By Sylvia Westall

BEIRUT, Dec 17 (Reuters) - The World Bank said on Thursday it would lend Iraq $1.2 billion in emergency support to help it deal with the economic effects of its fight against Islamic State militants and low oil prices.

The budget support loan will be disbursed in a single tranche and should be available to Iraq before the end of the year, said Ferid Belhaj, a senior World Bank regional official who oversees Iraq.

"These twin shocks, coming at this particular juncture, are threatening the stability of the country," he told Reuters in a telephone interview, saying it was vital to prevent Iraq falling into deeper crisis.

"Iraq falling into chaos means an even more chaotic Middle East. At this particular juncture, nobody wants that. We have enough chaos about," said Belhaj, director for the Mashreq region, which includes Iraq, Lebanon, Jordan, Syria and Iran.

Iraq's state finances are heavily dependent on oil revenues, which have sunk as oil prices have plunged. At the same time, Baghdad has ramped up military spending in its battle against the hardline Islamic State group, which has killed and displaced thousands, and destroyed services and infrastructure.

Iraq has been fighting back after Islamic State overran a third of the country in 2014. The jihadists still hold territory in Iraq, including the second city Mosul, and swathes of neighbouring Syria.

Belhaj said Iraq had committed to undertake economic reforms to fix structural distortions that had dragged on its economy even before the current crisis.

"Sometimes a crisis opens a window of opportunity and we believe that this is one such chance," he said.

These include efforts to make state-owned enterprises more efficient, improve management in the energy sector and reduce the dominance of state-owned commercial banks Rasheed Bank and Rafidain to leave space for private lenders.

"For the first time, we have started levelling the playing field in the financial sector," Belhaj said. "This is really a major, major departure after years and years of monopoly."

He also said it was essential for Iraq to keep up the pace of these reforms and maintain fiscal discipline even if the economic situation stabilises.

"When tomorrow the prices of oil go back to acceptable levels for the Iraqis, they should not lose the incentive to continue with those reforms ... We are really setting our foot in the door for these reforms," he added.

The new loan takes World Bank lending to Iraq to nearly $2 billion, including $355 million for improving transport and road safety and $350 million agreed in July to support the reconstruction of areas affected by Islamic State violence.

"We went to the field and saw the situation, it was dire. Places that were occupied by (Islamic State) and destroyed and populations fleeing their homes," he said.

The aim of the emergency loan was to help rebuild and return basic services for citizens. "So far, the project is really meeting or even going beyond some of our preliminary targets," Belhaj said. (Editing by Catherine Evans)

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