Public Information Notice No. 01/95

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Islamic Republic of Iran

September 18, 2001

On September 6, 2001, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic Republic of Iran.¹

Background

Iran's overall economic performance improved significantly in 2000/01. Real GDP grew by an estimated 5.6 percent, up from 2.8 percent in 1999/2000, reflecting mainly strong growth in the oil sector and a partial recovery in agriculture from last year's drought. Other sectors also registered robust growth performance, particularly manufacturing and construction. Inflation, as measured by the consumer price index, declined to an average 12.6 percent in 2000/01 from 20.1 percent in 1999/2000, reflecting the relatively cautious monetary policy during the first half of 2000/01, the slowdown in the increase in food prices, and lower import prices in dollar terms. Total unemployment remained broadly unchanged.

The external position strengthened. The current account surplus doubled to the equivalent of 13 percent of GDP, mainly reflecting the sharp increase in crude oil exports. Lower capital inflows and accelerated debt service payments resulted in a decline in the outstanding external debt to US$8 billion (8.3 percent of GDP). Consequently, the overall balance surplus amounted to US$6.9 billion and gross official reserves, including the Oil Stabilization Fund (OSF), stood at about 8 months of imports of goods and services.

The overall fiscal balance improved in 2000/01, recording a surplus of 8.6 percent of GDP. The sharp rise in oil revenues allowed a build up of savings in the recently established OSF equivalent to 8 percent of GDP. Non-oil revenue, however, increased only by 4 percent, owing to the underperformance of income tax receipts and profit transfers from public enterprises. Expenditure and net lending increased by 32 percent, or 1 percentage point of GDP, reflecting mainly a relatively high growth of current expenditure (30 percent) due to retirement bonuses for public sector employees, compensation for the losses caused by the drought, and higher-than-budgeted spending on education, social benefits, and defense.

Although monetary policy was relatively cautious during the first half of 2000/01, broad money grew at a rapid pace of close to 30 percent for the full year, the highest observed since 1996/97. This outcome was due to an expansion of bank lending to the private sector and public enterprises and the build-up of net foreign assets. The average exchange rate quoted at the Tehran Stock Exchange depreciated by 2 percent in nominal terms in 2000/01, resulting in a real appreciation of 17.5 percent.

Further steps in the reform of the exchange and trade systems were taken. In addition to the elimination of the "export rate", a more market-based exchange rate system was introduced; banks were allowed to conduct limited interbank foreign exchange trading (on behalf of their clients) and have open positions within established prudential limits; the trade regime was further liberalized, with the expansion of the positive list; and the authorities adopted a program to replace the nontariff trade barriers with tariffs by end 2001/02. In addition, active preparations were underway to unify the exchange rates by March 2002.

Advances were made toward improving tax administration and reforming the financial system. These included the establishment of a large taxpayer unit and preparation for the introduction of a value-added tax. An OSF was established in 2000/01, ahead of the Third Five-Year Development Plan's target of 2001/02. The establishment of private banks and insurance companies was authorized and the government adopted a plan to re-capitalize the state-owned commercial banks. In March 2001, the Central Bank of the Islamic Republic of Iran, started issuing the Central-bank Participation Papers as a prelude to introducing indirect monetary policy management.

Reforms, however, proceeded at a slower pace in other important areas, including increasing the flexibility of financial rates of return and reducing directed bank credit; adjusting domestic petroleum product prices; accelerating the privatization program; and introducing labor market and social safety net reforms.

Executive Board Assessment

Executive Directors commended the authorities' efforts at maintaining prudent fiscal and monetary policies, which, together with favorable oil prices, had strengthened the fiscal and external positions in 2000/01. International official reserves increased, external debt was reduced, and further progress was made in trade liberalization and exchange rate reform. The main challenge ahead is to build on these accomplishments with decisive structural reforms to sustain higher rates of growth and employment creation to absorb the rapidly increasing labor force in a context of declining inflation and financial stability.

Directors stressed the need for continuing fiscal restraint, and emphasized that containing current expenditure will be critical, notably regarding subsidies. Regarding revenue measures, they welcomed preparations for introduction of a value-added tax and the ongoing restructuring of tax administration, and looked forward to further measures to simplify the tax system and reduce the budget's reliance on oil revenue. Directors supported the buildup of fiscal surpluses in the OSF, and commended the importance placed by the authorities on transparency and accountability in OSF operations. Directors noted that the functions of the OSF are to promote intergenerational equity and to provide protection against exogenous shocks, and recognized that both functions need to be taken into account in determining the type of assets that is appropriate for the OSF to hold. They emphasized the importance of all assets held by the OSF being of good quality.

Directors welcomed the authorities' intention to prepare a comprehensive plan to reform the subsidy system, including making all subsidies on essential goods explicit, introducing a targeted subsidy mechanism, and phasing out most subsidies over the next few years. They also noted the importance of bringing domestic energy prices in line with market prices. Directors emphasized the need for a well-designed social safety net that would build on the current extensive social welfare network to help mitigate the cost of price adjustments for the needy.

Directors welcomed the authorities' intention to contain money growth in 2001/02 to prevent an acceleration of inflation, particularly in light of the rapid liquidity expansion during the previous year and the expected continuing buildup of official international reserves. They also welcomed the authorities' preparedness to take preemptive measures to achieve this target, including issuance of additional Central Bank Participation Papers and restraining bank lending to public enterprises.

Directors welcomed the preparatory efforts under way to unify the exchange rates by the target date of March 21, 2002. They commended the authorities' commitment to eliminate all exchange restrictions for current account transactions by the time of unification, and their intention thereafter to accept the obligations of the IMF's Article VIII, Sections 2(a) and 3. They observed that the decision to fully budget the cost of unification would enhance its chances of success. Directors supported the authorities' intention to move to a managed float exchange system after unification, but cautioned that exchange rate policy should reflect market conditions. Accordingly, official intervention should aim only to smooth out foreign exchange market fluctuations. They noted that ongoing trade reforms, including tariffication of nontariff barriers would, if complemented by further streamlining of the trade regime, help to forestall excessive appreciation of the real exchange rate. They also noted the crucial role of prudent financial policies in limiting inflation and thereby helping to preserve international competitiveness.

Directors welcomed the process of liberalizing and opening up the economy that the authorities have embarked on, and looked forward to Iran's economic performance gradually coming closer to its great potential. Regarding structural reforms in the near term, they welcomed the authorities' emphasis on reducing the size of the government and the role of the state in the economy, encouraging private sector activity, and reforming the financial system. Directors encouraged the authorities to accelerate the restructuring and privatization of public enterprises, to streamline the regulatory environment for private sector investment, including by enacting the new foreign direct investment law, and to liberalize labor laws. They noted the desirability of minimizing impediments to the growth of small- and medium-sized private enterprises, which could make a major contribution in creating jobs.

Directors welcomed the establishment of private banks and encouraged the authorities to press ahead in fostering a liberalized and more competitive financial sector, with market-determined rates of returns on assets, along the lines of the recommendations of the joint Fund/World Bank Financial Sector Assessment Program mission. At the same time, they emphasized the need for liberalization to be accompanied by strengthened supervision and prudential regulations as well as by reduced reliance on directed lending and a shift to indirect instruments of monetary management. They welcomed the planned phasing out of the remaining credit controls over the next two years. Directors underscored the need for monetary policy formulation and implementation to be independent. They looked forward to Fund technical assistance continuing to support the evolution of Iran's financial system and policy framework.

Directors welcomed progress in improving Iran's statistical database and the authorities' intention to subscribe to the IMF's Special Data Dissemination System (SDDS). They encouraged the authorities to address the remaining statistical weaknesses, and supported the provision of Fund technical assistance for this purpose, as well as to facilitate the subscription to the SDDS.