Statement at Donor Meeting

Statement on the IMF's Staff Macroeconomic Assessment of Iraq, Delivered by Lorenzo Perez, IMF Mission Chief for Iraq, to the International Donors' Conference for the Reconstruction of Iraq

October 23, 2003

1. In the context of the United Nations-World Bank Needs Assessment, IMF staff prepared a macroeconomic assessment on Iraq, a summary of which was used as an input to the Joint Needs Assessment Report issued on October 8, 2003.

2. Our macroeconomic assessment provides a preliminary appraisal of the current state of the Iraqi economy, the near-term prospects for its recovery, and the macroeconomic strategy. The current state of economic dislocation in Iraq owes much to a combination of pervasive state intervention, costly militarization, three wars, and over a decade of international sanctions. The economic dislocation led to a remarkable deterioration in Iraq's human development indicators, which only two decades ago exceeded regional averages. Despite proven oil reserves of about 112 billion barrels, second only to Saudi Arabia, GDP per capita declined from over US$3,600 in the early 1980s to about US$770-US$1000 in 2001. Even before taking into account reparation claims, Iraq is among the most heavily externally indebted countries in the world.

3. Economic activity continues to be hampered by the hostilities, looting and sabotage activities. Despite steps taken by the Coalition Provisional Authority and Iraqi officials, security conditions have made it difficult for economic activity to fully resume. GDP in U.S. dollar terms for 2003 is likely to decline by 20 percent (or a decline similar to the one estimated for 2002), reflecting a 40 percent decline in oil production, a 30 percent drop in electricity production, and the closure and restructuring of half of the state-owned enterprises (SOEs). Consumer price inflation is likely to be less than 15 percent by end-2003, helped by the fact that the prices of energy, and water, and some other prices continue to be heavily subsidized. Exchange rate fluctuations have remained subdued. The Oil-for-Food Program (OFFP) has continued to provide the majority of Iraqis with the basic necessities, averting a major humanitarian crisis.

4. Several key macroeconomic policy measures were taken in 2003:

· The budget for the second half of 2003 was adopted in July 2003 and is being financed by oil export sales, grants by the United States government, and official Iraqi assets held abroad. The implementation of this budget has not been without difficulties, reflecting disruptions in the payments system and infrastructure. But, as of August 2003, wage and pension payments have been regularized, and rehabilitation work has started.

· A banknote exchange program started on October 15, for a period of three months, to provide badly needed liquidity, and to remedy fears of counterfeiting.

· A reform agenda is being formulated to move to a market economy and liberalize prices. As part of this strategy, in September 2003, the newly appointed economic ministers announced reforms in the areas of foreign investment, the financial system, and taxes to encourage private sector participation, including foreigners, in the reconstruction of Iraq.

5. Looking forward, IMF staff believe that there can be a strong economic recovery in 2004 driven by a pick up in oil output and private investment, provided sufficient security is restored and the functioning of basic utilities returns to more normal levels. The inflation outcome in 2004 will be affected by the conduct of macroeconomic policies and by the extent to which price subsidies are phased out.

6. The draft 2004 budget assumes oil revenue of US$12 billion, negligible non-oil revenue, operating (recurrent) expenditures of almost US$20 billion (including spending associated with remaining contracts of the OFFP), and minimal investment expenditures. The resulting deficit is very large at US$8.5 billion or 55 percent of GDP, but should be fully financed by official Iraqi assets held abroad and existing contracts under the OFFP. This projection of the fiscal deficit does not include the accruing interest bill on external debt which could be very large. External debt data is still being collected; however, based on partial information, the external debt stock is projected at close to nine times GDP.

7. In IMF staff's view, policymaking in Iraq is rendered particularly challenging by the combination of problems associated with the emergence from a conflict situation and inherited features of a transition economy.

8. In this context, an ambitious macroeconomic strategy is being developed to promote the establishment of an open, market-based economy to improve living standards and reintegrate Iraq into the world economy. It is expected that institutions would be created based on international best practices and that would meet internationally accepted standards of transparency and openness. Safety nets should be designed to protect the poor and vulnerable from negative impacts of the transition.

9. These are important developments, but there are considerable challenges:

· The restoration of lasting security is absolutely essential to support economic recovery, promote private investment, and put to good effect donors' involvement in Iraq's reconstruction;

· The rich experience of the transition economies has also shown that reform strategies need to be carefully planned and implemented in a transparent manner to ensure broad political support in highly sensitive areas; and

· The collection of information on most essential macroeconomic is critical to the design of the macroeconomic strategy.

10. Due to the uncertainties about fiscal oil revenue, the large reconstruction needs, and the heavy debt burden, consideration should be given to adopting a broader-based tax revenue effort. On the expenditure side, a reform of the salary scale of the civil service has been implemented that appropriately decompresses the wage scale, but at the same time increases the wage bill by a large amount. Wage restraint will need to be exercised in the future and wage policy decisions will need to be coordinated with the reform of price subsidies and of the commodity distribution program under the OFFP.

11. With respect to government's transfers, it is essential that comprehensive strategies be developed:

· The reform strategy for SOEs should take into account the complexities of the existing environment, including the capacity of the economy to absorb the current high levels of unemployment;

· The removal of domestic oil price subsidies would need to be phased out in stages to avoid undue social disruption;

· A gradual, carefully monitored transition from the in-kind social safety net under the OFFP to a cash-transfer system could begin in 2004. The constitution of strategic food reserve to guarantee access to essential food commodities at international prices is critical until alternative private import supply channels develop. In addition, as means testing becomes feasible, the safety net needs to be well-targeted to limit costs.

12. While Iraq's fiscal situation will improve over time as oil production increases and a stronger domestic tax effort is implemented, public finances will remain under strain in the coming years. Under these circumstances, for Iraq to achieve sustainable debt service payments in the future, it will need generous external debt relief.

13. The conduct of monetary policy in the coming months will likely prove challenging. The primary objective for monetary policy should be to maintain broad price stability, by targeting currency in circulation, and monitoring closely inflation and exchange rate developments. A flexible exchange rate regime should be adopted.

14. The Central Bank of Iraq also needs to take steps to improve its banking supervision capacity to ensure that the banking sector plays its key role in the economy. Domestic banks will need to be strengthened at the same time as the financial system is opened to foreign investment.

15. In ending, I would like to emphasize that the IMF is committed to help in the reconstruction of Iraq through a variety of modalities in our areas of expertise.

Thank you.