Middle East Economic Survey
VOL. LI
No 9
IRAN
Iran Deals With The Oil Windfalls
By Jahangir Amuzegar
The following article was written for MEES by Jahangir Amuzegar, a distinguished economist and former member of the IMF Executive Board.
Iran’s unprecedented and spectacular oil boom of the last five years has had little effect in solving the country’s basic economic malaise. Nor has it had a perceptible impact on improving the plight of poorer income strata. In fact, the unexpected oil bonanza has gone hand-in-hand with virulent and rising inflation, stubborn double-digit unemployment, further recession in the country’s industrial sector, and reportedly larger gaps in domestic income distribution. More troubling still, while oil prices are expected to remain at current high levels, the mid-term economic outlook for Iran presented by international organizations (eg, the IMF) and foreign private sources (eg, the Economist Intelligence Unit) – show slower GDP growth, higher inflation, and larger unemployment in the next few years.
The failure of the oil windfall to put the manna on “everyone’s kitchen table” – as once promised by the president – has once again revived the belief in “the curse of natural wealth.” It has also caused widespread popular discontent with the current administration’s economic policies, and triggered strong criticisms by economic analysts, academic economists and private observers regarding Mr Ahmadinejad’s disposition of the rising oil export receipts. The president has been particularly blamed for squandering the oil windfalls during his 2.5 years in office – equivalent to six-years’ receipts during Mr Khatami’s administration, and eight-years’ income during the Rafsanjani presidency – on raising salaries and wages not warranted by enhanced productivity, wasteful energy and food subsidies, low-cost loans to highly inefficient “quick-return” projects, and superfluous handouts to the crowds greeting him on his nationwide tours.
Stung by the ferocity of daily attacks not only by the “reformist” opposition, but also by a large contingent of his conservative supporters in the Majlis and the media, the Expediency Council, and even a rebuke by Supreme Leader Ali Khamenei, the president recently invited a group of Iranian economists – the ones who had previously criticized his policies in a well-publicized open letter – for a dialog during which he asked them to tell him how best to spend the rising oil revenues. This review intends to examine some of the suggestions so far offered, and suggest one of its own. The suggestion will not be a panacea for all Iran’s economic problems, but only a proposal for a more desirable and satisfactory allocation of oil proceeds. It also assumes no further change in the Islamic Republic’s international status.
The Problem’s Genesis
Concerns about “optimal” allocation of oil export revenues arise only in countries, like Iran, where the ownership of mineral resources belong exclusively to the state by virtue of religion, tradition or law. And all proceeds from sales and exports of these minerals accrue to the national treasury for distribution and disposition. In free enterprise economies, where ownership of mineral resources is in private hands, the market serves as the allocation agent.
Experience in Iran and other oil exporting developing countries since the oil price explosion in the 1970s shows that state allocation has typically resulted in six undesirable consequences. First, a misconstrued belief in the magic power of money to solve all socio-economic problems has encouraged the state to adopt a maximalist approach in spending the oil windfall as fast as possible – in the vain hope of eradicating poverty and solving related development problems. Second, the speed by which the oil fund is earmarked by state planners for domestic projects has invariably lacked proper cost/benefit analyses, and resulted in hasty and wasteful financial commitments. Third, the oil money is often invested in capital-intensive, energy-based industries (eg, steel, aluminum, petrochemicals) with little or no consideration given to other needed complementary inputs (eg, water, technology, and management). The result has been low total factor productivity, and continued high unemployment. Alternatively, funds have been diverted to politically instigated white-elephant projects with little or no economic returns. Fourth, required companion policy imperatives – needed to cope with the inflationary consequences of increased liquidity and heightened aggregate demand – are often sacrificed at the altar of ad hoc, popular, and often wasteful decisions. The outcome has been the emergence of a “petroculture” where quick money-making has pushed aside normal work ethics. The spirit of self-reliance is overtaken by the adoption of a welfare-state mentality. Fifth, occasional efforts at privatization in some countries have been largely undermined by much larger new public investments. In Iran, for example, during 1990-2006, new public investments, reaching more than $130bn, were 40 times total privatized assets. And sixth, the governments, not needing taxes to finance public expenditures, have become more authoritarian and less democratic, assuming an increasingly dominant role in the economy.
President Ahmadinejad himself addressed these six economic afflictions when he spoke on 11 February 2008, the 29th anniversary of the 1979 Revolution, saying Iran’s economy needed “major surgery.” He said fiscal and monetary systems, channels of distribution, the foreign trade regime, the issuance of enterprise permits, and the subsidies program all needed reforms. The economy, he continued, was mired in corruption, rent-seeking activities, special deal-makings through right connections, and a planning apparatus devoid of “social justice.” He deplored the fact that the highest 30% of income receivers in Iran pay less than one-tenth of total taxes while receiving 70% of public subsidies. He further complained that: 55% of all bank credits go to only 1% of borrowers; the 120% margin between producers’ receipts and consumers’ supermarket costs is unduly excessive; all national imports and exports are in monopolistic hands; and the whole economy is rent-oriented, overly subsidized to the tune of $95bn a year, and neglectful of the ordinary citizens’ vital interests.
The “Optimality” Question
“Optimal” expenditure of revenues by the oil rich countries may not be examined in abstract. “Optimality” in each country will be a function of its national political agenda, size of energy reserves, domestic absorptive capacity, ready access to up-to-date technology, and the degree of care for inter-generational equity. Even for a given country, “optimal” allocation would change as relevant conditions undergo transformation over time.
In Iran’s case, the immediately pre- and post-1979 Revolution agenda presents a telling example. Under the Shah’s maximalist politico-economic plan, oil production was raised to near 6mn b/d, and the proceeds were earmarked for national defense, social welfare, rapid industrialization, and mechanized agriculture. By contrast, the anti-West, anti-imperialist, contingents of the revolutionaries after 1979 called for the reduction of oil output to the barest minimum need for internal consumption. Based on the fallacious, but crowd-pleasing, assumption that economic self-sufficiency is the sine qua non of political independence, the position held by a powerful minority in the anti-monarchy’s rainbow coalition was to cut trade with the West, and substitute oil-financed imports with domestic products. The argument was that the Shah’s policy of maximizing oil production was injurious to Iran’s national interests since (a) rising oil export income would be enjoyed at the expense of future generations; (b) the proceeds were spent on “useless arms,” grandiose projects, or massive consumer imports hurting local industries; and (c) the economy was becoming hazardously dependent on the West and particularly the US. Under the proposed scenario, there was no residual oil export income to allocate.
This minimalist policy, however, was soon abandoned, and with the outbreak of the Iran/Iraq war in 1980, efforts were made to increase production as fast as war conditions allowed. A total policy reversal occurred after the end of the war in 1989 where every subsequent five-year development plan called for a new and higher target for daily oil production to 5mn b/d. This target is still elusive, due to a continuous decline in output from old oil wells, US and UN economic sanctions, and the Islamic Republic’s inability to obtain necessary capital and up-to-date technology from reliable sources.
Iran today produces about 4mn b/d on average, and exports about 2.5mn b/d – bringing in about $65bn a year of export receipts to the treasury. Even with no appreciable increase in daily oil production in the coming years, and oil prices remaining at current levels, two major factors underscore the increasing necessity of “optimal” oil money allocation. First, under the mandates of the current Fourth Development Plan (2005-10), the budget’s dependence on oil receipts is to be gradually reduced to zero, and all current public expenses should be financed by taxes and other means, leaving funds in state hands larger than ever before. Second, under the recent interpretation of Article 44 of the Constitution – calling for wholesale privatization of public enterprises within eight years – upstream oil and gas production is excluded, and the state is to continue to be the sole recipient or oil and gas export sales.
Even assuming the near metaphysical certainty that, despite legal injunctions, the budget’s reliance on oil income for current expenditures and subsidies will not come to naught within this, or even the next, five-year plan, the problem of “optimal” allocation will still remain for the “residuals” foreign exchange income left in the government’s hands after the budget’s share. That is, given the Islamic Republic’s constitutionally mandated public ownership of energy reserves, and the current leadership’s decision to exempt their upstream operations from privatization, the treasury will continue to be the sole depository of oil export revenues. Thus, the government must still find sufficiently profitable outlets for absorbing the funds.
Rational Allocation Venues
Given the Islamic Republic’s unflattering performance record in its last 20 years, the consensus of professional opinion is that the state should no longer be allowed to have a direct allocating role in deciding the use of oil export receipts. There is an unwritten fiscal principle that as long as there is a pot of gold in state hands, popular demands will steadily rise until the last ounce of it is spent. Wholesale privatization is thus now widely considered not a matter of choice but one of necessity. Politically, the consensus argument is that: (a) huge oil money in the government’s hands has resulted in the enlargement of a state-dominated, oil-based, and overly subsidized economy; and (b) the oil-rich, non-tax dependent, state has become less and less democratic, and under no political constraint to use the oil money wisely. The economic record so far has been even less satisfactory. At the macro level, various targets (eg, growth, inflation, employment, welfare) in the four development plans so far have all deviated from planned figures – most often missing the goals. By official admission, average gestation period for planned projects has exceeded 10 years compared to a world average of two to three years. Capital-output ratio on average has often been ten-to-one versus three-to-four for a similar venture elsewhere.
Responding to the president’s request for advice and guidance, several proposals have been offered by Iranian analysts. The simplest has been to divide the oil revenue equally among the entire population, letting them decide how to spend their share. A twin version has been to distribute the shares of the National Iranian Oil Company, as a public corporation, equally among all citizens. A third proposal has been to follow the mandates of the Fourth plan faithfully and assiduously, setting a decreasing portion of the expected oil revenue each year in the annual budget, and placing the rest in the Oil Stabilization Fund to be used in emergency and for loans to the private sector in approved investment projects.
The flaw in the first scheme is its conceptual nature: it is enormously difficult to administer, highly regressive, corruption-bound, wasteful, inflationary, and inequitable. First, in a country with no reliable population census, no registered postal addresses everywhere, no widespread bank accounts, and a corruption-riddled bureaucracy, the equal distribution and delivery of oil money can hardly escape wrongful manipulations. Second, giving the wealthiest residents of north Tehran and the poorest occupants of the surrounding shanty towns the same share is inequitable, and regressive. Third, given Iranians’ legendary high propensity to consume, the bulk of distributed funds would most probably be spent on imports, travel to holy places, and purchases of superfluous wares – not contributing to production, and fueling inflation. And, above all, the plan would be highly unjust because it totally disregards the future generations’ share in their homeland’s wealth. The twin version shares the above failings, but also suffers from other widely discussed flaws of the current “justice shares” distribution under the program championed by President Ahmadinejad this year. The continuation of the present arrangement, suggested in the third proposal, is also futile because of its statutory defects. This was originally a rational and promising scheme to deal with the problem. But instead of setting up as a separate “fund” immune from further political interference, the Majlis set it up as an “account” in the Central Bank of Iran (CBI) subject to future draw-downs at the legislature’s pleasure. For this reason, both President Ahmadinejad and the 7th Majlis have so far routinely ignored its mandate, and depleted its reserves through frequent supplementary budget legislation. The need is thus for a new solution which may differ from the previous ones in both form and substance.
A New Suggestion
In the context of this review, allocation “optimality” may be approached when three basic conditions are met. First, since the receipts from the sale of crude oil is not income, but merely a transaction involving the exchange of a natural asset for cash, the elementary principle of capital preservation requires that the proceeds be turned into another, ie, a new physical or human capital asset. Second, another elementary rule – profit maximization – necessitates the use of proceeds in a most rewarding venture in either monetary or other values. And, third, the organizational and staffing process of “optimal” allocation, once adopted, should enjoy both strict legal standing and permanence – immune from subsequent political interference.
These conditions require that the government stays away from trade and business in the ordinary sense of these terms. In the purely economic realm, government tasks would be limited to the preparation of periodic mid-term economic outlooks, protection and empowerment of the private market, and the establishment of
a level-playing field for all.
But under Iran’s present economic conditions, the government cannot be expected to cover all its current budgetary expenditures without any injection from the oil receipts – as it should under ideal conditions, and as envisioned by the Fourth Plan law. Such factors as the relatively small active labor force, an extremely low tax base, hundreds of money-losing public enterprises, meager non-oil exports, hundreds of religious and charitable organizations on the public dole, and a long-pampered and richly-subsidized citizenry will not for some time allow an “ideal” allocation. The only hope is that the current 60% budget dependence on oil funds be gradually reduced to near zero within a few years when basic structural adjustments in the budgetary, banking, subsidies, privatization, and exchange regimes will be hopefully completed.
In the interim, an “optimal” allocation of the funds left after meeting the government’s basic needs for foreign currency, may be guided by a new program. As a start, the government would be enjoined from making any new investment in non-traditional public areas, and would proceed with further privatization of current public enterprises as ordered by the Supreme Leader. As the next step, a special new public corporation would be chartered by the Majlis to handle the “residual” oil funds. All these proceeds would be deposited in the corporation’s account in the CBI, without the bank having control over it. The corporation would be an independent business entity, having only one outstanding share belonging to the government. It would be managed by a seven-to-nine member board of trustees, elected by the legislature from a list of non-political and business-savvy individuals nominated by the president. The trustees would be tenured for 10-15 years, removable from offices only for dereliction of their fiduciary duty, or other malfeasance – to be proved in an open trial by a competent high court. Their salaries and perks would be equal to those of the highest government officials below the president in order to relieve them of the necessity of looking for extra income. They would have no other position or duty in the bureaucracy, and will be beholden to no other entity or authority except the Majlis, and only in the context of its basic charter.
The new corporation’s three basic tasks would be first to lend money to the treasury at zero interest rate if the price of crude oil plummeted sharply, and the essential foreign exchange needs of the government could not be met by non-oil export revenues. The loans would have to be repaid once the shortfall ended, and oil prices rose. Second, acting similar to an investment or venture capital bank, it could make medium to long-term secure loans to private business entities for viable investments in profitable industrial, agricultural, or service projects. Third, foreign funds remaining at the corporation’s disposal at any given time would be invested exclusively in safe foreign capital market instruments at the best obtainable terms, and treated as a saving account for future generations. No amount of the “residual” funds would be used for subsidies. The oil money on the poor table would have to come from the total restructuring of the current wasteful, unfair, and corruption-ridden subsidy regime into a target-based system.
Although the establishment of such a corporation may meet the criteria for “optimal” allocation, its efficiency and durability might still face the threat of political interference as the Majlis can at any time revoke its charter, or amend its functions to draw down on its funds. For this reason, there is need for a new constitutional provision, or at least an irrevocable edict by the Supreme Leader, to safeguard the corporation’s integrity and permanence. While the chances for such a guarantee to be put in place remain low – as neither the Majlis nor the government may be willing to voluntarily give up its power of the purse – the creation of such a scheme remains the only credible alternative to “optimal” allocation.