Islamic Republic of Iran
Recent Economic Developments

The Islamic Republic of Iran inherited a highly centralized economy. The state-owned enterprises had monopolies over large sectors of the economy, including the financial system. This was compounded by Iran's excessive dependence on the volatile oil exports. Iran's five-year development plan aims at accelerating growth to create sufficient employment opportunities for a rapidly expanding labor force. De-monopolizing the economy, liberalizing trade, promoting private investment, strengthening the financial system, and improving the fiscal and monetary policy settings is required.

Abstract

The Islamic Republic of Iran inherited a highly centralized economy. The state-owned enterprises had monopolies over large sectors of the economy, including the financial system. This was compounded by Iran's excessive dependence on the volatile oil exports. Iran's five-year development plan aims at accelerating growth to create sufficient employment opportunities for a rapidly expanding labor force. De-monopolizing the economy, liberalizing trade, promoting private investment, strengthening the financial system, and improving the fiscal and monetary policy settings is required.

I. Overview

1. At the end of the war with Iraq in 1988, the Islamic Republic of Iran inherited a highly centralized economy. Most of the economic resources were administratively allocated through the vast public sector, widespread price controls, administratively mandated grid of financial rates of return and charges and credit allocations, extensive trade and exchange restrictions, heavily subsidized energy and petroleum products, multiple exchange rates, and restrictive labor and business practices. Furthermore, the state-owned enterprises had monopolies over large sectors of the economy, including the financial system. These distortions were compounded by Iran’s excessive dependence on the volatile oil exports, which account for about 70 percent of export receipts and half of government revenue.

2. Over the past decade, the authorities have attempted to address these distortions and restore sustained economic growth. The First Five Year Development Plan (FFYDP), covering the period 1989/90-1993/94 (fiscal year ending March 20), initiated steps aimed at decontrolling significant part of domestic prices, raising public utility rates, removing some nontariff trade barriers, lowering income tax rates, starting to privatize public enterprises, and liberalizing the exchange system. The economy responded well and real GDP grew by an average of 7 percent during the FFYDP with significant improvements in the social indicators. However, the main emphasis of the FFYDP was on infrastructure development and reconstruction programs which were financed by expansionary policies. The impact of these policies was exacerbated by significant drop in oil prices and the weakening of Iran’s external position that was financed mostly by a large buildup of short-term external debt (due in part to Iran’s lack of sufficient access to medium- and short-term credit), which eventually led to a growing stock of external payment arrears.

3. The broad liberalization direction of the FFYDP was reemphasized under the Second Five Year Development Plan (SFYDP), covering the period 1994/95-1999/2000. However, opening of the economy continued to progress at a slow pace despite the recovery of the oil prices during the first three years of the Plan. The period of the SFYDP was characterized largely by macroeconomic instability and declining economic growth. As a result, the authorities’ policy priorities were shifted to rectify the macroeconomic and external debt imbalances, while the much needed structural reforms were delayed. Significant success was achieved in regularizing external debt arrears, and the accumulated short-term debt arrears had been largely amortized by mid-1998/99.

4. Iran’s internal and external positions deteriorated sharply in 1998/99 as a result of an unanticipated sharp drop in global oil prices (Table 1). Real GDP growth decelerated to 2.1 percent in 1998/99 from 3.1 percent in 1997/98 and the external current account shifted from a surplus of US$2.2 billion in 1997/98 to a deficit of US$2.1 billion in 1998/99 (about 2 percent of GDP). The authorities’ immediate response was to draw down official foreign reserves (to about three months of imports), restrict imports, re-phase external debt service payments to major creditor countries, and allow the Iranian rial to depreciate in the Teheran Stock Exchange (TSE) market.

Table 1.

Islamic Republic of Iran: Key Economic Indicators, 1995/96-1999/2000 1/

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Sources: Data provided by the Iranian authorities; and-Fund staff estimates.

Iranian years ending March 20.

Changes in percent of initial broad money.

5. The sharp drop in oil revenue caused a significant widening of the budget deficit to 6.7 percent of GDP, despite sizable compression of capital outlays. The deficit was largely bank financed resulting in an acceleration of monetary expansion to 26 percent in 1998/99 from 16 percent in 1997/98, and inflation picked up to an estimated 20 percent from 17 percent in 1997/98, At the same time, unemployment rate remained high at about 13 percent.

6. In response to the worsening economic conditions in 1998/99, the authorities formulated a broad program of economic adjustment and reform as part of a National Rehabilitation Plan issued in August 1998, which underpinned the Third Five Year Development Plan (TFYDP, 2000/01-2004/05 (Appendix I)). The official program involved restoring market-based prices, reducing the size of the public sector and encouraging private sector investment. As a result, in 1999/2000 domestic petroleum prices were raised by 70 percent, a more market-based TSE exchange rate was introduced, and steps toward financial sector reforms were initiated. The backlog of queued foreign exchange demand was cleared in early 1999/2000 through a combination of significant additional foreign exchange sales in the TSE market and allowing a substantial further depreciation of the TSE exchange rate. By end of 1999/2000 the differential with the parallel market shrank to less than 2 percent from 40 percent at the end of 1998/99 and the “export rate” was abolished. These reforms were supported by monetary tightening and opening up of a new facility at the Bank Markazi Iran (BMI) to manage banks’ excess liquidity. Progress on other structural reform front was slow including on trade liberalization.

7. The recovery of oil prices during 1999/2000 significantly strengthened Iran’s external and fiscal positions. Nevertheless, the supply response remained weak and the growth of real GDP increased marginally to about 2.4 percent. The average inflation rate remained broadly unchanged at 20 percent, reflecting in part, the large liquidity overhang at the end of 1998/99. However, inflation started to decelerate toward the end of 1999/2000. The strengthening of the external position was reflected by a large current account surplus of about US$4.7 billion with gross official reserves rising to US$5.6 billion or the equivalent of about five months of imports. External debt service payments were accelerated in order to regularize the re-phased debt obligations, resulting in a drop in the outstanding external debt to about 10 percent of GDP. The sharp increase in oil revenue and continued tight expenditure policy have resulted in fiscal surplus of about 1 percent of GDP in 1999/2000.

8. The TFYDP aims at accelerating growth to an average of 6 percent per year in order to create sufficient employment opportunities for a rapidly expanding labor force (at an estimated 5 percent annually during the next five years). For this purpose, the TFYDP calls for a balanced transition to a market economy as a means for accelerating growth while according strong emphasis to social justice. It calls for structural reforms and privatization, de-monopolizing the economy, promoting private investment (both domestic and foreign), liberalizing trade and establishing a fully market based exchange system, strengthening and developing the financial system, and improving the fiscal and monetary policy settings.

II. The Domestic Economy

A. Economic Performance During 1995/96-1999/2000

Overall trends in production and expenditure

9. Real GDP growth (at factor cost) remained weak in 1999/2000 for a second year rising only marginally to 2.4 percent from 2.1 percent in 1998/99. compared to 3.7 percent average growth rate during the period 1995/96-1997/98 (Chart 1 and Table 2).1 The decline in oil output has contributed to the weak real GDP growth in 1998/99 and 1999/2000. In particular, real oil and gas sector GDP fell by about 1 percent in 1999/2000 as a result of the OPEC agreement to restrain output in March 1999. Non-oil sector growth also slowed to 2.6 percent and 3 percent in 1998/99 and 1999/2000, respectively, from an average of 4.5 percent over the period 1995/96-1997/98. While agriculture was the main source of growth in 1998/99, its growth declined sharply in 1999/2000 due to severe drought (Chart 2). Industry and services, on the other hand, recovered and led growth in 1999/2000 as the supply constraints were eased with rising oil prices and the availability of foreign exchange.

Chart 1.
Chart 1.

Islamic Republic of Iran: GDP Growth and Inflation, 1995/96-1999/2000

(In percent)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Table 2.

Islamic Republic of Iran: Aggregate Output and Expenditure Trends, 1995/96-1999/2000 1/

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Source: Bank Markazi Jomhouri Islami Iran.

Iranian years ending March 20.

Includes oil and gas production, refining, and distribution.

Inpercent of GDP at factor cost, current prices.

In percent of GDP at current market prices.

Chart 2.
Chart 2.

Islamic Republic of Iran: Sectoral Distribution of Annual GDP Growth, 1995/96-1999/2000

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

10. Consumption expenditure displayed a moderate growth in 1999/2000, while investment expenditure fell. Total consumption expenditure is estimated to have risen by 3.7 percent in real terms in 1999/2000 compared with 2.8 percent 1997/98 and 2.4 percent in 1998/99. The private sector consumption grew by 3.1 percent, and public consumption by 6.8 percent. As a ratio to GDP, consumption expenditure is estimated to have reached 74.8 percent in 1999/2000, with a contribution of 61.2 percent from private consumption. Gross domestic investment decreased by 6.4 percent in 1999/2000 against a 22 percent increase in 1997/98 and 12 percent in 1998/99, despite an 8 percent increase in gross capital formation as stocks fell. Over the period 1995/96-1999/2000, the ratio of gross national savings to GDP exhibited sharp annual fluctuations, ranging from 21.8 percent in 1998/99 to 32.6 percent in 1995/96, it stood at an estimated 25.3 percent during 1999/2000. These variations partly reflect exchange rate movements, import controls and changes in real rates of return.

The oil and gas sector

11. Crude oil production was 3.4 million barrels per day (mbpd) in 1999/2000, in line with the quota set by OPEC in March 1999. Reflecting lower output, export of crude oil fell by 10 percent from 2.3 mbpd in 1998/99 to 2.1 mbpd in 1999/2000. The average price for crude oil exports was approximately US$19 per barrel, which is equivalent to a gain of US$8 per barrel over the previous year, and led to an increase in oil export earnings by 64 percent to US$16.3 billion. The net exports of refined product increased from 113,000 barrels per day (bpd) in 199S/99 to 197,000 bpd in 1999/2000, representing over 74 percent increase despite a small decline in total crude oil deliveries to domestic refineries from 1.39 mbpd in 1998/99 to 1.37 mbpd in 1999/00. Domestic consumption fell from 1.25 mbpd in 1998/99 to 1.13 mbpd in 1999/00, a 9.6 percent decline, reflecting, in part, the continued shift towards gas for domestic energy consumption as well as increases in domestic fuel prices in 1999/2000 (Appendix II, Table 13). In addition, efforts have been geared towards expanding domestic refining capacity so as to supply domestic market with refined products, reduce overreliance on crude oil exports and expand export of products with higher value added.

12. The government has placed emphasis on expanding the petrochemical industry to generate products with higher value added and higher export earnings. Iranian petrochemical production has more than doubled in the last five years, making Iran the second largest producer in the region (after Saudi Arabia). Total petrochemical output was estimated at about 12 million tons in 1998 compared with 2.4 million tons in 1989. The country has the plan to triple annual output of petrochemical products to 30 million tons within 20 years. The National Petrochemical Company (NPC) has embarked on initiatives for ensuring continued future growth of the sector through a dominant role for private investment. To achieve this goal, the NPC has processed the necessary decisions and legislation for the establishment of a Special Petrochemical Economic Zone at Bandar Imam which is intended to promote investment in the petrochemical industry by attracting foreign capital.

13. Iran has the second largest gas reserves in the world. The production of gas increased from 72.5 billion cubic meters in 1998/99 to 80 billion cubic meters in 1999/2000 (Appendix II, Table 14), representing a 10 percent increase. At the same time, the consumption of gas moved from 51.5 billion cubic meters in 1998/99 to 58.7 billion cubic meters. The increase in domestic gas consumption is in line with the authorities’ objective of reducing domestic demand for petroleum products and thereby free more crude oil for exports. The completion of additional gas pipelines is expected to allow greater use of gas products in lieu of petroleum products. A 36-inch wide pipeline which came on stream in August 1999, can carry 220 million cubic feet to 270 million cubic feet of gas a day from the Pazanan gas fields in Gach. Another gas pipeline linking Iran and Armenia, and also the Trans-Caspian pipeline linking Iran and Turkmenistan, is under construction.

Agriculture

14. Real growth in agriculture declined to 0.3 percent in 1999/2000, after a sharp growth of 9.5 percent in 1998/99. The rapid growth observed in 1998/99 reflected the good performance of the farming sector arising from a rise in rainfall in the agricultural year 1997/98 by 52 percent over the previous year and improved availability of inputs. However, during 1999/2000, a major drought resulted in lower output. Cotton production fell by 9 percent with other important crops such as wheat and barley also declining by 27 percent and 39 percent, respectively (Appendix II, Table 16). Despite various attempts by the government to reduce dependence of this sector’s performance on changes in rainfall through the construction of dams, irrigation and drainage networks, agriculture remains highly sensitive to climate developments.

15. Government continues to gear efforts toward reducing its role in agriculture and encouraging private sector activities and the growth of cooperatives, while limiting its role to the provision of infrastructure. The amount of subsidies to agricultural inputs has been reduced over the last few years including pesticides and fertilizers, which have been reduced in real terms. However, there are still subsidies to some basic agricultural products, in particular wheat, which accounts for approximately 80 percent of the total explicit subsidies. The government sets its procurement prices for agricultural products using a cost-based approach which allows for a gross profit margin of 20-25 percent and also takes into consideration international prices. These prices serve as a guaranteed benchmark, which usually fall below market prices.

Industry and construction

16. The industrial sector has continued to be dominated by relatively few but large public enterprises accounting for approximately 70 percent of value added in manufacturing. Real growth in the industrial sector in 1999/2000 is estimated to have fallen slightly to 4.4 percent from 5.0 percent for the period 1994/95-1998/99 and reports a number of structural factors, including technical and managerial weaknesses, delayed privatization and restructuring, and low productivity. Growth in the construction remained broadly unchanged at 5 percent in 1999/2000, and was facilitated by an increase in private sector investment in housing and construction, and by expanded credit allocation to this sector and the initiation of several housing projects.

Services

17. Services are the largest sector in the economy, contributing approximately 40 percent to GDP for the year 1999/2000. After marginal contraction in 1998/99, this sector grew by 4.3 percent in 1999/2000. However, the growth performance of the various service subsectors was mixed in 1999/2000, with trade, banking and insurance showing modest growths of 1.9 percent and 2 percent, respectively. On the other hand, dwellings, transportation and communication, and public services showed higher growth rates of 4.4 percent, 5.0 percent, and 6.5 percent, respectively.

B. Prices, Employment, and Wages

Prices and subsidies

18. Inflation in Iran has varied significantly over the past decade and has reflected variations in macroeconomic politics in response to fluctuations in oil export receipts and external imbalances. These issuesare further elaborated in Appendix I. The economy witnessed a 17 percent increase in the 12-month rate of change in the consumer price index (CPI), with the year-on-year inflation remaining unchanged at 20 percent. Part of the increase in the general price level could be attributed to monetary overhang toward the end of 1998/99 and larger increases in administration prices in 1999/2000. In the latter year, the ratio of increases in price of food, beverages, and tobacco group of goods (accounting for approximately 37 percent of the CPI basket), housing and health care moderated to 22 percent, 16.2 percent, and 23 percent, respectively. On the other hand, other components of the CPI witnessed an increase in their rate of inflation: clothing, 8.1 percent; household, 15.5 percent; transport and communication, 26 percent; water, fuel and power, 47.8; health and medical care, 23 percent; recreation, 18.6 percent; and other goods and services experienced an inflation rate of 26.7 percent.

19. A number of goods and services are subject to price controls and subsidies (Appendix II, Tables 31, 32, and 33), which have mainly been administered by the Organization for the Protection of Consumers and Producers (CPPO). During 1995/96-1999/2000, CPPO continued to perform its three main functions: (a) determination of administered prices; (b) payment of subsidies for basic goods (through 1995/96); and (c) collection of the difference between some officially determined prices (which are, however, not administrated) and market prices. The price-setting role of the CPPO covers goods that are subsidized and made available through the coupon system (sugar, wheat, edible oil, milk, cheese, red meat, rice); related goods and services (flour, labor used to produce sugar cubes, sugar beet waste to feed animals, etc); goods produced by monopolies (e.g., paper, agricultural machinery, petrochemicals, and automobile batteries); other goods imported at the appreciated floating exchange rate of Rls 1,750 per US$1 (e.g., detergents, medicine); and selected other goods (e.g., syringes)2. For the price-controlled goods, prices are determined at all levels (producer, wholesale, and retail). Price determination is based on cost calculations allowing for a certain markup; these calculations are made at all stages of the production and distribution chain, i.e., from the producer all the way to the retail level. While most of the officially determined prices are not administered prices, nonobservance of CPPO price guidelines is subject to payment of a fine. For certain goods, the companies selling them for more than the official price pay some of the difference between the official price and the actual price to the Ministry of Finance (prior to 1997/98 the payments were made through the CPPO). Specifically, 30 percent of this difference can be used for approved investments.

20. Budgetary subsidies in 1999/2000 were in the magnitude of Rls 6,881 billion, with wheat subsidies accounting for approximately 80 percent of the total. A coupon system is in place for all subsidized goods with the exception of wheat. The Ministry of Commerce issues coupons through the banking system. Currently, imports of subsidized goods are made mainly by the government trading corporations at the floating exchange rate.

21. Large implicit subsidies emanate from underpricing domestic consumption of petroleum products in relation to the international price levels of these products. Despite a large 70 percent increase in prices of such products, this category of implicit subsidy is estimated by the staff to have risen from 7 percent of GDP in 1998/99 to 17 percent of GDP in 1999/2000, as world prices rose sharply. The largest implicit subsidy is on the consumption of gas oil and it also constitutes the largest share of domestically consumed petroleum products.

Employment and Wages

22. There has been a relative decline in the importance of agricultural sector in terms of its share in overall employment. As of 1986, the agricultural sector’s employment share was 29 percent. However, recent estimate suggests this has declined to about 23 percent. On the other hand, share of industry has shown upward movement, It increased from about 25 percent in 1986 to 31 percent in 1999/2000. The share of the service sector has remained broadly unchanged at 46 percent. The share of the public sector, including state enterprises, in overall employment is estimated at about 70 percent of total employment in 1996, and the official unemployment rate is estimated at about 13 percent in 1999/2000.

23. The only available data on wages in the private sector is on compensation to private sector construction workers, who experienced an increase of nominal wages of 13 percent from January 1998/99 to January 1999/2000, implying that real wages in private construction decreased by about 6 percent.

C. Foreign Direct Investment

24. Foreign direct investment (FDI) has remained at a low level, with flows estimated at US$400 million in 1999/2000, mostly in the oil sector. FDI is governed by the Law of Attraction and Protection of Foreign Investment, which requires, inter alia, that the investment be in industry, mining, agriculture or transportation; and that it be at least self-sufficient with respect to foreign exchange. A draft for encouraging private investment and more FDI inflow has been prepared. It contains proposals to eliminate ownership restriction on the private sector, reduction in the time required for the approval of FDI, and clarifications of Article 44 as regards areas to be left to the public sector. Foreign investments in the oil sector relies mostly on buyback arrangements, under these arrangements, foreign investors receive a portion of the output generated by the project.

D. Social Issues

25. Policies have been implemented to improve both education and health in the country and the key social indicators have improved in Iran since the beginning of the 1980s. The enrollment rate in primary education is nearly 100 percent (compared with 87 percent in 1980), and many students continue to secondary education, where the enrollment rate has increased to close to 70 percent (compared with 42 percent in 1980); the literacy rate increased from about 50 percent in 1987/88 to around 80 percent in 1997/98. There have been improvements in indices of educational quality. At the same time, students-to-school, students-to-class, and student-to-teacher ratios have fallen (Basic Data).

26. There have also been significant improvements in several health-related indicators over the last 10 to 20 years. These include the coverage of health services, access to safe water and sanitation, as well as the number of physicians, nurses, and hospital beds per person. Furthermore, special attention has been given to the immunization of children. Health policies have achieved a decrease in infant mortality rate to 26 per 1,000 live births in 1997/98, compared with 91 per 1,000 live births in 1980. In order to rationalize population growth, a family planning program has been implemented; it has contributed to a reduction in population growth from 3.2 percent in 1984 to 1.7 percent in 1998.

27. Over the last 15 years, there has also been an improvement in income distribution, but there are still vulnerable segments of the population that require support. In order to improve the situation for the most vulnerable segments, especially in rural areas, the government is considering an anti-poverty program comprising expanded provision of food, clothing, health care, education, social security, and bank credits to these groups. Social safety net constitutes an important component of TFYDP.

III. The Public Finance

A. Overall Trends3

28. Iran has a tradition of relatively prudent budgetary management. Following three years of relatively low deficits, the budget outcome deteriorated substantially in 1998/99 when revenues fell on account of the sharp drop in crude oil prices and the budget deficit soared to close to 7 percent of GDP (Chart 3 and Table 3). In 1999/2000, mirroring the oil price increase, budget performance improved sharply and the central government achieved a small surplus of 1 percent of GDP. This strong improvement in budgetary performance reflected primarily higher oil revenue, but also expenditure restraint. In view of the expected strong oil and gas revenues performance, the budget for 2000/01 calls for a buildup in surplus which would be transferred to the Oil Stabilization Fund (OSF) which will become operational in 2001/02.

Chart 3.
Chart 3.

Islamic Republic of Iran: Central Government Fiscal Operations, 1995/96-2000/01

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Table 3.

Islamic Republic of Iran: Central Government Fiscal Operations, 1995/1996-2000/01 1/

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Table 3.

Islamic Republic of Iran: Central Government Fiscal Operations, 1995/1996-2000/01 1/ (concluded)

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Sources: Bank Markazi Jomhouri Islami Iran; Plan and Budget Organization; and Fund staff estimates and projections.

Fiscal year ending March 20.

Including Rls 11.1 trillion contingency budget, to be implemented only if crude oil prices remain above US$ 15.75 per barrel.

From sale of a portion of oil and gas revenues at the “export” and TSE exchange rates.

Mostly revenue of the Social Security Organization and medical services provided by universities.

Counterpart of earmarked revenue.

Budget outlays to cover the foreign exchange losses of the central bank.

29. The budget deficits prior to 1999/2000 were largely financed by credit from the BMI and issuance of participation papers as well as pre-financing for oil deliveries in 1998/99. In the process, the stock of domestic and external government debt increased through 1998/99, peaking at about 15 percent of GDP and 13½ percent of GDP, respectively.4 However, the stock of external debt was substantially reduced in 1999/2000 to about 10 percent of GDP, while domestic debt fell to an estimated 11 percent of GDP. The structures of the public sector and the fiscal policy are described in Appendix I.

B. Revenue Developments

30. Budgetary revenues continue to rely heavily on proceeds from the exports of oil and gas, and overall revenue performance varies strongly in line with the crude oil price (Chart 4 and Table 3; Appendix II, Table 25). Over the past five years, on average, more than 50 percent of total budget revenues originated directly from the oil and gas sector. In 1999/2000, revenue from oil and gas export proceeds rose strongly (by 5 percentage points of GDP) compared with the previous year as a result of the sharp rise in the crude oil price. In addition, the sale of larger shares of the proceeds at the market-based TSE exchange rate contributed strongly to revenues.

Chart 4.
Chart 4.

Islamic Republic of Iran: Central Government Revenue, 1995/96–1999/2000

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

31. By contrast, tax revenues have remained low, averaging less than 6 percent of GDP over the last five years. In 1999/2000, tax revenue collection improved somewhat compared with the previous year, as both direct and indirect taxes increased slightly relative to GDP. While revenue from the corporate profit tax rose broadly in line with GDP, collections from taxes on wages and salaries increased significantly. Among indirect taxes, revenue from the sales tax on cigarettes fell short of the budget target and remained lower in nominal terms than in 1998/99, despite an increase in the tax rate, suggesting intensified tax evasion and smuggling. This shortfall was, however, more than offset by a strong rise in revenue from sales taxes on automobiles and special goods (e.g., mobile phones). Revenue from import taxes remained low, reflecting large exemptions and the fact that all imports continued to be valued at the official floating exchange rate for customs valuation purposes.

32. Few tax policy changes were introduced over the past five years except for adjustments in rates of specific indirect taxes and customs tariffs for individual products (e.g., sales tax on cigarettes). The general structure of the tax system has, therefore, remained broadly unchanged and continues to be distortionary, inequitable, and revenue inelastic. There exist a plethora of indirect taxes, customs duties, and fees, causing significant collection costs for the tax authorities and excessive compliance costs for taxpayers. The personal income tax is characterized by a high marginal rate and numerous exemptions. The corporate income tax rate generates very little revenue as its rate is low (10 percent) and the tax base has been eroded by many exemptions.

33. Nontax revenues rose strongly in 1999/2000, as a result of increases in domestic administered energy prices. At the beginning of that fiscal year, domestic petroleum prices were raised, on average, by 70 percent, and the water and electricity tariffs were increased by 25 percent and 20 percent, respectively. By contrast, nontax revenue from dividends of state-owned enterprises was much lower than expected and fell in real terms vis-à-vis 1998/99, reflecting in part, a further overall deterioration in the financial performance of these enterprises. Earmarked revenues have remained flat relative to GDP at about 2.5 percent over the past five years.5

C. Expenditure Trends

34. In an attempt to avoid sharp budgetary deficits, expenditures (mainly capital outlays) have in the past been adjusted in response to fluctuations in oil and gas revenues. Overall expenditures remained broadly stable at about 28 percent of GDP during 1995/96-1997/98 before falling to about 26 percent of GDP in 1998/99, in response to the sharp drop in revenues which fell to 19 percent of GDP (Chart 5). Current expenditures expanded significantly in 1999/2000 to 16 percent of GDP, largely reflecting a significant increase in the wage bill, which was facilitated by oil and gas revenues. Subsidies to households and current transfers to state-owned enterprises rose roughly in line with nominal GDP over the past five years, with the exception of 1998/99 when explicit subsidies and transfers to households rose significantly (to more than 4 percent of GDP).

Chart 5.
Chart 5.

Islamic Republic of Iran: Economic Classification of Central Government Expenditures, 1996/97-2000/01

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

35. The functional classification of current and capital expenditures (Chart 6, Appendix II, Tables 29 and 30) changed little during the past five years. As regards current expenditures, social sector outlays increased significantly in 1997/98 relative to GDP, but fell in 1998/99 as a result of overall expenditure retrenchment because of low oil prices, and remained low in 1999/2000.6 Specifically, education spending rose by about 1 percentage point of GDP during the period 1995/96-1997/98, in part, reflecting a significant increase in the number of teachers. Defense outlays rose from 2.8 percent of GDP in 1995/96 to 3.2 percent of GDP in 1997/98, and after remaining at this level in the subsequent year, were cut to 2.7 percent of GDP in 1999/2000. Capital outlays were cut sharply in 1998/99 to 5.4 percent of GDP from an average of 7 percent in the previous two years in response to lower oil revenues. Such expenditures were kept below the budgetary level at 6.5 percent of GDP in 1999/2000. The budget does not reflect the large quasi-fiscal subsidies that the government provides mainly through nonmarket prices. While fluctuating over time, implicit subsidies arising out of the low domestic prices of petroleum products are estimated by the staff to have increased to about 11 percent of GDP in 1997/98 before falling to 7 percent of GDP in 1998/99 as global prices of such products fell. However, in 1999/2000, implicit subsidies are estimated by the staff to have risen to 17 percent of GDP despite a 70 percent upward adjustment in domestic prices of such products as world prices rose sharply.

Chart 6.
Chart 6.

Islamic Republic of Iran: Central Government Total Expenditure by Functional Classification, 1995/96-1999/2000

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

D. The 2000/01 Budget

36. The 2000/01 budget is the first under the TFYDP (Appendix I, Table 1). Reflecting all regular expenditure commitments as well as the “contingency budget”, and allowing a likely increase in capital spending beyond the budgetary target, implementation of the 2000/01 budget is expected to generate a surplus of about 2½ percent of GDP.7 Revenue is projected to increase significantly (from 27 percent of GDP to 29 percent of GDP), essentially on account of higher proceeds from exports of crude oil, and sales of a larger share of foreign exchange at the TSE rate. The budget includes a few marginal tax policy reforms, including an increase in customs tariffs on manufactured imports and a decrease in the sales tax on cigarettes. The budget’s revenue projections can be generally considered as conservative, with the exception of an optimistic estimate of collections from the sales tax on cigarettes.

37. On the expenditure side, the wage bill, which accounts for slightly more than half of the total outlays, is budgeted to rise by about 18 percent. However, the budget entails a “backward indexation” provision, requiring the government to compensate civil servants for the difference between the projected and actual inflation rate experienced in 2000/01. This provision creates a potentially large contingent liability for the 2001/02 budget. Explicit consumer goods subsidies are projected at Rls 8.5 trillion, equivalent to an increase of about 23 percent compared with the previous year. As in previous years, the bulk of this amount (about 75 percent) will be used to subsidize imports and domestic purchases of wheat. Capital outlays are budgeted to increase little in nominal terms and decline relative to GDP (from 6½ percent last year to 6 percent this year).8

38. As part of the 2000/01 budget, the authorities intend to sell US$5.5 billion at the floating exchange rate (Rls 1,750 per US$1), compared with US$2.5 billion last year, while up to US$7.5 billion would be sold at the depreciated TSE exchange rate. As in previous years, foreign exchange, sold at the floating exchange rate, will be used within the budget framework to finance imports of essential goods (e.g., wheat, sugar, rice, vegetable oil), military equipment medical supplies, debt service payments, and a variety of current and capital expenditure items (e.g., imports for the oil sector).

39. In addition to the regular budget, the parliament approved a contingency budget, equivalent to Rls 11.1 trillion (about 2 percent of GDP). Expenditure commitments and envisaged debt repayments under this contingency budget will only become effective if the crude oil price remains above US$15.75 per barrel, which is very likely. Such contingency outlays include (a) repayment of external debt in the amount of US$869 million; (b) retirement of Rls 2.3 trillion of debt to domestic commercial banks and the central bank; (c) provision of Rls 3 trillion in subsidies to those importers who have no longer access to foreign exchange at the export rate; (d) transfer of Rls 3 trillion to banks that could be used for lending to state enterprises under a special lending facility; (e) repayment of Rls 0.5 trillion of government debt to the pension funds; (f) increase in the capital of the Export Development Bank by Rls 0.8 trillion; and (g) payment of Rls 1.5 trillion as bonus to retiring government employees.

40. The authorities are committed to setting up an OSF at the beginning of the fiscal year 2001/02. The primary objective of this fund will be to smooth revenues and shield the budget from the adverse impact of volatile and unpredictable movements of the crude oil world market price (short-term stabilization function). The authorities indicated that they would transfer to the OSF all revenues from crude oil and gas exports over and above the budgetary targets by the end of this fiscal year. Starting next year, the authorities intend to base the operations of the OSF on a price-contingent rule and all oil revenue over and above a price of, say US$15.75 per barrel of crude oil will be transferred to the OSF.

IV. The Financial Sector

A. The Structure of the Financial Sector

The banking system

41. The Iranian financial sector is dominated by ten state-owned banks, including six full-service commercial banks, and four sectorally specialized. In addition, four small private nonbank credit institutions have recently been licensed. Total number of state-owned bank branches at end of 1998/99 was 14,518 compared with 11,634 in 1994/95, an increase of about 25 percent.9 Four private nonbank credit institutions were licensed in 1999/2000 and three started operation. The main difference between these institutions and banks is that they are not allowed to offer their clients payment services. Otherwise, they offer all the financial services that are offered by banks.10

42. Commercial banks accept demand, savings and time deposits; engage mainly in short-term lending, primarily to the private sector and public nonbank financial enterprises; and act as agents of depositors in the investment of funds. The profits (losses) from these investments are then distributed to depositors based on the duration and amount of the investment. Specialized banks lend mainly on a long-term basis (five years or more) and have equity participation in the agricultural, industrial, mining, housing, and export sectors. Their sources of funds are low-cost, long-term government deposits and loans, with the exception of the Housing Bank whose resources are largely private deposits.

Capital markets

43. In 1994/95, the issuance of partnership papers in line with Islamic finance principles was approved by the Money and Credit Council. The first issue of partnership papers was carried out by the Teheran Municipality and all subsequent issues have thus far been on behalf of specific public sector agencies, and have been related to specific projects. Government papers, in the form of National Participation Papers, were issued for the first time at the beginning of 1998/99 to finance government development expenditures. These papers are issued with specific rates of return and cannot be discounted in secondary market trading, and banks are not allowed to invest in them.

44. There is an active stock market—the TSE—which benefited from a wave of privatization in the early 1990s. Stock market capitalization of Rls 38 trillion at end-1999 corresponds to about 9 percent of GDP (it peaked at about 14 percent in October 1996), though relatively few of the shares are routinely available for purchase by the general public and liquidity, at 10 percent per annum turnover, is still low by international standards. The TSE has consolidated its position in recent years, showing a good rate of return in the past couple of years. However, the TSE total capitalization remains small, liquidity is very limited and the price-earnings ratio so low as to suggest a considerable degree of investor caution.

45. Ownership of listed stocks is highly concentrated: the largest five shareholders account, on average, for more than 82 percent of company shareholdings. A small handful of institutional investors dominate the market as a whole. These are all either government institutions or state-owned banks or their subsidiaries, albeit operating on market-oriented basis. Over the past two years an overhaul of the TSE regulations was undertaken resulting in an increase in transparency and protection against insider abuses. Further regulatory strengthening and other innovations are be considered, including relaxing the restrictive features of listing requirements (which may have contributed to the slowness of fully private firms to list). There has been a proliferation of unregulated “investment companies” particularly during the past two years. These companies have been offering brokerage and mutual fund investment services.

B. Monetary Policy Structure

46. The monetary policy objectives and instruments are elaborated in the monetary and credit policy statement that is usually issued in conjunction with the annual fiscal budget and approved together by parliament. The statement sets the targets for, inter alia, broad money growth, bank credit growth, distribution of bank credit between the private and public sectors, the targeted sectoral and provincial distribution of bank credit, the deposits (per type) and lending (per sector) rates and required reserve ratios. However, BMI credit expansion is not included in the statement. The monetary program is executed by BMI.

47. Several instruments are available to BMI for implementing its monetary policy. These include (a) direct credit management, (b) reserve requirements, (c) lending and deposits rates of return, (d) sectoral credit allocations, (e) allocation of government bonds to the banking institutions, and (f) penalties for overdrafts. However, BMI has not actively used most of these instruments in executing its monetary and credit policies. Legal reserve requirement ratios, bank lending and deposits rates, and the allocation of government bonds to banks, have basically remained unchanged over the past few years. Although, minor changes were made on the sectoral allocations of credit, BMI has enforced it flexibly, allowing banks to deviate somewhat from the plan and in many instances the BMI adjusted its allocation requirements to encourage certain sectors.

48. The BMI has moved away from setting bank-by-bank credit ceilings. However, it still has significant powers in determining the direction of bank credit. All bank lending to public enterprises must be approved by BMI. Also all bank lending to the private sector enterprises in excess of Rls 5 billion or to individuals in excess of Rls 0.5 billion per loan must be approved by BMI.

49. Bank rates of return on deposits are set administratively by the BMI according to the maturity of deposits rising up to 18.5 percent for deposits of five years maturity. For lending, the rates are set as ranges according to the sector of economic activity to which credit is extended with the lowest rates applying to agriculture (13-17 percent), and the highest for trade and services (22-26 percent). Under the Iranian Islamic banking law, these rates are determined in several ways. On the deposits side, current accounts do not earn income. For investment deposits, the announced rates are expected rates of return; ex-post rates may be higher or lower than the quoted rates, depending on the profitability of the projects financed by banks and of the banks themselves. In practice, however, the ex-post rates have rarely deviated from the quoted rates. The mandated lending rates, on the other hand, represent the rate of profit that banks are allowed to collect from its lending operations.

C. Developments during 1999/2000

Monetary and credit developments

50. Broad money growth decelerated in 1999/2000 to about 20 percent compared with about 26 percent in 1998/99 (Tables 4 and Appendix II, Table 37). This monetary growth was caused primarily by significant improvement in the net foreign assets (NFA) positions of the BMI and banks and by sharp increase in bank credit to the private sector. The rising oil prices during the second half of 1999/2000 coupled with continued import compression, led to significant buildup of NFA of about US$3.2 billion (one-third of which is at the banks) by end-1999/2000, contributing 3.4 percentage points to broad money growth as compared with 4.7 percentage points in 1998/99 (Charts 7 and 8). The growth of the banking system net domestic credit (NDC) and its contribution to monetary growth were reduced markedly in 1999/2000 to 22.5 percent and 25.4 percent, respectively, compared with 29.2 percent and 32.3 percent in 1998/99. The containment of NDC growth was achieved through a sharp reduction in government and public sector borrowing. Assisted by a fiscal surplus, the banking system’s net claims on government contributed about 1.3 percentage point decline to broad money growth while tight controls on credit to public enterprises limited their borrowing increase to 2.6 percent of broad money. Lending to the private sector was by far the leading factor contributing to NDC growth. Banks’ claims to the private sector grew by over 40 percent in 1999/2000 contributing 24.1 percentage points of broad money growth (the highest levels recorded in the past decade). The increase in lending to the private sector reflects the authorities’ efforts to reform the public enterprise sector and encourage private sector growth.

Chart 7.
Chart 7.

Islamic Republic of Iran: Contribution to Broad Money Growth, 1995/96-1999/2000

(In percent of initial broad money stock)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Chart 8.
Chart 8.

Islamic Republic of Iran: Contribution to Broad Money Growth, 1995/96-1999/2000

(In percent of initial stock of broad money)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Table 4.

Islamic Republic of Iran: Selected Monetary Indicators, 1995/96-1999/2000 1/

article image
Source: Bank Markazi Jomhouri Islami Iran.

Iranian years ending March 20.

Data for 1997/98 and 1998/99 have been revised to reflect implementation of the improved classification system and errors in reporting by few banks that were discovered in the course of implementing the new system. Data prior to 1997/98 are still based on the old classification system. Central bank balances were not affected.

51. Developments in BMI’s monetary aggregates have largely mirrored those of the banking system. Reserve money growth decelerated to 16.5 percent in 1999/2000 compared with 18.4 percent in the previous year, led by significant increase in BMI’s NFA, which rose by about US$2 billion, and lending to banks, which accounted for all BMI’s lending (Table 4 and Appendix II, Table 38). There was a contraction in lending and in net claims on government. The increase in BMI’s NFA and lending to banks contributed 5.4 percentage points and 16.5 percentage points to reserve money growth in 1999/2000, respectively, compared with -5.9 percentage points and -2.7 percentage points in 1998/99.

52. The broad money multiplier remained virtually unchanged in 1999/2000. However, financial intermediation continued to improve, albeit at a slow pace, with currency-to-total deposits ratio declining from 12.9 percent in 1998/99 to 12.6 percent in 1999/2000, continuing a long-term trend that spanned the past ten years. This decline occurred despite modest increase in the demand for currency as evidenced by the increase in the currency-to-demand deposits ratio from 31.1 percent in 1998/99 to 31.7 percent in 1999/2000. This development, however, might be related to the exchange market reforms that were undertaken in 1999/2000. More importantly, the ratio of time and savings deposits to demand deposits has increased from 1.42 percent in 1998/99 to 1.52 percent in 1999/2000 (a growth of about 7 percent).

Monetary policy developments

53. The authorities’ monetary policy stance during 1999/2000 was shaped mainly by two concerns: containing the large monetary overhang that was created at the end of 1998/99 and the desire to support private sector-led growth, especially in housing construction and agriculture sectors.

54. Owing to the sharp increase in bank financing of the budgetary deficit in 1998/99 and the traditional end-year clearance of budgetary balances of government agencies and public enterprises, significant liquidity expansion occurred toward the end of 1999/2000. As a result, banks’ excess reserves (deposits at BMI and cash in vaults) doubled at end-1999/2000 from their level at end of 1998/99 and their share in reserve money rose from 4.8 percent to 8.1 percent. The authorities responded to the buildup in excess reserves by establishing a remunerated time deposit facility, the Open Deposit Account (ODA), at BMI in which banks were encouraged to invest their excess reserves instead of on-lending them.11 Tight monetary policy was also implemented with reserve money declining slightly during the first quarter. Finally, the exchange rate at the TSE was allowed to appreciate, which contributed to significant absorption of excess liquidity.

55. The tight policy stance was loosened somewhat toward the end of the second quarter, and bank financing was expanded for housing construction and agriculture. Housing construction was viewed as a vehicle that could generate new employment opportunities in a relatively short period of time and additional financing for agriculture was needed to counter the effects of the continued drought. Banks were instructed to increase their lending to those two sectors, and broad money grew by over 5 percent during the second quarter (contributing by about one-third to overall broad money growth in 1999/2000). The additional lending was funded, at least in part, by significant draw down of excess reserves by banks at the end of the second quarter. Excess reserves are estimated to have declined by 2.5 percentage points (or by about 30 percent) of reserve money between the sixth and seventh months of the year.

Liquidity management

56. Traditionally, incentive-based liquidity management arrangements do not exist in Iran. There are no interbank market, tradable liquid securities, or central bank facilities for banks to manage their short-term liquidity needs.

57. The launching of the foreign exchange market liberalization program at the beginning of 1999/2000 heightened the need to institute an arrangement for the BMI to manage banks’ liquidity to support the reform process. The BMI also needed to move expeditiously to mop up the large liquidity overhang that emanated from the end-year budgetary operations. As indicated earlier, the ODA was activated at BMI effective April 22, 1999 for the commercial banks to deposit their excess reserves, initially at rates ranging from 14 percent to 18 percent for deposits of 3-12 months in maturity.

58. Deposits at the ODA reached Rls 1.1 trillion in the first quarter or the equivalent of about 1.2 percent of demand deposits, at an average rate of return of 16 percent per annum, mopping up much of the excess liquidity. The deposits declined to about Rls 0.65 trillion by the end of the second quarter and further to a negligible level during the second half of the year. The ODA partially succeeded in achieving the BMI’s monetary policy objective by blocking significant portion of banks’ usable excessive reserves and thus preventing a sharper exchange rate depreciation when the exchange rate was freed at the beginning of the year. This outcome, however, was not entirely incentive-based (as the ODA rate of return was substantially lower than banks lending rates) but also was facilitated to a certain degree by limiting bank credit operation early in the year.

59. The relatively low rates on the ODA and the lack of movements in these rates to counter liquidity movements have rendered the ODA dormant. Another difficulty with the ODA design is the inability of BMI to make the offered rates be market-determined and tradable in interbank market. To address these shortcomings, BMI allowed the establishment of interbank funds market and have decided to issue its own securities—the Central Bank Participation Paper (CPP).

60. Until last year, banks did not lend to other banks except if allowed to or instructed by BMI. Early last year, the BMI lifted this prohibition; banks were encouraged to establish an interbank market and the BMI set the interbank rate at 18 percent. This measure, however, was largely ineffective as very little interbank lending occurred and no formal market structure emerged. The CPP holds a greater promise for developing into an effective instrument that is liquid and with market-determined price.12

D. Banking Supervision

61. Given the controlled rate of return environment, state ownership of all banks, the considerable role of government ministries in directing credit, and the pre-approval by BMI of most of the banks’ large loans and of foreign exchange activities, prudential regulation and supervision has in the past played a limited role in the operation of the banking system. However, in anticipation of further financial system liberalization under the TFYDP, BMI have started reorganizing its internal banking supervision structure. The Banking Supervision Department has been split into two: the banking information department which would handle off-site supervision and financial reporting by banks, and banking supervision department which would handle the on-site supervision as well as being responsible for drafting banking regulations.

62. In addition, a comprehensive review of bank accounting and disclosure practices was undertaken in 1999/2000 in cooperation with the Fund and the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Based on this review, a range of measures have been developed that would be needed to bring accounting and disclosure in conformity to AAOIFI and (when applicable) IAS standards. The BMI also concluded a comprehensive review of bank financial reporting practices and accordingly revised the general monetary and credit classification system. Finally, Iran undertook in 1999/2000 a comprehensive assessment of its financial system under the Fund/Bank Financial Stability Assessment Program (FSAP) pilot project for selected countries.

V. The External Sector

A. Overall Trends

63. Following a strong balance of payments performance in 1996/97, mainly on account of the high oil prices, the period 1997/98-1998/99 witnessed a deterioration in external accounts triggered by tumbling oil prices and stagnant low non-oil exports. Imports were compressed due to the resulting scarcity of foreign exchange, and Iran negotiated re-phasing of part of its rescheduled external debt in 1998 in order to alleviate balance of payments pressures. Gross official reserves fell to a decade low of US$3.7 billion by the end of 1998/99, the equivalent of three months of imports. In 1999/2000, however, a sharp increase in oil prices, enhanced by a 9 percent growth in non-oil exports and a continued compression of imports, allowed for a swift recover)’ in external sector accounts.

B. Balance of Payments Developments

64. The overall external balance dropped from a surplus of US$2.8 billion in 1996/97 to a deficit of US$4 billion in 1997/98 (Table 5 and Chart 9). A gradual but significant improvement was recorded over the next two years, as the balance of payments deficit declined to US$1.5 billion in 1998/99 and shifted into a surplus exceeding US$2 billion in 1999/2000. Consequently, following the large drop in gross official reserves from US$9.4 billion in 1996/97 to US$5.3 billion in 1997/98, reserves declined by US$1.5 billion in 1998/99 before rising by nearly US$2 billion in 1999/2000 to reach US$5.6 billion. Underlying this improvement, however, were major swings in both current and capital account balances. Indeed, the current account balance shifted from a surplus of US$2 billion (1.5 percent of GDP) in 1997/98 to a US$2 billion deficit (2.2 percent of GDP) in the following year, but ended the year 1999/2000 with a renewed and even larger surplus of US$4.7 billion (4.7 percent of GDP). These sharp movements mirrored, to a great extent, oil price fluctuations. The capital account balance, including errors and omission, reveals equally large swings as the deficit of US$6 billion in 1997/98 turned into a surplus of US$600 million in 1998/99 before shifting back to a deficit of US$2.6 billion in 1999/2000 as debt repayments increased.

Table 5.

Islamic Republic of Iran: Summary Balance of Payments, 1995/96–1999/2000 1/

(In millions of U.S, dollars)

article image
Sources: Data provided by Iranian authorities; and Fund staff estimates.

Iranian years ending March 20.

Including errors and omissions.

Chart 9.
Chart 9.

Islamic Republic of Iran: Current Account Developments 1995/96-1999/2000

(In billions of US$)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Current account developments

65. Given that oil exports account for the bulk of current receipts, changes in the current external balance in Iran are primarily driven by oil price changes. A 52 percent drop in the average oil export price between 1997/98 and 1998/99, coupled with a 4 percent decline in the volume of crude oil exports, caused a US$5.5 billion fall in receipts from these exports. Hence, despite a 9 percent improvement in non-oil export receipts, total exports fell by about 29 percent in 1998/99 to US$13 billion, compared with US$18 billion in the previous year. In the process, trade balance shifted from a surplus of US$4.3 billion in 1997/98 to a deficit exceeding US$lbillion in 1998/99.

66. In 1999/2000, reflecting a 77 percent increase in the average export price of Iranian crude oil, proceeds from crude oil exports rose by 60 percent, despite a decline in the export volume. In addition, the substitution of gas for petroleum products in domestic consumption allowed for increased exports of these products, leading to the doubling of proceeds from these exports. Non-oil exports also rose by about 9 percent to US$3.5 billion, encouraged by a depreciation of the TSE exchange rate. Imports also declined by about 5 percent to US$13.5 billion. As a result, the trade balance registered a massive improvement in 1999/2000, moving into a US$6.2 billion surplus from a US$1.1 billion deficit in the preceding year.

67. The composition of non-oil exports has remained broadly unchanged. Consumer goods accounted for 55 percent of such exports on average over the past three years, followed by raw materials and intermediate goods (about 38 percent on average over the same period). Carpets remain the single most exported Iranian non-oil product. Such exports have significantly declined over the second part of the 1990s, from US$2 billion in 1994/95 to US$570 million in 1998/99, which is attributed to competition from low-priced competitor carpet-producing countries. Exports of fresh and dried fruits, at about US$600 million in 1998/99, have captured a larger share of the total. Chemicals are the most prominent export of raw materials and intermediate goods, hovering at about US$450 million over the past three years. The direction of exports has also remained broadly unchanged during the past four-five years (Appendix II Table 53). While Japan and the United Kingdom remain the largest importers of Iranian goods (absorbing about 16 percent and 17 percent of total exports, respectively), Germany and the U.A.E. continue to be the main destination for nonoil exports, capturing 13 percent and 16 percent of these exports, respectively. Other important destinations for Iranian exports are Italy (6 percent of non-oil exports and 9 percent of total exports), Greece and South Korea (5 percent of total exports), and Turkey (5 percent of non-oil exports).

68. Iran imports mainly raw materials and intermediate goods and capital goods; imports of consumer goods, at about US$2 billion per annum, represent only about 14 percent of total imports (Appendix II, Table 54). Imports of machinery and tools average about US$4 billion to US$5 billion annually during 1999/2000-1998/99 which cover the bulk of capital goods imports. The next most important imports for Iran are grains and derivatives (about US$1.8 billion annually). These imports fell drastically in 1998/99 however to below US$900 million. Iran also imports a large quantity of chemical products, totaling about US$1.8-US$2.0 billion per annum. The most important sources of Iranian imports are Germany (12 percent), Japan (7 percent), and Italy (6 percent) (Appendix II, Table 55).

69. Private transfers decreased slightly from an average of US$450 million in 1996/97-1998/99 to US$345 million in 1999/2000, driven by a decline in transfers from Iranian workers living abroad. The balance on the services account which has been in deficit over the past few years, improved somewhat in 1998/99 as the deficit fell by about US$1 billion to US$1.5 billion before increasing again to reach SI.8 billion in 1999/2000. The renewed deterioration in the services balance in 1999/2000 occurred despite lower interest payments on the reduced stock of debt as travel payments rose and services receipts fell by about 26 percent, partly due to a decline in freight, insurance, and transport receipts because of the decline in the volume of oil exports, but also due to the decline of other public and private service receipts.13

Capital account and official reserves developments

70. Medium and long-term capital movements were dominated by large debt repayments over the past two years. Indeed, repayments of rescheduled debt exceeded, on average, US$2.5 billion per annum over the period 1997/98-1999/2000, while average net disbursement of funds related to bilateral project financing was slightly above US$100 million on an annual basis. Overall, medium- and long-term capital movements registered a net US$2.6 billion outflow in 1997/98. However, inflows through medium-term oil pre-financing agreements14 coupled with borrowing undertaken by the ministry of finance and the increased disbursement from a Japanese long-term loan allowed for a reduction in the net medium- and long-term capital outflow to about US$800 million in 1998/99. In 1999/2000, while disbursements of medium- and long-term loans remained below US$800 million, repayments increased strongly, in part, representing accumulated repayment of the loan contracted by the ministry of finance in 1998/99. In the process, net outflow of medium- and long-term capital remained high at US$2.6 billion in 1999/2000.

71. Net short-term capital movements shifted from a US$180 million net inflow in 1997/98 to a net outflow of US$259 million in 1998/99, and over US$700 million in 1999/2000. The outflow in 1998/99 was on account of repayments of oil pre-financing debt, which was not compensated for by similar inflows (the new oil pre-financing contracts were medium term). The short-term net outflow in 1999/2000 is due to a decline in letters of credit borrowing, in part, as a result of the reduced of cover by export credit agencies.

72. The overall external balance position translated into a decline in net foreign assets of BMI in 1997/98-1998/99 followed by a build up in these assets in 1999/2000. Iran also succeeded in clearing all remaining arrears on letters of credit over that period, which accentuated these reserve losses albeit to a small extent. Consequently, after declining to the equivalent of about three months of imports in 1998/99, gross official reserves rose to the equivalent of five months of imports in 1999/2000. This level of international reserves was more than sufficient to cover short-term debt and the ratio of reserves to imports or to broad money compares with several OECD countries, suggesting a comfortable external position.

C. External Debt Developments

73. Iran reduced its stock of debt by almost 40 percent over the past three years, from US$16.8 billion (16.1 percent of GDP) in 1999/2000 to US$10.4 billion (10 percent of GDP) in 1999/2000. The bulk of this reduction took place in 1999/2000 as medium - long-term debt declined by about US$2 billion, short-term debt by about US$1 billion, and all remaining arrears were cleared (US$169 million). Previously, in 1998, owing to the large drop in oil prices and its negative effect on external accounts, the government had negotiated bilateral rephasing agreements. with major creditors with respect to liabilities formerly rescheduled in 1994 (Appendix II, Tables 57 and 58).15

74. LCs related borrowing traditionally constituted the majority of short-term debt in Iran. Given the medium-term nature of oil pre-financing agreements contracted in 1998 and onwards and the clearing of all arrears, short-term debt presently comprises only LCs. Because of the loss of cover by major export credit agencies following Iran’s liquidity problems in 1998/99, the amount of new LCs opened decreased gradually from US$6.4 billion in 1997/98 to US$5.6 billion in the following year and US$4.1 billion in 1999/2000.16 Total short-term debt consequently fell from US$4.8 billion in 1997/98 to US$4.5 billion in the following year, and US$3.6 billion in 1999/2000. Despite this declining trend, however, the ratio of short-term debt to total debt slightly edged upward to 35 percent from 34 percent in 1998/99.

75. As oil export revenues dropped in 1998/99, the ratio of external debt to exports deteriorated significantly but strengthened again by end- 1999/2000 to 52 percent from an average of 85 percent in the previous three years, because of both debt repayment and export receipts. The debt-to-GDP ratio improved for last year to 10.4 percent in particular, and average interest rate on medium- and long-term debt remains below LIBOR. Average debt maturity remains relatively low, however, not only because the share of short-term debt in the total is slightly above one third, but also because oil pre-finance and rescheduled debt, which capture another 29 percent of total debt, have relatively short average maturities, of two and three years, respectively, with more than two-thirds of the total amount due in 2000/01. Average maturity as of end 1999/00 for the stock of long-term debt was 6.8 years, while that of bilateral debt was 3.5 years.

D. Exchange Rate Developments

76. After the introduction of the TSE rate in July 1997 and until March 2000, three officially recognized exchange rates have coexisted in Iran: the official floating rate of Rls 1,750 per U.S. dollar, which applies to oil and gas export receipts, imports of essential goods and services, and repayment of external debt; the “export” rate, fixed at Rls 3,000 per U.S. dollar since May 1995, which applied to all other current account transactions prior to July 1997 but in the latter part of 1999/2000 mostly applied to capital goods imports of public enterprises; and the variable TSE rate arising from the trading of import certificates on the TSE market which stood at Rls 8,180 per U.S. dollar in May 2000. In addition, an active curb market was reflected in a parallel exchange rate with a significant mark-up above the TSE rate until mid-1999.

77. While the floating and export rates remained fixed, the TSE rate depreciated by 42 percent in 1998/99 and by another 20 percent in 1999/2000, with significant step-adjustments in the third week of September 1998, the first two weeks of March 1999 (an initial, partial attempt to start clearing the market), and the third week of May 1999 (Chart 10 and Appendix II, Table 59). BMI, the main supplier of foreign exchange on the TSE market,17 has been able to closely control demand in that market through trade policy. Only importers holding a valid license were allowed to purchase foreign exchange on the TSE market and the government could curb such demand by restricting import licensing. However such an instrument could only work with a lag. Indeed, large shortages in foreign exchange arose in late 1998 and the first few months of 1999, due to a run-down in international reserves (reflecting low oil prices) and an unwillingness to allow the TSE rate to adjust. This prevented the TSE market from clearing and led to the formation of a significant queue for foreign exchange.

Chart 10.
Chart 10.

Islamic Republic of Iran: TSE and Parallel Market Exchange Rates March 1998-April 2000

(Iranian Rials per US $)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

78. To resolve this queue, the authorities increased their foreign exchange sales and allowed a significant depreciation of the TSE rate in May 1999, acting to clear this market on a daily basis thereafter. This policy seems to have succeeded as the TSE market has stabilized and the parallel rate appreciated during the second half of 1999, implying greater market confidence. By the end of 1999/2000, the parallel market premium had fallen below 2 percent; its subsequent rise in the first quarter of 2000/01 is mainly attributed to political uncertainty surrounding the recent parliamentary elections. Currently, BMI sets the trend for the TSE rate (broadly based on inflation differentials, but with willingness to take into account shifts in foreign exchange demand and supply resulting from factors such as terms of trade shocks) on an annual basis but with quarterly revisions, and undertakes frequent interventions to smooth short-term fluctuations of the exchange rate around that trend.

79. In mid-March 2000, the government officially eliminated the export rate, moving all transactions undertaken at that rate to the TSE market.18 At the same time, as a step toward further liberalization and integration of foreign exchange markets, banks were allowed to begin purchasing foreign exchange from any source other than exporters at freely negotiated rates, to trade it among themselves and to sell it to customers for the same purposes as for purchases from the TSE, plus a few specific additional purposes.19

80. During 1999/2000, the Iranian rial depreciated by about 16 percent in real effective terms in the TSE markets, compared to a 2 percent appreciation in 1998/99 (Chart 11). However, only about 37 percent of current account transactions were undertaken at that rate (or at the slightly more depreciated parallel market rate, but to a very small extent), with other transactions taking place at the export and official rates. Consequently, based on the average weighted exchange rate, the real effective depreciation of the Iranian rial was below 1 percent in 1999/2000.

Chart 11.
Chart 11.

Islamic Republic of Iran: Real Effective Exchange Rates, 1992/93-1999/2000

(1992/93-100)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

2/ Most depreciated rate used until introduction of the TSE rate since 1997/98

E. The Exchange and Trade Systems

81. Iran’s exchange and trade system remains closely controlled and relatively complex, despite the gradual liberalization policies introduced since 1998/99. As previously stated, from July 1997 to March 2000, three officially recognized exchange rates co-existed, and each rate applied to a specific set of transactions. In addition, import and export transactions are subject to a complicated system of regulations. Iran is a member of the Asian Clearing Union (see Box 1 for details).

Sources and uses of foreign exchange

82. On the export side, oil revenues (which accrue to the government and are surrendered to BMI) are allocated at different exchange rates for different uses. The share earmarked for debt repayments, additions to foreign exchange reserves, and imports of basic commodities is recorded at the official floating rate. Until recently, another share was sold at the export rate, mainly to public enterprises for capital goods imports or to finance specific service payments. Current account transactions undertaken at the export rate were gradually shifted to the TSE rate; the process was completed with the elimination of the export rate by law20 in March 2000 (with explicit subsidies being granted by the government in the current transitional period). A third share of oil revenues is sold on the TSE to meet foreign exchange demand in that market. BMI also sells foreign exchange directly to large importers at the TSE rate, rather than have these large importers potentially destabilize the relatively thin TSE market.

Islamic Republic of Iran: The Asian Clearing Union

  • Iran is one of the founder member countries of the Asian Clearing Union (ACU), established in December 1974 to provide a mechanism for the settlement of transactions among countries in the Asia-Pacific region. Members are Bangladesh, Burma, India, Nepal, Pakistan, Sri Lanka, and Bhutan (which joined only recently).

  • The ACU’s main stated objectives are to economize on the use of hard currencies and to promote trade and banking systems cooperation among member countries. Trade-related transactions between member countries are recorded in separate accounts for each member country and the balance of the accounts is settled once every two months, on the even month of the calendar year. The unit of account used within the ACU is the Asian Monetary Unit (AMU), which was equivalent to SDR1 originally; however, since 1996, the US dollar is used to convert the balances at the rate of AMU1 = US$1. The clearing system within the ACU has been functioning successfully since inception, as no default or delays in payment was ever recorded. The volume of trade taking place within the ACU rose from US$50 million in 1975 to US$5.2 billion in 1999 (about 5 percent of trade undertaken by all member countries put together). All goods and services are tradable within the ACU.

  • Since inception and until 1983, Iran was traditionally a net debtor in the ACU, importing from other member countries more than it exported. However, starting 1983, when crude oil and oil products were allowed to be traded within the ACU, Iran became a net creditor and remains so until today.

  • Iran undertakes about 3 percent of its total trade within the ACU. Bangladesh, India, Pakistan, and Sri Lanka, are the most important importers of Iranian oil and oil products. Other exports from Iran to these countries include handicrafts and machinery equipment, purchased mainly by the first three countries listed. Iran’s imports from ACU member countries include machinery, spare parts, and spices from India, jute from Bangladesh, and rice and cotton from Pakistan. Iran’s trade with the remaining member countries is negligible: it imported rice from Burma once and imports from time to time rubber from Nepal.

  • Iranian trade within the ACU is subject to the same regulations as trade undertaken with non-ACU members.

83. While government oil export revenues are the largest source of hard currency in Iran, non-oil export proceeds provide additional foreign exchange inflows. Apart from the retention “bonus” for early repatriation (see below), these proceeds are subject to 100 percent repatriation and surrender requirements. These requirements were recently modified (see below). Until end 1999/2000, upon surrendering non-oil export revenues to banks (which in their turn transferred the foreign exchange to BMI), exporters obtained the equivalent in Iranian rials (valued at the export rate) and an “import certificate” equivalent to 100 percent of the surrendered amount. This certificate granted its owner the right to purchase back the foreign exchange at the same rate of Rls 3,000 per U.S. dollar. Exporters had the choice to either use this certificate to repurchase the foreign exchange themselves for import purposes, or to sell the certificate on the TSE to other importers with valid import licenses. The price, at which these certificates were traded on the TSE market added to the Rls 3,000 per U.S. dollar applicable for the repurchase of foreign exchange gave rise to the effective TSE exchange rate.

84. With the elimination of the export rate in March 2000, non-oil exporters still have to repatriate their foreign exchange revenues but upon depositing them with commercial banks they are issued foreign exchange certificates of deposits (FX CDs) which can be sold on the TSE market for the same purposes as the import certificates, directly at the effective TSE exchange rate. This policy change is one step closer to making the TSE market an actual foreign exchange market and eliminates the requirement to surrender foreign exchange to BMI.21

85. An alternative officially recognized source of foreign exchange resides in the so-called “externally sourced” funds. Iranians are allowed to bring into the country foreign exchange earned and held abroad, and can deposit them in foreign currency accounts with local banks, to be used for almost any purpose.22 These accounts are registered as “externally sourced” and earn a rate of interest of one percent above LIBOR. Interest payments and withdrawals are all in foreign currency, and these monies can be retransferred abroad without restrictions. They can also be sold domestically at a freely negotiated rate, usually quite close to the parallel market rate, but may loose certification as “externally sourced” after the first such transfer, especially if this domestic transfer is not done through the banks’ clearing system (for example, if done in cash). In that case, they become “domestic sourced” and cannot legitimately be used for external transactions. However, by allowing banks to purchase foreign exchange from any source at freely negotiated rates as of the beginning of 2000/01, the government began abolishing the difference between externally sourced and domestie-sourced foreign exchange, which will help to form a deeper and more unified foreign exchange market in the future.

Import regulations

86. Goods are classified as “authorized” “conditional” or “prohibited” imports. Authorized goods do not require a special license for importation, such as imports by government corporations or companies whose expenses are provided for by the budget, or imports of goods not involving the transfer of foreign currency. Conditional goods require licensing by the relevant ministry for importation, subject to a registration fee.23 Imports permitted at the TSE rate and the recently eliminated export rate are listed in Appendix II, Table 60. Imports at the official floating rate that government corporations are allowed to make are listed in Appendix II, Table 61.24 The category 30 of the list of imports at the TSE rate (Table 60) was added in 1999/2000 while categories 31-41 (covering over 70 different goods) were only introduced in the beginning of the current year.

87. Import licenses are granted by the respective ministries mainly depending on whether or not the good is produced domestically and in sufficient quantities.25 As of 2000/01, a major reduction in the number of goods subject to this licensing requirement took place, mainly affecting items under the jurisdiction of the Ministry of Industry.26 After a license is granted, the importer has to register with the Ministry of Commerce (for information purposes only) before opening a letter of credit with a commercial bank. Letters of credit can only be opened after advance deposits are made. These deposits are unremunerated but refundable. Non-budgetary imports at the floating rate and imports at the TSE rate for which importers acquire foreign exchange directly from BMI are subject to advance deposits requirements of 20 percent, 25 percent, 40 percent, 60 percent, or 75 percent. In these cases, importers have to apply to BMI for obtaining the foreign exchange prior to opening a letter of credit. Imports at the TSE rate are subject to 100 percent advance deposits (importers had to buy import certificates27 on the TSE market before going to commercial banks to obtain a letter of credit).28 When imports are cleared at customs, the importer pays relevant duties and tariffs; for this purpose, all imports are valued at the official floating rate (even if they were originally financed at the TSE rate).

Export regulations

88. Effective 1997/98, the list of permissible exports was expanded and then replaced by a negative list, before being completely eliminated. A license was until quite recently still required for export purposes however. In 1999/2000 this licensing requirement was partly eliminated and new trading regulations issued for the year 2000/01 abolished all remaining licensing obligations except for the case of genetically protected products, antiques and historical assets, and subsidized commodities. In addition, the previous rule prohibiting exports on the basis of a “domestic need” was also removed.

89. Non-oil exporters have to repatriate all their receipts within eight months from the export date29 and, until recently, had to surrender them at the export rate to BMI through commercial banks. As mentioned earlier, the requirement to surrender foreign exchange to BMI was formally eliminated with the introduction of FX CDs in March 2000 and exporters currently receive an FX CD from banks which they either use for licensed imports themselves or sell on the TSE market. Revenues from exports to CIS countries however can be used for imports immediately without prior repatriation and surrendering. A “bonus” of one percent per month applies for earnings repatriated before the eight-month deadline expires.30 This bonus was raised in early 1999 to 1.5 percent for exporters using letters of credit (about 30-40 percent of non-oil exports). Before January 1998, it was given as a sum in Iranian rials in exchange for the surrendered foreign currency; since then, it is granted in the form of a foreign exchange retention allowance on non-oil export revenue.31

90. As explained in the preceding section, until March 2000, exporters obtained an import certificate when they surrendered their foreign exchange earnings. This certificate was valid for three months. Exporters had the first month to decide if they wanted to sell the certificate or use it themselves to repurchase the foreign exchange for import purposes.32 Exporters could then use the next two months to sell the certificate on the TSE, but had only one more month to use it for their own imports. Similar deadlines apply to the newly introduced FX CDs. Owners of FX CDs must use them within three months for import purposes; past this deadline, they can sell them to banks within an additional three months period, and banks can in their turn sell these FX CDs on the TSE within one month.

Services regulations

91. Individuals receiving medical treatment abroad may obtain foreign exchange at the official floating rate up to an amount specified by the Ministry of Health. Foreign exchange allowances are also provided on a monthly basis at the official floating rate for students on scholarships abroad following approval by the Ministry of Education.

92. Foreign exchange required for other service payments has to be acquired either at the TSE rate or (without specific limits) at the parallel rate from externally sourced accounts.33 For service payments, residents have to obtain a permit from BMI that enables them to buy foreign exchange from commercial banks at the closing TSE rate of the previous day. No registration fee applies for these payments. Such permits are granted with limits. Nonscholarship students abroad are allowed to purchase foreign exchange for tuition and board within limits specified by the Ministry of Education, depending on their location. Travelers are allowed specific amounts depending on the nature of their trip: US$500 per trip for business travel upon the approval of the Ministry of Commerce, US$500 per individual per year for travel under “group passports,” US$1,000 per individual per year for other travelers. For travel to neighboring countries and South East Asia, the allowance is lower, at US$300 and US$500 respectively. A fee of Rls 70,000 for the first trip and Rls 120,000 for consecutive trips, payable to the treasury any time before departure, applies to Iranian nationals leaving the country. Airline tickets can be paid in Iranian rials for the first two segments of a trip, with airlines using a TSE-based rate, but additional legs of a trip are payable in foreign currency. Foreign travelers can bring into the country an unlimited amount of foreign exchange; a declaration is needed only for amounts exceeding US$5,000.

93. Should travelers, medical patients abroad, or students need foreign currency in addition to the limited amounts specified above, they can acquire it legitimately from other sources, in particular from externally sourced accounts. This is very common and seems to work without causing significant delays. Other types of service payments can also be financed using these accounts. Foreign nationals working in the public sector can remit up to 50 percent of their net salaries per month with prior approval by BMI, up to an annual limit of US$500. Previously, this was done at the export rate; with the elimination of this rate, this transaction is undertaken at the TSE rate. Workers in the private sector could only remit their salaries through external sourced accounts. The authorities are considering a policy change whereby all foreign workers would be allowed to remit 100 percent of their salaries (as confirmed by the employer) at the TSE rate.

Other external sector developments

94. There have been no recent changes in regulations regarding foreign investment. A project to reform the FDI law is still ongoing, and more than one version of a new law are under consideration. In the meantime, the 1955 Law on the Attraction and Protection of Foreign Investment still applies, whereby such investments (both portfolio and direct) are allowed up to a 49 percent equity share in any company and the repatriation of profits and dividends overseas at the TSE rates. Nonresidents may invest in all instruments traded on the TSE.

APPENDIX I Islamic Republic of Iran: Selected Issues

A. The Third Five Year Development Plan1

Overview

1. The Third Five Year Development Plan (TFYDP) covering the period 2000/01-2004/05, this plan succeeds the Second Five Year Development Plan (SFYDP) which expired in 1999/2000. With unemployment rate already high at an officially estimated 13 percent,2 the rapidly rising demand for jobs poses the single most challenging policy (economic and social) task that faces the authorities. The TFYDP and the SFYDP share many of the basic macro objectives (Table 1); and a relatively significant number of the structural measures that were envisaged, but not implemented, under the SFYDP were carried over to the TFYDP. The SFYDP has targeted a fairly ambitious growth target with a single digit inflation by the end of the SFYDP period. The SFYDP also envisaged, inter alia, reducing the country’s reliance on oil revenue, encouraging non-oil exports, liberalizing the trade and foreign exchange regimes (including exchange rate unification), reforming the taxation and expenditure structures, public enterprise reforms (including a fairly ambitious privatization program), opening up the financial system to the private sector, introduction of liquid instruments, and more market based central banking operations.

2. The outcome of the SFYDP, however, was modest. Growth fell well below the target, unemployment rose–inflation rate soared to more than double the targeted level - and many of the structural measures were not implemented, implemented partially, or reversed after implementation. At the onset of the SFYDP, the macroeconomic environment deteriorated markedly as a result of unsterilized large liquidity buildup at the end of 1994/95, that caused sharp depreciation in the recently liberalized exchange rate,3 and the weakening of oil prices. The declining availability of financial resources and the authorities attempt to stabilize the economy (including through policy reversal to direct controls), pushed back many of the important reforms that were needed to boost economic growth.

Table 1:

Islamic Republic of Iran-Selected Determinants of Growth

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3. Despite the similarity between the SFYDP and the TFYDP, there are important differences that give more credibility to the current reform efforts. First, the TFYDP has conceptually moved, to a certain degree, from the mere “planning modes” of the previous two plans where objectives were generally not tied to measures, to a more specific reform plan where objectives were addressed within specific policy actions with clearer understanding of the implications of these actions. Second, the TFYDP starts with important reform measures either being undertaken (e.g., exchange rate reform) or approved (e.g., allowing private banking). Third, the macroeconomic environment is relatively stable owing to the proactive policy actions that were taken during the 1999/2000. Finally, oil prices have recovered strongly and are projected to remain reasonably strong in the near future. This combination of factors provides a unique window of opportunity to implement a wide ranging reform program.

4. The macroeconomic framework of the Plan targets real GDP growth averaging 6 percent as a means for increasing employment by 760,000 jobs on average per year, and reducing unemployment to 11.5 percent by 2004/05 from 15 percent presently. For this purpose, gross investment is envisaged to grow by an annual average rate of 7.1 percent, with emphasis on private investment, while the budget would remain in approximate balance. There would have been only a limited adjustment of domestic petroleum product prices toward world market levels. The draft envisaged an accommodating monetary program with an inflation rate declining gradually to 14 percent at the end of the five-year period, resulting in an average rate of 16 percent for the Plan period; the authorities viewed such an inflation rate as consistent with the targeted growth rate which is considered as necessary to meet their employment target.

5. The TFYDP, however, has its limitations. Most importantly, the TFYDP envisages only modest increases in domestic oil prices (see below) which would keep these prices at well below international prices and at a huge cost to the budget. On balance, the TFYDP is expected to achieve better growth performance than observed under the SFYDP, but it is unlikely to reach the envisaged high growth rates without mobilizing additional financial resources. The following are some of the more important reform measures that are envisaged under the TFYDP:

Price reform

6. The TFYDP limits the price increases of goods and services produced by state enterprises (SE) and government agencies to a maximum of 10 percent unless specifically approved by parliament. In cases where the government forces lower prices, the affected SE and agency will be compensated directly from the budget. This cap on price increases also covers domestic energy prices. The TFYDP instructs the government to implement a foreign exchange policy that protects the value of the national currency.

State enterprise reform

7. The TFYDP seems to adopt a three-pronged strategy to reform the SE sector: it calls for improving SE operations, opening up the SE to private sector competition and limiting their monopoly powers, and envisages an ambitious privatization program.

8. To improve the SE operations, the TFYDP calls, inter alia, for limiting the authority to create new SE to the parliament, requiring Cabinet of Ministers (CoM) authorization for nonfinancial SE investment in other SE, closing all SE branches and offices abroad (except those established for noneconomic reasons). To increase the SE exposure to private sector competition, the TFYDP stipulates measures to reduce government monopolies of certain economic activities and opening them to the private sector, authorizes the government to take (within one year of the TFYDP approval) legal actions to eliminate monopolies and monopolistic behavior, and requires the government to not discriminate when seeking goods and services against nongovernment entities.

9. The TFYDP does not consider privatization as a goal by itself, rather as a vehicle serving to achieve other reform objectives. Wide authority is accorded to the government to sell all SEs whose activities in the public sector are not needed, excluding those whose government ownership is mandated by the constitution, or because of national security, or if privatization creates monopolies. The TFYDP establishes a High Privatization Board (HPB) to be responsible for all privatization aspects including, inter alia, the selection of companies, method of privatization, and marketing. Privatization could follow: (i) direct sale to individual investors for small SEs, (ii) direct sale to groups, cooperatives and corporations for medium size SEs, and (iii) share offering for large SE. The TFYDP also permits the transfer of SE management to the private sector. The TFYDP stipulates allocating 50 percent of the privatization proceeds to reforming the SE that are about to be privatized, including debt reduction. The remaining 50 percent will be transferred to the budget.

10. The private sector will be allowed to participate in activities relating to refining, distribution and transportation of oil products, provide mail and telecommunication services, and invest in utilities, air, rail, and maritime transportation. The TFYDP also envisages the sale of up to 49 percent of Iran’s various government-owned transportation companies (including the national airlines and shipping companies, and the national oil tanker company).

Fiscal policy reforms

11. The TFYDP calls for the elimination (starting 2000/01) of all tax and custom exemptions for government and nongovernment entities with the exception of international organizations, cultural sector, and paper imports, and to centralize all tax related issues in a new government body: the “Civil Organization for taxing Affairs.” The budgetary structures of the provinces would be strengthened with emphasis on development expenditures and increased fiscal autonomy.

12. To stabilize the foreign exchange and domestic currency budgetary revenues, the TFYDP calls for the establishment, effective 2001/02, of “Foreign Exchange Reserve Acquired from the Revenue of Crude Oil Account” and the “Rial Reserve Account”—an Oil Stabilization Fund. All oil revenue in excess of the oil revenue benchmark projected under the plan will be transferred to these funds. The budget will be allowed to draw from the account (on six months interval basis) only when oil revenue fall below the benchmark for the year and if there is no possibility to raise funds through taxation or other sources. On the other hand, if the budget is assured that its revenue for the year will be higher than the benchmark, portion of the foreign exchange could be sold (at the market rate) to support the economy’s import needs (the rial counterparts will be kept in the rial reserve account).

Financial sector

13. The main emphasis of the TFYDP in the financial sector would be on reforming the banking system by allowing private banking and strengthening the financial position of the existing state-owned banks through recapitalization. The TFYDP authorizes the government to issue up to Rls 5 trillion of participation papers and use the proceeds to capitalize the banks. These papers will be serviced from the banks’ pre-tax profits. The BMI is also authorized to issue CPPs and to use them to regulate liquidity. Steps are envisaged to establish special exchanges for negotiable papers and commodities, strengthen the TSE, and establish regional stock markets.

External trade

14. In order to liberalize the external trade regime and promote non-oil exports, the TFYDP calls for the removal of all non-tariff barriers and convert them into tariffs. The TFYDP lifts all restrictions on the type of goods to be exported (except national treasures, genetically protected plants and animals, and subsidized goods), eliminates all taxes and fees on exports, and removes all permit and licensing requirements for exports. Furthermore, the TFYDP extends to the exports of services, and all promotions and preferences that exist for export goods will be extended to export services. Banks will also be encouraged to provide financing facilities for exports. Finally, a High Council of Non-Oil Export Development (chaired by the president or his first deputy) work be established to promote exports and remove regulatory hurdles.

External debt

15. The TFYDP has set limits on the country debt structure and total borrowing. The schedule of foreign debt repayments (including medium - short-term, but excluding reciprocal purchase) would be set so that total payments would not exceed 30 percent of the government’s foreign exchange revenue in the last year of the TFYDP (about US$3.6 billion based on the TFYDP oil revenue projection of US$12 billion in 2004/05). In addition, it is stipulated that the net present value of the country’s total foreign debt should not exceed US$25 billion.

Agriculture

16. The TFYDP envisages increased budgetary support for agricultural and water investment, including through funding nongovernment agricultural entities, calls for granting of tracts of land to individuals to establish agriculture business and provide employment opportunities. Banks will continue under the TFYDP to allocate at least 25 percent of their lending facilities to the agriculture sector.

Social safety system

17. Under the TFYDP, social safety would be addressed through improving the existing structure that is composed of insurance schemes, social security system, and basic goods subsidies. In addition, the TFYDP requires the government, inter alia, to reduce its debt obligations to insurance organizations by 50 percent and expand the insurance coverage for specified basic needs (e.g., medicine, critical care, invalids, etc.). The TFYDP specifies certain measures to strengthen the social secuiity system, including reorganization to eliminate overlapping responsibilities of different agencies, preventing the creation of new organizations, and reducing administrative burdens and operational costs. Finally, the TFYDP envisages a continuation of the policy of subsidizing basic goods (including, wheat, rice, vegetable oil, sugar, cheese, medicine, and dry milk) and basic agricultural inputs (fertilizers, pesticides, and seeds) as was the case under the SFYDP.

Employment

18. The Plan calls for reviewing the labor laws and regulations but does not seem to take a view on the final objective of the review. Tax and other incentives would be provided to companies employing new labor (through the Employment Services Center at the Ministry of Labor) and to companies investing in less developed areas of the country. In support, the banking system would provide low cost funding for poor entrepreneurs or the unemployed to establish their business operations. Moreover, free technical and professional schools will be established and small scale and labor-intensive industries would be encouraged.

The Islamic Republic of Iran: Objectives and Outcomes of the Development Plans

(Annual average percentage change)

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Source: Bank Markazi Johnhouri Islami Iran

B. Determinants of Economic Growth in the Islamic Republic of Iran—The Long View1

Introduction

1. Over the past decade, the Iranian economy has been characterized by wide fluctuations in economic growth around a trend of declining long-term growth rate. This pattern has been preceded by a period of rapid and sustained expansion in real GDP during 1964/65-1971/72; increased fluctuations during 1972/73-1977/78 associated with declining average growth rate; negative real growth during 1978/79-1988/89 which was characterized by the Iran-Iraq war, sanctions, and restrictive domestic policies; and a brief economic recovery during the two post-war years (1990/91-1991/92) following policy liberalization. During the period since 1991/92, economic growth has slowed down to around an average of about 3-4 percent.

2. It has been difficult to clearly define the determinants of growth in Iran owing, in part, to data difficulties, the frequent external shocks including global oil price fluctuations, sanctions, and economic dislocations, Iran-Iraq war, and important socio-political, legal, and institutional changes. This note aims to estimate the evolution of the “potential” growth rate and to examine the maj or determinants of growth in Iran during the past four decades. Staff estimates show that actual output had significantly lagged potential output during the 1980s, but converged to potential output in the 1990s, during which the latter declined. The rate of investment, the size of the government, and macroeconomic instability have been found to be the major determinants of economic growth.

Estimation of potential output and growth

3. The potential output is estimated by specifying a Cobb-Douglas production function in logarithms form, where output at time t, yt depends on the level of technology (level of total factor productivity), at, the stock of physical capital, kt and the labor force, lt:

yt=at+aktβlt(1)

The potential output can be derived as:

y^t=al^t+(1a)k^t+a^t(2)

where y˄ is potential output, I˄ the labor input trend, k˄ the capital input trend and a˄ the trend in total factor productivity, The actual level of the capital stock generally replaces its trend. The trends in employment and total factor productivity are derived using Hodrick-Prescott (HP) filters.

The growth rate of potential output is presented in equation (3):

y^˙=al^˙t+(1a)k^˙t+a^˙t(3)2

Estimates of α and β have been derived for the Iranian economy by Sarel (1997), where a value of 0.3 was derived for a and 0.7 for β.

4. The annual average potential output growth is estimated to have fallen from 8 percent over the period 1961/62-1978/79, to about 0.4 percent in the course of the period 1979/80-1987/88, with a recovery in the potential growth rate to 4 percent during 1989/90-1997/98. Declining total factor productivity has been the major force behind the fall in potential output growth.

Macroeconomic determinants of growth

5. The wide fluctuations in economic growth and the long-term trend toward a slower growth path in terms of the macroeconomic determinants and exogenous shocks are described by adopting the Goldsbrough, et al, and study (1996). These determinants include investment/GDP ratio, government consumption GDP ratio, macroeconomic instability index, measures of the degree of openness, and changes in the terms of trade. It is postulated that an increase in investment/GDP ratio would facilitate growth and output per worker, while an increase in consumption/GDP ratio would have an adverse effect. Similarly, greater trade openness would imply increased competitiveness of the economy and, thus, benefit growth. Macroeconomic stability index which measures the relative inflationary pressures is a useful proxy for the official macroeconomic policy stance, an increase in the instability index would have a negative effect on growth.3 Finally, an improvement in terms of trade would typically be associated with higher oil export receipts, and thus capacity to increase investment, with a resultant positive impact on growth.4

6. The following growth equation is used to determine the relative importance of the variables mentioned-above on growth in Iran

yy=β0+β1*INVGDP(+)+β2*GCGDP()++β3inf ()i+β4*XGDP(+)+β5*MGDP(+)+β6ΔpxPm()+β7()Dw+β8(+)Dfdp(4)

where GDP is Gross Domestic Product at current market price; INV/GDP captures investment as a ratio to GDP; GC/GDP, is a government consumption as a ratio to GDP; infi, is an index of macroeconomic instability, Dw is the dummy for the war period (1979-88) X/GDP indicates exports as a ratio to GDP; M/GDP, imports of goods as a ratio to GDP ΔPx/Pm, change in terms of trade and Dfdp captures the dummy for the First Development Plan (1989/90-1993/1994).

Growth rate is estimated to be determined mainly by:

y˙y=17.04(2.7)0.23* inf (1.78)i1.18* GCGDP(2.55)+0.84*INVGDP(2.72)5.87* Dw(2.06)(5)
R2=0.43DW=2.0

7. The index of macroeconomic stability (infi) is found to have a negative impact on the economic growth, a 10 percent increase in the index of macroeconomic instability generates 2.3 percent decrease in output growth rate. Also, the size of the government as proxied by the ratio of government consumption expenditure to GDP is negatively related to the growth rate of per capita income, a 1 percent increase in government consumption expenditure as a ratio of GDP generates approximately 1 percent decrease in per capita output growth rate. On the other hand, the ratio of investment to GDP has positive and significant effect on the rate of economic growth; a 1.percent increase in the investment GDP ratio generates 0.84 percent increase in the per capita growth rate. A dummy variable was introduced to capture the war events of 1980-1988. The rate of growth during that period was significantly below the average for the entire period.

8. Charts 1 and 2, and Table 1 summarize the evolution of these determinants and the annual growth rate of real GDP. It is important to note that the rapid sustained growth during 1964/65-1972/73 was associated with a high degree of macroeconomic stability, a steady investment/GDP ratio of around 10 percent and total factor productivity grew at about 5 percent per year. The 1973/74-1978/79 period was characterized by very wide fluctuations in the macroeconomic instability index and in total factor productivity, which despite a sharp increase in the investment/GDP ratio were associated with fluctuations in the real GDP growth rate, averaging below that in the previous period. The Iran-Iraq war period was impacted by extensive economic dislocation, fall in the investment/GDP ratio, and negative growth in total factor productivity, which led to the negative growth of GDP. The short temporary economic recovery following the end of the Iran-Iraq war was associated with a pick-up in investment and increase in total factor productivity. The current growth experience has been significantly affected by the wide fluctuations in the macroeconomic instability. index, lack of growth in total factor productivity, and the fall in import/GDP ratio which has created supply bottlenecks.

Chart 1:
Chart 1:

Islamic Republic of Iran -Selected Determinants of Growth, 1964/65 - 1997/98

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Source: World Bank database on economic growtfi, IFS, and staff estimates
Chart 2:
Chart 2:

Islamic Republic of Iran -Selected Determinants of Growth, 1964/65 -1997/98

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Source: World Bank database on economic growth, IPS, and staff estimates

C. Macroeconomic Determinants of Inflation in Iran1

1. This note attempts to explore the inter-linkages of key macroeconomic variables in Iran during 1989/90-1998/99 so as to assess their impact on inflation, Specifically, equilibrium relationships pertaining to the markets for money, foreign exchange, and goods are established. By developing statistically stable error-correction model (ECM) for money, foreign exchange, and goods markets, along with their dynamic specifications, the study establishes the major determinants of inflation.

2. Based on behaviors of the long-run model for all three markets, ECMs are incorporated in the formulation of the dynamic model. Results strongly support the argument that inflation is a monetary phenomenon in Iran. The combined effect of excess money supply and contemporaneous monetary growth are key determinants of inflation dynamics, A higher price level, in turn, intensifies asset substitution from money to foreign exchange, thereby exerting significant pressures on the market exchange rate. Overall, there is a need for a prudent monetary policy stance on a sustained basis in order to rapidly reduce inflation and stabilize the foreign exchange market so as to support the needed structural reforms and economic liberalization over the medium term.

3. General form of dynamic equations is estimated for inflation. The disequilibria2 (ECMs) in markets for goods, money, and foreign exchange are represented by ECMoutput, ECMmoney, and ECMexchage. Excess money supply (ECMmoney) was found to have significant adverse impact on the short-term dynamics of inflation. The output gap (ECMoutput), however, was estimated to have no impact on the rate of inflation.

4. A dynamic specification of inflation can be written in terms of the excess money supply (ECMmoney), monetary growth (dm), changes in the difference between the parallel market rate and weighted average official exchange rates (dprem), and expected rate of inflation (dp(-t), that is the first difference of the lagged price variables. Specifically, given the trade regime, the difference between the parallel market rate and weighted average official rates is used as a measure of the degree of exchange restriction in Iran. The greater the restrictions, the higher the foreign exchange subsidies through allocation, and therefore, the lower the weighted-average exchange rate. The inclusion of dprem is necessary to measure the impact of exchange. liberalization on inflation. A liberalization of the exchange regime in Iran will be reflected in a reduction in the allocation of foreign exchange at subsidies rates (thus an effective depreciation of the weighted average exchange rate) and an improved market condition for the foreign exchange trading in the Tehran Stock Exchange. This will result a narrowing of the exchange rate premium (or a decline in prem).

The dynamic equation for inflation (after removing insignificant arguments) stimulated as:

dp=0.02(5.04)+0.67*ECMmoney(1)(4.83)+1.66* dm(3.47)+0.38* dp(4)(3.50)(1)
R2=0.8,σ=0.03,DW=2.0

5. As expected, excess money supply has a significant impact on inflation. The “speed of adjustment” is relatively fast: a 10 percent excess money supply is likely to push up the rate of inflation by 7 percent in about three months. The elasticity of 1.7 percent with respect to the contemporaneous monetary growth is high, reflecting a compounding effect of a monetary expansion and the contributing effect on monetary overhang. Inflation expectation, expressed by the lagged variables of the rate of inflation, was found to have a significant self fulfilling effect on the inflation dynamics—a 10 percent expected rate of inflation would push up the contemporaneous rate of inflation by 4 percent. The absence of a significant impact on inflation from the exchange market (both in terms of short-run variation and long-run disequilibrium) is not unusual as the causality test indicates that the parallel market exchange rate tends to reflect the movements in the rate of inflation, but not the other way around. Besides, the parallel market exchange rate also contains other random noises emanating from the political and social events, which may not be captured in the empirical analysis on inflation. Chart 1 shows the actual and fitted rate of inflation, while Chart 2 presents both the inflation rate and monetary growth.

Chart 1.
Chart 1.

Islamic Republic of lran : Actual (Projected) and Fitted Rate of lnflation

(1990/91-1999/2000)

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Chart 2.
Chart 2.

Islamic Republic of lran : Annual Inflation Rate and Growth of Money 1990/91-1999/00

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

D. Relationship between Inflation and Growth—Global Experience and an Application to Iran1

Introduction

1. Most economists now accept the hypothesis that no long-run trade-off exists between inflation and output. However, Fischer (1993), Lucas (1994), and Motley (1994) have found that inflation has a quantitatively significant and negative long-run effect on real GDP or real GDP growth. The question of whether a trade-off exists between output growth and inflation has been a controversial issue in economics. The issue is particularly salient in the case of Iran as it embarks on the Third Five Year Development Plan (TFYDP). This note argues that the idea of a sustained inflation-output tradeoff has been rejected both at theoretical and empirical levels. Iran has had higher than average inflation as compared to other countries and a negative relationship between the two variables is present in Iran. In particular the note looks at the experience of developing countries, transition economies, and the group of oil producing countries encompassing Iran.

Global experience

2. Several studies have analyzed the relationship between inflation and growth. Most of the earlier studies were based on the Summers and Heston 1991 data sets and concentrate on cross-sectional aspects of the data. Chart 1 shows the data for inflation and output for the world as a whole and for the subset of developing countries. There has been a steady decline in the world inflation in the last decade (1989-99) which has been associated with generally rising growth rates. In the case of the developing countries, we also see a general decline in inflation, but there does not seem to be a direct relationship between inflation and output. Consider that for the developing countries in 1989 the average inflation was 7.2 percent while growth was 4.0 percent, by the end of the decade inflation was 6.5 percent and average growth was 3.8 percent.

Chart 1.
Chart 1.

Islamic Republic of Iran: Output Growth and Inflation for Worid and Developing Countries

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

3. In general, the literature has found that there is either no relationship or, if any, a negative relationship between growth and inflation. Levine and Renelt (1992) find that those countries that grew faster than the mean have average inflation rate of 12 percent per year over the period, while those countries that grew more slowly had an average inflation rate of 31 percent. Many authors have found a non-linear relationship between inflation and output. The non-linearities can occur in two different senses. First, although a reduction in inflation is associated with higher growth, the magnitude is affected by the level of inflation. Second some studies have found that for very low inflation, an increase in inflation may actually have a positive effect on growth, A study by Fischer (1991) which divides the countries into different groups by inflation categories, finds that a 10 percentage point increase in the inflation rate is associated with a 1.3 percentage point decrease in growth rate in those countries in the low inflation range, 0.75 percentage point decrease for the middle range countries, and a 0.2 percentage point decrease in those countries with high inflation. Roubini and Sala-i-Martin (1992) find that a 10 percentage point increase in the inflation rate is associated with a decrease in the growth rate of between 0.5 and 0.7 percentage points. Barro (1995), attempts to control for institutional factors, but still finds a negative effect of inflation that he estimates to be between 0.2 and 0.3 percentage points for every 10 percentage points increase in inflation.2

Regional experience
A. Transition economies

4. With a few exceptions, all transition economies experienced an initial spike in inflation as a result of reduction in price controls. In response to high inflation, the authorities implemented extensive disinflation programs. The speed and the success of the disinflations were markedly different across the group. The periods of disinflation were accompanied by sharp drops in output but as inflation stabilized growth resumed. The inflation and growth experience of the transition economies can be observed in Chart 2, which exhibits a negative relationship between output and inflation.

Chart 2:
Chart 2:

Output Growth and Inflation in Transition Economies, 1989—1999

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

5. A few studies have attempted to conduct formal tests of relationship between inflation and growth in transition economies. Lougani and Sheets (1997) find that, controlling for progress with transition reform in addition to other variables, output growth is negatively related to inflation. Other studies have also looked at whether there might be non-linearities in the relationship between inflation and output. Christofferson and Doyle (1998), using a panel of 22 of the 25 transition economies, find an inflation threshold of about 13 percent. Inflation above that level reduces output growth, while no significant effect is visible for inflation below 13 percent. This break point is somewhat higher than is generally accepted for market economies suggesting that this threshold may fall for the transition economies as they become more market based.

B. Regional oil producers

6. Results are broadly similar for the regional oil producing countries. We choose to look at the regional oil producers in order to isolate any difference that may arise due to the high dependence of Iran on oil exports and to capture any regional differences that may exist. The regional oil producers data is an average of the data from GCC countries, Libya and Algeria. Excluding the impact of the Gulf war, there does not seem to be a clear cut relationship between inflation and output, although the certain years with low growth rates are marked by higher than average inflation.

Output and inflation experience of Iran

7. In order to exclude the impact of the major shocks experienced by Iran in the form of the Iranian revolution and the prolonged Iran-Iraq war, this note only considers data from the period 1989-99. In general, Iran has had higher than average inflation as compared to other groups of countries evaluated above. On the output side the experience is much more varied.

Panel 1 of Chart 4 above plots the average inflation of the world, developing countries and Iran. Early in the decade, Iran had below average inflation with the lowest inflation being 9 percent for 1990 while the average inflation for the world and developing countries was higher earlier in the decade. By the second half of the decade average inflation had fallen throughout the world. While Iran was able to reduce its inflation it still remains substantially above the world average. For 1998, the average inflation in developing countries was about 10 percent while inflation in Iran stood at 22 percent. On the growth side the trend is reversed; although earlier in the decade Iran experienced higher than average growth, by the end of the decade its growth rates had fallen below the average growth rates for the world and the group of developing countries. Chart 5 above attempts to capture the relationship between output and inflation in Iran. The periods of low inflation seem to be associated with higher growth and vice versa. The negatively sloped trend line indicates a negative relationship between output and inflation.

Chart 3:
Chart 3:

Inflation and Growth in Regional Oil Producers, 1989-1999

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Chart 4:
Chart 4:

Comparison of Iran with the World and Developing Countries, 1989-1999

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

Chart 5:
Chart 5:

Islamic Republic of Iran: Inflation and Output Growth in Iran, 1989-1999

Citation: IMF Staff Country Reports 2000, 120; 10.5089/9781451818925.002.A001

E. The Role of the Public Sector and Fiscal Policy 1

Introduction and background

1. This note discusses the role of the public sector, and objectives and instruments of fiscal policy in Iran, with particular focus on the past decade. Iran’s public sector is large and comprises the central government (including the provincial administrations), municipalities, and state-owned enterprises and banks. In addition quasi-fiscal activities, including those emanating from the maintenance of a multiple exchange rate regime, have generally played an important role in Iran, which makes it necessary to broaden the scope of fiscal analysis.2

2. The role of the public sector increased in the Iranian economy during the 1980s, following sweeping nationalizations in the first few years after the Islamic revolution of 1979 and reflecting in part the difficult economic conditions during the Iran-Iraq war. Since then, and notwithstanding an episode of economic liberalization during 1993/94 as well as some degree of relaxation in a few policy areas (e.g., price decontrol), the public sector has largely maintained its dominant role in the Iranian economy.

3. Fiscal and other policies have been strongly influenced by redistributive and social considerations. In this pursuit, taxation and expenditure policies have been combined with manifold and large quasi-fiscal activities through the exchange and trade systems, low domestic energy prices, directed lending at low interest rates, and other channels. These policies have given rise to price distortions and misallocation of resources.

4. More recently, economic policies have begun to emphase the need to liberalize the economy, increase efficiency, and establish a more market-oriented system. The macroeconomic situation has improved, helped in large part by the sharp rise in oil prices and revenues over the past year. During 1999/2000 and in the first few months of the current fiscal year (2000/01),3 the Iranian authorities have initiated a number of fiscal policy reforms, including streamlining the tax system, reducing explicit subsidies, and limiting quasi-fiscal activities.

The public sector and fiscal policy in Iran
The size of the government and the public sector

5. The constitution stipulates that Iran’s economic system is to consist of three sectors: public, cooperative, and private.4 The cooperative sector can be entirely or partly privately owned, and other articles of the constitution affirm the right of everyone to choose his or her own line of work, and affirm private property rights as long as they do not go beyond the bounds of Islamic law or harm society. The constitution also charges the government with the responsibility of providing every citizen with the opportunity to work, although the government itself must not become a major or dominant employer. It calls for planning of the national economy at each stage of its growth; and the provision of basic necessities to all citizens, whereby basic necessities are defined to include “accommodation, food, clothing, health care, medicine, education, and the necessary facilities for the establishment of a family.” Finally, it proclaims that everyone has the right to benefit from social security with respect to retirement, unemployment, old age, disability, destitution benefits, as well as health care, to be provided through insurance or other means.

6. Against this background, the Iranian public sector has become large, although it is difficult to determine its size, especially if the focus is only on conventionally measured indicators such as the ratio of government revenue and expenditure to GDP. The following indicators show that the size of the government is not particularly large, but the more widely defined public sector is very large and controls or dominates much of the Iranian economy:

  • Central government revenues and expenditures as a share of GDP averaged slightly more than 25 percent over the past four years and the 2000/01 budget. However, if revenues and expenditures of municipalities and state-owned enterprises (SOEs) are taken into account, staff estimates suggest that the public sector accounts for at least 60 percent of Iran’s GDP.5

  • Analogously, the share of central government workers in overall employment is relatively limited at approximately 13 percent of all employed persons (2.1 million out of a total of about 18 million employed persons). Although official data on the number of employees in state-owned enterprises (SOGs)for recent years are unavailable, one official estimate suggests that at least 4.8 million persons, equivalent to almost one third of total employment, are employed in the government and SOGs.6

  • On a more disaggregated basis, data suggest that the public sector is even more important than the above mentioned estimates would suggest. The most important sectors of the economy are entirely or largely owned or controlled by the government, including the production and distribution of oil and gas, heavy industries (e.g., steel), and important industrial and transport sectors (e.g., automobiles, shipping). For example, the National Iranian Oil Company’s (NIOC) export revenue from oil and gas exports accounts for approximately 80 percent of total exports proceeds.

  • In the services sectors, all banks are currently state-owned. SOGs control or dominate the import and domestic distribution of large quantities of major essential items (e.g., wheat, sugar).7

  • A number of public or quasi-public institutions, including the government-controlled Social Security Organization (SSO) which is primarily responsible for the administration of pensions and other social insurance activities, are important economic players (Box 1). The SSO owns about 70 enterprises in various sectors, has large financial reserves and real estate holdings, and is by far the largest non-bank institutional investor at the Teheran Stock Exchange (TSE).

The fiscal policy stance

7. Although Iran is characterized by a product budgetary strain, the conduct of fiscal policy has generally been complicated by the strong dependence on the highly volatile oil and gas revenue. Revenue directly accounts for approximately 50 percent of government revenues. In addition, a significant part of tax and nontax revenues is indirectly related to the exploitation and distribution of oil and gas. Faced with an adverse oil price shock, the government has typically tended to use capital spending as a first line of defense to absorb the shock—investment spending was cut when the oil price fell below expectations.8 By contrast, recurrent spending has remained relatively unaffected and has, in fact, tended to increase relative to GDP during the past decade. As recurrent spending was not adjusted and the scope for reducing capital spending was limited, budget deficits have tended to increase significantly when the oil price fell. Also, it is noteworthy that although budgetary performance improved when the oil price recovered, no surpluses have been achieved. To a large extent, budgetary deficits have been financed through borrowing from the central bank, which has contributed importantly to the high level of inflation and macroeconomic instability, thus significantly hampering real GDP growth.9

The tax system

8. Iran’s tax system places much emphasis on equity and income redistribution, but at the same time it is distortionary, revenue inelastic, and inefficient. It is characterized by a plethora of indirect taxes, a personal income tax with a high maximum marginal rate, numerous exemptions, and an outdated, and weak tax administration which often relies on bilateral negotiations with taxpayers. The collection of indirect tax revenue is costly for the tax authorities, while compliance costs for taxpayers are also high. The heavy reliance on oil revenue and non-tax revenues, has in the past resulted in the neglect of taxation as an instrument of revenue generation. Iran’s tax-to-GDP ratio has remained low, averaging less than 6 percent of GDP over the last five years. The tax structure is highly inelastic with respect to nominal income due to narrow tax bases, manifold tax loopholes, and lags in tax collection. However, the authorities envisage overhauling this system fundamentally over the next few years, with technical assistance from the Fund and the World Bank. They aim at introducing a simpler system of personal income taxation with a lower maximum rate, replacing the plethora of indirect taxes with the VAT, and reducing and simplifying import taxation in combination with eliminating quantitative import restrictions.

9. The corporate income tax has yielded little revenue (2½ percent of GDP), largely as a result of the low standard tax rate (10 percent) and a porous tax base. There are widespread exemptions of preferential tax rates for enterprises in a variety of sectors, including agriculture, publishing, tourism, and high-growth sectors such as mining. In addition, enterprise profits derived from exports as well as those of cooperatives and a number of large foundations (bonyads) remain essentially under taxed. Enterprises located in Iran’s free trade zones benefit from corporate income tax holidays of up to l5 years.

10. The relatively low level of the corporate profit tax is combined with a cumbersome and highly progressive personal income tax schedule with 9 brackets, a top marginal rate of 54 percent, and a relatively large deduction from the tax liability (equivalent to almost half of the average government wage in 1999/2000). Revenue from the personal income tax remains low (1½ percent of GDP) because of a combination of (i) high marginal rates which give rise to tax evasion; and (ii) salaries of certain professional groups (e.g., university professors) are taxed at a low standard rate (10 percent) or entirely exempted (e.g., defense and domestic security staff, dividends received by individuals from banks and government securities).

11. The revenue yield of indirect taxes has been small (on average about 2 percent of GDP over the past few years), with the bulk of the collections stemming from import taxes (1½ percent of GDP). There are many specific sales taxes, a smaller number of excise duties (including on petroleum products, cigarettes, vehicles, cement, steel, telephones and telecommunication services, and soft drinks).10 To provide protection, in some cases (e.g., automobiles, and cigarettes) imports have higher excise tax rates than domestically produced goods. Because of their specific character and infrequent adjustments, the revenue yield of many domestic sales taxes has declined relative to GDP.

12. The customs administration collects revenue from some 30 different import taxes, levies, and charges; many of these are specific in nature. Although some of the statutory rates are high (e.g., the maximum combined tariff and “commercial benefit tax” on certain manufactured items is currently 240 percent), effective import taxation is substantially lower because all imports are valued for customs purposes at the overvalued official exchange rate (currently Rls 1,750 per U.S. dollar as compared to the TSE rate of about Rls 8,200 to the U.S. dollar). In combination with the multiple exchange rate regime, this system provides ample opportunity for rent-seeking. Moreover, there are many customs exemptions (e.g., all govenrment imports), and according to official estimates and anecdotal evidence smuggling and tax evasion are substantial.11

Expenditure policies

Wage outlays and consumer subsidies

13. Government expenditures have generally been strongly influenced by oil price developments. As indicated above, capital expenditures have generally served as the major shock absorber in the case of a sharp drop in the oil price. On the other hand, current expenditures have expanded steadily over the past decade, from less than 13 percent of GDP at the beginning of the 1990s to more than 16 percent of GDP in recent years. Although disaggregated official data on current spending by economic classification are unavailable for more recent years, staff estimates suggest that this trend is essentially the result of relatively strong increases in the central government wage bill, on the one hand, and subsidies and transfers to households and state-owned enterprises on the other hand (Appendix II, Table 28).

14. Wages and salaries form the largest component in current expenditures. Following a significant increase in the wage bill relative to GDP in the first half of the 1990s, the government has sought to keep wage increases more in line with inflation.

15. Explicit subsidies to households and state-owned enterprises comprise the second-largest component of government current expenditures. The government provides explicit subsidies through the (CPPO), which sells a number of essential items (e.g.