Report No. 35141-IQ Iraq Rebuilding Iraq: Economic Reform and Transition February 2006 Middle East and North Africa Region Social and Economic Development Group Document of the World Bank Contents Preface vi Acknowledgements v11 Executive summary 1 Recent developments 1 Challenges ahead 2 Generating growth and employment 3 Protectingthe poor and the vulnerable 9 Improvingpublic management and accountability 10 Chapter 1.Recent developments and challenges ahead 15 Security and recovery 18 Progress on policy and institutionalreform 23 Foundations o f security and cohesion 25 The three main challenges ahead 27 Redefiningthe role ofthe state 28 Part I.Generatinggrowth and employment 30 Chapter 2. Creatingjobs andrebuilding services 30 Labor market conditions and outlook 30 Jobs, investment, and diversification 35 Labor market policies 41 Summary o frecommendations 44 Chapter 3. Fixingprices and incentives for growth 47 Pricingreforms 47 Food security 50 Domestic he1subsidies 55 Electricitypricing andmanagement autonomy 65 Trade and investment 72 Summary o frecommendations 79 Part II.Protecting thepoor and the vulnerable 82 Chapter 4. Reforming social safety nets and pensions 82 Poverty andvulnerability inIraq 82 Socialprotection 85 Pension reform 87 Summary o frecommendations 89 ... 111 Part III.Improvingpublic management and accountability 92 Chapter 5. Managing oil revenues 92 The Dutchdisease and oil price volatility 93 Enhancing fiscal discipline 96 Summary o frecommendations 97 Chapter 6. Strengthening governance 98 Fiscalpolicy andpublic finance 98 Intergovernmentalfiscal relations 100 Humanresource management 104 Anticorruption 105 Summary o f recommendations 107 Annex. Iraq at a glance 110 References 112 Figures 1.1. Iraq's gross domestic product andvalue o foil exports, 1997-2006 15 1.2. Vulnerability o f the oil and electricity sectors inIraq 16 1.3. Iraq's security situation, 2003-05 19 1.4. Iraq's external public debt at the end o f 2004 24 1.5 Patterns o frecovery from shocks and conflicts 26 2.1 Unemployment inIraq, 2004 31 2.2 Iraq's labor market, 2004 32 2.3 Iraq's employment and hourly wages, 2004 32 2.4 Employment by sector and gender, 2004 34 2.5 Unemployment scenarios for private-sector and state-led recoveries 35 3.1. Exchange rates, consumer prices, and interest rates inIraq, 2003-05 48 3.2. Iraqelectricity production and oil inputs into electricity generation 66 3.3. Geographical distribution o f Iraq's imports, 2004 73 4.1 Gender and poverty by household income percentile, 2003 83 4.2 Regional patterns o fpoverty inIraq 84 4.3 Income replacement patterns o fpensionsystems inthe Middle East andNorthAfrica 89 Tables 1.1. Selectedeconomic indicators for Iraq, 2002-05 17 3.1. Subsidies inIraq 49 3.2. Fuelprices inIraq and on internationalmarkets, 2005 56 3.3. Impact o f he1price increases on electricity production cost 59 3.4. Scenario for fuel price reforrn inIraq 62 3.5. Electricity tariffs inIraq 67 4.1 Iraq's per capita household income by income quintiles, 2003 and 2004 83 4.2 Contributors andbeneficiaries inthe Iraqipension system, 2004 87 iv Boxes 1.1. Data quality issuesinIraq 20 1.2. Iraq and the MillenniumDevelopment Goals 21 2.1 The informal sector inIraq 33 2.2 The resource curse 36 2.3 Jobs and reintegrationfor demobilized soldiers 43 3.1. Iraq's Public Distribution System 51 3.2 Impact o f subsidyreforms on the imports o frefined oil products 61 3.3. Impact o f subsidyreforms on the agricultural sector 71 5.1. Generating oil revenues inIraq 93 5.2. Transparency inmanaging oil revenues 96 6.1. Strengtheninggovernance after conflict 98 6.2. Decentralization 102 V Preface This report focuses on the cross-cutting issues at the heart o f Iraq's transition, including the immediate challenges o f reviving the economy and creating jobs, rebuilding public services responsive to citizens' needs, and strengthening safety nets to protect the poor and vulnerable. It also addresses some overarching issues in public sector governance, particularly the management o f oil revenues, the realignment o f economic incentives and prices, the reform o f human resource management, and the implementation o f anticorruption efforts. The report begins by surveying recent developments and reforms to date. Each chapter concludes with specific recommendations for the future. The report is intended for three audiences: Iraqi policymakers, the international donor community, and World Bank staff. For the Iraqi audience, the most important o f the three, the report analyzes what worked and what did not in other countries, including those inthe Middle East and North Africa, and strives to support the Iraqi government in strengthening its policymaking capacity in the context o f the National Development Strategy. Instead of prescribing policies, the report lays out the options available to the Iraqi authorities and discusses tradeoffs under each option. For the international donor community, the report may help to refine approaches to reconstruction assistance and improve the efficiency o f cooperation with Iraqi counterparts. Finally, for World Bank staff, the report aims to provide an integrative analytical platform for the Bank's Interim Strategy for Iraq. Drawing on sectoral studies o f the Iraqi economy and policy discussions heldin2003-05 with senior Iraqi counterparts from a wide cross-section o f agencies, the report builds on extensive data collection and analytical work undertaken by Iraqi government agencies and independent experts, as well as by many international institutions involved in reconstruction assistance. Surveys organized and fhded by the U.N. Development Programme, the World Food Program, and the International Labour Organisation and implemented by Iraq's Central Organization for Statistics and Information Technology (COSIT) provided valuable information on social development standards inIraq. Project and advisory work undertakenby U.N.agencies and bilateral donors, such as the U.K. Department for International Development (DFID), the U. S. Agency for International Development (USAID), and many others supplied hrther information. Iraqi and international experts providedvery helphl comments on earlier versions o fthis report. A word o f caution is needed about the quality o f data underpinningthe analysis in this report. Although data has improved and several wide-ranging surveys have been undertaken since 2003, substantial gaps remain. Further data collection and research are needed to deepenthe understanding o f challenges facing Iraq. vi Acknowledgements This paper i s prepared by the Economic and Social Development Unit o f the Middle East Department, Middle East and North Africa Region o f the World Bank, led by Mustapha Kame1Nabli, who has provided overall guidance and supervision. The core team was led by Sergei Shatalov and included Richard Allen, Pierre Audinet, Robert Beschel, John Blomquist, Monali Chowdhourie-Aziz, Julia Devlin, Matthias Grueninger, Masami Kojima, Catherine Laurent, Susan Razzaz, David Robalino, Hania Sahnoun, John Speakman and Shane Streifel. Other contributors include Ali Al-Abdulrazzaq, Basil Al- Hussaini, Randa Akeel, Hamid Alavi, and Jennie Litvack. Macroeconomic scenarios were formulated by Maryla Maliszewska and Hania Sahnoun. Companion papers were prepared by John Blomquist, Monali Chowdhurie-Aziz, Julia Devlin, Ndiame Diop, Neville Edirisinghe, Samir El Daher, Deane Jordan, Matthias Grueninger, Bartek Kaminski, Masami Kojima, SusanRazzaz, DavidRobalino and John Speakman. This volume was reviewed internally by Shahrokh Fardoust and Linda van Gelder and externally by Tarik Yousef. It has received valuable guidance and comments from Ehtisham Ahmad, Zoubida Allaoua, Adam Bennett, Gordon Betcherman, Nadereh Chamlou, Dipak Dasgupta, Sebastien Dessus, Kathryn Funk, Dominique Guillaume, Faris Hadad-Zervos, Farmkh Iqbal, Tufan Kolan, Charles McPherson, Lorenzo Perez, Carlos Pinerua, Joseph Saba, Carlos Silva-Jauregui, Thirumalai Srinivasan, Tjaarda Storm van Leeuwen, Jonathan Walters, and Paolo Zacchia. The document was expertly prepared for publication by Mary Lou Gomez, and editedby Bruce Ross-Larson, Carol Rosen, and Jodi Baxter o f Communications Development Incorporated(CDI). The team would like to thank all o f those who contributed and participatedinthe various stages o f production o f this book, including those whose names may have been inadvertently omitted. vii Executive summary Iraq has a rich and diverse resource base-the third-largest oil reserves in the world, abundant water, and a national labor force o f more than 7 million people-much larger than any member country of the Gulf Cooperation Council. This combination of resources i s expected to enable the country to regain in only a decade the middle-income status it enjoyed earlier. To do so, however, Iraq will need to make three transitions: from conflict to rehabilitation, from state domination to market orientation, and from oil dependence to diversification. The report lays out some o f the policy options to accomplish these transformations. Recent developments Iraqi reconstruction i s being stalled by the lack o f security. Oil production and exports have yet to reach prewar levels, and nonoil sectors remain sluggish. Highunemployment, poverty, and weak social protection systems dominate public concerns and threaten the fragile democracy. Violence and crime, which have increased substantially since late 2003, hamper reconstruction and undermine governance efforts. Increased violence also limitspeople's access to much-needed public services and thus stifles progress inhuman development, particularly for the growing number o f the poor and the vulnerable. Thirty years ago, Iraq led the Middle East and North Africa region in social development indicators, such as maternal and child mortality, nutrition, literacy, and secondary school enrollment. Since then, as a result o f decades o f conflict, sanctions, and underinvestment, living conditions have declined. Many o f these indicators have fallen to the levels typical for low-income countries. Violence in Iraq remains much worse than in other conflict-ridden countries at a comparable point after the end o f open warfare. The incidence o f conflict in Iraq in the past two decades has been three times as high as in the Middle East and North Africa region as a whole, which itself has one o f the highest incidences o f conflict inthe world. Losses to social capital have been massive. Success in reconstruction and recovery will depend on how quickly a social consensus emerges on reform priorities and tradeoffs. That consensus i s essential: a comparative analysis o f trends in GDP per capita in the decade following conflicts shows that countries developing a cohesive and consistent reform strategy outperform those unable to develop such a consensus by about 50 percent. About 8-10 percent o f the Iraqi population i s now estimated to be living in absolute poverty, and a further 12-15 percent i s vulnerable to falling into absolute poverty. Both monetary and nonmonetary aspects o f poverty have worsened dramatically in recent decades. Several population groups are especially at risk: unemployed youth, demobilized soldiers and militia, war victims with disabilities, and internally displaced persons, refugees, and returnees. Iraq's volatile security i s likely to have continuing consequences for poverty and vulnerability. 1 Some early progress was made in 2003-04 on policy and institutional reforms in public finance, trade, the business climate, and the financial system. Reforms sought to remove price distortions, increase competitiveness, and enhance economic efficiency. Iraq is also reintegrating into the international financial system: in 2004 it adopted a stabilization program supported by the InternationalMonetary Fund, negotiated a highly concessional debt rescheduling, gained access to concessionary resources from the International Development Association, and submitted a request for full membership in the World Trade Organization. Nonetheless, severe problems remain. By many measures o f social development, Iraqhas fallen below most other countries in the region and middle-income countries around the world (see "Iraq at a glance" tables in the annex). Access to utilities i s high-almost universal connection to the national electricity grid and 81 percent access to improved water sources-but the quality o f these services has declined sharply in the past decade. In2004, only 20 percent had safe and stable drinkingwater, and a mere 15 percent of households had a stable electricity supply. In October 2004 the government announced its National Development Strategy, which outlines long-term priorities for reconstruction and reform. The strategy offers a vision o f economic revival driven by private enterprise and supported by a strong and transparent public sector. It was welcomed by the international donor community, but it needs more specific sectoral strategies to become an actionable agenda. It needs to be further developed by the incoming Iraqi Government. Challenges ahead Iraq has made less speedy progress than expected in addressing the most critical condition for the economic recovery: reversing violence and insecurity. Buildingup law enforcement and strengthening a representative form o f government would allow conflicts to be resolved through political means, rather than through violent confrontation. Restoring law and order, engaging all important stakeholders, and reintegratingcombatants into civil society are thus the highest priorities for Iraq. Beyond the need to credibly establish security, Iraq's reconstruction strategy should also be designed to create productive jobs that will engage Iraq's burgeoning labor force, to improve the well-being o f the most vulnerable groups, and to rebuild public services in ways that are accountable and responsive to citizens' needs. Experience from other successfid postconflict transitions indicates that all o f these objectives need to be met simultaneously, guaranteeing that all citizens share in a vision o f a just and prosperous Iraq. Realizing this vision calls for three main policy approaches: (a) generating growth and employment in the private sector by rebuildingneeded services and reforming incentive systems; (b) protecting the poor and the vulnerable as prices are freed by establishing strong formal safety nets and sustainable pensions; and (c) improving public management and accountability, especially for oil revenues and other public resources, by 2 strengthening governance, reforming public finance and human resource management, and increasing anticorruption efforts. In Iraq, as in all countries, there are choices for the role of the state. The Iraqi state remains central to the reconstruction task, but its role will likely evolve. In the initial postconflict years, it will continue to createjobs, rebuildhuman and physical capital, and restore vital services. But it should scale back its direct involvement in economic activities to concentrate its human and financial resources on the provision o f vital public goods-such as law and order, a sound trade and investment regime, and strong social safety nets. The pacing o f reforms should incorporate goals targeting women's development and employment, since gender-neutral pacing may not protect most women. Some pricing reforms should proceed faster than others to realize quick gains while protecting the vulnerable groups. All three areas o f reform are interconnected, and care is needed in their pace and sequence. Reform o f the subsidy system needs to generate fiscal savings for reconstruction andjob creation. Effective public resource management remains central to the success o ftransition. Generatinggrowthandemployment Iraq's labor force is growing rapidly (at 2.4 percent a year) and will continue to do so in the medium term. The current demand for labor cannot absorb large numbers o f unemployed and new entrants to the labor market. As a result, Iraq has one o f the highest unemployment rates in the region-close to 30 percent, almost twice the average in the Middle East and North Africa region. More than half o f young urban males are unemployed. Iraq also has very high underemployment (over 23 percent), while its female labor participationi s a mere 19percent-low even by Middle Eastern standards. Once security concerns are addressed, the situation may improve. Reconstruction should expand the demand for labor substantially, given Iraq's enormous needs for basic services. Although the vast majority o f the population has access to the national electricity grid and improved water sources, the quality o f these services had declined sharply inthe past decade. In2004, only one-fifth o f the population had safe and stable drinking water, and less than one-sixth had a stable electricity supply. Many new jobs will be inthe public sector, since reconstruction programs will be initiated by the state, fundedfrom its oil revenues. Creatingjobs and rebuilding services Iraqi policymakers face a choice on the relative roles o f the public and private sector in job creation. Other labor-abundant countries show that job creation i s most effective when the public and private sectors are strengthenedsimultaneously. Duringearly stages of transition, the public sector may indeed be the chief job engine. However, where the 3 state dominates investment and service delivery and crowds out the private sector, efficiency eventually declines, and unemployment remains stubbornly high. Where the state moves early to facilitate private enterprise and concentrates on the provision o f key public goods, private enterprise flourishes and strongly expands the demand for labor. A vibrant private sector inIraq would deliver notjust ample jobs, but more productivejobs as well. A simulation analysis conducted for this report suggests that a strategy that relies on public-sector reconstruction without enabling the private sector will run out o f steam to generate jobs and growth within five to eight years. This simulation demonstrates the urgency o fpromoting private-sector development immediately. Women's labor force participation contributes significantly to development. Research from other Middle East and North Africa countries shows that, while the public sector has been the main employer o f female labor, in the private sector women face higher barriers to employment than men. Labor market strategies should seek to eliminate these barriers. Increasing investment Private-sector job creation is driven primarily by investment. To improve the climate for investment, Iraqneeds to strengthen the institutionalunderpinnings (such as the laws and regulations together with their monitoring, implementation, and enforcement capabilities) and develop a creative and targeted set o fprograms to focus investment on substantial job creation. Indeed, job creation should be the key metric by which economic development programs are gauged. This strategy will require close attention from the top leadership and efficient cross-ministerial coordination. Indeliveringon this agenda Iraqwill have to deal with two additional challenges: (a) managing public investment and restructuring state-owned enterprises and (b) in the longer term diversifying the economy through a strong competitive industrial sector. For the private sector to become the primejob generator inIraq, critical steps to improve the investment climate include establishing clear property rights, stable regulatory frameworks, and low entry and exit barriers for businesses. Barriers to entry (time and cost o f administrative approvals for settingup a private company) are high, and access to finance i s still limited. Regulations do not facilitate the restructuring o f viable businesses or permit failing firms to close expediently, thus raising the social and economic costs o f bankruptcy. The judicial system i s slow, and enforcement unpredictable. Infrastructure is weak and impedes business activity. Corruption drives many private firms into the grey economy and discourages possibly even a greater number o f entrepreneurs, especially women, from launching their own businesses. In all o f these areas Iraq has made important first steps, but muchremains to be done. Much more can also be done to increase what the Iraqi private sector does in reconstruction. Stronger and more transparent procurement systems are needed, as are appropriate mechanisms to resolve critical market failures that hamper private-sector 4 enterprises (such as market access, information, technical knowledge, and finance). To deal with security and infrastructure needs, economic development zones can be established. Managing public investmenti s critical. Even under the private-sector development model and beyond the early reconstruction years, the government will be an important provider o f employment in Iraq during recovery. But because the government will not be able to createjobs for everyone, it needs to change from primary employer to partner increating and sustaining the opportunities for employment. The government should also finalize its diagnosis for state-owned enterprises and proceed with restructuring public enterprises. Many o f the state-owned enterprises in the tradable sector have the potential to regain profitability, even in a very open economy with substantial foreign direct investment inflows andlow import duties. Inthe longer term, strongjob creation canbe ensured only by economic diversification (particularly in services such as tourism), efficient import substitution, and export industries, since Iraq's petroleum sector does not generate thejobs commensurate with its role in the economy. Iraq faces a dilemma typical for all oil exporters: as oil revenues flow into the country, they pushup the real exchange rate and the prices o f nontradables, including labor. This weakens the ability o f domestic producers o f traded goods to compete against imports (the so-called Dutch disease). Many Iraqi entrepreneurs already complain about the flood o f cheap imports. A temptation thus arises to rebuild a highly protectionist trade system and to shield inefficient state-owned enterprises. The tradeoff is that these state-owned enterprises and protected private-sector enterprises would reduce economic efficiency. A better approach would be to diversify while maintaining an open trade regime, low price distortions, and a competitive exchange rate. Expanding the variety o f export products requires overhauling viable state-owned enterprises and encouraging new Iraqi exporters. That will take substantial time and resources, but inthe longrunwill bringmore stablejob creation and growth than Iraq's protectionist model of the 1970s. Integration into the global economy through the World Trade Organization and free trade agreements can give an additional impetusto economic diversification. Improving labor markets Iraq faces a choice in strengtheningthe performance o f labor markets: one option is to continue with large public-sector interventions; the other is to strengthen private markets to generate more jobs. An analysis o f labor markets in Iraq, undertaken with the limited data that are available, suggests that most private-sector jobs are informal and have very low productivity. With more high-paying public-sector jobs, private labor markets have lost attractiveness, while queuing for public-sector jobs has risen sharply. The government needs to address this by: (a) stimulating private-sector activity; (b) contracting out more reconstruction tasks to the private sector; and (c) moderating wage expectations inthe public sector. Active labor market programs can tackle labor market dislocations inIraq, but they need to be carefully targeted and monitored because o f their potentially high fiscal costs. To 5 cushion workers during the restructuring of state-owned enterprises, urgent measures are required, such as severance payments, retraining programs, and assistance from employment agencies and public works programs to help displaced workers reenter the job market. Women generally have a harder time than men integrating into private-sector work, and given the supply o f private-sector jobs that will be initially available inIraq- mostly male-dominated work in construction-it i s likely that women will find fewer opportunities than men. Thus, safety nets would need to recognize gender differences in determiningneed. Inthe short term, steps are needed to expand the supply of reconstructionjobs. Iraq's capital spending in the budget averaged 23 percent o f GDP in 2004-05. Most o f this investment is capital and import intensive. The labor content of reconstruction could be improved by designing employment-intensive programs, by scaling down the size o f contracts to make them feasible for local execution, and by building up the capacity o f local contractors. Increasing the local content o f purchases and encouraging growth o f sectors with strong links to the domestic economy (such as housing) would also help. Local development strategies should focus onjob creation and income generation. Reforming thepricing system In2003-04 Iraq made significant progress inprice liberalization. Most key prices inthe economy are free. At the macroeconomic level, exchange-rate policies have sought to stabilize the foreign-exchange market, and it will be prudentto continue managing it well so that domestic production inthe nonoil sectors remains competitive. Financial markets are still nascent, and interest rates will need to remain free as well. Most sectoral output prices are free. But the subsidies on several key prices-especially food, fuel, and electricity-are very large, adding up to possibly more than 50 percent of GDP. Iraq faces crucial choices indealing with these untargeted subsidies, which result inlarge fiscal costs and serious disincentives in the economy while leaving massive demand for public services unmet. Carefully planned price reforms are needed to: (a) reduce the cost to society resulting from market inefficiencies caused by government actions or market failures (so-called deadweight loss); (b) improve incentives for private-sector producers; and (c) save fiscal resources for the production ofvital public goods. Simulations using a simplifiedcomputable general equilibrium model of the Iraqi economy confirm all three points. Food prices. The Public Distribution System prevented a humanitarian crisis in Iraq during more than a decade of sanctions. Today, however, the system poses a difficult dilemma for policymakers. It i s effective in reaching the poor and guaranteeing a minimumstandard o f living, but it accomplishes this goal ina very costly and inefficient way-absorbing 21percent o f government revenue and costing about $6.30 to transfer $1 worth of food to a poor person. The dilemma i s further complicated by the fact that there are no other large-scale safety nets functioning inIraqthat could take over the role o f the Public Distribution System. Three aspects of inefficiency are particularly noteworthy. First, because the system is available to all households-not only poor households-the 6 cost is considerably higher than for a targeted safety net. Second, as a result o f rudimentary accounting, communication, and tracking systems, the Public Distribution System i s highly vulnerable to waste, theft, and corruption. Over 2004-05 the system's reliability worsened significantly: many items in the food basket are now delivered with long delays, if at all. Third, because o f its magnitude and noncompetitive procurement practices, the system has crowded out and reduced efficiency in many parts o f the food supply chain. Unfortunately, an appropriate policy response i s not easy to design: eroded private-sector capacity in food markets, absence o f a functioning banking system, and lack o f data that can be used for actively targeting the poor all restrict the options for rapid reform o f the system. Nevertheless, there are a number o f concrete steps the government can take, including: gradually introducing targeting, reducing the number o f products inthe ration basket, increasing the role and capacity o f the private sector inthe Public Distribution System and in food markets generally, and improving the procurement and financial management o fthe system. Fuelprices. Domestic fuel prices in Iraq are among the lowest inthe world. This leads to a rampant black market and fuel smugglingout o f the country; inadequate maintenance, let alone modernization or expansion o f the production, transport, and distribution facilities; and waste and overconsumption. The budget i s directly hit, since state-owned refineries cover less than halfthe domestic demand, and the government has to import the rest. Black market prices are 10 to 40 times above the official ones. Raising prices i s the most efficient way to address these distortions. Econometric simulations indicate that a sixfold increase infuel prices would lead to a 16percent decline infuel imports and a 30 percent decline inblack-market sales. Government savings would amount to about $1.73 billion, allowing for additional investmentor compensation transfers to households. The government certainly has grounds to be concerned about the pace o f price rises. The welfare impact o f price increases on the poor can be substantial, and compensation options are under consideration. International experience suggests that designing effective targeted compensation for liquid fuels is very difficult. Without a mechanism for targeted subsidies already inplace, the cost o f administering an effective targeted fuel price subsidy program could far exceed its benefits. Ideally, the policy focus should not be on the fuel sector alone but on how policies across different sectors (food, water, electricity, fuels, education, and health) are affecting the poor and how to assist them with direct income transfers to help them purchase the goods they consume. Finally, because fuels are inputs in almost all sectors o f the economy, fuel price increases need to be coordinated with policies in other sectors, especially the fuel-intensive ones, such as transport, power, and cement. Electricityprices in Iraq are also among the lowest inthe world (a fraction o f a cent per kilowatt hour). Collection rates in 2004-05 were low-30 percent or less o f the billed amounts-as distributing companies were awaiting improved security to strengthen billing and collection procedures. The negative effects o f the electricity subsidy are similar to those for fuels. The national grid i s currently unable to satisfy the demand, and Iraqis buy electricity from small, privately operated diesel generators, at a high price necessary to cover the cost o f operating these relatively inefficient sources o f electricity. 7 How fast and to what level the tariffs should be increased are critical policy issues, but not the only ones the government faces. Iraqis enjoy wide access to the electricity grid, and this should be preserved. Low-income groups connected to the grid may need subsidized access for a given period. This could take the form o f a cross subsidy built into the electricity tariff, where larger consumers are proportionately charged more than lower consumers. There i s an urgent need to improve metering, billing, and revenue collection. Service reliability must improve for the tariff hikes to become acceptable. Furthermore, to enable adequate investment allocations and optimal deployment o f capital across the industry, electricity service needs to revert to its earlier structure o f autonomous companies, away from the direct control o fthe Ministryo f Electricity. Maintaining an open trade regime An open trade regime is the key element o f Iraq's pricing system reform. In2003-04 the government took steps to liberalize its trade policy. Border restrictions on merchandise trade were removed. A uniform reconstruction levy (tax) o f 5 percent was instituted, and foreign exchange markets were liberalized. Maintaining this open regime will realize trade's beneficial impacts on job creation and growth. These effects can be direct and indirect: trade inservices can generate substantial demand for labor; open trade for goods helps keep the prices o f inputs and capital goods low for domestic Iraqi producers and thus stimulates the growth o f production. To minimize Dutch disease problems and to rebuild a diversified economy, it is necessary to ensure that the nonoil sector remains lightly taxed and has easy access to capital goods and key inputs. The effects of open trade will be maximized if it is combined with a friendly regime for foreign direct investment. This would encourage both foreign and domestic investment in the nonoil sector and significantly increase the demandfor labor. Indefiningits long-term trade policy, Iraqfaces a choice between a zero tariff and an optimal tariff, which can support broader policy objectives. An optimal tariff maximizes a country's welfare, which can be approximated by its real national income. In a nondistorted, small open economy, the optimal tariff i s zero. A modest degree o f protection (not exceeding 10 percent) from international competition can be advisable, at least for the initial period. International experience suggests that a uniform moderate rate will contribute to efficiency inthe economy while providing support for domestic value added. This i s preferable to having multiple rates for individual products, a trade regime that invites corruption and creates unnecessary distortions. A modest uniform tariff across all goods and all importers will also be a welcome sign for investors. It will reduce the cost o f capital and intermediate goods, provide access to modern technologies, simplify customs clearance and valuation procedures, and put Iraq's trade regime close to that o f its most open neighbors. The service sector, including trade in services, is likely to be the largest source o f employment in Iraq. Efficient provision o f "backbone" services (power, telecommunications, transportation and logistics, and finance) i s crucial to productivity and international competitiveness. Stimulating competition in the service sector and 8 providing access to state-of-the-art technologies and management practices-by allowing investors access to the domestic market for services-should be a central thrust o f Iraq's development strategy. A liberal regime for foreign direct investment is also essential to promoting Iraq's integration in global markets for manufacturing, agriculture, and food processing. The much-needed but technically difficult regulatory reforms in services can be supported by accession to the World Trade Organization (WTO). Iraq's application for WTO membership in 2004 sent an important signal to investors that Iraq i s willing to commit to transparent, rule-based, and liberal trade policies. WTO compatibility for domestic regulations and policies does not in itself create a high-quality institutional environment, but WTO commitments can be used to leverage domestic reforms and to integrate Iraq's economy into global markets, with wide-ranging beneficial consequences for growth andjob creation. Iraq's short-term priorities for its trade regime are rehabilitating the customs authority, maintaining product standards, and ensuring food safety. Iraq's success in agricultural and manufacturing exports hinges on enhancing the quality o f domestic products. Building the institutional capacity o f the State Standardization and Metrology Agency will be central to success. There also may be scope for near-term initiatives to bolster selected industries or commodity subsectors that have some export track record yet are likely to face difficulties gaining access to markets because o f nonconforming product quality, safety, or certification. Protectingthe poor and the vulnerable Iraq faces a choice between considerably broadening and strengthening its formal safety nets or continuing reliance on untargeted subsidy schemes and subsidized services. The choice i s imminent since large segments o f Iraq's population face unprecedented social and economic risks. About one in every ten Iraqis is now living in absolute poverty (according to best available estimates), and another one in every seven or eight i s at risk o f falling into absolute poverty. Those most vulnerable include (a) the unemployed, who make up about 30 percent of the labor force and more than 50 percent o f urban youths, (b) the legions o fdemobilized soldiers and ex-militia, (c) war victims, who have suffered disabilities or lost household providers, and (d) the refugees, displaced persons, and returnees who are resettling after conflict. Recent assessments confirm the importance o f developing social protectionmechanisms that mitigate the pains o f economic transition. Strengthening safety nets A first priority is to undertakecomprehensive household expenditure surveys to identify the Iraqipoor; these surveys are starting. The next step is to design formal safety nets and finance them ina sustainable fashion. Apart from the universal food safety net (the Public Distribution System), social protection consists o f a collection o f program interventions and providers, including 9 direct family assistance, private and charity aid, and government programs. Private and nongovernmental safety nets probably account for most o f the current social protection. The government-sponsored system has been weakened by wars and sanctions, and the cash benefits currently paid are modest, reaching fewer than 15 percent o f the needy. None o f these transfers is based on a consistent definition o f need, and leakages to the less needy are highly possible. State-sponsored institutions for disability care have been severely damaged and have inadequate supplies, and the number o f their beneficiaries is small. Reforming thepension system Simulations conducted for this study suggest that the Iraqi pension system i s financially unsustainable, despite the fact that it covers a small share o f the population. It i s also inefficient and inequitable. Only part o f these problems stems from the emergency pension policy put in place in 2003. To a large extent the problems are structural and mustbe addressedunder any circumstances: 0 The dual structure o f the Iraqi pension system leads to inequality and excessive administrative cost and restrains the efficient allocationo f labor. 0 The system i s unaffordable because it pays very highbenefits-close to 100 percent of the last salary for the average full-career worker. 0 Benefit formulas and eligibility conditions distort labor supply and savings decisions and generate adverse distributional transfers (i.e., from low- to high-income workers). 0 Current financing mechanisms can impose large costs on employers and discourage job creation. These structural problems reduce incentives to diversify the sources o f savings for retirement, particularly among middle- and high-income workers. In addition, they limit the coverage in the private sector, which is already unacceptably low. Employers systematically underreport the number o f employees to remain below the minimum at which pension enrollment becomes mandatory. Finally, the governance structure and administrative capacity o f the pension system are causes o f concern. The pension system staff needs skills to design and implement necessary reforms, and then to properly manage the reformed pension fund. Modernization o f information and payment systems i s also needed. Improvingpublic managementandaccountability The need for more accountable and transparent public management is at the forefront o f Iraq's reform agenda. The most immediate challenge is to build a legitimate state and ensure the security, basic rights, and freedoms o f Iraqi citizens. Equally pressing is to determine the size and scope o f the government and the appropriate division o f responsibilities between ministries and decentralized authorities. Other basic questions that must be resolved include, How should oil revenues be distributed? How should financial and human resources be organized and optimally deployed? And how can Iraq 10 ensure public-sector integrity? The new Iraqi constitution should address many of these issues. Managing oil revenues Iraq faces a choice between redistributing its oil revenue directly to the people and managing it through the central budget for overall development impact. Inthe short term, oil production and exports remain heavily constrained by rundown facilities and sabotage. Over the medium to long term, however, Iraq's oil export revenues can rise dramatically-provided that oil production recovers strongly. The economic performance o f oil exporters i s often inferior to that o f resource-poor countries. This may be explained by the negative impact o f oil export revenues on real exchange rates in the nonoil sector (the Dutch disease) and oil wealth on governance issues through rent-seekingbehavior. The volatility o f oil export revenues may hamper the prospects of Iraq's reconstruction program, since volatility increases uncertainty, leads to wasteful public investment in boom times, and depresses investment when oil prices are low. These effects may combine to undermine economic diversification and growth. Smoothing expenditures i s the key to avoiding any adverse economic impact from oil price volatility. Investment levels should fluctuate substantially less than the price o f oil. The government needs to determine a sustainable level of capital and current spending, based on whether the current revenue flow i s temporary or permanent and whether the expected financial and social returns justify the expenditure. Given Iraq's poverty and highunemployment, the government will find it hardto withstandthe pressures to spend and invest. Sound fiscal policy and financial institutions can help the government maintain a more stable investment strategy. The quality o f investmentmatters as much as the quantity: oil windfalls have often produced huge inefficient projects-"white elephants." To address volatility, a number o f oil-exporting countries have developed both mechanisms to accumulate foreign reserves during periods o f high revenues and fiscal rules for spending these funds. Others have introduced state oil funds, from which an annual transfer i s made to meet the needs o f the nonoil deficit in the budget. It i s important to distinguishbetween (a) savings funds, which ensure that future generations benefit from the oil wealth even after the oil deposits are depleted and (b) stabilization fimds, which are intended to achieve expenditure smoothing. InIraq, the benefits o f a savings fund or a fiscal rule appear to be limited, since the rates o f return on investment in the depleted physical and human capital are likely to be vastly superior to returns realized from the stock of financial assets that such a fund could hold overseas. Stabilization, in contrast, is a legitimate concern; it can be most effectively achieved if pursued within a unified budget framework. Hence, a stabilization fund can be virtual, intendedprimarilyto ensure that each investmentproject, once started, canbe completed. 11 Given the importance of oil revenues in the Iraqi economy, good governance in their management is crucial. Transparency i s needed in the flow o f budgetary funds, as well as inthe accounts ofthe DevelopmentFundfor Iraq' andthe nationaloil company, once itis created. Transparency and good governance help to foster a democratic debate, increase accountability, improve macroeconomic management, and enhance access to finance. Minimal standards include transparency o f the oil-sector finances; independent, credible, and transparent audits; and the involvement o f civil society. The sustainability o f any major political solution in Iraq critically depends on transparent management o f the national oil wealth. Strengtheninggovernance andpublic management Strengtheningthe budgetary framework and anchoring it ina medium-term context is the main fiscal issue now facing Iraq. In light o f Iraq's large reconstruction needs and uncertain environment, a flexible medium-term fiscal framework i s the optimal way to manage oil revenues. The budget system. Twenty years ago, Iraq's budget system was fairly efficient and robust. Elements o f this system remain, but are hampered by poor security, difficulties in communication, and nontransparent recording o f subsidies. In certain areas, such as the reporting o f fiscal data, the system appears to have deteriorated further since the war. This has degraded the government's ability to allocate resources effectively and to track spending and outcomes. Urgent reforms are needed to address the fragmentation o f the budget, to report revenues and expenditures adequately, andto ensure accountability. The new Financial Management Law (2004) established principles for strengthening the budgetprocess. However, the law does not itself provide a complete picture o f the fiscal architecture required to rebuild the budget as the primary policy instrument; getting the complete picture would require further political and administrative decisions on the appropriate roles for various institutions. A fundamental problem is budget fragmentation. There are several parallel spending plans, but virtually no coordination in their preparation or execution. Critical reforms include improving the transparency and the coverage o f the budget, so that it incorporates all significant government revenues and expenditures. It i s also important to ensure that all donor aid i s brought within the budget. The roles o f the Ministry o f Finance and MinistryofPlanninginpreparingthe budgetsfor capital andrecurrent expenditures need to be unified within a medium-term expenditure framework. Institutions need to be strengthened in all areas o f the budget cycle, and in some areas (e. g., internal auditing and the parliamentary budget and finance committee) new institutions need to be developed from a rudimentary base. New skills are needed for treasury operations, debt management, financial auditing, and many other budget activities. Clearly such reforms will take many years to design and implement, although a useful start has been made in some important areas. Public procurement. Reforming the public procurement environment i s also urgently needed, but the process will be challenging, because long-established procedures in the 12 ministries and state-owned enterprises are likely to generate inertia and resistance to change. Success will require a major training effort and supporting leadership. The lack o f adequate procurement audit practices, the absence o f a code o f ethics for procurement officers, and the widespread culture o f bribery constitute additional challenges. Strengthening records management requirements and standardizing practices for procurement are also badly needed. The most urgent action needed from government is to clarify the legal fi-amework for public procurement and enact the legal and regulatory instruments needed to support it, either by deciding to enforce the new Public Procurement Law and issuing adequate regulations or by preparing and enacting an entirely new law and suitable regulations. The establishment o f an adequately staffed procurement policy body, to be primarily entrusted with formulating the regulations and preparing the standard documents that are so badly needed, i s therefore a very high priority. Civil service. Rebuilding Iraq's civil service hinges on making changes in how its employees are organized, including (a) the statutory basis under which civil servants function; (b) the scope andcomprehensiveness of the civil service; (c) the management o f the civil service system; (d) the composition o f categories and grades; (e) the salary structure and benefits; (0 the process o f recruitment and promotion; (g) the procedures for disciplinary action and termination; and (h) the boundary between the political and administrative spheres. These issues call for early attention. In addition, the gender differences in all these areas should be addressed. Several directives from the Coalition Provisional Authority addressed various aspects o f civil service reform, but the record o f implementation was uneven. One o f the most urgent steps is to create two units with responsibility for human resource management throughout the civil service: one within the executive branch, focusing on human resource management and policy issues; the other with some degree o f constitutional independence, overseeing compliance with human resource guidelines and providing an appeals function. Inthe near term, it i s o f paramount importance that robust payroll and humanresource controlsbeput inplace to provide an accurate picture o fthe civil service and to avoid the pilferage of government resources. New human resource laws and regulations are needed to enhance meritocracy and protect workers from harassment and discrimination. Modem human resource practices are needed, including measures to strengthen the capacity of line ministries and departments to manage their staff. Eventually, issues of organizational structure and appropriate staffing levels will require attention. IntergovernmentuZJiscuZ relations. As with most countries in the Middle East and North Africa region, Iraq has a dominant central government and weak local governments. Three northern governorates are run by the Kurdish regional government and are autonomous in effect. The other 15 governorates are administrative units with no control over revenues and expenditures. The efforts o f the Coalition Provisional Authority to strengthen local governments, which were intended to prepare the ground for a democratic federation, did not build on the existing governance structures and therefore did not live up to expectations. Newly created local councils often have lacked basic 13 skills and have found it difficult to exercise authority over departments o f central government ministries, which remain in control o f service delivery. A confusing patchwork o f legislation and practice has emerged. There are no technical answers to the question o f how Iraq will proceed with decentralization: this i s typically determined by political imperatives. Decentralized governance can accommodate diverse populations; maintain national unity; empower people to support democratization; and improve the efficiency o f service delivery. The new Iraqi constitution will need to address three vital questions: Should Iraqbe a federal or unitary country? Should decentralization be symmetrical or asymmetrical (equal autonomy for all subnational units or greater autonomy to certain areas)? And how should national revenues be shared? Other key concerns are how to ensure public safety andhow to promulgate the rule o flaw. A second layer o f questions about decentralization concerns the assignment o f responsibilities to each level of government. The guiding principle would be to give responsibilities for public services to the level o f government that can discharge them most effectively. The determination o f appropriate budget transfer mechanisms and local tax bases would follow. Given the predominance o f oil revenue, intergovernmental transfers will remain the main source o f financing for local governments. If they are responsible for delivering public services, they must be able to finance them. Finally, institutional arrangements need to be developed to define accountability and incentive frameworks for each level o f government. Corruption. Corruption is widely perceived to be significant in Iraq. To combat it, the government launched several initiatives: the independent inspectors general within individual Iraqi ministries, the new Commission on Public Integrity, andthe revival o f an existing Supreme Board o f Audit. The inspectors general were authorized to perfonn a variety o f functions, including auditing all records and activities o f the ministry; conducting administrative investigations against any ministry official, including the minister; auditing the economy, efficiency, and effectiveness o fthe ministry's operations; and reviewing any ministry systems for measuring performance. The Commission on Public Integrity was charged with the criminal investigation o f corruption cases and violations o f the code o f conduct. However, these new institutions have not yet taken root, and their impact i s uncertain at this stage. To succeed in anticorruption efforts, Iraq must (a) strengthen its legal and regulatory framework; (b) develop strong accountability institutions; (c) support prevention within individual agencies; and (d) enhance public opinion and awareness. Note The Development Fundfor Iraq(DFI)was established pursuant to UnitedNations Security Council Resolution 1483 and holds the proceeds o fpetroleumexport sales from Iraq, as well as remaining balances from the UNOil-for-Food Programand other frozen Iraqi funds. Disbursements from the DFImustbe used for the benefit of the Iraqipeople. It i s directed by the Iraqi interim administration. See www.iamb.info. 14 Chapter 1.Recent developmentsand chalIenges ahead Iraqi recovery and reconstruction is progressing at a much slower pace than expected. The economy imploded inthe 2003 conflict, with nominal gross domestic product (GDP) hittinga low of $12 billion. In2004, GDP recovered to an estimated $25.7 billion, and income per capita rose to about $948 (figure 1.1 and table 1.1). Almost all growth has been in the oil sector, propped up by unusually strong world oil prices. Oil production, however, has not risen above prewar levels, and other basic services, such as electricity, remain too disrupted to support strong economic growth (figure 1.2). Although the nonoil sector surged in late 2003 and early 2004, it has slowed sharply since then. GDP per capita remains less than a third o f what Iraq enjoyed 25 years ago, before the economy began its decline. Recovery has generated few jobs; unemployment and underemployment are pervasive. Figure 1.1. Iraq's gross domestic product and value of oil exports, 1997-2006 Oil exportsare recovering and driving GDPgrowth. (US$,billion) 35 30 25 20 15 10 5 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 &8 GDPat market prices &8 OilExports Note: Data for 2004-05 are preliminary estimates. GDP estimates are prone to significant errors, because o f the multiple exchange rates and pricing regimes that existed prior to 2004. Source: World Bank and IMF staff estimates; InternationalEnergy Agency 1999. 15 Figure 1.2. VuInerabilityof the oil and electricitysectors in Iraq Electricity supply is inadequate.. . ...while oil output remains belowprewar levels Hours of electricity available daily Thousands o fbarrels a day 000 I -Production 500 000 600 DO0 F-04 A-04 J-04 A-04 0 0 4 D-04 F-05 A-05 J-05 A 4 5 0-05 D-05 F-06 M- D- J- F- S- A- N- J- J- A- M-0- M- D- 98 98 99 00 00 01 01 02 03 03 04 04 05 .05 Source: Brookings Institution, various dates; International Energy Agency 1999; World Bank staff estimates. The state-controlled oil and gas sector dominates the Iraqi economy, accounting for about two-thirds o f GDP and almost all o f exports and budget receipts (excluding grants). Its recovery from the total halt in mid-2003 remains weaker than initially expected. Oil production and exports in2004 and 2005 were at about 2 million and 1.4 million barrels per day, respectively, still below the 2000-01 levels, which themselves were about a quarter below the peak levels reached in late 1970s. Oil revenues in 2004-05 exceeded the projected levels only because o f very strong world oil prices. Rundown facilities, which were starved of investment for 30 years; extensive looting inthe wake o f the 2003 invasion; and persistent sabotage have all hindered productivity. The short-term outlook for significant rise in oil production and exports is very uncertain. Maintaining even the current levels of production would require annual investments o f $1 billion to $1.5 billion; boostingproduction further calls for much larger investment. 16 Table 1.1. Selected economic indicators for Iraq, 2002-05 2002 2003 2004e 2005e Economic growth and prices Nominal GDP (US$ million) 18,970 12,602 25,724 33,182 Ofwhich non-oil GDP (% o f GDP) 33.4 33.1 32.5 38.0 Real GDP (% change) -7.8 -41.4 46.5 2.6 Of which non-oil GDP (% change) 0.2 -40.2 14.9 8.0 GDPper capita (US dollars) 743 479 948 1189 Oilproduction (million bpd) 2.01 1.29 1.84 2.20 Oil exports (million bpd) 1.29 0.90 1.38 1.70 Consumer price index (% change) 19.3 34.0 31.7 32.8 National accounts (percent of GDP) Gross domestic investment 26.5 29.1 Of which public 22.3 25.6 Gross domestic consumption 97.1 95.4 Ofwhich general government 56.3 59.6 Gross national savings -10.2 14.7 O fwhich public - - -39.1 14.6 Fiscal and oil sector accounts (percent of GDP) Revenues and grants - - 80.0 93.6 Ofwhich oilrevenues 50.3 69.6 69.6 67.8 Ofwhich foreign grants 0 0 9.2 23.2 Expenditures 120.6 104.5 Operating expenditures 98.3 78.9 Of which Public Distribution System 18.6 8.4 Ofwhich salaries andpensions 12.1 17.7 Capital expenditures 22.3 25.6 Overall fiscal balance (including grants) -40.5 -10.9 Overall fiscal balance (excluding grants) - - -49.8 -34.1 Balance of payments (percent of GDP) Current account balance - - -36.8 -14.4 Trade balance -0.6 0.2 -7.0 -4.9 Merchandise exports 51.2 80.0 69.1 68.7 Ofwhich oil 50.9 67.1 67.4 66.8 Merchandise imports 51.8 79.8 76.2 73.6 Ofwhich OFFP 13.6 5.8 Ofwhich refinedoil products 10.3 10.3 Income and services (net) 37.5 30.8 Transfers 7.8 21.4 Financialaccount 42.1 18.6 Foreign direct investment 0.8 0.9 Other capital (net) 41.4 17.7 Overall externalbalance 6.1 4.7 Financing -25.3 -4.2 Central Bank reserves (increase -) -24.6 -4.2 Net change in arrears (decrease -) -135.9 -84.3 Debt forgiveness 135.2 84.3 External public debt' Estimated debt stock (US$billion) - 125.0 78.2 51.2 I n percent of GDP - 992 304 154 I n percent of exports - 1240 440 225 17 Memorandum items Population(millions, mid-year) 25.5 26.3 27.1 27.9 Oil prices (US$ per barrel)2 20.5 26 31.6 43.1 Gross reserves inmonths o f imports - 1.3 3.2 3.1 Exchange rate, IDper US$1 (period average) 1957 1957 1455 1467 Notes: 2004-05 data are preliminary estimates; - is not available. 1. Debt data assume full application o f the first (2004) and second (2005) tranches o f the Paris Club debt rescheduling agreement by the dates stipulated by the Pans Club, and o f comparable treatment by other creditors, but not the thirdtranche o f debt relief. 2. Iraqi oil blends (Basra light, Kirkuk)are traded at a discount which reflects their lower quality and frequent supply interruptions. I Sources: IMF and World Bank staff estimates, COSIT. Trade: UN Comtrade reported by partner countries. Oil: International EnergyAgency. Security and recovery Risingviolence continues to weigh heavily on socioeconomic revival. The incidence o f conflict in Iraqinthe past two decadeshas been three times as highas inthe Middle East and North Africa region as a whole, which itself has one o f the highest incidence o f conflict inthe world. As a result, Iraq incurred enormous losses to its social and physical capital. While formal war stopped fairly quickly, the incidence o f violence has increased since late 2003 and i s not abating (figure 1.3). Criminal activities (kidnappings, robberies, murders, etc.) are rampant as well. Baghdad, for example, records an average o f 90 crime-related murders per 100,000 residents every month-three times higher than in most major cities inthe world. Many aid organizations andprivate companies continue to work out o f neighboring countries. While the insurgency is most intense inthe centre o f Iraq, attacks occur in all major cities, indicating that no part o f the country is beyond the reach o f hostile elements. The level o f violence in Iraq remains much worse than that in postwar Afghanistan or Bosnia and Herzegovina. In Afghanistan, civilian deaths were very few after the end o f the war, and cumulative foreign troop fatalities were about one- tenth o f those in Iraq. Bosnia and Herzegovina saw almost no violence following the Dayton Peace Accord in December 1995 and the deployment o f international peacekeepers. 18 Figure 1.3. Iraq's security situation, 2003-05 Violencehas continued. Reported civilian deaths Attacks on oil infrastructure and personnel (left scale) (right scale)- 1000 1414/I 1 40 800 30 600 20 400 10 200 0 Jun-03 Oct-03 Feb04 Jun-W Oct-04 Feb05 Jun-05 Oct-05 -+Reported cidlian deaths +Attacks on oil infrastructure and personnel Source: IraqPipeline Watch, IraqBody Count; and Brookings Institution, various dates. Studies o f other conflict situations indicate a strong inverse relationship between violence and economic recovery (Putnam 2000; Keefer and Knack 2001). In Bosnia and Herzegovina annual GDP growth averaged some 62 percent in the early postwar period (1996-97). GDP per capita more than doubled from $546 in 1995 to about $1,300 in 1997, and social services and school enrollment improved sharply. InAfghanistan, three years after the cessation of war, annual real GDP growth averaged about 20 percent, and per capita GDP nearlydoubled (from$123 to $200). InIraq, incontrast, oil has propelled real GDP growth to 47 percent in 2004, but in 2005 real growth slumped to less than 3 percent. Economic activity in the nonoil sectors remains weak. Violence and corruption severely disrupt trade and investment flows and eat into reconstruction spending. Donor agencies and contractors report security and insurance outlays at 25-40 percent o f the total cost o fworks. Since early 2004, there has been an exodus o fwealthy Iraqis andtheir capital abroad.' Foreign banks that had secured licenses to operate in Iraq have yet to enter the country. Regional obstacles to recovery. Regional disparities in security affect the strength of recovery. While the KurdishNorth has also seen violence inthe past two years, its levels were lower than in rest of the country, and much lower than in the Central region. Not surprisingly, nonoil economic activity was consistently stronger in the three Northern governorates (Arbil, Dohuk, andSulaimaniya) than inthe rest o f Iraq. As a result, median incomes in the three Northern governorates were estimated in 2004 to be 20-25 percent higher than in the rest of the country. A substantial labor migration from the Central region to the North i s reported, driven by better security and higherprivate-sector wages. 19 Iraq's social fabric remains very fragile. High unemployment, widespread poverty, and weak social protection systems are some o f the problems confronting the society. Although reliable data on poverty incidence and other socioeconomic trends are spotty or absent (box 1.l), surveys undertaken in 2003-04 suggest that the incidence o f absolute poverty in Iraq may be as high as 10 percent." Both monetary and nonmonetary aspects o fpoverty have increased dramatically inIraq. As a result, over the past 20 years Iraq has moved away from the targets specified in the MillenniumDevelopment Goals (box 1.2). The number o f widows and orphans, war wounded, and disabled grows by the day, the social exclusion o f these large vulnerable threatens the fragile democracy and the reconstruction process. Apart fi-om the universal Public Distribution System, formal safety nets cover less than 15 percent o f the population and face an imminent fimding crisis. The employment situation is precarious, with more than 2 million unemployed- almost 30 percent o f the workforce (ILO 2004; COSIT 2003). Unemployment among young urban males i s twice as high, and women's labor participation is low even by r regional standards. Box 1.1. Data quality issues inIraq Evaluating Iraq's socioeconomic trends remains complicated by the lack o f data. The Center o f Statistics and Information Technology (COSIT) in the Ministry o f Planning and Development Cooperation i s the leading government agency responsible for the production o f nationwide data. COSIT has been working closely with the UnitedNations and other international agencies to meet the data needs o f the government and the donor community. Elsewhere inthe government, statistical capacity remains sparse. Even basic data such as population i s wanting in reliability and timeliness. The most recent census was held in 1997; population trends for later years are estimates. Recent surveys produced population estimates that differ by as much as 5 percent o f the total. It is particularly hard to estimate the numbers of refugees, internally displaced persons, returning exiles, and other vulnerable groups. This paucity o f data affects the estimation o f development indicators and the MillenniumDevelopment Goals. Information on household incomes and poverty i s also scarce. Price and monetary data are reported regularly, but balance-of-payments and fiscal data remain incomplete. The coverage o f COSIT's price indexes i s unclear, as information from regions other than Baghdad i s very unreliable. Very little information is available about the nonoil sector. Because communication with many parts o f the country i s very difficult, information on local economic trends is problematic. International assistance for recovery. The international donor community mobilized to support the rebuilding o f Iraq. UN Security Council Resolution 1483 (May 22, 2003) called for the international donor community to assist the people o f Iraqinreconstruction. A conference of donors, meetinginMadridinOctober 2003, pledgedabout $32 billion in grants and soft loans to Iraq reconstruction. This amount included bilateral assistance programs and the donor governments' contributions to the International Reconstruction Fund Facility for Iraq (IRFFI), designed by the World Bank and the UNDevelopment Group. IRFFI, hnded in the amount o f about $1 billion, not only helps donors channel their resources, but also assists the coordination of national donor programs. RFFI encompasses two trust funds: the Iraq Trust Fund, administered by the World Bank, and the UN Development Group Iraq Trust Fund (UNDG Trust Fund), administered by the United Nations. IRFFIis reviewed every six months at the Donor Committee meetings, 20 the most recent of which was hosted by the government of Jordan in July 2005. Reconstructionprojects are identified and approved by an interministerial body, the Iraqi Strategic Review Board. InDecember 2004, Iraq formally requested fimding from the World Bank's International Development Association (IDA). Following detaiIed discussions between the Iraqi authorities and the World Bank, a strategy was developed to define the uses o f an exceptional IDA allocation of $500 million. The strategy also provides the framework for additional funds channeled through the World Bank Iraq Trust Fund. The Board of Directors o f the World Bank approved the strategy on September 15, 2005, and by end- 2005 the first IDAproject was approved. A similar strategy governs the use o fthe UNDG Trust Fund in 2005-07. Actual aid disbursements and their reconstruction impact have been much lower than expected, because o f the extreme security risks. Security costs consume 25-30 percent o fthe total o freconstruction assistance. Box 1.2. Iraq and the MillenniumDevelopmentGoals Economic dislocation has led to major deterioration in Iraq's human development indicators, many o f which were superior to averages in the Middle East and North Africa region just two decades ago. N o official review o f Millennium Development Goals has been issued inIraq, but the country's ability to attain most of these goals appears highlyuncertain at this time. Goal I: Eradicate extreme poverty and hunger. Reliable data on poverty are unavailable, but estimates based on recent surveys suggest that the incidence o f absolute poverty can be over 10 percent, with a further 12-15 percent o f the population close to the international absolute poverty line o f $1 per day. Up to 60 percent o f the population is dependent o n the food ration system. Goal 2. Achieve universalprimary education. By 1980, Iraq had aclueved near universal primary school enrollment. Gross enrollment inprimary school remains high at 102 percent. (Gross enrolment can exceed 100 percent because some children begin school early or repeat grades.) Secondary school gross enrollment, however, dropped from 47 percent to 36 percent. The attendance rate remains highat 93 percent, but i s lower for girls inrural areas (86 percent). By mid-2003, some 12,000 schools were inneed o f repair; so far, some 3,000 schools have beenrehabilitated, with repairs under way inanother 1,500. Goal 3: Promote gender equality and empower women. In 1985, Iraq's ratio o f girls to boys in primary and secondary education was comparable to the Middle East and North Africa regional average of 72 percent. Whle the regional ratio improved steadily to reach 95 percent in2000, Iraq's ratio only increased to 76 percent (in 1999). The ratio o f young literate females (ages 15-24) to males is 50.1 percent, compared with 60 percent inYemen, and 100.3 percent inJordan. The gender distortion i s worse inrural areas. Goal 4: Reduce child mortality. During the 1970s and1980s, key health indicators steadily improved; since 1990, however, they have deteriorated sharply again. Mortality o f children under five years old reached 115 per thousand in 2003 (33 inJordan, 107 inYemen) and is twice as high inthe South and Central regions o f the country as it is inthe North. Infant mortality has increased by 2002 to 102 per thousand live births (105 in Sub-Saharan Africa). It i s believed that the majority o f infant deaths are due to diarrhea as a result o f poor water and sewerage quality and overcrowding. The incidence o f the most important vaccine-preventable disease, measles, has declined since vaccine coverage improved in the 199Os, but in the North the disease is still the third most common cause o f death among children five and younger. Goal 5: Improve maternal health. Maternal mortality i s extremely high at about 300 per 100,000 live births (compared with 41 inJordan and 350 inYemen). The share o fbirths delivered without trained assistance in2000 was about 28 sercent nationwide and close to 40 sercent inrural areas. 21 Soal 15: Combat HIV/AIDS, malaria, and other diseases. Typhoid, cholera, and malaria are endemic. In the center indsouth o fthe country the situation remains critical, with 20 percent ofthe population at risk from lack o f access to safe water and sanitation. The reported incidence o f tuberculosis (at 132 per 100,000 o f population) is markedly iigher than in neighboring countries. Iraq is categorized as highly vulnerable to HIVIAIDS, but no reliable data are wailable to support this rating. The registered number o f cases o f HIViAIDS i s low (about 250); however, risk factors are present for increasedrates o ftransmission. Goal 7.Ensure environmental sustainability. Destruction and deterioration o fkey ecosystems and habitats, including waterways, forests, and marshlands, are widespread. Access to improved drinking water sources has declined over the past two decades and stands at 81 percent-below the regional average o f 88 percent. Emissions from the rapidly growing and often obsolete vehicle fleet and open burning o f solid waste cause major air pollution. Attacks on the oil infrastructure lead to oil fires and serious air pollution over vast areas. Untreated hazardous and municipal waste accumulates as a result o f fighting, while no appropriate sanitary landfills exist. Goal 1 :Eradicate extreme povertyand hunger Goal 2: achieve universal primary 14 , education 4 - 2 0` ," b 5 7 1991 2004 2015 a s z 1990 2004 2015 Goal 3 :promote gender equality and empower women Goal 4: reduce child mortality , /- 6 -vl - 0.75 U -k c o 1990 2004 2015 1990 2003 2015 1 1 1 1 - `progress made 0 benchmark goal progress neededto achievethe goal 0 mostrecent 22 Progress on policy and institutional reform Early on, the authorities made progress on a variety o f policy and institutional reforms. Most reforms undertaken in 2003-04 were concerned with new legislation and institutional changes: establishing a modern central bank; enacting commercial banking and anti-money laundering laws; liberalizing trade; promulgating laws on public finance, audit, and procurement; liberalizing bankruptcy and company laws; and establishing interministerialcommissions on reconstruction, privatization, oil, and economic reform. Fiscal and monetary policies. Upholding its independence under the 2004 law, the Central Bank o f Iraq did not provide any new lending to the government. The Central Bank also successfully introduced the new Iraqi dinar in early 2004. Since then, and in line with its policy o f securing exchange-rate stability, auctions were used ineffect to peg the dinar's exchange rate to the US. dollar. Since then and until late 2005 the exchange rate premiumsbetweenthe street market and the auction rates remained low. Base money grew by 117 percent in 2004, reflecting rapid remonetization of the economy. This growth, however, was largely mirroredby the accumulation o f foreign exchange reserves, which were equivalent to 3.2 months o f merchandise imports by end-2004. Although fiscal and monetary policies have generally been prudent, pressures on the exchange rate emergedin Spring 2005, as the daily demand for currency more than doubled, probably as a result o f private-sector capital flight. The accumulation o f reserves has slowed significantly. Trade policies. Important steps have been taken to liberalize Iraq's external trade. Restrictions on trade were cancelled, and imports were subsequently subjected to a uniform reconstruction levy o f 5 percent, with broad exemptions granted to imports o f many humanitarian items. A national committee has been established to design a rules- based, transparent, and stable foreign trade regime that meets requirements o f the World Trade Organization. These measures are intended to remove price distortions, increase competitiveness, and enhance the efficiency o f the Iraqi economy. Iraq has gained an observer status in the World Trade Organization, and in December 2004 submitted a request for full membership. International finance and debt. Iraq is reintegrating into the international financial system. The International Monetary Fund and the World Bank determined in July 2004 that they could work with the interim Iraqi government (2004-05) as the legal government o f Iraq. The Iraqi authorities moved promptly to adopt their first IMF- supported stabilization framework, the Emergency Post Conflict Assistance Program, which opened the way to the normalization o f external public debt. The outlook for debt sustainability was much improved by the highly concessional debt rescheduling granted by the Paris Club in November 2004. It envisaged the write-off o f 80 percent o f sovereign debt in three phases: (a) an immediate cancellation o f 30 percent o f the debt stock; (b) a further 30 percent reduction upon approval by the IMF o f a Stand-by Arrangement, which took place on December 23, 2005; and (c) a final tranche o f 20 percent upon completion o f the IMF Board review o f the third year o f the Stand-By Arrangement, expected no later than December 31, 2008. The remaining debt stock i s 23 being rescheduled over 23 years, with a 6-year grace period. By end-2005 Iraq has already signed implementation agreements with most individual Paris Club countries. It also seeks comparable treatment"' o f its debt owed to other external public and private creditors (figure 1.4). Several non-Paris Club countries have granted debt relief on terms comparable to Paris Club countries. However, progress has been very slow on renegotiating debt with GCC countries. Assessments indicate that debt sustainability would be achievable only if all three tranches o f debt relief were provided in full and if other creditor groups granted comparable treatment. Under an optimistic scenario for oil prices and production, Iraq's debt-to-GDP ratio will fall below 84 percent o f GDP by 2010, while the ratio of debt service to exports will decline to a manageable 6-8 percent by the end of the current decade. However, should oil production plateau at 3 million barrels per day and/or oil prices weaken, the debt-to-GDP ratio will remain above 100 percent until 2010. Debt-service payments are projected to remain low-under 1percent o f GDP until2010. Figure 1.4. Iraq's external public debt at the end of 2004 Governments outsidetheParis Club hold about half of Iraq's debt. Multilateral c o r n - 1 cia1 10.57 I ParisClub 23.8 Nor Club Note: Amounts outstanding reflect the first tranche o f debt relief grantedby the Pans Club in2004 and full comparable treatment. Source:World Bank and IMF staff estimates. Development strategy. In October 2004 the Iraqi government presented to the donors its first National Development Strategy, which outlined long-term priorities for reconstruction and reform. The strategy document was further updated by the transitional Iraqi government inJuly 2005. The strategy document offers a vision o f economic revival drivenbyprivate enterprise and guaranteed by a strong and transparent public sector. The strategy recognizes that the Iraqi economy could not function well if price incentives were distorted, and charts a reform of the subsidy system, supported by strong formal 24 social safety nets to protect the poor and the vulnerable. The strategy seeks to establish a strong governance system in Iraq to foster fair and accountable institutions, with a particular focus on integrated budgets, strong public financial management, and a degree of fiscal decentralization. With regard to private enterprise, the strategy calls for an enabling investment climate, which will lower entry and exit barriers, and a strong legal and judicial system. The financial system is to be reformed to offer equitable access to finance for all businesses, public and private. The state will lead the rehabilitation o f social services and infrastructure to ensure the supply o f skilled labor and vital services. The strategy also discusses a course toward diversification, with decreasing dependence on oil exports. The National Development Strategy was welcomed by the international donor community, but has not gone far enough inoffering meaninghl sector strategies or reconstruction priorities. Foundationsof security and cohesion Learning from other recoveries. One of the most important lessons from other postconflict episodes i s that recovery hinges on the degree o f cooperation and cohesion reached by the different sociopolitical groups. An analysis o f the postconflict recovery paths in ten countries conducted for this study suggests that success in reconstruction depends on the degree to which social consensus emerges on the priorities andtradeoffs o f the reform process (figure 1.5). The analysis identifiedtwo archetypes o f postconflict evolution: (a) countries that manage to achieve reasonable cohesion and cooperation through domestic and external political bargaining, which produces sustained economic and social progress and (b) countries that remain mired in deep divisions and are thus unable to make headway for extendedperiods o f time. Over the first postconflict decade, countries that develop a cohesive reform strategy outperform those that are unable to develop such a consensus by about 50 percent interms o f GDPper capita. 25 Figure 1.5. Patterns of recovery from shocks and conflicts Countries with a cohesive postconflict strategy outperform those unable to develop consensus. A Tale of Two Archetypes--Patterns of Recovery from Shocks and Conflicts 140 130 120 b : 110 .-P100 CI 90 2 ao 70 60 50 1 2 3 4 5 6 7 8 9 1 0 1 1 Years After Shock Note: Trends are based on the experience o f ten countries: Algeria, Angola, Bangladesh, Bosnia and Herzegovina, Bulgaria, Hungary, Korea, Indonesia, Iran, and Jordan. Source: World Bank staff estimates. Rodrik (1999) arrives at a more generalized conclusion from the examination o f growth experience in a larger sample o f countries during 1960-89. H i s study suggests that many partso fthe world, especially inLatinAmerica, the Middle East, and Sub-Saharan Africa, have suffered large collapses in long-term growth when faced with shocks or conflicts, because they lacked internal institutions or settings to resolve the distributional conflicts that such shocks gave rise to. H e suggests that "when social divisions run deep and institutions o f conflict management are weak, the economic costs [of shocks from conflict-] are magnified by the distributional costs that are triggered"(p. 385). There is little doubt that such risks are currently high in Iraq. Yet, many countries with cleavages along lines o f wealth, ethnic identity, geographic region, and other divisions have done very well in post-conflict situations-a trend most clearly,evident earlier in East Asia (Indonesia, Korea, Malaysia, Singapore) and in more recent settings elsewhere in South Asia (Sri Lanka), Latin America (El Salvador, Guatemala), and Eastern Europe (Bosnia- Herzegovina). Two main lessons emerge. First, citizens, groups, and their political representatives can make a striking difference to their welfare andthose o f their children by showing a greater willingness to work out a cohesive approach to the future. Second, this effort o f cohesion needs to be reinforced by clear objectives and a supporting framework o f government policies. Both lessons are eminently feasible to implement and will deliver rapid recovery in economic and social conditions. Much will depend on the ability o fthe Iraqis themselves to fashion such a prospect. 26 Restoring law and order. In any conflict situation, the most critical condition for economic recovery i s the end o fviolence and insecurity. Inthe case o f Iraq, the two main strategies for ending violence and insecurity are: (a) building up the internal security and law enforcement institutions, so that the government is able to uphold law and order and (b) strengthening a representative form o f government, so that differences are resolved through debate, representation, and contest in the political sphere, rather than in violent political conflict and confrontation. Inboth o f these respects, progress i s being achieved, with the enlargement and training o f the Iraqi national security forces and with two rounds of national elections and the constitutional referendum in 2005. The immediate and critical task i s to reintegrate combatants into the civil society. Successful postconflict experiences (Bosnia and Herzegovina, El Salvador, Guatemala) indicate that essential steps include providing ample civilian jobs, training, and social and economic opportunities for former combatants (as well as disarming them). The development consequences of these actions can be enormously positive, but they are expensive to design and implement. Finding the mechanisms to stop the violence in the specific circumstances o f Iraq is a difficult challenge, but one that needs to be met. A representative political system that gives a voice to all stakeholders in the society allows grievances to be resolvedthrough negotiations andcontestable elections. This task acquires particular importance in resource-rich economies, where the potential or actual flows o f revenue from abundant natural resources can transform the political process into a competition for access to that revenue. In countries as diverse as Angola, Colombia, Indonesia, Nigeria, and Venezuela, natural wealth was the most powerful driver o f conflict. Working out a political solution and ensuring the restoration o f law and order are thus the highest priorities. Without achieving these markers o f social cohesion, reconstruction and development will not happen. Sustainable political solutions demand the transparent management of national wealth. Corruption and the lack o f accountability will fracture political stability anddoom reconstruction. The three main challengesahead Assuming that the process of reversing the violence gains credibility and restores the basic functions of representative government, the reconstruction o f Iraq is likely to be shapedbythree main challenges: e Generating growth and employment. Key objectives for the recovery are reconstructing war-ravaged infrastructure, laying the economic foundations to generate faster and more efficient economic growth in all sectors, and giving Iraqi citizens access to an increasing number o f productive jobs. Specific reforms to meet these objectives include improving the price and incentive systems, liberalizing trade, and strengthening labor market policies. The goal is to achieve an economic transformation from state domination to private entrepreneurship, from a closed to open economy, and from oil dependence to diversification. 27 Protecting the poor and the vulnerabze. Another major objective for the recovery i s ensuring that poor and vulnerable social groups have access to vital services and to gainful employment opportunities. Specific reforms include shifting from universal and untargeted subsidies to strong formal safety nets, thus ensuring social safety for the poor and vulnerable and dealing with the costs o f economic transition as prices are freed. Many victims o f conflicts and postconflict tensions will not regain fbll productivity and will crucially depend on some form o f social support. Opening up the economy is already hurting the poor and needs to be mitigated by efficient and targeted safety nets, as well as reform o fold pensionsystem. Improving public management and accountability. The recovery also depends critically on building more accountable institutions and transparent management o f public resources, especially oil. These reforms will amount to a transition from closed to open and accountable public finances. Another important aspect o f improving public management focuses on delivering public services more efficiently and responsively. These reforms signify a transition from top-down to more decentralized and participatorypublic services delivery and institutions. All three challenges need to be met simultaneously to ensure that an increasingmajority o f citizens share ina vision o f ajust andprosperous Iraq and to permit the government to undertake an ambitious transition programthat lies ahead. Redefining the role of the state Meeting each o f these three challenges requires a departure from previous role o f the state in Iraq. The government will remain central to the reconstruction task, but substantivelyits role is likely to be very different from what is was in the past or from what is traditional for many Middle Eastern and North African countries. In the first postconflict stage the state plays the crucial role in creating jobs, rebuilding the human andphysical capital of the country, and restoringpopulation's access to vital services. In the long term, however, the state-led model cannot provide sufficient economic dynamism andjob creation. Ineconomies as diverse as Chile, China, India, and Russia, the state's role has evolved over the past 20 years to providing only essential public goods (of which law and security are the key ones), fostering a transparent and predictable business climate, and stamping out corruption. Inpostconflict environments as diverse as South Korea in the 1950s, Vietnam in the 1980s, and Bosnia and Herzegovina inlate 1990s, most o fthe newjobs were created byprivate entrepreneurs. The rest o f this report discusses actions that Iraqi authorities may wish to consider in addressing the three reconstruction challenges. Chapters 2 and 3 propose ways to generate growth and employment. Chapter 2 discusses the immediate challenge o f reviving the economy and creating morejobs, and chapter 3 considers the realignment o f economic incentives and the pricing system. Inexamining how to best protect the poor and the vulnerable during recovery, chapter 4 addresses the issues o f strengthening formal social protection and reforming the pension system. Then chapters 5 and 6 investigate options for improving public management and accountability. Chapter 5 28 discusses the investment regime and oil revenue management. Chapter 6 examines overarching public governance concerns, including public finance and human resource management, intergovernmental fiscal relations, and anticomption efforts. The pace and sequence o f reform actions will need to be considered carefully. All postconflict societies are by definition fragile, and achieving social consensus in support of the reform program is essential for its success. Incentive reforms to change prices need to be expertly calibrated: some reforms are likely to proceed faster than others, so as to achieve quick returns while not hurting the socially vulnerable groups before adequate safety nets have been established. Actions to strengthen safety nets must take into account their short- and long-term costs, so as to maintain fiscal sustainability-a particularly vital concern for the high-debt situation Iraq finds itself in today. Effective public resource management is also central to delivering and prioritizing key social and infi-astructural services. The menu o f actions will obviously need to be tailored carefully to Iraq's unique situation and circumstances. Notes i Friedrich Ebert Stiftung (2005) estimates that $2 billion o f Iraqi capital entered Jordan in2003-04; over the first eight months o f 2005, another $2 billion entered Jordan. Iraqis accounted for over half o f all Amman property purchases by nonresidents in 2003-05. As a result o f this demand, Amman property values more than doubled over two years. Usingthe international poverty line o f $1per day. Iraqhas neither a national poverty line nor a national report o n the Millennium Development Goals. The estimates o f poverty in Iraq are preliminary, as collection o fpoverty data isjust beginning. ... 111This does not reflect comparable treatment o f non-Paris Club debt in the first tranche of debt relief, which is conditional. Ifthe first tranche o f debt relief were applied to all bilateral and commercial debt, the end-2004 debt ratio would have declined to 306 percent. The Paris Club Agreed Minutes include a clause of "comparability o f treatment," which aims to ensure a balanced treatment among all external creditors o f the debtor country. According to this clause, the debtor country commits itself to seek from nonmultilateral creditors, notably other official bilateral creditor countries that are not members o f the Paris Club and private creditors (mainlybanks, bondholders, and suppliers), a rescheduling on comparable terms to those negotiated within the Agreed Minutes. 29 Part I.Generatinggrowthand employment Chapter 2. Creatingjobs and rebuildingservices Iraq's reconstruction needs are enormous and are likely to generate massive labor demand. Reconstruction i s driven by the need to rebuildthe country's depleted physical and social capital. Thirty years ago, Iraq led the Middle East and North Africa region in social development indicators; since then many o f these indicators have declined to the levels characteristic for the low-income countries. Access to infrastructure services is nominally high (e. g., almost universal connection to the national electricity grid; 83 percent access to an improved water source), but the quality o f these services has declined dramatically inthe past decade. In2004, 85 percent o f households had unstable electricity supply-the national grid supplies 3-6 hours o f electricity daily. A mere 20 percent o fhouseholds have safe and stable drinkingwater. While reconstruction and associated public-sector jobs are important in the initial phase o f Iraq's recovery, they will not create a sufficient number o f jobs to meet the population's needs inthe long term, even ifrecovery i s on a massive scale. The private- sector job engine must be engaged to meet the demand, and it needs equal prominence from the beginning. Many countries in Middle East and North Africa region and elsewhere in the world tried to create jobs by applying a statist industrial strategy. This was the case o f Iraq in the 1970s. In the long run, the experiences have been disappointing. Instead, a successful growth model must equally rely on the entrepreneurial talents o f the nation and on the state as the provider o f key public goods, such as the rule o f law, the appropriate regime for trade and investment, and the safeguards o f strong social safety nets. Labor market conditions and outlook Iraqhas a highpopulation growth rate, a very young population, and a substantial growth rate for its labor force-2.4 percent per year. Every year, 170,000 new workers enter the labor market (ILO 2004).' The outlook i s for continued rapid growth o f labor supply: population growth will remain high, as declines in fertility are likely to be offset by the much-awaited improvements in maternal and children's health. Inthis respect, some o f the features o f Iraq's labor market are similar to other labor-abundant Middle East and North Africa countries, such as Algeria, Iran, and Syria. Some lessons learned by these countries could apply to Iraq. The demand for labor i s currently too low to absorb all new entrants and the existing unemployed. Conflicts and economic decline have destroyed vast number o fjobs inboth formal and informal sectors." Already before the 2003 invasion, employment inlarge and medium enterprises was about one-third less than in 1985-89. As for the small (family- based) enterprises, the Iraqi Federation o f Industries, which unites small artisan-type family firms, reported in 2004-05 that out o f some 30,000 members barely 4,000 were active. As a result, Iraq has one o f the highest unemployment rates in the region-close to 30 percent (figure 2.1). Among the urban youth, more than half are unemployed. Iraq 30 also has very highunderemployment (over 23 percent); its female labor participation rate (13 percent) is low evenbyMiddle East andNorthAfrica standards. Figure2.1. UnemploymentinIraq, 2004 Iraq's unemployment is among the highest in the region. .. ...and Iraqiyouth is the most vulnerable to it. mRl1 n Algena7 80 70 Morocco 60 50 40 30 Syna 20 Lebanon IO 0 5 Youth 10 15 20 25 30 LaborForce Fnpbyed,% Unenpbyed,% Unenpbyed, % participation Worldng age ofLaborForce of Worldngage Unenpbymnt percentof labor force Population population (15-24) IFemle 0Male Source: ILO (2004)'; World Bank staffestimates. Analysis o f other episodes o f conflict indicates a very strong reciprocal relationship between the lack of security and high unemployment (World Bank 1998 and 2003b). Although 25 years o f conflict and isolation have greatly exacerbated Iraq's labor problems, their roots lie deeper, and are similar to Middle East and North Africa countries unaffected by conflict. These problems are captured by three contrasts: (a) between the oil sector and the rest of the economy; (b) between the private and public sectors; and (c) betweenjob opportunities for men andwomen. The oil sector versus the rest of the economy Oil generates less than 1 percent o f demand for labor in Iraq (figure 2.2). Like any petroleum-based economy, Iraq faces the challenge o f using its oil wealth to foster growth and job creation in downstream sectors. In the 1970s and 1980s Iraq's state-led diversification was well advanced, but most downstream enterprises could function only by relying on massive input subsidies, artificially high output prices, and hyper- protectionist barriers. In the 1990s, even this artificial diversification waned: currently, thepetroleum sector accounts for about two-thirds o f GDP. 31 Figure 2.2. Iraq's labor market, 2004 Employment by sector and structure of GDPby sector. (percent) --..-- B%Labor %GDP Manufacturin 0Yo 20% 40% 60% 80% 1 Source: Ministryo f Planning and Development Cooperation/UNDP 2005; and World Bank and IMF staff estimates. Thepublic sector versus theprivate sector The current state o f the labor market documents the difficulties o f reconstruction stifled by insecurity and institutionalweaknesses (figure 2.3). Security costs have eaten into the government investment budget."' Foreign aid moved much slower than originally expected. Private enterprise is also hamperedby conflict, andmost o f its demand for jobs lies in the informal sector. These jobs are very low-paid and carry no social protection (box 2.1). Figure2.3. Iraq's employment and hourly wages, 2004 Most jobs are created in the private sector.. . ...but its wages are the lowest in the economy. other 6% Health and social work Public administration Financialsenices Transpoltand communication Constructionand manufacturing Trade Agriculture 0% 50% 100% 150% 200% 250: 1 I Percentageof medianhourlywage Note: Breakdown o f wages by firm ownership i s not available. It is approximated by sectoral distribution: public administration and social services are in the public sector; agriculture, trade, construction, and manufacturing are o f either private or mixed ownership. "Other" i s unspecified. Source: Ministryo f Planning and Development CooperatiodUNDP 2005 32 Box 2.1. The informal sector in Iraq Since late 198Os, Iraqi households had increasingly relied on the informal sector to cope with economic hardships caused by the Iran-Iraq war, the first Gulf War, and economic sanctions. The number o f Iraqis seeking additional income from informal economic activities grew so quickly that in 1989 the Iraqi Council o f Ministers convened three times to discuss the issue o f state employees working "outside the official working hours." Today, the economic condition of households has improved, and public sector salaries have risen dramatically compared to the pre-2003 period, benefiting about 1millionemployees and their families and increasing consumption spending. However, unemployment remains very high. Security concerns continue to stifle private investment, both domestic and foreign, and prevent market mechanisms from playing their anticipated role. Slow job creation inthe public sector, and the inability o f the formal private sector to absorb all surplus labor combined with rapid population growth produce a pool o f workers who can find employment only inthe country's expanding informal economy. A World Bank study o f the informal economy in 110countries (Schneider 2002) found that the average size o f the informal economy as a share o f official GNI in2000 was 41 percent. Such estimates are arrived at by measuring inconsistencies in the national accounts (for example, the difference between actual and expected currency holdings; or using electricity consumption as a proxy for actual GDP level). Data gaps in Iraq are massive (see box 1.1) and do not even allow the approximate evaluation o f the size o f the informal sector. In assessing the current state o f the informal economy in Iraq, we can rely only on anecdotal evidence. I Iraq's current economic difficulties are typical for conflict-tom countries. Economic agents pursue multiple strategies to cope with hardship and diversify their sources o f income. Schneider and Enste (2002) show that the informal economy encompasses a number o f activities with different degrees o f sophistication and criminality. The informal sector offers both legitimate and illegitimate income opportunities. Legitimate ones are derived frompursuing economic activities similar to those inthe formal sector, such as flea markets, street selling o f small quantity goods, small scale food production, transport, and repair and recovery services. Illegitimate activities comprise smuggling, corruption, kidnapping for ransom, extortion, and larceny. Present-day Iraqi s rife with bothtypes o f activities. Given typically high risk levels, /informal economic activities are not necessarily rewarding and may actually deepen the poverty trap (Morrisson 1991). Nevertheless, the informal economy remains a major job engine inIraq, and for [wllmany Iraqis, it i s the only chance for survival. Informal activities provide the vulnerable with at least some income opportunities where formal mechanisms remain paralyzed by conflict. Once the security improves and more jobs are created in construction, services, and public administration, the public sector's demand for labor will likely grow. Simultaneously, reconstruction will fuel job creation in the private sector, first in construction and services, and then in broader range o f sectors, including downstream industries. Long-term efficiency considerations require that industrial restructuring remains compatible with the pricing system reforms and open trade regime that now exists inIraq. Long-term development prospects will suffer if attempts are made to revive the industrial behemoths o f the past that could function only behind the hyper- protectionist barriers. Men'sjobs versus women'sjobs Another contrast in the Iraqi job market is its gender gap. The pool o f female jobs is much smaller and less diverse thanjobs available to men. Two features that stand out are 33 the prevalence o f female workers in education and a large share o f female jobs in agriculture. In education women predominate in absolute terms, filling 60 percent of all positions. In only three other sectors i s women's share above the 17 percent average- agriculture, health, and social and financial intermediation (32-38 percent o f the total). Ofthese three sectors, only agriculture is a fairly large employer o fwomen (figure 2.4). Figure2.4. Employmentby sector and gender, 2004 Structure of male employmentbysector Structure of female employment bysector Agriculture, hunting and forestrv 2% Agnculture, Education u 25% Public administration nications repairs and defence 1% 2P/o 14% Source: Ministry ofPlanningand DevelopmentCooperatiodUNDP 2005. Prospectsfor employmentgrowth The outlook for the Iraqi labor market depends on the growth paradigm it follows. The short-term prospects are clearer: once the reconstruction process gets under way, demand will surge for both skilled and unskilled labor for rebuilding infrastructure, social services, and the like. Much o f what needs to be done inthese first years will have to be initiated by the state. Experience of other countries demonstrates, however, that beyond the first five to eight years, labor-market outcomes are likely to diverge: 0 Some labor-abundant countries choose to maintain the leading role of the state in investment and service delivery (e. g., Egypt, Venezuela). Almost all o f them face decelerating growth outcomes and stubborn unemployment problems. Large public sectors provide quality employment for the lucky few; but they also crowd out private investment. In some cases (such as Bosnia and Herzegovina), privatization progressed, but the state was less successful in addressing efficiency and accountability concerns, which stifled the private-sector response. 0 Other countries used the early reconstruction years to establish a facilitating regime for private enterprise and then moved to gradually reduce the state's role in the productive sectors, relying increasingly on public-private partnerships (e. g., Chile, Indonesia). Inthese countries private businesses proliferated and pulledinto the labor force large numbers o funemployed and part-time workers. 34 Analytical scenarios for the Iraqi labor market were formulated for this study. The findings o f this analysis are summarized in figure 2.5. The first reconstruction years (2005-08) are similar under either scenario, as large public resources are channeled into public goods provision. In the later years, however, the state-led model i s likely to encounter the problem o f declining efficiency. Incontrast, ifthe government supplements large public works program with early action to create a credible, transparent, and supportive environment for its private entrepreneurs, the private sector's demand for labor will grow very fast and absorb large numbers o funemployed. Figure 2.5. Unemployment scenarios for private-sector and state-led recoveries 1 40% I O % / 2004 2005 2006 2007 2008 2009 2010 201.1 2012 2013 2014 2015 I -0-PVT SECTOR LED RECOVERY STATE-LED RECOVERY Source: WorldBank staffestimates. Jobs, investment, and diversification Job creation i s primarilydrivenby investment-typically by a mix of public and private investment. InIraq, this presents four challenges: 0 The need to strengthen public-sector investment, particularly to avoid the "resource curse"4istortions that often accompany public investment and that were so typical for Iraq inthe past 0 The need to address the problems o fthe state-owned enterprise sector 0 The needto develop quickly significant levels ofprivate investment 0 The need over the long term to encourage investment and diversification through a strong and competitive industrial sector. Strengtheningpublic-sector investment Efficient management o f public-sector investment i s critical in promoting economic growth and empIoyment (box 2.2). An examination o f other Middle East and North 35 Africa counties, which were spared by conflicts, but embraced the same state-led development model, reveals problems similar to those o f Iraq: declining productivity, massive hidden unemployment, rising workers' insecurity, and undermined public finances. For example, in the 1990s Iraqi enterprises were shut off from their export markets and were shedding labor. Eventhe remaining employment rolls were overstaffed significantly,'" while the public-sector productivity was eroding fast. Such overstaffing i s not unique to Iraq-public sectors o f most Middle East and North Africa countries face the same problem. Recent estimates put labor redundancies inpublic enterprises at about 35 percent in Egypt and nearly 40 percent in Jordan (Ruppert Bulmer 2002). All of these problems were typical for the socialist model as well, which had much in common with Iraq's development path. Even in Western Europe labor encountered a similar dilemma: policies intended to provide economic security for organized labor, to enhance human capital, and to promote socially responsible development have eventually become a source o f economic insecurity. Even under the private-sector-led development model and beyond the reconstruction years, government will remain an important provider o f formal-sector employment in Iraq. However, the government's role in the economy needs to be redefined from being the primary employer to a partner in creating and sustaining opportunities for employment. A vital state role inimproving social services-especially health, education, and social security-is essential to establishing the conditions that will permit workers to thrive andeconomies to grow at competitive rates. Box 2.2. The resource curse All oil-exporting countries use mineral wealth to spur growth and job creation inthe nonoil sector. The state captures most oil revenues and typically plays a central role inthis process. In the Middle East and North Africa region, this state-led development model was embraced by many resource-poor countries as well. The model, which is defined ina recent World Bank study as "interventionist-redistributive" (World Bank 2004d), can be characterized by (a) a preference for redistribution and equity ineconomic and social policy; (b) a preference for states over markets inmanaging national economies and inproviding welfare and social services; and (c) the adoption o f import-substitution industrialization and the protection o f local markets from global competition. During the 1980s, this Middle East and North Africa development model delivered some o f the highest growth rates inthe world (3.7 percent per capita a year), low-income inequality, and dramatic improvements in human development indicators. Iraq was at the forefront of these gains, leading the region inmany human development indicators. The collapse o f oil prices inthe mid-1980s has made the interventionist development model unaffordable. Inthe late 1980s, a growing number o f Middle East and North Africa states recognized that it was not performing and opted for resmcturing. Iraq, however, moved in the opposite direction: wars and international isolation provided the former regime with a justification to tighten the interventionist grip fbther. It came at a price o f rapid increases inpublic debt and declining productivity inmost sectors o f the economy. Reducing wage (and benefits) premiums in the public sector will help to improve the competitiveness o f the private sector for skilled labor. It would be more efficient ifwages in the public sector are set in line with productivity and not merely according to education credentials and years o f service. Recruitment to public-sectorjobs must also be based on an appraisal o f fiture performance. Better conditions o f work in small and 36 medium enterprises, side by side with their growth, are needed in order to create more formal-sector employment and thus give more balance to the labor market. Reforming state-owned enterprises Iraq faces specific challenges with regard to jobs inits state-owned enterprises. With over 500,000 workers on the payroll, state-owned enterprises are a major source o f employment. Yet, appraisals undertaken in 2004 suggest that many o f these enterprises are grossly overstaffed (DFID 2004). The challenge for state-owned enterprises is to find their way to being profitable in a liberalized Iraqi economy, which welcomes foreign investment and imposes a very low level o f import duties. The outlook will differ for the two big groups o f state-owned enterprises. The utilities, which produce nontradable goods and services, are more difficult to restructure, because o f their critical role in supporting the rest o f the economy and the welfare of households. The state-owned enterprises involved intradable goods, however, cannot be immune fi-om competition and will need to be restructured soon. Protectingthem by reviving the previous protectionist regime would only hamper long-term growth prospects. A number o f state-owned enterprises, for example in the petrochemical sector, can, with sufficient financing for rehabilitation, potentially be profitable even with inputs priced at world market levels. Chapter 3 provides more detailed analysis o f a trade policy regime that could ensure optimal growth outcomes. Promotingprivate-sector investment The National Development Strategy envisages the private sector becoming the primejob generator in Iraq. A shift fi-om the public to the private sector as the main engine o f growth and employment requires more than the realignment o f price incentives. For private enterprise to be able to offer a sufficient number o fjobs for the Iraqipopulation, it must generate investment through a strong enabling investment climate. To create more jobs, private-sector employers need clear property rights, a regulatory fi-amework, and low entry and exit barriers. Strong public-sector governance i s essential: corruption drivesmany private firms into the grey economy and discourages possibly even a greater number o f entrepreneurs from launching their own business. Private entrepreneurs also need access to finance: at present, Iraqi state-owned banks are stalled, while small local private banks do not have sufficient capital to handlethe risks o f lendingto the emerging private sector. A number ofMiddleEast andNorthAfrica countries have tried, with a varying degree of success, to facilitate the development o f national enterprise. In most cases the share o f value added in the private sector increased only marginally in the 199Os, with the same unfortunate pattern characterizing the share o f the private sector intotal investment. This disappointing outcome i s explained by the limited progress in making the investment climate more accommodative. Barriers to entry, in the time and cost o f administrative approvals, remain quite high. Access to finance i s still very limited. Regulations do not facilitate the restructuring of businesses that are still viable, whereas nonviable firms are 37 not permitted to close operations expeditiously, thereby raising the social and economic costs o fbankruptcy. Thejudicial system i s slow, and enforcement is unpredictable. Businesses also suffer from weaknesses inthe financial system and inthe administration o f licensing, regulations, taxes, and import duties. Furthermore, weaknesses in telecommunications and transport infrastructure greatly impede business activity and investment. In all of these areas, Iraq has made important first steps, primarily in adopting business-friendly legislation. Butmuch remains to be done. Reconstruction flows present an enormous opportunity to develop the private sector. For the Iraqi entrepreneurs to benefit fully from the reconstruction drive, efforts are neededto foster business skills, entrepreneurial development, and business associations. Bureaucracies will need training in administering public investment and conducting regulatory oversight. The greatest possible Iraqi participation in the allocation and use o f these reconstruction funds i s essential to ensure that they not only serve genuine needs, but are seen to do so. A focus on institution building would reflect investors' various needs. They need to know their property rights are respected. They need competitive costs o fbusiness, so they can make a profit. And whether Iraqis believe it now or not, the private sector will benefit from competition. This theme o f institution building i s important particularly inpostconflict or transition situations. Experience has shown that, where perceived risks are high, initial investors may not be particularly professional, a deformity that can be very hard to change later. Moreover, work can begin in this area now. As the experience in West Bank and Gaza shows, institutional reform can be initiated and continue even inthe most hostile environments. Another promising area now i s the potential o f small and mediumenterprises to generate jobs. Assistance with moving the unemployed into self-employment can be very effective. Help can be given in setting up business plans and in securing credit. In addition, industrial estates can be set up to provide infrastructure and other facilities to small enterprises. Much of what constitutes support to small enterprises dovetails with encouraging competition in product and financial markets. Labor legislation (minimum wage, health, and safety regulations and other regulations on business registration, zoning, etc.) must be applied intelligentlyto small enterprises, neither forcing firms out o fbusiness nor condoninghazardous or underpaid employment." The UN-World Bank Joint Needs Assessment noted the existence o f micro lending programs in southern Iraq that could be expanded, and the assessment proposed the establishment o f a credit facility for small and medium enterprises. This could be particularly effective in major cities. As an example, it might aim to support subcontracting between larger and smaller enterprises, especially in diversifying oil- related activities and in raising value added in agricultural processing. An immediate possibility would be to link credit programs for small business explicitly to new job creation. Much can be done to assist small businesses by encouraging them to associate freely and express their common concerns, by supplyinginformation on market trends, or byliberalizingmarkets andthus makingsuchtrendstransparent. 38 The key priority is to strengthen critical institutions that support the private sector. At present the authorities' attention i s drawn to business constraints, such as the weak infrastructure, financial system, and security. What i s less obvious i s that the necessary institutional underpinnings for a strong private sector are also very weak. The building blocks o f a competitive investment framework include: 0 Creating a commercial legal and regulatory regime. 0 Building the institutional capacity o fthe public sector. 0 Strengthening the private sector's institutionalcapacity. 0 Increasingthe capacity o fbusinessesto access markets for trade and investment. 0 Developing the framework for regional economic development institutions. 0 Revitalizing the infrastructure to facilitate trade by addressing key bottlenecks, such as customs administration. A multiphasedapproach is required. The first phasewould support specific priority areas with the following type o f support: (a) a business plan for the institution, which deals with strategy and direction, organizational issues, resource and training needs, and sustainability questions; (b) guidance and training on operating processes; (c) support for feasibility studies on initiatives; (d) seed financing for initial initiatives; and (e) draft enabling regulations. The second phase would apply the lessons learned from the first phase to a much wider array o f institutions (competition authorities, customs administrations, nongovernmental organizations, industry associations, and the like). This follow up would also provide a second round o f support for the first-phase activities. A considerable amount o f effort already seeks to encourage Iraqi private-sector involvement in reconstruction. Nevertheless, more could be done, particularly in regard to the flows that the government i s managing itself. What's needed is to build a strong procurement system for both internally developed and internationally provided flows, so as to encourage Iraqi private-sector participation. The proposed economic development zones do not rely on any tax or customs advantage for their justification. They are a response to the need to maintain security, control red tape, and provide infrastructure. In an environment where these problems are insurmountable on a countrywide scale, development zones will encourage focused resolution o fthese issues. Iraq needs a public awareness campaign on the benefits o f a strong private sector in meeting the challenges of generating jobs, diversifying the economy, and sustaining growth. In Iraq, a strongly held philosophy, shared with some Middle East and North Africa neighbors, views public investment as sufficient to meet these challenges and sees foreign investment as a major challenge to sovereignty. Iraq's huge reconstruction needs will clearly absorb all the public investment finds available; broader growth and job creation canbe ensured only ifprivate enterprise i s engaged fblly. Finally, implementation capacity i s required. Energizing the private sector will require a significant effort, including-as an essential matter-close attention from the senior leadership o f Iraq. Many o f the agenda items will require coordination across ministries. The final recommendation therefore is the establishment o f an interministerial working 39 group on the investment climate, to coordinate with other aspects o f economic reform and act as a bridge to the infrastructure and financial sectors. Encouraging investment and diversification Openness to trade and export diversification is critical for enhancing the efficiency o f investment in an oil-exporting country. Otherwise, there is a risk that high public spending to expand infrastructure and employment will recreate a closed economy riddledwith highinflation and exchange-rate distortions. Underthis scenario, the existing polarities inthe Iraqi economy and labor market will only become sharper. A small group o f mineral-resource-based industrieswill integrate successfully into the global economy, providing quality jobs to the privileged few, while the majority o f the nation will remain inthe informal sector, with low skills andlowpay(Taylor 2002). Iraqhas a new foundation on which it can recreate a diversifiedeconomy. The challenge, however, i s to do it on a firm basis, by investing invital social services and infrastructure; improving the quality o f human capital; and maintaining a regime supportive o f private investment and foreign direct investment. The losses from recreating a rent-seeking environment with massively distorted prices, which existed under the previous regime, could be massive. Integration into the global economy through the World Trade Organization and open regional trade agreements can give a strong impetus to export diversification. Evidence for other developing regions suggests that trade agreements can have a positive and significant impact on export variety in sectors such as textiles and garments, wood and paper, machinery, and transport. Chapter 3 discussesthese issues ingreater detail. Foreign investors can be a source o f developing export potential and value added in oil- exporting countries. In Mexico, foreign companies generate nearly two thirds o f manufactured exports (UNCTAD 2002). In addition to capital, technology, and managerialknow how, transnational corporations also provide enhanced access to global, regional, and nationalmarkets. Value added i s increasinglybeing created as multinational corporations build long-term direct supply relationships with locally owned producers, rather than extracting local resources into foreign-owned production, transport, and distribution facilities. Local firms also gain from the presence o f export-oriented affiliates by copying their operations, employing stafftrainedbyforeign companies, andbenefiting from improvements ininfrastructure. Policies to promote the benefits o f foreign investment are particularly important for oil- dependent economies and are essentially policies to strengthen the investment climate. The introduction o f a flat, uniform tax for corporate and personal income and a value- added tax, together with elimination o f customs duties and speeding up o f customs procedures, can greatly enhance the benefits to firms for becoming involved in international trade. The investment climate also improves by removing restrictions and approval requirementsfor foreign investors and relying on domestic legislation to govern all investment,without distinguishing betweenforeign and domestic investors. Avoiding 40 the targeting of certain industries through subsidies or investment incentives will mitigate problems o f distorted investmentdecisions, bureaucratic discretion, and corruption. Expanding export product variety at the firm level will require overhauling viable state- owned enterprises and encouraging entry by new exporters. Evidence fiom other developing countries suggests that both o f these initiatives require substantial resources. Many o f Iraq's industrial firms have a legacy o f narrow product lines, weak management and information systems, poor product quality, and overly centralized structures. The experience o f transition economies suggests that upgrading the export potential o f existing state-owned enterprises that are considered viable can require substantial time and resources. Nonetheless, upgrading is worthwhile because it enhances f export potential while maintaining employment. A restructuring plan for product-constrained firms, such as textile companies inPoland, for example, includedthe following steps: 0 Financial restructuring. Steps include extending the maturity o f existing loans, converting government debt into equity, enhancing access to working capital, and providing long-term loans to finance capital investment andrestructuring. 0 Product restructuring. Steps include introducing new products, optimizing certain existing products to act as "cash cows" in the short term, and marketing products more effectively. 0 Product rationalization and consolidation. Measures may include closing certain plants, subcontracting specific tasks, retrofitting machinery, and investing in selected new equipment. 0 Management restructuring. Steps involve introducing quality controls, accounting, informationmanagement, andother control systems (Taylor 1994). The restructuring requires good coordination among many institutions, public and private, with a focus on the long-termprofitability ofthe company inquestion. Labor market policies A variety of labor market institutions, regulations, and programs can broadly improve working conditions and the functioning o f the labor market in Iraq. In addition, specific measures can help to mitigate the effects o f conflict and industrial restructuring on the labor force. The broad institutional interventions could focus on the following labor marketpolicies:vi 0 Legislation. As the private sector gains prominence, modern labor legislation i s needed that determines terms o f hiring and firing and employment conditions. Draft legislation is underconsideration and needs to be codified soon. 0 Industrial relations. A good record o f negotiation between capable workers' and employers' associations i s a sign o f industrial democracy inaction. Bothparties to the collective bargaining process should be representative and independent. The rules o f the negotiatingprocess shouldbeset by labor regulations, andthe rules for dismissing labor should be transparent and designed to prevent arbitrary decisions. The new Iraqi 41 Labor Code (currently in draft) lays down the conditions under which a workers' association must be recognized for bargaining purposes. Through an active bargaining process, social partners can expect to play a constructive role in the formulation o f state policy on employment and related safety and health standards. Labor-intensive public works. Such public projects provide temporary income and employment by providing immediately needed services with low start-up and overhead costs (such as security guard duties, cleaning and painting, reconstructiono f buildings, and irrigation works). Such activities could create thousands o fjobs. Training and skills development. The National Development Strategy calls for a strategy for sustainable job opportunities, especially for vulnerable groups. Rehabilitation o f vocational training centers operated by the Ministry o f Labor and Social Affairs would help to upgrade the skills o f the unemployed and to prepare the labor force to use new technologies necessary to compete ina global economy. There i s an urgent need to develop a training system reflecting the demand for labor arising from the private sector. The ministry has the key role in monitoring the quality o f training. School leavers are likely to require most o f this training, and there will be a need to include vocational training in secondary schools as well. To be most useful, such initial training needs to prepare young workers for learning a variety o f skills in later life. State-provided training outside the education system needs credibility inthe eyes o f employers. Microfinance programs. These programs help vulnerable groups to meet their emergency needs and to build assets. Microfinance programs should be designed to generate as many jobs as possible and could be specifically targeted to assist returningrefbgees andinternally displaced persons. Employment support programs. Focusing on generating jobs at the local level, these programs are runby local councils andcivic and nongovernmentalorganizations. Job-matching services. Such services reduce periods o f unemployment and raise productivity by facilitating the connection between employers and jobseekers. They require the collection and dissemination o f labor market information. In 2003 the Ministry of Labor and Social Affairs initiated a nationwidejob-matching service; by end-2004, the ministryhadregistered more than 0.6 million active jobseekers. Active labor market policies also extend to helpingparticular groups inthe labor market in the aftermath of conflict or industrial restructuring. Policies can help to reintegrate demobilized army personnel and retrain displaced state-owned enterprise workers, as discussed below. In other postconflict countries, incentives to employers in the form o f wage subsidies or social security payment credits have been efficient in assisting such disadvantaged groups. 42 Mitigating the effects of conflict Iraq's reconstruction efforts provide an opportunity not only to restore infrastructure and services interrupted or damaged by conflict, but also to reintegrate former soldiers into the postconflict workplace (box 2.3). The scale of the proposed reconstruction is substantial and could support a variety o f goals. Iraq's budgeted capital spending averaged 24 percent of GDP in 2004-05, and donors have also undertaken additional large capital spending outside o f the budget framework. Yet, given the existing security risks, the actual levels o f investment have been lower than anticipated, and in any case most o f the investment taking place i s capital- and import-intensive. The International Labour Organization estimates that the employment impact o f the Madrid package o f financial assistance is likely to be insufficient to significantly affect overall employment, perhaps providing temporary jobs to only 10percent o fthe unemployed ina year. Box 2.3. Jobs and reintegration for demobilized soldiers To help former soldiers and militia members to find civilian jobs and better reintegrate into society, international evidence indicates that it i s important to develop a new sense o f identity, one not linked to the conflict. A healthy civilian identity can be encouraged through remunerative employment, vocational training, and constructive work that contributes to individual and community well being. Training and work activities of ex-soldiers and militia members can contribute to the reestablishment o f values, behaviors, and norms. There are very few examples o f successful reintegration programs among postconflict societies. However, several interventions may be considered to cater for ex-soldiers and to give them access to the postwar restoration and reconstruction o f infrastructure. Well-targeted demand-driven skills enhancement can help ex-combatants to enter the labor market or to become entrepreneurs. Microcredit and small business development support can assist the most entrepreneurial clients, and labor-intensive public works foster temporary employment opportunities. Inaddition, employment-specific and psychosocial support services frequently feature as essential ingredients o f any comprehensive reintegrationprogram. I Source: World Bank 2004a; United Nations and World Bank 2003b. Mitigating the effects of industrial restructuring As recovery and industrialrestructuringproceeds, designingmeasuresto cushionworkers from the effects o f enterprise reform i s a matter o f priority. These social safety-net measureswill likelyinclude: 0 Generous redundancy or severancepayments 0 Retraining programs to impart or upgrade needed skills 0 Programs to assist workers to reenter the job market, such as the establishment o f employment agencies 0 Public works programs. These measures may take a variety o f forms. Egypt has successfully transformed a number o f state-owned enterprises, making use o f a generous compensation scheme. The government redundancy scheme may provide a lump-sum payoff or offer a monthly payment for a set period. Vouchers can be used to pay for retraining, which could also 43 kick-start private-sector training institutions (with quality control by the Ministry o f Labor and Social Affairs). Above all, redundancy i s to be handled in a transparent manner, according to principles in the new Iraqi Labor Code. Negotiation with workers and their representatives can make the criteria used in the redundancy process more acceptable. Managing redundancy in a fair and acceptable manner will also be the first stage in establishing an appropriate industrial relations climate within functioning state- owned enterprises and will contribute to good labor practices even inthose units that are subsequently privatized. It is important to be open and honest about the short-term negative employment impacts o f enterprise reform and to introduce these safety-net measures so that laid-off employees can benefit from them whenever andwherever necessary and inparallel to the reform o f state-owned enterprises. Difficult though these problems are, Iraqis can take heart from the many other countries that have successfully tackled major overemployment in state- owned enterprises. More broadly, the experience o f other Middle East and North African countries suggests that well-designed labor market programs can help tackle a variety o f labor-market dislocations. However, the experience also suggests that, despite their political appeal and contribution to poverty alleviation, such policies do little to remedy structural problems inlabormarkets or to reducehighunemployment. Only a small share ofthe labor force is likely to be covered by these programs. Furthermore, active labor market policies need to be carefully targeted and monitored, as suchprograms may have highfiscal costs. Summary of recommendations To immediately improve the labor content o f the reconstruction effort, the Iraqi government could undertake these measures: Divert resources to more employment-intensive programs and use more employment-intensive techniques for approved projects. Scale down the size o fprojects to make them feasible for local execution. Exercise the technical supervision needed to use more unskilled labor and still meet proper standards. Build up the capacity o f municipalities and local bodies to supervise and implement small-scale construction. Build up the capacity o f local contractors to undertake labor-intensive construction projects. Increase the local raw material content o f purchases o f inputs and encourage their productionby small-scale enterprises. Encourage the growth o f sectors, such as housing, with strong linkages to the domestic economy. Given the big housing deficit with apparently 1.5 million units to be constructed or repaired, housing programs are likely to stimulate activity inmany other industries as well. Improve the access o f low-income groups to productive infrastructure and basic social services. 44 0 Design local development strategies that focus on job creation and income generation and incorporate elements o f basic social protection and social dialogue at the local level. To generate economic growth and productive employment in the short term, the government may wish to consider the following steps: 0 Strengthen implementation and coordination across ministries to improve the investment climate, possibly by establishing an interministerial working group. 0 Conduct a public-awareness campaign on the benefits o f a strong private sector in meetingthe challenges o fjob generation and economic diversification. 0 Strengthen critical institutions, including the commercial, legal, and regulatory codes; the rules o f access to various markets for trade and investment; the frameworks for regional economic development; and the infrastructure to facilitate trade. 0 Create a supportive environment for private entrepreneurs by establishing clear property rights and regulatory frameworks, low entry and exit barriers for businesses, access to finance and infrastructure, and strong public-sector governance. 0 Provide training to government staff in administering public investment efficiently and conductingregulatory oversight. 0 Reduce public-sector wage and benefit premiums to improve the private sector's competitiveness for skilled labor. Set public-sectorwages to reflect productivity. 0 Implement measures to cushion workers from the effects o f enterprise restructuring, including generous redundancy payments, retraining and reentry programs, and employment opportunities through public works. Inthe longer term, the government may wish to consider the following steps to build labor-market institutions and improve working conditions: Maintain efficient management o f public-sector investment, proceed with the restructuring state-owned enterprises that produce tradable goods, and decide what to do with those that produce nontradables. Formulate an action plan for upgrading the export potential o f state-owned enterprises, including financial, product, and management restructuring. Improve conditions o f work in small and mediumenterprises to create more formal-sector employment and thus give more balance to the labor market. Encourage Iraqi private-sector involvement in reconstruction. Build an efficient procurement system for both internally developed and internationally provided flows. Support economic development zones to offer security and infrastructure services and to minimize redtape. Foster private-sector business skills, entrepreneurial development, and business associations. Improve social services to establish the conditions that will permit workers to thrive and economies to grow at competitive rates. Enhance the potential o f small and medium enterprises to generate jobs by 45 helping with business plans and credit and by providing infrastructure facilities by setting up industrial estates. Consider establishing a credit facility for small and medium enterprises and link its availability to new job creation. Apply labor legislation (e. g., minimum wage, health, and safety regulations) intelligently to small and medium enterprises, neither forcing firms out o f business nor condoning substandard employment. 0 Use the requirements o f the World Trade Organization and open regional trade agreements as tools o f economic diversification. 0 Encourage foreign investors by removing restrictions and streamlining approval requirements. 0 Avoid granting investment incentives to selected industries, to mitigate problems of distorted investment decisions, bureaucratic discretion, and corruption. Notes iThese numbers appear low, giventhe estimated annual population growth o f 2.8 percent. Ifthe population growth rate is correct, the number o fnewjobseekers couldbe closer to 200,000 a year. " The formal sector i s characterized by a formal relationship between the employer and employee, typified by the latter's access to social insurance (pensions, unemployment insurance, severance schemes). The informal sector comprises vast number o fjobs inwhich workers do not have access to social insurance and are in temporary or unstable relationships with employers, which are often small or mediumenterprises. Many ... non-OECD economies have much larger informal than formal employment sectors. 111Reports indicate that actual investment spending in2004-05 was well below the budgeted levels inmany sectors. However, h s needs to be validated, as the quality o fbudgetary reports is weak. iv Recent state-owned enterprise appraisals suggest that a large number o f their staff positions are redundant (DFID 2004). The new IraqiLabor Code raises the possibility o f slightly different legislative approaches for companies withfewer than 15regular employees. vi This section draws on ILO (2004a). 46 Chapter 3. Fixingprices and incentives for growth Most key economic prices in Iraq are now fiee-evidence o f significant liberalization in the postwar period. Still, the remaining price distortions are exceptional by any measure. Iraq maintains the largest untargeted food subsidy program in the world: the cost o f the Public Distribution System (PDS) amounts to 12-14 percent o f its gross domestic product, compared with 1-3 percent o f GDP for food subsidy schemes in other Middle East and North Africa countries. Domestic fuel prices, electricity, and water tariffs are among the lowest inthe world. Subsidies add up to more than 50 percent o f GDP and are already squeezing the budget, notwithstanding the currently high oil prices. Iraq faces crucial choices on whether to accelerate price reforms or to continue these untargeted subsidies, which have large fiscal costs and produce serious disincentives inthe economy while vast demands for public goods and services remain unmet. The overall message of this chapter is that carefully planned price reforms can enhance public welfare, since such reforms will: (a) reduce the deadweight losses' that result from inefficiency in the economy; (b) improve incentives to private-sector producers; and (c) save fiscal resources for the production o fvital public goods and services. Pricingreforms In2003-04, Iraqmadeprogress onanumberofpricingreforms: 0 For decades Iraq operated a system o f multiple exchange rates. The gap between the dinar's official parity o f about ID 1/$3.2 and its black market rate was growing ever wider; by 2002 the latter was over ID2,00O/$l/ID. Inearly 2004, the new dinar was introduced, and old banknotes were exchanged at the prevailing street rate for new ones. Since then, the market has determined the dinar exchange rate. After a short initial period o f volatility, the dinar stabilized at around ID 1,465/$1. The daily foreign exchange auctions are open to all competitive bidders. Premiums between the auction rate and the street rates remain under 1 percent. The central bank uses the auction system to maintain exchange-rate stability, which i s one o f its declared policy goals. 0 For prices o f goods, the most important development has beentrade liberalization. All border tariffs and controls disappeared with the collapse o f customs in 2003. Private- sector imports grew twentyfold over 2002-04, quickly saturating the pent-up demand for consumer goods. Most prices on domestic outputs are now free. 0 In the past decade, the purchasingpower o f Iraqi wages waned as the dinar declined. Monthly wages of $10-15 were not uncommon by 2002. The resumption o f the flow o f oil revenues since mid-2003 allowed the government to begin raising public-sector salaries. The 2005-06 budgets brought further wage hikes, with an average civil service salary exceeding $200 a month. More recently salaries o f workers in state- owned enterprises andthe private sector begancatching up as well. 0 Iraq liberalized the interest rates inMarch 2004-an important step toward creating a modem financial sector and enabling lenders and borrowers to make their own decisions guided by efficiency and profitability considerations. Very little credit is 47 being issued, however, and the interest rates do not yet play a visible role in the allocation o f capital. Real interest rates are negative (figure 3.1). These early pricing reforms have shifted the structure o f household consumption. Under the previous regime, consumption was maintained primarily by rations through the Public Distribution System (PDS) and by other subsidies (taken together, these accounted for an estimated 80 percent o f total private consumption). The rest was coming from monetary incomes-wages and pensions, which by early 2000s were not buyingmuch. As a result of early pricing reforms and several rounds o f salary increases, the share o f monetary incomes had risen significantly, but the subsidies continue to account for at least half o f consumption (and a highershare inpoor households that relyheavily on the PDS). Rapidly rising monetary incomes o f households and security-related disruptions o f the supply chains were possibly among the key drivers o f inflation in 2004-05. Vital needs of households are still met by subsidized goods and services; hence, the families could focus their higher purchasing power on the previously unavailable consumer goods. Until mid-2004 the consumer price index was relatively stable." However, moving goods inthe domestic market was becoming increasingly risky, and security costs and insurance premiums (both formal and informal) shot up. Administrative measures taken in early 2005 to normalize the situation in some key markets (inparticular, hel) had their effect, andthe consumer price index declinedfor two months inarow. Figure3.1. Exchangerates,consumer prices, and interestratesinIraq, 2003-05 Prices accelerated since mid-2004.. . ...while real interest rates remain negative. 1200 1 I I70 1300 730 12 l4 150 1400 140 n o 1500 P O 1600 1x) x)O 1 1700 90 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Dec-03 Mar-04 Jun-04 Sep-04Dec-04M ar-05 Jun-05 Sep-05 Dec-05 +T-Bills +Overnight deposits +Comm -tQD/uS$ Bank Deposits -I --Comm Bank Loans (e.o.p.,inverse scale) Ihs d C P I Index,Dec.Z003=x)O,rhs Note: lhs i s left-hand scale; rhs is right-hand scale. Source: CBI 2004; WorldBank and IMFstaff estimates. The share o f monetary incomes intotal household consumption i s much higher now, but the subsidies are still pervasive (table 3.1). Some subsidy schemes are on budget, like the PDS, while others are off budget (e. g., the electricity tariff). These subsidies are untargetedand nontransparent. The rest o fthe chapter suggests that significant efficiency gains are possible fi-om the reform o f the subsidy system. Experience o f price reforms in 48 2003 suggests that gains in growth from further reform o f the subsidy system can be large. The Iraqi subsidy system is not unique in the Middle East and North Africa region or among the resource-rich developing countries. Most of them use budgetary subsidies to redistribute oil wealth to the nation and to stimulate growth inthe nonoil sector; some use subsidies to foster the private sector. Many governments in the Middle East and North Africa make less than full cost recovery for a variety of public services, such as energy, water, housing, public transportation, and postal service. Table 3.1. Subsidies in Iraq Sector Type of Recipients Form of subsidy Estimated Implications subsidy volume (% of 2005 GDP) Food Imports o f Households In-kind (ration card) 12-14 Maintains a vital safety net for foodstuffs all the population, but explicitly undermines domestic agriculture, budgeted distorts domestic food markets, andfuels corruption and smuggling Fuels Only import Households Official prices at the 25-30 Encourages smuggling; black- (gasoline, costs are and producers pumpare below market dealings, and corruption; kerosene, explicitly operating costs anti-poor; reduces ability o f diesel, budgeted refineries to self-finance LNG) rehabilitation; results inmajor quality problems Electricity Implicit Households Fuel for generators is 5-8 Creates major quality problems andproducers below opportunity cost; (cuts, voltage fluctuations); depreciation for amounts due cannot be collected; equipment is not the national gridis unable to self- accounted inpricing; finance rehabilitation charges to consumers are below the cost o f delivery Utilities Only partly Households Charges to consumers 3-5 Lowers service quality; providers and urban explicit andproducers are symbolic, well are unable to self-finance services through below cost o f delivery rehabilitation budgetary transfers to municipalities Agriculture Only a Farmers Seeds, fertilizers, fuel, 8-10 Creates artificialprofitability; fraction i s power, and equipment functions as a major safety net explicitly are all at very low for rural households; anti-poor budgeted as official prices; farmers' guaranteed purchase support prices. Some subsidies are expectedto be phased out soon. Inputsto Implicit Downstream Data not Causes operating losses for input state- industries available- providers (oil, gas, refining, and owned (petrochemica most state- electricity sectors); low enterprises 1, construction owned efficiency and overstaffing in materials, enterprises recipient state-owned enterprises etc.) are idle 49 Not all subsidies are damaging to the economy. A case can be made for subsidizing public goods that increase the human capital o f the nation (primary education, primary health care) or support social overhead capital (roads, bridges). If used wisely, such subsidies enhance economic growth and social welfare. To some degree, even liberalized economies subsidize selected public goods, but every country must use care to keep the subsidyprograms fiscally sustainable. Experience shows that, in every country that uses subsidies, they tend to become progressively wasteful and pervasive. Subsidies on marketable goods,' such as food, fuel, and power, are particularly risky, because they can be a serious barrier to efficient markets. Subsidies crowd out private investment and distort production incentives, leading private producers to supply insufficient quantities or poor quality of goods. Subsidies also adversely impact income distribution, as their incidence i s typically proportionalto purchases (greater benefits are captured by the rich). If the government is concerned that the poor cannot afford even basic levels of consumption o f food, fuel, and power, alternative supports can be explored. Such mechanisms are considered inthe following three sections. Food security Food security remains the Iraqi government's focus o f attention. A survey by the World Food Program in 2004 (WFP 2004) found that food insecurity i s persistent, and is an important dimension o f poverty in Iraq. A significant part o f the population-about 11 percent, or 2.6 million people-faces real difficulties inaccessing adequate food, despite the Public Distribution System, while many others-about 25 percent, or some 6 million people-are vulnerable becausethey depend heavily on the PDS. The nutritional status o f the population continues to be a significant problem, with chronic malnutrition rising after the 2003 war as a result o f insufficient nutrients and poor infrastructure and services, including, for example, health care, water, and sanitation. Among children under 5 years old, 4.4 percent suffered from acute malnutrition; 11.5 percent were underweight, and 27.6 showed signs o f chronic malnutritionor stunting. The extremely poor lack the income needed to purchase sufficient food for their households. Low purchasing power is associated with high rates o f unemployment, underemployment, and illiteracy, particularly in rural areas. In the short term, Iraq's poorest households will continue to need the PDS. For this group, the PDS ration represents by far the single most important food source inthe diet. Supply shortfalls thus affect them disproportionately, given their higher dependency rates than other households. Social protection mechanisms targeting these groups must be carefully considered inthe context o fpossible PDS reform. 50 Box 3.1. Iraq's PublicDistributionSystem Iraqbecame a net importer of food 40 years ago and currently imports about 70 percent o f its food supply. The Iraqi Public Distribution System (PDS) is the largest public food,program operating inthe world today and i s perhaps the most visible program o f the Iraqi government, costing more than 20 percent o f government revenue. The PDS provides all Iraqi households with 100percent o f the minimumdaily calorie requirement and more than 60 percent o f the food consumed inIraq. The food basket provided today remains very similar to the ration distributed under the United Nation's Oil for Food Program in 1997-2003. The monthly basket o f rationed goods currently includes 9 kgo fwheat flour, 3 kgo frice, 2 kgo f sugar, 0.2 kgo f tea, 1.5 liter o f vegetable oil, 1 kg o f powder milk, 1.5 kg o f driedbeans, 0.15 kg o f iodized salt, 0.25 kg o f soap, and 0.5 kg of detergents. Infants less than a year old get baby care products and formula. Consumers pay ID250 per ration (ID50 for flour and ID 200 for the remaining products). The ration's resale market value i s estimated at about ID6,000. In2000-02 this difference was slightlybiggerinterms ofIraqi dinars, butnot interms of U.S. dollars because the Iraqi currency appreciated since 2003. Until2004, most of the deliveries were imports organized under the Oil for Food Program, and the cost o f subsidization was not reflected inthe state budget. After the transition in 2004, the PDS i s fully included inthe 2005 budget. The PDS is managed by the Ministry o f Trade and implemented by a combination o f state-owned enterprises and private-sector companies. While importing, rice processing, and warehousing fimctions are largely performed by state-owned enterprises, wheat processing, transportation, and retailing activities are predominately contracted out to the Iraqi private sector. During the years o f economic sanctions, all PDS ration goods were imported directly by the Ministryo f Trade. In the past year, efforts have been made to use locally produced goods (especially Iraqi wheat) and to use Iraqi import companies. These efforts have had mixed success because o f problems o f low product quality and insufficient capacity o f the import companies. I Source: Razzaz 2005. The Public Distribution Systemhas successfully preventedhumanitarian crises inIraq for more than a decade. The 1990 Gulf War and the imposition o f sanctions resulted in dramatic declines inthe health status o f the Iraqi population (see "Iraq at a glance" tables inthe annex). Risingpoverty and declining accessto food imports were a significant part of this deterioration. In response, the government o f Iraq in 1991 introduced the PDS, which provided approximately 50 percent o f caloric needs. When the Oil for Food Program began in 1997, government revenue and the ability to import food increased, and the PDS rations increased as well (box 3.1). Throughout this period, the PDS has effectively reached the vast majority o fthe population, dramatically increasinghousehold incomes and insulating households against food shortages and price fluctuations. Although the ration does not provide sufficient micronutrients and malnutrition remains high,the situation would be considerably worse without this food safety net for the Iraqi people. If the PDS were discontinued abruptly, many lower-income households would not be able to meet their food requirements. 51 What is wrong with the Public Distribution System? The financial cost o f the PDS is extremely high-approximately $4 billion in 2005- implying a transfer from the government o f $150 per person per year to each o f the 27 million people inIraq. The program i s expensive for two reasons: (a) it provides generous transfers to each beneficiary and (b) even the wealthiest Iraqis receive benefits. Still, the highfinancial cost isnot necessarily unsustainable. To be sustainable, the expenditures o f the government o f Iraq must be in line with the revenues generated from oil sales and tax collection. The specific programs on which the revenues are spent, however, depend on the priorities o fthe Iraqi government andpublic. What the large financial cost o fthe PDS tells us is that the continuationo f such a generous, untargeted program would come at the expense o f other services, such as education, health, and infrastructure. Distortions occur in any market in which government actions impact prices. Distortions occur on the supply side o f the food markets-that is, the incentives o f private-sector food producers are affected. Distortions also occur on the demand side o f food markets- that is, the incentives o f consumers are affected: 0 Producers' incentives. The dominant role played by the PDS in food markets has massively distorted the incentives faced by Iraqi farmers and private enterprises. Because the PDS is a government in-kindtransfer o f food, the distortions are even greater than they would be inthe case of input subsidies paid to the farmers and occur throughout the supply chain. One o f the largest distortions created by the PDS is not because o f rationing itself, but because the food supplied through the system i s imported. This large injection o f imported food pushes domestic food prices below international prices, thereby reducing the incentive for domestic production. Artificially low domestic prices o f rationed goods create incentives for smuggling goods outside o f Iraq, where they canbe sold at a higher price. 0 Consumers' incentives. By providing large transfers to households and changing the relative price o f consumer goods, the PDS may distort labor supply and consumption patterns. Consider first the impact o fthe transfer on the household supply o f labor. As with any unearned income, the transfer o f resources through the PDS may reduce the incentive to work. Indeed, with the PDS transfer approximately doubling household income, the negative impact on labor supply would be expected to be large. In the current situation, however, the PDS does not appear to be a determining factor for employment rates: labor supply remains significantly greater than demand, as indicated by high unemployment. In terms o f consumption patterns, there i s little evidence that low prices on rationed foods are causing households to overconsume food, though there i s some evidence to suggest that households are consuming too little o f the more expensive nonrationed foods, such as fresh produce and animal protein. Optionsfor reforming the Public Distribution System 52 The Iraqi National Development Strategy discusses long-term reform o f the Public Distribution System, moving away from a universal food ration toward an efficient, targeted safety-net system. Such reform will indeed happen only over the medium -to long term. At this point it i s also useful to think o f short-term reforms, which can improve the situation incrementally even though they may not solve the problems entirely. A number o f ideas have been floated recently about modifying the PDS, which take incrementalsteps toward long-term reform, but canbe implementedinthe near term. Indesigningthe permanent safety-net system, two issues need to be considered. First is the form o f the transfer. Cash transfers and food stamps, instead o f in-kindtransfers, are among the common program types that are being discussed now in the Iraqi context. Each o f these program types has different benefits and costs. Second i s the issue o f targeting. Although most people agree that some targeting i s desirable, there is no consensus yet on how narrowly to target-that is, what proportion o f the Iraqi public should be eligible-or what targeting mechanism to use. A wide variety o f targeting mechanisms have been successfully used in other countries. The question is, what is the most appropriate mechanism for the Iraqi context? In addition to designing an appropriate permanent safety-net system, the timing and sequencing o f reform must be carefully considered. There i s a clear need to begin reforms-even ifincremental-as soon as possible. Several ideas recently proposed include: (a) removing high-income civil servants from the PDS ration lists as a first step toward targeting; (b) giving households the option o f either receiving their regular food ration or a cash transfer worth more than the ration; and (c) increasing the role o f domestic food producers and the private sector within the existing PDS. Timing and sequencing issues have to be considered carefully in a broader context, beyond the economic benefits, to ensure that reforms do not trigger humanitarianor political crises. Implementation The advantages o f cash transfers over the current in-kindrations are clear, since cash transfers do not substantially distort the prices inthe economy. If a cash transfer system were implemented, food prices would likely be higher than they are now, thereby increasing the incentives for domestic farmers and food producers. Although food prices may not be a major concern in the long run, they are an important consideration in the medium term. Large fluctuations in prices are likely as the country transitions to a market-based economic model and as security problems may continue to interrupt the availability o f commodities. Cash transfers would fail to buffer households from price fluctuations, which are a major form o f food insecurity. Another major question about cash transfers i s whether they could be implemented inthe current environment. Three concerns need to be studiedindetail: 0 Iraq's banking system i s not sufficiently developed to handle the huge number o f transactions required under the PDS. Rather, cash would have to be physically distributedthroughout the country. 53 0 Cash would be vulnerable to theft, particularly inthe current security environment. The cost would be enormous to provide reasonable security measures for the transport and distribution o f large sums o fmoney. 0 Ifacashtransfersystemwereadopted,short-tomedium-ternmeasureswouldneedto be taken to prevent interruptions in food supplies and extreme price volatility. Although there i s little doubt that the Iraqi private sector could eventually provide an efficient supply o f food, the government would need to ensure that access to food remains adequate while the private sector adjusts to freer markets. Food stamps have most o f the same problems as cash transfers, though to a lesser extent. Where food stamps are widely distributed, they tend to become a form o f currency. Targeting issues. Many different mechanisms can be used to target safety-net programs to the poor. Options include means testing, proxy-means testing, categorical targeting, and self-targeting. The most appropriate mechanisms must be chosen on the basis o f the specific situation of Iraq. Means testing i s not yet possible, because data on income and assets are not widely available and are not easily verifiable. Proxy-means testing and categorical mechanisms are useful only if clear associations can be made between easily observable household characteristics (such as the sex o f the household head or the district of residence) and need, usually based on a high-quality household survey. This may not be possible to accomplish with existing data, although in the longer term it may be feasible. Proxy-means testing and categorical mechanisms can also be politically contentious if there i s any debate over the association o f need with certain geographic regions andultimately the religious and ethnic groups that live there. Self-targeting can be an extremely useful mechanism and has been implemented successfully in a number o f countries, though the program must be carehlly designed to avoid creating any unintendedincentive effects. Public works projects and food-for-work projects are common examples o f self-targeted safety nets. These programs tend to work well ifthe needy are unemployed. However, ifthe program benefits are overly generous, the programs may draw individuals out o f existing, possibly more productivejobs. Financial issues. It would be a mistake to think that all reform options would be financially less costly than the PDS. For each option that is considered, it is important to identify whether it will be cheaper than the PDS, and if so, where the cost savings will come from. Two issues are particularly important: 0 Targeting is expensive. Data must be collected and verified to identify whether particular households are eligible. Targeted cash and food stamp programs often spend 10 percent of their budget on targeting. While a targeted program may be less expensivethan a universal system, there is a tradeoff between the quality o f targeting andthe administrative costs o fthe program. 0 Even if a food stamp or cash transfer program i s adopted, the Iraqi government will need to continue to be involved in the physical distribution o f food (at least until the private sector builds sufficient capacity to take over). Duringthis interim period, there are not likely to be any financial savings. In fact, the costs o f the program in the 54 transitional period could be higher than at present. Considerations before beginning reforms How to start the targetingprocess? It is now widely recognized that full means-testing i s not possible in the short term, because reliable income data are not available for the general population. Civil servants, however, are the one group for which reliable income data are at hand. The suggestion has therefore been made to eliminate all civil servants whose salaries are above some cutoff (possibly ID 1,000,000) from the ration lists. Two practical issues to consider are (a) how to link the data on government employment with the ration lists and to accurately determine the number o f individuals dependent on the civil servant's salary and (b) how to determine the size o f the group affected. To significantly lower the financial costs o f the PDS, it must impact a reasonably large proportion o f the population. Another, more important consideration i s the likely reaction o f the civil servants. They may have a strong negative reaction because they are singled out-denied eligibility while even more well-off households inthe private sector are not affected. And (especially because o f their position in the government) a disenfranchised civil service could launchan effective campaign against the reform. How much choice to give households? The proposal to give households the choice between receiving their ration or a cash transfer i s attractive because it could facilitate a gradual transition from the pure ration system to a cash transfer system. However, this proposal i s likely to have an even higher financial cost than the existing PDS. To see why, consider the following. To prevent food shortages and extremeprice increases, the government is likely to continue to purchase and transport to food agents sufficient food for the entire population. The government's cost to purchase and transport the food is approximately $10 per person per month, and the food itself has a resale value o f approximately $4 per personper month. The proposal calls for offering a cash alternative greater than $4 to make it attractive to households. Say the value o f the cash transfer i s $6. To keep the cost per person per month from increasingto $16, the government would need to be reimbursed$6 by food agents for the food distributedto the households who take the cash option. Clearly food agents would not be willing to pay $6 for food that has a resale value o f only $4. Infact, there i s no price the food agents wouldbe willing to pay that would not create an increase inthe financial cost to the government. Another crucial argument against this proposal is the long-term expectations it creates. Because cash is desirable to all households (including the wealthiest), a cash transfer system could be even more difficult to remove than a food transfer. It could be very risky to convert to a cash transfer before implementingan effective targeting mechanism. Domesticfuelsubsidies Fuelprices in Iraq rank among the lowest inthe world. A survey o f consumer prices o f super gasoline and diesel conducted in 171 countries on November 17-20, 2004, indicatedthat only Turkmenistan had end-user prices as low as those inIraq (GTZ 2005). Table 3.2 compares official domestic prices in Iraq with the free-on-board prices in the Gulf countries. The latter do not include the cost o f transportation, storage, and 55 distribution, but still are markedly higher than the end-user prices in Iraq. Table 3.2. Fuelprices in Iraq and on international markets, 2005 LPG Gasoline Kerosene Diesel Fuel oil Natural Regular Premium gas per cubic Unit per 12kgper liter per liter per liter per liter per liter meter Domestic price, ID 250 20 50 5 10 10 1 Gulf2004 average, $ 4.18 - 0.28 0.28 0.27 0.16 n.a. Gulf2004 average, ID 6,054 - 402 408 391 236 n.a. Note; - indicates not available; n.a. indicates not applicable; LPGindicates liquefied petroleum gas. Source: Iraq prices as o f January 2005, except for natural gas where the price i s as o f 2002. Gulf prices are free-on-board as reported in the Platts Oilgram Price Report for all the fuels, except for LPG where the price i s Saudi Aramco's contract price for propane. Premium gasoline for Gulf is 95`research octane unleaded. The extremely low consumer prices found in Iraq lead to a number o f serious problems. These include an unsustainably large burden on the government budget; undersupply o f the domestic market; smuggling o f subsidized fuels out o f the country; inadequate maintenance, let alone modernization or expansion, o f physical infrastructure for production, transport, and distribution o f subsidized fuels; lack o f attention to fuel efficiency; waste; and overconsumption o f fuels for nonessential purposes. InIraq, all o f these adverse effects are observed. Refineries in Iraq are inmajor need o f modernization and incapable o f producing adequate quantities o f products with appropriate quality (for example, gasoline without lead additives). Despite Iraq's large natural gas reserves, little use is made o f gas in the economy, and more gas i s flared than consumed. Adverse effects can even extend to other natural resources. An example is the impact o f the availability o f cheap diesel on undergroundwater inYemen, where cheap diesel usedby farmers has led to the depletion o f underground water as a result o f excessive pumping for irrigation. Raising fuel prices to reflect the real cost to the economy i s an important consideration in stimulating fuel efficiency, as well as in reducing nonessential fuel use. For example, a recent U.S. study showed that increasing the price of gasoline by raising the fuel tax, rather than tightening fuel efficiency standards, was by far the most cost-effective option for fuel conservation. Higher gasoline prices from higher fuel taxes were estimated to start reducing consumption immediately, and the market effect would gradually drive the transition to more fuel-efficient vehicles (AutomotiveEnvironment Analyst 2004). Where trade i s permitted and domestic prices are far below those on the world market, refineries have an artificial incentive to export as muchproduct as possible. An example i s the Russian Federation following the devaluation o f the ruble in 1998, which brought domestic crude and refinedproduct prices well below world levels. Exports surged, and in response to the dwindling supply of fuels on the domestic market, the Russian government in 1999 and 2000 took a series o f steps to control the petroleum sector, such as puttingquantitative restrictions onproduct exports and reintroducing export duties. 56 Because the consumer prices inIran are closest to those in Iraq among its neighbors, it i s informative to review recent developments in the Iranian government's fuel-pricing policy. As in Iraq, there is a serious shortage o f gasoline in Iran. For the fiscal year endingon March 20, 2005, the government spent 30 trillion riyals (about $3.4 billion) on gasoline price subsidies, far in excess o f the $1.5 billion allocated inthe national budget. Iran's gasoline consumption has recently grown at an annual rate o f 12 percent, partly because prices are kept artificially low. In January 2005, an Iranian government official reportedthat the estimated cost to the government o f smuggledfuels was 10trillionriyals annually. Iran's 2004-05 draft budget contained only a modest rise in gasoline prices from 650 riyals ($0.075) a liter to 800 riyals ($0.09). Under a five-year economic plan developed in 2004, fuel prices were to rise gradually to international levels, starting in March 2005, but in January 2005, the Iranian parliament voted to freeze fuel prices for the entire fiscal 2005-06. This setback notwithstanding, eventhe low officially controlled price o f gasoline in Iran is several times higher than that in Iraq, providing ample incentive for fuel smugglingfrom Iraqto Iranand on to other countries. Raising prices i s the most efficient response to correct the distortions introduced in the economy by fuel subsidies. This raises several questions for the government: to what level, how fast, with what consequences, and are there adverse effects o f price increases that would require government intervention? Targetprice levels Broadly, target price levels can be classified into three categories: Cost recovery. Cost-recovery prices entail no direct subsidy to end-users. Cost- recovery levels account for rehabilitation, modernization, and expansion o f oil and gas fields, as well as associated physical infrastructure. Iraq currently imports light fuel products, and for these imported fuels, cost-recovery and economic opportunity costs are the same. Because prices below cost recovery entail direct subsidies and a claim on the government budget, raising prices to recover costs would be an immediate priority. Border prices. Prices inthe countries bordering Iraqvary considerably, ranging from very highprices inTurkey to very low inIran. Matching border prices would curtail smugglingto a considerable extent. Any reduction insmuggling is expected to affect cost-recovery prices by reducingthe quantities o f imported fuels. Economic opportunity cost. Domestically produced crude can be sold on the world market at international prices or to domestic refineries. Ifthe price paid by domestic refineries were below what producers can get on the international market, then given free choice, producers would not sell crude on the domestic market. For refined products, the economic opportunity costs would be either import-parity or export- parity prices, depending on the trade balance. If Iraq were to become self-sufficient with no imports or exports of refined products, then the economic opportunity cost could be defined as the export-parity crude price plus processing and transportation costs, cappedby import-parity product prices. 57 It is almost certain that consumer prices inIraqwill not beraised inone step to economic opportunity costs. It may therefore be helpful to use the first two prices as intermediate targets, while using economic opportunity cost as the benchmark price. Setting prices below the economic opportunity cost would mean a loss o f revenue that could otherwise be used by the government for the creation and maintenance o f social overhead (roads, bridges, railroads), human capital (education, training), and other vital public programs. Once fuel price subsidies are phased out, consideration can be given to fuel taxation (e. g., a general consumption tax). Excise taxes are usually imposed on petroleum products, but they tend to be low in major oil-producing countries. That said, excise taxes on transport fuels serve as a means o f collecting road-user charges. Many countries have poor road systems because maintenance i s not adequately funded. A fuel tax may be the most obvious and acceptable proxy for direct charging. Because diesel-powered trucks cause most o f the wear and tear on roads, a diesel tax might be an appropriate proxy for direct roadmaintenance charges. Welfare impact How would fuel price increases affect the welfare o f the poor? Unfortunately, data on household spending inIraq are not available to offer quantitative estimates. We do know, however, that such increases are often regressive: while the rich may pay more in absolute terms following price increases, the poor are adversely affected because the increases affect a greater share o ftheir spending. The consequences o f price increases can be categorized into direct and indirect effects. Direct effects concern the impact arising from consuming the fuels in question. Indirect effects arise because goods purchased have fuels as inputs in their production or transportation. In Iraq, households use liquefied petroleum gas (LPG) and kerosene extensively for cooking and heating. Available data on seasonal variation in demand for kerosene suggest that kerosene i s widely used as a heating fuel. Gasoline and diesel are used by vehicle owners, who are not typically among the poorest. Diesel, however, i s usedingoods transport and agriculture, so a diesel price increase will have an economy- wide impact. In markets without price subsidies, expenditures on electricity tend to be the highest among the various forms o f household energy consumption. Because heating could require considerable energy in a cold climate, expenditures on heating fuels can also be significant. For poor households in Iraq, the impact o f large increases in the prices o f kerosene, LPG, and electricity (arising from an increase inthe input price o f fuels at the power plant gate) will require attention from policymakers. Depending on how much public transport is used (usually a substantial amount for the poor, who generally do not own vehicles), the impact o f higher public transport costs can also be important, because the fuel cost makes up a significant fraction o fvehicle operating costs. It is important to note that the welfare impact depends on the effective price increases, which differ from the official price increases. Estimating the effective price is 58 complicated by the presence o f a large black market with considerable price variation over time and place. No quantitative information i s available on the volume-averaged effective prices paid by households for different fuels, but the actual prices paid have been known to be higher by an order o f magnitude or more at certaintimes. For example, in January 2005, some residents in Baghdad were paying ID 300 (against the official price o f ID 5) per liter o fkerosene and ID 3,000 (against the official ID 250) per cylinder o f LPG. The higher prices actually paid would clearly make the direct welfare impact o f raising official prices smaller. To examine the impact o f raising the prices o f natural gas, fuel oil, and diesel on the cost o f power production, illustrative calculations are shown intable 3.3. The results show the incremental impact o f raising the fuel price on the cost o f power production. Natural gas and fuel oil are assumed to be burnedat power plants for supplying grid electricity, and diesel in small generation sets. Table 3.3. Impact of fuel price increases on electricity production cost Priceper unit Costper MMBtu Costper kWh Fuel I n dinars In dollars In dollars I n dollars I n dinars Natural gas (in cubic meters) 1.o 0.001 0.02 0.000 0 13 0.009 0.25 0.003 4 26 0.018 0.50 0.005 7 38 0.026 0.75 0.008 11 1.o 50 0.035 1.oo 0.010 15 Fuel oil (inliters) 0.001 0.02 0.000 0 5.0 0.003 0.09 0.001 1 50.0 0.034 0.87 0.009 13 100.0 0.069 1.74 0.018 25 200.0 0.138 3.49 0.035 51 Diesel (inliters) 10 0.01 0.20 0.003 4 50 0.03 1.oo 0.014 20 100 0.07 2.01 0.027 40 200 0.14 4.02 0.055 80 300 0.21 6.02 0.082 119 500 0.34 10.04 0.137 199 Note: Power plant fuel efficiency o f 34 percent for natural gas and fuel oil i s assumed, which i s currently considered appropriate for Iraqi power plants. Calorific value o f natural gas assumed to be 1MME3tuper 1000cubic feet. Diesel generationsets are assumedto have 25 percent fuel efficiency The he1 cost per kilowatt-hour (kWh) in the case o f natural gas can be decreased by more than 30 percent if generation i s done in a gas turbine with a combined cycle design and fuel efficiency o f 50 percent. Cost-recovery prices o f associated natural gas at the wellhead in Iraq may be on the order of $0.50-0.70 per million British thermal units (MMBtu).A gasprice of $0.75-1 .OO per MMBtuat the power plant gate, comparedwith the current ID 1per cubic meter, adds another ID 11-15 per kWh to the cost o f power production. At a thermal efficiency o f 50 percent, rather than the assumed 34 percent, the additional fuel cost falls to ID7-10 per kWh. Incomparison, increasing the price o f he1 oil to approach market prices adds considerably to the cost o f power production. Evenat 59 ID 100per liter, which is equivalent to only $11per barrel, the additional cost from the fuel price increase is about ID 25 per kWh. At 40 percent efficiency (the maximum achievable using fuel oil), the additional cost of power generation for ID 100 per liter i s ID22 perkWh. Iraqi households are increasingly turning to diesel generation sets. Raising the price o f diesel will raise the cost o f electricity from this source further. The economic opportunity cost o f diesel, which i s imported, i s much higher than those o f natural gas and fuel oil. Unlikethe prices of natural gas and fuel oil suppliedto power plants, information on the actual prices paid for diesel for this use i s limited, making it difficult to estimate the likely consequences on end-user prices. At ID 500 per liter, which is the import-parity price o f diesel, the cost o f fie1alone is equivalent to $0.14 per kWh. Estimated effects of energyprice increases in Iran An examination of energy price subsidies in fiscal 2001-02 inIran and o f the impact o f raising domestic energy prices to 10-year average border levels gives useful insights (World Bank 2003~). Domestic Iranian prices in 2001-02 were particularly low compared with border prices for fie1 oil (7.8 times lower), kerosene (6.9), diesel (6.9), and natural gas (5.1). The annual average o f the energy subsidies over the previous decade was about 11percent o f Iran's GDP. The subsidies were found to be inequitable and regressive. For some forms o f energy, the price subsidies benefitedthe richest 10 percent o f the population 12 times more than the bottom 10 percent. Energy inefficiencies in industry were large compared with other countries. Cement plants and iron and steel mills inIranwere estimated to consume about 40-60 percent more energy than those inJapan. Domestically manufacturedrefrigerators andcars were similarly much less efficient than the imported ones. In aggregate, raising domestic prices to border prices prevailing in 2001-02 entailed a fourfold increase in volume-average prices. The impact on economy-wide price levels was calculated to be 30.5 percentage points above the baseline. This figure represents an upper bound because price and income elasticity effects were not taken into account in the calculation. In practice, an energy price adjustment o f this magnitude would be expected to result inmore rational or efficient consumption o f energy, as well as a fall in demand, reducing the increase inthe general price level. Aside from the energy sectors, 5 out o f43 sectors studied (goods transport, brick, gypsum, cement, andwater) experienced price increases o f more than 70 percent. The proportional loss in welfare arising from higher energy prices declined with increasing household expenditure in both urban and rural areas, but was felt more heavily among rural households. The impact on the poorest rural group (which spent 15 times more on kerosene purchase as a share o f their total expenditures than the urban rich) was nearly twice that o f the richest urban group. Therefore, in the absence o f compensating action from the government, the envisaged energyprice increases inIraqwould probably be strongly regressive. 60 A scenariofor firelprice increases in Iraq As a part o f at his study, a standard computable general equilibrium model was developed for Iraq to simulate the impact o f a reduction in subsidies to refined oil products (box 3.2). Complementing that modeling exercise, a more detailed analysis o f fuel price rises i s also useful. When price increases are as large as those in Iran in the preceding study and those envisaged in the model for Iraq, the impact on demand is expected to be significant. Furthermore, inIraq a sizable fraction o f "demand" is actually for he1 smuggling, which i s sustained purely by large cross-border price differences. Although the extent of fuel smuggling is not known, estimates range as high as 30 percent of the volume o f refined product imports. This not only creates a fuel shortage, raising black market prices inside the country, but also imposes a large drain on the budget by artificially inflating demand for imported fuels. Raising official prices significantly will have a markedand immediate impact on perceived demandby reducing incentives for smuggling. Box 3.2. The impactofsubsidy reformson the importsof refinedoil products A standard small open economy computable general equilibrium model was developed for Iraqto simulate the impact o f a reduction insubsidies to refined oil products. The exercise simulated a sixfold increase o f prices o f Iraqi refined oil products (ROP). Such an increase would significantly reduce the extent o f smuggling and the domestic black market. It would also decrease government expenditures o n subsidies to domestically produced refined oil products and imports. The model includes four producing sectors, three oil sectors (crude oil, refined oil products, and the black market for refined products), and the rest o f the economy. There are two factors o f production-labor and capital; one household and one account each for government, investment-savings, and rest o f the world Domestic production o f refined oil products i s held constant, reflecting current government policies and security-related supplybottlenecks. Results indicate that a sixfold increase in domestic prices o f refined oil products would lead to a fall o f 39 percent inhouseholds' consumption o f refined oil products, while imports o frefined oil products would fall by 15.6 percent. Government savings would amount to ID 2.5 trillion ($1.7 billion), allowing for additional investment or transfers to households to compensate for higher prices. Higher domestic prices o f refined oil products would reduce incentives for black market sales-their volume would decrease by 30 percent. As a result o f increased spending stimulated by a more efficient use of available resources, production inthe rest of the economy would increase by 2 percent. Domestic production Domestic supply Imports (trillion ID) HHconsumption (trillion ID) price index (trillion ID) Bench- Increase Bench- Increase Bench- Increase Bench- Increase mark ofROP mark ofROP mark ofROP mark ofROP prices prices prices prices Crude oil 0.054 0.054 1 1 n.a. n.a. n.a. n.a. ROP 0.157 0.157 1 6 0.122 0.103 0.055 0.008 Black market 0.617 0.432 1 1.416 n.a. n.a. 0.546 0.359 ROE 5.252 5.349 1 1.001 28.035 28.599 8.999 8.387 T h i s version o f the model i s only illustrative. It i s now being extended to (a) examine indetail the impact of a reduction o f fuel subsidies on the nonoil sectors (agriculture, transport, construction, etc) and (b) incorporate linkages and cross-subsidization among the extraction o f crude oil, refineries, and the power sector. A disaggregation o f households into rural and urban reflecting their different income and consumptionpatterns will be undertaken as more data become available. 61 Note: The data sources used to construct the social accounting matrix (SAM) for this model include the Iraqi government budget data, national accounts statistics, the 1988 input-output table (provided by COSIT), World Bank and International Monetary Fundestimates, UNComtrade data, International Energy Agency data, and U.S.Department o f State data. The constructiono f the matrix has highlighted severe data problems. Some o f the data compilation effort and adjustments have been based on assumptions. With respect to the black market, the simulation assumes that households and enterprises in the rest o f the economy consume the same volume o f fuel at the subsidized and the black market prices, with black market prices being ten times higher. The impact ofprice increases on the demand for fuels by end-users is difficult to forecast even qualitatively. Two factors distort demand at present in ways that make forecasts difficult: wildly fluctuating and occasionally extremely high (even by international standards) black market prices that consumers pay, and serious fuel shortages that deny access to fiels even to those who are willing and able to pay very high black market prices. It is entirely possible that among certain population groups-gasoline purchasers inurban areas, for example-demand could even increase ifofficial prices are raised and fuel shortages are eased. More quantitative data, especially on prices and volumes purchasedby end-usersyare neededto make abetter assessment. Table 3.4. Scenario for fuel price reform inI r a q LPGa Gasoline Kerosene Diesel Fuel oil Total Vnrinhlc! R e d a r Premium Official price (IDper liter or cylinder, early 2005) 250 20 50 5 10 10 Current consumption (millions o f liters or cylinders) 127 5,000 1,200 3,700 5,900 3,100 Current revenue (millions of dollars) 22 69 41 13 41 21 207 Revisedprice (ID per liter or cylinder) 1,500 120 150 70 80 50 Percentage fall inconsumption 10 15 5 10 15 0 Future consumption (millions o f liters or cylinders) 114 4,250 1,140 3,330 5,015 3,100 Future revenue (millions of dollars) 118 352 118 161 277 107 1,132 Incrementalrevenue (millions o f dollars) 96 283 77 148 236 86 925 Fall inimports (millions o f liters or cylinders) 13 750 60 370 885 Import price (dollars per liter or cylinder) 4.18 0.24 0.28 0.28 0.27 Import savings (millions of dollars) 53 180 17 104 239 592 Net government revenue (millions o f dollars) 149 463 93 252 475 1,517 Note: Consumption estimates are from the UK Treasury. Price elasticities are arbitrary. The breakdown o f gasoline consumption into regular andpremium i s not known; an 80/20 split i s assumed. a. LPG price is for a 12 kg cylinder o f liquefied petroleum gas, and consumption is in number of cylinders. Import prices are the Gulf prices found intable 3.2, except regular gasoline. To give some idea of the budgetaryimpact o f fie1price increases, a hypothetical scenario is sketched out in table 3.4. Reductions in consumption ranging from 0 to 15 percent are assumed. The budgetary impact is twofold: the government receives higher revenues from higher fuel prices (much o f which i s currently captured by the black market) and 62 pays a lower bill for fuel imports (estimated in the 2005 budget to be $2.5 billion). For the four imported fuels, the new prices are in the vicinity of, or lower than, the black market prices quoted inthe media. The incremental government revenue from higher prices amounts to $925 million. A reduction in fuel imports gives savings o f $592 million, giving the government net revenue o f $1.5 billion. Although all the assumptions in this illustration can be questioned, this calculation gives an order-of-magnitude estimate o fthe budgetary impact o f near-term fuel price increasesinIraq. International experience on access of thepoor to essential household energy Gasoline prices in Iran, Iraq, and Turkmenistan notwithstanding, it i s rare for a government to subsidize gasoline heavily. Gasoline i s used almost exclusively as an automotive fuel and to a considerable extent in privately owned vehicles. Given the concentration o f car ownership and use in the upper-income groups in developing countries and the weak systems for direct taxation, a high incidence o f taxation on gasoline is a progressive tax, making it relatively easy to win political support for high fuel taxes. Most governments indevelopingcountries therefore price gasoline higher, and sometimes muchhigher, than other fuels. Diesel i s used in goods and public passenger transport, agriculture, and industry. It is viewed as a "social fuel" inmany countries, and its price is almost universally lower than that o f gasoline through differential taxation. The large difference between gasoline and diesel prices has historically led to much greater consumption o f diesel than gasoline as an automotive fuel, with adverse effects on air pollution and public health. Kerosene has also been considered by many governments to be a social fuel. It can be more easily transported to rural areas than LPG and i s used for lightingby those who are not connected to grid electricity. Kerosene has historically been subsidized in a number of countries, at least on paper. But ifkerosene is much cheaper than gasoline and diesel, adulteration o f gasoline with kerosene and large-scale diversion o f kerosene to the automotive diesel sector become widespread. Replacing diesel with kerosene has virtually no impact on vehicle performance and is hence financially attractive. InIndia, as much as 50 percent o f heavily subsidized kerosene intendedsolely for use by households has been estimated to be diverted to other sectors, costing the government close to $1 billion in 1999-2000 (ESMAP 2003). There i s no example o f an effective targeted kerosene price subsidy scheme, in large measure because o f the nearly perfect substitutability between kerosene and diesel and the ease o f transporting and selling kerosene. LPG i s used by households for cooking and heating, especially in areas without piped natural gas. It i s also one o f the cleanest commercial fuels. LPG price subsidies tend to benefit better-off urban households much more than the rest o f the population, and as such are regressive. This also means that eliminating LPG price subsidies would have little welfare impact on the poor. InIraq, because o f the extremely low LPG price in'the 63 past, its historical use has reportedly been extensive and common even in remote rural areas. This would need to be verified. Iftrue, the welfare impact o fthe LPGprice subsidy phase-down could be more serious than inother developing countries. Natural gas has the potential to become the cheapest household fuel in Iraq inthe future. Electricity and natural gas, which are delivered through networks, have one advantage over liquid fuels: they are more difficult to divert. One possible approach for protecting the welfare o f the poor i s to have a rising block tariff structure, whereby a small first block at a subsidized tariff is made available to help the poor, cross-subsidized by higher tariffs for higher blocks. All benefit from the subsidy in the first block, but the rich, who consume more energy, pay more on average on a unit basis. Risingblock tariffs are not without problems and are prone to political capture. One serious and commonly encountered problem i s the political pressure to increase the size o f the first block, a politically popular move that i s extremely costly. Careful analysis o f the market is needed before deciding whether and how to adopt such tariffs. International experience amply demonstrates that it i s difficult to design an effective targeted subsidy for liquid fuels. The most suitable approach, if administratively and technically feasible, i s to shift the focus away from fuels, consider how policies across different sectors (food, water, electricity, fuels, education, health) are affecting the poor in aggregate, and assist them with a direct income transfer to help them purchase the basket o f goods they consume. But absent an already existing mechanism, the cost o f administration-from identifyingbeneficiaries to deliveringdirect cashpayments-could far exceed the intended benefits. A direct income transfer i s unlikely to be a feasible option inIraq inthe near term. Because the official fuel prices are extremely low today, even increasingprices fivefold or tenfold to reach ID 100-200 per liter would yield prices that are still low by world standards. It would be best if any compensation in the initial stages o f price adjustments were temporary. Over time, if and as fuel prices are raised toward economic-opportunity prices, a sustainable mechanism to enable the poor to meet their household energy requirements will needto be designed as part of a broader social safety-net package. Integratingfuel price increases withpolicies in other sectors Because fuels are inputs in almost all sectors o f the economy, fuel price increases need to be coordinated with policies inother sectors, especially those that are fuel-intensive such as transport and power. At present, primary resource prices are set virtually at zero for some users. For example, the price o f a barrel o f oil sold to local refineries i s ID 300 ($0.21). Iti s important to start raisingprimary resource prices at the point o f origin, to the level sufficient to cover long-run development and operating costs. Raising prices at any point along the supply chain has immediate implications downstream. The input prices at refineries and power plants are likely to be increased at the same time, adding on transportation costs. The first goal i s be to raise ex-refinery prices to allow for recovering the cost of maintenance and investing in upgrading processes. Installation o f cracking units, which convert fuel oil to lighter products, would substantially reduce the need for 64 product imports in Iraq. Electricity tariffs will need to reflect fuel cost increases. Allowing full cost recovery will not only help sustain current production levels, but will provide incentives for investment innew capacity to meet rising demand. Electricitypricingandmanagementautonomy The Iraqi government recognizes that adjusting energy prices i s one o f the keys to rehabilitating the electricity sector. The adjustment o f energy prices can improve cost recovery and help to ensure that the right investment choices are made in that critical sector. Even under a new price regime, however, the electricity sector will not be able to recover unless electricity utilities have greater management autonomy. This section discusses some o f the possible approaches to electricity reform and their likely impact on households andthe budget. These considerations all bear uponthe scope o freform inthe electricity sector: Reforming electricity price subsidies ought to be part o f a broad government effort to free more resources for investment and improve the targeting o f the incentives across sectors. Inparticular, reducing subsidies for electricity needs to be coordinated with similar policies applied to other essential goods (such as food subsidies) to sequence their implementation inaway that reduces the potentialpoliticalbacklash. Electricity price reforms are acceptable only if the supply o f electricity is reliable, a goal toward which the government i s currently working. Electricity price reforms have to be conducted inparallel with efforts to improve the management and the use o f oil revenues, since current electricity price subsidies (and direct fuel price subsidies) are one o f the many ways through which Iraqi citizens perceive a benefit from oil production. Rebuilding a deteriorated electricity supply Electricity production has grown by nearly 10 percent per year over the past 30 years- albeit with noticeable bumps along the way-despite war, sanctions, depletion o f capital stock, and other major difficulties (figure 3.2). Most o f the generation has been fueled by heavy fuel oil, with a smaller contribution from hydropower. Since the Gulf War, a significant share o f generation has been from burning crude oil, as the availability o f natural gas associated with oil production has fallen. Roughly a fifth of generation was based on natural gas before 1991. After the recent conflict, as oil production fell off from prewar levels, little gas was put into pipelines, which resulted intoo little pressure to fuel connected gas turbines. As power plants switched from gas to more crude oil and gas oil, the efficiency o fgeneration has dropped significantly. 65 Figure 3.2. I r a q electricity production and oil inputs into electricity generation Iraq Electricity Production (Gwh) 35000 _ _ Oil inputsinto ElectricityGeneration (mt) -- ~ 30000 25000 20000 15000 10000 5000 I 71 75 80 85 90 95 01 I 71 75 80 85 90 95 01 Note: HFO indicates heavy fuel oil. Source: World Bank staff estimates. In 1990, the total installed generating capacity was 9,295MW, with a peak demand o f about 5,100 MW. Approximately 87 percent o f the populationhad access to electricity. In 2002, an estimated 2.6 million out o f a total 3 million households were connected to the power grid. Households represented 80 percent o f all customers and consumed 48 percent o f all the power generated. Industry,with less than 1percent o f customers, consumed 20 percent, and much o f the rest went to government (13 percent), commercial (6 percent), and agricultural (4 percent) uses. Industry and commercial enterprises also rely on their own standby generators, which could be in excess o f 1,000 MW. About 40 percent o f electricity i s consumed inthe Baghdad area. Per capita consumptionhad been suppressed at around 1,400 kWh from the 1991Gulf War untilthe start o f the 2003 conflict; recent consumptionhas been about half o fthat. A combination of wars, lack of maintenance, sanctions, looting, and vandalism has severely affected the entire power infrastructure inIraq. In 1991, the available generation capacity was reduced to 2,325MW, and power cuts o f up to 15 hours or more a day were common. Repairs helped make available about 4,500MW o f generating capacity in2002, and about 5,300MW in mid-2004. After the most recent conflict, the situation has considerably deteriorated again. In spite o f repairs, generating equipment is aging, fuel supplies are often interrupted, and fuel quality inadequate. As a result, generators frequently fail, and thermal efficiencies are extremely poor. Transmission and distribution systems remain highly unreliable, and total losses are currently about 30 percent. Power cuts have become more frequent. This is the case particularly during the summer, when demand i s at its peak. Electricity is currently available only a few hours a day (8.5 hours per day on average throughout Iraqinthe first week o f January 2005). 66 Table 3.5. Electricity tariffs in Iraq Household 0.0007 1.ooo 1-1,500 0.0027 4.000 1,1501-2,100 0.0047 7.000 2,101-3,000 15.000 3,001-5,100 0.02 30.000 5,101 or more Commercial 0.0013 2.000 1-300 0.0027 4.000 301-600 0.0053 8.000 601-900 0.008 12.000 901-1,500 0.0013 20.000 1,501-3,000 0.0166 25.000 3,001 or more 1ndustrial 0.0057 8.500 0.4 kv 0.002 3.000 0.0017 2.500 0.0013 2.000 132kv Governmental 0.0013 2.000 1-1 0,000 0.017 2.500 10,001-20,000 0.002 3.000 20,00140,000 0.0027 4.000 40,001- 100,000 0.0033 5.000 100,001 or more Agricultural 0.0033 5.000 Note: Black market exchange rates as o f December each year for 1996 and 2001. These exchange rates fluctuated widely. Source: Iraqi Ministry o f Electricity, World Bank staff estimates. To reconstruct the existing electricity infrastructure, the World Bank and UnitedNations have estimated that investments o f $13 billion would be needed up to 2007 (United Nations and World Bank 2003a). This amount covers the costs o f gradually bringingback the power system to a reliable and efficiently runsystem similar to the pre-1991 levels o f total capacity and service access. The needs were estimated assuming a potential demand inthe order of6,500-7,000MW, to be matched by supply in2007 with the addition o f a little less than 4,000MW over 2005-07. Getting electricityprices to reflect costs Iraq has the advantage o f being able to shift to natural gas-fired generation over time, which will improve the overall efficiency o f operations and substantially reduce emissions. That shift requires significant investments, however. If the government plans to phase out subsidies and attract private capital (and management) into the electricity sector, the legal and regulatory framework will probably have to be updated to enable tariff setting above cost-recovery levels. 67 Electricity tariffs are now held at very low levels-among the lowest in the world. Although tariffs have increased in recent years, household tariffs, as measured by the black market exchange rate rangedfrom $0.002 per kWh fiom low consumption to $0.04 per kwh for high consumption in,2001. Given the features o f Iraq's power system (fuel use, generation capacity, consumer density, etc.), tariffs in the range o f $0.05-0.07 per kWh would probably better reflect actual cost. The extremely low cost o f electricity to consumers provides no incentive to conserve energy, especially for households, and probably leadto wasteful consumption. Inprinciple, tariffs were setsothat operatingandmaintenance costswouldbecoveredat subsidized fuel prices, but that was barely the case. Total tariffs collected in 2002 were $44 million, compared with costs of about $1 billion, according to estimates made at international fuel prices for the Iraqi Commission o f Electricity. Indeed, the annual fuel bill o f about $9 million at subsidized fuel prices would be on the order o f $800 million at recent international prices. In the Commission o f Electricity's 2002 budget, fuel costs represented only 6 percent o f total expenditures, compared with about two-thirds incountries where energy prices are market-based. At present very limited amounts o frevenue are being collected, as distributingcompanies are awaiting security to improve billing and collection procedures. Yet, the capacity o f consumers to pay i s likely to be much higherthan the existing tariff. Inspite o f the lack o f security affecting economic activity, opening Iraq's borders in 2004 has generated a spurt in demand for electrical appliances. As a result, electricity demand has reportedly increased by about 30 percent, mainly from the household sector. Since the existing centralized grid i s currently unable to satisfy all electricity demand, Iraqis are increasingly resorting to producing their own electricity with small, often portable, stand-alone diesel power generators. In densely populated urban areas with sufficient income, private suppliers are providing power to clusters o f households with a single generator, charging a flat rate for the connection. This is likely to be much higher than the prevailing electricity tariff. Reducing the subsidies on diesel prices and increasing the reliability o f electricity supplied through the grid are likely to boost demand for grid electricity, possibly improving the profitability o f the central power supply system. More important, the high price o f electricity fiom stand-alone diesel ... generators could indicate a significant willingness to pay for electricity services."' Therefore, the Commission o f Electricity has a significant margin o f maneuver to raise electricity rates, increase revenue collection, and improve the financial health o f the utilities. Increasing tariffs i s essential but not sufficient. Iraqused to benefit from a relatively wide access o f its population to electricity. This i s well worth preserving. Low-income groups already connected to the grid will probably need some kind o f subsidized access for awhile. This subsidy could take the form o f a cross subsidy built in the electricity tariff, where larger consumers are charged proportionately more than smaller consumers (a 68 block tariff). This type o f tariff structure would imply a significant increase in electricity prices for larger consumers; hence the subsidized tariff for small consumers would need to be set for as low a level o f consumption as possible, such as 50 kWh per month, and maintained at that level. If the assessed need for social support i s expected to put a burdenon larger consuming groups with a risk ofpolitical backlash, as a very last resort, a block tariff could be associated with a small direct electricity price subsidy, limited in time. Although the direct price subsidy is known to lead to poor targeting and considerable waste of expenditures, since a lot o f the recipients are not necessarily the ones who need financial support, its administrative cost i s limited, and it could be designed as part o f the transition to prices reflecting economic opportunity costs. If chosen, such a system would need to permit monitoring o f expenditures. Implementation of support mechanisms with an impact on the public budgetwould have to be coordinated with the improvement of safety nets (see chapter 4). Inconclusion, Iraqnow urgently needsto mobilize efforts to improve the basic functions o f electricity service: efficient generation, delivery, metering, billing, and revenue collection. Although raising tariffs i s the key to improving service in the long term, the reliability o f service needs to improve before consumers will accept price increases. Inparallel, there is a need for a detailed analysis of the use of electricity, the need for social protection, the appropriate tariff structure, and the options available to work out a transparent and well-targeted support mechanism. To work this out, detailed information on the cost o fproducing and distributingelectricity needto be gathered. Management autonomy of electricity utilities Inspite of its current problems, Iraq's electricity system has several advantages: a large transmission grid and a relatively expansive access to electricity, abundant primary energy resources o f oil and gas, competent utility personnel, and an industry structure that has-in the past-experienced a relative autonomy from political interference. Yet, the challenges are huge: first, to rebuild the existing facilities and meet the existing demand and, second, to set the pace for reforming the utilities and providing them with sufficient autonomy to operate and fund their future expansion. For the electricity utilities to reintroduce more internal financial responsibility, better cost accounting, and eventually lower productioncosts, they will needmore management autonomy. The Ministry of Electricity is currently responsible for policymaking and electricity supply throughout the country. (The ministry is the successor o f the Commission o f Electricity.) The Commission o f Electricity provided corporate services, operated the National Dispatch Center, and oversaw the operation o f three regional generation and transmission companies (400kV and 132kV), four regional distribution companies, and four other companies responsible for construction, manufacturing o f equipment, and information technology. The Ministryo fElectricity was recently reorganized into a number o f directorates largely maintaining the Commission o f Electricity structure, but power generation, transmission, 69 and distribution operations are now reorganized into 18 geographically based directorates, which report to a senior deputy minister. Total staff i s estimated at about 43,000. The two electricity departments in Kurdistan (Dohuk, Erbil, and Suleimania governorates), which are not connected with the main grid, report to another official in the Ministryof Electricity and have an estimated 7,300 employees. Electricity supply will have to rapidly revert to its earlier structure o f autonomous companies, away from the direct control o fthe Ministryo f Electricity, to enable adequate investment allocations and rapid and optimal deployment o f capital investments across the industry. Gradually, financial accountability o f the managers at all level will need to be enforced, and three measureswill have to be implemented: 0 Prepare programs to reduce technical losses within each o f the generation, transmission, and distribution entities. 0 Set objectives and measures to improve metering, billing, and revenue collection in the four distribution entities. 0 Expand financial accounts to assess the true cost o f producing, transporting, and distributing electricity. 0 Consider reorganizing generation, transmission, and distribution activities into corporate entities. The Ministryo f Electricity has to give careful consideration to moving away from direct management o f the electricity utilities and insteadplaying the following roles: 0 Formulating electricity policy on the timetable for switching to natural gas for power generation; the role o f the private sector; the rules, monitoring, and regulation o f competition; andthe goals for electricity access. 0 Protecting low-income consumers by defining the size and nature o f possible cash supports to soften the negative impact o f electricity price rises. 0 Monitoring supply, demand, and reliability o f electricity services and identifyinggaps ingeneration investments. 0 Creating a favorable investment climate and a clear regulatory framework for private and public enterprises to supply electricity to the grid. 0 Determiningandenforcing safety and environmentalguidelines for electricity supply. As Iraq moves toward reforming its pervasive system o f subsidies on food, domestic fuels, and electricity, it may be able to draw lessons from other sectors o f the economy, especially experiences in agriculture (box 3.3). By moving on all these fronts to bring domestic prices more in line with world market prices-and indoing so fostering growth and competition in the country's private sector-Iraq would also be positioning its economy to take more advantage o ftrade and foreign investment opportunities. 70 3ox 3.3. Impact o f subsidy reforms on the agricultural sector Igriculture in the national economy. Decades o f war, sanctions, inadequate public resources, limited nivate investment, and heavy state intervention have degraded facilities and distorted incentives, resulting n low productivity and decreasing the contribution o f agriculture to rural incomes. For more than two lecades, agricultural production was determined by government intervention, with little regard to :fficiency or comparative advantage, creating major disincentives for private initiative. The agricultural trategy o f the previous government, aggravated by an embargo, promoted the production o f strategic crops wheat, maize, cotton, and sunflowers). For these crops, the government supplied farmers with inputs and :quipment at subsidized prices, provided free extension services, acted as the main buyer o f the crops at ;overnment-set prices, and arranged storage, marketing, and processing. The UN and World Bank Needs issessment (United Nations and World Bank 2003a) estimated the total amount o f subsidies for agriculture it $582 million for that year. About 45 percent o fall subsidies were for fertilizers. Most prices, production, indagricultural commodity markets were controlled by the government. Export markets were lost when an :mbargo was imposed in 1991. Inresponse, the government established a network o f state enterprises for he provision o f inputs, purchase o f crops, and processing o f strategic commodities. In 2003 this network xoke down; some private entrepreneurs emerged to fill the void. Although the public facilities and their :mployees have remained in place, they are now largely inactive. The private sector has only slowly and nsufficiently developed the capacity to provide the goods and services that were formerly provided by the government. Nonetheless, agriculture still provides 6-8 percent o f Iraq's GDP and absorbs about 20 iercent of the Iraqilabor force, supporting a rural population o f about 7 millionpeople. Effect of input subsidies and output price support. Input and output price interventions by the state have xeated market distortions leading to an inefficient allocation o f resources. They created major iisincentives for private investment, initiative, and innovation and dramatically reduced sectoral xoductivity and competitiveness. In addition, large-scale farmers benefited disproportionately from the subsidies, because they used larger amounts o f subsidized inputs and outputs. However, price interventions 2nd state procurement systems have generally offered predictable and stable incomes for producers oj strategic agricultural products, providing some social safety net for part o f the rural population. Fertilizer production used to be exclusively in the hand o f three state-owned factories with a capacitj sufficient to meet domestic demand. During the war o f 2003, fertilizer production was suspended, and the prewar capacity has never been reached again, primarily because o f the lack o f electricity. Inthe absence 0: governmental supplies, private traders have started to sell imported fertilizers at market prices. Tht government intends to restore fertilizer production, but gradually to phase out fertilizer subsidies by 2008 Farmers are facing two major issues: the timely availability o f sufficient amounts o f fertilizers at loca markets and the gradual transition to market-based prices for inputs. Cereal markets are strongly distorted by the Public Distribution System. Before the war, the Ministry o f Agriculture used to announce producer prices for wheat and barley before each planting season. The farmers planted according to these prices and received strongly subsidized inputs. The Ministry o f Trade's State Company for Trading Grains procured the farmers' produce, stored it at government-operated silos, and fed it into the milling and distribution processes under the Public Distribution System. Although Iraq has begun its transition toward a market-oriented agricultural sector, the earlier system i s still inplace as well. Farmers are facing two major issues inthis transition: they will need to orient their production toward the requirements o f domestic and international markets, and they will need to organize the marketing of their products (inthe absence o f the guaranteed state procurement o f agricultural outputs). Government strategies for the agriculture sector. The objective o f the National Development Strategy is to foster market-led growth. A variety o f measures are being implemented, to increase agricultural productivity through input and output price liberalization, increased purchase o f goods for the Public Distribution System from local farmers at international prices, improvements ininput supplies and supporl services, investment for irrigation and critical rural infrastructure (e.g., storage); improved natural resource management; and the reform o f state-owned enterprises. Related strategies on food security and regional development call for procuring more food from domestic suppliers, liberalizing food prices, maintaining an 71 open trade regime, and reducing the disparities among governorates and between rural and urban areas. Expected impact ofprice reforms. While a quantitative analysis o f the net effect o f these reforms has yet to be conducted, the elimination o f subsidies and product price supports will change relative prices among agricultural products and between agricultural and nonagricultural products. Resources will move to agricultural products with higher net returns; some resources will shift between agriculture and other sectors. Evidence from other countries shows that the income effect o f low producer prices is usually not compensated by input subsidies. The net income effect o f eliminating price distortions is therefore expected to be positive. More efficient resource allocation and increased incentives for private investment are expected to lead to increased sectoral productivity and competitiveness, resulting in higher incomes for farmers, but leaving nonfarm rural families more vulnerable because o f higher food prices. Policy reforms affecting agricultural input and output prices work best if coordinated with strengthening the social safety nets. The extent to which the potential for higher productivity and competitiveness can be realized will depend on farmers' willingness and capacity to adapt their production interms o f output type, quantity and quality, intensity level, and long-term investment. Functioning input and output markets, financial services and risk management (crop insurance, floor prices, etc.), marketing and transportation infrastructure, and effective farmer training and information are critical inthis transition. Trade andinvestment Trade has a potential to significantly boost the Iraqi reconstruction process. Already in the current tense security situation private trade has been growing rapidly, providing jobs for thousands. This job creation potential will grow manifold as soon as the security risks are addressed. For trade to play this facilitating role, however, a trade regime must be designed that i s transparent, open, and resistant to instability stemming from highly volatile oil markets. Trade reforms are part of a broader development and reconstruction strategy that will succeed only if harmonized with the domestic price liberalization and reform o f Iraq's complex subsidy system. This section examines Iraq's trade structure and recent performance; key underlying issues in mainstreaming trade in Iraq's development strategy; components o f a sound trade agenda; and short-term challenges. Iraq's trade structure and recentperformance It should not be surprising that Iraq's exports are currently highly concentrated in petroleum and other oil-related products (98 percent), given the recent history o f conflict and sanctions. Such concentration was not always the case, however. By the mid 1970s, Iraqwas well on its way toward developing a more diversified export structure, with over 90 partners and a wide range o f export products. Trade expanded rapidly from the mid- 1960s to the mid-l970s, with a 40 percent increase in the number o f trade partners and nearly 20 percent increase in total export products. Total exports increased in value by over 700 percent between 1965 and 1975, decelerating a bit by the mid-1980s. In the mid-l970s, Iraq's trade partners spanned countries in the Middle East and North Africa, the Organisation for Economic Co-operation and Development, Latin America, and Asia, and reached to markets as distant as Iceland. Few of the export sectors were competitive on a global scale, with the exception o f dried fruit, sulfur, and petroleum. Sanctions have 72 cost these nonoil exporters their foreign markets. These producers have either disappeared completely or are currently idle. The only noticeable nonoil exports are now dates and other food products, amounting to 1percent o ftotal exports. The export volume o f oil and related products increased significantly in the late 199Os, reaching $16.5 billion in 2000, before following a declining trend ever since. Exports in 2003 were just about half o f the level reached in 2000. Imports followed a similar trend. They increased gradually to reach a maximum o f $10.5 billionin2002, andthendeclined sharply in 2003. Iraqi imports are much more diversified than exports, with machinery, food, and a large number o f other products imported. The collapse in imports o f machinery, which dominated imports in 2001-02, drove the total decline in imports in 2003. At the same time, Iraq experienced a boom-almost a twentyfold rise since 2003- in private-sector imports. This has filled the Iraqi markets with a variety o f previously unavailable goods. Overall, Iraq's trade surplus remains high at $4.5 billion in2003. Iraq's major partners for imports include Germany, Iran, Jordan, Turkey, United Kingdom, and United States. Iraq actively pursuedbilateral regional trade arrangements with its Arab neighbors before the 2003 invasion. According to the MinistryofTrade, the government signed free trade agreements with 11 Arab countries. Most o f these agreements were signed in2001-02 as part o f Iraq's efforts to skirt the UNinternational trade embargo (Kaminski 2004). As shown in figure 3.3, however, Arab countries accounted for only 12percent o f Iraq's imports in2004. Figure3.3. GeographicaldistributionofIraq's imports,2004 I Other 7% Arab countries r n n , 48% Source: Central Bank of Iraq 2004. Mainstreaming trade in Iraq's development To integrate trade policy into Iraq's broader development and reconstruction strategy, three issues are worth considering: Fiscal consolidation, restructuring, and diversijkation. While oil revenues will continue to be the mainstay o f government revenue streams, it will be important to encourage 73 development o f a more diverse fiscal base, reflecting the underlyng volatility o f oil, the highdemand for reconstruction, and the need to service debts inthe short and medium term. Within such a diversified structure, sensibly chosen taxes on imports can play a modest but nonetheless important role, especially when world prices o f oil are low. Tariff revenues will supplement oil royalties to fund government expenditure without resort to additional taxation, largely or wholly relieving the nonoil traded sector and the private service sector o f other forms o f direct and indirect taxations. Whatever the difficulties o f creating customs administration and working tariff regimes, they are likely to be easier and more immediate to achieve, and easier to sustain, thanintroducing more broad-based domestic taxes (income tax, value-added tax, or sales tax) or export-supporting schemes, such as duty drawbacks. Minimizing Dutch disease effects. Iraq i s an oil-rich economy with tangible prospects for expansion of production. Income per capita i s likely to increase significantly over the coming ten years. Higher income will boost consumption o f nontraded goods and services, bidding up their prices, resulting in overvalued and uncompetitive exchange rates and reduced relative profitability o f the nonoil traded goods sectors (agriculture and industry). These are the classic symptoms o f Dutch disease. To minimize such problems andmaintain a diversified economy, it is necessary to ensurethat the nonoiltraded sector remains lightly taxed, flexible exchange rate policy and labor legislation i s in place, red tape i s kept to a minimum, and capital goods and inputs are not subject to hightariffs. Improving the investment climate. The success o ftrade reformwill heavily rest on private investment response and job creation. Combined with policies f?iendly to foreign direct investment and other measures to improve the investment climate, this i s likely to encourage both foreign and domestic investment in the nonoil sector and increase the likelihood o f absorbing workers currently unemployed, as well as new entrants to the labor force. Changes in the trade and investment climate are critical complements in benefiting labor markets. Reinvigorating trade reforms, when combined with complementary actions to spur private investment, will likely lead to much faster employment growth inaggregate. Aproposed tradeagenda As Iraq reconfigures its agenda for trade, it should consider reforms to streamline the tariff structure, stimulate trade in the service sector, and, encourage foreign direct investment. Tariffpolicy. In the prewar period most o f Iraq's trade was through the U. N. Oil for FoodProgram, underwhich imports entered the country tariff free. Private-sector imports that took place outside the program were subject to tariffs in the 15-20 percent range, with tariff peaks of 100to 200percent on some products, including luxury cars. In 2003-04, the Iraqi government took a number of trade policy measures. Border restrictions to merchandise trade were lifted, a uniform tax o f 5 percent instituted, foreign exchange markets liberalized, and the decision was made to negotiate membership inthe 74 World Trade Organization. Iraq has started to unwind decades o f state control, price distortions, and high protection. Over the longer term, the main task will be to put in place a tariff structure that can yield important benefits to the country's broader policy objectives. International experience suggests a few rules o f thumb that could guide policymakers when designinga tariff structure: 0 Simpler is better. A regime with a uniform moderate rate that injects efficiency inthe economy while providing a degree o f support for domestic value added is preferable to one with multiple levels and peaks on individual products. Multilevel and specific product tariffs can foster fraud, corruption, and economic distortions. 0 Lower is better. A low uniform tariff (e. g., not exceeding 10 percent) provides domestic value added with a modest degree o f protection, but also exposes the tradable sector to some international competition, which places an upper bound on the inefficiencies that can emerge inclosed markets. 0 Broader is better. Even simple structures can be hard to administer if there are countless ways to legally avoid paying duties, e. g., exemptions for the government, for nonprofits, or for specific expenditures and industries. The proposed tariff structure-low uniform tariff across all goods and all importers-has many advantages. It would send a clear signal to investors, reduce the cost o f much neededcapital and intermediate goods, provide increased access to modem technologies, facilitate trade by simplifying customs clearance procedures and customs valuation, and put Iraq's trade regime close to that o f the Gulf Cooperation Council with which Iraq may want to eventually affiliate. In addition to the free trade agreements signed with Arab countries, Iraq is likely to engage in an agreement with the United States and, possibly, with the European Union. The bulk o f Iraq's trade may be governed by trade agreements in the medium run, and a low uniform tariff could help avoid costly trade distortions. To put Iraq's trade regime into perspective, it i s worth noting that the simple average tariff in Middle East and North Africa is 16.5 percent-higher than any region except South Asia. About 16 percent o f tariff lines are subject to at least one nontariff barrier in the Middle East andNorth Africa. Only Jordan, which has an average tariff o f 16.2 percent, has done away completely with its nontariff barriers. Syria has high protection, with an average tariff o f 21 percent, and Saudi Arabia also has moderate protection (12 percent average tariffs), as well as fairly prevalent nontariff barriers. The proposed tariff reform should also be consistent with overall tax policy. If the objective i s to introduce a value-added tax, such taxes would have to be collected at the border. If the same principles of simplicity and broadness are applied to the tax reform, thenthe efficiency o fthe tariffreformwillbe enhanced. Trade in services. The service sector i s likely to be the largest source o f employment and, to a lesser degree, value added in Iraq. A vibrant service sector can also be a source o f exports-for example, the United Arab Emirates have been moderately successful in developing tourism, re-export trade, shipping, telecommunications services, broadcasting and media, and financial services (World Bank 2003d). Efficient provision o f so-called backbone services, including telecommunications, power, transportation, and finance, i s 75 crucial to economy-wide productivity and therefore to international competitiveness. These services also have a direct impact on living standards. Stimulating competition in the service sector and providing access to state-of-the-art technologies and management practices, by allowing foreigners access to the domestic market for services, should be a central thrust o f Iraq's development strategy. The benefits o f this strategy are clearest in sectors that are normally the province o f the private sector throughout the world, such as retailing and wholesaling, banking, even though many o fthese sectors are state-driven at present inIraq. The regime for foreign direct investment. Foreign direct investment-or foreign establishment-is by far the main vehicle through which the domestic service sector can be exposed to international competition. Other modes o f international service provision identified in the General Agreement on Trade in Services include temporary movement o fworkers, remote provision (e. g., through the internet), and movement o f consumers (e. g., tourism). Thus, a new regime for foreign direct investment is a crucial platform for facilitating trade inservices and promoting efficiency across the Iraqi economy. As in the case o f services, a liberal foreign direct investment regime is also essential to promoting Iraq's trade integration in global markets for manufacturing, agriculture, and food processing by providing risk capital, technology, access to markets, and management know-how, as well as enabling Iraqto enter the international value chain in sectors where it has comparative advantage. Finally, foreign direct investment can be a crucial source o f development finance during Iraq's reconstruction phase. Increased reliance on foreign direct investmentmay help to develop Iraq's still largely unexploited oil production potential and also contribute to the country's debt-reduction objective. As Iraq undertakes these much-needed, but technically difficult regulatory reforms in services, it may wish to focus initially on services directly related to logistics and facilitating trade. These backbone services facilitate resource flows and economic transactions between countries. They are critical to attracting "production blocs" from abroad because they allow for production fragmentation. Without high-quality backbone services, Iraq's domestic and foreign investment will be hindered, with resulting loss in trade (Kaminski 2004) Membership in the World Trade Organization. Iraq's application for World Trade Organization membership in 2004 sent an important signal to investors that Iraq is willing to commit to transparent, rule-based liberal trade policies. It also had a symbolic dimension, signaling to the world that Iraq wants to reintegrate into the broader world community after a long period o f diplomatic isolation and war. The move will fiu-ther help to ensure that products originating in Iraq would be subject to most favored treatment across the World Trade Organization membership. IfIraq binds its tariffs at a lower level (e. g., 10percent), it would send a strong signal o f stability to its partners. Since the Uruguay Round in 1994, the accession process has been notably successful in helping countries shift toward stable, transparent, rule-based foreign trade regimes. 76 Beyond traditional trade policies, there has been a tendency among current World Trade Organization members to insist that new entrants remove even a wide range o f behind- the-border barriers, frequently compelling them to introduce far-reaching institutional reforms. Inthe case o f Iraq, World Trade Organization members will likely push Iraq to reduce or eliminate certain discriminatory policies and laws, as well as discretionary import licensing, subsidies, monopolistic state-owned enterprises, and similar harmhl practices. There are practical limits, however, in using World Trade Organization accession as a "lock-in" mechanism to meet demand for reforms in these areas and implement regulatory agreements that emerged from the Uruguay Round. Contrary to tariffs that have to be bound inthe World Trade Organization, many o f these reforms are not requirements o f World Trade Organization members. The government has to choose to implementthem. Furthermore, simply promulgating domestic regulations and policies compatible with World Trade Organization standards does not in itself create a high-quality institutional environment. Nor does it ensure that rent-seeking will disappear. In the case o f Kyrgyzstan, the World Trade Organization accession process itself had opened the door to domestic special-interest lobbying. That country started the accession process with a low, uniform tariff and ended it with 11tariff bands and the maximum rate triple the level o f the preaccession tariff. Accession means having to bargain with other World Trade Organization members over conditions for opening to competition from imports. For a particular country eager to join, the exchange o f "concessions" may not necessarily add up to the best and most productive trade regime. There are many paths to the World Trade Organization, and most countries look at the process as one o f mercantilist bargaining, treating liberalization and compliance with World Trade Organization rules as bargainingchips rather than as opportunities to improve overall economic welfare. For these reasons, the key factor in reforming trade and institutions i s likely to be the political will to modernize institutions. UsingWorld Trade Organization commitments as a strategy to leverage domestic reforms and to integrate Iraq's economy into global markets could thus be effective if two conditions are met. First, the Iraqi government must genuinely commit itself to multilateral liberalization, with the accession process serving as a shield and driver o f reforms. Second, accession must fit within a broader strategy o f structural reforms. The primaryobjective is not compatibility with the World Trade Organization, but a high-quality institutional environment that ensures macroeconomic stability and a healthy climate for economic activity. Short-term challenges Priorities include the rehabilitation o f the customs administration, the establishment o f safety standards for imported and exportedproducts, and need to link trade liberalization with domestic reformo fprice subsidiesand state-owned enterprises Customs administration. In the past year, important steps were made in this area. Customs were transferred back under the control o f the Ministry o f Finance, with a new director general and key staff appointed. Several points o f entry were made operational, 77 with the basic infrastructure rebuilt and basic information technology installed. Customs regulation and procedures were clarified and disseminated. Customs staff has made study tours to well functioning customs operations inthe Arab world and elsewhere. Still, there remain significant deficiencies: transport and communications equipment is often lacking, and many staff positions are vacant. Customs operations consist o f sets o f interlocking processes. To be efficient and effective, they need to be adapted to changing trade practices and modern management approaches, and they need to reflect the various objectives o f the country. Simplified customs procedures will therefore need to be established with modem techniques o f risk management and selectivity, and staff will needto be intensively trained inthese procedures. While the present legislation isjudged adequate for the time being, new simplified customs procedures and tariff classification needto be made available inArabic to the business community andcustoms officers. International experience shows that effective customs modernization processes generally start with good initial diagnostic work to identifythe shortcomings o f the existingsystem, to define a strategy for the reform, and to mobilize stakeholder support. It also requires a comprehensive approach, i. e., one that encompasses all aspects o f a customs administration to address the issues identified, as well as an adequate sequencing o f actions. Strategies need to be realistic and consider the country's capacity for implementation, the time that i s required, and the level o f stakeholder and political support that is needed. The overall modernization program would aim to assist the Iraqi customs to adhere to professional standards as close as possible to those provided inthe Revised Kyoto Convention o f the World Customs Organization. Safety standards. The 2003-04 import boom experienced in many nonmachinery products has filled the Iraqi markets with a variety o f previously unavailable goods. There have been many reported cases o f imports o f unsafe or adulterated products. The Iraqi government is moving to assess the current and prospective safety hazards associated with expanded private-sector imports. Then, it will strive to design an appropriate set of public actions, involving tighter and more systematic inspections (at border sites or in the distribution system)-either by government agencies or contracted thirdparties-recognition of product certification from accredited trade partner agencies, and other measures as necessary. These steps are important for both imports and hture nonoil exports. The ability o f Iraq to expand exports o f agricultural and manufacturing products will require measures to enhance the quality consciousness o f producers, induce wider adoption o f recognized good practices-which impart safety and quality-in agriculture and manufacturing and put in place product conformity systems which are recognized and accredited internationally. To identify current capabilities and weaknesses, as well as near-term priorities for technical assistance and capacity building, an assessment is needed o f Iraq's system o f standardization, accreditation, and quality certification, reflecting capacities in both the public andprivate sectors. The development o f organizational capacities-for example, the State Standardization and Metrology Agency, which i s accredited to issue certificates on I S 0 9000 standards 78 on quality or IS 14000 series-would encourage improvements in the quality o f domestically produced goods. The issuance o f local "quality markings," certificates that Iraq meets international standards, and contests for the best-manufactured products would be a good investment. The best option would be to follow international practice by accepting standards and certificates from recognized international and national bodies. Iraq should take a first step-establishing a modern, market-based system o f technical regulations, product standards, and certification. This requires a legal framework to ensure that there i s an organizational split between accreditation or certification processes and privatizing laboratories. While more general reforms and institutional strengthening are being planned, there may be scope for some near-term initiatives involving training, technical assistance, and other support directed at selected industries or commodity subsectors that have an established export track record, yet are likely to face market access problems because o f nonconformingproduct quality, safety, or certification systems. Any such pilot initiatives will benefit from strong private-sector involvement, in both their design and implementation. Domestic price liberalization and state-owned enterprise reforms. Iraq will remain a large net importer o f food, and it will benefit from a liberal trade environment. However, the country has a complex system o f controlled prices, and the establishment o f the proposed uniform tariff for finished goods may be difficult in the face o f continued domestic price controls. Ifthe timing o f trade policy reform and price liberalization is not worked out carefully, the response is likely to be a long list o f exemptions. Furthermore, as long as food and other products are subsidized so heavily, some export controls will be necessary to avoid smuggling. Trade reforms will be more effective if closely linked to gradual food and energy price liberalization. At the same time, the food distribution system needs to be adapted to the new context, and adequate safety-net arrangements need to be put in place to protect the poor and vulnerable. Needless to say, moving forward on these reforms (price liberalization and privatization o f the food distribution system) would need to be carefully timed, taking into account the current highly volatile security situation. Chapter 4 discusses some o fthe possible safety-net solutions. Summary of recommendations Price adjustments o f the magnitude required inIraq carry large and complex implications for the economy and society. Care is needed to evaluate the likely consequences and to formulate a coordinated approach. The following recommendations canbe offered for the short term: Food security 0 Give careful consideration to the speed and sequencing o f reforms before choosing a future direction for thePublic Distribution System or its replacement system. 0 Maintain the existinginefficient safety net (i. e., the PDS) until a more efficient safety net i s inplace. 79 0 Prioritize collecting and analyzing data on poverty and assessing the institutional capacity o fthe government to implement safety-net programs. Domesticfuel subsidies 0 Raise prices at least to the level that eliminates or significantly reduces smuggling, as a first step toward reforming fuel subsidies. Given the very low fuel prices today, immediate price increases are warranted, in coordination with price adjustments in other affected sectors. 0 To the extent possible, set prices o f gasoline, kerosene, and diesel at comparable levels to minimize interfuelsubstitution. 0 Minimize the use o f fuel price subsidies, as these are not pro-poor. Include compensation for he1price increases as a component o f a broader social safety-net package. Electricity pricing and management autonomy 0 Launch a detailed analysis o f energy use and costs o f producing and distributing electricity to evaluate the precise need for social protection, to define the appropriate electricity tariff structure, and to determine the nature o f a social support mechanism that i s transparent inthe public budget and well targeted. 0 Incoordinationwith end-user electricitypricereforms, initiate amove toward pricing heavy he1oil at internationalparity price levels for the power sector. 0 In coordination with price subsidy reforms in other sectors (in particular, food), design a sequence to gradually bringback electricity prices to cost-recovery levels. 0 Revert electricity supply to its earlier structure o f autonomous companies, away from the direct control o f the Ministry of Electricity, to enable adequate investment allocations and abetter control o f costs. Trade and investment Maintain a low uniform tariff across all goods and all importers. This will reduce the cost o f much-needed capital and intermediate goods, provide increased access to modem technologies, and facilitate trade by simplifying customs clearance procedures and customs valuation. It will also put Iraq's trade regime close to that o f the GulfCooperation Council, with which Iraq may want to eventually affiliate. Bind the tariff structure at a lower level (e.g., 10 percent) at the World Trade Organization, to send a strong signal o ftransparency and stability to Iraq's partners. Seek coherence between the proposed tariff reform and overall tax policy. Ifa value- added tax i s to be introduced, it i s best implemented using the same principles o f simplicity and broadness underlyingthe proposedtariff structure. Revise the foreign direct investment regime to allow greater foreign investment in Iraq. Foreign direct investment i s by far the main means through which the domestic service sector can be exposed to international standards. World Trade Organization accession can be usedto make "opening offers" inthe services sector. Rehabilitate the customs administration by investing in new communications equipment and training staff. The present legislation i s judged adequate for the time being, but new simplified customs procedures and tariff classifications need to be made available inArabic to the business community and customs officers. 80 0 Assess Iraq's system o f standardization, accreditation, and quality certification, reflecting capacities within the public and private sectors, to identify current strengths and weaknesses, as well as near-term priorities for technical assistance and capacity building. 0 Linkvery closely the timingoftrade policyreform andprice liberalizationto avoid a long list o f tariff exemptions. As long as food and other products are subsidized heavily, maintain some export controls to avoid smuggling. Notes iDeadweight loss is the costs to society created by market inefficiency. It can result from government actions (taxes, price controls) or from market failures (externalities, market control). The introductiono f the new dinar inearly 2004 produced a short-lived decline inprices The cost o f distributed generation depends inpart on the price paid by the generators for primary fuel. Furtheranalysis would have to investigate the price o f electricity from distributed generators to analyze the precise capacity o f Iraqi consumers to pay. Worldwide, the average cost for household consumers o f electricity productionby such distributed-generation technologies is around $0.11-0.17 per kWh. 81 Part 11.Protectingthe poor and vulnerable Chapter4. Reformingsocial safety nets and pensions Iraq faces a choice between considerably broadening and strengthening its formal safety nets or continuing to rely on untargeted subsidy schemes and subsidized services. The choice i s imminent because Iraq's social fabric remains very fragile, with large segments o f the population facing unprecedented social and economic risks. The continuing conflict, high unemployment, widespread poverty, and so far limited economic response to reform are some of the problems that the society must confront. The incidence o f absolute poverty i s significant. Whether measured by monetary income or nonmonetary indicators such as health, nutrition, and life expectancy, poverty has worsened dramatically during the turbulent recent decades. Several population groups are especially vulnerable: unemployed youth; demobilized soldiers and militia; war victims with disabilities; and internally displacedpersons, refugees, andreturnees. Iraq's volatile security i s likely to have continuing consequences on poverty and vulnerability. The limited ability to manage these risks, coupled with the social exclusion o f large vulnerable groups, threatens the nascent Iraqi democracy and the reconstruction process. Recent assessments confirm the importance o f developing social protection programs that can help to mitigate the consequences o f economic transition. The first priority would be to undertake comprehensive household expenditure surveys to identify the Iraqipoor. These surveys are starting. The next step would be to design formal safety nets and finance them ina sustainable fashion. Poverty andvulnerability in Iraq A systematic assessment of poverty has yet to be undertaken in Iraq, but available data suggest that the incidence o f poverty is significant.' About 1in 10 Iraqis lives in absolute poverty, and the same number are near the brink o f the international poverty line o f $1a day (table 4.1). At the same time, surveys register relatively low inequality. The ratio o fmedian incomes o f the lowest and the highest quintiles was relatively low in2003 at 3.7. In2004 conflict andeconomic transition exacerbated inequality andpushedthis ratio up to 5.3. Similarly, poverty indicators other than income also reveal relatively low inequality (e. g., in child malnutrition). These outcomes suggest the impact o f the state-led redistributive development model that Iraq followed for decades and, more recently, the success o f the Public Distribution System insecuring the nutritional standards o f the Iraqi people. 82 Table 4.1. Iraq's per capitahouseholdincome by income quintiles, 2003 and 2004 (inU.S. dollars) Year Income quintile 25thpercentile Medianfor quintile 75thpercentile within quintile within quintile 2003 Lowest income 427 585 780 Low income 661 873 1,132 Mediumincome 847 1,179 1,545 Highincome 1,137 1,544 2,072 Highest income 1,470 2,158 3,025 2004 Lowest income 555 809 1,104 Low income 1,029 1,374 1,833 Mediumincome 1,433 2,070 2,638 Highincome 2,053 2,797 3,698 Highest income 3,057 4,3 14 6,211 Source: Ministry o f Planningand DevelopmentCooperation/UNDP2005. An important aspect of Iraq's poverty is its concentration in female-headed households, whose median incomes are 15-25 percent below comparable male-headed households. The gender gap is particularlypronouncedamong the poorest (figure 4.1). Figure4.1. Gender and povertyby householdincomepercentile,2003 Percentageof medianfor eachincome group I I 75th income percentile Medianncom Source: Ministry of Planning andDevelopment CooperationIUNDP2005. Iraqi poverty has a distinct regional dimension (figure 4.2). The three Northern Kurdish governorates register consistently higher incomes than the rest o f the country, while several Southern governorates, particularly Muthanna and centrally located Salah A1Din, report distinctly lower incomes. This poverty gap does not appear to be a rural-urban divide, at least not nationwide: the gap between median incomes o f rural and urban households was less than 10 percent in 2003-04. Regional disparities are also pronounced in the nonmonetary poverty indicators, such as health and education conditions. 83 Figure 4.2. Regional patterns of poverty in Iraq Median Per Capita HouseholdIncomein Iraqi Dinars (thousands) 175-a4 85-94 H95.104 1 105.114 0115. Source: Ministry ofPlanning andDevelopmentCooperatiodUNDP !OM. ~~ Societies can have both chronic and transitory poor people. In Iraq, there are many groups that are especially vulnerable to poverty, social exclusion, and other social ills, giventhe current environment. These include, among others: Unemployed youth. The labor force participation rate among Iraqi youth i s estimated at less than 30 percent, while for the economy as a whole it i s over 40 percent (Ministry o f Planning and Development Cooperation/UNDP 2005). Youth do not have the experience to compete in tight labor markets, and many also do not have the skills that employers need. Unemployment early inworking life has been shown to increase the probability o f future joblessness and lower future wages and can leadto alienation and social unrest (ILO 1998-99). Former military, police, and ex-militia. Many young people are among the former military and paramilitary forces that were disbanded following the fall o f the old regime. While military forces are being reconstituted, it is expected that some 250,000 to 300,000 former members o f the military, some with disabilities, and another 20,000 private militia members need civilian jobs. These large numbers make redeployment and reintegrationa formidable challenge, particularly because many ex-soldiers are not oriented toward private-sector occupations. They are vulnerable to social and lifestyle adjustments; their alienation poses a risk to the formation o f a stable Iraq. Already over 300,000 former military and militia and their families receive cash assistance under the government's reintegration program. War victims with disabilities. Exact statistics for the number o f civilians injured in the conflict are difficult to come by. A standard assumption i s that the number o f neonle iniured in a war i s at least three times the number o f deaths. Estimates o f 84 the injured in Iraq, including combatants, range from between 20,000 up to 135,000, dependingon the source and the methodology." Children, too, often are affected long after a conflict stops. UNICEF has concluded that by July 2003 more than 1,000 children had been injured since the end o f the war as a result o f unexplodedordinance. That number continues to increase. 0 Internally displaced persons, refugees, and returnees. These groups form a vulnerable population that has limited recourse to traditional risk-coping mechanisms, such as personal or family assets or faith-based support. Internally displaced persons include a prewar group displaced by the policies o f the former regime (perhaps as many as 800,000 in the Northern governorates and up to 200,000 inthe South, includingMarshArabs and displaced Shi'a families). Iraq's volatile security i s likely to have continuing consequences on poverty and vulnerability. Lack o f access to work and social services will cause temporary hardship ' for a large segment o f the population. Long-term, chronic poverty will also result in households whose primary earners are killed or whose livelihood i s destroyed, and for those whose education i s cut short. Even in the optimistic scenario o f a stable security and political situation, the Iraqi economy will be undergoing a major market-oriented transformation, which will create temporary unemployment as labor allocation moves to more productive areas. There will certainly be winners and losers in this transformation and changes in the distribution o f income. The nature o f these changes, however, is uncertain and, given the number o f changes occurring simultaneously, the changes will be difficult to predict. Inthis context, efforts to monitor changes inthe nature and extent of poverty and measuresto provide reliable safety nets to the poor will be crucial. Social protection Social protection in Iraq consists o f a collection o f program interventions and providers, including direct support from families, assistance from private and charitable organizations, and programs administered by the government, as well as temporary interventions from donors and the international community. Altogether, the system i s similar to other social protection arrangements in the Middle East and North Africa region and elsewhere. It has been profoundly weakened by the policies o f the previous regime, coupled with the years o f conflict and the resulting burdenplaced on the limited public assistance. Subsidies The Public Distribution System is the mainpublicly supported safety net available to the whole Iraqi population. Other subsidies are off budget and amount to transfers to households possibly in excess of 50 percent o f GDP. These subsidies were analyzed in chapter 3. 85 Cashandin-kind assistance For families without adequate support, including the blind and disabled, as well as single- parent families and the elderly, the Ministry o f Labor and Social Affairs provides a monthly cash transfer. This flat benefit i s modest (less than 10 percent o f the median income o f the lowest quintile) and reaches only about 112,000 families, whereas ... conservative estimates have put the number o f needy families at more than 850,000."' Small cash transfers are also provided to demobilized military personnel covered under the government demobilization and reintegrationprogram. The 2005 budget allocates ID 375 million for the 300,000 demobilized personnel, implyingan average benefit o f about 10 percent o f the median income o f the lowest income quintile, similar to the Family Allowance. Neither o f these transfers is based on a consistent definition o f need, nor takes adequate account o f family size in determining benefits. It i s likely that some benefits are spilling over to those less needy and that better targeting methods, such as individual or proxy means testing, would improve the equity and efficiency o fpayments. The ministry also provides limited institutional care for the blind and disabled. It maintains approximately 130 facilities, including kindergartens,orphanages, institutes for the disabled, elderly homes, andcooperative society workshops. Many o f these have been severely damaged and have inadequate supplies. The number o f beneficiaries i s quite small, numbering only about 6,300 in2004. The facilities andin-kindservices offered are not designedto promote independent livingor integrationinto society. Privateand informalsafe@nets The extent o f nongovernmentalmechanisms for social protection is unknown. It is likely that family and personal networks account for the majority o f social protection and that charity and faith-based institutions provide significant assistance to the most vulnerable. Recent surveys suggest that more than 90 percent o f households had more than one source o f income in 2003, with nearly a quarter reporting three or more sources. Households are relying on multiplejobs andjob holders within the family and possibly in some cases contributions from outside the family to survive. Nongovernmental organizations (NGOs)could have a significant role inthe provision o f social safety nets. Currently, there i s not enough information at hand to determine the level o f assistance actually provided by NGOs. Official estimates put the number o f registeredNGOsat more than2,500 at the end o f 2004, following the adoption o f statutes designed to encourage the formation o fNGOs and community groups. As inmany majority Muslim countries, zakat and waqfare common forms o f assistance from individuals, typically given to community charitable organizations or to mosques, which then direct the use o f funds. The government, through the official Awqaf Divans, helps to coordinate the distribution o f some o fthese resources. 86 Pension reform Pensions are another kind o f formal social protection mechanism. All public-sector workers and employees o f private firms with five or more employees are entitled in principle to social insurance, including pensions, medical insurance, disability, sickness, and maternity leavebenefits. Having an insurance mechanism in place to protect against poverty in old age is an important element of the social contract for workers in Iraq. Formal pensions have existedinvarious forms since 1922. Unfortunately, the pension system covers a minority o f workers, given the large infonnal-sector workforce, and it i s very expensive. The system now faces critical problems o f financial sustainability, equity, and efficiency. These problems stem in part from the implementation o f a series o f emergency policies put inplace after the war without proper assessment of the financial implications. To a large extent, however, the problems o f the pension system are structural and would have hadto be addressed inany circumstance. The Iraqi mandatory public pension system is composed o f two separate funds: (a) the State Pension System, which covers civil servants, the military and security forces, and employees o f state-owned enterprises and (b) the Social Security System, which covers private-sector workers. Both are defined-benefit schemes financed on a pay-as-you-go basis. Excluding the military, the two systems together cover roughly 15 percent o f the labor force-mostly public sector workers. Indeed, from a total o f 1.1million workers accruing pension rights with either system, 1 million are civil servants or employees in state- owned enterprises (table 4.2). Only around 76,000 workers inthe private sector currently are enrolled inthe Social Security System-a mere 1percent o f the labor force. Table4.2. Contributorsandbeneficiariesinthe Iraqipension system, 2004 Military Civil servants Private sector Total Contributors n.a. 1,733,686 76,200 n.a. Share labor force (percent) n.a. 17 1 n.a. Length of service Less than More than Less than More than 25 years 25 years 25 years 25 years Beneficiaries 322,164 156,685 320,510 235,538 14.125 1,072,791 , , Ofd-age 105,120 116,205 1811968 1691209 61108 620,825 Survivor (one) 91,151 15,709 84,092 41,827 8,017 231,049 Survivor (more than one) 125,893 24,771 54,450 24,502 220,917 Total expenditures (ID million) 407,526 286,259 472,185 595,971 11,683 1,405,987 Share o f GDP (percent) 1.09 0.76 1.26 1.59 0.03 3.74 Average monthly benefit (ID) 105,414 152,247 122,769 210,855 68,929 109,216 n.a. is not applicable. Note: GDP in 2004 was ID 37,556 billion. Data are as o f December 2004. Data regarding the demographic structure and the finances o f the pension system remain very limited. Sources: Ministryo f Finance, Ministryof Labor and Social Affairs. 87 Implementation ofemergencypolicies After the termination of major military operations in Iraq, the Coalition Provisional Authority replaced regular pensions with emergency "flat" payments, which amounted to about 3.7 percent o f GDP in2004. These payments have been increased continuously and now range between ID 80,000 per month ($53) and ID 200,000 per month ($133). The motivation was to compensatepensioners whose payments had been significantly eroded by inflation. General civil service salaries were also increased. Together, these measures imply a larger government debt with the pension system. Costs are likely to increase further, given the needto design compensation and reintegration programs for military, security forces, and ex-members o fthe militia. It is desirable to normalize pensionpayments as soon as possible, but going back to the previous pension formulas would be counterproductive. Indeed, as discussed inthe next section, these formulas have several problems that compromise the financial sustainability of the pension system and are a source o f inefficiencies and inequities. Current emergency "flat" pension payments could be preserved until the new pension system i s ready. These payments would be financed out o f the general budget, but they would be rationalized to control costs. Assuming that individuals continue to retire with emergency payments during the next 12 months, it i s estimated that costs would peak at 7.6 percent o f GDP in2006 and then gradually decline. Structural issues The pension system in Iraq, as in other Middle East and North Africa countries, faces structural problems that compromise its financial sustainability, reduce economic efficiency, and create intra- and intergenerational inequalities: 0 A first problem is the dual structure o f the pension system, which is a source o f inequalities. Provisions differ between schemes, with civil servants receiving more generous benefits. Dualism also increases administrative costs and, more important, can restrain the movement o f the labor force, thus precluding efficient allocation o f labor. As the role o f the private sector expands, a dual pension system would be a drag on the Iraqi economy. 0 The second problem is related to the mandate o f the pension system, which is unaffordable. Both schemes offer very high gross replacement rates, close to 100 percent o f the last salary for the average full-career worker. These are among the highest replacement rates observed inthe region (figure 4.3). This reduces incentives to diversify the sources o f savings for retirement, particularly among middle- and high-income workers and thus limits alternative means o f managing financial and longevity risks. 88 Figure 4.3. Income replacement patterns of pension systems in the Middle East and North Africa 1 2 5 125 ...mF ........ ........................ ............. (D -; 1 E 1 ; C C 0) 0) E -mn 75 -mn 75 2 5 2 w 5 v) e .I.-.-.-.-.-., Djibouti e 25 25 O O .5 1 1.; 2 2 5 3 0 0 .5 1 1.5 2 2.5 3 Individual earnings, proportion of average Individual earnings, proportion of average Source: World Bank staff calculations. The Iraqi pension system is accumulating unsustainable pension liabilities as a result o f the misalignment between the contribution rates, the targeted replacement rates, and the retirement age. Accrued-to-date pension liabilities with current contributors-that is, excluding the liabilities with current retirees-are estimated at over 60 percent o f GDP. This is due, in part, to recent salary increases for civil servants. The contribution rate necessary to equilibrate the old-age pension component (i. e., without taking into account disability and survivorship pensions) would need to be set at over 30 percent o f the covered wage. This level o f taxation can cause a severe loss in competitiveness, a reduction in the demand for labor, and the possible expansion o f the informal sector. Moreover, as the demand for public resources continues to increase, pension payments would crowd out the production o f other public goods and services potentially o f higher social value (e. g., health and education). The low coverage rate o f the scheme for private-sector workers i s another cause o f concern. Only about 2.5 percent o f private-sector workers are enrolled in the pension scheme. Managers report high levels o f evasion. Employers systematically underreport the number o f employees to remain below the minimum at which pension enrollment becomes mandatory. A final concern is the governance structure and administrative capacity o f the pension system. The current staff will need additional skills to properly manage a reformed pension fimd and to design and implement necessary reforms. Information technologies will needto beupdated, including recordkeepingandpayment systems. Summary of recommendations The social protection systeminIraq faces enormous challenges. Unemployment, poverty, and other vulnerabilities are prevalent under current conditions, and the resources and capacity to assist the needy and help them manage risks effectively are limited. Yet, the difficult transition that Iraq is enduringpresents an opportunity for strategic development of effective social protection for the hture. Several recommendations emerge from the initial review o f the system: 89 Improve information for policy design. To design and implement effective social programs, it is critical to have timely and reliable information on the poor and vulnerable in society. Data and information will need to be collected at two levels: the national population level and the program level. Improving the information base includes implementing comprehensive household surveys on income, expenditure, and use of services as soon as conditions permit, together with reestablishing administrative data sources at the program level. Enhance institutional capacity and coordination. The capacity o f many ministries and agencies with social protection mandates has been weakened inrecent years, even before the current conflict. The infrastructure to collect and process data, the institutional ability to analyze data, and the administrative and technical capabilities to effectively run, monitor, and evaluate programs need to be improved. Coordination between agencies with overlapping mandates or beneficiaries must be improved as well. Government safety-net interventions, NGOs, and Islamic charities largely operate independently o f one another at present. Rationalize existing social safety nets. There i s considerable scope for improving the targeting and efficiency o f existing programs to reach more needy families while containing costs. An important element i s the design o f the interventions, which can benefit from moving toward more individual needs-based targeting criteria. The performance o f the Public Distribution System, for example, can be improved by altering the set o f commodities or developing income or asset-based tests o f need. Alternatively, the subsidymay gradually be replaced by a targeted cash transfer that would reach more disadvantaged families while reducing administrative costs. It i s advisable to reexamine in-kindservices to ensure that they are helpingbeneficiaries to become more productive and independent, especially with respect to institutional care. Develop new interventions to preserve human capital and respond to the needs of vulnerable groups. Appropriate analysis will be needed before considering new interventions, including a conditional cash transfer program to improve education and health outcomes among youth and programs for former combatants and displaced families. Utilize community-based, informal, and private social protection mechanisms. Community and faith-based assistance i s a vital component o f an effective strategy to alleviate poverty and mitigate social risks. Religious charities and foundations appear to be among the most active providers of safety-net assistance, and NGOs have emerged as potential contributors as well, after havingbeen suppressed for many years. Incorporating local capacities and strengths in the provision o f services i s also consistent with the federalist thinking of the interimgovernment. Improve the design of the pension system. Iraq has the unique opportunity to fundamentally revise the design o f its pension system. The current scheme i s financially 90 unsustainable now and can be improved interms of both equity and efficiency. The main components o f a strategy may be summarized as follows: Within a period of one to two years, a new, integrated pension system would be designed and implemented. This new system would: (a) provide adequate and affordable pensions for plan members; (b) be financially self-sustainable; (c) allow for transparent and equitable redistribution; (d) minimize economic distortions; and (e) incorporate the best internationalpractices inthe scheme design andmanagement. The current schemes would be closed to new entrants, and the current plan members along with the new entrants would start contributing and accruing rights in the new system. The rights accrued to date inthe old systembycurrent employees would berespected and the associated pension liabilities made explicit by the government. To improve transparency and the credibility o f the fiscal framework, the implicit pension debt o f the new system will be explicit. This can be done if all the surpluses o f the pension fundareinvestedingovernment debt instruments. A new noncontributory scheme, financed out o f general revenues, could be created to provide a basic pension to all individuals reaching a certain age (say, age 65). Individuals benefitingfrom the "flat" emergency payment scheme will not be eligible for this new basic pension. Any incentive package for military or ex-members o fthe militia who fall outside the rules o fthe new Pension Law, the new noncontributory scheme, or the "flat" pensions emergency payments, would require separate financing mechanisms andwould not be managed by the new pension fund. It is very important that the fiscal impacts of any reform program are assessed. The key feature of the proposed design is that the surpluses of the new pension system would be reinvestedin government debt, thus helpingthe government to finance the cost o fthe implicit pension debt. Notes Income data should be interpreted with caution: recent income surveys may have been hampered by the security situation and a large role of informal sector (see box 1.1). Certain groups o f the population were not covered, including recent returnees and internally displaced persons fleeing combat areas such as Falluja. More o f these households are likely to fall into the lowest income category, and their exclusion couldhave artificially inflated income levels. iiVarious sources report a range between 20,000 and 135,000 deaths over 2003-04. iiiData are for 2004. The Ministry o f Labor and Social Affairs has recently increased the Family Care Allowance for a single person from ID 30,000 to ID 40,000 (about $28) and for families with more than one person to ID 50,000 ($35). The ministry also intends to expand the number o f families covered to 300,000 in 2005, resources permitting (Ministry o f Labor and Social Affairs data; United Nations and World Bank 2003a). 91 Part 111. Improving public management and accountability Chapter 5. Managing oil revenues Oil is central to the Iraqi economy and will remain so for the foreseeable hture: its oil reserves can drive economic growth for decades to come. Even if it extracted 6 million barrels o f crude oil a day-three times the current level o f production-Iraq has more than50 years' worth of oil left inits proven and developed reserves; more oil is likelyto be discovered in areas that await exploration. But managing oil revenue well has challenged many producing countries, rich or poor. The economic performance o f oil exporters i s often inferior to that o f resource-poor countries, an outcome often attributed to the harmful influence o f oil wealth on governance and on the real exchange rate for the rest o fthe domestic economy (the Dutch disease). Evenwith vast reserves, Iraq faces large uncertainties about its hture revenues, because of the volatility inthe volume and price o f oil exports. Inthe short term, production and exports are heavily constrained by rundown facilities and sabotage (box 5.1). Over the medium term, however, revenues can rise dramatically, if oil production capacity recovers strongly and oil prices stay high. Even in the case o f declining oil prices, Iraq may be able to maintain high export revenues by building up the volume o f oil exports significantly. Alternatively, revenues may be considerably lower, if oil production stalls and prices decline. In 2004-05, oil export revenues ranged from $1.1 billion to $2.7 billion per month. Whether rising or falling, revenues require production. InIraq, substantial investment is needed to rehabilitate and expand the oil sector, which has long suffered from a lack o f capital, deteriorating technology, and an aging workforce. Large investments are also requiredinthe refining, petrochemical, and natural gas sectors. Without such investment, Iraqwill have difficulty maintaining and expanding capacity. Iraq faces an additional challenge o f developing competitive, labor-generating nonoil traded sectors to diversify its economy. The National Development Strategy correctly calls for reducing oil dependency over the medium term by promoting market-based, private-sector development o f nonoil traded sectors. Three main reasons underlie this strategy: 0 Preventing a rent-seeking society. Oil revenues, or "rents," find their way into the economy through the government's fiscal system, which can create a dependency on the state. The government often becomes the largest employer and relies heavily on a very narrow tax base (the oil industry).The result is a "rent-seeking" society, i.e., an economy characterized by excessive, unproductive activities in exchange for government finance and support, which results in widespread corruption and stagnation. 0 Creating more jobs. Despite its economic importance, the oil sector generates very little domestic employment. For the medium to long term, economic growth andjobs 92 will need to originate from more labor-intensive, traded goods sectors, focused on market-based private investment. 0 Reducing vulnerability and volatility. Dependence on a single export makes an economy vulnerable: any deterioration inthe terms of trade will hamper consumption, welfare, and stability. In Iraq, as in other oil economies, vulnerability is aggravated by the fiscal dependence on oil prices, which are notoriously volatile: price shocks inevitably leadto fiscal crises. Beyond using the government budget to direct oil revenues to the needs o f the nation, there exists an option of their direct distribution to people. Despite its apparent advantages, the direct distribution option is: (a) difficult to implement in Iraq's current circumstances; (b) prone to corruption and leakages; and most importantly, (c) at Iraq's current level of development and opportunities (unlikeNorway or Alaska), the social rate of return to investment inpublic goods and targeted social spending i s much greater and more equitable than the private rate o freturnon consumptionby distributingoil revenues to all households. Redistribution o f oil revenues to Iraq's provinces is becoming an equally serious problem, a part o f an intergovernmental system design discussed in chapter 6. Box 5.1. Generating oil revenues in Iraq In addition to managing oil revenues, Iraq faces the challenge o f generating export revenues from its massive oil reserves. Iraq's oil sector has long suffered from lack o f investment-and more recently from looting and sabotage-and i s inneed o f substantial investment to rehabilitate its oil fields and infrastructure and to increase its production capacity in the coming years. Many fields have been damaged by excessive injection o f liquids to sustain output, and producing wells are badly inneed o f rehabilitation. The industry also has suffered fkom a lack o f spare parts and equipment, a long reliance on outmoded technology, and a need to retrain and expand the workforce. The sector can absorb a lot o f oil export revenues itself; it also needs technology and managerial and technical skills. Iraq faces a range o f options in financing its oil-sector development needs. This can be done by (a) using oil revenues to hire technical, managerial, and engineering skills the country might need to expand oil extraction; (b) funding these needs with additional borrowing; and (c) attracting equity capital from private investors. Attracting private investors into the oil sector can be valuable. Such investors, however, require appropriate legal, fiscal, and contractual fkameworks-and this will take time. The Dutch disease and oil price volatility The Dutchdisease, which got its name from the experience o fHollandafter the discovery of North Sea gas in the 1960s, describes the weakening o f domestic industries in an economy that discovers and exploits an abundant natural resource, such as oil. An increase in net oil exports, irrespective o f the exchange rate regime, typically leads to a real appreciation of the exchange rate. This reduces the competitiveness o f domestic products ininternational markets, leading to a decline innonoil exports, a rise inimports, and often some short-term hardship and adjustment in domestic industries. Although the fiscal authority that receives most o f the oil rent could sterilize it entirely by accumulating only foreign assets, this i s not a realistic option because then no benefits from oil exports would accrue to the nation. Hence, a portion o f the rent will be spent domestically, some real exchange-rate appreciation will occur, and the nonoil traded 93 goods sector to some extent will be harmed. As nonoil traded goods decline, employment is maintained by the expansion o fnontraded goods and services, very often inthe form o f an expansion o f the public sector. Although Iraq shows some signs o f Dutch disease, its challenge i s not adjusting to an oil boom, but preventing oil dependence from stifling job generation. The effect o f the real appreciation can, in time, be more than offset by increases in productivity, if the boom can finance technological progress and draw investment. Policies aimed at improving the investment climate in the nonoil economy are the key antidote for the Dutch disease. Stable fiscal policy to encourage a stable real exchange rate and a sustainable public investment program can be augmented by targeting investment and other government expenditure at productive public goods. Best-practice policies for the oil economies are no different from any other (nonoil) context, but the oil economies have greater need for fiscal prudence because o fthe extreme volatility of oil revenue. When oil prices fluctuate widely, the government transmits that external shock to the rest o f the economy, and through repeated boom-bust cycles volatile oil prices translate into a volatile real exchange rate. The increased uncertainty inthe nonoil traded sector i s likely to depress investment, long-run diversification, and growth. Reducing the transmission o f revenue volatility to the economy may be accomplishedby expenditure smoothing. Ifbudgetary expenditure i s planned and implemented according to "permanent" rather than "transitory" prices, then destructive swings in public expenditure can be avoided, and this will help stabilize the real exchange rate. Otherwise, public expenditure pattern based on current (boom) prices will not be sustainable, because when prices fall expenditure is forced to contract. It is often public investment that contracts first and most, because politically and socially it i s usually the easiest budget item for governments to cut. This stop-go public investment behavior has long- runnegative consequences. Just as expenditure smoothing i s necessary for macrostability, smoothing public investment can enhance its efficiency. Fluctuations in infrastructure investment reduce the efficiency o f the investment program. Building roads, schools, and other facilities requires relatively skilled workers, and when investment levels decline unexpectedly, workers are laid off and buildings are abandoned. Erratic, stop-go investment entails high adjustment costs and waste. Because it i s costly to adjust to changes in the level o f investment, the optimal rate of investment should fluctuate substantially less than the price o f oil. Subsidies, such as free education, free energy, and interest-free loans for housing or business, create economic activity through spending and lead to a lack o f financial discipline in the budget and political instability when governments try to roll back commitments. In Algeria, Indonesia, Iran, Mexico, Nigeria, Trinidad, and Venezuela, subsidies in the 1980s rose twice as fast as nonoil GDP. During periods o f oil price decline, capital projects were canceled, but subsidies, together with public wages and salaries, were politically difficult to roll back. Unsustainable spending commitments 94 based on overly optimistic oil revenue forecasts should not be introduced in the first place. Many oil-exporting governments find it difficult to strike the right balance between short- runneeds and long-run growth `and stability, and if they are also combating pervasive poverty and highunemployment, they will also find it difficult to withstand the pressures to spend. However, strong fiscal policies and institutions can help governments maintain a more stable investment strategy in an environment o f highly volatile oil revenues. Oil price changes can be temporary or permanent; if they are likely to be permanent, governments would be wise to adjust the level o f investment spending to the new sustainable level o f future investment. The quality o f investment matters at least as much as the quantity, as oil windfalls have often produced huge, unproductive "white elephant" projects. Investment in heavy industry to promote diversification has generally contributed to huge, insolvent state- owned firms. Oil-exporting countries tend to experience periods o f rapid expansion in investment and growth, followed by a collapse ingrowth that far outweighs the decline in investment.' From 1965 to 1998, per capita GNP among members o f the Organization o f Petroleum Exporting Countries decreased on average by 1.3 percent per year, with an average ratio o f gross domestic fixed investment o f 23 percent. The quality o f investment i s a key factor that separates resource-rich countries that have grown rapidly from those that have had less success (Gylafson and Zoega 2001). Oil-based economies seem to be particularly susceptible to poor governance and corruption because the government i s the direct recipient o f the rents. Patronage politics play an important role in determining the use o f oil revenues, when fiscal linkages are narrow and public scrutiny i s weak. Developing mechanisms to enhance public oversight o f expenditures can enhance transparency inmanagingoil revenues (box 5.2). In Iraq, there is a premium on speed in allocating donor funds to rapidly disbursing reconstruction projects. Clearly, the priority i s to address urgent needs o f the population, but authorities are well advised to do so inways that do not undermine the fkture fiscal and financial soundness o f the Iraqi economy. Over the medium term, authorities would benefit by developing more capacity for independent evaluations. Such evaluations could include conducting cost-benefit analysis, projecting rates o f return, analyzing risks and sensitivities, and evaluating client impact. An independent capacity to evaluate investments would significantly help to alleviate pressures for spending oil revenues hastily and help to improve the choice o fprojects. 95 Box 5.2. Transparency in managingoil revenues Given their importance in the Iraqi economy, oil revenues must be managed with open and readily accessible policies and procedures. Such transparency can help foster a democratic debate, increase accountability, improve macroeconomic management, and enhance access to finance. Transparency is needed both inthe flow o f budgetary funds and inthe accounts of the national oil company. The following characteristics are increasingly recognizedas minimal standards indealing with transparency inthe oil sector: An independent and credible audit o f revenues generated by the oil sector and financial flows between the producers and marketers o f crude oil and refined oil products, including the national oil company and the government. It i s advisable to extend the audit to all actors (national as well as international oil companies, if the latter are involved in the sector) and to physical production, sales, and costs. The results o f the audit should be independentlypublishedand made available to the public. The active involvement of civil society i s very desirable. The civil society, for example, can review and raise concerns about the terms o f reference for the audit andthe implications o f its findings. A financially sustainable plan for transparency should be developed and implemented by the government. Complementary activities include institutional strengthening in tax administration, the central bank, and other institutions involved inreceiving and managing oil revenues. These principals would directly apply to the Development Fund for Iraq, owing to its central role in managing the oil revenue flow. The International Audit and Monitoring Boardfound systemic irregularities inthe use of resources by the Development Fund for Iraq under the Coalition Provisional Authority, (www.iamb.info). The Iraqi government i s considering measures to strengthen the accountability and transparency procedures for those funds. A joint IMF and World Bank public expenditure mission (February 2005) recommended setting up a committee to examine operations o f the DevelopmentFundfor Iraqand to enhance the transparency o f tracking Iraq's oil resources and other spending. Inthe short to medium-term, it will be important to develop accounting concepts, rules, andproceduresin the form o f an accounting manual clearly specifying the accounting requirements, particularly those related to direct foreign investments, other bank accounts, oil assets, letters of credit, and other types of investments. Enhancingfiscaldiscipline A number o f oil-exporting countries employ fiscal rules to help determine sustainable level o f capital and current spending. While fiscal rules can help to break the link between current commodity prices and current expenditure levels, they also lessen the ability o f fiscal policy to respond to severe, unforeseen shocks. In Iraq, this rigidity would be unwelcome, because o f the country's need for fiscal flexibility and massive reconstruction in the face o f uncertainty. Furthermore, fiscal rules require strong fiscal institutions to support them, which i s not yet the case inIraq. Some oil-producing countries have set up oil funds to help inthe implementation o f fiscal policy. While funds have taken various forms, the basic aim i s to set aside some portion o f government oil revenues for when these revenues decline. Two main types o f funds exist: (a) stabilization funds seek to reduce the impact o f volatile oil revenues on the government and the economy and (b) savings funds aim to create a store o f wealth for future generations. Inmany cases, governments use these funds for bothpurposes. 96 Although oil funds generally focus on managing revenue, expenditure policies are really the primary consideration for fiscal management and saving for future generations. Oil funds do not guarantee fiscal stability (Devlin and Titman 2004). Well-designed oil funds can enhance the transparency o f oil revenues and expenditures, but they are no substitute for fiscal policy and overall improvements inpublic resource accountability (Devlin and Lewin 2005). A well-designed oil fund should be integrated with the budget and have appropriate asset-management strategies and mechanisms to ensure full transparency and accountability (Davis and others 2001). In Iraq, an oil fund might be worth exploring in the medium and long term as one o f several measures to exert adequate fiscal discipline over volatile oil revenues. However, in the short run the benefits of an oil fund will be limited, as the rates of return on investment inthe depleted physical and human capital are likely to be vastly superior to returns realized from the stock o f financial assets that such a fund could hold. Inother words, the immediate benefits o f an intergenerational transfer o f wealth seem to be less relevant for Iraq, simply because the government has to give priority to the need for immediate investments over the potential for saving oil revenues. Yet, Iraq's large oil reserves provide a solid reason to explore how such a fund could be set up inthe future. Inthemeantime, expenditure smoothingcanpossiblybemore effective, ifpursuedwithin a unified budget framework with carefully designed fiscal rules. Summary of recommendations To maximize the long-term development impact o f future oil export revenues, the Iraqi government may wish to consider the following steps: I n the near term 0 Use oil revenues to address urgent needs o f the population, but be careful not to embark on policies or programs that undermine long-term fiscal sustainability o f the Iraqi economy. 0 Develop transparent mechanisms to enhance public oversight of oil revenue expenditures, ensure accountability, and improve macroeconomic management. In the medium to long term 0 Minimizeboom-bust cycles through expenditure and investmentsmoothing. 0 Prevent development o f a rent-seeking society dependent on government handouts from oil revenues, engaged in nonproductive economic activities, and susceptible to poor governance and corruption. 0 Diversify away from oil and generate employment in nonoil traded sectors by creating an enabling regime for private investment. Note iRodriguez and Sachs (1999) show that overinvestmentcould explain the sluggishgrowth performance of resource-dependenteconomies. 97 Chapter 6. Strengtheninggovernance Regardless o f the contours of the nation that emerges from Iraq's transition, any Iraqi governments will need to establish good governance and public administration. This chapter addresses four objectives that are most important for Iraq's long-term development: (a) strengthening budgeting and financial management, so that it can deliver key public services and facilitate private-sector growth; (b) determining the size and scope o f government and the division o f responsibilities between ministries and different levels o f government, so that appropriate hnctions can be devolved to the provincial and municipal levels; (c) reforming human resource management policy and procedures, so that financial and human resources can be optimally deployed; and (d) combating corruption, so that the integrity o f the public sector can be ensured. These issues will be at the forefront o f Iraq's reform agenda for many years, as they have been inother countries following conflict (box 6.1). Box 6.1. Strengthening governance after conflict ~ Strengthening governance i s central to the successful recovery o f countries that have endured conflict. Several lessons canbe drawn from their experience: Building an efficient administration i s a key task and i s best achieved by focusing, especially in the immediate aftermath o f conflict, on the basics o f good administration-effective budgets, streamlined business processes, efficient civil service, andpolitical and managerial accountability. 0 One critical but often neglected priority is the creation o f robust mechanisms for policy formulation and coordination at the center o f government. Combating corruptionis important, right from the beginning. 0 There are often significant political pressures to increase public-sector employment to cope with challenges such as demobilization. Most postconflict societies will want to measure visible success in terms o f the delivery o f vital services-roads, power, water, sewerage, schools, and hospitals. Fiscal policy and public finance Iraq's systems for public financial management have beenhampered by the poor security environment, the difficulties in communication, and the nontransparent recording of subsidies, which degrades the government's ability to allocate resources or to track overall spending. Urgent reforms are needed to address weaknesses in the budget and financial management systems. The budget system Before the Saddam regime, the budget system in Iraq was fairly efficient and robust. Elementso fthis system still remain, but have degraded substantially inthe past 20 years. Controls and efficient reporting have largely broken down. Budget execution reports, for example, were formerly submittedon a timelybasis; now there are substantial delays and no reconciliation between above- and below-the-line fiscal operations. This reflects difficulties of communication and gaps in reporting by governorates and decentralized agencies in Baghdad, as well as the absence o f consolidated information on balances in 98 government bank accounts (or even accurate knowledge on the number o f bank accounts). Furthermore, information is lacking on the operations and activities of major bilateral donors. The lack o f accurate, timely financial information makes it virtually impossible to hold managers accountable, and any Iraqi government will need to solve this reporting problem if it is to exercise adequate financial discipline over line departments. This points to another fundamental problem within Iraq's budget practices-the extraordinary fragmentation inthe budget. Currently, several parallel spending plans that include both recurrent and capital expenditures exist in Iraq. The official Iraqi budget is financed by tax and nontax revenues, of which oil-export sales constitute the lion's share. Inprevious years, other sources of finance included letters of credit issuedunder the Oil for Food Program managed by the United Nations. Other streams include expenditures financed through external assistance from donors (including both grants and loans) and spendinginsome autonomous government institutions. There is virtually no coordination inthe preparation or execution of these various spendingplans, which often takes place through separate mechanisms. 0 There i s inadequate recording and reporting in government accounts o f goods purchased through letters o f credit issued under the Oil for FoodProgram inprevious years, though these goods could represent a substantial share o f a ministry's recurrent andcapital expenditure. 0 Donor-financed expenditures are taking place outside o f the budgetprocess. Inmany instances, donors discuss assistance directly with the relevant departments in line ministries, without necessarily informing the Ministry o f Finance or the Ministry o f Planning and Development Cooperation. Often several donor agencies have projects incertain sectors, without coordinatingwith each other or the concerned ministry. In some instances, donors pay civil servants directly in cash. The Ministry o f Finance does not receive any records on the execution o f external assistance. Payments for the execution o f these expenditures are mostly taken outside o f Iraq or made directly in cash. 0 Total revenues and expenditures o f some noncommercial government agencies, such as the Election Commission, are not includedinthe budget. Thus, critical elements o f the government's budget reform program could be (a) improving the coverage o f the budget, so that it incorporates all significant revenues and expenditures made by the government, and (b) improving its transparency in line with international classificationand accounting standards. It i s also important over the medium term to ensure that all projects financed by donor aid are brought within the budget. While this will not be possible immediately, a useful first step could be adopting a unified framework inwhich spendingentities would report plans and execution to the Ministry o f Finance. 99 Financia1managemeitt In September 2004, the interim government agreed to a number o f important commitments with the International Monetary Fund to improve the quality o f Iraq's financial management. These include the preparation o f regulations to implement the Financial Management Law adopted in June 2004. These agreements included introducing a single treasury account; reporting monthly consolidated fiscal accounts; implementing modules for the Financial Management Information System; reforming the systemo fbudgetclassification; andstrengthening expenditurecontrols and audit. A subsequent joint World Bank-International Monetary Fundreport on public financial management (Ahmad and others 2005) includes a comprehensive analysis o f the existing system and recommendations for a range o f short- and medium-tern measures to strengthen budget preparation and execution. The government has since agreed with the World Bank, the International Monetary Fund, and bilateral donors on a program o f technical assistance and capacity buildingto implementthe Financial Management Law, including budget classification, accounting, debt management, direct foreign investment, control and audit, andpayroll and humanresource management. The Financial Management Law does not itself provide a complete picture o f the fiscal architecture required to rebuild the budget as the primary policy instrument o f government. This will require further political and administrative decisions in key areas. One i s the appropriate roles for various institutions within the expenditure management process. Consistent with emerging best practice in other areas, the government may, for example, wish to consider downsizing the role and responsibilities o f the Ministry o f Planning and, scaling up the role and capacity o f the Ministry o f Finance to take on full responsibility for all activities related to budget preparation and execution. Another would be developing the role o f the parliament and the Supreme Board o f Audit as the key institutions for overseeing the budget process and the value for money o f budgetary expenditures. Finally, extensive capacity building is needed in a host of areas, ranging from treasury operations to debt management to financial auditing. Strengtheningthe budgetary framework appears to be the main fiscal policy issue. In light o f Iraq's large reconstructionneeds and uncertain environment, a flexible medium- term fiscal framework i s the optimal way to manage oil revenues. Intergovernmental fiscal relations As with most countries inthe MiddleEast and NorthAfrica region, Iraqunder the Ba'ath regimewas a centralized, constitutionally unitary country with fiscal, administrative, and political relations favoring a dominant central government and weak local governments. For the most part, the system o f local government developed inIraqunder reconstruction reflects the structures that existed on paper under the Ba'ath regime, but were largely overshadowed. There were 18 governorates (or provinces), whose borders have not been changed under reconstruction. They were administrative rather than governmental units, 100 in that they had no real control over revenues and expenditures, which were decided by central authorities (Doane 2003). Under the Coalition Provisional Authority, a number of efforts were made to transform the system of subnational governance and empower local governments to assume responsibility for a wider array o f basic services. The provisional authority decided in mid-November 2003 to accelerate the transfer o f authority to Iraqi officials, which led to the,top-down creation o f new council structures and selection procedures. The purpose o f this "refreshment" was to make Governorate Councils more representative and more consistent across governorates. Unfortunately, the refreshment exercise did not fully live upto its expectations. Newly created councils often lackedbasic skills andhadno greater legitimacy than the councils initially created bythe coalition forces. The result has been a confusing patchwork o f legislation and practice. The former local government framework still exists, except where explicitly overridden by more recent legislation and regulations. These legal structures decentralized authority at least to the governorate level. Governorate Councils are elected bodies (as o f January 2005) funded through the national budget. They appoint a governor, review the line ministry plans and budgets, and organize the administration o f public services within the governorate. They have the authority to raise revenues from their own sources. The gap was immense between the formal law and the practice under the former regime, and a number of these discrepancies continue into the present day. As a general rule, local councils have found it difficult to exercise their authority over staff from central line departments, who continue to report through traditional ministerial reporting relationships. Actual control over many decisions concerning basic services continues to rest with the central line ministries, who report to the Supreme Council o f Ministers. However, there are exceptions. The Kurdistan regional government, for example, appoints employees, including healthcare workers and teachers, who are paid by the central government in Baghdad and operate under central government regulations ( h a d and others 2004). At present, a commission i s working to sort out this mixture o f leftover and temporary law as part o f the constitutionalprocess. As Iraq finalizes its constitution and reflects on a wide range o f issues that will define the nature and structure of its government, designing a coherent system o f intergovernmental fiscal relations will require careful attention. To what extent should Iraq decentralize? Although there are no clear technical answers to this question, anecdotal experience indicates the value o f decentralization. Countries in every region o f the world, whether they have unitary governments (e. g., China, Mexico, Uganda) or federal (Brazil, India, Russia), have increasingly moved to more decentralized governance structures for a variety o freasons (box 6.2). 101 Box 6.2. Decentralization Decentralization can play a useful role in empowering people to support processes o f democratization, and it can help accommodate diverse populations and maintainnational unity.It can improve the efficiency o f service delivery by moving decision making closer to the citizenry, which i s particularly important in countries where central governments are failing to perform their functions adequately. Countries have also occasionally chosen to decentralize for problematic reasons-to reduce large budget deficits by pushing expenditures down to locallevels, while retaining revenues at the central level. Political imperatives typically determine the extent and modalities o f decentralization. However, fiscal and administrative questions will have an important impact on key development outcomes, such as the efficiency o f service delivery, the equity o f government expenditure, and the stability o f the economy. Any future Iraqi government will need to address a number o f important issues in this area. Some are basic questions that will help define the nature o f the state, while others are more technical and will help determine the effectiveness o f the state. Different degrees o f local autonomy are possible ineither a federal or a unitary framework, but the rights o f local governments are enshrined only in federal countries. Whether Iraq ultimately follows a unitary or federal path, harmonious intergovernmental relations will depend on, the perceived equity inthe sharing o f benefits from the nation's oil resources. Furthermore, Iraq's decentralization can be either symmetrical or asymmetrical (i. e., either giving equal autonomy for all subnationalunits or providing greater autonomy to certain areas). Inmany countries, asymmetry inthe way different regions are treated (often in response to ethnic, religious, or economic heterogeneity) has worked towards building national allegiance. Examples include both developed and developing countries: Belgium, Bosnia-Herzegovina, Canada, China, Japan, Germany, Indonesia, Philippines, Spain, and Switzerland. How many levels of government does Iraq need? Should the current system o f governorates be transformed into elected provincial governments? Although the political participation o f provinces is already mandated through their involvement in the determination o f the new constitution (i. e., the ability for three provinces to veto any proposed constitution), their overall roles in governance need to be considered much more comprehensively. In addition, local capacity will require attention. Decades o f isolation have deprived administrators o f exposure to international experience and associational benefits (e. g., regional municipal associations). Regionalvariations inadministration are fairly pronouncedas well. For whichfunctions should each level of government be responsible? An important guiding principle can be that o f subsidiarity, whereby responsibilities for public services are given to the lowest possible level where they can be discharged effectively. Where geographic spillovers occur, the appropriate level o f service provision i s best determinedon the basis o f externalities. Thus, garbage collection i s seen as a local issue, although local delivery o f public health or education are seen as issues that can affect the whole country and, as such, their provision may be ensured at the central level. Because such spillovers vary within sectors, it i s advisable to determine jurisdictional responsibility at the level o f the functions. The other key issues affecting jurisdictional responsibility involve public safety and the rule o f law, particularly concerning arrangements for local, regional, and national internal security forces. There i s much 102 scope in Iraq for greater decentralization o f functions. Formal statutory establishment of responsibilitieswill be key. How should local governments befinanced? Since ideally "finance follows function," once fbnctions are assigned, the determination o f appropriate local revenues may follow. Typical sources o f finance for each level o f government are intergovernmental transfers, local taxes, user charges, and local borrowing. Given that over two-thirds o f Iraq's GDP is generated from oil, intergovernmental transfers will continue to be the main source o f financing for local governments for the medium term. Different types o f transfers can be used to address different concerns. Of primary importance for intergovernmental grants is the need to ensure "vertical balance"-that is, to enable local governments to finance the functions for which they are responsible. Block grants are typically assigned to subnational levels for this purpose, often based on population size and sometimes adjusted for the varying cost o f delivering services throughout the country. In addition, conditional grants are assigned to local levels to ensure that services delivered locally but o f national importance (e. g., public health, education) are adequate. Finally, depending on the degree o f "horizontal equity" desired ina particular society, intergovernmental grants are allocated to redistributeresources. An important question for Iraq i s to what extent should transfers contain a redistributive element to bring up standards in the lagging regions? The answer depends on how differentiated the provinces are in their income levels and their own potential sources of revenues. One o f the main goals o f intergovernmental transfers i s to equalize, at least to some degree, development and well-being across all subnational governments. Thus, poor subnational governments can be assured o f some minimumfinancial support to provide a nationally agreed-upon minimumlevel. How the equalization transfer i s constructed therefore becomes critical to the overarching goal o f poverty reduction. At the same time, it signals the government's seriousness about achievingnational cohesion. Given the centralized tax base and the inevitable importance o f intergovernmental transfers in Iraq, it i s particularly important that transfers be transparent and predictable, so as to enable local planning and hard budget constraints (clear knowledge by local governments that they must manage their resources within a fixed budget envelope provided by the central government). Although transfers will continue to play the key role in financing local services, local taxes are an important method o f strengthening accountability, because these marginal revenues can be clearly linked to local officials' decisions about marginal expenditures. Expanding local tax bases is an important aspect of improving subnational governance. Although subnational borrowing on credit markets may be a desirable financing mechanism in the fbture, it could be destabilizing now. Until a clear intergovernmental framework i s implementedand its credibility proven, any borrowing that rapidly expands local expenditures and softens budget constraints could possibly threaten macroeconomic stability. Thus, a clear regulatory framework to strengthen transparency and determine the rules o f subnational borrowing would need to be developed over time. 103 How should local governments be held accountable? Because the draft constitution remains vague on the lines o f authority and responsibility are now unclear between central and subnational administrations, institutional arrangements need to be developed that would define accountability and create appropriate incentives for each level o f government. One issue that could be clarified, for example, i s which level o f government has the authority to hire and fire different types o f officials. Furthermore, channels o f "social accountability" need to be opened and strengthened, so that local governments and their constituents will have opportunities to engage inproductive dialogue andpartnerships. Perhaps the most important point to emphasize at this early stage o f Iraq's decentralization effort i s that each o f the issues mentioned above must be considered both on its own and inconjunction with the others. Experience throughout the world highlights the danger o f unintended consequences and the disturbing propensity o f states to move toward an incoherent or inconsistent intergovernmental framework.' Decentralizing expenditure functions, for example, without adequately fimding them leads to weak service delivery. Soft budget constraints between levels o f government can create incentives for local governments to act irresponsibly (i. e., to overspend, undertax, overborrow, or use local state-owned enterprises or state banks to cover local expenditures) in the expectation that the central government will bail them out. But unless the central government provides adequate supplemental provisions for the poorer regions, decentralizing expenditure functions can lead to growing inequality. Fiscal decentralization without adequate political and administrative accountability can lead to local corruption. A coherent framework for decentralization-and for intergovernmental relations broadly-needs to take into account this multitude o fissues. Humanresourcemanagement Iraqnow lacks many o f the features o f modern humanresource management. Institutions with a clear mandate to manage the civil service are absent. Administrative skills and experience are lacking, and some areas are overstaffed and functions misaligned. Guidelines governing the basic elements o f employment, promotion, termination, recruitment, and performance evaluation are not yet inplace or enacted. Controls are not robust. Because basic data-gathering fimctions are nonexistent, most employment data are unreliable. Budgets are not reconciled and financial safeguards are weak, leading to strong suspicion that fraud i s pervasive. The civil service i s a high priority for reform o f human resource management. Primary legislation (National Civil Service Law 24, dating from 1983 but first issued in 1960, Staff Law 25 o f 1960, and the Instruction o f 1960) is preserved only insofar as it may be used to provide "redress for adverse managerial actions," which is unsatisfactory in the absence o f guidelines governing the many potential forms o f termination. There is also little guidance to help civil service managers and protect civil servants from potentially contentious issues. Underthe Coalition Provisional Authority (Order 30), the Ministry of 104 Finance i s the primary authority for all policy, procedure, and disciplinary issues relating to public service employees, an arrangement that does not conform to international best practice. The payroll process and disbursement systems are also known to be weak. An audit report produced by the accounting firm o f KPMG in June 2004 provides examples o f weaknesses in controls. Areas o f the payroll system that are vulnerable to irregular payments or reporting have been identified. Fundamentally, there is an urgent need to provide a resilient and secure end-to-end payroll process that incorporates significant fraud-prevention, effective internal controls, and individually traceable disbursements across the whole o f the civil service. Anticorruption Problems o f corruption are widely perceived to be a significant governance and developmental concern in Iraq. In 2003, the country ranked 11lth on Transparency International's Corruption Perception Index, the lowest o f any country within the Middle East and North Africa region. By 2004, Iraq ranked 129th out o f 145'countries, in the company o f Cameroon, Kenya, and Pakistan. The recently established Commission on Public Integrity receives about ten calls a day reporting various abuses or perceived abuses. A number o f audit reports have identified consistent irregularities inaccounts and lax financial andprocurement controls: In January 2005, a report of the U.S. Inspector General found that the Coalition Provisional Authority disbursed $8.8 billion to Iraqi ministries "without assurance the moneys were properly accounted for." InJuly 2004, an audit ofthe DevelopmentFundfor Iraquncovered anumber of areas of concern, including the absence o f oil metering; the use o f barter transactions for certain oil sales; and the use o f noncompetitive bidding procedures for some contracts. The audit concluded that the weaknesses in monitoring oil extraction and financial transactions required corrective action. The audit also found problems with an inadequate control environment within Iraqi spending ministries, including outdated management information systems, limited computerization, inadequate training, and poor dissemination o f the Ministry o f Finance's policy manual on accounting procedures. A reportby the Office ofthe Inspector General ofthe CoalitionProvisionalAuthority reached similar conclusions, identifying the lack o f transparency of Iraqi funds since the transfer o f power to the Iraq Interim Government as being particularly problematic. U.S. Defense Contract Audit Agency examinations related to nearly $7 billion in reconstruction work and found $133 million inquestionable costs and $307 million in unsupported costs. Although anecdotal evidence indicates that corruption i s a significant problem in Iraq, it is difficult to confirm these perceptions empirically. N o surveys have explicitly addressed corruption issues, and there i s little robust statistical information on the scope and scale o f the problem. The public opinion information that does exist indicates that perceptions o f corruption do not appear to weigh heavily upon the public's mind. Problems o f poor 105 security, unemployment, crime, occupation, and infrastructure are consistently cited as being o f greatest public concern, and corruption is not among the top ten issues o f greatest importance. Several interpretations could account for these findings. The first is that they reflect a hierarchy o f values, inwhich safety, security, and economic well-being are thought to be more important than clean and transparent government. They could also reflect a general acceptance o f at least certain types o f corruption as a way o f life, rather thanan administrativepathologyto bestamped out. To combat problems of corruption, a number o f initiatives launched under the Coalition ProvisionalAuthority remain inplace. Perhaps the most significant was the establishment o f independent offices o f inspectors general within individual Iraqi ministries. The inspectors general were authorized to perform a variety o f functions, including auditing all records and activities o f the ministry; conducting administrative investigations against any ministry official, including the minister; auditing the economy, efficiency, and effectiveness o f the ministry's operations; and reviewing any ministry systems for measuring performance. As o f July 2004, inspectors general were inplace in all cabinet ministries, although their effective functioning will take time to develop. Inaddition, the Commission on Public Integrity was created, and the existing Supreme Board o f Audit was revitalized and tasked with enhancing the economy, efficiency, effectiveness, and credibility o f the Iraqi government. It was also tasked with collaborating with the Commission on Public Integrity and the inspectors general o f individual ministries to ensure that the government remains honest, transparent, and accountable. The Commission on Public Integrity was charged with the criminal investigation o f corruption cases and violations of the code o f conduct, including those coming from anonymous sources. It was charged with promulgating mandatory financial disclosure regulations and a revised code o f conduct for public officials. It was also tasked with responsibility for public information and awareness. Assessments o f the external audit function by the World Bank and the International Monetary Fundhave indicated that the Supreme Board of Audit's design and legal framework are largely adequate. Nonetheless, there i s a significant need to strengthen its independence, improve transparency, upgrade business processes, and initiate capacity buildingand training. To be successful, Iraqi anticorruption efforts need to operate along a number dimensions. The four described below are particularly important. It i s also important that any efforts to combat corruption be grounded in a rigorous, empirically based analysis o f the scope and magnitude o fthe problem. e Strengthening the legal and regulatory framework. Issues that need to be addressed include (a) the definition o f corruptionwithin the penal code and the legal mandate o f various accountability institutions charged with detecting and combating it, (b) the links within the accountability chain, including procedures for investigating, prosecuting, and trying cases involving corruption or administrative discipline and sanctions, and (c) the legislation intended to promote integrity within the public sector, ranging from ethical codes o f conduct to financial disclosure and conflict o f interest provisions. 106 Developing strong accountability institutions. Accountability institutions, such as supreme audit boards, anticorruption agencies, inspectors general, ombudsmen, and the like are another important link within the disciplinary chain. Often, such agencies lack the necessary mandate, staffing, budget, and independence to function effectively. Their administrative and investigative procedures can be ponderous, their equipment inadequate and antiquated, and their staff lacking inimportant skills, such as forensic accounting or techniques o fnet asset evaluation. Supportingprevention within individual agencies and line departments. Corruption i s not spread uniformly throughout the public sector, but is often concentrated in departments with significant revenue (tax and customs), expenditure (education and public works), or regulatory functions (police and building inspection). It i s therefore important that the departments most prone to corrupt activity have active programs aimed at minimizing their vulnerability. Prevention i s typically the first and most important step, and many solutions canbe employed at the organizational level. Some enhance transparency and monitoring performance, either internally or externally; others streamline business processes to reduce opportunities for graft and speed money; others improve internal financial controls or reform personnel practices. Many are under the control o f the organization itself and can be put inplace rapidly, ifsignificantpoliticalwillexists.Insomecases(suchasimprovinghumanresource management), broader changeswithinthe public sector maybenecessary. Enhancingpublic opinion and awareness. Many o fthe most successful anticorruption programs involve a component addressing public awareness and education. Hong Kong's highly successhl Independent Commission Against Corruption, for example, devoted the greatest proportion o f its administrative budget to raising awareness within the community as to what constitutes corruption and what can be done about it. The result was a significant shift inpublic attitudes and awareness and a greater willingness to come forward with complaints. Summary of recommendations The new Iraqi government will face a host o f critical governance and public administration challenges that will take a decade or more to fully resolve. Many issues, such as the appropriate devolution o f responsibilities to the provincial and municipal level, are hndamentally political innature. As such, they will be informed by technical judgments,but not determined bythem. Inthe narrower field of public administration, in the short-term, any Iraqi government will need to focus upon gettingthe basic systems and procedures inplace that will allow it to mobilize financial andhumanresources efficiently, deliver services effectively at the most appropriate level, and preserve integrity within government. These basic reforms should be implemented in a fashion that, at a minimum, does no harm to the effective medium-to long-term functioning o f the Iraqi state-such as, for example, avoiding the pernicious practice o f salary top-ups by donor organizations, which distort the incentive 107 framework within the civil service. More positively, such reforms will facilitate the evolution o f the public sector into an effective, high-performing entity. For publicfinancial management 0 Improve the comprehensiveness and transparency o f the budget process, integrating all important revenue and expenditure streams. 0 Determine the appropriate role o f institutions in the expenditure process, including unification o fthe budget preparation process within the Ministryof Finance. 0 Improve internal reporting, control, accounting (particularly for oil revenues), and audit procedures. 0 Strengthen capacity o f the Ministry of Finance (particularly in public debt management) and o fthe Supreme Board o fAudit. For intergovernmental fiscal relations 0 Forge a political consensus on the optimum number and appropriate assignment o f responsibilitiesto various levels o f government. 0 Analyze expenditure assignments and costs o f service delivery at various levels o f government, so that the fiscal requirements are known. 0 Devise a system o f grant and transfer payments, taxes, user fees, and borrowing that matches the assignment o f expenditures. 0 Develop appropriate legislation, regulations, and incentives to prevent corruption and problems o f irresponsible fiscal behavior among subnational governments. For human resource management Establish two regulatory bodies to oversee the civil service: one to make human relations policy, and the other to monitor compliance and serve as an independent avenue o f appeal. Create basic human relations and payroll management tools, including a review o f staff grading across ministries, an employee verification process, capabilities for establishment control and manpower planning, streamlined payroll calculation rules, and comprehensive vacancy lists. Enact new legislation that defines the guidingprinciples o f public sector employment and identifies or creates institutions responsible for civil service management. Introduce regulations to define contractual terms and conditions for the civil service: recruitment and selection procedures; terms and conditions o f employment; policy statements and operational guidelines to avoid discrimination; employee rights; employee benefits; disciplinary and grievance procedures; redundancy and transfers; termination. Develop the capability within each line ministry to make human relations strategy operational. Enhance payroll technology and develop an operational payroll and job application strategy. For anticorruption 0 Review legal codes addressing corruption, asset disclosure, conflict of interest, and whistleblower protection and revise as necessary. 108 0 Conduct survey and diagnostic work to better understand public attitudes toward corruption and identify key problem areas. 0 Strengthen the capacity o f independent anticorruption agencies, such as the Commission on Public Integrity and the inspectors general. 0 Develop ministerial and departmental anticorruption plans for key revenue, expenditure, and regulatory agencies most vulnerable to corruption. 0 Develop a public awareness and education program. Note InSouth Africa, however, a post-apartheid White Paper had providedthe country with an excellent road map for reforming and decentralizing government: www.treasury.gov.za. 109 Annex. Iraq at a glance Middle East Lower POVERTY AND SOCIAL and North middle- Developmentdiamond' lraq Africa income 2005 Population,mid-year (millions) 27.9 312 2.704 Life expectancy GNI per capita (US$) 1,188 2,210 1,490 GNI ( US$billion) 33.2 744 3,900 T Average annual growth, 1999-05 Population(%I 2.8 1.9 0.9 GNI Gross Laborforce (%) 2.4 2.9 1.2 primary capita Per nrollment Most recentestimate (latest year available, 199905) Poverty(% of populationbelow nationalpovertyline) - - - Urban population(% of totalpopulation) 67 58 49 Life expectancy at birth (years) 61 69 69 Infant mortality(per 1,000live births) 102 43 33 Child malnutrition(% of children under 5) 12 - 11 Access to improved water source - Accessto an improvedwater source (% of population) 61 88 81 Lliteracy(% of populationage 15+) 65 69 90 Gross primary enrollment (% of school-age population) 110 95 111 lraq Male 120 98 111 ._ ..Lowermiddleincome WOUD Female 100 90 110 KEY ECONOMICRATIOSAND LONG-TERM TRENDS 2000 2001 Economic ratios 2004' ^^^^ ^^^. 2002 2003 2004 ^^^^ ^^^^ --" 2005 ---- 1 GDP (US$ billion) 25.9 18.9 20 5 13.6 25.7 33.2 Gross domesticinvestmenffGDP - - - - 26.6 37.1 Trade Exportsof goods and servicedGDP 63.8 63.5 47.4 74.1 69.1 68.7 Gross domesticsavingslGDP - - - - 2.9 4.6 Gross nationalsavingslGDP - - - - -10.2 6.9 Domestic CurrentaccountbalancelGDP - - - - -36.8 -144 savings Investment Total External Public DebffGDP - - - 896 309 154 Total debt servicelexports(actual amounts paid) 0 1 Presentvalue of debtfGDP - - - - - 896 309 Indebtedness Presentvalue of debtfexports - - - 1,209 447 (real averageannualgrowth) 2000 2001 2002 2003 2004 2005 - lraq GDP -4.3 -6.6 -7.8 -41.4 46.5 2.6 GDP per capita 0.2 2.0 -5 4 -44.2 43.7 -0.2 ......- Lowermiddle-incomegroup STRUCTURE OF THE ECONOMY Is/, of GDP) 2000 2001 2002 Growth of investmentand GDP (%) 2003 2004 2005 ~ Oil sector 83.9 76.1 68.0 68.0 67.7 Non-oilsector 16.1 23.9 32.0 32.0 32.3 Agriculture 5.4 8.1 11.1 - 9.8 Manufacturing 0.9 1.6 1.7 1.7 1.5 Services - - 19.2 21.3 21.o Privateconsumption - - - - 40.8 General government consumption - - - - 56.3 59.6 - GDI +GDP Importsof goods and services - - 47.9 74.0 92.7 93.1 (average annualgrowth) 2000 2001 2002 2003 2004 2005 Growth of exDortsand irnnorts (%) 150 Agriculture -11.6 1.2 17.0 -29.1 - Industry 1.9 0.8 -10.9 -37.7 - 100 Manufacturing -4.5 9.2 -14.5 -28.5 - Services 5.4 0.4 2.5 -33.4 - - 50 Privateconsumption - - - - - - 0 General government consumption - - - - - Gross domesticinvestment - - - - - - -50 ----Exports *Imports Importsof goodsand sewices - - - 2.5 137.0 29.5 -is not available Note 2004 and 2005 data are preliminary estimates a The diamondsshow four key indicatorsInthe country (inbold)comparedwith its income-groupaverage Ifdata are mlssing the dlamondwill be incomplete 110 PRICES AND GOVERNMENT FINANCE 2000 2001 2002 2003 2004 2005 Domestic prices Inflation(Yo) 1 (77 change) Consumer prices 5.0 16.4 19.3 34.0 31.7 32.8 Implicit GDP defiator 52.6 -13.1 9.8 24.0 4.0 26 Government finance (% of GDP, grants) Current revenue 80.0 93.6 Current expenditure 98.3 78.9 Capital expenditure 22.3 25.6 Overall surplusldeficit -40.5 -10.9 -GDP deflator - 0 - C P I I FOREIGN TRADE 2000 2001 2002 2003 2004 2005 (US$ million) Merchandiseexports and imports Total exports (fob) 16,527 12,009 9,711 10,082 17,782 22,781 (US$ billion) Crude oil 16,476 11,941 9,653 8,459 17,329 22,176 25 Petroleumproducts - - - - - - Manufacturedproducts - - - - - - 20 Total imports (cia 3,320 5,180 9,817 10,063 79,587 24,416 Governmentimports - - 9,434 7,114 13,779 14,596 15 10 UN Oil For Food Program - - - - 3,468 1.929 Post OFFP govt. consumption - - - - 3,843 3.528 Refinedoil products - - 138 2,651 3,428 Capitalgoods - - -0 - 3,799 5,711 Private sectorimports - - 384 2,620 5,809 9,820 5 Consumergoods - - 288 1,126 - - I Capital goods - - 96 1,692 - - 0 98 99 W 01 02 03 04 Crude petroleumprice ($/bbl)' 24.7 19.9 20.5 26.0 31.6 43.1 Proven oil reserves (billionbarrels) 113 115 115 115 115 115 Exoorts rn lmoorts O5 BALANCE OF PAYMENTS (US$ mi/lion) 2000 2001 2002 2003 2004 2005 Current account balance to GDP ("A) Exportsof goodsand servicesd 16,527 12,009 9,711 10,082 17,782 22,781 Importsof goodsand servicesd - - 9,817 10,063 23,847 30,893 Resourcebalance - - -106 19 -6,065 -8,112 Net income - - - - -5,395 -3,741 Net currenttransfers - - - - 2.004 7.090 Current accountbalance -9,460 -4,763 Financingitems (net) -1,559 -1,409 Changes in net reserves -6,332 -1,409 Memo: Reservesincludinggold (US$ million) - - - 1,134 7,902 9,311 -40 1 Conversion rate (NlD/US$) 1,930 1,929 1,957 1,957 1,455 1,467 98 99 W 01 02 03 04 05 EXTERNAL LIABILITIES (US$ million) 2000 2001 2002 2003 2004 2005 Externaldebte Compositionof external public debt as of Total debt outstandingand disbursed - _ - 121,900 79,400 51,200 December 31,2004 (US$ billion) Multilateral organizations 635 690 890 Multilate- IBRD 101 0 0 Comwr- ral 1 IMF 80 436 436 cia1 l0.5'\ I Paris Club Creditors 36,900 23,800 18,100 Ofwhich Japan 7,249 - - France 5,580 - - Germany 5,482 - - UnitedStates 4,010 Italy 3,920 -0 -0 Russia 3,598 - - Non-ParisClub governments 67,365 43,000 - Of which Gulf CooperationCouncil 48,190 - - Commercialcreditors 15,000 10,500 3,000 Of which commercialbanks 2.500 1,750 - UNCCCompensations' 18.992 52.466 .,..- .-, .. b. Fiscalaccomts are a consoidaironof governmembudgets.a:a flows, and spenaing ~y the DevelopmentFdd of Iraq(DFI). c. .raql oil pr ces carrya aiscoLnt tnat reflectstne qda ty of Iraqi0 endsana frequentsecurity-relatedslrppty interruptions o Datafor serwces :s only aJaiiaDleon a net Oasis and ;s aOOeOto imports;expons data Snown nere arefor mechana.seexports only. e Esi.ma!es Dasedon patial data from tne creaitors These have not been reconcile0and may oe incompete. Datafor 2004 and 2005 assume b,lappicationof tne firstand secona stage ofOeDt reoJcion.inclang comparabletreatment of non-ParisCIJDdeot. f UhCC ,s the UN Compensa! on Commhon (Nww.mcc.cn) Amounts awaraeo for 2005 are oLtstanang as of Januaty 24, 2006 111 References Abdul Rasool, FaikAli. (2003) "Iraq: Transition to Market Economyfiom Low Cost, Subsidies, Food, Oil Products, Electricity." World Bank, Washington, D.C. Ahmad, Ehtisham, R.Broadway, G. Brosio, R. Ebel, andR.Searle. (2004) "Iraq: IntergovernmentalFiscal Relations." 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