AGGREGATE DOMESTIC INVESTMENT BEHAVIOR IN IRAN

Theoretically, investment decisions can be made either by individuals, firms, governments, or all of them. In the oil-driven economy of Iran, the government intervenes in the country’s economic life. This includes assigning a budget for capital spending as a tool for promoting investment activities.⁶¹ The government regulates the quantity of credits allocated to the economy for investment through different methods. Firstly, the government determines the credits that are to be directly distributed in its annual budgets. Secondly, it controls the supply of credits provided by the Iranian banks through a system of bank specific lending quotas (CBI, 2002). The government further sets the quantity of credits allocated for the major economic sectors including agriculture, manufacture, construction, exports and services in order to give priority to its preferred sectors. In addition, the government sets the official lending and deposit rates of return in the banking systems, which is one of the key determinants of investment according to the neoclassical theory of investment.⁶²

Thus, the Iranian government supports investment expenditure through intervention in the financial markets.⁶³ Such interventions have resulted in a rather rapid expansion of a system of deposit mobilization and high overdues on loans. For instance, the expansion of subsidized credits coupled with low lending real rates of return encouraged excessive lending in the country’s banking system, which resulted in as high as 25 percent growth of non-performing loans in 2010 (CBI, 2010; Shajari and Shajari, 2012).⁶⁴ In addition to their lending practices, these banks take deposits; yet, a considerable part of their loanable funds is financed by the central government and the Central Bank of Iran (CBI). The latter supervises all the credit institutions and banks. Once the government approves the annual budgets, the CBI presents its credit and monetary policies to the Money and Credit Council (MCC), where the annual credit allocation to various economic sectors including the private sector is set.

61 The budget is subject to the availability of a key source of finance, i.e. oil income. Since oil activities are under the control of the Iranian state, an essential part of the income generated in this sector accrues to the government in the form of government resource (or oil) revenues.

62 See Chapter Two (Sections 2.2 and 2.3) for a discussion on the role of the state in the process of capital accumulation and the evolution of investment institutions in Iran during the study period.

63 Although, the CBI is formally an independent institution, in practice it does not have the ability to design or conduct proactive monetary and fiscal policies. The government instead controls lending and investment activities of the banks (Jafari-Samimi, 2010; see also Chapter Two Section 2.3).

64 A non-performing loan is ‘defined as a loan that is not earning income when the bank can no longer anticipate the full payment of principal and interest which are past due by 90 days or more, or at least 90 days of interest payments have been capitalized, refinanced or delayed by agreement’ (Shajari and Shajari, 2012, p.166).

120

The lending and deposit rates are centrally administrated and change only at infrequent intervals, hence do not reflect market conditions. Due to highly persistent inflation and the deterioration of the value of the Iranian currency, these rates have been kept superficially very low with zero or negative real returns on deposit and saving accounts.⁶⁵ This, in return, has discouraged savings and has adversely affected the flow of funds through the financial intermediaries and within the banking system, and so the availability of finance for investment activities.⁶⁶ The unavoidable consequence of low lending rates has been excess demand for bank credits and credit rationing. Consequently, the domestic credit markets in Iran operate under tight controls and lending rates are not market-determined, making them relatively non-responsive to the changes in the economy’s inflationary pressures.

In 1979, the lending rates for short-term and long-term deposits were 7 percent and 8 percent, respectively. In 1984, after the approval of the interest-free banking, the MCC approved legal limitations and conditions necessary for granting of banking facilities. Since then these rates have been fluctuating widely between 4 and 23 percent across various economic sectors; the former and the latter corresponding to the minimum and the maximum expected rates of profits on facilities to the agriculture sector and commerce, respectively (see Appendices 2B and 2C).

The legal reserve rates are set to mainly control the implementation of the monetary policy and the inflationary effects of credits granted by the banking system in the Iranian economy. First used in 1946, the banks were required to deposit 15 percent of their deposits in the Central Bank. This ratio demonstrated an ascending trend until 1973. For example, this rate increased to 20 percent and 30 percent in the 1950s and 1960s, respectively; but in 1974, following the sudden increase in oil prices, the CBI lowered the required reserve deposit ratio to 25 percent to

65 This situation is worsened especially when the black market for gold coins, cars and foreign currency provides higher returns in the short-run.

66 Under the arrangement of Islamic banking, interest paying deposits with the banking system are viewed as participation in the investment activities of the banking system. Such deposits are subject to two profit rates. An initial rate, known as the ‘provisional’ or ‘alal-hessab’ rate which is announced at the time deposits are placed with the banks; and a ‘final or actual’ rate which is computed on the basis of the bank’s operations at the end of the year.

However, in practice, the provisional and actual returns are very close. See Chapter Two Section 2.3 for a more detailed account of Iran’s financial and banking system.

121

provide further credits for the private sector. In 1978, because of the political and economic upheavals in the country and people’s inclination to withdraw their deposits from the banking system, this ratio decreased to as low as 10 percent (Izadi and Izadi, 2013). After the Islamic revolution, depending on the banks’ liabilities and fields of activities and in accordance to the Iranian Monetary and Banking Law, the CBI has been determining this rate within a range of 10 and 30 percent.

During the years under consideration, the tax system in the country has helped finance only a trivial share of the government’s expenditures due to the small fraction of taxes in total government revenues. Between 1971 and 2010, the share of taxes in total government revenues averaged only about 30 percent per annum with small variations throughout the period. The highest average per annum share of taxes was related to corporate tax (11%) followed by import tax (9%), sales and consumption tax (5%) and wealth tax (1%). Compared to the post-revolutionary years, during the years from 1970 and 1978, the average annual share of taxes in total government revenues recorded a slightly lower rate. In addition to the expected rates of profit on facilities in the large state-owned commercial banks, limited credits at subsidized rates have been available for various economic sectors and the state has paid the difference between the lending and the subsidized rates. In the years after the revolution, the cost of loans has often been lower for those firms with access to the state-owned banks’ credits as the private banks and non-bank credit institutions are able to charge about 4-5 percent per annum higher lending rates on their loans. Small enterprises have often been rationed with low collaterals.

There are also hidden costs associated with obtaining loans including long waiting lists (Jalali-Naini, 2008).

Figure 5.1 displays the aggregate investment-GDP ratio in the Iranian economy during the years under consideration. The average ratio was as high as 33% p.a. during 1965-2010, typically for commodity exporters, and particularly oil producers, due to investment-inducing effects of large influx of commodity income in these economies.⁶⁷ Nevertheless, the country’s output growth did not record as high as its investment growth. For most of the years under study, the aggregate

67 See Cherif and Hasanov (2012) for a detailed discussion on oil exporting countries’ investment share.

122

investment rate fluctuated and followed a similar pattern to the movements of real oil revenues and international oil prices, with three distinct trending patterns.⁶⁸ The aggregate investment rate rose during most of the 1960s and 1970s, with a substantial increase following the first oil shock in 1973.

The share of aggregate investment in GDP illustrated a considerable downward trend during the 1980s largely due to the revolution and the uncertain political atmosphere it left in its aftermath, the Iran-Iraq war and the third oil shock of the mid-1980s. After the war and given the favorable international oil prices, the investment rate recovered for most of the 1990s and 2000s. An exception was the decline of the aggregate investment rate in the mid-1990s chiefly due to the country’s foreign debt crisis coupled with lower international oil prices, which in return, left insufficient foreign exchange resources to finance capital spending on a large scale.

Figure 5-1 Investment-GDP ratio

Note: Constructed based on data in billion Rials at constant 2004/05 prices. Source: CBI.

Figure 5.2 depicts the evolution of the real Incremental Capital-Output Ratio (ICOR), defined as the ratio of gross investment to changes in output, which is the reciprocal of marginal product of capital stock. The ICOR measures the increment in capital needed to produce an additional unit of output and therefore can be considered as a measure of efficiency of capital. During the years under consideration, the ICOR exhibited a fluctuating and upward trend, with recurrent hikes particularly after the revolution since 1980s, suggestive of the destruction of existing capital due to the war and the declining investment efficiency in the country. At large, is seems that Iran has

68 See Chapter Two Section 2.4.2 for graphs and discussion on the co-moving pattern of real aggregate investment and the growth rate of real oil prices. Also see Section 2.4.2 in Chapter Two for graphs and discussion on the development of real aggregate investment, real public and private investment growth rates and real sectoral investment during the period under study.

.20 .25 .30 .35 .40 .45 .50 .55

1959/60 1961/62 1963/64 1965/66 1967/68 1969/70 1971/72 1973/74 1975/76 1977/78 1979/80 1981/82 1983/84 1985/86 1987/88 1989/90 1991/92 1993/94 1995/96 1997/98 1999/00 2001/02 2003/04 2005/06 2007/08 2009/10 Aggregate investment/GDP ratio, 1959-2011

123

rather over-invested particularly since the implementation of its post-revolutionary development plans and that the government has played an interventionist role in the size of real investment and in the allocation of mainly oil-based financial resources to various economic sectors.

Figure 5-2 Incremental capital-output ratio

Note: Constructed based on data in billion Rials at constant 2004/05 prices.

Source: Calculated by the author based on data from CBI.

As discussed in Chapter Two, during the years under study, Iran experienced some major political events and its political economy and institutions underwent substantial changes. These included different oil shocks, the revolution, the war with Iraq, and the implementation of various economic reforms reflected in the country’s development plans throughout the study years. Therefore, although the above analysis allows investigating the long-run relationships between the theory-motivated variables under study, it could be expected that at least some of these events to have affected some of the variables in the models stated above.

In brief, from the mid-1960s until the early 1970s, real oil revenues gradually increased.

Although the oil sector share in GDP was about 20 percent on average, this was achieved in a rather low inflationary economic environment due to higher oil output growth. However, the 1970s were characterized by considerable oil price increases with oil revenue growth of about 14% p.a. on average during that time. In particular, oil revenues increased over 30% p.a. Until the mid-1970s. Consequently, the Shah’s regime injected significant sums of money into the economy and replaced the development plans’ projections by ambitious targets. As a result, the oil sector’s share in the economy grew to about 50%, yet the production capacity did not increase comparatively. The state’s rapid fiscal expansion considerably increased the liquidity base and the dependency of the country on oil windfalls, and resulted in inflationary pressures in the economy.

-40 -20 0 20 40 60

1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

124

The 1980s were characterized by the regime shift, the war between Iran and Iraq, the big nationalization of various private sectors and stagnation. In the immediate post-war era, high growth rates seemed feasible with injections of money in the economy. During 1989-1996, assessments in the first post-revolutionary development plan aimed at rapid expansion of the oil sector, export promotion, reduced import controls and attracting foreign investment.⁶⁹ The key objectives of the first plan were to employ expansionary financial policy including monetary expansion and short-run external borrowing to finance public investment spending, maintaining negative real lending rates as well as depreciated exchange rates.

However, the experience of the Iranian economy during the first plan was unstable growth due to short-term planning and speculations. The optimism regarding the amount of oil windfalls due to oil price fluctuations in the 1980s proved not to be adequate. At first, the volatility of oil prices was attributed to the Iran-Iraq war and considered transitory.

But, persistent fluctuations of oil prices throughout the first plan made policy makers realize that oil prices were determined in the international markets. During this period, the government’s economic liberalization policies, along with the single floating exchange-rate mechanism fueled inflation and income disparity. Also, price distortions led to further inflationary pressures in the economy.

The second plan, implemented during Rafsanjani’s presidency, was more inward-looking and drawn with two high-end and low-end scenarios for resources and quantitative goals. The second plan focused on issuing investment certificates, promoting private non-bank credit institutions and setting lending rates at levels that ensured positive real return on bank deposits.

The economy, however, witnessed the reoccurrence of stagflation (which it suffered from during the 1980s) due to the debt crisis of 1993, high inflation and slowed economic growth. Although economic performance started to recover at a steady level since 1994, the actual annual rates of growth and investment remained lower than their targets.

Coinciding with Khatami’s presidential years, the third plan’s main macroeconomic policies focused on the privatization of the large public sector, limiting subsidies and price decontrols,

69 See Chapter Two Table 2.1 for a comparison of projected versus actual figures on economic indicators in Iran.

125

moving away from administered credit allocation and establishing an oil fund. Also, the plan aimed at encouraging investments through reducing aggregate consumption for the promotion of faster fixed capital formation and FDI. The former proved to be disappointing mainly because both public and private consumption expenditures highly exceeded their projected figures. The increase in the private sector expenditure was driven by plentiful oil receipts, greater money supply and new possibilities for purchases on credit. The higher than targeted increase in public consumption was partly because of the reckless spending inclination among public agencies and stickiness of government current expenditures. The real expected rates of return on facilities remained mandatorily low. Further, due to increased use of capital-intensive technology and the choice of capital-intensive projects, capital productivity did not increase much.

The main objective of the establishment of the Oil Stabilization Fund (OSF) during this period was to cushion the economy from unexpected oil price fluctuations and eventual oil price decline. The government was authorized to draw from the OSF only when the oil windfalls fell below the budget target for the year. In practice, however, during the plan’s period which coincided with steady increase in oil prices, the parliament (Majlis) frequently allowed withdrawals from the fund to curb budget deficits. The rest of the fund was partially used to support the war veterans, disabled and military militia (Basij), to help the agriculture sector against drought and to finance subsidies. The plan proved to be unable to control prices and inflation. Even though the actual oil windfalls earnings in the fourth plan were about three times of the projected amount, their economic impact was much less than expected.

The real annual average investment growth recorded much lower than its target, contributing further to low GDP growth and high inflation.

Accordingly, it could be expected that at least some of the events above to have affected the estimation models presented in Section 5.3. According to Juselius (2006), the need for dummies could be (tentatively) identified by checking the residuals, but should only be considered if the large residual corresponds to a known intervention, a reform or a regime shift. Further, a large

126

residual does not imply that the model exclusively needs an impulse dummy. A large outlier could indicate a shift in the level of one or more variables. Hence, the appropriate procedure is first to examine whether there has been a shift in the equilibrium mean (using a step dummy) and, if so, to estimate the model with such a shift plus additionally an impulse dummy (blip dummy) in the short-run part of the model. If the step dummy is insignificant, then only the impulse dummy can be included in the model. Given that the interventions in the Iranian economy have been very significant, a priori one would expect to see changes in the equilibrium means. When appropriate, therefore, dummy variables are included in the empirical models to capture their associated effects on the models (see Section 5.5.2). In what follows, the estimation investment model for the oil-based economy of Iran is explained and a number of hypotheses are stated.