Mission Concluding Statement 

Iraq: Staff Concluding Statement of the 2022 Article IV Consultation Mission

December 7, 2022

Washington, DC :

High oil prices have provided Iraq’s economy with much-needed respite after a near-crisis in 2020. Nevertheless, underlying imbalances and oil dependence continued to increase. Using the opportunity provided by high oil revenues to reverse the trend of rising vulnerabilities and modernize the economy will be of paramount importance in the face of multiple looming challenges, which could severely test the limits of the current economic model. A meaningful economic transformation must start with a prudent, patient, and disciplined fiscal policy aimed at building financial buffers, reducing oil dependence, and reorienting expenditures toward priority investment and social needs. A careful calibration of the 2023 budget will be crucial to preserve gains from recent policy efforts. Alongside, decisive structural reforms will be critical to improve socio-economic conditions and promote private sector development as the key driver of growth and employment.

Economic Outlook and Risks

1. The economy is gradually recovering amid rising underlying vulnerabilities. Real GDP is projected to grow by 8 percent in 2022, driven by a 12-percent expansion in oil output. Meanwhile, real non-oil GDP is expected to expand at a more moderate pace of 3 percent after rebounding by 21 percent in 2021. Inflation has been relatively contained, averaging 5 percent during the first 10 months of 2022, as the pass-through from high global commodity prices has been muted by food and fuel subsidies. Helped by high oil prices, this year’s fiscal and external current account balances are expected to reach surpluses of 6 and 11 percent of GDP, respectively, while foreign exchange reserves of the central bank could exceed $90 billion by end-year. At the same time, these surpluses veil widening of the non-oil fiscal balance, and Iraq’s dependence on oil continued to increase with the oil price needed to balance the government budget (“budget breakeven oil price”) reaching US$66 per barrel in 2022, up from US$52 per barrel in 2019.

2. Near-term outlook is positive, but vulnerabilities could manifest themselves in the medium term. Oil output is projected to gradually rise from 4.4 to 5 million barrels per day by 2027. Non-oil real GDP growth is expected to accelerate to 4 percent in 2023—helped by the stimulus from the Emergency Law for Food Security and Development—before moderating to 3.5 percent in the medium term. Under the baseline projection of declining global oil prices and continued expansionary fiscal stance, both fiscal and external balances are projected to decline and turn into deficits by 2025. Alongside, foreign exchange reserves could peak at around US$100 billion in 2024 and rapidly decline over the medium term.

3. This outlook is subject to significant downside risks, amid multiple looming challenges. A faster decline in global oil prices could reignite financing pressures sooner. Government finances are particularly vulnerable to faster accumulation of losses in the electricity sector and the depletion of the State Pension Fund, as well as the rising costs of climate change.

Policy Priorities

4. A sound fiscal framework will be critical to tackle Iraq’s economic challenges. Policymakers need to carefully balance the goals of saving the oil windfall to strengthen resilience to future oil price volatility, and increasing critical social spending and public investments, while gradually reducing dependence on oil. IMF staff recommends a commitment to a fiscal rule targeting a gradual reduction of the non-oil primary fiscal deficit to build a fiscal stabilization buffer which would improve the government’s ability to smooth expenditures in response to future oil price declines. At the same time, the fiscal strategy should seek to allocate sufficient resources for public investments and the social safety net to support Iraq’s critical development needs and the vulnerable population.

5. Careful calibration of the 2023 budget parameters will be pivotal. It would be important to provide adequate indexation of targeted cash transfers and low-income pensions to protect the most vulnerable from the rising cost of living. At the same time, a large procyclical boost to expenditures is not advisable as it could fuel inflation pressures, further increase the government budget’s dependence on oil revenues and create conditions for a costly boom-bust cycle. IMF staff recommends saving a significant portion of the oil windfall by targeting a non-oil primary fiscal deficit of ID 114 trillion (58 percent of non-oil GDP) in 2023, most importantly by containing growth of the government payroll and mobilizing non-oil revenues.

6. Elevated inflation risks warrant vigilance on the part of monetary policy. Although inflation has remained stable in recent months, there are significant risks of its acceleration in the near term with a looser fiscal stance and second-round effects of high global commodity prices. Should these risks begin to materialize, it would be important for the central bank to be prepared to tighten domestic financial conditions as needed to avoid fueling domestic drivers of inflation.

7. Implementation of the proposed fiscal framework needs to be accompanied by sustained policy efforts in several key areas:

• Upgrading public financial management notably by urgently establishing a Treasury Single Account and implementing an Integrated Financial Information Management System (IFMIS), in addition to strengthening control over commitments and contingent liabilities.
• Diversifying government revenues , including by making payroll taxes more progressive, eliminating regressive exemptions, strengthening tax and customs administration, and introducing taxes on the sales of selected non-essential goods and services.
• Reducing the government wage bill , which consumes around 40 percent of the annual budget, crowding out other priorities, and cannot be sustained in the long run, which puts a premium on promoting private sector job creation. A multi-pronged approach should focus on strengthening control over payroll; an attrition-based employment reduction strategy; and close alignment of government pay and allowances with the private sector. In parallel, IMF staff encourages developing a civil service reform and a national employment strategy to improve labor force participation, remove obstacles for private employment, and reduce informality.
• Enhancing the social safety net. Limiting eligibility for the untargeted food ration card program would allow to significantly augment the budget for targeted cash transfers. Automatic inflation indexation of cash transfers would ensure adequate protection. Furthermore, a pension reform is increasingly urgent, most importantly to restore the financial sustainability of the State Pension Fund. Going forward, close alignment or integration of pension systems for private and public sector workers is needed to facilitate labor mobility and strengthen incentives for private sector employment.
• Fixing the electricity sector , which incurs an annual loss in excess of 3 percent of GDP while being unable to meet domestic demand. A comprehensive reform strategy should focus on enhanced monitoring and transparency of the sector’s costs, a review of the tariff structure, investments in gas capture and renewable energy sources, and sustained efforts to improve collection and reduce technical losses.
• Strengthening Financial Stability. Accelerating implementation of core banking systems and initiating the restructuring of large state-owned banks remains a critical priority. The IMF team welcomes the completion of Iraq’s first AML/CFT national risk assessment and agrees with the authorities’ plans to swiftly proceed with implementing its key recommendations. IMF staff also supports the central bank’s efforts to strengthen monitoring of transactions through the foreign exchange auction and its plans to explore alternative trade finance mechanisms to facilitate trade. In parallel, the mission recommends developing liquidity management tools to better support exchange rate stability.
• Improving Governance. IMF staff welcomes the authorities’ efforts to implement the 2021-24 National Integrity and Anti-Corruption strategy and emphasized the importance of continuing to strengthen governance, including through timely completion and publication of the audit reports of government accounts, improving the legal framework and streamlining the institutional structure for combatting corruption, and advancing digitalization of government institutions.

The IMF team would like to thank the authorities for their hospitality and the quality of the discussions.