Islamic Republic of Iran: Staff Report for the 2003 Article IV Consultation

Domestic demand continued to grow at rapid rates, despite corrective fiscal and monetary policy measures. Although trade and financial sector reforms advanced and foreign direct investment (FDI) regulations were liberalized, there was less progress in improving the business environment, reducing labor market rigidities, and restructuring and privatizing public enterprises. IMF staff stressed the need for further advances in trade liberalization, improved fiscal management, financial system restructuring, labor market reform, privatization, and elimination of subsidies. The managed float exchange regime remains appropriate for Iran.


Domestic demand continued to grow at rapid rates, despite corrective fiscal and monetary policy measures. Although trade and financial sector reforms advanced and foreign direct investment (FDI) regulations were liberalized, there was less progress in improving the business environment, reducing labor market rigidities, and restructuring and privatizing public enterprises. IMF staff stressed the need for further advances in trade liberalization, improved fiscal management, financial system restructuring, labor market reform, privatization, and elimination of subsidies. The managed float exchange regime remains appropriate for Iran.

I. Introduction

1. During the first three years of the Third Five-Year Development Plan (TFYDP) (2000/01–2002/03), real GDP grew by 5.8 percent on average, despite declines in oil output during the past two years. At the same time, real per capita GDP and per capita private consumption increased on average by 4.1 percent and 4.7 percent, respectively. In addition, the overall macroeconomic situation improved significantly compared to the previous five-year development plan (Text Table I): the external current account was in surplus, the external debt was reduced to a very low level, international reserves increased significantly, and fiscal savings were accumulated in the OSF. This performance has taken place against the background of increased openness of the economy to international trade and investment, and increased economic reforms (Box 1), but also benefited from sustained high oil prices and fiscal stimulus.

Table I.

Islamic Republic of Iran: Selected Indicators, 1990/91–2004/05

(Period average percentage change, unless otherwise indicated)

Sources: Central Bank of Iran; and Fund staff estimates.

Three-year average, 2000/01–2002/03.

At factor cost at constant 1990 prices.

2. Notwithstanding these achievements, the Iranian economy continues to face important challenges: employment creation has not been sufficient to meet the rapid increase in the labor force; inflation is high and rising again; price subsidies and controls continue to hinder economic efficiency; and structural impediments for private sector development remain.

3. The authorities’ reform strategy under their development plan has effectively addressed many of these issues and helped improve economic performance in line with Fund’s policy advice and technical assistance recommendations. The successful unification of the exchange rate and the positive response of the private sector to trade liberalization and other reforms have created a favorable policy climate and stimulated the preparations of additional reforms. However, the need for political and social consensus continues to slow down the pace of implementation of reforms that have short-term adverse social effects. Following up on the Fund’s assessment and recommendations regarding macroeconomic policies in the context of the 2002 Article IV consultation, the authorities cut expenditure and enhanced revenue collection, thereby reducing the non-oil fiscal deficit by 1.6 percent of GDP compared to the initial budget estimates. Action was also taken by the central bank to absorb excess liquidity. However, the package of measures fell short of the recommended adjustment to contain liquidity growth and inflation, mainly out of concern for the negative impact of fiscal tightening on employment (Text Table II).

Table II.

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

Source: Fund staff estimates.

Major Structural Reforms in 2000–03

Iran has undertaken several major structural reforms in the past three years. Among them, the most important are:

Exchange and trade regimes:

  • Exchange rate unification and elimination of most foreign exchange restrictions for current account transactions (March 2002).

  • Trade liberalization: elimination of most export restrictions, replacement of nontariff barriers (NTBs) with tariffs, streamlining of import licensing procedures, and rationalization of the tariff structure (2000/01–2003/04).

  • Approval of a new FDI law (2002) that establishes a clear legal framework for foreign investment in Iran.

Financial sector reforms:

  • Introduction of Central Bank Participation Papers (CPPs); more flexibility in setting rates of return1/ (on both deposits and lending rates); licensing of four private banks; authorization of private insurance companies; and implementation of risk-based banking supervision.

  • Preparation of a draft law on capital markets.

Fiscal reforms:

  • Establishment of the OSF in December 2000 with the objective of insulating the budget from fluctuations in oil prices.

  • Tax administration: Setup of the National Tax Organization (which includes a Large Taxpayer Unit) in June 2001.

  • Tax reform: In 2002/03, personal income tax rates were reduced significantly and minimum nontaxable income raised along with a reduction of corporate tax rates (from a high of 64 percent to 25 percent); and tax assessment and collection methods were made less discretionary. As a part of rationalization of indirect taxes, in 2003/04, several taxes and fees were combined in a single sales tax of 3 percent on all goods and services; and all import duties, taxes, and charges (except commercial benefit taxes) were unified into a single customs duty rate of 4 percent.

  • Submission to Parliament of a draft law on the value-added tax (VAT).

  • Reflection of the cost of most subsidies in the budget: The 2002/03 budget included exchange rate subsidies and this year’s budget explicitly identifies the cost of energy subsidies (about 10 percent of GDP).

  • Reduction in government employment by about 5 percent during 2000–03.

1/ Under Islamic banking principles, ex-ante rates are not allowed, but financial rates of return are used, based on expected profitability.

II. Recent Developments

4. Growth was high and broad-based in 2002/03 Real GDP is estimated to have grown at 6.8 percent, with non-oil GDP expanding by 7.9 percent (Text Table III, Figure 1, and Table 1). Positive supply shocks, including the effects of ongoing reforms, good weather conditions, and higher oil prices contributed to growth acceleration. At the same time, enhanced business confidence and monetary and fiscal stimuli spurred domestic demand, with private and public investment registering particularly high growth rates. Following strong wage growth, private consumption also increased rapidly (Figure 2). Preliminary indications point to a pick-up in the rate of employment creation in 2002/03, leading to a decline in the unemployment rate. This may be attributable to the acceleration of growth, and, to some extent, to the impact of recent employment incentive schemes such as subsidized credits and tax incentives for employment creation.

Table III.

Islamic Republic of Iran: Sectoral Growth Rates, 2000/01–2002/03

(Annual percentage change at constant prices)

Source: Central Bank of Iran.
Figure 1.
Figure 1.

Islamic Republic of Iran: Unemployment Rate and Real GDP, CPI, Oil, and Non-oil GDP, 1996/97–2003/04

(Annual percentage change, unless otherwise indicated) 1/

Citation: IMF Staff Country Reports 2003, 279; 10.5089/9781451818949.002.A001

Table 1.

Islamic Republic of Iran: Selected Macroeconomic Indicators, 1998/99–2003/04 1/

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

Iranian fiscal year ends March 20.

Using the current account balance from the balance of payments and the market-determined exchange rate.

Using 1999/2000=100.

Assuming fiscal and monetary policy adjustment.

Figure 2.
Figure 2.

Islamic Republic of Iran: Breakdown of Domestic Demand Growth, 1998/99–2003/04

(Annual percentage change at constant prices) 1/

Citation: IMF Staff Country Reports 2003, 279; 10.5089/9781451818949.002.A001

Sources: Iranian authorities; Fund staff estimates and projections.1/ Last observation: projection for 2003/04.2/ Last observation: 2002/03.

5. CPI inflation accelerated to 15.8 percent in 2002/03 from 11.4 percent in 2001/02, owing to a relatively expansionary fiscal stance and accommodating monetary policy (Figure 3). Moreover equity and real estate prices continued to increase rapidly not only in response to economic liberalization measures, but also owing to the high growth of money and credit, as well as a relatively stable exchange rate (Figure 4).1

Figure 3.
Figure 3.

Islamic Republic of Iran: Inflation Developments, 1999–2003 1/

(12-month percentage change)

Citation: IMF Staff Country Reports 2003, 279; 10.5089/9781451818949.002.A001

Source: Iranian authorities.1/ Last observation: May 2003.2/ Excluding food, beverages, and tobacco.
Figure 4.
Figure 4.

Islamic Republic of Iran: Financial Market Indicators, 1995/96–2002/03

Citation: IMF Staff Country Reports 2003, 279; 10.5089/9781451818949.002.A001

Sources: Iranian authorities; and Fund staff estimates.1/ Last observation: 2002/03.2/ Last observation: March 2003. TSE index stood at 9,596.1 on July 30, 2003.

6. Rapidly growing domestic demand weighed on the external current account balance. The current account surplus is estimated to have narrowed to 3 percent of GDP in 2002/03 from 5.3 percent in 2001/02 (Table 2). Exports continued to grow on account of higher oil prices and strong performance of non-oil exports, but imports rose sharply due to buoyant domestic demand, recent trade liberalization measures, and a build-up of inventories in the period leading up to the Iraq war. The current account surplus, together with large capital inflows,2 led to the increase in gross official reserves by $4.8 billion (to the equivalent of about seven months of next year’s estimated imports). A large outflow under errors and omissions may reflect unrecorded imports and some capital outflows through the offshore interbank market for foreign exchange (see below). External vulnerability indicators point to a strong international liquidity position (Table 3), and Iran’s external debt remains low (8.4 percent of GDP).

Table 2.

Islamic Republic of Iran; Balance of Payments, 2000/01–2003/04 1/

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

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

Fiscal year ending March 20.

Projection is based on WEO prices.

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

Some letters of credit have maturities in excess of one year.

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

Represents the part of OSF that is kept in foreign exchange.

Excluding short-term debt.

Table 3.

Islamic Republic of Iran: Vulnerability Indicators, 1998/99–2002/03 1/

Sources: Iranian authorities; and Fund staff estimates.

Iranian Fiscal years ending on March 20.

Excluding interest receipts and payments.

Excluding short-term external debt.

The classification is not consistent with international practices.

7. Despite efforts to cut expenditure, fiscal policy was expansionary in 2002/03. The overall fiscal balance is estimated to have shifted to a deficit of about 2.3 percent of GDP, compared to a surplus of 1.8 percent of GDP in 2001/02 (Table 4). This deterioration mainly reflects the budgetary cost of the exchange rate unification and rapid growth of capital expenditures. In the meantime, the non-oil deficit is estimated to have widened sharply by 5.4 percentage points to 19.3 percent of GDP, notwithstanding expenditure cuts introduced in the fall of 2002 (amounting to 1.6 percent of GDP).

Table 4.

Islamic Republic of Iran: Central Government Operations, 2001/02–2003/04 1/

(In billions of rials)

Table 4.

Islamic Republic of Iran: Central Government Operations, 2001/02-2003/04 1/ (concluded)

(In percent of GDP, unless otherwise indicated)

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

Fiscal year ends March 20.

Reflects mainly transactions with the social security organization.

Parliament has instructed the government to cut expenditure to compensate for lack of financing.

Based on fiscal and monetary policy adjustment measures.

8. Monetary policy was accommodating. Although the central bank issued additional CPPs to reduce excess liquidity, it could not independently adjust the rates of return, which in fact were reduced for retail lending.3 The central bank accommodated the higher credit demand by increasing significantly its claims on banks and nonfinancial public enterprises. This, together with unsterilized purchases of foreign exchange from the government4 and higher money multiplier (Figure 4),5 led to the acceleration of M2 growth to 30 percent while credit to the private sector grew by 35 percent.

9. State-owned banks remain unprofitable and undercapitalized. Low profitability is attributable to controls on rates of return and high operating costs. The authorities intend to reinvest nearly $2 billion of post-unification revaluation gains in banks’ capital, raising capital adequacy ratios to around 8 percent from the current 4½ percent (Table 3). Banks’ direct exposure to the equity market is limited, as margin lending for purchases of stocks is prohibited and investment in stocks by banks is limited to 2 percent of deposits.

10. After a period of stability following the March 2002 exchange rate unification, the unified exchange rate has depreciated in nominal and real terms since September 2002. Under the managed floating exchange rate regime, the central bank has not committed to or publicly announced a specific exchange rate target, but has aimed to smooth out fluctuations in the exchange rate using an undisclosed basket of currencies. It has also permitted a nominal depreciation of the Iranian rial vis-à-vis the basket, to offset the deterioration in competitiveness resulting from the high inflation differentials between Iran and its trading partners. As a result, the nominal effective exchange rate and the REER depreciated by 17 percent and 4 percent, respectively, from March 2002 to April 2003 (Figure 5). Since the exchange rate unification, the parallel market premium has remained below 0.5 percent, except during the war in Iraq, in part due to central bank intervention in the offshore market throughout the year.6

Figure 5.
Figure 5.

Islamic Republic of Iran: REER and NEER Developments, 1997/98–2002/03 1/

(1999/00 = 100)

Citation: IMF Staff Country Reports 2003, 279; 10.5089/9781451818949.002.A001

Source: Fund staff estimates.1/ Initial observation: April 1997. Last observation: April 2003. NEER denotes nominal effective exchange rate, PPI-producer price index, WPI-wholesale price index, and ULC-unit labor costs.2/ Initial observation: April 1997. Last observation: March 2003.

11. Despite the REER depreciation in 2002/03, the trend since 1999 has been for real appreciation. The CPI-based and ULC-based REER show an average appreciation of 18 percent and 30 percent, respectively, during the 2000–02 period with respect to the previous four-year period. Despite this real appreciation, non-oil exports grew by about 11 percent on average during this period, reflecting improved access to imported intermediate and capital goods used as inputs in the export sector, as well as the implicit energy subsidies that reduce export costs relative to competitors. These factors are temporary however, and their effect may taper off, leading to a significant loss of competitiveness in the future if the REER appreciation trend continues.

12. Since the last Article IV consultation, structural reforms have advanced unevenly across reform areas. While trade and financial sector reforms advanced, there was less progress in improving the business environment, reducing labor market rigidities, and restructuring and privatizing public enterprises.

13. Steadfast progress has been made in liberalizing Iran’s trade regime. Recent decisions include: (a) consolidating customs duty rates and other import charges and fees into a single customs duty rate at 4 percent; (b) eliminating exemptions from the customs duty; (c) reducing sharply the number of commercial benefit tax (CBT) rates to 24 from 60; (d) continuing replacement of NTBs with tariffs; and (e) reducing significantly the number of NTBs. Despite these efforts, the combined simple average import tariff rate7 is still relatively high at 27.6 percent.8

14. Financial sector reform has gained momentum (Box 2), Four private banks have been licensed, two mid-size public banks are expected to be privatized, and legislation authorizing private insurance companies has been passed. Moreover, some progress is being made in establishing indirect instruments of monetary policy and de-regulating rates of return in the banking system. In the area of banking supervision, the authorities have made significant progress, with Fund TA, in establishing a risk-based banking supervision. In addition, regulations for banking and credit institutions on anti-money laundering and combating the financing of terrorism (AML/CFT) were approved by the MCC in February 2003, and legislation on AML/CFT has been submitted to parliament. However, progress in modernizing the payment system and developing a sound framework for regulation and supervision of capital markets has been slow.

15. In other areas, positive steps have been taken, but the pace of reform has remained slow. Following the passage of the FDI law in 2002, the government approved relevant by-laws, determining a clear framework for FDI in Iran. Steps to reduce consumer and energy subsidies have been taken in the form of increases in retail prices of gasoline, flour, rice, and sugar. Moreover, preparatory work to phase out implicit energy subsidies is being carried out with assistance from the World Bank. Divestiture of government’s shares to the private sector and the Social Security Organization have continued without transfer of majority control. Finally, an amendment of the labor code has liberalized hiring and firing regulations for small companies.

Financial Sector Reform

Central to efforts to increase the efficiency and flexibility of the financial system are measures to increase competition and private sector participation in the banking sector. In the past year, four privately-owned banks were established, and although their share of banking system assets is very small, they are expanding rapidly and putting pressure on state-owned banks to improve the range of services available to customers.

The Central Bank of Iran (CBI) is also moving toward a more market-based, indirect approach to monetary policy implementation.

  • The CPPs were introduced in 2001. Although their returns are set by the Monetary and Credit Council (MCC) and cannot fluctuate in the secondary market, CPPs have played an important role in sterilization operations;

  • More recently, the central bank has eased direct controls over retail lending rates and the sectoral allocation of credit; and

  • It also plans to introduce auctions for commercial bank fixed-term deposits with central bank. This is likely to introduce benchmark market rates of return, particularly if an active secondary interbank market in such deposits develops.

Measures are also being taken to facilitate international trade and investment. Since March 2003, banks have been permitted to deal in foreign exchange in the offshore market, mainly in Dubai and the Kish Free Trade-Industrial Zone. Most of these transactions are trade-related, and now account for around one-third of total foreign exchange market turnover. Banks’ exposures in the offshore market are constrained by foreign exchange regulations applying to banks on a consolidated basis, and transactions are subject to new AML/CFT regulations.

Measures arc being taken to enhance the strength of the financial system.

  • A comprehensive program to develop and implement a risk-based regulatory and supervisory framework for the banking sector is underway. Key regulatory reforms are in place, including licensing and net open positions, or in the process of being prepared; supervisory functions have been unified under one single department at the central bank, on- and off-site inspections have begun, using risk-based criteria; and reporting forms and supervision manuals are being developed.

  • The authorities are planning to raise state-owned banks’ capitalization to conform to Basel standards.

Draft legislation to enhance the supervisory and regulatory framework governing the Tehran Stock Exchange (TSE) is being considered by the government, and the TSE has very recently established a separate regulatory unit.

III. Report on the Discussions

16. The discussions focused on the appropriate policy mix for 2003/04 and medium-term challenges. There was agreement that conditions were favorable for high growth to continue in 2003/04, but the staff suggested that fiscal and monetary policy be tightened to contain inflationary pressures. It also discussed the authorities’ structural reform program aimed at sustaining high growth, increasing employment creation, and fostering an optimal use of oil wealth.

A. Short-Term Policy Issues

Outlook for 2003/04

17. The investment and growth momentum of the past few years is expected to continue in 2003/04. Real GDP growth is projected at 6.5 percent, reflecting higher oil output,9 continued strong performance of non-oil activities (6.2 percent), though at a more moderate pace than during last year, as agriculture output returns to its trend growth. Downside risks to this outlook include regional instability and uncertainties about oil prices, which could affect investment and business confidence.

18. The staff expressed concern about the pro-cyclical nature of the authorities’ policy stance. It underscored that in Iran’s current cyclical position—in which oil prices are high, capital inflows are increasing, and inflation is rising—the government should be running fiscal surpluses and accumulating savings in the OSF. Also of some concern is the projected shift into a small deficit of the current account balance (0.6 percent of GDP) at a time when oil prices are relatively high, even though the overall balance of payments is expected to be in surplus (about $2 billion) owing to sustained FDI in the oil sector,

19. The authorities and the staff shared the view that the fiscal policy stance based on the budget approved in February 2003 would exacerbate demand pressures, leading to high liquidity growth and inflation. The sizable liquidity impact of the fiscal deficit financing, continued private capital inflows, and sustained growth in private demand could cause domestic liquidity to grow by about 35 percent. Recognizing these risks, the authorities indicated that they had approved a package of monetary policy measures and were considering fiscal measures aimed at containing domestic demand and limiting inflation to 18 percent. Despite the projected tightening of monetary policy, inflation is still expected to be higher in 2003/04 than in 2002/03, owing to lagged effects of M2 growth in 2002/03 and readjustments of administered prices.

20. The authorities remain concerned about the impact of fiscal tightening on employment. The staff argued that stimulating employment through expansionary fiscal policy at a time when output seems to be above its potential can be costly in terms of inflation (Figure 6), particularly if unemployment is of a structural nature as is the case in Iran. Moreover, given the strong private sector response to economic reforms in recent years, and the fact that a large share of employment creation originated in the private sector, a fiscal stimulus was not necessary (Text Table IV).

Figure 6.
Figure 6.

Islamic Republic of Iran: Output Gap, 1990–2003

(at 1990 constant prices, in logarithms)

Citation: IMF Staff Country Reports 2003, 279; 10.5089/9781451818949.002.A001

Sources: Fund staff estimates and projections based on Hodrick-Prescott filler.
Table IV:

Islamic Republic of Iran: Employment in the Public and Private Sectors, 1997–2000

(In percent; unless otherwise indicated)

Sources: Central Bank of Iran; and Fund staff estimates.

Fiscal policy

21. The staff noted that budget revenue was overestimated and capital expenditure and lending from the OSF were budgeted to increase significantly. The budget calls for an increase in non-oil revenue by 2.3 percent of GDP (Table 4), which appears highly optimistic even if additional revenue measures are accounted for (Box 1). The overall shortfall of non-oil revenue and financing, mainly on account of taxes on international trade, privatization proceeds, and telecommunication license fees, could reach Rls 35 to Rls 38 trillion (3.5 percent to 3.8 percent of GDP). Total expenditure is budgeted to remain largely unchanged in 2003/04 relative to GDP, compared with the outcome for 2002/03, but capital expenditure and net lending from the OSF are budgeted to increase sharply (by 1.3 percent of GDP).

22. The authorities plan to introduce fiscal measures in the second half of the current fiscal year. An interagency budget committee was considering revenue measures, including raising taxes on international trade10 and expenditure cuts to offset the expected revenue shortfall. The authorities indicated that across-the-board cuts of 3 percent were already being applied to nonwage current outlays and the investment budget was expected to be curtailed significantly, which would bring the fiscal deficit down to 2.2 percent of GDP. The staff advised against raising import taxes, which would undermine ongoing trade liberalization efforts. It also called for additional cuts mostly in capital expenditures and improved revenue collection that would bring down the fiscal deficit to the equivalent of 1.4 percent of GDP corresponding to a non-oil deficit of 15.4 percent of GDP (Table 4). The authorities concurred that such a deficit would be consistent with their monetary objective and with the need to achieve a gradual adjustment to a possible downturn in oil prices.

Monetary policy and financial system stability

23. The authorities agreed on the need for monetary policy to focus on disinflation, which would enhance the credibility of the monetary anchor (M2) under the managed float exchange regime. In this regard, the staff indicated that achieving the authorities’ inflation objective would require a deceleration in M2 growth to 20–25 percent and reiterated the importance of the recommended fiscal adjustment and monetary restraint (Table 5). The authorities agreed with this target and indicated that the MCC had already approved a range of monetary policy measures to contain domestic liquidity growth. These include: (a) sterilization operations of up to Rls 10 trillion (6 percent of end-period base money) through issuance of CPPs and auctioning of bank deposits with the central bank; and (b) raising the rates of return on government participation papers to 17 percent.

Table 5.

Islamic Republic of Iran: Monetary Survey, 2000/01–2003/04 1/

(In billions of rials; unless otherwise indicated)

Sources: Central Bank of 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.

Fiscal and monetary policy adjustment scenario.

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

24. The staff welcomed these steps, but noted potential upside risks to liquidity growth. In particular, negative real rates of return and further increases in central bank’s claims on banks could lead to higher credit growth and jeopardize the achievement of the M2 target. In this context, the staff recommended that the central bank should have sufficient flexibility in determining the rates of return on its facilities, including overdrafts, and the minimum rates of return in the banking system. Moreover, the staff urged the authorities to strengthen banking supervision and discourage banks from their large use of overdraft facilities. The authorities indicated that the central bank had full control on the rates of return of the auctioned deposit facility, and that the MCC could increase the rate of return on CPPs to make them more attractive. They were confident that the increase in claims on banks would be limited, owing to stronger supervisory efforts and moral suasion. The authorities also indicated that consideration was being given to enhancing the independence of the central bank in light of the experience of other countries.

25. The mission discussed the potential risks to the stability of the financial system associated with rapid credit growth and a possible downward adjustment in stock prices. The staff drew the authorities’ attention to the relative deterioration in most prudential indicators (Table 3) and urged the authorities to enforce new prudential regulations after the expiration of the transition periods for full compliance. The authorities expressed concern about rising nonperforming loans, but did not see major immediate risks associated with rapid credit growth given the adequacy of banking supervision. They also maintained that the risks associated with banks’ exposure to the real estate market were manageable because of high collateral and an effective enforcement of foreclosures by the courts. Regarding the stock market, the authorities expressed the view that recent price increases reflected the low starting point of the equity market, which had been dormant for several years, and were confident that a sharp downward adjustment was unlikely to take place since the major investors—the Social Security Organization, government pension funds, and other large institutional investors—would not exit the market in a disorderly manner, given the long-term nature of their commitment and the limited alternatives for investment (Text Table V). The staff stressed the need for early adoption of a draft capital market law, which will help strengthen the supervision of the stock market.

Table V.

Selected Countries: Price/Earning Ratios in Selected Stock Markets, mid-2003

Sources: Datastream; Morgan Stanley Capital International; and Iranian authorities.

Provided by the Iranian authorities.

Exchange rate policy

26. The staff concurred that the foreign exchange market had operated smoothly since the exchange rate unification, but highlighted the risks associated with higher inflation. The staff argued in favor of increased exchange rate flexibility that would also be consistent with the need to achieve the monetary policy objective. This should be supported by tighter fiscal policy and further trade liberalization to take some pressure off the exchange market. The staff also noted that the risk of acceleration of inflation associated with the continuation of expansionary policies poses a serious challenge to exchange rate management. Further significant real appreciation could erode competitiveness over the medium term, as the temporary factors that have recently boosted competitiveness taper off. The authorities acknowledged this risk and shared the staff views that under Iran’s current circumstances, larger and lasting gains in competitiveness should be obtained through structural reforms.

27. The staff discussed the potential vulnerabilities that could arise from the involvement of Iranian banks in the offshore foreign exchange market. These include potential difficulties to intermediate large and volatile capital inflows and the exposure of parent banks to offshore branches. The authorities indicated that the operations in the offshore markets were mainly related to current account transactions. Should there be evidence of large capital outflows through this channel, the authorities would be able to re-impose restrictions on offshore market transactions. The authorities also stated that banks’ exposure to offshore branches is constrained by foreign exchange regulations applying to banks on a consolidated basis, and requested Fund’s TA on the adequacy of the relevant prudential regulations.

28. The staff welcomed the authorities’ continued interest in accepting the obligations of Article VIII, Sections 2(a) and 3 of the Fund’s Articles of Agreement. In this respect, it had further discussions with the authorities regarding foreign exchange regulations or practices that are inconsistent with Article VIII obligations (Appendix I). Since the 2002 Article IV consultation, the authorities have eliminated the multiple currency practice resulting from exchange rate subsidies on certain imports. The staff is reviewing documentation relating to recent changes in relevant Iranian regulations, as well as other issues regarding Iran’s foreign exchange regime.11

B. Structural Reforms and Medium-Term Policy Issues

29. The staff welcomed the authorities’ intention to further liberalize trade through the remaining years of the TFYDP. It emphasized that efforts in this area should aim at eliminating any remaining NTBs, rationalizing the tariff structure by having a uniform schedule, and reducing the number of tariff bands and the average and maximum rates. Simultaneously, efforts will need to continue in streamlining customs and administrative procedures.

30. The staff encouraged the authorities to develop a medium-term fiscal framework that would help smooth out the impact of fluctuations in oil prices, build savings for future generations, and reduce the scope of implicit and explicit subsidies. As a first step in this direction, the authorities would need to strictly adhere to the OSF objectives of helping absorb the shocks coming from oil price volatility. In this regard, the staff reiterated its concern that OSF resources were being run down at a time when oil prices were high, thereby leaving little financial room to cushion the impact of a decline in oil prices (Text Table VI). The next step would be to give consideration to accumulating long-term savings to maintain per capita oil wealth constant across generations. The authorities indicated that the preparation of the next five-year development plan offered an opportunity to consider these and other medium-term reforms, which are at various stages of preparation. In this regard, while implementation of the VAT is scheduled for 2005/06, the reform of energy subsidies is still at an early stage of preparation in collaboration with the World Bank. The authorities favor a gradual approach to the energy price reform, but specific plans have not yet been developed. The staff encouraged the authorities to accelerate the preparation of these reforms, including putting in place an adequate social safety net with appropriately targeted assistance for households in need and phasing out subsidies.

Table VI.

Islamic Republic of Iran: Operations of the Oil Stabilization Fund, 2000/01–2003/04

(In millions of U.S. dollars)

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

Assuming fiscal adjustment.

31. Wide-ranging reforms to increase the efficiency and stability of the financial system are essential for the development of the Iranian economy. The staff welcomed the authorities’ commitment to complete implementation of the risk-based regulation and supervision in the banking system, including adoption of remaining prudential regulations, and to overhaul the payment system. In addition, it endorsed the authorities’ intention to encourage increased private sector participation in the financial sector and welcomed their plans to privatize two state-owned banks in the coming years. These, together with further easing of directed credit and controls on the rates of return, will help enhance efficiency and improve banks’ profitability. The staff also urged the authorities to press ahead with measures to implement a more indirect, market-based approach to monetary policy implementation. The authorities indicated that the envisaged draft legislation to improve capital markets regulation would establish a Security and Exchange Commission and strengthen the supervision of the stock exchange. The staff recommended that efforts in this direction be accelerated.

32. The staff pointed out that labor market reform and increased private sector participation would accelerate employment creation. Labor market reform should aim at reducing labor market rigidities, including high dismissal costs, excessive regulation, an inefficient information system to match job seekers and potential employers, and government determination of salaries in most industries.12 This, together with privatization, increased competition, and a reform of the education system, would enhance productivity and growth. The authorities confirmed their intentions to move gradually with such reforms. They intend to draw lessons learnt from the experiment with liberalizing labor regulations in small companies before expanding the reform to other companies. The staff cautioned against excessive reliance on tax and credit incentives as a means to reduce unemployment. In the area of privatization, the authorities indicated that a more ambitious privatization plan that would help bring about managerial expertise and know-how was under active consideration. Large-scale privatization, however, would be preceded by reforms in subsidies and competition policy.

33. The mission discussed with the authorities the medium-term outlook (2004/05–2008/09) for the Iranian economy, based on a scenario of a gradual decline in oil prices, an easing of regional tensions, and a gradual implementation of the above structural reforms (Box 3). Under such a scenario, real GDP growth would average about 5 percent; unemployment would remain high; and external vulnerability might increase (Table 6 and Figure 7). An alternative scenario, assuming a fall in oil prices to $18 per barrel beginning in 2004/05 and lower FDI in the oil sector highlights the vulnerability of the budget and external accounts to these two assumptions (Figure 8). These scenarios, however, are indicative and are subject to considerable uncertainties. The authorities indicated that the next five-year development plan (2005/06–2009/10) would aim at achieving much higher growth rates than projected by the staff, but the related medium-term macroeconomic framework and policies were at an early stage of preparation.

Table 6.

Islamic Republic of Iran: Baseline Medium-Term Scenario Under Current Policies, 2000/01–2008/09 1/

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

Iranian fiscal year ending March 20.

Using the current account balance from the balance of payments and the market-determined exchange rate.