The International Monetary Fund’s delegation discussed issues related to the fourth season of 2003 with Iranian officials during the visit to Tehran from 14 – 26 June 2003. The preliminary findings of the delegation and its recommendations are as follows:

Despite instability in the region, it is expected that investments and economic growth model witnessed during 2003-04 to continue.

Iran has enjoyed the most rapid economic growth rate in comparison to other Middle Eastern and African states during the past four years. During the first three years of the Third Five-Year Economic Development Plan, gross domestic product grew by an average 5.8%. Despite reduction of oil production during the past two years, per capita growth of gross domestic product has averaged 4.1% while per capita consumption at the fixed price has increased by 4.7%. The grounds for the said growth include opening economy to international investments and trade, implementing economic reforms and creating financial and monetary motivations, persistence of a high oil price, improved macroeconomic conditions which led to more trust on the part of domestic and international investors as well as investment growth.

In fact, macroeconomic conditions have greatly improved in comparison to the Second Five-year Economic Development Plan. Foreign liabilities have been slashed, foreign current account has had a surplus, international deposits have risen and financial savings have been settled to the Forex Reserve Fund. Presenting governmental bonds to the European markets twice with relatively good conditions is a sign that foreign investors trust in the improvement of economic fundaments of the country and the course taken by economic reforms.

Nonetheless, Iranian economy is still faced with important obstacles: job creation has failed to meet rapidly increasing demand, inflation is high and continues to rise and the private sector is facing structural problems. Officials are trying to solve these complicated problems, but the pace of reforms has not been consistent due to political and social skirmishes. Controlling domestic demand that increased during the past two years due to enforcing expansive financial and monetary policies and led to a surge in inflation rates and a weakening of the foreign current account must be reviewed.

Economic growth remained high in 2002-03 and enjoyed a wide base (7.9% was related to non-oil sectors). The reason was private investments and activities. Primary evidence indicates that the employment rate will rise during 2003-04 and, for the first time during several years, the unemployment rate will fall. This can be a sign of increase in growth speed and, to some extent, the result of job creation plans. Strong domestic demand helped increase liquidity and enhance inflation. Inflation rate that was 11.4% in 2001-2 reached 15.8%. The surplus of foreign current account decreased. However, the positive performance of net capital inflow increased official deposits to such an extent that was equal to seven months of imports during the following year.

Despite hefty oil revenues and increase in tax revenues, financial balance for 2002-3 shows a surplus equal to 1.7% of gross domestic product and the deficit occurred after two years of surplus revenues. The deficit was higher in non-oil sectors and reached 4.5% of gross domestic product. Weakening of the financial situation is basically a reflection of the budgetary expenses of forex rate unification and rapid increase in capital expenses. Officials took immediate measures to reduce credit allocation of the approved budget and exact more taxes. However, the overall financial situation of the country continued to press the domestic demand and speed up increase in liquidity. A reason for this situation was huge drawings by the government on financial resources of the Central Bank of Iran to make up for budget deficit.

Monetary policies did nothing to rectify liquidity of the budget. Although the Central Bank took action to reduce volume of liquidity by selling participation bonds, it increased cash flow to banks considerably and despite increase in credits and inflation, the yield remained constant. As a result, the volume of money presentation (M2) continued to grow at a 30% rate. Officials had considered a 25% figure for this growth.

The exchange rate of foreign currency unit reduced by a nominal 3% compared to the US dollar up until March 2003. However, the true exchange rate increased 7%. Officials permitted foreign branches of Iranian banks to enter foreign markets and engage in current and, to some extent, capital dealings. Access of branches to foreign markets increased access to foreign currency and brought foreign exchange rate in domestic and foreign markets close together.

The outlook for 2003-4 looks promising. Despite instability in the region, it is expected that investments and economic growth model witnessed during 2003-04 will continue. The reasons for this optimism include: economic reforms, relatively good conditions of the oil market and continued domestic demand. The true growth of gross domestic product is projected at 6.5% that reflects increase in oil production and non-oil activities (6.2%), which was of course slower than the preceding year.

The government’s expansive budget will keep its last year situation, but if the government faced budget shortage, it would be expected to reduce its expenses in the course of the year. If domestic demand is not controlled, it would increase due to inflationary pressures. Foreign current account balance will show slight deficit for the first time in five years, which would basically be a reflection of increased imports. However, the deficit would be compensated with surplus of capital account which would be a result of accumulation of about $2 billion of international capital.

The hazards threatening this outlook, in view of uncertainty of dimensions and the timetable of financial and monetary reforms, will continue to be the momentous pace of inflation. Also, the country’s overall situation is vulnerable to reduction or increase in oil price and regional developments.

Negotiations about policies are pivoted around the need for a high growth rate and job creation under an atmosphere of financial stability and ambitious structural reforms. The delegates are especially concerned that huge state expenses that are done through oil revenues would boost domestic demand and increase the pace and speed of inflation and its vulnerability to a possible oil price slump.

The delegation believes that in this stage of the economic cycle of Iran, when the oil price is high and capital inflow is rising and inflation is two-digit, the government must have some financial surplus and speed up structural reforms to realize sustainable development based on the private sector and reduce unemployment.

The delegation shares Iranian officials’ concerns about job creation, but believes that it would be better realized through reforms, especially structural reforms in the labor market. It must be noted that during the recent years most jobs have been created by the private sector. Expansive financial and monetary policies are temporary cures that would entail medium-term hazards such as increased forex exchange rate, high inflation as well as an upsurge in prices and assets. Fortunately, restricting governmental expenses is possible in Iran, but it may have negative quantitative effects on growth, because the private sector strongly reacts to economic reforms.

The delegation welcomes the government’s plan for reducing its expenses during the remaining months of the current Iranian calendar year (ending 20 March 2004). In addition to the need for compensating these deficits, the government’s expenses must be attuned to reduce pressure of domestic demand and control growth of liquidity. The delegates recommend that budget deficit which is being estimated at about 2.2% of gross domestic product, be reduced to 1.4%. This will be basically possible through reducing expenses.

The delegation encourages officials to go on with their medium-term plans for reviewing subsidies and specially make revisions about the energy price and draw up a plan for supporting the poor with more efficiency. In this regard, the recent adjustment in prices of gasoline and other basic goods was a step in the right direction. Also, mentioning implicit cost of these subsidies in budget documents (about 10% of gross national product) is evidence to the determination of state officials to improve subsidies paid on energy and boost financial transparency.

Monetary policy, under the aegis of financial discipline, must be focused on inhibition or reduction of inflation. Rapid growth of liquidity during the past two years is in contrast with stability of the macro-economy and there are signs that the inflation rate is increasing and everybody is expecting it to rise. International experience shows that when inflation becomes institutionalized in a country, any reduction in liquidity growth must be relatively big, so that people think that an adjustment has been made in relation to inflation.

The delegation is of the opinion that slowing down the inflation necessitates that the annual growth of monetary base should be lowered by about 20%. This would only be possible when the Central Bank is more independent in using monetary policy tools and would be able to be more resilient, if needed. However, the Central Bank does not seem to enjoy any of these.

Capability of the Central Bank in adjusting liquidity in financial sector through selling participation bonds is limited because it does not control the return rate of the bonds. In addition, rigidity in determining the rate of return would restrict the change in liquidity conditions to small scale loans. Although steps have been taken to reduce obstacles, there should be more resilience toward policymaking and more reliance on market forces for realization of monetary objectives.

The delegation specially thinks that in addition to the said financial adjustments, adoption of the following policies would help the realization of official goals for reducing growth of liquidity and inflation during 2003-04:

a. The Central Bank must retrieve 10,000 billion rials of surplus liquidity through publishing bonds and selling deposits of the bank. The Central Bank must also have more authority to determine the rate of return of such instruments.

b. The minimum rate of return of the banking system should always be reviewed and if speed of growth of credits is not slackened, the rate must be increased.

c. The officials must be encouraged to make arrangements to present participation bonds to secondary markets and sell the bonds in the primary markets to get the benchmark price.

d. Recent decision for delegating more powers to state-run banks for determining the rate of return as well as allocation of credits is a step forward in the right path and it should be followed with next steps.

Since the unification of the forex rate, the foreign exchange market has been calm and the controlled floating forex system is performing in the correct manner. The real rate of exchange has increased as a result of the wide gap between the inflation rate in Iran and countries with which it has transactions, but growth in non-oil exports has not led to a worrisome competitive situation.

Nevertheless, the outlook of a soaring inflation is a serious challenge to exchange rate management, which can deprive Iran of competing powers in the medium term. It would be difficult for the Central Bank to curb its real growth, especially when financial and monetary policies are expansive. In addition, the delegation believes that under current circumstances in Iran, the ability to compete would only be gained through structural reforms.

It is important for financial and monetary policies to aim at reducing inflation and commitment of officials to the realization of the figure set for liquidity growth must be so strong as not to boost inflation. Also, exchange rate management must allow for exchange rate fluctuations according to market conditions and the rate must not be determined on the basis of the government’s monetary policies.

The delegation welcomes the interest shown by officials in accepting commitments of paragraphs 2(A) and 3 of Article 8 of the International Monetary Fund’s agreement. More talks have been carried out with officials about foreign exchange regulations or any measure that might not be compatible with Article 8 commitments. Some problems have been solved and it is anticipated that the remaining points would be settled after a review of instruments related to recent changes in relevant Iranian regulations by the International Monetary Fund.

The delegation welcomes the government’s structural reforms during the current five-year economic development plan. There has been consistent progress in liberalizing Iran’s commercial regime. The latest decisions include: integrating customs and other duties levied upon imported goods in a single customs tariff; rapid reduction of the instances of commercial profits; persistent tariffing of non-tariff obstacles and remarkable reduction of these obstacles.

The officials’ intention for considering more commercial facilities during the remaining years of the Third Economic Development Plan is a good step and efforts in this regard must aim to eliminate all remaining tariff obstacles, as well as decrease the number of tariffs and maximum and medium rates. At the same time, administrative and customs formalities should be reduced to a minimum.

More efforts to increase credibility of budget management must be made in such a way as to make the projection of revenues and expenses as accurate as possible and make them compatible with the framework of macroeconomic policies, so that, when faced with revenue shortage, potential expenses would not need to be revised frequently in a destructive manner.

The delegation recommends that a medium-term financial framework be provided according to which savings would be done for future generations to defuse the effect of oil price fluctuations. The first step to be taken by officials in this regard requires that the goals of the foreign exchange reserve fund be pursued so as to cushion shocks resulting from oil price fluctuations.

Wide-ranging reforms to increase the efficiency and stability of the financial sector are necessary for developing the Iranian economy. The delegation is pleased with implementation of reforms recommended by the review program for 2000 for the financial sector. The main points include: establishment of non-governmental banks and reforms underway to enact bank regulations based on risks and supervise performance of banks.

Initial measures also are being taken to improve and modernize the system of payments and draw up regulations for the capital market, which are still at the preliminary stages. The delegation appreciates approval of laws to fight money laundering and financing terrorists and recommends those laws to be put into force. We expect progress to be made in all these fields during the next year. The delegation discussed possible damages resulting from involvement of the Iranian banks at foreign exchange markets and proposed to provide technical assistance in this regard.

Other medium-term reforms are at different stages of evolution such as levying tax on added value, adjusting energy subsidies and projected reforms in the labor market. The delegation encourages officials to hurry for providing the preliminaries for these reforms including formulating a suitable social security system that would be implemented to protect the poor families.

The delegation discussed with officials the medium-term (2004-05 and 2008-09) prospects of the Iranian economy based on gradual reduction in oil price, decrease in regional tensions and relatively mild pace of the implementation of the said structural reforms. In such scenarios, the growth in true gross domestic product can be about 5%, unemployment would stay high and foreign vulnerability would enhance. However, if structural reforms are sped up and management of macro-economy becomes healthier in parallel with it, the medium-term prospects of the country’s economy would be more promising. Each of the above scenarios would be amenable to many probable changes.

Improvement in Iran’s statistical information system has continued and the delegation is pleased to see that progress has been made along the lines of recommendations of the International Monetary Fund in 1999. We witnessed that the transition to financial accounts method of 1993 has been complete in March 2003 and the Central Bank has already prepared quarterly statistics on gross domestic product for 2002-03 while coverage of financial information in budget has increased.

However, more is needed including monetary and banking statistics, information on the labor market and coordination between the Central Bank and Iran Statistics Center.

It is a pleasure that much has been accomplished on transparency. Steps taken so far include publication of all the reports of the International Monetary Fund about consultation on the fourth season of 2002 and the report on observing standards and regulations of budget writing. In addition, more coverage has been provided for budget and, for the first time, energy subsidies have been included in the budget document.

The delegation encourages officials to increase transparency of affairs day by day, especially integration of accounts related to the foreign exchange reserve fund, social security and Retirement Fund through operations of the Central Bank of Iran.

It is also recommended that information about international reserves be published continuously. The delegation welcomes officials’ intention to publish reports on paragraph 4 of the year 2003.