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1. Iran is endowed with vast hydrocarbon resources, but its capacity to increase hydrocarbon production is limited. In 2006, Iran had the second largest proven oil and gas reserves, and it was the fourth largest oil producer in the world. However, its oil production has remained virtually flat in recent years and will most likely stagnate in the medium term due to insufficient investment.
2. Iran has the largest economy in purchasing power parity terms in the Middle East and Central Asia (MCD) region, with a sizeable and diversified non-oil sector (Figure 1). Iran’s economy is closely linked to intraregional trade and capital flows. On the one hand, Iran has benefited from rapid growth in the MCD region by increasing its regional non-oil exports. On the other, Iran’s robust growth in recent years has had some positive impact on smaller Gulf Cooperation Council countries serving as transit points for Iranian imports and trade financing.
3. Fund policy advice has focused on measures to reduce inflation and structural reforms aimed at stimulating growth and employment creation. Consistent with Fund recommendations, in 2007/08 the authorities reduced the non-oil fiscal deficit, contained energy subsidies, improved revenue administration, and intensified their efforts to bring banking supervision closer to international standards. However, there has been no political consensus to implement other Fund recommendations such as tightening monetary policy and reducing government interference in resource allocation.
4. Against the background of strong demand pressures and an uneven pace of structural reforms, the consultation discussions focused on: • Policies to reduce inflation, • Medium-term fiscal challenges, and • Key growth-oriented structural reforms.
5. Real GDP growth is estimated to have picked up to 6.6 percent in 2007/08, from 6.2 percent in 2006/07. Increased direct government support to priority sectors, scaled-up budgetary capital expenditure, and strong credit growth underpinned a robust and broad-based growth of the non-oil economy. Oil production, however, increased modestly, mainly owing to insufficient investment (Figure 2 and Table 1).
6. Intensified international pressures on Iran have negatively affected economic activity. UN and U.S. sanctions against certain Iranian institutions have created difficulties for trade financing and payments, discouraged foreign investment, and adversely affected the profitability of the targeted financial institutions.
7. Reducing unemployment has remained a challenge. The officially reported unemployment rate declined only marginally to 9.8 percent in the year to December 2007, in part reflecting a decline in the labor participation rate.
8. Inflation has been on the rise. Expansionary policies against the background of capacity constraints and to some extent rising import prices caused 12-month CPI inflation to increase to 24.2 percent in April 2008, from 16.8 percent in April 2007. CPI inflation excluding food and energy also increased to more than 20 percent in April 2008, suggesting strong underlying domestic demand pressures.1
9. High oil prices supported a further strengthening of Iran’s external position in 2007/08. The current account surplus is estimated to have increased from 9.2 percent of GDP in 2006/07 to 10.2 percent in 2007/08 (Table 2). Notwithstanding large capital outflows ($5.5 billion in 2007/08), gross official reserves, including the Oil Stabilization Fund’s (OSF) foreign assets, increased from $61 billion (10 months of imports) at end-2006/07 to $82 billion (almost 12 months of imports) at end-2007/08.
10. Despite recent rapid real effective exchange rate (REER) appreciation, the tradable non-oil sectors have performed relatively well (Figure 3). This could be explained by some initial currency undervaluation (Box), increased subsidies, and the rapid growth in trading partner countries. In addition, import-substituting manufacturing has benefited from relatively high import tariffs.
11. Fiscal policy was tightened in 2007/08 following a significant fiscal relaxation during 2005/06–2006/07. The non-oil primary fiscal deficit rose from about 15 percent of GDP in 2004/05 to 21 percent in 2006/07, as the government increased transfers to households, subsidies, capital expenditure, and OSF lending (Figure 5 and Tables 3–4).2 The non-oil primary deficit, however, is estimated to have been reduced to 17 percent of GDP in 2007/08 through the rationing of subsidized gasoline, a reduction in nonwage current outlays, more moderate growth of capital expenditure, and a decline in OSF lending.
12. The Central Bank of Iran’s (CBI) ability to influence monetary policy decisions has been further curtailed. In 2007/08, the Monetary and Credit Council chaired by the CBI Governor was integrated into the government’s supreme council for economic management and planning.
13. Credit conditions were loosened in 2007/08 and the rial continued to depreciate, albeit at a slower pace. Faced with a reduction in budgetary expenditure and OSF lending, both private and state-owned enterprises intensified pressures for increased bank credit. The government’s decision to reduce banking rates of return in mid-2007/08 exacerbated these pressures.3 To satisfy the growing demand for loans, state-owned commercial banks increasingly resorted to the CBI overdraft facility. As a result, the CBI’s claims on banks became one of the main sources of money and credit growth (Figure 6 and Tables 5–6). A net redemption of Central Bank Participation Papers (CBPPs) and net purchases of foreign exchange were additional sources of liquidity growth. The authorities continued to target a slow rial depreciation vis-à-vis a basket of currencies, but the weight of the U.S. dollar in the basket was significantly reduced in late November 2007. As a result, the monthly depreciation of the nominal effective exchange rate (NEER) has recently declined (Figure 7).
14. The deepening of financial intermediation has slowed down and dollarization has increased recently. As real rates of return on domestic currency deposits became increasingly negative, the inflow of rial deposits into the domestic banking system began to slow down in 2007/08. At the same time, relative returns on foreign currency deposits became more attractive, which led to a significant rise in dollarization, albeit from a low base. Notwithstanding the sharp increase in foreign currency deposits, the velocity of broad money (including foreign exchange deposits) remained unchanged in 2007/08, in contrast with a significant decline in previous years. The securities market has remained relatively modest.
15. The legislative framework for banking supervision has continued to improve, but some banking system vulnerabilities persist. The CBI approved new regulations on asset classification, provisioning, and banks’ investment, and issued new guidelines on liquidity management and internal controls. While an anti-money laundering (AML) law became effective in January 2008, the law still contains deficiencies and its implementation will require the adoption of detailed regulations. In addition, Iran does not currently have in place an appropriate framework to counter the financing of terrorism (CFT). Regarding banking system indicators, the nonperforming loans ratio increased to about 16 percent at end-March 2007 (Table 7), and as mentioned earlier, the profitability of banks under sanctions has been adversely affected. Against this background, the authorities have recently recapitalized three state-owned banks by transforming OSF deposits funding loans to domestic enterprises ($3 billion, about 1 percent of GDP) into government equity. However, some state-owned banks were still undercapitalized as of end-March 2008.
16. Progress on other structural reforms has been uneven. The increase in implicit energy subsidies was contained through the rationing of gasoline at higher prices. In addition, the preparatory technical and legislative work for implementing the VAT is close to completion, and tax collection agencies have been upgraded with new IT technology. Following the 2006 reinterpretation of Article 44 of the Constitution, the divestment process has gathered pace. However, given the lack of large private investors, many government-owned entities were acquired through noncash or deferred settlements by quasi-public sector institutions. Furthermore, remaining weaknesses in the business climate, in particular in the areas of employing workers and dealing with licenses, constitute an obstacle to private sector development and employment creation (Figure 8).
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