## _cr1494 ## Source details **Canonical URL:** [_cr1494](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr1494.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr1494.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr1494.pdf.json) --- ### Introduction and reform design - Targeted Subsidy Reform (TSR) aimed to remove subsidies on energy and other products; energy subsidies were estimated at about 20 percent of GDP. - Reform replaced direct price subsidies with universal cash transfers to households and envisaged direct assistance to enterprises and the government to facilitate adjustment. - Reform reached more than 70 million citizens and launched a months-long public relations campaign. - Planned transition: bring domestic relative prices for energy products close to international levels over five years, reduce pollution, and help transform Iran into a more competitive market economy. - After a smooth start in December 2010, the second phase was postponed in mid-2012 amid worsening economic conditions and implementation problems. ### Box 1 — TSR law mechanics: price targets, revenue sharing, institutions, and weaknesses - Price targets and coverage: - Domestic liquid fuels’ prices to be brought to a level not less than 90 percent of the Persian Gulf FOB prices. - Average domestic price of natural gas to be adjusted to about at least 75 percent of average export price of natural gas. - Prices for electricity and water to reflect full cost price. - Subsidies on wheat, rice, cooking oil, milk, sugar, postal services and air and rail transportation services to be removed by 2015. - Revenue redistribution (as specified in the law): - 50 percent of net proceeds from price increases allocated to households as cash and noncash transfers and for a comprehensive social security system. - 30 percent allocated to enterprises and utilities as grants, facilities, and subsidies on bank loans to optimize energy consumption and support producers. - 20 percent to the government budget to pay for higher utilities’ costs and investment needs. - Law allowed annual budget changes of up to 10 percentage points among households, enterprises and government shares. - Institutional setup: - Established the Targeted Subsidies Organization (TSO) governed by a ministerial board; TSO budget submitted to Parliament; semiannual reporting requirements to Parliament and Supreme Audit Court. - Noted weaknesses: - Exact timing and magnitudes of price increases not fully specified. - Financial support to households and enterprises presented as permanent rather than temporary transition assistance. - No guidance on price adjustments in the event of an unexpected depreciation of the currency. - Not explicit on how monthly cash transfers would be adjusted if projected revenues failed to materialize. - Law implied a broader mandate to help enterprises than merely improving energy efficiency. ### Macroeconomic developments and policy responses (2010–2013) - Pre-reform context: - Non-oil GDP was growing at around 6 percent on average in the last three quarters preceding the launch (end-2010). - Average inflation was down to 10 percent from 25 percent two years earlier. - Current account surplus was around 6.5 percent of GDP. - Parallel market premium on the exchange rate had been rising since mid-2010. - Post-reform deterioration: - Real GDP growth declined to 3 percent by March 2012 (Iranian year ends on March 20th). - CPI-inflation doubled to 22 percent in December 2011, one year after the launch. - Current account surplus reached 11.5 percent of GDP and foreign exchange reserves increased by US$20 billion in 2011. - Monetary and fiscal stance: - Central Bank of Iran (CBI) expanded credit prior to the reform; opened a credit line in September 2010 to finance initial two-month worth of cash transfers. - CBI used foreign exchange sales to sterilize excess rials, reducing international reserves. - Spread between parallel market rate and official rate rose from 1 percent in September 2010 to more than 8 percent by June 2011, and to 35 percent in December 2011. - Fiscal policy tightened but non-oil budget deficit improved by 2 percentage points in 2011. - Shock escalation in 2012: - Intensification of sanctions on international financial transactions and oil exports in late 2011 and early 2012 led to sharp depreciation of the rial in the parallel market and disrupted imports. - Industrial output declined by more than 10 percent as enterprises struggled to import inputs. - Removal of some administrative price caps and exchange rate pass-through brought annualized monthly inflation above 30 percent in February 2012. - CBI policy adjustments in 2012: - Small policy interest rate increase (first in six years) and a small official exchange rate depreciation. - Base money and M2 increased by about 30 percent in 2012, fueling inflation. - Stagflation and macro outcomes: - Oil exports almost halved in 2012; oil production fell by about 25 percent. - Consumer price inflation exceeded 35 percent at end-2012 and hit 41 percent by March 2013. - Real GDP growth contracted by about 6 percent in 2012 and unemployment rose to 13 percent. ### Postponement of the second phase - Authorities submitted plans in January 2012 to implement the second phase before end-March 2012, including large price adjustments and reportedly eliminating high-income households from cash handouts. - Parliament voted to postpone the second phase in 2012 citing high inflation, foreign exchange volatility, and new sanctions. - Parliament passed a law banning energy price increases until mid-June 2012, reduced by half the revenue target from price increases in the draft budget bill, and in November 2012 formally voted to delay the second phase, keeping existing cash transfer program intact and barring further price increases. ### Initial outcomes and short-term impacts - Consumption and energy intensity: - Domestic consumption of liquid fuels fell by about 3 percent in 2011 compared to 2009. - Diesel consumption kept increasing but at a slower pace; diesel constituted one third of total liquid consumption. - Natural gas consumption, accounting for about 60 percent of the energy consumed in Iran, continued to rise but at a slower pace. - Growth in electricity consumption dropped to 2 percent in 2011. - Consumption of wheat fell in 2011, for the first time in a decade. - Energy intensity briefly declined during the first phase. - Growth in consumption of subsidized products rebounded in 2012 as the second phase was suspended and inflation and nominal incomes rose. - Distributional effects and cash transfers: - Direct cash transfers improved income distribution in the short term. - Salehi-Isfahani et. al., (2012) found the poverty rate declined by about 5 percentage points, mostly in rural areas, and indicators of inequality registered declines in the first three months of the program. - Monthly cash transfers were 445,000 rials (about US$ 45 when the reform was launched) per person. - Transfers represented about 15 percent of the average income of a median income family of four in 2011. - For many large and poor families the transfers doubled incomes and brought per capita income above the US$2 per capita threshold. - The Gini coefficient is estimated to have improved to 0.37 in 2011 from 0.41 in 2010. - Sharp contraction of the economy, rapid increase in inflation and decline in real value of wages and cash transfers likely eroded some gains in 2012 and beyond. ### Assessment of implementation: weaknesses and catalysts of reversal - Macroeconomic policy shortcomings: - Monetary policy was not tight enough; central bank continued to finance the Mehr housing program. - Official nominal exchange rate was kept fixed while prices surged, contributing to an overvalued official exchange rate and widening spread with the parallel market. - Interest rates remained negative in real terms; central bank attempts to raise rates were constrained by the Money and Credit Council. - Overreliance on the foreign exchange rate as a nominal anchor and limited operational independence of the central bank complicated policy when reserves could no longer be used to sterilize. - Administrative price controls and market distortions: - Administrative price ceilings forced enterprises to seek bank support or run arrears, increasing banking sector pressure and central bank funding needs. - Caps on interest rates impeded efficient allocation of capital. - Fiscal and TSO problems: - The cash deficit of the TSO remained high at about 1–2 percent of GDP since inception. - Reform began with a deficit because revenue from price increases did not fully cover cash handouts and other payments. - Causes of deficit: failure to impose budget discipline on high energy users; higher number of households receiving higher cash transfers than planned; collection problems; keeping energy price increases at minimum envisaged range for some sectors (e.g., diesel price rollback for transportation). - With 75 percent of TSO revenues coming from the sale of natural gas and gasoline, and industry as main natural gas user, the TSO could not reach revenue targets; National Iranian Gas Company faced cash flow problems. - Electricity tariff increases did not help TSO budget because power companies used extra receipts to cover their own deficits. - Rolling back cash transfers looked increasingly difficult because households perceived them as permanent. - Quantified TSO and fiscal figures (in percent of GDP): - Targeted Subsidy Organization Balance (In percent of GDP) - Revenues: 0.8 (2010/11), 4.8 (2011/12), 4.5 (2012/13) - Price increases: 0.8 (2010/11), 4.8 (2011/12), 4.5 (2012/13) - Expenditures: 2.7 (2010/11), 6.4 (2011/12), 6.1 (2012/13) - Cash transfers: 2.6 (2010/11), 6.4 (2011/12), 6.1 (2012/13) - Assistance to Social Security and Health: 0.0 (2010/11), 0.0 (2011/12), - (2012/13) - Deficit: -1.8 (2010/11), -1.6 (2011/12), -1.6 (2012/13) - TSO estimates indicate support to enterprises reached 1.25 percent of GDP in 2012. - Other implementation failures: - No progress in restructuring enterprises or improving energy efficiency; enterprises received preferential tariffs and tolerated arrears. - TSO accounts and legally required audit reports to Parliament were not made public. - External shocks: - Large external shocks in 2012, including large depreciation of nominal exchange rate, derailed the first phase. - Reform law linked domestic sale prices to international Persian Gulf FOB prices with targets expressed relative to exchange rates used in annual budgets; a depreciating currency turned those targets into moving targets with no guidance in the law for large swings. ### Lessons and policy recommendations for next steps - Keep subsidy reform a top priority: - Subsidized energy prices encourage overconsumption, worsen pollution, benefit mostly high-income households, distort investment toward capital intensive projects, discourage private sector investment in energy, and create incentives for smuggling. - Leverage achieved public perception shift: - Substantially raising energy prices in the first phase altered public perception and showed more efficient ways of sharing oil wealth than indiscriminate energy subsidies. - Use lessons and international best practice to redesign strategy: - Sharing hydrocarbon wealth with all citizens should remain the cornerstone, supported by the right framework and macroeconomic policies. - Strong and coherent macroeconomic policy framework is essential for the second phase; strong monetary and fiscal policies are critical to anchor inflationary expectations. - Address the reform’s deficit while preserving distributional goals: - Eliminating the reform’s current deficit should be balanced against sharing hydrocarbon wealth. - Priority measures to increase cash inflows include: - Enforcing stricter collection of energy bills. - Eliminating lower priced gasoline and diesel quotas. - Differentiation of cash handouts among income groups or instituting re-enrollment requirements could help contain cash outflows. - Enforcement and enterprise restructuring: - All energy users, particularly enterprises, should pay energy bills in full. - Enterprises should face hard budget constraints; payment arrears and loan subsidies should not substitute for subsidized energy. - Authorities should reinforce collection and foreclosure mechanisms and strengthen bank supervision to incentivize enterprise restructuring. - Improve targeting of cash transfers: - Cash transfers could be more conditional and targeted, tilted toward specific socially important expenditures. - The law allows switching expenditures under the reform; international experience shows targeting is difficult but remains the best tool to protect low income groups. - Depoliticize energy price setting: - Establish an automatic pricing formula and publish detailed information on the pricing mechanism. - Consider assigning responsibility for implementing automatic pricing to an independent body. - Link transfers to hydrocarbon sector profitability and smoothing: - Cash transfers should be linked to total profitability of Iran’s oil and gas sector so transfers rise with sector profits and fall when profitability declines. - A hybrid structure allowing smoothing could be designed to achieve stability of cash transfers while ensuring investment in hydrocarbon production remains a priority. ### Monetary policy, model-based assessment, and institutional reform options - Model context and key parameters: - Stylized model (Cecchetti, 1998) used to illustrate tradeoff between inflation and non-oil output stabilization. - Loss function: L = (π_t − π*)^2 + (1 − α)(y_t − y*)^2. - Estimated degree of inflation aversion α equals 0.49 for 1991–2010 benchmark. - Observed ratio of output and inflation variability for 2011–12 corresponds to α = 0.32. - Estimated γ from VAR yields ߛ = 0.78 in one instance; alternative specifications produce comparable estimates. - Empirical and narrative findings (2011–12 shocks): - Immediately after subsidy reform monetary policy appears relatively tight; in 2012 stance reversed and monetary policy turned expansionary even as exchange rate depreciated and inflation soared. - Benefits in terms of output stabilization from accepting higher inflation are diminishing; large inflation variability did not prevent a spike in output variability. - Flat inflation/output variability frontier (steep aggregate supply curve) implies output costs of disinflation could be small. - Institutional constraints identified: - Monetary and Banking Act of 1960 lists four CBI objectives that do not explicitly prioritize price stability. - Money and Credit Council (MCC) with 13 members constrains CBI operational independence; MCC determines interest charges and returns on participatory notes. - CBI lacks full control over instruments; reserve requirements and prudential measures limited in effectiveness. - Exchange rate has been de-facto nominal anchor since 2002 unification but is suboptimal. - Reform options and lessons from other emerging markets: - Clarify mandate with a clear commitment to price stability. - Strengthen operational independence of the CBI. - Enhance accountability mechanisms and public communication. - Adopt short-term interest rates as main policy instrument; deemphasize quantitative monetary targets. - Reforms must be accompanied by measures to overcome fiscal dominance: modernize public financial management, reform tax codes, limit central bank financing of fiscal deficits. - Case study: Turkey illustrates institutional reform impact: - Pre-crisis estimates: α=0.24 and ߛ =0.96; post-crisis: α=0.71 and γ=1.66. - Institutional reforms included granting full operational independence to the central bank, making price stability primary objective, creating a monetary policy committee, banning direct lending to the Treasury from November 2001, and adopting an implicit inflation-targeting regime. ### Financial relations in the hydrocarbon sector and transparency - Financial relations between state enterprises in the hydrocarbon sector and the central government should be more transparent. - Current opaque relations undermine accountability and incentives for profitability. - Many oil-producing countries run national oil companies on a commercial basis: pay royalty and transfer profits to treasury as dividends; Iran’s system mimics this structure but lacks transparency. ### National Development Fund of Iran (NDFI): objectives, challenges, and recommendations - Purpose and institutional context: - NDFI is a subclass of sovereign wealth funds (SWFs) to contribute to national economic development. - Established in Iran’s Fifth Five-Year National Development Plan (March 21, 2010 to March 20, 2015) via Articles 80–84. - NDFI objectives: (1) save part of oil and natural gas rents for future generations; (2) increase income returns from accumulated savings; (3) support Iran’s economic development and diversification. - NDFI financing shares: - NDFI received 20 percent of oil and gas revenues in 2011, 23 percent in 2012, 26 percent in 2013, and is expected to reach 32 per cent in the long term. - Operational and policy recommendations: - Reforms to fiscal policy framework could strengthen countercyclical role and macroeconomic coordination. - OSF resources could be replenished soon to support noninflationary budget financing and build buffers. - Decisions on saving and investing NDFI resources should be coordinated with macro policies and backed by explicit safeguards and transparency. - Adopt multi-year budget planning and expand general government coverage to enhance monitoring and accountability. - Prioritizing a stabilization role: - Shared revenue base of NDFI, OSF, and general government requires clear prioritization and coordination. - Policy option: adjust NDFI funding formula to account for general government fiscal position; make fiscal formula for hydrocarbon resources countercyclical: - When oil prices and exports are above trend, excess revenues should be saved in the OSF first. - Only when OSF is adequately funded should fiscal surpluses be transferred to the NDFI. - When oil prices and output fall, savings in OSF and NDFI could be tapped. - Financing public capital infrastructure: - Allow NDFI to support well designed public infrastructure projects, especially those with high social returns; use PPPs where appropriate. - Asset management, transparency, and governance: - Invest a large share of NDFI assets in reliable and reasonably liquid securities; disclose and audit that part of the portfolio. - Improve governance to align with Santiago Principles on Transparency and Accountability. - Develop in-house management capacity; consider hiring international managers and opening offices in key financial centers. - Structure compensation and contracts to create strong long-term performance incentives. - Promoter of domestic development — sequencing: - First priority: help finance budget deficits to reduce inflationary financing. - After macroeconomic stability is restored, NDFI should actively support private sector using banks, private equity, venture funds, and specialized funds that supplement financing with active corporate management. - Address corporate governance and agency problems in privatized enterprises; consider in-house private equity and venture capital capacity. *Italic: Excerpt from IMF staff report section on the Targeted Subsidy Reform (TSR), monetary policy assessment, and NDFI (cr1494).* ### References ________________________________________________________________________________ 20 ### References ________________________________________________________________________________ 20 ### Introduction and reform design - Iran’s Targeted Subsidy Reform (TSR) aimed to remove subsidies on energy and other products; energy subsidies were estimated at about 20 percent of GDP. - The reform replaced direct price subsidies with universal cash transfers to households and envisaged direct assistance to enterprises and the government to facilitate adjustment. - The reform reached out to more than 70 million citizens and launched a months-long public relations campaign. - The planned transition was to bring domestic relative prices for energy products close to international levels over five years, reduce pollution, and help transform Iran into a more competitive market economy. - After a smooth start in December 2010, the second phase was postponed in mid-2012 amid worsening economic conditions and implementation problems. ### Box 1 — Targeted Subsidy Reform Law and its mechanics (key provisions and weaknesses) - Price targets and coverage: - Domestic liquid fuels’ prices to be brought to a level not less than 90 percent of the Persian Gulf FOB prices. - Average domestic price of natural gas to be adjusted to about at least 75 percent of average export price of natural gas. - Prices for electricity and water to reflect full cost price. - Subsidies on wheat, rice, cooking oil, milk, sugar, postal services and air and rail transportation services to be removed by 2015. - Revenue redistribution (as specified in the law): - 50 percent of net proceeds from price increases allocated to households as cash and noncash transfers and for a comprehensive social security system. - 30 percent allocated to enterprises and utilities as grants, facilities, and subsidies on bank loans to optimize energy consumption and support producers. - 20 percent to the government budget to pay for higher utilities’ costs and investment needs. - Law allowed annual budget changes of up to 10 percentage points among households, enterprises and government shares. - Institutional setup: - Established the Targeted Subsidies Organization (TSO) governed by a ministerial board; TSO budget submitted to Parliament; semiannual reporting requirements to Parliament and Supreme Audit Court. - Noted weaknesses: - Exact timing and magnitudes of price increases not fully specified, creating ambiguities and uncertainty. - Financial support to households and enterprises presented as permanent rather than temporary transition assistance. - No guidance on price adjustments in the event of an unexpected depreciation of the currency. - Not explicit on how monthly cash transfers would be adjusted if projected revenues failed to materialize. - Law implied a broader mandate to help enterprises than merely improving energy efficiency. ### Macroeconomic developments and policy responses (2010–2013) - Pre-reform context: - Non-oil GDP was growing at around 6 percent on average in the last three quarters preceding the launch (end-2010). - Average inflation was down to 10 percent from 25 percent two years earlier. - Current account surplus was around 6.5 percent of GDP. - Parallel market premium on the exchange rate had been rising since mid-2010. - Post-reform deterioration (Appendix I referenced): - Real GDP growth declined to 3 percent by March 2012 (Iranian year ends on March 20th). - CPI-inflation doubled to 22 percent in December 2011, one year after the launch. - Balance of payments: current account surplus reached 11.5 percent of GDP and foreign exchange reserves increased by US$20 billion in 2011. - Monetary and fiscal stance: - Central Bank of Iran (CBI) expanded credit prior to the reform; opened a credit line in September 2010 to finance initial two-month worth of cash transfers. - CBI used foreign exchange sales to sterilize excess rials, reducing international reserves. - The CBI could not raise profit (interest) rates despite negative real rates. - Spread between parallel market rate and official rate rose from 1 percent in September 2010 to more than 8 percent by June 2011, and to 35 percent in December 2011. - Fiscal policy tightened but non-oil budget deficit improved by 2 percentage points in 2011. - Shock escalation in 2012: - Intensification of sanctions on international financial transactions and oil exports in late 2011 and early 2012 led to sharp depreciation of the rial in the parallel market and disrupted imports. - Industrial output declined by more than 10 percent as enterprises struggled to import inputs. - Removal of some administrative price caps and exchange rate pass-through brought annualized monthly inflation above 30 percent in February 2012. - CBI policy adjustments in 2012: - Initial policy response included a small policy interest rate increase (first in six years) and a small official exchange rate depreciation. - CBI increased credit to public sector enterprises and the government; later slowed bank lending to rein in base money growth after sterilization became infeasible. - Base money and M2 increased by about 30 percent in 2012, fueling inflation. - Stagflation and macro outcomes: - Oil exports almost halved in 2012; oil production fell by about 25 percent. - Consumer price inflation exceeded 35 percent at end-2012 and hit 41 percent by March 2013. - Real GDP growth contracted by about 6 percent in 2012 and unemployment rose to 13 percent. ### Postponement of the second phase - Government intentions and parliamentary actions: - In January 2012, authorities submitted plans to Parliament to implement the second phase before the end of the Iranian year in March 2012; plans included large price adjustments and reportedly eliminating high-income households from cash handouts. - Parliament voted to postpone the second phase in 2012 due to concerns about high inflation, foreign exchange volatility, and new sanctions. - Parliament first passed a law banning energy price increases until mid-June 2012, then effectively froze the second phase by reducing by half the revenue target from price increases in the draft budget bill. - In November 2012, Parliament formally voted to delay the second phase, keeping the existing cash transfer program intact and barring further price increases. ### Initial results and lessons - Reform objectives reiterated: - Better utilize hydrocarbon resources, enhance economic efficiency, and improve income distribution. - Cut domestic energy consumption growth to allow more energy exports and investment. - Encourage enterprises to adopt energy-efficient technologies with transitional support. - Cash transfers intended to reverse regressive subsidy effects and compensate households for higher energy prices. - Implementation outcomes and constraints: - Energy consumption fell in the early months after launch but rose again as inflation reduced the real cost of energy. - Cash transfers’ real value fell sharply due to high inflation, reducing benefits to lower-income groups. - Expected revenues from energy price increases largely failed to materialize, creating cash-flow imbalances and shortfalls relative to committed transfers. - Supportive macroeconomic policy coordination was insufficient; competing fiscal priorities (e.g., financing the Mehr housing program) compromised implementation. - Even careful preparation did not guarantee success without a cohesive package to maintain macroeconomic stability. ### Figure 1 — Developments in subsidized products' consumption (notes and indicators) - Sources: BP Statistical Review of World Energy; Central Bank of Iran; USDA; and IMF staff calculations. - Price conversion note: Prices converted to cents per liter using the parallel market exchange rate, then taken as a share of the end-of-year U.S. Gulf Coast gasoline spot price. - Figure panels (as presented): - Oil and Natural Gas Consumption (In thousand barrels per day), 2000–2012, showing a marked rise and the timing of the subsidy reform start. - Energy Intensity (In BOE per unit of value added), 1990–2012. - Fuel Consumption (In percent change from 2009–2011) for Diesel, Fuel oil, Gasoline, Natural gas, Total liquid fuels. - Wheat Consumption per Capita (In tonnes of wheat per 1,000 people), 2000–2012. - Electricity Consumption (In billions of kw/h), 2000–2012. - Consumption of Energy Products, 2000/01–2011/12 (In thousand barrels of oil equivalent per day) with series for Gas oil, Fuel oil, Gasoline, Kerosene, Liquid petroleum gas, Other products, and Natural gas (RHS). *Prepared by Ozgur Demirkol and Paul Zimand; Islamic Republic of Iran — International Monetary Fund* ### 16. The TSR had some initial positive outcomes, but many proved short-lived. In particular: ### _cr1494 - 16. The TSR had some initial positive outcomes, but many proved short-lived. In particular: ### Initial outcomes and short-term impacts - Consumption and energy intensity - Domestic consumption of liquid fuels fell by about 3 percent in 2011 compared to 2009, driven by the decline in gasoline and fuel oil consumption. - Diesel consumption, one third of the total liquid consumption in the country, kept increasing but at a slower pace due to government decision to supply industry with diesel at subsidized prices. - Natural gas consumption, accounting for about 60 percent of the energy consumed in Iran, continued to rise but at a slower pace; the rise despite a precipitous increase in its price is partly explained by expansion of natural gas network in the country. - Growth in electricity consumption dropped to 2 percent in 2011, its slowest pace in a decade. - Consumption of wheat fell in 2011, for the first time in a decade. - Some indicators suggest that energy intensity briefly declined during the first phase of the reform. - Despite initial demand response, growth in consumption of subsidized products rebounded in 2012 as the price increases under the second phase were suspended and inflation and nominal incomes rose. - Distributional effects and cash transfers - Direct cash transfers to households improved income distribution in the short term. - Salehi-Isfahani et. al., (2012) found the poverty rate declined by about 5 percentage points, mostly in rural areas, and indicators of inequality registered declines in the first three months of the program. - Monthly cash transfers were 445,000 rials (about US$ 45 when the reform was launched) per person. - Transfers represented about 15 percent of the average income of a median income family of four in 2011. - For many large and poor families the transfers doubled incomes and brought per capita income above the US$2 per capita threshold. - The Gini coefficient is estimated to have improved to 0.37 in 2011 from 0.41 in 2010, with a sharp drop in inequality in rural areas. - Although no official data is available, the sharp contraction of the economy, rapid increase in inflation and decline in real value of wages and cash transfers likely eroded some gains in 2012 and beyond. ### Assessment of implementation: weaknesses and catalysts of reversal - Macroeconomic policy shortcomings - Weak macroeconomic policies and ensuing inflation undermined reform implementation. - Monetary policy was not tight enough; the central bank continued to finance the Mehr housing program despite signs it complicated macroeconomic management. - Official nominal exchange rate was kept fixed while prices surged, contributing to an overvalued official exchange rate and a widening spread with the parallel market. - Interest rates remained negative in real terms; central bank attempts to raise rates were constrained by the Money and Credit Council. - Overreliance on the foreign exchange rate as a nominal anchor and limited operational independence of the central bank complicated policy when foreign exchange reserves could no longer be used as the main sterilization tool. - Administrative price controls and market distortions - Administrative price ceilings forced enterprises with rising input costs to seek bank support or run arrears to suppliers, increasing banking sector pressure and central bank funding needs. - Caps on interest rates impeded efficient allocation of capital. - Leaning against market pressures cost foreign exchange reserves and policy credibility. - Fiscal and TSO (Targeted Subsidy Organization) problems - The cash deficit of the TSO remained high at about 1–2 percent of GDP since its inception. - The reform began with a deficit because revenue from price increases did not fully cover cash handouts and other payments. - Causes of deficit included failure to impose budget discipline on high energy users, higher number of households receiving higher cash transfers than planned, collection problems, and keeping energy price increases at the minimum envisaged range for some sectors (e.g., diesel price rollback for transportation). - With 75 percent of the TSO revenues coming from the sale of natural gas and gasoline, and industry as the main user of natural gas, the TSO could not reach its revenue targets; the National Iranian Gas Company faced cash flow problems as some large customers could not stay current and sought rescheduling. - Electricity tariff increases did not help the TSO budget because power companies used extra receipts to cover their own deficits. - Rolling back cash transfers looked increasingly difficult because households perceived them as permanent. - Quantified TSO and fiscal figures (in percent of GDP) - Targeted Subsidy Organization Balance (In percent of GDP) - Revenues: 0.8 (2010/11), 4.8 (2011/12), 4.5 (2012/13) - Price increases: 0.8 (2010/11), 4.8 (2011/12), 4.5 (2012/13) - Expenditures: 2.7 (2010/11), 6.4 (2011/12), 6.1 (2012/13) - Cash transfers: 2.6 (2010/11), 6.4 (2011/12), 6.1 (2012/13) - Assistance to Social Security and Health: 0.0 (2010/11), 0.0 (2011/12), - (2012/13) - Deficit: -1.8 (2010/11), -1.6 (2011/12), -1.6 (2012/13) - TSO estimates indicate support to enterprises reached 1.25 percent of GDP in 2012 (amount almost equal to the share originally promised under the reform law). - Other implementation failures - No progress in restructuring enterprises or improving energy efficiency; enterprises received preferential tariffs and tolerated arrears rather than direct TSO assistance for efficiency upgrades. - Lack of public information: TSO accounts and legally required audit reports to Parliament were not made public, preventing thorough assessment and public debate. - External shocks - Large external shocks in 2012 (including large depreciation of the nominal exchange rate) derailed the first phase of the reform. - The reform law linked domestic sale prices to international Persian Gulf FOB prices with targets expressed relative to exchange rates used in annual budgets; a depreciating currency turned those targets into moving targets requiring very large price increases with no guidance in the law on addressing large swings in the exchange rate. ### Lessons and policy recommendations for next steps - Keep subsidy reform a top priority - Subsidized energy prices continue to encourage overconsumption, worsen pollution, benefit mostly high-income households, distort investment toward capital intensive projects, discourage private sector investment in energy, and create incentives for smuggling. - Leverage achieved public perception shift - Substantially raising energy prices in the first phase altered public perception that energy prices should remain low in a large energy producing country and showed more efficient ways of sharing oil wealth than indiscriminate energy subsidies. - Use lessons and international best practice to redesign strategy - The sharing of hydrocarbon wealth with all citizens should remain the cornerstone, but must be supported by the right framework and macroeconomic policies. - A strong and coherent macroeconomic policy framework is essential for the second phase; strong monetary and fiscal policies are critical to anchor inflationary expectations and instill confidence. - Address the reform’s deficit while preserving distributional goals - Eliminating the reform’s current deficit should be balanced against the principle of sharing hydrocarbon wealth. - Priority should be given to increasing cash inflows of the reform, for example by: - Enforcing stricter collection of energy bills. - Eliminating lower priced gasoline and diesel quotas. - Differentiation of cash handouts among income groups or instituting re-enrollment requirements could help contain cash outflows. - Enforcement and enterprise restructuring - All energy users, particularly enterprises, should pay energy bills in full to restore incentives for energy efficiency. - Enterprises should face hard budget constraints; payment arrears and loan subsidies should not substitute for subsidized energy. - Authorities should reinforce collection and foreclosure mechanisms and strengthen bank supervision so enterprises have incentives to restructure. - Improve targeting of cash transfers - Cash transfers could be made more conditional and targeted, tilted toward specific socially important expenditures. - The subsidy reform law allows switching expenditures under the reform; international experience shows targeting is difficult but remains the best tool to protect low income groups. - Depoliticize energy price setting - Establish an automatic pricing formula and publish detailed information on the pricing mechanism to distance authorities from direct political control over energy prices. - Consider assigning responsibility for implementing automatic pricing to an independent body. - The law aimed to bring liquid fuel and natural gas prices to 90 percent and 75 percent of their comparable international prices, respectively, but did not specify a pricing mechanism. - Link transfers to hydrocarbon sector profitability and consider smoothing - Cash transfers should be linked to total profitability of Iran’s oil and gas sector so transfers rise with sector profits and fall when profitability declines. - A hybrid structure allowing smoothing could be designed to achieve stability of cash transfers while ensuring investment in hydrocarbon production remains a priority. *Italic: Source — Excerpt from IMF staff report section on the Targeted Subsidy Reform (TSR) and its assessment.* ### 36. Financial relations between state enterprises in hydrocarbon sector and links with the ### 36. Financial relations between state enterprises in hydrocarbon sector and links with the ### Financial relations and transparency - Financial relations between state enterprises in the hydrocarbon sector and links with the central government should be more transparent. - Despite the clear distribution of oil and gas export revenues between state enterprises and central government in the budget, financial relations among different enterprises in hydrocarbon sector and budget remain opaque. - Many other oil producing countries run national oil companies on a commercial basis: they pay a royalty to extract hydrocarbon resources and also transfer profits to treasury as dividends to the main shareholder. - Iran’s current system mimics this structure but opaque financial relations undermine the accountability of these enterprises and incentives for profitability. ### Appendix I — Macroeconomic developments after the reform: headline findings - Economic growth: - Quarterly growth rate dropped to 2 percent in the last quarter of 2011, from 5 percent in the same quarter of the previous year. - Real GDP growth declined to 3 percent by March 2012, half of the growth achieved in the previous year. - Inflation: - CPI inflation rose from 13 percent (year-on-year) in December 2010 to about 22 percent over a twelve month period following the subsidy reform. - Prices of food, clothing, household equipments and medical expenses increased at about 20 percent over the three quarters following the launch of the reform. - Transportation sector prices rose above 30 percent. - 12-month PPI inflation accelerated from about 13 percent in December 2010 to almost 40 percent in December 2011. - Balance of payments and reserves: - Iran’s current account surplus doubled from the previous year and reached 11.5 percent of GDP in 2011. - Gross international reserves increased by US$20 billion to above US$90 billion by the end of 2011. - Corporate sector and financial markets: - Tehran Stock Exchange reached record highs after the subsidy reform but equity prices for sectors most affected by the reform declined later in 2011. - Real returns rapidly declined in the remainder of 2011 in parallel to weakening economic activity. - Sectoral production and costs: - Deceleration in growth became more visible from September 2011: cash transfer effects on private consumption waned, construction activity slowed, and industrial production declined markedly. - Large increase in input costs associated with higher energy prices weakened corporate sector profitability. - Production in large energy-intensive sectors (automobile, steel, cement and petrochemicals) continued to grow at a declining rate. ### Monetary policy and the inflation-output tradeoff: summary - Three stylized facts for Iran over the last two decades: - The level and variability of inflation have been persistently above the median of other oil-exporting countries. - Variability of non-oil output has been below the median. - Both inflation and output variability rose markedly since the mid-2000s. - Policy tradeoff: - Monetary policy can stabilize either prices or output in the face of supply shocks, but not both. - Examining outcomes after well-identified supply shocks (2011–12) sheds light on authorities’ revealed preferences. - Model inference (1991–2010 benchmark and 2011–12 shocks): - The estimated degree of inflation aversion α equals 0.49, indicating only a mild preference for inflation stabilization (α < 0.5). - The inverse of the aggregate supply curve γ (from VAR impulse responses) yields ߛ = 0.78, implying a steep aggregate supply curve and that output costs of disinflation could be small. - A relatively low γ suggests companies adjust prices rapidly when inflation changes (low nominal rigidity), so output is less responsive to inflation. ### A brief narrative of the 2011–12 shocks and policy responses - The subsidy reform (2011): - Caused sharp increases in prices of subsidized energy products (gasoline, fuel oil, kerosene, diesel, and electricity), raising input costs for businesses and households. - Authorities initially reduced base money growth by selling foreign exchange and gold, but this response faded later in 2011. - Domestic liquidity injections from credit to specialized banks (largely associated with funding to the Mehr Housing Program) and the government were too large to sterilize with FX interventions. - The exchange rate began to depreciate in the parallel market around April 2011, more abruptly toward year-end. - Monetary policy had limited response besides tightening credit to other sectors while accommodating social programs. - International sanctions (2012): - Sanctions on oil exports and financial transactions impaired Iran’s ability to import production factors and transact in the international financial system. - The MCC raised rates of return on bank deposits and central bank-issued participation papers in early 2012; some private banks set interest rates above official ceilings on some term deposits. - Real interest rates descended into increasingly negative territory; few banks were interested in buying participation papers. - The CBI’s impaired ability to transact in dollars prevented large-scale foreign exchange interventions to sterilize liquidity injections. - Authorities introduced a two-tiered official exchange rate system, with the appreciated rate applying to imports of food and other basic goods. - Large real depreciation in the parallel foreign exchange market coincided with sharp acceleration in inflation. ### Policy implications and interpretation - The policy response to the 2011–12 negative shocks is consistent with a higher tolerance for inflation and a greater emphasis on output stabilization. - Possible explanations for limited inflation control include institutional weaknesses in the conduct of monetary policy and constraints on the CBI’s ability to contain inflation amid sanctions and large liquidity injections. - The analysis suggests a need to rethink and strengthen Iran’s monetary policy framework to better balance inflation and output stabilization objectives going forward. *ISLAMIC REPUBLIC OF IRAN INTERNATIONAL MONETARY FUND* ### 6. Examining the policy response of 2011–12, the model suggests a shift in preferences ### 6. Examining the policy response of 2011–12, the model suggests a shift in preferences ### Model findings on preferences and the inflation/output variability frontier - The subsidy reform and the intensification of sanctions enter the model as negative realizations of ݏ ௧, forcing Iranian authorities to trade off inflation versus output stabilization. - The model’s solution is interpreted as a frontier of inflation and output variability; each point corresponds to a different degree of inflation aversion α. - The observed ratio of output and inflation variability for 2011–12 corresponds to α=0.32. - Because the inflation/output variability frontier is relatively flat, lowering output variability during 2011–12 came at the expense of a significant increase in inflation variability. - The estimated α for 2011–12 is likely an upper boundary because administered measures introduced after the subsidy reform contained recorded inflation variability; without these controls recorded inflation variability would likely have been higher. ### Evidence from the policy reaction function (GMM regression) - A GMM regression of base money growth on the output gap and the deviation of inflation from target is estimated over 1991–2010. - Two departures from Clarida, Gali, and Gertler (2000) in this specification: - Base money replaces the interest rate as the dependent (policy) variable. - The nominal exchange rate is used as an indicator of inflation instead of direct inflation, given the high share of tradeables in the consumption basket. - Using the estimated reaction function and realized gaps in 2011–12: - Immediately after the subsidy reform monetary policy appears relatively tight, with negative base money growth despite a widening output gap. - In 2012 the stance reversed: the central bank scaled back sterilization, monetary policy turned expansionary even as the exchange rate depreciated and inflation soared. ### Implications: limited benefits from accommodating inflation - The benefits in terms of output stabilization from accepting higher inflation are diminishing: - Since 2011, significant increases in inflation variability did not prevent a spike in output variability. - The flatness of the inflation/output variability frontier (steep aggregate supply curve) implies output is largely driven by supply-side constraints and is relatively unresponsive to demand; demand shocks mainly affect prices, especially at high inflation. - Policy implication from Cecchetti’s (1998) framework: - To regain control over output movements at reasonable inflation variability, the economy should move leftward on the frontier by raising α (policy preference for inflation stabilization). - One crucial determinant of α is the institutional design of the monetary policy framework. ### Institutional constraints and trade-offs faced in 2011–12 - Official mandate and objective ambiguity: - The Monetary and Banking Act of 1960 lists four objectives for the CBI: (i) maintaining a stable exchange rate; (ii) keeping the balance of payments in equilibrium; (iii) facilitating trade; and (iv) raising economic growth. Price stability does not appear as an explicit overarching objective. - Limited operational independence and fragmented instrument control: - The Money and Credit Council (MCC) decides monetary policy stance; it has 13 members: three monetary policy experts (including the CBI Governor as chairman) and ten representatives from government and the private sector; voting is by simple majority. - The CBI does not have full control over instruments: the MCC determines interest charges on standing facilities and returns on participatory notes; specialized banks receive subsidized funding from the CBI that affects base money; foreign exchange interventions are under CBI control but sanctions impaired sterilization via reserves. - Remaining tools include reserve requirements and prudential measures, whose effectiveness is limited without full control over base money and interest rates. - Accountability complications: - The General Assembly of the CBI is responsible for scrutiny and appraisal, but without legal guidance on goal hierarchy it is difficult to judge performance when goals conflict. - The exchange rate as de-facto nominal anchor: - Since 2002 unification the exchange rate has been the de-facto anchor, but it is not necessarily optimal because multiple official objectives complicate interpretation of exchange-rate targets. - Periods of relatively stable exchange rates (e.g., 2006–08) could signal different stances; rising inflation in that period suggests policy was likely too expansionary. - Restrictions on capital outflows weaken automatic feedback between monetary policy and the exchange rate. ### Reform options and lessons from other emerging markets - Core reform options highlighted for Iran: - Clarify the mandate with a clear commitment to price stability. - Strengthen the operational independence of the CBI. - Enhance accountability mechanisms. - Improve communication with the public about the monetary policy stance and inflation goals. - Common elements of successful reforms in comparable emerging markets: - Public announcement (and eventual legal enshrinement) of central bank operational independence, typically prohibiting central bank financing of government deficits and dissociating appointments from the political cycle. - Price stability becoming the primary (often sole) objective; output and employment can be secondary explicit goals (examples: Malaysia and Turkey). - Greater transparency and accountability: regular publication of reports, forecasts, and policy committee minutes; governors appearing before parliament. - Adoption of short-term interest rates as the main policy instrument; deemphasis of quantitative monetary targets as base money becomes endogenous and money demand proves unstable. - Necessity of supportive macroeconomic framework: - Reforms need to be accompanied by measures to overcome fiscal dominance, including modernizing public financial management, reforming tax codes, and limiting central bank financing of fiscal deficits. ### Case study: Turkey (illustrative of institutional reform impact) - Pre- and post-crisis parameter changes from Cecchetti’s (1998) model for Turkey: - Pre-crisis estimates: α=0.24 and ߛ =0.96. - Post-crisis estimates: α=0.71 and γ=1.66. - Interpretation: institutional reform can dramatically increase α and improve control over output movements. - Macroeconomic context and crisis facts cited: - Average economic growth in the 1990s was 4 percent, with swings from 9 percent (1990) to –5 percent (1994). - Inflation averaged close to 80 percent per year in the 1990s. - During the 2001 crisis: overnight interest rates shot up to around 5,000 percent (annualized); the stock market lost 40 percent of market capitalization; the currency depreciated more than 50 percent in 2001; public debt rose to close to 100 percent of GDP; real GDP declined 5 percent peak-to-through; unemployment climbed into double digits from 6 percent prior to the crisis. - Post-crisis institutional changes included granting the Central Bank of Turkey full operational independence, establishing price stability as the primary objective, creating a monetary policy committee, banning direct lending to the Treasury from November 2001, and adopting an implicit inflation-targeting regime. - Noted statistic: inflation fell from 29.7 percent in 2002 to (text truncated). ### Concluding assessment - A flat inflation/output variability frontier reduces the costs of disinflation: when aggregate supply is steep, demand changes predominantly affect prices rather than output, implying that inflation stabilization can be achieved with negligible output costs. - The shocks of 2011–12 exposed constraints in Iran’s monetary framework; reorienting the CBI’s mandate toward price stability, bolstering independence, and enhancing transparency and accountability could materially reduce inflation variability while avoiding large output swings. *Source: 6. Examining the policy response of 2011–12, the model suggests a shift in preferences (_cr1494).* ### 7.7 percent in 2005; at the same time, growth actually strengthened from 5 to 8 percent. A fully-fledged IT ### Appendix I. Model to Illustrate the Tradeoff Between Inflation and Output Stabilization ### Context and motivation - Supply shocks move output and inflation in opposite directions, creating a tradeoff between stabilizing inflation and stabilizing non-oil output. - The model used is a simple, stylized macroeconomic framework by Cecchetti (1998) where supply shocks, demand shocks, and monetary policy determine output and inflation. ### Model structure and equations - Non-oil output and inflation are given by: - y_t = (γ) m_t + d_t + u_t (equation (1) — variables as in source) - π_t = (γ) m_t + d_t* + ξ_t (equation (2) — variables as in source) - Variable definitions (as given): - y_t is non-oil output. - m_t is base money (the monetary policy instrument). - d_t and u_t are demand and supply shocks. - γ and ξ are parameters measuring relative responses of output and inflation to demand and supply shocks. - γ also gauges the relative impact of policy shocks (changes in m_t on non-oil output and inflation), with the impact normalized to one in equation (2). - Loss function representing policy preferences: - L = (π_t − π*)^2 + (1 − α)(y_t − y*)^2 (equation (3) — preserving the form and parameters from source) - α is the relative preference for inflation stabilization. ### Key implications and intuition - The model implies the degree to which authorities offset supply shocks depends on α, γ, and ξ. - Higher α (greater preference for inflation stabilization) leads to higher non-oil output variability relative to inflation variability. - Higher γ (output more sensitive to monetary policy; i.e., a flatter aggregate supply curve) lowers output variability relative to inflation variability. - Diagrammatic implication: - Changes in α move policy along the variability frontier. - Different values of γ tilt the variability frontier. ### Empirical identification and estimation - Targets for inflation and non-oil output can be set using: - (i) Official targets in the government’s successive five-year plans, or - (ii) The trend component of the HP-filtered series of inflation and non-oil output. - The estimate of γ is computed as the ratio of the average impulse response of output to the average impulse response of prices to a shock to base money. - Impulse responses derive from a three-variable VAR of base money, consumer prices, and non-oil output. - Identification uses a Cholesky decomposition with ordering: base money, prices, output. - An alternative specification includes the value of oil exports as an exogenous variable to control for international oil market shocks; this yields a virtually identical estimate of γ. ### Quantitative result - Using the observed ratio of non-oil output and inflation variability and the estimated γ, equation (4) gives an estimate of α = 0.49. - Interpretation: Iranian authorities assigned equal importance to stabilizing inflation and output around their targets. - Note: Equal weight in the loss function does not imply the empirical variability ratio equals one; γ (the structure of the economy) affects the observed outcomes. --- ### Ending fiscal dominance and monetary regime transition (selected excerpts) ### Policy developments and reforms - Ending fiscal dominance was a critical element in the reform strategy, helping to break entrenched inflationary expectations. - A new government came into office in 2002 on the platform of fiscal consolidation. - Supported by financial assistance from the IMF, the government focused on generating sustained primary surpluses by increasing tax revenue and cutting inefficient government spending. - The Public Financial Management and Control Law of 2003 strengthened the fiscal framework, improving budget execution, control, and medium-term planning. - A fully-fledged IT regime became operational in 2006. ### Observed macroeconomic outcomes (selected figures from narrative) - Inflation at one point cited as 7.7 percent in 2005. - Growth strengthened from 5 to 8 percent over the referenced period. --- ### Appendix II. Monetary Policy Regimes — Selected country features ### Structure used in appendix - For each country the appendix lists: - Primary Policy Objective - Nominal Anchor - Accountability Mechanism - Main Policy Instrument - Independence (governance and appointment arrangements) ### Representative country entries (as presented) - Brazil - Primary Policy Objective: Price stability - Nominal Anchor: Inflation - Accountability Mechanism: If inflation breaches the target, the Governor is required to write an open letter to the Minister of Finance explaining the reasons and measures and time frame to bring inflation back to target. - Main Policy Instrument: Collateralized overnight interbank rate target. - Independence: Board of Directors consists of the Governor and eight Deputy Governors. The Governor is appointed by the President and does not have a fixed term. - Indonesia - Primary Policy Objective: Price stability - Nominal Anchor: Inflation - Accountability Mechanism: BI submits quarterly monetary policy reports to the Indonesian Parliament. If inflation target is missed, BI and government present an explanation before parliament and public. - Main Policy Instrument: Overnight interbank rate target. - Independence: Governor and Senior Deputy Governor nominated and appointed by the President upon approval of the House of Representatives; Deputy Governors nominated by the Governor and appointed by the President upon approval of the House of Representatives; Board members serve five-year terms and may be reappointed for one additional term. - Kazakhstan - Primary Policy Objective: Price stability - Nominal Anchor: Exchange rate (U.S. dollar) - Accountability Mechanism: NBK submits annual reports to the President for approval. - Main Policy Instrument: Issuing short-term notes, taking bank deposits, refinancing loans, conducting Repo operations. - Independence: Supervisory Board of nine members; Governor appointed by the President and approved by Parliament for a six-year term; composition details as listed. - Mexico - Primary Policy Objective: Price stability - Nominal Anchor: Inflation - Accountability Mechanism: BM sends specified documents to President and Congress in January, April, and September; BM submits quarterly reports on inflation and economic development to Congress; Congress may summon the Governor. - Main Policy Instrument: Overnight interbank rate target. - Independence: Board members appointed by the president, approved by the senate; Governor serves six-year term; Deputy Governors serve eight-year terms. - Malaysia - Primary Policy Objective: Price stability - Nominal Anchor: Unspecified - Accountability Mechanism: Board submits annual reports to the Minister of Finance; report presented before the Senate and House of Representatives. - Main Policy Instrument: Overnight interbank rate target. - Independence: Board composition and appointment terms as listed. - Nigeria - Primary Policy Objective: Price stability and sustainable economic growth. - Nominal Anchor: Broad Money (M2). - Accountability Mechanism: Bank must submit annual report to the President within four months of fiscal year end and annual accounts within two months. - Main Policy Instrument: Open market operations in T-bill market. - Independence: Board composition and appointment terms as listed. - Saudi Arabia - Primary Policy Objective: Price stability (incl. exchange rate). - Nominal Anchor: Exchange rate (U.S. dollar). - Accountability Mechanism: SAMA renders to the government half-monthly and annual statements through the Minister of Finance. - Main Policy Instrument: Repo and reverse-repo rates. - Independence: Board appointed by Royal Decree for five years; removal only by Royal Decree. - Turkey - Primary Policy Objective: Price stability. - Nominal Anchor: Inflation. - Accountability Mechanism: Governor makes biannual presentations before the Council of Ministers and the Planning and Budget Commission of the Grand National Assembly; if inflation target missed, written explanation required. - Main Policy Instrument: Benchmark one-week repo rate. - Independence: Board consists of Governor and six members elected by the General Assembly; members serve three-year terms with staggered renewal; reelection permitted. --- ### The National Development Fund of Iran (NDFI): Issues and challenges ### Purpose and institutional context - The NDFI is a subclass of sovereign wealth funds (SWFs) that undertakes domestic activities to contribute to national economic development. - Established in Iran’s Fifth Five-Year National Development Plan (March 21, 2010 to March 20, 2015) via Articles 80–84. - NDFI objectives (threefold): 1. Save part of the oil and natural gas rents for use by future generations. 2. Increase income returns from the accumulated savings. 3. Support Iran’s economic development and diversification. ### Rationale and international context - Resource-rich countries face challenges transforming resource wealth into assets that support sustained development while avoiding boom-bust cycles from revenue volatility. - Since 2000 Iran established the Oil Stabilization Fund (OSF) to address fiscal stabilization; the NDFI (2010) aims to improve intergenerational allocation of hydrocarbon wealth. - Internationally, SWFs are classified into categories such as stabilization funds, savings funds for future generations, international reserve investment corporations, development funds, and contingent pension reserve funds; most funds (including the NDFI) have multiple objectives. ### Operational and policy recommendations (discussion points) - Reforms to the fiscal policy framework could strengthen its countercyclical role and enhance macroeconomic coordination. - A revised fiscal framework supported by OSF and NDFI could better balance macroeconomic stability, intergenerational equity, and development. - OSF resources could be replenished soon to support noninflationary budget financing and build buffers for future shocks. - Decisions on how to save and invest NDFI resources could be better coordinated explicitly with macro policies and underpinned by more explicit safeguards and transparency. - Adopting multi-year budget planning and expanding the coverage of the general government could enhance operational conduct, monitoring, and accountability of fiscal policy and contribute to improved long-term macroeconomic stability to support economic growth. ### NDFI financing shares (as specified) - In 2011, the NDFI received 20 percent of oil and gas revenues. - The share rose to 23 percent in 2012 and 26 percent in 2013. - It is expected to reach 32 per cent in the long term. --- *Excerpted and summarized from the IMF staff report content provided in the PDF chapter.* ### 8. The NDFI complements the Oil Stabilization Fund (OSF), which was launched in 2000 ### 8. The NDFI complements the Oil Stabilization Fund (OSF), which was launched in 2000 ### Institutional background and key differences - The OSF was launched in 2000 to play primarily a fiscal stabilization role. - The OSF was to save all revenues from oil exports in excess of the budget allocation and was effectively only an account at the CBI. - The OSF was allowed to lend up to US$10 billion to banks for on-lending to the private sector. - In practice, the OSF has not achieved its main stabilization and sterilization role. - The NDFI has been fully institutionalized with: - its own Board of Trustees and Operating Board of Executive Directors; - professional oversight from the Committee of Supervisors; - its own staff and monthly publication reporting the value of its assets and allocation of loans by intermediating commercial banks and sectors of the economy. - On June 26, 2012 the NDFI’s Board of Directors approved detailed Manual of Terms and Conditions for Granting Facilities. ### Prioritizing a stabilization role — findings and recommendations - Shared revenue base: - The NDFI, the OSF, and the general government rely on the same revenue source—oil and gas exports. - Funding rules for each entity need clear prioritization and coordination. - NDFI’s domestic development investment mandate needs integration with public sector development spending and financing needs. - Historical outcome and risks: - Under current funding rules, the NDFI receives a fixed percentage of all oil and gas revenues regardless of fiscal or macroeconomic situation. - The fund accumulated significant financial savings for future generations while the government faced a fiscal revenue shortfall, forcing drastic public spending cuts and resorting to inflationary financing, including deep cuts in capital spending. - High inflation and FX market volatility undermined NDFI’s ability to promote domestic private sector development. - Policy option: - Adjust the NDFI funding formula to take into account the general government fiscal position. - Fiscal discipline should be at the core of government policymaking; fiscal surpluses should lead to transfers to the OSF and the NDFI. - Fiscal formula for hydrocarbon resources should be countercyclical: - When oil prices and exports are above trend, excess revenues should be saved in the OSF first. - Only when the OSF is adequately funded should fiscal surpluses be transferred to the NDFI. - When oil prices and output fall, savings in the OSF and NDFI could be tapped to minimize negative impacts of government borrowing. - Maintaining high fiscal discipline and building stabilization reserves is important, particularly following years of high oil and gas export prices. ### Financing public capital infrastructure - Current constraints and risks: - NDFI is not allowed to lend to the government or the public sector; its lending promotes private sector development. - Iranian commercial banks screen borrowers and projects; loans are authorized by the NDFI and disbursed mostly as payments for imports. - As oil revenues fell, the NDFI came under pressure to support the economy, with risks to project quality and incentives for rent seeking. - Recommendation: - Allow the NDFI to support well designed public infrastructure projects, especially those with high social returns. - Use efficiently designed and implemented public-private partnerships (PPP) to improve timeliness and quality versus direct government implementation. - NDFI would need mechanisms to assess private and social returns and to monitor selected projects. ### National insurer, wealth builder, and promoter of national development - Insurer of macroeconomic stability and lender of last resort: - The NDFI could offer a fiscal and external buffer to mitigate temporary shortfalls in fiscal and export revenues. - Centralized savings pool can increase macroeconomic stability and international credibility, making buffer use unlikely. - NDFI assets could be a supplementary buffer to central bank international reserves, drawn under specific rules or conditions. - Availability of such reserves would improve Iran’s risk ratings and reduce future international borrowing costs. - Historical examples cited: East and South East Asian reserve build-ups after the Asian crisis, Norway, and Chile. - Asset management and transparency recommendations: - A large share of NDFI assets, relative to Iran’s imports and debt service payments, should be invested in reliable and reasonably liquid securities. - That part of the portfolio should be well disclosed and ideally audited by reputable independent auditors to ensure adequate reporting of reserves. - NDFI could benefit from practices of SWFs that score high on the Santiago Principles, especially Transparency and Accountability. - NDFI should continue to improve governance to earn trust of other countries and investors. ### Long-term wealth building and operational capacity - Investment strategy and constraints: - Well managed assets tend to earn higher returns compared to traditional reserve investments; SWFs seek higher returns via long-term investments in equities and lower quality bonds to capture equity premiums. - Achieving such diversification cost-effectively is not easy and the foreign part of NDFI’s assets will need to remain with the CBI for the time being. - Human capital and management capacity: - NDFI should develop strong in-house corporate management capacity; the required breadth and depth of knowledge is scarce and valuable. - Initially, Iran may need to hire international managers and open offices in key financial centers to attract staff. - Merit-based recruitment of staff of highest integrity and ethical standards is critical; opening the fund to international professional staff is recommended. - Examples of staff scale in other funds: - Norway’s NBIM reports employing 340 staff from 27 countries in offices in Oslo, London, New York, Shanghai, and Singapore. - Temasek has 450 staff from 23 countries. - GIC has 1200 staff from 30 nationalities in nine offices globally. - Investment practices and governance: - Asset managers must put in place investment policies and operational practices to shield NDFI from risks associated with active asset management. - Few asset managers succeed in outperforming broad market indices in the long term. - Best practice for long-term investors focuses on building portfolios that mostly track broad market indices to match long-term market returns while minimizing management and trading costs; periodic portfolio rebalancing helps. - Norway’s GPFG model highlights: - Professional asset management by Norges Bank Investment Management (NBIM). - Management strategy focused on minimizing management and other costs. - Broadly diversified global portfolio. - Use of a combination of passive index-based investments and modest active management targeting a small excess return of 25 basis points. - Chile’s prudent learning-by-doing strategy: two funds rely on a Financial Committee of six independent investment professionals elected for two-year terms and have gradually expanded investments beyond high rated sovereign debt and money market funds. ### Promoter of domestic economic development — roles and sequencing - Current practice and risks: - NDFI implements its development mandate by using Iranian commercial banks to screen borrowers and projects. - Some Iranian domestic banks may not maximize economic and social returns; borrower defaults could make NDFI the insurer of the banking sector, potentially resulting in NDFI taking over nonperforming loans and becoming controlling shareholder in banks and corporate clients. - Recommended sequence and instruments: - First priority: help finance budget deficits to reduce the damaging impact of inflationary financing. - Some financing could be directed to capital development projects, possibly under well designed PPPs. - Only after macroeconomic stability is restored should NDFI actively support the private sector. - Mechanisms include continued lending through banks and participation in special purpose funds such as private equity and venture funds. - Specialized funds that supplement financing with active corporate management can help restructure companies to restore international competitiveness as subsidies, negative real interest rates, and protection are phased out. - Corporate restructuring and governance: - Many privatized enterprises face limited pressure to deliver best performance; dispersed small shareholders or large diversified institutional owners create agency problems. - NDFI will need to address agency relationship weaknesses and decide whether to prioritize maximizing social welfare of all Iranians, the welfare of a city, a company, or employees. - Developing in-house private equity and venture capital management capacity would help: - Select the best outside managers for portfolio companies. - Actively manage some portfolio companies. - Examples of institutional development groups and domestic development arms cited: Temasek’s Enterprise Development Group, Kuwait’s Investment Authority (KIA), Abu Dhabi’s Mubadala Development Company, Qatar Investment Agency’s Qatari Diar, Malaysia’s Khazanah Nasional Bhd. ### Design and operational issues — cross-country lessons - International lessons to inform NDFI design and operations: - Singapore and Hong Kong offer lessons in fiscal prudence and overall economic management. - Alaska, Chile, and Norway offer sound fiscal models for establishing fiscal rules and relations between the general budget and the SWF and supporting them with appropriate institutions. - Norway offers lessons for managing external assets. - Singapore and Malaysia’s funds are examples of development funds to learn from. - Some other funds provide lessons of what does not work. *Source: _cr1494 - 8. The NDFI complements the Oil Stabilization Fund (OSF), which was launched in 2000* ### 26. The available interdisciplinary research offers some important lessons. In particular: ### _cr1494 - 26. The available interdisciplinary research offers some important lessons. In particular: ### Setting clear objectives - SWFs routinely face multiple objectives. This is unavoidable due to their public nature and exposure to diverse stakeholders. However, ensuring clarity and prioritizing the objectives can help guide daily operations. - The NDFI’s founding documents should clearly spell out its two objectives: over-generational saving and promoting economic development, in a hierarchical manner. - The objective of saving hydrocarbon rents for future generations should dominate and be supported by the objective of promoting national development. - The two hierarchically imposed objectives will guide the fund’s investment strategies, the buildup of its human capacity and organizational structure. ### Separating political oversight from operational management - The NDFI, like most SWFs, is a “social institution.” As such it is supervised by a political body (Board of Trustees) representing numerous stakeholders’ interests. Such representation is necessary to ensure political legitimacy of the institution. However, it also carries risks.15 - Separating political oversight from asset management is the first and foremost challenge faced by a sovereign wealth fund. - The executive branch of the Iranian government maintains a voting majority on the fund’s supervisory body. - The fund needs to be operated primarily on a commercial basis. Individual investment decisions must be driven by commercial considerations, not short-term political or even social needs. - Trustees should establish economically sound and internally consistent objectives for NDFI’s Board of Directors to follow and let the professional management implement them without further political interference. ### Operational independence and governance mechanisms - The fund’s operational management needs to be relatively immune from the changing balance of power in the legislature, government ministries, the central bank, and other politically elected bodies. - The fund’s founding documents need to clearly delineate the separation of oversight from operational management. Singapore’s Government Investment Corporation (GIC) offers an example of such an arrangement. The GIC is a private company wholly owned by the Government of Singapore. It manages assets and is paid a fee for services. “The Government, which is represented by the Ministry of Finance in its dealings with GIC, neither directs nor interferes in the company's investment decisions. It holds the board accountable for the overall portfolio performance.”16 - The founding documents need to be enforced. Ensuring the legal separation is in theory easy but not in practice. Policymakers should envisage situations where a future small political majority could use the fund for its own benefit. Strong legal and practical safeguards to prevent this from happening are needed. - Requiring super majority votes and an agreement from other independent bodies to change the fund’s rules could be one way of strengthening the fund’s independence. - Appoint the fund’s operational leadership in a manner that maximizes its operational independence, while ensuring the fund pursues its main objectives. - Longer term, difficult to break—except for specific misbehaviors—management contracts offer one way to strengthen operational independence. The contracts must be supported with well designed incentives; and need to impose broad operational limitations, such as objectives, broad investment strategies, and risk limits. - Structure compensation rules to create strong long-term performance incentives for both members of the supervisory body and the fund’s leadership and staff. - Contracts should have strong incentives for long-term profit maximization under acceptable risk profiles, while also including short-term performance benchmarks to create strong overall performance incentives and accountability. ### Defining fiscal relationships and investment guidelines - Define the relationship between the fund and the sovereign’s fiscal needs. The funding formula is important to enhance the fund’s independence. - For fiscal stabilization funds, knowing the relationship to the budget allows fund management to anticipate and respond to possible calls on assets. When the call for fiscal support arrives, the relationship between fund managers and its political overseers is likely to improve. - Instilling high level of predictability of future inflows and government planned outflows instills confidence in the fund’s operational stability, and fosters healthy relationship with its political supervisors. - Develop clear and transparent investment guidelines that ensure proper domestic and external diversification of assets. - Authorities may choose to commit the NDFI to follow the “indexers’ model” committing the fund to buy a broadly diversified stock market portfolio. - Under more active strategies, NDFI supervisors could impose single-company, single sector, and single country and region exposure limits, and set a matrix of limits on holdings of specific classes of securities. - The investment guidelines will depend on the expected timing of calls on the fund’s assets to support fiscal expenditure and other needs. ### Tax and international considerations - Tax policies inside and outside Iran will influence NDFI’s asset management strategies. - Fleischer (2008) looks at taxation of SWF incomes and discusses challenges to ensure policy neutrality. - Knoll (2009) emphasizes the benefits of cross-border diversification that encourage SWF to invest internationally, even in countries with less favorable tax policies and rates. - Knoll shows that relative tax rates matter more than absolute tax rates, and develops recommendations for reforming the international tax system to make it more neutral and encourage cross-border capital flows, including from SWFs. *ISLAMIC REPUBLIC OF IRAN INTERNATIONAL MONETARY FUND* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr1494.pdf_