This note examines the transition of the Iranian economy in the post-JCPOA era, towards its current recovery path by reviewing available options in the context of renewed uncertainties around credibility of the nuclear deal and the prospect of domestic policy reforms.
Following removal of the nuclear sanctions, the Iranian economy has passed the point where contraction turned into expansion. The sanction-led bust began in 2011 with cumulated foregone real GDP and per capita terms amounted to 19.9 and 22.7 percent of their initial levels, respectively. Although, due to regaining of the market share, oil output induced an unprecedented economy-wide double-digit growth rate in 2016, in real per capita units, the 2016 figure of GDP is still below that of 2011, meaning that the duration of economic output loss has lasted for 5 years.
Two shocks are the primary causes of the economic shrinkage, i.e. prolonged trade and financial sanctions, followed by a more recent oil price fall. According to the IMF, the magnitude of loss of oil revenues associated with the twin shocks is around $185bn and $166bn respectively, which in sum equals to GDP of 2016.The IMF’s assessment asserts that the recovery path of the economy looks V-shaped, which implicitly indicates a quick reversal in a symmetric fashion. Constraints on the restoration, however, may transform the journey to “U” or even “L” shaped paths. This originates from the fact that the pace and sustainability of the recovery is subject to the implementation of pending internal policy reforms as well as the outlook of the nuclear deal. Contraction took place in three layers. Part of the planned/expected oil proceeds did not realize due to barriers on exports and limitations of access to proceeds, owing to financial sanctions and oil price fall. Secondly, real GDP shrank because of constraints on investment in the oil sector, and second-run effects of sanctions on tradeable GDP. Lastly, investment descended as the result of disconnection of correspondent banking and de-risking of international Tier 1 banks, accompanied with cloudy horizon for deep engagement of the private sector, and inadequate fiscal space to support public sector investments.
Although implementation of the JCPOA quickly reversed contraction in the first layer into an expansion, recovery in the second layer is gradual and not necessarily symmetric. Restoration of the lost capacity along the third layer is nevertheless pending on a mix of favorable external environment and domestic reforms. While restoration in the upper levels boosts the speed of recovery, the deeper levels ensure its sustainability.
Noticeably the lifting of the nuclear sanctions enabled the oil industry to increase total output to well above pre-sanction levels, and even briefly, in March 2017 reaching export higher than the extents reported since the Islamic Revolution in 1979. In this regard, with OPEC having granted Iran an exemption from a recent oil production cap imposed on its member countries, the economy has further benefited from an increase in oil revenues. To sustain this one-shot gain, it nonetheless remains vital to strengthen the economic capacity and employment opportunities available within the non-fossil fuel sectors.
Durability of economic restoration depends on having in place a favorable mix of external environment and remedial policy measures to boost growth of the economy. The scope of recovery both at the level and growth dimensions are aimed at regaining the pre-sanction GDP per capita position. The former strives for the cardinal level of income while the latter intends to close the income gap with peer countries to achieve its pre-sanction position. An influx of foreign investment is essential to foster the convergence path.
Internal policy reforms remain an area for continued development toward enhancement of domestic market conditions. This is especially needed as the external uncertainty pertaining the future of the nuclear deal remains a political wild card which further blurs the transition path for recovery. Forces that navigate the economy to the new steady state, including external and internal factors attributable to a blend of environment and structural reforms, may not therefore be necessarily favorable at the same time.
In the absence of reliable external signals that mitigate uncertainties around the outside environment, given the opportunity costs of inaction, waiting a favorable policy signal may not be a promising option for the administration.
One may thus recommend domestic policy-makers to focus their attention on enabling internal economic reforms that nonetheless remain fruitful and can support sustainability of the recovery process. On the policy front it seems that the priority should be assigned to fiscal and financial reforms due to the centrality of the domestic decision-making process of the former and sizeable spillover effects of the latter. Along this line, securitization of the public debts represents a sound starting point, with lower risk and considerable reward. It is a solid step towards gauging the fiscal space in a more accurate fashion with significant advantages for the banking sector. Moreover, lowering the fiscal break-even oil price is warranted by mobilization of non-oil revenues and continued adaptation of fiscal discipline and austerity measures. This, combined with initiatives for leveraging development government expenditures, like Public-Private Partnerships (PPP), can boost the effectiveness of fiscal spending. Additionally, enlargement of the tax base is a complementary component for the fiscal reform agenda. Furthermore, key structural reforms in banking and the business environment will result in considerable improvements in domestic market conditions which will prepare Iran for a future wherein external policy factors may become more advantageous.
By committing to domestic economic reforms, the administration could kill two birds with one stone. Reforms can give momentum to the promised recovery agenda, immunize the sustained growth path and turn the sanction-led inertia into a long awaiting economic boom. This can further demonstrate their willingness and commitment towards improving market conditions to the outside world which will in no doubt be encouraging for refinement of market sentiment for large-scale inflows of investments. This approach can help the government to gain more confidence and build political capital to aim at more ambitious and demanding reforms where consensus building may be more challenging.
Farhad Nili is Senior Advisor to Executive Director, and Tara Shirvani is Infrastructure and Climate Change Specialist, both at the World Bank. The views and opinions expressed in this note belong solely to the authors and do not reflect position of the Board or Management of the World Bank.