Developments in 2001/02

The Iranian economy performed well in the second year of the Third Five-Year Development Plan (TFYDP 2000/02 - 2004/5), reflecting in large measure a steadfast pursuit of prudent macroeconomic policies and structural reforms envisioned in the TFYDP. Despite lower oil production resulting from three consecutive downward revisions in OPEC quotas, the real economy expanded by 4.8 percent, thanks to a stronger broad-based growth in the non-oil sector. Inflation declined further to an average of 11.4 percent, mainly due to deceleration in prices of tradable goods and food. Fiscal and external positions remained in surplus and gross official reserves strengthened, reaching a comfortable level of nearly 10 months of imports of goods and services. The rise in international reserves, combined with a continued fall in the external debt, enhanced Iran’s position as a net external creditor, with reserves approaching 250 percent of the total external debt stock. This performance accompanied by progress in structural reforms boosted business confidence and paved the way for Iran’s return to international capital markets, after a 23-year absence, with successful floating of a euro 625 million Eurobond issue in July 2002. These advancements notwithstanding, however, unemployment increased as job creation lagged behind the growth in the labor force.

Fiscal policy was prudent in 2001/02. Despite a sharp drop in oil and gas revenue, the fiscal position remained in surplus. Non-oil revenue rose on account of higher social security contributions, while total expenditure increased. The higher oil revenue, compared with conservative budget assumptions, allowed a further accumulation of savings in the Oil Stabilization Fund to US$7.4 billion. For the first time in Iran’s recent economic history, these policies signaled a break with the boom-bust cycles of the past.

Broad money grew by 26 percent last year despite central bank’s efforts to mop up excess liquidity by reducing lending to commercial banks and issuing Central Bank Participation Papers (CPPs). This reflected an accumulation of foreign exchange inflows, excluding the OSF, as well as increasing bank credit to the private sector and public enterprises. Growth in broad money was also due to a reduction in reserve and advance import deposit requirements. Prudent fiscal policies, moderation in inflation expectations, due to stability of the market exchange rate, and relaxation of supply constraints in the tradable goods sector, enhanced by increased imports, helped further reduction in the inflation rate.

The external current account remained in surplus, notwithstanding a 20 percent decline in oil and gas exports, and a surge in imports, stemming from a buoyant domestic demand and further trade liberalization. Non-oil exports grew by 5 percent, mainly due to rapid growth in exports of chemicals and petrochemicals. Despite the sizable reduction in debt repayments and the sharp rise in oil prefinancing, the outstanding stock of external debt fell to around 6 percent of GDP, a level not witnessed in Iran’s recent history, while the debt maturity profile continued to improve, with short-term debt now representing one-third of the total external debt stock. The surplus in the overall balance led to an increase in gross official reserves and to a further improvement in vulnerability indicators.

Structural reforms, as articulated in the TFYDP, continued in many areas. After substantial technical and operational preparation, with Fund technical assistance, the exchange rate was unified on March 21, 2002 with foreign exchange transactions now being effected in the interbank market. The strength of fiscal accounts and the external position as well as the stability in the market exchange rate facilitated a smooth process of exchange rate unification and adoption of a managed floating exchange rate system.

There was further progress in opening the economy through trade liberalization. Trade restrictions were eased by reducing non-tariff barriers (NTBs) and their replacement with tariffs, streamlining licensing procedures, adopting a negative list of prohibited imports, and reducing tariffs. Moreover, the need for and the amount of advance import deposit requirement were left to the discretion of commercial banks, and foreign exchange allocation procedures for authorized imports as well as the surrender requirement for foreign exchange receipts by non-oil exporters were eliminated.

On structural fiscal reforms, with Fund technical assistance, a national tax organization (NTO) and a large taxpayer unit (LTU) were established following which amendments to the direct taxes law reduced and simplified the corporate and income tax rates. Elimination of tax exemptions for public enterprises and foundations has further enhanced efficiency and transparency of the tax system. A draft law on the VAT was also submitted to the Cabinet for approval.

The new Foreign Direct Investment (FDI) Law was passed in June 2002, providing added protection and incentives to foreign investors and allowing foreign investment in all economic sectors that are open to domestic private companies.

In the financial sector, the parliament approved the law for the establishment of private insurance companies, three private banks were licensed, and the state-owned banks were recapitalized in line with the FSAP recommendations.

Progress in privatization continued as the regulatory environment governing privatization was streamlined and divestiture of government’s equity shares proceeded.

Policies in 2002/03

The authorities intend to maintain prudent demand management policies and to consolidate recent macroeconomic gains. They will focus on implementing structural reforms aimed at attaining higher growth rates and creating job opportunities to absorb the rapidly growing labor force. Economic growth is expected to be broad based and is projected at close to 6 percent, buoyed by higher oil prices, rising domestic demand, and increased business confidence. Based on the present budgetary and monetary policy stance, inflation is expected to accelerate. The authorities agree that there is an urgent need to shift the policy focus for the remainder of this budget year toward ensuring macroeconomic stability, and, as indicated in the staff statement, are contemplating a policy mix of fiscal adjustment and monetary action to contain liquidity growth. Fiscal position, based on the present approved budget, is estimated to swing from a surplus of 1 percent to a deficit of 5 percent of GDP. This expectation reflects primarily the budgetary cost of exchange rate unification. It is worth noting that this year’s budget was prepared according to GFS and explicitly reflects all the exchange rate subsidies in the budget. In line with the commitment to a balanced budget envisioned in the TFYDP Law, a high level coordination committee, chaired by the President of the Republic, is in the process of formulating revenue-raising and expenditure-restraining measures to be introduced in the second half of the current fiscal year. In this context and notwithstanding a one-time withdrawal from the OSF, envisaged in the 2002/03 budget to compensate for the exchange rate unification cost, every effort will be made to contain the non-oil fiscal deficit and to preserve the integrity of the OSF by not withdrawing from its accumulated deposits.

Monetary policy will focus on containing liquidity growth and inflation. In coordination with fiscal tightening, the authorities intend to limit broad money growth to around 20 percent, using all available instruments, including issuing additional CPPs, activating the central bank’s special open deposit account, an instrument which has been successfully used in the past to help mop up excess liquidity, and restricting commercial banks’ access to central bank’s overdraft facility.

The authorities are committed to a managed float regime, limiting interventions to correct large exchange rate movements not warranted by market conditions and economic fundamentals. The authorities are mindful of the need to avoid further real appreciation that could harm export competitiveness. As indicated in the Selected Issues paper, inflation expectations in Iran are highly sensitive to large movements in nominal exchange rates, stability of which has exerted substantial influence in dampening these expectations. On a related issue, the analysis in the Selected Issues paper points to the extremely low total factor productivity growth in Iran, which in turn explains the low employment content of growth. In this context, the authorities are fully cognizant of the fact that an accelerated pace of implementation of structural reforms is needed to improve total factor productivity growth and improve competitiveness.

In the external sector, increased exports will help keep the current account in surplus at above 3 percent of GDP, despite a 20-percent projected rise in imports reflecting continued trade liberalization and buoyant economic activity. External debt stock is expected to rise to about 7 percent of GDP, while gross official reserves, including the OSF, are projected to increase further, approaching the level of 11 months of imports.

The authorities are persevering with the implementation of their structural reform agenda and the remaining reform objectives of the TFYDP. In the trade area, after carefully assessing the impact of the reforms already introduced in domestic activities, the authorities will proceed with further rationalizing the tariff structure, reducing the dispersion of tariff bands, and lowering the simple average tariff rate. They intend to eliminate the remaining exchange restrictions, in line with the recommendations of the recent MAE/LEG mission, to facilitate Iran’s acceptance of the Article VIII obligations.

On structural fiscal reforms, the authorities have requested Fund technical assistance in strengthening the administrative capabilities of the NTO, including for the planned introduction of a 10 percent VAT in 2005/06. Work is also underway, with assistance from the World Bank, to reduce subsidies and introduce a targeted social safety net in the next year’s budget, and to bring domestic oil prices close to the border price level over the medium term. In this context, in line with the budget law mandate for next year, all oil-related entries will be made at border prices, and oil subsidies will be made transparent by their explicit incorporation in the next year’s budget. Moreover, building on recent progress in enhancing transparency, the authorities intend to implement the recommendations of the recent fiscal ROSC mission.

Following the ratification of the new FDI Law, its executive bylaws and implementing regulations entered into force on September 15, 2002. To increase the effectiveness of the OSF, the authorities are reviewing the relevant staff recommendations, contained in their report and the Selected Issues paper, as well as other countries’ experience with such funds, including their usefulness in helping sterilize large oil revenue inflows. The authorities intend to establish, with Fund technical assistance, an investor relations center which will focus on providing assistance and information to prospective investors.

In the financial sector, banks will be allowed more freedom in allocating credit and setting the lending rates of return paving the way for the establishment of an interbank money market. With three private banks already licensed, further applications are being considered. In line with the recommendation of the FSAP, the authorities will implement their comprehensive action plan aimed at a fundamental risk-based banking supervision reform and will further strengthen compliance with the Basle Core Principles. A proposed bill on capital market is under consideration by the Ministry of Finance to regulate the issue of listed and unlisted securities.

Iran has strongly supported international efforts in anti-money laundering and combating the financing of terrorism within the framework of the United Nations, the European Union, the Bonn Meeting, and the Islamic Conference. A bill on anti-money laundering was submitted last week to the parliament and is presently under discussion in its Judiciary and the Economic Affairs Commissions. Following the cabinet’s approval of the draft AML/CFT bill, establishment of the financial police is now under active consideration. The Supervision Department of the Central Bank has prepared executive by-laws for customer recognition and prohibition of the use of the financial system in money laundering and financing of terrorism. The central bank has also issued directives to all bank and non-bank financial institutions to report suspicious transactions with detailed information on customers and transactions. Moreover, an AML/CFT Unit has been established in the Supervision Department of the Central Bank.

The authorities are studying ways and means of removing obstacles to acceleration of the implementation of the privatization agenda of the TFYDP. An independent law is being drafted to ensure continuity in the privatization of public enterprises beyond the TFYDP. According to a draft bill, aimed at seeking improvement in the privatization process, holding companies will be obliged to cede shares of the affiliated firms directly to private entities.

On statistical issues, the authorities are committed to improving data production and dissemination and intend to subscribe to the SDDS as soon as possible. Preparatory work is underway to achieve this objective in line with the action plan recommended by the recent STA mission.

Medium-Term Objectives

Iran faces the challenge of deepening structural reforms to promote higher sustainable growth, and to reduce unemployment. Therefore, increasing job opportunities remains a key objective of the authorities’ medium-term reform strategy. As indicated in the Selected Issues paper, demography, rapid urbanization, and a shift in the country’s economic structure are cited as the main causes of rising unemployment in Iran. The relatively low employment intensity of growth stems from excess labor in many public enterprises, bias in favor of energy-intensive industries, labor market rigidities, and low private sector penetration in services sector. The authorities have taken initiatives to promote employment, including the provision of vocational training, development of an information databank on job seekers, tax exemptions for new employees, subsidized credits to small enterprises, and lending to private firms at international market rates in foreign exchange from the OSF. Recent amendments to the legislation on direct taxes and the ratification of the new FDI Law promise to encourage productive domestic and foreign investment to create additional jobs. To address labor market rigidities, a tripartite committee comprising representatives of the government, labor organizations, and employers is examining possible improvements in the present Labor Law. Recognizing that there are no quick-fix solutions to the unemployment problem, the authorities remain committed to steadfast implementation of the ambitious reform agenda contained in the TFYDP. They share the staff view that by establishing appropriate social safety nets, the temporary adverse effects of reforms on employment could be mitigated allowing employment generation to rise over the medium term.