Public Information Notice No. 08/86

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with the Islamic Republic of Iran

July 18, 2008

On July 14, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Islamic Republic of Iran.¹

Background

Iran's growth performance has been robust in recent years, benefiting from high oil prices, regional growth, and a strong policy stimulus. Real GDP growth is estimated to have increased from 6.2 percent in 2006/07 (Iranian fiscal year starts on March 21) to 6.6 percent in 2007/08, with real non-oil GDP growth estimated at 7.3 percent, on account of buoyant domestic demand and increased government support for the priority sectors. Real oil GDP is estimated to have increased by about 1 percent, as production capacity was constrained by insufficient investment. Unemployment declined slightly to 9.8 percent in the year to December 2007.

The external position is estimated to have strengthened significantly in 2007/08. The current account surplus rose to 10 percent of GDP in 2007/08, from 9.2 percent in 2006/07. Gross official reserves reached $82 billion (12 months of imports) and the external debt is estimated to have declined to 9 percent of GDP by end-March 2008.

Inflation rose to 24.2 percent in April 2008, from 16.8 percent in April 2007. A significant increase in inflation excluding food and energy suggests strong underlying domestic demand pressures. Higher import prices constituted an additional cost-push factor.

While the fiscal stimulus was reduced somewhat in 2007/08, the budget continued to provide impetus to domestic demand growth. The non-oil primary fiscal deficit declined to 17 percent of GDP in 2007/08 from 21 percent in 2006/07, on account of the rationing of subsidized gasoline, a reduction in nonwage current outlays, slower growth of capital expenditure, and lower OSF lending. However, budgetary expenditure increased by almost 15 percent in 2007/08 in addition to a cumulative rise of more than 40 percent during 2005/06-2006/07.

Broad money growth remained relatively high in 2007/08. Reduced banking rates of return, pressures on commercial banks to expand credit, and unsterilized purchases of foreign exchange by the Central Bank of Iran contributed to this outcome. While the banking supervision legislation has been improved, some state-owned banks were still undercapitalized as of end-March 2008. Moreover, the deepening of financial intermediation has slowed down in response to negative banking rates of return in real terms.

Progress in structural reforms has been mixed. The increase in energy subsidies has been contained through the rationing of gasoline at increased prices, the VAT is close to implementation, and tax administration has been modernized. Moreover, following the 2006 reinterpretation of Article 44 of the Constitution, the divestment process has gathered pace. However, given the lack of large private investors, many government-owned entities have been acquired through non-cash or deferred settlements by quasi-public sector institutions. Furthermore, remaining weaknesses in the business environment hinder private sector development and employment creation.

The growth and external prospects for 2008/09 are good, but on current policies inflation is expected to remain high. Real GDP growth is projected at 5.7 percent in 2008/09. Notwithstanding buoyant domestic demand, the external current account surplus would remain broadly unchanged at 9-10 percent of GDP, as oil prices are assumed to remain well above their 2007/08 level. The non-oil primary fiscal deficit is projected to increase to 18.5 percent of GDP in 2008/09, from 17 percent in 2007/08. This, together with the maintenance of the current monetary policy stance, will most likely cause inflation to remain at about 25 percent in the near term.

Executive Board Assessment

Executive Directors welcomed Iran's continued strong growth performance, particularly in the non-oil sector. The country's external position had strengthened further, reflecting the impact of higher oil prices. They noted, however, that inflation is rising, largely due to the expansionary policy stance and also, in part, to higher import prices. Looking forward, Directors encouraged the authorities to act promptly to prevent inflationary expectations from becoming entrenched, against a background of a generally favorable short-term growth outlook.

Directors viewed that strengthening the fiscal position in 2008/09 will help to ease demand pressures and limit the liquidity impact of fiscal operations. They welcomed the authorities' intention to contain expenditure below the budget level, and observed that there is room for additional fiscal measures, particularly in the area of energy subsidies.

Directors emphasized that, in the medium-term, further fiscal consolidation will be needed to reduce inflationary pressures, prevent an erosion of external competitiveness, and reduce the economy's vulnerability to a possible decline in oil prices. They agreed that adopting a rolling medium-term fiscal framework and focusing the operations of the Oil Stabilization Fund (OSF) on its stabilization objective would facilitate fiscal management in the face of oil price volatility.

Directors welcomed the authorities' plans for far-reaching fiscal reforms and looked forward to their steadfast implementation. In particular, they supported the intention to replace the current subsidy program by targeted cash transfers to the poor. Directors encouraged the authorities to move ahead with measures to improve tax administration and streamline budgetary personnel expenditure.

Directors emphasized that the recent rise in inflation calls for monetary policy to be tightened. They expressed doubt about the effectiveness of moral suasion and interbank market operations in mopping up excess liquidity to slow money growth. They encouraged a significant increase in banking rates of return as a more effective way to tighten monetary conditions and support financial intermediation. Directors generally recommended increased reliance on market-based instruments in monetary operations. Most Directors were also of the view that greater exchange rate flexibility would enhance the effectiveness of monetary policy.

Directors observed that strengthening the operational independence of the central bank and establishing low inflation as its main objective will increase the effectiveness of monetary policy and anchor inflationary expectations. They looked forward to the resumption of work on a new central bank law.

Directors noted the importance of a strengthened and deregulated banking system, welcomed recent steps to improve banking supervision and the authorities' plans to recapitalize state-owned banks. These measures would be enhanced by accompanying improvements in the central bank's capacity to enforce prudential norms and a gradual deregulation of banking rates of return and credit allocation.

Directors looked forward to the prompt completion of ongoing work in the area of anti-money laundering legislation through the adoption of appropriate implementing regulations, and noted the authorities' commitment to establishing an appropriate framework for combating financing of terrorism. They welcomed the authorities' intention to continue cooperating with international financial institutions on these issues.

Directors noted that achieving the authorities' objectives of improving competitiveness and boosting economic growth and employment creation would require an intensification of structural reforms aimed at stimulating private sector development. In particular, they underscored the need to gear the divestment process to private investors and improve the business climate in close cooperation with the World Bank.

Directors also encouraged the authorities to take the necessary steps to eliminate the exchange restriction related to certain investments under the foreign investment law.

Directors welcomed the recent improvements in data dissemination and the authorities' intention to provide more information on Oil Stabilization Fund operations to the public. They observed that further efforts were needed to broaden the coverage of the central government operations and the timeliness of financial sector vulnerability indicators.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.