Iran’s Large and Growing Financing Gap

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The Iranian economy is experiencing a severe bout of instability which, in terms of scope and depth, has no historical precedence since the end of the Iran-Iraq war three decades ago. Iran’s current economic crisis can be attributed to decades of poor governance whose ramifications are now exacerbated by pressure from new sanctions unilaterally imposed by the U.S.

For a prolonged period of time, the real per-capita GDP in Iran has stayed flat and inequality has been on the rise. Erosion of state legitimacy and social capital along with entrenchment of corruption, particularly in the form of powerful interest groups within the state, have gradually hampered the state capacity for embarking on economic reforms, even in the most obvious cases such as fuel subsidies. Also, natural resource reserves—which directly constitute about a quarter of the value added in the economy—were unsustainably extracted for decades without being replaced with durable assets to ensure income generation in the future. Moreover, the country’s catastrophic privatization process is coming to an end while it neither boosted productivity and innovation nor reduced the financial burden of many loss-making state-owned enterprises on the government. Instead of financing its expenditure by expanding the tax base, the government has filled the budget deficit by seigniorage, withdrawals from the National Development Funds, and directed lending from banks which, in essence, has turned into a massive Ponzi scheme.

Even though the vast majority of public debt in Iran is denominated in local currency (thus constantly reduced by the country’s high inflation), the stock of public debt (including non-securitized) in Iran has reached about 50% of the GDP [2]. Historical trends and future projections of Iran’s primary deficit and effective interest payments on public debt are shown in Figure 1. This figure also shows Iran’s other major deviations from the conditions associated with normal sustainable growth: banks’ financial health (increase capital adequacy ratio to 8% and reduce non-performing loans to 5% of gross loans), capital investments (increase net capital formation to 15% of GDP), and balance the country’s water use (increase food imports to the levels discussed in reference [3]). Using this simple framework, we estimate that the size of Iran's annual economic shortfalls (relative to its GDP) has increased from less than 15% in 2011 to over 30% in 2018, and it will likely reach 40% in the next few years. The results imply that Iran’s primary deficit, effective interest payments, and other major economic deviations in the coming years will hover around $130B per year (of which, about $35B to improve banks financial health is a one-off payment and will not be carried over to next year once paid).

It is under such dire situation that Iran’s economy is yet again subjected to sanctions by the U.S. In general, the main mechanisms by which sanctions affect Iran’s economy include (I) reducing oil revenue, (II) increasing fiscal deficit and inflation expectations, (III) increasing international transaction costs, (IV) disrupting industries by interrupting the supply of imported intermediate goods, and (V) changing household and firm expectations to lower expenditure and investment.

As the primary impact of sanctions, Iran’s annual oil exports—which amounted to $50-60B—have slumped to approximately $10B in recent months. This development is not only causing intolerable fiscal pressure but also pushing the balance of payment into deeper negative values. If the current sanctions remain in place with no significant changes, the foreign reserves of the country, which has already been in decline since 2015, will likely shrink to about half its current size by 2021 (Figure 1). The recent paradigm shift in the global oil market from scarcity to abundance [1] has made the global economy less vulnerable to disruptions occurring for a medium-sized producer such as Iran.

The past two decades in Iran has been a period of economic stagnation, environmental degradation, and political decay. The period resembles the Brezhnev stagnation era when the much-needed reforms to fix an unworkable economy were postponed until it became too late. The scope and sequencing of future inevitable reforms in Iran’s should be carefully planned as otherwise they may prove to be destabilizing.

1 Compound annual growth rate between 2011 and 2021 would be equal to -7% 2 sum of gross foreign reserves of the Central Bank, NDFI, and commercial banks 3 estimated based on monthly data from reference [5] 4 method adapted from IMF Public Debt Sustainability Analysis framework [6] 5 projected values are based on estimates for inflation 6 residual values (2011-2016) were calculated by considering primary deficit and automatic debt dynamics obtained in this work and changes in gross public debt as reported in references [2, 7] 7 capital needed to raise banks’ capital adequacy ratio to 8% and reduce NPLs to 5% of gross loans. 8 calculated as the gap between the actual net capital formation and a healthy level equal to 15% of GDP (as observed a decade earlier).

References

1. S. Dale, B. Fattouh, Peak oil demand and long-run oil prices, BP, 2018.
2. Iran 2018 Article IV Consultation, International Monetary Fund, 2018.
3. M. Mesgaran, P. Azadi, A National Adaptation Plan for Water Scarcity in Iran, Stanford Iran 2040 Project, Working Paper 6, August 2018.
4. Economic Time Series Data, The Central Bank of Iran.
5. OPEC Monthly Oil Market Report, September 2019.
6. Staff Guidance Note For Public Debt Sustainability Analysis in Market-Access Countries, IMF, 2013.
7. Evaluation of Public Debt Sustainability of Iran in the Medium-term, Majlis Research Center, 2016.