Islamic Republic of Iran: Selected Issues Paper

International Monetary Fund

doi:10.5089/9781451819007.002.A001

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Islamic Republic of Iran: Selected Issues Paper

Author: International Monetary Fund

Publication Date:: 27 Sep 2004

eISBN:: 9781451819007

Language:: English

Keywords:: ISCR; CR; central bank; GDP; rate of return; monetary policy; price; oil price; GDP ratio; financial system; production function; exchange rate; Labor force; Oil prices

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This Selected Issues paper analyzes economic growth in Iran. It uses a growth-accounting exercise to quantify the historical sources of growth over 1960–2002, including human capital accumulation and the contribution of Total Factor Productivity to growth. The paper presents an empirical study to quantify the role of several other contributing factors commonly discussed in the cross-country growth literature, including macroeconomic stability, financial development, trade openness, and the change in the terms of trade. The paper also examines issues in medium-term management of oil wealth in Iran.

Abstract

Chapter I: Economic Growth In The Islamic Republic Of Iran¹

I. OVERVIEW

1. Iran faces the challenge of increasing its growth rate to reduce unemployment and improve the living standards of its population over the medium term. Growth performance in recent years (6 percent during 2000–03) has been satisfactory, and was driven by major economic reforms as well as by transitory factors, such as high oil prices and expansionary fiscal and monetary policies. Questions about the determinants of growth in Iran and the long-term sustainability of relatively high growth rates arise. Given that past experience shows that the Iranian economy can grow at relatively high rates over an extended period, a first step is to examine the historical sources of growth and discuss the relevance of various contributing factors for the medium term. The second step is to provide an analytical framework for the formulation of growth-enhancing policies.

2. This chapter uses a growth accounting exercise to quantify the historical sources of growth over the period 1960–2002, including human capital accumulation and the contribution of Total Factor Productivity (TFP) to growth. The chapter also presents an empirical study to quantify the role of several other contributing factors commonly discussed in the cross-country growth literature, including macroeconomic stability, financial development, trade openness, and the change in the terms of trade.²

II. Growth Literature: Stylized Facts

3. The empirical studies on the determinants of growth can be broadly divided into two main categories. First, growth accounting exercises, which consist of estimating contributions to growth of basic factor inputs—labor, physical capital, and human capital—and a residual that captures the efficiency at which physical and human capital resources are used, or TFP. Second, several empirical studies analyze cross-country growth regressions to find the relationship between different explanatory variables and growth.

4. Some stylized facts arise from the cross-country growth regressions. The most relevant in the case of Iran are:

A positive relation between the level of education of the labor force and economic growth. Barro (1991, 1997), and Benhabib and Spiegel (1994) show that the initial level of education is an important factor to explain subsequent growth. However, Bils and Klenow (2000) find that the causality goes from growth to increases in school enrollment rates.
Macroeconomic stability—usually defined as a combination of a low inflation rate, low budget deficits, and undistorted foreign exchange markets—improves the business environment and reduces the uncertainty on the return of investment projects, and therefore, has a positive relationship with economic growth. Fischer (1993) and Bleaney (1996) find that macroeconomic instability (measured by a combination of high inflation, fiscal imbalances, and high volatility of the real exchange rate) had a significant negative effect on economic growth and possibly also a negative effect on investment. More specifically, the literature finds a negative relationship between inflation and growth. Khan and Senjhadji (2001) find that an inflation rate above 11–12 percent is associated with a significant reduction in growth in developing countries. Sarel (1996) finds that high inflation—above 8 percent per annum—has a negative and statistically significant effect on growth, and that doubling the inflation rate would reduce the average growth rate by 1.7 percentage points. Barro (1997) finds a smaller effect: an increase in the inflation rate of 10 percentage points would reduce the growth rate by 0.2–0.3 percentage points.
Financial development reduces the cost of capital and has generally a positive correlation with growth, but the direction of the causality is difficult to establish. Demetriades and Husein (1996) studied the experience of 16 countries: 4 displayed causality from financial depth to growth, 4 displayed causality from growth to financial depth, and 7 displayed a feedback relationship between finance and growth. Regarding financial repression and growth, both Roubini and Sala-i-Martin and Arestis and Demetriades (1997) find a negative relation between financial repression indicators and growth. The only exception was Korea, in which financial repression favored the growth-leading export sector.
Trade openness generates technology spillovers and provides the economy with access to specialized inputs from abroad. The literature finds a significant effect of trade openness on growth. Greenaway, Morgan, and Wright (1998) cover 73 countries and use a dynamic regression framework to investigate potential lagged effects of openness on growth. They find that the positive effect of trade openness on growth becomes more significant over the long term, while in the short term, this effect is much less important. Improvements in the terms of trade are generally associated with faster growth (see Barro [1996, 1997], Easterly, Kremer, Pritchett and Summers [1993], and Fischer [1993]).
Finally, other factors such as political variables and income inequality may also play an important role in economic growth. Alesina et al. (1996) find a significant negative relationship between political instability and growth. This result is particularly strong when there are significant changes in the ideological position of the executive branch. In another empirical study, Mauro (1997) finds a negative correlation between political risk and economic growth. Other empirical studies show mixed results on the relationship between income inequality and economic growth.

5. In the case of Iran, the analysis covers a period of 42 years (1960–2002), which witnessed significant political and social changes as well as periods of instability (1979 revolution, the war with Iraq, economic sanctions, etc). The analysis in Section IV shows that:

The five-fold improvement in the average level of education of the labor force since 1960 may explain up to one-half of total economic growth in the last 42 years.³ However, it is difficult to determine precisely the magnitude of the contribution of investment in education to growth due to the lack of data to measure the effect of education attainment on productivity.
Trade openness is significantly associated with faster GDP growth. An increase in the imports to GDP ratio of 1 percentage point is associated with faster growth of 0.3 percentage points. A Granger causality test shows that there is a mutual feedback between growth and trade openness: faster growth implies a more-than-proportional-higher demand for imports (as expected), but also an increase in the imports to GDP ratio increases GDP growth.
Regarding macroeconomic stability and growth, there is a positive link between growth and lower inflation in Iran. This relationship is statistically significant, and the paper finds that a reduction in the inflation rate of 1 percentage point with respect to the historical average of 14 percent would increase potential growth by 0.3 percentage points.
Given the inefficiencies in the financial sector, the link between financial deepening and growth in Iran is not clear. In fact, when financial development is proxied by changes in the M2 to non-oil GDP ratio, the relationship between these two variables becomes negative. Given the cross-country empirical evidence of a generally positive relationship between financial development and growth, it is likely that changes in the financial system that would increase its efficiency would yield potentially large gains in terms of long-term growth, reversing the observed negative relationship between financial depth and growth.
Changes in the political environment have had a major impact on economic growth in Iran. The periods of relative political stability and absence of major external conflicts (1960–76 and 1989–2002) are clearly associated with high GDP growth, while the political turmoil and war period of 1977–88 was associated with negative growth. The paper shows that the average annual growth rate during the 1977–88 period was reduced by 6 percentage points due to these factors.

III. Growth Performance in Iran

6. In the period 1960–2002, real GDP growth in Iran averaged 4.6 percent a year (2 percent in per capita terms). Non-oil GDP grew at a faster pace of 5.5 percent during the period.⁴ There are three distinct sub-periods (Figure 1.1):

During 1960–76, Iran enjoyed one of the fastest growth rates in the world: the economy grew at an average rate of 9.8 percent in real terms, and real per capita income grew by 7 percent on average. As a result, GDP at constant prices was almost 5 times higher in 1976 than in 1960. This stellar performance took place in an environment of relative domestic political stability, low inflation (Figure 1.2), and improved terms of trade, as evidenced by the rising oil price relative to import prices (Figure 1.3). Both oil output and oil prices increased significantly during the period: oil production grew at an annual average rate of 10 percent while oil prices relative to import prices increased by 214 percent during the sub-period.
The growth trend was reversed during 1977–88, reflecting the fallout of the turmoil in the aftermath of the 1979 revolution, the eight-year war with Iraq, the international isolation of Iran, the increased state dominance of the economy, and the plummeting in oil output and revenue. In 1988, oil production was only 36 percent of its level in 1976; and oil prices were 40 percent lower in real terms. This resulted in negative real GDP growth of 2.4 per year on average. Excluding oil output, non-oil GDP also declined, albeit at a more moderate pace (0.5 percent per year).
With the reconstruction effort and a partial recovery in oil output, real economic growth recovered during 1989–2002 to an average of 4.7 percent per year. This period, however, was marked by sharp fluctuations in the growth pattern, as the postwar economic boom (1989–93) was followed by the stagnation of 1993–94 when the economy was hit by lower oil prices, lack of external financing, and economic sanctions. The ensuing severe debt crisis, together with inappropriate macroeconomic policies, had an adverse impact on growth, which hovered around 3.6 percent during 1995–2000. In the more recent period (2000–03), real GDP growth picked up to 6 percent due to significant progress in economic reforms—such as the exchange rate unification, trade liberalization, the opening up to foreign direct investment, and financial sector liberalization—but also to high oil prices and expansionary fiscal and monetary policies.
The growth performance of Iran compares favorably with the rest of the countries in the Middle East and North Africa (MENA) region, which averaged 4.2 percent a year during the 1960–2002 period (Table 1.1). Among the 17 countries in the region, only four—Oman, Syria, the U.A.E., and Yemen—grew faster than Iran. However, historical growth in Iran also exhibits higher variability than in the rest of the region: the standard deviation of Iran’s growth rate is only exceeded by those of Kuwait, Lebanon, and Libya (Table 1.2).

Table 1.1.

MENA Region: Economic Growth, 1960–2002

(In percent, average for the period)

Source: International Financial Statistics (IFS).

^{^1/}Excluding Iran.

Table 1.1.

MENA Region: Economic Growth, 1960–2002

(In percent, average for the period)

		1960–76	1977–88	1989–2002	1960–2002
Iran		9.8	-2.4	4.7	4.6
Oil-producing MENA countries ^1/
	Algeria	5.9	2.3	2.0	3.5
	Bahrain	4.5	4.3	4.7	4.5
	Kuwait	4.1	-2.1	1.6	1.4
	Libya	14.0	-0.2	-0.2	4.5
	Oman	9.8	6.0	4.8	6.9
	Qatar	7.0	-0.3	4.4	3.8
	Saudi Arabia	7.7	2.0	2.5	4.2
	United Arab Emirates	12.5	-0.5	6.2	5.1
	Average oil MENA countries	8.2	1.5	3.3	4.2
Non-oil MENA countries
	Egypt	4.6	5.7	3.3	4.5
	Jordan	4.8	5.4	3.5	4.5
	Lebanon	-3.9	5.2	0.3	0.3
	Morocco	4.3	4.1	2.7	3.7
	Pakistan	3.9	6.1	3.8	4.5
	Sudan	2.9	2.4	4.3	3.2
	Syria	7.9	3.8	4.3	5.5
	Tunisia	7.1	4.2	4.4	5.3
	Yemen	9.5	5.7	5.0	6.6
	Average non-oil MENA countries	4.6	4.7	3.5	4.2
MENA average (exc. Iran)		6.6	2.8	3.4	4.2

Source: International Financial Statistics (IFS).

^{^1/}Excluding Iran.

Table 1.1.

MENA Region: Economic Growth, 1960–2002

(In percent, average for the period)

		1960–76	1977–88	1989–2002	1960–2002
Iran		9.8	-2.4	4.7	4.6
Oil-producing MENA countries ^1/
	Algeria	5.9	2.3	2.0	3.5
	Bahrain	4.5	4.3	4.7	4.5
	Kuwait	4.1	-2.1	1.6	1.4
	Libya	14.0	-0.2	-0.2	4.5
	Oman	9.8	6.0	4.8	6.9
	Qatar	7.0	-0.3	4.4	3.8
	Saudi Arabia	7.7	2.0	2.5	4.2
	United Arab Emirates	12.5	-0.5	6.2	5.1
	Average oil MENA countries	8.2	1.5	3.3	4.2
Non-oil MENA countries
	Egypt	4.6	5.7	3.3	4.5
	Jordan	4.8	5.4	3.5	4.5
	Lebanon	-3.9	5.2	0.3	0.3
	Morocco	4.3	4.1	2.7	3.7
	Pakistan	3.9	6.1	3.8	4.5
	Sudan	2.9	2.4	4.3	3.2
	Syria	7.9	3.8	4.3	5.5
	Tunisia	7.1	4.2	4.4	5.3
	Yemen	9.5	5.7	5.0	6.6
	Average non-oil MENA countries	4.6	4.7	3.5	4.2
MENA average (exc. Iran)		6.6	2.8	3.4	4.2

Source: International Financial Statistics (IFS).

^{^1/}Excluding Iran.

Table 1.2.

MENA Region: Standard Deviation of Economic Growth, 1960–2002

Source: International Financial Statistics (IFS), and IMF staff estimations.

^{^1/}Excluding Iran.

IV. Sources of Growth

A. Growth Accounting

7. A standard growth accounting framework is used to discuss the historical sources of growth in Iran. We use the following Cobb-Douglas production function:

\begin{matrix} Y_{t} = A_{t} K_{t}^{a} H_{t}^{1 - α} & (1) \end{matrix}

where Y, K, and H represent output, physical capital, and human capital respectively, a represents the contribution of physical capital to output, and t is an index for time. The term A represents TFP, or the efficiency at which the economy operates, which depends on factors such as domestic political and international environment, the legal and regulatory framework, the creation and diffusion of more efficient technologies through international trade or foreign direct investment, and the effect of structural reforms such as financial sector or labor market liberalization. Physical capital is considered as a homogeneous capital good, with no distinction made between equipment and non-equipment capital goods, or between private and public capital goods (implicitly assuming that the productivity of the two types of capital is the same).⁵

8. To account for the effect of education on economic growth, a human capital index is constructed as a function of both the labor force and its average years of schooling. However, in Iran it is difficult to measure the contribution of schooling to human capital because of the lack of an education quality index that would account for the changes in the productivity of education during the 1960–2002 period.⁶ Therefore, the paper considers two different specifications of human capital, which result in two different growth accounting exercises.

9. A basic specification of human capital is to equal human capital to raw labor, that is, H_t = L_t. Under this specification, an increase in the average years of schooling of the labor force does not increase the productivity of labor. Given that the cross-country empirical evidence points to a positive effect of education on the productivity of labor, under this simple specification, the contribution of TFP to growth is overstated because it implicitly takes into account the effect of the quality of the labor input on output and growth.

10. A different assumption is to consider that schooling increases the productivity of the labor force along the following specification of human capital (Lucas, 1988):

\begin{matrix} H_{t} = L_{t} e_{t} & (2) \end{matrix}

where L represents the labor force and e is the average years of schooling of the labor force.

11. The above specified production function implies that human capital accumulation exhibits increasing returns to scale. This means that, if we double both the number of workers and the average education years of the labor force, then human capital increases four-fold. Since some evidence—such as the increased proportion of college graduates with non-marketable skills—points to a reduction in the quality of education in Iran over the period under study, the growth accounting exercise using this technology specification may result in an overstatement of the contribution to human capital—and an understatement of the contribution of TFP—to growth.

12. Taking natural logarithms and differentiating with respect to time, the following decomposition of growth is obtained:

\begin{matrix} g_{Y} = g_{A} + α g_{K} + (1 - a) g_{H} & (3) \end{matrix}

where g denotes the growth rate of the variable in the subscript. If factor markets are competitive, the first-order profit-maximizing conditions for the firm imply that a corresponds to the share of rental payments to capital in total income, that is, α = (r-d)^*K/Y, where r is the net rate of return on capital and d is the depreciation rate of capital. The derivation of the time series of the capital stock and the data sources are presented in the Appendix.

13. The results of the growth accounting exercises under the two alternative specifications for human capital (H_t = L_t. and H_t = L_t e_t) are shown in Tables 1.3 and 1.4, respectively.

Table 1.3.

Islamic Republic of Iran: Sources of Economic Growth (Raw Labor), 1960–2002