Iraq: 2022 Article IV Consultation-Press Release; and Staff Report

1. Iraq’s economy remains in the grip of a self-perpetuating cycle of fragility. During the past two decades, insecurity and political instability have discouraged private investments and put pressure on the state to maintain a social compact based on government provision of jobs and subsidies which, in turn, is entirely dependent on oil revenues. Weak institutions and governance have undermined efficiency in the use of oil resources and the government’s ability to provide adequate public services. Political polarization and social discontent have led to frequent episodes of policy paralysis precluding deep structural reforms to diversify and modernize the economy. The absence of meaningful reforms, in turn, has held back economic development and reinforced dependence on oil—a critical vulnerability in a world that is fighting climate change.

Abstract

1. Iraq’s economy remains in the grip of a self-perpetuating cycle of fragility. During the past two decades, insecurity and political instability have discouraged private investments and put pressure on the state to maintain a social compact based on government provision of jobs and subsidies which, in turn, is entirely dependent on oil revenues. Weak institutions and governance have undermined efficiency in the use of oil resources and the government’s ability to provide adequate public services. Political polarization and social discontent have led to frequent episodes of policy paralysis precluding deep structural reforms to diversify and modernize the economy. The absence of meaningful reforms, in turn, has held back economic development and reinforced dependence on oil—a critical vulnerability in a world that is fighting climate change.

Context

1. Iraq’s economy remains in the grip of a self-perpetuating cycle of fragility. During the past two decades, insecurity and political instability have discouraged private investments and put pressure on the state to maintain a social compact based on government provision of jobs and subsidies which, in turn, is entirely dependent on oil revenues. Weak institutions and governance have undermined efficiency in the use of oil resources and the government’s ability to provide adequate public services. Political polarization and social discontent have led to frequent episodes of policy paralysis precluding deep structural reforms to diversify and modernize the economy. The absence of meaningful reforms, in turn, has held back economic development and reinforced dependence on oil—a critical vulnerability in a world that is fighting climate change.

2. The authorities’ strong policy response has brought the economy back from the brink of a crisis in 2020. Securing macroeconomic stability at the outset of COVID-19 pandemic and the accompanying oil price collapse entailed difficult measures, including freezing government hiring and wages and a devaluation of the exchange rate. Since then, short-term prospects have improved with waning incidence of COVID-19 and favorable oil market conditions which provide an important opportunity to tackle economic challenges.

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Covid-19 Daily New Cases and Deaths: 2020–22

(7-day average)

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: Our world in Data (OWID).

3. However, the reform momentum has stalled. A political stalemate between the October 2021 Parliamentary elections and the formation of a new government in October 2022 prevented the adoption of a 2022 government budget and put the authorities’ reform agenda largely on hold. The implementation of the recommendations of the 2020 Article IV Consultation has been limited (Annex I). The dispute over resource sharing between the federal government and the Kurdistan Regional Government (KRG) has added a layer of complication while geopolitical strains, risks of social unrest, weak institutions, and corruption persist as formidable obstacles to reforms.

4. Meanwhile, longer-term challenges are beginning to loom large. In addition to short- and medium-term vulnerabilities to oil price volatility, the need for post-war reconstruction, and meeting the Sustainable Development Goals (SDGs), strong demographic pressures amid high youth unemployment coupled with extreme vulnerability to the effects of climate change and the global energy transition could severely test the limits of the current economic model.

Recent Developments

5. The economy is gradually recovering. Real GDP is estimated to have increased by 8 percent in 2022, driven by a 12-percent expansion in oil production, which was supported by near-doubling of oil investments. Real non-oil GDP has rebounded by 21 percent in 2021 and continued to expand at a more moderate pace, estimated at 3.2 percent in 2022. The recovery has been led by contact-intensive activities—notably retail, trade, transportation, and hospitality—and, more recently, the construction sector, which benefited from increased public investment and lending support by the central bank (Box 1).

6. Despite large shifts in global food and energy prices, domestic inflation remained stable. Following the dinar devaluation in December 2020, headline and core inflation rose, peaking at 8.4 and 8.6 percent (y-o-y), respectively, in November 2021. Since then, inflation has declined sharply and hovered around 5 percent throughout most of 2022 despite surging global food and energy prices. The limited pass-through can be attributed to the prevalence of administered prices and food and fuel subsidies. Core inflation stood at 4.2 percent as of October 2022.

7. The external position strengthened amid improved terms of trade. Helped by the exchange rate adjustment and a near-doubling of oil prices, the external current account balance swung from a double-digit deficit in 2020 to a surplus of 7.8 percent of GDP in 2021.1 In the first half of 2022, higher consumption of oil for electricity generation and a build-up of inventories owing to disruptions at export terminals have affected the volume of oil exports. Nevertheless, with rising oil prices, monthly oil export revenues increased sharply, peaking at a record-high level of $11.5 billion in June 2022. Alongside, the current account surplus is estimated at 11.6 percent of GDP in 2022. Gross international reserves rose to over $90 billion as of end-2022 from $64 billion at end-2021 (171 percent of the IMF reserve adequacy metric adjusted for potential oil price volatility).

The foreign exchange (FX) market has been broadly stable, and the market exchange rate generally remained within 2 percent of the official rate through most of 2022, although the spread rose somewhat in recent weeks due to tightening of AML/CFT controls over FX auction sales, including enhanced beneficiary disclosure requirements.2 The real effective exchange rate (REER) appreciated by 4.4 percent (y-o-y) in the first ten months of 2022 on the back of strengthening U.S. dollar.

8. The overall fiscal position improved, but the government’s dependence on oil increased. The headline budget deficit shrank from almost 14 percent of GDP in 2020 to 0.4 percent of GDP in 2021, helped by recovering oil revenues and freezing of government employment and wages. Reflecting a large oil price-driven increase in nominal GDP, the government debt-to-GDP ratio fell from 84 percent in 2020 to 59 percent in 2021.3 Nonetheless, the underlying fiscal stance remained loose as a large increase in public investments overshadowed savings in current expenditures.4 During the first half of 2022, in the absence of an adopted budget, monthly government expenditures (excluding oil investments) were constrained to 1/12th of their 2021 envelope generating large surpluses. In June 2022, spiking energy and food import and subsidy bills have prompted the adoption of the Emergency Law for Food Security and Development (henceforth “Emergency Law”), which authorized additional spending of ID 22.2 trillion (5.5 percent of GDP) on social assistance, conversion of daily workers to contractual employees, food and energy subsidies, and public investment, and set aside ID 2.8 trillion (0.7 percent of GDP) for repayment of overdue bills to farmers and energy suppliers (Text Table 1).5 The total allocation (ID 25 trillion) is equivalent to more than a third of the projected oil revenue increase in 2022. Staff estimates that the 2022 headline fiscal surplus has reached 6.3 percent of GDP in 2022 but with the non-oil primary deficit widened to 63 percent of non-oil GDP in 2022.

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Selected High Frequency Economic Indicators, 2019–22

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: Iraqi authorities; World Food Program; Food and Agriculture Organization of the United Nations; Central Bank of Iraq; Baghdad Borsa App; and IMF staff calculations.
Text Table 1.

Allocations Under the Emergency Law on Food Security and Development 2022

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Sources: Iraqi authorities; and IMF staff calculations.

9. Domestic financial conditions have been relatively accommodative. Iraq’s financial system has been largely shielded from tightening global financial conditions given its relatively closed capital account and negligible external commercial borrowing. The moratorium on loan repayments and lower required reserve requirements, which were introduced early in the pandemic, have been phased out. Since bottoming in mid-2021, deposit interest rates rose marginally while lending interest rates declined further. Credit to the private sector grew at an annualized rate of 14 percent in the first nine months of 2022 helped by fiscal loosening, which provided state-owned banks (SOBs) with significant additional liquidity, and the augmentation of the Central Bank of Iraq’s (CBI) lending initiatives (Box 1).6

10. The authorities worked to enhance the supervision of large state-owned banks, which remain undercapitalized. Iraq’s SOBs collectively account for over 80 percent of the banking system. Large legacy assets, past directed lending practices, and political interference have taken a heavy toll on their financial positions, which have been difficult to assess due to lack of core banking systems, large branch networks, and weak accounting practices. The CBI and the Ministry of Finance (MoF) have developed an action plan to improve lending practices, introduced approval requirements for loans over ID 1 billion, and developed new by-laws to enhance corporate governance, which are awaiting the approval by the State Council. Non-performing loans in SOBs have increased from 10 percent to 17.2 percent between 2019 and 2022 Q2. Private banks remain small and play a limited role in intermediation instead relying on currency exchange, commission-based services, and short-term trade finance.7

CBI Lending Initiatives

In 2015, the CBI launched two subsidized lending programs: i) ID 5 trillion, channeled through specialized SOBs and the housing fund, to support real estate, industrial, and agricultural sectors; and ii) ID 1 trillion to finance small and medium enterprises through private banks. Demand for real estate financing has been very strong while the uptake in other sectors has been limited.

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Domestic Interest Rates: 2019-22

(In percent)

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: Central Bank of Iraq (CBI).Note: Deposits are one year fixed. Loans are more than one year and less than five years.

In mid-2020, the first initiative was augmented by ID 9 trillion (4.5 percent of GDP) and the second by ID 1 trillion (0.5 percent of GDP), and later increased to ID 3 trillion. Lending terms were further eased with interest rates as low as zero for the housing sector. The bulk of the uptake continued to be in real estate sector. In 2021, the CBI launched initiatives to finance renewable energy projects and large projects (over ID 20 billion), allocating ID 1 trillion for each.

Allocations and Disbursement Under the CBI Lending Initiatives 1/

(In billions of Iraqi dinars)

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Source: CBI and Staff calculations

Until September 2022

Outlook and Risks

11. The near-term outlook is positive due to a large oil windfall. Real GDP growth is expected to moderate to 4.2 percent in 2023, with oil production averaging 4.6 million barrels per day (mbd) for the year and real non-oil GDP growth also projected at 4.2 percent. The fiscal and current account balances are projected to post surpluses of 6.1 and 8.1 percent of GDP, respectively, boosting foreign exchange reserves to US$105 billion (10 months of prospective imports). Public debt is expected to decline slightly to 40 percent of GDP.

12. The underlying vulnerabilities will likely manifest themselves in the medium term. Staff’s baseline projections assume that structural reforms will remain sluggish while oil prices would gradually decline, in line with the IMF’s October 2022 World Economic Outlook.

  • Growth and inflation are expected to moderate. Oil output is projected to gradually reach 5 mbd, while non-oil real GDP growth rate would moderate toward its potential, which, at 3.5 percent, would remain constrained by electricity shortages, water scarcity, limited access to credit, security concerns, labor market challenges, and difficult business environment.

  • The overall fiscal balance is projected to turn into a deficit around 2025 as current expenditures—driven by the wage bill—surpass one third of GDP. Without significant reforms, the non-oil primary fiscal deficit (NOPD) would remain above 63 percent of non-oil GDP, and the government would remain heavily oil dependent. Fiscal savings would be exhausted, and the declining trend in the government debt-to-GDP ratio would reverse, although the overall debt burden would remain manageable (Annex III).

  • The external position would follow a similar path. A current account (CA) deficit is projected to emerge starting 2026. Foreign exchange reserves would peak at $114 billion in 2025 and to decline to $95 billion (8 months of prospective imports) by 2027.

13. This outlook is subject to significant risks (Annex IV). While a stronger global recovery and oil prices could support larger fiscal and external surpluses, a deeper global slowdown could put downward pressure on oil revenues. Insistent demands for government jobs and subsidies could further aggravate the underlying fiscal vulnerabilities. Sanctioning of Russian energy companies could disrupt oil production.8 Stronger pass-through of global inflation and new waves of COVID-19 could disproportionately affect the vulnerable and reduce domestic demand. Realization of contingent liabilities (estimated at $21 billion in 2017) could weigh on debt sustainability (Annex III). Political polarization, social unrest, and escalation of regional tensions could dampen sentiment and paralyze policy making.

14. Iraq is particularly vulnerable to climate change and the global energy transition (Annex V). Over the past four decades, Iraq’s average temperatures increased by over 1.5 degrees Celsius. Growing water scarcity and more frequent extreme weather events are taking an increasingly large toll on socio-economic conditions, exacerbating electricity shortages, and reducing potential output, particularly in agriculture. Meanwhile, acceleration of international efforts to stem greenhouse gas emissions could trigger a precipitous contraction of global demand for oil—the lynchpin of Iraq’s economy.

Policies

Discussions focused on short-term measures to address the rising cost of living and medium-term policies to i) strengthen fiscal sustainability while making the space for critical investment priorities; ii) improve the social safety net; and iii) promote private sector development; with governance reforms encompassing all areas. Consistent with staff’s Country Engagement Strategy (Annex VI), discussions covered policies to improve governance, strengthen the fiscal framework, diversify government revenues, rein in the wage bill, reform the social safety net, fix the electricity sector, and enhance financial stability.

15. The immediate priority is to address the cost-of-living crisis. Although inflation has remained stable in recent months, there are risks of its acceleration as high global commodity prices feed through into the prices of imported manufactured goods. Should these risks begin to materialize, staff emphasized the importance of tightening domestic financial conditions—including phasing out CBI’s lending support programs, raising interest rates and reserve requirements—to contain domestic drivers of inflation. Staff recommended tightening the fiscal stance in 2023 to save the bulk of the oil windfall and avoid a procyclical spending boost, which could exacerbate inflation pressures. The 2023 budget law should provide adequate indexation of targeted cash transfers and low-income pensions to protect the vulnerable from the rising cost of living.

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Economic Goals and Priority Reform Areas

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Source: IMF staff.

A. Enhancing the Fiscal Framework

16. A sound fiscal framework is needed to manage Iraq’s oil wealth in a highly uncertain global environment. In the coming years, fiscal policy will need to balance three key objectives:

  • Strengthening resilience to oil price volatility. High oil revenues helped to rebuild Iraq’s financial buffers, a valuable cushion against short-lived oil price declines. But larger and more sustained shocks could quickly erode these buffers and reignite financing pressures.

  • Making the space for critical expenditures. With a quarter of the population living in poverty, social spending needs remain significant. In addition, fiscal policy will need to accommodate large investments for post-war reconstruction, meeting the SDGs, adapting to climate change, ending gas flaring, and boosting electricity generation. While the size of the needed public investments is yet to be identified, existing estimates are quite significant.9

  • Ensuring long-term fiscal sustainability amid a global energy transition. Ensuring long-term sustainability as the world moves away from fossil fuels would require a significant reduction of Iraq’s dependence on oil on a potentially accelerated timetable (see Annex V). This is a formidable challenge as limited institutional capacity, governance and political economy constraints, and socio-economic fragilities severely limit the scope for sweeping reforms.

17. A risk- and rules-based approach to fiscal policy would help achieve these goals. A key element of the proposed approach is continued fiscal saving for short-term stabilization purposes and to support long-term sustainability. Furthermore, containing current expenditures while raising non-oil revenues will help create the fiscal space for priority needs and improve the ability to adjust to shocks. The third element entails formulation of medium-term policies with an eye on long-term challenges, notably the need to reduce dependence on oil. Toward these ends, staff recommended establishing a fiscal rule based on an annual ceiling on NOPD that is consistent with its reduction by at least 2 percent of non-oil GDP per year. Deviations from the rule in any year would be gradually compensated over the next four years, on a rolling basis, with a view to reduce the NOPD by around 10 percent of non-oil GDP over a five-year period. The rule’s adequacy would be reviewed every five years. Such an approach would gradually strengthen Iraq’s fiscal resilience and prepare the economy for the consequences of the global energy transition (see Annex V).10

18. Staff proposed a medium-term macroeconomic reform framework consistent with these considerations. Under the baseline oil price projections, which remain high, the proposed framework would facilitate augmenting the fiscal savings for stabilization purposes to ID 43 trillion—over two thirds of the level calibrated to enable smooth government expenditures amid oil price volatility without depleting the fiscal savings with a 90-percent probability (ID 59 trillion, see Annex V)—while maintaining public debt on a declining trajectory. The proposed adjustment would be accomplished by a combination of current expenditure restraints and non-revenue measures (see below), which would allow gradually scaling up non-oil public investments and enhancing the social safety net.

19. Continuing to improve public financial management will be essential. The budget process would benefit from better macro-fiscal planning, budget preparation and execution, and a strategic medium-term approach. Improving non-oil investment planning, project selection, and transparent execution will ensure effective use of limited resources. Implementing the framework for managing government guarantees, monitoring contingent liabilities, and avoiding extra-budgetary expenditures will help contain fiscal risks. Accelerating progress with strengthening cash management and forecasting and implementing a comprehensive commitment control system, key recommendations of past IMF technical assistance (TA), will limit expenditure arrears and improve budget execution. Establishing a Treasury Single Account and accelerating the implementation of an Integrated Financial Information Management System (IFMIS) will help to significantly improve control over public resources.

Selected Indicators: Baseline

(In percent of GDP, unless otherwise indicated)

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Sources: IMF staff estimates.

Selected Indicators: Adjustment Scenario

(In percent of GDP, unless otherwise indicated)

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Sources: IMF staff estimates.

The positive growth impact of increased investments and efficiency gains from reforms is assumed to broadly offset the negative impact of fiscal adjustment.

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Baseline and Staff-Proposed Reform Scenarios, 2019–27

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: IMF staff calculations and estimates.1/Net government debt is total government debt net of TX reserves.

Authorities’ Views

20. The authorities broadly agreed with these priorities while citing pent-up spending pressures as a key obstacle to progress in the near term. The authorities expected to enunciate their 2023 budget plans in early 2023. While the government’s economic program aims at strengthening public finances and reducing dependence on oil, the authorities underscored significant spending pressures stemming from unfulfilled promises made after the 2019 protests, legally mandated hiring of certain university graduates, large investment and social needs, and continued enrollment into non-contributory pension schemes. Consequently, they saw limited scope for savings in the near term.

B. Diversifying Government Revenues

21. A medium-term strategy to progressively raise non-oil revenues would support critical expenditures while reducing reliance on oil. Given limited capacity and a low base (non-oil revenues account for around 8 percent of total revenues), efforts should start with measures that are easy to administer in better-controlled collection points (e.g., public sector entities, border crossings, and easy-to-monitor points of sale) and be gradually expanded along with improvements in administrative capacity. Due to past difficulties of sustaining non-oil revenue reforms—which were introduced in annual budget laws and automatically expired—it would be important for such policies to be reflected in stand-alone laws. TA from the IMF and other international partners could support the design of a revenue mobilization strategy.

22. Staff recommended several policy options to raise revenues in the short term. These include making payroll taxes more progressive by increasing the rate applicable to higher-income groups and applying such taxes to total earnings, including allowances; raising taxes on oil and oil derivatives, which would also promote greater energy efficiency; introducing selective sales and excise taxes on items such as luxury goods, hotels, telecom services, automobiles, alcohol and tobacco; introducing turnover taxes on retail outlets; and removing exemptions from customs duties.

23. Efforts to strengthen tax and customs administration should support revenue mobilization efforts. Priorities include improving the organizational structure of tax administration along functional lines, implementing a tax information technology (IT) system, and strengthening compliance by large taxpayers. Recent progress with digitalization of customs procedures needs to be accelerated and complemented with stronger cross-border management, including through anti-smuggling initiatives, and alignment of customs valuation, classification, and other procedures with international standards. Modernization of the customs law and re-engineering business processes for automation purposes would strengthen the legal and operational frameworks underpinning these changes.

Authorities’ Views

24. The authorities recognized the importance of mobilizing non-oil revenues and saw enhancing customs administration as a key priority. A new customs law has been drafted to align with international standards, and the authorities sought IMF’s assistance with its review. In addition, the authorities are rolling out the Automated System for Customs Data (ASYCUDA) with the assistance of the United Nations Conference on Trade and Development. The rollout is expected to be completed during the next two years, and the authorities expect boosting customs revenues (0.6 percent of non-oil GDP in 2022) by as much as fifty percent over the medium term. Prospects for other non-oil revenue measures were seen as less certain given heightened social tensions and past difficulties in securing Parliamentary approval of such measures.

C. Reining in the Government Wage Bill

25. A determined effort to reduce the government wage bill will be critical for fiscal sustainability. Iraq’s government employs nearly 38 percent of the labor force, spending around 40 percent of its annual budget—one of the largest in the world. Generous allowances and benefits associated with public employment also discourage private sector job creation. In recent years, the government wage bill has expanded rapidly as large groups of daily and contractual workers and university graduates have been admitted into the civil service. A hiring freeze, implemented as part of the 2021 budget, has temporarily interrupted this trend. More sustainable reforms are needed to contain the government payroll while promoting private employment.

26. Staff proposed a multi-pronged approach to wage bill reform:

  • Strengthening control over payroll by completing biometric registration and creating a centralized database of government employees coupled with detailed and regular reporting requirements by each government agency on the size of the workforce by grade, type of employment and compensation, as well as retirements, hiring, and promotions. Replacing statutory promotions with performance-based ones within an overall limit would help reduce wage drift.

  • An attrition-based employment reduction strategy coupled with efforts to identify and eliminate redundant positions to lessen excess employment. Over the next five years, on average, staff proposed replacing every three retirees with one new hire.

  • Enhancing the gatekeeper role of the Federal Civil Service Commission (FCSC) in approving hiring decisions and aligning such approvals with the budget planning and execution processes. This should be accompanied by eliminating the provisions in various laws that mandate automatic government employment of university graduates in various areas.

  • Closer alignment of compensation with the private sector and productivity, for example, by capping the maximum size of non-wage compensation (allowances) and linking future wage increases to economy-wide productivity gains.

While implementing these measures, staff recommended that the authorities, with TA from international partners, prepare a blueprint for a comprehensive civil service reform to be executed over the medium term.

27. Efforts to control the government wage bill should be accompanied by broader labor market reforms. The 2021 Labor Force Survey shed light on significant obstacles faced in the labor market by Iraq’s youth and women (Box 2). Staff encouraged the authorities to develop a national employment strategy with active labor market policies aimed at increasing labor force participation, removing obstacles for private employment, especially among women, addressing mismatches between educational curricula and the skills needed in the private sector, strengthening the pension system (¶30), and reducing informality.

Labor Market Conditions

The 2021 Labor Force Survey (LFS) was the first conducted in Iraq in over a decade. The overall unemployment rate was estimated at 16.6 percent with a labor force participation of under 40 percent— well below the MENA region average of 52 percent—and a median monthly earning of ID 614,000 (US$423). Among other things, the survey highlighted two key distortions in the labor market:

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Youth Unemployment by Gender

(In percent, latest available data)

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: ILOSTAT; and IMF staff calculations.Latest Available Data. OI: MENA Oil Importer, OE: MENA Oil Exporters

Youth and women face significant challenges. Only about a quarter of Iraq’s youth participate in the labor market and over 35 percent of them are unemployed. Similarly, of only 11 percent of working-age women who participate in the labor force, 28 percent are without jobs. Employed women typically hold at least a university degree and occupy professional positions. By contrast, less than 5 percent of women with primary education participate in the labor market (70 percent among men).

The State dominates the labor market. The share of Latest Available Data. OI: MENA Oil Importer, OE: MENA Oil Exporters public sector employment in Iraq (37 percent) is the highest among MENA countries. Over two thirds of all employed women work for the public sector—compared to less than a quarter in other MENA countries— whereas private sector employment is dominated by men with more than a half of private jobs accounted by the informal sector and concentrated in construction, transportation, and trade. Government jobs are overwhelmingly more attractive than those in the private sector with average wage premium of over 120 percent (even higher when accounting for more generous pension benefits).

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Public Employment Share of Total Employment

(In percent)

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: ILOSTAT; and IMF staff calculations.1/MENA Countries include latest available data for Egypt, Iraq, Iran, Jordan, Lebanon, Morocco, Oman, Qatar, United Arab Emirates, and West Bank and Gaza.
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Employees’ Average Monthy Earning Per Employment Sector

(In thousands of Iraqi dinars)

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: Labour Force Survey; Iraq Central Statistical Organization; and IMF staff calculations.

Authorities’ Views

28. The authorities highlighted some progress in public payroll control while underscoring challenges for deeper reforms. After adding over 100 thousand employees to the civil service in 2022, the government intends to halt hiring of daily and contractual workers—a key pressure point on the wage bill. In addition, the FCSC plans a biometric registration of civil servants and is strengthening the hiring process. At the same time, weak private sector job creation and high youth unemployment were seen as key obstacles to substantive reforms of the civil service. The authorities expected wage bill pressures to continue amid demands for substantial cost-of-living adjustment (after a two-year wage freeze), hiring requests from local governments, and legally guaranteed public employment of various university graduates.

D. Strengthening Social Safety Nets

29. Improving the targeting, coverage, and adequacy of the social safety net will be essential to ease socio-economic fragilities. Iraq’s social safety net is fragmented and inefficient, split among the cash transfers program, the Public Distribution System (PDS)—a universal in-kind food distribution program—and the pension system. These systems comprised almost 30 percent of current expenditures in 2021 (8.7 percent of GDP). While previous efforts have improved targeting of the cash transfer program, coverage gaps remain, and an estimated 1.7 million households who were identified as eligible do not receive assistance due to insufficient funding. At the same time, the PDS, which consumes 1.4 percent of GDP, covers almost the entire population. Staff recommended to significantly downsize the PDS (and gradually phase it out) by limiting eligibility to those in the social security database and use the savings to augment the budget for targeted cash transfers. Coverage of the latter should be expanded to include all eligible households with regular updates of the population registry and the targeting criteria, including to avoid downsizing the PDS affecting the most vulnerable. Staff also recommended introducing automatic indexation of cash transfers to inflation to preserve adequate protection on an ongoing basis.

30. A comprehensive reform of the pension system would strengthen fiscal sustainability and promote private job creation. Significant expansion of public pension benefits in recent years with unchanged contributions threaten the financial sustainability of the State Pension Fund (SPF). Meanwhile, non-contributory pensions (to families of martyrs and victims of terrorism and political persecution) combined with “legacy pensions” (to those who retired prior to 2006), which are no longer supported by contributions, require annual budget outlays of nearly 4 percent of GDP. The public pension system is significantly more generous than that of the private sector, putting the latter at a disadvantage in the labor market. Staff, in collaboration with the International Labor Organization (ILO) and the World Bank, presented a blueprint for a medium-term pension reform strategy.11 The proposed strategy would initially improve financial sustainability of the public pension system through parametric changes affecting the retirement age, the replacement rate, and the methodology for calculating pension benefits.12 Limiting survivor benefits to immediate family members, as in other countries, would help contain the future cost of non-contributory schemes. Looking ahead, reforms should align the pension schemes for private and public sectors to facilitate labor mobility and private employment.

Authorities’ Views

31. The authorities are studying options to strengthen the social safety net, a key government priority. They highlighted that the Emergency Law already raised assistance under both PDS and cash transfers programs, and the government is considering additional options. While agreeing with scope to further improve targeting, the authorities noted that eligibility for PDS assistance is already limited to those with monthly incomes below ID 1.5 million and cited the provision of increased food rations to those in the social security database. They agreed with the need for pension reforms to ensure sustainability of the SPF although cited the political economy constraints as formidable. The authorities saw improved collection of pension contributions, particularly in state-owned enterprises, as an area where progress can be made in the short term.

31. The authorities are studying options to strengthen the social safety net, a key government priority. They highlighted that the Emergency Law already raised assistance under both PDS and cash transfers programs, and the government is considering additional options. While agreeing with scope to further improve targeting, the authorities noted that eligibility for PDS assistance is already limited to those with monthly incomes below ID 1.5 million and cited the provision of increased food rations to those in the social security database. They agreed with the need for pension reforms to ensure sustainability of the SPF although cited the political economy constraints as formidable. The authorities saw improved collection of pension contributions, particularly in state-owned enterprises, as an area where progress can be made in the short term.

31. The authorities are studying options to strengthen the social safety net, a key government priority. They highlighted that the Emergency Law already raised assistance under both PDS and cash transfers programs, and the government is considering additional options. While agreeing with scope to further improve targeting, the authorities noted that eligibility for PDS assistance is already limited to those with monthly incomes below ID 1.5 million and cited the provision of increased food rations to those in the social security database. They agreed with the need for pension reforms to ensure sustainability of the SPF although cited the political economy constraints as formidable. The authorities saw improved collection of pension contributions, particularly in state-owned enterprises, as an area where progress can be made in the short term.

E. Fixing the Electricity Sector

32. The loss-making electricity sector burdens public finances while hampering private sector development.13 Caught in a cycle of inefficiency, loss-making and underinvestment, the electricity sector recovers only about a tenth of its cost and incurs annual losses in excess of 3 percent of GDP (over 6 percent of GDP if the implicit fuel subsidy is factored in). The lack of reliable access to electricity is a major constraint to private sector development and a source of social discontent. As the demand for electricity is projected to grow with the increasing population and rising temperatures, a continuation of past trends and policies is becoming increasingly unsustainable.

33. An ambitious sectoral reform strategy should seek to ensure sustainability. Key elements of a strategy should include i) enhanced monitoring and transparency of the sector’s explicit and implicit costs to inform fiscal planning and avoid arrears; ii) sustained efforts to improve collection supported by accelerated implementation of smart metering, especially for large consumers, to enhance cost recovery and facilitate tariff restructuring; iii) financing the sector’s investment needs based on prioritizing efficiency-enhancing projects, including in gas capture and renewable energy; iv) strengthening the regulatory framework for private sector participation and reviewing the tariff structure with a view to reaching cost recovery over the medium term; v) efforts to maximize productivity of existing assets and reduce technical losses. The authorities agreed with these priorities but saw fixing the electricity shortage as the most pressing priority underpinning their focus on an ambitious investment plan to boost generation.

F. Enhancing Financial Stability

34. Restructuring large state-owned banks would support private sector development. While welcoming recent progress, staff underscored the importance of maintaining the reform momentum. Key priorities include obtaining final approval of the new by-laws for large SOBs by the State Council and certification of the banks’ past financial statements by the Federal Bureau of Supreme Audit (BSA).14 These steps would pave the way for launching the international audits and asset quality reviews to determine potential recapitalization needs. At the same time, accelerated implementation of core banking systems, continued improvement of lending standards and practices, and close supervision will be essential to mitigate future risks.

35. Continued improvement of the AML/CFT framework, including in the banking sector, would strengthen financial stability and facilitate correspondent banking relationships. Prioritizing and addressing the risks identified in the first national risk assessment (NRA) will be important ahead of the mutual evaluation by the Middle East and North Africa Financial Action Task Force (MENAFATF), which is planned for 2023. This should be accompanied by informing all stakeholders, including regulated entities, of the NRA’s findings and ensuring their cooperation in implementing the recommended actions. Further improvements of risk-based AML/CFT supervision of banks are needed, including on sanctioning large SOBs for non-compliance, which has been identified as a priority in the NRA.

Authorities’ Views

36. The authorities highlighted notable progress in the AML/CFT area but limited advancement of SOB reform. They cited Iraq’s removal from the EU’s list of high-risk jurisdictions and the completion of the first national risk assessment, which will be presented to the government soon, as key milestones. The authorities envisaged a two-year implementation period of the assessment’s recommendations and requested IMF support. They highlighted, that international audits of large SOBs continue to await BSA’s certification of past financial statements while the revised by-laws are yet to be finalized. They expected implementation of core banking systems at one of the SOBs by end-2023, while noting that it is held back at the largest SOB by significant administrative challenges. The central bank noted its work on a new trade finance mechanism and requested IMF TA.

G. Improving Governance and Statistics

37. Broader anti-corruption efforts need to continue. While many of the reforms outlined above would strengthen governance, staff emphasized the importance of continuing other efforts to reduce corruption, including through implementation of the 2021-24 National Integrity and Anti-Corruption Strategy.15 Staff also reiterated past advice on the need for improving the legal framework and streamlining the institutional structure for combatting corruption, enhancing the asset declaration regime, increasing transparency of oil and gas contracts, and digitalization of key public registries and databases (such as for property and real estate transactions). Moreover, staff recommended strengthening oversight of SOEs and closing data gaps in regulatory frameworks (such as product market regulation and trade facilitation).

38. Data provision has serious shortcomings that significantly hamper surveillance owing to limited technical capacity and weak IT systems, which affect quality and coverage, particularly of the real and external sector statistics. It was agreed that advancing digitalization and significant TA provision remain important to address these shortcomings.

Authorities’ Views

39. Combatting corruption was declared a top priority of the new government. The Integrity Commission is evaluating key government agencies’ anti-corruption efforts and plans to present its findings to the government in early 2023. The authorities also pointed out several high-profile prosecution cases and enhanced cooperation with the civil society as examples of their stepped-up efforts. Among key obstacles, they cited administrative challenges, insufficient cooperation by foreign jurisdictions in the recovery of stolen assets, and weak IT systems preventing, for example, efficient verification of senior officials’ asset declarations. The authorities emphasized advancing e-government, expanding capacity and the investigative powers of the Integrity Commission, continuing to enhance the legal framework and institutional structure for anti-corruption efforts as key priorities and welcomed IMF’s assistance.

Staff Appraisal

40. The economy is recovering well, and the near-term outlook is positive amid a large oil windfall. Real GDP is estimated to have increased by 8 percent in 2022, driven by a 12-percent expansion in oil production, which is projected to continue rising from 4.4 to 5 mbd by 2027. Real non-oil GDP growth is expected to accelerate from 3.2 percent in 2022 to 4 percent in 2023, helped by the stimulus from the Emergency Law for Food Security and Development, and settle at 3.5 percent in the medium term. Inflation remains subdued due to significant subsidies and price controls. Owing to strong oil revenues, fiscal and current account surpluses are expected to reach 6.1 and 8.1 percent of GDP, respectively, in 2023, boosting foreign exchange reserves to US$105 billion (10 months of prospective imports).

41. Nonetheless, the underlying vulnerabilities have increased and could manifest themselves in the medium term. The non-oil primary fiscal deficit has widened from 45 percent of non-oil GDP in 2019 to an estimated 63 percent of non-oil GDP in 2022 and is projected to remain elevated. With gradually declining global oil prices, both fiscal and external current account balances are expected to turn into deficits over the medium term, resulting in renewed financing pressures, drawdown of foreign exchange reserves, and exhaustion of fiscal savings. This outlook is subject additional downside risks related to a faster decline in oil prices, social unrest, escalation of geopolitical tensions, and realization of contingent liabilities, notably in the electricity sector.

42. Near-term policies should focus on addressing the cost-of-living crisis and saving the bulk of the oil windfall. Providing adequate indexation of targeted cash transfers and low-income pensions will be important to protect the vulnerable from the rising cost of living. The central bank should stand ready to tighten domestic financial conditions should inflation risks begin to materialize. The 2023 budget law should avoid a procyclical spending boost and aim to increase savings with a gradual tightening of the fiscal stance.

43. A sound fiscal framework would allow to better manage Iraq’s oil wealth and reduce vulnerabilities in a highly uncertain global environment. Adopting a fiscal rule targeting a gradual reduction of the non-oil primary fiscal deficit and building a fiscal stabilization buffer would help to carefully balance the goals of improving resilience to oil price volatility and long-term sustainability; containing the growth of current expenditures—most importantly the government wage bill—while raising non-oil revenues to create the space for priority social and development needs; and reducing Iraq’s dependence on oil.

44. Achieving sustainable and inclusive private sector-led growth in the medium term will entail accelerated structural reforms aimed at better protecting the vulnerable, creating a level playing field in the labor market, and improving private sector’s access to electricity and finance. To these ends, the authorities should prioritize enhancing the social safety net, including by making the pension system more sustainable and equitable, developing a national employment strategy, stemming losses and improving reliability of the electricity sector, and revitalizing the financial sector through restructuring of state-owned banks and continued enhancement of the AML/CFT framework.

45. The authorities should continue to advance their anti-corruption agenda. In addition to strengthening of public financial management, key priorities include advancing digitalization of key public institutions and business processes, expanding capacity of the Integrity Commission, and improving the legal framework and institutional structure for anti-corruption efforts.

46. Staff will continue to support the authorities’ efforts to improve data provision which still has serious shortcomings that significantly hamper surveillance.

47. It is proposed that the next Article IV consultation take place on the standard 12-month cycle.

Figure 1.
Figure 1.

Iraq: Economic Developments and Medium-Term Projections, 2015–27

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: Iraqi authorities; IMF staff projections.

Figure 2.
Figure 2.

Iraq: Fiscal and Debt, 2015–27

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: Iraqi authorities; IMF staff projections.

Figure 3.
Figure 3.

Iraq: Social, Governance, and Labor Market Indicators, 2012–21

Citation: IMF Staff Country Reports 2023, 075; 10.5089/9798400229305.002.A001

Sources: IMF expenditure assessment tool (EAT); World Bank WDI; ILO STATS; World Bank Worldwide Governance Indicators (WGI); and IMF staff calculations.

Table 1.

Iraq: Selected Economic and Financial Indicators, 2019–27

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

Converted from GDP in local currency using the period-average exchange rate (1191 in 2020).

Negative price differential of about $2.9 per barrel compared to the average petroleum spot price (average of Brent, West Texas and Dubai oil prices) in 2021 - 2027.

Adjusted to exclude (i) full year estimates of federal government transfers to the Kurdistan Regional Government, and (ii) non oil tax revenues from the KRG to the federal government.

Adjusted to exclude full year estimate of federal government transfers to the Kurdistan Regional Government.

Includes arrears. The debt stock includes legacy arrears to non-Paris Club creditors on which the authorities have requested (but not yet obtained) Paris-Club comparable relief. Implementing comparable terms will substantially reduce debt (e.g. by 15 percent of GDP in 2017). THe 14 percentage points increase in 2020 is partly attributed to a devaluation in mid-December 2020 which led to an upward revision of external debt.

Converted from the total government debt in local currency using the end-of-period exchange rate (1450 in 2020).

Positive means appreciation.

Table 2.

Iraq: Central Government Fiscal Accounts, 2019–27

(In trillions of Iraqi dinars; unless otherwise indicated)

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

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

Adjusted to exclude full year estimates of federal government transfers to the Kurdistan Regional Government.

Adjusted to exclude (i) full year estimates of federal government transfers to the Kurdistan Regional Government, and (ii) non oil tax revenues from the KRG to the federal government.

The non-oil primary fiscal balance on cash basis adjusts the non-oil primary balance measured on accrual basis by subtracting the spending financed by arrears’ accumulation during that period, and adding the repayment of arrears from previous years.

Table 3.

Iraq: Central Government Fiscal Accounts, 2019–27

(In percent of GDP)

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

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

Adjusted to exclude full year estimates of federal government transfers to the Kurdistan Regional Government.

Adjusted to exclude (i) full year estimates of federal government transfers to the Kurdistan Regional Government, and (ii) non oil tax revenues from the KRG to the federal government.

The non-oil primary fiscal balance on cash basis adjusts the non-oil primary balance measured on accrual basis by subtracting the spending financed by arrears’ accumulation during that period, and adding the repayment of arrears from previous years.