Iran’s economy has shown signs of stability since President Hassan Rouhani took office in August 2013, according to a new report by the International Monetary Fund (IMF). Inflation declined to about 29 percent in January 2014, down from about 40 percent in late 2013. But Iran’s “near-term economic outlook remains uncertain,” according to IMF economists. The economy is expected to contract this fiscal year due to continued restraints on oil revenues and inability to access the international financial system.
A final nuclear deal between Iran and the world’s six major powers could improve the outlook for Iran. The due date for a deal is July 20. Domestic reforms, however, are also badly needed — especially on subsidies that have hampered the economy for decades. The following are excerpts from the IMF survey.
In their annual health check of the economy, the first in 2½ years, IMF economists say that Iran’s near-term economic outlook remains uncertain. Facing continued constrained prospects for oil revenues and international transactions, Iran is expected to see its real GDP growth begin to stabilize in the current fiscal year after two consecutive years of sharp contraction. The still-weak recovery is expected to benefit from potential improvements in the external environment and some early signs of modest revival in growth in domestic demand.
The new Iranian administration that took office in August 2013 has made some headway in improving the external environment and confidence in the outlook, the report notes. The authorities have reached an interim agreement with the P5+1 group of countries (the five permanent members of the United Nations Security Council plus Germany). This agreement (which took effect in January 2014 and provides for a limited, temporary easing of sanctions) allows Iran to stabilize oil exports, grants some access to Iran’s funds held abroad, and temporarily waives sanctions on petrochemical exports and the automobile industry.
Iran now needs to focus on the domestic reform agenda to fully benefit from the country’s economic potential. “This window of opportunity to advance comprehensive reforms should not be missed,” said Martin Cerisola, Assistant Director of the IMF’s Middle East and Central Asia Department.
Staff Appraisal
Iran had achieved considerable progress in raising per capita income in previous decades, but large shocks and weak macroeconomic management in recent years have had a significant impact on macroeconomic stability and growth. A combination of shocks, associated with the implementation of the first phase of the subsidy reform, social-programs inadequately funded, and a marked deterioration in the external environment have weakened the economy. Inflation and unemployment are high, while the corporate and banking sectors are weak. The experience over the past several years has exposed structural weaknesses in the economy and in the
policy framework.
The economic outlook remains highly uncertain. Facing continued constrained prospects for oil revenues and international transactions, the economy is expected to have continued to contract in 2013/14. With some positive tailwinds from the external side and incipient signs that the pace of contraction in domestic demand is slowing, economic activity would begin to stabilize in 2014/15. But the current outlook remains highly uncertain and subject to downside risks. The authorities are taking steps to make the regulatory framework for foreign investment in the oil sector more attractive, while the interim agreement with the P5+1 brings upside risks.
The opportunity to advance comprehensive reforms should not be missed. There is a need to advance reforms to the product, labor, and credit markets to promote stability, investment, and productivity. The authorities should avoid postponing reforms and “muddling-through” in the hope of an improved external environment. Advancing reforms would lay the basis for sustained high growth and employment, especially should the external environment continue to improve.
Dealing with stagflation requires several measures, careful sequencing and coordination. A three-pronged strategy should be centered on tightening monetary policy, some balanced fiscal consolidation, and structural reforms to boost the supply side. Staff welcomes the steps taken to remove the financing of the Mehr program from the Central Bank of Iran’s balance sheet, which bode well for stabilizing inflation in the future. The authorities are encouraged to find an alternative noninflationary source of financing for this program to minimize macro-stability risks ahead. Increasing profit rates gradually would help to firmly anchor expectations and contain second-round effects from the planned increases in domestic energy prices. The 2014/15 budget continues with the government’s decision to consolidate fiscal policy and would help balance the support for disinflation and needs of the economy. Staff welcomes the proposed measures to begin broadening the revenue base away from oil, most notably, the decision to bring forward and increase the scheduled VAT rate, as well as the reforms to strengthen tax administration and reduce exemptions. Staff sees scope to further increase the VAT rate in the years ahead—as it remains well below those of other resource-intensive countries—as well as to expand the taxation to specific activities that have experienced large gains. These measures would help to improve the quality of the fiscal adjustment and help lay the ground for a sustainable fiscal policy ahead.
Reforms to the monetary and fiscal policy frameworks are also essential to entrench macroeconomic stability. The Central Bank of Iran’s mandate needs to be simplified and refocused toward price stability. To build a solid foundation for the future, it is essential to bring the institutional decision-making setup at the Money and Credit Council in line with those of countries that have successfully resolved high chronic inflation. Reforms to the fiscal policy framework should strengthen its countercyclical role, limit fiscal risks, and enhance macroeconomic coordination. The current framework supported by the Oil Stabilization Fund (OSF) and the National Development Fund of Iran (NDFI) could better balance the goals of macroeconomic stability, intergenerational equity, and development. For this, OSF resources need to be replenished soon to support noninflationary budget financing and build buffers for future shocks. Decisions on how to save and invest NDFI resources should be better coordinated explicitly with macro policies and underpinned by more explicit safeguards and transparency. Adopting a multi-year budget planning and expanding the coverage of the general government should enhance the operational conduct, monitoring, and accountability of fiscal policy, and thus limit fiscal risks. Staff encourages the authorities to review how best to bring quasi-fiscal activities into the budget to make them explicit so as to reform or discontinue them.
The authorities’ intention to unify the foreign exchange market by mid-2015 is
welcome. In the transition, the authorities should manage the exchange rate flexibly in light of external risks and still high inflation. The assessment of the official exchange rate is subject to an unusual degree of uncertainty. In the current circumstances, the official exchange rate would be moderately overvalued, with the bureau/parallel market rate closer to equilibrium. Staff recommends Executive Board approval of the retention of the exchange restrictions and multiple currency practices referred to in paragraph 20 since these are maintained for balance of payments reasons, are nondiscriminatory, and are temporary in light of the authorities’ commitment to unify the exchange rate regime and to remove the restrictions by mid-2015.
The subsidy reform needs to proceed with the right supporting framework and macroeconomic policies. Iran’s design of the subsidy reform has been exemplary and the reform remains a priority. The implementation of the first phase has faced significant and varied difficulties and there is a need to make the lessons known to the public. Plans to increase domestic prices gradually are prudent but should be underpinned by an adjustment mechanism with strong political backing to support full implementation. The proposed distribution of resources among households and specific sectors presents a departure from the original design. The process for identifying and excluding less vulnerable groups requires criteria that are simple, transparent, and perceived as fair. In addition, the distribution of resources for supporting energy-intensive sectors needs to ensure a framework that fosters the adoption of new technologies and tighter budget constraints. In subsequent stages of the reform, transfers could be made more conditional on social goals and tilted toward private savings for the broader population.
There is an urgent need to strengthen the Central Bank of Iran’s supervisory powers and enforcement capacity. The CBI should be able to swiftly take action in case banks fail to abide by regulatory standards. Staff welcomes the CBI’s initial steps toward a risk-based approach to supervision. Staff shares the view of some market participants about the scope for leveling the field of competition in the system through further privatization and reforms to government-mandated credit policies. Current proposals to deal with nonperforming loans and recapitalize public banks need to be supported by restructuring plans and reforms to enhance their risk management and accountability. In terms of crisis preparedness, it would be important to strengthen the bank resolution framework and putting the deposit guarantee fund on a sustainable financial footing.
Reforms to improve the business environment and the labor market are
complementary and essential to restore stability and boost employment and growth. The scope to improve the business environment is large and can provide a significant boost to productivity and growth in the years ahead. Enhancing the enforcement of the rule of law and property rights, maintaining policy and macroeconomic stability, and enhancing the transparency of policy making are fundamental pillars that would also pave the way for taking advantage of the growing foreign investor interest. Advancing reforms on AML/CFT would also help reinsert the domestic financial system into the global economy, lower transaction costs, and provide an important impetus to productivity. With large potential entrants to the labor force in the years ahead, reforms are needed to facilitate the reallocation of labor across sectors and lower nonwage labor costs. Staff encourages the authorities to review labor regulations to ease the rigidity of contracts and nonwage costs.
There is a good opportunity to improve the timeliness of official statistics publication and to reaffirm the underlying methodology behind consumer price and unemployment data. In recent years, the quality and timeliness of price and unemployment statistics have come under increased scrutiny. The authorities have taken some steps under difficult circumstances, but there is scope for further improvement in the reporting and timeliness of official statistics. Technical assistance in these areas would help address these issues.
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