RECONSTRUCTING IRAQ: YEAR ONE

Transcription

1 RECONSTRUCTING IRAQ: YEAR ONE The economy is recovering from wartime depths Recovery is driven mainly by oil and private spending Fighting and the lack of public security continue to weigh down heavily on economic recovery in Iraq. The Iraqi economy disintegrated after the initiation of 2003 conflict, with nominal GDP hitting a low of US$12 billion. In 2004, GDP is projected to recover to about US$21 billion, and income per capita to about US$780. This remains well below the 2000 level, which itself was quite low, as it resulted from two decades of debilitating wars and international sanctions (see Annex). Even if growth continues into 2005 as currently projected, GDP per capita will be just a quarter of what Iraq enjoyed 25 years ago, before the economy began its decline. So far, recovery has generated few jobs possibly less than 100, and unemployment remains pervasive. The main engine of recovery is the oil sector, which accounts for 80 percent of GDP and over 95 percent of exports and budget receipts. Oil production is projected to recover in 2004 to 2.1 million barrels per day (mbpd), compared to 1.3 mbpd in Oil is likely to generate in 2004 over US$16 billion in Government revenues. Sustainable crude oil production and export capacities are currently estimated at 2.5 mbpd and 2 mbpd respectively, but so far Iraq could reach these levels only for short periods of time, due to sabotage. Oil sector recovery depends on the resourcefulness of Iraqi technicians and firefighters, who have learned to put out fires and repair the installations in record time. High world oil prices have so far compensated for lower than expected export levels. The Government is consolidating its control over the oil industry via the Supreme Oil Council, established in July It also reconstituted the Iraqi National Oil Company (INOC) an integrated national oil company similar to Saudi Aramco. This allows the Government to retain strategic control over the oil sector while letting in significant private investment. Talks with major international oil companies are already under way. Another driver of Iraqi recovery is private spending. It is fed by a significant rise in civil servant salaries, remittances from abroad and possibly even by some dissavings. The extent of this spending can be glanced from a steep rise in private sector imports (see Annex). On the contrary, aid is moving much slower than expected, due to security risks. Reforms had started in earnest Early efforts at opening up the Iraqi economy, until recently--one of the most closed in the world, have yielded certain results. Most reforms have been on paper and concerned with legislation and institutional changes: a new Law establishing independent Central Bank; trade liberalization; new laws on public finance, audit and procurement; liberal banking, bankruptcy, and company laws; the establishment of interministerial

2 commissions on reconstruction, privatization, oil, economic reform, and the reorganization of the Iraqi Stock Exchange. A lot remains to be done for the new legislation and institutions to take root. filling the consumer markets... bringing price and monetary stability... The liberalization of Iraqi trade in 2003 reflected the breakdown of the heavily protectionist system which existed prior to that date. Trade liberalization aims at integrating the Iraqi economy with the global economy, removing distortions in the local prices of commodities and services, increasing competitiveness of Iraqi enterprises, and of the economy as a whole. All restrictions on trade are now removed; imports are subject solely to a uniform custom duty of 5% (food and medicine are exempt). The liberalization sparked a dramatic eighteen-fold rise in private sector imports over , and filled the domestic consumer markets with a variety of previously unavailable goods. Price differentials on consumer goods between Baghdad and other regional capitals--amman, Beirut, Damascus and Dubai--are now merely percent, which is modest, given the risks to transportation. This wild liberalization also had negative consequences, as the Government initially could not enforce the quality standards for many imported consumer items (e.g. used cars). At present, the Government is rebuilding its regulatory role in international trade. The next steps would be to design a rules-based, transparent and stable trade regime that is both supportive of reconstruction and WTO-compatible. An early payback of liberalization reforms has been the easing of inflation. After rising by 36 percent in 2003, consumer price index decelerated to 5.7 percent over January-August Inflation, howeverm is unlikely to remain low for long. If the recovery continues, demand for consumer and investment goods may push inflation back into double-digits in In early 2004, the Central Bank of Iraq (CBI) successfully introduced the new Iraqi Dinar; since then, daily auctions stabilized its value at about NID1465 per US$1. The auction system boosted liquidity in commercial banks, supplied foreign exchange to private sector, and helped the CBI to add US$3 billion to its reserves. In another sign of revival, the economy is remonetizing rapidly: base money grew by over 60 percent in the first six months of Still, dollarization remains pervasive. In a departure from monetary financing of government deficits, the new Law on the Central Bank bars it from extending credit to the Government, and defines the CBI s key tasks as maintaining domestic price and financial system stability. The Central Bank is working to increase the flexibility of its monetary policy via the creation of a lender-of-last-resort facility and an overnight credit/deposit facility. The treasury bill auctions were launched in July, in order to spur a secondary market, which will allow the CBI to conduct open market operations

3 and strengthening the financial system. Wars and sanctions have all but destroyed Iraq s banking infrastructure: the economy depends on inefficient and risky cash transactions. Recently, steps were taken to reduce the dominance of cash. In July, twenty commercial banks activated a VisaNet international payments and clearing system, which connected them to the global banking network. This interim system supports only basic services, but plans exist to extend it to payroll, debit cards, and credit advances. In March 2004, the CBI liberalized interest rates on loans, deposits and securities. This ended more than a decade of artificially low interest rates and was an important step towards restoring confidence in the banking system. Also, restrictions on international transactions by Iraqi banks were removed. Over a dozen commercial banks are now handling international payments and letters of credit. Plans are being drawn up to overhaul six state-owned banks---the two largest, Rafidain and Rasheed, which between them have 90 percent of the banking sector assets (US$1.8 billion), and four smaller specialized banks (Agricultural, Industrial, Real Estate, and Socialist). To increase the exposure of Iraqi banking sector to modern banking practices, the CBI has granted six licenses to foreign banks to operate in the Iraqi market. Despite recent growth, human deprivation remains pervasive Even under the most optimistic scenario, Iraq needs substantial time to regain the high human development standards it enjoyed a generation ago. If violence does not subside, time required will be even longer. As of now, even the fundamental needs of Iraqi population are not guaranteed: Food security is a concern. One-half of population is dependent on food rations, and about 27 percent of children under five suffer from chronic malnutrition. While the World Food Program and the Iraqi Ministry of Trade report no systemic food shortages, food distribution is erratic in crisis regions such as Falluja. This has forced thousands of internally displaced persons (IDPs) to move to safer areas. The food situation of IDPs, returnees and refugees is vulnerable, as the rations require pre-registration; Jobs remain scarce. Reconstruction had created less than 100,000 new jobs. Two nationwide employment surveys conducted within the past 12 months suggest that unemployment remains broadly stable at 27 percent. Of particular concern is the unemployment among young men (age bracket 15-35) in some governorates it exceeds 50 percent. Underemployment is also widespread at 21 percent of economically active population. Unemployment levels are further boosted by refugees and internally displaced persons, many of whim have minimal skills and are difficult to employ. Lack of rewarding jobs adds massively to the sense of economic vulnerability, and may have contributed seriously to Iraq s security problems; - 3 -

4 Health and education are very weak, with many facilities in critical condition. The Ministry of Education has rehabilitated 1000 schools, but a further 2500 need rehabilitation. Current budgets of the Ministries of Health and Education mostly pay the salaries; rehabilitation of facilities requires at least twice the budgeted amount. Severe shortages of pharmaceuticals are registered throughout the country, particularly in crisis areas. The authorities are mitigating these via imports (budgeted in 2004 at about US$600 million), but a large share of imported medicines leak into the black market. Distortions in the economy loom large. Prices of socially sensitive goods and services remain fixed at very low levels, and amount to massive subsidization of households and downstream industries. A large section of population critically depends on the Public Distribution System for food (PDS), which in 2004 was budgeted at about 30 percent of total oil revenues (20 percent of GDP). Of less relevance to the vulnerable social groups is the fuel subsidy, which exceeds 20 percent of GDP and causes widespread smuggling of refined oil products to the neighboring countries. Tariffs for electricity, water and other public services are also heavily subsidized, while collections are not enforced. The Government recognizes the risks of pervasive subsidies to long-term growth and fiscal stability. However, it also recognizes that social fallout of ill-prepared and hasty reforms could also be severe, particularly regarding food prices, since the Government is formulating a sequenced approach to the reform of the subsidy system. To protect the most vulnerable, social safety nets will be further strengthened prior to such reforms. Continued reform requires strengthening the Government s capacity Recently, the reforms have stalled as security worsened, and power was handed over to the Iraqi Interim Government (IIG). However, questioning the IIG s commitment to reforms may be too early. The Annex to Transitional Administration Law (interim constitution) prohibits the IIG from taking any actions affecting Iraq s destiny. The IIG s period of authority is limited until the legislative elections expected in early More importantly, in Iraq, as in any country, carefully prepared and sequenced reforms could yield better long-term results that hasty leaps. Reforms can only succeed if they are fully owned by a sovereign Government of Iraq, supported by a broad social consensus, and driven by widely shared strategic vision of the new Iraq. As is demonstrated by the recently published draft of the National Development Strategy, such vision is already emerging. The IIG has taken important steps to assert ownership of the policy formulation process and to redeem institutional weaknesses which stifle the reforms progress. Several inter-ministerial committees, such as the Supreme Economic Council, the Supreme Council for Oil Policy and the Council for Reconstruction were established to improve interagency - 4 -

5 coordination. The Iraqi Strategic Review Board serves as the focal point for coordinating donor activities. The IIG has drafted a medium-term National Development Strategy (NDS), which offers a vision of future Iraq anchored in continued market-focused reforms, economic diversification, and strong social safety nets. Much depends on the outcome of external debt renegotiation strengthening public finances One of Iraq s top priorities is the renegotiation of its external debt, which is among the highest in the world, and equals US$125 billion--about six times the 2004 GDP. Of this amount, around one third (US$42 billion) is owed to the Paris Club; another very large portion is owed to Arab governments. It is hard to be precise about how much debt relief is needed to return Iraq to debt sustainability, but it is likely to be substantial under any scenario. Debt sustainability parameters depend heavily on assumptions about future oil prices and export levels: lower than anticipated oil exports can make external debt unsustainable even after deep relief. As an interim measure, the Paris Club creditors have granted Iraq a moratorium on all debt payments until the end of Debt relief is linked to Iraq s performance under an IMF-supported program (Emergency Post Conflict Assistance EPCA), which was approved on September 28. Iraqi representatives have been visiting a number of non- Paris Club creditors (particularly the Gulf countries) to prepare for debt relief negotiations. The dampening effect of security risks on the Government s oil revenues were offset by the high oil prices. The same risks, however, have undermined the Government s ability to raise non-oil revenues, which remain well below 5 percent of the total. The reconstruction levy, introduced earlier in 2004, is collected at very few border checkpoints. The reintroduction of income tax has stalled. In addition to disappointing performance of non-oil revenues, public finances are marred by widespread transparency problems. The 2003 Interim Budget was the first to be published in many years, but its execution results were never disclosed. Most capital spending and a large part of recurrent spending remains outside of the budget, while information on local government spending is sparse. Levels of oil production and exports cannot be verified due to metering problems. The recent audit of the Development Fund for Iraq (DFI), into which oil exports proceeds are deposited, revealed widespread irregularities in the DFI s operations prior to the June 28 handover of power 1. Data on DFI operations after that date are not yet available. The wrap up of the Oil-for- Food Program has involved large resource flows, which have yet to be 1 The DFI was established pursuant to UN Security Council Resolution 1483 and holds the proceeds of petroleum export sales from Iraq, and remaining balances from the UN Oil-for-Food Program and other frozen Iraqi funds. The International Advisory and Monitoring Board (IAMB) is an oversight body for the DFI. After the handover of power on June 28, 2004, the IAMB continues to work with the IIG, as set out in United Nations Security Council Resolution The IAMB documentation is found at

6 disclosed. There is little public involvement in budget formulation and execution. Budgetary spending continues to focus on security, key public services (health, schooling, electricity, water), and infrastructure. The implementation of a new salary scale dramatically improved the living standards of about one million civil servants and their commitment to continue their public sector careers. The pensions are lagging behind, but will likely rise in the near future. Regular pensions were replaced in 2003 by emergency payments, which now benefit around 1.3 million individuals, including the majority of former civil servants and military personnel. The number of new pensioners is likely to increase further, due to demobilization and recent agreements with militia groups. Regularizing these emergency payments is an urgent need, since total public wage and pension bill already exceeds 14 percent of GDP and is likely to grow further. Most immediately, the Government needs to contain the accumulation of pension obligations, and to identify sustainable financing mechanisms. The next step is to begin formulating pension reforms for public and private sector. local governance and restructuring the state owned enterprises. Another paramount concern for Iraq is local governance. Under the Interim Constitution, regional authorities are allowed a degree of control over resources held within their own territory, but their precise mandates have yet to be determined. Communication with many governorates is difficult, and the central Government has little information about local finances. Local governments also voice concerns, in particular about the lack of, or slowness of budgetary transfers. The three northern governorates (Duhouk, Erbil and Sulaimaniya) have de facto revenue and expenditure autonomy. In the South, three governorates--basra, Dhi-Qar, and Misan--formed an association seeking to retain a portion of oil revenues generated in their territory. Recently, the central government has stepped up its interaction with the governorates. In July, senior-level IIG team visited the North and agreed on the inclusion of its development projects in the nation-wide list to be presented to the donors. Strengthening local finances and preparing the local governments to an expanded role in public service delivery are the key concerns of the central Government. The Iraqi public sector comprises 192 state-owned enterprises (SOEs), which employ half a million workers. A few deliver vital public goods and services; others are engaged in commercial activities. Most SOEs remain idle due to wartime damage and looting. While some SOEs can be easily turned around, the sector as a whole is a massive drag on public finances. In 2004, subsidies to SOEs claimed about 4 percent of GDP, which goes towards their salary payments and operational capital. Plans have been drawn up for leasing some of these enterprises to private sector operators; however, the implementation of these plans is stalled by security risks and low investor interest. The Government is preparing to launch a major - 6 -

7 diagnostic of all SOEs, to determine which ones can be restructured, and which should be closed for good. Risks and promises going forward particularly focused on job creation The National Development Strategy offers a vision of future Iraqi economy, and emphasizes improving the security environment, creating adequate number of jobs, implementing an efficient reconstruction program, and restoring key public services, accompanied by deepening market-focused reforms. To gain broad-based acceptance in the society, reforms must offer credible ways of rebuilding the high living standards which Iraq enjoyed 25 years ago. The challenge of job creation will remain of critical importance. Before the reconstruction process begins to visibly dent unemployment, the National Development Strategy proposes a number of short-term policy steps: (a) Make-work schemes, to provide temporary income and employment generation via rapid and efficient cash transfers through activities with low start-up and overhead costs, such as security guards, cleaning and painting, but also the reconstruction of schools, hospitals, and irrigation works. Such activities would create thousands of jobs; (b) Skills development. A strategy for sustainable job opportunities, especially for vulnerable groups, should be developed. Rehabilitation of vocational training centers operated by the Ministry of Education and Ministry of Labor and Social Affairs would contribute to upgrading the skills of the unemployed. The Ministry of Culture plans to initiate soon training and capacity building in the protection of cultural heritage. Given Iraq's enormous cultural heritage, job creation potential here is substantial; (c) Micro-finance programs helping vulnerable groups to meet their emergency needs and to build assets. These programs should be designed so as to maximize the job generation impact. Microfinance should also support job generation for the returned refugees and IDPs; (d) Also under study are financial windows to support employment programs run by local councils and civic and non-governmental organizations. Economic revival and job generation is a formidable challenge, but Iraq possesses ample wealth--both human and natural--to pursue it. However, implementation risks are also substantial: The resource curse risk: there always exists a temptation to put off painful reforms by merely selling more oil. As oil wealth pushes up the real exchange rate, the downstream industries lose their competitiveness, economic structure becomes lop-sided and - 7 -

8 excessively dependent on volatile oil prices. Furthermore, public sector governance is often the first fatality of rising oil wealth. As oil revenues are contested by competing political forces, the state would use the oil wealth to buy political stability at the expense of reforms critical for long-term growth and diversification. In Iraq, this risk is particularly acute, due to urgent pressures to create jobs and to extreme fragmentation of the political scene. The risk of reviving the statist economy: Where oil wealth is controlled by the state, the latter usually maintains its involvement in the economy well beyond what is optimal on the long-term efficiency grounds. Iraq already was on this trajectory in the past, and should be wary of re-running it. Early action is needed to rebalance the relative roles of public and private sector. The state should concern itself primarily with the role of overall regulator and provider of vital public goods, such as security, good governance, and infrastructure. The state also has an important role to play in rebuilding the Iraqi human capital, by investing in health, education, and well-targeted safety nets; The aid effectiveness/domestic capacity risk: in the near future, aid volume is likely to be very large, while the Iraqi implementation capacity is currently low. Due to large natural resource endowment of Iraq, the donors capacity to influence the course of reforms is likely to be limited. Hence, it is essential to consolidate the Iraqi ownership of the reform agenda and to overhaul the civil service, in order to retain the best cadre capable to carry the reforms forward. Mitigating these risks is not an easy task, and requires strengthening of institutional capacity, viable options on domestic energy pricing, strengthening the social safety nets, and better public sector governance. But all of this depends critically on resolving the security situation and a return to normalcy

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