Bahrain, Brunei, Chad, Ecuador, Gabon, Equatorial Guinea, Iran, Kazakhstan, Kuwait, Libya, Mexico, Norway, Oman, Qatar, Russia, Sudan, Timor-Leste, Trinidad and Tobago, and Venezuela. The State of Alaska and the Province of Alberta also have funds, and Alberta also has a fiscal rule.

E. Conclusions

43. A strong policy framework can help Iraq manage the challenges arising from its heavy dependence on volatile oil revenues. The procyclicality of fiscal policy has led to short-term economic volatility and hindered long term development. Important fiscal institutions such as fiscal rules, stabilization funds, and fiscal responsibility laws that exist in many resource-rich countries are lacking in Iraq. The authorities need to move away from formulating fiscal policy in the context of the annual budget to multi-year fiscal planning, underpinned by robust budget processes and PFM systems. This will help Iraq delink expenditure from oil revenue, scale up and protect capital expenditure to support reconstruction, and safeguard long-term fiscal sustainability.

44. Moving to a risk- and rules-based approach can be part of the new policy framework and would be timely. The two main building blocks of this approach involve anchoring fiscal policy on maintaining adequate fiscal buffers, and introducing operational fiscal rules designed to achieve this target for buffers and protect capital expenditure. A well-designed and communicated fiscal rule can help manage public expectations and resist spending pressures as oil price recover from the sharp decline in 2014–16. Fiscal rules would also help lock-in the consolidation achieved during that period.

45. The choice and design of a fiscal rule is guided by a set of desirable features which should be assessed against Iraq’s specific circumstances including policy priorities and capacity limitations. A rule on current expenditure of the central government is proposed for Iraq on the basis of its simplicity, operational guidance, ease of monitoring and control, and the support it would provide to protecting public investment. Allowing adjustment of the rule ceiling to durable increases in non-oil revenue would help encourage revenue diversification.

46. Calibration of the rule shows that Iraq should set a ceiling consistent with current expenditure growth of between 1.8–2.5 percent annually over the medium term (the upper limit is consistent with the 2 percent growth in primary current spending—excluding one-off factors—recommended in the attached staff report). This would strike a reasonable balance between mitigating risks and creating space to scale up capital expenditure in the coming years. Controlling current expenditure in this range would allow Iraq to cover about half of post-ISIS reconstruction spending over the medium term and would enable the authorities to gradually build fiscal buffers equivalent to 12 percent of GDP, sufficient to withstand one year revenue loss from a permanent oil price shock.

Annex I. Fiscal Rules in Selected Resource-Rich Countries

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Sources: IMF, Fiscal Rules Dataset (2016) and Budina and others (2012), “Fiscal Rules at a Glance: Country Details from a New Dataset” (http://www.imf.org/external/pubs/cat/longres.aspx?sk=40101.0)

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1

Prepared by Gazi Shbaikat.

2

See Iraq: Reconstruction and Investment.

3

The recently adopted General Financial Management Law (GFML) offers an opportunity to address many of these issues (see ¶13).

4

At projected production rates, Iraq’s oil reserves will last over 100 years. Extraction of oil and export proceeds are projected to rise over the medium term, albeit subject to large risks on account of constraints on export capacity, OPEC quotas, and the path of international oil prices.

5

Fiscal rules are defined as constraints on fiscal policy through a simple numerical target on fiscal aggregates such as expenditure, revenue, the budget balance, cyclically adjusted balance, and debt. Rules are often enshrined in legislation, signaling the importance attached by the government to fiscal consolidation, and detail the circumstances under which the rule can be amended.

6

As income levels increase, both the demand for public goods and services (“Wagner’s law”) and the cost of providing them (“Baumol’s cost disease”) increase relative to other goods and services produced in the country, leading to a rising expenditure-to-GDP ratio (IMF Fiscal Monitor, 2015).

7

The rule combines a commitment at the end of the mandate with flexibility in terms of adjusting the path of spending to both the end-of-mandate target and the position in the business and commodity cycles.

8

Similar to evidence in in other countries including in the GCC (IMF 2017).

9

Linking the expenditure targets to revenue changes is practiced in a number of countries. For example, under the expenditure benchmark rule in the EU, public spending is not allowed to increase faster than medium-term potential GDP growth, unless it is matched by adequate revenues.

10

Ceilings on gross debt, expressed in percent of GDP, is another common long-term anchor for fiscal policy; in 2015, about 70 countries had an explicit cap on public debt. In resource-rich countries, the concept of net debt or net wealth is more appropriate than gross debt, as some of these countries have large financial savings in addition to substantial underground assets. A standard anchor for these countries is to maintain net wealth to achieve intergenerational equity based on permanent income hypothesis (PIH) benchmarks, which entails sustaining a smoothed level of consumption out of the oil wealth across generations. Versions of this rule were modified for low income countries to allow frontloading of spending to support development. For countries with a long resource horizon like Iraq, however, fiscal policy may be better anchored in a medium-term framework that focuses on delinking expenditure from oil revenue changes, which would help address pro-cyclicality and sustainability issues (IMF, 2015).

11

Government expenditure at year t was reduced by the same amount of the buffer build up. The buffer was used in 2015–17 to maintain the level of expenditure in 2014. The simulation is based on a 1 standard deviation shock-equivalent buffer.

12

This size of the buffer is in line with the methodology used for calculating reserves adequacy metric for oil exporting countries that augments the standard metric with a buffer based on the gap between current oil prices and futures prices one year ahead one standard deviation below the central futures forecast.

13

The government may decide to maintain a certain level of readily available funds as a self-insurance mechanism against oil price shocks or tightening financing conditions. Other factors that may prompt the government to borrow to build assets include the initial debt level, relative cost of borrowing versus return on buffer, and other policy objective such as developing domestic financial markets.

14

This ceiling—on the growth of overall current spending—is equivalent to the ceiling of 2 percent growth proposed in the accompanying staff report, which is set on primary current spending excluding one-off compensation payments to Kuwait.

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  • World Bank, 2019, “Global Financial Inclusion (Global FINDEX) Databasehttps://globalfindex.worldbank.org/

1

Prepared by Salim Dehmej and Amgad Hegazy, with research analysis by Alexander de Keyserling.

2

Financial development refers to the development of financial intermediation, institutions, markets and instruments. Financial inclusion covers access to and use of formal financial services by households and firms (Sahay and others, 2015), and can be assessed through indicators covering (i) access to financial services such as payment, savings, credit and insurance; (ii) usage by clients; and (iii) their quality (i.e., the extent to which they match client needs).

4

The World Bank Enterprise Survey found that less than 3 percent of firms rely on banks to finance investment projects.

5

Until recently, private banks derived considerable profits by purchasing FX from the Central Bank, and reselling to the private sector at a sizable spread, and they largely abstained from traditional lending operations. As FX spreads have narrowed over the past year, the profitability of such transactions has fallen sharply.

6

According to the World Bank World Development Indicators.

7

Global Financial Development Database, World Bank.

8

The aggregate figures also mask gender disparity since the ratio is only 20 percent for females against 26 percent for males (World Bank FINDEX Database).

9

Branch network and ATM figures are obtained through the IMF Financial Access Survey Database.

10

Deposits measured under this indicator include cash, electronic deposits or other money transfers.

11

The highest ratio in the region was in Iran, where 24 percent of adults had borrowed from a bank or other financial

12

Credit card ownership is much higher in the most advanced financial markets in the region, such as 45 percent in UAE.

13

This compares with a global average of 26 percent, according to the World Bank Enterprise Survey.

14

According to the World Bank’s Enterprise Survey, the ratio was 2.7 percent in 2011, which is the latest available data. The ratio for other countries is much higher: 14.6 percent in Egypt (2016), 34.8 percent in Morocco (2013), 46.8 percent in Jordan (2013), and 53.1 percent in Lebanon (2013). The average for this ratio is 23.7 percent for MENA (excluding high income countries). Even for low income countries the ratio is higher (16.9 percent). This is also consistent with the low level of households borrowing from financial institutions, estimated at 3 percent in 2017 (FINDEX Database).

15

Latest data available (2011), according to the World Bank’s Global Financial Development Database.

16

Iraq’s score for getting credit is zero, while the regional average is 36 (on a scale from 0 to 100).

17

The ratio exceeds 100 percent in Jordan, Lebanon, and even in a number of oil exporters in the GCC.

18

24 percent for Iraq, compared to a range of 90–100 percent for Jordan, Kuwait, Morocco, Qatar, and UAE.

19

Lending over deposit rates. The deposit rate for Iraq was higher than those in the GCC countries for which data was available during 2016–17.

20

The initiative includes also financing large projects, with an amount of ID 5 trillion (around USD 4.2 billion).

21

CBI Financial Stability Report (2017). The total amounts given to banks until December 31, 2018 exceeded ID 73 billion dinars. CBI Statement, January 14, 2019 “initiative of one trillion dinars to finance small- and medium-sized enterprises.”

22

Love, Martinez Peria, and Singh (2016) find that the introduction of collateral registries for movable assets can increase the likelihood of firms accessing bank financing by 10 percentage points, while reducing lending rates and increasing loan maturities.

24

Mobile subscriber penetration in Iraq is between 50 and 60 percent (GSMA-Middle East & North Africa-The Mobile Economy 2018).

25

Zain Cash was launched in Iraq in 2015 by Zain and Iraq Wallet, and licensed by the Central Bank of Iraq. Zain Cash allows customers to have a mobile money account linked to their SIM card or mobile application, through which they can make a range of financial transactions (money transfer, electronic bill payment, funds disbursement service).

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