Iran: Troubling times ahead for the economy
1) Macroeconomic management continues to deteriorate.
2) Economic expansion is being driven by higher government spending.
3) Current policies unsustainable in the medium-term.
While the international community has focused on Iran's nuclear program, the economy has continued to suffer from poor macroeconomic management. Although the overall economy is being supported by high oil prices, growth is far short of potential and populist policies are placing pressure on the fiscal and inflation outlooks. Meanwhile, true market reforms have stalled. Indeed, the performance of the economy is leading to increased criticism of President Mahmoud Ahmadinejad domestically, from both reformists and conservatives. The conservative critics are concerned Ahmadinejad has raised expectations for living standards to a level that it is impossible to deliver through the oil price cycle, which in turn could lead to a weakening of their political position.
Central bank data indicates real GDP growth expanded by 5.4% in FY 2005/06 (April 2005-March 2006). Although this is an acceleration from the previous year's rate of 4.8%, there are negative trends behind this figure. Iran has been unable to reach the strong growth recorded in FY 2002/03 and 2003/04, when the economy expanded by 7.5% and 6.7%, respectively, and it fell short of the 6.5-7.0% rate originally projected by the central bank. The weaker than expected growth in FY 2005/06 was a result of oil production remaining stagnant, which resulted in the oil sector expanding by just 0.6% in real terms. Given the already difficult investment environment and concerns over the nuclear program, Iran has been unable to upgrade its oil facilities and increase production capacity. Instead, the growth is being driven by higher government spending. While growth in the oil-sector stagnated, non-oil activity remained buoyant, increasing by 6.0%. Indeed, when looking at GDP by expenditure, government consumption grew by 5.4% in real terms - the highest rate of growth in five years.
Negatively, growth is forecast to decelerate in the current fiscal year, in line with lower OPEC production levels. In Q2 2006, central bank data indicates that oil GDP contracted by 3.0% y/y. Consequently, we have revised down our real GDP growth forecast for FY 2006, to 4.9%, although the non-oil sector will continue to be supported by the expansionary fiscal position. Given the marked rise in expenditure, the budget only realised a surplus of 4.4% of GDP in FY 2005/06, despite the historically high oil price and the associated increase in government revenues. This highlights the need for greater fiscal prudence as strong government spending is eroding much of the higher oil revenue; while hydrocarbon revenue increased by 28.3%, expenditure grew by a massive 39.6%.
With spending remaining strong in FY 2006/07, we forecast a further fall in the fiscal surplus, despite revenue continuing to increase. We are forecasting a surplus of just 0.5% of GDP. The fiscal balance is now estimated to fall into a deficit in FY 2007/08. Under the current budget, increased spending was agreed in areas such as education and regional development. However, parliament pushed the government to reduce the subsidy budget. The allocation for fuel imports was reduced to USD 2.5bn from USD 4bn in the previous fiscal year. However, in November parliament voted to add USD 2.5bn to this fiscal year's budget to finance petrol imports. Although Iran is the world's 4th largest oil producer, it currently produces 57% of the country's daily petrol consumption due to a shortage of domestic refining capacity.
Indeed, along with the higher budgetary expenditure, the government has also been increasingly tapping into the Oil Stabilisation Fund (OSF), which means the budget data overstates the strengths of public finances. Apart for the additional funding for petrol imports, the government has been withdrawing funds to boost current spending and support local industries, especially following the increased reluctance of international banks to lend to Iranian companies. Withdrawals from the OSF reached USD 7.4bn in the first five months of the current fiscal year; this is close to the total amount withdrawn from the OSF in FY 2005/06 of USD 7.7bn.
Negatively, the higher government spending is resulting in rapid monetary growth and fueling inflationary pressures. Iran's inflation rate stood at 12.1% in FY 2005/06. However, inflation has been accelerating, to 14.6% y/y in September. Moreover, many within Iran have questioned the accuracy of official statistics, suggesting the actual rate is higher. Negatively, as we have highlighted in earlier research, populist motivated policies by the government have reduced the already limited tools available to the central bank. In the latest development, the rate for lending (the de facto interest rate) has been reduced to 14% for FY 2006/07, from 16%. Given the fact that inflation is currently running above 14%, real interest rates are now negative. Furthermore, the government has set limits on rates of lending for private banks; previously there were no restrictions on this front. These factors have resulted in broad money expanding by 36% in the year ending June 2006.
Regarding reform, the Supreme Leader Ayatollah Ali Khamenei issued a decree to re-start the privatisation program in July. Article 44 of the constitution has been amended to reduce the number of sectors to be maintained under state control. However, even this program will have a populist component. The privatisation will be stock exchange-based and 'justice-shares' will be transferred to low income households; up to 50% of the shares could be disbursed through this method. The government has agreed the first phase of the distribution at end-October, with the shares initially being distributed to two provinces. Apart from the need to restructure public companies to be attractive to potential buyers, the justice shares may act as a further deterrent.
Negatively, Iran's economic outlook will deteriorate given the poor economic management and difficult business environment. These factors are compounded by concerns of Iran's nuclear program and the possibility of sanctions, although any such sanctions are unlikely to undermine the country's trading ability. With output increases remaining constrained owing to a lack of investment, and the oil price forecast to decline, the economy will come under increasing pressure. Government officials have indicated that FDI into the country has plummeted in 2006. Foreign investment remains vital to increasing oil and refining capacity and even with the recent changes to the buyback system and energy development contracts, investment in this vital sector will remain below the levels required. Although in the current fiscal year the government will be able to continue to support growth through increased spending, going forward this strategy is not possible without severely undermining the fiscal position. The key question is, will this deteriorating economic position ultimately bring Iran back into the international economic and investment system? |
