By Amir Ali Nourbakhsh - Editor
Iran Focus November 2004 (Aban-Azar 1383), VOL 17 NO 10
This article is from the political-economic monthly IRAN FOCUS, published by the UK based Menas Associates. For more on Menas Associates please visit www.menas.co.uk 

A year into his first term as president of Iran, Mohammad Khatami admitted that the Iranian economy was “chronically ill ... and it will continue to be so unless there is fundamental restructuring”. His economic team has managed to address a number of economic shortcomings but many problems are still unresolved.

The remaining difficulties can be attributed to the limited capability of his team, the structure of the economy and society, and also the power struggle. As Khatami’s second term in office comes to a close without much hope for crucial change in the remaining time until May, the rise of the conservatives is making prospects for easier change even hazier.

The emergence of what can be called the neoconservatives (see below) in the Majlis has added to the number of influential actors in the political and economic spheres and has adversely affected Khatami’s liberalization policies (Iran Focus 17:9, October 2004, 7, 8, 10).

Given Iran’s political landscape, the future of Iran’s economy is driven by the three following mindsets.

Reformists The majority of these support Khatami’s liberalization policies, advocate transparency and endorse IMF guidelines. The level of openness towards IMF policies and emphasis on social justice varies among sub-factions.

Traditional conservatives These are affiliated with the bazaar and favor a trade-oriented and protected economy. They are not that hostile to engagements with foreigners but do not find international commerce and technology particularly significant. This capitalist-mercantilist group seeks rents and monopolies and is open to conditional liberalization policies. Although politically at odds with the reformists, some pragmatic conservatives may share some of the ideas of the reformist camp. These centre-right pragmatists consist of technocratic and professional elitists well connected to the political conservatives. Their difference with the reformists is mainly a result of the fact that the source of their power is their support for the traditional conservatives.

The neoconservatives These have a limited and sectarian view of liberalization policies, advocate a state-run economy, over-emphasize social justice, often in a demagogic manner, and are mainly xenophobic. These fundamentalist ideologues, given their power in the Majlis, embrace populist economic policies based on state intervention, price controls and subsidies. Most of them are opposed to reforms by the World Bank and the IMF, and reject globalization categorically as un-Islamic.

In this context, the opportunity for “fundamental restructuring” that Khatami referred to in 1998 is becoming narrower by the day as the number and power of the conservative groups increases. This article presents a macro-analysis of Iran’s political economy with a view to the current macroeconomic problems.

The current situation
Iran’s economy during the Third Five-Year Development Plan has been praised by the IMF because of Iran’s above average GDP growth, a surplus in the external current account, a lower level of external debt, increased international reserves, and reduced unemployment.

The IMF sees this “positive” performance as a result of increased openness of the economy to international trade and investment and economic reforms, but also sustained high oil prices.

Nevertheless, the Fund still urges Iran to maintain high growth and create more jobs to achieve a stable macroeconomic environment. Iran is being criticized for keeping inflation at double-digit rates through its expansionary fiscal and monetary policies and because of its substantial reduction in the external current account surplus despite high oil prices.

The IMF is pushing Iran more towards structural adjustments, which it believes would enhance economic efficiency and foster private sector development and growth. Iran is advised to reform its financial sector and its privatization procedure, expand trade liberalization and improve the business climate.

The IMF board of directors welcomes Iran’s strong growth performance over the past four years, which has been supported by important structural reforms implemented at the beginning of the Third Plan, as well as by favorable oil market conditions.

Two points need special attention here. First, even if IMF policies were to benefit Iran’s economy in its current malaise, the rise of the conservatives and the likelihood of their victory in next May’s presidential election would cloud prospects for frictionless continuation of pro-IMF policies. With the neoconservatives in strength in the Majlis, even a pragmatist conservative cabinet inclined towards economic liberalization would have difficulties pursuing economic policies even similar to those that have been adopted by Khatami.

Second, IMF’s judgment of Iran’s economy is questionable. The economic “growth”, at least of the past two years, has resulted from factors that are external to the economy – extremely high oil prices, two relatively good agricultural years after three consecutive years of drought and Iranians’ habitual high domestic consumption.

As far as real growth is concerned, there has hardly been any investment of note in areas other than governmental sectors and the semi-state energy and automotive sectors. There has not been any real transfer of technology, no proper training has taken place and most of the economic irritants preventing growth are still in place. Rampant corruption (corruption does not necessarily prevent growth, but in Iran is has been a major obstacle), extensive money laundering (Iran Focus 17:5, May 2004, 1), an underground economy, a deficient banking system (Iran Focus, 17:7, July-August 2004, 8) an unbiased and inefficient judicial system, and many political factors that threaten stability for investors.

Even the IMF stresses that Iran suffers from acute unemployment, a large public sector with inefficient state enterprises, poor coordination of macroeconomic policy, slow progress on privatization and a wasteful policy of energy subsidies.

So it is a question how Iran’s economy has been praised for its high growth rate, if growth is not only a quantitative but also a qualitative value.

The IMF’s praise of Iran’s performance is based on the assumption that good economic performance requires the government to reduce its role and interference in the economy. According to the Fund, only then would private markets allocate resources efficiently and generate robust growth. In addition to its disregard of social justice, the IMF’s overemphasis on low inflation, for instance, also disregards the fact that an efficiently functioning market also requires sound financial regulation, competition policy and policies to facilitate the transfer of technology and encourage transparency. What is necessary for a well-functioning market is sustainable, democratic and egalitarian (as opposed to elitist) development. Iran lacks, to say the least, complementary strategies to advance these goals together.

Iran–IMF relations are partly politically motivated. The pro-reform group in Iran believes that economic liberalization in the long run leads to democracy and termination of monopolies and rent-seeking activities. The reformists have been so obsessed with a political rapprochement with the West and displaying their anti-xenophobic and economic liberal attitudes that they have disregarded the impact of the IMF and World Bank’s destructive policies on such states as Russia and those in East Asia.

In contrast to the reformists, the populist neoconservatives use concepts such as independence, price control and subsidies to increase their political following.

Their total rejection of liberalization policies is based on their traditional leftist economic views as their prominent figures still live in the shadow of the Cold War and are hell bent for power (Iran Focus, 17:9, October 2004, 8).

The traditional conservatives, similar to the reformists, see political dividends in Iran’s international economic relations. Despite their apparent anti-West slogans, Iran has already applied for membership of the World Trade Organization on 18 occasions.

This would not have been possible without the consent of the leaders of this group. Many believe WTO membership could bring political dividends. Yet this group is also aware of the political implications of, say, IMF structural adjustments. This wisdom among the traditional conservatives makes their pro-liberalization policies conditional, inconsistent and unreliable.

In short, Iran’s macroeconomic stability is being held hostage to the power ambitions of political factions. Some observers might argue that bringing economic incentives into the election race (next May’s presidential election) is a sign of political maturity in a society that has hitherto chosen its elites on the basis of political ideologies and populist slogans. But economic arguments has been used in Iran’s foreign policy all the way.

The traditional conservatives who first applied for Iran’s membership of the WTO in 1995 were aware of the economic repercussions such as obstacles to the support of local industry and Iran’s gradual loss of control over preserving religious and cultural values. Yet a political incentive for the same group might have been the inevitable interaction of Iran with other member countries, such as the US. Notably, forces from within the faction have always looked for pretexts to improve relations with the US without necessarily addressing its security concerns.

Whatever each group’s considerations, macroeconomic stability has long suffered from the attitudes of major political forces. The traditional conservatives were expected to follow Khatami’s liberalization policies, in case they win the May presidential elections. However, the rise of the neoconservatives will certainly make pursuing such policies difficult, irrespective of whether or not the Fund’s policies could contribute to macroeconomic stability in Iran.

Criteria for macroeconomic stability
Inflation The IMF attitude towards controlling inflation might have negative implications for a country like Iran. Overemphasizing the significance of low inflation might be weighed more heavily than the risk of adverse effects on output and unemployment. Hence, even if maintaining low unemployment were valued more highly than low inflation, Iran would be still pushed by the IMF to keep inflation low.

This is while the experience of other countries has shown that only high inflation (40% and above) is costly. There are even cases where low levels of inflation (as against a zero inflation rate) have proven in line with positive economic performance. In short, overemphasizing low inflation might distort economic policies, prevent growth and reduce economic flexibility.

Although Iran’s pro-economic liberalization politicians are blindly supporting IMF policies, the neoconservatives blame the private sector’s opportunism and greed as well as overpricing and corruption of state officials for high inflation rates.

Output and growth Macroeconomic stability, as conceived by the IMF, downplays stabilizing output or unemployment. In the short run, high unemployment such as in Iran does not only lead to inefficiency in general but can also be conducive to poverty increases, a fall in living standards, and political and social turmoil – all detrimental to long-run growth and output.

An essential growth factor is providing finances for research and development. Iran’s international crises, its difficulties in negotiating loans and its meager attention to research are reasons for insufficient allocation of resources to research and development. This has led to slower total factor productivity growth, which has been the emphasis of the Fourth Plan (2005–10), which is currently under fire from the neoconservatives (Iran Focus 17:9, October 2004, 11).

Another factor undermining the level of output is the unstable political environment. Perceptions of political instability have strengthened with the escalating political struggle. The repercussions of the seventh Majlis’s adverse decisions against foreign investors have worsened the situation for foreign direct investment in Iran. Every forgone foreign investment opportunity not only signifies a loss of capital and knowledge, but, by and large, also deals a blow to stability for investment. So the current Majlis has not only made business difficult for such companies as TAV and Turkcell (Iran Focus, 17:9, October 2004, 8) that it has targeted, but the parliamentarians’ approach could in the long run destabilize investment inflows. What is more, by its actions the Majlis has also caused problems for the thousands of employees of the closed airport.

Employment, R&D, political security and FDI are prerequisites for output and growth that Iran has deliberately undermined since the seventh Majlis has come to power.

Financial reforms One of the major setbacks to establishing a standard financial system in Iran could be sought in its traditional economic institutions
(Iran Focus, 17:5, May 2004 for money laundering and 17:7, July–August 2004 for privatization of banks). The important role of a robust financial system lies in collecting and aggregating savings of various agents and correctly allocating them to other agents with better chances of maximizing capital. Iran’s financial system allocates capital to low-productivity investments and fails to select appropriate projects. The existence of monopolies, rents and nepotism are among the domestic reasons for allocation of resources to inadequate agents.

Also, in terms of monitoring the use of funds and ensuring their productive use, Iran’s financial system seems to be in a rather poor condition. Other functions of a sound financial system such as risk reduction, transparency and the distribution of information face major setbacks too. All three are essential to the growth of capital and an increase in total factor productivity.

The existence of parallel and unaccountable institutions such as interest-free Islamic funds, Islamic foundations and economic activities of the security and military forces raise the risk of financial activities in Iran.

As for transparency, it is noteworthy that capital markets require auditing standards, effective legal systems to discourage fraud and provision to investors of adequate information on companies’ assets and liabilities in order to protect minority shareholders. Nepotism and corruption is a big obstacle to this. Moreover, only a few companies in Iran expose such information to the public. The dominating perception that the judicial system is affiliated with one political group also deals a blow to hopes for financial reforms in the near future.

Other important factors for macroeconomic stability, such as competition, budget and current account deficits, free trade and privatization, face similar problems.

These other factors are subject to the IMF’s ideological economic attitude. For instance, the IMF categorically rejects any kind of budget or current account deficit irrespective of the nature of Iran’s cyclical state of the economy, prospects for growth, use of government spending, and levels of national savings and investment, or if these factors (for example, competition) are adversely affected by the power struggle among the main political currents.

In addition to all this, Iran has been commercializing its relations with many countries to overcome the obstacles of its current nuclear crisis. Granting concessions to some countries in return for political support is another example of allocation of the resources to ineffective agents.

Conclusion
Domestic and foreign policy challenges to Iran have led to a static economic state of affairs. Given the setbacks that prevented the complete implementation of the Khatami team’s proposals during his presidency, it is safe to say that the prolongation of such policies – even if they were to the advantage of Iran’s economy – would be more difficult under a conservative Majlis and possibly a conservative government next year. Hence, any notable economic restructuring is expected to face serious hurdles.

Attempts to downsize the activities of the government will be more difficult than before. Moving away from an oil-oriented economy would face serious resistance from the traditional sectors, which nurture themselves on crude oil incomes. Approaches such as privatization of banks, insurance companies and other state-controlled agencies will probably depend on which of the two conservative branches will get an upper hand on the economy next year.

With the backing of substantial oil revenues in the Oil Stabilization Fund, the neoconservatives might backtrack on unpopular policies such as the removal of subsidies and the creation of an effective taxation system. Also for their political benefit, they might oppose the current investment law and refrain from changing extremely worker-friendly labor law. Both Iran’s investment law – changed under Khatami – and hopes that the labor law would be reformed have been eyed by investors as future incentives for investment. Given the world view of the emerging elite, transparency with respect to the budget and fiscal operations is expected to decline. All this is despite the fourth Plan’s emphasis on these liberal policies. Hence, most of the emerging policies will be results of political affiliations and disagreements and not economic wisdom or even conviction.

As the political struggle for power continues, the economy is becoming an omnipresent factor in factional rows. In Iran, experts with a good understanding of the country’s economic shortcomings who are at the same time non-ideological are being kept away from politics and considered gheire khodi (outsiders). The majority of the khodi (insider) forces are either sectarian, unqualified, over-politicized and obsessed with power politics or a combination of these and hence incapable of adopting the right economic policies.

Most important, the state is moving towards a double-standard approach to the economy. This is similar to the policies that Iran has often adopted in foreign policy. On the one hand, the powerful traditional conservatives seem more inclined towards continuing Khatami’s policies. Iran’s current international standing might also necessitate the state moving more towards integration into the international community. On the other hand, the neoconservatives seem determined to use their power in favor of state-controlled economic policies. It is more this duality that is jeopardizing the economy than the question whether Iran should open or close its economy to the world.

Higher oil prices may lead to impressive figures but Iran’s economic structure remains at least as deficient as in the past with little hope for restructuring or enhanced macroeconomic stability. More important, the economy is likely to be dragged between factions as a tool to political power.