Iran: High oil price masks structural imbalances

The economy continues to benefit from the strong oil price and many economic indicators have improved as a result. Highlighting the strengthened external position, Iran's current account surplus increased to USD 7.1bn in H1 FY2005/06, almost three times the surplus realised over the same period in the previous fiscal year. Foreign exchange reserves increased to USD 45 billion in March 2006, the healthiest foreign liquidity position since the revolution. Furthermore, oil revenues increased to USD 41.85bn in the first 11 months of FY 2005/06, up 13.0% from full year FY 2004/05.

There has also been a pickup of real GDP growth, fuelled by the higher oil price and government spending. We forecast real GDP growth will increase to 6.0% in fiscal 2005/06, with the economic expansion being broad based. Real GDP growth increased by 5.6% y/y in the first half of the fiscal year. There was a slowdown in the second quarter, to 4.8% from 6.4% in the previous quarter, owing to the political uncertainty surrounding the presidential election in June. Going forward, high oil prices and increased government spending will continue to drive growth. We forecast growth of 5.5% in 2006/07.

However, major structural imbalances exist and economic management has deteriorated in recent times. Fiscal policy has come under pressure, as one of the main priorities of the new administration has been the more equitable and greater distribution of oil wealth. Increased spending has resulted in the fiscal balance deteriorating, and we forecast deficit of 6.5% of GDP in 2005/06 and 7.4% in 2007/08. Current spending rose 37% y/y in the first half of fiscal 2005/06 and was almost 25% over budget. The expansionary stance will continue. The budget for 2006/07 plans to increase spending by 27% from the government's estimate for expenditure levels in 2005/06. This includes measures to raise regional expenditure by 180% and increase education spending by 50%.

Furthermore, the Iranian fiscal position faces severe problems due to large-scale subsidies. The Majlis' decision in January to freeze already low petroleum and gasoline prices to 2003 levels, along with some utility prices, will increase the subsidy costs. Subsidies already account for a quarter of total spending. The government has also increased funding to conservative institutions. To finance the sharp rise in subsidy costs, the parliament voted to spend an extra USD 3bn in fiscal 2005/06. Of this, USD 2.6bn will come from the Oil Stabilisation Fund (OSF), which is funded by higher than budgeted oil revenues. Although reserves and the OSF continue to increase, the current policy is not sustainable in the medium-to long-term. In the event of weaker oil prices, government borrowing would have to increase substantially to continue this level of spending. Furthermore, the counter-cyclical role the OSF could play in times of lower oil prices will be limited by revenues being unwisely spent at times of high prices.

Year-on-year consumer price inflation averaged 11.1% in the second quarter of fiscal 2005/06, down markedly 15.9% in the first quarter. This is mostly due to the freeze on the price of subsidies of good and services. However, higher government spending is placing upward pressure on the inflation outlook and we forecast prices accelerate in fiscal 2006/07. The government is unlikely to meet its target of reducing inflation to single digits in the current five-year development plan (starting fiscal 2005/06). Negatively, moves by the government have further reduced the limited tools available by the monetary authorities to manage liquidity and control inflation. The Majlis removed the authority of the central bank to issue participation paper for sterilization purposes; this now has to be approved by parliament. Political will to reduce liquidity will remain weak going forward.

Interest rates are also inflexible and pressure from parliament has resulted in the unification of profit rates for lending (de facto interest rates) to 16% for state banks. Previously rates varied from 13.5% for agriculture to 21% for trade and services. In the case of private banks, the maximum loan rate has been reduced to 19%; they were previously charging 25% or more. Real interest rates are much lower than required by the economy (forecast at 0.4% in 2006/07). Negatively, parliament passed a law in April for the government and central bank to reduce lending rates to single digits by 2010. Any further reduction would result in a return to negative-real interest rates, which would further fuel inflation.

Although the five-year development plan envisages further reform, such as privatisation, we feel political appetite for this will remain weak, especially measures like privatisation which would likely result in reducing bloated staff levels of publicly owned companies. Meanwhile, Ahmedinejad has repeatedly called for domestic investors to be favoured over foreign ones in the oil sector. Contracts will still be awarded to foreign companies, although at a slower rate. The policy favouring domestic companies will have wide ranging implications for the most important sector in the economy in areas of efficiency and technology. Foreign investment in the oil and gas sector remains vital to upgrading the current facilities and increasing production levels going forward. On a wider level, FDI is crucial in increasing employment opportunities, which remains a key challenge for the economy. However, the appetite of foreign investors will have been diminished by the negative signal sent by the Majlis in 2005 when it decided to reduce the stake of a foreign investor in Iran's second mobile license to 49% from 70%.

The business and investment climate is also increasingly being negatively affected by the escalation of Iran's dispute with the international community over its nuclear programme. A number of companies have held back from investing in the country until there is a clearer picture on the sanctions issue, this is especially the case for European companies. A number of banks, underwriters and export credit agencies have also put Iran on hold. Lines of credit have dried up and where deals are being done financing costs have spiralled. Payment terms of Iranian companies have also tightened and new transactions are only approved when old payments have been made. Meanwhile, companies (especially with US directors or subsidiaries) have reduced links with Iran due to the stronger enforcement of the Iran-Libya Sanctions Act by the US.

Negatively, there are also indications that some purchasers of Iranian oil have started looking to reduce imports from Iran and find new suppliers. Negatively, both the domestic and the international political environments will continue to place downward pressure on Iran's economic outlook. On the domestic front, populist policies will increase structural imbalances. On the international front, the business and investment environment will not improve without a resolution to the nuclear issue. The imposition of sanctions would further deteriorate the economic position.