(Recasts; adds more details, IMF comment)

By Alister Bull

WASHINGTON, Aug 2 (Reuters) - Iraq has taken steps to strengthen its economy but there will be no real progress until the country's dire security situation has improved, the International Monetary Fund said on Thursday.

Announcing the completion of the fifth review of Iraq's $727 million standby arrangement, which Baghdad wants as a precaution and not because it badly needs the money, the IMF said the country faced some serious economic challenges.

"The expansion of oil production is lagging and inflation, while on a downward path, remains high reflecting in large part shortages associated with the security situation, notably of fuel products," the IMF said in a statement.

"A turnaround hinges critically on an improvement in the security situation," it said.

The United States has rushed 30,000 extra troops to reinforce a clampdown aimed at stemming sectarian violence, which has pushed Iraq to the brink of all-out civil war.

U.S. President George W. Bush has said he hopes the surge of military force will curb the bloodshed while efforts aimed at kick-starting the economy cut crippling unemployment, which has pushed many young men into the anti-U.S. insurgency.

The IMF said it welcomed steps taken by the Iraqi government to bolster the economy and cited increases in official fuel prices as a step in the right direction.

The hikes have lifted the official price of gasoline from pre-2003 invasion level of around 3 U.S. cents a liter to around 32 cents a liter, meaning money previously spent on subsidies can go toward more pressing public projects.

OIL PROBLEMS

However, the IMF was definitely worried by a lack of progress in revamping the country's crucial energy industry.

"Measures to speed up reconstruction and increase investment, especially in the oil sector, are needed," it said.

Iraq sits on the third largest oil reserves in the world and depends on oil sales for almost all its foreign currency earnings. These funds will be vital for rebuilding its infrastructure and public services, which have been badly run down by years of international sanctions and war.

But foreign investment to modernize the industry has been held up while Iraqi politicians fight over a new oil law to determine how revenues will be shared between its majority Shi'ite and minority Sunni Arabs, and the Kurds.

"Unlocking Iraq's oil wealth requires advancing the enactment of a new legislative framework for the hydrocarbon sector, in view of the large investments needed to increase oil production," it said.

The IMF said it had approved an extension of the standby arrangement by three months to Dec. 28.

It waived certain performance criteria under the deal, including an interim audit of the Central Bank of Iraq's 2006 financial statement, a census of all public service employees, and improvements to the budget classification and accounts.

However, IMF officials said the central bank audit and budget classification changes had since been adopted by the Iraqi authorities, albeit a few weeks after deadline, and took this as an encouraging sign of progress.

The IMF also said the central bank ought to continue its tight monetary and exchange rate policy to curb inflation and de-dollarize Iraq's economy.

Monthly inflation rose 6 percent in June after a spike in black market fuel prices and recorded a 46 percent year-on-year gain, after a 38 percent increase the previous month.

But core inflation, excluding fuel, edged down slightly to a 19 percent yearly pace from 21 percent in May, and a 32 percent level at the end of 2006.

The Iraqi central bank has raised interest rates and the Iraqi dinar has strengthened sharply against the dollar, in a deliberate effort to squeeze inflation and improve confidence in the domestic currency.

This was relaunched at some cost after the fall of Saddam Hussein, and officials want to stem the widespread use of dollars and coax people back to dinars.

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