Herein, we discuss the evolution of macroeconomic policies in Iran and provide an overview of the country’s monetary policy landscape. The latter part discusses the structural aspects of the Central Bank of Iran (CBI) and evaluates its performance based on key monetary and banking variables. At the end, we set forth institutional and policy reforms to improve monetary policy outcomes in the future.
After decades of low and non-inclusive economic growth, Iran’s economy seems to be approaching a significant turning point. Of the twenty-six million people in the labor market, upwards of three million, mostly young and highly educated, are not only unemployed but becoming unemployable. Severe water scarcity has become the new norm, suggesting that the output from the agriculture sector will shrink. Hence, food security for the country’s large and growing population can no longer be taken for granted. Crude oil production has already reached its levels before the nuclear sanctions and, in the absence of large investments, significant production growth in the short to mid-term seems unlikely. Despite taking draconian import control measures to push the country’s import substitution agenda toward industrialization, the manufacturing and industrial sectors have struggled to find a way to incentivize innovation and attract private investments, thereby becoming trapped in a prolonged period of poor productivity, which has eliminated their competitive advantage.
On the financial front, bouts of instability—which have reached a historically unprecedented level—are making the underpinnings of the economy increasingly fragile. The financial sector is heading for a Wile E. Coyote moment where the overall stability of the banking system and the value of currency can both plunge suddenly. High positive real interest rates (nominal interest rate minus inflation) have dampened investment for a prolonged period, while—considering the sluggish realities of the real sector—private savings will be channeled to the currency market (hence depreciating the rial and accelerating capital flight) should the interest rate be reduced. The banking system—with enormous amounts of non-income-generating assets—faced a severe cash flow problem and essentially turned into a country-wide Ponzi scheme, with growing pressure first on the balance sheets and subsequently on the real sector. Another looming challenge facing the economy is the pension funds crisis. While Iran is still in the midst of its demographic window of opportunity when the ratio of the working age population to elderly is high, some of the country’s largest pension funds are already becoming insolvent. As large cohorts of the population approach retirement age, the country’s pension time bomb not only will erode the economic well-being of vulnerable pensioners but also will leave no fiscal space for capital expenditure. In the absence of a prompt and determined policy response, these crises are likely to be compounded in an accelerating manner.
With an average inflation rate of 20% over the past three decades, the Central Bank of Iran has systematically failed to achieve its primary goal of price stability. Many reasons are behind the poor outcome of Iran's monetary policy, among which are the fiscal dominance and lack of proper monetary instruments at the CBI’s disposal. The government’s chronic fiscal deficit has been, directly or indirectly, financed through borrowing from the central bank (seigniorage) instead of issuance of government papers. The government has been unwilling (or unable) to collect tax from the bonyads (which are large quasi-private conglomerates), reduce energy subsidies, and borrow from the lenders in the market (from liquidity). Instead, by systematically filling the budget gap by increasing the money supply, the government and the CBI have implicitly been collecting a hidden regressive tax from all citizens. As such, it can be said that the CBI has acted as the bank of the government rather than the bank of the country.
In addition, the CBI has a limited set of instruments at its disposal for conducting effective monetary policy. This is primarily due to the lack of a developed financial sector in the country and the obligation of the central bank to operate based on the Islamic finance framework. The latter has given rise to another macroeconomic vulnerability: a stronger procyclical linkage between the financial and the real sectors.
Furthermore, the banking system in Iran is faced with multiple intertwined crises that have brought the country’s financial sector to the verge of a major collapse. In fact, it is now plausible that the consequences of previous irresponsible actions and economic misconduct, which have thus far been limited to low output growth, will morph into a full-fledged financial crisis that would, in turn, result in a significant loss of output and employment. The root cause of problems in the banking system in Iran has some elements from fiscal dominance, institutional weakness of the CBI, endemic corruption, and a general misconduct in the banking system itself. Trends in the financial soundness indicators demonstrate a marked deterioration of the banking sector's health in terms of accumulation of non-income-generating assets (non-performing loans (NPLs) and claims on government), build-up of debt to the central bank, decline in capital adequacy ratio (CAR) which represents banks' ability to absorb losses, and lower return on assets (ROA) which represents banks profitability.
Major structural and operational reforms are needed in order to restore the ability of the CBI to conduct effective monetary policy. First and foremost, the issue of chronic fiscal dominance needs to be addressed as sound public finance is a decisive prerequisite for monetary policy. One can infer from the historical monetary data presented earlier that high inflation—as long as it would not have seemed to provoke social unrest—has persistently been of little concern to both the legislative and executive branches of the Iranian government. In addition to much-needed fiscal reforms, Iran should embark on a number of fundamental reforms in the structure, governance, and operation of the central bank to avoid a similar catastrophic outcome from monetary policy in the future. These reforms can be broadly categorized into those that (a) target the objectives of the CBI, (b) improve the governance of the central bank, (c) create more effective tools for implementing monetary policy, and (d) enhance bank supervision.