My Iranian authorities thank Ms. Purfield and her capable team for the high-quality report and for their candid assessment and sound policy advice. The authorities are also thankful for Fund technical assistance in support of their reforms. The Article IV discussions this year rightly focused on parameters, pace, and sequencing of an economic reform agenda aimed at macroeconomic stability and job creation. The authorities agree with the thrust of staff assessment and recommendations.
Recent Economic Developments and Outlook
The landslide re-election of President Rouhani for a second term in May 2017 ensured the continuation of economic policy reforms. The implementation of the Joint Comprehensive Plan of Action (JCPOA) and the lifting of nuclear-related sanctions in January 2016 paved the way for Iran’s reintegration into the global economy. Notwithstanding external uncertainties, Iran has made significant gains since 2016 in restoring macroeconomic stability and pushing ahead with structural reforms, with the welfare of population as its focus. The restoration of Iran’s oil production to pre-sanction levels and the firming up of international oil prices provided a major boost to the oil sector, with significant knock-on effects on nonoil activity. After the initial spurt to 12.5 percent in 2016/17 (Iranian year starting March 21), real GDP growth moderated to around 4 percent, but with greater depth and breadth. Staff projects growth to be range-bound around 4 percent over the medium term. The authorities feel that, given the country’s abundance of natural resources and human capital, Iran’s growth potential is conceivably higher; indeed, higher growth rates are needed to strengthen the economy’s resilience to external shocks, absorb Iran’s highly educated youth in the labor force, and eradicate absolute poverty. They further believe that prudent macroeconomic policies and deep and multi-faceted structural reforms are key to achieving these objectives, but with the recognition that realizing the economy’s potential will be facilitated by the full normalization of international trade and financial relations.
One of the major achievements during the government’s first term was to lower inflation from over 40 percent in 2013 to around 10 percent by end-2015—a level that has been maintained since—through prudent fiscal and monetary policies. Stabilizing inflation at low levels, while reducing fuel subsidies, anchored economic policy and lessened the burden on the population, especially the vulnerable who were also supported by income transfers during the transition. Unemployment also edged down, but remained high, especially among Iran’s educated youth and women.
With higher oil exports and firmer prices, and despite higher imports following removal of nuclear-related sanctions, the current account recorded a surplus of around 4 percent of GDP in the past two years. In 2016, the full year in which sanctions were lifted, exports to the EU jumped by 344 percent and imports by 26 percent, albeit from sanction-depressed levels, and this accelerating trend is likely to have continued into 2017. Despite the positive current account outcome, foreign reserves declined, and Central Bank of Iran (CBI) had difficulties in accessing its foreign assets maintained with some trade partners. Still, foreign reserves remain sizable (15 months of imports) and foreign debt is minimal (2 percent of GDP). With inflation more firmly anchored around 10 percent, the CBI depreciated the official exchange rate more aggressively and moved more imports from the priority list to market rate, but market pressures intensified in late 2017 and early 2018 mainly because of speculative activities.
My authorities are in broad agreement with staff regarding the balance of risks to the medium-term outlook. Adverse geopolitical developments and lower oil prices are the major external risks and constant reminders of the need for a proactive policy of building strong fiscal and external buffers. While external factors may affect the pace of reforms, they will not sway the authorities from the path of reforms. The authorities are indeed committed to pushing ahead with the reform agenda enshrined in the Sixth Five Year Development Plan (6th FYDP, 2016/17–2020/21) and many of the initiatives planned for 2018/19 and beyond are consistent with the 6th FYDP medium-term objectives and targets.
The “augmented” central government deficit narrowed to 2.3 percent of GDP in 2017/18 through expenditure restraint and strengthened tax administration. As noted by staff, tax collections have exceeded oil revenues as the main source of budget revenue since 2015/16—a major step towards reducing Iran’s reliance on natural resources. Regularization of historical government arrears in the last two years brought greater transparency to government obligations, while at the same time increasing the debt-to-GDP ratio almost four-fold to close to 50 percent in 2016/17. Higher oil revenues in 2018/19 will allow government to increase spending on infrastructure and social welfare, while trimming the deficit even further to 2.1 percent of GDP. The authorities are cognizant of the need to create fiscal space, not only to meet the interest bill related to bank recapitalization and arrears securitization—which together is estimated to increase from 0.2 percent of GDP in 2017/18 to 5.2 percent of GDP in five years—but also to meet infrastructure needs and take a leap forward towards the longer-term objective of eradicating absolute poverty in Iran. The staff recommendation of generating 4–5 percent of GDP in savings over the next 4–5 years through subsidy reform, expenditure restraint, and revenue effort seems feasible, but contingent on garnering broad political and public support. Fuel subsidies will be eliminated before end-2020/21 and the cash transfer program will be better targeted by removing the richest 20 percent of household recipients. More targeted means testing will be conducted to restrict cash transfers to the neediest. Disbursements by the National Development Fund of Iran (NDFI) will also be curtailed as a smaller share of oil revenues will be transferred to it, and as a better-capitalized banking sector will assume a larger role in lending to the private sector. NDFI financing will also be gradually restricted to infrastructure development in needy and remote areas where bank financing is not typically available. On the revenue front, the focus will be on expanding the tax base and reducing and, to the extent feasible, eliminating tax exemptions, especially those benefiting foundations and other entities. In this regard, tax exemption of the largest religious foundation in Iran was withdrawn earlier this month, with significant revenue implications. Review of other entities’ exemptions is in progress.
On the institutional side, performance-based budgeting is already in place in one third of all ministries and transition to accrual-based accounting is in progress. Together with greater transparency by recognizing government obligations, the authorities are developing a comprehensive debt management strategy. The medium-term budgetary framework will also be strengthened, and annual budgets will be better aligned with 5-year plans, placing greater focus on nonoil primary balance for formulating fiscal policy.
Monetary and Exchange Rate Policies
The CBI is determined to preserve the significant gains already achieved on the inflation front. Formally establishing low and stable inflation as the central bank’s primary policy objective is one the key elements of the CBI bill before parliament. Inflation pressures in past years have generally stemmed from pass-through of exchange rate depreciation, administered price adjustments, and high rates of liquidity expansion. While these pressures are moderating, they are expected to persist until the ongoing reforms are well entrenched. With this in mind, the CBI is determined to tighten monetary conditions: measured by CD rates issued by banks (with a return of 20 percent on rial-denominated CDs and 4 percent on exchange rate-linked but rial-denominated CDs), real interest rates are significantly positive. Additionally, CBI lending to banks—including paying depositors of Unlicensed Financial Institutions (UFIs), all closed since September 2017; assistance to distressed banks; and targeted schemes—is being contained, and the CBI is making emergency liquidity support to banks contingent on advance submission of liquidity management plans. The CBI bill before parliament also contains provisions to modernize the monetary policy framework, including through greater use of market-based instruments for liquidity management, developing an interbank market, and enhancing central bank independence and operational autonomy.
On the exchange rate front, the gap between the official rate and market rate, which was around 30 percent in early 2018, narrowed somewhat after the CBI allowed banks in February to issue high-yield CDs. The premium that the market rate holds over the official rate has, however, widened somewhat in more recent weeks largely due to seasonal factors ahead of the Iranian New Year.
My authorities consider exchange rate unification as the lynchpin of their reform program. The initial timeline to unify the rates by March 2018 has slipped by one full year, primarily because of heightened external uncertainties that are pressuring the market, and weak correspondent banking relationships (CBR). These constraints make it difficult for the CBI to step in effectively at times of intense exchange market pressures. Nevertheless, in preparation for eventual unification, and in addition to tightening macroeconomic policies and depreciating the official rate, the implicit subsidy element in the official rate is being gradually eroded by trimming the priority list imports that are effected at the official rate; as of February 2018, 78 percent of all imports in terms of product code and 48 percent in terms of value were at the market rate, and the shares are rising. The intention is that, starting in early 2018/19, all imports are moved from the priority list to the market rate, with notable exception of basic foodstuffs and medicine. Once a critical mass of imports with a sufficiently high share of total value is moved to the market rate, and once other supporting conditions are comfortably in place, the rates could be unified with a lower risk of undershooting or chasing a moving target. Following unification, the intention is to revert to the managed floating system of the past.
The Iranian banking system, still burdened by past policy mismanagement and legacy issues, has been in distress for a few years. Although the situation varies considerably among banks, many banks—both in the public and private domain—are saddled by high NPLs, inadequate capitalization and bad-loan provisioning, and low profitability. The UFI problem that surfaced in earnest last year prompted the CBI to close several UFIs or merge them with commercial banks, transfer their balance sheets to licensed credit institutions, and amend the legal framework to make the CBI the sole responsible body for licensing and regulating all financial institutions. Important progress has also been achieved on several other fronts. As mentioned earlier, an audit identified additional legacy government debt to various creditors, including banks. Interest-bearing and marketable securities were issued by the government to partially clear its arrears and support banks’ income, while restricting dividend payments. Banks are undercapitalized; the government also issued securities to partially recapitalize some state banks. The CBI is planning to launch an Asset Quality Review in early 2018/19, with MCM advice, to quantify the exact recapitalization need of banks. Amendments to banking law, pending with parliament, aim to strengthen the CBI’s supervisory authority and its resolution powers, which are critical in the major restructuring of the banking system that is underway.
Amendments are also with parliament to bring the AML and CFT laws fully in line with international standards, and dedicated AML/CFT units are already operational in virtually all banks. Progress is evident in Iran gaining observer status in the Eurasian AML/CFT group. Moreover, the CBI has already requested an IMF assessment of the AML/CFT framework to be completed by late 2019. My authorities once again reiterate their commitment to full compliance with AML/CFT international norms, guidelines, and provisions.
The authorities are concerned about the rising deficit of the pension system, and are aware that the current high youth unemployment and the evolving demographics over the next 2–3 decades are not working in Iran’s favor as far as financing of the social security system is concerned. Many of the largest public employers in Iran (e.g., the national oil company, state banks, national railways) have their own well-funded pension schemes, but that does not diminish the importance or urgency of increasing the transparency, broadening the coverage, and improving the finances of the general pension system. Iran has already benefitted from Fund TA and a parametric pension reform plan is being developed in line with staff recommendations.
Iran’s structural challenges and policy and reform agenda are outlined in the 6th FYDP. Broadly, the aim is to reduce the economy’s reliance on the energy sector through diversification, notwithstanding the country’s abundant oil and gas reserves; improve the business climate and broaden the role of the private sector; close the infrastructure gap; and most importantly create jobs for Iran’s highly-educated youth. Youth unemployment in Iran has a deep-rooted structural element and addressing it requires a holistic approach, long-term commitment, and adequate funding. The problem arises, inter alia, from the high capital-intensity of production (oil and gas and other minerals), a young population profile, skill mismatch, high reservation wages, limited labor mobility due to the high housing cost, family protection for the unemployed, and social norms. The coverage of female employment issues in the report is praiseworthy; however, in the context in which it is raised, we fail to see the link between limitations on women foreign travel and the issue of women seeking employment or starting businesses in Iran. Young women in Iran are, on average, better educated than men and the share of women with tertiary education is above men’s. It is more likely that the low female labor force participation (FLFP) reflects under-or-nonreporting of part time work, social norms against women working in certain occupations (i.e. construction, transportation, forestry and fishery, but not agriculture), and limited availability of affordable child care. Despite the low FLFP, the share of women in total employment increased by 4 percentage points between mid-2014 to mid-2017. Nevertheless, increasing FLFP is imperative to raising Iran’s growth potential.
Creating jobs for Iranian youth, both men and women, has many overlapping elements, but it may be more difficult for women as the skill mismatch is greater and social and cultural norms are stronger. As also noted by staff, the authorities are planning to introduce a nation-wide pilot internship program in conjunction with a two-year exemption from social security contributions to employers retaining interns. Courses on entrepreneurship skills are now being taught in secondary schools and it is planned to create incentives, or increase penalties, in the reformed pension system to extend employment tenure.
Most other structural reforms hinge on the normalization of international trade, investment, and financial relations. FDI is critical to Iran’s future growth in both the oil and nonoil sectors. As reported by staff, FDI approvals jumped almost five-fold in 2016 following the removal of nuclear-related sanctions early that year, although because of their typically long gestation period the associated inward flows are still to be reflected in the balance of payments data. In the oil sector, the new model of oil contracts (Iran Petroleum Contracts) created greater incentives for foreign operators and investors. New large-scale projects with foreign participation were also approved in copper and other minerals, of which Iran holds substantial reserves. The business environment is improving, despite difficult external circumstances—notably weak CBR—but much remains to be done. The high administrative cost of delays in processing exports is expected to be greatly alleviated by the proposed amendments to the customs law. Access to finance is probably the greatest constraint on businesses, which a recapitalized and healthier banking system is expected to address more effectively. Finally, Iran is tackling a number of important environmental issues in the areas of water management, air pollution control, and protection of green areas and forests, and is an active participant in international environmental fora.
The Iranian economy continued to strengthen in 2016 and 2017, supported by sound economic and financial policies and major reforms, successful implementation of the JCPOA, and recovery of oil production and prices. The implementation of the JCPOA generated optimism in Iran that trade and financial normalization will usher in investment and durable economic prosperity. The “dividend” however has been so far small and uncertain. My Iranian authorities expect that most JCPOA P5+1 signatories will adhere to the letter and the spirit of the agreement, and with that expectation, they are pressing ahead with their economic reform program, with the ultimate objective of bringing back Iran and its people to a level of prosperity that is more in line with the country’s wealth of natural resources and human capital. At the same time, they are confident that greater global integration benefits all.
On this auspicious day of Iranian New Year, which conveys a message of peace and prosperity to mankind in a tradition that goes back thousands of years, I join my Iranian authorities in thanking Fund staff, management, and the Executive Directors for their continuous support.