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; bank auditor; specialized bank; Iran's financial system; concept of bank soundness; credit allocation; Stock markets; Capital markets; Credit
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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

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.

Chapter III. The Iranian Financial Landscape23

I. Introduction

51. The Iranian financial system has evolved through a number of stages since the 1979 Revolution. After widespread nationalizations in the 1980s, reforms of the financial system in the 1990s and 2000s focused on improving the regulatory environment and streamlining controls to enhance efficiency, while more limited steps were taken to open the sector to private sector participation and foster competition. These efforts, however, have only marginally altered the structure of the financial system, which remains underdeveloped and exhibits several weaknesses that are typical of countries in transition from a “command” and relatively closed economy to an open and market-oriented economy. These features include ownership and dominance by the public sector over financial institutions, even though a number of private banks have started operations in recent years; the widespread use of administrative controls on credit allocation and rates of return (interest rates) and a lack of competition among banks; relatively weak bank supervision; shallow and weakly regulated capital markets; and an underdeveloped insurance industry (Table 3.1). Financial system reform needs to continue in line with the gradual opening up of the economy to foreign trade and capital inflows, the increasing role of the private sector in economic activity, and the need to enhance bank supervision and improve monetary policymaking.

Table 3.1.

Iran and MENA: Comparative Financial Development Indicators

(Comprehensive Index, Scale 0–10, 2000–01)

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Source: Creane et al (2003).

Within overall scale of 0–10, intermediate scales are as follows: High—Above 6, Medium—4-6, Low—Below 4.

52. State-owned banks, including the specialized banks, continue to be the major providers of financing to the corporate sector, albeit their lending is rationed and highly concentrated on a small number of large companies or priority sectors (notably agriculture) to which they lend at subsidized rates. Despite its increasing capitalization (24 percent of GDP), the stock market has a relatively low level of liquidity and provides little fresh financing to the corporate sector.

53. The financial system has operated in a volatile macroeconomic environment. Over the period 1989/90–2003/04, real GDP growth varied considerably around an average of about 5 percent, with standard deviation amounting to 3¾ percentage points. Also, average annual CPI inflation fluctuated in a range of 11–49 percent, and the official exchange rate depreciated from Rls 80 to Rls 8,400 per US$1. More recently, large unsterilized purchases of foreign exchange and the relaxation of credit policy have led to high rates of growth of credit and money (with annual average growth rates of 36 and 29 percent, respectively, in the last three years). This has led to the persistence of inflation at 15½ percent for two years in a row.

54. The Iranian financial system lags behind in many respects compared to other MENA countries. According to an overall index of financial development prepared by the IMF staff (see Creane et al., 2003), Iran ranks low among MENA countries, with particularly low scores for monetary policy making and the development of the banking and nonbanking financial sectors (see Table 3.1).24

55. This chapter reviews key issues and reform challenges in the financial sector in Iran. Section II provides information on the evolution of the size and structure of the banking system, capital markets, insurance sector, and foreign exchange market. Section III discusses issues of regulation and governance of Iran’s financial system and highlights the reasons behind the relatively low level of financial intermediation. It also provides an update on the implementation of FSAP recommendations. Section IV presents links between financial sector reforms and the performance of the real economy drawing on cross-country experience, and outlines the reform agenda in selected areas, based on earlier FSAP recommendations. Section V concludes with a summary and main recommendations.

II. Overview of Financial System

A. Banks and Nonbank Credit Institutions

56. Following the 1979 Revolution, all commercial banks were nationalized and foreign participation in banking was banned. At the time of nationalization, the banking network included 36 banks with various degrees of government and foreign ownership, comprising 7 specialized banks, 26 commercial banks, and 3 regional financial institutions. Only since 2001 have private banks been re-authorized to operate in Iran.

57. The structure of the banking system has not changed substantially following the nationalization, which also reflected the continued dominance of the public sector in the economy in general. Currently, the banking system consists of six state-owned commercial banks, four state-owned specialized banks, 25 a state-owned Postal Bank (licensed in 2004) and four recently established small private banks. State-owned commercial and specialized banks dominate the banking system, holding about 98 percent of deposits. The consolidated assets of banks amounted to 49 percent of GDP, while broad money, excluding foreign currency deposits, represented 45 percent of GDP at end-March 2004.26 These ratios are below those recorded in the 1990s, or those of most comparable MENA countries (Figure 3.1). Lack of progress in deepening financial intermediation is largely attributable to high inflation (about 20 percent on average over the last 10 years) and various administrative controls on banking operations (Section III).

Figure 3.1.
Figure 3.1.

Selected MENA Countries: Broad Money/GDP Ratio, 1990–2002

(In percent)

Citation: IMF Staff Country Reports 2004, 308; 10.5089/9781451819007.002.A003

Source: World Economic Outlook.

Specialized Banks

There are four specialized banks: in housing (Maskan), agriculture (Keshavarzi), export development (Export Development Bank), and industry and mining (Sanat-O-Madan). The four specialized banks also take deposits, but by far the greater part of their loanable funds comes from commercial banks, the central bank, and other public sources, including the central government.

Bank Keshavarzi (Agricultural Bank) is by far the largest among the specialized banks and its size is comparable to other state-owned banks, except Bank Melli. The loan portfolio of this bank amounted to Rls 29 trillion (2.5 percent of GDP) accounting for about 60 percent of the banking system loans to agriculture as of end-March 2004. The government’s contributions, central bank loans, deposits of other banks, as well as a growing number of deposits by nonbanks constitute the resource base. Bank Keshavarzi has offered a wide range of Islamic finance instruments for agricultural financing and set up an Agricultural Insurance Fund covering 63 commodities. Such an insurance system, which is largely used in developed countries, is rare among developing countries, given the high risks associated with agricultural activity. However, the government has provided large financial support to the bank to compensate for drought-related losses.

58. The financial position of the banking system is relatively weak. Despite a recapitalization of state-owned banks in 2002, amounting to Rls 5,000 billion (0.7 percent of GDP) and the reinvestment of post-unification foreign exchange gains in equity capital of state-owned banks in 2004, the risk-weighted capital adequacy ratio at 7.2 percent is below the 8 percent recommended by the Basel I Capital Adequacy Accord. The return on assets is estimated at 1 percent and the ratio of nonperforming loans was reportedly 5.2 percent during the same period (Table 3.2).27 Private banks, however, have a much stronger financial position than implied by the banking system average ratios (Table 3.2).

Table 3.2.

Islamic Republic of Iran--Financial Soundness Indicators, 2003/04

(In percent)

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Sources: Central Bank of Iran.

59. The degree of concentration in the banking system remains high with the state-owned Bank Melli controlling about one-third of assets. There is also substantial loan concentration in individual state-owned banks. On a weighted average basis, the twenty largest exposures of each of the state-owned banks account for 24.3 percent of their total committed financing facilities in 2000. This suggests a lack of diversification in the asset portfolios of banks. Furthermore, following the exchange rate unification in March 2002, the degree of dollarization of the banking system has increased, albeit from a low base.

60. The recently licensed private banks, which have emerged from private nonbank credit institutions that were authorized in the mid-1990s, are mainly active in some market niches, such as short-term bridge financing of medium-sized enterprises, 28 mortgage lending, and retail consumer lending. The private banks have started to exert competitive pressure on state-owned banks.

61. Iran’s financial system also includes a number of small banking institutions and informal financial intermediaries. About 6,000 “Qarz-ul-Hasanah” funds, which raise zero-interest funds and provide interest-free loans, operate on a small scale. Almost 1,000 registered credit cooperatives are also in operation, but these are very small, with total assets well below Rls 1,000 billion (0.1 percent of GDP). Moreover, some bonyads (charitable foundations) run quasi-banking institutions, one of which has recently received a credit institution license. Finally, informal finance is common with high rates of return, reflecting lack of access to bank financing by small- and medium-sized enterprises.

B. Capital Markets and Insurance

62. Following the 1979 Revolution, the activities of TSE came to a standstill. The TSE was reopened in 1989 when the government listed many state-owned companies in an effort to start a divestiture program and develop the private sector in the context of the first five-year development plan. Since then, the TSE activity has continued to grow, despite some volatility that reflected uneven progress in macroeconomic stabilization and structural reforms, as well as the variations in oil prices.

63. Since 1998 the size of the capital market has been increasing rapidly. By end-April 2004, the capitalization of TSE reached US$37.5 billion (24 percent of GDP), mainly due to a more than 600 percent increase in the TSE share price index since the last downturn of late 1998, but also due to the increased number of listed securities (Figures 3.2–3.3). Capitalization of the TSE relative to GDP, however, remains below those in Egypt and Jordan (Figure 3.2). Despite the increase in capitalization, little fresh financing has been provided to the corporate sector.

Figure 3.2.
Figure 3.2.

Selected MENA Countries: Market Capitalization, 1998–2003

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 308; 10.5089/9781451819007.002.A003

Sources: country authorities and Fund staff estimations.
Figure 3.3.
Figure 3.3.

Selected MENA Countries: Share Price Indices, 1998–2003

(1998=100)

Citation: IMF Staff Country Reports 2004, 308; 10.5089/9781451819007.002.A003

Sources: country authorities and Fund staff estimations.

64. The recent increase in the stock market capitalization has been driven by a number of factors. First, the market is recovering from the low level of 1998 when price/earning (P/E) ratios were about three. Second, business confidence has strengthened as a result of the recent reforms and liberalization measures, rapid economic growth, and high oil prices, thereby significantly improving investors’ expectations of future profit growth. Third, a relaxation in the monetary policy stance during the years 2002–04 may have contributed to portfolio adjustment away from bank deposits, which carry negative real rates of return in favor of investment in the stock market. Fourth, anecdotal evidence suggests that unrecorded portfolio investments from Iranians living abroad may have also contributed to the stock market rally. Finally, the opening of new regional branches of the TSE has attracted a growing number of investors from the provinces, increasing demand for equity investment. While the average P/E ratio is still moderate compared to those in other equity markets (about 9), its level might be understated given possible weaknesses in accounting and reporting rules (Table 3.3).

Table 3.3.

Selected Emerging Markets: April 2004 Price/Earning and Turnover Ratios

article image
Sources: IFC; Tehran Stock Exchange.

65. Most listed companies are parastatal enterprises with a varying degree of direct and indirect government ownership. The on-going divestment program has remained modest so far (1 percent of GDP per year).29 From a sectoral point of view, automobile industry, mining, petrochemicals, and financial intermediaries represent the largest components of the TSE capitalization.

66. Despite the recent stock market rally, the market turnover remains low. At about 0.2 for 2003/04, it is substantially lower than the turnover ratios for other emerging markets (Table 3.3). This reflects a relatively large presence of a few institutional investors (Table 3.4), which also explains a low proportion of “free float”.30 A large share of capitalization is reportedly accounted for by cross-shareholdings of some companies and insufficiently regulated investment companies.

Table 3.4.

Islamic Republic of Iran: Capitalization of the Tehran Stock Exchange by Investor, end-2003/04

(In percent of total capitalization)

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Source: Tehran Stock Exchange.

67. The insurance sector is still very small. The Central Insurance Authority (Bimeh Markazi) is regulator, supervisor, as well as a market participant in its own right through reinsurance. Five companies owned directly or indirectly by the government collected about 1 percent of GDP in premiums in 2002/03. The recent authorization and licensing of private insurance companies is expected to enhance the development of this sector.

C. Foreign Exchange Market

68. After years of tight restrictions, Iran has largely liberalized current account transactions and made progress in trade liberalization. On March 21, 2002, the exchange rate was unified, most exchange restrictions on current account transactions were eliminated, and import-related transactions in the financial system were liberalized. At present, there are no derivative instruments to hedge against exchange rate risk, and all transactions are carried out in the spot market. The central bank remains the main seller in the domestic and off-shore foreign exchange markets (mainly the Kish Island).

69. Some capital account liberalization measures have recently been undertaken. A new FDI law approved in 2002 established a clear legal framework for foreign direct investment in Iran and contributed to the increase in FDI commitments, excluding oil and gas, to US$1.8 billion in 2003/04 from about US$70 million in 2001/02. Other forms of capital inflows are subject to restrictions—mainly through limitations on non-Iranian non-residents’ investment in the stock exchange and real estate. Non-resident Iranian nationals appear to have recently increased substantially their portfolio investment in Iran, which is legally authorized, but not statistically recorded.

70. Regarding outflows, following the exchange rate unification, two important avenues have been opened for legal, but largely unregulated access to foreign exchange for current and capital account transactions. First, unregulated transfers of rials can be made to off-shore zones (subject to compliance with AML regulations) where they can be exchanged into foreign exchange without restrictions. Second, use of foreign exchange initially originating from export proceeds, short-term capital inflows in banking deposits, and remittances of Iranians abroad is largely unregulated.

III. Governance and Regulatory Oversight

71. The Iranian financial system operates under Islamic finance principles based on the Law on Usury-Free Banking of 1983. Under these principles, ex-ante pre-set interest rates are prohibited and the return on financial instruments must be linked to purchase and resale of goods (and services) or to profit and loss sharing on projects. However, in practice, little uncertainty exists on future rates of return in Iran. Commercial banks achieve this by smoothing the returns (i.e., implicitly building up and drawing down reserves for equalizing returns over time) and through implicit or explicit government guarantees on returns and principal of financial instruments issued by state-owned banks.

72. The Iranian financial system is subject to financial repression (Box 3.2.), which is reflected in various forms of control, in particular on the banking system. These controls have contributed to low profitability and under-capitalization of state-owned banks. The banking system in its present form largely fulfills quasi-fiscal functions in the context of a public sector-dominated economy. It channels financial resources to priority sectors, as defined by the government, rather than to the projects with the best risk-return opportunities. Moreover, full transparency in relations between state-owned banks, on the one hand, and public enterprises, charitable foundations (bonyads) and influential large private companies on the other, appears to be lacking. Anecdotal evidence suggests that this lack of transparency manifests itself in long waiting lists and rationing in loan applications at negative real rates of return.

73. Low profitability and capital adequacy of state-owned banks are interconnected problems. The former mainly stems from administrative controls on rates of return on both deposits and loans (Tables 3.5–3.6), sectoral credit allocation (Table 3.7), directed credits, high reserve requirements (Table 3.8), government interference in management, and high operating costs. Some forms of administrative controls have recently been eased in line with FSAP recommendations, in particular those related to sectoral credit allocation, but other controls have continued to hinder competition and profitability. In turn, the low profitability contributes to a slow build-up of equity capital.

Table 3.5.

Islamic Republic of Iran: Rates of Return on Deposits, 1999/2000–2003/04 1/

(In percent per annum)

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Source: Central Bank of Iran.

Iranian fiscal years end March 20.

Long-term deposits over one year introduced in 1990/91 and 2000/01.

These rates are effective from 22 ordibehesht 1380 (May 12, 2001).

Table 3.6.

Islamic Republic of Iran: Rates of Charges on Bank Facilities, 1999/2000–2003/04 1/2/

(In percent per annum)

article image
Source: Central Bank of Iran.

Iranian fiscal years ending March 20.

These are announced rates representing the minimum payable return. As such, they may be lower or higher than the actual ex-post rates of return.

These rates are effective from 22 ordibehesht 1380 (May 12, 2001).

Only for bank Maskan (housing bank).

Minimum rate.

Table 3.7.

Islamic Republic of Iran: Approved Sectoral Allocation of Credit to the Nonpublic Sector, 1999/2000–2003/04 1/

(In percent)

article image
Source: Central Bank of Iran.

Iranian fiscal years ending March 20.

Table 3.8.

Islamic Republic of Iran: Reserve Requirements on Bank Deposits, 1999/2000–2003/04 1/2/

(In percent of total deposits)

article image
Source: Central Bank of Iran.

Iranian fiscal years end March 20.

From 2001/02, reserve requirements on all bank deposits in free trade zones are 10 percent.

Noninterest bearing savings deposits. Housing savings deposits are subject to a 2 percent requirement.

Financial Repression: Definitions and Cross-Country Evidence

Financial repression is defined as the set of policies, laws, regulations, taxes, qualitative and quantitative restrictions, and controls imposed by the government which do not allow financial intermediaries to operate at their full potential (Roubini and Sala-i-Martin, 1995). These public policies “artificially” increase demand for base money of banks (for example, through high required reserves) and of households (for example, via constraints on financial innovations and the imposition of ceilings on a range of return-earning instruments). Given artificially higher demand for base money, revenue from inflation tax is increased. This revenue is “spent” indirectly through subsidized directed credits and directly via financing of the government. Even though it is possible to generate a higher inflation tax under financial repression than under a liberal financial system in the short run, many distortions and inefficiencies created by financial repression impede growth in the medium and long term. The empirical research on the relation between financial repression and growth (Roubini and Sala-i-Martin, 1992; Levin, 1996; and Demetriades et al., 1998) suggests that there are three channels through which financial repression affects growth. First, the productivity of investment is reduced (low and declining total factor productivity). Second, the overall savings and investment are lower. Third, intermediation costs of allocating savings to investment are higher. The last two channels are associated with disintermediation and financial system weakening.

74. The four private commercial banks are not subject to controls on rates of return and do not benefit from implicit guarantees of deposits. As a result, their costs of funds, including deposit rates, are higher, which tends to be reflected in higher lending rates compared with those of state-owned banks. Despite this pricing disadvantage, private banks have been able to increase their market share, owing to better customer services, including faster speed of processing of applications, more customer-tailored banking products, and credit rationing by state-owned banks.

75. Banking supervision is undergoing major changes, but is still focused on compliance with government directives rather than risk assessment. The central bank is in charge of supervising banks and large credit institutions. However, small nonbank credit institutions, including credit unions and “Qarz-ul-Hasanah”, are not subject to supervision either by the central bank or the ministry of finance and economy. These institutions have been authorized by the ministry of interior, which is also responsible for their oversight together with other non-profit organizations. Legislation bringing these institutions under the central bank supervision is awaiting Parliamentary approval.

76. A comprehensive program to develop and implement a risk-based regulatory and supervisory framework for the banking sector is currently under way in line with FSAP recommendations. Some regulatory reforms are in place, including licensing, net open positions in foreign exchange, the definition of statutory capital, capital adequacy, large exposures, connected lending, and anti-money laundering regulations for banks. Supervisory functions have been unified under one single department at the central bank. On- and off-site inspections have begun, using risk-based criteria. Finally, reporting forms and supervision manuals are being developed. Despite this progress, a full-fledged, risk-based supervision framework has not been established yet, and the supervision of state-owned banks continues to rely on tight monitoring of credit allocation and compliances with administrative restrictions.

77. Regulatory oversight of publicly traded securities and the stock exchange operations is relatively underdeveloped as well. The TSE operates based on the Stock Exchange Act adopted in 1966 and is managed by a TSE Board headed by the central bank governor. There is no independent supervisory entity that oversees issuance and trading of securities. With few laws covering stock market operations, the TSE has itself introduced by-laws to cover insider trading, market manipulation, and disclosure and transparency requirements. These are, however, difficult to enforce, owing to lack of proper legislation. A bill covering anti-money laundering activities in the entire financial system, including trading in securities, is still awaiting Parliamentary approval.

78. The insurance regulatory framework is also outdated. The compulsory reinsurance, tight tariff and contract regulation, and the “specified proportions” approach to achieving prudent investments tend to result in excessive premiums and limit innovation and development of this predominantly state-owned industry.

IV. Reform Agenda

79. As highlighted earlier, the reform of the financial sector in Iran is incomplete and further progress is needed to promote efficiency and facilitate the development of a dynamic and competitive financial sector meeting the demands of an increasingly open and liberalized economic environment (Box 3.1.). While many reforms are needed in all segments of the financial system, high priority should be given to the banking sector, given its relative size and role in allocating savings in the Iranian context.

A. Banking System

80. The remaining reform agenda in the banking sector covers virtually all aspects of banking activity. Appropriate sequencing of reforms is important to their success in deepening financial intermediation. The highest priority should be given to completing the establishment of a risk-based supervisory framework, which should precede further steps in banking sector deregulation. Subsequently, state-owned banks would need to be restructured and their operational environment liberalized. Finally, state-owned banks might need to be recapitalized in connection with their possible privatization.

81. The reform of banking supervision needs to be stepped up in connection with the ongoing liberalization and opening up of the sector to private sector participation. It is also urgently needed to protect the banking system against the risks associated with the rapid credit growth, as has been the case in recent years. The remaining reforms include the preparation, passage and implementation of essential regulations pertaining to liquidity risk, asset classification, provisioning, and investments. The banking legislation (Banking Act) should also be amended to incorporate the concept of bank soundness among the objectives of bank supervision; enlarge the range of sanctions to banks that do not comply with the regulations; define banking services and other services that banks and other financial entities are allowed to deliver; and define the role of external bank auditors. Furthermore, staff training and IT development are essential for successful implementation of this reform. Finally, smaller deposit-taking institutions would need to be brought under the supervision of the central bank as envisaged in the draft law on these institutions submitted to Parliament.

82. Banking restructuring involves managerial, operational, and financial reorganization. Reforming the corporate governance of state-owned banks is key. As a first step, management of commercial banks could focus more on improving performance and strengthening the financial position of banks. Also, undue influence of large public companies and bonyads on management of banks would need to be eliminated. Since under the current system, managers of state-owned banks have little incentives or expertise to manage risks effectively, it will be important to provide adequate training in risk management, in particular in the area of credit risk.

83. Once a risk-based banking supervision has been established and corporate governance of banks has been improved, further steps in deregulating the banking institutional environment could be implemented. Rates of return on loans and deposits could be gradually liberalized and the share of loans subject to sectoral allocation limits could be gradually reduced to zero. This will foster competition in the banking sector, improve pricing of risks, and contribute to more efficient allocation of financial resources. A reduction in administrative controls will also stimulate a more effective utilization of existing Islamic finance instruments and development of new ones in line with recent international experience in this area (Sundararajan and Errico, 2002).

84. With respect to financial restructuring, the degree of undercapitalization of individual state-owned banks needs to be assessed based on internationally accepted norms. Furthermore, high lending concentration on large borrowers should be discouraged through strict implementation of the recently approved regulations on large exposures. Moreover, restructuring of banks would only be effective if accompanied with restructuring of large state-owned companies, which are the major debtors. In this regard, the program of restructuring and privatization of public companies would need to be elaborated together with banking system restructuring plans.

B. Capital Markets and Insurance

85. In light of the rapid increase in equity valuation, the reform agenda for capital markets needs to focus on tightening the supervision of issuance of securities and facilitating the market entry of properly supervised capital market intermediaries. Efforts are under way to introduce a new capital market law, which will cover securities issued inside and outside the TSE. This law will seek to ensure the efficient functioning of securities markets; protect investors against unfair and fraudulent practices; ensure that adequate and timely information is provided to investors and the general public on companies issuing securities; and regulate activities of market intermediaries. A key reform should be to establish an independent securities and exchange commission. The development of market infrastructure is also important (electronic trading, registration, and settlement of transactions, etc.), and should go hand in hand with tangible progress in regulatory oversight.

86. Similarly to the other segments of the financial system, a risk-based insurance regulatory framework would need to be put firmly in place and the Central Insurance Authority should divest from its reinsurance business and concentrate on regulation and supervision.

C. Capital Account Liberalization

87. The authorities have adopted a gradual approach toward capital account liberalization which reflects a cautious approach given Iran’s current circumstances. This approach focuses mainly on attracting FDI, as reflected in the recent FDI law. Short-term flows, including portfolio investment, would be liberalized gradually. The draft portfolio investment law, which rightly takes a gradualist approach to liberalizing short-term in flows, is expected to authorize limited portfolio investment of non-resident institutional investors with time limitations on the repatriation of principal capital.

88. At present, more emphasis should be put on reforms that would help meet key preconditions for capital account liberalization and enhance its benefits (Ishii et al., 2002 and Prasad et al., 2003). Key preconditions include macroeconomic stability; an appropriate exchange rate regime; a strong and well supervised financial system with developed and liquid capital markets; and significant improvements in key institutions, including the legal framework and corporate governance.

89. While progress has been made in all these areas, further advances are needed toward meeting the preconditions for capital account liberalization. Macroeconomic stability must be firmly established, as inflationary pressures persist and the economy remains vulnerable to large sudden changes in oil prices. Although a managed float exchange rate regime has been established, increased flexibility in the exchange rate is needed to deal with potential volatility in capital flows and fluctuations in oil revenue. Moreover, hedging instruments would need to be developed to increase the resilience of the financial system to exchange rate risk. As highlighted above, there is a need for banks and the capital markets to strengthen their capacity to monitor and assess potential risks associated with volatile capital flows.

V. Conclusion

90. While Iran has made progress in reforming its financial system, important challenges remain and the reform agenda for the period ahead would need to focus on restructuring the financial system and reducing its vulnerabilities. Reform of the banking system is of paramount importance and should give priority to the strengthening of the supervisory framework and corporate governance of banks. These would ensure that a reduction in controls on credit allocation and rates of return will result in better financial intermediation. Managerial and organizational restructuring could be followed with recapitalization, privatization and greater openness to foreign participation in domestic banks. Banking sector reform would need to be underpinned by restructuring of large state-owned companies that are the banks’ major clients.

91. Proper supervision of the rapidly growing stock market is also needed together with advances in developing the market infrastructure. The new capital market law is expected to address these needs and create a sound legal framework that would help foster the development of capital markets. Further capital account liberalization could be considered in step with progress in reducing inflation, financial sector reform, and other supporting reforms.

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23

This chapter draws on the Financial Sector Assessment Program (FSAP) undertaken in 2000, and provides updated information and analyses on several aspects of the Iranian financial system. It is prepared by V. Kramarenko

24

Monetary policy issues are discussed in Chapter IV.

26

These ratios do not include the Postal Bank and some banking institutions, which are not covered by the monetary survey.

27

These ratios are not fully comparable to those in other countries owing to differences between Iran’s accounting standards and the International Accounting Standards (IAS), as well as lack of proper regulations on loan classification and provisioning.

28

Since there are long waiting lists for loan applications in state-owned banks, many companies in urgent need of liquidity apply for bridge loans from private banks, which are subsequently refinanced by state-owned banks.

29

The divestment program mainly offers large blocks of shares to strategic institutional investors.

30

The proportion of shares that are held by the public at large and are freely available for trading.

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Cover IMF Staff Country Reports
Islamic Republic of Iran: Selected Issues Paper
Author: International Monetary Fund
Volume/Issue:
Volume 2004: Issue 308
Publisher:
International Monetary Fund
ISBN:
9781451819007
ISSN:
1934-7685
Pages:
72
DOI:
https://doi.org/10.5089/9781451819007.002
  • View in gallery

    Selected MENA Countries: Broad Money/GDP Ratio, 1990–2002

    (In percent)

  • View in gallery

    Selected MENA Countries: Market Capitalization, 1998–2003

    (In percent of GDP)

  • View in gallery

    Selected MENA Countries: Share Price Indices, 1998–2003

    (1998=100)

Selected MENA Countries: Broad Money/GDP Ratio, 1990–2002

(In percent)

Selected MENA Countries: Market Capitalization, 1998–2003

(In percent of GDP)

Selected MENA Countries: Share Price Indices, 1998–2003

(1998=100)