The World Bank IRAN ECONOMIC MONITOR SEIZING THE OPPORTUNITY March 2016 Global Practice for Macroeconomics & Fiscal Management MIDDLE EAST AND NORTH AFRICA REGION IRAN economic monitor | seizing the opportunity Preface The Iran Economic Monitor provides an update publications, please contact Nada Abou Rizk on key economic developments and policies over (nabourizk@worldbank.org). For questions and the past six months. It examines these economic comments on the content of this publication, please developments and policies in a longer-term and contact Shahrzad Mobasher Fard (smobasherfard@ global context, and assesses their implications for the worldbank.org) or Eric Le Borgne (eleborgne@ outlook for the country. Its coverage ranges from the worldbank.org). Questions from the media can be macro-economy to financial markets to indicators of addressed to Mona Ziade (mziade@worldbank.org). human welfare and development. It is intended for a wide audience, including policy makers, business Cover Photo: Shah Emam Mosque – Isfahan / leaders, financial market participants, and the Mohammad Reza Domiri Ganji / gravity.ir. community of analysts and professionals engaged in Iran. The Iran Economic Monitor is a product of the World Bank’s Global Practice for Macroeconomics & Fiscal Management team. It was prepared by Eric Le Borgne (Lead Economist), Abdoulaye Sy (Senior Economist), Shahrzad Mobasher Fard (Economist), and Samer Matta (Economic Analyst) under the general guidance of Auguste Tano Kouame (Global Practice Manager). The Special Focus on the banking system was prepared by Michael Edwards (Lead Financial Specialist), and the one on the oil and gas sector by Hossein Razavi (Consultant). Zeina El Khalil (Communications Officer) print-produced the report. The findings, interpretations, and conclusions expressed in this Monitor are those of World Bank staff and do not necessarily reflect the views of the Executive Board of The World Bank or the governments they represent. For information about the World Bank and its activities in Iran, including e-copies of this publication, please visit http://www.worldbank.org/ en/country/iran To be included on the email distribution list of the Iran Economic Monitor series and related Preface | 1 The World Bank IRAN economic monitor | seizing the opportunity Table of Contents Preface......................................................................................................................................................... 1 EXECUTIVE SUMMARY................................................................................................................................ 6 Recent Economic and Policy Developments............................................................................ 8 Recent Economic and Policy Developments................................................................................................. 8 Output and Demand........................................................................................................................................ 8 Labor and Employment.................................................................................................................................. 12 Public Finances.............................................................................................................................................. 14 Monetary Policy and the Financial Sector....................................................................................................... 17 External Position............................................................................................................................................ 20 Economic Outlook and Risks....................................................................................................................... 21 Economic Outlook......................................................................................................................................... 22 Risks to the Outlook...................................................................................................................................... 27 Special Focus 1: Prospects for Iran’s Oil and Gas Export Revenues.......................... 28 Introduction................................................................................................................................................... 28 Prospects for Increasing Oil Export Revenues................................................................................................ 30 Prospects for Increasing Gas Export Revenues............................................................................................... 34 Selected Policy Issues.................................................................................................................................... 38 Special Focus 2: Iran’s Financial Sector at the Dawn of the Lifting of Sanctions................................................................................................................................................ 41 Structure and recent developments in the banking and financial sector.................................................. 41 The banking sector......................................................................................................................................... 41 Recent banking sector policy developments and key AML/CFT outstanding issues........................................ 45 Implications of the lifting of sanctions........................................................................................................ 46 Key areas of potential financial sector reform............................................................................................ 47 Annex 1 Iran’s Financial Infrastructure.................................................................................. 52 Annex 2 Capital markets and non-bank financial sector................................................ 53 Annex 3 Guide to International Financial Sector Related Standards..................... 55 Selected World Bank publications on Iran........................................................................... 56 List of Figures Figure 1. Iranian economy posted modest growth  following the 2014 economic recovery........................ 8 Figure 2. Sanctions relief and reforms by the new administrationhave improved trade........................... 10 Figure 3. ... and economic growth............................................................................................................ 10 Figure 4. ... and eased inflationary pressures............................................................................................ 10 Figure 5. Timeline of main political and economic events........................................................................ 11 Figure 6. Real GDP growth was Driven by net exports............................................................................. 11 Figure 7. Real GDP growth on the production side was broad-based....................................................... 11 Figure 8. Turkey’s imports of mineral fuel and oil products, crude oil and unclassified products from Iran... 12 Figure 9. Labor market performance remains feebledespite stronger economic growth.......................... 13 Figure 10. Unemployment rate by a  ge group and educational attainment, 2011........................................ 13 Figure 11. Severance payment by worker’s tenure i n Iran and in Malaysia, 2015....................................... 13 Figure 12. Budget balance has remained relatively balanced  in recent years.............................................. 14 Figure 13. The structural non-oil balance has improved as of late of 2006................................................. 14 Figure 14. Share of VAT revenue relative to GDP  in Iran remains low........................................................ 15 Figure 15. Iran VAT collection efficiency remains low relative to  comparative countries............................ 15 Table of Contents | 3 The World Bank Figure 16. Cost of cash subsidy program relative to GDP is declining........................................................ 15 Figure 17. Debt-to-GDP ratio and external Debt-to-GDP are very modest................................................. 15 Figure 18. Iran: current flow of funds of oil and gas revenues (as of March 2016)..................................... 16 Figure 19. The Iranian Rial depreciated slightly in 2014 but the gap between the official and parallel rates has narrowed................................................................................................................................................. 19 Figure 20. Monetary policy is significantly tighter since July 2014.............................................................. 19 Figure 21. The intensification of sanctions led to a large depreciation of the Rial and high inflation........... 19 Figure 22. Tighter monetary policy contributed to reigning in inflation...................................................... 19 Figure 23. Procedures for exporting and importing in Iran are lengthy....................................................... 20 Figure 24. Cost of exporting and importing goods in Iran is high............................................................... 20 Figure 25. Equity prices have stabilized in 2014  as monetary policy tightened........................................... 21 Figure 26. The current account surplus has declined in recent years.......................................................... 21 Figure 27. Oil exports and GDP.................................................................................................................. 23 Figure 28. Energy consumption in 2014 (MTOE)........................................................................................ 29 Figure 29. Energy intensity using purchasing power parity for Iran and comparable countries................... 29 Figure 30. Oil Reserves for Iran and comparable countries 2015............................................................... 31 Figure 31. Iran’s oil production, consumption and export.......................................................................... 31 Figure 32. Evolution of Iran’s export revenue............................................................................................. 34 Figure 33. Evolution of Iran’s export revenue............................................................................................. 34 Figure 34. Natural gas reserves in Iran and comparable countries.............................................................. 35 Figure 35. Iran’s oil and gas consumption.................................................................................................. 35 Figure 36. Gas export projection for 2016-2020......................................................................................... 37 Figure 37. Gas export revenue for 2016-2020............................................................................................ 37 Figure 38. Iran: bank credit growth............................................................................................................ 42 Figure 39. Share of economic sectors in facilities extended by banking sector (2013/14, percentage out of 2,362 trillion Rials)......................................................................................................................................... 43 Figure 40. Regulatory capital to risk-weighted assets (CAR) for Iran and comparator countries................. 43 Figure 41. Return on equity for banks for Iran and comparator countries................................................... 44 Figure 42. Return on assets for banks for Iran and comparator countries................................................... 44 List of Tables Table 1. Islamic republic of Iran: Select macroeconomic and financial indicators (2012-15)..................... 9 Table 2. Infrastructure ranking in Iran and in comparator countries (ranking among 144 economies unless indicated otherwise)............................................................................................................................ 20 Table 3. Global growth rate (%)............................................................................................................... 22 Table 4. Coefficient estimates of the VECM............................................................................................ 23 Table 5. Islamic Republic of Iran: Selected Economic Indicators (2012-2018)......................................... 25 Table 6. Details of the 2016 budget (thousands of billions of Rials)........................................................ 26 Table 7. Medium-term prospects for Iran’s oil production and export revenues..................................... 33 Table 8. Medium-term prospects for Iran’s gas export revenues............................................................. 37 List of Boxes Box 1. Macroeconomic impact of the partial lifting of sanctions under the JPOA in 2013.................... 10 Box 2. How precise and reliable are official GDP estimates?................................................................ 12 Box 3. Youth unemployment in Iran..................................................................................................... 13 Box 4. Oil wealth in Iran: allocation and savings management............................................................. 16 4 | Table of Contents IRAN economic monitor | seizing the opportunity Box 5. The 2015 budget........................................................................................................................ 17 Box 6. Trading across borders and infrastructure quality...................................................................... 20 Box 7. Global economic outlook........................................................................................................... 22 Box 8. Estimating the impact of oil and gas exports on growth............................................................. 23 Box 9. The sixth five-year plan directive................................................................................................ 24 Box 10. The 2016 central government budget........................................................................................ 26 Box 11. Status of natural gas export pipeline schemes........................................................................... 36 Box 12. Management of the oil and gas sector in Iran............................................................................ 38 List of Maps Map 1. Iran’s oil and gas fields.............................................................................................................. 31 List of Key Abbreviations Used bps Basis points H1, H2: First half of the year, second half of the year. 3mma: Three-months moving average pp Percentage points Q1 (Q2, Q3, Q4): First (second, third, fourth) quarter of the year qoq: Quarter-on-quarter sa: Seasonally adjusted saar: Seasonally adjusted, annual rate yoy: Year-on-year lhs, rhs: Left hand side, right hand side (for axis of figures) Table of Contents | 5 The World Bank EXECUTIVE SUMMARY I. Following the partial lifting of nuclear-related are projected to gradually abate but a slower than sanctions in November 2013 under the interim Joint expected pace would present downside risk to our Plan of Action (JPOA), Iran’s economy rebounded forecast. in 20141 and is estimated to have expanded by 0.5 percent in 2015. A less accommodative monetary III. While Iran has one of the most diversified policy stance reduced inflationary pressures, with economy among OPEC producers, its economy the Consumer Price Index falling to 8.9 percent in remains highly dependent on oil and gas. In our February 2016, from a peak of 45.1 percent in June first Special Focus, we assess short and medium- 2013. Notwithstanding this positive development, term prospects for the growth of Iran’s oil and gas the pace of job creation has remained weak and the export revenues in a post-sanction environment. unemployment rate rose to 11.7 percent in 2015, These critically depend on two variables: the speed up from 10.6 percent in 2014. The fiscal balance at which investments are mobilized to rehabilitate, of the central government also deteriorated, mostly expand and develop various oil and gas fields; and due to low oil prices, from a deficit of 1.2 percent the price of oil. To take account of this uncertainty of GDP in 2014 to a deficit of 2.7 percent of GDP three scenarios for the growth of oil and gas export in 2015. Similarly, the current account surplus is revenues (baseline, upper limit, and lower limit). In estimated to have shrank from 3.8 percent of GDP a baseline scenario, exports of oil and oil products in 2014 to 0.6 percent of GDP in 2015 due to falling could increase from 1.27 million barrels per day oil receipts. (mbpd) in 2014, to 2.32 mbpd by 2017 and 2.53 mbpd by 2020 equivalent to additional revenues of II. The implementation of the JCPOA on US$3.5 billion by 2017 and US$19 billion by 2020. January 16, 2016 is expected to help lift Iran’s real For gas, exports could increase from 4 billion cubic GDP growth rate to 4.2 percent and 4.6 percent in meters (bcm) in 2014, to 10.3 bcm in 2017 and 2016 and 2017, respectively. Key growth benefits 27.1 bcm by 2020 equivalent to additional revenues include increased oil exports, the resumption of of US$0.75 billion in 2017 and US$6.51 billion by access to the SWIFT by the Central Bank of Iran 2020. Achieving these export revenue, however, and Iranian financial institutions, the provision of require reforms to: (i) improve the attractiveness to insurance and reinsurance, the financial support International Oil Companies of Iran’s oil contract; for trade with Iran, and commitments for grants, (ii) raise the efficiency of natural gas transmission, financial assistance and concessional loans to the distribution and consumption; (iii) reduce gas Government of Iran. To further boost and sustain flaring and venting; and (iv) strengthen oil wealth high and inclusive growth rates, wide ranging management. and longstanding structural reforms are required. Significant residual country risk remains—such as IV. Iran’s financial sector is critical to propel the possibility that sanctions are reinstated or the Iran’s economy towards the high, sustained and extension of non-nuclear related sanctions; these inclusive growth targeted in the country’s draft sixth five-year development plan.2 The sector, 1  All references herein designate the Iranian calendar, which runs from March 21 to March 20 of the following year. There 2  The sixth five-year development plan is yet to be approved. is therefore a difference of a quarter between the Iranian and The fifth five-year development plan has been extended by a Gregorian calendar years. year to ensure continuity of Iran’s developmental agenda. 6 | Executive Summary IRAN economic monitor | seizing the opportunity however, has been battered by the disruptive impact of the sanctions but also by longstanding distortive policies including directed lending schemes and effective interest rate ceilings amid high inflation. Our second Special Focus reviews the structure of Iran’s banking and financial sector, the implications of the lifting of the sanctions, and outlines key structural reforms areas. While the lifting of the sanctions will provide much needed breathing space to the financial sector, in and by themselves, they can only deliver moderate gains in terms of growth and jobs; only when coupled with essential structural reforms can Iran be expected to reach the growth target of its sixth five- year plan. Structural reforms include improving the independence and effectiveness of the CBI to fulfill its monetary policy, and banking regulatory and supervisory mandates. Executive Summary | 7 The World Bank Recent Economic Developments and Outlook Real GDP Growth (%) Recent Economic 12% 10% and Policy 8% 6% 4% Developments Y/Y Chg. 2% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -2% Following the partial lifting of nuclear-related -4% sanctions in November 2013 under the interim Joint -6% Real GDP at Basic Prices Non-oil Real GDP at Basic Prices Plan of Action (JPOA), Iran’s economy rebounded -8% Note: Iranian calendar years, running from March 21st to March 20 of the following year. in 2014. While the signing and the implementation of the Joint Comprehensive Plan of Action (JCPOA) FIGURE 1. Iranian economy posted modest growth  following the 2014 economic recovery. during the 2015 Iranian calendar year significantly Source: Iranian authorities. raised the economic prospects of the country, the uncertainty regarding the lifting of the sanctions and the viability of the accord resulted in growth advancing President Rouhani’s administration came to power in at an estimated pace of 0.5 percent in 2015. A less July 2013 with a mandate to boost economic growth, accommodative monetary policy stance reduced focused, inter alia, on normalizing Iran’s economic inflationary pressures, with the Consumer Price Index relations with the rest of the world. This resulted in the falling to 8.9 percent in February 2016, from a peak partial lifting of the sanctions under the interim JPOA of 45.1 percent in June 2013. Notwithstanding this in November 2013.3 This, along with improvements positive development, the pace of job creation has to business and consumer confidence, provided a remained weak and the unemployment rate rose temporary boost to the economy, with real GDP to 11.7 percent in 2015, up from 10.6 percent in expanding by 3 percent in 2014, albeit from a low 2014. The fiscal balance of the central government base (contractions of 6.8 percent and 1.9 percent in also deteriorated, mostly due to low oil prices, from 2012 and 2013, respectively—Figure 1 and Table 1). a deficit of 1.2 percent of GDP in 2014 to a deficit of See Box 1 for more details on the economic impact 2.7 percent of GDP in 2015. Similarly, Iran’s current account surplus is estimated to have shrunk from 3.8 percent of GDP in 2014 to 0.6 percent of GDP in 2015 due to the fall in oil exports. 3  The economic recovery came as a result of the partial lifting of sanctions under the interim Joint Plan of Action (JPOA) signed between Iran and the P5+1 (i.e., China, France, Germany, Russia, the United Kingdom and the United States) in November 2013, and the related rise in consumer and business confidence. Under Output and Demand the terms of the JPOA, Iran agreed to curb the development of its nuclear program while the international community enacted a temporary and partial easing of sanctions on the country. These sanctions relief included the partial removal of constraints 1. The state of international sanctions on on Iran’s oil exports, and the supply chain in key sectors of Iran have been the key underlying factor behind the economy—such as in the automobiles industry—and on fluctuations in economic growth in recent years. international and domestic banks’ international transactions, as well as partial access to Iran’s frozen assets held abroad. 8 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity Table 1. Islamic republic of Iran: Select macroeconomic and financial indicators (2012-15). 2012 2013 2014 2015 Real GDP growth, at factor cost -6.8 -1.9 3.0 0.5 Agriculture 3.7 4.7 3.8 3.0 Industry* -18.3 -4.7 4.9 3.9 Services 1.4 -0.8 1.7 -2.0 Real GDP growth, at constant market prices -6.6 -1.9 4.3 1.6 Private Consumption -0.7 -9.3 3.1 1.1 Government Consumption -7.2 1.6 2.7 -8.9 Gross Fixed Capital Investment -23.8 -6.9 3.5 -1.2 Exports, Goods and Services -20.5 0.0 12.0 6.3 Imports, Goods and Services -23.1 -18.7 -5.7 -15.4 Prices         Inflation (Consumer Price Index) 30.5 34.7 15.6 14.2 Current Account Balance (% of GDP) 4.0 6.0 3.8 0.6 Fiscal Balance (% of GDP) -0.6 -0.9 -1.2 -2.7 *Industry includes the oil and gas sector; Source: Government data and World Bank staff calculation. of the JPOA. The signing of the JCPOA4 on July 14, reached 1.4 million barrels per day (mbpd) in 2014 2015 and its subsequent implementation on January up from 1.1 mbpd in 2013. Asian countries (i.e., 16, 2016 lifted the economic prospects of the China, India, Japan and South Korea) absorbed much country. Key benefits include increased oil exports, of this increase with oil exports to these destinations the resumption of access to the SWIFT by the Central reaching 1.12 mbpd in 2014 (up 19.8 percent from Bank of Iran and Iranian financial institutions, the 2013 to 2014). The rise in consumer and business provision of insurance and reinsurance, the financial confidence led to an increase in consumption support for trade with Iran, and commitments for and investment spending, with investment in grants, financial assistance and concessional loans machinery and equipment rising by 8.7 percent to the Government of Iran. Uncertainty regarding compared to a contraction of 16.1 percent in 2013. the timing of the lifting of sanctions and the viability New manufacturing operating permits rose by of the JCPOA constituted a headwind to growth, 16.7 percent and the value of new manufacturing with growth fizzling to an estimated 0.5 percent in investments increased by 11.2 percent in 2014. 2015. See Figure 5 for a timeline of main political and economic events in Iran. 3. On the production side, economic growth was broad-based. The main contributors to growth 2. Growth was largely driven by exports while were the services sector (1.6 pp of GDP), followed consumption and investment remained tepid. On by industries and mining (1.4 pp), oil and gas (0.5 pp) the demand side, the main contributions to growth and agriculture (0.3 pp) (Figure 7). The production in 2014 were net exports (3.1 percentage points, index of large manufacturing establishments rose pp, of GDP), followed by private consumption (1.5 by 9.6 percent in 2014 with the most significant pp of GDP), investment (0.9 pp of GDP) and public increases being recorded by the automotive industry consumption (0.2 pp of GDP) (Figure 6). Oil exports (49.8 percent), machinery and equipment industry (10.8 percent) and basic metal industry (3.9 percent). 4  Under the terms of the JCPOA, Iran agreed to limit the development of its nuclear program in exchange for the lifting of all nuclear-related sanctions imposed by the United Nations 4. While Iran’s national accounts statistics Security Council, the European Union and the United States on provide relatively good estimates of Iran’s the country. Recent Economic Developments and Outlook | 9 The World Bank Box 1. Macroeconomic impact of the partial lifting of sanctions under the JPOA in 2013. In late 2013, the Iranian economy began benefitting from sound policymaking along with the partial lifting of sanctions through the JPOA. The new administration elected in July 2013 made improving the economy its key priority and implemented a number of initiatives including, most notably: (i) the tightening of fiscal and monetary policies leading to a marked decline in inflationary pressures on the economy; (ii) the setting of key lending rates in relation to the inflation rate, leading to positive real interest rates; (iii) the expansion in the availability of credit through the reduction of non-performing loans relative to total loans through the establishment of a committee within the Central Bank of Iran tasked with monitoring these loans and the adoption of legislation to impose penalties on defaulting borrowers; (iv) the reduction in credit risk through the establishment of a credit bureau; and (v) the signing of the JPOA between Iran and the P5+1 which allowed the partial lifting of sanctions on Iran and which offered prospects for the full lifting of sanctions on the economy. The economy recorded a modest improvement in the first quarter of 2014 following the lifting of sanctions and began accelerating in the second quarter. In the quarter following the partial sanctions relief under the JPOA (2013Q4, according to the Iranian calendar year), lower trade costs led to an increase in exports of 14 percent while imports grew by 4 percent year-on year (Figure 2). This momentum was, however, insufficient to pull the economy out of recession, thereby leading to a year-over- year contraction of 1.8 percent in the third quarter of 2013. This appears to have been driven by a moderate response of oil GDP growth to the lifting of sanctions and a slow response of non-oil GDP (Figure 3). In each of the first two quarters of 2014—i.e., the two quarters following the partial lifting of sanctions—the economy expanded by 3.8 percent year-over-year supported by an increase in oil value-added by 7.3 percent and 10.4 percent year-over-year in the first and second quarter of 2014, respectively, while the non-oil segment of the economy rose by 3.4 percent and 3.2 percent year-over-year in the first and second quarter of 2014, respectively. Inflation eased as the Central Bank of Iran adopted a less accommodative monetary policy stance and as supply constraints abated. CPI inflation dropped to 24 percent y-o-y in 2013Q4—i.e., the quarter following the lifting of sanctions—from 33 percent in the previous quarter (Figure 4). This came as the central bank reduced the growth of the monetary base. The lifting of sanctions also reinforced the slowdown in the depreciation of the exchange rate (as the new government strived to improve macroeconomic conditions following the presidential elections in 2013Q2). The gap between the official and the parallel exchange rate has also narrowed (see Monetary and Financial Sector Section). Trade in Goods Balance 30% 5% Election of new Sanctions relief government 4% 20% 3% 10% 2% 1% 0% Y/Y Change Y/Y Change 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 0% -10% -1% -20% -2% -3% -30% Import -4% Exports -40% GDP at Factor Cost (rhs) -5% FIGURE 2. sanctions relief and reforms by the new administrationhave improved trade. Source: Iranian authorities and WB staff calculations. Oil and Non-oil GDP Growth Inflation 20% 5% 50% 40,000 Election of new Sanctions Relief Election of new Sanctions relief 45% government 15% government 4% 35,000 40% 10% 3% 30,000 35% 5% 2% 25,000 30% 0% 1% Y/Y Change IRR/USD 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 Y/Y Change Y/Y Change 25% 20,000 -5% 0% 20% 15,000 -10% -1% 15% -15% -2% 10,000 10% -20% -3% 5,000 5% -25% Oil GDP -4% Non-Oil GDP 0% 0 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 -30% GDP at Factor Cost (rhs) -5% Inflation Official Exchange Rate (rhs) Parallel Exchange Rate (rhs) FIGURE 3. ... and economic growth. FIGURE 4. ... and eased inflationary pressures. Source: Iranian authorities and WB staff calculations. Source: Iranian authorities and WB staff calculations. 10 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity FIGURE 5. Timeline of main political and economic events. economy, the intensification of sanctions may sanctions on Iran in recent years may have increased have raised the extent of unrecorded economic informal activities to evade sanctions and unrecorded activities. Existing estimates suggest that the share of economic activity may have risen as a result. However, unrecorded economic activity relative to GDP in Iran given the high level of statistical development in in the previous decade was significantly lower than Iran, the official estimates are believed to provide a the regional average (Box 2). The intensification of relatively precise understanding of Iran’s economy. Demand Side Contribution to Real GDP Growth Supply Side Contribution to Real GDP Growth 8% 10% 6% 8% 4% 6% Percentage point contribution to growth Percentage point contribution to growth 4% 2% 2% 0% 2009 2010 2011 2012 2013 2014 0% 2009 2010 2011 2012 2013 2014 -2% -2% Private Consumption -4% -4% Investment -6% Statistical Discrepancy -6% Public Consumption -8% Net Indirect Taxes Services -8% Net Exports Industries and Mines Oil and Gas -10% -10% GDP at Market Prices Agriculture GDP at Factor Cost -12% FIGURE 7. Real GDP growth on the production side was FIGURE 6. Real GDP growth was driven by net exports. broad-based. Source: Iranian authorities and WB staff calculations. Source: Iranian authorities and WB staff calculations. Recent Economic Developments and Outlook | 11 The World Bank Box 2. How precise and reliable are official GDP estimates? Existing estimates suggest that Iran’s unrecorded GDP in the early and mid-2000s was lower than the regional average. Taiebnia and Mohammadi (2008) estimate the size of the underground economy in Iran to be close to 20 percent of GDP. Schneider (2005) estimates the level of unrecorded GDP for a sample of 110 countries.* He finds that in 2000, unrecorded GDP in Iran was 18.9 percent of official GDP, compared to 19.4 percent of GDP in Jordan, 32.1 percent Turkey, 35.1 percent of GDP in Egypt and 36.4 percent of GDP in Morocco.** More recently, Schneider, Buehn and Montenegro (2010) find that the size of the shadow economy in Iran was equivalent to 17.4 percent of GDP in 2006, compared to 17.7 percent of GDP in Jordan, 29.5 percent of GDP in Turkey, 32.8 percent of GDP in Egypt and 34.8 percent of GDP in Morocco. The extent of misreporting of economic activities may have increased in recent years as a result of the intensification of sanctions imposed on Iran. A deterioration in the exhaustiveness and quality of trade reporting, for instance, will undermine the accuracy of official GDP measurement. This has arguably been the case of imports from Iran. To illustrate, starting in 2012, 12.7 percent of reported world imports from Iran have no assigned commodity classification, compared to only 0.04 percent and 0.01 percent of goods in 2010 and 2011, respectively (Figure 8). As such, the value of goods traded may have also been misreported. Mirror trade data, however, indicate the reporting of 95 percent of these transactions by Turkey and much of the remainder by Afghanistan. Given that both of these countries share common borders with Iran, these products could be re-exported to other countries. These transactions appear at about the time that oil and other mineral fuel imports drop sharply. 12,000 Turkey's Oil-related Imports From Iran 10,000 8,000 USD, Millions 6,000 4,000 2,000 0 2008 2009 2010 2011 2012 2013 2014 Mineral fuels and oil products Crude oil Non-classified products Note: The following HS classifications were relied on: mineral fuel and oil products: . non-classified products:99. 27; crude oil: 2709; and FIGURE 8. Turkey’s imports of mineral fuel and oil products, crude oil and unclassified products from Iran. Source: World Integrated Trade Solution. *Schneider (2005) uses the DYMIMIC (Dynamic Multiple-Indicators Multiple-Causes) model which considers multiple causes and multiple indicators of the phenomenon to be measured and uses a factor-analytic approach to measure the hidden economy as an unobserved variable over time. **For methodologies to adjust GDP for unrecorded activities see for example Bloem and Shrestha (2000). percent in 2013 (Figure 9) and was again marked Labor and Employment by stark gender differences: women at 19.7 percent against 8.8 percent for men. Significant differences 5. Iran’s labor market remains weak, with also arise along the age dimension with the youth low participation rate and high unemployment particularly affected (between the ages of 15 and despite the improved economy. The labor force 29, the unemployment rate reaches 21.9 percent for participation rate, already at a low level, declined men and 40.1 percent for women) and in urban areas further in 2014, to 37.2 percent, down from (11.6 percent in urban areas against 7.9 percent in 37.6 percent in 2013. This average participation rural areas). The incidence of underemployment6 rate masks sharp gender differences with men’s has also become more prevalent, with an estimated participation rate at 62.5 percent while women score 9.6 percent of workers being underemployed (10.5 a low 12.0 percent.5 The unemployment rate also worsened in 2014, to 10.6 percent, up from 10.4 6  The Statistical Center of Iran defines underemployment as the situation in which labor market participants are involuntarily 5  The labor force in Iran is the population 10 years of age or performing less than 44 hours of work during the reference above. week. 12 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity Iran Labor Market Dynamics percent for men and 4.2 percent for women) in 2014, 38.5 14.0 up from 8.9 percent in 2012 (9.8 percent for men 13.5 38.0 13.0 and 4.3 percent for women). Underemployment is 12.5 largely concentrated among the youth population 37.5 and in rural areas (12.9 percent in rural areas against Percent (%) Percent (%) 12.0 37.0 11.5 8.2 percent in urban areas). 11.0 36.5 10.5 6. Stimulating private sector growth and job 36.0 2010 2011 2012 2013 2014 10.0 creation is a mounting challenge in light of the Labor Force Participation Rate* Unemployment Rate* (rhs) large growing number of working age citizens. *Population 10 years of age and over. Iran’s demographic profile is characterized by a FIGURE 9. Labor market performance remains feeble disproportionately high youth population (with despite stronger economic growth. over 60 percent of Iran’s population of 78.5 million Source: Iranian authorities. individuals estimated to be under the age of 30 Box 3. Youth unemployment in Iran. According to the 2011 Census, unemployment is much more prevalent among the more educated youth population in Iran. For young men, unemployment was particularly high among university graduates (35 percent), youth with graduate studies (30 percent) and high school graduates (29 percent), and less prominent among youth with some college education (26 percent). For young women, the unemployment rate remained high across all levels of educational attainment (Figure 10). New entrants to the labor market faced difficulties landing their first job and remained unemployed for a lengthy period of time due to weak economic growth and rigid labor market policies. Egel and Salehi-Isfahani (2010) find that youth who did not find a job immediately after graduation remained unemployed for a period of three years on average. This was largely explained by the weak pace of economic growth as well as rigid labor market conditions—most particularly related to severance payment—that tend to protect tenured workers. This is illustrated in Figure 11 which compares the severance payments to be paid to a redundant worker in Iran and Malaysia. In Malaysia, a firm would be required to pay the equivalent of two months of salary to dismiss a redundant worker with five years of tenure, while in Iran a firm would be required to pay the equivalent of a little over five months of salary (Figure 11). Furthermore, the gap between the two countries was found to increase with the length of tenure. Despite considerable gains in the educational attainment level in recent decades, the educational system is not providing youth with the skills needed to become employed and to be productive in their jobs. There is a dissociation between the knowledge and skills acquired by students in the educational system and the requirements of the labor market. Pedagogical methods emphasize memorization over the acquisition of problem solving skills that enhance productivity. As such, in spite of the high level of educational attainment reached by many Iranians today, the quality of the education received remains inadequate. Private sector employers are understandably reluctant to hire young graduate workers at the prevailing wages for their educational attainment level without obtaining additional information about their skills and potential productivity. Finally, students’ choice of field of study often does not take into consideration their likelihood of becoming employed, but rather target high paying jobs which also have high unemployment rates associated with them. 60% All age groups Youth Iran Malaysia 50 50% 45 43.3 40% 40 Number of Weeks of Salary 30% 35 30 20% 25 21.7 10% 20 16.7 0% 15 All Primary or less High school Some college Graduate School All Primary or less High school Some college Graduate School University University 10 8.3 4.3 5 1.7 0 Men Women 1 year 5 years 10 years FIGURE 10. Unemployment rate by a ge group and n FIGURE 11. Severance payment by worker’s tenure i educational attainment, 2011. Iran and in Malaysia, 2015. Source: Iranian authorities and WB staff calculations. Source: Iranian authorities and WB staff calculations. Recent Economic Developments and Outlook | 13 The World Bank Budget Balance (% of GDP) Structural Non-oil Balance 20 2 15 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 0 10 -2 -4 5 Percent of GDP (%) -6 Percent of GDP (%) 0 -8 2012 2013 2014 2015 -10 -5 -12 -10 -14 -15 -16 -18 -20 Capital Expenditures Current Expenditures Other Revenues Oil Revenues Tax Revenues Budget Balance -20 Overall Balance, Excluding Grants and Other Revenue and One-off Operations Structural Non-oil Balance FIGURE 12. Budget balance has remained relatively FIGURE 13. The structural non-oil balance has improved n recent years. balanced i as of late of 2006. Source: Iranian authorities and WB estimates.. Source: Iranian authorities and WB indicators.. in 2014). In addition, the low female labor force 2014. Transfers through the Cash Subsidy Program participation mentioned above is increasingly at declined to 3.8 percent of GDP in 2014, from 4.5 odds with the large share of women educated at percent of GDP in 2013, with the entitlement of the tertiary level (where gender parity has been 2.943 million individuals being eliminated based achieved). The government estimates that 8.5 on proxy means measures and the benefit being million jobs should be created in the following two unindexed to inflation (Figure 16). The financial years to reduce the unemployment rate to 7 percent shortfall of the Targeted Subsidy Organization stood by 2016. Tackling youth unemployment in particular at 1 percent of GDP bringing the expanded deficit to is a pressing policy issue (Box 3). 2.2 percent of GDP. 8. Taking a medium-term perspective, Iran’s structural non-oil deficit has shrank significantly over the past decade as non-oil tax revenues rose, Public Finances but remains elevated (Figure 13). Since bottoming out at an estimated deficit of 17.7 percent of GDP in 7. Falling oil revenue are estimated to have 2006, the structural non-oil balance has since been led to a widening of the central government fiscal reduced to 8.9 percent of GDP in 2014. deficit in 2015. The fiscal deficit is estimated to have reached 2.7 percent of GDP in 2015, up from 9. While the government has made strides in a deficit of 1.2 percent of GDP in 2014 (Figure 12). raising the VAT rate to bring it more in line with the Government revenue is estimated to have declined rates prevailing in other oil producing countries, its to 12.9 percent of GDP in 2015, down from 14.6 collection and efficiency could be improved (Box percent of GDP in 2014, in line with the fall in oil 5). The VAT is a key element of the government’s revenue to 3.9 percent of GDP in 2015, down from efforts to raise and improve revenue from the non- 5.7 percent of GDP in 2014, due to plummeting oil oil economy. The VAT rate has been progressively prices. Non-oil government revenue is estimated to raised from 3 percent in 2009 to 6 percent in 2013 have remained relatively unchanged at 9.0 percent and further to 8 percent in 2014. VAT revenue stood of GDP in 2015, compared to 8.9 percent of GDP at 1.5 percent of GDP in 2014 which is low compared in 2014. This was supported by the VAT rate to other oil-producing countries which, excluding increase from 8 percent to 9 percent in March 2015. Nigeria, recorded VAT revenue ranging from 5.1 Meanwhile, government expenditure is estimated percent of GDP in Botswana to 10.7 percent of GDP to have tightened slightly to 15.6 percent of GDP in Norway in 2012, the latest year for which data in 2015, compared to 15.8 percent of GDP in are available (Figure 14). The efficiency of the VAT 14 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity 12% Share of VAT Revenue Relative to GDP Cash Subsidy Relative to GDP 10.7% 10.3% 10% 9.6% 9.7% 9.9% 78 7% 77 6% 8% 76 Percent of GDP 6.4% 5% 75 6% 5.3% 5.7% 5.1% 74 4% 4% 73 3% 72 2% 1.5% 2% 0.8% 71 0.1% 0% 1% 70 Kyrgyz Republic South Africa Iran (20112) Iran (2014) Azerbaijan Federation Botswana Mongolia Australia Norway Nigeria Chile Russian 69 0% 2011 2012 2013 2014 Number of Beneficiaries of the Cash Subsidy Program (Millions of Individuals) (LHS) Amount Disbursed Through the Cash Subsidy Program as a Share of GDP (RHS) n Iran FIGURE 14. Share of VAT revenue relative to GDP i FIGURE 16. Cost of cash subsidy program relative to GDP remains low. is declining. Source: Iranian authorities and World Development Indicators. Source: Iranian authorities VAT Collection (%) Debt-to-GDP Ratio 70 25 60 60 50 20 50 40 40 15 Percent (%) Percent (%) Percent (%) 30 30 10 20 20 5 10 10 0 Jordan Morocco Lebanon Tunisia Iran Egypt Algeria 0 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 *Calculated as VAT revenue divided by the product of VAT rates and private consumption Debt-to-GDP Ratio (%) (LHS) External Debt to Total Debt (%) (RHS) FIGURE 15. Iran VAT collection efficiency remains low FIGURE 17. Debt-to-GDP ratio and external Debt-to-GDP  omparative countries. relative to c are very modest. Source: IMF, Fair Taxation in the Middle East and North Afric. Source: Iranian authorities – defined as the ratio between VAT revenues and a and of the desire to reduce reliance on oil and gas measure of potential revenues equal to the product revenues to finance the deficit, the government between consumption and the VAT rate7 – which is considering debt issuance. Three strategies are stood at 37.4 percent in 2014 (Figure 15) is also currently under consideration: (i) the issuance of relatively low compared to other MENA countries bonds denominated in Iranian rials with guaranteed indicating significant scope for broadening the base return at a suitably high coupon rate, over and above and strengthening the administration of the VAT. that which would be offered from a B/B+ rated sovereign; (ii) the issuance of bonds denominated 10. Given the country’s high capital in Iranian rials with the option of being redeemed requirements and lack of a sovereign debt credit in Iranian rials as well as in any major currency rating over the past few years, the government has (i.e., Euros, Japanese yen, British Sterling and Swiss been considering a number of strategies for debt Francs) at the prevailing spot rate of the day the buyer issuance to support investor appetite. Iran’s debt decides to redeem the paper; and (iii) the issuance is low with a debt-to-GDP ratio of 13.6 percent and a of several major international bonds. The domestic share of external debt to total debt of 5.3 percent in currency bonds could also be issued by the National 2014, (Figure 17). In light of this strong debt position Iranian Oil Company (NIOC) or the National Iranian Gas Company (NIGC), guaranteed by the sovereign. 7  In this definition consumption should be valued at VAT- exclusive prices. Recent Economic Developments and Outlook | 15 The World Bank Box 4. Oil wealth in Iran: allocation and savings management. Between 2011 and 2015, 63.5 percent of projected oil and gas revenue (in excess of the 14.5 percent retained by the National Iranian Oil Company, NIOC) were transferred to the budget, with the share mandated to decrease by 3 percentage points per year until 2015. The remaining revenues were dedicated to deprived and oil-producing regions (2 percent of projected revenue) and Iran’s oil wealth management funds, i.e., the Oil Stabilization Fund (OSF) and the National Development Fund (NDF). These two funds play different, but complementary roles of budget stabilization and national development, respectively. The Oil Stabilization Fund was established in 2000 under the third five-year development plan. The objective of the OSF was to serve as a budget stabilization mechanism to insulate the budget from fluctuations in oil revenues and to generate returns on the investment. Until the creation of the NDF, it also played the role of a domestic private sector development fund to support economic diversification. The OSF is legislated to receive all oil and gas export revenue in excess of the revenue projected in the annual budget law and the 14.5 percent revenues retained by the National Iranian Oil Company (NIOC). The OSF also maintains a stock of funds but the allocation of these funds across capital injections, the NDF and for budget financing remains currently unclear. As of early 2016, no assets are left in the OSF and the 2016 budget does not envisage a role for the fund any more. Oil and Gas Export Revenues 85.5 percent allocation 14.5 percent retained by the NIOC 53.5 percent of projected oil 30 percent of projected oil and 2 percent of and gas revenues, gas revenues in 2016, projected decreasing by 2 percentage increasing by 2 percentage National Iranian Oil Company (NIOC) oil and gas points per year under the 6th points per year under the 6th revenues five-year development plan five-year development plan Deprived and Oil- State Budget National producing Regions Development Fund Funds loaned to agent banks for development projects and investment Agent Banks FIGURE 18. Iran: aurrent flow of funds of oil and gas revenues (as of March 2016). Source: National authorities. The National Development Fund was established under the fifth five-year development plan to undertake the OSF’s role as a domestic development fund to promote exports, investments and FDI ventures, as well as to support greater intergenerational equity of natural resource wealth. The NDF had US$62 billion of assets under management in 2014. As of early 2016, the total value of assets under management is unclear, partly because a large share of these assets where lent to the domestic private sector (e.g., SMEs) during the sanctions period—as access to finance was difficult; these likely have become non-performing, for reasons similar to the large non-performing loan portfolio that Iran’s banking system is grappling with. In 2011, 20 percent of projected oil and gas export revenue was allocated to the NDF, with this share legislated to increase by 3 pp per year to reach 32 percent of projected oil and gas export revenue by the end of the fifth five-year development plan in 2015. This target was not reached, however, given the tightening of sanctions and drop in oil revenues starting in June 2014. For 2016 the proposed share of oil and gas revenues destined to the National Development Fund is 30 percent (see Figure 18). Funds may be withdrawn from the NDF to provide loans to private sector companies, cooperatives and economic enterprises owned by public non-governmental institutions. The NDF is currently held at the CBI. 11. With improved prospects for increasing reliance on oil revenues (draft 6th five-year plan8), oil and gas exports (Special Focus 1), designing the government is taking steps to combine the Oil and implementing a comprehensive oil wealth management framework is warranted.   With 8  The sixth five-year development plan is yet to be approved. continued commitment to reduce the budget’s The fifth five-year development plan has been extended by a year to ensure continuity of Iran’s developmental agenda. 16 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity Box 5. The 2015 budget. The 2015 Budget focused on strengthening domestic policies and developing a “resistance” plan to bolster the country’s resilience against external shocks. On the revenue front, measures aim to enhance tax compliance and broaden the tax base away from oil revenue, with the ultimate aim of reducing the share of oil revenue to total revenue from an average of 45 percent to 31.5 percent. This government objective is expected to be attained through a phased approach of increasing the share of oil and gas revenue destined to the National Development Fund. This should contribute toward improving the structural non-oil balance of the government which remains negative, with a deficit averaging over 9 percent of GDP in 2009-2014 (Figure 13). These measures would include a better targeting of large tax payers and other indirect taxes, such as on professional income and the taxation of capital gains in equity and real estate. Lower reliance on oil revenue would also be achieved through greater economic diversification. Much of the country’s ability to further diversify its economy will largely hinge on structural reforms to strengthen the business environment, in particular to improve the infrastructure system as well as the ease and cost of trading across borders, which remain weak relative to comparator countries (Box 6). The government is taking a number of steps to raise non-oil revenues. The VAT rate was increased from 8 percent to 9 percent (of which 3 percentage points go to local governments) in March 2015 to compensate for the revenue shortfall related to the collapse of oil prices in 2014, which brings it more in line with those seen in other resource-rich countries, which currently range from 10 percent in Australia to 25 percent in Norway (with the exception of Nigeria which has a VAT rate of 5 percent). Overall, on the revenue side, the 2015 government Budget projects an overall revenue increase of 18.1 percent driven by a rise in taxation revenue more than offsetting a decline in oil revenue and a 19.8 percent increase in other revenue components. On the expenditure side, the 2015 Budget projects total spending to rise by 6.8 percent as a result of a 26.8 percent increase in wages, a 33.7 percent increase in capital expenditure and a 7.5 percent decline in other components. Stabilization Fund (OSF) and National Development revenues to a savings and/or stabilization fund; Fund (NDF), and to clarify the rules for deposits and (iv) setting transparent rules for withdrawals from withdrawals from the NDF (Box 4). However, Iran the sovereign fund for economic stabilization; (v)  lacks a comprehensive framework for optimizing establishing clear guidelines for the management of oil wealth management within a long-term planning the sovereign wealth fund’s portfolio; and, critically, framework that brings together various dimensions (vi) having a robust governance regime in place. including oil production and sustainability of oil reserves, fiscal impact, impact on the economy and the balance of trade, government debt management, and savings through the National Development Fund. For example, the 2016 budget provides for Monetary Policy and the 53.5 percent of oil and gas export revenues to be allocated to the central government budget (see Financial Sector Box 4). Such a rule, if continued would impart a strong pro-cyclical bias to the budget, and to 12. The period of sanctions had major capital spending in particular as oil receipts are implications on Iran’s foreign exchange rate earmarked for such projects. Based on a diversity and on its inflation rate. Following a period of of cross country experiences,9 a good practice for relative exchange rate stability against the U.S. countries with strong hydrocarbon (and more dollar, between August 2011 and October 2012, generally non-renewable) wealth is have a long-term sanctions (including their expectations) led to the framework by: (i) devising an oil and gas production, widening of the official and bureau/parallel rates as consumption and export profile that ensures long- a result of speculative transactions in the foreign term sustainability of hydrocarbon reserves; (ii) exchange market (Figure 19). The annual inflation managing the injection of the export revenues to rate consequently advanced to a peak of 45.1 the current and capital budget in a manner that percent in June 2013. Inflationary pressures eased does not weaken the tradable sectors (avoiding a with the narrowing of the official and bureau/parallel Dutch disease); (iii) allocating a clear share of export rate gap through the establishment of the Center of 9  For a review of this literature see Van Der Ploeg (2011) “Natural Resources: Curse of Blessing,” Journal of Economic Literature, Vol. 49(2), pp. 366-420. Recent Economic Developments and Outlook | 17 The World Bank Foreign Exchange Transactions10 starting in October 14. The stronger monetary policy environment, 2012. The government induced a devaluation combined with the lifting of supply constraints of the Iranian rial (IRR) in July 2013, from 12,260 following the JPOA, have resulted in the easing IRR/USD to 24,738 IRR/USD, in order to close its of inflationary pressures on the economy. The financing gap which became more challenging with inflation rate declined from a year-on-year peak the intensification of international sanctions. A more of 45.1 percent during the Iranian calendar month conservative fiscal policies have enabled the Central ending in June 2013 to 8.9 percent in February 2016 Bank of Iran to run a tighter monetary policy with a (Figure 22). resulting decrease in inflation, down to 8.9 percent in February 2016, the Iranian rial has continued to 15. The design of a flexible inflation-targeting erode in value against the dollar, to 30,274 for the framework is currently under consideration official rate and 34,480 for the bureau rate, as of April by the CBI, with underlying exchange rate and 7, 2016. The gap between the official and the bureau broad money growth anchor targets. The current rate remains elevated, at around 13 percent, but this framework is based on an exchange rate anchor vis- nonetheless represents a marked improvement from à-vis a currency composition, with determinants the 187 percent observed in the second quarter of such as the difference between internal and global 2012. inflation, the internal demand for and supply of foreign exchange, and the exchange value of major 13. The monetary policy framework has foreign currencies against each other, particularly in significantly improved under the Rouhani the SDR portfolio, being relied upon according to administration. The Rouhani administration Article 81 of the Five-Year Development Plan. The adopted a more conservative fiscal policy which CBI is targeting a single-digit inflation by late March also resulted in a less accommodative monetary 2017 (this was last achieved in 1990). policy stance—the CBI does not independently set monetary policy and monetary policy has historically 16. The ratio of non-performing loans (NPLs) been under severe fiscal dominance. This included in the banking system has improved in recent setting clearer guidelines on the composition and years but the high level remain a concern (see the growth of the monetary base, and on directing Special Focus 2). Banks aggregate NPL ratio was lending facilities to productive economic activities, 14.4 percent in March, 2014 and is believed to be while ensuring that a balancing act is struck between higher for private banks, which hit a peak of 23 a less accommodative monetary policy stance and percent in 2010. This level of NPLs remain high economic growth. The CBI raised the policy lending compared to some peer countries; the ratio of NPL rate from 14 percent and 15 percent for loans with to gross loans are 1.2 percent for Saudi Arabia, 1.6 maturity below and above 2 years, respectively, in percent in Malaysia and 2.7 percent for Turkey. June 2014 to 21 percent in June 2015 (Figure 20). NPL net of provisions to capital are 7 percent for In 2014, the supply of liquidity advanced by 22.3 Malaysia and 3.8 percent for Turkey. The high NPLs percent and the monetary base expanded by 10.7 in Iran have arisen due to combination of factors, percent in 2014. This, along with more conservative including explicit or implicit directed lending, weak lending practices, the easing of international credit provision practices and risk management in sanctions on Iran—which led to a repatriation of the banking sector, the sharp recession that followed frozen assets abroad— and the greater stability in the sanctions in 2012 (including the devaluation of financial markets have contributed toward a greater the rial); some of these NPLs are with state-owned stability of the exchange rate (Figure 21). enterprises (SOEs). As some SOEs re-gain access to their assets that were frozen due to the nuclear- related sanctions, prospect for a regularization of 10  The official rate applies to basic necessities such as humanitarian goods while the bureau/parallel rate were a large amount of NPLs should result in a notable available for other transactions. The Center of Foreign Exchange improvement in recorded NPLs. On concern, Transactions manages the balance between the supply and however, is that Iranian bank provisioning practices demand for foreign exchange. 18 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity Iranian Rial’s Official and Parallel Rates Inflation and Exchange Rate 40,000 50 30,000 45 Inflation, percent y-o-y 35,000 Exchange rate, Rials per US dollars (rhs) 25,000 40 30,000 35 20,000 25,000 30 Percent (%) 20,000 IRR/USD IRR/USD 25 15,000 15,000 20 10,000 10,000 15 5,000 10 5,000 0 5 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1 2014Q1 2015Q1 0 0 Official Rate Parallel Rate 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1 2014Q1 FIGURE 19. The Iranian Rial depreciated slightly in 2014 FIGURE 21. The intensification of sanctions led to a large but the gap between the official and parallel rates has depreciation of the Rial and high inflation. narrowed. Source: Iranian authorities. Source: Iranian authorities. Lending Rate Inflation and Money Supply 25 50 Inflation, percent y-o-y M2 growth, percent y-o-y (right axis) 35 45 20 30 40 35 25 15 30 Percent (%) 20 Percent (%) Percent (%) 25 10 15 20 Average Lending Rate for Loans with Maturity Below 2 Years 15 10 5 Average Lending Rate for Loans with Maturity Above 2 Years 10 5 5 0 0 0 2009Q1 2009Q2 2009Q3 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2014Q3 2014Q4 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 Mar-11 May-11 Jul-11 Sep-11 Nov-11 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 FIGURE 20. Monetary policy is significantly tighter since FIGURE 22. Tighter monetary policy contributed to July 2014. reigning in inflation. Source: Iranian authorities. Source: Iranian authorities. for impaired assets are different from traditional 18. Thanks to the lifting of the sanctions, (non-Islamic) banks, which likely results in materially the Tehran Stock Exchange (TSE) index has lower provisions; this, in turn, likely overstates the outperformed global indices. While the partial (already low) reported capital levels. lifting of sanctions under the JPOA had little effect on the performance of the stock market, the JCPOA, 17. Bank profitability has sharply declined however, materially and positively impacted the relative to the pre-sanctions level (see Special stock market, with the index rising by 26.3 percent Focus 2). Compared to the pre-sanctions level, bank since Implementation Day on March 21, 2016. As profitability measures plunged in the post sanctions of end-2014, a total of 317 firms were listed on TSE era reaching 7.5 percent in 2013 compared to 14.5 and market capitalization is close to $100 billion percent in 2011. Similarly, return-on-assets (ROA), (see Special Focus 2). SME’s are listed on the OTC which was already low at 1 percent in 2011, had markets, which can trade stocks and participation halved by 2013 reflecting the impact of the economic bonds. TSE and OTC have together 500 firms listed slowdown in 2011-2013, the accumulation of NPLs, on the stock exchange. and weak management of bank assets. Recent Economic Developments and Outlook | 19 The World Bank Box 6. Trading across borders and infrastructure quality. Trading across Iranian borders remains cumbersome and costly according to the World Bank 2015 Doing Business assessment. In 2015, the number of days required to export goods from Iran was 25 days compared to 13 days and 19.4 days for Turkey and the MENA region, respectively. Importing goods into Iran took 37 days compared to 14 days and 23.8 days on average for Turkey and the MENA region, respectively. Furthermore, 11 documents were required to import goods into Iran compared to 8 documents for Turkey and the MENA region. The cost of exporting and importing goods to Iran were 36 percent higher than Turkey and 16 percent higher than the MENA region (Figures 23 and 24). Iran ranked 82nd on the quality of its overall infrastructure system, well behind comparator countries such as Turkey (33rd) and Malaysia (20th). Iran ranked relatively poorly on the quality of roads, port infrastructure, air transport infrastructure, available airline seat per km/week and mobile telephone subscriptions. In contrast, it ranked relatively well on the quality of railroad infrastructure, electricity supply and fixed telephone lines (Table 2). 40 Ease of Exporting and Importing in Iran Cost of Exporting and Importing in Iran 1,600 35 1,400 30 1,200 25 1,000 20 800 15 600 10 400 5 200 0 0 Documents to export (number) Time to export (days) Documents to import (number) Time to import (days) Cost to export (US$ per container) Cost to export (deflated US$ per container) Iran Turkey Middle East and North Africa Region Iran Turkey Middle East and North Africa Region FIGURE 23. Procedures for exporting and importing in FIGURE 24. Cost of exporting and importing goods in Iran are lengthy. Iran is high. Source: 2015 Doing Business, World Bank Source: 2015 Doing Business, World Bank Table 2. Infrastructure ranking in Iran and in comparator countries (ranking among 144 economies unless indicated otherwise). Iran Turkey Malaysia Quality of overall infrastructure 82 33 20 Quality of roads 63 40 19 Quality of railroad infrastructure 45 49 12 Quality of port infrastructure 80 57 19 Quality of air transport infrastructure 122 34 19 Available airline seat km/week, millions 56 17 22 Quality of electricity supply 61 72 39 Mobile telephone subscriptions/100 pop. 112 105 30 Fixed telephone lines/100 pop. 27 65 73 Source: The Global Competitiveness Report 2014-2015. which was only partially offset by lower imports External Position (Figure 26). Net exports declined from 3.5 percent of GDP in 2015 to 0.2 percent of GDP in 2015. The 19. Sinking oil prices have led to a further current account remains markedly lower than in the norrowing of Iran’s current account surplus in immediate pre-sanction year (i.e., a surplus of 10.2 2015. The current account surplus shrank from 3.8 percent of GDP in 2011), though this predominently percent of GDP in 2014, to 0.6 percent of GDP in reflects lower oil receipts which were twice their 2015. This came amid a decline in oil export values, current level on account of both higher oil prices and 20 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity Equity Prices Current Account Balance 100,000 160 12 90,000 140 10 80,000 120 70,000 8 60,000 100 6 USD, Billions % of GDP Index 50,000 80 4 40,000 60 30,000 2 40 20,000 20 0 10,000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 0 0 -2 Current Account Balance (RHS) Imports (LHS) Sep-05 Sep-06 Sep-07 Sep-08 Sep-10 Sep-09 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Nov-08 Nov-05 Nov-06 Nov-07 Nov-09 Nov-10 Nov-11 Nov-12 Nov-13 Nov-14 Nov-15 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 May-13 May-14 May-15 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-12 Jul-10 Jul-11 Jul-13 Jul-14 Jul-15 Exports (LHS) Energy Exports s FIGURE 25. Equity prices have stabilized in 2014 a FIGURE 26. The current account surplus has declined in monetary policy tightened. recent years. Source: Iranian authorities. Source: Iranian authorities. volumes. As detailed in the first Special Focus below, prospects for a rapid return to pre-crisis export Economic volumes are good. Years of sanctions, however, have eroded the export sector’s competitiveness, Outlook and especially in terms of infrastructure and trade policies (Box 6). Risks 20. Foreign exchange reserves were estimated at USD 117.5 billion in 2015, which was equivalent to 19.4 months of imports. The liquidity With nuclear-related international sanctions and currency composition of these reserves have, materially lifted following Implementation Day on however, been affected by difficulties in accessing the January 16 2016, Iran’s real GDP growth is forecast international payment system and making payments to accelerate from an estimated 0.5 percent in 2015 in convertible currencies due to the intensification to 4.2 percent and 4.6 percent in 2016 and 2017, of international sanctions in 2012. The high level of respectively. To further boost and sustain high and import coverage also reflects the sharp reduction in inclusive growth rates, wide ranging and longstanding imports that occurred during the sanctions. structural reforms are required. The electoral gains from moderates and reformists during the February 21. In recent years, Iran has largely been 2016 Parliamentary elections bode well for the ability unsuccessful in attracting foreign direct investment of the pro-reform administration to pass reforms given the high level of idisyncratic country risk highlighted in Iran’s sixth five-year plan (designed and, most notably, because of sanctions. Foreign by Supreme Leader Ayatollah Khamenei). Significant direct investment rose modestly to USD 3.14 billion residual country risk remains—such as the possibility in 2014, from USD 3.05 billion in 2013. Agreements that sanctions are reinstated or the extension of signed in the immediate post Implementation Day non-nuclear related sanctions; these are projected of January 16, 2017, however, point to a robust to gradually abate but a slower than expected pace increase in FDI in the months and years to come. would present downside risk to our forecast The extent to which these would materialize depend on whether and how quickly residual country risk can be abated. Finalization of a new oil contract aim to bring in the needed level of capital and expertise that some international oil operators have, could also result in a material increase in oil-related FDI. Recent Economic Developments and Outlook | 21 The World Bank Box 7. Global economic outlook. Global growth is projected to be tepid over the short- to medium-term, averaging 3.2 percent in 2016-2017 (Table 3). The upward growth trajectory is due to improvements in the United States and the Euro area which benefitted from lower oil prices. The American economy is expected to expand in the medium-term driven by an increase in private consumption. In particular, growth in the U.S. is projected to advance at an average rate of 2.6 percent in 2016-2017. In the Euro area, economic activity is also expected to accelerate on account of lower oil prices and a weakened Euro currency. Despite the Greek crisis, growth in the Euro area is projected to average 1.6 percent in 2016-2017. On the other hand, growth in China, a major importer of Iran’s oil, is expected to decelerate in the coming years from an estimated 7.4 percent in 2014 to a projected 7.1 percent and 7.0 percent in 2015 and 2016, respectively. Table 3. Global growth rate (%). 2010 2011 2012 2013 2014e 2015e 2016p 2017p World 4.1 2.8 2.4 2.5 2.6 2.8 3.3 3.2 High-income countries 3.0 1.6 1.4 1.4 1.8 2.0 2.4 2.2 Developing countries 7.4 6.1 4.9 5.1 4.6 4.4 5.2 5.4 MENA 3.8 1.0 1.3 0.5 2.2 2.2 3.7 3.8 Source: World Bank Global Economic Prospects (June 2012 and June 2015 and World Bank Iran team. e: expected; p: projected. some international banks to do so by end-2017. On Economic Outlook the latter, which will depend to some extent on the former, full access is expected during the second half 22. While growth is projected to accelerate of 2016. Changes to this timetable, especially if due to materially, a significant degree of uncertainty policy measures, could materially impact our growth nonetheless remain which, until resolved, will outlook. Our forecast also assume a continuation of continue to hold down economic activity. Our the relatively accommodative monetary stance in forecast assumes continued full implementation Iran and in the U.S., and of the modest international of the JCPOA. De jure, Iran received significant economic growth (Box 7). Oil prices are expected to benefits from the lifting of the sanctions on (or average USD37.0 and USD48.0 in 2016 and 2017, soon after) Implementation Day (January 16 2016), respectively.12 such as the unfreezing of its assets held abroad11 and the reconnection of many of its banks to the 23. While diversified, Iran’s economy SWIFT network. De facto, some of these benefits remains critically dependent on its hydrocarbon would take time to be fully realized; these include sector, with a 10 percent increase in oil exports the ability of the banking system to restore normal estimated to boost real GDP growth by 1.7 commercial banking activity with (non-U.S.) foreign percent. To quantity the impact on economic counterparts, and the effective access and means growth of oil exports, an econometric time series to move previously frozen assets, potentially back model was developed. More specifically, a Vector to Iran. On the former, we expect mid-tier regional Error Correction Model (VECM) which captures both banks to resume such activity by end-2016, with short run and long run relationships and dynamics between oil exports and total and non-oil real GDP 11  According to the Iranian authorities, of the USD 100-120 billion of frozen assets held abroad only USD 30-60 billion 12  Information on the latest World Bank commodities price are liquid. It is still unclear to what extent the assets will be forecast can be accessed at: http://pubdocs.worldbank.org/ used to: (i) strengthen the domestic currency market; (ii) pubdocs/publicdoc/2016/1/548631453821462743/CMO-Jan- support the provision of imported capital goods; (iii) allocate 2016-Historical-Forecasts.pdf. to internationally active funds; and (iv) invest in oil production, refineries and/or petrochemical plants. . 22 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity Box 8. Estimating the impact of oil and gas exports on growth. Choice of model and specification. We use the Vector Error Correction Model (VECM) methodology to estimate the impact of increased oil exports which could be expected from a lifting of sanctions on total GDP and non-oil GDP growth. Figure 27 illustrates that total real GDP and non-oil real GDP follow a similar pattern as oil exports (expressed in log terms), indicating the possible presence of long-run relationships between these variables. We use quarterly time-series data on the Iranian economy during the period Q1-1991 to Q4-2013. The set of endogenous variables consists of total real GDP (rgdp), non-oil real GDP (non_oil_gdp) and Oil exports (oil_exp). Furthermore, we add the GDP deflator (gdp_defl), illustrated as an additional endogenous variable in order to control for inflation which, according to Esfahani et al. (2013), is found to have a statistically significant negative long-run impact on real GDP. Figure 27 also shows the presence of two structural breaks: (i) the high volatility in oil prices in 2007-08 (Hamilton, 2009) and (ii) the tightening of US and EU sanctions on Iran since mid-2012. The first exogenous shock will be represented by a dummy variable, denoted by crisis, that takes the value of 1 between Q3-2007 and Q2-2009 and 0 otherwise, while the second, will be presented by a dummy variable, denoted by sanctions, that takes the value of 1 between Q3-2012 and Q4-2013 and 0 otherwise. In sum, our set of endogenous variables will be I={real GDP or rgdp , real non-oil GDP or non_oil_gdp, oil exports or oil_exp and the GDP deflator or gdp_defl} while the set of exogenous variables will be E={crisis, sanctions}. Given that we are interested in understanding the impact of an increase in oil exports on both total real GDP and non-oil real GDP we employ two different VECMs where the first one, denoted by model 1, includes the following set of endogenous variables I1= {rgdp, oil_exp and gdp_defl}, while the second one, denoted by model 2, includes I2={non_oil_gdp, oil_exp and gdp_defl}as the set of endogenous variables. In both models we also employ the set of exogenous variables E.* The Augmented Dickey Fuller (ADF) test shows that all the four endogenous variables are stationary after first differencing. In addition, we only find one significant (weakly significant) cointegration relationship in model 1 (2).** Consequently, the econometric specification (in vector notation) for model 1 is where vector represents the short-run dynamics’ coefficients while the matrix includes the error corrections and cointegration coefficients. On the other hand, model 2 is specified as where the vectors of coefficients and represent the short-run impacts whereas the matrix includes the error corrections and cointegration coefficients. Results. The results, presented in Table 4, suggest that in the long-run, a 1 percent increase in oil exports is associated with a 0.17 (0.19) percent increase in total real GDP (non-oil real GDP). The coefficients on the Error Correction terms are negative, meaning that, in the short-run, deviations from the long-run equilibrium are adjusted. In particular, the magnitude of the coefficients suggests that 10.6 (12.6) percent of any diversion from the long-run equilibrium in model 1 (2) is adjusted within each quarter. Total real GDP Table 4. Coefficient estimates of the VECM. 5.9 Non-oil real GDP 5.5 5.8 Oil exports 5.3 5.7 5.1 5.6 US and EU sanctions on oil sector 4.9 5.5 07-08 Oil Shock 5.4 4.7 5.3 4.5 5.2 4.3 1991Q1 1992Q1 1993Q1 1994Q1 1995Q1 1996Q1 1997Q1 1998Q1 1999Q1 2000Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 2013Q1 FIGURE 27. Oil exports and GDP. Source: Central Bank of Iran and Authors’ own calculations Note: t-values in bracket. *, **, *** indicate significance at 10%, 5% and 1% level respectively. ^ For model 1 (2) we only report the reduced-form error correction equation where Δ(ln_rgdp) (Δ(ln_non_oil_gdp)) is the dependent variable. * The optimal lag length for model 1 and 2 according to the Akaike information criterion (AIC) is 2 and 3, respectively. ** We specify an intercept and a trend in the cointegration equation given that oil_exp and gdp_defl are found to be trend stationary. Recent Economic Developments and Outlook | 23 The World Bank Box 9. The sixth five-year plan directive. The sixth 5-year plan (2016-21) is comprised of three pillars, namely, the development of a diversified economy, progress in science and technology, and the promotion of cultural excellence. The directive called for, most notably, the attainment of an economic growth rate of 8 percent—through private sector development and foreign direct investment, ran to become a leader in the region in science and technology and the government to increase defense spending. This sixth directive is a continuation of the fifth directive, with the exception of the target for defense spending which, at 5 percent of the government’s budget, signals Iran’s interest in boosting military capabilities in light of regional tensions. On the economic front, the development plan envisages implementation of reforms of state-owned enterprises, the financial and banking sector, and the allocation and management of oil revenues among the main priorities of the government during the five-year period. is relied upon (Box 8). The analysis presented only 25. On the non-hydrocarbon side, covers oil exports, since gas exports from Iran are consumption and investment are expected to still marginal and major investments are needed to increasingly contribute to growth. The lifting of build a surplus above domestic consumption needs sanctions on the banking and financial sector has (expected only after 2017, beyond the timeframe of allowed Iran to rejoin the SWIFT mechanism which, the projections presented here). Results of the VECM once normal international banking relationships have suggest that in the long-run, a 10 percent increase returned, will ease trade and lower transaction costs in oil exports is associated with a 1.7 (1.9) percent with the rest of the world. With a 2014 population of increase in total real GDP (non-oil real GDP). The 78.5 million and a skilled labor force, Iran is of major coefficient estimates of the VECM are then used to interests to investors. The government’s efforts to determine how the increased oil exports estimated improve the business environment, reduce the in Special Focus 1 affect both GDP and non-oil GDP. footprint of state-owned enterprises in the economy As presented in the baseline scenario of Special and stimulate competition will be key to ensuring Focus 1, we retain the following assumptions for investors’ confidence and transform that interest into oil exports: 1.47 million barrels per day (mbpd) in growth and job-creating investment. Total investment 2015 up from 1.27 mbpd in 2014, 1.73 mbpd in is projected to increase by 2.7 percent and 4.7 2016, and 2.32 mbpd in 2017. Beyond oil exports, percent in 2016 and 2017, respectively. With regard our growth projections—detailed below—also to consumption, increased consumer confidence incorporate the government’s fiscal plans, both on as well as an expected increase in employment are the expenditure and revenue side, and expectations expected to bolster private consumption, which is of improved consumer and business confidence, projected to grow at an average rate of 3.1 percent mostly stemming from the lifting of the sanctions. in 2016-2017. 24. Economic growth is projected to accelerate 26. With the economy rebounding, the in 2016-2017 partly on account of a surge in energy associated reduction in the output gap is likely exports. Following a meagre 0.5 percent real GDP to exert inflationary pressures on the economy growth measured at factor cost due to a 0.1 percent unless supply-side structural reforms are contraction in the non-oil sector, economic activity implemented. While the Iranian economy has is expected to rise to 4.2 percent and 4.6 percent operated well below its potential output for the in 2016 and 2017, respectively, with the oil and gas past few years, a rapid closing of the output gap sector projected to expand by 12.9 and 12.2 percent risks running into inflationary pressures, given the in 2016 and 2017, respectively (Table 5). These relatively high inflation environment the country growth rates remain lower than the annual growth has operated in over the past decades (which has rate of 8 percent being targeted in the directives shaped inflation expectations). While high growth of the Sixth Five-year Development Plan recently rates and capital inflows are expected to translate issued by Ayatollah Khamenei (Box 9). Achieving 8 into an increased confidence in the Iranian rial which percent will require the implementation of significant in turn will put downward pressure on inflation in the structural reforms, as detailed in the sixth plan itself. medium-term, long standing structural reforms are 24 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity Table 5. Islamic Republic of Iran: Selected Economic Indicators (2012-2018)*. Source: Government Data and World Bank Staff Calculation. * Fiscal year ends March 20. For example, 2013 corresponds to the fiscal year of 2013/2014. ** IRR: Iranian Rial Recent Economic Developments and Outlook | 25 The World Bank Box 10. The 2016 central government budget. For its 2016 budget, the Rouhani government maintains the fiscal discipline of its previous two budgets. Central government expenditure planned to increase at the same pace at the projected rise in revenue (Table 6). On the revenue side, the 2016 budget projects total revenue increase of 15.0 percent driven by an increase of 17.4 percent in taxation revenue, 2.8 percent in oil revenue, 45.2 percent in sale of assets and 11.4 percent in other revenue components. On the expenditure side, the 2016 budget projects a total expenditure rise of 15.0 percent as a result of a 18.8 percent increase in current expenditures, a 24.9 percent rise in capital expenditures and a 5.6 percent decline in other components. The government remains committed to improving the fiscal framework. On the revenue front, the government measures aim to enhance tax compliance and broaden the tax base away from oil revenue. Measures would include a better targeting of large taxpayers and other indirect taxes, such as on professional income and the taxation of capital gains in equity and real estate. Lower reliance on oil revenue would also be achieved through greater economic diversification. Much of the country’s ability to further diversify its economy will largely hinge on structural reforms to strengthen the business environment, in particular to improve the infrastructure system as well as the ease and cost of trading across borders, which remain weak relative to comparator countries. Table 6. Details of the 2016 budget (thousands of billions of Rials). 2014* 2015* 2016 Y/Y %** Central Government Revenue 2,188 2,674 3,074 15 Taxes 661 861 1,011 17.4 Oil 777 711 731 2.8 Sale of Assets 224 312 453 45.2 Other 526 789 879 11.3 Central Government Expenditures 2,188 2,674 3,074 15 Current Expenditures 1,430 1,660 1,972 18.8 Capital Expenditures 378 478 597 24.9 Other 380 535 505 -5.6 Source: Iranian authorities. * Actual figures. ** Year-on-year growth rate of projected 2016 figures relative to actual 2015 figures. required for the economy to grow at the sustained 28. The current account balance is projected and inclusive pace laid out in the sixth five-year plan. to continue to deteriorate in 2016—to post its first deficit since 2004—but is projected to return to 27. The central government fiscal stance is a surplus in subsequent years. After an estimated forecasted to be slightly contractionary; visibility modest surplus of 0.6 percent of GDP in 2015, the on the wider public sector stance is, however, current account balance is projected to turn to a limited. Following an estimated central government deficit of 0.4 percent of GDP in 2016 as a result of fiscal deficit of 2.7 percent of GDP in 2015, the the substantial drop in energy prices. As volumes deficit is projected to shrink gradually over the of oil exports start picking up13 thanks to the lifting forecast horizon (Table 5) as oil prices rebound, oil of the nuclear-related sanctions, global oil prices export volumes rise, and the non-oil revenue expand are also projected to modestly firm up over the along with the recovery in economics activity. With forecast period, and tourism services are projected the easing of financing constraints total expenditures to rebound, Iran’s current account is projected to are projected to expand from 15.6 percent of GDP return to a surplus in 2017. in 2015 to 15.9 percent of GDP in 2016 due to a marked rise in the investment budget. 13  Oil exports are projected to rise from 1.47 million barrels per day (mb/d) in 2015 to 1.73 mb/d and 2.32 mb/d in 2016 and 2017. 26 | Recent Economic Developments and Outlook IRAN economic monitor | seizing the opportunity oil exports. Further degradation of regional security Risks to the Outlook and stability in Iraq and Syria in particular would negatively impact the Iranian economy. 29. One important downside risk to Iran’s recovery is a delayed normalization of Iran’s 32. Finally, Iran should properly manage the country risk premium linked to international new era of sanctions relief. In particular, failure sanctions or even the possible return of sanctions. to improve the business environment, such as Significant residual business risks related to the promoting competition and limiting the footprint possibility of lifted sanctions to be re-imposed and of the government on the economy, would have an to the continuation and potential widening of the adverse effect on the appetite of foreign investors non-nuclear sanctions—including the inability to to invest in Iran. Furthermore, implementing proper use the U.S. financial and banking infrastructure and fiscal and monetary policies coupled with an effective remaining sanctions on over 200 Iranian entities— public investment strategy aimed at revitalizing the are likely to constrain faster trade and investments energy sector and benefitting from the freed frozen flows. In addition, the JCPOA includes a “snap assets, among other things, will be key to simulating back” mechanism whereby sanctions could be re- the economy. Iran should also improve its anti- introduced.14 A clarification from the U.S. Treasury money laundering and terrorism financing laws and and Congress on the legal situation of U.S. companies regulations to reduce business risks for banks and and citizens but also foreign companies, especially the private sector. banks—fearful of legal actions which in the past have reached multi billion dollars in penalties—regarding business opportunities in Iran could materially alter the pace of trade normalization between Iran and the rest of the world. 30. Risks to oil prices remain largely tilted to the downside. These include a possible increase in supply due to: (i) resilient oil production in non- OPEC countries as a result of some cost-efficiency measures; and (ii) a rise in output from OPEC producers such as Iraq and Saudi Arabia. Moreover, slower demand in China and other leading emerging markets may put additional downward pressure on oil prices. 31. A third risk relates to slower global growth and regional conflict and security. A stronger dollar following an expected rate increase by the Federal Reserve Board could slow down the pace of economic recovery in the US and hence have spillover effects on global growth. Furthermore, decelerating demand in China, a major importer of Iranian oil, may have an adverse impact on Iranian 14  Paragraph 36 of the JCPOA, Iran’s failure to meet its commitments under the Agreement could lead any of the P5+1 countries to “cease performing its commitments under this JCPOA in whole or in part and/or notify the U.N. Security Council that it believes the issue constitutes significant non- performance.” Recent Economic Developments and Outlook | 27 The World Bank Special Focus 1: Prospects for Iran’s Oil and Gas Export Revenues consisting of 93 MTOE (37 percent) of oil, 153 MTOE Abstract (61 percent) of gas and 6 MTOE (2 percent) of other forms (hydro, coal and nuclear) of energy (Figure While Iran has one of the most diversified economy 28). Iran’s energy consumption had been almost among OPEC producers, its economy remains highly entirely based on oil until the 1970s. Domestic oil dependent on oil and gas. In our first Special Focus, use had doubled in a five-year span of 1970-1975. we assess short and medium-term prospects for the The rapid growth of energy consumption and its oil growth of Iran’s oil and gas export revenues in a dependence had raised significant policy concerns post-sanction environment. These critically depend about the sustainability of oil exports. As a result, a on two variables: the speed at which investments very ambitious program of natural gas development are mobilized to rehabilitate, expand and develop and distribution was initiated in the 1970s and took off various oil and gas fields; and the price of oil. To at a high pace in the 1980s. The share of gas in energy take account of this uncertainty three scenarios for consumption has since increased from 11 percent in the growth of oil and gas export revenues (baseline, 1980 to 61 percent in 2014. Oil consumption is now upper limit, and lower limit). In a baseline scenario, limited mostly to the transport sector. Even there, the exports of oil and oil products could increase from government has launched some aggressive efforts to 1.27 million barrels per day (mbpd) in 2014, to 2.32 promote the use of compressed natural gas (CNG) mbpd by 2017 and 2.53 mbpd by 2020 equivalent where technically feasible. However, Iran’s energy to additional revenues of US$3.5 billion by 2017 intensity is one of the largest in the world indicating and US$19 billion by 2020. For gas, exports could a lot of room for improving energy efficiency (Figure increase from 4 billion cubic meters (bcm) in 2014, to 29). Domestic energy consumption imposes a hard 10.3 bcm in 2017 and 27.1 bcm by 2020 equivalent constraint on Iran’s ability to increase its oil and to additional revenues of US$0.75 billion in 2017 gas exports. As the economy becomes more open and US$6.51 billion by 2020. Achieving these export to the international markets, the opportunity cost of revenue, however, require reforms to: (i) improve domestic use of oil and gas becomes more explicit the attractiveness to International Oil Companies of and tangible reinforcing the need to rationalize Iran’s oil contract; (ii) raise the efficiency of natural energy consumption. gas transmission, distribution and consumption; (iii) reduce gas flaring and venting; and (iv) strengthen oil 34. Export of oil has been pursued aggressively wealth management. throughout the modern history of Iran though it has been also intertwined with the political developments. Oil exports peaked at about 5.5 million barrels per day (mmb/d) in the mid-1970s, Introduction collapsed to less than 1 mmb/d after the 1979 revolution and stabilized at about 2 to 2.5 mmb/d from mid-1990s to 2011. Subsequently oil exports 33. Iran is one of the largest energy producer in dropped to about 1.2 mmb/d after the imposition the world, but also one of the most energy-intensive of sanctions in 2011-2012. Export and import country. Iran’s primary energy consumption in of natural gas at small amounts were launched in 2014 was 252 million tons of oil equivalent (MTOE) early 2000s. At the same time, the government had 28 | Special Focus IRAN economic monitor | seizing the opportunity Energy Consumption Energy Intensity Using Purchasing Power Parity Other (hydro, nuclear, etc.) 16,000 14,000 Oil 12,000 (BTU/year 2005 dollar) Gas 10,000 8,000 6,000 4,000 2,000 0 Venezuela Korea, South United States China Mexico Saudi Arabia Russia Europe India Pakistan Iraq Middle East World Iran Egypt FIGURE 29. Energy intensity using purchasing power FIGURE 28. Energy consumption in 2014 (MTOE). parity for Iran and comparable countries. Source: IEA 2015. Source: IEA 2015. planned some large-scale gas export schemes most may remedy some of the issues in the previous of which stalled due to the prevailing sanctions. buyback contracts and may provide a stronger incentive for the international oil companies to 35. The lifting of the nuclear-related sanctions return to Iran’s oil and gas sector; it should be is expected to have a significant impact on the noted, however, that the management of these development of Iran’s oil and gas sectors and more flexible contracts would require a strong in particular the potential export revenues from and skillful body that needs to be established; these sectors. The purpose of this chapter is to (i) review the recent developments of the oil and gas • The long-term prospects of Iran’s hydrocarbon sector; and (ii) outline the prospects of the increasing sector relies more on gas than oil production. oil and gas export revenues in the short and medium Accordingly, the government’s new strategic terms. The chapter is organized in three parts. Part I framework aims at shifting emphasis from provides an analysis of the prospects for increasing oil to gas, and increasing the value added of oil export revenues, Part II contains a description of the downstream and petrochemical activities. the potentials for increasing gas export revenues, However, domestic consumption of gas is and Part III presents a discussion of some relevant huge (the third largest in the world) and suffers policy issues. from various types of inefficiencies. A better understanding of efficiency gains along the 36. We project oil export revenues to grow natural gas transmission, distribution, and from about $44 billion in 2014 to $63 billion in consumption could lead to the introduction 2020 (Iranian calendar years). The upper and lower of policies that could generate substantial bounds to the 2020 projected amounts are $92 and domestic consumption gains—which would be $36 billion. Similarly we project gas export revenues transformed into gas exports and revenues; to increase from $2.8 billion in 2014 to $9.4 billion in 2020. The upper and lower limits are projected at • While Iran’s position as the second largest $12.9 billion and $6.3 billion. gas reserve holder in the world supports the idea of the country becoming a large scale gas The following points are critical to the above export exporter, there are some outstanding issues revenue projections: regarding the availability and desirability of gas exports. A better understanding of Iran’s natural • The new upstream model contract, called the gas production, utilization, and export strategy Iran Petroleum Contract (IPC) that is currently would enable the country to achieve this status under preparation by the Ministry of Petroleum in an efficient and sustainable manner; Special Focus | 29 The World Bank • Iran’s practice of gas venting and flaring imposes b/d in 2012 and 2.5 mb/d in 2013. In 2014, crude a large economic loss on the country and a oil production increased by about 100 kb/d to reach serious adverse impact on health and on the almost 2.6 mb/d, while production of total oil (crude global environment. Capturing and processing oil and condensates) reached 3.05 mb/d. this gas would generate substantial gains for the country. 39. Expansion of oil exports faces the challenges of marketability in the short-term and sustainability in the medium term. Prior to sanctions, Iran sold its oil to China, India, Japan, South Korea, the EU, Turkey, South Africa, and the Prospects for United Arab Emirates.15 After the sanctions some buyers like the EU countries stopped while others Increasing Oil reduced their oil imports from Iran. The speed at which Iran can regain the lost market is expected Export Revenues to be of at least an additional 300 kb/d of oil by mid-2016 and a further 600 kb/d by mid-2017. The 37. Iran has an estimated 158 billion barrels of potential purchasers are Korea, India, China, Turkey proved crude oil reserves, representing the fourth and some European countries including Greece, largest reserves in the world (Figure 30), and Spain, and Italy. the third largest among the Organization of the Petroleum Exporting Countries (OPEC). More than 40. The sustainability of oil exports after 2017 70 percent of Iran’s crude oil reserves are located would need additional action on Iran’s side. In onshore (Map 1). Iran’s largest producing oil fields are particular, it would depend on Iran’s ability to: (a) the onshore Ahwaz-Asmari, Marun, and Gachsaran slow down the decline in the productivity of its fields, all of which are located in Khuzestan Province. old oil fields; (b) recommission some of the shut- The Abuzar field in the Persian Gulf is Iran’s largest in reservoirs; and (c) invest in developing the new offshore field, with a production capacity of 175 oil fields. The potential increase in oil production thousand barrels per day (kb/d). Iran also has some during 2016-2020 is estimated to include oil and proved offshore oil reserves in the  Caspian Sea, condensate increases of 300 kb/d in 2016 and 600 but exploration and development of these reserves kb/d in 2017. Therefore, Iran is expected to regain have been halted due to territorial disputes with its pre-sanction oil production of 4.2 mb/d by 2017 neighboring Azerbaijan and Turkmenistan. when the oil production capacity will consist of 3.5 mb/d of crude oil and 0.7 mb/d of condensate 38. Iran’s oil production capacity grew capacity. Although there is a high likelihood that the gradually to reach 2 mmb/d by 1965, and production capacity of 4.2 mb/d will be available and subsequently jumped to about 6 mb/d in a perhaps utilized by the end of 2017, there will be period of 10 years (1965 to 1975); Figure 31. four important developments that would affect the Sustainability and optimality of this rapid expansion production capacity during 2018 to 2020: were debated in the late 1970s. However, the level of production collapsed to about 1.5 mb/d after the • NIOC expects to develop the new fields in Iranian revolution and the start of war with Iraq. the West Karoun region. These fields include Subsequently, oil production gradually increased some large deposits such as Azadegan, Yaran, to 2.5 mb/d by the late 1980s, and then with some Yadavaran, and Darquain, as well as some significant rehabilitation investments, the production capacity increased to about 4.2 mb/d by 2007. This 15  In 2011, prior to the tightening of sanctions, Iran exported 2.3 million b/d of oil liquids (crude oil and other oil liquids). The level of production was maintained until 2011. larger importers of the Iranian oil were: China (550 kb/d), India Afterwards, oil production dropped significantly (320 kb/d), Japan (315 kb/d), South Korea (250 kb/d), the EU from almost 3.7 million b/d in 2011 to 2.7 million (600 kb/d), Turkey (185 kb/d), South Africa (75 kb/d), and the United Arab Emirates (95 kb/d). 30 | Special Focus IRAN economic monitor | seizing the opportunity Map 1. Iran’s oil and gas fields. Source: http://www.lib.utexas.edu/maps/map_sites/oil_and_gas_sites.html Oil Reserves Oil Production, Consumption and Export 350 7,000 300 6,000 250 billion barrels) 5,000 200 (000 barrels/day) 4,000 Oil Production 150 100 3,000 50 Oil Export 2,000 0 Iran Iraq Kuwait United Arab Emirates Russian Federation Venezuela Saudi Arabia Canada Libya Nigeria 1,000 Oil Consumption 0 FIGURE 30. Oil Reserves for Iran and comparable FIGURE 31. Iran’s oil production, consumption and countries 2015. export. Source: Oil and Gas Journal (January 2015) Source: BP (2015) smaller fields like Jofier, Bande Karkheh, fields to about 1 mb/d. The production capacity and Soosangerd. The West Karoun fields are of these fields in 2020 is estimated at 400 to 800 currently producing only 100 kb/d of oil. NIOC kb/d depending on NIOC’s ability to mobilize expects to increase the production from these the required investments. Special Focus | 31 The World Bank • A high priority investment program will be availability of condensates for export will plateau implemented to increase the oil production at 500 kb/d in 2016 and gradually decline to 330 capacity in the mature fields such as Ahwaz, kb/d by 2020 when domestic use of condensate will Gachsaran and Marun, and to bring into operation reach about 500 kb/d17. some of the previously shut-in fields. The output of the Ahwaz field is expected to rebound rather 42. Export of petroleum products is also fast while the output of other fields may increase expected to increase in the medium term. In gradually. The increase in the total output by the past, Iran has been somewhat dependent on 2020 may amount to 200 to 400 kb/d. imports of refined products, especially gasoline, to meet domestic demand. It has now rehabilitated, • Despite the above investments there will still be upgraded and expanded some refineries enabling a natural decline in the output of some very old the country to produce a larger volume and a more fields at the rate of 100 kb/d per year. desirable mix of products. This additional refinery yield and the additional products from the domestic • Condensate production is expected to increase processing of condensates will result in Iran’s substantially as the new phases of South capacity to export 700 kb/d of petroleum products Pars16 come into full operation. The increase in by 2020, comprising of 220 kb/d of fuel oil, 170 kb/d condensate output by 2020 is expected to be of gasoil, 140 kb/d of gasoline and 170 kb/d of LPG. about 300 to 500 kb/d. 43. To assess the prospects for increasing oil 41. Iran’s oil exports comprise crude oil, export revenues, this section develops a range for condensates (and gas liquids), and petroleum the expansion of oil (crude oil and condensate) products. Iran’s condensates production mostly and petroleum products based on the analysis of comes from the South Pars natural gas field, with the previous sections. Three scenarios (i.e., a base smaller volumes produced at Nar, Kangan, and at case, lower bound and upper bound) are considered other fields. Iran’s condensate production is expected in these projections, with the key underlying to increase from about 450 kb/d in 2014 to about assumptions for each being oil export volume and 830 kb/d by 2020. At the same time, there is a plan the international price of oil. The basic assumptions under implementation to process the condensates of the three scenarios are as follows: into products (mostly naphtha, diesel and kerosene). Presently Iran uses about 160,000 b/d of condensates • The base case assumes an increase in the oil in its two (Borzuyeh and BooAli Sina) petrochemical production capacity from almost 4 mb/d in 2015 plants. However, this will increase significantly in to 4.5 mb/d in 2020. About half of the capacity the next 4 to 6 years as the Persian Gulf Star (PGS) increase is due to additional yield of condensates processing plant (capacity of 360 kb/d) and the SIRAF from South Pars and other gas fields. This processing plant (with capacity of 480 kb/d) are scenario assumes that the international price of commissioned. Commissioning of the PGS plant is (Brent) crude oil18 will fluctuate in the range of expected between 2016 and 2018. Commissioning $50 to $60/bl (averaging $55/bl) during 2015 and of the SIRAF plant is somewhat uncertain. By the time both plants are commissioned the availability 17  With the commissioning of Phases 12 to 16 of South Pars of condensate for export will disappear while some in 2014-2015, condensate production increased by about 200 kb/d to 650 kb/d in 2015. It is expected that Phases 17 to 21 will amount of products (about 150 kb/d of naphtha and be commissioned by 2020. Condensate production will then about 400 kb/d of diesel and kerosene) will become reach 830 kb/d. available for exports. The likely scenario is that the 18  Iran’s crude oil production stream consists of mostly Iran heavy and Iran light. The heavy crude has been traditionally sold 16  South Pars development entails 24 phases. The first 10 to the Asian markets while the light crude has a wider market. phases were commissioned during 2002-2010. Phases 12, 15 The Iranian heavy and light crudes have been selling at a discount and 16 were commissioned in 2014-2015. Phases 17 and 18 are of $3 and $1/bl, respectively, relatively to the Brent crude price. scheduled for commissioning in 2016. Most other phases are Petroleum products exports consist of fuel oil, gasoil, naphtha expected to be commissioned by 2020. and an increasing amount of gasoline. 32 | Special Focus IRAN economic monitor | seizing the opportunity Table 7. Medium-term prospects for Iran’s oil production and export revenues. Year (Iranian calendar) 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Base Case Projections Production Crude Oil (mb/d) 3.70 2.70 2.50 2.60 2.70 2.90 3.50 3.60 3.70 3.70 Condensates (kb/d) 380 395 420 450 610 690 720 750 790 830 Total Oil (mb/d) 4.08 3.10 2.92 3.05 3.31 3.59 4.22 4.35 4.49 4.53 Crude Oil Allocation Domestic Refining (mb/d) 1.70 1.70 1.80 1.80 1.90 2.00 2.10 2.20 2.20 2.20 Export (mb/d) 2.00 1.00 0.70 0.80 0.80 0.90 1.40 1.40 1.50 1.50 Condensates Allocation Domestic Processing (kb/d) 150 155 160 165 170 190 350 450 500 500 Export (kb/d) 230 240 260 285 440 500 370 300 290 330 Petroleum Products 1.85 1.86 1.96 1.97 2.07 2.19 2.45 2.65 2.70 2.70 Domestic Consumption 1.75 1.76 1.78 1.79 1.84 1.86 1.90 1.96 1.98 2.00 (mb/d) Export (kb/d) 100 100 180 180 230 330 550 690 720 700 Exports Export of crude oil (mb/d) 2.00 1.00 0.70 0.80 0.80 0.90 1.40 1.40 1.50 1.50 Export of condensates (kb/d) 230 240 260 285 440 500 370 300 290 330 Export of products (kb/d) 100 100 180 180 230 330 550 690 720 700 Total Exports (mb/d) 2.33 1.34 1.14 1.265 1.47 1.73 2.32 2.39 2.51 2.53 Export Revenues ($billion) Base Case 93.0 52.7 43.9 44.3 28.7 33.8 47.8 52.5 58.8 63.0 Upper Bound 93.0 52.7 43.9 44.3 28.7 40.6 57.5 65.7 76.7 92.4 Lower Bound 93.0 52.7 43.9 44.3 28.7 33.0 36.2 36.4 36.1 35.8 Source: BP (2015); Barclay (2015); IEA (2015); EIA (2015), FGE (2015); OPEC (2015) and author’s analysis. 2016. Beyond 2016, the price increases gradually would also remain at about 700 kb/d; and that to reach $70/bl by 2020. international price of oil will remain in the range of $50 to $55/bl during 2015 to 2020. • The upper bound scenario assumes that Iran achieves the expansion targets that it has 44. The results are summarized in Table 6 and indicated for production of crude oil (4.3 mb/d) Figures 32 and 33. In the base case, exports of oil and and condensate (930 kb/d) by 2020. This scenario oil products could increase from 1.27 mbpd in 2014, assumes an optimistic trend for the price of oil to 2.32 mbpd in 2017 and 2.53 mbpd in 2020. Under which is to reach $70/bl in 2017 and $80/bl by the above oil price projections this would increase oil 2020. export revenues from $44 billion in 2014, to US$47.7- 63.0 billion by 2020. If government goals are achieved • The lower bound scenario assumes realization of (production of 4.3 mbpd of crude oil and 930 kbpd several risks: that oil production capacity will reach of condensates by 2020), oil exports could reach as 3 mb/d by 2017 but will remain at that level until much as US$92 billion by 2020 but could fall to US$36 2020 implying that the incoming investments will billion if investments are insufficient to compensate only be sufficient to compensate for the decline in for the decline in productivity of old fields. the old oil fields; that production of condensates Special Focus | 33 The World Bank Iran's Oil Export Revenue Iran's Oil Export Revenue 100 90 80 100 Upper Bound 70 90 Price Effect 60 80 ($ billion) 50 70 Output Effect 40 60 ($ billion) Output Effect Base Case 30 50 20 40 Price Effect Lower Bound 30 10 20 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 10 Base Case Upper Bound Lower Bound 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 FIGURE 32. Evolution of Iran’s export revenue. FIGURE 33. Evolution of Iran’s export revenue. Source: Authors’ calculations Source: Authors’ calculations most instances, were done with the involvement of Prospects for western companies in the pre-sanctions era. Phases 15 and 16 are near completion and will eventually Increasing Gas produce at their full capacity of 21 bcm/year of natural gas and 80,000 b/d of condensate. Export Revenues 46. In addition to the South Pars field, Iran 45. With a proved gas reserve of 34 trillion cubic has at least 15 other major gas fields (the largest meters (tcm), Iran is the second-largest natural gas ones include Kish, North Pars, Tabnak, Forouz and reserve holder in the world, behind Russia (Figure Kangan). The development of some of these fields 34). Iran’s largest natural gas field is South Pars which is is presently being handled by domestic entities but also the largest gas field in the world. It was discovered actual production from them is unlikely until after in 1990 and is a shared gas field with Qatar.19 Pars Oil 2020. Iran does not undertake gas exploration and Gas Company (POGC), a subsidiary of NIOC is activities but continues to discover new reserves, a undertaking a 24-phase development of South Pars clear indication that the country has abundant gas with an estimated total cost of more than $100 billion. resources. Each of the 24 phases has a combination of natural gas with condensate and/or natural gas plant liquids 47. Iran initiated a program of gas production (NGPL) production. Annual production is projected in the early 1970s. However, gas production and to reach 270 billion cubic meters (bcm) per year domestic consumption took a high growth path after when all phases are online. Iran’s gas master plan had the late 1980s with a marked acceleration following originally envisioned phases 1-10 of South Pars being the discovery of the South Pars field (Figure 35). Iran’s used for domestic consumption and reinjection while gross gas production was about 232 bcm in 2014 gas from other subsequent phases could be allocated ranking third in the world after the United States and to exports. Phases 1-10 and 12 are complete and, in Russia. The marketed gas stood at 184 bcm while the remainder was partly (31 bcm) reinjected into oil 19  In Qatar the field is known as the North Field. Iran and wells to enhance oil recovery and partly (17 bcm) Qatar concluded a delimitation agreement with each other in vented and flared. About 98 percent of the marketed 1969. However, there has been little cooperation between the two countries in developing the joint field. Qatar implemented gas was consumed domestically. Gas demand has an ambitious development program to increase gas production grown at a high pace. The country has even struggled from 6 bcm in 1990 to 176 bcm in 2013. As a result Qatar has become one of the largest exporters of gas in the world. It has with natural gas shortages during the winter months since 2005 declared a moratorium on further development of and has looked to imports from Turkmenistan to the North Field, to give the country more time to study the balance the market during peak periods. structure and the sustainability of the field’s reservoir. 34 | Special Focus IRAN economic monitor | seizing the opportunity Natural Gas Reserves Oil and Gas Consumption 300 60 250 50 (million tons of oil equivalent) (trillion cubic meters) 200 Gas Consumption 40 30 150 20 100 10 Oil Consumption 50 0 0 FIGURE 34. Natural gas reserves in Iran and comparable FIGURE 35. Iran’s oil and gas consumption. countries. Source: Oil and Gas Journal (2015) Source: BP (2015), EIA (2015) 48. Gross gas production is expected to 49. Iran has a small volume of gas trade via increase at an average rate of 5 percent p.a. pipelines to neighboring countries. On the export from 241 bcm in 2015 to 307 bcm in 2020. Most side, these include Turkey, Armenia, Azerbaijan. The of this will be produced from the 28 phases of the total volume of gas export was 6.9 bcm in 2014, South Pars field while the outputs from other fields of which 94 percent went to Turkmenistan and 6 (Kish, North Pars, Tabnak, Forouz and Kangan) are percent to Azerbaijan. Gas export to Turkey is under expected between 2020 to 2025. The expanded a long-term contract. Armenia and Azerbaijan have gas production capacity would need to meet the swap arrangements with Iran; Armenia exports requirements for gas reinjection into the oil fields electricity to Iran to compensate for the natural and the domestic gas demand before any allocation gas volumes it receives; Azerbaijan repays Iran for to exports. Gas reinjection volume is expected to the natural gas sent to its Nakhchivan exclave by increase from 35 to 49 bcm during 2015-2020. exporting similar volumes to northeastern Iran via the Domestic gas consumption is expected to grow at 3 Astara-Kazi-Magomed pipeline. On the import side, percent p.a. from 185 in 2015 to 215 bcm in 2020. imports are coming from Turkmenistan and started Iran’s ability to expand gas exports would depend in 1998 based on a 25-year contract for a volume on the speed at which investments are undertaken of 5–6 bcm/year. These imports were interrupted in the final phases of South Pars and other fields. in 2007 because of Turkmenistan’s objection to the NIOC estimates an investment need of about $30 prevailing contracted gas price (about $3/million billion in the upstream gas development. This BTUs) but resumed in 2009 based on a new pricing is more likely to materialize by 2025 than 2020. formula ($9 to $10/million BTUs per $100/bl oil20). The country’s ability to increase gas export is also The import volume reached 11 bcm in 2011 but dependent on the government’s success in limiting then dropped to less than 5 bcm in 2012 and 2013 the growth of domestic gas consumption. Low before recovering to 6.8 bcm in 2014. Imports of domestic gas prices and lagging energy efficiency are Turkmen natural gas are essential to Iran’s ability considered partly responsible for the rapid growth to meet both seasonal peak demand and industrial in gas consumption. There is a need to carry out demand in northern Iran. a comprehensive assessment of the technical and economic efficiency of gas transmission, distribution 50. Iran has envisioned, and in some instances and consumption. The scenarios of gas export should has planned for the construction of a number take account of the uncertainty in the expansion of of major gas export schemes including a set of gas production capacity as well as uncertainties in pipeline and liquefied natural gas (LNG) projects. achieving contractual, financing and implementation agreements. 20  Gas price in most of Iran’s contracts is linked to oil, and expressed in $/MMBTU per $100/bl oil. Special Focus | 35 The World Bank Box 11. Status of natural gas export pipeline schemes. Expansion of Gas Exports to Turkey. Iran has been exporting natural gas to Turkey since 2001 under a long-term take or pay deal of 10 bcm/y. Iran has been trying to convince Turkey to increase its import volumes to 20 bcm/y, but price has been an issue. Turkey is paying Iran a gas price of about US$14/MMBTU (per $100/bl oil) that is (about 20 percent) higher than the price Turkey pays for gas imports from Russia and Azerbaijan. The industry sources indicate that the Iran and Turkey are in the process of negotiating a lower price and higher volume of gas export. Iran-Pakistan Pipeline. This scheme was originally envisioned in early 1980s as a 40 bcm/y pipeline that would transport Iranian gas to Pakistan and onto India. However, India dropped out of the project in 1990s while Iran and Pakistan have continued their attempt to construct the pipeline system. In 2007 Pakistan and Iran signed a 30-year agreement according to which Iran would supply 21.7 bcm/year of gas with potential to increase to 33.1 bcm/year. The negotiated price is about $9/MMBTU per $100/bl oil. The 900km pipeline segment on the Iranian side has been completed. However, Pakistan has had difficulty mobilizing the required finance for building its 750km section of pipeline. Iran-Iraq Pipeline. The gas sale-purchase contract between the two countries was signed in 2013. The contract is for an export volume of 9 bcm/y in the first phase of the agreement and increasing to 14 bcm/y in the second phase. Construction of the pipeline system is almost complete. However, there are security concerns and some disagreement about pricing issues. There is also a separate, initial agreement between Iran and the Basrah Provincial Council for a further 7.2 bcm/year gas import from Iran. It is expected that the two countries will reach agreement by end 2015 and Iran could supply by end 2016 at least 2.5 bcm/year using existing gas infrastructure to the Basra power plant, which is close to the Iranian border. Iran-United Arab Emirates (UAE) Pipeline. In 2001 Iran signed a 25-year contract to supply gas from its Salman field to the UAE- based Crescent Petroleum at Sharjah in the UAE. The contract required Iran to export 5.2 bcm/y of unrefined sour gas to UAE at a reportedly low price. The project was supposed to have been completed in 2005 but there have been significant delays. Crescent Petroleum eventually took NIOC to arbitration in 2009 for the four year delay in supplying gas. The arbitration deliberations continue while the corresponding scheme has been the subject of much discussion in the press. The industry specialists have raised the idea that Iran and Abu Dhabi can cooperate in transporting gas from the Salman field to the neighboring Abu Bakhoosh field which is owned by Abu Dhabi and is nearly depleted. The distance between the two fields is only one kilometer and all infrastructure already exist on the Abu Dhabi side. The potential project is reportedly being discussed between the two sides. Iran-Oman Pipeline. Oman’s domestic gas production has stagnated in the recent years while its domestic consumption has increased sharply. As a result the amount of feed-gas to Oman’s two LNG export facilities have fallen. Therefore, Oman has some excess capacity in its LNG facilities. It has agreed in March 2014 to import about 10 bcm/year of gas from Iran. It is estimated that some 30 to 50 percent of the imported gas would be liquefied and sold on the global markets. The pipeline system will involve construction of a 200 km of undersea pipeline, and is expected to have a construction cost of about $ 1 billion and a construction time of about 3 years. Price of gas (and LNG processing fee) are still under negotiations. Iran-Kuwait Pipeline. The two countries have been discussing since early 2000s the construction of a 350-mile pipeline to carry about 2.5 bcm/year of Iranian gas to Kuwait. In the meantime Kuwait started importing LNG in 2009 to meet its growing domestic demand, which peaks during the summer. Although the seasonality of Kuwait’s demand gives LNG a comparative advantage, a pipeline supply (with suitable price terms) may still be worth consideration. The former include projects to Europe, Pakistan, during 2012 to 2016 but they stalled after the India, Iraq, UAE, Oman and Kuwait; the latter include sanctions made it nearly impossible for western the Iran LNG, the Pars LNG, and the Persian LNG. companies to provide the required technology to Among the pipeline projects, the export schemes build liquefaction trains. Iran has reportedly spent to Europe and India are not likely to materialize in more than $2 billion on the Iran LNG project to the short to medium terms. Among other schemes, build port facilities, tank storage, and the necessary there are prospects for the expansion of gas export infrastructure. The missing piece is the liquefaction to Turkey, and implementation of pipelines to Oman, plant which requires western technology. Iran has Iraq, Kuwait and Pakistan (details are provided in expressed that it will welcome investors’ interest in Box 11). completion of this plant. The plant may be completed and operational by 2020. Other LNG plants are likely 51. On the LNG front Iran pursued three to be shelved for the foreseeable future. major projects: Iran LNG and Pars LNG each with a capacity of 10.8 million tons/year, and Persian 52. Gas Export Revenues: In assessing the LNG with a capacity of 16.2 million tons/year. potentials for increasing gas exports this chapter These plants were supposed to be commissioned takes account of the ongoing negotiations and plans 36 | Special Focus IRAN economic monitor | seizing the opportunity Table 8. Medium-term prospects for Iran’s gas export revenues. Year (Iranian calendar) 2014 2015 2016 2017 2018 2019 2020 Base Case Projections Production and Consumption (bcm) Gross Gas Production 232 241.2 251.4 263 277.5 294 307 Gas Venting/Flaring 17 17.2 17.4 17 16.5 16 16 Gas Reinjection 31 35 37 39 41 45 49 Marketed Gas 183 189 197 207 220 233 242 Domestic Consumption 180 185.4 191 196.7 202.6 208.7 214.9 Net Exports (bcm) 4 3.6 6 10.3 17.4 24.3 27.1 Turkey 9 9 9 15 17 20 20 Armenia/Azerbaijan 1 1 1 1 1 1 1 Turkmenistan (import) 6 6.4 6 9.2 10.6 10.2 10.9 Iraq 0 0 2 3.5 5 6 7 Oman 0 0 0 0 5 7.5 10 Kuwait 0 0 0 0 0 0 0 Iran LNG 0 0 0 0 0 0 0 Gas Export Revenue ($million) Base Case 2,871 1,542 2,045 3,619 5,771 8,107 9,381 Upper Bound 2,871 1,542 2,045 3,619 6,690 11,207 12,939 Lower Bound 2,871 1,542 1,269 3,189 4,283 6,034 6,341 Source: BP (2015); Barclay (2015); IEA (2015); EIA (2015), FGE (2015) and author’s analysis. Source: authors calculations Projections of Gas Exports Projections of Gas Exports 50.0 45.0 14,000 Upper Bound Upper Bound 40.0 12,000 35.0 10,000 Base Case 30.0 Base Case 8,000 ($ billion) 25.0 (bcm) 20.0 Lower Bound 6,000 Lower Bound 15.0 4,000 10.0 2,000 5.0 5.0 0 2014 2015 2016 2017 2018 2019 2020 2014 2015 2016 2017 2018 2019 2020 FIGURE 36. Gas export projection for 2016-2020. FIGURE 37. Gas export revenue for 2016-2020. Source: Authors’ calculations Source: Authors’ calculations described in the previous section. In the base-case lower bound scenario assumes that the Iraq pipeline scenario, it is assumed that gas exports to Turkey comes online later in 2018, and that none of the will start to increase in 2017, the Iraq pipeline will other new schemes are commissioned before 2020. start delivering gas in 2017, and the Oman pipeline The results are summarized in Table 7 and Figures will become operational by 2018. The upper bound 36 and 37. scenario makes two optimistic assumptions that the pipeline to Kuwait is completed by 2018 and the Iran LNG plant will be commissioned in 2019. The Special Focus | 37 The World Bank Box 12. Management of the oil and gas sector in Iran. The Ministry of Petroleum has the overall responsibility for the strategic management of the country’s hydrocarbon resources. Under the supervision of the Ministry, there are four state-owned companies responsible for the activities of the oil and natural gas and petrochemical industry. There include: -- National Iranian Oil Company (NIOC) that is responsible for the planning, implementation and operation of various oil sector activities including exploration, drilling, production, research and development, and export of crude oil. NIOC is one of the world’s largest oil companies. It has numerous subsidiaries including seventeen production companies and eight technical service companies. -- National Iranian Has Company (NIGC) that is responsible for natural gas downstream activities with a focus on processing, delivering, and distributing gas for domestic us. NIGC is one of the top ten gas companies in the gas industry in the Middle East and operates through several subsidiaries. -- National Petrochemical Company (NPC) that is responsible for planning, organizing, developing, supporting and leading the country’s petrochemical industry. NPC’s activity was initially limited to operating a small fertilizer plant. But now it is considered as one of the largest petrochemical companies in the Middle East. -- National Iranian Oil Refining and Distribution Company (NIORDC) that is responsible for crude oil refining, products distribution and export and import of petroleum products. It has 19 subsidiaries and affiliated companies including refineries and various service companies. Selected Policy projects to the visiting international oil companies in Tehran in November 2015. The list of projects Issues included upstream gas projects (South Pars Phase 11, North Pars, Forouz, and Kish gas fields), and oil 53. A comprehensive coverage of Iran’s oil development projects (Azadegan, Yadavaran , the and gas sector issues is beyond the scope of this Salman Re‐development, Azar, Darquain Phase 3, chapter. Nevertheless, a few of the outstanding Sohrab, Arvand, Sepehr, and several mature field). issues with direct relevance to the prospects for The Government is also contemplating a broader increasing oil and gas export revenues are discussed presentation of the proposed projects at a forum in below. London. 54. Iran has an ambitious plan for the rapid 56. There are numerous press reports about development of the oil and gas sector. Investment the interest of western oil companies to return to requirements for 2016-2020 are estimated at $100 Iran. It seems that the international oil companies to $150 billion. At the same time, international (IOCs) are eager to take advantage of the Iranian oil sanctions have affected Iran’s oil and gas sectors and gas business opportunities that are technically by limiting the foreign investment, technology, and more attractive than the remaining potentials in expertise needed to expand the production capacity other parts of the world. According to NIOC, the and to slow down the declines at some mature oil marginal cost of oil production in Iran is estimated at fields. In recent years Iran has had to depend mainly $8/bl for onshore and $15 for offshore development. on local companies to develop oil and gas fields. This is compared to an international average of $45 During the sanctions period, all western companies to $60/bl. Still IOCs are expected to be cautious halted their activities in Iran, save for some Chinese about “above the ground” risks including political and Russian companies. and contractual risks, and conditions of international oil market. Also an instrumental factor in the IOCs’ 55. To boost the economy, the Iranian decision will be the terms of contracts. government intends to bring back foreign investment and technology to the oil and gas 57. Since the Iranian constitution prohibits sector. It has already identified more than 50 oil and foreign or private ownership of natural resources, gas projects and presented more than 20 of these the ownership of all oil and gas resources and 38 | Special Focus IRAN economic monitor | seizing the opportunity facilities should remain with NIOC, and therefore sufficient gas to: (a) meet the growing domestic contractual arrangements such as “production gas consumption; (b) supply the huge requirement sharing agreements” could not be applied in Iran. of gas reinjection to enhance oil recovery; and (c) In order to attract foreign investors to the sector, dedicate a considerable amount of gas to export the Iranian government introduced in 1989 a projects. In particular, there are two outstanding formulation called “buyback” contracts that would issues regarding availability and desirability of gas require an IOC to invest its own capital and expertise exports. First, Iran has been negotiating gas export for development of oil and natural gas fields. After transactions with a number of countries for several the field is developed and production has started, decades but has not achieved a level of supply the project’s operatorship reverts back to NIOC or that is significantly above its own domestic needs. the relevant subsidiary. The IOC does not get equity Thus the track record does not provide the level of rights to the oil and gas fields, or to the output. certainty that is required for the formulation and NIOC uses revenue from the sale of oil and gas financing of gas export projects. Second, in the past to pay the IOC back for the capital costs. Buyback there has been an internal controversy (particularly contracts have been unpopular with IOCs due to between the government and the parliament) lack of flexibility of cost recovery, the period of about the desirability of exporting gas while the contract being too short (5 to 8 years), lack of upside country has a very large requirement for domestic benefit for the IOC, and in some cases the NIOC’s consumption and reinjection. The international best limited expertise to slow down the field decline rates practice indicates that an effective tool for creating a in comparison to the IOC that developed the field.21 technical and policy consensus is for the government to prepare a gas strategy that would be endorsed 58. To remedy some of the issues in by the relevant committees in the parliament. The buyback contracts, the Ministry of Petroleum strategy document should present quantitative is preparing a new upstream contract, called targets for production, consumption and export of the Iran Petroleum Contract (IPC). Although still gas. It should also cover policy issues that would in draft form, the model contract is expected to enable the country to achieve these targets in an include the following key elements: (a) include the efficient and sustainable manner. exploration, development, and production phases, along with the possibility to extend into enhanced 60. Government’s new strategic framework oil recovery phases; (b) cover a longer time period aims at shifting emphasis from oil to gas, and of between 20 to 25 years; and (c) link the IOC increasing the value added of the downstream compensation to the output of the oil and/or gas and petrochemical activities. However, domestic field. Therefore, IPC is expected to facilitate flexible consumption of gas is large (the third largest in the “risk-reward” transactions. However, negotiation world) and suffers from various types of inefficiencies. and management of such contracts would require In particular, efficiency in gas transmission and substantial technical, commercial and legal skills and distribution is undermined by significant gas experience. International experience (e.g., Mexico, leakages and low load factors, while efficiency of gas Brazil, Algeria, Egypt) indicates that this can be best consumption is negatively affected by subsidized achieved by establishing a specialized agency for prices and obsolete technologies. An integrated this purpose. study on improving the efficiency of natural gas transmission, distribution and consumption would 59. Iran’s position as the second largest gas be warranted. reserve holder in the world supports the idea of the country becoming a large scale gas exporter. 61. Iran’s gas venting and flaring reached However, the medium-term picture is more complex 17 bcm in 2014 when Iran became the world’s because it is not clear whether Iran can produce largest gas-flaring country, surpassing Russia. Gas is flared because of the lack of infrastructure to 21  According to Facts Global Energy, the rate of return on capture and transport it where it could be effectively buyback contracts ranges between 12 percent and 17 percent. Special Focus | 39 The World Bank utilized. The flared/vented gas has a market value of approximately $4 to $6 billion/year. Aside from this significance economic waste, gas flaring imposes a serious impact on health and the global environment. Gas venting has an even much larger (per unit) impact. The potential impact of gas flaring/venting on the global environment has been recognized by the international community (Buzcu-Guven, B. et al., 2010). It has become an area of serious attention in the United Nations Framework Convention on Climate Change (UNFCCC), the COP 21, and other conventions.22 62. Iran’s petrochemical industry is one of the largest in the Middle East. Activities of the National Petrochemical Company (NPC) was initially limited to operating a small fertilizer plant. However, it now brings in the most revenues to the country’s economy after crude oil exports. The industry may gain significantly from sanctions relief. Export of petrochemical products peaked at about $15.2 billion in 2011 but declined to $12 billion in 2012 to 2014. The government intends to expand this industry in order to extract more downstream value-added from the hydrocarbon resources. The pros and cons of such expansion should be studied while taking account of the opportunity cost of the feedstock and the prospects in the international markets. 22  The World Bank has launched a public- private partnership initiative called Global Gas Flaring Reduction (GGFR) in 2002 to provide technical assistance to the countries and companies that attempt to reduce gas flaring/venting. Several bilateral and multilateral climate change funds, particularly the Clean Investment Fund, provide financial assistance to the projects that are aimed at reducing gas flaring and venting. 40 | Special Focus IRAN economic monitor | seizing the opportunity Special Focus 2: Iran’s Financial Sector at the Dawn of the Lifting of Sanctions this chapter highlights some early sequential actions Abstract in order to better define the needed financial sector reform measures to follow. Iran’s financial sector is critical to propel Iran’s economy towards the high, sustained and inclusive 64. The special focus is divided into three growth targeted in the country’s sixth five-year sections. Section A provides a broad overview of development plan. The sector, however, has been the contemporary Iranian financial sector and recent battered by the disruptive impact of the sanctions relevant policy developments in the financial sector. but also by longstanding distortive policies including Section B identifies some of the possible effects of directed lending schemes and effective interest rate lifting of sanctions on financial development. Finally, ceilings amid high inflation. Our second Special Section C highlights key reform measures needed Focus reviews the structure of Iran’s banking and to further strengthen the resiliency of the financial financial sector, the implications of the lifting of the sectors and to provide for its long term sustainability. sanctions, and outlines key structural reforms areas. The text is further supplemented by three Annexes While the lifting of the sanctions will provide much on the financial architecture, capital markets and needed breathing space to the financial sector, in non-bank financial institutions and a short summary and by themselves, they can only deliver moderate of international financial sector standards. gains in terms of growth and jobs; only when coupled with essential structural reforms can Iran be expected to reach the growth target of its sixth five-year plan. Structural reforms include improving the independence and effectiveness of the Central Structure and Bank of Iran to fulfil its monetary policy, and banking regulatory and supervisory mandates. recent developments in the banking and financial sector Introduction 63. This special focus offers a high level overview of the Iranian financial sector and possible impacts of the lifting of sanctions under The Banking Sector the JCPOA. The preparation and supporting analysis of the financial sector has been constrained however The Iranian banking system is large and financial owing to the limited availability of data regarding access is high. The government is heavily involved banks, non-bank financial institutions, securities in the sector directly through public banks, and market and the financial infrastructure. As such, the moreover, through directed lending schemes and in scope and the detail of findings and recommendations establishing and maintaining effective interest rate were constrained. Notwithstanding these limitations, ceilings. Special Focus | 41 The World Bank 65. The Iranian banking system is large, with total assets of near 150 percent of GDP in 2010 (including assets by the CBI). The system consists of 35 institutions divided into four broad categories: three government owned commercial banks, five specialized government banks, 27 private banks and one near bank (Credit Institution for Development) in 2014. Banks Melli (public), Mellat (privatized), Maskan (public) and Parsian (private) dominate the market. State and privately owned banks alike are often subject to state influence, as their shares may be acquired by state affiliated entities, which can FIGURE 38. Iran: bank credit growth. influence banking policies (EUI, 201423). Moreover, some private banks are financial extensions of large Source: “Islamic Republic of Iran” IMF Staff report for the 2014 Article IV consultation. March 13, 2014 parastatal, commercial and/or industrial groups. The reduction of these cross-shareholdings is among the stated goals of the Central Bank of Iran (CBI). percent private banks, 18.5 percent public specialized Moreover, the Iranian banking system is fully Islamic, banks and 68 percent public commercial banks. among the highest in the world at 100 percent. Subsequently, the partial privatization of a number Comparator countries such as Saudi Arabia, Brunei of public banks was launched, wherein a small and Kuwait are less than 50 percent. portion (about 10-15 percent) of equity was placed on the Tehran Stock Exchange. By 2011, the market 66. Iran has the second highest banking shares in all bank segments shifted dramatically. penetration rates in the MENA region (Business The private banks had about a 20.5 percent market Monitor International, 201524). A total of 74 percent of share according (IMF, 201126). The newly privatized adults have an account at a formal financial institution (or former public) banks had about a 33.8 percent and 20 percent of them made savings using a formal market share and public commercial banks and account (Demirguc-Kunt and Klapper, 201225). Only specialized banks had 21.8 percent and 23.9 percent 3.1 percent of adults have credit cards, which is low share, respectively (for a total of 54.7 percent). for Iran’s economic size and population. Debit cards are common, while electronic payment points and 68. Through the central bank’s Monetary POS systems and ATM networks are extensive and and Credit Committee27 (MCC) the Government debit card issue rose from 24 to 155 million cards determines deposit rates, interest equivalent held between 2006 and 2012 (Business Monitor borrowing charges and intervenes through key International, 2015). Annex 1 provides an overview of banks’ credit allocations for specific sectors. The Iran’s financial infrastructure. specialized banks depend on CBI refinancing to implement large, directed credit programs of the 67. Banks’ market shares (or percentage of government. As an illustration of the scope of public total system assets) have changed considerably funding, by end-2010 the CBI lent the specialized in recent years owing largely to a series of partial banks an amount equivalent to about half the deposits privatizations launched by the Government. In of the private banks (believed to mostly support 2007, the banking system was composed of 13.5 26  IMF (2011) “Islamic Republic of Iran: Selected Issues 23  Economist Intelligence Unit (2014) “Industry report, Iran paper,” Country report No. 11/242, Washington DC Financial Services,” September, London. 27  The MCC, established under Article 18 of the 1972 24  Business Monitor International (2015) “Iran Business Monetary and Banking law, is chaired by the CBI Governor and Forecast Report: Q1 2015”. composed of, inter alia, a number of Government ministries, the 25  Asli Demirguc-Kunt and Leora Klapper (2012) “Measuring Budget Bureau, Bankers’ Association, the Prosecutor General. Financial Inclusion: The Global Findex Database” World Bank It is authorized to approve CBI regulations, provide credit Policy Research Working Paper 6025, April, Washington DC. allocation recommendations and some CBI decisions. 42 | Special Focus IRAN economic monitor | seizing the opportunity 12.9 Capital to Risk Weighted Assets Services 35.5 Misc 12.2 Agriculture Manufacturing and Mining Construction and Housing 0.1 Trade 29.9 9.4 FIGURE 39. Share of economic sectors in facilities FIGURE 40. Regulatory capital to risk-weighted assets extended by banking sector (2013/14, percentage out of (CAR) for Iran and comparator countries 2,362 trillion Rials) Source: Data from CBI Annual Review. Year: 1392 (2013/14). Source: FSI (IMF eLibrary Data on 8/5/2015) and CBI data. housing finance). While such large schemes have economic volatility (Al Monitor, 201529). Of note, in substantially abated in recent years, past government 2013 two of the largest specialized government banks directed lending and on-going interest rate equivalent (Bank Maskan and Bank Keshavarzi, for housing and ceilings lead to higher Non-Performing Loan (NPL) agriculture, respectively), each realized negative ratios, the misallocation of capital, undermining net interest income. Together with high NPL’s, low banks’ profitability and capital. Credit growth under spreads contributed to reduced cash flows, increased these conditions can weaken the soundness of banks provisions / write-offs and reduced ability for lending. even further. 71. Against the backdrop of tightened sanctions, 69. Between 2007 and 2014, banks shifted their during 2010-11 the government intervened credit portfolios toward government exposures further in the banks’ credit allocation to support (Figure 38). Claims on public sector have grown job creation as access to foreign capital became more than claims on non-public sector during this more restricted. The MCC recommended that banks period (IMF, 2014). However, negative real interest allocate 80 percent of their increase in deposits to rate spreads on the back of high inflation and interest priority sectors—37 percent to manufacturing and equivalent rate ceilings reduced banking profits even mining, 25 percent to agriculture, 20 percent to lower, as spreads reduced from 0.1 to -3.8 percent construction and housing, 10 percent to trade, and between 2010 and 2013 (Insignia Consulting, 201528). 8 percent to export (Figure 39). The remaining 20 percent of the increase in deposits could be used 70. Moreover, negative real deposit rates due freely, although there are sub-limits on credit for to high inflation in 2013 caused depositors to shift consumer durables or home improvement loans (IMF, assets to other areas such as property or gold. 2011). The cumulative effect of these constraints is Indeed, the gold and foreign currency held by public to severely limit banks’ credit underwriting and risk is estimated around US$21.5 billion, five times more management decision making and otherwise depress than the US$3.9 billion gold reserves of central bank. earnings and moreover, capital accumulation. However, promoting public trust to attract and utilize these resources in the banking system to increase Capital levels and key performance ratios have lending ability may be challenging due to past deteriorated markedly in recent years and the banking system appears vulnerable in the event of further shocks. 28  Insignia Consulting (2015), “Banking Sector Reforms,” 29  Al Monitor (2015) “Action needed to reform Iranian banks,” June. January 13. Special Focus | 43 The World Bank Return on Equity for Banks Return on Assets for Banks FIGURE 41. Return on equity for banks for Iran and FIGURE 42. Return on assets for banks for Iran and comparator countries. comparator countries. Source: Financial Soundness Indicators (FSI). Data Extracted from Source: FSI (IMF eLibrary Data on 8/5/2015) and CBI data. IMF eLibrary Data on 8/5/2015 and CBI data. 72. The banking system remains vulnerable to 74. Moreover, Iranian bank provisioning shocks, as it is currently operating with limited practices for impaired assets are different from capital. Iran’s system-wide Regulatory Capital to traditional (non-Sharia) banks, resulting in Risk-Weighted Assets (CAR) dropped from a peak of substantially lower provisions -- likely overstating 10.0 percent in 2008 to 7.6 percent in 2014 (Figure reported capital levels. Under Sharia banking 40). This sharply declining trend suggests banks’ principals, losses are generally ‘shared’ between the loss absorptive capacity is weak. Regional cross creditor and borrower at the time the borrower’s country comparisons suggest Iran’s banking sector obligation falls due. Given that Iran’s banking system is the most vulnerable to shocks, as the CAR is is 100 percent Sharia (among the highest in the significantly below its peers (even prior to the onset world) limits direct comparisons with other Islamic of the latest sanctions). countries’ NPL provisioning levels, as most such countries have a smaller portion of Sharia banking 73. Banks’ NPL ratios are comparatively high practices in place. in Iran, and may be understated given the large public and quasi-public bank sectors, indicating 75. Banks’ profitability has sharply declined the need for more efficient credit provision relative to the pre-sanctions levels. Profitability practices and better risk management. Banks’ measured by banks’ overall return on equity (ROE) aggregate reported NPL ratio was 12.0 percent in plunged in the post sanctions era, reaching 7.5 March, 2014 and is higher for private banks (16.5 percent in 2013 compared to 16.1 percent in 2010 percent) -- which hit a peak of 26.2 percent in (Figure 41). Similarly, return-on-assets (ROA), which 2009. Bank loans, which contracted more than was already low at 1.1 percent in 2010, dropped deposits in 2013 are expected to continue to grow to 0.5 percent in 2013 (Figure 42), indicating the more slowly than deposits in coming years. In impact of the economic slowdown in 2011-2013, comparison, the ratio of NPL to gross loans is 1.2 the accumulation of NPLs and weak management of percent for Saudi Arabia, 1.6 percent in Malaysia bank assets. As illustrated in both the ROA and ROE and 2.7 percent for Turkey.30 This fact points out figures, Iran’s bank profitability measures are the by to the necessity of having more efficient credit far the lowest when compared to peer countries. provision practices and better risk management for the banking sector. 76. Importantly, liquidity in the Iranian banking system has sharply declined since 2008, signaling that banks have little room to maneuver 30  Data from Financial Soundness Indicators (FSI) and in the event of need. Overall, banks’ liquid assets extracted from IMF eLibrary Data on 8/5/2015 44 | Special Focus IRAN economic monitor | seizing the opportunity as a percentage of total assets has fallen from an and practices, and anti-money laundering and already low 13.6 percent in 2009 to 8.3 percent in terrorism financing law. 2014. Equally, the broader measure of bank liquidity -- liquid assets as a percentage of short-term 78. The CBI’s regulatory reach was expanded liabilities -- mirrors this sharp decline in liquidity. after 2010 to strengthen its supervisory powers, Thus, banks are dependent upon wholesale or especially towards public banks. In particular, institutional funding, confirmed by the fact that the the CBI has been given authority to disqualify relatively high 2014 LDR of 118.4 percent is higher directors and senior officers of banks, and extend than any of Iran’s comparator countries. its fit and proper tests to public bank officers. However, CBI’s means to strengthen its governance, 77. Finally, giving rise to serious concerns influence inflation and directed lending or utilize its as to banks’ exposure and management of their enforcement (or “cease-and-desist”) powers are assets, some banks have made large investment in circumscribed. As an example, regulatory violations mines, buildings, shopping malls, steel factories, are referred to a Bank Disciplinary Committee, etc. This practice appears to be pervasive, as the which is comprised of non-CBI members. CBI declared in mid-2014 that banks’ investments in non-banking sector asset holdings are not to exceed 79. More broadly, Iran has begun improving 40 percent of their capital (Financial Times, 201431) banking practices and standards of information As well, the CBI requested banks submit a list of disclosure and corporate governance through the the companies they directly and indirectly owned listing of recently privatized banks. Currently near by September 2014, and divest excessive holdings half of the banking system (by number of banks) within three years32. Banks’ use of deposit resources now disclose some financial information through for these investments inevitably reduces financial the Securities and Exchange Organization on a access for other borrowers, can sharply impact bank quarterly basis, thereby improving transparency of liquidity and exacerbate financial difficulties if the the banking sector (IMF, 2011). Furthermore, the investments do not generate expected cash flows. CBI issued a regulation in 2007 on the classification and provisioning of banking that made core financial soundness more comparable, helping to illustrate the extent of forbearance required for banks to work in the context of economic isolation (IMF, 2011). Recent Banking Sector 80. Crucially, the government has recognized Policy Developments the need to introduce additional financial sector reforms to modernize its banking, capital markets and Key AML/CFT and government debt infrastructure. To that end, President Rouhani issued a potentially far- Outstanding Issues reaching Executive Order in mid-2015 to establish a task force of MoF, CBI and other officials to The new government recognizes the need focus on developing a time-bound reform plan in tomodernize its banking, capital markets and accord with the following three broad parameters: government debt infrastructure, including (i) Banking: better regulate SME financing; reduce strengthening CBI’s policy and operational NPLs; improve accounting standards for banks and independence, banks’ financial disclosure standards borrowers alike; regulate illegal credit institutions; improve banks’ capacity to finance working capital 31  Financial Times (2014) “Iranian banks pressed to retreat lending; (ii) Capital Markets: better direct long- from asset speculation” by Najmeh Bozorgmehr, September 8. term financing (or infrastructure) lending to the 32  Calculations from above note #12 indicate that the official capital market or foreign sources; deepen firms’ resources estimate banks’ total investments in their companies access to capital market financing (debt or equity); to be around 53 percent of their total capital. Special Focus | 45 The World Bank and (iii) Government Debt Markets: assess and re- a result, corporate and financial sector vulnerabilities profile payment of government debt held by banks; combined with external trade and cash flow develop new instruments and approach to public restrictions in the corporate sector (especially in debt auction. SOEs) have reduced banks’ asset quality, profitability and capitalization levels. Public banks, as previously 81. Nevertheless, Iran’s international ranking indicated, are further exposed through numerous on anti-money laundering and terrorism financing directed lending schemes and weak SOE borrowers. remain very negative, exacerbating risk perceptions Moreover, banks’ reported NPLs may be under- abroad. The Basel Institute published its 2015 estimated due to past supervisory forbearance and Basel Anti-Money Laundering (AML) AML Index33, weak loan classification and enforcement standards. ranked Iran the worst of 152 countries surveyed according to their risk of money laundering and 83. Prolonged economic isolation and directly terrorist financing. The August 2015 edition of the targeted sanctions on financial and insurance Basel AML Index report is developed by the Basel industries have led to both sectors operating Institute on Governance and is derived from 14 well below their potential compared to other indicators based on publicly available sources such countries. For example, Iran’s financial services as the FATF, Transparency International, the World exports were only US$94 million (1.4 percent of total Bank and the World Economic Forum. The scores are service exports) and imports were US$445 million aggregated as a composite index using a qualitative (3.3 percent of total service imports) in 2013/14 and expert-based assessment. (CBI, 2014). Turkish financial services exports were US$531 million and imports were $1,221 million during 2014, while insurance services exports were US$869 and imports were US$1276 million35. In terms of FDI, Turkey attracted approximately US$14 Implications of the billion of FDI in financial and insurance services last five years, 2010-201436. lifting of sanctions 84. Iran has an estimated US$100-120 billion The lifting of sanctions will serve to substantially of frozen assets held abroad due to numerous reconnect Iranian banks to (parts of) the international economic sanctions, of which about US$30-60 may financial market infrastructure34 thereby reducing be available. In addition, the CBI has limitations with time and cost of doing business and trade. its hard currency reserves, since substantial amount of Iranian international trade (with main partners 82. Sanctions and Government policies alike Russia and China) are made in kind (such as oil for have affected banks’ lending, asset quality, liquidity goods) rather than cash. Additional sanction measures and profitability, thus eroding their overall capital adopted in early 2013 prevented Iran from taking its levels. Numerous sanctions over time have created hard currency back and prohibited transfer of these external shockwaves to the economy, reduced oil currencies to a third country for payments, hence revenues, limited trade, investment opportunities and forcing Iran to buy products of countries that import substantially disconnected Iran from international oil from Iran. Transfer of precious metals to Iran is also financial system. Domestic conditions such as prohibited. In addition, many foreign credit cards will volatility of inflation and output further deteriorated not function in Iran due to international sanctions. In the operational environment of firms and banks. As the event the sanctions are lifted, there is tremendous scope to begin to reform, re-capitalize and consolidate 33  See: https://index2015.baselgovernance.org/sites/default/ files/aml-index/Basel_AML_Index_Report_2015.pdf the government owned banking system. 34  The US non-nuclear sanctions (e.g., related to terrorism) will remain in place and will not allow Iranian banks to use the US 35  Data from the UN Trade Database. financial and banking infrastructure including via correspondent banks. 36  Data updated Apr 2015; 2013 and 2014 are predictions. 46 | Special Focus IRAN economic monitor | seizing the opportunity 85. The CBI and many Iranian banks have been liberalization, reforms and recapitalization of the blocked from the international funds exchange financial system. Moreover, new strategic investors39 network (SWIFT)37, effectively precluding the ready bring additional know-how and technology transfer transfer of funds in and out of country. Exclusion to the financial sector, which will further strengthen from SWIFT system has left affected Iranian banks its resiliency and ability to innovate. The removal of more dependent on other domestic banks, driving sanctions is expected to pave the way in the medium up their costs and inhibiting their foreign business term to a wide range of financial sector reforms dealings. Even non-sanctioned Iranian banks have affecting financial institutions and consumers alike. difficulties to find international counterparts, which are wary of being excluded from US financial system due to their transactions with Iran. 86. In terms of access to international Key areas of financial markets, Iran has the second lowest regional position, in line with Libya, Syria and potential financial Yemen – and only above Afghanistan. Most Iranian banks’ international operations and money transfers sector reform are routed through other financial institutions, thus are more time consuming and expensive with The prospect of lifting sanctions provides an relatively few banks able to maintain European and opportunity to engage into much needed structural Asian correspondent bank accounts (BMI, 2015). reforms, the specifics of which should be informed This situation further restricts international business by, inter alia, a comprehensive asset quality review of opportunities of Iranian companies due to increased banks, and a benchmarking exercise of the financial costs and time for international transactions. The sector regulatory and supervisory regime against prolonged isolation is likely to have resulted in applicable international standards. the increase in hawala money transfers, which are completely unregulated, informal and honor 88. Iran’s banking system is in need of based. Additionally, the increase in use of smaller structural reforms to fulfill its role of boosting scale, or unlicensed institutions to conduct financial growth, job creation and prosperity. The banking transactions is likely to have occurred (though system is likely to need, inter alia, new capital, liquidity by definition such cannot be corroborated): non- and knowledge transfer to support development of licensed credit institutions reportedly constitute both a more resilient banking sector and a more around 15 percent of Iranian banking activities (CBI, robust, comprehensive prudential regime. With 2015)38. many variables at issue internally and externally, the envisaged structural reform process will oblige 87. Looking forward, the removal of sanctions consistent coherence on behalf of the authorities can expand access of Iran’s financial sector, aid and moreover, will take time to be realized. in the attraction of new credit lines, capital, technology and know-how. The return of foreign 89. The below reform measures could be credit lines, which are likely to initially be slowly put considered to strengthen the asset quality, in place, will enable banks to help stimulate domestic financial stability and supporting regulatory, lending demand, thereby creating new business and supervisory and institutional framework. Some economic growth opportunities for Iran. Equally, of the key weaknesses in the banking system the lifting of sanctions is likely to promote further can be addressed within the near term, inter alia, through modernizing the regulation, supervision 37  SWIFT stands for the Society for Worldwide Interbank Financial Telecommunication. 39  Strategic investors, as compared to financial investors, 38  Central Bank of Iran (2015) “Banking Sanctions will be typically follow after foreign credit lines are successfully 0re- lifted once nuclear agreement is implemented,” May 17. opened Special Focus | 47 The World Bank and the bank resolution frameworks. In the longer to be a key constraint to profitability, new lending term, financial sector linkages within the corporate, and capital accumulation. Moreover, strategic government and banking sectors can be addressed investors will require banks’ balance sheets through restructuring, new capital and the transfer to be scrutinized and NPLs addressed before of knowledge. providing much needed new equity capital. Fortunately, there is a wide body of knowledge available regarding such matters from Malaysia, Possible short-term financial sector Indonesia and Turkey. actions (about one year): 90. Drawing from the earlier asset quality • Undertake a comprehensive review of the review and corporate governance diagnostic central bank’s legal, regulatory, supervisory, assessments, Iran could form a standing high- macro-prudential, resolution and supporting level Financial Sector Commission composed of frameworks. To strengthen the policy and key stakeholders. The proposed Commission could operational independence of the CBI and align develop and begin to take further concrete, time- its legal mandate and supervisory and regulatory bound steps to align with international prudential framework with international norms, a series of and supervisory norms for banking, insurance, thorough assessments will be essential in the securities, corporate governance, insolvency, following areas: bank supervision, regulation, deposit insurance, anti-money laundering, payment financial stability, crisis management (e.g., systems, etc. Regulatory and electronic systems in deposit insurance, bank resolution, lender of banking sector and financial markets (specifically last resort facility) and anti-money laundering/ capital markets) need to be compatible with counter-terrorism financing areas. Overall the international systems for inter-operability to provide independence of the CBI is constrained at a fast, accurate, secure cross-border transactions. number of levels. Annex 3 provides an extensive summary of international financial sector benchmarks which will • Launch a comprehensive triage exercise help the authorities determine the scope, sequence utilizing objective solvency and corporate and quantum of reforms to be put in place. governance assessments of each public and quasi-public bank. Develop an accurate 91. To stem the flow of new non-performing understanding of the asset quality, capital and borrowers, an upgrade and expansion of the governance issues at each bank is essential to existing credit registry, in line with accepted determine prospective solutions and fiscal costs consumer data protection and risk mitigation alike. standards, would be desirable. In this context, establishment of a mandatory prudential provision • Thoroughly assess the bankruptcy or to oblige each licensed credit provider to provide insolvency regime for both enterprises and data on its borrowers will enable better risk persons to align with best practice standards, management and the eventual establishment of as deficiencies could have important individual borrowers’ credit scoring and corporate implications for the resolution of banks and borrowers’ credit ratings based on their financials, NPLs alike. business model and management quality. These agencies can rate banks, listed companies and debt • Consideration could be given to the issuers, improving transparency and accountability establishment of either a public asset in the corporate sector. management company and/or special creditors’ court to expedite the resolution of banks’ NPLs. Bad loans and the dominance of highly leveraged state owned banks will continue 48 | Special Focus IRAN economic monitor | seizing the opportunity Potential longer-term Action Plan (from with International Financial Reporting Standards one to three years): (IFRS) Sharia standards and strengthen external audits by issuing regulations on audit standards • Develop time-bound financial and/or and manage approval of external auditors by the operational restructuring plans for each CBI. Proper audits would contribute to improving public and quasi-public bank. The merger of the competitiveness and transparency of banks, some banks may be necessary to most efficiently enabling to raise more equity or debt through allocate financial and human capital. Equally, the Tehran Stock Exchange, or later, abroad. as discussed above, the overall stock of public enterprise NPLs may oblige the formation of a • Anti-money laundering and counter-terrorism public asset management company (AMC) to financing (AML/CFT). In light of the new CFT resolve such obligations and ‘clean’ remaining law recently passed in Parliament, the earlier public banks’ balance sheets. proposed assessment would offer the authorities concrete findings and recommendations to • The bank solvency assessment is to be mitigate such risks, align its AML/CFT regime to followed, inter alia, by selected bank re- international norms and accordingly, improve capitalizations. This will be essential for Iranian perceptions aboard. banks to better compete domestically, invest in needed technology, risk management and staff • Reduction of cross shareholdings among capacity building -- and to successfully undertake banks and different parts of economy is business abroad. essential. This would affect those institutions with linkages to many financial and non- • To better ensure the viability of remaining financial parts of economy. Linkages between banks and minimize fiscal outlays going banks and large borrowers through ownership forward, the scope of government involvement or connected lending must be reduced, as in the banking sector should be more narrowly these linkages can delay or block restructuring defined. This is especially the case regarding when they are either sector specific or beyond credit allocation targets, management and board accepted large exposure limits (IMF, 2011). appointments, deposit and interest equivalent As well, these cross-shareholdings and equity rate ceilings. Continuing such involvement investment can magnify shocks across different undermines effective credit risk management, sectors, threatening the solvency of financial corporate governance and internal control. It is institutions. necessary to improve bank profitability, capital and liquidity levels. Resulting productivity gains • Stronger financial reporting, accounting and can enable public banks to better compete and regulatory disclosure standards should be introduce new Islamic banking instruments. adopted. This should especially be the case for financial institutions and other TSE listed firms, • Banking and central bank laws should be and for adopting IFRS Sharia requirements to modernized to strengthen the authority of promote transparency, strengthen investors’ the CBI to issue and enforce its regulations, confidence and thus, stimulate new demand. monitor and act on threats to financial stability and to better control weak, failing or illegal • Financial consumer protection regime should banks. The authorities should adopt a suitably be independently assessed against best robust macro-prudential framework to identify practice standards. Public confidence in the and mitigate potential risks to financial stability. financial sector is enhanced when depositors Inconsistent regulation and supervision weakens and borrowers alike understand both their rights the banking system. Equally, the CBI can oblige and banks’ obligations to disclose the true or banks to prepare their financial statements in line all-in cost of credit. Mandating a consistent Special Focus | 49 The World Bank financial consumer disclosure regime will enable government ownership. Privatization process customers to compare banks’ offers, stimulating created complex ownership patterns where competition and enhancing transparency in many firms have shareholders, which are deposit taking and lending activities. partly owned by government or its related agencies. Although a large number of private • Professional knowledge and skill development shareholders are also involved, the extent of key public financial sector staff should be of their holdings compared to State or organized. Key areas for skills development parastatal organizations needs to be known. could include, inter alia, corporate governance, Deepening of capital markets towards credit risk management, IT security training, private companies is important for efficient international accounting and auditing standards, allocation of financial resources towards that international financial reporting standards and part of the economy. Basel related reforms. This could be undertaken through additional resources provided either the b. Developing a stronger insurance sector. CBI and/or the Iranian Bankers’ Association. The sector is only about 2 percent of GDP in Iran, offering tremendous scope for risk • Iranian foreclosure, collateral execution and mitigation and growth. Iran will especially insolvency laws need improvement to reduce need help of international firms (capital and the stock of NPLs. Collateral execution related know-how, etc.) to revive insurance and re- weaknesses yield the lowest recovery rates insurance in, inter alia, the oil and shipping within peer group of countries such as Turkey, industries, which fits their goal of becoming Egypt, Saudi Arabia, BRIC countries (Insignia a regional hub. Consulting, 2015). Equally, the insolvency regime should be effective and bankruptcy c. Cross listing of some companies between should be a credible threat for persons, enterprise TSE and other markets. The regulatory and owners and management alike. This will require institutional alignment reduces cost of listing removal of political interference in the insolvency for the firms, and also serves to help attract process and more efficient courts with adequate capital. expertise in corporate restructuring (IMF, 2011). • Iran could review its foreign investment regime • Informal finance seems a widespread to best utilize new financial investments. alternative for borrowers who do not access Currently, banking regulations allow foreigners the formal banking system (IMF, 2000)40. to have 40 percent stake in local banks, however Iranian financial system has non-licensed credit there are European and Arab investors, among institutions that offer higher deposit rates and others, interested in establishing new banks, account for around 10-15 percent of banking open branches and buy stakes in private banks activities (CBI, 2015). The continued existence of (CBI, 201541). In exchanges and OTC markets, such non-licensed lenders—some of which may foreign non-strategic investors are subject to accept deposits—warrants careful consideration following limits (TSE, 201242): The number to address given the potential social implications. of shares of these investors cannot exceed 20 percent of total share number of firms (listed • Capital and technology inflows in the non- on exchange or OTC markets) or 20 percent bank sectors need improvement. This can be of shares number of any company (listed on achieved through: exchange or OTC markets). The number of a. Having the majority of market capitalization 41  Central Bank of Iran (2015) “Banking Sanctions will be lifted once nuclear agreement is implemented,” May 17. made up by companies with no indirect 42  Tehran Stock Exchange (2012) “Iran’s Capital Market. How 40  IMF financial sector evaluation report on Iran, 2000. to invest in Tehran Stock Exchange (TSE),” TSE guide. 50 | Special Focus IRAN economic monitor | seizing the opportunity shares owned by each investor in any listed Energy Information Administration (EIA), 2015, “Iran company cannot exceed 10 percent of shares Country Report,” June 2015, http://www.eia.gov/ number of that company. beta/international/analysis_includes/countries_long/ Iran/iran.pdf • The limits on foreign financial investments need to be updated over time to incentivize Esfahani, H., Mohaddes, K., & Pesaran, H. (2013). long-term flows. The authorities optimal pace Oil exports and the Iranian economy. The Quarterly of liberalization need to be decided and the Review of Economics and Finance, 53 221– 237. financial markets need to be supported with strong regulatory and supervisory standards as Facts Global Energy (FGE), 2015, “Iran Post- well as investor protection to better ensure long Sanctions: A World of Opportunities,” Presentation term investment opportunities rather than short by FGE President to Petroleum Executives, Tokyo, term flows, which can be destabilizing. Japan, July 2015. Hamilton, J. (2009). Causes and Consequences ofthe Oil Shock of 2007–08. Brookings Papers on Economic Activity. References International Energy Agency (IEA), 2015, “Medium- Adriaan M. Bloem and Manik L. Shrestha Term Market Report: Analysis and Forecast to 2020,” (2000): Comprehensive Measures of GDP and Paris, 2015. the Unrecorded Economy”. IMF Working Paper WP/00/204. Organization of Petroleum Exporting Countries (OPEC), 2015, “Monthly Oil Market Report,” July Barclays Cross Asset Research, 2015, “Iran Primer: 2015, Vienna. The Long Road Ahead,” July 2015, Barclays, United Kingdom. Schneider, Friedrich, Andreas Bueh and Claudio Montenegro (2010). Shadow Economies All over the British Petroleum (BP), 2015, “Statistical Review of World New Estimates for 162 Countries from 1999 World Energy,” 2015, http://www.bp.com/en/global/ to 2007. World Bank Policy Research Working Paper corporate/about-bp/energy-economics/statistical- No. 5356. review-of-world-energy Taiebnia, Ali and Shapour Mohammadi (2008). Buzcu-Guven, B., et al, 2010, “Gas Flaring and Underground Economy and Tax Gap. Iranian Venting: Extent, Impacts and Remedies,” Energy Economic Review, Vol.13, No.22, Fall 2008. Forum, James Baker Institute for Public Policy, Houston, September 2010. World Bank a. (2015). Global Economic Prospects June 2015: The Global Economy in Transition. Djavad, Salehi-Isfahani, 2009. “Poverty, Inequality Washington D.C. and Populist Politics in Iran”, Journal of Economic Inequality, 7, 5–28. World Bank b. (2015). World Bank Commodities Price Forecast, Washington D.C., October 20, 2015. Egel, D. and D. Salehi-Isfahani (2010). Youth Transitions to Employment and Marriage in Iran: Evidence from the School to Work Transition Survey, with Daniel Egel, Middle East Development Journal, 2(1), 89–120. Special Focus | 51 The World Bank Annex 1. Iran’s Financial Infrastructure 1. The CBI has begun to improve its 3. The CBI also started testing of electronic monitoring of the banking system through system for check clearance (CHAKAVAK) to implementation of new electronic systems, which standardize checks among banks, harmonize help to secure financial system transactions. process of check issuance, eliminate physical These arrangements include implementation of check clearance, and enable the full electronic systems for retail fund transfers, establishment and transfer of checks. operation of interbank financial telecommunication/ transaction systems (SEPAM), electronic card payment and settlement system (SHAPARAK), and creation of infrastructure to centralize payment operations of governments. 2. The financial infrastructure also includes small value wire transfer system (SAHAB), automated clearing house system (PAYA-for small funds transactions), RTGS system (SATNA-for large fund transfers) and interbank clearing house. Data indicates that transactions processed through SATNA and PAYA systems increased more than 100 percent in 2013/14 compared to the prior year and for SAHAB and SHETAB systems 95 percent and 47 percent respectively. The major reform steps taken in 2013/14 include: • Expansion of interbank information transfer network (SHETAB) for trilateral fund transfers, • Improvement of the government’s financial operations by CBI’s integrated comprehensive wire transfer system, • The launch of script-less securities through the pilot system of securities depository, • Design of the Mobile Payment System (SEPAS) and the Mobile Wallet (KIVA), • Launch of a pilot system to control funds transfer using the Nationwide Standard Bank Account Number (SHEBA). 52 | Annex IRAN economic monitor | seizing the opportunity Annex 2. Capital markets and non-bank financial sector 1. The over the counter (OTC) market- be guaranteed minimum return, non-guaranteed Iranian Fara Bourse- has different components: minimum return or expected return. Finally, The OTC markets involve various activities such as they can engage in securities as well as gold or IPO’s with block or retail offerings, underwriting of commodities markets. securities, and stock trade as well as transactions of other securities such as CD’s, sukuk and mortgage 4. The mutual funds industry is highly backed securities (MBS). concentrated (EUI, 201447). As of September 2014, the top 10 mutual funds accounted for 79 percent of 2. The Iranian Mercantile Exchange (IME) total mutual funds industry. Among these, seven are trades spot contracts of agricultural products, fixed income funds, while the remainder are stock manufacturing and mining products, and oil funds. The largest mutual fund is the Bank Kehavarzi and petrochemical products. The IME provides (Agriculture) fixed income fund, which represents spot, credit and forward transactions totaling 428 44 percent of total mutual funds industry with about trillion Rials43 (or about US $12 billion equivalent). $ 600 million of total assts. It is also planning to offer crude oil contracts and futures44 and to launch new petrochemical 5. Mutual funds industry supports the stock contracts on the Iranian Oil Bourse on Kish Island markets: As of 2011, there were 2 million active to promote existing and planned contracts45. direct retail accounts in TSE, which represent half According to the IMF 2011 selected issues paper, of the market turnover and 21 percent of market Iran intends to use prices in IME as benchmark to capitalization. The rest were held by closed end adjust domestic prices for the subsidy reform. investment companies (25 percent), pension funds (17 percent), government affiliated investment 3. The mutual fund industry grew fast in companies (16 percent), banks (5 percent) and recent years, as open ended funds rose from justice shares (16 percent), which are mostly 21 to 120 between 2009 and 2014 and started passive investors (Agah Group, 201548). to invest through the TSE in 2009. By end-2014, there were 136 funds established, with total assets 6. Iran has a large pension system with of just over US $1 billion under management, heavy government involvement. The Social with much more potential to grow and attract Security Organization managing pensions of retail investors to the market (Thompson Reuters, private sector employees, is the largest public fund. 201446). In terms of underlying assets, they can There is also Civil Service Retirement Organization be stock, fixed income or hybrid funds. The (CSRO) for civil servants and the Armed Forces mutual funds can have their liquidity guaranteed Social Welfare Investment Organization (SATA). In or non-guaranteed. In addition, their returns can 2010, SATA took control of power stations and six petrochemical plants. Moreover, there are pension 43 Ibid. funds of two largest automotive manufacturers in 44  “Islamic Republic of Iran: Selected Issues Paper”, August Iran, which became the main buyers of the shares 2011, IMF 45  “Petrochemical Contracts to Be Offered in Iran’s Oil 47  Economist Intelligence Unit (2014) « Industry report, Iran Bourse” July 26, 2015. http://www.defenddemocracy.org/ Financial Services,” September, London. 46  Thompson Reuters (2014) “Persian Profits” Zawya, Nov 24. 48  Agah Group (2015) Iran’s Capital Market Review. Annex | 53 The World Bank in companies, through which the Government companies can set themselves up in six free trade reduced its stakes in September 2010. zones of Iran but there are also discussions to allow foreign insurers to operate in mainland. 7. The pension funds are heavily involved with governmental sector, as pensions include the parastatal sector and share ownership in many privatized companies. About a decade ago, mandatory pension schemes of Iran covered more than 40 percent of labor force; given public sector size, the coverage could be higher (Robalino et al., 200549). There were also occupational plans as substitutes to the main scheme:  Iran had at least  20 occupational pension plans, all defined-benefit arrangements (Robalino et al., 2005). Management of pension funds had mandates unrelated to their core functions such as to finance economic and social development projects. 8. The recent Iranian privatizations enabled parastatal pension funds to acquire equity ownership in privatized SOE’s in lieu of cash payments due. Additionally, the Social Security Organization’s (SSO) investment company, SHASTA, is one of the largest investment fund companies. The SSO has holdings in 150 firms with a combined market value of $15 billion in 2012, and has since increased its purchases of government bonds and shares of SOE’s to relieve government’s fiscal pressures (Harris, 201350). 9. The insurance sector is under-developed in Iran: Total premiums are only 2 percent of GDP as of 2014, however this is similar to Saudi Arabia (0.85 percent) and UAE (2 percent), with 90 percent of premiums coming from the non-life market (EUI, 201451). There were 30 insurance companies operating by March 2014, the largest being state owned Iran insurance, which accounted for 41 percent of total premiums in Iranian insurance sector as of March 2012 (EUI, 2014). Foreign 49  Robalino David with Edward Whitehouse, Anca Mataoanu, Alberto Musalem, Elisabeth Sherwood, and Oleksiy Sluchynsky (2005) “Pensions in the Middle East and North Africa: Time for Change,” Orientations in Development Series, World Bank. 50  Harris, Kevin (2013) “The rise of the Subcontractor State. Politics of Pseudo Privatization in Islamic republic of Iran,” International Journal of Middle East Studies, Vol. 45. 51  Economist Intelligence Unit (2014) “Iran: League tables, Financial Services” May 28, London. 54 | Annex IRAN economic monitor | seizing the opportunity Annex 3. Guide to International Financial Sector Related Standards Featured below are key international financial corporategovernanceprinciples/31557724.pdf sector related standards to guide the authorities in determining the scope, sequence and quantum AML / CFT: http://www.fatf-gafi.org/media/ of financial sector reforms to be undertaken in the fatf/documents/recommendations/pdfs/FATF_ coming years: Recommendations.pdf Central Bank governance: http://www.bis.org/search /?q=central+bank+goverance Payment, clearing and settlement systems: http:// www.bis.org/press/p100202.htm Bank Supervision and Regulation: http://www.bis. org/publ/bcbs230.htm Credit reporting and registries: http://siteresources. worldbank.org/FINANCIALSECTOR/Resources/ Core Principle for Islamic Bank Regulation: http:// Credit_Reporting_text.pdf www.ifsb.org/standard/IFSB17-20Core%20 http://www.ifc.org/wps/wcm/connect/ Principles%20for%20Islamic%20Finance%20Regula 0f572a804dde8d028f9daf7a9dd66321/ tion20%28Banking20Segment29-April202015_final. Credit+Reporting+lowres+NEW. pdf pdf?MOD=AJPERES Macro-prudential stress testing: http://www.imf.org/ external/np/pp/eng/2012/082212.pdf ; https://www. imf.org/external/pubs/ft/wp/2013/wp1368.pdf Transparency and Beneficial Ownership: http:// www.fatf-gafi.org/media/fatf/documents/reports/ Guidance-transparency-beneficial-ownership.pdf Capital Markets Supervision and Regulation: https:// www.iosco.org/library/pubdocs/pdf/IOSCOPD154. pdf Deposit Insurance: http://www.iadi.org/docs/ cprevised2014nov.pdf Insolvency and Creditor Rights: http://web. worldbank.org/WBSITE/EXTERNAL/TOPICS/ EXTLAWJUSTICE/EXTGILD/0,,menuPK:6487417 3~pagePK:4789692~piPK:4789698~theSite PK:5807555,00.html Corporate Governance: http:// www.oecd.org/corporate/ca/ Annex | 55 The World Bank Selected World Bank publications on Iran (for an exhaustive e-list, see: http://www.worldbank.org/en/country/iran/research ) Ianchovichina, Elena ; Devarajan, Shantayanan ; Calabrese, Daniele ; Kalantari, Khalil ; Santucci, Lakatos, Csilla (2016), “Lifting economic sanctions Fabio M. ; Stanghellini, Elena (2008) “Environmental on Iran : global effects and strategic responses,” policies and strategic communication in Iran : the Policy Research Working Paper No. 7549, World value of public opinion research in decisionmaking,” Bank, Washington DC. Report No. 42535, World Bank, Washington DC. World Bank (2015), “Doing Business 2016: Hakimian, Hassan (2008) “Institutional change, Measuring Regulatory Quality and Efficiency—Iran, policy challenges, and macroeconomic performance Islamic Republic of,” Working Paper No. 100751, : case study of the Islamic Republic of Iran (1979- World Bank, Washington DC. 2004),” Working Paper No. 57725, World Bank, Washington DC, and Commission on Growth and ______ (2014), “Doing Business 2015 : going Development, Working Paper No. 26. beyond efficiency - Iran, Islamic Republic,” Working Paper No. 92044, World Bank, Washington DC. World Bank (2007a), “Iran - Power sector note,” Policy Note, Report No. 38360, Washington DC. ______ (2013), “Doing business 2014 : Iran - understanding regulations for small and medium- Van Greuning, Hennie ; Iqbal, Zamir (2007), “Risk size enterprises,” Working Paper No. 82864, World analysis for Islamic banks,” Report No. 42481, Bank, Washington DC. World Bank, Washington DC. Cortez, Rafael ; Pande, Aaka ; Eozenou, Patrick Dobronogov, Anton ; Jalali-Naini, Ahmad R. (2006) ; Leive, Adam ; Smitz, Marc ; Ozcelik, Ece (2013) “Explaining large inventories : the case of Iran,” “Iran, Islamic Republic of - Macro-fiscal context and Working Paper No. 37849, World Bank, Washington health financing factsheet,” Brief No. 80266, World DC. Bank, Washington DC. Kobayashi, Hayato ; Arif, Sherif ; Loayza, Fernando World Bank (2010), “Doing business 2011 : (2006), “Mainstreaming environment in the energy Iran, Islamic Republic - making a difference for sector - the case of the energy- environment review entrepreneurs : comparing business regulation for Iran,” Brief No. 38177, World Bank, Washington in 183 economies,” Working Paper No. 58750, DC. Washington DC. World Bank (2005a), “Iran - Report on public financial ______ (2009), “Islamic Republic of Iran - World management, procurement, and expenditure trade indicators 2009 : Trade brief,” Brief No. 72639, systems in Iran,” Policy Note, Report No. 34777, World Bank, Washington DC. Washington DC. ______ (2008), “Islamic Republic of Iran - Health ______ (2005b), “Iran - Management of Healthcare sector review : Main report,” Health Sector Review, Waste Policy Note,” Policy Note, Report No. 33286, Report No. 39970, World Bank, Washington DC. Washington DC. 56 | Selected World Bank Publications on Iran IRAN economic monitor | seizing the opportunity ______ (2005c), “Iran, Islamic Republic of - Cost Washington DC. Assessment of Environmental Degradation,” Policy Note, Report No. 32043, Washington DC. ______ (1996b), “Iran - Education, training and the labor markets (Vol. 2) : Annexes,” Report No. 13233, ______ (2005d), “Islamic Republic of Iran - Transport Washington DC. sector review and strategy note,” Policy Note, Report No. 34600, Washington DC. ______ (1995a), “Iran - Economic management and prospects : country economic memorandum,” ______ (2004a), “Iran - An agricultural policy note,” Report No. 13029, Washington DC. Policy Note, Report No. 29428, Washington DC. ______ (1995b), “Iran - Environment strategy study,” ______ (2004b), “Iran - Energy - Environment Report No. 12806, Washington DC. Review Policy Note,” Policy Note, Report No. 29062, Washington DC. ______ (1994a), “Iran - Services for agriculture and rural development: Main report,” Report No. 11956, ______ (2004c), “Iran : strategies for the housing Washington DC. sector,” Policy Note, Report No. 28983, Washington DC. ______ (1993a), “Iran - Industrial and mining sector study: Executive report,” Report No. 10867, Mehryar, Amir (2004), “Primary health care and the Washington DC. rural poor in the Islamic Republic of Iran,” Working Paper No. 30816, World Bank, Washington DC. ______ (1991a), “Iran - Reconstruction and economic growth : Main report,” Report No. 9072, World Bank (2003a), “Iran - Medium term framework Washington DC. for transition, converting oil wealth to development : economic memorandum,” Country Economic ______ (1991b), “Iran - Reconstruction and economic Memorandum, Report No. 25848, Washington DC. growth (Vol. 2) : Annexes and statistical appendix,” Report No. 9072, Washington DC. ______ (2003b), “Iran - Shelter for the poor and housing,” Brief, Report No. 91961, Washington DC. ______ (2003c), “Iran - The pension system in Iran : challenges and opportunities : Main report,” Policy Note, Report No. 25174, Washington DC. ______ (2003d), “Iran - The pension system in Iran : challenges and opportunities (Vol. 2) : Technical appendix,” Policy Note, Report No. 25174, Washington DC. Jensen, Jesper ; Tarr, David (2002), “Trade, foreign exchange, and energy policies in the Islamic Republic of Iran : reform agenda, economic implications, and impact on the poor,” Policy Research Working Paper No. 2768, World Bank, Washington DC. World Bank (1996a), “Iran - Education, training and the labor markets : Main report,” Report No. 13233, Selected World Bank Publications on Iran | 57 NOTES NOTES NOTES The World Bank www.worldbank.org/ir