28. With these policies, the budget deficit would decline moderately to 19 percent
of GDP in 2010, before falling markedly to 6 percent in 2011, and moving back into
surplus in 2012 as oil revenues increase. In the event that oil revenues are higher than
budgeted, half of the additional revenues (up to a specified limit) could be used for further
investment. The remaining half would be used to build up buffers in the DFI. If oil revenues
are less than budgeted, the authorities will reduce spending and aim to mobilize additional
(external) financing. The 2010 deficit will be financed by a further drawing down of
government balances in the DFI and the CBI, a significant amount of domestic financing,
and external support, including from the Fund. The authorities also intend to use the SDR
allocation, equivalent to $1.7 billion, to finance the budget deficit. With regard to domestic
financing, the authorities plan to further develop the Treasury bill market by improving the
auction process with the assistance of the US Treasury and the Fund. This would enable the
government to attract deposits currently held by commercial banks with the CBI and would
contribute to the development of a secondary market. The authorities will also start
preparations for the introduction of a sales tax with the purpose of broadening the revenue
base over the medium-term.
E. Monetary and Exchange Rate Policies
31. The CBI intends to maintain its present monetary and exchange rate policies,
which are aimed at keeping inflation in the single digits and further reducing
dollarization. In the absence of an effective monetary transmission mechanism, the
exchange rate remains the CBI’s main policy instrument. Up until late 2008, the CBI had
allowed the dinar to appreciate gradually to bring down core inflation to near single digit
levels. Once inflation was brought under control, the CBI returned to its earlier policy of
maintaining a stable dinar, as it had been specified in the last SBA. The CBI also intends to
keep the policy interest rate positive in real terms (as measured by core inflation).
32. The lack of data and large structural changes in the Iraqi economy preclude any
meaningful estimation of the equilibrium real exchange rate. A very crude assessment
suggests that the dinar is broadly in line with fundamentals.4 With the drop in oil prices, it
appears that a possible prior undervaluation has disappeared, and that the dinar could even be
somewhat overvalued. The relative low levels of headline and core inflation, however, do not
suggest any significant deviation from the equilibrium real effective exchange rate.
Moreover, as oil revenues are expected to rise substantially over the medium- to longer term,
the equilibrium real exchange rate is likely to rise as well. More importantly, a nominal
depreciation could undermine confidence in the dinar, destabilize expectations, lead to
increased dollarization, and reignite inflation, reversing the hard-won gains made in recent
years. The CBI therefore intends to continue to keep the exchange rate stable, but will consult with staff if its reserves were to fall significantly below the program targets.
33. The authorities are committed to a liberal exchange regime and to removing all
restrictions under Fund jurisdiction. Iraq has a generally unrestricted current account
regime and a significantly liberalized capital account. However, four measures have been
identified to give rise to exchange restrictions subject to Fund approval. Three relate to a
requirement to pay all obligations and debts to the government before relevant payments are
transferred abroad, and one to an inoperative bilateral payments agreement with Jordan. The
authorities are considering measures to remove the identified restrictions, with a view to
accepting Article VIII of the Fund’s Articles of Agreement, but it may take time to resolve
the last restriction because of the pending resolution of Iraq’s debts to Jordan.
36. The CBI is further developing its institutional capacity. The CBI’s reserve
management practices are being brought in line with the reserve management guidelines
adopted in mid-2008, but further training and better reporting are still required (MEFP ¶25).
The CBI also completed the set of prudential regulations for commercial banks, and work on
the relevant reporting tables for banks is expected to be finalized soon. A full assessment of
the banking supervision department at the CBI that is currently underway with foreign
assistance should provide a roadmap for further improvement (MEFP ¶23). The accounting
and reporting framework, and the internal audit function of the CBI, will also be
strengthened as a control committee appointed by the CBI is developing control procedures
and manuals with the assistance of external advisors (MEFP ¶24). To make sure that these
reforms move forward at the same time, the CBI is seeking resident advisors with
international experience in a broad range of areas such as IT, banking supervision, and
reserve management. Finally, commercial banks have been instructed to conform their
accounting norms to International Financial Reporting Standards (IFRS), and to prepare a set
of financial soundness indicators that could be used by the CBI to monitor sectoral
developments (MEFP ¶23).
45. An update safeguards assessment of the CBI is underway. The assessment will
also focus on the procedures governing the government’s treasury accounts with the CBI. An
internationally reputable external auditor has already completed a special audit of the CBI’s
international reserves as of June 30, 2009 (a prior action under the program). The external
auditor is expected to complete the full audit of the 2008 CBI accounts in the coming weeks,
which will be a key input for the update safeguards assessment. An external auditor will also
be appointed shortly to conduct the audit of the 2009 CBI accounts (another prior action). To
better safeguard the Fund going forward, the scope of the special audits will be expanded to
cover, for all program test dates, CBI data reported to the Fund and the procedures in place
over the government accounts at the CBI.
V. STAFF APPRAISAL
48. Iraq has continued to make progress in rebuilding its economy and achieving
macroeconomic stability under very difficult security and political circumstances.
During the last Fund-supported program, inflation was successfully brought down into single
digits, the international reserves position was further strengthened, and the CBI’s
institutional capacity was strengthened. Moreover, with the reduction in violence, the
prospects for an increase in oil production and non-oil activity have improved.
49. Nevertheless, Iraq still faces major challenges, which were exacerbated by the
fall in oil prices in 2009. With both the balance of payments and the government budget
heavily dependent on oil revenues, the lower oil receipts have created balance of payments
and fiscal gaps, which so far the authorities have been able to cover through the financial
buffers built up in previous years. As oil prices and production are projected to increase,
these financing gaps are expected to be temporary.
55. Staff supports the CBI’s intention to continue to manage the exchange rate with
a view to keeping inflation under control. Although difficult to assess, the exchange rate
appears to be broadly in line with fundamentals, taking into account the expected increase in
oil production. Moreover, a strong and stable currency provides a solid anchor for the
public’s expectations. The CBI should continue to keep a close watch on inflation and be
ready to raise the policy interest rate if core inflation were to pick up again.
5. The Central Bank of Iraq (CBI) has been successful in keeping inflation under
control, by managing the exchange rate and by keeping the policy interest rate positive in
real terms. When inflationary pressures emerged in 2008, the CBI stepped up the rate of
appreciation of the dinar vis-à-vis the U.S. dollar (to about ½ percent per month until late
2008), which also helped counter dollarization. As a result, headline inflation fell to
6.8 percent by end-2008. Inflation remained well below the target of 6 percent in 2009, with
prices falling by 4½ percent, mainly because of a further decline in fuel prices. Food price
inflation has picked up more recently, however, and core inflation (excluding fuel and
transportation) ended 2009 a 6 percent, down from 12 percent at end-2008.
6. With headline and core inflation low, the exchange rate has been stable since the
beginning of 2009. The policy interest rate has been reduced gradually to 7 percent. Net
international reserves increased to $50.2 billion at end-2008, but have fallen to $44 billion
at end-2009, reflecting the drawdown of the government’s deposits with the CBI.
VIII. Safeguards assessments:
The Central Bank of Iraq (CBI) is subject to an update safeguards assessment in respect
of the proposed SBA. The earlier safeguards assessment, in conjunction with the SBA
approved on December 19, 2007, was finalized on March 7, 2008. It concluded that
accounting and control governance at the CBI needs to be strengthened. Steps are being
taken to address the issues that continue to give rise to heavily qualified external audit
opinions, but accounting and internal control procedures are not yet fully effective.
Measures to mitigate the safeguards risks, notably through continued external audits
and adoption of foreign reserves management guidelines were recommended.
IX. Exchange rate arrangement:
The Central Bank of Iraq has been conducting foreign exchange auction on a daily basis
since October 4, 2003. The central bank followed a policy of exchange rate stability
which has translated in a de facto peg of the exchange rate since early 2004. However,
from November 2006 until end 2008, the CBI allowed the exchange rate to gradually
appreciate. As a result, the exchange rate arrangement of Iraq was reclassified to the
category of crawling peg effective November 1, 2006. Since the start of 2009, the CBI
returned to its earlier policy of maintaining a stable dinar. Consequently, the exchange
rate arrangement of Iraq was reclassified effective January 1 2009 as a stabilized
Iraq continues to avail itself of the transitional arrangements under Article XIV. Iraq has
a generally unrestricted current account regime and a significantly liberalized capital
account. However, four measures (plus one exchange restriction maintained for national
or international security) have been identified to give rise to exchange restrictions
subject to IMF approval, namely, (i) the requirement to pay all obligations and debts to
the government before proceeds of investments of investors, and salaries and other
compensation of non-Iraqi employees may be transferred out of Iraq, (ii) the
requirement to submit a tax certificate and a letter of non-objection stating that the
companies do not owe any taxes to the government before non-Iraqi companies may
transfer proceeds of current international transactions out of the country, (iii) the
requirement that before non-Iraqis may transfer proceeds in excess of ID 15 million out
of Iraq, the banks are required to give due consideration of legal obligations of these
persons with respect to official entities, which must be settled before allowing any
transfer, and (iv) an Iraqi balance owed to Jordan under an inoperative bilateral
payments agreement. In addition, one exchange restriction maintained for security
reasons should be notified to the IMF under the framework of Decision 144-(52/51).
X. Article IV consultations:
The last Article IV consultation was concluded on August 1, 2007. The staff report
(IMF Country Report No. 07/301) was published on August 31, 2007, and is available
on the internet at http://www.imf.org/external/pubs/cat/longres.cfm?sk=21301.0.