Background

During the first four years of the Third Five-Year Development Plan (TFYDP) (2000/01- 2003/04), real GDP grew by 5.6 percent on average, the external current account was in surplus, external debt was reduced to a very low level, international reserves increased, and the unemployment rate declined. This performance has taken place against the background of increased openness of the economy to international trade and investment and economic

reforms, but also sustained high oil prices and expansionary fiscal and monetary policies.

Notwithstanding these achievements, the Iranian economy faces the challenge of maintaining high growth and employment creation in a stable macroeconomic environment. The expansionary fiscal and monetary policies of recent years have maintained inflation at double-digit rates and led to a substantial reduction in the external current account surplus at a time when oil prices were high. Moreover, there is a pressing need to step up implementation of structural reforms to enhance economic efficiency and foster private sector development and growth. These include financial sector reform, privatization, further trade liberalization, and improvement of the business climate.

Real GDP grew by 6.7 percent in 2003/04 (fiscal year ending on March 20), with strong contribution from both the oil and non-oil sectors. The unemployment rate declined to 11.2 percent from 14.1 percent in 2000/01. Domestic demand continued to grow rapidly under the impetus of an expansionary policy mix, as reflected in high rates of growth of credit and money supply (M2). As a result, average CPI inflation remained at 15 ½ percent in 2003/04.

The external current account surplus declined to about 1½ percent of GDP in 2003/04 from 3.1 percent in 2002/03. Despite a significant increase in both oil and non-oil exports, imports continued to rise significantly, on the strength of domestic demand. The capital and financial account recorded a large surplus, largely on account of increasing FDI inflows—mainly in the energy sector—and short-term financing through letters of credit. Gross official reserves increased by $3.0 billion to $24.5 billion, equivalent to 6½ months of next year's imports of goods and services. External debt remained low at $11.9 billion, equivalent to 8.7 percent of GDP.

While fiscal policy was tightened in 2003/04, the fiscal stimulus was not fully withdrawn. The non-oil fiscal deficit was brought down to 16½ percent, or close to 2 percent of GDP lower than in the previous year, mainly through expenditure restraint, while non-oil revenue remained unchanged relative to GDP. The overall fiscal deficit also declined from 2.4 percent of GDP to 0.2 percent.

Monetary policy was expansionary in 2003/04. The average bank lending rates have remained broadly unchanged in both nominal and real terms. Unsterilized purchases of foreign exchange from the government by the central bank and increased central bank lending to commercial banks led to rapid growth of base money. This, together with a higher money multiplier, fueled private sector credit and M2 growth to the tune of 39 percent and 30 percent, ² respectively. The managed float exchange regime has continued to operate smoothly.

Progress in structural reforms slowed down in 2003/04. While the preparation of medium-term reforms advanced and some progress was made in trade liberalization and banking supervision reforms, little progress was made in reforming the labor market, implementing privatization, or streamlining administrative procedures.

Real GDP is projected to grow at 6.5 percent in 2003/04 on account of high oil prices and the continuation of the current expansionary policy stance. The authorities aim at achieving a money growth target of 20-24 percent to reduce inflation.

Executive Board Assessment

Directors welcomed Iran's strong growth performance over the last four years, which has been supported by important structural reforms implemented at the beginning of the Third Five-Year Development Plan (2000-04), as well as by favorable oil market conditions. Directors noted with satisfaction that unemployment has declined, gross official reserves have continued to increase, and the external debt has remained low. These positive developments have been associated with strengthened confidence in the economy, and a rise in private sector activity and foreign direct investment, including in the non-hydrocarbon sector. Directors considered that key challenges going forward will be to further strengthen the foundations for strong and sustained economic growth and diversification to provide the basis for continued job creation in an environment of macroeconomic stability. Iran's pursuit of stronger macroeconomic policies and far reaching structural reforms will be crucial for underpinning its transition to a market economy and away from oil dependence.

The outlook for the Iranian economy remains favorable. Directors urged the authorities to use the opportunity of high oil prices and improved business confidence to better balance the policy mix by undertaking an upfront tightening of the fiscal and monetary policy stance to bring about a sustained reduction in inflation, which has persisted at double-digit levels. They considered that fiscal policy has a crucial role to play in assisting monetary policy to reduce inflation by containing the growth of domestic demand. In this regard, they welcomed the authorities' intention to scale down expenditure from the high level budgeted for 2004/05, and to improve revenue collections. They noted, however, that additional fiscal adjustment measures may be needed to ease demand pressures and reduce the liquidity effects of spending. To continue strengthening the fiscal position, especially for the medium term, they called for further containment of capital spending and net lending, the phasing out of explicit subsidies, early implementation of the Value Added Tax, and further strengthening of tax administration. Directors also underscored the need to increase savings in the Oil Stabilization Fund while oil prices are high, and encouraged the authorities to resist pressure to relax fiscal policy in the likely event of higher than expected oil revenue.

Directors stressed the importance of setting a medium-term framework for fiscal policy that aims to preserve an adequate level of wealth from non-renewable hydrocarbon resources, while ensuring that fiscal policy supports macroeconomic stability. Directors also encouraged the completion of the preparatory work on energy price reform, which aims at phasing out implicit energy subsidies while putting in place a well-targeted and integrated social safety net.

Directors endorsed the authorities' intention to tighten monetary policy, and welcomed the range of measures that have been approved to contain domestic liquidity growth, including stepped up sterilization operations. They urged the authorities to work toward establishing a clear monetary policy framework that serves to promote disinflation. This should be accompanied by further steps to strengthen indirect instruments of monetary policy, curtail the use of direct credit controls, introduce more market-based flexibility in setting rates of return, and limit the recourse by banks to the central bank's overdraft facilities. They looked forward to the establishment of central bank independence and to the further development of money markets.

Directors endorsed the efforts underway to strengthen Iran's financial system and improve its resilience to exogenous shocks. Directors welcomed the licensing of private banks and leasing companies and supported actions to restructure public banks and strengthen their capital base. They urged the authorities to move quickly to complete the establishment of a risk-based supervision framework to effectively monitor potential risks that may emerge from rapid credit growth, and to monitor developments in asset prices. Directors encouraged the authorities to seek early approval of the capital markets law, which aims at improving the regulatory framework for the issuance and trading of securities and strengthens the supervision of the Tehran Stock Exchange. They welcomed steps to improve transparency and oversight of charitable institutions, and called for early passage of a comprehensive anti-money laundering law covering the entire financial system.

Directors agreed that the managed floating exchange rate regime, which has been in place since the March 2002 exchange rate unification, has served Iran well, and that the current level of the exchange rate is broadly appropriate. They welcomed the assurance that, going forward, exchange rate policy will give considerably greater weight to monetary policy objectives. They commended the authorities for eliminating most exchange restrictions for current international transactions and their intention to phase out the remaining ones, and for accepting the obligations under Article VIII, Sections 2, 3, and 4 of the Fund's Articles of Agreement.

Directors welcomed the authorities' aim to develop the private sector as the major engine of growth and to further open the economy to international trade and foreign investment. Several Directors noted that the Fourth Five-Year Development Plan legislation containing key reforms is undergoing further deliberation, and welcomed the assurance that its approval is expected soon. They stressed the importance of further improving the business climate by streamlining administrative procedures, disengaging the government from commercial activities that can be carried out more efficiently by the private sector, and increasing labor market flexibility to raise the employment content of growth.

Directors noted the steps taken to improve data quality and transparency, including in the presentation of fiscal accounts and the oil sector, and encouraged the authorities to accelerate preparatory work on moving toward compliance with the Special Data Dissemination Standard.

Iran is a bilateral creditor for two heavily indebted countries. Directors commended the Iranian authorities' commitment to provide Iran's share of debt relief to these countries under the Heavily Indebted Poor Countries Initiative.