1.      The Kurdistan Region of Iraq (KRI) is a constitutionally recognized
semiautonomous region in northern Iraq. Its government, the Kurdistan Regional
Government (KRG), based in Erbil, has the right—under the Iraqi constitution of 2005—
to exercise legislative, executive, and judicial powers according to the constitution,
except in what is listed therein as exclusive powers of the federal authorities. The Iraqi
constitution defines the Kurdistan Region as a federal entity of Iraq. KRG has a
parliamentary democracy with a regional assembly that consists of 111 seats.

2.      KRI has been largely immune to the insecurity and conflict witnessed elsewhere
in Iraq, especially following the 2003 Iraq War. This has allowed KRG to promote its
burgeoning private sector and attract foreign investments in both oil and non-oil sectors.
However, starting from mid-2014, the plunging of oil prices coupled with increasing
threats to security have intensified pressure on the overall Iraqi as well KRI’s economies,
necessitating a need for action to address the immediate and medium-term challenges
presented in this report. Government of Iraq (GoI)’s fiscal position has deteriorated and
political tensions have increased with widespread demonstrations demanding reforms
across legislative, executive, and judicial branches.

3.      KRG is facing a wide range of immediate and medium to longer-term
challenges that are intrinsically linked to the overall macroeconomic situation of Iraq
as well as the regional and global environment. The immediate challenge consists in
coping with (a) the deep fiscal crisis, and (b) the security and social problems brought
about by the conflict with the Islamic State in Iraq and Syria (ISIS) group and the
resulting influx of Syrian refugees and Iraqi Internally Displaced Persons (IDPs). These
challenges are clearly immediate priorities for the KRG, and would bear significant
repercussions nationally and internationally if inadequately addressed. The medium to
longer-term challenges pertain to moderating dependence on the oil sector and
transforming the KRI economy into a diversified one that supports private sector-led
economic growth and job creation in a sustainable manner.

4.     Similar to the rest of Iraq, the fiscal crisis and the security challenge posed by
the ISIS insurgency have had a significant adverse impact on economic growth in the
KRI. The fiscal shock is severe. KRG has been dealing with the fall in revenues by a
combination of postponing its investment projects, letting payments fall in arrears
including wages and salaries of government employees, borrowing domestically from
private and foreign companies and banks, and borrowing externally. The impact of
reduced investment in infrastructure will be felt in the medium-term through lowering
private sector productivity and crowding out private investment. Also, arrears in
payments to oil companies and contractors create an uncertain business environment.
These, in turn, discourage investment both foreign and local. The ISIS insurgency has put
significant pressures on the Government through increased security spending and the
influx of refugees and IDPs.

5.      To address short-term as well as medium- to long-term structural issues, the
Government requested the World Bank support to develop and implement a structural
economic reform roadmap. This work is a response to an official request of the KRG
Prime Minister H.E. Nechirvan Barzani in a letter to the World Bank President Dr. Jim
Yong Kim in February 2016 seeking a partnership for growth and development to
address the economic and developmental challenges. As a response to the Government
request, this report proposes reform options for fiscal adjustment and for the
diversification of the economy in addition to social mitigation measures to protect the
vulnerable from impacts of the external shocks. The proposed economic reform roadmap
is expected to guide policy makers in KRG as they address the immediate and more
medium- to long-term challenges facing the region in the context of increasing
vulnerabilities confronting Iraq as a whole. This work builds upon the World Bank’s
extensive analytical and technical assessments conducted under the Economic Growth
Diagnostics Study for the KRI, as well as technical assistance for social protection reform
and modernization of public procurement system. The report also draws on IFC’s
experience with the private sector in KRI over the last few years to identify the necessary
reforms that would help KRG move to the next level of attracting necessary private sector
investments in the context of a challenging domestic and regional environment. KRG is
in need of a structural economic reform roadmap, which is inclusive and serves as
Government’s umbrella framework for reform actions in the short to medium-term. The
Ministry of Planning (MoP) laid out broad objectives as guidelines for policy formulation
through the Kurdistan Region of Iraq 2020: A Vision for the Future, with the
diversification of the KRI’s economy away from the oil sector being at the core of these
objectives. The success of these reforms and the ability to deal with multiple shocks will
require support from KRG’s partners. This report is the first phase of the potential World
Bank assistance to the KRG to design and implement long-standing reforms. The second
phase of the technical assistance is expected to provide implementation support for the
Government. The KRG has already started implementing austerity measures including
wage bill and subsidy reforms.

Initial Conditions: Structural Issues and Recent Multiple Crises

Similar to the rest of Iraq, the KRI economy is characterized by severe dependency in
four areas:

  I.   High dependency on the oil sector. Either directly or indirectly, KRI’s economy
       is highly dependent on oil sector. Despite a series of negotiations, a dispute with
       the central government about the sharing of oil revenues and the budget transfer
       has not been resolved. Oil export revenues, which had been received from the
       central government as budgetary transfers (recently suspended), constituted about
       85 percent of the Government’s fiscal revenues. However, the sector’s estimated

                                            ii
          share is only 1 percent in region’s employment. Such a high level of oil sector
          dependency has become a “Dutch disease� particularly at times of high oil prices.
          Combined with a difficult enabling environment for private sector business
          development, skill formation that is not as advanced as desirable, and strong
          incentives for people to seek jobs in the public sector, it undermines other sectors’
          competitiveness in local and international markets and suppresses private sector
          development and domestic production in tradable sectors and exports.

          High oil dependency has created a rentier state, a boom-bust business cycle and
          an uncertain business environment. The boom period concealed the structural
          problems the KRG faces. In the past, flush with oil money the government
          became complacent to identify and address the structural problems. The current
          bust period has brought all structural problems to the surface.1

    II.   An excessive role of the public sector in the economy. The public sector dominates
          the KRI economy. The KRG public spending to GDP ratio is over 50 percent,
          compared to 61 percent for the whole Iraq. The KRG is the main employer with a
          share of more than 50 percent in total employment (26 percent in non-military
          employment). Similar to the rest of Iraq, payments for salaries, pensions, social
          assistance and subsidies (electricity, fuel, water supply, and agriculture) comprise
          over 50 percent of the budget. Taxes constitute only 4.7 percent of total revenue.
          As a result, public expenditure is a primary driver of economic growth. A key
          problem is high volatility of public expenditure, which translates into high
          volatility of growth through the fiscal multiplier.2 Volatility of expenditure
          originates, in turn, from volatility of the KRG revenues, which varies widely
          reflecting fluctuations in oil prices, interruptions in production and transportation
          of oil driven by conflict, and most importantly the dispute with the central
          government about sharing of oil revenues. Despite the strong entrepreneurial
          spirit and potential, the local private sector in KRI is small and under-developed
          due to the significant crowding out by the public sector.

III.      Dependency on imports. Due to the relatively undiversified nature of the overall
          Iraqi economy, there is a large gap between demand for and local production of
          tradable products in KRI (hydrocarbon exports account for around 95 percent of
          the total export basket of Iraq—the highest among Upper Middle Income

1
  To manage the oil revenue better KRG approved a law that authorizes establishment of a Sovereign
Wealth Fund (The Oil and Gas Revenue Fund Law, approved in April 2015), which could help pursue a
dual objective of stabilizing the economy and saving to optimize the investments. The law identifies five
areas where oil revenues may be allocated for: the Kurdistan Region's annual budget, investment spending,
oil infrastructure, environmental protection, and a “future generation’s� wealth fund. This is a step in the
right direction, which will also help with establishing accountability and transparency in spending the
natural resource revenues. However, although the law and a fund could provide the necessary infrastructure
for fiscal management of natural resource revenues, by themselves they are not sufficient. A carefully
designed principle for operating these funds, e.g., a fiscal rule, and the political will to pursue those
principles are equally important.
2
  One would expect a high fiscal multiplier in KRI because income tax rate and marginal propensity to save
are very low although marginal propensity to import is high.

                                                    iii
          Commodity Exporters). The gap is filled by imports, which amount to about 90
          percent of non-oil GDP. Local production is confined to retailing of imported
          products, small-scale tradables, and other services including bloated public
          services. Exports of locally produced goods are very limited. This is a typical
          feature of a rentier economy. This is aggravated by weak behind the border
          policies. Under the current policy regime, it is hard for the local businesses to
          compete with imports to diversify and grow.

IV.       Weak financial system and dependency on cash-economy. An inclusive and
          efficient financial system is critical for private sector development. A well-
          developed financial system would fund greater investment for larger numbers of
          people. KRI has a poorly developed financial sector, including weak financial
          infrastructure and low access to finance, especially for small and medium-sized
          enterprises (SMEs). There is a strong preference for cash in business transactions.
          Around three percent of companies rely on the banking sector for investment and
          working capital (over 20 percent in the Middle East and North Africa). This is
          explained partly by the pervasive atmosphere of mistrust in the banking sector
          created by frequent financial disruptions and instability in the region.

These structural challenges have been aggravated by a series of recent shocks:

      ï‚·   Conflict with the ISIS group since mid-2014within 13 miles of Erbil;
         Influx of 1.8 million Syrian refugees and Iraqi IDPs increased KRI’s population
          by 28 percent;
      ï‚·   A sharp decline in international oil price, from US$115 a barrel in June 2014 to
          US$35 in December 2015 which means less revenues from direct sales; and
      ï‚·   A sharp fall in revenue transfers from the central government, from US$12 billion
          in 2013 about US$1 billion in 2014, which was suspended in June 2015.3

6.     The growing inflow of Syrian refugees and internally displaced Iraqis into the
KRI has imposed additional strains on the budget and service delivery. This major
influx severely constrained the Government’s ability to deliver health, education, and
social protection programs to the increased population. The standard of living of the
population has deteriorated, and many people have fallen into or are vulnerable to falling
into poverty. As a result of the multiple crises, the poverty rate for KRI doubled in host
communities—with the largest increase in Dohuk which experienced the highest influx of
IDPs. When the IDP and refugee population is included, the poverty rate increased even
higher: poverty in KRI increased to 12.5 percent in 2014. More than 75 percent of the
refugees and IDPs are women and girls who are very vulnerable. KRG is providing
3
  In December 2014, a new agreement was reached between KRG and the Central Government to resolve
the dispute. According to this agreement, KRG would export 550,000 bpd through Ceyhan, Turkey
(250,000 bpd from its own fields and 300,000 bpd from federal fields) for the Central Government State
Oil Marketing Organization (SOMO). In return, the Central Government would resume transferring the 17
percent of its budget to KRG. The agreement was not been fully implemented; KRG did not receive its 17
percent share fully, and has delivered less than 550,000 bpd to SOMO. Dispute continued. Finally, in June
2015, the Central Government suspended transfers, and KRG stopped delivering its oil to SOMO and
continued exporting independently.

                                                   iv
public goods for the entire region and delivering services to this increased population.
The needs of the displaced population are significant and cannot be adequately met under
the fiscal crisis that the KRG is confronted with. According to the joint World Bank and
KRG Ministry of Planning study entitled The Kurdistan Region of Iraq: Assessing the
Economic and Social Impact of the Syrian Conflict and ISIS, the stabilization needs
assessment of the IDPs and Syrian refugees were evaluated at US$1.4 billion in 2015.

Diversifying the KRI Economy: Main Contours of a Structural Economic Reform
for the KRI

7.      Kurdistan Region of Iraq 2020: A Vision for the Future provides the KRG’s
overarching view for its structural reforms. Presented in 2013, the Vision calls for “a
Kurdistan Region of Iraq where all people enjoy the benefits of freedom, health, welfare,
and economic security and opportunity.� It defines policy priorities in four areas: Putting
People First (health, education, inclusivity, and labor); Building the Region
(infrastructure); Creating an Economically Prosperous Region (agriculture, the private
sector, and environmental protection); and Putting Government to Work for the People
(effectiveness, transparency, fiscal responsibility, and civil service reform). By producing
the Vision, the KRG has established the foundation upon which any structure economic
reform for the KRI must be built.

8.     The KRG is committed to significant structural reforms to secure fiscal
consolidation and achieve sustainable and inclusive growth in the KRI. The region is
faced with multiple challenges but also with an opportunity to move forward with long-
standing reforms and diversification of the economy. The deteriorating fiscal deficit
exposes KRG to greater risks and calls for gradually strengthening fiscal position by
containing expenditure growth and improving revenue generation. KRG will use the
opportunity to reform the economy to address continuing structural issues. The
Government is committed to implementing much-needed critical reforms ranging from
subsidies and public employment to financial sector and energy sector reforms. These
will contribute to a higher degree of efficiency in public spending. Furthermore,
deepening economic reforms aimed at diversifying the economy away from oil would
help encourage private sector development and create jobs.

9.      Rebalancing of the public sector is essential to cope with the uncertain and
volatile revenue transfers and to support the private sector-led economic
diversification. The strategy that could bring the region out of the fiscal crisis and
gradually put the region’s economy on a balanced and sustainable growth path needs to
have two core pillars and supporting structural policies. These core pillars are fiscal
consolidation for macro-stability and laying the foundations for sustainable and inclusive
growth. The Government should introduce fiscal reforms to strengthen its fiscal capacity
to isolate core expenditures from fluctuations in fiscal revenues, and enhance its budget
credibility and sustainability in the medium and long term.

10.   Fiscal adjustment includes expenditure and revenue-side measures.
Expenditure-side reforms would include rationalization and reprioritization of public


                                             v
expenditures including targeting subsidies and retrenching excess civil servants while
simultaneously preparing them for the private sector with adequate retraining and other
direct labor market policies. These reforms would increase the productivity of public
expenditure and crowd in private investment supporting diversification. Rebalancing
requires redistribution of public expenditure towards infrastructure (where private
investments and financing are not forthcoming or there is no commercial viability for
private investments), education, and health services, which could be achieved by
restructuring subsidies and resizing public sector employment. The Government has
already launched an unprecedented fiscal adjustment equivalent to 37 percent of GDP in
less than three years, by slashing almost half of its expenditures. On the revenue side,
revenues collected from regional sources should be raised to cushion the impact of
volatility in oil prices and the central government budget transfers. There is also a need to
underpin fiscal adjustment with strengthening of the public financial management
system, starting with the resumption of annual budgets, and their approval by the regional
legislature (a constitutional requirement), to restore a cycle of accountability, on which
systems of improved financial control and management, reporting, procurement,
accounting, and external audit can be built.

11.     Connecting sector strategies to resource allocation is critical. To cope with the
volatile fiscal situation and highly unpredictable budgetary process, the medium-term
expenditure planning should be delinked from the short-term revenue transfer estimates.
This would require a medium term fiscal framework (MTFF) which in turn could be
developed into a full medium term expenditure framework (MTEF) to guide annual
budgeting. Such a framework should be based on identification of essential needs, some
agreed upon standards to budget for core expenditures, and the fiscal capacity of KRG.
The MTFF/MTEF would also assure the quality and sustainability of expenditure levels
by ensuring that capital projects are completed as planned and budgeted, rather than their
completion being contingent on the fluctuations of oil revenues and transfers.

12.     In the medium-term, spurring private sector activities in non-oil sectors is a
core objective of the Government. To achieve this objective, an enabling business
environment coupled with entrepreneurship support (particularly for the youth labor
force) and firm-level support to improve productivity, quality, innovation, and local and
global market access would be critical. Policies and programs to enable SMEs to grow
would be critical to create jobs. At the same time, encouraging larger companies to
become competitive both in the local and global market, preferably in partnership with
Foreign Direct Investment (FDI) and/or public sector, would be also important. Building
a strong, diversified, and competitive private sector is a critical economic objective as
discussed in the Vision 2020. A large number of complementary policy tools in a variety
of areas could be used in conformity for an extended period to achieve this goal. A
prioritized and sequenced program would include (i) reforming laws and regulations that
make it difficult to start, run and close a business; (ii) piloting and scaling up
interventions to promote entrepreneurship, especially among the youth; (iii) Scaling up
firm-level interventions related to product and service quality upgrade and innovation by
becoming a part of local or global value chain; (iv) building a strong advocacy and
lobbying organization for the private sector development; (v) making the borders more


                                             vi
efficient so that transit trade can grow; (vi) putting in place an effective technical and
vocational education and training program; (vii) increasing access to finance, especially
for SMEs; and (viii) improving infrastructure services (especially power).

13.     KRI’s financial sector needs to be strengthened to contribute to private sector
development. Despite a large number of banks operating in KRI, its banking sector
remains underdeveloped. It does not serve its basic function of channeling financial
resources to the private sector to support its development. Banks are not engaged in their
core function of providing loans to KRI’s real-sector economy or financing long-term
investment projects. As a simple yardstick, to bring the ratio of private credit to GDP
from a current 2 percent to the MENA region average of 50 percent, banks would need to
provide credit to the KRI private sector of ID 15 trillion (US$13 billion). Presently, banks
in KRI are facing a severe liquidity crisis, which has crippled their operations and has had
negative effects on KRI’s economy. The current situation is exacerbated by weak
banking-sector supervision as functions of the Central Bank have been subordinated to
the direct control by the KRG Ministry of Finance and Economy (MoFE).

Prospects for Growth and Development of the KRI

14.     Services could play an important role in economic diversification efforts .
Services are essential inputs in any form of production, as well as a major component of
the regional connectivity, hence a key determinant of KRI’s competitiveness and ability
to join and move up regional and global value chains. Services could also become an
important source of exports outside the oil and gas sector, along models in the region, and
provide jobs outside the public sector. Being landlocked, the KRI is even more relying on
services; this situation could be turned into an opportunity, and KRI could become a
platform for transit and services provision in the region, given it is sharing borders with
large potential markets. In particular, the KRI could become a gateway for the provision
of a large array of services in other areas of Iraq. Therefore, this is a win-win situation for
overall Iraq. This will require, however, that the KRI first removes a number of barriers
to services trade that remain, given that services trade mainly takes place at the
intermediary level and within global networks. It will also require restoring some legal
certainty, adapting modern laws and regulations, and building capacity (skills, standards,
and infrastructure). Beyond the economic dimension, the reform of the regulatory
framework and the improvement of the services offered in the KRI will first and foremost
benefit the local population, given that major gaps exist, for example in the health or
education sectors.

15.     Regional connectivity can be improved through ICT and transport services .
There are complementarities to be realized from trade in IT services in addition to the
benefits of enhanced ICT services as an enabling platform for trade. In addition to being
an important sector of the economy, ICT, and broadband in particular, is a powerful
enabler of trade development. The transformative role of digital technologies in the KRI
resides in its ability to create jobs, diversify the economy and increase the overall
competitiveness and efficiency of the private sector. To harness this potential, the KRG,
in coordination with the central Baghdad authorities, needs to foster the development of


                                              vii
high-speed Internet connectivity and the IT market through a set of actions and regulatory
reforms. These include i) opening the market to competition through new licenses, open
access policies, new supply models such as PPPs, and sharing of infrastructure; ii)
strengthening the monitoring capabilities and regulatory powers of the Ministry of
Transport and Communications; iii) leveraging the geopolitical location to establish KRI
and the rest of Iraq as a hub for international connectivity that serves the regional and
international Internet markets; iv) devising a national IT strategy to address the
weaknesses in supply and demand of IT services; and v) stimulating innovation in
content development in the Kurdish language. Based on good geostrategic location, in
addition to ICT services, transport network plays a very important role for the economic
development of the region. Transport sectors in KRI is mainly dependent on roads as the
most developed transport sector, but it is neither well connected nor maintained at the
proper level. Besides this sector, air transport needs significant upgrade. Railway sector
and logistic hubs are not developed which is a constraint for KRI to benefit from regional
economic opportunities. Furthermore, the legislation for the transport sector is outdated.
It is necessary to carry out customs and trade facilitation reforms to strengthen
cooperation among neighboring counties. Therefore, with improved transport and ICT
services, KRI has a significant potential to become a transport and logistics hub for the
whole region based on its proximity to major markets and relatively safe geopolitical
position.

16.     Electricity sector reforms can reduce fiscal burden, enhance energy trade, and
improve electricity service delivery. Although power generation capacity in KRI has
expanded manifold over the last decade due to private sector investments, the sector
continues to be characterized by heavy fiscal burden of subsidies, dependence on costly
liquid fuels to address natural gas shortages, transmission bottlenecks, high technical and
commercial losses, low tariffs, poor institutional capacity, and poor quality of supply. A
strategy based on three pillars is proposed to address the immediate as well as longer
term challenges in the KRI’s power sector: (i) Adopt an enabling legal, policy and
regulatory framework based on clear roles and mandates for different entities. The
framework would include a new electricity law, an independent sector regulator,
unbundling of the vertically integrated sector, corporatization of sector entities, and their
eventual privatization. (ii) Undertake crucial infrastructure investments to ensure
adequate power availability, reliability, reduction of losses, and trade of surplus
electricity with neighboring areas of Iraq as well as Turkey. Given the constrained fiscal
situation, it is imminent that private sector resource induction would be required.
However, private sector investments need to be undertaken carefully to ensure that
current sector performance attracts adequate private sector interest, as well as sufficient
ramp-up in institutional capacity and legal-policy-regulatory framework to manage a
complex ecosystem. (3) Undertake measures to support performance improvements and
accountability. This would include a systematic rationalization of electricity tariffs as
well as a focused program for loss reduction and revenue enhancement. While full
privatization of the distribution business is a complex undertaking, loss reduction and
revenue enhancement can be achieved through a well-structured contract with the private
sector to manage billing and collection services. In addition, a clear policy framework



                                            viii
and robust program for energy efficiency, energy conservation, and renewable energy can
help contain the growing electricity demand.

17.     Agriculture presents an opportunity for the KRI, and the sector’s development
will be associated with divergent needs for investment and labor. KRI’s agricultural
sector has been subjected to numerous shocks during the past 30 years, including low
priced food imports under the oil-for-food program, the oil boom (which moved
resources out of agriculture to the public sector and construction), and high cereal
subsidies (which moved resources out of non-wheat commodities). To restart the sector,
in addition to required agricultural investment projects, KRG must work on the following
fronts: i) data improvement should start including a launch of an agricultural survey,
price collection, creation of soil and water maps as well as a land registry; ii) all
subsidies, taxes, import bans, and licensing fees should be reconsidered; and iii) an
effective research and extension mechanism should be put in place, which should be
undertaken in coordination with the Ministry of Agriculture and Water Resources, the
existing Research Stations, and the Colleges of Agriculture. Furthermore, a significant
agricultural rehabilitation program can generate localized economic activity and
employment.

18.     Investments in the water sector are required to reach a more sustainable use of
water. Water shortages are becoming increasingly common. The sector is faced with
dwindling supplies due to smaller inflows into KRI and deteriorating water quality. Yet,
the demand for water from agriculture, households and industry (including for oil sector)
is increasing rapidly. In addition, water is needed for hydropower and environmental
flows. The increasing water shortages are likely to increase over time as upstream
riparians are planning to develop more water infrastructure, making KRI increasingly
vulnerable. The policy mix for addressing gaps between supply and demand will depend
on a range of social, environmental, economic, and technical factors. Closing the gaps is
within KRG’s reach if it makes the necessary adjustments to include supply management
strategies into an integrated approach that also addresses demand-side issues. To reap
benefits of the large investments that have been made in developing water resources, it is
recommended that the Government introduces broad and poverty-targeted interventions
affecting not only water resources development and management but also water service
delivery. Priority areas would be: (i) water security planning and management; (ii)
improving service delivery; and (iii) strengthening governance mechanisms and water
users associations.

Strengths of the Region and the Way Forward

19.     The KRI has strengths and opportunities to get the economy out of the fiscal
crisis and on a balanced sustainable growth path. These include: (i) large oil and gas
resources; (ii) fertile agricultural land; (iii) young population; (iv) central location at
crossroads of trade routes; (v) a government that is determined to implement reforms; (vi)
a donor community that is eager to help; (vii) the entrepreneurial spirit of its population;
and (viii) a relatively stable location as of now to do business in comparison to the rest of
the country. If these strengths and opportunities are used effectively in a supportive


                                             ix
policy environment, the KRI economy has a good chance to overcome the current
difficulties and have a more diversified economy and sustainable high growth in the
medium to longer term.

20.     The acceleration of economic growth and diversification of the KRI economy
requires simultaneous effort in the main sectors of the economy. The Government
could begin the reform process which should involve sectoral restructuring and further
developing the legal and regulatory framework needed for a market economy. Sectoral
reforms should be implemented in tandem and in a well sequenced manner. This is
because the effectiveness of reform in one sector is often dependent on the success of
reform in other sectors of the economy. In KRI, these linkages will be accounted for by
sequencing and coordinating reform in and among the various sectors. This roadmap
brings together concrete sectoral policy reforms for Government’s implementation.

Mitigating the Adverse Social Impact and Building a Robust Social Protection
System

21.     The most immediate priority is to stabilize the economy without further
increasing socio-political fragility. Strengthening and retooling social protection
mechanisms to deal with the emergency are critical priorities for the Government. In light
of the emergency, social protection should be a top short-term priority. Existing social
protection mechanisms should be strengthened and to extent possible retooled to handle
the ongoing social and humanitarian crisis. The Government has recently developed a
robust social protection framework to protect the poor and the vulnerable. Furthermore,
the reform program proposes a range of actions, which should be carefully assessed to
identify the vulnerable population groups likely to be affected, and to estimate the size of
the adverse welfare impact. In particular, actions related to changes and increases in
income taxes; phasing out and lowering subsidies on petroleum, electricity, wheat, and on
agricultural inputs have the potential to adversely impact less-well off households. In
addition, given the size of the public sector, which employs individuals of varying
education levels, some of the proposed reforms to the civil service, such as rationalization
of public sector employment, could adversely affect the less-well off.

22.     The poor and the vulnerable will need to be protected. The proposed reforms
affect different groups of the population in a heterogeneous manner. A poverty and social
impact analysis exercise should be undertaken to understand the size and nature of the
impacts of the reform program as a whole. This exercise will help estimate the size of the
compensating transfer needed to protect the poor and vulnerable in a fiscally sustainable
way. For social safety nets, targeting is the main challenge. The categorical targeting used
in KRI does not consider the poverty line or the size of the household leading to high
leakage. The transfer of ID 150,000 is allocated to beneficiary household regardless of
size of the household nor its status, as defined relative to the poverty line or consumption
level. Cash transfers use broad social categories instead of more effective targeting
mechanisms to determine eligibility which explains why the majority of the poor do not
benefit from this program. As such, only 11 percent of the bottom quintile currently are
receiving the cash transfer. Currently, a proxy means test (PMT) to determine eligibility


                                             x
under such a poverty-targeted safety net program is being developed, and discussions are
underway about transitioning the Social Security Network (SSN) from a categorically
targeted program to one where eligibility is determined based on the PMT. This targeted
safety net system will be underpinned by a unified registry, and transparent and fair
governance and grievance mechanisms.

23.      Even prior to the crisis, KRI had been faced with the challenge of reforming its
social protection system. KRI faces the daunting task to increase the size and dynamism
of the private sector where most future employment growth is expected to come. The
employment challenge comes from the small size of the private sector, a fast growing
labor force due to natural population growth and geopolitical events. The employment-to-
population rate in KRG stands at 22 percent and is similar to the average for the non-
GCC Middle East. The employment rate is very much affected by the very low labor
force participation rate of working age (15-64) women at 14 percent that nevertheless
rises to 17 percent if students are excluded.

24.     The pensions and social insurance system in KRI is not sustainable, suffers
from low coverage, and is inefficient. In 2014 the total pension spending in KRG was
estimated to be around ID 1.3 trillion (or 2.8 percent of GDP), which is high compared to
other economies at a similar stage of demographic ageing. More than 50 percent of the
labor force in KRI is covered by the social insurance system. However, most of them are
employees in the public sector. In the private sector, around 84 percent of the labor force
is not covered. Also, only around 50 percent of people above the age of 65 in KRG are
currently receiving a benefit from the pensions system (mostly retired public sector
employees). The rest of the elderly have to rely on informal care, or public transfers as
social assistance (non-contributory social safety nets). The main challenges of the social
insurance system in KRI can be summarized in four points: (i) administrative capacity is
low; (ii) schemes are inequitable and financially non-sustainable; (iii) the system is
fragmented, leading to distortions in the labor market between the public and the private
sector; and (iv) the system suffers from low coverage in the private sector.

25.     To address the above challenges, KRG has outlined an ambitious strategic
framework for reforming social protection in KRI. The KRG Social Protection Strategic
Framework supports implementation of this reform through an integrated package of
strategies, legislation, institutions, and programs. The proposed strategies align well with,
and provide the mechanisms for implementation of, the Vision 2020 policy priorities. The
strategies are as follows: (i) KRG will create an effective labor supply of well-equipped
job seekers and skilled workers through the education and training systems and market
driven incentives; (ii) KRG will take measures to reduce the duality between employment
in the public sector and private sector and thus contribute to a more dynamic private
sector; (iii) KRG will develop regulatory and institutional frameworks based on timely
data analysis, well-designed employment policies, and constructive dialogue among the
social partners; (iv) KRG will implement parametric reforms to the current schemes to
ensure financial sustainability and will move towards integrating public, private and other
(occupational) pension schemes; (v) KRG will design and implement conventional and
alternative mechanisms to expand pensions and social insurance coverage; (vi) KRG will


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design and implement an Unemployment Insurance Program; (vii) KRG will use poverty
as a main determinant of eligibility for its social safety net programs (including the PDS)
and provide effective social care for vulnerable and disadvantaged groups; and (viii)
KRG will protect its human capital by providing incentives for better health and
education.

Risks to the Reform Program

26.     There are substantial risks that could jeopardize the success of the reform
program, which is ambitious and far-reaching in its implications. The risks range from
security threats to political and economic challenges. Political tensions between the KRG
and the Central Government could continue to persist. Furthermore, political tensions
between the main political parties in the KRG could endure. In parallel, security risks
remain significant. ISIS could continue to pose a security threat to the KRI. The potential
for a takeover of Mosul by the Iraqi military force may increase the influx of IDPs to the
KRI. Moreover, oil prices could remain depressed for a protracted period of time, thereby
limiting the scope for higher fiscal revenues and economic growth. Should any of these
risks materialize, their impact on the progress of the reform program may be disruptive.

The Lay-Out of the Report

27.     The detailed action plan presented in this reform roadmap is prepared in light
of the strategic objectives discussed above. This work builds on an ongoing productive
engagement of World Bank Group teams with line ministries, private sector, academia
and the international partners which resulted in development of in-depth technical
assessments and analytical work in all sectors of the economy, as well as IFC’s growing
footprint in the region across diverse sectors. The findings and policy recommendations
of these evidence-based analytical work are based on comprehensive consultations with
all stakeholders in KRI. The report covers economy-wide issues such as private sector
development, trade and investment regime, labor market as well as sectoral issues. The
first chapter provides a macroeconomic background while second and third chapters
introduce proposed short-term reform actions in the form of fiscal consolidation measures
and medium-term targets to lay the foundations for diversified, sustainable and inclusive
economic growth. The fourth chapter discusses upcoming social sector reform actions to
address ongoing major social and humanitarian crisis in KRI. The fifth and sixth chapters
focus on the governance issues and reform actions including accountability, institutional
framework, and judicial oversight. The final chapter presents proposed implementation
modalities of the three-year structural economic reform roadmap.




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