## 1irqea2019002

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### Context
- Iraq’s oil proceeds exceeded $850 billion between 2003–18.
- Institutional weaknesses (governance, public financial management, capacity) diverted resources toward current spending, notably the public sector wage bill, with little saved in financial assets.
- Large development needs remain, including wide infrastructure gaps and high unemployment; unrest highlighted poor water and electricity quality.
- Estimated damage from the war with ISIS: $46 billion.
- Pledged donor support: $30 billion.

### Fiscal policy challenges
- Oil revenue accounted for about 92 percent of total budget revenue in 2018.
- At current production levels, every dollar change in oil price results in a change in total revenue by 1.1 percent of non-oil GDP ($1.5 billion), compared with 0.6 percent in other oil-exporting countries in the MENA region.
- Non-oil revenue in 2018 represented less than 5 percent of non-oil GDP; specific figure: Non-oil revenue in Iraq was 3 percent of GDP in 2018.
- Oil price shocks can involve prices moving by as much as 40–80 percent for as long as a decade; volatility increased sharply during the 2014-15 commodity price shock and renewed volatility since Q4 2018.
- Differential between Iraq export prices and international prices fluctuated between +1 and -10 since 2004.
- Fiscal policy has been highly procyclical: correlation between growth in government spending and oil prices was 0.7 during 2003–18.
- Non-oil capital expenditure represented only 4 percent of total expenditure in 2018.
- Iraq has experienced greater economic volatility and lower investment rates relative to comparator countries.

### Proposed fiscal policy framework
- Long-term objective: leverage depleting oil wealth to promote sustainable economic development, balancing conversion of oil revenues into real/financial assets or consumption, considering fiscal sustainability and intergenerational equity.
- Short- to medium-term objective: meet post-conflict demands and address infrastructure gaps while maintaining macroeconomic stability.
- Fiscal policy aims:
  - Create space within the budget through tight control on current spending and increasing tax revenue to scale up infrastructure and social spending, reflecting $30 billion of pledged donor support.
  - Manage oil revenue volatility and avoid procyclical fiscal policy by building adequate fiscal buffers to protect capital expenditure during downturns.
- Fiscal rules and stabilization buffers to be considered as complementary instruments; about one quarter of oil-exporting countries have combined fiscal rules with stabilization funds.
- Adopting a numeric fiscal rule should complement, not substitute for, a strong medium-term budget framework.

### Medium-term budget planning
- Develop a medium-term orientation to dampen procyclicality and ensure sustainable spending.
- Key components:
  - Medium-term fiscal framework (MTFF) with forecasts for broad fiscal aggregates, formulated in line with the fiscal anchor.
  - Medium-term budget and expenditure frameworks translating aggregate forecasts into disaggregated expenditure ceilings, initially for larger categories and progressively with greater granularity.
  - Strengthening macroeconomic forecasting, with a strong analytical capacity supported by proper national accounts, reliable methodologies, and well-qualified staff; consider establishing a macro-fiscal unit at the Ministry of Finance.
- The Ministry of Finance has begun preparing indicative three-year projections for individual expenditure items as part of its budget submission; ministries should commit to these ceilings and develop medium-term plans.

### Robust annual budget and supporting fiscal institutions
- Priority PFM improvements:
  - Unify and make comprehensive the budget process; eliminate practices/legislation allowing spending outside budget processes.
  - Base the budget on the best possible forecasts and conduct repeated comparisons between adopted budgets and execution outturns in-year and soon after fiscal year end.
  - Adhere to the expenditure envelope even if oil prices exceed budget projections; using more realistic oil price assumptions enhances planning and transparency.
  - Improve fiscal reporting to reflect international standards, ensuring timeliness and frequency, and include within-year reporting.
- The General Financial Management Law (GFML) adopted in 2019:
  - Defines general government for the first time.
  - Establishes the need for a medium-term fiscal framework and enshrines fiscal transparency requirements.
  - Limits parliament’s capacity to amend the budget and the scope for spending outside budget processes.
  - Requires subsidiary legislation and/or council of ministers decisions for implementation and to address remaining gaps relating to guarantees and commitment controls.
- Robust fiscal institutions (fiscal rules, stabilization funds, fiscal responsibility laws, independent fiscal agencies/councils) can increase commitment and accountability; they require strong political commitment and adequate administrative capacities and should be introduced gradually and flexibly given Iraq’s fragilities.

### Targeting the right fiscal indicators
- Conventional indicator: overall (primary) fiscal balance—linked to financing needs and public debt—but can be cyclical and misleading in resource-rich contexts.
- For resource-rich countries, measures that exclude or smooth volatile oil revenue are more informative:
  - Non-oil primary balance (NOPB): suitable for assessing fiscal risks and long-term sustainability; indicates dependency on oil and direction of fiscal policy; should be assessed against long-term benchmarks.
  - Overall balance based on price-smoothing (structural primary balance): complements NOPB; requires choosing a reference price via automatic smoothing formulas (backward/forward moving averages) or an independent committee.
  - Primary current balance and current expenditure: particularly informative for Iraq to track use of oil revenue, focus on fiscal risks, and protect public investment. Containing current spending growth helps create space for capital spending.
- Practical considerations:
  - Aggregate measures of public expenditure should be monitored to guard against creative accounting.
  - Difficulty exists in classifying current vs. capital expenditure.
  - Indicators like the NOPB should be normalized by non-oil GDP to avoid fluctuations caused by oil price changes and better reflect the domestic economy.

### Fiscal rules — main functions, relevance and international experience
- Main functions:
  - Commitment device: tying the hands of the government and limiting the scope for fiscal discretion.
  - Signaling effect: increasing transparency and revealing government priorities and plans.
  - Political function: imposing numerical limits may serve as a focal point for politicians, facilitating coalition formation and coordination.
- Why rules matter:
  - Fiscal rules help control expenditure, limit deficit and procyclicality biases, and counter expenditure creep.
  - Procyclical fiscal policy is common; rules constrain such discretion.
- Relevance to Iraq:
  - Structural pressures: high dependence on oil revenue, demographic/labor demands, large fiscal burden from an inefficient SOE sector, and inefficiencies in public spending.
  - Non-oil revenue in Iraq was 3 percent of GDP in 2018.
  - Expenditure-based consolidation has historically been the pattern in Iraq.
- International experience:
  - Number of resource-rich countries with fiscal rules rose from five in 2000 to 18 by 2015.
  - Rules targeting the budget balance are most common; expenditure rules gaining popularity.
  - Performance mixed due to design flaws and weak institutions; successful examples include Botswana, Chile, and Norway.
  - Lessons: political commitment, supporting institutions (robust budget planning, PFM capacity, fiscal transparency, fiscal councils), sound design with flexibility/escape clauses, and appropriate timing for introduction.

### Why an expenditure rule is recommended for Iraq
- Key rationales:
  - Expenditure rules effectively reduce expenditure volatility, a priority for Iraq.
  - Expenditure is the budget component most directly controlled by government, increasing compliance likelihood.
  - Expenditure rules help create buffers in good times and link to absorptive capacity, avoiding overheating and large current account deficits.
- Comparisons with non-resource balance (NRB) rules:
  - NRB rules include non-oil revenue and link to long-term sustainability.
  - Given Iraq’s limited non-oil revenue (3 percent of GDP in 2018) and that expenditure drives non-oil balance movements, an expenditure rule offers similar stabilizing benefits with greater simplicity.
  - Recommendation: consider moving to a non-oil revenue rule anchored on long-term benchmarks as non-oil revenue grows.

### Design and implementation considerations for an expenditure rule in Iraq
- Coverage choices:
  - Determine layers of government and expenditure categories included in the ceiling; many resource-rich countries limit coverage to central government.
  - Common exclusions: interest payments, cyclically-sensitive expenditure, capital expenditure, and security-related spending.
  - Trade-off: more comprehensive coverage is preferable for sustainability, but exclusions may preserve investment priorities or reflect control limitations.
- Potential shortcomings and mitigations:
  - Combine expenditure rules with other rules (e.g., debt rule or structural balance rule) to ensure macroeconomic consistency.
  - Empirical evidence shows combining rules is associated with higher primary balances and lower primary spending.
- Capacity constraints:
  - Iraq’s technical and institutional capabilities to adopt complex rules are limited.
  - Fiscal reporting systems are not aligned with international standards; many indicators are not publicly used.
  - Simplicity in rule selection is important given capacity limitations.

### Rationale for a central-government ceiling on current primary spending
- Excluding capital expenditure from the rule:
  - Supports scaling up and protecting public investment for reconstruction and closing infrastructure gaps.
  - Prevents buildup of fiscal risks during oil price booms by controlling growth of current spending.
- Preconditions for effectiveness:
  - Strengthen public expenditure management to ensure efficiency of capital spending and prevent creative accounting.
  - Expand rule coverage in the future to general government and include capital expenditure once capital stock has been built and monitoring capacity improves.
- Time horizon and form:
  - Multi-year horizon supports medium-term planning and limits circumvention; risks reduced compliance during frequent macroeconomic changes.
  - Targets should be adopted before the annual budget process.
  - Preferred metric: ceiling on expenditure in nominal terms for simplicity, transparency, and stabilization.

### Adjustments, shocks, legal and enforcement features
- Adjust for structural changes in non-oil revenue via procedures that adjust the expenditure target to permanent revenue changes; adjustments should be symmetrical and apply only to permanent changes.
- Mechanism for large oil price shocks:
  - Rule should specify the size of overall deficit that triggers adjustment to the current expenditure ceiling.
  - Include a defined correction mechanism that specifies when and over what period past deviations should be corrected, with an explicit enforcement procedure.
- Legal backing:
  - Rule can initially be formalized through a cabinet decree, ultimately supported by legislation once capacity and implementation track record exist.

### Calibration approach — three steps overview
- Step 1: Anchor and buffer (risk-based)
  - Benchmark: maintain a buffer covering part of the revenue loss from a potential permanent oil price shock estimated at one standard deviation (SD) of forecast errors.
  - Simulation 2010–18: maintaining a buffer equivalent to one year ahead revenue loss could have built a buffer of over $104 billion (45 percent of GDP) by 2014, sufficient to cover the oil price shock in 2015–16 and still large by 2018.
  - Projected revenue loss: a one SD negative oil price shock implies an annual revenue loss of about 28 percent of Iraq oil export proceeds in one year ahead; the loss reaches 40 percent by 2024 as forecast uncertainties rise.
  - Proposed buffer target: about the potential revenue loss in one year ahead, about 12 percent of GDP on average over 2019–24.
- Step 2: Overall fiscal balance path consistent with buffer target
  - Accounting identity: OB* = ΔFiscal Buffer + Δfinancing.
  - Buffer build-up should avoid excessive or overly expensive borrowing; asset-liability management considerations apply.
  - Debt and macro assumptions used in illustration:
    - Debt to GDP ratio of 49.9 percent on average over 2020–24.
    - Nominal GDP growth 7 percent annually on average over 2020–24.
    - After 2024, long-term GDP growth assumed 6 percent and debt to remain at its 2024 level (49.2 percent of GDP).
  - Convergence illustrations:
    - Achieve target over five years (by 2024): overall balance should not exceed -1 percent of GDP during convergence (derived as -2.6 percent of GDP initial level and 1.6 percent of GDP additional adjustment).
    - Converge over 10 years (recommended to allow scaling up capital expenditure): overall balance can be relaxed to -2 percent of GDP over 2020–24 and tightened to -1.3 percent of GDP over 2025–29 to meet target by end of that period.
- Step 3: Translate overall fiscal balance into an operational expenditure ceiling
  - Revenue projections used:
    - Beyond 2024, oil revenue (r_oil) projected to grow by 3 percent (1 percent increase in oil exports and 2 percent increase in oil prices).
    - Non-oil revenue (r_nonoil) grows in line with nominal non-oil GDP growth of 8 percent.
  - Expenditure consistent with the rule is the residual: E* = (r_oil + r_nonoil) - OB*.
  - Creating space for capital expenditure:
    - Set a ceiling on current expenditure (ce*) so capex* is a target under the rule: e* = ce* + capex*.
    - Benchmarks: Iraq’s capital stock estimated at 125 percent of GDP versus 175 in the GCC region.
    - Proposed scaling up:
      - Increase non-oil capital expenditure from about 1.4 percent of GDP in 2018 to about 5 percent over the medium term.
      - Total capital expenditure (including oil-linked component) would increase from about 5.3 percent in 2018 to 9 percent of GDP in 2024.
      - This would help cover about half of war damage estimated at $88 billion.
    - Unexecuted capital spending should be saved in the buffer per the rule.
  - Time horizon choice and illustrative ceilings:
    - To achieve the buffer target of 12 percent of GDP over the medium term and increase capital spending to 4.8 percent by 2024 and remain constant afterwards, annual growth in current expenditure should not exceed 1.8 percent.
    - A more gradual 10-year approach allows higher annual growth in current spending of 2.5 percent.

### Adjustment mechanism for structural increases in non-oil revenue (ex-post)
- Adjustment should take place on an ex-post basis to avoid using overly optimistic revenue projections to relax the rule.
- One option: adjust the ceiling by one year lagged change in the moving average of the ratio of non-oil revenue to non-oil GDP.
- The ceiling—on the growth of overall current spending—is equivalent to the ceiling of 2 percent growth proposed in the accompanying staff report, which is set on primary current spending excluding one-off compensation payments to Kuwait.
- This adjustment would give more flexibility without risking long-term sustainability and would not affect the buffer target and its coverage to oil price risks.

### Fiscal buffers and their role; determinants and pragmatic approach
- Saving a share of oil resources for precautionary reasons helps manage oil revenue volatility; building buffers during good times provides self-insurance and supports countercyclical policy.
- Examples of pre-announced thresholds:
  - Mexico: oil revenues in excess of 4.6 percent of GDP are saved in the reserve fund and can be drawn when oil revenues fall below this benchmark.
  - Russia: savings deposited when current oil prices are above the benchmark long-term oil price until reserve fund reaches 7 percent of GDP; thereafter allocations split as specified.
- Determinants of appropriate buffer size:
  - Larger when revenue dependence is higher, volatility larger/persistent, and the country is credit-constrained.
  - Also depends on government balance sheet strength, expenditure structure, and costs/speed of adjustment.
- Iraq’s past buffer experience:
  - Iraq saved only 8 percent of oil revenue on average annually during 2004–18.
  - During 2011–14, when oil prices exceeded $100 on average, a very small share—less than 4 percent of oil revenues—was saved.
  - Factors impeding buffer buildup: intra-year spending increases via supplementary budgets and off-budget spending despite conservative oil prices in annual budgets.
- Pragmatic approach proposed:
  - Government targets a certain level for the fiscal buffer over the medium term.
  - Include alternative macro-fiscal scenarios in budget documents to determine size of precautionary buffers.
  - Use existing central bank government balances as a “virtual” stabilization fund initially; as assets build, establish rules for transparency and management.
  - A formal stabilization fund with fixed rules may prove difficult to design and operate at this stage.

### Methods to calculate buffers (literature guidance)
- IMF (2012): value-at-risk (VaR) approach or model-based approach to estimate minimum buffer to absorb tail risks.
- IMF (2015): calibrates financial savings so investment returns on financial assets are sufficient to avoid a large fiscal adjustment if commodity prices fall; illustration computes level of financial assets to cover half the lost revenue over five years with 75–90 percent probability.

### Conclusions and policy recommendations (summary)
- Move from annual-budget fiscal policy to multi-year fiscal planning, underpinned by robust budget processes and PFM systems to delink expenditure from oil revenue, scale up and protect capital expenditure for reconstruction, and safeguard long-term fiscal sustainability.
- Two main building blocks: anchoring fiscal policy on maintaining adequate fiscal buffers, and introducing operational fiscal rules to achieve buffer targets and protect capital expenditure.
- A well-designed and communicated fiscal rule can help manage expectations and resist spending pressures as oil prices recover.
- Recommended rule for Iraq: ceiling on current expenditure of the central government for its simplicity, operational guidance, ease of monitoring and control, and support for protecting public investment.
- Calibration guidance: set a ceiling consistent with current expenditure growth of between 1.8–2.5 percent annually over the medium term (the upper limit is consistent with the 2 percent growth in primary current spending—excluding one-off factors—recommended in the attached staff report).
  - Controlling current expenditure in this range would:
    - Allow Iraq to cover about half of post-ISIS reconstruction spending over the medium term.
    - Enable the authorities to gradually build fiscal buffers equivalent to 12 percent of GDP, sufficient to withstand one year revenue loss from a permanent oil price shock.

### Financial development and inclusion — overview, constraints, and policy priorities
- Rationale:
  - Financial development and inclusion channel funds to profitable projects, help diversify the economy, promote private sector and job creation, relax credit constraints for SMEs/households, and support financial stability when supervised adequately.
- Stylized facts:
  - Private banking sector: 63 generally small banks.
  - Public banks account for the lion’s share of banking system assets, lending and deposits.
  - Private sector credit: 9 percent of GDP.
  - Iraq scores “zero” on the depth of credit information index.
  - Loan-to-deposit ratio: 40 percent.
  - Rafidain and Rasheed together hold about 71 percent of banks’ deposits (86 percent held in total by public banks) and extend 54 percent of credit (80 percent extended in total by public banks).
  - Deposits-to-GDP ratio: 23 percent for 2016; financial system deposits-to-GDP in Iraq: 24 percent (compared to a range of 90–100 percent for Jordan, Kuwait, Morocco, Qatar, and UAE).
  - NPLs: around 37 percent for private commercial banks; around 13 percent for public banks.
  - Interest rate spread: about 7 percentage points (lending over deposit rates).
- Household financial inclusion:
  - Only a quarter of adults have accounts at financial institutions (20 percent for females; 26 percent for males).
  - Branch network: four branches per 100,000 adults (MENAP average around 12).
  - ATMs: three ATMs per 100,000 adults (MENAP average 32; GCC 50).
  - Only 6 percent of adults with an account reported an ATM withdrawal within a 12-month period.
  - Fewer than 30 percent received any deposits into their account in the previous 12 months.
  - Less than 3 percent borrowed from a financial institution in the previous 12 months.
  - Only 2 percent possess a credit card.
  - Share of employees with wages paid into an account at a financial institution: 15 percent.
- SME finance and constraints:
  - MSMEs contribute almost 90 percent to private sector employment.
  - Lending to SMEs accounts for only 9 percent of bank loans in 2017.
  - Only 2.7 percent of firms have financed investment projects through bank loans (latest available 2011 data).
  - Banks generally demand collateral of more than 150 percent of the loan value.
  - Composite SME financial inclusion index places Iraq second lowest in MENAP and CCA after Afghanistan.
- Conflict and structural constraints:
  - Conflicts, most recently with ISIS in 2014–17, undermined business environment, infrastructure, bank asset quality and investor confidence.
  - Weak legal/institutional frameworks, informational asymmetries, high collateral requirements and informality constrain lending.
- Policy recommendations:
  - Macroeconomic and structural reforms to reduce uncertainties and crowding out.
  - Legal, judiciary and governance reforms to reinforce property rights, contract enforcement and insolvency regimes.
  - Strengthen financial and institutional architecture: efficient credit information systems, improved auditing/accounting, expand acceptable collaterals, consider credit guarantee schemes.
  - Strengthen financial regulation and supervision: establish deposit insurance, restructure weak banks, extend supervision to microfinance and mobile payments, promote financial education.
  - Fintech and digital financial services: leverage mobile penetration (between 50 and 60 percent) to expand electronic payments; complementary investments in infrastructure and cybersecurity required.
  - Banking sector restructuring and competition: accelerate restructuring of public banks, establish core banking systems for audits, consider consolidation and promote banking competition; accelerate localization of salaries to enlarge deposit base.

### Quantified potential gains and key indicators
- Closing SME financial inclusion gap: 2.7 percent increase in GDP (above MENAP and CCA levels estimated at 1 percent) and reduction in unemployment of more than 1 percentage point.
- Firm loan employment effect: 1 to 3 percentage points increase in employment growth.
- Small firms contribution to new jobs: 45 percent of new jobs.
- CBI SME finance initiative (2015–17): 1,095 projects; totaling ID 1 trillion ($840 million); individual loans ID 5 million to ID 50 million.
- Initiative for large projects: ID 5 trillion (around USD 4.2 billion).
- Total amounts given to banks until December 31, 2018 exceeded ID 73 billion dinars.
- Mobile subscriber penetration in Iraq: between 50 and 60 percent.

*Source: IMF staff report excerpt (Content unit: 1irqea2019002 - 42. Adjusting the ceiling upward in case of structural increase in non-oil revenue).*

### References ______________________________________________________________________________ 32

### A Risk and Rules-Based Approach to Fiscal Policy

### Context
- Iraq’s oil proceeds exceeded $850 billion between 2003–18.
- Institutional weaknesses (governance, public financial management, capacity) diverted resources toward current spending, notably the public sector wage bill, with little saved in financial assets.
- Large development needs remain, including wide infrastructure gaps and high unemployment; unrest highlighted poor water and electricity quality.
- Estimated damage from the war with ISIS: $46 billion.
- Pledged donor support: $30 billion.

### Fiscal Policy Challenges
- Oil revenue accounted for about 92 percent of total budget revenue in 2018.
- At current production levels, every dollar change in oil price results in a change in total revenue by 1.1 percent of non-oil GDP ($1.5 billion), compared with 0.6 percent in other oil-exporting countries in the MENA region.
- Non-oil revenue in 2018 represented less than 5 percent of non-oil GDP.
- Oil price shocks can involve prices moving by as much as 40–80 percent for as long as a decade; volatility increased sharply during the 2014-15 commodity price shock and renewed volatility since Q4 2018.
- Differential between Iraq export prices and international prices fluctuated between +1 and -10 since 2004.
- Fiscal policy has been highly procyclical: correlation between growth in government spending and oil prices was 0.7 during 2003–18.
- Non-oil capital expenditure represented only 4 percent of total expenditure in 2018.
- Iraq has experienced greater economic volatility and lower investment rates relative to comparator countries.

### Proposed Fiscal Policy Framework
- Long-term objective: leverage depleting oil wealth to promote sustainable economic development, balancing conversion of oil revenues into real/financial assets or consumption, considering fiscal sustainability and intergenerational equity.
- Short- to medium-term objective: meet post-conflict demands and address infrastructure gaps while maintaining macroeconomic stability.
- Fiscal policy aims:
  - Create space within the budget through tight control on current spending and increasing tax revenue to scale up infrastructure and social spending, reflecting $30 billion of pledged donor support.
  - Manage oil revenue volatility and avoid procyclical fiscal policy by building adequate fiscal buffers to protect capital expenditure during downturns.
- Fiscal rules and stabilization buffers to be considered as complementary instruments; about one quarter of oil-exporting countries have combined fiscal rules with stabilization funds.
- Adopting a numeric fiscal rule should complement, not substitute for, a strong medium-term budget framework.

### Medium-Term Budget Planning
- Develop a medium-term orientation to dampen procyclicality and ensure sustainable spending.
- Key components:
  - Medium-term fiscal framework (MTFF) with forecasts for broad fiscal aggregates, formulated in line with the fiscal anchor.
  - Medium-term budget and expenditure frameworks translating aggregate forecasts into disaggregated expenditure ceilings, initially for larger categories and progressively with greater granularity.
  - Strengthening macroeconomic forecasting, with a strong analytical capacity supported by proper national accounts, reliable methodologies, and well-qualified staff; consider establishing a macro-fiscal unit at the Ministry of Finance.
- The Ministry of Finance has begun preparing indicative three-year projections for individual expenditure items as part of its budget submission; ministries should commit to these ceilings and develop medium-term plans.

### Robust Annual Budget and Supporting Fiscal Institutions
- Priority PFM improvements:
  - Unify and make comprehensive the budget process; eliminate practices/legislation allowing spending outside budget processes.
  - Base the budget on the best possible forecasts and conduct repeated comparisons between adopted budgets and execution outturns in-year and soon after fiscal year end.
  - Adhere to the expenditure envelope even if oil prices exceed budget projections; using more realistic oil price assumptions enhances planning and transparency.
  - Improve fiscal reporting to reflect international standards, ensuring timeliness and frequency, and include within-year reporting.
- The General Financial Management Law (GFML) adopted in 2019:
  - Defines general government for the first time.
  - Establishes the need for a medium-term fiscal framework and enshrines fiscal transparency requirements.
  - Limits parliament’s capacity to amend the budget and the scope for spending outside budget processes.
  - Requires subsidiary legislation and/or council of ministers decisions for implementation and to address remaining gaps relating to guarantees and commitment controls.
- Robust fiscal institutions (fiscal rules, stabilization funds, fiscal responsibility laws, independent fiscal agencies/councils) can increase commitment and accountability; they require strong political commitment and adequate administrative capacities and should be introduced gradually and flexibly given Iraq’s fragilities.

### Targeting the Right Fiscal Indicators
- Conventional indicator: overall (primary) fiscal balance—linked to financing needs and public debt—but can be cyclical and misleading in resource-rich contexts.
- For resource-rich countries, measures that exclude or smooth volatile oil revenue are more informative:
  - Non-oil primary balance (NOPB): suitable for assessing fiscal risks and long-term sustainability; indicates dependency on oil and direction of fiscal policy; should be assessed against long-term benchmarks.
  - Overall balance based on price-smoothing (structural primary balance): complements NOPB; requires choosing a reference price via automatic smoothing formulas (backward/forward moving averages) or an independent committee.
  - Primary current balance and current expenditure: particularly informative for Iraq to track use of oil revenue, focus on fiscal risks, and protect public investment. Containing current spending growth helps create space for capital spending.
- Practical considerations:
  - Aggregate measures of public expenditure should be monitored to guard against creative accounting.
  - Difficulty exists in classifying current vs. capital expenditure.
  - Indicators like the NOPB should be normalized by non-oil GDP to avoid fluctuations caused by oil price changes and better reflect the domestic economy.

*Source: IRAQ, INTERNATIONAL MONETARY FUND, July 3, 2019.*

### 17.      Fiscal rules can promote fiscal discipline in three main ways:

### 17.      Fiscal rules can promote fiscal discipline in three main ways:

### Main functions of fiscal rules
- Fiscal rules act as a:
  - Commitment device: tying the hands of the government and limiting the scope for fiscal discretion.
  - Signaling effect: increasing transparency in a context of imperfect information, and revealing the government’s priorities and plans.
  - Political function: by imposing numerical limits, rules may serve as a focal point for politicians, facilitating the formation and stability of political coalitions, and enhancing coordination (Eyraud and others, 2018).

### Why fiscal rules matter (general findings)
- Fiscal rules help control expenditure, and limit deficit and procyclicality biases.
  - Economic theory and empirical evidence point to a tendency for government expenditure to rise over time (expenditure creep), whereas taxes tend to grow more slowly, leading to higher deficits and the accumulation of public debt.
  - Procyclical policies are common: fiscal position is loosened during good times and tightened in downturns; fiscal rules constrain the scope for such discretion (Eyraud and others, 2018).

### Relevance to Iraq: risks and priorities
- Structural pressures in Iraq that increase the case for rules:
  - High dependence on oil revenue creates high expenditure volatility.
  - Demographic and labor structure that will exert increasing demand on public employment and public services.
  - Large fiscal burden and contingent liabilities from a large and inefficient SOE sector.
  - Inefficiencies in public spending.
- Specific numeric and country facts from the source:
  - Non-oil revenue in Iraq was 3 percent of GDP in 2018.
  - Expenditure-based consolidation has historically been the pattern in Iraq.

### International experience with fiscal rules (selected findings)
- Prevalence and evolution:
  - The number of resource-rich countries with fiscal rules increased from five in 2000 to 18 by 2015.
  - Rules targeting the budget balance are the most common; expenditure rules are gaining popularity among resource-rich countries.
  - Many resource-rich countries adapt standard rules to account for commodity price volatility; non-resource balance and structural balance rules are common among resource-rich countries.
- Mixed performance and causes:
  - Performance in resource-rich countries has been mixed owing to design flaws and weak institutional arrangements.
  - Successful implementations: Botswana, Chile, and Norway cited as examples.
    - Chile’s fiscal rule contributed to a 20 percentage point of GDP reduction in net public debt before the global financial crisis (IMF 2015).
  - Common failures: frequent modification and suspension during both down- and upswings in resource prices; rules more likely to be breached in bad times.
- Lessons for successful implementation:
  - Political commitment (Chile, Norway).
  - Supporting institutions: robust budget planning and monitoring, adequate PFM capacity, fiscal transparency, fiscal responsibility laws, and fiscal councils (e.g., Chile’s fiscal council provides estimates of the structural balance).
  - Design matters: incorporate sufficient flexibility and appropriate escape clauses (Norway permits temporary deviations over the nonoil cycle; Chile’s structural balance rule provides room for countercyclical policy).
  - Timing matters: introduce rules in stable conditions and preferably after a period of adjustment (examples: Mexico and Spain). Introducing rules amid extreme volatility is ineffective (example: Argentina, 1999).

### Desirable features of effective fiscal rules (operational aspects)
- Simplicity: easily understood and translatable into operational budget guidance.
- Controllability: targeted aggregates should be largely under policymakers’ control.
- Resilience: sustained presence to build credibility; not easily abandoned after temporary shocks.
- Ease of monitoring and enforcement: compliance should be easily verifiable; accountability for deviations.
- Flexibility: ability to modify in case of permanent economic shocks; use of debt brakes and escape clauses with pre-established triggers.

### Trade-offs across rule types (summary of comparative advantages/shortcomings)
- Overall Balance Rules
  - + Closely linked to debt sustainability
  - + Easy to communicate/monitor
  - + Clear operational guidance
  - – Not under direct control of policymakers
  - – Can lead to procyclicality
  - – Could adversely affect quality of adjustment
- Debt Rules
  - + Directly linked to debt sustainability
  - + Easy to communicate/monitor
  - – Not under direct control of policymakers
  - – Can lead to procyclicality
  - – Could adversely affect quality of adjustment
- Golden Rules (Current Balance)
  - + Protect public investment
  - + Intergenerational equity
  - – Weak link to debt sustainability
  - – Creative accounting
- Structural/Price Smoothing Rules
  - + Foster economic stabilization
  - + Help achieve long-term sustainability
  - – Difficult to compute and monitor
- Expenditure Rules
  - + Easy to communicate, monitor, and control
  - + Reduce volatility/allow countercyclical fiscal policy
  - + Encourage PFM reforms
  - + Can improve expenditure composition
  - + Clear operational guidance
  - – Narrow coverage and weaker link to financing needs and debt
  - – May reduce incentive to raise revenue
- Non-Resource Primary Balance Rules
  - + Easy to monitor and control
  - + Could encourage non-resource revenue generation
  - – Difficult to communicate: balance always in deficit
  - – Narrow coverage and weaker link to financing needs and debt

### Why an expenditure rule is recommended for Iraq
- Key rationales:
  - Expenditure rules are effective in reducing expenditure volatility, which is a priority for Iraq.
  - Expenditure is the budget component most directly controlled by government, increasing compliance likelihood (empirical studies: Cordes and others, 2015).
  - Unlike deficit caps, expenditure rules help create buffers in good times when revenue windfalls can increase spending pressures (Ayuso-i-Casals, 2012).
  - Expenditure rules are more directly linked to absorptive capacity, supporting macroeconomic management (e.g., avoiding overheating and large current account deficits) and reducing spending inefficiencies.
- Comparisons with non-resource balance (NRB) rules:
  - NRB rules include non-oil revenue and thus broader coverage, and can link to long-term sustainability and intergenerational equity.
  - Given Iraq’s limited non-oil revenue (3 percent of GDP in 2018) and that expenditure drives non-oil balance movements, an expenditure rule provides similar stabilizing benefits with greater simplicity and ease of monitoring.
  - Recommendation: consider moving to a non-oil revenue rule anchored on long-term benchmarks as non-oil revenue grows and intergenerational equity becomes a priority.

### Design and implementation considerations for an expenditure rule in Iraq
- Coverage choices:
  - Determine layers of government and expenditure categories included in the ceiling.
  - Many resource-rich countries limit coverage to central government for operational feasibility.
  - Common exclusions: interest payments, cyclically-sensitive expenditure, capital expenditure, and security-related spending.
  - Trade-off: more comprehensive coverage is preferable for fiscal sustainability, but excluding items may help preserve investment priorities or reflect control limitations.
- Potential shortcomings and mitigations:
  - Expenditure rules only cover one side of the budget; combine with other rules (e.g., debt rule or structural balance rule) to ensure consistency with macroeconomic stabilization and sustainability.
  - Empirical evidence shows combining expenditure rules with other rules is associated with higher primary balances and lower primary spending (IMF, 2015).
- Capacity constraints:
  - Iraq’s technical and institutional capabilities to adopt complex rules (structural or cyclically adjusted rules or oil price smoothing rules) are limited.
  - Fiscal reporting systems are not aligned with international standards; many indicators (structural and non-resource balances) are not publicly used or included in fiscal policy analysis.
  - Simplicity in rule selection is therefore important given capacity limitations.

*Source: 1irqea2019002 - 17.      Fiscal rules can promote fiscal discipline in three main ways:*

### 31.      In Iraq’s case, setting the ceiling on current primary spending at the central

### 1irqea2019002 - 31.      In Iraq’s case, setting the ceiling on current primary spending at the central

### Rationale for a central-government ceiling on current primary spending
- Excluding capital expenditure from the rule would:
  - Support scaling up and protecting public investment to rebuild after the war and close infrastructure gaps.
  - Prevent buildup of fiscal risks during oil price booms by controlling growth of current spending, which is difficult to reverse during shocks.
- International practice:
  - More than a third of resource-rich countries with expenditure rules protect public investment by excluding it from the rule, or include capital expenditure but allow higher growth limits for capital than for current spending.
- Preconditions for effectiveness:
  - Strengthen public expenditure management to ensure efficiency of capital spending and prevent creative accounting (reclassification of spending items) to circumvent the rule.
  - Expand rule coverage in the future to general government and include capital expenditure once capital stock has been built and monitoring capacity improves.

### Time horizon and form of the rule
- Multi-year horizon advantages:
  - Supports movement to a medium-term fiscal framework.
  - Allows prioritization and consideration of future impacts of current spending over several years.
  - Limits circumvention via postponing recording of expenditures or delaying structural adjustments.
- Multi-year horizon risks:
  - May reduce compliance when macroeconomic conditions change frequently (Iraq’s high exposure to oil price swings).
- Operational timing:
  - Targets should be adopted before the outset of the annual budget process so the spending rule guides budget preparation and execution.
- Preferred metric:
  - A ceiling on expenditure in nominal terms is recommended for Iraq, for simplicity, transparency, and stabilization:
    - Alternatives include nominal expenditure (levels or growth), growth of expenditure in real terms, or expenditure as a share of GDP (or non-resource GDP).
    - Expenditure expressed as a share of GDP is harder to control and associated with lower compliance.
    - Using GDP-based targets in Iraq would be procyclical due to oil-driven nominal GDP fluctuations and could increase expenditure unsustainably during oil price booms.

### Adjustments, shocks, and institutional design
- Adjusting for structural changes in non-oil revenue:
  - Develop procedures to adjust the expenditure target to permanent increases/decreases in non-oil revenue.
  - Adjustments should be symmetrical and apply only to permanent revenue changes to create incentives to diversify revenues without increasing fiscal risk.
- Mechanism for large oil price shocks and correcting deviations:
  - Rule should specify the size of overall deficit that triggers adjustment to the current expenditure ceiling.
  - Include a defined correction mechanism that specifies when and over what period past deviations should be corrected, with an explicit enforcement procedure.
  - Correction can be applied at aggregate level or at spending-unit level.
- Legal backing:
  - Rule can initially be formalized through a cabinet decree, but ultimately should be supported by legislation once capacity is built and implementation shows success.
  - Many emerging countries back fiscal rules with fiscal responsibility laws and transparency/accountability features.

### Calibration approach — three steps overview
- Step 1: Identify and calibrate the rule’s anchor using a risk-based approach suitable for oil revenue volatility—build fiscal buffers to mitigate oil price shocks.
  - Benchmark: maintain a buffer covering part of the revenue loss from a potential permanent oil price shock estimated at one standard deviation (SD) of forecast errors.
  - Simulation 2010–18: maintaining a buffer equivalent to one year ahead revenue loss could have built a buffer of over $104 billion (45 percent of GDP) by 2014, sufficient to cover the oil price shock in 2015–16 and still large by 2018.
  - Projected revenue loss: a one SD negative oil price shock implies an annual revenue loss of about 28 percent of Iraq oil export proceeds in one year ahead; the loss reaches 40 percent by 2024 as forecast uncertainties rise.
  - Proposed buffer target: set at about the potential revenue loss in one year ahead, about 12 percent of GDP on average over 2019–24.
  - Buffer anchor can be revisited once large buffers beyond precautionary levels are accumulated.
- Step 2: Derive the overall fiscal balance path consistent with the buffer target (12 percent of GDP), accounting for below-the-line financing:
  - Accounting identity: OB* = ΔFiscal Buffer + Δfinancing.
  - Buffer build-up should avoid excessive or overly expensive borrowing that would make gross debt unsustainable; asset-liability management considerations apply.
  - Debt and macro assumptions used in illustration:
    - Debt to GDP ratio of 49.9 percent on average over 2020–24.
    - Nominal GDP growth 7 percent annually on average over 2020–24.
    - After 2024, long-term GDP growth assumed 6 percent and debt to remain at its 2024 level (49.2 percent of GDP).
  - Convergence illustrations:
    - Achieve target over five years (by 2024): overall balance should not exceed -1 percent of GDP during convergence (derived as -2.6 percent of GDP initial level and 1.6 percent of GDP additional adjustment).
    - Converge over 10 years (recommended to allow scaling up capital expenditure): overall balance can be relaxed to -2 percent of GDP over 2020–24 and tightened to -1.3 percent of GDP over 2025–29 to meet target by end of that period.

- Step 3: Translate the overall fiscal balance into an operational expenditure ceiling
  - Revenue projections used:
    - Beyond 2024, oil revenue (r_oil) projected to grow by 3 percent (1 percent increase in oil exports and 2 percent increase in oil prices).
    - Non-oil revenue (r_nonoil) grows in line with nominal non-oil GDP growth of 8 percent.
  - Expenditure consistent with the rule is the residual: E* = (r_oil + r_nonoil) - OB*.
  - Creating space for capital expenditure:
    - Set a ceiling on current expenditure (ce*) so capex* is a target under the rule: e* = ce* + capex*.
    - Benchmarks indicate Iraq’s capital stock is well below comparators: 125 percent of GDP versus 175 in the GCC region (estimates follow uniform public investment accumulation and do not reflect war destruction).
    - Proposed scaling up:
      - Increase non-oil capital expenditure from about 1.4 percent of GDP in 2018 to about 5 percent over the medium term.
      - Total capital expenditure (including oil-linked component) would increase from about 5.3 percent in 2018 to 9 percent of GDP in 2024.
      - This would help cover about half of war damage estimated at $88 billion.
    - Unexecuted capital spending should be saved in the buffer per the rule.
  - Time horizon choice and illustrative ceilings:
    - To achieve the buffer target of 12 percent of GDP over the medium term and increase capital spending to 4.8 percent by 2024 and remain constant afterwards, annual growth in current expenditure should not exceed 1.8 percent.
    - A more gradual 10-year approach (staff suggestion under current oil price projections) allows higher annual growth in current spending of 2.5 percent.

*Source: IMF staff analysis as presented in the provided chapter excerpt.*

### 42.      Adjusting the ceiling upward in case of structural increase in non-oil revenue.

### 42. Adjusting the ceiling upward in case of structural increase in non-oil revenue

### Adjustment mechanism for the rule ceiling
- Adjustment should take place on an ex-post basis to avoid using overly optimistic revenue projections to relax the rule.
- One option: adjust the ceiling by one year lagged change in the moving average of the ratio of non-oil revenue to non-oil GDP (ܴ
௡௢௡).
- The ceiling—on the growth of overall current spending—is equivalent to the ceiling of 2 percent growth proposed in the accompanying staff report, which is set on primary current spending excluding one-off compensation payments to Kuwait.
- This adjustment would give more flexibility in the rule without risking long-term sustainability and would not affect the buffer target and its coverage to oil price risks.

### Fiscal buffers and their role
- Saving a share of oil resources for precautionary reasons would help Iraq manage oil revenue volatility.
- Building fiscal buffers during good times provides self-insurance and helps smooth expenditures and support countercyclical policy.
- Empirical evidence: well-designed funds help achieve policy objectives if supported by strong institutions, closely linked to broader policy objectives, and backed by strong political commitment.
- Examples of pre-announced thresholds in other countries:
  - Mexico: oil revenues in excess of 4.6 percent of GDP are saved in the reserve fund and can be drawn when oil revenues fall below this benchmark.
  - Russia: savings deposited when current oil prices are above the benchmark long-term oil price until reserve fund reaches 7 percent of GDP; drawn when prices are below benchmark.
- Many other resource-rich countries accumulated buffers without specific rules, relying on discretionary transfers; net flows into stabilization funds can be residuals of overall fiscal balance and financing decisions.

### Determinants of appropriate buffer size
- Precautionary buffers should be larger when:
  - The country is more dependent on resource revenues (less diversified revenue base).
  - Volatility of resource revenue is larger and more persistent.
  - The country is credit-constrained.
- The optimal buffer size also depends on:
  - Strength of the government’s balance sheet.
  - Structure of expenditure.
  - Costs and speed of adjustment in the event of shocks.
- For Iraq: considerations point to the need for sizable buffers, weighed against pressing development needs that make very large buffers difficult to justify and achieve.

### Iraq’s past buffer experience and pragmatic approach
- Iraq does not have formal arrangements to save from oil revenues but has built buffers during windfalls; these were insufficient to withstand large oil price shocks.
  - Iraq saved only 8 percent of oil revenue on average annually during 2004–18.
  - During 2011–14, when oil prices exceeded $100 on average, a very small share—less than 4 percent of oil revenues—was saved.
- Factors that impeded buffer buildup: intra-year spending increases via supplementary budgets and off-budget spending despite conservative oil prices in annual budgets.
- Pragmatic approach proposed:
  - Government targets a certain level for the fiscal buffer over the medium term.
  - Include alternative macro-fiscal scenarios in budget documents (different oil price and production scenarios) to determine size of precautionary buffers and required budget space to achieve target.
  - Use existing central bank government balances as a “virtual” stabilization fund initially; as assets build, establish rules for transparency and management.
  - A formal stabilization fund with fixed rules may prove difficult to design and operate at this stage in Iraq.

### Methods to calculate buffers (literature guidance)
- IMF (2012) options: value-at-risk (VaR) approach or model-based approach to estimate minimum buffer to absorb tail risks in resource revenue volatility; buffer should be large enough that—with a high probability—it is not fully depleted over the forecast horizon.
- IMF (2015) approach: calibrates financial savings so investment returns on financial assets are sufficient to avoid a large fiscal adjustment if commodity prices fall.
  - Illustration in IMF (2015): computes level of financial assets that would generate sufficient investment returns to cover half the lost revenue over five years with 75–90 percent probability.

### Conclusions and policy recommendations (E. Conclusions, paragraphs 43–46)
- A strong policy framework can help Iraq manage challenges from heavy dependence on volatile oil revenues.
  - Procyclicality of fiscal policy has caused short-term volatility and hindered long-term development.
  - Iraq lacks important fiscal institutions common in resource-rich countries: fiscal rules, stabilization funds, fiscal responsibility laws.
  - Authorities should move from annual-budget fiscal policy to multi-year fiscal planning, underpinned by robust budget processes and PFM systems to delink expenditure from oil revenue, scale up and protect capital expenditure for reconstruction, and safeguard long-term fiscal sustainability.
- Move to a risk- and rules-based approach:
  - Two main building blocks: anchoring fiscal policy on maintaining adequate fiscal buffers, and introducing operational fiscal rules to achieve buffer targets and protect capital expenditure.
  - A well-designed and communicated fiscal rule can help manage expectations and resist spending pressures as oil prices recover; it can also lock-in consolidation achieved after the 2014–16 decline.
- Choice and design of a fiscal rule should reflect Iraq’s circumstances, policy priorities, and capacity constraints.
  - A rule on current expenditure of the central government is proposed for Iraq for its simplicity, operational guidance, ease of monitoring and control, and support for protecting public investment.
  - Allowing adjustment of the rule ceiling to durable increases in non-oil revenue would encourage revenue diversification.
- Calibration of the rule:
  - Iraq should set a ceiling consistent with current expenditure growth of between 1.8–2.5 percent annually over the medium term (the upper limit is consistent with the 2 percent growth in primary current spending—excluding one-off factors—recommended in the attached staff report).
  - Controlling current expenditure in this range would:
    - Allow Iraq to cover about half of post-ISIS reconstruction spending over the medium term.
    - Enable the authorities to gradually build fiscal buffers equivalent to 12 percent of GDP, sufficient to withstand one year revenue loss from a permanent oil price shock.

*Source: IMF staff report excerpt (Content unit: 1irqea2019002 - 42. Adjusting the ceiling upward in case of structural increase in non-oil revenue).*

### 2009. The application of any of the fiscal rules may be suspended for up to three years

### 1irqea2019002 - 2009. The application of any of the fiscal rules may be suspended for up to three years

### Fiscal rules and exceptions (Peru and Russia examples)
- Exception framework (up to three years) applies when:
  - (a) real GDP is declining, with the ceiling on the deficit being raised up to 2.5 percent of GDP, with a minimum annual reduction of 0.5 percent of GDP until the 1 percent deficit ceiling is reached; and
  - (b) in other emergencies declared by the Congress at the request of the Executive.
- Under exceptions, the Executive must specify in its request the ceilings to be applied during the period of exception for the deficit and expenditure rules, with the minimum annual reduction of 0.5 percent of GDP on the deficit applying also in this case.
- 2012 adjustments to expenditure measurement and exclusions:
  - Expenditure on maintenance of infrastructure, expenditure on goods and services of social programs covered by the Performance-Based Budgeting scheme and equipment intended for Public Order and Security were excluded from current expenditure.
  - The rise in the average annual CPI for Metropolitan Lima rather than the BCRP target was used to calculate real growth of current expenditure.
- Subsequent developments:
  - In 2013, the application of the expenditure rule was waived.
  - Law 30099: non-financial expenditures of national government cannot exceed the limit consistent with the guidelines of the structural balance set by the macro-fiscal policy statement.
- Debt rules (DR, 2013):
  - Debt ceiling of NFPS is 30 percent of GDP.
  - For subnational governments (SNGs), debt/(average of last four years revenue) <100 percent.
- Russia — oil-price based fiscal rule (effective from 2013):
  - Sets a ceiling on expenditures equal to oil revenue at the “base” oil price, plus all nonoil revenues, plus a net borrowing limit of 1 percent of GDP.
  - Oil revenues above the “base” oil price need to be saved in the Reserve Fund until it reaches 7 percent of GDP (with some allowable exceptions under the law).
  - Once the Reserve Fund reaches this threshold, at least half of excess oil revenues should go to the National Wealth Fund, while the remaining resources would be channeled to the budget to finance infrastructure and other priority projects.
  - Starting in 2013, the rule will use a five-year backward-looking average of oil prices as the base, which will gradually increase to a ten-year average by 2018.
- Historical note on Russian BBR:
  - BBR (2007–09): Budget relied on the non-oil balance; included a long-term non-oil deficit target of 4.7 percent of GDP.
  - This target was suspended in April 2009 and formally abolished in 2012.

*Sources: IMF, Fiscal Rules Dataset (2016) and Budina and others (2012), "Fiscal Rules at a Glance: Country Details from a New Dataset"*

### Financial development and inclusion — overview and policy rationale (Iraq)
- Financial development and inclusion can:
  - Channel funds to profitable projects, help diversify the economy, promote a vibrant private sector and create jobs.
  - Relax credit constraints facing SMEs and households, enabling smoothing of consumption and investment when shocks occur.
  - Support financial stability by helping banks diversify funding sources and portfolio composition, subject to adequate supervision.
- Authorities’ actions and priorities:
  - Central Bank of Iraq initiatives to promote financial inclusion and upgrade prudential regulations and supervision (including AML-CFT measures).
  - Plans to restructure the two largest public banks, develop a deposit insurance scheme, strengthen payment systems and encourage direct salary payments.
- Key reform priorities highlighted:
  - Strengthen and refocus bank regulation and supervision on the two largest public banks.
  - Improve credit information and strengthen legal procedures to reduce collateral requirements.
  - Promote fintech and mobile banking leveraging relatively large wireless mobile coverage.

### Stylized facts on Iraq’s financial sector (financial development)
- Structure and scale:
  - Private banking sector comprises 63 generally small banks that together account for a modest share of assets.
  - Public banks continue to account for the lion’s share of banking system assets, lending and deposits.
- Public banks’ vulnerabilities:
  - The two largest public banks—Rafidain and Rasheed—have lent directly to the government and undertaken numerous quasi-fiscal operations, carrying legacy assets from the Saddam Hussein era.
  - These factors undermined liquidity, solvency and profitability and increased risks to financial stability.
  - Repeated cleansing and restructuring efforts have yet to be successfully concluded, partly due to lack of accurate data about their financial position.
- Financial depth indicators:
  - Private sector credit is only 9 percent of GDP.
  - Iraq scores “zero” on the depth of credit information index.
  - Loan-to-deposit ratio is 40 percent (second lowest among MENAP countries).
  - Domestic credit from the financial sector and comparative regional indicators show Iraq well below peers.

### Household financial inclusion — access and usage indicators (Iraq)
- Account ownership and access:
  - Only a quarter of adults have opened accounts at a financial institution.
  - Gender disparity: 20 percent for females versus 26 percent for males.
  - Branch network: four branches per 100,000 adults (MENAP average around 12 branches).
  - Automated teller machines: three ATMs per 100,000 adults (MENAP average 32; GCC 50).
- Usage metrics:
  - Only 6 percent of adults with an account reported an ATM withdrawal within a 12-month period.
  - Fewer than 30 percent of Iraqis received any deposits into their account in the previous 12 months.
  - Less than 3 percent of adults borrowed from a financial institution in the previous 12 months.
  - Only 2 percent of adults possess a credit card.
  - Share of employees with wages paid into an account at a financial institution: 15 percent.
  - Usage of digital technology to make payments remains lower than peer countries despite some increase over time.
- Barriers identified by surveys:
  - Branches too far away, financial services perceived as too expensive, insufficient funds to open an account, and lack of trust in financial institutions.
  - Underdevelopment of mobile/e-banking limits broader access.

### SME financial inclusion and credit constraints (Iraq)
- SME structure and activity:
  - MSMEs contribute almost 90 percent to private sector employment.
  - MSME density (MSMEs per 1,000 people) is substantially lower than both the MENA region and emerging and developing countries.
- Access to finance for firms:
  - Lending to SMEs accounts for only 9 percent of bank loans in 2017 (Iraq and MENAP average).
  - Only 2.7 percent of firms have financed investment projects through bank loans (latest available 2011 data), compared with MENA average 23.7 percent (excluding high income countries).
  - Lending standards are stringent; banks generally demand collateral of more than 150 percent of the loan value.
  - Iraq’s score for “getting credit” in the World Bank Doing Business report (2019) is zero (regional average 36 on a 0–100 scale).
- Composite SME financial inclusion:
  - A principal component analysis–based composite index places Iraq with the second lowest SME financial inclusion score in the MENAP and CCA region after Afghanistan.

*Prepared by Salim Dehmej and Amgad Hegazy, with research analysis by Alexander de Keyserling; sources within text include Central Bank of Iraq, World Bank, IMF databases and surveys.*

### 14.      The scale and frequency of conflicts, most recently with ISIS in 2014–17, is a major

### 1irqea2019002 - 14.      The scale and frequency of conflicts, most recently with ISIS in 2014–17, is a major

### Conflict and structural constraints on financial development
- Conflicts, most recently with ISIS in 2014–17, are a major factor behind the lack of financial development, undermining the business environment and confidence, weakening infrastructure, and negatively affecting bank asset quality (direct misappropriation of assets and indirect borrower distress).
- Structural factors limiting financial development:
  - The structure of the economy: the government accounts for a large share of economic activity and mainly re-distributes oil wealth rather than providing an enabling environment for private enterprise; the size of the government (including SOEs) has impaired private sector development, especially SMEs, through crowding out and preferential financial terms exacerbated by the dominant role of public banks.
  - Oil price shocks: a decline in oil prices may weaken the financial system and depress government revenues, forcing cuts in public investment, government withdrawal of deposits at commercial banks and accumulation of arrears, which impacts suppliers that have borrowed from banks (IMF, 2016).
  - Weak legal and institutional frameworks: deficiencies in property rights, shareholder protection, contract enforcement, insolvency regimes, governance and corruption undermine the business climate and complicate asset recovery and risk management for banks.
  - Informational asymmetries and informality: poor financial reporting standards and lack of credit history (credit registries/bureau) discourage bank lending to SMEs and households; lending to SMEs carries higher risk premia and high collateral requirements.
  - High collateral requirements and lack of acceptable collateral: banks typically seek fixed assets (land and real estate) while private firms mainly possess movable assets such as equipment and inventories; banks also use checks as collateral because they are easier and faster to enforce.

### Financial sector factors and performance
- Weak financial architecture:
  - Undercapitalization of several banks, poor corporate governance, lack of independence of public banks, deviations from international prudential practices (e.g., classification of NPLs and provisioning), lack of comprehensive published audits, and absence of an operational deposit insurance scheme undermine confidence, depressing deposit collection and lending capacity.
  - Imperfect risk management systems, not fully digitized, inhibit effective screening and monitoring of borrowers and increase operational costs.
- Bank concentration and dominance of public banks:
  - Rafidain and Rasheed together hold about 71 percent of banks’ deposits (86 percent held in total by public banks) and extend 54 percent of credit (80 percent extended in total by public banks).
- Low deposit mobilization:
  - Iraq has the lowest deposits-to-GDP ratio in the region (at 23 percent for 2016).
  - The size of financial system deposits-to-GDP in Iraq is 24 percent for Iraq, compared to a range of 90–100 percent for Jordan, Kuwait, Morocco, Qatar, and UAE.
- Credit quality and funding costs:
  - High non-performing loan (NPL) ratios: the official ratio—around 37 percent for private commercial banks—is three times above the MENAP average; public banks show lower NPLs, around 13 percent, though this may understate the true picture due to (uncalled) government guarantees and loans not fully serviced but not shown as non-performing.
  - High interest rate spread: Iraq has the highest interest rate spread in the MENAP region, at about 7 percentage points (lending over deposit rates), implying high funding costs for the private sector; deposit rates for Iraq were higher than those in the GCC countries for which data was available during 2016–17.
- Operational efficiency:
  - Bank competition is subpar despite many private banks; high overhead costs, cost-to-income ratios and interest spreads compared with regional peers contribute to inefficiency.

### Benefits of financial development and inclusion
- Channels through which financial inclusion promotes growth and stability:
  - Financing new projects (boosting growth), smoothing consumption and investment (dampening growth volatility), reducing inequality by financing opportunities for poor households and firms, and improving monetary transmission and price stability (IMF, 2019).
- Financial inclusion supports financial stability when accompanied by appropriate regulation, supervision and financial education/literacy; it diversifies funding sources and portfolio allocation via additional deposits and new projects.
- Electronic/mobile payments and transfers deliver benefits: lower uncertainty about transfers, broader reach, lower transfer costs for social programs and remittances, lower corruption and crime, higher transparency, and building payment/credit histories that improve access to credit and enhance lenders’ risk management (Demirguc-Kunt, Klapper, and Singer, 2017).
- Savings access benefits: safety against theft, cash management, remuneration (interest income), and establishing proof of saving capacity for later borrowing.
- Evidence on credit: robust benefits for payments and savings; empirical results are less conclusive for credit—reflecting tradeoffs with financial stability.
- SME and employment linkages:
  - Firms that secure a loan see employment growth rise by 1 to 3 percentage points relative to financially constrained firms (Ayyagari and others, 2016).
  - SMEs represent almost half of the workforce in emerging and developing countries; small firms are the largest contributors to employment growth (45 percent of new jobs) (Ayyagari and others, 2014).
- Quantified potential gains for Iraq from closing the SME financial inclusion gap:
  - A 2.7 percent increase in GDP (above the MENAP and CCA levels, estimated at 1 percent).
  - A reduction in unemployment of more than 1 percentage point.

### Policies to strengthen financial development and inclusion in Iraq
- Central Bank of Iraq (CBI) initiatives already launched:
  - 2015 CBI initiative to finance SME projects through banks specialized in agricultural, industrial and commercial activities: 1,095 projects financed during 2015–17 totaling ID 1 trillion ($840 million), with individual loans ranging from ID 5 million to ID 50 million.
  - Initiative includes financing large projects, with an amount of ID 5 trillion (around USD 4.2 billion).
  - Total amounts given to banks until December 31, 2018 exceeded ID 73 billion dinars (CBI Statement, January 14, 2019).
  - Efforts to modernize payment systems, promote electronic payments and encourage banks to open more branches.
  - A large share of public employees already receive salaries via public banks through electronic cards (Qi cards); an initiative to grant employees the choice of receiving salaries electronically via private banks is underway.
- Recommended reform package and priorities:
  - Macroeconomic and structural reforms: sound economic policies to reduce uncertainties, encourage investment, limit government financing needs and avoid crowding out; diversify the economy, stimulate the private sector and encourage formalization.
  - Legal, judiciary and governance reforms: reinforce property rights, shareholders’ protection, contract enforcement, effective insolvency regimes, governance and anti-corruption to lower uncertainty and bank costs.
  - Strengthen financial and institutional architecture:
    - Establish efficient credit information systems (credit registries and bureaus) to reduce informational asymmetries and improve borrower creditworthiness assessment.
    - Improve auditing and accounting standards and corporate governance.
    - Expand the range of accepted collaterals (both fixed and movable); evidence shows collateral registries for movable assets can increase the likelihood of firms accessing bank financing by 10 percentage points and reduce lending rates and increase loan maturities.
    - Consider well-designed credit guarantee schemes to alleviate financing constraints while avoiding market distortions and contingent fiscal risks.
  - Strengthen financial regulation and supervision:
    - Establish an operational deposit insurance corporation to increase trust and level the playing field, accompanied by restructuring weak banks and strengthening supervision to avoid exposing the government to undue contingent liabilities.
    - Extend supervision beyond the banking sector to include microfinance and mobile payments.
    - Promote financial education/literacy and consumer protection institutions.
  - Fintech and digital financial services:
    - Use fintech to improve risk management, enhance competition, reduce operational costs and deliver customized services (payments and transfers) instantly and 24/7.
    - Build on mobile coverage: mobile subscriber penetration in Iraq is between 50 and 60 percent (GSMA–Middle East & North Africa–The Mobile Economy 2018).
    - Examples: Zain Cash launched in 2015 (mobile money account linked to SIM or app) offers money transfer, electronic bill payment, funds disbursement.
    - Complementary reforms needed: investments in infrastructure (electricity, telecom and internet nationwide), human capital (IT skilled employees), lower user costs, strengthened regulation and cybersecurity.
  - Banking sector restructuring and competition:
    - A clear, comprehensive plan to accelerate restructuring of public banks; priority is to establish core banking systems to allow international audits, accurate assessment of capital needs and eventual recapitalization.
    - Scope for consolidation in private banking to build healthier institutions that can compete nationally and exploit economies of scale.
    - Promote banking competition while ensuring a level playing field between public and private banks to foster innovation and SME-targeted products.
    - Accelerate localization of salaries (paying employees through banks’ accounts instead of cash) to enlarge the deposit base and familiarize new customers with banking services.

### Key statistics and indicators (reported exactly as in source)
- Conflicts: ISIS in 2014–17.
- Deposits-to-GDP ratio: 23 percent for 2016 (Iraq); financial system deposits-to-GDP in Iraq: 24 percent (compared to a range of 90–100 percent for Jordan, Kuwait, Morocco, Qatar, and UAE).
- Rafidain and Rasheed deposit share: about 71 percent of banks’ deposits (86 percent held in total by public banks).
- Credit share: Rafidain and Rasheed extend 54 percent of credit (80 percent extended in total by public banks).
- NPLs: around 37 percent for private commercial banks; around 13 percent for public banks.
- Interest rate spread: about 7 percentage points (lending over deposit rates).
- CBI SME finance initiative (2015–17): 1,095 projects; totaling ID 1 trillion ($840 million); individual loans ID 5 million to ID 50 million.
- Initiative for large projects: ID 5 trillion (around USD 4.2 billion).
- Total amounts given to banks until December 31, 2018 exceeded ID 73 billion dinars.
- Mobile subscriber penetration in Iraq: between 50 and 60 percent.
- Growth benefits from closing SME FI gaps for Iraq: 2.7 percent increase in GDP (above MENAP and CCA levels estimated at 1 percent).
- Employment benefit: reduction in unemployment of more than 1 percentage point.
- Employment growth effect of firm loans: 1 to 3 percentage points increase.
- Small firms contribution to new jobs: 45 percent of new jobs.
- Credit registry movable asset impact: increase likelihood of firms accessing bank financing by 10 percentage points (Love, Martinez Peria, and Singh, 2016).

*International Monetary Fund — chapter content (1irqea2019002).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1irqea2019002.pdf_