Islamic Republic of Iran: Selected Issues

This Selected Issues Paper on Iran reviews that monetary factors are the main determinants of inflation in the country. Government spending out of oil revenues leads to large liquidity injections that the central bank accommodates owing to its efforts to prevent a significant nominal appreciation of the rial and the lack of effective sterilization instruments. The growing discontent with inflation, however, has compelled policymakers to focus on this issue, bringing it to the forefront of the policy agenda.

Abstract

This Selected Issues Paper on Iran reviews that monetary factors are the main determinants of inflation in the country. Government spending out of oil revenues leads to large liquidity injections that the central bank accommodates owing to its efforts to prevent a significant nominal appreciation of the rial and the lack of effective sterilization instruments. The growing discontent with inflation, however, has compelled policymakers to focus on this issue, bringing it to the forefront of the policy agenda.

III. Operations of the Oil Stabilization Fund 28

This chapter examines the operations of the Oil Stabilization Fund (OSF) in Iran. It starts with a brief discussion of the role of oil in the Iranian economy. Subsequently, the chapter presents a detailed description of the OSF’s design and operations. It concludes with recommendations on how to strengthen the OSF’s role in macroeconomic management by focusing on its stabilization objective and integrating its operations with the central government budget in the context of a rolling medium-term fiscal framework.

A. The Design and Operations of the OSF

Historical background (1970–99)

46. While the oil sector has played an important role in the Iranian economy, the sector was very volatile during the 1970s–1990s.29 In the 1970s, oil value added accounted for over 40 percent of GDP due to high oil prices and production volumes. However, following significant declines in oil production, this share shrank to about 10 percent immediately after the 1979 Revolution (Figure III.1). During the war with Iraq (1981–88), the contribution of oil value added to GDP bottomed at 3 percent in 1986, mainly because of war-related damages to oil production facilities and declining oil prices. In the 1990s, the oil sector recovered somewhat, with oil extraction value added fluctuating around 15 percent of GDP, reflecting the volatility of oil prices. As a result of oil sector fluctuations, government oil revenue ranged from 3 percent of GDP (25 percent of government revenues) in 1986 to about 16 percent of GDP (73 percent of government revenues) during 1993–94. This revenue volatility was reflected in large expenditure fluctuations, particularly in capital expenditures. The pro-cyclical fiscal stance exacerbated the variability of output, inflation, and the real effective exchange rate.

Figure III.1.
Figure III.1.

Islamic Republic of Iran: The Role of the Oil Sector in the Economy, 1965/66-2007/08

Citation: IMF Staff Country Reports 2008, 285; 10.5089/9781451819069.002.A003

Sources: CBI; IMF IFS; The Laws of the Third and Fourth Economic, Social, and Cultural Development Plans; and Fund staff estimates.1/ Average crude oil price; the 2007 constant price calculated based on the U.S. CPI.

OSF objectives

47. To address the shortcomings stemming from expenditure volatility, the Iranian authorities set up an Oil Stabilization Fund (OSF) in 2000 as a separate public sector institution.30 Article 60 of the Third Five-Year Development Plan (TFYDP, 2000–05) established the following objectives of the OSF:

  • Stabilize the government’s annual budgets; and

  • Provide financial means to commercial banks for on-lending to private and cooperative entities carrying out projects in the priority sectors identified by five-year plans.

OSF accumulation and spending rules

48. The accumulation of OSF deposits was to be driven by the difference between projected and actual oil revenues. Specifically, Article 60 of the TFYDP and Article 1 of the Fourth Five-Year Development Plan (FFYDP) stipulated that annual crude oil export revenue up to a certain limit should be directly drawn by the central government, and that all excess oil revenue should be deposited in the OSF. The oil revenue projections were based on conservative oil price assumptions.

49. The TFYDP and FFYDP envisaged two types of withdrawals from the OSF. First, at the beginning of the plan’s third year, the central government could draw from the OSF account if the government’s oil export receipts fell short of the budgeted amount for that year. Second, an amendment to the TFYDP law in November 2000 stipulated that up to 50 percent of the OSF’s balance should be set aside for lending foreign exchange to domestic private entrepreneurs in priority sectors via commercial banks. Loans were to be repaid in foreign exchange within eight years, with a three-year grace period, at an interest rate of LIBOR+2 percentage points (later capped at 10 percent).

OSF’s institutional arrangements

50. Management and supervision:

  • Through mid-May 2008, the OSF was managed by a seven-member Board of Trustees. It comprised the Head of the Management and Planning Organization (MPO),31 the Minister of Economy and Finance, the Governor of the Central Bank of Iran (CBI), and four representatives who are appointed by the President (of whom at least two are appointed from among the ministers). The Board set the priorities for projects that can use loans from the OSF; determined loans terms and conditions; specified the contractual framework between the MPO and the banks that on-lend OSF resources; and approved banks’ charges and commissions for OSF-funded loans.

  • In mid-May 2008, the OSF Board of Trustees was dissolved, and the Government Economic Committee was made responsible for OSF oversight.

51. Transparency of operations:

  • In practice, members of the OSF’s Board of Trustees periodically disclosed information about OSF asset holdings to mass media. In addition, the CBI disseminates information on the accumulated balances and sectoral allocation of OSF loans.32 Furthermore, aggregated data on OSF cash flows are reported to the Fund during annual Article IV consultation discussions and published in IMF staff reports. However, the OSF itself does not disseminate the information on its operations to the public on a regular basis nor does it have its own website.

  • Parliament approves the allocation of oil revenue between the central government budget and the OSF based on implicit oil price assumptions in the context of five-year plans. It also approves additional withdrawals from the OSF, as well as annual limits on OSF lending to domestic companies, in the context of annual budgets and mid-year budget revisions. However, the OSF operations are not consolidated with the central government operations in the budget documents discussed by parliament.

52. Investment management:

  • OSF foreign assets are managed as part of the CBI’s foreign assets. The Monetary and Credit Council (MCC)33 determines the rate of return on OSF foreign currency deposits at the CBI.

  • The OSF domestic assets comprise claims related to commercial banks’ lending, which it funds. The banks are required to review loan requests to ensure that projects are in conformity with the technical, financial, and economic feasibility criteria approved by the Board of Trustees.

B. OSF’s Track Record

53. The creation of the OSF coincided with the on-set of a significant increase in oil prices. After bottoming up at about $9 per barrel in 1999, the oil price trended sharply upward, exceeding $100 per barrel in early 2008. As a result, Iran’s annual oil export receipts increased from just under $17 billion in 1999/2000 to an estimated $66 billion in 2007/08.34 At the same time, consolidated government oil revenues rose from 10 percent of GDP in 1999/2000 to an estimated 21 percent in 2007/08 (Figure III.1).

54. Sizeable oil price increases during 2000/01–2007/08 made it politically difficult to contain expenditure growth within the initial five-year plans’ envelopes. In the context of the annual budget deliberations and mid-year budget revisions, parliament approved central government withdrawals from the OSF to finance central government expenditures, with a part earmarked for specific programs or projects, including to cover gasoline imports (Tables III.12).

Table III.1.

Islamic Republic of Iran: Oil Revenues in the Five-Year Economic, Social, and Cultural Development Plans, 2000/01-2007/08 1/

article image
Sources: Iranian authorities; and Fund staff estimates.

The Third FYDP was based on an oil price of $19 per barrel. The Fourth FYDP was based on an oil price of $40 per barrel. The budget was supposed to spend all oil receipts earned at the budget price. Only excess receipts were to be saved in the OSF.

As specified in the Third (2000-04) and Fourth (2005-09) Five-Year Economic, Social, and Cultural Development Plans.

Table III.2.

Islamic Republic of Iran: Operations of the Oil Stabilization Fund, 2000/01–2007/08

article image
Sources: CBI; and Fund Staff estimates and projections.

55. In contrast to the central government budget overspending, the OSF’s domestic loans portfolio remained well below the 50 percent ceiling on the total OSF balance during 2000–05. This was mainly attributable to relatively unattractive terms and the small size of the private sector. Many borrowers viewed dollar-denominated OSF loans as too expensive, considering in particular the rapid rial depreciation during 2000–x05. Indeed, the equivalent rial rates of return on OSF loans were estimated to have reached 20 percent, well above the official 15 percent rate charged by the state-owned banks on rial-denominated loans.35 Equally important, the limited number of private sector companies involved in exporting activities significantly limited the pool of prospective loan applicants.

56. Since 2005, OSF lending rules have been gradually softened to increase loan attractiveness, which has led to approaching the 50 percent ceiling. Projects in “depressed regions” and certain enterprises experiencing financial difficulties saw the maturity of OSF loans extended up to 17 years, and the interest rate reduced to 3 percent. Also, OSF financing was made available to state-owned companies, partly to counter the impact of international sanctions that limited their access to foreign borrowing. In 2007/08, the government converted some of the OSF deposits at selected state-owned commercial banks into equity to strengthen their capital.

C. Options Going Forward 36

57. Certain aspects of the OSF could be improved taking into account the lessons learned from its own experience and best international practices.

Objectives

58. Maintaining the OSF’s stabilization objective appears appropriate, as the budget is projected to remain vulnerable to oil price declines in the medium term. Precautionary savings are particularly justified in the case of Iran because of lack of access to international financial markets and limited opportunities for domestic non-inflationary financing to ride out a period of lower oil prices.37

59. Long-term sustainability and intergenerational fairness considerations do not represent a binding constraint. The non-oil primary fiscal deficit is estimated at 17 percent of GDP and implicit energy subsidies are estimated at 22 percent in 2007/08. Their combined ratio to GDP is well below the sustainable real expenditure from oil wealth, which is estimated at 65 percent of GDP in 2007/08 assuming a conservative oil price of $85 per barrel (at constant U.S. dollar terms). Therefore, there is no compelling need to save more oil revenue than justified by precautionary motives.

60. Transferring OSF’s domestic lending operations to the budget would facilitate fiscal planning. Should the authorities choose to maintain policy-motivated foreign currency lending, it would be advisable to transfer the administration of this lending to the central government. In this case, lending amounts should be approved by parliament in the context of the central government budget. This approach will de-link the amount of OSF withdrawals from oil price fluctuations, contributing to the fulfillment of the OSF’s stabilization objective.

Accumulation and spending rules

61. The existing OSF accumulation and spending rules should become more flexible and responsive to oil price and macroeconomic developments:

  • Align OSF accumulation and spending rules with its stabilization objective. Specifically, allocating all oil revenues to the OSF and limiting the use of its resources to financing the non-oil budget deficit will help focus OSF operations on its stabilization objective and improve expenditure management.

  • Implement a rolling medium-term budget framework (MTBF). As a first step in this direction, the existing five-year development plans should be updated annually reflecting the most recent information on oil prices, inflation, and balance of payments developments, as well as shifting government priorities. The authorities may draw on the recent experience of Mexico, the Russian Federation, or Timor-Leste in improving Iran’s national MTBF. Mexico and the Russian Federation embarked on ambitious reforms to introduce rolling multi-year budgets that are updated every year to take into account changes in the outlook, including oil price projections. Mexico’s Fiscal Responsibility Law requires that budgets aim at a zero balance, and the Russian Federation’s framework sets an upper limit on the non-oil fiscal deficit. Timor-Leste adopted a long-term fiscal policy framework that includes rolling three-year projections based on sector investment programs with detailed plans to guide expenditure.

  • Review the usefulness of assuming unrealistically low oil prices in the budget planning process. This practice proved ineffective in discouraging pro-cyclical fiscal policy in Iran as well as in other oil-producing countries (IMF, 2007). Instead, it is better to rely on market-based indications of future oil prices and incorporate risk analysis and contingency planning in the MTBF. In particular, the targeted medium-term paths for the non-oil fiscal balance and the accumulation of the OSF deposits under the baseline oil price scenario should take into account possible fluctuations in oil prices. Moreover, contingency plans should describe how the budget would respond to deviations from the budget’s oil price assumptions (e.g., draw-down/or increase in the OSF’s deposits, and areas of expenditure reductions or increases). The extent of such adjustments could be determined based on judgment on the possible duration of the deviations of oil prices from the budget assumptions, or based on mechanical rules (e.g., a moving average oil price).38 In addition, a probabilistic approach can be used to determine the optimal size of the OSF’s foreign assets and the corresponding fiscal balances to stabilize spending (Bartsch, 2006).

  • Check the consistency of the non-oil primary balance with the short-term macroeconomic objectives, including economic growth and inflation. This will require improving the coordination between fiscal and monetary policies.

Governance structure and transparency

62. The OSF’s transparency can be further enhanced.39 The information that is publicly available (e.g., the key legal documents governing the OSF operations and disseminated elements of OSF financial operations) could be usefully posted on an OSF-dedicated website. In addition, more detailed information, including annual cashflow statements and summary balance sheets, could be disseminated to the public on a regular basis. Websites of a growing number of oil funds, including Norway’s Government Pension Fund-Global, can serve as good examples of transparent communication with the general public.40

Investment policy and management

63. Going forward, the OSF may benefit from diversifying its foreign exchange asset portfolio to increase long-term returns. The current practice of managing the OSF foreign assets in the same pool as gross official reserves appears justified because the end-2007/08 OSF deposits are estimated to cover only about 22 percent of the budgeted 2008/09 expenditure. If the government decides to build up a larger precautionary balance, which can be used to facilitate expenditure adjustment to prolonged periods of oil price declines, the OSF deposits could be invested in somewhat less liquid and riskier assets.

References

  • Allen, R., and D. Radev, 2006, “Managing and Controlling Extra Budgetary Funds,” IMF Working Paper WP/06/289 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Amuzegar, J., 2005, Iran’s Oil Stabilization Fund: A Misnomer, Middle East Economic Survey, Vol. XLVIII, No. 47.

  • Bandiera L., N. Budina, M. Klijn, and S. van Wijnbergen, 2007, “The ‘How To’ of Fiscal Sustainability: A Technical Manual for Using the Fiscal Sustainability Tool,” World Bank Policy Research Working Paper No. 4170 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Barnett, S., and R. Ossowski, 2002, “Operational Aspects of Fiscal Policy in Oil-Producing Countries,” IMF Working Paper WP/02/177 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Bartsch, U., 2006, “How Much Is Enough? Monte Carlo Simulations of an Oil Stabilization Fund for Nigeria,” IMF Working Paper WP/06/142 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Carcillo, S., D. Leigh, and M. Villafuerte, 2007, “Catch-Up Growth, Habits, Oil Depletion, and Fiscal Policy: Lessons from the Republic of Congo,” IMF Working Paper WP/07/80 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Cashin, P., H. Liang, and C.J. McDermott, 2000, “How Persistent Are Shocks to World Commodity Prices,” IMF Staff Papers Vol. 47, No. 2 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Davis J.M., R. Ossowski, and A Fedelino, eds., 2003, Fiscal Policy Formulation and Implementation in Oil-Producing Countries (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hunt, B., P. Isard, and D. Laxton, 2001, “The Macroeconomic Effects of Higher Oil Prices,” IMF Working Paper WP/01/14 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2005, Guide to Resource Revenue Transparency, http://www.imf.org/external/pubs/ft/grrt/eng/060705.htm (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • International Monetary Fund, 2007, The Role of Fiscal Institutions in Managing the Oil Revenue Boom, Fiscal Affairs Department, http://www.imf.org/external/np/pp/2007/eng/030507.pdf. (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Karbassi, A.R., M.A Abduli, and E.M. Abdollahzadeh, 2007, “Sustainability of Energy Production and Use in Iran,” Energy Policy, Vol. 35, pp. 517180.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Kia, A., 2006, “Deficits, Debt Financing, Monetary Policy and Inflation in Developing Countries: Internal or External Factors? Evidence from Iran,” Journal of Asian Economics, Vol. 17, pp. 879903.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Krichene N., 2005, “A Simultaneous Equations Model for World Crude Oil and Natural Gas Markets,” IMF Working Paper WP/05/32 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Krichene N., 2006, “Recent Dynamics of Crude Oil Prices,” IMF Working Paper WP/06/299 (Washington: International Monetary Fund).

  • Krichene N., 2007, “An Oil and Gas Model,” IMF Working Paper WP/07/135 (Washington: International Monetary Fund).

  • Limi, A., 2006, “Did Botswana Escape from the Resource Curse,” IMF Working Paper WP/06/188 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Mehrara, M., and K.N. Oskoui, 2007, “The Sources of Macroeconomic Fluctuations in Oil Exporting Countries: A Comparative Study,” Economic Modelling, Vol. 24, pp. 36579.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • National Petroleum Council, 2007, Facing the Hard Truths About Energy—A Comprehensive View to 2030 of Global Oil and Natural Gas, available at http://www.npchardtruthsreport.org (Washington: National Petroleum Council).

    • Search Google Scholar
    • Export Citation
  • Olters, J-P., 2007, “Old Curses, New Approaches? Fiscal Benchmark for Oil Producing Countries in Sub-Saharan Africa,” IMF Working Paper WP/07/107 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Segura, A., 2006, “Management of Oil Wealth Under the Permanent Income Hypothesis: The Case of São Tomé and Príncipe,” IMF Working Paper WP/06/183 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Shabsigh, G., and N. Ilahi, 2007, “Looking Beyond the Fiscal: Do Oil Funds Bring Macroeconomic Stability,” IMF Working Paper WP/07/96 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • World Bank, 2006, Mainstreaming Environment in the Energy Sector—The Case of the Energy- Environment Review for Iran, Report No. 38177 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Zamani, M., 2007, “Energy Consumption and Economic Activities in Iran, Energy Economics, Vol. 29, pp. 113540.

28

This chapter was prepared by Roman Zytek.

29

For an in-depth analysis of the role of oil and gas in the Iranian economy, see World Bank (2006), Karbassi, Abduli, and Abdollahzadeh (2007), Kia (2006), and Zamani (2007).

30

For details on the OSF’s history, see Amuzegar (2005). For a general review of the operational aspects of fiscal policy in oil-producing countries, see Davis, Ossowski, and Fedelino (2003), and IMF (2007). In addition, Hunt, Isard, and Laxton (2001), Mehrara and Oskoui (2007), and Shabsigh and Ilahi (2007) present comparative studies of macroeconomic fluctuations in oil-exporting countries.

31

The MPO has been recently integrated into the presidential administration.

32

See Bulletin and Economic Trend, CBI periodic publications.

33

The MCC has been recently integrated into the supreme council for economic planning and management.

34

The Iranian fiscal year ends on March 20.

35

The government’s attempts to mandate insurance against foreign currency risk failed because the insurance companies were unwilling to provide such services, citing their lack of experience in this field and the overly long coverage periods that made risks difficult to price.

36

For a comprehensive discussion of the issues related to managing extrabudgetary funds, see Allen and Radev (2006).

37

Limi (2006), Segura (2006), Carcillo, Leigh, and Villafuerte (2007), and Olters (2007) present country studies of different approaches to fiscal management in oil-producing countries. Bandiera and others (2007) provide a technical manual for using fiscal sustainability analysis in oil-producing countries.

38

For an analysis of long-term trends in commodity prices (including oil) see Cashin, Liang, and McDermott (2002); for a review of global demand and supply conditions for petroleum products see National Petroleum Council (2007), and Krichene (2005, 2006, 2007).

39

See IMF (2005) for a detailed discussion of transparency issues related to revenues from natural resources.

40

For the Alaska Fund, see http://www.apfc.org; and for the Norway’s Government Pension Fund-Global, see http://www.regjeringen.no.

Islamic Republic of Iran: Selected Issues
Author: International Monetary Fund