## CHAPTER I : ECONOMIC GROWTH IN THE ISLAMIC REPUBLIC OF IRAN ## Source details **Canonical URL:** [CHAPTER I : ECONOMIC GROWTH IN THE ISLAMIC REPUBLIC OF IRAN](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04308.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04308.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04308.pdf.json) --- ### I. Overview - Recent challenge: increase growth rate to reduce unemployment and improve living standards over the medium term. - Recent performance: growth of 6 percent during 2000–03 driven by major economic reforms and transitory factors (high oil prices; expansionary fiscal and monetary policies). - Analytical approach: - Growth accounting exercise for 1960–2002 including human capital accumulation and Total Factor Productivity (TFP). - Empirical analysis quantifying roles of macroeconomic stability, financial development, trade openness, and terms of trade changes. ### II. Growth literature: stylized facts and Iran-specific empirical results - Cross-country stylized facts (as used in the chapter): - Education: positive relation between education level and growth. - Macroeconomic stability: low inflation and low budget deficits associated with better growth. - Khan and Senjhadji (2001): inflation above 11–12 percent → significant reduction in growth. - Sarel (1996): high inflation—above 8 percent per annum—negative; doubling inflation reduces average growth by 1.7 percentage points. - Barro (1997): increase in inflation of 10 percentage points reduces growth by 0.2–0.3 percentage points. - Financial development: generally positive correlation with growth; causality ambiguous. - Trade openness: positive long-term effect via technology spillovers and specialized inputs. - Terms of trade improvements: generally associated with faster growth. - Political instability: negatively related to growth. - Iran-specific findings (1960–2002): - Education: five-fold improvement in average level of education since 1960 may explain up to one-half of total economic growth in the last 42 years. - Trade openness: increase in imports/GDP ratio of 1 percentage point associated with faster growth of 0.3 percentage points; Granger causality shows mutual feedback. - Macroeconomic stability: reduction in inflation rate of 1 percentage point with respect to the historical average of 14 percent would increase potential growth by 0.3 percentage points. - Financial sector inefficiencies: when proxied by changes in M2 to non-oil GDP ratio, relationship with growth is negative; improving financial-system efficiency could reverse this. - Political environment: relative stability (1960–76; 1989–2002) linked to high GDP growth; turmoil and war (1977–88) associated with negative growth and a reduction of the average annual growth rate by 6 percentage points during 1977–88. ### III. Growth performance (1960–2002) — aggregate outcomes and sub-periods - Aggregate statistics: - Real GDP growth averaged 4.6 percent a year (2 percent in per capita terms) during 1960–2002. - Non-oil GDP average growth: 5.5 percent (1960–2002). - Relative price of oil GDP increased by an average of 3 percent per year (1960–2002). - Nominal oil GDP to total GDP increased from 12.8 percent to 22.1 percent (1960–2002). - Sub-period averages: - 1960–1976: average real growth rate 9.8 percent; real per capita income growth 7 percent. - 1977–1988: average growth rate -2.4 percent; non-oil GDP declined 0.5 percent per year. - 1989–2002: average growth rate 4.7 percent. - 2000–03: recent growth picked up to 6 percent. - Key shocks and impacts: - 1977–88 reversal due to 1979 revolution aftermath, eight-year war with Iraq, international isolation, increased state dominance, plummeting oil output and revenue. - In 1988 oil production was 36 percent of its level in 1976; oil prices were 40 percent lower in real terms. ### IV. Growth accounting results (Cobb-Douglas production function) - Production function: Yt = At Kt^α Ht^(1-α). - Human capital specifications: - Raw labor: Ht = Lt. - Education-adjusted: Ht = Lt e^t (Lucas, 1988). - Growth decomposition (Raw Labor specification): - 1960–1976: Average Growth Rate 9.8; Capital 3.9; Raw Labor 1.2; TFP 4.7. - 1977–1988: Average Growth Rate -2.4; Capital 1.7; Raw Labor 1.4; TFP -5.5. - 1989–2002: Average Growth Rate 4.7; Capital 2.3; Raw Labor 1.5; TFP 1.0. - 1960–2002: Average Growth Rate 4.6; Capital 2.1; Raw Labor 1.4; TFP 1.1. - Growth decomposition (Education specification): - 1960–1976: Average Growth Rate 9.8; Capital 3.9; Human Capital 2.7; TFP 3.2. - 1977–1988: Average Growth Rate -2.4; Capital 1.7; Human Capital 5.5; TFP -9.6. - 1989–2002: Average Growth Rate 4.7; Capital 2.3; Human Capital 4.3; TFP -1.8. - 1960–2002: Average Growth Rate 4.6; Capital 2.1; Human Capital 3.7; TFP -1.2. - Interpretation: - TFP positive in 1960–76 and negative in 1977–88 under both specifications. - For 1989–2002 TFP sign depends on human capital specification; a realistic TFP estimate likely lies between extremes and may be very small or negative during 1989–2002. ### V. Empirical analysis of non-oil GDP growth (1961–2002) — estimated equation and diagnostics - Variables/proxies: - Trade openness: imports to non-oil GDP ratio. - Macroeconomic stability: CPI inflation rate. - Terms of trade: change in oil prices / import prices of industrial goods. - Financial development: change in M2 to non-oil GDP ratio. - Oil production (lagged) and dummy for 1977–88 included. - Estimated equation (selected coefficients and diagnostics): - Constant: 4.280022 (T-value 22.3848) - Chg oil production (-1): 0.056112 (T-value 12.6605) - Imports GDP ratio: 0.322526 (T-value 6.3954) - CPI: -0.310064 (T-value 4.7403) - Oil imports price ratio: 0.047942 (T-value 2.9851) - M2 GDP ratio: -0.274083 (T-value 3.4136) - Dummy 1977/88: -5.987645 (T-value 5.3164) - R^2: 0.82758 - Diagnostic tests (Table 1.5): - Chow (1982:1): 0.4842 (Prob 0.9348) - Chow (1998:1): 0.5893 (Prob 0.6728) - AR 1-4 test: 1.1225 (Prob 0.3638) - ARCH 1-4 test: 0.1132 (Prob 0.9768) - Hetero test: 4.6767 (Prob 0.9458) - Key empirical findings: - All explanatory variables significant at the 95 percent confidence level. - Model explains 82.7 percent of variance of non-oil GDP growth. - No structural changes detected; no autocorrelation; no heteroscedasticity. - Positive correlates of non-oil growth: higher lagged oil production; greater trade openness; lower inflation; improvements in terms of trade. - Strongest negative effect: political instability and war (dummy 1977–88) reducing growth by about 6 percentage points per year during 1977–88. - Financial deepening proxied by change in M2/non-oil GDP shows a negative coefficient; possible interpretation: inefficient financial intermediation channeling resources to low-productivity investments. Alternative specifications using changes in real money can render this relationship insignificant. ### VI. Sectoral growth patterns and investment efficiency - Average sectoral growth rates (1960–2002): - Agriculture: 4.2 percent. - Oil and Gas: 2.4 percent. - Industries and Mines: 7.6 percent. - Services: 5.4 percent. - Non-oil GDP growth: 5.5 percent. - GDP: 4.6 percent. - Sectoral dynamics: - Industrial output strongest: 7.6 percent average; industrial output 23 times higher in 2002 than 1960. - Industry share of GDP rose from 7 percent to 25 percent (1960–2002). - Oil sector grew by 2.5 times; weight fell from one third of GDP at constant prices in 1960 to less than 13 percent in 2002. - Agricultural output grew at 4.2 percent, above population growth of 2.6 percent. - Despite high investment, low or negative TFP and high physical capital investment suggest low productivity of investment—linked to trade restrictions and inefficient public sector investment. - Trade policy note: average (unweighted) tariff rate in 2002 was 30 percent (11th highest tariff rate out of 193 surveyed countries). - Comparative investment and growth (1962–2002 averages): - Iran: Average GDP Growth 4.6; Average Investment/GDP 30.5; Investment/GDP Growth 6.6. - Six high-growth Asian economies (average): Average GDP Growth 6.9; Average Investment/GDP 27.8; Investment/GDP Growth 4.0. - Policy implication: high investment rate in Iran does not translate into commensurate growth; focus on improving efficiency of investment projects rather than raising investment rate. ### VII. Policy lessons and recommendations - Overarching message: structural reforms within a stable political environment are key to raising long-term growth above historical trend of 4.6 percent by increasing productivity (TFP). - Recommended structural reforms: - Trade and FDI liberalization. - Privatization and deregulation to expand the private sector. - Financial sector reform to eliminate financial repression. - Elimination of subsidies (notably energy subsidies). - Fiscal, monetary, and exchange rate policies to increase macroeconomic stability. - Human capital and education: - Importance of increasing efficiency of human capital through education investment. - Since 1979 average schooling of working population tripled from 1.5 years to about 5 years. - Policy recommendations: allocate increased resources to primary and secondary education; promote on-the-job training programs. - Persistent challenge: illiteracy rate about 20 percent. - Investment efficiency: - Investment rate averaged more than 30 percent (1960–2002); priority is to improve investment efficiency. - Sources of low efficiency: subsidized energy and inputs; negative real interest rates on bank financing; inefficient public sector investment. - Physical infrastructure requires upgrading and modernization. ### VIII. Data sources and methodology (selected points) - Data sources: - Real GDP and investment for Iran: latest Central Bank of Iran database. - Real GDP and investment for other countries: IFS database. - Employment data: ILO database (1960–90) and Central Statistical Office of Iran (after 1990). - Average years of schooling: Barro and Lee database every 5 years, extrapolated within 5-year periods. - Growth-accounting methodology follows Barro and Sala-i-Martin (1995), Chapter 10. - Capital assumptions: - Depreciation rate: 4.9 percent. - Initial capital stock determined by “rough-guess” method. - Average annual rate of return on capital: 7 percent (Siegel (1998)). - Human capital estimated following Lucas (1988). *Prepared by J. Bailén. Source: CHAPTER I: Economic Growth in the Islamic Republic of Iran (1960–2002).* ### CHAPTER I: Economic Growth in the Islamic Republic of Iran..............................................4 ### CHAPTER I : ECONOMIC GROWTH IN THE ISLAMIC REPUBLIC OF IRAN ### I. Overview - Iran faces the challenge of increasing its growth rate to reduce unemployment and improve living standards over the medium term. - Growth performance in recent years (6 percent during 2000–03) has been satisfactory, and was driven by major economic reforms as well as by transitory factors, such as high oil prices and expansionary fiscal and monetary policies. - The chapter uses a growth accounting exercise for 1960–2002 to quantify historical sources of growth, including human capital accumulation and the contribution of Total Factor Productivity (TFP). - An empirical study quantifies roles of macroeconomic stability, financial development, trade openness, and changes in the terms of trade. ### II. Growth Literature: Stylized Facts - Growth accounting decomposes growth into contributions from labor, physical capital, human capital, and a residual TFP. - Cross-country growth regressions yield stylized facts particularly relevant to Iran: - Education: A positive relation between the level of education of the labor force and economic growth (Barro (1991, 1997); Benhabib and Spiegel (1994)); Bils and Klenow (2000) find causality from growth to increases in school enrollment rates. - Macroeconomic stability: Low inflation, low budget deficits, and undistorted foreign exchange markets are associated with better growth outcomes (Fischer (1993); Bleaney (1996)). - Khan and Senjhadji (2001): inflation rate above 11–12 percent associated with significant reduction in growth in developing countries. - Sarel (1996): high inflation—above 8 percent per annum—has a negative and statistically significant effect on growth; doubling inflation reduces average growth by 1.7 percentage points. - Barro (1997): increase in inflation rate of 10 percentage points would reduce the growth rate by 0.2–0.3 percentage points. - Financial development: Generally positive correlation with growth but causality is ambiguous (Demetriades and Husein (1996)); financial repression linked negatively to growth (Roubini and Sala-i-Martin; Arestis and Demetriades (1997)). - Trade openness: Significant positive effect on growth via technology spillovers and access to specialized inputs; effect becomes more important over the long term (Greenaway, Morgan, and Wright (1998)). - Terms of trade improvements: Generally associated with faster growth (Barro (1996, 1997); Easterly et al. (1993); Fischer (1993)). - Political variables and inequality: Political instability negatively related to growth (Alesina et al. (1996); Mauro (1997)); mixed results for income inequality. - Specific findings for Iran (1960–2002) summarized: - The five-fold improvement in the average level of education of the labor force since 1960 may explain up to one-half of total economic growth in the last 42 years. - Trade openness: an increase in the imports to GDP ratio of 1 percentage point is associated with faster growth of 0.3 percentage points; Granger causality test shows mutual feedback between growth and trade openness. - Macroeconomic stability and growth: a reduction in the inflation rate of 1 percentage point with respect to the historical average of 14 percent would increase potential growth by 0.3 percentage points. - Financial sector inefficiencies: when financial development is proxied by changes in the M2 to non-oil GDP ratio, the relationship with growth is negative; improving financial-system efficiency could reverse this relationship. - Political environment: periods of relative political stability and absence of major external conflicts (1960–76 and 1989–2002) associated with high GDP growth; political turmoil and war period (1977–88) associated with negative growth. The paper shows that the average annual growth rate during the 1977–88 period was reduced by 6 percentage points due to these factors. ### III. Growth Performance in Iran (1960–2002) - Aggregate outcomes: - Real GDP growth averaged 4.6 percent a year (2 percent in per capita terms) during 1960–2002. - Non-oil GDP grew at an average of 5.5 percent during the period. - Note: the relative price of oil GDP increased by an average of 3 percent per year during 1960–2002; the ratio of nominal oil GDP to total GDP increased from 12.8 percent to 22.1 percent even though real oil output increased at a slower pace. - Three sub-periods identified: - 1960–76: - Average real growth rate: 9.8 percent. - Real per capita income growth: 7 percent on average. - Result: GDP at constant prices almost 5 times higher in 1976 than in 1960. - Environment: relative domestic political stability, low inflation. - Oil sector: oil production grew at an annual average rate of 10 percent; oil prices relative to import prices increased by 214 percent during the sub-period. ### Key Figures and Indicators (as reported) - Recent growth rate: 6 percent during 2000–03. - Historical average real GDP growth, 1960–2002: 4.6 percent. - Historical average real per capita growth, 1960–2002: 2 percent. - Non-oil GDP average growth, 1960–2002: 5.5 percent. - Average annual oil production growth (1960–76 sub-period): 10 percent. - Increase in oil prices relative to import prices (1960–76 sub-period): 214 percent. - Relative price of oil GDP average annual increase, 1960–2002: 3 percent per year. - Nominal oil GDP to total GDP: increased from 12.8 percent to 22.1 percent (1960–2002). - Historical average inflation referenced: 14 percent. - Estimated effect: reduction in inflation rate of 1 percentage point (from the historical average of 14 percent) would increase potential growth by 0.3 percentage points. - Trade openness effect: increase in imports/GDP ratio of 1 percentage point → growth +0.3 percentage points. - Education improvement: five-fold increase in average level of education since 1960 may explain up to one-half of total economic growth in 1960–2002. - Political turmoil and war (1977–88) reduced average annual growth by 6 percentage points relative to other periods. *Prepared by J. Bailén. Source: CHAPTER I: Economic Growth in the Islamic Republic of Iran (1960–2002).* ### 5.7 p ercen t ### 5.7 p ercen t ### Growth overview and historical patterns - Growth trend: - 1960–1976: average growth of 9.8 percent. - 1977–1988: average growth of -2.4 percent. - 1989–2002: average growth of 4.7 percent. - 1960–2002: average growth of 4.6 percent. - Key historical shocks and impacts: - The growth trend was reversed during 1977–88 due to the aftermath of the 1979 revolution, the eight-year war with Iraq, international isolation, increased state dominance, and plummeting oil output and revenue. - In 1988, oil production was only 36 percent of its level in 1976; and oil prices were 40 percent lower in real terms. - Negative real GDP growth of 2.4 per year on average occurred during 1977–88. Excluding oil, non-oil GDP declined at 0.5 percent per year during that period. - Reconstruction and partial oil recovery supported a recovery with average real growth of 4.7 percent per year during 1989–2002. - Real GDP growth picked up to 6 percent in 2000–03 due to exchange rate unification, trade liberalization, opening to foreign direct investment, financial sector liberalization, high oil prices, and expansionary fiscal and monetary policies. ### Comparative performance (MENA region) - Iran’s average growth (1960–2002): 4.6 percent. - MENA region average (excluding Iran): 4.2 percent. - Among 17 MENA countries, only Oman, Syria, the U.A.E., and Yemen grew faster than Iran over 1960–2002. - Variability: - Iran’s standard deviation of economic growth (1960–2002): 8.32. - MENA average (excluding Iran) standard deviation: 7.68. - Iran’s growth variability is exceeded only by Kuwait, Lebanon, and Libya. ### Growth accounting framework and results - Production function used: Cobb-Douglas Yt = At Kt^α Ht^(1-α). - Two specifications for human capital: - Raw labor: Ht = Lt. - Education-adjusted: Ht = Lt e^t (Lucas, 1988) where e is average years of schooling. - Implications: - Ht = Lt may overstate TFP by absorbing education quality effects. - Ht = Lt e^t may overstate the contribution of human capital if education quality fell. - Growth decomposition (Raw Labor specification, Table 1.3): - 1960–1976: Average Growth Rate 9.8; Contribution of Capital 3.9; Contribution of Raw Labor 1.2; Contribution of TFP 4.7. - 1977–1988: Average Growth Rate -2.4; Contribution of Capital 1.7; Contribution of Raw Labor 1.4; Contribution of TFP -5.5. - 1989–2002: Average Growth Rate 4.7; Contribution of Capital 2.3; Contribution of Raw Labor 1.5; Contribution of TFP 1.0. - 1960–2002: Average Growth Rate 4.6; Contribution of Capital 2.1; Contribution of Raw Labor 1.4; Contribution of TFP 1.1. - Growth decomposition (Education specification, Table 1.4): - 1960–1976: Average Growth Rate 9.8; Contribution of Capital 3.9; Contribution of Human Capital 2.7; Contribution of TFP 3.2. - 1977–1988: Average Growth Rate -2.4; Contribution of Capital 1.7; Contribution of Human Capital 5.5; Contribution of TFP -9.6. - 1989–2002: Average Growth Rate 4.7; Contribution of Capital 2.3; Contribution of Human Capital 4.3; Contribution of TFP -1.8. - 1960–2002: Average Growth Rate 4.6; Contribution of Capital 2.1; Contribution of Human Capital 3.7; Contribution of TFP -1.2. - Interpretation: - Under both specifications TFP contribution positive in 1960–76 and negative in 1977–88. - For 1989–2002, TFP positive under raw labor assumption but negative under education-adjusted assumption. A realistic TFP estimate may lie between these extremes; likely very small or negative contribution of TFP during 1989–2002. ### Empirical analysis of non-oil GDP growth - Variables and proxies: - Trade openness: imports to non-oil GDP ratio. - Macroeconomic stability: inflation rate (CPI). - Terms of trade: change in ratio of oil prices to import prices of industrial goods. - Financial development: change in ratio of broad money (M2) to non-oil GDP. - Oil production and a dummy for 1977–88 included. - Estimated equation (Table 1.5) for Non-oil Annual GDP Growth, 1961–2002: - Constant: 4.280022 (T-value 22.3848) - Chg oil production (-1): 0.056112 (T-value 12.6605) - Imports GDP ratio: 0.322526 (T-value 6.3954) - CPI: -0.310064 (T-value 4.7403) - Oil imports price ratio: 0.047942 (T-value 2.9851) - M2 GDP ratio: -0.274083 (T-value 3.4136) - Dummy 1977/88: -5.987645 (T-value 5.3164) - R^2: 0.82758 - Diagnostic tests (Table 1.5): - Chow (1982:1): 0.4842 (Prob 0.9348) - Chow (1998:1): 0.5893 (Prob 0.6728) - AR 1-4 test: 1.1225 (Prob 0.3638) - ARCH 1-4 test: 0.1132 (Prob 0.9768) - Hetero test: 4.6767 (Prob 0.9458) - Key empirical findings: - All variables significant at the 95 percent confidence level. - Model explains 82.7 percent of variance of non-oil GDP growth. - No structural changes detected; no autocorrelation; no heteroscedasticity. - Positive correlates of non-oil growth: higher oil production (lagged), greater trade openness, lower inflation (macroeconomic stability), improvements in terms of trade. - Strongest negative effect: political instability and war (dummy 1977–88) reducing growth by about 6 percentage points per year during 1977–88. - Financial deepening (change in M2 to non-oil GDP) shows a negative coefficient; possible explanation is an inefficient financial system channeling resources to low-productivity investments. Alternative specifications (e.g., changes in real money) make this relationship statistically insignificant. ### Sectoral growth patterns - Average sectoral growth rates (1960–2002): - Agriculture: 4.2 percent. - Oil and Gas: 2.4 percent. - Industries and Mines: 7.6 percent. - Services: 5.4 percent. - Non-oil GDP growth: 5.5 percent. - GDP: 4.6 percent. - Sectoral dynamics: - Industrial sector strongest performer: industrial output grew at 7.6 percent per year on average; industrial output was 23 times higher in 2002 than in 1960. - Share shifts: industry share of GDP rose from 7 percent to 25 percent (1960–2002). - Oil sector grew by 2.5 times; its weight fell from one third of GDP at constant prices in 1960 to less than 13 percent in 2002. - Agricultural output grew at 4.2 percent, above population growth of 2.6 percent. - Despite rapid industrial growth, low or negative TFP and high physical capital investment suggest low productivity of investment in industry, possibly reflecting trade restrictions and inefficient public sector investment. - Trade regime note: the average (unweighted) tariff rate in 2002 was 30 percent (11th highest tariff rate out of 193 surveyed countries). ### Key statistics and comparisons - Investment and growth comparison (1962–2002 averages): - China, P.R.: Hong Kong — Average GDP Growth 7.0; Average Investment/GDP 26.1; Investment/GDP Growth 3.7. - Indonesia — Average GDP Growth 5.4; Average Investment/GDP 21.7; Investment/GDP Growth 4.0. - Korea — Average GDP Growth 7.8; Average Investment/GDP 27.9; Investment/GDP Growth 3.6. - Malaysia — Average GDP Growth 6.7; Average Investment/GDP 28.6; Investment/GDP Growth 4.3. - Singapore — Average GDP Growth 7.9; Average Investment/GDP 36.0; Investment/GDP Growth 4.5. - Thailand — Average GDP Growth 6.7; Average Investment/GDP 26.5; Investment/GDP Growth 4.0. - Average (six high-growth Asian economies) — Average GDP Growth 6.9; Average Investment/GDP 27.8; Investment/GDP Growth 4.0. - Iran — Average GDP Growth 4.6; Average Investment/GDP 30.5; Investment/GDP Growth 6.6. - Iran’s average investment rate (1960–2002): averaged more than 30 percent. - Implied policy message from ICORs: payoff to investment does not suggest raising investment rate further; focus should be on improving efficiency of investment projects. ### Policy lessons and recommendations - Main policy lesson: Structural reforms, within a stable political environment, are key to improving medium- and long-term growth and raising the economy’s long-term growth rate above the historical trend of 4.6 percent per year by increasing productivity (TFP). - Recommended structural reforms: - Trade and FDI liberalization. - Privatization and deregulation to increase the size and role of the private sector. - Financial sector reform to eliminate financial repression. - Elimination of subsidies. - Fiscal, monetary, and exchange rate policies aimed at increasing macroeconomic stability. - Human capital and education: - Increases in the efficiency of human capital through education investment are important for growth. - Since 1979, the average level of schooling of the working population tripled (from 1.5 years to about 5 years). - Further recommendations: allocate increased resources to primary and secondary education; promote on-the-job training programs. - Persistent challenge: illiteracy rate of about 20 percent. - Investment efficiency: - Iran’s investment rate is high by international standards, averaging more than 30 percent during 1960–2002. - Policy priority: improve efficiency of investment projects rather than increase the investment rate. - Sources of low investment efficiency: subsidized energy and inputs, negative real interest rates on bank financing, inefficient public sector investment. - Despite high investment rates, physical infrastructure requires upgrading and modernization. *Italic: Source — IMF staff report, Islamic Republic of Iran, growth analysis (content unit: _cr04308 - 5.7 p ercen t).* ### 25. The source for real GDP and investment data for Iran is the latest Central Bank of Iran ### _cr04308 - 25. The source for real GDP and investment data for Iran is the latest Central Bank of Iran ### Data sources and growth-accounting methodology - Real GDP and investment data for Iran: latest Central Bank of Iran database. - Real GDP and investment data for the rest of countries: IFS database. - Employment data: - 1960–90: ILO database—1956, 1966, 1976, and 1986 census. - After 1990: Central Statistical Office of Iran annual census. - Growth-accounting methodology: follows Barro and Sala-i-Martin’s Economic Growth, Chapter 10 (1995). - Capital stock assumptions: - Depreciation rate: 4.9 percent (consistent with Central Bank of Iran estimates). - Initial capital stock: determined through the “rough-guess” method suggested by Barro and Sala-i-Martin. - Rate of return and human capital: - Average annual rate of return of capital: 7 percent (long-term international average estimated by Siegel (1998)). - Average years of schooling: Barro and Lee database for every 5 years, extrapolated within 5-year periods. - Human capital estimated following Lucas (1988) standard definition. ### Long-run fiscal/energy framework and objectives - Long-term objective: preserve hydrocarbon wealth for future generations while reducing inflation and vulnerability to oil price declines. - Analysis focus: central government operations consolidated with the Oil Stabilization Fund (OSF). - Exclusions: quasi-fiscal activities in banking system, fiscal dominance over monetary policy, and public enterprises’ relationship with central government finances. - Analytical approach: intertemporal optimization framework to estimate optimal government consumption and savings out of hydrocarbon wealth (Engel and Valdes (2000) and Box 2.1). ### Optimal-consumption model (Box 2.1) — key equations and parameters - Welfare function: U = 1/(1-ρ) ∑ β^t C_{G,t}^{1-ρ} - Net wealth definition: W_{G,0} = F_{G,0} + ∑ (1+r)^{-s} Y_{G,s} - Optimal consumption path: - C_{G,0} = (1- α)(1+r)W_{G,0} - C_{G,t+1} = [β(1+r)]^{1/ρ} C_{G,t} - α = (1+n) [β(1+r)]^{1/ρ} / r - Special case: β(1+r)=1 simplifies to C_{G,0} = (r-n) W_{G,0}. - Numerical illustration: about 3-percent growth in consumption consistent with ρ=1.5 if β=0.99 and R=0.04. ### Simulation scenarios for consumption out of hydrocarbon wealth - Three simulation assumptions: - Discount rate below real rate of return → positive long-term per capita growth; society is patient. - Discount rate equal to real rate of return → no long-term real per capita growth; per capita consumption constant indefinitely. - Preservation target: discount rate higher than real rate of return given positive population growth → preserve real hydrocarbon wealth. - Important considerations: - Whether savings are invested in financial or physical assets does not affect general conclusions; public investment must be productive enough to generate tax revenue at least equal to financial asset returns. - Government consumption out of hydrocarbon wealth measured by non-oil current deficit (including implicit energy subsidies) minus net interest income. - Uncertainty drivers for estimated consumption paths: long-run oil and gas prices, proven reserves volume, extraction rate, real rate of return, further discoveries, development of alternative energy sources. ### Implicit energy subsidies (2003/04) — key figures (Table 2.1) - Domestic sales prices in rials: - Kerosene (rial/liter) 160 - Fuel oil (rial/liter) 88 - Gasoline (rial/liter) 713 - Gas oil (rial/liter) 160 - Electricity (rial/kwh) 130 - Natural gas (rial/m³) 71 - Border prices in rials (at market exchange rates): - Kerosene (rial/liter) 1,187 - Fuel oil (rial/liter) 676 - Gasoline (rial/liter) 1,696 - Gas oil (rial/liter) 1,131 - Electricity (rial/kwh) 421 - Natural gas (rial/m³) 410 - Implicit subsidy (in trillions of rials) 117 - Kerosene 11 - Fuel oil 5 - Gasoline 18 - Gas oil 25 - Electricity 33 - Natural gas 26 - Memorandum items: - Implicit subsidy in percent of GDP 10.4 - Implicit subsidy in billions of dollars 14.2 ### Oil and gas wealth parameters (Table 2.2) — assumptions used in estimates - Proven oil reserves (in billions of barrels) 130.7 - Proven gas reserves (in trillions of cubic meters) 26.7 - Oil production in 2002/03, millions of barrels per day 3.2 - Gas production in 2002/03, bn m3 100 - Long-term real price for Iranian crude oil (in $ per barrel) in 2003/04 dollars 22 - Long-term real price of Iranian gas (in $ per cubic meter) in 2003/04 dollars 41 - Long-term annual (real) return on capital (percentage) 4.0 - Expected average annual rate of population (percentage) 1.1 - Government net debt (in billions of $) at end-2003/04 7.3 ### Aggregate wealth and baseline estimates (text and Table 2.3) - Overall oil and gas wealth, net of government debt, represents about $861 billion in 2003/04 dollars. - Government domestic and external debt, net of OSF foreign exchange deposits, estimated at about $10 billion (text); government net debt in Table 2.2: 7.3 (in billions of $) at end-2003/04. - Table 2.3 (consumption out of oil wealth, 2003/04, at current billions of U.S. dollars): - Total 861... - Oil wealth 645... - Gas wealth 226... - Initial debt, net of OSF foreign exchange deposits 10... - Estimated consumption out of oil wealth if: - Oil wealth constant in real terms 34 35 - Oil wealth constant in real per capita terms 25 26 - Optimal consumption out of oil wealth 8 8 - Estimated consumption out of oil wealth if (in percent of GDP): - Oil wealth constant in real terms 25.2 22.2 - Oil wealth constant in real per capita terms 18.4 16.4 - Optimal consumption out of oil wealth 5.9 5.3 - Estimated consumption: 29 34 - (In percent of GDP) 21.6 21.4 - Non-oil primary balance, excluding capital expenditure 15 17 - Implicit subsidies 14 17 ### Simulation outcomes and implications - Optimal-consumption simulation: - Optimal consumption out of hydrocarbon wealth estimated at US$8 billion in 2003/04 versus actual realization of about US$29 billion. - Under the optimal path, optimal per capita consumption should increase every year, keeping consumption out of hydrocarbon wealth roughly constant at about 5 percent of GDP indefinitely (assuming 3 percent real GDP growth in the long run). - Constant real per capita wealth simulation: - To maintain hydrocarbon wealth constant in real per capita terms, consumption out of hydrocarbon wealth estimated at US$25 billion in 2003/04. - Under this framework, consumption grows in constant dollars at the rate of population growth but declines rapidly as a share of GDP because population growth of 1 percent is below assumed long-run GDP growth of 3 percent. - Maintaining the intertemporal budget constraint long term implies current primary deficits would need to decline in the future, requiring additional fiscal measures. ### Policy implications and recommendations (from chapter framing) - Medium-term fiscal framework should: - Address heavy dependence on hydrocarbon revenue, low non-hydrocarbon revenue, pro-cyclical fiscal policy, and excessive subsidization. - Incorporate long-term considerations with emphasis on maintaining real per capita hydrocarbon wealth constant in the medium term. - Use the OSF and improved expenditure management and transparency to cushion oil price fluctuations and contain expenditure growth. - Practical constraints and cautions: - Estimates are highly sensitive to oil and gas prices, reserve volumes, extraction rates, and real rate of return; frequent reassessment of consumption paths is required as new information arrives. - Fiscal sustainability requires public investment productivity sufficient to generate tax revenue at least equal to the prevailing return on financial assets of the equivalent amount. *Source: Central Bank of Iran; IFS; ILO; Central Statistical Office of Iran; Barro and Sala-i-Martin (1995); Barro and Lee database; Siegel (1998); World Bank; Fund staff estimates and projections (as presented in the supplied IMF chapter excerpt).* ### 38. Simulation of consumption out of oil wealth consistent with maintaining ### Simulation of consumption out of oil wealth consistent with maintaining constant real wealth ### Maintaining constant real hydrocarbon wealth - The real return on the entire hydrocarbon wealth is US$34 billion; this amount could be consumed from 2003/04 onward while keeping hydrocarbon wealth constant in real terms. - Long-run implication: consumption out of hydrocarbon wealth in both real per capita terms and relative to GDP would decline steeply under this assumption. - Fiscal implications: maintaining the intertemporal budget constraint could warrant sharp increases in taxation or reductions in expenditure. - Macro risks not captured by the framework: - A substantial real effective exchange rate appreciation could result from large spending out of foreign currency–denominated oil revenue. - If sustained, such appreciation could cause a Dutch disease that would hinder development of the non-oil sector. ### Sensitivity to oil price assumptions - Only under the simulation of the optimal policy scenario can consumption out of hydrocarbon wealth be maintained constant relative to GDP indefinitely. - The corresponding current primary non-oil deficit is estimated at about 5 percent of GDP and is sensitive to oil price assumptions. - Sensitivity rule (relative to the baseline oil price of $22 per barrel): - Optimal long-run consumption out of hydrocarbon wealth would increase (decrease) by about ¼ percent of GDP for each dollar in excess of (or below) the baseline price. - Example scenarios: - If the assumed real oil price is $30 per barrel, the optimal level of consumption out of hydrocarbon wealth is 6.8 percent of GDP (about 2 percent of GDP above the level consistent with the baseline price of $22 per barrel). - To maintain indefinitely consumption out of hydrocarbon wealth at its 2003/04 level relative to GDP (22 percent), the assumed real oil price would need to be about $88 per barrel. - Effects on consumption out of oil wealth in 2003/04 under alternative preservation criteria: - Preservation of real per capita wealth: consumption out of oil wealth is estimated to increase (decrease) by $1 billion in 2003/04 for each dollar in excess of (or below) the baseline price. - Maintaining total real oil wealth: consumption out of oil wealth is estimated to increase (decrease) by almost $2 billion in 2003/04 for each dollar in excess of (or below) the baseline price. ### Consistency of the baseline medium-term framework with long-term parameters - A stylized baseline medium-term fiscal scenario (Table 2.4) is developed as a reference; it incorporates: - Assumptions on reforms in the draft fourth five-year development plan. - A conservative assumption of a steady decline in oil prices to about $24 per barrel at the end of the plan period. - A gradual fiscal adjustment achieved mainly through additional revenue measures, including the energy subsidy reform and VAT implementation in 2006/07. - Gradual reduction in explicit subsidies and some “forced” expenditure restraint in capital spending and net lending owing to financing constraints. - Despite the “forced” fiscal adjustment, OSF deposits are likely to be depleted by the end of the projection period. - Key baseline numerical excerpts (2003/04 column and related): - Total hydrocarbon exports (in billions of U.S. dollars): 27.0 (2003/04). - Average oil export price (in U.S. dollar/barrel): 28.0 (2003/04). - Real GDP at market prices (annual percentage change): 6.6 (2003/04). - Real non-hydrocarbon GDP (annual percentage change): 6.5 (2003/04). - CPI inflation (average): 15.6 (2003/04). - Revenue (percent of GDP at factor cost): 27.0 (2003/04). - Oil revenue (percent of GDP at factor cost): 16.3 (2003/04). - Non-oil revenue (percent of GDP at factor cost): 10.7 (2003/04). - Expenditure and net lending (percent of GDP at factor cost): 27.2 (2003/04). - Balance (percent of GDP at factor cost): -0.2 (2003/04). - Non-oil balance (percent of GDP at factor cost): -16.5 (2003/04). - Gross official reserves (in billions of U.S. dollars): 24.4 (2003/04). - OSF foreign exchange deposits (in billions of U.S. dollars): 8.6 (2003/04). - All three long-term simulations indicate the need for a change in the fiscal stance under the baseline scenario. - The baseline scenario is somewhat tighter than needed to preserve hydrocarbon wealth in real terms over the next five years. - Maintaining real per capita hydrocarbon wealth constant calls for additional moderate fiscal tightening relative to baseline. - Shifting to the optimal consumption path requires a drastic fiscal tightening relative to baseline, not feasible over the medium term. ### Transition path and timing - A transition toward the optimal consumption path can maintain consumption out of hydrocarbon wealth constant relative to GDP indefinitely but must be implemented in stages over the long run. - Suggested sequencing: - First step: target preservation of real per capita hydrocarbon wealth over the medium term. - Subsequent step: consider moving closer to maintaining constant consumption out of oil wealth relative to GDP. ### Recommended fiscal adjustment and short-term constraints - To maintain oil wealth constant in real per capita terms, consumption out of oil wealth under the baseline would need to be reduced by about 4 percentage points of GDP during 2004/05–2005/06, plus a smaller adjustment of about 0.5 percentage point of GDP during 2007/08–2009/10. - Policy preference: an upfront fiscal adjustment is preferable because it is less costly to implement from a position of strength when oil prices are high. - However, a fiscal tightening of about 4 percentage points of GDP per year at the beginning of the projection period, relative to baseline, appears excessive due to potentially unacceptably high output cost. - Short-term constraints in oil-producing countries: - Large injections of oil revenue increase domestic demand and liquidity growth. - In Iran, fiscal relaxation in 1999/2000–2003/04 led to difficulties achieving monetary policy objectives: - Central bank was unable to fully sterilize liquidity effects through sales of foreign exchange or issuance of participation papers. - Exchange rate continued to depreciate in nominal terms, monetary aggregates grew faster than targeted, and inflation increased during 2002/03–2003/04. - An upfront fiscal tightening relative to baseline would help reduce money growth and inflation and support monetary objectives. ### Conclusion: policy implications and feasible options - The paper evaluates three long-run criteria: maintaining total real hydrocarbon wealth constant; preserving real per capita hydrocarbon wealth; and targeting optimal consumption out of hydrocarbon wealth. - The baseline fiscal scenario is broadly in line with maintaining total real hydrocarbon wealth constant. - Additional fiscal adjustment relative to baseline is needed to: - Move toward preserving real per capita hydrocarbon wealth. - Converge with the optimal path for consumption out of hydrocarbon wealth. - Given short- and medium-term constraints, a feasible option is likely to be close to the preservation of hydrocarbon wealth in real per capita terms rather than the optimal path. - Implication: additional fiscal measures might need to be considered beyond the medium term to address the projected decline in consumption out of hydrocarbon wealth relative to GDP. ### The Oil Stabilization Fund (OSF) — operational features and recent data - Established in December 2000 to insulate the budget from fluctuations in oil prices; held as a foreign currency account at the central bank and managed by an Executive Committee. - TFYDP established a U.S. dollar ceiling on oil export revenue transferable to the budget, based on an oil price of about US$16 per barrel; additional transfers require Parliament approval. - Mechanism: oil revenues in excess of the budgeted amount are transferred to the OSF; if realized crude oil export revenue is less than the annual budget allocation by the end of the eleventh month of fiscal year, the central bank draws from the OSF to compensate the shortfall. - OSF asset use and lending: - All OSF foreign assets are held in a foreign currency deposit account at the Central Bank. - At most 50 percent may be lent domestically in foreign currency through the domestic banking system to the private sector at rates of return close to LIBOR. - Firms may borrow over an eight-year period and must reimburse from the fifth to the eighth year; required collateral may include land, machinery, equipment, and corporate bonds. - Table 1 OSF data (In millions of U.S. dollars): - Use of oil revenue approved in the TFYDP: 11,731 (2000/01); 12,864 (2001/02); 11,058 (2002/03); 11,579 (2003/2004). - Actual use of oil revenue: 14,726 (2000/01); 15,279 (2001/02); 17,800 (2002/03); 20,949 (2003/2004). ### Subsidies and energy consumption - Explicit subsidies include budgetary subsidies to households for wheat, rice, oil, sugar, milk, cheese; imports of medical equipment and pharmaceuticals; fertilizers; and some debt service payments on publicly-guaranteed debt. - Food subsidies are rationed through coupons given to all households irrespective of income; food subsidies still constituted about 4 percent of GDP in 2003/04. - Implicit energy subsidies have led to misallocation, waste, and overconsumption of energy products. - Total oil consumption amounted to 1.5 million barrels per day in 2002/03. - Iran became one of the most energy-intensive countries in the world; comparable oil consumption to Spain’s despite Spain having a GDP six times higher than Iran’s. - Air pollution is emerging as a main environmental and health problem, especially in Tehran. *Source: IMF staff report excerpts (2003/04 data and related simulations).* ### 54. The Iranian financial system lags behind in many respects compared to other MENA ### 54. The Iranian financial system lags behind in many respects compared to other MENA ### Comparative financial development — key findings - According to an overall index of financial development prepared by IMF staff (Creane et al., 2003), Iran ranks low among MENA countries, with particularly low scores for monetary policy making and the development of the banking and nonbanking financial sectors. - Table 3.1 (Comprehensive Index, Scale 0–10, 2000–01) — selected values: - Iran: Comprehensive Index 2.2; Banking Sector 2.5; Nonbank Financial Sector 3.0; Regulation & Supervision 3.7; Monetary Sector & Policy 0.6; Financial Openness 0.0; Institutional Environment 3.7. - MENA average: Comprehensive Index 5.4; Banking Sector 5.3; Nonbank Financial Sector 4.8; Regulation & Supervision 6.5; Monetary Sector & Policy 5.4; Financial Openness 6.1; Institutional Environment 4.7. - Financial development levels (average scores): High — Banking Sector 7.5; Nonbank Financial Sector 7.3; Regulation & Supervision 6.7; Monetary Sector & Policy 8.9; Financial Openness 7.3; Institutional Environment 8.9; (other category) 5.9. - Financial development levels (average scores): Medium — 5.3 5.0 4.1 6.5 5.6 6.1 4.8. - Financial development levels (average scores): Low — 3.3 3.1 2.7 3.5 3.1 3.9 3.8. - Within the overall 0–10 scale, intermediate scales are: High—Above 6; Medium—4-6; Low—Below 4. ### Structure and size of banking system (overview and evolution) - Historical and structural context: - Following the 1979 Revolution, all commercial banks were nationalized and foreign participation in banking was banned. - At nationalization the banking network included 36 banks: 7 specialized banks, 26 commercial banks, and 3 regional financial institutions. - Private banks were re-authorized to operate only since 2001. - Current composition (as described in the source): - Six state-owned commercial banks. - Four state-owned specialized banks. - A state-owned Postal Bank (licensed in 2004). - Four recently established small private banks. - State-owned commercial and specialized banks hold about 98 percent of deposits. - Size indicators: - Consolidated assets of banks amounted to 49 percent of GDP. - Broad money, excluding foreign currency deposits, represented 45 percent of GDP at end-March 2004. - These ratios are below those recorded in the 1990s and below most comparable MENA countries. - Factors constraining financial deepening: - High inflation (about 20 percent on average over the last 10 years). - Various administrative controls on banking operations. ### Specialized banks (Box 3.1) - There are four specialized banks: Maskan (housing), Keshavarzi (agriculture), Export Development Bank, and Sanat-O-Madan (industry and mining). - Specialized banks take deposits but most loanable funds come from commercial banks, the central bank, and other public sources, including the central government. - Bank Keshavarzi (Agricultural Bank): - Largest among specialized banks; size comparable to other state-owned banks except Bank Melli. - Loan portfolio amounted to Rls 29 trillion (2.5 percent of GDP) as of end-March 2004. - Accounted for about 60 percent of the banking system loans to agriculture as of end-March 2004. - Resource base includes government contributions, central bank loans, deposits of other banks, and growing deposits by nonbanks. - Has offered a wide range of Islamic finance instruments for agricultural financing and set up an Agricultural Insurance Fund covering 63 commodities. - Government provided large financial support to the bank to compensate for drought-related losses. ### Financial soundness and performance (Table 3.2 and narrative) - Financial position described as relatively weak despite recent recapitalization and reinvestment: - Recapitalization of state-owned banks in 2002: Rls 5,000 billion (0.7 percent of GDP). - Risk-weighted capital adequacy ratio: 7.2 percent (below the 8 percent recommended by the Basel I Capital Adequacy Accord). - Return on assets: estimated at 1 percent. - Ratio of nonperforming loans: reportedly 5.2 percent during the same period. - Private banks have a much stronger financial position than implied by the banking system average ratios. - Table 3.2. Islamic Republic of Iran -- Financial Soundness Indicators, 2003/04 (In percent) — reported values: - Risk-weighted capital adequacy of banks (in percent): Banking System 7.2; State-owned Commercial Banks 5.5; State-owned Specialized Banks 15.4; Private Banks 19.5. - Ratio of nonperforming loans of banks (in percent): Banking System 5.2; State-owned Commercial Banks 4.7; State-owned Specialized Banks 8.5; Private Banks 2.1. - Return on average assets of banks (in percent): Banking System 1.0; State-owned Commercial Banks 0.6; State-owned Specialized Banks 3.0; Private Banks 3.7. - Return on equity (in percent): Banking System 20.4; State-owned Commercial Banks 16.7; State-owned Specialized Banks 23.9; Private Banks 35.0. - Net open position in foreign exchange to capital (In percent): Banking System 30.0; State-owned Commercial Banks 40.0; State-owned Specialized Banks 14.0; Private Banks 9.0. - Sources: Central Bank of Iran. - Caveat: Ratios are not fully comparable to other countries due to differences between Iran’s accounting standards and IAS, and lack of proper regulations on loan classification and provisioning. ### Market concentration, dollarization, and nonbank intermediaries - Degree of concentration: - State-owned Bank Melli controls about one-third of assets. - Twenty largest exposures of each state-owned bank account for 24.3 percent of their total committed financing facilities in 2000 (weighted average). - Dollarization: - Following exchange rate unification in March 2002, degree of dollarization of the banking system has increased, albeit from a low base. - Nonbank financial institutions and informal intermediaries: - About 6,000 “Qarz-ul-Hasanah” funds (zero-interest funds, interest-free loans) operate on a small scale. - Almost 1,000 registered credit cooperatives operate; total assets well below Rls 1,000 billion (0.1 percent of GDP). - Some bonyads run quasi-banking institutions; one recently received a credit institution license. - Informal finance is common with high rates of return, reflecting lack of access to bank financing by SMEs. ### Private banks and market niches - Recently licensed private banks emerged from private nonbank credit institutions authorized in the mid-1990s. - Private banks focus on market niches: - Short-term bridge financing of medium-sized enterprises. - Mortgage lending. - Retail consumer lending. - Private banks have started to exert competitive pressure on state-owned banks. - Note: Many companies in urgent need of liquidity apply for bridge loans from private banks, which are subsequently refinanced by state-owned banks. ### Capital markets and insurance sector - Tehran Stock Exchange (TSE) history and growth: - TSE activities halted after 1979 Revolution; reopened in 1989 as government listed many state-owned companies. - Since 1998 the size of the capital market has been increasing rapidly. - By end-April 2004, TSE capitalization reached US$37.5 billion (24 percent of GDP), driven by a more than 600 percent increase in the TSE share price index since the late 1998 downturn and increased number of listed securities. - Capitalization relative to GDP remains below Egypt and Jordan. - Despite increased capitalization, little fresh financing has been provided to the corporate sector. - Drivers of the recent stock market increase: - Recovery from 1998 low when P/E ratios were about three. - Strengthened business confidence from recent reforms, liberalization measures, rapid economic growth, and high oil prices. - Relaxation in monetary policy stance during 2002–04 encouraging portfolio shift away from bank deposits. - Anecdotal evidence of unrecorded portfolio investments from Iranians living abroad. - Opening of new regional branches of the TSE attracting provincial investors. - Price/earning (P/E) and turnover context: - Average P/E ratio in Iran about 9, though may be understated due to possible weaknesses in accounting and reporting rules. - Table 3.3. Selected Emerging Markets: April 2004 Price/Earning and Turnover Ratios (Market P/E Turnover): - Egypt 13.3 1.5 - Indonesia 9.6 4.2 - Islamic Republic of Iran 9.0 0.2 - Jordan 19.8 1.3 - Malaysia 21.7 2.8 - Morocco 16.7 1.1 - Russia 17.0 4.9 - Turkey 10.0 17.5 - Sources: IFC; Tehran Stock Exchange. - Market structure and turnover issues: - TSE turnover low: about 0.2 for 2003/04 (substantially lower than other emerging markets). - Large presence of a few institutional investors explains low proportion of “free float”. - Table 3.4. Capitalization by investor, end-2003/04 (In percent of total capitalization): - Total 100.0 - Social Security Organization 14.0 - Investment companies belonging to state-owned banks 15.0 - Bonyads 4.0 - Government pension funds 5.0 - Non-government pension funds 8.0 - Others 54.0 - Source: Tehran Stock Exchange. - Large share of capitalization reportedly accounted for by cross-shareholdings and insufficiently regulated investment companies. - Insurance sector: - Still very small. - Central Insurance Authority (Bimeh Markazi) is regulator, supervisor, and a market participant through reinsurance. - Five companies owned directly or indirectly by the government collected about 1 percent of GDP in premiums in 2002/03. - Recent authorization and licensing of private insurance companies expected to enhance sector development. ### Foreign exchange market and capital account measures - Liberalization progress: - Iran has largely liberalized current account transactions and made progress in trade liberalization. - On March 21, 2002, the exchange rate was unified; most exchange restrictions on current account transactions were eliminated; import-related transactions in the financial system were liberalized. - Market characteristics: - No derivative instruments to hedge exchange rate risk; all transactions carried out in the spot market. - The central bank remains the main seller in domestic and off-shore foreign exchange markets (mainly the Kish Island). - FDI and capital inflows: - New FDI law approved in 2002 established a clear legal framework for foreign direct investment in Iran. - FDI commitments (excluding oil and gas) increased to US$1.8 billion in 2003/04 from about US$70 million in 2001/02. - Other capital inflows subject to restrictions, including limitations on non-Iranian non-residents’ investment in the stock exchange and real estate. - Non-resident Iranian nationals appear to have recently increased substantially their portfolio investment in Iran, legally authorized but not statistically recorded. - Outflows and largely unregulated avenues post-unification: - Unregulated transfers of rials can be made to off-shore zones (subject to AML regulations) where they can be exchanged into foreign exchange without restrictions. - Use of foreign exchange originating from export proceeds, short-term capital inflows in banking deposits, and remittances of Iranians abroad is largely unregulated. ### Governance, Islamic finance framework, and financial repression - Legal and practical features: - Financial system operates under Islamic finance principles based on the Law on Usury-Free Banking of 1983. - Ex-ante pre-set interest rates are prohibited; returns on financial instruments must be linked to purchase/resale of goods or profit-and-loss sharing. - In practice, commercial banks smooth returns (implicitly building and drawing down reserves) and rely on implicit or explicit government guarantees on returns and principal of instruments issued by state-owned banks. - Financial repression and its manifestations: - Financial repression defined (Box 3.2) as policies, laws, regulations, taxes, and controls that prevent financial intermediaries from operating at full potential, increasing demand for base money and enabling extraction of inflation tax used for subsidized directed credits and government financing. - In Iran, financial repression manifests through various controls on the banking system, contributing to low profitability and under-capitalization of state-owned banks. - Banking system performs quasi-fiscal functions, channeling resources to government-defined priority sectors rather than to projects with best risk-return. - Lack of transparency in relations between state-owned banks and public enterprises, bonyads, and influential large private companies — anecdotal evidence of long waiting lists and rationing in loan applications at negative real rates of return. - Root causes of low profitability and capital adequacy of state-owned banks: - Administrative controls on rates of return on deposits and loans (Tables 3.5–3.6). - Sectoral credit allocation (Table 3.7) and directed credits. - High reserve requirements (Table 3.8). - Government interference in management. - High operating costs. - Some administrative controls have been eased in line with FSAP recommendations (not specified here); others persist and hinder competition and profitability. - Low profitability slows the build-up of equity capital. ### Deposit rate structure (Table 3.5) - Table 3.5. Islamic Republic of Iran: Rates of Return on Deposits, 1999/2000–2003/04 (In percent per annum): - Short-term: - 1999/2000: 8.0 - 2000/01: 8.0 - 2001/02: 7.0 - 2002/03: 7.0 - 2003/04: 7.0 - Long-term (1-year to 5-year): - 1-year: 1999/2000 14.0; 2000/01 14.0; 2001/02 13.0; 2002/03 13.0; 2003/04 13.0. - 2-year: 1999/2000 15.0; 2000/01 15.0; 2001/02 13–17; 2002/03 13–17; 2003/04 13–17. - 3-year: 1999/2000 16.0; 2000/01 16.0; 2001/02 13–17; 2002/03 13–17; 2003/04 13–17. - 4-year: 1999/2000 ...; 2000/01 17.0; 2001/02 13–17; 2002/03 13–17; 2003/04 13–17. - 5-year: 1999/2000 18.5; 2000/01 18.5; 2001/02 17.0; 2002/03 17.0; 2003/04 17.0. - Source: Central Bank of Iran. - Note: Iranian fiscal years end March 20. Long-term deposits over one year introduced in 1990/91 and 2000/01. Rates effective from 22 ordibehesht 1380 (May 12, 2001) for noted period. *Source: IMF staff chapter text (Creane et al., 2003; Central Bank of Iran data) as presented in the provided content unit.* ### 74. The four private commercial banks are not subject to controls on rates of return and ### _cr04308 - 74. The four private commercial banks are not subject to controls on rates of return and ### Banking market structure, pricing, and market share - The four private commercial banks are not subject to controls on rates of return and do not benefit from implicit guarantees of deposits. - As a result, their costs of funds, including deposit rates, are higher, which tends to be reflected in higher lending rates compared with those of state-owned banks. - Despite this pricing disadvantage, private banks have been able to increase their market share owing to: - better customer services, including faster speed of processing of applications; - more customer-tailored banking products; and - credit rationing by state-owned banks. ### Rates of charges on bank facilities (Table 3.6) — 1999/2000–2003/04 (In percent per annum) - Agriculture: 13–16 | 13–16 | 14–15 | 13-14 | 13.5 - Industry and mining: 17–19 | 17–19 | 16–18 | 16 | 16.0 - Housing: 15–16 | 15–16 | 15–16 4/ | 14-15 4/ | 15.0 4/ - (unlabeled row) 18–19 | 18–19 | 17–19 | 16-18 | 18.0 - Trade and services: 22–25 | 22–25 | 23 5/22 5/ | 21.0 5/ - Export: 18 | 18 | 18 | 17 | 15.0 - Source: Central Bank of Iran. - Notes: - 1/ Iranian fiscal years ending March 20. - 2/ These are announced rates representing the minimum payable return. As such, they may be lower or higher than the actual ex-post rates of return. - 3/ These rates are effective from 22 ordibehesht 1380 (May 12, 2001). - 4/ Only for bank Maskan (housing bank). - 5/ Minimum rate. ### Approved sectoral allocation of credit to the nonpublic sector (Table 3.7) — 1999/2000–2003/04 (In percent) - Share not subject to credit allocation in total new loans: 25 | 25 | 25 | 25 | 35 - Share subject to credit allocation: 75 | 75 | 75 | 75 | 65 - Of which: - Agriculture: 25.0 | 25.0 | 25.0 | 25.0 | 25.0 - Industry and mining: 33.5 | 33.5 | 33.5 | 33.5 | 33.0 - Housing and construction: 29.0 | 29.0 | 29.0 | 28.5 | 28.5 - Trade, services, and others: 12.5 | 12.5 | 12.5 | 13.5 | 13.5 - Of which: export finance: 8.0 | 8.0 | 8.0 | ... | 9.5 - Source: Central Bank of Iran. - Note: 1/ Iranian fiscal years ending March 20. ### Reserve requirements on bank deposits (Table 3.8) — 1999/2000–2003/04 (In percent of total deposits) - Commercial banks: - Demand deposits: 30.0 | 30.0 | 20.0 | 20.0 | 20.0 - Qarz ul-Hasanah savings deposits 3/: 25.0 | 20.0 | 20.0 | 20.0 | 20.0 - Short-term investment deposits: 25.0 | 25.0 | 20.0 | 20.0 | 20.0 - One-year investment deposits: 25.0 | 25.0 | 20.0 | 20.0 | 20.0 - Two-year investment deposits: 15.0 | 15.0 | 10.0 | 10.0 | 10.0 - Three-year investment deposits: 15.0 | 15.0 | 10.0 | 10.0 | 10.0 - Four-year investment deposits: ... | 10.0 | 10.0 | 10.0 | 10.0 - Five-year investment deposits: 10.0 | 10.0 | 10.0 | 10.0 | 10.0 - Specialized banks: - Demand deposits: 10.0 | 10.0 | 10.0 | 10.0 | 10.0 - Qarz ul-Hasanah savings deposits 3/: 10.0 | 10.0 | 10.0 | 10.0 | 10.0 - Short-term investment deposits: 10.0 | 10.0 | 10.0 | 10.0 | 10.0 - One-year and other long-term investment deposits: 10.0 | 10.0 | 10.0 | 10.0 | 10.0 - Source: Central Bank of Iran. - Notes: - 1/ Iranian fiscal years end March 20. - 2/ From 2001/02, reserve requirements on all bank deposits in free trade zones are 10 percent. - 3/ Noninterest bearing savings deposits. Housing savings deposits are subject to a 2 percent requirement. ### Supervision and regulatory frameworks — banking, securities, and insurance - Banking supervision: - Undergoing major changes but still focused on compliance with government directives rather than risk assessment. - The central bank supervises banks and large credit institutions. - Small nonbank credit institutions, including credit unions and “Qarz-ul-Hasanah”, are not subject to central bank or ministry of finance and economy supervision; they are authorized by the ministry of interior and overseen by it together with other non-profit organizations. - Legislation to bring these institutions under central bank supervision is awaiting Parliamentary approval. - Risk-based supervision program: - A comprehensive program to develop and implement a risk-based regulatory and supervisory framework is under way in line with FSAP recommendations. - Reforms in place include licensing, net open positions in foreign exchange, definition of statutory capital, capital adequacy, large exposures, connected lending, and anti-money laundering regulations for banks. - Supervisory functions unified under a single central bank department. - On- and off-site inspections have begun using risk-based criteria; reporting forms and supervision manuals are being developed. - A full-fledged, risk-based supervision framework has not yet been established; supervision of state-owned banks continues to rely on tight monitoring of credit allocation and compliance with administrative restrictions. - Securities market oversight: - Regulatory oversight of publicly traded securities and the stock exchange operations is relatively underdeveloped. - The TSE operates based on the Stock Exchange Act adopted in 1966 and is managed by a TSE Board headed by the central bank governor. - There is no independent supervisory entity that oversees issuance and trading of securities. - The TSE has introduced by-laws on insider trading, market manipulation, and disclosure and transparency requirements, but enforcement is difficult owing to lack of proper legislation. - A bill covering anti-money laundering activities in the entire financial system, including trading in securities, is awaiting Parliamentary approval. - Insurance regulation: - The insurance regulatory framework is outdated. - Compulsory reinsurance, tight tariff and contract regulation, and the “specified proportions” approach to prudent investments tend to result in excessive premiums and limit innovation and the development of this predominantly state-owned industry. ### Reform agenda — overview (Section IV) - Reform objective: promote efficiency and facilitate development of a dynamic and competitive financial sector in an increasingly open and liberalized economic environment. - High priority: banking sector given its relative size and role in allocating savings. - Key reform areas: banking system, capital markets, insurance, capital account liberalization. ### Banking system reform priorities (A) - Sequencing: - Complete establishment of a risk-based supervisory framework (highest priority) before further banking deregulation. - Restructure state-owned banks and liberalize their operational environment. - Potential recapitalization of state-owned banks in connection with possible privatization. - Supervision reform actions: - Prepare, pass and implement regulations on liquidity risk, asset classification, provisioning, and investments. - Amend the Banking Act to: - incorporate concept of bank soundness among objectives of supervision; - enlarge range of sanctions for noncompliance; - define banking services and services allowed for banks and other financial entities; - define role of external bank auditors. - Staff training and IT development are essential. - Bring smaller deposit-taking institutions under central bank supervision per draft law submitted to Parliament. - Corporate governance and operational reform: - Reform corporate governance of state-owned banks. - Management should focus on improving performance and strengthening financial positions. - Eliminate undue influence of large public companies and bonyads on bank management. - Provide training in risk management, particularly credit risk. - Deregulation steps (post-supervision & governance improvements): - Gradually liberalize rates of return on loans and deposits. - Gradually reduce share of loans subject to sectoral allocation limits to zero. - Expected outcomes: foster competition, improve pricing of risks, more efficient allocation of financial resources. - Reduction in administrative controls to stimulate better use and innovation in Islamic finance instruments. - Financial restructuring: - Assess undercapitalization of individual state-owned banks based on internationally accepted norms. - Discourage high lending concentration on large borrowers via strict implementation of recently approved large exposure regulations. - Coordinate bank restructuring with restructuring and privatization of large state-owned companies that are major debtors. ### Capital markets and insurance reform (B) - Capital markets: - Focus on tightening supervision of securities issuance and facilitating market entry of properly supervised intermediaries. - Efforts underway to introduce a new capital market law covering securities inside and outside the TSE. - Objectives of the law: ensure efficient functioning of securities markets; protect investors against unfair and fraudulent practices; ensure adequate and timely information disclosure; regulate market intermediaries. - Key reform: establish an independent securities and exchange commission. - Develop market infrastructure (electronic trading, registration, settlement) alongside regulatory progress. - Insurance: - Implement a risk-based insurance regulatory framework. - Central Insurance Authority should divest from its reinsurance business and concentrate on regulation and supervision. ### Capital account liberalization (C) - Approach: - Authorities have adopted a gradual approach focused mainly on attracting FDI, reflected in the recent FDI law. - Short-term flows, including portfolio investment, to be liberalized gradually. - Draft portfolio investment law proposes limited portfolio investment by non-resident institutional investors with time limitations on repatriation of principal capital. - Preconditions and priorities: - Emphasize reforms to meet key preconditions for liberalization: macroeconomic stability; an appropriate exchange rate regime; a strong, well supervised financial system with developed and liquid capital markets; improvements in key institutions, including legal framework and corporate governance. - Further advances needed: reduce inflationary pressures, increase exchange rate flexibility to handle capital flow volatility, develop hedging instruments, strengthen banks and capital markets capacity to monitor and assess risks from volatile capital flows. ### Conclusion (V) - Progress has been made in reforming Iran’s financial system, but important challenges remain. - Reform priorities: - Restructuring the financial system and reducing vulnerabilities. - Strengthening the supervisory framework and corporate governance of banks to ensure that reductions in controls on credit allocation and rates of return yield better financial intermediation. - Managerial and organizational restructuring could be followed by recapitalization, privatization and greater openness to foreign participation in domestic banks. - Banking sector reform should be underpinned by restructuring of large state-owned companies that are the banks’ major clients. - Proper supervision of the rapidly growing stock market and development of market infrastructure are needed; the new capital market law is expected to address these needs. - Further capital account liberalization should be considered in step with progress in reducing inflation, financial sector reform, and other supporting reforms. ### Monetary policy framework and fiscal dominance (Chapter IV introduction & Box 4.1) - Rationale for reform: - A reform of the monetary policy framework is needed in connection with an increasingly liberalized financial system and the authorities’ objective of reducing inflation to a single-digit number. - The chapter sketches a transition path from a system characterized by administrative controls and fiscal dominance toward one based on market incentives and signals, relying increasingly on indirect liquidity management instruments consistent with Islamic finance principles. - Key reform imperatives: - Clarify monetary policy objectives and targets. - Enhance central bank instrument independence. - Improve coordination between monetary and fiscal policies. - Develop indirect instruments of liquidity management. - Recommend a transition toward monetary aggregate targeting. - Fiscal dominance (Box 4.1): - Fiscal dominance has been an important source of high liquidity growth and inflation in Iran. - Two channels of fiscal dominance highlighted: - Direct central bank financing of government deficits (“pure” seigniorage). - Spending out of export oil revenue denominated in foreign currency, which has substantial impact on base money and real rates of return. - Historical notes: - The role of “pure” seigniorage has been steadily declining; direct central bank credit to the government was virtually discontinued in 1998/99 (except bank recapitalization operations and some quasi-fiscal subsidies financed by the central bank), while central bank credit to NFPEs continues at a small scale. - Variation in expenditure and liquidity effects from oil revenue have been high. - Implication: the central bank has been unable to offset large sudden liquidity changes stemming from fluctuations in government sales of foreign currency-denominated oil revenue, compounded by insufficient development of appropriate instruments of liquidity control. - Figure 4.1 (description from source): - Title: Islamic Republic of Iran: Sources of Base Money Growth, 1991/92–2002/03 (Increase as a percentage of the beginning-of-period base money). - Chart labels include ranges: -100.0, -50.0, 0.0, 50.0, 100.0, 150.0, and years 1991/92 through 2002/03 with series for: - Change in CBPP/base money; - Change in claims on banks/base money; - Liquid impact of non-oil deficit/base money 1/; - Change in net claims on government and NFPE/base money. - Note: 1/ Estimated by subtracting all sources of financing from oil revenue. *Source: IMF staff extract from the referenced chapter and tables.* ### 95. The current approach to monetary policy formulation gives the government a decisive ### _cr04308 - 95. The current approach to monetary policy formulation gives the government a decisive ### Monetary policy formulation and institutional arrangements - Five-Year Development Plans (FYDP) set annual targets for monetary growth and inflation, which are approved by Parliament and used as benchmarks for formulating monetary programs by the central bank. - The Monetary and Credit Council (MCC) is responsible for day-to-day monetary policy decisions; the Governor is a member, but the Minister of Economy and Finance is chairman and other ministers are represented. - Parliament and the government can issue directives for credit allocation, with implications for monetary policy implementation. - In practice, targets for M2 and inflation fixed in FYDP are usually revised by the MCC in its annual monetary guidelines, but these revised targets are often inconsistent with fiscal financing requirements and administratively set rates of return and direct banking controls. ### Performance against FYDP targets and key statistics - The central bank has not been able to meet its intermediate target for M2 since the inception of FYDPs. - Targets for M2 and inflation were exceeded by large margins; inflation rate objectives were not achieved during the first two FYDPs. - The average CPI target for the third FYDP is likely to be met, but there is a risk that the inflation target of 13 percent for 2004/05 fixed in the third FYDP would be exceeded by 2 or 3 percentage points. - Table 4.1 (percentage change) — 1989/90–1993/94 | 1995/96–1999/2000 | 2000/01–2004/05 (Plan / Outcome / Plan / Outcome / Plan / Outcome 1/): - GDP 2/: 8.1 / 7.4 / 5.1 / 3.3 / 6.0 / 5.6 - M2: 8.2 / 24.1 / 12.5 / 25.5 / 16.4 / 29.1 - CPI: 14.8 / 18.7 / 12.4 / 6.2 / 15.9 / 13.9 - Sources: Central Bank of Iran; and Fund staff estimates. - 1/ Four-year averages, 2000/01–2003/04. - 2/ At factor cost at constant 1997/98 prices. ### Instruments of monetary policy and key challenges - Direct administrative controls predominated in the early 1990s; policy decisions on credit ceilings, directed credits, and rates of return were often inconsistent with stated M2 or inflation objectives. - Gradual evolution away from direct instruments, but important direct controls remain: - Sectoral credit allocation limits and controls on rates of return of state-owned banks remain significant; share of banking credit subject to sectoral allocation limits reduced to 55 percent, leaving 45 percent of loans free of sectoral restrictions but still bound by administered rates of return. - Controlled rates of return on both loans and deposits were negative in real terms for most of the period, contributing to inflationary pressures and lack of financial deepening. - Real rates of return display a pro-cyclical pattern (negatively correlated with the output gap). - Required reserves: - Remain high and differentiated by maturity; weighted average required reserve ratio declined to 16 percent in 2003/04 from 23 percent in 1990/91. - Required reserves are remunerated at 1 percent per annum. - Central bank overdraft and standing facilities: - Overdraft facilities frequently accommodate liquidity shortfalls; overdraft rates had been set at only 2 percentage points above directed credits until 1993/94, then replaced with a progressive schedule of overdraft rates at 20, 24, and 30 percent depending on access levels. - If overdraft periods exceed three days, an additional 4 percentage points is added to each tier. - Overdraft rates have not been revised despite revisions to other administered rates and sharp inflation fluctuations; penalty waivers have occurred. - Standing credit facility provides financing up to one year. - Standing deposit facility (open deposit accounts) introduced in 1998/99 has played a marginal role; auction attempts in 2003/04 had no demand. ### Central Bank Participation Papers (CBPP) and Government Participation Papers (GPP) - CBPP introduced in March 2001; Shariah-compatible bearer securities issued in parcels of Rls 1, 2, 5, and 10 million with maturities 6 or 12 months and quarterly coupon payments (not taxable). - CBPP design features limiting effectiveness: - Issued at pre-announced fixed rates of return and only to nonbanks in the primary market. - Secondary trading only at par; commercial banks obliged to rediscount them in the secondary market at par and guarantee the initial yield to maturity. - CBPP are backed by underlying central bank claims on the government and have a retail focus. - Rapid increase in CBPP stock raised concerns about sustainability and cost to the central bank; central bank has at times been unable to achieve targeted amount of issues at the rate fixed by the MCC. - GPP: - First issued in 1998; used to finance non-specific government infrastructure projects with five-year maturity; issued at pre-announced fixed rates of return. - Banks obliged to rediscount GPP similar to CBPP. - Tax-adjusted rates of return on GPP were below those on CBPP despite longer maturity, implying a negatively-sloped yield curve. - Table 4.2 (In billions of Rials, unless otherwise indicated) — Government Participation Papers (national) and Central Bank Participation Papers, 1997/98–2002/03: - Government Participation Papers (national): - Amount issued (gross): 1997/98 = 2,174; 1998/99 = 2,500; 1999/2000 = 1,927; 2000/01 = 0; 2001/02 = 0; 2002/03 = 2,400 - Average maturity (years): 3.0 / 3.0 / 4.0 / n.a. / n.a. / 5.0 - Average rate of return (in percent, p.a.): 20.0 / 20.0 / 19.0 / n.a. / n.a. / 15.0 - Central Bank Participation Papers: - Amount issued: 1997/98 = 0; 1998/99 = 0; 1999/2000 = 0; 2000/01 = 0; 2001/02 = 12,359; 2002/03 = 17,052 - Average maturity (years): n.a. / n.a. / n.a. / n.a. / 0.8 / 1.0 - Average rate of return (in percent, p.a.): n.a. / n.a. / n.a. / n.a. / 17.5 / 17.0 - Stock (e.o.p.): n.a. / n.a. / n.a. / n.a. / 9,443 / 17,052 - In percent of the beginning-of-period base money: n.a. / n.a. / n.a. / n.a. / 10.5 / 17.6 - Source: Central Bank of Iran. ### Exchange rate unification, sterilization, and macro linkages - 2002 exchange rate unification and establishment of a managed float raised the issue of an appropriate nominal anchor and supporting policies. - Central bank increasingly focused implementation on M2, but credibility to anchor inflation expectations was insufficient. - After 2002 unification, exchange rate considerations remained dominant: initially to stabilize the nominal rate, subsequently to preserve competitiveness through gradual nominal effective depreciation to compensate for past inflation differentials. - Dual objectives (monetary aggregate control and nominal depreciation) became difficult to sustain amid increased foreign exchange supply from fiscal relaxation and FDI inflows. - Central bank used CBPP to mop up excess liquidity at relatively attractive fixed rates of return, bearing sterilization costs directly; rapid CBPP stock increase made these operations costly and less effective against large injections of oil revenue. - Central bank sales of foreign exchange in 2002/03: - Amount = about $13 billion (or almost 100 percent of beginning of period base money). - The policy of nominal depreciation did not prevent real effective exchange rate appreciation by 7.5 percent during 2002/03–2003/04. - Rapid credit growth, large unsterilized purchases of foreign exchange from the government, and negative real rates of return on loans contributed to nominal exchange rate depreciation and inflationary pressures. ### Institutional constraints and independence - Current legislation limits the central bank's authority to use monetary policy instruments (e.g., rates of return, CBPP issuance) without prior approval of the MCC, headed by the Minister of Finance and Economy. - Government or parliament ability to issue credit directives undermines the central bank’s ability to meet intermediate targets. - Granting central bank instrument independence is essential for successful implementation of monetary aggregate targeting, combined with: - Stringent accountability requirements before various layers of authority and the public. - Transparent procedures for resolving potential conflicts between monetary policy and broader economic policy objectives. ### Operational targets and recommendations for next steps - With a managed float, price stability should be an overriding objective of monetary policy. - Possible intermediate targets: monetary aggregate (M2 or M1) or a measure of consumer price inflation; monetary aggregates may be more familiar and have less stringent pre-requisites than inflation targeting. - An indicative inflation objective could be formulated as a band to accommodate forecast errors when setting an annual target for M1 or M2 growth. - Given limited development of money markets, possible operational targets include base money or money market rates; base money could be initially selected as an operational target. - Because of money multiplier instability, the base money target should be revised periodically in light of new information to maximize chances of hitting intermediate M1 or M2 targets. - Fiscal policy must be consistent with the operational base money target; assess liquidity impact of fiscal operations at the budget preparation level and ensure non-oil deficit financing size and composition are consistent with monetary operational and intermediate targets. - Grant central bank instrument independence, paired with accountability and conflict-resolution procedures, to allow rapid response to changes in money and credit conditions. *Source: _cr04308 - 95. The current approach to monetary policy formulation gives the government a decisive (IMF staff report excerpts).* ### 107. The range of instruments at the disposal of the central bank could be broadened and ### The range of instruments at the disposal of the central bank could be broadened and ### Broadening and adapting monetary instruments - The required reserve ratios could be unified and reduced to lower the cost of financial intermediation, provided that offsetting measures to mop up excess liquidity are implemented. - Access to standing credit facilities could be tightened and made more onerous to discourage frequent use. - Indirect instruments of monetary policy would need to be redesigned and gradually become the preferred instruments facilitating the emergence of a benchmark rate of return. - Once money markets gain in depth and experience, the operational target could be changed from base money to a rate of return on an appropriate money market instrument. - Foreign exchange operations will continue to be important, but the central bank needs to gradually shift the emphasis in these operations from the exchange rate to base money by more actively using indirect instruments of monetary policy and tolerating greater fluctuations in the exchange rate. - Monetary instruments alone are unlikely to be sufficient to sterilize the liquidity impact of injections of government oil revenue in the system (Box 4.1) or large capital inflows; fiscal policy actions would also be needed. - In the longer run, financial markets deepening considerations call for incorporating market-based principles in the design of government participation papers and increasing their outstanding volumes and liquidity. - Footnote references in the source: 36, 37. ### Shariah-compliant indirect instruments of monetary policy — overview - Designing short-term financing instruments that are Shariah-compliant presents difficulties because they must be interest-free, rely on profit and loss sharing linked to real transactions, or be based on purchase and resale contracts, and have values determinable at high frequency to facilitate short-term trading and money market operations. - Several central banks (notably in Malaysia, Sudan, and Bahrain) have developed Islamic financial instruments to facilitate liquidity management and public borrowing (Majid, 2003). - Asset securitization techniques have been used to design Islamic securities for issuance in regional and international capital markets (Hassan, 2002), opening the door for short-term instruments for monetary operations. ### Characteristics required for effective market-based monetary instruments - A relatively risk-free instrument that can serve as a benchmark to price other more risky instruments of varying maturities and strongly influence the marginal cost of funds for banks; - sufficient supply of the instrument to meet both monetary policy needs and portfolio needs of investors; - the instruments must be widely held by both banks and nonbanks to support a liquid market; - the payment settlement system must be robust and reliable to facilitate trading in the instrument. ### Assessment of instrument types under Islamic finance principles - Securitization of a range of Islamic financial contracts is identified as the most promising structure for monetary operations because other market instruments fail to meet one or more of the effective-operation criteria. - Purely equity-based instruments (Musharaka): - Can carry high returns that raise costs to the government. - Volume of issuance may not be sufficient for monetary policy purposes, as issue amounts are limited by government ownership in high quality enterprises. - Purely commodity resale type instruments (Murabaha) and participation papers with guaranteed minimum returns: - Cannot trade at prices different from par under Islamic finance principles, and thus cannot be a reliable basis for developing inter-bank money markets. - Pure debt-type contracts (Mudarabah), such as interbank deposit placements linked to bank profits: - Not suited for liquidity absorption operations of central banks, given difficulties in linking returns to central bank profits. - Differences in perceived bank risks might limit the volume of interbank placements. - Mixed-contract securities (combining Musharaka, Mudarabah, and Ijara): - Offer the best chance of being issued in sufficient volume, achieving adequate market liquidity, and providing flexibility in the mix of risks and return. - The mix of contracts should be transparent so investors can assess risks and form expectations of returns based on expected performance of the underlying cash flow. - Footnote reference in the source: 38 (noting the proportion of pure equity type contracts could be higher for longer maturities). ### Transforming Iran’s CBPP into an effective monetary instrument Options to transform ongoing issues of CBPP in Iran into effective instruments of monetary management include: - Identifying a wider range of government assets and cash flows that can be securitized; - Strengthening coordination of public expenditure management and government financing program to ensure an optimal combination of assets that can be securitized; - Adopting high quality and transparent accounting and disclosure framework for communicating the value and returns on the underlying assets; - Adopting auction-based primary issuance that helps to reflect market expectations in the price of the security; - Supporting the liquidity of the instrument in the secondary market through repurchase facilities; - Organizing efficient trading and payment settlement arrangements. - Expected outcome: overcome current constraints on Iran’s CBPP, allow more flexible rates of return, develop better functioning secondary markets, and facilitate more effective monetary and public debt management. ### Conclusion — institutional and policy priorities - The current system of monetary policy formulation and implementation still relies on administrative controls to a large extent in the context of fiscal dominance. - Administrative controls are used to alleviate the inflationary impact of fiscal dominance and direct credit resources according to government priorities, and are also motivated by slow progress in developing money market financial instruments consistent with Islamic finance principles. - The need for a properly sequenced financial liberalization and the stated objective of reducing inflation call for major changes in the monetary policy framework in Iran. - Initial steps could seek to develop monetary aggregate targeting. - Major ingredients of success: central bank instrument independence, stringent accountability requirements, and the development of indirect instruments of monetary policy. - Although developing liquid money market instruments consistent with Islamic finance principles may be difficult, the obstacles are surmountable as evidenced by the experience of other countries. - Reforming monetary policy alone will not remove inflationary pressures or enhance financial intermediation; the elimination of fiscal dominance, the restructuring of the banking system with a greater emphasis on private sector participation and competition, and other institutional reforms are key to achieving sustainable low-inflation growth. *Source: _cr04308 - 107. The range of instruments at the disposal of the central bank could be broadened and (IMF PDF content provided).* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04308.pdf_