Islamic Republic of Iran: Staff Report for the 2006 Article IV Consultation

This 2006 Article IV Consultation highlights that with high oil prices and a significant policy stimulus, the Iranian economy continued to grow strongly in 2005–06. Real GDP growth is estimated at 5½ percent. Oil GDP growth was modest owing to capacity constraints, while non-oil GDP growth was broad based, reaching 6 percent. The tensions associated with the nuclear issue, however, had some adverse effects on private investment. With energy prices projected to remain high and external demand continuing to support non-oil exports, Iran’s near-term growth prospects look favorable.

Abstract

This 2006 Article IV Consultation highlights that with high oil prices and a significant policy stimulus, the Iranian economy continued to grow strongly in 2005–06. Real GDP growth is estimated at 5½ percent. Oil GDP growth was modest owing to capacity constraints, while non-oil GDP growth was broad based, reaching 6 percent. The tensions associated with the nuclear issue, however, had some adverse effects on private investment. With energy prices projected to remain high and external demand continuing to support non-oil exports, Iran’s near-term growth prospects look favorable.

I. Introduction

1. The main challenge faced by Iran is the need to attain and sustain higher rates of growth to provide employment for its fast growing labor force while lowering inflation. Every year approximately 750,000 Iranians enter the labor market for the first time, putting enormous pressure on the ability of the economy to create jobs. Attempts to support economic activity and job creation through fiscal and monetary stimuli have resulted in persistent double-digit inflation, which undermines the objective of achieving high sustainable growth rates over the medium term. Against this background, the consultation discussions focused on:

  • The adjustments in fiscal, monetary, and exchange rate policies that are necessary to achieve a significant reduction in inflation.

  • The need to address the distortions caused by extensive administrative controls on prices and rates of return (interest rates), as well as large subsidies, particularly those on energy products.

  • The authorities’ structural reform plans, including their decision to reinvigorate the privatization program.

Fund surveillance in recent years has focused on the macroeconomic imbalances associated with an expansionary policy stance and structural obstacles to growth and job creation (Box 1).

Effectiveness of IMF Surveillance

Fund advice has concentrated on the need to reduce the non-oil fiscal deficit and enhance fiscal transparency, improve the effectiveness of monetary policy, and accelerate structural reforms.

On the fiscal side, the authorities have made progress in strengthening the tax administration and improving transparency, and have established the Oil Stabilization Fund (OSF) to address oil price volatility. However, containing current expenditures and phasing out subsidies has proven difficult, as the authorities continue to face strong political pressure to increase spending in order to promote growth and reduce unemployment.

In the monetary and exchange rate areas, the Fund has called for increasing central bank independence, eliminating administrative controls, and allowing for greater exchange rate flexibility. Although discussions to strengthen the role of the central bank are under way, the effectiveness of monetary instruments remains weak and progress in increasing exchange rate flexibility has been limited.

On the structural front, several important reforms were implemented during 2000/01-2002/03, including exchange rate unification, trade liberalization, tax reform, and the adoption of a new foreign direct investment (FDI) law. Significant changes have also been introduced in the financial sector through the adoption of a number of the 2000 Financial Sector Assessment Program (FSAP) recommendations. Progress has been slow, however, in the areas of privatization and subsidy reform.

II. Recent Developments

2. The government’s economic priorities have been reassessed after the change of administration. Structural reforms introduced during 2000/01-2002/03 fostered the integration of Iran in the global economy. Since the administration of President Ahmadi Nejad took office in 2005, the focus of economic policies has shifted toward reducing social and regional disparities. This new approach has entailed using much of the additional revenue from high oil prices to finance higher government spending.

3. The economy experienced robust growth in 2005/06, but unemployment remained high. Real GDP growth is estimated at 5.4 percent in 2005/06, boosted by high oil prices, a weather-related recovery in agriculture, and strong fiscal and monetary stimuli (Figure 1a and Table 1). Oil GDP growth was modest owing to capacity constraints, while non-oil GDP growth was broad-based, reaching 6 percent. The tensions associated with the nuclear issue, however, had some adverse effects on private investment, particularly FDI. The unemployment rate increased to 11.5 percent in 2005/06 (Figure 1b), before declining to 10.2 percent in the first half of 2006/07.

Figure 1a.
Figure 1a.

Islamic Republic of Iran: Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2007, 100; 10.5089/9781451819038.002.A001

Sources: Iranian authorities; and Fund staff estimates and projections.
Figure 1b.
Figure 1b.

Islamic Republic of Iran: Real Per Capita Income Growth and Unemployment Rate

(In percent)

Citation: IMF Staff Country Reports 2007, 100; 10.5089/9781451819038.002.A001

Sources: Iranian authorities; and Fund staff estimates and projections.
Table 1.

Islamic Republic of Iran: Selected Macroeconomic Indicators, 2004/05–2007/08 1/

(Quota: SDR 1,497.20 million)

(Population: 68.6 million)

(Per capita GDP: US$2,802)

(Poverty rate: 20.9 percent)

(Main exports: oil, gas, chemical and petrochemical products, and pistachios.)

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

The Iranian fiscal year ends March 20.

4. Inflation decelerated through April 2006, but increased markedly in recent months. End-of-period inflation declined from 16.7 percent in 2004/05 to 10.2 percent in 2005/06, owing mainly to a fall in food prices associated with a bumper harvest and a slower rate of depreciation of the currency (Figure 2). After declining further to below 7 percent in April 2006, the 12-month rate of inflation increased in recent months, reaching 14.7 percent in November.

Figure 2.
Figure 2.

Islamic Republic of Iran: Inflation Rate

(End of period; percent change)

Citation: IMF Staff Country Reports 2007, 100; 10.5089/9781451819038.002.A001

Source: Iranian authorities.

5. The fiscal stance in 2005/06 was highly expansionary. The original 2005/06 budget sought to reduce the non-oil fiscal deficit by raising revenue and keeping government expenditures constant relative to GDP. However, two supplementary budgets passed by parliament contained additional appropriations to cover higher gasoline imports and food subsidies, bring teachers’ salaries in line with those of other civil servants, and improve rural infrastructure. As a result, despite the large increase in oil revenue, the consolidated surplus of the central government and the OSF (commitment basis) declined from 1.7 percent of GDP in 2004/05 to 1.1 percent in 2005/06, with the non-oil deficit widening from 15.2 percent of GDP to more than 20 percent over the same period (Figures 3a and 3b).

Figure 3a.
Figure 3a.

Islamic Republic of Iran: Budgetary Aggregates

(As a percentage of non-oil GDP)

Citation: IMF Staff Country Reports 2007, 100; 10.5089/9781451819038.002.A001

Sources: Iranian authorities; and Fund staff estimates and projections.
Figure 3b.
Figure 3b.

Islamic Republic of Iran: Budgetary Aggregates

(As a percentage of GDP)

Citation: IMF Staff Country Reports 2007, 100; 10.5089/9781451819038.002.A001

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

6. The fiscal expansion is projected to continue in 2006/07. Notwithstanding a projected increase in non-oil revenues associated with a strong performance of direct taxes, a further increase in both current and capital outlays would result in a roughly balanced overall fiscal position (commitment basis) in 2006/07, with the non-oil deficit rising further to 21 percent of GDP (Text Table 1 and Tables 2 and 3).1 Substantial resources were withdrawn from the OSF during 2005/06–2006/07 to finance government spending as well as net lending to the private sector (Table 4).2 As a result, reserves in the OSF rose by only US$1.2 billion in 2005/06, reaching US$10.7 billion at the end of that fiscal year. OSF reserves are expected to increase further to US$12.4 billion by end-2006/07.

Text Table 1.

Islamic Republic of Iran: Consolidated Accounts of the Central Government and the Oil Stabilization Fund, 2004/05–2006/07

(In percent of GDP)

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Sources: Iranian authorities; and Fund staff estimates and projections.
Table 2.

Islamic Republic of Iran: Consolidated Accounts of the Central Government and the Oil Stabilization Fund, 2004/05–2007/08

(In billions of rials)

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Sources: Central Bank of Iran; and Fund staff estimates and projections
Table 3.

Islamic Republic of Iran: Consolidated Accounts of the Central Government and the Oil Stabilization Fund, 2004/05–2007/08

(In percent of GDP; unless otherwise indicated)

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Sources: Iranian authorities; and Fund staff estimates and projections.
Table 4.

Islamic Republic of Iran: Operations of the Oil Stabilization Fund, 2004/05–2007/08

(In millions of U.S. dollars)

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

7. A large portion of the additional expenditures committed in the last budget amendment for 2005/06 was shifted to 2006/07, which is expected to increase the pressures on monetary policy. Due to this deferred spending, the fiscal outturn on a cash basis for 2005/06 was considerably better than that on a commitment basis. As these resources are spent, a considerable injection of liquidity is expected to take place this fiscal year.

8. Monetary policy remains constrained by fiscal dominance and limitations on the effective use of the available monetary instruments. The large spending out of oil revenues has continued to challenge the ability of the Central Bank of Iran (CBI) to meet its monetary targets. Broad money increased at an annual rate of about 35 percent in 2005/06 and the first half of 2006/07, with base money growing even more rapidly (Tables 5 and 6). Credit to the private sector has continued to grow at a strong pace. The CBI’s efforts to mop up liquidity by placing central bank participation papers (CBPPs) have been hampered by the need to obtain parliamentary approval for new issues. Moreover, monetary conditions were eased in March 2006 by lowering the rate of return for state-owned banks’ lending from 16 to 14 percent and setting the rate of return for private banks’ lending, which was previously freely determined, at 17 percent.3 In addition, in April 2006 parliament approved legislation that commits the government and the CBI to reduce the rate of return on bank facilities to single digits by the end of the Fourth Five-Year Development Plan (FFYDP), in 2009/10.

Table 5.

Islamic Republic of Iran: Central Bank Balance Sheet, 2004/05–2007/08

(In billions of rials; unless otherwise indicated)

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Sources: Central Bank of Iran; and Fund staff estimates and projections.
Table 6.

Islamic Republic of Iran: Monetary Survey, 2004/05–2007/08 1/

(In billions of rials; unless otherwise indicated)

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

The Iranian fiscal year ends March 20.

Includes on-lending of the Oil Stabilization Fund resources and claims under letters of credit for trade financing.

9. The nominal effective exchange rate appreciated in 2005/06. From March 2002 (when the exchange rate was unified) through end-2004, exchange rate policy was mainly driven by concerns about external competitiveness, and succeeded in keeping the rial broadly stable in real effective terms. In 2005/06, to help contain the rapid monetary expansion associated with the buildup of international reserves, the rial was allowed to appreciate in nominal effective terms by 2.1 percent. This trend was partially offset during April-September 2006, as the U.S. dollar weakened against the euro. Owing to the inflation differential with its trading partners, Iran’s real effective exchange rate appreciated by over 11 percent from March 2005 to September 2006 (Figure 4).

Figure 4.
Figure 4.

Islamic Republic of Iran: Exchange Rate Developments

(Index, 2000=100)

Citation: IMF Staff Country Reports 2007, 100; 10.5089/9781451819038.002.A001

Sources: Datastream; and Fund staff estimates and projections.

10. Reflecting the sharp increase in oil prices, external indicators continued to improve in 2005/06. The external current account surplus rose to 7.4 percent of GDP, from 1.2 percent in 2004/05. Oil production was slightly over 4 million barrels per day (mbd) in 2005/06, with a substantial part being absorbed domestically. Oil export volumes remained flat at about 2.4 mbd, but higher crude prices led to a sharp increase in export receipts (Table 7). Despite the real exchange rate appreciation, non-oil exports grew rapidly, while import growth slowed following a substantial increase in the two previous years (Text Table 2).4 The strong export performance continued in the first half of 2006/07, with import growth accelerating to over 20 percent. Gross international reserves, including those in the OSF, rose to US$55.6 billion at end-September 2006 (nine months of imports of goods and nonfactor services), and the external debt declined to about 11 percent of GDP (Table 8).

Text Table 2.

Islamic Republic of Iran: Sectoral Contributions to the Annual Growth in Exports and Imports, 2003/04–2005/06

(In percent; unless otherwise indicated)

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Sources: Iranian authorities; and Fund staff estimates.
Table 7.

Islamic Republic of Iran: Balance of Payments, 2004/05–2011/12 1/

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

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

The Iranian fiscal year ends March 20.

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

Letters of credit related borrowing, a minor part of which may have maturities in excess of one year.

Including commercial banks.

Including valuation adjustments.

Represents the part of the Oil Stabilization Fund that is invested together with the gross international reserves.

Excluding short-term debt.

Table 8.

Islamic Republic of Iran: Vulnerability Indicators, 2001/02–2006/07 1/

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Sources: Iranian authorities; and Fund staff estimates.

The Iranian fiscal year ends March 20.

Excluding interest receipts and payments.

Excluding service of short-term external debt.

Including contingent liabilities under letters of credit. The substantial increase in 2003/04 arises from a reclassification in line with STA recommendations.

Islamic banks exhibit important differences in their risk profile and asset classification, which limit international comparability.

As of January 15, 2007.

11. After increasing sharply in the two previous years, the stock market declined markedly in 2005/06. Prices in the Tehran Stock Exchange (TSE) dropped by 22 percent owing to the political uncertainty associated with the presidential elections and the escalation of tensions on the nuclear issue (Figure 5). The correction had little repercussion on the financial sector due to the banks’ limited exposure to the market (1 percent of assets). Stock prices recovered by about 5 percent from April 2006 to mid-January 2007.

Figure 5.
Figure 5.

Islamic Republic of Iran: Tehran Stock Exchange Index

Citation: IMF Staff Country Reports 2007, 100; 10.5089/9781451819038.002.A001

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

12. Structural reforms slowed during the initial months of the current administration, but the government recently decided to provide new impetus to the privatization program. Following the amendment of Article 44 of the constitution, in July 2006 Iran’s supreme leader Ayatollah Khamenei issued an executive order to privatize 80 percent of the state-owned companies over the next 10 years (excluding the upstream oil sector, crucial infrastructure, and some banks). The program has a strong social orientation, as part of the shares of a significant number of enterprises will be allocated to the poorer segments of the population (Box 2).

13. Under a new Capital Markets Law, the authorities have established a Security and Exchange Commission, and regulations are being developed on investment banking, mutual funds, and supervision of investment companies.

III. Policy Discussions

14. During the discussions, the authorities indicated that their policies and reform strategy continue to be guided by the main directives contained in the FFYDP, adjusted in light of the higher oil revenues. Specifically, the authorities stated that their main policy priority was to use the additional oil revenue to sustain growth and job creation, with particular emphasis on the expansion of the activities of small- and medium-size enterprises, the reduction of economic disparities among regions, and the social needs of the population. The authorities also noted that special attention will be given to the completion of a large number of investment projects.

Public Enterprises and Privatization

Iran’s economy is state dominated. A large number of state enterprises and quasi-state institutions (bonyads) are engaged in economic activities in virtually all sectors. Purely private firms are currently found mostly in agriculture, domestic and foreign trade, small-scale manufacturing, and mining. The private sector’s role in large-scale economic activity remains negligible.

An initial effort toward privatization began in the late 1980s—largely through stock market offerings. A second wave of reform in the late 1990s sought to create a more attractive investment environment and included a new privatization program. However, complicated regulatory and legal structures and weak political support prevented an effective implementation of this program. The executive order issued in July 2006 has given new impetus to privatization. Excluded from privatization are the upstream oil sector, crucial infrastructure, some banks, and a few entities in the insurance, utilities, and transport sectors.

The current privatization program has a strong regional and social orientation. Priority access to subsidized financial support will be accorded to less developed and deprived regions, which will receive some 30 percent of total privatization proceeds. In the case of a significant number of small profitable enterprises, some 40 to 100 percent of the shares will be allocated to the poorest segments of the population (justice shares). The shares will be sold to holding companies or mutual funds, on behalf of the poor, at a 50 percent discounted price and with a 10-year repayment period. The government will retain 20 percent of the shares in the enterprises, and the remainder will be offered on the TSE. Foreign investors will be permitted to participate within a 10 percent limit, with approval of the Ministry of Economic Affairs and Finance. A number of other companies will be offered fully at the TSE.

About 19 enterprises have already been identified for privatization. Of these, 15 small-sized firms have been fully given away as justice shares, and four large firms have had 40 percent of their shares distributed as justice shares; another 40 percent will be offered to the private sector at the TSE.

The program envisages an annual privatization rate of 20 percent of state-owned companies, beginning with small-sized firms. State-owned banks will be privatized in the next 2 to 3 years, and the program as a whole should be completed by the end of the Fifth Five-Year Development Plan, in 2014/15.

15. With energy prices projected to remain high and external demand continuing to support non-oil exports, Iran’s near-term growth prospects look favorable. Real GDP growth is projected at 5.8 percent in 2006/07 on account of continued strong activity in the non-oil sector. Though the external current account surplus would decline owing to the fiscal expansion, the international reserves position is expected to strengthen further. The continuation of the current macroeconomic policies, however, poses a serious risk of a further intensification of inflationary pressures, with detrimental effects on Iran’s medium-term growth and employment prospects.5

16. The staff encouraged the authorities to address these risks through a significant fiscal adjustment supported by a tighter monetary policy and greater exchange rate flexibility, along with structural reforms. Discussions also focused on the importance of addressing the numerous distortions stemming from the extensive regulations and controls on prices and rates of return, as well as the credit targets for specific sectors, and of phasing out subsidies, in particular those on domestic fuels, to increase economic efficiency and contain environmental degradation.

17. The authorities noted that while they attached the highest priority to promoting growth and job creation, they were also concerned about inflation and inten