By Mohsin Khan
Following a long period of persistent state intervention, costly militarization, three wars and over a decade of international sanctions, the Iraqi economy is in a state of disarray. After attaining middle-income status in the 1970s, most of Iraq's human development indicators are now among the lowest in the region, and per capita income has dropped to a fraction of its previous level.
Unemployment is high (at near 30%) and under-employment is pervasive. Moreover, nearly half a million people are employed by state-owned enterprises, most of which are unprofitable and inefficient, and about 60% of the population depends on the government's food distribution
system for subsistence.
Even in a very difficult security and political environment, several key policy measures have been taken over the past year to facilitate progress towards a more market-oriented economy. These steps are designed to strengthen institutions and bring about macroeconomic stability. The measures include completion of a national currency exchange, introduction of a budgetary framework and a new tax law, liberalization of interest rates, simplification of the trade regime, new central bank and commercial bank laws, and establishment of the Trade Bank of Iraq.
More recently, the ministry of finance completed its first Treasury bill auction. The oil industry, considered the bedrock of the Iraqi economy, is gradually recovering and has reached its pre-war level of production, but attempts to expand oil production beyond current levels are being hampered by the unstable security situation, with insurgents often targeting this sector.
An economic recovery is underway in Iraq, though uneven and fragile: commercial activity is brisk in some of the cities, but manufacturing activity is recovering more slowly than anticipated. Inflationary pressures are under control, and the exchange rate has been stable, providing a conducive environment for economic growth.
Looking forward, and provided security improves, a fairly strong economic recovery in 2005 and onward is foreseen, driven mainly by a pick-up in oil output and private-sector activity. This recovery will be sustained by the reforms being undertaken to establish an open, market-based economy that will allow for the reintegration of Iraq into the regional and world economy. There are still, however, many policy challenges that need to be addressed by the Iraqi authorities.
Policy challenges
First, there is a scarcity of data, particularly on monetary and real sector indicators, which makes policy design and implementation difficult. The Central Bank of Iraq relies on a policy of exchange rate stability to keep inflation low and establish confidence in the new currency, providing some sense of economic stability in a turbulent political and security environment.
However, over the medium term, better data is needed to allow for a more comprehensive assessment of which exchange rate arrangement is best suited to Iraq's circumstances, particularly given its dependence on oil and the impact of oil price fluctuations on the economy. The Iraqi authorities, with the assistance of the IMF, are in the process of developing a quantitative framework linking together all financial flows in the economy. This will help in assessing the need for changes in the policy stance in response to information on inflation and economic performance.
Second, on the fiscal front, the government's budget relies heavily on oil revenues, and for several years will need to depend on external assistance to finance most investment projects. There is therefore a need to diversify the government's revenue base away from the oil sector while maintaining a tax regime supportive of economic growth. Measures in this area could include a wider use of excise taxes, and eventually a general sales tax. This should be supported by a rationalization of expenditures, including the reduction of price subsidies on petroleum products and transfers to state-owned enterprises. These efforts will not only strengthen Iraq's fiscal position but also promote transparency and accountability in the use of Iraq's oil revenues.
Third, structural reforms have been unavoidably delayed by the political process and the security situation. In the period ahead, there will be a need to reduce domestic price subsidies, reform state-owned enterprises, restructure state-owned banks, and monetize the commodity distribution system. The task is a daunting one and the IMF, the World Bank and other international financial institutions are working closely with the Iraqi authorities on developing an action plan to transform the economy into a market-based one.
Fuel and energy subsidies remain a key issue. At present, domestic fuel and energy prices inside Iraq are only a fraction of world prices and much lower than prices observed in neighbouring countries. This is creating incentives for smuggling and excessive consumption. It is, of course, understood that some of the structural reforms may have negative consequences on the poor. Accordingly, these measures will need to be complemented by a social safety net to protect the most vulnerable segments of the population.
Finally, Iraq has to address its large external debt, which stands at about $125 billion. Discussions with the Paris Club are underway for possible debt relief. The IMF's calculations suggest that substantial debt relief is needed to render Iraq's debt position sustainable. Given the magnitude of the existing foreign claims on Iraq, decisions will need to be taken soon on the amount and terms of any possible debt restructuring. In this context, progress is needed in reconciling debt data with external creditors and developing a strategy for debt negotiations. The authorities are in the process of hiring an investment firm to assist them in designing a strategy for the debt negotiations.
IMF support
Discussions on an economic programme that could be supported financially by the IMF are well advanced. In the first instance, the IMF's support is likely to be in the form of Emergency Post-Conflict Assistance (EPCA). The EPCA could then be followed by a more ambitious programme sometime in 2005. Moreover, the IMF is providing extensive technical assistance and training to Iraqi officials in the fiscal, monetary and statistical areas.
Iraq has tremendous potential. It faces, however, daunting challenges, both politically and in the economic sphere. Important steps have already been taken over the past year. But much more needs to be done. The main risk to better economic prospects is the difficult security situation, and the speed of reconstruction of Iraq depends obviously on how fast security is improved.
Mohsin Khan is director of the Middle East and Central Asia department at the IMF.