EXECUTIVE SUMMARY
Recent Economic and Policy Developments
Iraq’s economy continued its recovery after the sharp, pandemic-induced recession in 2020 but growth constraints in the oil sector have reemerged. Real gross domestic product (GDP) growth accelerated to 7.0 percent in 2022 driven by the tapering of OPEC+ production cuts in the first nine months of 2022. Oil GDP, accounting for 61 percent of real GDP in 2022, grew by 12.1 percent despite the OPEC+ agreement in the last quarter of the year. In contrast, non-oil GDP growth was muted as non-oil industries stagnated and agriculture activities contracted due to the drought and associated water shortages. The recent growth spurt pushed per capita GDP growth to 5.4 percent in 2022, however, as the capital-intensive oil sector drove the rebound, the positive impact on the labor market was limited. Iraq’s rapid population growth (2.4 percent per annum) highlights a need for higher growth to improve welfare outcomes and to close the growing income gap with peers. Oil GDP, the main driver of recent growth has been constrained by new crude oil production limits announced in late 2022 and extended in April 2023. As a result, GDP growth fell to 2.6 percent (year-on- year) in the first quarter of 2023.
After moderating in 2022, consumer price inflation ticked up in early 2023, fueled by the depreciation of the Iraqi dinar in the parallel market. The June 2022 emergency law for urgent needs for food security and energy imports helped curb headline and core inflation to 5.0 and 4.3 per- cent in 2022, respectively. Tighter enforcement of financial reporting standards for Central Bank of Iraq (CBI) dollar auctions since November 2022 caused supply-demand mismatch of dollars and led to the depreciation of the dinar in the parallel market, pushing inflation to 7.2 percent year-on-year in January 2023. In response to the currency depreciation, the CBI revalued the dinar in February 2023 to IQD1,300/USD, up by 10.3 percent. Inflation and the parallel market rate depreciation have since moderated but the gap over the official rate remains significant, highlighting persisting exchange rate pressures.
Fiscal and external account balances benefitted from the oil windfall in 2022 but this trend significantly moderated in early 2023. Total government revenues surged by 48.2 percent in 2022, spurred by higher oil prices and export volumes. Total expenditures grew less than revenues (by 20.5 percent). Growth in the former was the result of the passing of the Emergency Food Security Law (June 2022), before which expenditures had been constrained to their 2021 (nominal) levels due to a lack of an approved budget for the year. As a result, the fiscal balance recorded a significant surplus of 11.7 percent of GDP and debt-to GDP moderated to 53.8 percent. Despite rising imports, the current account registered a sizeable surplus of 20.7 percent of GDP (US$55 billion) in 2022, as exports (dominated by oil) increased by 74 percent. The favorable oil market dynamics brought total reserves excluding gold up to US$89.0 billion (covering 14.7 months of imports). However, this trend in reserve accumulation slowed in early 2023 as external account pressures resurfaced with the lower oil prices, leading reserves to start declining in May 2023.
The new budget is excessively expansionary, and lacks the structural reforms that Iraq needs to develop a vibrant and sustainable economy. Two decades after the 2003 war, Iraq’s highly oil dependent development model is set to endure. The drive for fiscal reforms to address budget rigidities and to mobilize non-oil revenues has yet to materialize. The current government, formed in October 2022 after a year-long political stalemate, proposed a budget covering a three-year 2023-2025 horizon which was only ratified in June 2023 and signals a significant expansionary fiscal stance. Expenditures, heavily skewed toward recurrent spending, are set to increase by 59 percent notably due to a sharp increase in the wage bill, which will likely crowd out much-needed investments. The budget does not sufficiently address longstanding structural challenges, including on economic diversification, improving public financial management, addressing fiscal rigidities, and boosting domestic revenue mobilization. With revenues dominated by oil, the budget assumes an oil price of US$70/bbl and 3.5 mbpd of exports whereas the breakeven oil price to cover all expenditures actually stands at US$112/bbl (almost double 2022). This will result in a fiscal deficit of US$39.7 billion representing 14.3 percent of GDP and equivalent to almost half of the record reserves accumulated following the 2021-2022 oil boom. If fully executed, the highly pro-cyclical budget could lead to a rapid depletion of the recent oil windfall and renewed fiscal pressures, especially given the recent and pronounced dip in global oil prices to US$71/bbl in May 2023 and extension of production quotas.
Iraq’s economic outlook in the medium term continues to hinge on oil sector developments. Overall GDP is forecast to contract by 1.1 percent in 2023 driven by a projected 4.4 percent contraction of oil GDP (assuming oil production is bound by the April 2023 OPEC+ production quotas). By contrast, non-oil GDP growth is projected to accelerate in 2023, partly assisted by the budget expansion. Limited linkage between oil and non-oil sectors coupled with public sector dominance in formal employment is pro- jected to continue to result in a stunted and largely informal private sector. Low appetite for reforms, even amid softening oil prices, and modest non-oil growth potential, in part due to a deteriorating business environment and continued widespread corruption, are expected to constrain long-term economic growth. Higher public expenditures and imports will weigh on both the fiscal and current account balances, with the former turning into a deficit. The revaluation of the dinar is expected to reduce dinar-denominated oil revenues while expenditures are set to increase significantly with the budget. A stronger dinar is expected to also lead to higher imports and undermine export competitiveness.
The economic outlook remains subject to significant risks, largely due to deep structural challenges. High dependence on oil leaves the economy vulnerable to shocks in oil markets and global demand as highlighted by the recent softening of oil prices. Pre-existing drivers of fragility, including a high prevalence of corruption, low labor force participation, especially females, high private sector informality, the lack of job opportunities, financial sector imbalances, poor service delivery, and security risks remain key challenges. Heightened climate change vulnerabilities and further commodity price volatility associated with the Russian invasion of Ukraine would intensify existing poverty trends and raise food insecurity. The recent spike in inflation has also highlighted the exchange rate market as a source of risk that had been previously contained with the currency peg. On the upside, the improvements in domestic political tensions regarding government formation can pave the way for further investment in the economy and boost potential GDP. Furthermore, the prospects of reduced regional geopolitical tensions could boost regional trade and FDI opportunities for Iraq.
Urgent implementation of financial sector reforms and modernization of its banking sector architecture, currently major barriers to economic diversification, are a critical condition to bolster the private sector and unlock much-needed job creation. Financial access in Iraq is amongst the low- est in the world, with only 19 percent of adults owning a bank account, highlighting a significant underutilized source of financing. Crucially, lack of financing remains the top constraints for small and medium enterprises and firms operating in the informal sector, undermining private sector-led growth and job creation. As this report’s Special Focus highlights, this is in part due to the banking sector structure and operations, which is dominated by undercapitalized state-owned banks with weak institutional capacities that primarily provide financing to public sector entities and state-owned enterprises. The private commercial banking sector is weak and has limited capacity to support financial intermediation and is geared towards maximizing revenues from the foreign exchange auctions. Furthermore, the non-banking financial sector is nascent with small and underdeveloped capital markets, unregulated Micro Finance Institutions, and an underdeveloped insurance sector. To tackle these challenges, the sector’s reform priorities include institutional reforms in state-owned banks, and incentivizing digital financial services so as to increase financial intermediation and promote financial inclusion in Iraq. The full implementation of these reforms can help restore public confidence in the financial sector and help mobilize Iraq’s wealth towards solving the pressing development challenges of the country.