VOL. XLV

No 33

19-August-2002

 

IRAN

 

IMF Mission Commends Iran’s Economic Performance But Warns Of Challenges Ahead

 

The overall economic situation in Iran was favorable in 2001-02 and is likely to remain so in 2002-03, with high rates of growth, low external debt and high foreign exchange reserves, the IMF mission said after completing Article IV consultations with Iran over the period 26 June-11 July. Nevertheless the IMF warns of serious challenges in a number of sectors and the need to embark on the necessary reforms. The IMF also commended the Iranian authorities for the exchange rate unification and the smooth transition to a new exchange rate regime, which enhanced business confidence and the credibility of the reform process. The mission welcomed the “successful floating of the €500mn Eurobond, which attests to the confidence of the international markets in Iran’s economic prospects and the authorities’ commitment to economic reforms.”

 

The consultations with the IMF this year have once again highlighted the need for Iran to press ahead with much needed economic reforms. Although the IMF’s assessment of the country’s economic situation is rather positive, a number of serious problems remain. These include the acute unemployment situation, a large public sector with inefficient state enterprises which absorbs the lion’s share of the budget, inflationary high liquidity growth, poor coordination of macroeconomic policy, slow progress on privatization and a wasteful policy of energy subsidies. While some groups in the government are committed to introducing reforms, the present political configuration in the country is not conducive to their prompt implementation. The ongoing differences between reformists and conservatives could delay approval of new legislation to liberalize the economy, as happened recently with the law on foreign direct investment. 

 

The main points raised in the IMF Concluding Statement on the consultations are summarized below:

 

Developments In 2001-02 And Outlook For 2002-03

Overall economic activity in 2001-02 remained strong for the second consecutive year, with real GDP growing at 4.8% despite lower oil production (Table 1). Performance of the non-oil sector was strong and broad-based, with a growth of 6% driven by higher domestic demand and improved confidence. Employment creation grew at a lower rate of 3% and the unemployment rate in urban and rural areas remained at 16% in 2001-02, according to the Central Statistics Office. Average consumer price index inflation continued to decline to 10.3% in 2001-02, compared to 11.7% the previous year. Fiscal policy was relatively prudent in 2001-02 and the fiscal position remained in surplus despite the decline in oil revenue. Non-oil revenue was broadly in line with economic growth, and total expenditure rose by about 5% in real terms, with growth in current expenditure more than offsetting the decline in capital outlays.

 

Iran’s current account surplus declined to 4.8% of GDP from 13.4% in 2000-01 due to lower oil and gas exports, as well as a 20% increase in imports. Non-oil export receipts rose by about 5% due to high growth in exports of chemicals and petrochemicals. The capital and financial account continued to be in deficit, reflecting a significant reduction in debt repayments and a sharp rise in capital inflows comprising buybacks and oil prefinancing. The surplus in the overall balance was $4.9bn, and gross official reserves, including the $7.4bn in the Oil Stabilization Fund (OSF), were equivalent to 9.7 months of imports (Table2).

 

Despite efforts by the Central Bank of Iran (CBI) to mop up excess liquidity by reducing lending to commercial banks and issuing Central Bank Participation Papers (CPPs), broad money grew by 26% in 2001-2002 following a 30% rise in the previous year. The exchange rate of the rial against the dollar was relatively stable on the Tehran Stock Exchange, but remained under pressure to appreciate.

 

Looking forward to 2002-03, the IMF notes that the growth outlook is relatively favorable, but that the expansionary policy stance could lead to higher inflation and put pressure on the real exchange rate to appreciate. Real GDP growth is projected at about 5.8%, but real oil GDP is likely to decline by 1% compared to the previous year. Growth in non-oil GDP will rise by 6.3%, underpinned by strong public sector demand, increased business confidence and gains in household disposable income.

 

The fiscal position is expected to deteriorate significantly because of the expansionary spending in the 2002-03 budget and the cost of the exchange rate unification. The external current account surplus is estimated to decline to the equivalent of 1.5% of GDP. At the same time exports of oil and gas are expected to increase by almost 3%. The average oil export price is projected at $22/B for 2002-03 and $19.2/B for 2003-04. A surplus in the capital and financial account is projected. Iran’s outstanding external debt is projected to increase slightly in 2002-03 to $7.3bn, or 6.9% of GDP, but the debt service will continue to decline to about 4% of exports of goods and services. Official international reserves are projected to rise to about $20.2bn, equivalent to nine months of imports. Monetary growth is estimated to reach about 40% in the absence of corrective fiscal measures.

 

Fiscal Policy

The mission notes that the Iranian authorities are exploring appropriate measures to contain the fiscal deterioration and its impact on monetary and exchange rate policies. It also suggests that such measures take into consideration the need to reduce current expenditure, ensure an orderly scaling down of capital expenditure that would not be harmful to future economic growth and preserve the integrity of the OSF by not drawing on past accumulated resources. On the revenue side, the mission recommends a reduction in tax exemptions, better collection of tax arrears and an increase in excise taxes.

 

Monetary Policy

In 2002-03 monetary policy is confronted with a complex setting marked by excess liquidity in the banking system, a relaxation of fiscal discipline, upward pressure on the exchange rate and inadequate instruments of liquidity management. Monetary policy cannot contain the liquidity and inflationary effects of a deterioration in the fiscal stance of 2002-03, nor would it be sufficient to prevent further appreciation of the real exchange rate. The mission adds that a policy mix of fiscal adjustment and monetary policy actions to mop up excess liquidity would be essential to bring domestic liquidity growth under control.

 

Exchange Rate Policy

The authorities have reiterated their commitment to a managed exchange rate system, while recognizing the merits of nominal rate stability in the short run to ensure a smooth transition to the new unified interbank market rate. The government is also aware of the need to avoid a further real appreciation of the currency, and realizes that when conditions are appropriate it would ensure that the nominal effective rate depreciates against major hard currencies, guided by the inflation differential with major trading partners. The mission also pointed out the CBI would need to move to ensure that the exchange rate at the interbank market fluctuates as warranted by market conditions and economic fundamentals.

 

Outlook For Third Five-Year Development Plan

The medium-term outlook for the remainder of the plan (2000-01 – 2004-05) remains relatively favorable under current oil price projections and the assumption that the fiscal expansion will be corrected during the remainder of 2002-03 and the following years. Given the objectives of achieving a real GDP growth rate of 5% over the plan period, the overall external position will remain in surplus, albeit on a declining trend, but the external debt will remain low and international reserves will be maintained at a comfortable level. However achieving the targeted real GDP growth and increasing employment will be subject to uncertainties, including oil prices, weather conditions, the pace of structural reforms and the prospect of regional stability. The question of employment, however, remains a serious challenge. Over the past three years, the labor force grew by about 3.5% per year, with close to 600,000 newcomers to the job market each year. On the supply side, employment creation has been around 450,000 per year on average, resulting in a rise in unemployment to 16% in 2001-02.

 

 

Fiscal Reform Strategy

The mission commends the authorities for implementing reforms in a number of areas, mainly the exchange rate unification, the passage of the foreign direct investment law aimed at attracting foreign investment and enhancing the transparency of investment procedures, the reform of direct taxation and the licensing of private banks. In addition a law for value added tax (VAT) has been submitted to the cabinet for approval. The IMF mission also welcomed the elimination of tax exemptions for public enterprises and bonyads and advised against excessive recourse to tax incentives and privileges as instruments of industrial and social policy.

 

The mission and the authorities have agreed that the effort to reform must be deepened to yield tangible results in terms of sustained growth and employment creation. In particular the reform process must now focus on achieving greater openness of the economy by further liberalizing trade, eliminating the remaining exchange restrictions and attracting foreign direct investment. Also fiscal management will need to be enhanced to allow for the build up of financial savings and the transfer of resources to future generations, domestic price setting must be overhauled, the financial sector reformed and government state enterprises restructured or privatized. Progress in privatization has so far been limited. The IMF mission underscores the need to set up more ambitious privatization targets with the clear objective of disengaging the government from key activities that can be carried out more efficiently by the private sector, such as telecommunications, transportation, insurance, tourism and other services.

 

Finally the IMF says that the authorities remain committed to eliminating all remaining exchange restrictions and accepting the obligations of Article VIII by the end of the current year on 20 March 2003. An IMF technical assistance mission has reviewed the remaining exchange restrictions and discussed with Iran the timetable for their elimination.