Iran’s Economy: Short Term Performance and Long Term Potential

Djavad Salehi Isfahani
Djavad Salehi Isfahani
Djavad Salehi Isfahani Professor of Economics - Virginia Tech

May 23, 2008

In recent remarks at a Congressional staff briefing hosted by Security for a New Century, Djavad Salehi-Isfahani addressed current trends in Iran’s economy. He noted that high levels of investment, an increasingly active private sector, low poverty levels, and a lively public debate on the economy provide hope for long-term stability and development. Yet high levels of youth unemployment, especially among women, and weak institutions remain areas for concern. An edited version of his remarks follow.

I begin with a discussion of Iran’s short-run macroeconomic situation, which I believe is the source of some misunderstanding in how Iran’s economic challenges are reported in the media in this country. What is the record of Iran’s economic growth in recent years and how has it impacted the standard of living of the average person and of the poor?

The first point to make is that Iran has experienced robust economic growth in the last ten years, mostly thanks to rising oil prices. Figure 1 shows Gross Domestic Expenditures (GDE, which is closely linked to GDP) growth, which exhibits huge fluctuations in economic activity and steady increase in incomes since the end of the war with Iraq. Several characteristics of this growth are worth noting. First, note that robust economic growth in the last ten years has brought income per capita nearly back to the average for 1974-77, which is the height of the prosperity that most older Iranians remember and younger Iranians think they have missed (World Bank measures of income per capita in international or Purchasing Power Parity dollars show a more complete recovery). At this rate, about 3 percent per capita, the standard of living of Iranians would double in a generation, which provides the average person with a fairly optimistic future. Yet, Iranians are very disappointed. I try to explain why in a little bit. I think it has something to do with how globalization is coming, and how the youth bulge is being handled, but the average person is doing okay.

Second, high economic growth is the result of a high rate of savings and investment, about one-third of GDP. Figure 1 also depicts the series for fixed capital formation, which is most closely responsible for growth. There was a fair amount of investment in infrastructure: rural health, urban development, roads, and so on. In Figure 2, you see the rising share of investment in machinery and equipment in total investment relative to construction, which is a good thing for job creation.

Also, more importantly, in Figure 3, you see that most of the investment has been done by the private sector. Of course, in Iran there is some ambiguity about what is private and what is public. Privatization has been slow but even some of those public companies that have been “privatized” maybe still under the control of the government or government-owned banks. I am not sure how the issue of attribution is resolved by those who collect the statistics. The important point is the trend, which is in the direction of more private ownership and more private employment. If you trust these figures you might conclude that there are lots of people in Iran—the private sector—who are using their own money betting on the future of Iran’s economy, at least in the short and medium term, and seem very optimistic. If they were pessimistic, they’d be putting everything into assets such as land; they wouldn’t be buying equipment.

There is finally an interesting shift in the structure of the economy in recent years, away from services and toward manufacturing, which is somewhat puzzling, given the rising inflow of oil revenues which usually favors services and other non-tradable sectors. Services dominate the economy but their share in non-oil GDP has been declining. This may not last long though as the so-called Dutch disease may soon reverse this trend. Iran had been exporting some goods other than oil in recent years, but as the price of oil rises, it becomes harder to export anything other than oil.

You can see the effect of the influx of foreign exchange in the behavior of prices—labor costs and the price of traded relative to non-traded goods. The high cost of labor in Iran is the reason why Iranian exports are not competitive. Unskilled labor costs about $12 per day, which is higher than labor costs in high-export countries of China and India. At the same time, price of non-traded goods have increased much faster than traded goods.

Figure 4 shows how prices of different types of goods have changed over time. Prices have been rising the fastest for medical care and housing. Both are income elastic and cannot be imported. So, as incomes increase their prices tend to rise faster than other types of goods. At the other extreme is clothing, which has registered the slowest rate of increase, mainly because of cheap imports from East Asia. Iran’s textile sector has failed to modernize, but even with better technology, higher labor costs would put them at a competitive disadvantage vis-à-vis China.

This is the part of inflation that can only be avoided, if at all, with more sophisticated fiscal policy (to moderate the rate of expenditure of oil revenues and therefore the expansion of demand), and with some level of protection for industries that can be competitive in the long run, once the price of oil comes back to some long run level. Unfortunately, the Ahmadinejad government has lacked the sophistication to follow such a policy. Instead, in an attempt to redistribute oil revenues more equitably, and following his populist instincts, he has allowed too much of the oil windfall in the last two years to enter the economy, pushing the prices of land, housing and medical care up rapidly, and placing Iran’s traditional manufacturing sectors, such as sugar refining and textiles, under severe stress.

In terms of institutional change, that is increasing the scope for private sector and privatizing public enterprises, there has been little progress. So, the private sector, while expanding its scope in the last decade, has not been furnished with a sort of institutional infrastructure on which it can flourish. This has added to the ills of the Dutch disease. To its credit, and thanks to the efforts by former president Rafsanjani who now heads the Expediency Council, the law to define and limit the scope of Article 44 of the Constitution was finally drawn up and passed by the Parliament and the Guardian Council. Article 44 proved the rationale for government ownership; the new law basically requires the government to not expand its activities into new areas and to divest of the enterprises that it already owns as long as they are not related to Iran’s security. There has been little progress on the privatization front, mostly because of the weak legal and institutional basis for transfer of state assets without outcries of corruption. Part of the blame also goes to Iran’s restrictive labor laws that prevent new private owners from restructuring public enterprises they buy. A liberal foreign investment law also allows 100 percent foreign ownership, but so far, possibly because of political uncertainty, there has not been much capital inflow. Of course, given that Iran has been flush with foreign exchange in the last few years one would not expect much enthusiasm for attracting foreign money.

Another policy initiative of the Ahmadinejad government, which inhibits the development of financial markets, is the recent decree to place a ceiling on interest rates at a time when inflation is getting out of hand. The new decree requires banks to borrow and lend at about 10 percent, which is about one-third of the rate of inflation. The decree was so controversial that the newly appointed governor of the Central Bank refused to announce it to the banks! The policy to control interest rates is in line with the Ahmadinejad administration’s general dislike of private banks. The last ten years have seen the emergence of private banks in Iran. Private banks have been doing well in attracting deposits away from government owned banks because they are run much better and offer better services. How the struggle over the capital market plays out in the coming months is anyone’s guess at this point.

This discussion brings me to a point that is obscured by the simplistic descriptions of Iran’s political system as dictatorial and of President Ahmadinejad himself as a dictator. To the contrary, there is a very lively debate on all aspects of Ahmadinejad’s economic policies inside Iran, most of which is harshly critical of the government, and is rarely reflected in the western press. Last month, the outgoing Economy Minister turned his farewell speech into scathing criticism of Ahmadinejad’s economic policies.

What is the role of sanctions in all this? The answer is not much. Sanctions do impose a cost on Iran’s economy but, in my opinion, their potential damage is much less than the influx of oil revenues and bad government policies. Iranians pay more for certain goods because it costs to maneuver around the sanctions. Often these maneuvers come with less transparency in economic activities, setting back the efforts of the Rafsanjani and Khatami governments to increase economic transparency. Some sanctions are not possible to maneuver around, such as in airplane parts, for which Iranians pay a cost in reduced safety of domestic air travel. What is not very clear is whether the intended target of the sanctions, the government, is bearing the brunt of the costs.

I now wish to turn to the long run prospects for growth, which I believe are far more positive.

The most promising aspect of Iran’s long term potential is the change in the demographic behavior of families, from traditional (high fertility, low investment in child education) to modern (low fertility, high investment in child education). This is particularly noticeable in rural areas, where policies before the revolution failed to make a difference in terms of education and fertility. Fertility has been low in Tehran and among the educated upper class for some time, but family behavior was highly dualistic. It may come as a surprise that, during the Shah’s White Revolution in the 1960s when most Iranians think that Iran was very modern, only 3 percent of rural women could read. Now, about 70 percent of them can. Moreover, about two-thirds use modern birth control. This is modernization big time! But somehow among the sophisticated residents of Tehran, who seem to have the ear of foreign reporters, it pales in comparison to the high price of cucumbers. This modernization is particularly interesting in view of the fact that the Islamic governments have been pushing for tradition. In the 1960s Iran combined a modern family law with traditional behavior, now it has traditional family law with modern family behavior.

The family behavior of low fertility and high investment in education bodes well for growth in the long run, because it promotes human capital which is the backbone of modern economic growth. I have elsewhere pointed to the weaknesses of the education system in Iran, which fails to take full advantage of this demographic gift.

The rich hydrocarbon wealth is another very important positive factor in Iran’s long run growth, provided that it is managed effectively. A lot has been done, and more can be done, in using oil revenues effeciently in developing infrastructure—roads, electricity, rural health, and the like. More can be done in expanding the internet, which has put Iran far behind its neighbors, mostly for political reasons.

There have also been significant improvements in poverty reduction, which is important for social cohesion as well as for long term growth. Poverty rates have fallen precipitously since the mid 1990s (see Figure 5), and are in single digits (about 6 percent) based on the international standard of $2 per day per person. The poverty rates in Figure 5 assume a poverty line of about $3.65 for urban and $2.75 for rural individuals. The downward trend of poverty is particularly interesting because most observers of the rise of Ahmadinejad believe that his election owes to widespread poverty, as a result of the liberal economic policies of his predecessor. But the consistent decline in poverty in the years leading to his election strongly suggests that the reasons for the recent rise of populism should be sought elsewhere. Declining poverty is not so difficult to believe, considering the huge influx of oil revenues in the last decade into the coffers of a pro-poor government. Why would poverty fail to respond?

Where there has been no progress is in reducing inequality. Figure 6 shows that inequality (measured by the familiar Gini coefficient) is lower than what it was just before the revolution but that it has stayed constant at a relatively high level by Middle Eastern standards, though not by Latin American standards. I liken the resilience of inequality in the face of deep revolutionary change to a situation in which the economic ladder on which individuals stand has remained the same while the people who stand on particular rungs have changed places. Changing the economic structure may take much longer and require the source of wealth to change from oil to human capital. Viewed in this light, Ahmadinejad’s attempt at redistribution using expenditure of oil money may create more inflation than redistribution. I don’t think any Iranian government is really in control of inequality.

The area where the government and the economy have failed most spectacularly is in providing jobs for the burgeoning youth population. The recent census of population revealed what surveys have been measuring for a number of years—an overall unemployment rate of 12.8 percent. This is an average figure that masks a huge difference between the rates of unemployment for those younger and older than 30. Figure 7 shows the rate of unemployment by age group. Young men suffer from unemployment rates in excess of 20 percent and women twice that. In contrast, older workers face unemployment rates less than 5 percent. Four out of every five unemployed persons are under the age of 30.

Coping with youth unemployment is not merely a matter of more investment. As we have seen, there has been plenty of that already. What is needed is more sophisticated economic and social policy. In particular, the young need the opportunity to compete with older workers for jobs, which can only happen if there is greater flexibility in the labor market. Lack of hope among youth has led to high rates of drug addiction and suicide. Something must be done, and done soon, to prevent generations of Iranians from entering adult life as parents, workers, and citizens having experienced social exclusion and lacking hope.

As with labor market reform, the greatest long term challenge is reforming the laws that set the rules of economic activity and therefore determine the rewards to individual effort, both in human capital and in private investment. Doing so requires deep institutional change in education and the labor markets to raise the reward to individual skills, and in the legal system to increase rewards to private economic activity. Iran is in need of better enforcement of existing laws and of more sophisticated laws, such as contract laws, as the economy becomes more complex. Even now, there are laws on the books against private and state monopolies, but enforcement is a matter of an independent and well functioning judiciary. So far, there is no evidence that the power of the para statals (bonyads) in the economy has diminished. The tension between the traditional and the modern interpretations of the sharia continues. The challenge is how to reconcile religious tradition with the needs of a modern economy and is, therefore, harder than fighting poverty. Politics interfere at every turn to prevent a compromise that would allow a competitive economy to function.

In many ways the overall picture is optimistic. Some very difficult social problems have been dealt with, chief among them has been persuading conservative rural families to adopt birth control and to send their children, especially girls, to school. There is parity now between boys and girls in school enrollment and attainment. There is plenty of “micro optimism” in the decisions of the families in how hard they work to educate their children and in their private sector investment behavior. Yet, at this time the political scene seems highly uncertain, giving room for “macro pessimism”. How Iran’s political leaders proceed to face the remaining challenges of modernization will determine if Iran can harness its immense human and natural resource potential to emerge as an Islamic Tiger rather than bogy man.