Public Information Notice No. 02/108

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Islamic Republic of Iran

September 26, 2002

On September 18, 2002 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic Republic of Iran.¹

Background

Overall macroeconomic developments in 2001/02 were marked by sustained economic activity in the non-oil sector, improved fiscal and external positions, and declining inflation trends. Against a background of improved business confidence, the authorities continued to implement economic reforms in line with their Third Five-Year Development Plan. They also successfully issued a €625 million Eurobond, marking Iran's return to international financial markets.

Real GDP growth in 2001/02 was strong and broad-based, with non-oil activities growing by 6 percent in real terms. However, reflecting a decline in oil output owing to a downward revision in OPEC production quotas, total real GDP growth decelerated to 4.8 percent. CPI inflation declined to 11.4 percent. Registered unemployment remained high at 16 percent at end-2001/02, as employment creation lagged behind the increase in the labor force.

The external current account position remained in surplus (4.8 percent of GDP) in 2001/02, albeit lower than during the previous year. Exports declined, as lower oil export receipts were only partially offset by 5 percent growth in non-oil exports, mainly representing chemicals and petrochemicals. At the same time, imports expanded by 20 percent owing to buoyant domestic demand and progress in trade liberalization. The decline in the current account surplus was partly offset by a significantly smaller deficit in the capital and financial account. This was attributable to a sizable decline in debt repayments and a sharp rise in capital inflows in the form of buybacks and oil pre-financing. The surplus in the overall balance was US$4.9 billion, which financed the increase in gross official reserves to the equivalent of almost 10 months of imports of goods and services.

Fiscal policy was prudent in 2001/02. Reflecting mainly lower oil prices and revenue, the central government's overall surplus shrank to 0.9 percent of GDP, down from 8.8 percent of GDP in the previous year. The government continued to take advantage of the sustained high oil revenue to increase its deposits with the Oil Stabilization Fund (OSF) to US$7.4 billion, and reduced the external public and publicly guaranteed debt to 6.3 percent of GDP.

Growth of monetary aggregates remained relatively high in 2001/02, despite the central bank's action to mop up excess liquidity by reducing its lending to commercial banks and issuing Central Bank Participation Papers. The money growth reflected the build-up of foreign exchange reserves, excluding the OSF, and a rapid credit expansion to public enterprises and the private sector. The real effective exchange rate appreciated by about 17 percent in 2001/02, following an 18 percent appreciation in 2000/01.

During 2001/02 and the first quarter of 2002/03, the authorities pressed ahead with their economic reforms. These included the exchange rate unification, the passage of the foreign investment law, on-going trade reform, changes in tax legislation, licensing of private banks and approval of private insurance companies. These steps have boosted business confidence and laid the ground for improved growth prospects.

The exchange rate unification was a landmark reform. The exchange rate was unified on March 21, 2002, with foreign exchange transactions now taking place in the interbank market. The authorities adopted a managed float exchange rate system. The transition has been smooth with the central bank seeking to maintain stability in the nominal rate during the period immediately following the exchange rate unification.

The growth outlook for 2002/03 is relatively favorable, with oil prices expected to remain relatively high, real GDP projected to grow by 5.8 percent, and the non-oil activities expected to expand by 6.3 percent. However, the large projected fiscal deficit under the current budget for 2002/03 could lead to higher inflation, put further pressure on the real exchange rate to appreciate, and increase the economy's vulnerability to a downturn in oil prices. The authorities are examining appropriate measures to contain the fiscal deterioration and its impact on monetary and exchange rate developments.

Executive Board Assessment

Directors noted that the Iranian economy performed well in 2001/02, as real GDP growth was strong, inflation declined, and, despite lower oil prices, the fiscal and external current account balances remained in surplus, allowing the authorities to reduce significantly the external debt, build large foreign exchange reserves, and accumulate fiscal savings in the OSF. Iran's strong economic performance over the past two years has now laid the basis for the authorities to meet the challenges of their medium-term economic reform strategy, which aims at achieving sustained economic growth and creating jobs in an environment of macroeconomic stability while correcting a legacy of distortions and imbalances. Directors commended the authorities for the strong ownership of their reform program under the Third Five-Year Development Plan, and expressed their appreciation for the close cooperation between the Fund and Iran that has contributed positively to economic reform in an environment of broad-based domestic consensus.

Directors commended the authorities for the sound execution of their plan for exchange rate unification which, combined with the new exchange rate regime and a more liberal payments and trade system, will help enhance efficiency and underpin growth. They viewed the favorable response of foreign investors to the issue of a Eurobond in July 2002 as acknowledgement that Iran is on a path of economic reform and reintegration into the global economy and financial markets.

Directors observed that maintenance of macroeconomic stability will be crucial for the success of Iran's economic reforms. They considered that the expansionary fiscal stance under the current year's budget, as adopted, and continued expansion of domestic liquidity, risk adding to inflationary pressures and further real exchange rate appreciation, and will require the implementation of timely corrective measures. Directors, accordingly, welcomed the authorities' intention to ensure macroeconomic stability by introducing measures in the remainder of 2002/03 to reduce the fiscal deficit and contain the growth of domestic liquidity. In this context, the authorities should consider a comprehensive set of measures, ranging from steps to curb the growth of current spending and prioritize and scale down non-growth-reinforcing capital expenditure, to reducing tax exemptions, improving tax arrears collection, and increasing excise taxes. By helping to reduce the financing needs of the central government, these measures should also eliminate the need to draw from the OSF, thereby maintaining its integrity. Directors also welcomed the authorities' intention to use all available monetary policy instruments, in conjunction with fiscal tightening, to reduce the recent strong growth of broad money during the remainder of 2002/03 in line with the objective of containing inflation. They also recommended that the OSF's operations be based on stringent and transparent rules.

Directors commended the authorities for making all implicit exchange rate subsidies explicit in the budget, thereby increasing fiscal transparency and taking a first step toward reforming the subsidy system. They encouraged the authorities to continue working with the World Bank to adopt a comprehensive medium-term plan to overhaul subsidies, including on energy prices, and to consider how to replace them with a targeted subsidy scheme in ways that better protects the poor, enhances economic efficiency, and redirects budgetary resources toward more productive uses. They urged the authorities to follow through on the recommendations of the fiscal Reports on the Observance of Standards and Codes mission.

Directors supported the authorities' decision to move to a managed float exchange rate regime and to introduce an interbank foreign exchange market. They noted that market stability so far has been underpinned by strong oil revenues and lower inflation, and considered that, over time, it will be important for exchange rate developments to be in line with economic fundamentals. In this context, market participants should be exposed to exchange rate fluctuations and discouraged from building expectations of a de facto pegged nominal exchange rate. Directors drew attention to the need to avoid, mainly through appropriate fiscal policy, a sustained appreciation of the real effective exchange rate, which in the absence of strong and lasting gains in productivity, would harm competitiveness and economic diversification. They welcomed the authorities' intention to eliminate the remaining multiple currency practices and exchange restrictions as steps to facilitate Iran's acceptance of the obligations of Article VIII of the Fund's Articles of Agreement.

Over the medium term, Directors saw the reduction of the high unemployment rate as a crucial challenge facing the Iranian economy, given the high growth rate of the labor force, rising participation rate, and the low employment content of growth. Policies that promote openness, greater economic efficiency, and an improved business climate will foster private sector growth and investment as well as contribute significantly to job creation. In this context, Directors welcomed the progress achieved recently with respect to foreign investment legislation and the licensing of private banks. They also welcomed the initiatives to improve vocational training and to develop a data bank on job seekers. Directors agreed with the view that tax and financial incentives established to increase employment are likely to be of limited value. Rather, they encouraged the authorities to take steps to address impediments to the business environment, including administrative impediments. In addition, elimination of labor market rigidities, restructuring and privatization of public enterprises, and the pursuit of further trade liberalization will serve to promote investment, employment, and growth. Directors also considered that, as a more supportive regulatory and financial infrastructure is set in place, the Iranian economy should offer considerable potential, over time, for non-oil sector investment and associated growth in private sector activity and employment.

Directors encouraged the authorities to press ahead with financial sector reforms aimed at enhancing the efficiency of bank intermediation through the introduction of more market-determined rates of return and greater competition. They welcomed the authorities' intention to implement a comprehensive action plan aimed at fundamental risk-based banking supervision in line with the recommendations of the Financial Sector Assessment Program, and their work on a comprehensive securities market reform. Directors also welcomed the progress made with legislation on anti-money laundering and combating the financing of terrorism, and looked forward to its early approval by the National Assembly and its full implementation.

Directors welcomed the progress in the production and dissemination of economic statistics, including the preparation of quarterly national accounts data and the adoption of Government Finance Statistics classification in the presentation of fiscal data. They commended the authorities for the steps taken to subscribe to the Special Data Dissemination Standard in conjunction with the technical assistance provided by the IMF Statistics Department. Directors encouraged the authorities to follow up on the action plan recommended by the technical assistance mission.

Iran is a significant bilateral creditor for some heavily indebted poor countries, and the hope was expressed that Iran will provide its share of relief under the Heavily Indebted Poor Countries Initiative.