Public Information Notice No. 05/117

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Iraq

August 16, 2005

On August 1, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Iraq.¹

Background

The last Article IV consultation with Iraq was concluded by the Executive Board 25 years ago, on February 29, 1980. Following the resumption of normal relations with Iraq, the Executive Board approved a request by the government of Iraq for a purchase in an amount equivalent to SDR 297.1 million (about US$436.3 million; 25 percent of quota) under the Fund's policy on Emergency Post Conflict Assistance (see Press Release No. 04/206). The EPCA-supported program, which runs through the end of 2005, underscored the authorities' commitment to a comprehensive economic and financial program. However, the implementation of the EPCA program has been hampered by the difficult security situation, a slow-moving process of reconstruction, the protracted electoral process, and slower-than-expected progress in strengthening administrative and institutional capacity. As a result, performance under the EPCA program has been mixed.

Economic activity rebounded in 2004, with real GDP estimated to have increased by nearly 50 percent, mainly reflecting the recovery of the oil sector. After an upsurge in consumer prices in late 2004 and January 2005—mostly due to supply shocks—inflationary pressures have subsequently subsided, but the 12-month inflation rate through June (at 37 percent) still exceeds by a wide margin the original EPCA-supported program projection for end-2005 of 15 percent.

The Central Bank of Iraq (CBI) reports net international reserves of US$7.4 billion at end-December 2004, well above the program floor of US$4 billion. After appreciating in early 2004 following the introduction of the new currency, the exchange rate of the dinar has remained broadly stable since May 2004. More recently the exchange rate has been under pressure, with dollar sales volumes at the daily CBI foreign exchange auctions having almost doubled. Recently, the CBI broadened its menu of monetary policy instruments by activating separate dinar and dollar overnight deposit facilities to better manage overall liquidity in the banking system.

The fiscal deficit for 2004 was somewhat larger than targeted under the EPCA program. Spending on goods and services was higher than under the budget, with larger outlays for defense and security. Grant-financed reconstruction expenditure in 2004 fell significantly short of expectations. Although donors to the International Reconstruction Fund Facility for Iraq deposited about US$1 billion into this facility, only about US$103 million were disbursed to finance projects in 2004.

The implementation of all structural benchmarks under the EPCA program has been delayed, including the commitment to increase domestic prices of refined oil products, the development of payment systems, the full implementation of a financial management information system, and the establishment of an automated payroll system. This is due to the continuing lack of security, communications problems, and the need to tailor the required systems to the circumstances of Iraq. Nevertheless, progress has been made in developing a monetary survey, in drafting a new payments system legislation, and improving the banking regulatory framework.

On November 21, 2004, the Paris Club creditors agreed to debt reduction terms for Iraq to be implemented in three stages and amounting to a total of 80 percent debt reduction. The Iraqi government has begun to reconcile external claims and move toward concluding bilateral agreements with Paris Club and most non-Paris Club official creditors. The Iraqi authorities also held a meeting for private creditors in Dubai on May 4.

Executive Board Assessment

Executive Directors welcomed the resumption of Article IV consultations with Iraq, which represents a further important milestone in Iraq's relations with the Fund, and in its reintegration into the global economy. Directors commended the authorities for having established and maintained a degree of macroeconomic stability under extremely difficult circumstances, and for having initiated structural reforms. However, the economy remains fragile, and much work remains to be done to transform Iraq into a market economy, firmly based on a path of sustained growth. Directors stressed that, in the near term, the authorities will need to be ready to act resolutely to contain potential macroeconomic imbalances, most importantly, those that may arise from spending pressures, fluctuations in oil revenue, or adverse monetary developments. While recognizing that the pace of reconstruction and recovery will to a large extent depend on how the political and security situation evolves, they also urged the authorities to proceed with the most urgent structural reforms, and to maintain the policy momentum overall.

Directors noted that rebuilding Iraq's economy and infrastructure, while at the same time improving the standard of living of its people, will place significant demands on the country's limited resources. While the long-run prospects are well supported by its substantial resource base, Iraq still faces daunting challenges and downside risks in reconstructing its economy. To speed up investment in essential infrastructure, social services, and poverty reduction, Directors underscored the importance of strong action on fiscal and oil sector reforms, along with the timely disbursement of aid commitments.

Directors stressed the critical importance of putting in place a coherent fiscal strategy aimed at prioritizing the use of available resources, while containing recurrent expenditures, particularly on wages, pensions, transfers, and non-essential projects. In this connection, Directors encouraged the authorities to maintain a cautious fiscal stance by strengthening public expenditure management, continuing to adhere to the "no overdraft" rule, and avoiding the accumulation of arrears. Directors noted that a key challenge facing the authorities is the elimination of existing price distortions, with a view to alleviating market distortions and sources of corruption, and generating additional budget resources to support priority sectors, such as education, health, and security. While recognizing the politically and socially difficult context, they urged the authorities to start phasing out the significant government subsidies on petroleum products as quickly as feasible. Directors underscored that the successful implementation of this measure will require careful preparation and supportive policies, including an effective communication and public education strategy, consideration of a pre-announced schedule, and careful social impact assessment. The role for technical assistance from the Fund and World Bank in helping the authorities in these areas was emphasized.

Directors welcomed the recent steps to enhance transparency and accountability in government activities, particularly the intention to appoint an international auditor to conduct an audit of the operations of the central bank, and the steps being taken to modernize the payments system and tackle corruption. They considered that these efforts will need to be broadened with additional measures to support budget execution and financial management, as well as with action to strengthen governance and the management of oil sector operations. In this context, Directors urged the full implementation of the Financial Management Law. They underscored, in particular, the need to implement without delay the recommendations of the International Advisory and Monitoring Board, specifically those regarding the metering of oil production and exports, and strengthening of internal controls and audit in ministries. The authorities were also encouraged to subscribe to the Extractive Industries Transparency Initiative (EITI) to help ensure improved transparency of oil revenues.

Directors agreed that the authorities' reliance on exchange rate stability as the pillar of their framework for monetary policy has served the economy well. They advised continuation of the exchange rate peg to the dollar in view of the relative stability achieved thus far and the absence of a suitable alternative nominal anchor. Directors stressed however that, in order for the peg to be credible, the central bank should refrain from resorting to administrative measures to limit the amount of dollars sold in the foreign exchange auctions and should satisfy the total amount demanded at the cutoff rate. Persistent pressures on the exchange rate should instead be met with a tightening of monetary policy, including by raising interest rates on the central bank's overnight deposit facility, and Directors welcomed the recent move in this direction. They encouraged the authorities to remain vigilant and closely monitor developments that may threaten their inflation objective, including by actively using their monetary policy instruments to adjust liquidity conditions as needed. Going forward, the development of additional monetary instruments would also facilitate the implementation of monetary policy.

Directors urged the authorities to take steps to advance their structural reform efforts. While recognizing that continuing security problems have contributed to delaying the reforms identified in the program supported by the 2004 EPCA, Directors stressed that steady progress on a well-focused reform agenda will be key to creating the conditions for sustainable, broad-based growth. This should include: the development of a strategy for restructuring the state banks and other state-owned enterprises as part of a strategy toward reducing the role of the state over the medium term; the preparation of an overall restructuring plan for the oil sector, including by reviewing the fiscal framework governing the sector; the formulation of a strategy for the reform and monetization of the in-kind social safety net in parallel with the ongoing reform of the payments system; the phasing out of price distortions; and the modernization of prudential banking regulations and the supervisory framework. Further steps to strengthen financial management in the public sector, diversify revenues and the economy more generally, and enhance governance will also be important. Directors noted that the international community will have a continued role to play in supporting the authorities' reform and institution-building efforts.

Directors underscored the need for Iraq to reach agreement on debt rescheduling terms for non-Paris Club and private creditors comparable to those agreed last year with Paris Club creditors. They urged the authorities to accelerate the process of debt reconciliation with official creditors, so as to facilitate progress toward securing bilateral agreements as soon as possible. Directors welcomed the authorities' commitment to proceed in good faith toward the resolution of Iraq's external debt arrears. They were encouraged by the steps being taken, and called on the authorities to pursue a constructive dialogue with all creditors, and to consult with the Paris Club with respect to comparability of treatment.

Directors welcomed the authorities' intention to establish a liberal foreign trade and exchange regime and looked forward to Iraq's acceptance of the relevant Article VIII obligations. In order to facilitate the process of acceptance, the authorities should move expeditiously to review and overhaul their legislation and regulations in order to remove any possible exchange restrictions that may fall under Fund jurisdiction. Directors noted the progress made on putting in place a legal framework for Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) matters, and looked forward to its implementation.

Notwithstanding some progress in the preparation and dissemination of statistics, Directors noted that the statistical information that the Iraqi authorities are able to provide to the Fund is just adequate for surveillance purposes. They urged the authorities to make further efforts to strengthen their statistical framework, in particular in the fiscal area.

Directors took note of the authorities' desire to enter into a Stand-By Arrangement by the end of 2005. They pointed out that progression to a Stand-By Arrangement would help underpin a sound macroeconomic framework for the continuation of Iraq's reconstruction and recovery, as well as pave the way for Iraq to move forward to a sustainable external debt situation under the terms of the Paris Club. They urged the authorities to continue to build on their track record of policy implementation by continuing to implement the program supported by EPCA, focusing on a reinvigoration of structural reforms and further steps to improve governance and the country's institutional and administrative capacity. A strengthening of the quality and timeliness of basic economic data that are essential for program monitoring will also be needed.