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Iran's Oil Stabilization Fund: A Misnomer


By Jahangir Amuzegar

Middle East Economic Survey, VOL. XLVIII, No 47, 21-November-2005


The following article was written for Middle East Economic Survey (MEES) by Jahangir Amuzegar, a distinguished economist and former member of the IMF Executive Board.


In Iran’s presidential election last June, a factor that was deemed to have clinched the victory for Mahmoud Ahmadinejad was undoubtedly his seductive and crowd pleasing promise “to put the oil manna on everyone’s sofreh (dinner table).” Hinting darkly about an oil-sucking domestic mafia that was depriving the poor of their rightful share of the national oil wealth, he vowed to rectify the injustice. Ignored in his campaign rhetoric, and unchallenged by rival candidates, however, was the fact that the poor’s dinner table had never been without the oil bounty. Inadequate transparency in the national budget and the balance sheets of state-owned enterprises do not permit an accurate assessment of the subsidies enjoyed by Iran’s poor. Yet there is no doubt that the new president’s core constituents have always been the beneficiaries of an estimated $6.5bn explicit subsidies spent by the Treasury on consumer staples (bread, rice, sugar, cooking oil, cheese, and prescription drugs). The poor have also partially benefited from another $14bn of estimated implicit subsidies on energy and fuel products.  And they have enjoyed government-supplied utilities (water, power, telephone, and urban transport) sold to them below cost – all courtesy of the oil revenues. On top of this all, thanks to the skyrocketing crude oil prices in the last few years, and a future-be-damned attitude in spending its proceeds, the government has not only used the oil-export receipts to finance more than 60% of its annual budget directly or indirectly, but has also profligately dipped into its national nest egg – partly to help the poor.


A Rainy-Day Insurance Scheme

The Islamic Republic’s Oil Stabilization Fund (OSF) has been in existence for a brief period since 2000. Yet the impetus in other oil exporting countries for setting up such funds dates back to the breakdown of the price fixing power by the oil oligopoly. Ever since mid-October 1973, when OPEC countries wrested the age-old control of price determination from the so-called Seven Sisters, oil price volatility has been a major economic and political concern for many OPEC members. Repeated cycles of oil boom and bust since then have played havoc with these countries’ fiscal budgeting, domestic development efforts, and external payment obligations. And the search for a stabilization machinery has been one of their prime endeavors ever since. 


The economic rationale for creating an oil stabilization fund is based on three main considerations. First, there is the necessity and desirability of eliminating, or at least lowering, the costs of stop-go public expenditures associated with ups and downs of crude oil prices in the world markets. The second objective is to maintain fiscal discipline through decoupling public spending from oil price volatility so that planned levels of annual government expenditures would be maintained regardless of the behavior of world oil prices, or the size of export  revenues. And third, there is the goal of avoiding excessive real appreciation or depreciation of the national currency resulting from fluctuations in annual oil exports receipts.


Despite a near consensus among development economists regarding the benefits of achieving these objectives, there is no unanimity among them as to whether oil funds are the proper instrument to accomplish the task. The expressed skepticism, simply phrased, revolves around three cogent arguments. First, if the fund is not integrated with the national budget, it is likely to create a dual machinery, and interfere with sound fiscal management. Second, these funds entail risks of fragmenting asset management, and reducing accountability and transparency. Third, they involve the thorny intergenerational issue of transferring funds from a possibly prudent and farsighted government that currently accumulates wealth to a possibly imprudent future government that could subsequently misuse this wealth. For these reasons, some economists believe that almost all the objectives of such funds could be accomplished by other means such as the use of financial instruments for hedging, accumulation of financial assets by investing budget surpluses in high-return projects, and the pursuit of a proper non-oil fiscal balance.


Iran’ Third Plan Initiative

Iranian development planners in the Islamic Republic, having had their fingers burned twice in 1986 and again in 1997-98 by an oil bust, decided to follow the examples of Kuwait, Oman, Norway and others in establishing an oil reserve fund. The goal was to smooth out the pattern of oil-dependent government expenditures, and to escape the so-called “resource curse.” Reflecting this sentiment, Article 60 of the Third Five-Year Development Plan (2000-05) called for the establishment, with the Central Bank, a “crude oil foreign exchange reserve account” for the purpose of stabilizing the government’s annual budgets during the plan’s life. According to the main provision of this article, all foreign exchange incomes received from crude oil exports over and above the figure specifically projected in the plan for each year, had to be deposited in that account. As of the beginning of the plan’s third year, the Treasury could draw from the OSF account if the government’s oil export receipts fell below the budgeted amount for that year. An amendment to the original plan law in November 2000, stipulated that 50% of the Fund reserves should be set aside for lending to domestic private entrepreneurs – in foreign exchange, and at low interest rates for “productive” investments in the third plan’s priority sectors. The rial proceeds of OSF operations were to be placed in a Rial Reserve Fund for eventual budget deficit financing.


While the principal objective of the OSF, like similar funds elsewhere, was to protect the economy from future oil price downfalls, and a sudden oil income crunch, the Iranian model has been unique in many respects. For example, it is different from the highly successful Norwegian Petroleum Fund that is an integral part of the Norwegian national budget. Moreover, while the latter fund is known for its cautious investing, observing distinct fiscal procedures, and investing its assets exclusively abroad in order to avoid domestic inflationary consequences, the Iranian scheme has no such safeguards. Iran’s OSF is totally outside of the national budget, and is theoretically run by a seven-member Board of Trustees composed of senior government officials from various ministries under the chairmanship of the head of the Management and Plan Organization. Finally, while in Norway, a fiscal deficit in any year could be financed out of its fund resources, Iran’s reserves are specifically earmarked to fill only the gap in foreign exchange shortfalls. The use of the OSF resources for making up the Treasury’s inability to collect rials from tax and non-tax sources are strictly prohibited. 


The OSF Scorecard

The formal balance sheet of the OSF, despite a clear mandate by law, has never been submitted to the Majlis by its board of trustees, or published. The figures presented in this review have been collected and put together from different and conflicting statements by the Fund’s secretary general, Majlis deputies, and various government officials as well as occasional reports in the local press and periodicals. Collected data are in turn matched against fragmentary statistics provided by the Central Bank. The balance sheet presented here shows the Fund’s receipts and payments in US dollars although its assets might be held in several foreign currencies.


The picture shown here is rather unflattering because the Fund’s revenues have fallen short of the planned target, and its expenditures have involved a breach of the planners’ original intent. The total oil export revenues projected in the Third Plan amounted to $56.7bn – based on expected oil prices between $12/B and $19/B. However, with Iran’s oil prices rising during the period and averaging $35/B, the Islamic Republic’s oil revenues in the five-year period went up more than twice the projected figure, and amounted to $130.7bn. According to the law’s provisions, the $74bn surplus revenue had to be placed in the OSF. Instead, the total deposits in the Fund during the five years to March 2005 amounted to a mere $29.1bn – as the Majlis increased the regular “oil share” of the budget each year beyond the Plan’s targets. Meanwhile, the Fund’s own interest earnings of $1.1bn brought its total end-run assets to $30.2bn. Furthermore, in addition to depriving the OSF of its entitled $74bn, the Majlis, using its legislative prerogative, ignored the Fund’s original purpose, by-passed the fund’s Board, and authorized repeated withdrawals of nearly $17bn from even the short-changed $29bn reserves to finance a variety of projects. Of the total additionally legislated appropriations, some $7.6bn was paid to the Central Bank for losses incurred in foreign exchange unification, and $9.4bn was allotted to such “urgent” off-budget items as:  relief to draught-stricken farmers, end-of-year bonuses to government retirees, payments for gasoline imports, expansion of the Basij (volunteer militia) forces, grants to disabled war veterans, aid to Imam Khomeini’s Relief Committee, supplements for short-funded subsidies on “essential” consumer goods, promotion of non-oil exports to Africa and Asia, purchase of new equipment for the police, provision of tourism facilities, disaster relief to earthquake and snow victims, and expanded rail and air transport facilities. None of these projects had anything to do with the main objective of the Fund.


In the meantime, some $11bn credit was set aside for loans to the private sector. This was nearly 31% of the mandated total instead of the mandated 50%. Of this allocation, however, the Fund trustees approved only $6.8bn for specific projects, of which only $3.7bn was disbursed by March 2005. Average length of these loans was eight years and the annual interest rate charged was 2% over the LIBOR’s (or about 5.5%). For projects in “depressed regions” (eg, Sistan), and certain enterprises in financial difficulties (eg, textiles) the duration was extended to 10 years, and the interest rate reduced to 3%. In the case of cement that was badly needed in local construction, the length was exceptionally extended to 17 years. Of the total private sector credits, some 97% went to projects in the industrial and mining sector, and the rest was divided among transportation, technical services, and agriculture sectors.  Industrial projects included such sub-sectors as autos, aviation, electric power, foodstuffs, machine building, petrochemicals, pharmaceutical, and textiles.


One of the reasons for the relatively small portion of the OSF being used by the private sector is believed to have been the relatively unattractive terms of the loans. The money borrowed by private enterprises was denominated in foreign currencies, and its use had to be exclusively for foreign purchases. The loans also had to be paid back in foreign exchange. Thus while the low 3-5% interest loans from the OSF seemed highly enticing compared to the prevailing double-digit rates charged by commercial banks, the ultimate borrowing costs could have run much higher due to changes in the exchange rates. With the Iranian rial steadily depreciating against foreign currencies, and no medium-term hedging facilities available in the Iranian financial system, the exchange-adjusted effective annual interest rate to be paid by private borrowers in many cases could actually reach 20%. In such cases, the latter rate was higher than the official 15% rate charged by the state banks for their rials-denominated loans.


In sum, of the Fund’s total assets of about $30bn, nearly $17bn was used in the public sector, and $3.7bn was paid out as loans to the private borrowers. By the end of the Plan period, the OSF assets consisted of $9.4bn cash, and $3.5bn outstanding loans – for a total of $13bn.


Due to the larger-than-planned share of the public sector in the OSF allocation, and the preponderance of industrial projects in the private sector’s share, the Fourth Development Plan (2005-10) law requires that the agriculture sector’s share in the future OSF annual allocation be no less than 10%, and that the unutilized annual portion of the private sector’s allotment in any year be added to the next year’s figure for that sector so that the funds could not be used for public sector projects. In the current Iranian fiscal year (ending in March 2006) Iran’s expected oil export income is expected to reach $45bn – on a notional average oil price of $28/B.  The 2005-06 national budget’s ordinary share is set at $14bn. The rest of is to be deposited in the OSF, and used in public and private projects. Although the budget law repeats the injunction against the use of the OSF fund for budget deficit financing, this objective is as usual achieved through off-budget appropriation out of the Fund. Thus, $9.13bn is set aside for three public categories: $4.6bn for completing unfinished public development projects; $1.6bn for repayment of exchange unification debt to the Central Bank; and $2.93bn to pay for additional gasoline imports. Another additional $1.1bn is also earmarked for setting up a new fund for helping social needs of the youth. A total of $8bn is earmarked for loans to private entrepreneurs. According to press reports, some $5.3bn of the OSF has been used during the first seven months of the current year—74% rise over last year’s withdrawals, and 16% above the authorized appropriation for the period.


A Tentative Appraisal

The skepticism expressed by economists regarding the effectiveness of oil reserve funds in improving fiscal management seems to have been fully confirmed by the Iranian experience. Stripped of all other considerations, the record shows that not only were all public sector withdrawals during the Third Plan in violation of Article 60, as well as the OSF charter’s principles and procedures, but the sum total of these public projects even exceeded the government’s 50% share – by 31.5%.  In strict accounting terms, the Treasury’s overdraft, and its debt to the OSF by March 2005, amounted to more than $6.5bn. More significant still, while both the letter and spirit of the legislation meant that the government could draw from the OSF only if oil revenue for the year fell below the budgeted amount and there was no possibility of financing the budget deficit through taxes or other means, the practice has been totally different. That is, the OSF that was initially established to come to the Treasury’s rescue if the oil price dropped below $20/B was in fact drawn upon even when the price of Iran’s crude oil surpassed $54/B in mid-2005. Flagrant violations of the original intent of the law have actually turned the OSF into a secure pot of gold, and a ready financing source, for the legislators to use it mainly for off-budget pork-barrel projects.


The Majlis’ handling of the OSF has thus shown the futility, if not indeed the absurdity, of setting up a rainy day fund if it can be freely used while the sunshine had never been brighter. Still further, a mechanism that was put in place for stabilizing the economy has been turned on its head, and has actually become a destabilizing force at times – and making the stabilization fund a misnomer. The reason is not hard to see. When the Majlis authorizes withdrawals from the OSF for domestic expenditures, the Central Bank has to add the withdrawn foreign exchange to its own foreign assets, and issue its rials equivalent to the Treasury. Therefore, instead of sterilizing excess foreign funds, the Central Bank is forced to increase the so-called “money base”, and the result is increased overall liquidity and higher inflation.


Lessons Learned

So far, the experiences of a half-a-dozen nations with oil funds, corroborated by Iran’s case, show that this mechanism may be useful under certain specific circumstances, and not everywhere and not at all times. The totality of the lessons learned up to now indicates that an oil stabilization fund may work best as a stabilizing and balancing force where the country (1) is fairly rich, politically stable, and enjoys low inflation; (2) the national budget may alternate between deficit and surplus each year, but it is in balance over time; (3) the treasury’s credit for borrowing in the world capital markets is fairly high; and (4) foreign exchange surpluses earned during oil booms could be effectively sterilized by the Central Bank in order to contain domestic excess liquidity.  By contrast, in a country such as Iran, with (1) low middle per capita income, perennial budget deficits reaching 5% of GDP in some years; (2) protracted double-digit inflation; (3) a bond rating of no better than a B+; and (4) a weak central bank subservient to the legislature, such a fund is at best inconsequential, and at worst an inflation ratcheting and destabilizing device. To wit: when the Islamic Republic is currently paying 8.75% interest rate per annum on its sovereign Eurobonds, the government cannot convince the legislators to accept the wisdom of keeping billions of foreign exchange assets in the OSF earning less than 4% a year. Or, where the budget is perennially in the red, and more than 15% of the people live below the poverty line, the government cannot persuade the men and women on the street that the OSF resources should not be touched – even for current urgent needs – because these funds are destined to be saved for future generation. Given political realities in a country like Iran, as long as there are unmet social needs on the one hand, and ready cash at the politicians’ easy reach on the other, no government can resist political pressures to use the funds – unless there are additional provisions.


What Iran’s case has taught us is that a country like the Islamic Republic that wishes to set aside some of its oil export revenues for future use might succeed in achieving its goal only if (1) the objective is clearly and inviolably written in its fund charter, and all ad hoc exceptions are disallowed; (2) the fund’s management is composed of non-political individuals with long tenure, and totally independent of the legislature; (3) strict safeguards are in place to insure transparency and accountability in managing the fund’s resources; and (4) since the main purpose of the fund is to make up for the shortfalls in foreign exchange receipts from oil exports, the fund’s assets should be invested exclusively in safe hard currency instruments, at the best obtainable returns.  All other goals – including assistance to the private sector – should be pursued through other means, and carried out in the regular annual budgets and appropriations. Any mechanism short of these stipulations would be a dual budget, and another costly exercise in futility.



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