Abstract
This Selected Issues paper on Iran focuses on the Targeted Subsidy Reform Law (TSRL). This is the basic law governing the implementation of the subsidy reform in Iran. The TSRL envisaged bringing subsidized prices close to international levels over a five-year period. The paper reviews the implementation of the first phase of the subsidy reform, with a particular emphasis on macroeconomic management. The sharp depreciation of the exchange rate and high inflation significantly undermined progress under the reform. High inflation partially reversed the relative price change under the reform.
Targeted Subsidy Reform in Iran1
A. Introduction
1. Iran’s Targeted Subsidy Reform (TSR) was one of the most courageous moves to reform subsidies in an energy exporting country. This homegrown reform was unprecedented in Iran’s economic history in terms of its scale, preparations and potential implications. It primarily aimed at removing subsidies on energy and other products, with energy subsidies estimated at about 20 percent of GDP. The authorities reached out to more than 70 million citizens and engaged in a months-long public relations campaign. The reform envisaged to change the domestic relative price for energy products by bringing them close to international levels over five years, reduce pollution and help transform Iran into a more competitive market economy.
2. Iran’s reform was unique in its design (Box 1). The reform attempted to replace direct price subsidies with universal cash transfers to households. It also envisaged direct assistance to enterprises to facilitate adjustment to the new price structure and to the government, to facilitate payments of the government’s own higher energy bill. In the first phase of the reform, the authorities substantially increased the prices of all major petroleum products and natural gas as well as electricity, water, and bread. The plan was to use the revenue from these price increases to compensate households with universal cash transfers. In addition, the enterprises were to receive subsidized loans for the adoption of new, energy-saving technologies and credit lines to mitigate the impact of energy price increases on their production. The universal cash transfers to households were to improve income distribution because low income households, with their limited energy consumption, benefited little from subsidized domestic energy prices. Moreover, by opening up bank accounts for receiving cash transfers, financial access would be increased.
3. After more than three years of implementation, the reform has yet to fulfill its potential. After a smooth start in December 2010, the second phase of the reform was postponed in mid-2012 following the marked deterioration in economic conditions and with mounting implementation problems. Economic growth decelerated, inflation rose, and the exchange rate depreciated to record levels. The TSR, which was designed to be fiscally neutral, faced cash-flow imbalances, as a large share of the revenues expected from energy price increases failed to materialize, and such revenues fell short of committed cash transfers to households. Energy consumption, after falling in the early months following the launch of the reform, has been on the rise again, as high inflation reduced the real cost of energy. In addition, the real value of the cash transfers has fallen sharply, reducing their benefits to the lower income groups. However, assessing the direct impact of the TSR on the economy remains a difficult task in light of the severe deterioration in the external environment facing Iran during the course of implementation.
Targeted Subsidy Reform Law and Its Mechanics
The Targeted Subsidy Reform Law (TSRL) is the basic law governing the implementation of the subsidy reform in Iran. The law specifies post-reform price targets for subsidized products, sets rules for redistribution of revenue from price increases in subsidized products and lays down the basic structure of administrative management of the reform. Although some parts of the law were modified by other legislation (for example budget laws changing the distribution of revenues etc.), the underlying “philosophy” of the reform stayed largely intact during the implementation.
The TSRL envisaged bringing subsidized prices close to international levels over a five-year period. Domestic liquid fuels’ prices including for gasoline and diesel, would be brought to a level not less than 90 percent of the Persian Gulf FOB prices. The average domestic price of natural gas would be adjusted to about at least 75 percent of average export price of natural gas. Prices for electricity and water would be adjusted to reflect their full cost price. In addition to energy and water, subsidies on wheat, rice, cooking oil, milk, sugar, postal services and air and rail transportation services would be removed by 2015. The law, in view of the target of closing the gap between domestic and international energy prices, envisaged the adjustment of domestic prices in line with the exchange rate used in the relevant year budget and provided some room for stabilizing domestic prices in case of high volatility of international prices. The TSRL also authorized the Treasury to temporarily finance the initial cash flow deficit at the beginning of the reform as cash handouts would be deposited in advance of the price increases.
Proceeds from the price increases were expected to be distributed to households, enterprises, and the government. The law stipulated that 50 percent of the net proceeds from the price increase to be allocated to households as cash and noncash transfers by taking into account the household income and also spent on implementing a comprehensive social security system for the targeted population. The enterprise and utilities sectors would get 30 percent of the proceeds as grants, facilities, and subsidies on bank loans for optimizing their energy consumption, adopting new technologies of production, improving public transportation and supporting the producers in manufacturing industry and agricultural sector. The government budget would receive 20 percent of the proceeds to pay for its own higher utilities’ costs and investment needs. Also, the law allowed for changing households, enterprises and government’s shares up to 10 percentage points in annual budgets.
The law established the Targeted Subsidies Organization (TSO) to oversee the implementation of the reform. The TSO was to be governed by a board comprised of prominent ministers from the cabinet. The TSO would be a nonfinancial public enterprise and its budget would be submitted to the Parliament along with the annual budget. The TSO was envisaged to present semiannual reports to the Parliaments’ budget committee on performance of the TSR and TSO’s financial accounts. The Supreme Audit Court would also submit semiannual reports to the Parliament on the operations of the organization.
With the benefit of hindsight, the TSRL had several weaknesses. The exact timing and magnitudes of the price increases were not fully specified, creating ambiguities for policy makers and uncertainty for consumers. The financial support to households and enterprises could have been designed as temporary to allow them to adjust to the new relative prices; however, the envisaged transfers were presented as permanent. In addition, the law did not provide any guidance to price adjustments in the event of an unexpected depreciation of the currency. Also, the TSRL was not explicit on how monthly cash transfers would be adjusted if the projected revenues failed to materialize. Moreover, the law implied a broader mandate to help enterprises than just assisting in improving energy efficiency.
4. The paper reviews the implementation of the first phase of the subsidy reform, with a particular emphasis on macroeconomic management. The first part of the paper looks into the macroeconomic developments during the implementation of the first phase of the reform. The second part focuses on the implementation of the reform, assesses its performance, and explores the relevant factors behind the postponement of the second phase of the reform. The last part of the paper looks into the lessons and recommendations for future reforms.
B. Macroeconomic Developments and Policy Responses
5. The TSR was launched against a favorable economic backdrop. The economy had been on an upswing from the 2009 contraction, on the back of higher oil prices. Non-oil GDP was growing at around 6 percent on average in the last three quarters preceding the launch of the reform at end-2010. Average inflation was down to 10 percent from 25 percent two years earlier, and the current account surplus was around 6.5 percent of GDP. The exchange rate, however, was showing some incipient signs of stress. The premium between the parallel market exchange rate and the official rate continued to increase since mid-2010, first following the freezing of some Iranian nationals’ bank accounts in the UAE (under the UN resolution in June 2010), and later in September 2010 when the UAE financial centers stopped facilitating money transfers for Iranians in the Emirates’ currency.
6. Macroeconomic indicators deteriorated following the implementation of the reform (Appendix I). Economic growth slowed down markedly in 2011. The real GDP growth declined to 3 percent by March 2012, half of the growth achieved in the previous year.2 Inflationary pressures emerged and the CPI-inflation doubled to 22 percent in December 2011, a year after the launch of the subsidy reform. The corporate profitability declined, reflecting weakening economic activity. Banks’ asset quality and profitability deteriorated. On a positive note, balance of payments remained comfortable. Iran’s current account surplus reached 11.5 percent of GDP and foreign exchange reserves increased by US$20 billion in 2011.
7. During the reform, macroeconomic policies remained relatively accommodative, though uneven. The Central Bank of Iran (CBI) continued to expand credit on the eve of the subsidy reform. In addition to lending to a specialized bank (Maskan Bank) to finance the government’s housing program (Mehr), the CBI opened a new credit line in September 2010 to finance the initial two-month worth of cash transfers to households. Initially the CBI managed to control base money growth by partly sterilizing the excess rials by selling foreign exchange, reducing its international reserves. After the launch of the reform, the CBI maintained this “expand credit and sterilize” policy in place and tightened base money. However, it did not succeed in reducing money growth significantly. Furthermore, despite repeated attempts to convince the Money and Credit Council, the CBI could not increase profit (interest) rates that had become highly negative in real terms. Against this background, the demand for foreign exchange increased and the spread between the parallel market rate and official rate rose from 1 percent in September 2010 to more than 8 percent by June 2011, and subsequently to 35 percent in December 2011. Fiscal policy, on the other hand, was tightened but not sufficiently enough to offset the impact of monetary policy. The non-oil budget deficit, a better indicator of the impact of fiscal policy on domestic demand, improved by 2 percentage points in 2011.
8. The reform and the macroeconomic policy framework were seriously challenged in early 2012. The intensification of sanctions on international financial transactions and oil exports, in late 2011 and early 2012, respectively, led to sharp depreciation of the rial in the parallel market. The depreciation and the financial sanctions disrupted imports. Industrial output declined by more than 10 percent because enterprises found it increasingly difficult to import raw materials and intermediate goods. Removal of some administrative price caps, initially put in place to reduce the speed of the pass-through of inflation following the reform, and the pass-through from exchange rate depreciation brought annualized monthly inflation to above 30 percent in February 2012.
9. The policy response was mixed. The central bank attempted to manage this large shock with its limited policy instruments and many competing goals. The central bank’s initial policy response was for some increase in policy interest rates, the first interest rate increase in six years, and a small depreciation of the official exchange rate. At the same time, the central bank continued to finance the Mehr housing program. Later in the year, the CBI significantly increased its credit to the public sector enterprises and the government to help with their growing financing needs. Unable to sterilize large liquidity injections with foreign exchange sales following the introduction of the sanctions, the CBI slowed down its lending to the banks to rein in base money growth. Nonetheless, both base money and M2 increased by about 30 percent in 2012, fueling inflation.
10. The economy entered stagflation in 2012 as inflation accelerated and economic activity contracted. Oil exports almost halved in 2012 under the weight of sanctions, dragging down oil production by about 25 percent. With oil production and exports on a steep dive and CBI financing on the rise, the rial continued to depreciate during 2012 and inflation rose further. Consumer price inflation exceeded 35 percent at the end of 2012 and hit 41 percent by March 2013. As a result, the real GDP growth contracted by about 6 percent and unemployment rose to 13 percent in 2012.
11. The sharp depreciation of the exchange rate and high inflation significantly undermined progress under the reform. High inflation partially reversed the relative price change under the reform. The sharp depreciation of the currency depressed domestic energy prices in U.S. dollars terms, making it more difficult to bring them to the level of 90 percent of the Persian Gulf FOB level, the reform’s original target. The high inflation, plummeting currency, and deep contraction in economic activity likely reduced public support for the reform in 2012.
C. The Postponement of the Reform
12. Despite the worsening outlook early in 2012, the authorities had initially intended to proceed with the second phase of the reform. In January 2012, the authorities submitted their plans to the Parliament for implementation of the second phase of the subsidy reform before the end of the Iranian year in March 2012. The government seemed to continue favoring large price adjustments, notwithstanding the deterioration in economic conditions. At the same time, the authorities were reportedly planning to eliminate high-income households from receiving cash handouts.
13. After several rounds of discussions, the Parliament postponed the implementation of the second phase of subsidy reform in 2012. Concerned about high inflation and volatility in the foreign exchange market, and worried about the impact of the new sanctions, the Parliament voted to postpone the implementation of the second phase of the subsidy reform. First, the Parliament passed a law that banned any energy price increases until mid-June. Later, in June 2012, a parliamentary vote on the subsidy reform budget effectively froze the second phase of the reform, by reducing by half the revenue target from price increases in the draft budget bill. The government subsequently announced that it had decided to postpone the implementation of the reform. In November 2012, following a tumultuous period in the foreign exchange market, the Parliament formally voted to delay the implementation of the second phase of the reform. The Parliament’s vote kept the existing cash transfer program intact and barred further price increases.
D. A Brief Look at the Initial Results
14. The TSR was designed to better utilize hydrocarbon resources, enhance economic efficiency, and improve income distribution. The reform intended to cut down the growth of domestic energy consumption to create more room for energy exports and further investment in Iran’s energy sector. Also, the TSR envisaged that the enterprise sector would adopt energy efficient technologies—with transitional support—to reduce the energy intensity of the economy. Moreover, direct cash transfers to households were expected to improve income distribution by reversing the regressive nature of energy subsidies and by compensating for higher energy prices.
15. However, changing relative prices proved difficult. A smooth transition to a new set of relative prices requires a lot of foresight, coordination and a supportive economic policy framework. As evident in Iran’s case, even the most careful preparation does not guarantee successful implementation. Supportive policies, most notably a cohesive package to maintain macroeconomic stability, need to be in place. Although the Iranian authorities carefully planned and designed the reform’s mechanics, the many competing goals and priorities, such as the need to finance the Mehr housing program, compromised its effective implementation and, therefore, its success in changing relative prices, rationalizing energy use and improving economic efficiency.
16. The TSR had some initial positive outcomes, but many proved short-lived. In particular:
There was decline in the consumption of subsidized products (Figure 1). Domestic consumption of liquid fuels fell by about 3 percent in 2011 compared to 2009, driven by the decline in gasoline and fuel oil consumption.3 The diesel consumption, one third of the total liquid consumption in the country, kept increasing but at a slower pace, reflecting the government decision to supply the industry with diesel at subsidized prices to ease adjustment. Likewise, the growth in natural gas consumption, accounting for about 60 percent of the energy consumed in Iran, continued to rise but at a slower pace. The rise in natural gas consumption despite a precipitous increase in its price is partly explained by expansion of natural gas network in the country. Growth in electricity consumption, on the other hand, dropped to 2 percent in 2011, its slowest pace in a decade. Consumption of wheat, a key staple targeted by the subsidy reform, also fell in 2011, for the first time in a decade. In addition, the increase in fuel and wheat prices likely reduced smuggling of these products to neighboring countries. But despite the initial positive response of demand to price changes, the growth in consumption of subsidized products rebounded in 2012 as the price increases under the second phase of the reform were suspended and inflation and nominal incomes rose. Some indicators also suggest that the energy intensity briefly declined during the first phase of the reform.
Direct cash transfers to households improved income distribution. Salehi-Isfahani et. al., (2012) found that the poverty rate declined by about 5 percentage points, mostly in rural areas, and indicators of inequality registered declines in the first three months of the program. Monthly cash transfers, 445,000 rials (about US$ 45 when the reform was launched) per person, were by no measure small. They represented about 15 percent of the average income of a median income family of four in 2011. For many large and poor families the transfers doubled incomes and brought per capita income above the US$2 per capita threshold. Furthermore, transfers for families were, on average, more than increased expenditures on utility and energy related items, notwithstanding the increase in prices of other items in the consumption basket. As a result, the Gini coefficient is estimated to have improved to 0.37 in 2011 from 0.41 in 2010, with a sharp drop in inequality in rural areas. Although no official data is available, the sharp contraction of the economy, rapid increase in inflation and decline in real value of wages and cash transfers must have eroded some of the gains in improving income distribution in 2012 and beyond.
Islamic Republic of Iran: Developments in Subsidized Products Consumption
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: BP Statistical Review of World Energy; Central Bank of Iran; USDA; and IMF staff calculations.1/ Prices converted to cents per liter using the parallel market exchange rate, then taken as a share of the end-of-year U.S. Gulf Coast gasoline spot price.Islamic Republic of Iran: Developments in Subsidized Products Consumption
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: BP Statistical Review of World Energy; Central Bank of Iran; USDA; and IMF staff calculations.1/ Prices converted to cents per liter using the parallel market exchange rate, then taken as a share of the end-of-year U.S. Gulf Coast gasoline spot price.Islamic Republic of Iran: Developments in Subsidized Products Consumption
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: BP Statistical Review of World Energy; Central Bank of Iran; USDA; and IMF staff calculations.1/ Prices converted to cents per liter using the parallel market exchange rate, then taken as a share of the end-of-year U.S. Gulf Coast gasoline spot price.
Gasoline Prices 1/
(In percent of international prices)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.1/ Prices converted to cents per liter using the parallel market exchange rate, then taken as a share of the end-of-year U.S. Gulf Coast gasoline spot price.Gasoline Prices 1/
(In percent of international prices)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.1/ Prices converted to cents per liter using the parallel market exchange rate, then taken as a share of the end-of-year U.S. Gulf Coast gasoline spot price.Gasoline Prices 1/
(In percent of international prices)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.1/ Prices converted to cents per liter using the parallel market exchange rate, then taken as a share of the end-of-year U.S. Gulf Coast gasoline spot price.GINI Coefficient, 2009/10–2011/12
GINI Coefficient, 2009/10–2011/12
| 2009/10 | 2010/11 | 2011/12 | |
|---|---|---|---|
| National | 0.41 | 0.41 | 0.37 |
| Urban | 0.39 | 0.38 | 0.36 |
| Rural | 0.38 | 0.38 | 0.34 |
GINI Coefficient, 2009/10–2011/12
| 2009/10 | 2010/11 | 2011/12 | |
|---|---|---|---|
| National | 0.41 | 0.41 | 0.37 |
| Urban | 0.39 | 0.38 | 0.36 |
| Rural | 0.38 | 0.38 | 0.34 |
Household Expenditure, 2010–2011
(In millions of Rials)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Statistical Center of Iran; and IMF staff calculations.1/ The average Iranian household consisted of about 4 people in 2010–11.Household Expenditure, 2010–2011
(In millions of Rials)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Statistical Center of Iran; and IMF staff calculations.1/ The average Iranian household consisted of about 4 people in 2010–11.Household Expenditure, 2010–2011
(In millions of Rials)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Statistical Center of Iran; and IMF staff calculations.1/ The average Iranian household consisted of about 4 people in 2010–11.
Real Value of Cash Transfers
(In Rials, deflated by CPI)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.Real Value of Cash Transfers
(In Rials, deflated by CPI)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.Real Value of Cash Transfers
(In Rials, deflated by CPI)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.E. An Assessment of the Implementation
17. Despite the initial success, the implementation of the first phase was not executed as planned. Both domestic policies and external factors played a role in undermining the reform in the first phase. Weak macroeconomic policies and ensuing inflation, deficits in the originally budgetneutral cash transfer program, failure to impose tight budget constraints on enterprises, poor coordination within the government undermined the TSR implementation. Furthermore, large external shocks hit the economy in early 2012 when it was still trying to adapt to the new prices.
18. A supportive and coherent macroeconomic policy package was not put in place after the reform. The macroeconomic policy framework, particularly monetary policy, was not tight enough to preserve macroeconomic stability. The central bank continued to finance the Mehr housing program when there were signs that it was complicating macroeconomic management and conditions, such as the depreciation of the rial in parallel market and rising inflation. Also, the exchange rate soon became overvalued as the official nominal rate was kept fixed while prices surged. Increasing inflation, the widening spread between official and parallel exchange rate and rise in asset prices called for more austere monetary policy, including an increase in interest rates, which were already negative in real terms. Also, overreliance on the foreign exchange rate as a nominal anchor for monetary policy, with limited operational independence of the central bank, further complicated the central bank’s task when the central bank had to stop using foreign exchange reserves as the main sterilization tool.
19. The authorities’ administrative price control policy put further strain on the economy. Distorted prices did not clear markets. In products market, administrative price ceilings forced enterprises with rising input costs to either seek financial support from banks or run arrears to their suppliers. Thus, banks faced growing pressure for new loans and turned to the central bank for funding, impairing the conduct of monetary policy. In the money and capital markets, the caps on the interest rate on loans and deposits impeded the efficient allocation of capital. In the foreign exchange market, leaning against the wind for a long time cost both the loss of valuable foreign exchange reserves and policy credibility.
20. All in all, the authorities were not sufficiently proactive in their macroeconomic policy. In mid-2011, an initial attempt to depreciate the exchange rate was reversed despite growing signals from the exchange rate market. The CBI’s repeated attempts to increase interest rates were rejected by the Money and Credit Council. The authorities introduced policy changes, by increasing deposit rates and allowing for limited depreciation of the official exchange rate, only when they faced the large depreciation of the parallel market exchange rate in early 2012.
21. Adding to macroeconomic imbalances, the cash transfer scheme became source of a fiscal deficit. The cash deficit of the TSO remained high at about 1–2 percent of GDP since its inception. The original plan envisaged that revenue from price increases would cover cash handouts and other payments under the TSR. Nonetheless, the reform started with a deficit. The deficit stemmed from the shortcomings in the TSR law’s implementation, mostly related to the failure to impose budget discipline on high energy users as well as a higher number households receiving higher cash transfers than originally planned. Also, energy price increases were kept at the minimum of the envisaged range for some sectors. For example, the increase in diesel prices was rolled back for the transportation sector. Furthermore, collection problems negatively affected TSO revenues. The National Iranian Gas Company faced cash flow problems as some of its large customers could not stay current on their bills and asked for rescheduling of their obligations. With 75 percent of the TSO revenues coming from the sale of natural gas and gasoline, and industry as the main user of natural gas, the TSO could not reach its revenue targets. Moreover, tariff increases in electricity did not help the TSO budget because power generation and distribution companies used these extra receipts to cover their own deficits. In addition to the TSO deficit, rolling back the cash transfers looked increasingly difficult, because households perceived them permanent rather than temporary.
Targeted Subsidy Organization Balance
(In percent of GDP)
Targeted Subsidy Organization Balance
(In percent of GDP)
| 2010/11 | 2011/12 | 2012/13 | ||
|---|---|---|---|---|
| Revenues | 0.8 | 4.8 | 4.5 | |
| Price increases | 0.8 | 4.8 | 4.5 | |
| Expenditures | 2.7 | 6.4 | 6.1 | |
| Cash transfers | 2.6 | 6.4 | 6.1 | |
| Assistance to Social Security and Health | 0.0 | 0.0 | – | |
| Deficit | −1.8 | −1.6 | −1.6 | |
Targeted Subsidy Organization Balance
(In percent of GDP)
| 2010/11 | 2011/12 | 2012/13 | ||
|---|---|---|---|---|
| Revenues | 0.8 | 4.8 | 4.5 | |
| Price increases | 0.8 | 4.8 | 4.5 | |
| Expenditures | 2.7 | 6.4 | 6.1 | |
| Cash transfers | 2.6 | 6.4 | 6.1 | |
| Assistance to Social Security and Health | 0.0 | 0.0 | – | |
| Deficit | −1.8 | −1.6 | −1.6 | |
TSO Revenues and Expenditures, 2012
(In billions of Rials)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.TSO Revenues and Expenditures, 2012
(In billions of Rials)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.TSO Revenues and Expenditures, 2012
(In billions of Rials)
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Iranian authorities; and IMF staff calculations.22. The large depreciation of the nominal exchange rate in 2012 complicated the implementation of the reform. The reform law stipulated that domestic sale prices of energy carriers would be no less than the 90 percent of the Persian Gulf FOB prices by 2015 and calculation of these prices had to be based on the exchange rate used in the relevant annual budget. With a depreciating currency, these price targets turned into moving targets, requiring very large price increases at a time. Yet, there was no guidance in the law on how to address large swings in the exchange rate.
23. There was no progress in restructuring enterprises and improving energy efficiency—a key premise of the TSR. With TSO revenues hardly financing the cash transfers to households, enterprises did not get the originally envisaged direct assistance from TSO resources to adopt more energy efficient technologies. In addition, administrative price controls and increasing input costs must have squeezed corporate profitability. Also, the sanctions impaired enterprises’ access to foreign capital and technology. Against this background, adoption of new technologies and reforming the production structure remained low on the enterprise sector’s priority list. Nevertheless, in the absence of direct assistance from the TSO, the authorities supported the enterprise sector by granting access to energy at preferential tariffs and tolerating arrears to energy suppliers. The amount of such support reached 1.25 percent of GDP in 2012 according to the TSO’s estimates, almost equal to the share of enterprises promised under the original subsidy reform law, were the 30 percent of the revenue from price increases in 2012 allocated to the enterprises. This policy softened the budget constraint on enterprises, and combined with lack of promised assistance to adopt energy efficient technologies, did not provide enough incentives to change enterprises’ business model in the first phase of the reform. The business model of the enterprise sector, based on subsidies and preferential credit, stayed essentially the same as they continued to rely on more subsidized energy and loans during the reform. Also, the continued emphasis on the cash transfer program blurred the real objective of the reform—increasing energy efficiency.
24. The lack of public information on the implementation and the outcome of the reform prevent a thorough assessment and discussion on how to proceed with future reforms. In contrast to the period preceding the launch of the TSR, the authorities have not disclosed an assessment publicly during the implementation phase. Accounts of the TSO and legally required audit reports to the Parliament have not been made public, which has contributed to varying views on the causes and size of the deficit and how it was financed.
25. Finally, the external shocks in 2012 derailed the first phase of the reform. These shocks proved too large and significant for the authorities to have had the opportunity to correct some of the implementation problems in the first phase and pave the way for continuing with the second phase of the subsidy reform program. Against a backdrop of a rapidly deteriorating and uncertain external environment and fragile economic conditions, another large price shock would have significantly worsened macroeconomic stability.
F. Lessons for the Next Steps
26. The subsidy reform should remain a top priority for Iran. After three years of the launch of the subsidy reform, the economy still faces the very same challenges that led to its implementation. Subsidized energy prices continue to encourage overconsumption of energy, worsen pollution, and benefit mostly high-income households. Subsidized prices distort investment decisions by favoring capital intensive investments over labor intensive, at a time when unemployment is a serious concern. Furthermore, they discourage private sector investment in the energy sector and create incentives for smuggling.
27. In spite of drawbacks and difficulties, Iran is still in a good position to advance the subsidy reform. By substantially raising energy prices in the first phase, the authorities have successfully altered the public perception that energy prices should stay low in a large energy producing country. Also, they proved that there are more efficient ways of sharing oil wealth other than through indiscriminately subsidized energy prices.
28. The lessons learned from the first phase and international best practice should guide any new strategy. The sharing of Iran’s hydrocarbon wealth with all citizens should stay as the cornerstone of the program. This goal, however, needs to be supported by the right framework and macroeconomic policies to effectively deliver results. The weaknesses in implementation in the first phase of the reform and other international experience could help to improve the framework envisaged in the original law.
29. A strong and coherent macroeconomic policy framework and implementation should support the second phase. The macroeconomic policy implementation was uneven in the first phase of the reform and proved that strong monetary and fiscal policies are critical to anchoring inflationary expectations and instilling confidence. Also, the reform should be part of a broader strategy to reform other parts of the economy and other goods and services’ prices. Without a strong commitment to macroeconomic stability, gains from the reform will easily unravel and undo years of hard work, and waste the political capital put behind this difficult reform in the process.
30. The need to eliminate the reform’s current deficit should be carefully balanced against the principle of distribution of hydrocarbon wealth to all citizens. Universal cash transfers have shown the authorities’ willingness to share the hydrocarbon wealth with all citizens, notwithstanding the reform’s deficit. Rolling back the cash benefits from some recipients could be a challenging task, given the difficulties in identifying and means testing recipients under the program and the continuously moving nature of income deciles. Therefore, priority should be given to increasing the cash inflows of the reform, for example by enforcing stricter collection of energy bills and eliminating lower priced gasoline and diesel quotas. Differentiation of cash handouts among different income groups or instituting re-enrollment requirements could also help contain cash outflows.
31. All energy users, particularly enterprises, should pay their energy bills in full. Lack of enforcement in collection of energy bills contributed to the cash deficit and undermined incentives to adopt more energy efficient technologies in the first phase.
32. Enterprises should face hard budget constraint to have incentives to restructure. The use of payment arrears and loan subsidies should not substitute for subsidized energy. The authorities should send a strong message that enterprises need to adjust to the new reality by reinforcing collection and foreclosure mechanisms and strengthening bank supervision. The experience under the first phase of the reform exposed weaknesses in this area and should help lay down a roadmap for going forward.
33. Cash transfers could be made more conditional and targeted, and tilted towards specific socially important expenditure. The subsidy reform law already provides room for switching expenditures under the reform. Iran can benefit from the experience of some other countries which introduced similar targeted cash transfer programs (Box 2). The international experience shows that targeting the poor remains a difficult task and many programs often benefit other households at higher income levels. Nevertheless, targeted programs are still the best available tools to protect low income groups.
34. A depoliticized energy price setting mechanism should be put in place. Successful reformers moved toward more depoliticized energy price setting mechanism responding to changes in global energy prices. The subsidy reform law aimed at bringing liquid fuel and natural gas prices to 90 percent and 75 percent of their comparable international prices, respectively. The law, however, did not explicitly mention any price setting mechanism. Establishing an automatic pricing formula and publishing of detailed information on the pricing mechanism could help the authorities to distance themselves from energy pricing. Moreover, responsibility for implementing this automatic price setting could be given to an independent body to underline the technical nature of these decisions. Philippines, Turkey, and South Africa used such mechanisms to make transition to international prices.4
35. The calculation of hydrocarbon rent and transfers should be reconsidered. The cash transfers should be linked to the total profitability of Iran’s oil and gas sector. Under a liberalized price structure where domestic prices respond to change in international prices, any rise in output and international energy prices will likely result in a rise in profits of the oil and gas sector and therefore, higher transfers to households. On the other hand, a fall in output or international prices will erode the profitability of the sector and cut back the transfers. Also, some hybrid structure which allows for smoothing of prices could also be designed to achieve stability of cash transfers. This strong link to profitability also ensures that required investment to keep up the hydrocarbon production always remains a priority.
Household Targeting Systems
Over the last two decades many emerging market countries have introduced programs to make sure that social transfers reach the poor and vulnerable households. These countries employed different targeting instruments to determine eligibility for social transfers such as household assessment mechanisms (means testing, proxy means testing), broad categorical eligibility (geographical targeting), community selection and self-selection by applying for benefits. The international experience shows that there is no “blueprint” recommendation for household targeting systems and many countries adopt a combination of these systems. The success of the targeting systems critically depends on their design, data collection process, implementation and oversight.
Household assessment mechanisms aim at maximizing targeting accuracy in a transparent and affordable manner. Verified means testing (VMT) requires extensive verification of information and is technically infeasible in emerging market economies with large informal labor market. Unverified means testing (UMT) is a more feasible approach which can be implemented relatively quickly with less cost. Although targeting accuracy is within acceptable boundaries, measurements errors, lack of transparency and incentives for household underreporting could undermine its desirability when a long term program is being designed. Proxy means testing (PMT) is a widely used alternative for targeting cash transfers, particularly in developing countries with large informal labor market. Under this approach, an index of socioeconomic variables is used to predict household welfare. PMT has become quite popular in developing countries where information systems remain inadequate to verify income and wealth and cross checking data.
A hybrid approach, combining chosen household assessment method with broad categorical eligibility seems to improve accuracy of targeting. Geographic targeting is a widely implemented method under categorical eligibility criteria. Under geographic targeting, eligibility for benefits is determined by primary residence location of the household. Many emerging market countries complement proxy means testing with a certain degree of geographic targeting, prioritizing regions with high poverty.
Armenia introduced its Family Benefit Program (FBP) in 1999 to assist individuals and families that are below a certain income level. The FBP is self selection program which is means tested on income and other proxies for poverty risk factors. Targeting is done by a scoring formula, giving priority to more vulnerable segments of the society like single mothers, disabled and orphans. The evaluation is based on the information and documentation submitted by the applicant.
Brazil’s signature conditional cash transfer program, Bolsa Família Program (BFP), relies on unverified means testing (UMT) using data collected under a unified registry, the Cadastro Único, to screen families for eligibility. Information about income is declared by families and crosschecked using other administrative records, which keeps administrative costs of running the system at a minimum. Some geographic targeting seems to have been used in implementing these programs.
Indonesia has a temporary unconditional cash transfer program, Bantuan Langsung Tunai (BLT), which was deployed twice, first in 2005-06 after the reduction in fuel subsidies to mitigate the impact on poor and in 2008-09 during the global increase in food prices. BLT employed a mixture of community-targeting, self-assessment, and pre-existing lists to collect data, and proxy means testing to determine beneficiaries.
Mexico’s conditional cash transfer program, Progresa/Oportunidades, has been in operation since 1997. The program is a combination of geographic targeting, proxy means testing (PMT), and demographic targeting (taking into account the number of children in the household). Under the program, once particular families are determined as eligible, a public meeting is held to get community reaction to the choice of these families and to let other excluded families to apply for reconsideration. Moreover, benefits under the program are directly paid to female household heads.
The Philippines runs a conditional cash transfer program since 2008, Pantawid Pamilya, which uses the National Household Targeting System for Poverty Reduction (NHTS-PR). This system is based on proxy means test (PMT) methodology to estimate the level of economic welfare of a household and complemented by geographic targeting and validation. The PMT system uses several variables like household demographics, education and occupation of household members, housing conditions and access to basic services as good proxies of income. There are two different models for rural and urban households to account for the socioeconomic conditions.
36. Financial relations between state enterprises in hydrocarbon sector and links with the central government should be more transparent. Despite the clear distribution of oil and gas export revenues between state enterprises and central government in the budget, financial relations among different enterprises in hydrocarbon sector and budget remain opaque. In many other oil producing countries, national oil companies are run on a commercial basis. They pay a royalty to extract hydrocarbon resources and also transfer profits to treasury as dividends to the main shareholder. Iran’s current system mimics this structure but opaque financial relations undermine the accountability of these enterprises and incentives for profitability.
Appendix I. Macroeconomic Developments After the Reform
1. Economic growth slowed down markedly following the implementation of the reform. The quarterly growth rate continued to decelerate and dropped to 2 percent in the last quarter of 2011, just before the intensification of sanctions, from 5 percent in the same quarter of the previous year. The deceleration became more visible from September 2011 on, as the impact of cash transfers on private consumption waned, construction activity slowed down, and industrial production declined markedly. Large increase in input costs associated with higher energy prices weakened corporate sector profitability, as enterprises had difficulties in passing through rising costs to consumers. Production in some large energy intensive sectors such as automobile, steel, cement and petrochemicals continued to grow, albeit at a declining rate, supported by the rise in commodity prices in international markets and strong domestic demand in the first half of the year. Against this background, the real GDP growth declined to 3 percent by March 2012, half of the growth achieved in the previous year.
2. Inflationary pressures emerged and prices increased. The sharp rise in energy prices led to an acceleration in the CPI inflation, which rose from 13 percent (year-on-year) on the eve of the subsidy reform in December 2010 to about 22 percent over a twelve month period. Prices of food, clothing, household equipments and medical expenses increased at about 20 percent over the three quarters following the launch of the reform whereas transportation sector prices, which took the direct hit from increased energy prices, rose above 30 percent. Given the magnitude of the price increases in subsidized products, the rise in the CPI inflation was still on the low end of many estimates. This owed much to the authorities’ various policy measures including strict price controls and accumulation of inventories of strategic key staples. Favorable global food prices also helped limit food price increases in 2011. Developments in the producer price index (PPI), however, showed the true nature of the price shock with 12-month PPI inflation acceleration from about 13 percent in December 2010 to almost 40 percent in December 2011.
3. Supported by higher oil exports and energy prices, the balance of payments improved. Declining domestic oil consumption provided room for more exports as envisaged under the reform program. Iran’s oil and oil product exports increased in 2011, after three years of contraction. In addition, a depreciating currency in the parallel market, emerging difficulties in conducting international transactions and increases in trade tariffs to protect domestic industry kept the import growth under control. Iran’s current account surplus doubled from the previous year and reached 11.5 percent of GDP in 2011. Despite large capital outflows, Iran’s gross international reserves increased by US$20 billion to above US$90 billion by the end of 2011.
4. Corporate profitability was adversely affected. The Tehran Stock Exchange had reached record highs in the wake of the subsidy reform. This was partly caused by new successful IPOs, bearish performance of the other alternative investment options and, in the case of resource based industries, by increasing commodity prices in international markets. With the TSR implementation, equity prices for the sectors mostly affected by the reform declined later in the year. Real returns rapidly declined in the remainder of 2011 in parallel to the weakening economic activity.
Islamic Republic of Iran: Macroeconomic Developments
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Central Bank of Iran; IMF WEO database; Tehran Stock Exchange; and IMF staff calculations.Sources: Central Bank of Iran; International Financial Statistics; and IMF staff calculations.Islamic Republic of Iran: Macroeconomic Developments
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Central Bank of Iran; IMF WEO database; Tehran Stock Exchange; and IMF staff calculations.Sources: Central Bank of Iran; International Financial Statistics; and IMF staff calculations.Islamic Republic of Iran: Macroeconomic Developments
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Central Bank of Iran; IMF WEO database; Tehran Stock Exchange; and IMF staff calculations.Sources: Central Bank of Iran; International Financial Statistics; and IMF staff calculations.Islamic Republic of Iran: Macroeconomic Developments
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Central Bank of Iran; IMF WEO database; Tehran Stock Exchange; and IMF staff calculations.Sources: Central Bank of Iran; International Financial Statistics; and IMF staff calculations.Islamic Republic of Iran: Macroeconomic Developments
Citation: IMF Staff Country Reports 2014, 094; 10.5089/9781475516159.002.A001
Sources: Central Bank of Iran; IMF WEO database; Tehran Stock Exchange; and IMF staff calculations.Sources: Central Bank of Iran; International Financial Statistics; and IMF staff calculations.References
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