Islamic Republic of Iran: Staff Report for the 2002 Article IV Consultation
Author: International Monetary Fund
Publication Date:
27 Sep 2002
eISBN:
9781451818932
Language:
English
Keywords:
ISCR; CR; authority; revenue performance; oil; leg mission; restriction; managed float; nominal exchange rate; inflation rate; Iranian rial; short-term debt; Exchange rate unification; Exchange rates
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This 2002 Article IV Consultation for the Islamic Republic of Iran states that the overall macroeconomic developments in 2001/02 were marked by sustained economic activity in the non-oil sector, improved fiscal and external positions, and declining inflation trends. Against a background of improved business confidence, the authorities continued to implement economic reforms in line with their Third Five-Year Development Plan. They also successfully issued a €625 million Eurobond, marking Iran’s return to international financial markets.

Abstract

This 2002 Article IV Consultation for the Islamic Republic of Iran states that the overall macroeconomic developments in 2001/02 were marked by sustained economic activity in the non-oil sector, improved fiscal and external positions, and declining inflation trends. Against a background of improved business confidence, the authorities continued to implement economic reforms in line with their Third Five-Year Development Plan. They also successfully issued a €625 million Eurobond, marking Iran’s return to international financial markets.

I. Background and Recent Developments

A. Background

1. Iran is a major world oil and gas producer and the second most populous country in the Middle Eastern region, after Egypt, with per capita GDP of about US$1,300 in 2001/02.1 While oil and gas dominate several aspects of the economy, the production base is relatively diversified with agriculture and manufacturing accounting for about 30 percent of GDP, and services, including government services, representing close to one-half of GDP2. Oil and gas represented about 15 percent of GDP, but accounted for 82 percent of export earnings in 2001/02. The role of the public sector in the economy is significant, both in terms of ownership and share in GDP (60-70 percent), but the private sector is dominant in agriculture, construction, and certain services.

2. The authorities’ reform strategy under the current Third Five-Year Development Plan (TFYDP) for 2000/01-2004/05, together with strong oil market conditions, has helped improve Iran’s recent economic performance. Over the past two years, growth picked up, inflation was on a declining trend, the external debt was reduced to a very low level, international reserves were increased, and fiscal savings were accumulated in an Oil Stabilization Fund (OSF). More recent reforms, including the exchange rate unification, the passage of the foreign investment law, and licensing of private banks have boosted business confidence and laid the ground for a further opening-up of the economy and better growth prospects. Against this background, the authorities successfully floated a Eurobond issue of €625 million in July 2002,3 marking Iran’s return to the international financial markets since the revolution in 1979.

3. Important structural impediments to growth remain, however, and financial stability is by no means assured. Structural rigidities in the price system, the financial sector, and the labor market, as well as the dominant role of the state in the economy and the lack of competition in many sectors continue to weigh heavily on productivity and competitiveness. Moreover, high unemployment (16 percent) continues to exacerbate political pressure to increase government expenditure in the face of strong oil revenues. If unchecked, growth in government spending could lead to higher inflation and real exchange rate appreciation with further harmful effects on competitiveness.

4. The political climate for economic reform has improved. The successful unification of the exchange rate and the floating of the Eurobond have provided policymakers with added confidence and reinforced their determination to pursue other ambitious objectives of the TFYDP. To this end, policy coordination has been strengthened and major strides are being made in enhancing transparency and dissemination of information to the public and to market participants.

5. The Iranian authorities continue to value the policy dialogue with the Fund and its technical assistance, while maintaining a high degree of ownership of their economic reforms. In recent years, they have shown responsiveness to past policy advice in many areas, including the exchange rate reform, the establishment of the OSF, the reform of the tax system, the opening-up of the economy through trade reform and the approval of the foreign investment law, and the licensing of private banks. Equally important are the bold steps taken recently, with Fund technical assistance, to enhance transparency and improve the quality and dissemination of data. In other areas, however, the policy response has been too cautious either because of lack of political consensus (government spending, energy prices and subsidies, and privatization) or because of lengthy approval process (financial sector reform).

B. Developments During 2001/02 and the First Quarter of 2002/03

6. Overall macroeconomic developments in 2001/02 and the first quarter of 2002/03 were marked by sustained economic activity in the non-oil sector, improved fiscal and external positions, and declining inflation trends (Table I). Real GDP growth in 2001/02 decelerated to 4.8 percent, reflecting a decline in oil output owing to a downward revision in OPEC production quotas (Table 1 and Figure 1). Non-oil activities, however, grew by 6 percent in real terms, slightly higher than during the previous year. Improved confidence, following progress in trade reform and the stability of the parallel exchange rate, contributed to strong domestic demand, which, in turn, was key to good broad-based growth performance of the non-oil sectors (Table II). Registered unemployment, however, remained high at 16 percent at end-2001/02, as employment creation of 450,000 jobs lagged behind the increase in the labor force by 600,000 newcomers.

Table I.

Islamic Republic of Iran: Selected Indicators, 1999/2000-2001/02

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Sources: Iranian authorities; and Fund staff estimates.
Table 1.

Islamic Republic of Iran: Key Indicators, 1998/99-2002/03 1/

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

Iranian fiscal years ending March 20.

Based on central bank data.

Using TSE rate and 1999/2000=100.

Figure 1
Figure 1

Islamic Republic of Iran: Macroeconomic Indicators, 1995/96-2001/02

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

Sources; Iranian authorities; and Fund staff estimates.
Table II.

Islamic Republic of Iran: Sectoral Growth Rates, 1999/2000-2001/02

(Annual percentage change)

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Source: Bank Markazi Jomhouri Islami Iran.

7. The external current account surplus decreased to 4.8 percent of GDP in 2001/02 (Tables 2-3 and Figure 2). Exports declined, as lower oil export receipts were only partially offset by 5 percent growth in non-oil exports, mainly representing chemicals and petrochemicals. At the same time, imports expanded by 20 percent owing to buoyant domestic demand and progress in trade liberalization. The decline in the current account surplus was partly offset by a significantly smaller deficit in the capital and financial account. This was attributable to a sizable reduction in debt repayments and a sharp rise in capital inflows in the form of buybacks and oil pre-financing. The surplus in the overall balance was US$4.9 billion, which financed the increase in gross official reserves to the equivalent of almost 10 months of imports of goods and services.

Table 2.

Islamic Republic of Iran: Balance of Payments, 1999/2000-2003/04 1/

(In millions of U.S. dollars; unless otherwise indicated)

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

Iranian fiscal years ending March 20.

Includes World Bank lending as well as Eurobond borrowing in 2002/03.

Some letters of credit (LC) have maturities in excess of one year.

Reflecting borrowing of the Bank Markazi from the commercial banks and some deferred trade payments of banks.

Represents the part of OSF that will be kept in foreign exchange.

Excluding short-term debt.

Projection is based on WEO prices.

Table 3.

Islamic Republic of Iran: Summary External Debt and Debt Service, 1999/2000-2003/04 1/

(In millions of U.S. dollars)

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

Iranian fiscal years ending March 20.

Reflect authorities data (actuals) and projections of disbursements and amortization.

Includes World Bank loans and Eurobonds.

Some letters of credit (LC) may have maturities in excess of one year.

Includes interest on projected new borrowing for 2000/01-2001/02.

Figure 2.
Figure 2.

Islamic Republic of Iran: Balance of Payments and Exchange Rate Developments, 1995/96-2001/02

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

Sources: Iranian authorities; arid Fund staff estimates.1/ Last observation: March 2002.

8. Fiscal policy was prudent in 2001/02. Reflecting mainly lower oil prices and revenue, the central government’s overall surplus shrank to 0.9 percent of GDP, down from 8.8 percent of GDP in the previous year (Table 4 and Figure 3). Non-oil revenue rose by ½ percent of GDP on account of higher social security contributions, while expenditure increased by 1¼ percent of GDP, with the rise in current expenditure more than offsetting the decline in capital outlays. The government continued to take advantage of the sustained high oil revenue to increase its deposits with the OSF to US$7.4 billion, and reduced the external public and publicly guaranteed debt to 6.3 percent of GDP.

Table 4.

Islamic Republic of Iran: Central Government Fiscal Operations, 1999/2000-2002/03 1/

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

Iranian fiscal years ending March 20.

Includes OSF domestic lending facility.

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, inclusive of contingent liabilities due to exchange rate unification. For 2002/03, includes US$500 million on contingent liabilities to be financed by BMJII.

Figure 3.
Figure 3.

Iran: Revenue and Expenditure Developments, 1995/96-2002/03

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

Sources: Iranian authorities; and Fund staff estimates.

9. Growth of monetary aggregates remained relatively high in 2001/02. It reflected the build-up of foreign exchange reserves, excluding the OSF, and a rapid credit expansion to public enterprises and the private sector (Table 5). Base money grew by 9 percent, as the Bank Markazi Jomhouri Islami Iran (BMJII) only partially sterilized the impact of large direct purchases of foreign exchange from the government through the issuance of Central Bank Participation Papers (CPPs)4. This, together with an increase in the money multiplier,5 led to 26 percent growth of broad money (Figure 4). Regulated rates of return on loans declined slightly in 2001/02, contributing to high credit demand of the private sector (Figure 4).

Table 5.

Islamic Republic of Iran: Monetary Survey, 1999/2000-2002/03 1/

(In billions of Iranian rials; unless otherwise indicated)

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Sources: Bank Markazai Jomhouri Islami Iran; and Fund staff estimates and projections.

Iranian fiscal years ending March 20.

End-2001/02 were revalued at the unified exchange rate of March 23, 2002.

Data on foreign currency deposits before 2000/01 are reported under foreign liabilities.

Figure 4.
Figure 4.

Iran: Financial Market Indicators, 1995/96-2001/02

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

Sources: Iranian authorities; and Fund staff estimates.

10. CPI inflation continued its downward trend, despite the rapid monetary growth. The stability of exchange rates at the parallel market and Tehran Stock Exchange (TSE) and, to some extent, an improved agricultural output contributed to a further decline in average CPI inflation to 11.4 percent in 2001/02, with the decline affecting tradable goods, while nontradable inflation remained high. In contrast, an acceleration in broad money growth in the first quarter of 2002/03 appears to have initiated a modest pick-up in inflation (Figure 1 and Box 1). Although controls on the prices of public enterprises and essential imports contributed to the deceleration of inflation to some extent, they do not appear to have resulted in a substantial build-up of repressed inflationary pressures so far.

11. Asset prices rose significantly in the TSE, as measured by the TEPIX,6 and in the real estate market (Figure 4). This reflected improved fundamentals of the Iranian economy and higher real incomes, as well as the large differential in yields that helped attract capital inflows to the TSE7 and savings of Iranians living abroad through informal channels. The continuation of high growth rates of monetary aggregates may have also contributed to asset price inflation, in particular in the real estate market.

Has There Been a Change in the Relation Between Inflation and Money Growth Since 2000/01?

Iranian CPI inflation gradually declined from a year-on-year rate of 18 percent at end-1999/2000 to 11.7 percent at end-2001/02. Somewhat surprisingly, the disinflation took place against a background of strong growth in monetary aggregates, with the increase in Ml and M2 at 34 and 30.5 percent at end-2000/01 and, 19 and 26 percent at end-2001/02, respectively. This apparent inconsistency in the relation between money growth and inflation was due to a combination of factors, including positive supply shocks and the stability of the TSE and parallel market exchange rates, which exerted downward pressures on CPI inflation, and seem to have more than offset the effects of the increase in the money supply:1/

  • Agricultural output increased strongly from 2000/01-2001/02 relative to the earlier years, due to favorable weather conditions. The lessening of supply constraints has reduced the inflation of food prices, which amounted to a total weight of 31 percent in the CPI.

  • The gradual easing of trade barriers and increased import penetration have also relaxed supply constraints in the tradable goods sector. Moreover, the stability of the Iranian rial against the U.S. dollar in the TSE market, and the strength of the U.S. dollar against other currencies have curbed the relative price of imports. With increased competition from imports, domestic producers of tradables appear to have had little scope to raise prices, bringing the inflation of tradables to single digit levels in 2001/02.

  • The stability of the exchange rate at the parallel market, declining inflation, and strong output growth from 2000/01-2001/02 have increased real money demand, rendering the growth in nominal monetary balances less inflationary.

  • The significant contemporaneous correlation between the parallel market exchange rate and CPI inflation over the past decade suggests that in Iran, the exchange rate plays an important role in the formation of inflationary expectations, as has been the case in other economies that have experienced high inflation. From 2000/01-2001/02, the strong supply of foreign exchange by the government and the attractiveness of the real rates on return on domestic monetary instruments, such as the CPPs and deposits have buoyed demand for domestic currency and stabilized the parallel market exchange rate, which seems to have curbed inflationary expectations.

  • Under the TFYDP, which has been in effect since March 2000, the price increases of goods and services produced by public sector enterprises have been limited to 10 percent, as compared to a 25 percent limit in SFYDP. These price controls alone do not seem to have been binding to significantly alter the inflation rate, but they are likely to have had a restraining impact.

While these factors have so far generated a decline in overall CPI inflation, strong money growth fueled by high government spending has sustained the inflation of nontradables at high levels. Inflation of dwellings, for instance, stood at 18 percent at end-2001/02. Looking ahead, further excessive money growth would likely create considerable uncertainty regarding inflation and cause an upward revision in inflationary expectations. Early signs to this effect became apparent in the second month of 2002/03, when seasonal fruits and vegetables entered the CPI basket with significantly higher prices than in the previous year, pushing year-on-year inflation to above 14 percent, despite strong agricultural output.

1/ Econometric analysis conducted by Fund staff for the period 1990/91-2001/02 has established a strong effect of excess Ml balances on inflation with no statistically significant break in the inflation equation around 2000/01 (Oya Celasun and Mangal Goswami, (forthcoming), “An Analysis of the Inflationary Process in the Islamic Republic of Iran,” IMF Working Paper, Washington: International Monetary Fund). Excess M2 balances, however, were not found to significantly impact inflation. The study also reveals a strong link between inflation and the parallel market exchange rate depreciation, the stability of which seems to have been an important element in the disinflation process.

12. The trend of real exchange rate appreciation continued. The TSE rate and, subsequently, the exchange rate prevailing at the unified interbank market remained very stable while the CPI inflation rate averaged at about 12 percent in 2001/02 (Figure 1). The stability of the nominal exchange rate was made possible by the abundance of foreign exchange supplies due to strong oil export receipts and private capital inflows attracted by differentials in rates of return. Although the real effective exchange rate appreciated by about 17 percent in 2001/02, following an 18 percent appreciation in 2000/01, the appreciation vis-à-vis the five-year average real effective exchange rate index was only 20 percent (Box 2).

C. Progress in Structural Reform

13. Structural reform has continued in many areas, though at an uneven pace of implementation. The exchange rate unification was a landmark reform. After several months of extensive preparation, the exchange rate was unified on March 21, 2002, with foreign exchange transactions now taking place in the interbank market. The authorities also adopted a managed floating exchange rate system. The transition has been smooth with the BMJII seeking to maintain some stability in the nominal rate during the period immediately following the exchange rate unification. The law on foreign investment has been ratified, providing added protection and some incentives to foreign investors; the recently approved amendments to the legislation on direct taxes lowered and simplified the corporate and personal income tax rates; and a draft law on the value added tax (VAT) has been submitted to the cabinet for approval. Parliament also approved the establishment of the National Tax Organization and a large taxpayer unit in 2001/02. Trade reform focused on further reducing nontariff barriers and streamlining licensing procedures, with the bulk of import items now requiring only licensing at the Ministry of Commerce for recording purposes; the authorities also adopted a negative list of prohibited imports.8 In the financial sector, progress in implementing reforms has been relatively slow, although a key reform has been the licensing of three private banks, one of which was already operating as a nonbank credit institution. The private banks are allowed to conduct business in all banking areas and operate under the same regulatory framework. Furthermore, draft legislation on anti-money laundering has been submitted to the cabinet. Despite the recent recapitalization of state-owned banks, their capital adequacy ratio remained below the Basel-recommended 8 percent (Table 6) and there is a risk of a further deterioration of their loan portfolios in connection with the rapid credit expansion in the recent years.9 Progress in privatization has been limited to streamlining and clarifying the legislative and regulatory environment governing privatization, while actual privatization operations have mostly consisted of divestiture of government equity shares.

Table 6.

Islamic Republic of Iran: Vulnerability Indicators, 1998/99-2001/02 1/

(In percent; unless otherwise indicated)

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Sources: Iranian authorities; and Fund staff estimates and projections.

Iranian fiscal years ending on March 20.

Data valued at weighted average exchange rate.

New regulation has been issued with allowable limit on net open position for individual currencies at 10 percent of capital and an overall net open position limit of 30 percent of capital.

Estimates are preliminary and provided by Iranian authorities. Estimates from FSAP report (July 2000) indicate less favorable ratios.

Measures of the Real Effective Exchange Rate

Figure 1.
Figure 1.

Evolution of the REER and the NERR

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

Figure 2.
Figure 2.

REER using TSE and Weighted Rate

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

Figure 3.
Figure 3.

Evolution of Non-Tradable to Tradable Prices

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

Figure 4.
Figure 4.

Evolution of the CPI-based and ULC-based REER

Citation: IMF Staff Country Reports 2002, 211; 10.5089/9781451818932.002.A001

II. Policy Discussions

14. The discussions, which took place against the background of renewed optimism and improved confidence, also mirrored the policy dilemma facing the authorities as they make advances in implementing their economic reform strategy. Iran has now reached the point where a clear choice must be made between a strategy that continues to rely primarily on subsidies and government intervention to achieve gains in employment, but with long-term negative effects on macroeconomic stability and growth, and one aimed at sustaining long-term growth and employment creation through greater efficiency and private sector-led economic development. This policy choice has implications for the short-term outlook and the medium-term economic reforms.

A. Short-Term Policy Issues

15. The mission commended the authorities for the high degree of ownership of their economic reform strategy as outlined in the TFYDP and noted that the reform effort had started to pay off as evidenced by the high growth rates of non-oil activities, the pickup in domestic private sector investment, and the growing interest in investment in Iran on the part of foreign investors. In the short term, the growth outlook for 2002/03 is relatively favorable, with real GDP projected to grow at 5.8 percent and the non-oil sector by 6.3 percent, buoyed by relatively favorable oil market conditions, rising domestic demand, and increased business confidence (Table 1 and Table III). However, the expansionary policy stance embedded in the current budget for 2002/03 could lead to higher inflation, put further pressure on the real exchange rate to appreciate, and increase the economy’s vulnerability to a downturn in oil prices. If the authorities were to implement the budget as initially approved, the fiscal deficit would increase to 5.2 percent of GDP and monetary growth would reach about 40 percent. This, coming on the heels of two years of rapid liquidity growth, would heighten uncertainty about inflation, with the balance of risk shifting to the upside. Another by-product of this expansionary policy stance would be a further real appreciation of the rial that would erode competitiveness and increase vulnerability to external shocks, as OSF resources would be drawn down to finance the fiscal deficit.

Table III.

Islamic Republic of Iran: Selected Indicators, 2001/02-2002/03

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Sources: Fund staff estimates and projections.

16. The mission stated that the policy focus for the remainder of 2002/03 must shift toward ensuring macroeconomic stability. In this context, the staff discussed with the authorities a policy mix of fiscal adjustment and monetary action to contain liquidity growth. The fiscal deficit would need to be limited to about 2 percent of GDP, which together with a more active use of monetary instruments could limit broad money growth to 20-25 percent. Even though this growth rate is still high, it is a realistic target, which would help contain inflation and a further real appreciation of the rial. Moreover, tighter fiscal policy would lead to a smaller deterioration in the current account balance and allow the BMJII to accumulate higher gross official reserves (a US$5.5 billion increase). The government would also be able to refrain from drawing on the deposits of the OSF from its end-2001/02 level. Such a policy outcome would reduce the external and fiscal vulnerabilities to exogenous shocks. The authorities were in agreement with the above assessment and indicated that they were examining appropriate measures to contain the fiscal deterioration and its impact on monetary and exchange rate developments.

Fiscal Policy

17. The authorities indicated that the increase in government expenditure during the current fiscal year was due to the high cost of exchange rate unification and the need to deal with the high unemployment problem. The staff pointed out that the fiscal deterioration which is taking place amidst high oil revenue, is driven by a sharp increase in current and capital outlays as well as by the cost of the exchange rate unification. Preliminary estimates based on the initially approved budget suggest that the fiscal position would swing from a surplus of 0.9 percent of GDP in 2001/02 to an overall deficit of 5.2 percent of GDP in 2002/03 (Table III). The deterioration mainly reflects the impact of the exchange rate unification net of the revaluation of oil revenue (2.8 percent of GDP) as well as the increase in other expenditure and net lending (Table IV). The non-oil deficit is estimated to increase by 6.5 percent of GDP to the equivalent of 21 percent of GDP in 2002/03.

Table IV.

Islamic Republic of Iran: Factors Affecting the Fiscal Deficit Under Current Policies

(Increase in 2002/03 from 2001/02)

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Sources: Iranian authorities; and Fund staff estimates.

Deflated by the CPI inflation rate.

Including subsidies not related to exchange rate unification.

Excluding capital transfers related to the unification cost.

Excluding revaluation at the unified exchange rate.

18. With regard to the effect of the exchange rate unification, the mission welcomed the authorities’ decision to make all the implicit exchange rate subsidies explicit in the budget and noted that the high cost to the budget stems from the authorities* decision not to allow any pass-through this year of the exchange rate depreciation and bear the full cost to public enterprises of the exchange rate losses on letters of credits and other foreign liabilities (contingent liabilities). The mission noted that the budgetary impact of the exchange rate unification would be manageable if the authorities kept the lid on the growth of other current and capital outlays.

19. The authorities agreed with the mission’s assessment regarding the likely impact of the current fiscal stance on the macroeconomic situation. They indicated, however, that expenditure commitments, mainly capital expenditure, would not take place if there were a revenue shortfall, and that they planned to step up collection of tax arrears and mobilize additional external financing. Recognizing the importance of prompt measures to contain the fiscal deficit, the authorities indicated that discussions were underway within the high level coordination committee,10 chaired by President Khatami, to formulate appropriate corrective measures, which might be introduced sometime in the second half of 2002/03. However, the scope and the impact of the likely fiscal measures are yet to be determined. The staff suggested that the adjustment effort should be orderly and consistent with other macroeconomic objectives. In particular, fiscal measures should aim at reducing current expenditures, which have been budgeted to rise significantly; ensure an orderly scaling-down of capital expenditure, and preserve the integrity of the OSF by not withdrawing from past accumulated deposits. The staff also emphasized the need for revenue-raising measures which could include a reduction of tax exemptions and possible increases in excise taxes, in particular, the specific rates that have not been adjusted for inflation for some years. Moreover, an acceleration of privatization and divestiture of government equity shares would help mobilize significant additional resources.

Monetary Policy

20. The mission pointed out that monetary policy alone would not be able to contain the liquidity and inflationary effects of the envisaged deterioration in the fiscal stance in 2002/03. Indeed, the effectiveness of monetary policy action was made difficult by the excess liquidity in the banking system, a relaxation of fiscal discipline, pressures on the exchange rate to appreciate, inadequate instruments of liquidity management, and, until recently, limited policy coordination. While the authorities continue to target a broad liquidity growth (M2) of around 18 percent, this initial objective appears now difficult to achieve in the current policy environment, and the final outcome might be close to 40 percent, as indicated above, in the absence of corrective fiscal and monetary policy measures. As such, a policy mix of fiscal adjustment and monetary policy actions to mop up excess liquidity would be essential to bring domestic liquidity growth under control.

21. The staff mission discussed with the authorities an illustrative adjustment scenario11 based on the assumption of fiscal tightening, aimed at containing M2 growth to 20-25 percent. Under such a scenario, a reduction in the fiscal deficit to 2 percent of GDP would reduce the budgetary recourse to domestic bank financing to about Rls 6.3 trillion (Tables 4-5 and Table IV). Depending on the balance-of-payments outlook and the need for BMJII to accumulate foreign exchange reserves to avoid an undue appreciation of the nominal exchange rate,12 the central bank would need to increase the issue of CPPs to mop up liquidity by about Rls 24 trillion from the end-2001/02 stock. This would contain M2 growth to 20-25 percent and would help maintain inflation at about 15 percent. The authorities agreed to examine the possibility of increased recourse to CPPs and to other instruments such as a standing deposit facility (open deposit accounts) to mop up excess liquidity and sterilize the liquidity impact of the increased government spending. However, even if the legal ceiling on the net issuance of CPPs can be raised from its current level of Rls 10.4 trillion, the authorities concurred with the staff that this instrument should not be considered as a substitute for fiscal adjustment, but rather as a temporary instrument providing some time for fiscal policy to adjust.

Exchange Rate Policy

22. The authorities reiterated their commitment to a managed float exchange rate system. They recognized that the stability in the nominal rate has helped ensure a smooth operation of the new unified interbank foreign exchange market. They were confident that the market’s response was very much in favor of some stability in the rate in the short run and that no evidence of misalignment of the nominal exchange rate had emerged. At the same time, they noted that under current policies, the large supply of foreign exchange to the domestic market on account of high government financing requirements and a high share of spending out of oil revenue would likely result in a real appreciation during 2002/03. However, they were mindful of the need to avoid a sustained real appreciation that could worsen the competitiveness outlook.

23. The staff cautioned against the risk of building expectations of a de facto pegged exchange rate. While agreeing that keeping the nominal exchange rate stable in the short run was sensible in the interest of ensuring stability during the initial phase of the exchange rate unification, the staff was concerned that this could make subsequent exchange rate movements politically difficult. Moreover, the perceived fixity of the nominal exchange rate may contribute to attracting potentially volatile capital inflows. The authorities shared the staffs view that the central bank would need to move sooner rather than later to ensure that the interbank exchange rate fluctuate as warranted by market conditions and economic fundamentals.

24. While sustained appreciation of the real exchange rate would further exacerbate the “Dutch Disease” effects, the main impediments to competitiveness are structural in nature. The mission pointed out that competitiveness problems of the non-oil sectors lay mainly in the dominance of inefficient state enterprises in economic activity, the lack of competition in the domestic market, the relatively high tariff protection, the distortive effects of subsidies and price controls, and the rigidities of labor regulations.13 Removing these obstacles would require sustained implementation of reforms, together with efforts on the part of the private sector to enhance efficiency and raise productivity through restructuring and adopting modern management techniques. In this environment, exchange rate policy should neither be allowed to worsen the competitiveness outlook through continued real appreciation, nor should it be considered as a cure-all recipe for the ills of the non-oil economy.

Exchange Restrictions

25. The authorities have adopted a number of measures aimed at eliminating exchange restrictions and improving access to foreign exchange. In particular, the need for and the amount of advance deposits for opening letters of credit have been left to the discretion of commercial banks; the procedure of foreign exchange allocation for authorized imports has been eliminated; and the process of obtaining most import licenses has been streamlined by reducing centers issuing permits to a single entity, the Ministry of Commerce. Moreover, the surrender requirement for foreign exchange receipts by non-oil exporters has been eliminated, and the bonus payment for early repatriation has also been abolished. Notwithstanding the considerable simplification and liberalization of the exchange system, a recent MAE/LEG mission has identified a number of multiple currency practices and exchange restrictions.14 In particular, the exchange rate applying to the import of certain commodities and to debt service payments on the letters of credit contracted prior to March 21, 2002 by public enterprises is explicitly subsidized in the budget, giving rise to a multiple currency practice. The authorities plan to eliminate the remaining exchange restrictions to pave the way for Iran’s acceptance of Article VIE, Sections 2(a) and 3 of the Fund’s Articles of Agreement.

B. Medium-Term Outlook and Structural Reforms

26. Iran’s medium-term outlook is relatively favorable. Under the current WEO projections for oil prices and the assumption that the fiscal expansion would be corrected in a timely manner and that structural reforms would be accelerated, real GDP growth would average almost 6 percent, the overall external position would remain in surplus, albeit on a declining trend, the external debt would remain low, and international reserves would be increased substantially (Appendix IV). In the absence of fiscal adjustment and structural reforms, real GDP growth could decelerate to 4 percent, while inflation would pick up. In the latter case, the emergence of current account deficits early in the projection period, a slow pace of accumulation of gross official reserves, and a depletion of the OSF deposits would intensify the vulnerability of Iran to potential external shocks (Appendix IV). Both medium-term scenarios are subject to uncertainties on several fronts, including oil prices, weather conditions, and the prospects for regional stability. Regarding the impact of oil prices, a US$1 decrease in the assumed oil prices would result in a ¾ of 1 percent of GDP deterioration in the fiscal balance and a 1 percent of GDP worsening of the current account balance on average over the medium term.

27. Increasing employment opportunities remains a key objective of the authorities’ medium-term reform strategy. The authorities indicated that political pressure to increase government spending was likely to intensify given the need to provide employment opportunities to more than a half million Iranians who enter the labor force each year. They pointed to various initiatives they have taken recently to promote employment, including the provision of subsidized credits to small- and medium-sized enterprises, tax exemptions on the salaries of new employees, and lending to private companies in foreign exchange from the OSF. The authorities also expressed concern about the potential negative fallout on employment of certain economic reforms, such as accelerated trade liberalization and privatization of public enterprises.

28. The staff acknowledged the difficulty in reducing the current rate of unemployment given Iran’s demographic dynamics and the relatively weak employment content of growth compared to other countries.15 The latter stems from several factors, including the excess labor in many public enterprises, the low energy cost and subsidies, which introduce a bias in favor of capital intensive industries, the highly restrictive labor market regulations, and the lack of private sector penetration in sectors such as services, which can contribute significantly to employment creation. The staff expressed the view that while financial incentives to create new jobs may help alleviate unemployment problems in the short run, their effectiveness and possible distortive effects would need to be assessed after a short period of implementation. A more enduring alternative would be to accelerate the pace of implementation of structural reforms aimed at opening up the economy, attracting foreign direct investment, encouraging private sector development, enhancing competition, and eliminating labor market rigidities. The staff agreed that trade liberalization and privatization can worsen employment in the short run, given the existing distortions in the Iranian economy, but with a proper sequencing of reforms, this temporary effect can be mitigated allowing employment creation to rise over the medium term, as the business climate becomes more conducive to investment and growth. The staff underscored the need to put the economy on a sustained path of growth and employment creation that is driven by private sector initiative through competition and improved economic efficiency rather than by subsidies and government intervention.

29. Fiscal structural reforms should continue to ensure medium-term fiscal sustainability. The OSF has provided a useful tool of fiscal management, but would need to be used more effectively to smooth out the impact of oil price fluctuations and help enhance fiscal discipline. The staff encouraged the authorities to reflect on the merits of setting fiscal policy in a longer term framework that would seek to limit current consumption out of oil resources to ensure balanced inter-generational sharing of resources. In this respect, fiscal sustainability would be cast within a framework that takes account of the nonrenewable nature of oil resources and the need to build assets for future generations. As such, fiscal policy would focus on reducing the non-oil deficit to a level that would be compatible with the desired accumulation of long-term savings and precautionary assets. As the next step in that direction, consideration could be given to building long-term savings in the OSF with stringent and transparent rules of accumulation and withdrawals, and in the context of a consolidated framework of fiscal management. The authorities indicated that they were reviewing the experience of other countries with such funds, including their usefulness in helping sterilize large inflows of oil-related foreign exchange.

30. The staff advised against excessive recourse to tax incentives and privileges as instruments of industrial and social policy. Most prominently, such exemptions might undermine the authorities’ efforts to broaden and diversify the revenue base away from oil revenue. Similarly, exemptions from the proposed VAT would need to be kept to a minimum to facilitate the implementation of the new tax and avoid distortions. The authorities took note of the staff’s recommendations and expressed interest in receiving Fund technical assistance in strengthening the administrative capabilities of the National Tax Organization, including for implementing the VAT.

31. On the expenditure side, the staff called for determined efforts to contain the growth of wages and salaries, including through a civil service reform, and encouraged the authorities to enhance public expenditure management, including with technical assistance from the Fund and the World Bank. The authorities would need to firm up their plans to phase out subsidies and replace them with a targeted subsidy system and introduce a social safety net that would provide adequate protection of the vulnerable groups of the population. The authorities indicated that technical work on the elimination of subsidies was underway with assistance from the World Bank, including plans to reduce some subsidies in the budget for 2003/04 and to bring domestic oil prices close the border price level over the medium term.16

32. The staff underscored the need for rapid progress on financial sector reform along the lines of the FSAP recommendations (Box 3). It reiterated the need to develop monetary policy instruments that would provide the central bank with sufficient flexibility and agility in its conduct of monetary policy. The CPPs have provided a useful tool to mop up excess liquidity in the past year, but need some adaptation to be effectively used for open money market-type operations. Previous Fund technical assistance missions had advised the authorities to auction the CPPs to derive a benchmark rate of return, and remove restrictions on their secondary market trading. The authorities have not decided yet whether they would proceed with the recommended modifications to CPPs. They noted that work was continuing in other areas of financial sector reform in conformity with Islamic banking practices. These include allowing banks more freedom in setting the lending rates of return and establishing an interbank money market. In the meantime, the recently licensed private banks have been allowed more flexibility in credit allocation, and in the setting of deposit and lending rates of return, which would enhance competition and open the door for granting the same flexibility to state banks. The staff encouraged the authorities to follow through with their action plan for a fundamental banking supervision reform to improve compliance with the Basel Core Principles.

FSAP (2000) Recommendations on Financial Sector Reform

Monetary instruments and markets

  • Issue CPPs

  • Allow the CPPs to be auctioned and used in open market operations

  • Redesign the standing facilities

  • Reform reserve requirement

  • Introduce and develop intrerbank funds market

Bank competition and autonomy

  • Liberalize deposit and lending rates

  • Accelerate removal of directed credit and sectoral allocation of credit

  • Recapitalize the banking system

  • Tighten bank accounting rules that both take adequate account of Islamic instruments and are consistent with the International Accounting Standard (IAS)

  • Reorient the state-owned banks towards clear commercial objectives and financial autonomy

  • Move towards a more active and equitable competition between banks, and between banks and nonbank financial institutions and markets, including through financial sector liberalization and privatization

Prudential supervision and regulation

  • Move towards an overall evaluation of banking risks and of the banks’ capacity to manage them

  • Prepare and implement a new regulatory framework consistent with international standards

  • Intensify training of supervision staff

Capital Market

  • Enact a securities market legislation to replace the Stock Exchange Act of 1966, to regulate the issue of securities (listed and unlisted)

  • Create an independent securities commission

  • Upgrade accounting, auditing, and disclosure standards

33. The reform of the capital markets should be stepped up. In the absence of a general securities law which would govern the issuance of securities both inside and outside of the stock exchange, it remains difficult to address weaknesses in the stock exchange in areas such as insider trading, lack of protection of minority shareholders’ rights, unregulated activities of the investment companies, and the low level of disclosure of listed companies. The authorities agreed that these institutional weaknesses raised serious concerns in light of the recent stock market boom. In this regard, the staff emphasized that while regulations were being discussed by the TSE Board to address some of these concerns, a comprehensive approach to reforming the capital market would need to be developed along the lines of the recommendations of the FSAP follow-up technical assistance mission of March 2001.

34. Trade reform has advanced, but restrictive elements remain.17 The staff commended the authorities on the progress achieved in replacing nontariff barriers with tariffs, adopting a negative list of imports, and streamlining licensing procedures. It also noted Iran’s intention to become a member of the World Trade Organization (WTO) and welcomed the preparatory work toward achieving this objective. The staff noted, however, that further efforts were needed to reduce and rationalize tariff rates. In particular, the combined simple average tariff rate, including customs duties, commercial benefit tax, and other duties and charges, was relatively high (about 30 percent). The commercial benefit tax, with a simple average rate of 26 percent, has some 61 tariff rates, mostly ranging from 0 percent to 116 percent, with few even higher rates. The authorities indicated that they planned to consolidate all duties and charges on imports into one duty rate on imports. They also envisaged further rationalizing the tariff structure (including consolidating all duties and charges on imports into the tariff structure), reducing the dispersion of tariff bands, and lowering the simple average tariff rate. They intended, however, to move with caution in this area in line with the need to carefully assess the impact on domestic activities of the reforms already introduced and provide adequate time for some sectors to adjust to increased competition from abroad. The authorities also noted that some nontariff export barriers on subsidized goods would be phased out once the subsidies and price controls on these items were eliminated. The staff underscored the need to streamline customs and administrative procedures as part of the trade reform package.

III. Statistical Issues, Transparency, and Other

35. The authorities are committed to improving Iran’s statistical base as evidenced by their intention to subscribe to the Special Data Dissemination Standard (SDDS). To this effect, a multi-sector mission from the Fund’s Statistics Department (STA) visited Iran during June 18-July 1, 2002 to assess the current data dissemination practices and provide assistance on ways to improve the compilation and dissemination of macroeconomic statistics. The STA mission has identified a number of shortcomings including, in particular, the coverage of the government’s fiscal accounts, the classification of monetary data by sector and residency, and the reporting to the public of international reserves. The authorities intend to follow up, within the suggested timeframe, on the action plan recommended by the STA mission.

36. A recent Fund technical assistance mission has reviewed the practices of transparency and observance of standards and codes (ROSC) in the fiscal area in Iran. The preliminary conclusions of the fiscal ROSC mission highlight a number of positive elements. In particular, quasi-fiscal operations are increasingly being recognized; the audit framework for the public sector is based on a solid legal background; and fiscal reports are disseminated in the media. Improvements, however, are needed in the following three main areas (a) the government’s involvement in the economy would need to be more fully disclosed, including by clarifying financial relationships within the enlarged public sector; (b) the quality of fiscal information should be upgraded by widening its coverage and enhancing the timeliness of budget reporting (Annex III); and (c) the budget process would need to be strengthened, including by rationalizing banking operations of the government and integrating extra budgetary funds in the budget process. The authorities indicated that they would continue to work on improving fiscal transparency in line with ROSC recommendations.

37. The mission brought to the authorities’ attention the issue of Iran’s claims on two heavily indebted poor countries (HIPC) and encouraged the authorities to provide relief under the HIPC Initiative. The authorities indicated that this matter was under consideration, including the need to seek parliamentary approval.

IV. Staff Appraisal

38. The Iranian economy has performed well since the last Article IV consultation. Economic activity was strong during 2001/02, especially in the non-oil sectors; the fiscal and external positions remained in surplus, allowing the authorities to reduce the external debt, build large foreign exchange reserves, and accumulate fiscal savings in the OSF; and the inflation rate continued its downward trend. This performance has enhanced business confidence and put Iran in a much more favorable position to pursue its economic reform program under the TFYDP.

39. The Iranian authorities are to be commended for the timely implementation of the exchange rate unification and the smooth transition to a new exchange rate regime. Coming on the heels of progress in trade liberalization and the elimination of most exchange restrictions on current account transactions, the exchange rate unification is, indeed, a major step forward that enhances the credibility of the authorities’ reform strategy. The staff welcomes the successful floating of the Eurobond, which attests to the confidence of the international financial markets in Iran’s economic prospects and the authorities’ commitment to economic reform.

40. The outlook for 2002/03 is favorable, especially with regard to oil market conditions and the growth prospects of non-oil activities. Oil prices are expected to be slightly higher compared to the previous year, and real GDP is estimated to grow by close to 6 percent, with most sectors recording strong performance. Nonetheless, serious risks to the outlook are arising from the expansionary fiscal stance under the current budget, which if not corrected, could lead to higher liquidity growth, a pick-up in inflation, and further appreciation of the real exchange rate.

41. The expansionary fiscal policy in 2002/03 reflects increased spending beyond the cost of the exchange rate unification. The staff supports the authorities’ decision to make all implicit exchange rate subsidies an explicit entry in the budget following the exchange rate unification and make adequate allowance for the cost of contingent liabilities to public enterprises. This represents an important step in fiscal transparency and paves the way for the subsequent phasing out of subsidies. Nonetheless, the sharp increase in other budgeted current and capital outlays is a clear departure from past fiscal prudence and its timing could complicate macroeconomic management with heightened risks of igniting inflation and endangering the success of the unification of the exchange rates.

42. The staff urges the authorities to adopt appropriate corrective fiscal measures. The staff underscores the need for well thought out measures aimed at curbing the growth of current spending, which have been budgeted to rise considerably, and for an orderly scaling-down of capital expenditures that would not harm future growth. Also revenue measures that would help bring down the fiscal deficit while contributing to a diversification of the revenue base, such as a reduction in tax exemptions, improvement in collection of tax arrears, and increases in certain excise taxes, should not be discounted altogether. The staff strongly advises against drawing from the OSF’s past accumulated resources to finance the fiscal deficit, which otherwise, would carry a heavy cost in terms of loss of credibility of the OSF itself, given the prevailing high oil prices and the authorities’ policy of cushioning the effects of fluctuations in oil prices.

43. Monetary policy will need to focus on containing liquidity growth and inflation. The staff welcomes the authorities’ intention to use all instruments at the disposal of BMJII to contain the growth of liquidity, including issuing additional CPPs and using the standing deposit facility with the central bank. To be successful, however, these actions must be part of a comprehensive fiscal and monetary package aimed at containing liquidity expansion and inflation.

44. The staff welcomes the authorities’ commitment to a managed float exchange rate regime and notes the authorities’ intention to ensure that the exchange rate in the interbank market reflects market conditions and economic fundamentals. This would enhance the credibility of the authorities’ exchange rate policy and prevent a build-up of expectations of a pegged exchange rate regime. The staff reiterates its concern regarding the harmful effects of a sustained real exchange rate appreciation, but is aware that in the short run, it would be difficult to generate a depreciation of the nominal rate in the face of continued strong supply of foreign exchange by the government. As such, containing the inflation rate would offer a second line of defense in the effort to avoid an undue appreciation of the real exchange rate. The staff believes that while an active exchange rate policy aimed at depreciating the rate can help enhance the competitiveness of non-oil activities over the medium term, this cannot be a substitute for economic reforms that would remove the structural impediments to competitiveness.

45. The current high rate of unemployment presents the authorities with difficult and complex issues over the medium term against the background of high rates of growth of the labor force and relatively weak employment content of growth. Increasing employment creation in this environment would be a daunting task in Iran’s circumstances, given the existing distortions, the labor market rigidities, and the prevalence of inefficient and overstaffed public enterprises. Political pressure to address employment issues through higher government spending, subsidies, and other financial incentives would be difficult to resist, and implementation of needed economic reforms might be delayed out of fear of worsening the employment situation in the short run. Such a policy course would need to be assessed carefully against the concomitant risk of leading to financial instability or exacerbating the existing impediments to long-term growth and employment. A more enduring strategy would be to step up the economic reforms aimed at improving the overall business environment to foster investment and growth, make room for the private sector to grow and create jobs, and eliminate labor market rigidities.

46. Important steps have been taken in removing impediments to growth, but the pace of structural reforms needs to be accelerated. The staff welcomes the progress achieved in opening the economy through trade liberalization, the adoption of the foreign investment law, the licensing of three private banks, and the return to the international financial market, which would provide a strong incentive for further reform and sound economic management.

47. The staff underscores the need to step up financial sector reform aimed at deepening the financial market and enhancing the efficiency of bank intermediation. It also urges the authorities to strengthen the financial system supervisory and prudential framework in line with the FSAP recommendations. Determined efforts in this area will help address the potential risks that may emerge from the rapid credit growth in recent years, the growing inflow of foreign capital, and the recent asset price increases. To this end, the staff reiterates that restoring capital adequacy of banks should be accompanied by measures to enhance the profitability of banks and improve risk management.

48. Other important reforms that are already on the government’s medium-term reform agenda would need to be phased in rapidly to induce sustained improvement in productivity and growth. These include: enhancing competition and promoting the role of the private sector; strengthening fiscal management and reducing the budget’s vulnerability to fluctuations in oil prices; reforming the labor market to encourage employment creation; and overhauling price controls and the subsidy system together with the establishment of an appropriate social safety nets.

49. The production and dissemination of economic statistics has improved markedly, including the transition to the System of National Accounts 1993 Methodology; the preparation of quarterly national accounts data; and the adoption of Government Finance Statistics (GFS) fiscal classification. The staff commends the authorities for their intention to subscribe to the SDDS and welcomes the preparatory work underway to achieve this objective in conjunction with the technical assistance provided by STA. As a first step in this process, the staff encourages the authorities to disseminate data on international reserves.

50. The staff welcomes the progress achieved in enhancing fiscal transparency, including adopting GFS budget classification, making implicit subsidies an explicit entry in the budget, and disseminating fiscal information through the internet. Further commendable efforts in this area, include the authorities’ work with a Fund technical assistance mission to enhance fiscal management and transparency through a fiscal ROSC. The staff encourages the authorities to follow through with the ROSC mission’s recommendations.

51. It is recommended that the next Article IV consultation mission with Iran be held on the standard 12-month cycle.

APPENDIX I: Islamic Republic of Iran: Fund Relations

As of June 30, 2002

I. Membership Status: Joined: 12/29/1945; Article XTV

II. General Resources Account

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III. SDR Department

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Obligations to Fund: None

Under the Repurchase Expectations Assumptions:

Repurchase expectations apply to purchases after November 28, 2000 in the credit tranches, including the Compensatory Financing Facility, and under the Extended Fund Facility. Repurchases in the credit tranches and the Extended Fund Facility are expected to be completed in 2¼-4 years and 4½-7 years, respectively. The Fund has the option of extending the repurchase expectations upon request by members.

Nonfinancial Relations

VII. Exchange System

On March 21, 2002, a unified exchange rate regime, based on managed floating exchange rate system, was adopted and the former official exchange rate of Iranian Rls 1,750 per U.S. dollar was abolished. The new exchange rate is determined in the interbank foreign exchange market. As a result, effective March 30, 2002, the exchange rate arrangement of the Islamic Republic of Iran has been reclassified to the category of managed floating with no preannounced path for the exchange rate from the conventional pegged arrangement. Under new foreign exchange regulations (a) there is no surrender requirements of the foreign exchange earned by non-oil exporters; (b) the need for and the amount of advance deposits for opening LCs are now left to the discretion of the authorized financial institutions; (c) the procedure of foreign exchange allocation for authorized imports has been eliminated; (d) the distinction between internally and externally sourced foreign exchange deposit accounts has been largely eliminated; and (e) the base rate for converting the dollar value of imports for the collection of customs duties and commercial benefits taxes were revised from Iranian Rls 1,750 per U.S. dollar to the market rate.

Prior to March 21, 2002, the foreign exchange market operated mostly under a multiple exchange system, consisting of two officially approved rates: (a) an official exchange rate pegged at Iranian Rls 1,750 per U.S. dollar that applied mainly to imports of essential goods and services as well as servicing public and publicly guaranteed debt; and (b) an effective Tehran Stock Exchange (TSE) rate, applicable for imports from a positive list issued by the Ministry of Commerce (MOC). There was also an unofficial exchange market and the Bank Markazi Jomhouri Islami Iran (BMJII) allowed commercial banks limited access to this market to cover certain current transactions.

VIII. Last Article IV Consultation

The last Article IV consultation was concluded by the Executive Board on September 6, 2001.

IX. Technical Assistance

Since FY 1999, Iran received the following technical assistance:

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