Islamic Republic of Iran: Selected Issues and Statistical Appendix

This Selected Issues paper for the Islamic Republic of Iran deals with the analytical considerations relating to the choice of the exchange regime. This issue came to prominence with the exchange rate unification of March 2002. The paper also examines the competitiveness of the non-oil economy, fiscal sustainability, and the labor market of Iran. The paper concludes that a degree of flexibility in the exchange rate is needed at this juncture, given Iran’s exposure to oil price shocks, and the desire of the authorities to promote the development of non-oil activities.

Abstract

This Selected Issues paper for the Islamic Republic of Iran deals with the analytical considerations relating to the choice of the exchange regime. This issue came to prominence with the exchange rate unification of March 2002. The paper also examines the competitiveness of the non-oil economy, fiscal sustainability, and the labor market of Iran. The paper concludes that a degree of flexibility in the exchange rate is needed at this juncture, given Iran’s exposure to oil price shocks, and the desire of the authorities to promote the development of non-oil activities.

I. Overview

1. The Iranian authorities are implementing a number of reforms aimed at promoting market forces in resource allocation, opening up the economy to trade and foreign direct investment, promoting the role of the private sector in economic activity, and strengthening coordination between monetary and fiscal policies. These reforms raise a number of analytical issues which need to be discussed to shed light on the various policy options. This Selected Issues Paper presents five essays examining issues related to the choice of the exchange regime, the competitiveness of the non-oil economy, the monetary policy stance and inflation, fiscal sustainability, and the labor market. While each essay focuses on its core issue, links to other areas of economic policymaking are highlighted in the analysis.

2. Chapter II deals with the analytical considerations relating to the choice of the exchange regime. This issue came to prominence with the exchange rate unification of March 2002, which was a landmark reform that dramatically changed the economic policy framework. Chapter II concludes that a degree of flexibility in the exchange rate is needed at this juncture, given Iran’s exposure to oil price shocks, its gradualism in fiscal adjustment and trade reforms, and the desire of the authorities to promote the development of non-oil activities. In this regard, the authorities’ choice of a managed float exchange regime appears justified.

3. Chapter III examines the evolution of the competitiveness of the non-oil export sectors of the Iranian economy during the past 10 years. The analysis is made difficult by scant statistical data and distortive effects of various controls and the prevalence of explicit and implicit subsidization. The tentative result of this chapter is that competitiveness problems of non-oil activities are primarily due to structural impediments, but the problem could be compounded by a sustained real effective exchange rate appreciation.

4. Chapter IV analyzes money demand and inflation dynamics. Estimated money demand and inflation equations indicate that the stabilization of the foreign exchange market on account of strong oil revenues in 2000/01 and 2001/02 buoyed the demand for domestic money and contributed to the decline in inflation. Tests of model stability do not point to a structural shift in the inflation equation during the period of analysis. Chapter TV concludes that given that the scope for further money demand growth appears limited, continued strong money growth might lead to a disequilibrium in the money market in the near future and ultimately to an increase in inflation.

5. Chapter V provides a forward-looking analysis of long-term fiscal issues related to the allocation of oil wealth. Based on estimates of total oil wealth and permanent income in Iran, the section highlights the need to reduce government consumption out of oil and gas resources and to invest a large portion of government savings in financial assets abroad as well as in domestic assets. The latter, however, would call for a careful examination of the expected rate of return, the absorptive capacity of the non-oil economy, and the need for macroeconomic policy to smooth out the effects of oil price shocks.

6. Labor market issues are presented in Chapter VI. As mentioned in the preceding chapters, the pace of labor market reforms is an important consideration in the choice of the exchange regime, competitiveness, the transmission mechanisms of monetary policy, and the speed of fiscal adjustment. Chapter VI adds demographic, social, and structural dimensions to the analysis of high unemployment in Iran. It also examines the authorities’ current policy response and discusses alternative options to ease the pressing unemployment problem.