Iraq—Letter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding

Baghdad, September 24, 2004

Mr. Rodrigo de Rato
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. de Rato:

1. Iraq's economy is suffering the aftermath of decades of conflict, state control over economic and political activity, lack of investment in critical social areas, and over a decade of international isolation. The end result of this era of economic mismanagement and political repression is that Iraq's human development indicators are now among the lowest in the region. Iraq has enormous economic potential, but we face huge challenges in the reconstruction and rehabilitation of our country.

2. Despite continuing security problems, we have begun to implement an ambitious policy agenda, including macroeconomic stabilization, which will eventually facilitate progress toward a more market-oriented economy. In the political area, we are in the process of preparing for legislative elections early next year. The elected National Assembly will be charged with preparing a new constitution, which in turn will lead us to the election of a constitutional government by the end of next year. The assistance of the international community in both political and economic reform efforts has been invaluable. Nevertheless, significant financial and technical assistance will be needed to meet Iraq's reconstruction needs.

3. The attached memorandum describes the government's economic and financial program for the remainder of 2004 and for 2005. The principal objectives of the program are to improve the welfare of the Iraqi people, enhance political and social stability, and to enable Iraq to achieve a sustainable external debt position. The government believes that the policies and measures described in the attached memorandum of economic and financial policies will make it possible to reach the economic objectives of its program. Nevertheless, we remain ready to take, in consultation with the IMF, any additional measures that may be necessary to ensure the success of the program.

4. In order to support the implementation and success of the program, the government of Iraq hereby requests access to the IMF's policy for emergency post-conflict assistance (EPCA) in the amount of SDR 297.1 million, or the equivalent of 25 percent of quota. In addition, the government of Iraq hereby commits to retaining the full amount of this assistance in the country's SDR account at the IMF.

5. Satisfactory implementation of the EPCA-supported program should allow the government to move next year to a more ambitious economic program of reform that would address remaining structural impediments to long-term sustainable economic growth and fiscal and external sustainability. Such a program could be supported with a stand-by arrangement from the Fund, on the basis of a positive assessment that the government's capacity for planning and policy implementation is adequate.

6. The government of Iraq will provide the IMF with any information it may request on the progress made with program implementation.

Sincerely yours,

Memorandum of Economic and Financial Policies for 2004-05

I. Introduction

1. The liberation of Iraq from the Saddam Hussein regime has marked a critical opportunity to reverse more than two decades of economic decline. On June 28, 2004, Iraq's Interim Government undertook a task of economic and political rebuilding without historical parallel. Iraq has enormous economic potential, but we face huge challenges in the reconstruction and rehabilitation of our country. We have already made significant progress towards creating an open market economy, but require the assistance of the international community to support Iraq's substantial needs.

2. Iraq's needs stem primarily from the destructive actions of Saddam Hussein's regime and the impact of years of war and sanctions. Although Iraq has the world's second largest oil reserves, the previous regime squandered Iraq's oil wealth, neglecting investment in public infrastructure and failing to provide basic services. The policies of this highly centralized and corrupt authoritarian government led to major distortions of economic activity and the suppression of private sector development on an unprecedented scale. As a consequence, after attaining middle income status in the 1970s, Iraq's nominal GDP per capita had dropped to about US$700 by 2002, and many of Iraq's human development indicators are now the lowest in the region.

3. Key economic and institutional reforms have already been undertaken. A new currency was successfully launched. Monetary policy has been conducted with a view to guarding against inflation and maintaining a broad degree of stability in the exchange rate. New financial sector legislation has given autonomy to the central bank and paved the way for the creation of a modern banking sector. In the fiscal sector, important tax and customs policy measures were implemented. Several key reforms in the areas of trade and foreign investment liberalization have also been taken.

4. Important steps have also been implemented with a view to reintegrate Iraq into the world economy. Following the international recognition of our government, we have taken all necessary steps to normalize our relations with the IMF, including nominating a governor for the IMF, payment of Iraq's arrears to the Fund (SDR 55.3 million, and consenting and payment of our quota increase (raising it from SDR 504.0 million to SDR1,188.4 million). We are also taking steps to clear our arrears to the World Bank and the Arab Monetary Fund We have also begun working with our other external creditors towards the resolution of our unsustainable external debt burden.

5. The international community has played a vital role in providing assistance and support in Iraq's reconstruction. On October 23-24, 2003, Spain hosted a Ministerial-level Donors' Conference for Iraq. High level representatives from over 70 countries attended the conference, which succeeded in raising over US$32 billion in support of Iraq's reconstruction. The World Bank and the United Nations subsequently established the International Reconstruction Fund Facility for Iraq (IRFFI) to channel donor resources in support of priority projects. The Facility encompasses two trust funds: the World Bank Iraq Trust Fund (ITF) and the UN Development Group Iraq Trust Fund. Follow-up donors' meetings took place in April and May 2004 in Washington, D.C. and Doha (Qatar), respectively, and another one will take place in Tokyo in mid-October 2004.

6. Establishing the institutions and mechanisms necessary for a peaceful political transition is also an essential part of our agenda. An interim national assembly was selected by members of a national conference in August 2004, and will serve as a consultative legislative body to our interim government. In line with the transitional administrative law, a permanent national assembly will be elected to office no later than January 31, 2005. The national assembly will prepare a new draft constitution, which will be submitted to a popular referendum for approval before October 15, 2005. Elections for a new government under the constitution will take place before December 31, 2005.

II. Recent Economic and Policy Developments

7. As a result of the conflict, real GDP is estimated to have plummeted by about 35 percent in 2003, reflecting a contraction in oil production to an average 1.2 million barrels per day (mbpd) from a level of almost 2.0 mbpd in 2002, and a severe retrenchment in non-oil economic activity, which lasted for several months beyond the end of major conflict last year.

8. Real GDP is projected to rebound sharply, by about 50 percent in 2004, thanks in part to a stable macroeconomic environment; this is less than originally anticipated, mainly because of the continuing security problems. By end-July, oil production, which constitutes more than 75 percent of total economic activity, had risen to 2.1 mbpd and exports were up to 1.6 mbpd. Actual production and export levels, however, have recently fluctuated due to sabotage and a deteriorated infrastructure. Oil production is expected to average 2.1 mbpd in 2004, and exports 1.5 mbpd.

9. Non-oil economic activity has also been recovering, driven essentially by commercial and reconstruction activities, but many state-owned enterprises and private businesses are still not fully operational. Retail commercial activity is brisk, and there appears to be a revival of agricultural activity. But the recovery has still a long way to go in reducing unemployment, which was estimated at about 28 percent in mid-October 2003. Moreover, more than 60 percent of the population continue to rely exclusively on a commodity-distribution system for their basic needs.

10. Our policies have contributed to overall macroeconomic stability despite the difficult security environment. Consumer prices have remained relatively stable so far this year. The exchange rate has remained largely unchanged (at around ID 1,460 per US$) since the end of the banknote exchange in mid-January 2004. Furthermore, perhaps reflecting increased re-monetization of the economy, currency issued increased significantly in the first six months of 2004 (by about 53 percent since end-2003).

11. Fiscal policy has been geared towards restarting economic activity and public services, while limiting expenditures to available resources. In 2003, government spending was essentially limited to wage payments to civil servants and employees of state-owned enterprises, and towards guaranteeing the distribution of basic goods through the commodity-based safety net. In the first six months of 2004, budget execution began to be normalized with total spending amounting to US$10.5 billion (100 percent of GDP) in line with the budget. The budget is nevertheless under considerable pressure from rising security costs and the enormous costs associated with the reconstruction of Iraq's infrastructure and restoration of basic services.

12. There is a need to diversify Iraq's revenue base and maintain a tax regime that is conducive to growth and revenue generation. A simplified tax regime was put in place involving: a 5 percent reconstruction levy on imports, which was introduced in April 2004; revising personal and corporate income taxes to include a maximum marginal tax rate of 15 percent, while increasing the personal income tax allowances significantly, thereby making the system progressive; and introducing a wage withholding tax on higher-income civil servants. Pension contributions have also been introduced for civil servants.

13. On the expenditure side, fiscal reforms have been limited to the wage structure. The previous regime had put in place a wage system which was essentially rewarding affiliation and loyalty to the Baath party. In April 2003, a new more transparent wage scale was introduced, which was further revised in early 2004 to include a new 13-tier scale; at the same time, the average wage level was increased significantly. Pensions have also been revised. However, given the political and security environment, the 2004 budget had to be drawn keeping in place costly subsidy policies, including subsidies on the domestic price of oil refined products, transfers to state-owned enterprises, and the commodity distribution system.

14. A more integrated budgetary framework has become operational. The adoption of the second half of 2003 budget and the 2004 budget represented a significant step in integrating operating and investment expenditure, and covering general government operations in northern, central, and southern governorates. Expenditure financed by letters of credit issued under the oil-for-food program are managed by each relevant ministry. Expenditures financed by donors are not yet incorporated into the budget, but the Iraqi Strategic Review Board was created to help ensure consistency and coherence between activities financed by donors and the overall Iraqi priorities and budget.

15. Important steps have been taken towards ensuring effective and transparent fiscal management. To date, the major achievements include: (i) the establishment of a fiscal policy unit that will ensure coordination between the various departments of the ministry of finance; (ii) the establishment of the Development Fund for Iraq (DFI), to ensure transparent accounting of all oil export sales and government assets held abroad, and their channeling through the budget; (iii) the establishment of the International Advisory and Monitoring Board (IAMB), as an audit oversight board to ensure transparency in oil export sales, and in the administration and use of the DFI; and (iv) the strengthening of external controls by Iraq's Supreme Board of Audit.

16. In the monetary area, a new currency has brought confidence and reunified the country. After decades during which monetary policy was reduced to financing extra-budgetary expenditure of the old regime, a new central bank law provides for the independence and accountability of the Central Bank of Iraq (CBI) and prohibits the CBI from extending credit to the government. In addition, the CBI law established a nine-member governing board, consisting of the governor, two deputy governors, three senior managers, and three full-time outside directors. The first meeting of the governing board took place on August 16, 2004.

17. Monetary policy has focused on maintaining price stability, in the context of a stable exchange rate. The CBI has been conducting daily foreign exchange auctions to limit the impact on base money growth of the sale of the government's oil export earnings. This strategy has led to a period of low inflation and a significant accumulation of gross international reserves, which amounted to about US$4,273 billion at end-July 2004 (implying base money coverage of about 60 percent). In addition, the ministry of finance has started conducting bi-weekly treasury bill auctions to roll over bills outstanding with commercial banks. The intent is also to develop a secondary market that will facilitate open market operations by the CBI for the purpose of managing liquidity.

18. New financial sector legislation has paved the way for the creation of a modern financial sector. A new commercial banking law in line with international standards was adopted in October 2003. Since then, three foreign banks have already been licensed to begin operations, and more are slated to receive licenses this year. The CBI is now evaluating over 30 license applications and a number of foreign banks have shown interest in acquiring a minority ownership stake in private Iraqi banks. Commercial banks have also been required to strengthen their capital base.

19. In the external area, a liberal and open trade regime has been established. The current account deficit is estimated to have reached about US$1.89 billion (18 percent of GDP) in the first six months of 2004, reflecting the rebound of the economy, and was financed mainly through the transfer of government assets held abroad and letters-of-credit issued under the UN oil-for-food program. The Trade Bank of Iraq was established in December 2003 to help facilitate international trade. Iraq also recently secured observer status at the World Trade Organization.

20. The government has begun working with Iraq's external creditors towards the resolution of its unsustainable external debt burden. Iraq's debt at end-2003 was preliminarily estimated by Fund staff at US$125 billion (7 times Iraq's GDP), of which US$42 billion are due to Paris Club sovereign creditors, US$67.3 billion to non-Paris Club sovereign creditors, US$0.5 billion to international financial institutions, and US$15 billion to private creditors. IMF staff completed debt sustainability analysis (DSA) for Iraq in May which, in our opinion, shows that Iraq will need substantial debt reduction (in the neighborhood of 90% to 95%) to reach external and fiscal viability. Iraq's DSA has already been discussed with the Paris Club and Iraq's main non-Paris Club sovereign creditors. We are also making significant progress in reconciling our external debt and in improving data on total outstanding debt. A number of our major creditors have agreed to make efforts to reach agreement on restructuring Iraq's debt by the end of 2004.

21. In the area of structural reform, a new foreign direct investment law was enacted that allows ownership in most sectors of the economy (except natural resources, real estate, and insurance) providing national treatment for foreign firms. The legal and judicial systems have been revamped, and are independent from the executive branch of government.

22. Essential services and infrastructure are also being re-established. Improvements have been made to electricity generating capacity, though production still falls short of growing demand. Schools have been reopened despite shortages of educational materials. The public food distribution system has been continued in order to protect the most vulnerable groups in society. Hospitals and health services are being refurbished, though medicines and other supplies fall short of needs. Significant investment is being undertaken to improve water and sanitation standards. Measures to strengthen transparency and public governance—for example, improvements in the frequency with which economic and financial data are reported, as well as the amount of data that are reported—are also being implemented.

23. A comprehensive program of technical assistance (TA) agreed with the IMF and other donors has been implemented with a view to strengthening Iraq's administrative and institutional capacity. Workshops and seminars have been held since late 2003 on key aspects of fiscal and monetary policy, and in the area of statistics. In addition, technical advisors financed by USAID and other donors have been providing continuous support on the ground in Baghdad.

III. Government Program for 2004 and 2005

A. Main Challenges

24. The overarching goals of the Iraqi economic and financial policies are to improve the welfare of the Iraqi people, enhance political and social stability, and achieve a sustainable external debt position. Notable economic and structural reforms have been accomplished in a short period of time under extremely difficult circumstances. Nevertheless, in the immediate future, Iraq faces daunting challenges, including restoring security, preparing the new elections, strengthening administrative capacity, broadening the revenue base, stepping up reconstruction, developing an effective social safety net, and promoting the development of the private sector.

25. We are determined to confront these challenges by implementing a sound macroeconomic program and have begun planning and undertaking the structural reforms necessary to advance Iraq's transition to a market economy and establish the basis for sustainable growth. Iraq has great economic potential, but requires reforms to restructure the public sector, develop a sound banking system, modernize the central bank, establish a market-oriented legal framework conducive to private sector development, strengthen good governance and transparency, and continue efforts to increase domestic revenue and strengthen expenditure management. Notwithstanding our commitment to succeed, we recognize that the pace at which we will be able to implement our program may depend on a quick return to a more normal and secure environment. Furthermore, given the prominent role that oil will continue to have in the performance of the economy, success in achieving our program goals will be closely linked to developments in the international oil market and our ability to bring production and exports to their full potential.

B. Macroeconomic Objectives

26. Building on the progress achieved so far, the government aims at achieving a growth in real GDP of 52 percent in 2004, 17 percent in 2005, and 10 percent on average over 2006-2009. Growth is expected to come mainly from the expansion of oil production capacity, which is expected to reach 2.1 mbpd in 2004, 2.4 mbpd in 2005, and gradually increase to 3.3 mbpd by 2009. In non-oil sectors, economic expansion is expected to be mainly driven by reconstruction activities, particularly in the construction and utility sectors, a diversification in agriculture, trade, and a resumption of manufacturing activities related to the oil sector (including chemical industries). Significant levels of investment are expected to help meet these growth objectives, as the disbursement of donors' financial assistance accelerates, and the environment becomes more conducive to private investment in small and medium size enterprises.

27. The inflation rate is expected to be in the range of 4 to 7 percent per annum in 2004 and our program contemplates a rise in the inflation rate to about 15 percent in 2005, reflecting the assumption of rising economic activity and demand pressures in the context of a stable exchange rate, with consequent increases in prices of non-traded goods. This objective may need to be revised depending on the extent of the administered price adjustments that are eventually undertaken in 2005. Given the significant dollarization in the economy and the vulnerability of the economy to large oil price and production shocks, the CBI will aim to build up its net international reserves to at least US$5 billion by end-2004, and US$6 billion by end-2005.

C. Macroeconomic Policies

28. For the remainder of 2004 and 2005, our macroeconomic policy stance will remain guided by the following principles: fiscal policy will continue to be constrained by a resource envelope based on government revenues and available external resources. Monetary policy will be geared toward ensuring price stability, while avoiding unwarranted foreign exchange rate fluctuations.

Fiscal policy

29. The overall objective of fiscal policy for 2004 and 2005 is to accelerate Iraq's reconstruction and raise the level and quality of government services, while taking steps to ensure fiscal sustainability over the medium term. Cautious management of our oil export revenues and diversifying our revenue sources will be critical in this regard.

30. Consistent with the revised 2004 budget, the overall government fiscal deficit for 2004 is to be limited to US$9.0 billion (or 43 percent of GDP), and will be fully financed by external financing, including resources available from letters of credit issued by the UN under the oil-for-food program almost US$3.6 billion, and assets accumulated abroad held in the Development Fund for Iraq of US$5.9 billion. Consistent with the understandings reached in principle at the Paris Club, which should enable similar understandings with non-Paris Club official creditors, a moratorium on debt payments to our international creditors has been incorporated into our fiscal projections for 2004 and 2005.

31. In 2005, we are committed to constraining current budget expenditures while laying the foundation for sustained revenue growth. The overall government deficit will be limited to US$6.7 billion (or 28 percent of GDP), and will be fully financed through external sources, including about US$350 million in new bilateral and multilateral assistance; as in 2004, the budget assumes a moratorium on debt service due to foreign creditors. For budgetary purposes, the oil export price level was conservatively assumed at around US$26 per barrel, about US$6 below the level currently implied by oil prices on the futures markets. A 2005 budget incorporating the parameters mentioned above will be submitted for approval to the National Assembly by October 10, 2004, as required by law. In case there are additional revenues, priority will be given to using these resources for capital spending and financing the budgets of future years.

32. Revenues in 2005 are projected to increase by 14 percent compared to 2004, to US$19.5 billion (including oil export revenues of US$17.1 billion). By end-2004 the government will increase the domestic prices of oil derivative products (including gasoline), a measure that is expected to bring US$1 billion in revenue in 2005. This initial adjustment is part of a plan to bring domestic energy prices to cost recovery levels by end-2009. The government believes that this step will demonstrate the willingness of Iraqi people to implement fundamental reforms to put Iraq's public finances on a strong footing in the medium term. The government will continue to strengthen the capacity of the tax and customs administrations through extensive seminars and courses, and, with the support of external technical assistance, will develop by June 2005, a plan to overhaul the tax and customs administration.

33. We also have plans to broaden the tax revenue base in the medium term. Additional tax measures to be adopted in 2006 may include: (i) reducing exemptions to the reconstruction levy, and turning it into a uniform import duty; (ii) introducing a general sales tax with a single rate of 10 percent to be collected at the border and on manufacturing goods, as a first step towards introducing a value added tax over the longer term; (iii) introducing a uniform excise tax on imported cars; (iv) imposing a tax on cellular phones; and (v) introducing a fee on foreign visitors.

34. On the expenditure side, overall public expenditure in 2005 will be limited to US$36.7 billion, consistent with the overall resource envelope available from revenues, grants, and external financing. Off-budget expenditures will not be allowed, and any additional spending will need to be integrated into a revised budget, on the basis of the availability of additional resources.

35. The government considers the current level of wages, and salaries and pensions (which has already been increased several times in 2003 and 2004) as generally sufficient, and will limit the overall wage and pension bill to US$ 3.7 billion in 2005-2006, with a view to keeping it at a level of about 11 percent of GDP in the medium term (2006-09). To support this objective, a payroll covering all civil servants and government workers has been established, and an automated payroll system will be implemented in 2005.

36. With respect to government transfers, we recognize that many state-owned enterprises are not viable as currently structured, but further analysis of these businesses is necessary to develop specific recommendations regarding their future. We are committed to complete this analysis by end-2005, with the aim of producing plans for reforming or restructuring these enterprises. In the meantime, and in light of the social and economic importance of these enterprises, operating transfers will be made to help pay wages and finance some working capital of those enterprises that are not yet fully operational and profitable.

37. The government is also committed to enhance the effectiveness of the social safety net by moving over the medium term from a food ration system to a cash distribution system targeted at the poor and unemployed. This monetization of the food basket should help domestic agriculture, encourage private trade, and eliminate one of the most pervasive sources of price distortions, while at the same time ensuring that families in need are properly compensated within the social safety net. To ensure a successful transition towards a monetized system, the government will put an efficient payment system in place, and allow state trade entities to take up commercial business (in import activities as well as wholesale trading). An effective public information campaign on the benefits of moving to a monetized social safety net will also be mounted. Regions and local governments will also continue to receive significant transfers to carry out their responsibilities.

38. The government is continuing reforms to enhance the effectiveness and transparency of budgetary management. These reforms include (i) passing regulations related to the financial management law by end-2004; (ii) introducing a treasury single account by September 2005; (iii) adjusting budget appropriation through mid-year budget reviews; (iv) implementing in the whole country the reporting and control modules of a financial management information system (FMIS) by June 2005; (v) implementing the recommendations of the KPMG audit and of the IAMB, including ensuring that oil export sales are in line with international standards, and strengthening governance through the effective metering of oil production; (vi) publishing the government's final consolidated fiscal accounts by June of the following fiscal year, including expenditures financed by donors, starting in June 2005 and (vii) the introduction of a GFS-compatible budget classification.

Monetary and exchange rate policy

39. The current framework of broad exchange rate stability has worked well towards achieving price stability and we will preserve it for the time being. However, as the data situation improves and the CBI gains a better understanding of the transmission mechanism of monetary policy, the appropriateness of this policy regime as the best means in the medium term of delivering price stability will need to be reevaluated. The CBI would expect the exchange rate to be allowed to reflect the effects of structural changes in the economy and real shocks as needed. We will therefore be vigilant regarding developments that may call for greater flexibility of the exchange rate, including excessive downward pressure on the exchange rate that would threaten to reduce Iraq's foreign exchange reserves below a minimum acceptable level of $4 billion, or signs that inflation could exceed our forecast (as specified above).

40. In order to facilitate the task of assessing the appropriateness of the current policy stance, we have formulated a monetary program for 2004 and 2005. A key element of the monetary program is the projection for the growth of money demand. This projection is related to assumptions and forecasts on economic growth, inflation, and any potential structural shifts in money demand relating to further remonetization of the economy. The projected growth in currency in circulation is consistent with the projected accumulation in net international reserves mentioned earlier and a policy of no lending to the government by the CBI.

41. During 2004, the CBI has relied on foreign exchange auctions as the principal instrument in the conduct of monetary policy. The CBI has utilized the foreign exchange auction to manage liquidity in the system, to absorb excess dinars, as well as to provide foreign exchange to private sector activity. To allow for more flexibility in managing monetary policy, the CBI is in the process of broadening its set of monetary policy instruments. The CBI Board recently approved the creation of a lender-of-last-resort facility and an overnight standing credit/deposit facility, and has issued new regulations making the reserve requirement regime more flexible. The banking facilities should be in operation by October 1, 2004, and the reserve requirement regulation should be implemented by no later than December 1, 2004. Similarly, the newly introduced auction of treasury bills will help stimulate the development of a secondary market for these securities, which will enable the CBI to conduct open market operations. Moreover, in order to facilitate the formation of an appropriate benchmark interest rate, we will provide an adequate environment for the private sector's banks to increase their participation in the treasury bills auctions.

42. The CBI is developing a strategy for communicating its policies to the public. It is seeking to explain its monetary framework aimed at achieving price stability. To inform the public of its actions, the CBI has developed a website where it publishes the results of its daily currency auctions and its monthly balance sheet, and has begun to issue a policy statement after board meetings on monetary policy. The CBI is working diligently to expand and improve information on its operations.

43. In an effort to regularize the financial relations between the government and the CBI, the ministry of finance and the CBI are in the process of agreeing to restructure all government obligations held by the central bank. This agreement will be implemented in installments to facilitate the payments by the government, while minimizing any possible negative impact on the capital of the CBI, taking into consideration acceptable international accounting standards. The CBI also intends to return any excess realized profits (but only after the CBI's capital reaches its required regulatory minimum) to the ministry of finance. The government will be proposing an amendment to the CBI law that would facilitate the transfer of excess earnings to the ministry. The agreement also calls for a formal closure of the government overdraft facility at the CBI.

External sector policies

44. Data and information on the balance of payments is extremely limited, and a priority for the government will be to improve data collection so as to better evaluate external sector developments. Initial estimates indicate that despite a very large current account deficit (equivalent to 18 percent of GDP), there should be a balance of payments surplus in 2004, largely resulting from large public sector capital inflows. The outlook for 2005 for the balance of payments, however, is uncertain as it depends on the level of donor assistance that materializes. The projected current account deficit in 2005, equivalent to about 20 percent of GDP, is expected to be covered by donor assistance and public capital flows.

45. The government remains committed to an open trade and exchange system. In that regard, we are taking steps to become a full member of the World Trade Organization. Looking forward, the government will avoid imposing restrictions on payments and transfers for international transactions, to introduce new or intensify trade restrictions for balance of payments purposes, or resort to multiple currency practices. The government will also discuss with IMF staff the possibility of accepting as early as possible the obligations of Article VIII, Sections 2, 3, and 4 of the IMF's Articles of Agreement.

46. The success of Iraq's reconstruction and recovery effort, as well as our ability to attract the inflow of funds to develop the private sector, will depend on the reduction of Iraq's external debt burden to a sustainable level. The IMF staff's debt sustainability analysis makes it clear that deep debt reduction ranging from 90% to 95% is necessary to help restore debt sustainability. We have been encouraged by the reaction so far of the international community on this issue. Many countries have agreed to reduce substantially their claims on Iraq. We intend to reach agreement with the Paris Club on a substantial reduction in the value of Iraq's debt as soon as possible.

47. Recognizing that much of Iraq's debt is held by non-Paris Club creditors, our expectation is that those creditors will treat their claims comparably to any Paris Club treatment. In that regard, we are working with our legal advisors to develop a strategy for dealing with both non-Paris Club official bilateral and private sector creditors. We have already started contacting our non-Paris Club official bilateral creditors to begin a data reconciliation process with them. In addition, several non-Paris Club bilateral creditors have already indicated a willingness to reduce substantially their claims on Iraq.

D. Structural Reforms

48. The government has set up an interministerial committee to prepare an interim national development strategy for Iraq that will outline structural reforms expected to support the transition to a market economy, the development of the oil sector, the strategy for the diversification of economic activity, the improvement of social indicators, and the development of regions. A draft version of this strategy will be discussed at the next donors' meeting in Tokyo. The final draft of the strategy is expected to be discussed by the new national assembly in March 2005.

49. As regards the financial sector, we will take further steps towards the modernization of the central bank and the creation of a sound financial system. Problems in lending and payments mean that banks are unable to contribute to recovery and may impose fiscal costs, and, further, some small private banks may be nonviable. Reliable and regularly reported data for individual banks are the first step. The institutional capacity for bank resolution needs to be developed and a bank resolution strategy formulated. The legal and monetary elements of a systemic safety net should be developed to ensure that any bank insolvencies do not impair confidence. Finally, strengthening institutional capacity for payments and developing large value and retail payment systems would help ensure that a weak payments system does not inhibit the recovery. Specifically, we will focus our efforts on (i) enhancing the payments system through the establishment of an automatic clearing house and passing payments system law to regulate its activities; (ii) making CBI operations more transparent, particularly through the regular dissemination of monetary statistics and undergoing an external audit of the 2004 financial statements according to international standards by mid-2005 in accordance with the IMF's safeguards policy; (iii) enhancing the CBI's supervisory capacity; and (iv) adopting by end-June 2005 of a plan for the restructuring state-owned banks.

50. The government will also review the fiscal regime for the oil sector, and prepare an overall restructuring plan by end-2005. The government will also take steps to address governance issues in the oil sector, along the lines of the recommendations of the IAMB.

E. Statistics

51. The government is conscious that the timely provision of comprehensive macroeconomic data is critical for improving the design and monitoring of its policies. It is determined to ensure regular reporting to the Fund of data on government budget execution, monetary aggregates, inflation, real sector activities, and the balance of payments. Efforts to improve the compilation and dissemination of macro-economic and financial statistics will be intensified, based on the recommendations of, and with assistance from, the IMF Statistics Department. The Central Statistical Office (CSO) currently publishes a monthly consumer price index (CPI) excluding northern Iraq, but it plans to begin publishing a CPI covering the entire territory, as well as subannual statistics on agricultural and industrial production. The CBI will start collecting information on the banking system to allow for the preparation of a monthly monetary survey. Based on a population census and household expenditure survey, for which field work should be completed by end-2004, the government plans to develop poverty and social indicators. It will also ensure greater transparency in the production and dissemination of statistics.

F. Technical Assistance

52. To improve Iraq's capacity to design and implement policies and monitor macroeconomic developments, a broad technical assistance program in monetary, fiscal and other statistical areas is envisaged by the IMF for end-2004 and 2005. This will be supplemented with the substantial assistance being provided by other donors. In the context of this economic program, the government will particularly require technical assistance in the following areas: (i) banking supervision, monetary operations, and payments system; (ii) budget execution and public expenditure management, tax policy and administration, fiscal federalism, tax regime for the oil sector, and customs administration; and (iii) the compilation and dissemination of economic statistics.

IV. Program Monitoring

53. The duration of the program supported by the Emergency Post-Conflict Assistance will be from November 1, 2004 through end-December 2005. Performance under the program will be monitored using quantitative indicative benchmarks, and structural indicative benchmarks. Indicative quantitative benchmarks for end-December 2004, end-March 2005, end-June 2005, and end-September 2005, as specified in Table 1 (attached), relate to currency in circulation (range), CBI international reserves (floor), CBI lending to the government (ceiling), government primary fiscal balance (floor), external arrears on new disbursements (ceiling), and contracting and guaranteeing of nonconcessional external debt (ceiling).¹ Quantitative benchmarks are defined in the attached Technical Memorandum of Understanding (TMU). The program's structural benchmarks are specified in Table 2 (attached).

54. To coordinate and monitor the implementation of the program, the government will set up an interministerial technical committee. Furthermore, in order to support our efforts to implement and monitor this program, we are asking the Fund to assign a resident representative for Iraq. The government believes that the policies described herein will further strengthen our macroeconomic stabilization and structural reform efforts, and that they are adequate to achieve the objectives of our economic program for 2004 and 2005. We intend to remain in close consultation with the IMF, in accordance with IMF policies on such consultation, and will provide the IMF with information it requests for monitoring economic developments and implementation of policies under the program. The government stands ready to take further measures, in consultation with the IMF staff, which might be necessary to ensure that the overall objectives of the program can be achieved.

Table 2. Iraq: Structural Benchmarks,Under Emergency Post-Conflict Assistance Policy
Policy Actions
I. Structural Indicative Benchmarks
	March 2004
Development of a monetary survey.	· March 2005
Establishment of an automatic payroll system for all government employees.	· June 2005
Development of monthly fiscal accounts for the central government and the oil sector.	· December 2004
Issuance of regulations regarding bank licensing and standard prudential ratios.	· December 2004
Enactment of payments systems law.	· December 2004
Adoption of a plan to overhaul the tax and customs administration.	· June 2005

Technical Memorandum of Understanding

1. This memorandum describes the quantitative and structural indicators for the program supported by the Fund's emergency post-conflict emergency assistance facility policy. It also specifies the periodicity and deadlines for transmission of data to the staff of the International Monetary Fund (IMF) for program monitoring purposes.

I. Quantitative Indicators

2. The quantitative indicators are the following:

• a range on currency in circulation;
  
  
• a floor on net international reserves of the Central Bank of Iraq (CBI);
  
  
• a ceiling on lending to the government by the CBI;
  
  
• a ceiling on the primary deficit of the government;
  
  
• a ceiling on external arrears on new borrowing; and
  
  
• a ceiling on contracting and guaranteeing of non-concessional external debt.
  

II. Definitions

3. For purposes of monitoring under the program, a program exchange rate will be used. This program exchange rate will be the U.S. dollar/Iraqi dinar exchange rate on or about August 31, 2004, as reported by the CBI (ID 1,460 per U.S. dollar). The program exchange rate will be used to convert into Iraqi dinars the U.S. dollar value of all CBI foreign assets and liabilities denominated in U.S. dollars, as required. For CBI assets and liabilities denominated in SDRs and in foreign currencies other than the U.S. dollar, they will be converted in U.S. dollars at their respective SDR-exchange rates prevailing as of August 31, 2004, as published on the IMF's website.

4. For the purpose of measuring fiscal operations, unless otherwise indicated, the government is defined as the central government of Iraq, expenditures related to oil extraction and oil-related investment activities not reflected in the central government's budget, and all donor-financed expenditures (including through the U.S. supplemental budget).

5. Currency issued is defined as currency holdings by the public plus cash in the vaults of commercial banks. As of June 30, 2004, currency in circulation amounted to ID 7,003 billion.

6. Net international reserves (NIR) are defined as gross usable reserves minus reserve liabilities of the Central Bank of Iraq. Gross usable reserves of the CBI are claims of the CBI on nonresidents that are controlled by the CBI, denominated in foreign convertible currencies, and are immediately and unconditionally available to the CBI for meeting balance of payments needs, intervention in foreign exchange markets, and are not earmarked by the CBI for meeting specific payments. They include CBI holdings of monetary gold, SDRs, Iraq's reserve position in the IMF, foreign currency cash, and deposits abroad, except for the resources of the Development Fund for Iraq. Excluded from reserve assets are any assets that are pledged, collateralized, or otherwise encumbered; claims on residents; precious metals other than monetary gold; assets in nonconvertible currencies; illiquid assets; and claims on foreign exchange arising from derivatives in foreign currencies vis-à-vis domestic currency (such as futures, forwards, swaps, and options).

7. Reserve liabilities shall be defined as foreign currency denominated liabilities of the CBI to residents and nonresidents with original maturity of one year or less, and all liabilities to the Fund. They include: foreign currency reserves of commercial banks held at the CBI; commitments to sell foreign currency arising from derivatives (such as futures, forwards, swaps, and options); and all arrears on principal or interest payments to commercial banks, suppliers, or official export credit agencies. Excluded from reserve liabilities are the government's foreign currency deposits at the CBI. As of June 30, 2004, net international reserves amounted to US$ 3,017 million (ID 4,407 billion).

8. Lending by the CBI to the central government comprises holdings by the CBI of treasury bills plus the outstanding balance in the government overdraft account at the CBI, but excluding accrued interest that has not fallen due. As of end-June, treasury bill holdings by the CBI amounted to ID 2,528 billion and the balance of the overdraft account at the CBI stood at ID 1,458 billion. This limit will be fully adjusted in the event of any write-off resulting from the rescheduling agreement between the ministry of finance and the CBI.

9. The primary fiscal deficit is calculated as the difference between primary government expenditure, which is total government expenditure (including oil sector-related extraction costs and investments outlays, and donor-financed expenditures) excluding interest payments, and government revenue valued on a cash basis. The indicative ceiling for end-2004 will be measured in a cumulative basis from January 1, 2004; the quarterly indicative ceilings for 2005 will be measured on a cumulative basis from January 1, 2005.

10. A continuous indicative ceiling applies to the non-accumulation of external payments arrears on new external debt contracted or guaranteed by the central government or the CBI. External payment arrears consist of external debt service obligations (principal and interest) falling due after September 30, 2004 and that have not been paid at the time they are due, as specified in the contractual agreements.

11. As set forth in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt (Decision No. 12274-(00/85) August 24, 2000), the term "debt" will be understood to mean a current liability (i.e., not contingent), created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being: (i) loans, i.e., advances of money to the obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans, and buyers' credits), and temporary exchanges of assets that are equivalent to fully collateralized loans, under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers' credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement, excluding those payments that cover the operation, repair or maintenance of the property. Arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt.

12. For purposes of the program, the guarantee of a debt arises from any explicit legal obligation of the government or CBI or any other agency acting on behalf of the government to service such a debt in the event of nonpayment by the recipient (involving payments in cash or in kind), or indirectly through any other obligation of the government or CBI to cover a shortfall incurred by the loan recipient.

13. The limits on medium- and long-term external debt apply to the contracting or guaranteeing by the government of new, nonconcessional external debt with an original maturity of more than one year, excluding obligations to the IMF. This limit applies not only to debt as defined in point No. 9 of the Guidelines on Performance Criteria with Respect to Foreign Debt in Fund Arrangements (Decision No. 6230-(79/140), August 3, 1979, as amended by Decision Nos. 11096-(95/100), October 25, 1995, and 12274-(00/85), August 24, 2000), but also to commitments contracted or guaranteed for which value has not been received. External debt will be considered to have been contracted at the point the loan agreement or guarantee is ratified by the Iraqi parliament. Excluded from this limit are leases of real property by Iraqi embassies or other foreign representations. External debts will be expressed in U.S. dollar terms, with debts in currencies other than the U.S. dollar converted into U.S. dollars at the market rates of the respective currencies prevailing on August 31, 2004, as published on the IMF's website.

14. Concessionality will be based on currency-specific discount rates based on the Organization for Economic Co-operation Development (OECD) commercial interest reference rates (CIRRs). For loans of an original maturity of at least 15 years, the average of CIRRs over the last 10 years will be used as the discount rate for assessing the concessionality of these loans, while the average of CIRRs of the preceding six-month period will be used to assess the concessionality of loans with original maturities of less than 15 years. To the ten-year and six-month averages of CIRRs, the following margins will be added: 0.75 percent for repayment periods of less than 15 years; 1 percent for 15-19 years; 1.15 percent for 20-30 years; and 1.25 percent for over 29 years. Under this definition of concessionality, only loans with grant element equivalent to 50 percent or more will be excluded from the debt limits. The debt limits also will not apply to loans contracted for debt rescheduling or refinancing.

III. Provision of Information to the Fund Staff

Data

15. The Government of Iraq will establish an Inter-agency Technical Committee to coordinate and implement the EPCA and to provide data to the Fund. To monitor developments under the EPCA, the authorities agree to provide the Fund, the information specified below after EPCA approval. The program is designed with quarterly quantitative targets and the actual outcome should be provided within six weeks following the end of the quarter. However, in order to facilitate regular monitoring, many of the indicators should be provided with the frequencies indicated below.

• CBI gross foreign exchange reserves (weekly) and balances on the Development Fund for Iraq. This should be reported no longer than 2 weeks after the end of the reference week.
  
  
• The monthly balance sheet of the CBI, with a month lag.
  
  
• The balance sheets of Rafidain and Rasheed banks (quarterly).
  
  
• Weekly preliminary monetary and financial aggregates, including exchange rate data (daily), currency in circulation, demand and savings deposits held at commercial banks, balances on government accounts at the CBI, interest rates on savings deposits at commercial banks, holdings of government securities, and credit outstanding to the public and private sectors. The data, excluding exchange rates, should relate to no longer than three weeks after the end of the reference period.
  
  
• Consumer price index (CPI), including indices for main cities (monthly). These should be reported no longer than a month after the end of the relevant month.
  
  
• Detailed operational budget operations and their financing, including budgetary (wage and non-wage) support for state-owned enterprises, customs revenues collected, the amount of treasury securities outstanding, and interest rates on treasury securities. These data should be reported on a monthly basis and reported no more than a month after the end of the reference month.
  
  
• Detailed data on disbursement of external assistance from the US Supplemental and other donor assistance, including by recipient sector; foreign debt amortization and interest payments made; and total outstanding domestic and external debt.
  
  
• List of short, medium, and long-term government or government-guaranteed external loans contracted during each quarter, identifying for each loan: the creditor, the borrower, the amount and currency, the maturity and grace period, and interest rate arrangements (quarterly).
  
  
• Foreign trade statistics (imports, exports, re-exports) (quarterly). This should be reported no longer than eight weeks after the end of the reference period.
  
  
• Indicators of real economic activity (quarterly). These data should be reported no longer than eight weeks after the end of the reference quarter.

Structural Reforms

16. Review of the structural reforms. The authorities will prepare and send to the IMF reports, with appropriate documentation, indicating progress achieved, explaining any deviations relative to the initial planning, and specifying expected revised completion dates.

State-Owned Banks

17. The authorities will provide staff with relevant documents and information dealing with the restructuring of the commercial banks.

Other Information

18. Other details on major economic and social measures taken by the government that are expected to have an impact on program sequencing (such as changes in legislation, regulations, or any other pertinent document) will be sent in a timely manner to IMF staff, for consultation or information.