Iran: Troubling times ahead for the economy (page 1 of 2)

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.