Iran’s Subsidy Reform: A Progress Report

Published on Sunday, 19 Jun 21:05 pm

Dr Amuzegar is a distinguished economist and former member of the IMF Executive Board.


Nearly a year after a subsidies reform bill was passed by the Islamic Republic’s national assembly (Majlis) in January 2010, the law went into effect on 15 October 2010. The bill, as part of President Mahmoud Ahmadinejad’s so-called “great economic surgery” (MEES, 24 November  2008) was to go into effect by March 2010, but the government kept postponing its implementation due to various concerns. The legislation’s aim was to raise, within five years, the heavily subsidized and low prices of several products and services – oil products, natural gas, water, bread, rice, cooking oil, milk, sugar, postal services and airline tickets – close to their “international” levels. In order to offset the effects of higher prices on consumers and industrial users, the government was to give cash handouts to the affected families, and make financial assistance available to productive enterprises. Some 50% of revenues from raised prices were to compensate the households; 30% was to be given in grants to agricultural and industrial enterprises; and the remaining 20% was to go to the treasury for covering administrative costs.

The urgent need for the subsidy reform was a matter of universal consensus because the status quo was intolerably costly, wasteful, unfair, counter-productive, and altogether unsustainable. Iran’s national energy consumption was doubling every 10 years, or four times as fast as the world average. With only 1% of the world’s population, Iran was consuming 3% of global fossil fuels. Per capital energy consumption in Iran was five times that of Indonesia, four times that of India, twice that of China and 1.6 times the world average. Iran’s energy intensity was 17 times that of Japan’s, eight times that of East Asian countries and six times that of Europe. In addition to domestic over-consumption and gigantic waste, a good portion of domestic energy products was smuggled out to the neighboring countries where their lowest prices were still 30% higher than Iran’s.

To stop the resource waste and fiscal losses, the Fourth Five-Year Economic Development Plan law, passed by the “reformist” Sixth Majlis, required gradual annual adjustment of subsidized prices to their international standards in five years. But a Price Stabilization Act, passed by the “principle-ist” Seventh Majlis voided the mandate, and the Majlis speaker called the passage “a Nowruz gift” to the Iranian people. As a result, the gap between domestic and world prices steadily widened – in some cases by a factor of 10. In other cases, prices charged by the government for energy products could not cover even their refinery to market transport costs.


A Jump Start

Despite the subsidy reform act’s obvious potential benefits, the precarious status of the Iranian economy at the time led many concerned observers to call on President Mahmoud Ahmadinejad to postpone or revise the plan’s implementation. It was widely feared that a large reduction of subsidies would: (a) result in a sharp rise in inflation; (b) induce people to seek a “safe haven” (ie dump Iranian rials for gold or foreign currencies); (c) exert a depressive effect on the Tehran Stock Exchange; (d) cause widespread bankruptcies and drive energy-intensive state industries out of business; and (e) trigger a tsunami of popular anger and protests.

Rejecting these pessimistic predictions as nasty propaganda by “evil elements opposed to social justice,” President Ahmadinejad on 15 October 2010 announced the start of the subsidy reform. The program would start by the Treasury depositing some IR810,000 ($80) in the bank accounts of all registered individuals as a cushion against future price increases in the first two months. The money deposited in people’s accounts, however, could not be withdrawn until prices went up. The date of the subsidy bill’s full implementation was still kept secret – ostensibly to prevent hoarding and rising inflationary expectations.

Then, without prior notice, and in an impromptu late-night television address on 18 December 2010 – while Tehran’s 800 main checkpoints and major sites were reportedly secured – President Ahmadinejad announced the start of the program as of the approaching midnight. Still declining to spell out the details of the program (ie the number and types of goods to be affected, the amount of subsidies to be reduced, or the magnitude of price rises), he announced the government’s decision: (a) to pay an additional IR10,000 a month to each individual to offset the future higher bread price; (b) remove the embargo on the cash handouts already made, and (c) eventually double the monthly payments.

Interestingly enough, the original plan that had envisaged cash grants to families on the basis of their income, size, and place of residence – with a limit on total family members – was abandoned, the millions of financial questionnaires meticulously filled out by respondents ignored, and all individuals in a family were now given a uniform amount of cash. By mid-November 2010, some 20mn families, comprising 62.5mn of the country’s 75mn people, were reported to have registered and thus received their uniform cash share.

Thus, with less than two hours advance notice, the entire entrenched subsidies scheme began to be phased out. The next day, the Headquarters for Subsidy Reform issued its first press release announcing the oil products subject to price adjustments. In a subsequent announcement, new items were added to the list, and new prices for each item were published. The most eagerly watched item was gasoline – its rationing in 2007 had triggered widespread riots. The pump price was raised from $0.36/gallon for the rationed, and $1.46/gal for free market to $2.55/gal for non-rationed purchases. A small 13 gal/month ration was still allowed to be bought at $1.46/gal. The largest price increases, however, were the 20-fold rise in fuel oil, and ninefold hike in the price of diesel fuel, followed by a fivefold rise in natural gas prices for home heating and cooking, a nearly three times increase for water and power and a doubling for kerosene. Higher prices of other “basic items,” ie, bread and water, were also added to the list the next day. Prices for some of these items, however, were to be different in different geographic areas and for different groups of consumers depending on their magnitude of consumption. There was no official explanation of the formula behind different multiples, and no background briefings on how the decisions were reached.


A Surprising Non-Event

On the first day of price adjustments, the state radio and television stations steadfastly reported the people’s widespread and enthusiastic “welcome” to the news. True or not, the start of the cuts in fuel and food subsidies took place more smoothly and uneventfully than anybody had ever expected. There were no mass protests, no street riots, no sign of violence, no reports of clashes in major cities, no general strikes, no run on the banks and no panic buying. There was not even a commensurate reaction from the Majlis, whose main “intent and purposes” in the law were literally ignored by the government.       A poll, conducted by the Majlis Research Center in March 2011, in fact showed that some 42% of respondents regarded the government’s implementation of the subsidy reforms as “good” or “very good” and only 22% found the exercise “bad” or “very bad”.

What went right? While definitive answers still remain to be found, a number of factors already suggest themselves. During President Ahmadinejad’s dramatic gesture at 10.00pm on 18 December 2010 and the following day, all major gas stations, shopping malls, and the entire Tehran bazaar were closely watched by security forces, riot police, and special guards. Some 10,000 inspectors were reportedly working on three shifts a day to monitor events and prevent any retail price increases or any form of mass protest. Media organizations, businessmen, shopkeepers and industrial managers were reportedly ordered to abstain from analyzing the subsidy cuts or making criticism of the program. Transportation workers were told that if they stopped work, their union membership cards would be cancelled or they would be fined. Shopkeepers were warned against any type of “price gouging” at the risk of immediate arrest and punishment. The Consumers Protection Agency director told the press that due to the “comprehensive understanding” with major guilds, associations and bazaar merchants, prices of scores of articles were promised to be kept unchanged. Critics believe that the “understanding” was reached after a high government official told his business audience: “Our price policy package is ready, and prison doors are also open.”

Furthermore, having anticipated the potential contingencies, government planners had reportedly singled out some 35 key products (including food and fuel) on a watch list, and large stockpiles of essential items had been kept in storage facilities in order to prevent spot shortages, private speculation and economic sabotage. Worried consumers also had stocked up on some dry staples in anticipation of rising prices. Still further, some private analysts consider prior cash deposits in families’ bank accounts in anticipation of price rises as an imaginative policy ploy. They also single out other elements such as the long and numbing period between cash payments and price increases, strict control of the exchange rate to keep inflation in check, and the separation of energy and bread cash grants into two distinct categories.

Finally, sporadic boycotts and threats by truck and taxi drivers, chicken farmers, and bread bakers were stopped by quick payments of cash grants, extension of specific discounts, special rations, temporary postponement of price rises and gradual payment arrangements for higher input costs. There were also a multitude of temporary moratoria, partial exemptions, special assistance and other relief measures for affected groups.

The explanations offered by the Majlis Research Center (which was originally the strongest critic of the program and its most  pessimistic prognosticator of hyper inflation) point to such factors as inadequacy of the country’s input/output data for accurate economic projections, the actual time lag involved in reaching a new equilibrium (ie expected forthcoming price rises), the cautious manner of implementing the law (eg temporary exemptions given to certain energy users, special quotas set aside for certain industrial and agricultural producers), squeezing the middleman’s profits and threats of prosecution.


Subsequent Legislative Developments

Major differences between the president and the Majlis during the passages of the law regarding the specifics of subsidy reforms continued, and somewhat intensified, since the law’s implementation. Several influential deputies (including the speaker) have found the government’s actions contrary to the Majlis’s intents and purposes in eight specific instances. They argue that: (a) subsidized prices were supposed to reach near international standards within five years while the government has raised some prices to near such a level overnight; (b) while all citizens were to be compensated for price rises, over 12mn people had been excluded from initial cash distributions (and not all voluntarily); and (c) the hasty and ill-considered manner in which the bill is implemented would be socially explosive down the road.

In reality, most of these criticisms and objections have been rooted in: (a) the ambiguities of the law itself, and (b) the lingering analytical quarrel regarding the “optimal” policy for cost/price adjustment – the choice of shock therapy versus a gradual approach. The brevity and clumsy redaction of the original act has given rise to a number of such ambiguities. For example, does the 20% annual price rise envisaged in the act refer to 20% of the gap between national and international prices, or does it mean a 20% increase over and above existing prices? Does the five-year period of price adjustment prescribed by the law mean equal annual price rises? Or should prices be adjusted in five years – at the authorities’ own pace? Taking advantage of these ambiguities, the president and his close advisors – always believing in the efficacy of shock therapy over gradualism – decided to follow their own instinct. Their argument was that a five-year gradual price adjustment would have triggered steep inflationary expectations, while a speedier action has totally eliminated such a threat.

Rejecting both the government’s arguments and its implementation method, the current Majlis, in the course of approving the 2011-12 annual fiscal budget, has made a number of specific requirements for further implementation of subsidy reform. First, the president’s forecast of $62bn revenue from price rises this year has been reduced to $54bn. Second, the government has been allowed to increase prices by no more than 20% during the year. Third, the share of citizens from the proceeds of raised prices has been increased to 80% from the previous 50%; the 30% share of production units has been reduced to 20%; and the 20% share of the government has been altogether eliminated.

An Interim Assessment

Evaluating the six-month record of the subsidy reform program is exceedingly difficult since information regarding basic results of the scheme is still shrouded in secrecy, censorship and contradictory official figures. Lack of transparency on the part of the Reform Headquarters and the injunction on the press and NGOs regarding critical discussions of the subject, make it impossible to reach meaningful conclusions. There has been no published financial account of the sources and uses of funds so far collected and disbursed. According to one summary report by the head of the Subsidy Reform Organization, some $14.4bn was collected from higher prices in the last three months of 2010-11 – of which $8.5bn was paid back to families and $3.4bn set aside as the share of production units, transport vehicles and municipalities. Yet the head of Iran’s Chamber of Commerce and Industry, the Majlis speaker and several private sources have gone on record stating that no more than one-eighth of the producers’ share was paid to them. Left out of the official reports is also any explanation as to how the illiterate people in the country’s remote villages or small towns – officially estimated at 15-20% of the population – with no telephones, no post offices, no bank account and no access to internet – have been identified and included among the recipients. Similarly, there has been no information as to how the country’s state-owned energy-intensive industries – petrochemicals, steel, aluminum, cement – operating on dirt-cheap input until now – have coped with the situation.

Brief, scattered and hyped official reports on the physical outcome of the program add more to the confusion. Less than a month after energy price adjustments, there came official reports of “drastic decline” in gasoline, natural gas and electricity consumption. In mid-May 2011, President Ahmadinejad made fleeting references during several television appearances to reduced national consumption of subsidized items, increased enterprise productivity, and improvement in income distribution. Private estimates regarding four main energy products (gasoline, kerosene, diesel oil and fuel oil) during the first five months of operation indicate only a total of 750mn gallons – worth $2.5-3bn. The Ministry of Petroleum’s website shows a marked decline in gasoline consumption right after the price rise, but the late May 2011’s sales again topped 60mn liters/day – matching the pre-reform levels.

With respect to improved public welfare, President Ahmadinejad has predicted that there would be no poor in the country within two years. His finance minister, in a Washington interview, claimed that the Gini coefficient of income distribution had already improved by going from 4 to 3.5! He then added that with $1.50 cash paid to each citizen every day, no Iranian would go to bed hungry – a feat, he said, that even Japan cannot boast about! Other government officials claim that cash grant received by 70% of the families has been larger than their increased expenses caused by the new higher prices.

In the absence of reliable official reports, there have been abundant anecdotal accounts concerning the program’s widespread hardships. In April 2011, the Deputy Minister of Petroleum let drop that 30% of the country’s gas consumers had failed to pay their gas bills. Nothing more has been revealed about the boycott. Some Majlis deputies have gone on record indicating that reduced fuel consumption in their district has not been due to greater parsimony or higher efficiency, but simply the result of business closing in response to higher fuel costs. Others have pointed to farmers abandoning tractors use due to higher fuel costs, and going back to using working animals and old farming methods. A number of other Majlis deputies have reported higher unemployment in their districts due to higher gas and electric rates. A deputy from the Persian Gulf coast speaks of 100,000 fishermen quitting their jobs due higher diesel fuel costs. There is a report about stone-cutters in Qom left idle due to higher electricity rates. The head of the Bread Bakers Guild claims that 30% of Tehran bakers are facing bankruptcy due to higher fuel costs. There are sporadic reports of workers’ strikes due to missed wages.


A Potential Black Hole

Partisan political assessments of the subsidy reform program so far have ranged from such headlines as “Ahmadinejad’s masterstroke” and his “well-conceived scheme to end economic distortions and inefficiencies”, all the way down to “nothing but a weapon of political control” introduced to win friends and punish opponents.Due to a nearly total lack of verifiable official information on the subject – and the private media’s self-imposed censorship – any evaluation of these opposing views (as well as the program’s future) would be conjectural at best, and must be treated with caution.

With this caveat in place, the subsidy reform program seems likely to face four formidable challenges in the next few years. The first challenge is the program’s precarious financial balance. Of the total $54bn projected revenue from higher prices this year, a minimum of $44bn is needed to compensate the 72.5mn people reportedly registered to receive the $45.5 in monthly cash-back. While reform officials have repeatedly assured the Majlis that even without any new price hikes this year, the $54bn revenue will be readily collected and disbursed, a number of influential Majlis deputies believe that even with a further 20% increase in food and fuel prices no more than $32bn could be gained – of which only $24bn could be the people’s share – thus leaving a mammoth $18bn gap. The chairman of the Majlis’s Economic Restructuring Committee believes that this year’s revenues will be just enough to take care of cash-backs to individuals, and nothing will be left to meet the share of producers.

The second challenge involves the program’s potential inflationary impact. A consensus among most analysts before the program’s start was that a direct and immediate consequence of the price adjustments would be high inflation. The Majlis Research Center had predicted a 60% rise in prices. The World Bank and IMF staff foresaw about 30%. Although it is still impossible to gauge the program’s full inflationary impact, since all main prices are still controlled by the government, figures recently released by the Central Bank show: (a) a creeping month-over-month increase in food and fuel prices since the program’s start – with the consumer price index (CPI) for May 2011 registering a 14.2 increase; and (b) price increases in the last three month of 2010-11 going up twice as fast as it did during the corresponding period in 2009-10. With liquidity now expected to rise by 24.8% in 2011 – compared to 10.4% in 2010 – the inflation picture further looks ominous. The Majlis Research Bureau now predicts a 40% rise in CPI this year. More ominously, as the so-called temporary “understanding” with guilds, bazaar merchants, and other sellers not to raise prices for the first four months of the program operation now expired, and requests for price hikes are increasingly poured into the Organization for the Protection of Consumers and Producers, pressures for price decontrol are likely to increase. Should the government allow gradual price increases on products whose energy input costs have increased, not only would CPI reach new highs, but both state and private enterprises would further lose their international competitiveness. And if price rises were disallowed, further losses and bankruptcies would follow. This would be particularly the case for the country’s energy-intensive industries that have so far been using some 37% of national fuel oil consumption, 33% of electricity and 27% of natural gas – at highly discounted prices.

The third challenge is the impact of the reform on jobs and job growth. With oil prices now hovering in the high double digits range and Iran’s oil export receipts on the rise, the government can afford to blunt inflationary pressures for a while by further opening up the import gates. As in the last six years, the domestic market could be inundated with cheaper goods from around the globe – ranging from baby carriages to gravestones, and including items never previously on the Iran’s import list. By driving higher-cost domestic producers out of business and causing widespread factory closings, these cheap imports would aggravate the country’s prevailing ‘Dutch disease’, and further result in slow economic growth and higher unemployment. At the same time, lack of funds to help business enterprise renovate and adopt new energy-saving technologies in the face of rising input costs is likely to result in widespread bankruptcies and higher unemployment. The situation would be further aggravated if the government were to decide on limiting the foreign exchange value of the Iranian rial to the 11% devaluation announced on 7 June 2011 to contain inflation.

The fourth and by far a most formidable challenge is how to wrap up the program. Ironically enough, while the subsidy reform law is officially called the “Law of Targeting Subsidies,” there are no formal or explicit “targets” in the act, and no specific arrangements for its termination as public subsidies are not yet eliminated, but only changed in composition from lower prices to cash payments. Yet, given the facts that (a) the old subsidy system was unsustainable, (b) a move towards free and transparent market prices was necessary, and (c) an ultimate social safety net had to take care only of the needy, the current all-encompassing program must end sooner or later. Monthly cash payment to nearly the entire population – with no time limit in sight – is clearly contrary to the purposes of a subsidy “reform.”

Under the original version of the law: (1) the program was to be self-financing; (2) only 50% of the adjustment revenue was to be used as financial aid to families; and (3) the cash-back would end after five years when prices were brought up to international levels and there would be no further increase. It was optimistically expected that by then, consumers would have been able to rearrange their consumption pattern and adjust their monthly budget to the new realities. Under the amended statute, where: (1) nearly the entire population is now placed on government payroll; (2) some 80% of revenue is to be paid back to consumers; (3) the recipients do not seem to regard the bounty as temporary, and in fact expect it to be doubled (as promised by the president); (4) the number of beneficiaries is on the rise with annual population growth; and (5) the program’s revenue source is highly precarious – there is a totally new game ahead.

Now, as long as the oil price remains around $100/B and Iran’s crude exports hover around 2.2mn b/d, current monthly cash payments can theoretically be maintained. But neither of these two conditions is certain to hold. And three additional problems still remain. First the current fiscal year’s budget of $54bn for cash handouts is already equal to 75% of Iran’s average annual oil exports receipts during 2005-10 – leaving little room for additional fiscal maneuvers in the coming years – except at the expense of drastic reductions or total elimination of new public investments. And, any dollar earned from the sale of oil as an exhaustible resource devoted to consumption is a permanent loss of an investment dollar needed to replace the exhausted resource. Second, regular payments of cash subsidies to a large majority of the population are bound to institutionalize a pernicious culture of dependence on the state – undermining self-reliance and individual initiative. Third, and finally, regular monthly welfare funds will soon be regarded as a permanent “entitlement” right whose cancellation or even reduction would be fought tooth and nail by the recipients.

Finding reasonably effective solutions to these challenges under the Islamic Republic’s current conditions, ie political infighting among the governing elites, the president’s disputes with the Majlis and the judiciary, economic stagnation, dormant social unrest, regional diplomatic quarrels and biting universal sanctions would indeed require nothing short of a divine guidance. President Ahmadinejad, claiming that his government is daily supervised and directed by the Hidden Imam, may now need the latter’s blessings more than ever.

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