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https://www.imf.org/en/Publications/CR/Issues/2019/07/25/Iraq-2019-Article-IV-Consultation-and-Proposal-for-Post-Program-Monitoring-Press-Release-48527
2019 ARTICLE IV CONSULTATION AND PROPOSAL FOR POST - PROGRAM MONITORING—PRESS RELEASE; STAFF REPORT; AND STATEMENT BY THE EXECUTIVE DIRECTOR FOR IRAQ
IRAQ
IMF Country Report No. 19/248
July 2019
2019 ARTICLE IV CONSULTATION AND PROPOSAL FOR POST - PROGRAM MONITORING—PRESS RELEASE; STAFF REPORT; AND STATEMENT BY THE EXECUTIVE DIRECTOR FOR IRAQ
Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. In the context of the 2019 Article IV consultation with Iraq, the following documents have been released and are included in this package:
• A Press Release summarizing the views of the Executive Board as expressed during its July 19, 2019 consideration of the staff report that concluded the Article IV consultation with Iraq.
• The Staff Report prepared by a staff team of the IMF for the Executive Board’s consideration on July 19, 2019, following discussions that ended on May 2, 2019, with the officials of Iraq on economic developments and policies. Based on information available at the time of these discussions, the staff report was completed on July 3, 2019.
• An Informational Annex prepared by the IMF staff.
• A Statement by the Executive Director for Iraq.
The documents listed below have been or will be separately released.
Selected Issues
The IMF’s transparency policy allows for the deletion of market-sensitive information and premature disclosure of the authorities’ policy intentions in published staff reports and other documents.
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Press Release No. 19/301 International Monetary Fund
FOR IMMEDIATE RELEASE 700 19th Street, NW
July 26, 2019 Washington, D. C. 20431 USA
IMF Executive Board Concludes 2019 Article IV Consultation with Iraq
On July 19, 2019, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Iraq.
An improved security situation and the recovery in oil prices have improved near-term vulnerabilities. Large fiscal and current account surpluses—around 8 and 6 percent of GDP, respectively—were recorded in 2018, allowing the government to retire domestic debt and accumulate fiscal buffers. Gross international reserves reached $65 billion by end-2018.
However, post-war reconstruction and economic recovery have been slow. Non-oil GDP rose by only 0.8 percent year-on-year in 2018 in a context of weak execution of reconstruction and other public investment. Overall GDP contracted by around 0.6 percent as oil production was cut to comply with the OPEC+ agreement.
The 2019 budget implies a sizable fiscal loosening that will reverse the recent reduction in vulnerabilities. Current spending is expected to increase by 27 percent year-on-year, in part due to a higher public sector wage bill, while revenues will be dampened by the abolition of non-oil taxes. As a result, the budget is projected to shift to a deficit of 4 percent of GDP in 2019, and reserves are projected to decline.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.
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and to reduce vulnerabilities to corruption. In this context, Directors welcomed the newly adopted General Financial Management Law and encouraged its full implementation.
Directors emphasized that gradual fiscal adjustment, including containing current primary spending and boosting non-oil revenues is essential for maintaining fiscal and debt sustainability. They recommended that spending measures should give priority to containing the growth in wage bill and lowering subsidies to the electricity sector. Directors emphasized that the poorest and the most vulnerable must be protected from the adjustment process.
Directors underscored that an overhaul of the banking sector is necessary to maintain financial stability. They encouraged the authorities to restructure the large state-owned banks, enhance their supervision, and implement other reforms to increase financial intermediation. Directors highlighted the benefits of increasing financial inclusion, especially for the SME sector, which has a large potential to absorb entrants to the labor market.
Directors agreed that building public institutions and enhancing governance is key for success, and highlighted the scope for Fund capacity development to support these efforts. They welcomed progress in developing an anti-corruption framework and called for further modifications to the legal regime for combatting corruption coupled with stronger coordination between the relevant government agencies, while continuing to strengthen the framework for Anti-money laundering and combatting the financing of terrorism (AML/CFT). Directors also recommended strengthening Public Investment Management framework to ensure that spending is well directed and that donor funds targeting reconstruction are put to the most efficient use.
Directors looked forward to continued close engagement between the authorities and the Fund in the context of post program monitoring.
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IRAQ
July 3, 2019
STAFF REPORT FOR THE 2019 ARTICLE IV CONSULTATION AND PROPOSAL FOR POST-PROGRAM MONITORING
KEY ISSUES
Context. Forty years of upheaval has eroded physical and human capital and weakened public institutions. Social conditions remain harsh following the war with ISIS, with slow progress at reconstruction, weak public services and a lack of job opportunities. The recent rebound in oil prices helped deliver a large budget surplus and healthy build-up in reserves in 2018, but post-war recovery has been sluggish. The SDR 3.8 billion ($5.3 billion) Stand-by Arrangement approved in 2016 expires in July.
Outlook and risks. In the absence of policy changes, a widening budget deficit will divert resources away from essential investment to rebuild the country and improve public services, while eroding reserves and posing risks to medium-term sustainability. Expenditure rigidities and limited fiscal buffers imply a significant vulnerability to oil price shocks in a context of volatile prices.
Policy Recommendations
• Fiscal policy framework. Fiscal policy should be anchored on scaling up capital spending and building fiscal buffers within a risk- and rules-based fiscal framework. Expenditure ceilings should be established, supported by phased measures to lower current spending and boost non-oil revenue. A steady build-up of fiscal buffers will help the authorities reduce pro-cyclicality and protect investment in the event of oil price and other shocks.
• Reorienting public expenditure. Structural measures to curb the sharp rise in the public-sector wage bill will help create fiscal space for essential investment. Electricity reforms will entail significant capital spending in the near term, but should enable the authorities to tackle power outages and eventually reduce budget subsidies. Public investment practices require significant reforms. The authorities should review the adequacy and efficiency of social spending to help ensure that poor and vulnerable groups are protected throughout such reforms.
• Financial sector. Bank supervision should refocus on the two largest and troubled state-owned banks, which need to be audited and restructured prior to recapitalization over the medium term. Such reforms, along with efforts to promote financial inclusion could help tackle access to credit and promote private-sector job creation. Strengthened enforcement of the AML/CFT regime would support the integrity of the financial system.
• Combatting corruption. A multi-pronged strategy is required involving strengthening the legal framework, developing national anti-corruption policies, and fostering closer co-ordination between the involved agencies. An effective AML/CFT regime can complement enforcement efforts.
Approved By
Taline Koranchelian and Kristina Kostial
CONTENTS
Discussions were held in Amman (Jordan) during April 25–May 2, 2019. The staff team comprised Gavin Gray (head), Gazi Shbaikat (advance team lead), Kareem Ismail (Resident Representative for Iraq), Salim Dehmej (all MCD), Seyed Reza Yousefi (FAD), Chady El Khoury and Kathleen Kao (LEG), and Diva Singh (SPR). Maya Choueiri (Senior Advisor, OED) participated in the discussions. The mission met with Dr. Fuad Hussein, Deputy Prime Minister for Economic Affairs, Dr. Ali Mohsen Ismail Al-Allaq, Acting Governor of the Central Bank of Iraq, and staff from government ministries and the Central Bank of Iraq. Laila Azoor, Alexander de Keyserling, Cecilia Pineda, and Jawed Sakhi assisted from headquarters in the preparation of the report.
BACKGROUND: IMPROVED POLICY ENVIRONMENT BUT MEDIUM-TERM
RISKS ON THE RISE_________________________________ 4
A. Context ________________________________ 4
B. Recent Developments: Slow Post-War Recovery ___________________________ 6
C. Outlook and Risks: Vulnerabilities on the Rise Again __________________________ 7
ECONOMIC POLICIES TO SUPPORT SUSTAINABILITY AND PROMOTE
INCLUSIVE GROWTH ____________________________________________ 9
A. Building a Robust Fiscal Framework to Manage Oil Wealth ____________________ 10
B. Reallocating Public Expenditure to Promote Inclusive Growth _____________________ 15
C. Enhancing Financial Stability and Financial Intermediation _________________
D. Anti-Corruption ______________ 20
E. Future Fund Engagement _______________ 21
STAFF APPRAISAL ________________________ 21
BOX
1. Quantifying the Macroeconomic Benefits of Improved Governance ___________________ 11
FIGURES
1. An Oil Dependent Economy, 1980–2018 ___________________________ 23
2. Social Indicators, 2000–50 ______________________ 24
3. Recent Economic Developments, 2013–19 ___________ 25
4. Fiscal and Debt, 2013–18 ______________ 26
TABLES
1. Selected Economic and Financial Indicators, 2015–24 ___________________ 27
2. Central Government Fiscal Accounts, 2015–24 (In trillions of Iraqi dinars) ______________ 28
3. Central Government Fiscal Accounts, 2015–24 (In percent of GDP) ____________ 29
4. Central Government Fiscal Accounts, 2015–24 (In percent of non-oil GDP) ___________ 30
5. Balance of Payments, 2015–24 __________________________ 31
6. Monetary Survey, 2015–24 _____________________ 32
7. Central Bank Balance Sheet, 2015–24 ___________________ 33
8. Indicators of Fund Credit, 2016–24 ___________________________ 34
9. Inclusive Growth Indicators _______________________________ 35
ANNEXES
I. Capacity Development Strategy _________________ 36
II. Response to Past Fund Policy Advice____________________ 37
III. External Sector Assessment ______________ 38
IV. Iraq—Public and External Debt Sustainability Analysis _______________ 42
V. Risk Assessment Matrix ______________ 53
VI. Governance ____________________ 55
VII. International Experience with Public Wage Bill Management ____________ 63
BACKGROUND: IMPROVED POLICY ENVIRONMENT BUT MEDIUM-TERM RISKS ON THE RISE
A. Context
1. Despite its vast oil wealth, Iraq has major development needs and significant institutional weaknesses. It possesses the world’s fourth largest oil reserves, which are projected to last over 100 years at current production rates (Figure 1). Slow progress at channeling these resources into human and physical capital reflects decades of political upheaval and armed conflict as well as the resulting weakness of public institutions; weak governance and corruption are widely acknowledged elements of the problem.1 An exodus of skilled workers amidst poor security conditions since the second gulf war in 2003 has eroded human capital, while the more recent conflict with ISIS led to 100,000 deaths, five million internally displaced people and an estimated $46 billion of damage to infrastructure and property. 2 As a result, Iraq’s development needs include large infrastructure gaps, poor basic services, subpar health and education outcomes, and widespread poverty; GDP has barely grown in per capita terms over the past five years.
1 Prime Minister Adil Abdul-Mahdi has compared the impact of corruption on Iraqi society to that of the ISIS terrorist group ( http://www.rudaw.net/arabic/middleeast/iraq/3112201812).
2 See Iraq: Reconstruction and Investment.
2. Weak fiscal policy frameworks, which are ill equipped to cope with oil price shocks, have contributed to these outcomes. The authorities have generally saved little during oil price booms, instead ramping up current spending— particularly the civil service payroll and other items that are hard to cut—leaving them with limited buffers when oil prices dipped, and necessitating sharp cuts in investment and the accumulation of arrears. Such procyclical patterns coupled with poor public financial management and inefficient public procurement have hindered investment in infrastructure, especially electricity, 3 undermining both core public services and the overall business environment.
3. The Fund provided a $5.3 billion SBA in 2016 and significant capacity development (see Annex I) to support the authorities’ response to the twin shocks of ISIS and the collapse in oil prices. The main achievements under the SBA were the preservation of the pegged exchange rate, a large fiscal consolidation (albeit mainly through capital expenditure cuts), a reduction in external arrears, and progress on AML/CFT. However, a number of structural fiscal measures were reversed or not enacted, and there has been limited progress at restructuring public banks or strengthening public institutions, while the authorities’ response to Fund advice in the context of the last Article IV has been mixed (see Annex II). The SBA went off track after the second review in August 2017, and expires in July 2019.
4. An improved security situation and the windfall from higher oil prices offer an opportunity to rebuild the country and tackle longstanding social problems. The government faces a wide range of socio-economic challenges, including repairing infrastructure and other property destroyed in the war, as well as improving the provision of electricity, water supply and other public services. A young and fast-growing population is exerting strains on public institutions, while job opportunities for the estimated 800,000 annual entrants to the labor market are limited.
5. The obstacles to progress are formidable. Geopolitical strains are a distraction, with the re-imposition of U.S. sanctions on Iran complicating energy reforms. 4 Weak governance and corruption have impeded public institutions and discouraged private-sector investment and job creation. More positively, relations between Baghdad and the Kurdistan Regional Government (KRG) have improved over the past year.
3 Despite ample oil reserves, electricity supply has averaged only 17 hours per day in recent years, which is a key weakness of the business environment.
4 Around a third of electricity supply comes either directly from Iran, or from Iraqi plants reliant on Iranian gas.
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C. Enhancing Financial Stability and Financial Intermediation
35. An overhaul of the banking sector is essential to maintain financial stability and to transform the sector into an effective vehicle for intermediation that also supports inclusive growth. The two largest banks—Rafidain and Rasheed (R&R)—have portfolios heavily weighted towards public-sector assets, some of which are not being serviced, which limit their capacity to lend until they are restructured and recapitalized. A number of private banks are struggling with sharply reduced FX trading incomes while working out NPLs that emerged during the 2014–16 crisis. These weaknesses coupled with shortcomings in the financial architecture and legal framework help explain why lack of access to credit is a material weakness of the business environment.
36. The long-delayed restructuring of the public banks is beginning, and well-structured plans are required to bring it to a successful conclusion. R&R have contracted suppliers for core banking systems, and segregated legacy assets and liabilities into ‘bridge branches’. The Bureau of Supreme Audit (BSA) is working on finalizing their accounts for 2014 and subsequent years. Once the core banking systems are fully operational,13 the two banks should be audited to international standards, which would allow their capital needs to be assessed accurately. In the interim, and to prevent a further deterioration in their financial conditions, the authorities should strengthen governance and oversight over the two banks and develop long-term strategies for their future, while abstaining from piecemeal capital injections. All these steps would require coordinated government action in light of the potential fiscal implications of bank restructuring.
37. Strengthening banking supervision, with an increased focus on risks in the public banks, is essential to support stability during this transitional phase. Building on steps to improve the prudential framework, staff encouraged the authorities to commission a targeted quality review of the public banks’ main assets, especially loans to SOEs that are government guaranteed (and therefore zero risk weighted), yet are not being fully serviced. Such a review would help guide supervisory efforts, lower the risks of a further deterioration in the public banks’ balance sheets, and facilitate the transfer of assets to the core banking system. To reduce risks in the private banks, staff encouraged caution in licensing new banks, and urged the authorities to strengthen frameworks for handling troubled banks.
38. Tackling weaknesses in the banks coupled with wider structural reforms can help the authorities realize their goals of promoting financial development and inclusion.14 Work is underway to strengthen payment systems and encourage salary payments directly into bank accounts. Fintech can help banks strengthen risk management and channel additional financial resources, and in view of the extensive wireless coverage, there is considerable potential to improve financial inclusion by developing mobile banking. Improving credit information and strengthening legal procedures could also encourage banks to relax collateral requirements and facilitate access to
13 International experience suggests that it could take two to three years for the systems to be fully operational. In light of the work already done, the Iraqi authorities consider that the systems could be fully operational in 2020.
14 See the Selected Issues Paper ‘Iraq: Financial Development and Inclusion’.
39. credit. Plans are underway to develop a deposit insurance scheme, which would help level the playing field across the banking sector, but requires effective bank supervision to limit risks. In helping to boost the currently very low level of SME financial inclusion, such measures can add a significant impetus to growth and employment.
40. The authorities have made some progress in implementing the recommendations of the 2016 safeguards assessment of the CBI. Amendments to the law on the Central Bank of Iraq to strengthen CBI governance have been enacted, and the revised audit committee charter now prohibits CBI executive representation on the committee. However, progress in strengthening the capacity of internal audit and financial reporting has been slow.
Authorities’ Views
41. The authorities agreed on the need to address weak banks. They agreed on the scope for greater coordination between the Ministry of Finance, CBI, and BSA in restructuring R&R. They considered the progress on procuring core banking systems for the two banks as an important first step. The authorities concurred that the financial system is currently overbanked.
They expect the number of private banks to decline as non-profitable banks merge with others or exit the system. They expressed the need for continued strengthening of their capacity on banking supervision and resolution with Fund support.
42. The authorities also agreed on the importance of strengthening financial development and inclusion. They saw the main impediments as a cash-based culture that narrows the funding base, and pervasive non-repayment of credit due to sluggish legal processes and weak enforcement. They cited progress through recent measures to encourage deposits including paying public salaries through the banking system, and passing the law establishing a deposit insurance company. The authorities also highlighted the credit bureau system at the CBI, which they plan to eventually transfer to the private sector.
The CBI considered the weak credit to the private sector to be mainly due to weak demand and the limited capacity in the private sector to prepare financial statements and viability studies. They cited limited uptake on the CBI’s ID1 trillion initiative to finance SMEs and the difficulty in finding bankable projects.
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52. Restructuring of the public banks coupled with enhanced bank supervision is essential to preserve financial stability. The key next step is to install core banking systems in the two large public banks, which is a pre-requisite for these banks to be audited, restructured and eventually recapitalized. Steadfast supervision would help prevent a further deterioration in their balance sheets during this process, and to monitor vulnerabilities among private banks.
53. Successful restructuring of the banks coupled with structural reforms can help the authorities address long-standing problems with financial inclusion, including access to credit. Improving credit information and strengthening legal procedures would encourage banks to relax collateral requirements and facilitate access to credit. The planned deposit insurance scheme would also help level the playing field across the banking sector, but effective supervision is essential to limit risks. By strengthening SME financial inclusion, such efforts can have a significant impact on growth and employment.
54. Combatting corruption requires modifications to the legal framework and closer co-ordination between public agencies. A sound legal regime criminalizing all corruption offences and setting out effective sanctions will be necessary; public officials convicted of corruption should be prohibited from holding office. The authorities should also develop coherent national anti-corruption policies, based on a deeper understanding of the risks, and relevant agencies should coordinate more closely, with enhanced information exchanges. The system of asset declarations should be progressively strengthened by targeting the officials most exposed to corruption, sanctioning failures to submit declarations, digitalizing declarations and moving eventually to publication of asset declarations.
55. Bolstering AML/CFT implementation would help enhance the integrity of the financial system and support anti-corruption efforts. The Central Bank of Iraq (CBI) should implement risk-based AML/CFT supervision of banks and exchange houses to improve compliance with preventive measures, including those related to politically exposed persons and beneficial ownership. Such efforts would help identify proceeds of corruption and ease pressure on correspondent banking relationships. The CBI should also step up efforts to implement outstanding safeguards recommendations.
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Annex III. External Sector Assessment
Staff assesses the external position in 2018 to be substantially stronger than suggested by fundamentals and desirable policy settings. However, this is expected to reverse in 2019, with the current account (CA) weakening significantly, reserves falling, and the REER moving into overvalued territory. Ensuring external stability in the medium term will critically hinge on fiscal adjustment, to bring the CA and REER back into line with fundamentals, and maintain reserve adequacy.
1. From a surplus in 2018, Iraq’s CA balance is expected to worsen significantly in 2019 and average a deficit of 5 percent of GDP over the medium term. In 2017, Iraq’s CA registered a surplus of 1.8 percent of GDP, from a deficit of -8¼ percent of GDP in 2016, on the back of higher oil prices and fiscal consolidation under the program, while oil export volumes remained flat year on year. In 2018, preliminary estimates suggest that the surplus increased to 6.9 percent of GDP driven by a large increase in oil prices (by USD 16 year on year), with a minor increase in oil export volumes also contributing. Looking forward, the expected decline in oil prices in 2019 (by USD 9 year on year) together with fiscal loosening are projected to dramatically reverse the CA surplus this year to a deficit of 5¼ percent of GDP, despite a projected increase in oil export volumes of 4 percent year on year. Thereafter, the CA balance is expected to remain in deficit through the medium term, averaging –5 percent of GDP, with a gradual increase projected for oil export volumes while prices will remain roughly flat. The real effective exchange rate (REER) appreciated by 4¾ percent year on year in 2018, continuing a trend seen since 2013 (the REER has appreciated by 12½ percent in the past five years) mostly due to movements in the nominal effective exchange rate (NEER) dampened by inflation differentials.1
2. Iraq’s international reserves, while adequate in 2018, are expected to decline precipitously to levels well below conventional and IMF adequacy metrics over the medium term, given weak oil price prospects and rising financing needs. After increasing to $64.7 billion (29 percent of GDP) in 2018, reserves are expected to fall over the medium term to $14 billion (4¾ percent of GDP) in 2024. Oil prices are expected to decrease marginally from 2019–24, providing no contribution to reserve accumulation, while higher financing needs from the growing fiscal deficit and rising external debt service (from 1¼ percent of GDP in 2018 to almost 3 percent of GDP in 2024) will serve as a drain. Reserves will dip below the IMF’s augmented reserve adequacy metric for oil exporters (which adds a buffer to hedge against lower than projected oil prices) in 2019, and by 2023 they will fall to a level well below all IMF and traditional adequacy metrics.
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5. The Iraqi dinar peg with the U.S. dollar remains an appropriate nominal anchor for macroeconomic policies. The misalignment of the REER is expected to over-correct and move into slightly overvalued territory in 2019 as the CA weakens against its norm. Fiscal adjustment will be crucial to bring the CA back into line with fundamentals, preserve reserves, and ensure external stability over the medium term. In the longer-run, structural policies to improve competitiveness and achieve export diversification would also help support Iraq’s external position.
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Box 1. The Investment Needs Model for Natural Resource-Rich Developing Countries
Countries that are rich in exhaustible natural resources experience windfalls that can be consumed, saved or invested—with each of these options having a disparate impact on macroeconomic outcomes and external stability. Empirical studies indicate that most resource-rich developing and advanced countries save much of their windfalls in an attempt to smooth consumption and ensure intergenerational equity, in line with the permanent income hypothesis (Friedman, 1957), and therefore tend to run current account surpluses.1
However, drawing on a separate stream of development thinking,2 Araujo and others (2013) question whether resource-rich developing countries (RRDCs) with large investment needs and external borrowing constraints should save as much as their advanced economy peers, or instead use these windfalls for investment in much needed physical and human capital. They develop a neoclassical small open economy model that aims at assessing the optimal external balance and savings/investment decisions in response to windfalls in RRDCs. The model explicitly incorporates the role of investment given capital scarcity in these countries but also captures pervasive frictions in RRDCs, such as investment inefficiencies, absorptive capacity constraints, and external borrowing constraints. Investment inefficiencies are modeled as impediments that prevent a dollar of investment translating into a dollar of productive capital, thereby lowering the optimal level of investment. Absorptive capacity constraints are adjustment costs that arise when the speed of investment negatively impacts project selection, management and execution, thereby necessitating a slower pace of investment. Finally, imperfect capital mobility and borrowing constraints are modeled through a country risk premium that can be relaxed as natural resource endowments lower the premium.
The results of the model suggest that the optimal external balance and savings/investment decisions for windfalls in RRDCs depend heavily on the degree of investment frictions. Facing borrowing constraints, but absent investment frictions, the model indicates that RRDCs should mostly convert windfalls into private and public capital rather than save them in the form of foreign assets. This would imply lower current account balances or even deficits. Furthermore, if resource wealth reduces RRDCs’ risk premia thereby relaxing their borrowing constraint, this can facilitate further private and public investment, implying still lower current account balances. However, the presence of investment inefficiencies and absorptive capacity constraints in RRDCs modulates these results, making it optimal to delay or decelerate capital accumulation depending on the degree of the frictions, implying higher current account balances than otherwise would be the case.
On the whole, the model delivers optimal current account balances and savings levels for RRDCs that are significantly lower than those implied by conventional approaches such as the permanent income hypothesis, but the extent of these varies depending on the presence and severity of investment frictions.
1 See Berns and Carvalho (2009) and Bayoumi and Thomas (2009).
2 See Collier and others (2010) and van der Ploeg and Venables (2011).
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Statement by Mr. Hazem Beblawi, Executive Director for Iraq and Ms. Maya Choueiri,
Senior Adviser to the Executive Director
July 19, 2019
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8. The authorities remain committed to the peg to the U.S. dollar as it continues to provide a key nominal anchor to the economy.
9. The authorities are taking measures to enhance the stability of the banking sector. The two largest state-owned banks, Rasheed and Rafidain, are being restructured. The authorities have made progress in procuring suppliers for core banking systems and have segregated legacy assets and liabilities into “bridge branches.” The Bureau of Supreme Audit is working on finalizing their accounts for 2014 and subsequent years. Once the core banking systems are fully operational, the authorities intend to have the two banks audited to international standards, which would allow their capital needs to be assessed accurately.
10. At the same time, the Central Bank of Iraq (CBI) is pursuing its efforts to strengthen the regulatory framework and improve prudential regulations in banking supervision to align them with Basel II Committee on Banking Supervision standards and guidelines. In this connection, supervisory guidelines on bank internal audit and compliance functions were prepared in the fall, with Fund technical assistance. Work is progressing on early identification of bank risks and the way to deal with weak banks, including early intervention of supervisors, corrective actions and their enforcement, banking crisis management and the supervisor’s role, as well as techniques for liquidating unviable banks.
The CBI also intends to develop a deposit insurance scheme, which would help level the playing field across the banking sector. To promote financial development and inclusion, the CBI is working on strengthening payment systems and encouraging deposits, including public salary payments directly into bank accounts.
11. In June 2018, the Financial Action Task Force (FATF) welcomed Iraq’s significant progress in improving its AML/CFT regime and noted that “Iraq has established the legal and regulatory framework to meet the commitments in its action plan regarding the strategic deficiencies that the FATF identified in October 2013.”
FATF thus considered that Iraq was no longer subject to the FATF’s monitoring process under its ongoing global AML/CFT compliance process. The authorities will continue to work to strengthen the AML/CFT framework. They consider that continued progress on AML/CFT will also help them address the transfer of illicit gains.
12. Good progress has been made in implementing the recommendations of the 2016 safeguards assessment of the CBI. Amendments to the Law on the Central Bank of Iraq to strengthen CBI governance have been enacted, and the revised audit committee charter now prohibits CBI executive representation on the committee. Work is ongoing on strengthening the capacity of internal audit and financial reporting.
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Conclusion
Notwithstanding an improvement in security conditions and oil prices, Iraq faces the serious challenge of maintaining economic stability, while ensuring durable peace and inclusive growth.
The Iraqi authorities very much value the Fund’s policy advice in addressing its economic challenges, and they would welcome a Post-Program Monitoring engagement.
Continued Fund capacity development would be essential in the period ahead.
The authorities have been calling on the Fund to resume visits to Baghdad, similar to the practice of other international institutions.
They welcome the recent lowering of the Fund’s security rating for Baghdad to a medium level of residual risk and look forward to welcoming Fund staff again.
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2019 ARTICLE IV CONSULTATION AND PROPOSAL FOR POST - PROGRAM MONITORING—PRESS RELEASE; STAFF REPORT; AND STATEMENT BY THE EXECUTIVE DIRECTOR FOR IRAQ
IRAQ
IMF Country Report No. 19/248
July 2019
2019 ARTICLE IV CONSULTATION AND PROPOSAL FOR POST - PROGRAM MONITORING—PRESS RELEASE; STAFF REPORT; AND STATEMENT BY THE EXECUTIVE DIRECTOR FOR IRAQ
Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. In the context of the 2019 Article IV consultation with Iraq, the following documents have been released and are included in this package:
• A Press Release summarizing the views of the Executive Board as expressed during its July 19, 2019 consideration of the staff report that concluded the Article IV consultation with Iraq.
• The Staff Report prepared by a staff team of the IMF for the Executive Board’s consideration on July 19, 2019, following discussions that ended on May 2, 2019, with the officials of Iraq on economic developments and policies. Based on information available at the time of these discussions, the staff report was completed on July 3, 2019.
• An Informational Annex prepared by the IMF staff.
• A Statement by the Executive Director for Iraq.
The documents listed below have been or will be separately released.
Selected Issues
The IMF’s transparency policy allows for the deletion of market-sensitive information and premature disclosure of the authorities’ policy intentions in published staff reports and other documents.
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Press Release No. 19/301 International Monetary Fund
FOR IMMEDIATE RELEASE 700 19th Street, NW
July 26, 2019 Washington, D. C. 20431 USA
IMF Executive Board Concludes 2019 Article IV Consultation with Iraq
On July 19, 2019, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 with Iraq.
An improved security situation and the recovery in oil prices have improved near-term vulnerabilities. Large fiscal and current account surpluses—around 8 and 6 percent of GDP, respectively—were recorded in 2018, allowing the government to retire domestic debt and accumulate fiscal buffers. Gross international reserves reached $65 billion by end-2018.
However, post-war reconstruction and economic recovery have been slow. Non-oil GDP rose by only 0.8 percent year-on-year in 2018 in a context of weak execution of reconstruction and other public investment. Overall GDP contracted by around 0.6 percent as oil production was cut to comply with the OPEC+ agreement.
The 2019 budget implies a sizable fiscal loosening that will reverse the recent reduction in vulnerabilities. Current spending is expected to increase by 27 percent year-on-year, in part due to a higher public sector wage bill, while revenues will be dampened by the abolition of non-oil taxes. As a result, the budget is projected to shift to a deficit of 4 percent of GDP in 2019, and reserves are projected to decline.
1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.
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and to reduce vulnerabilities to corruption. In this context, Directors welcomed the newly adopted General Financial Management Law and encouraged its full implementation.
Directors emphasized that gradual fiscal adjustment, including containing current primary spending and boosting non-oil revenues is essential for maintaining fiscal and debt sustainability. They recommended that spending measures should give priority to containing the growth in wage bill and lowering subsidies to the electricity sector. Directors emphasized that the poorest and the most vulnerable must be protected from the adjustment process.
Directors underscored that an overhaul of the banking sector is necessary to maintain financial stability. They encouraged the authorities to restructure the large state-owned banks, enhance their supervision, and implement other reforms to increase financial intermediation. Directors highlighted the benefits of increasing financial inclusion, especially for the SME sector, which has a large potential to absorb entrants to the labor market.
Directors agreed that building public institutions and enhancing governance is key for success, and highlighted the scope for Fund capacity development to support these efforts. They welcomed progress in developing an anti-corruption framework and called for further modifications to the legal regime for combatting corruption coupled with stronger coordination between the relevant government agencies, while continuing to strengthen the framework for Anti-money laundering and combatting the financing of terrorism (AML/CFT). Directors also recommended strengthening Public Investment Management framework to ensure that spending is well directed and that donor funds targeting reconstruction are put to the most efficient use.
Directors looked forward to continued close engagement between the authorities and the Fund in the context of post program monitoring.
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IRAQ
July 3, 2019
STAFF REPORT FOR THE 2019 ARTICLE IV CONSULTATION AND PROPOSAL FOR POST-PROGRAM MONITORING
KEY ISSUES
Context. Forty years of upheaval has eroded physical and human capital and weakened public institutions. Social conditions remain harsh following the war with ISIS, with slow progress at reconstruction, weak public services and a lack of job opportunities. The recent rebound in oil prices helped deliver a large budget surplus and healthy build-up in reserves in 2018, but post-war recovery has been sluggish. The SDR 3.8 billion ($5.3 billion) Stand-by Arrangement approved in 2016 expires in July.
Outlook and risks. In the absence of policy changes, a widening budget deficit will divert resources away from essential investment to rebuild the country and improve public services, while eroding reserves and posing risks to medium-term sustainability. Expenditure rigidities and limited fiscal buffers imply a significant vulnerability to oil price shocks in a context of volatile prices.
Policy Recommendations
• Fiscal policy framework. Fiscal policy should be anchored on scaling up capital spending and building fiscal buffers within a risk- and rules-based fiscal framework. Expenditure ceilings should be established, supported by phased measures to lower current spending and boost non-oil revenue. A steady build-up of fiscal buffers will help the authorities reduce pro-cyclicality and protect investment in the event of oil price and other shocks.
• Reorienting public expenditure. Structural measures to curb the sharp rise in the public-sector wage bill will help create fiscal space for essential investment. Electricity reforms will entail significant capital spending in the near term, but should enable the authorities to tackle power outages and eventually reduce budget subsidies. Public investment practices require significant reforms. The authorities should review the adequacy and efficiency of social spending to help ensure that poor and vulnerable groups are protected throughout such reforms.
• Financial sector. Bank supervision should refocus on the two largest and troubled state-owned banks, which need to be audited and restructured prior to recapitalization over the medium term. Such reforms, along with efforts to promote financial inclusion could help tackle access to credit and promote private-sector job creation. Strengthened enforcement of the AML/CFT regime would support the integrity of the financial system.
• Combatting corruption. A multi-pronged strategy is required involving strengthening the legal framework, developing national anti-corruption policies, and fostering closer co-ordination between the involved agencies. An effective AML/CFT regime can complement enforcement efforts.
Approved By
Taline Koranchelian and Kristina Kostial
CONTENTS
Discussions were held in Amman (Jordan) during April 25–May 2, 2019. The staff team comprised Gavin Gray (head), Gazi Shbaikat (advance team lead), Kareem Ismail (Resident Representative for Iraq), Salim Dehmej (all MCD), Seyed Reza Yousefi (FAD), Chady El Khoury and Kathleen Kao (LEG), and Diva Singh (SPR). Maya Choueiri (Senior Advisor, OED) participated in the discussions. The mission met with Dr. Fuad Hussein, Deputy Prime Minister for Economic Affairs, Dr. Ali Mohsen Ismail Al-Allaq, Acting Governor of the Central Bank of Iraq, and staff from government ministries and the Central Bank of Iraq. Laila Azoor, Alexander de Keyserling, Cecilia Pineda, and Jawed Sakhi assisted from headquarters in the preparation of the report.
BACKGROUND: IMPROVED POLICY ENVIRONMENT BUT MEDIUM-TERM
RISKS ON THE RISE_________________________________ 4
A. Context ________________________________ 4
B. Recent Developments: Slow Post-War Recovery ___________________________ 6
C. Outlook and Risks: Vulnerabilities on the Rise Again __________________________ 7
ECONOMIC POLICIES TO SUPPORT SUSTAINABILITY AND PROMOTE
INCLUSIVE GROWTH ____________________________________________ 9
A. Building a Robust Fiscal Framework to Manage Oil Wealth ____________________ 10
B. Reallocating Public Expenditure to Promote Inclusive Growth _____________________ 15
C. Enhancing Financial Stability and Financial Intermediation _________________
D. Anti-Corruption ______________ 20
E. Future Fund Engagement _______________ 21
STAFF APPRAISAL ________________________ 21
BOX
1. Quantifying the Macroeconomic Benefits of Improved Governance ___________________ 11
FIGURES
1. An Oil Dependent Economy, 1980–2018 ___________________________ 23
2. Social Indicators, 2000–50 ______________________ 24
3. Recent Economic Developments, 2013–19 ___________ 25
4. Fiscal and Debt, 2013–18 ______________ 26
TABLES
1. Selected Economic and Financial Indicators, 2015–24 ___________________ 27
2. Central Government Fiscal Accounts, 2015–24 (In trillions of Iraqi dinars) ______________ 28
3. Central Government Fiscal Accounts, 2015–24 (In percent of GDP) ____________ 29
4. Central Government Fiscal Accounts, 2015–24 (In percent of non-oil GDP) ___________ 30
5. Balance of Payments, 2015–24 __________________________ 31
6. Monetary Survey, 2015–24 _____________________ 32
7. Central Bank Balance Sheet, 2015–24 ___________________ 33
8. Indicators of Fund Credit, 2016–24 ___________________________ 34
9. Inclusive Growth Indicators _______________________________ 35
ANNEXES
I. Capacity Development Strategy _________________ 36
II. Response to Past Fund Policy Advice____________________ 37
III. External Sector Assessment ______________ 38
IV. Iraq—Public and External Debt Sustainability Analysis _______________ 42
V. Risk Assessment Matrix ______________ 53
VI. Governance ____________________ 55
VII. International Experience with Public Wage Bill Management ____________ 63
BACKGROUND: IMPROVED POLICY ENVIRONMENT BUT MEDIUM-TERM RISKS ON THE RISE
A. Context
1. Despite its vast oil wealth, Iraq has major development needs and significant institutional weaknesses. It possesses the world’s fourth largest oil reserves, which are projected to last over 100 years at current production rates (Figure 1). Slow progress at channeling these resources into human and physical capital reflects decades of political upheaval and armed conflict as well as the resulting weakness of public institutions; weak governance and corruption are widely acknowledged elements of the problem.1 An exodus of skilled workers amidst poor security conditions since the second gulf war in 2003 has eroded human capital, while the more recent conflict with ISIS led to 100,000 deaths, five million internally displaced people and an estimated $46 billion of damage to infrastructure and property. 2 As a result, Iraq’s development needs include large infrastructure gaps, poor basic services, subpar health and education outcomes, and widespread poverty; GDP has barely grown in per capita terms over the past five years.
1 Prime Minister Adil Abdul-Mahdi has compared the impact of corruption on Iraqi society to that of the ISIS terrorist group ( http://www.rudaw.net/arabic/middleeast/iraq/3112201812).
2 See Iraq: Reconstruction and Investment.
2. Weak fiscal policy frameworks, which are ill equipped to cope with oil price shocks, have contributed to these outcomes. The authorities have generally saved little during oil price booms, instead ramping up current spending— particularly the civil service payroll and other items that are hard to cut—leaving them with limited buffers when oil prices dipped, and necessitating sharp cuts in investment and the accumulation of arrears. Such procyclical patterns coupled with poor public financial management and inefficient public procurement have hindered investment in infrastructure, especially electricity, 3 undermining both core public services and the overall business environment.
3. The Fund provided a $5.3 billion SBA in 2016 and significant capacity development (see Annex I) to support the authorities’ response to the twin shocks of ISIS and the collapse in oil prices. The main achievements under the SBA were the preservation of the pegged exchange rate, a large fiscal consolidation (albeit mainly through capital expenditure cuts), a reduction in external arrears, and progress on AML/CFT. However, a number of structural fiscal measures were reversed or not enacted, and there has been limited progress at restructuring public banks or strengthening public institutions, while the authorities’ response to Fund advice in the context of the last Article IV has been mixed (see Annex II). The SBA went off track after the second review in August 2017, and expires in July 2019.
4. An improved security situation and the windfall from higher oil prices offer an opportunity to rebuild the country and tackle longstanding social problems. The government faces a wide range of socio-economic challenges, including repairing infrastructure and other property destroyed in the war, as well as improving the provision of electricity, water supply and other public services. A young and fast-growing population is exerting strains on public institutions, while job opportunities for the estimated 800,000 annual entrants to the labor market are limited.
5. The obstacles to progress are formidable. Geopolitical strains are a distraction, with the re-imposition of U.S. sanctions on Iran complicating energy reforms. 4 Weak governance and corruption have impeded public institutions and discouraged private-sector investment and job creation. More positively, relations between Baghdad and the Kurdistan Regional Government (KRG) have improved over the past year.
3 Despite ample oil reserves, electricity supply has averaged only 17 hours per day in recent years, which is a key weakness of the business environment.
4 Around a third of electricity supply comes either directly from Iran, or from Iraqi plants reliant on Iranian gas.
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C. Enhancing Financial Stability and Financial Intermediation
35. An overhaul of the banking sector is essential to maintain financial stability and to transform the sector into an effective vehicle for intermediation that also supports inclusive growth. The two largest banks—Rafidain and Rasheed (R&R)—have portfolios heavily weighted towards public-sector assets, some of which are not being serviced, which limit their capacity to lend until they are restructured and recapitalized. A number of private banks are struggling with sharply reduced FX trading incomes while working out NPLs that emerged during the 2014–16 crisis. These weaknesses coupled with shortcomings in the financial architecture and legal framework help explain why lack of access to credit is a material weakness of the business environment.
36. The long-delayed restructuring of the public banks is beginning, and well-structured plans are required to bring it to a successful conclusion. R&R have contracted suppliers for core banking systems, and segregated legacy assets and liabilities into ‘bridge branches’. The Bureau of Supreme Audit (BSA) is working on finalizing their accounts for 2014 and subsequent years. Once the core banking systems are fully operational,13 the two banks should be audited to international standards, which would allow their capital needs to be assessed accurately. In the interim, and to prevent a further deterioration in their financial conditions, the authorities should strengthen governance and oversight over the two banks and develop long-term strategies for their future, while abstaining from piecemeal capital injections. All these steps would require coordinated government action in light of the potential fiscal implications of bank restructuring.
37. Strengthening banking supervision, with an increased focus on risks in the public banks, is essential to support stability during this transitional phase. Building on steps to improve the prudential framework, staff encouraged the authorities to commission a targeted quality review of the public banks’ main assets, especially loans to SOEs that are government guaranteed (and therefore zero risk weighted), yet are not being fully serviced. Such a review would help guide supervisory efforts, lower the risks of a further deterioration in the public banks’ balance sheets, and facilitate the transfer of assets to the core banking system. To reduce risks in the private banks, staff encouraged caution in licensing new banks, and urged the authorities to strengthen frameworks for handling troubled banks.
38. Tackling weaknesses in the banks coupled with wider structural reforms can help the authorities realize their goals of promoting financial development and inclusion.14 Work is underway to strengthen payment systems and encourage salary payments directly into bank accounts. Fintech can help banks strengthen risk management and channel additional financial resources, and in view of the extensive wireless coverage, there is considerable potential to improve financial inclusion by developing mobile banking. Improving credit information and strengthening legal procedures could also encourage banks to relax collateral requirements and facilitate access to
13 International experience suggests that it could take two to three years for the systems to be fully operational. In light of the work already done, the Iraqi authorities consider that the systems could be fully operational in 2020.
14 See the Selected Issues Paper ‘Iraq: Financial Development and Inclusion’.
39. credit. Plans are underway to develop a deposit insurance scheme, which would help level the playing field across the banking sector, but requires effective bank supervision to limit risks. In helping to boost the currently very low level of SME financial inclusion, such measures can add a significant impetus to growth and employment.
40. The authorities have made some progress in implementing the recommendations of the 2016 safeguards assessment of the CBI. Amendments to the law on the Central Bank of Iraq to strengthen CBI governance have been enacted, and the revised audit committee charter now prohibits CBI executive representation on the committee. However, progress in strengthening the capacity of internal audit and financial reporting has been slow.
Authorities’ Views
41. The authorities agreed on the need to address weak banks. They agreed on the scope for greater coordination between the Ministry of Finance, CBI, and BSA in restructuring R&R. They considered the progress on procuring core banking systems for the two banks as an important first step. The authorities concurred that the financial system is currently overbanked.
They expect the number of private banks to decline as non-profitable banks merge with others or exit the system. They expressed the need for continued strengthening of their capacity on banking supervision and resolution with Fund support.
42. The authorities also agreed on the importance of strengthening financial development and inclusion. They saw the main impediments as a cash-based culture that narrows the funding base, and pervasive non-repayment of credit due to sluggish legal processes and weak enforcement. They cited progress through recent measures to encourage deposits including paying public salaries through the banking system, and passing the law establishing a deposit insurance company. The authorities also highlighted the credit bureau system at the CBI, which they plan to eventually transfer to the private sector.
The CBI considered the weak credit to the private sector to be mainly due to weak demand and the limited capacity in the private sector to prepare financial statements and viability studies. They cited limited uptake on the CBI’s ID1 trillion initiative to finance SMEs and the difficulty in finding bankable projects.
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52. Restructuring of the public banks coupled with enhanced bank supervision is essential to preserve financial stability. The key next step is to install core banking systems in the two large public banks, which is a pre-requisite for these banks to be audited, restructured and eventually recapitalized. Steadfast supervision would help prevent a further deterioration in their balance sheets during this process, and to monitor vulnerabilities among private banks.
53. Successful restructuring of the banks coupled with structural reforms can help the authorities address long-standing problems with financial inclusion, including access to credit. Improving credit information and strengthening legal procedures would encourage banks to relax collateral requirements and facilitate access to credit. The planned deposit insurance scheme would also help level the playing field across the banking sector, but effective supervision is essential to limit risks. By strengthening SME financial inclusion, such efforts can have a significant impact on growth and employment.
54. Combatting corruption requires modifications to the legal framework and closer co-ordination between public agencies. A sound legal regime criminalizing all corruption offences and setting out effective sanctions will be necessary; public officials convicted of corruption should be prohibited from holding office. The authorities should also develop coherent national anti-corruption policies, based on a deeper understanding of the risks, and relevant agencies should coordinate more closely, with enhanced information exchanges. The system of asset declarations should be progressively strengthened by targeting the officials most exposed to corruption, sanctioning failures to submit declarations, digitalizing declarations and moving eventually to publication of asset declarations.
55. Bolstering AML/CFT implementation would help enhance the integrity of the financial system and support anti-corruption efforts. The Central Bank of Iraq (CBI) should implement risk-based AML/CFT supervision of banks and exchange houses to improve compliance with preventive measures, including those related to politically exposed persons and beneficial ownership. Such efforts would help identify proceeds of corruption and ease pressure on correspondent banking relationships. The CBI should also step up efforts to implement outstanding safeguards recommendations.
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Annex III. External Sector Assessment
Staff assesses the external position in 2018 to be substantially stronger than suggested by fundamentals and desirable policy settings. However, this is expected to reverse in 2019, with the current account (CA) weakening significantly, reserves falling, and the REER moving into overvalued territory. Ensuring external stability in the medium term will critically hinge on fiscal adjustment, to bring the CA and REER back into line with fundamentals, and maintain reserve adequacy.
1. From a surplus in 2018, Iraq’s CA balance is expected to worsen significantly in 2019 and average a deficit of 5 percent of GDP over the medium term. In 2017, Iraq’s CA registered a surplus of 1.8 percent of GDP, from a deficit of -8¼ percent of GDP in 2016, on the back of higher oil prices and fiscal consolidation under the program, while oil export volumes remained flat year on year. In 2018, preliminary estimates suggest that the surplus increased to 6.9 percent of GDP driven by a large increase in oil prices (by USD 16 year on year), with a minor increase in oil export volumes also contributing. Looking forward, the expected decline in oil prices in 2019 (by USD 9 year on year) together with fiscal loosening are projected to dramatically reverse the CA surplus this year to a deficit of 5¼ percent of GDP, despite a projected increase in oil export volumes of 4 percent year on year. Thereafter, the CA balance is expected to remain in deficit through the medium term, averaging –5 percent of GDP, with a gradual increase projected for oil export volumes while prices will remain roughly flat. The real effective exchange rate (REER) appreciated by 4¾ percent year on year in 2018, continuing a trend seen since 2013 (the REER has appreciated by 12½ percent in the past five years) mostly due to movements in the nominal effective exchange rate (NEER) dampened by inflation differentials.1
2. Iraq’s international reserves, while adequate in 2018, are expected to decline precipitously to levels well below conventional and IMF adequacy metrics over the medium term, given weak oil price prospects and rising financing needs. After increasing to $64.7 billion (29 percent of GDP) in 2018, reserves are expected to fall over the medium term to $14 billion (4¾ percent of GDP) in 2024. Oil prices are expected to decrease marginally from 2019–24, providing no contribution to reserve accumulation, while higher financing needs from the growing fiscal deficit and rising external debt service (from 1¼ percent of GDP in 2018 to almost 3 percent of GDP in 2024) will serve as a drain. Reserves will dip below the IMF’s augmented reserve adequacy metric for oil exporters (which adds a buffer to hedge against lower than projected oil prices) in 2019, and by 2023 they will fall to a level well below all IMF and traditional adequacy metrics.
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5. The Iraqi dinar peg with the U.S. dollar remains an appropriate nominal anchor for macroeconomic policies. The misalignment of the REER is expected to over-correct and move into slightly overvalued territory in 2019 as the CA weakens against its norm. Fiscal adjustment will be crucial to bring the CA back into line with fundamentals, preserve reserves, and ensure external stability over the medium term. In the longer-run, structural policies to improve competitiveness and achieve export diversification would also help support Iraq’s external position.
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Box 1. The Investment Needs Model for Natural Resource-Rich Developing Countries
Countries that are rich in exhaustible natural resources experience windfalls that can be consumed, saved or invested—with each of these options having a disparate impact on macroeconomic outcomes and external stability. Empirical studies indicate that most resource-rich developing and advanced countries save much of their windfalls in an attempt to smooth consumption and ensure intergenerational equity, in line with the permanent income hypothesis (Friedman, 1957), and therefore tend to run current account surpluses.1
However, drawing on a separate stream of development thinking,2 Araujo and others (2013) question whether resource-rich developing countries (RRDCs) with large investment needs and external borrowing constraints should save as much as their advanced economy peers, or instead use these windfalls for investment in much needed physical and human capital. They develop a neoclassical small open economy model that aims at assessing the optimal external balance and savings/investment decisions in response to windfalls in RRDCs. The model explicitly incorporates the role of investment given capital scarcity in these countries but also captures pervasive frictions in RRDCs, such as investment inefficiencies, absorptive capacity constraints, and external borrowing constraints. Investment inefficiencies are modeled as impediments that prevent a dollar of investment translating into a dollar of productive capital, thereby lowering the optimal level of investment. Absorptive capacity constraints are adjustment costs that arise when the speed of investment negatively impacts project selection, management and execution, thereby necessitating a slower pace of investment. Finally, imperfect capital mobility and borrowing constraints are modeled through a country risk premium that can be relaxed as natural resource endowments lower the premium.
The results of the model suggest that the optimal external balance and savings/investment decisions for windfalls in RRDCs depend heavily on the degree of investment frictions. Facing borrowing constraints, but absent investment frictions, the model indicates that RRDCs should mostly convert windfalls into private and public capital rather than save them in the form of foreign assets. This would imply lower current account balances or even deficits. Furthermore, if resource wealth reduces RRDCs’ risk premia thereby relaxing their borrowing constraint, this can facilitate further private and public investment, implying still lower current account balances. However, the presence of investment inefficiencies and absorptive capacity constraints in RRDCs modulates these results, making it optimal to delay or decelerate capital accumulation depending on the degree of the frictions, implying higher current account balances than otherwise would be the case.
On the whole, the model delivers optimal current account balances and savings levels for RRDCs that are significantly lower than those implied by conventional approaches such as the permanent income hypothesis, but the extent of these varies depending on the presence and severity of investment frictions.
1 See Berns and Carvalho (2009) and Bayoumi and Thomas (2009).
2 See Collier and others (2010) and van der Ploeg and Venables (2011).
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Statement by Mr. Hazem Beblawi, Executive Director for Iraq and Ms. Maya Choueiri,
Senior Adviser to the Executive Director
July 19, 2019
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8. The authorities remain committed to the peg to the U.S. dollar as it continues to provide a key nominal anchor to the economy.
9. The authorities are taking measures to enhance the stability of the banking sector. The two largest state-owned banks, Rasheed and Rafidain, are being restructured. The authorities have made progress in procuring suppliers for core banking systems and have segregated legacy assets and liabilities into “bridge branches.” The Bureau of Supreme Audit is working on finalizing their accounts for 2014 and subsequent years. Once the core banking systems are fully operational, the authorities intend to have the two banks audited to international standards, which would allow their capital needs to be assessed accurately.
10. At the same time, the Central Bank of Iraq (CBI) is pursuing its efforts to strengthen the regulatory framework and improve prudential regulations in banking supervision to align them with Basel II Committee on Banking Supervision standards and guidelines. In this connection, supervisory guidelines on bank internal audit and compliance functions were prepared in the fall, with Fund technical assistance. Work is progressing on early identification of bank risks and the way to deal with weak banks, including early intervention of supervisors, corrective actions and their enforcement, banking crisis management and the supervisor’s role, as well as techniques for liquidating unviable banks.
The CBI also intends to develop a deposit insurance scheme, which would help level the playing field across the banking sector. To promote financial development and inclusion, the CBI is working on strengthening payment systems and encouraging deposits, including public salary payments directly into bank accounts.
11. In June 2018, the Financial Action Task Force (FATF) welcomed Iraq’s significant progress in improving its AML/CFT regime and noted that “Iraq has established the legal and regulatory framework to meet the commitments in its action plan regarding the strategic deficiencies that the FATF identified in October 2013.”
FATF thus considered that Iraq was no longer subject to the FATF’s monitoring process under its ongoing global AML/CFT compliance process. The authorities will continue to work to strengthen the AML/CFT framework. They consider that continued progress on AML/CFT will also help them address the transfer of illicit gains.
12. Good progress has been made in implementing the recommendations of the 2016 safeguards assessment of the CBI. Amendments to the Law on the Central Bank of Iraq to strengthen CBI governance have been enacted, and the revised audit committee charter now prohibits CBI executive representation on the committee. Work is ongoing on strengthening the capacity of internal audit and financial reporting.
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Conclusion
Notwithstanding an improvement in security conditions and oil prices, Iraq faces the serious challenge of maintaining economic stability, while ensuring durable peace and inclusive growth.
The Iraqi authorities very much value the Fund’s policy advice in addressing its economic challenges, and they would welcome a Post-Program Monitoring engagement.
Continued Fund capacity development would be essential in the period ahead.
The authorities have been calling on the Fund to resume visits to Baghdad, similar to the practice of other international institutions.
They welcome the recent lowering of the Fund’s security rating for Baghdad to a medium level of residual risk and look forward to welcoming Fund staff again.
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Last edited by ikea on Sun Jul 28, 2019 1:53 pm; edited 1 time in total
