CONSUMPTION, CAPITAL ACCUMULATION AND NATIONAL SAVINGS

37 Figure 2-2 Oil prices and oil income

Crude oil prices Growth rates of oil prices and oil income

Source: See Appendix 5A for detailed references of the data.

Figure 2.2 (the panel on the right) displays the changes in nominal values of oil prices, oil revenues, and government total revenues. From this figure, it can be seen that the changes in oil revenues and government’s total revenues appeared to be associated for most of the years under study. Following the second oil shock, government revenues rose, although the start of the war with Iraq mitigated this increasing trend. As a result of the collapse of oil prices in 1986, both government revenues and oil revenues dropped considerably. Afterwards, revenues again started rising steadily. This rise particularly became sharp in the early 1990s due to an increase in oil prices caused by the Gulf War and because of the substantial devaluation of the Iranian currency in 1993. Since the mid-1990s, both government revenues and oil revenues displayed associations with changes in international oil prices. This demonstrated the extent to which the government’s income was oil-dependent.

2.4.2. CONSUMPTION, CAPITAL ACCUMULATION AND NATIONAL

38

1965-2010, are illustrated in the panel on the top left in Figure 2.3. During 1965-1978, government consumption in real terms increased on average by over 16% p.a., with private consumption registering annual average growth rate of over 9% p.a. throughout these years.

Table 2.3 Composition of gross national expenditure

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

By contrast, during 1979-1988, both consumption and investment growth initially levelled off and then fell respectively by just less than 1% p.a. following the Iranian revolution, the Iran-Iraq war and the period of precipitous decline of global oil prices. Real consumption and investment recovered after the war and during the implementation of the first plan (1989-1994), although started declining towards the end of the period when the Iranian economy was hit by the deficit crisis. Despite the fact that the growth rate of real investment rebounded after the debt crisis during 1995-1999, lower oil prices and foreign debt repayment did not leave sufficient foreign exchange resources to drive domestic consumption during that time. Thus, real consumption increased slightly during the years of the second plan. From 2000 to 2004, real consumption and investment rose again bred by the recovery of international oil prices.

The centrality of oil in Iran’s economy can further be understood by assessing the degree to which investment patterns have been affected by oil price changes over time. The panel on the bottom left in Figure 2.3 illustrates the annual variations in real investment and in real oil prices.

As for real GDP, the rate of growth in real investment followed a similar pattern to the movements of real oil prices for most of the years under consideration. This pattern of co-movement was only interrupted by the revolutionary upheavals of the late 1970s.

The annual growth rates of public and private investment and their shares in total gross fixed capital formation during the period under study are presented in Table 2.3. Investment by the public sector registered a higher growth compared to that of the private sector with respective

1965-1970 1971-1978 1979-1988 1989-1994 1995-1999 2000-2004 2005-2010 1965-2010 Real final consumption expenditure

Private 8.5 10.6 1.2 4.8 5.2 7.1 4.7 5.8

Public 17.8 14.7 -4.3 4.1 1.3 4.9 -0.77 5.1

Total 11.1 11.8 -0.7 4.4 4.2 6.5 3.6 5.6

Real gross fixed capital formation

Total 13.1 8.6 -0.96 4.6 10.1 11.6 5.2 6.7

Annual average growth rates

39

rates of 10% p.a. and 7% p.a. on average over the period 1965-2010. The share of public investment averaged 34.3% p.a. during 1965-2010. More than 64% of the public sector investment throughout this period was spent on construction and the remaining on machinery.

Figure 2-3 Consumption and investment

Consumption expenditure Public and private investment

Investment and oil prices growth rates Consumption and oil prices growth rates

Note: Constructed based on data in billion Rials at constant 2004/05 prices. Source: CBI; BP Statistical Review of World Energy 2010.

Interestingly, during 1965-2010, real public and private investment demonstrated an association for most of the years under study (see the panel on the top right in Figure 2.3). In fact, the common view that government investment crowds out private investment was not applicable to the case of the Iranian economy. In the pre-revolutionary years, due to the abundance of external finance in the country, the significant growth rate of investment by the public sector did not have a bearing on the interests of the private sector and its investment activities during the 1960s and the 1970s. In contrast, the support of the government for both domestic and private enterprises, coupled with the rapid growth of domestic demand following the available external

0 200,000 400,000 600,000 800,000 1,000,000 1,200,000

60 65 70 75 80 85 90 95 00 05 10

Real private consumption expenditure (billion Rials) Real public consumption expenditure (billion Rials) Real total consumption expenditure (billion Rials)

0 20,000 40,000 60,000 80,000 100,000 120,000 140,000

60 65 70 75 80 85 90 95 00 05 10

Real private gross fixed capital formation (billion Rials) Real public gross fixed capital formation (billion Rials)

-100 -50 0 50 100 150 200 250

60 65 70 75 80 85 90 95 00 05 10

Real investment growth rates (%) Real oil prices growth rates (%)

-100 -50 0 50 100 150 200 250

60 65 70 75 80 85 90 95 00 05 10

Real oil prices growth rates (%) Real private consumption growth rates (%) Real government consumption growth rates (%)

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finance during that time, resulted in the growth of investment by the private sector (Karshenas, 1990). Over the post-revolutionary period, likewise, the private sector grew along with the public sector as the Iranian government earmarked a greater amount of oil income for capital expenditure to stimulate growth and investment in that sector (Valadkhani, 2001).

Relative to the post-revolutionary period, investment by the public sector enjoyed a higher growth rate over the years 1965-1978. This was because investment activities of various ministries were merged into the expenditure plan during that time and the government imposed a greater degree of control over the public sector’s investment activities. Also, the availability of new external sources of investment funds, namely foreign capital and oil revenues, was translated into higher government expenditure with highly expansionary effects on the economy.

The role of the state, therefore, became that of a key producer in heavy and basic industries which resulted in the acceleration of investment by the public sector over that period (Karshenas, 1990).

The data on national savings and investment during the years under consideration are reported in Appendix 2D. Overall, real investment and national savings appeared to move together (see the panel on the left in Figure 2.4). The dramatic improvements in national savings as well as investment in the mid-1970s were associated with the significantly higher oil prices in that time.

During 1971-1978, the annual average growth rate and share of real gross national savings in total GDP registered 16% and 56.8%, respectively. However, the revolutionary instabilities, the war years and the sharp decline in oil prices contributed to the sharp decline in national savings and investment in the late-1970s and the 1980s. The fall in national savings maintained the high levels of consumption while the economy was experiencing high inflationary pressures and over-valued exchange rates during that period. Since the mid-1990s, despite some variations, the favorable growth of oil prices played an important role in the positive development of national savings in the Iranian economy. Over the years between 1989 and 1994, national savings growth recovered. However, during 1995-2010, savings grew at a slower pace (about 7% p.a.) than that of during 1965-2010. At large, similar to GDP and investment, the growth of national savings followed that of oil prices during most of the study period, signifying the importance of oil in shaping the development pattern of national savings in the country.

41 Figure 2-4 National savings and external debt

National savings and investment External debt and oil prices growth rates

Note: Constructed based on data in billion Rials at constant 2004/05 prices. Source: CBI; BP Statistical Review of World Energy 2010.

Iran’s total external debt fluctuated considerably during the study period between zero during 1970-1979 and 23.5 billion US $ in 1993, and was inversely related to the changes in real oil prices for most of these years (see the panel on the right in Figure 2.4).¹⁸ External debt rose in constant prices on average by 8% p.a. from 1979 to 1988 and by 29% p.a. during 1989-1994.

After the war and due to Iran’s reconstruction program reflected in the first plan coupled with its increased interaction with the rest of the world, the country’s appetite for foreign loans to finance its post-war reconstruction was significant. This resulted in the flow of foreign capital (mostly bank loans) into the country. However, the foreign debt had been unsustainably accumulated by 1992, which led to the debt crisis of 1993. In fact, the first plan’s implementation was considerably blemished by an increasing external debt crisis which, in particular towards the end of the plan, resulted in severe discrepancies in the country’s external accounts. The debt crisis in that period was further worsened due to the declining oil income.

In this setting, a matter of concern was the composition of the foreign debt, of which a great share was related to short-term debt. This was because debts of less than one-year maturity averaged 80% of the total debt over the years of the first plan’s implementation due to Iran’s isolationist stance and its inability to raise long-term credits. As a result, short-term finance was used on a large scale for medium and long-term investment projects with longer gestation periods. Consequently, austerity measures were introduced in 1994 to tackle external debt imbalances which were done mainly through import restriction policies. During the second plan,

18 External debts were financed by the World Bank, IMF and a number of private and commercial creditors (World Bank International Debt Statistics, 2013, pp.160-161).

0 40,000 80,000 120,000 160,000 200,000 240,000

60 65 70 75 80 85 90 95 00 05 10

Real gross national savings (billion Rials) Real gross domestic capital formation (billion Rials)

-40 -20 0 20 40 60

1994 1996 1998 2000 2002 2004 2006 2008 2010

Real external debt growth rates (%) Real oil prices growth rates (%)

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external debt decreased due to increasing oil prices and oil exports. During the implementation of the second plan between 1994 and 1999, the external debt contracted from 21 billion US $ in 1995 to 9 billion US $ in 1999, and the economy moved towards gradual recovery. External debt rose again (on average by 22% p.a.) during the third plan, however, benefited from favorable oil prices, it contracted during the implementation of the fourth plan.

Table 2.4 Real government consumption expenditure by function

Note: Constructed based on data in billion Rials at constant 2004/05 prices. ‘Others’ include disciplinary services, cultural and recreational services and municipalities. Economic affairs include urban and rural development, public utilities, manufacturing and mining, agriculture, transport, communication and commerce. Source: CBI.

Due to its size, government consumption expenditure exerted an important influence on income distribution during the period under consideration. The impact of the government’s development expenditure worked through the long-run structural changes it created in the Iranian economy.

At large, two types of government consumption expenditure can be identified namely general and productive expenditures.¹⁹ The former is related to general administration and military expenditure, while the latter is related to the expenditures on education, health, social as well as economic affairs. As presented in Table 2.4, a substantial share of total government consumption expenditure during 1965-2007 was absorbed by the general expenditure category, of which a great deal was spent on defense. For instance, the share of defense expenditure in total government expenditure averaged as high as 45% p.a. over the years 2005-2007. The share of education expenditure was the greatest among the productive expenditures followed by that of the economic affairs and housing. In total government expenditures, the share of education expenditure averaged 15.5% p.a. during 1965-2007, while that of economic affairs recorded an annual average rate of 9.5% over the same period.

19 See Karshenas (1990, p.195) for a similar classification of government consumption expenditures during 1963-1977.

1965-1970 1971-1978 1979-1988 1989-1994 1995-1999 2000-2004 2005-2007

General expenditure 45.0 39.2 39.5 23.6 23.7 32.9 48.4

General services 8.9 4.0 2.7 3.4 3.8 3.8 2.7

Defense 36.1 35.3 36.9 20.2 19.9 29.1 45.7

Productive expenditure 38.4 40.4 40.9 59.0 58.3 50.9 37.2

Education 18.2 11.0 19.1 24.7 20.9 21.5 15.5

Health and medical services 4.6 3.9 6.0 8.1 5.5 4.5 3.2

Social affairs and security 3.6 5.4 6.3 9.1 11.7 12.0 8.9

Economic affairs and housing 12.0 20.1 9.4 17.1 20.2 13.0 9.5

Others 16.6 20.4 19.6 17.4 18.0 16.2 14.4

Annual average % share in total government consumption expenditure

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Table 2.5 Growth and structural changes in capital formation

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

Table 2.5 presents the growth rates of sectoral real investment during the study period. Over these years, the economy of Iran witnessed a structural shift from agriculture to the manufacturing and the service sectors. During 1965-1979, real investment in all of the major economic sectors increased. Notably, real investment in the oil sector averaged over 32% p.a., whereas it was 9% p.a. in agriculture. After the revolution and during the war period, redistributive conflicts undermined investment incentives in the country. The fluctuations in oil prices and particularly the sharp collapse of oil prices in 1986 further contributed to the deterioration of real investment at both aggregate and sector-levels. As oil revenues shrank, so did the rate of growth in capital formation. Compared to the pre-revolutionary era, the real growth rate of investment contracted in all sectors, with the exception of the construction sector, which grew on average about 7% p.a. because of a high demand for new construction projects driven by the destructive consequences of the war.

Overall, various policies adopted by the governments of pre- and post-revolutionary periods together with the increased state control of resources altered the distribution of wealth particularly in favor of services and to a smaller degree manufacturing. This was an indication

1965-1970 1971-1978 1979-1988 1989-1994 1995-1999 2000-2004 2005-2010 1965-2010

Total 15,5 14,9 -4,7 6,6 8,4 10,7 5,8 7,3

Agriculture sector 5,7 13,5 -1,2 8 16,1 10,3 12,9 8,4

Manufacturing and mining sector21,6 16,2 -2,1 10,2 18,1 18,1 -0,32 10,4

Oil sector 34,4 30,4 -10,8 23,8 28,1 -2,6 -0,05 13,3

Services sector 16,3 14,3 -4,05 5,02 4,02 13,7 6,5 7,1

Private sector 11,5 11,9 1,9 2,4 14,8 13 4,7 7,6

Machinery 11,3 12,6 19,7 6,2 26,8 14,4 2,7 13,4

Construction 12,4 15,2 -1,7 -0,36 0,91 9,5 10,8 5,6

Public sector 31,6 24 -10,3 18,5 1,6 6,3 9,3 9,9

Machinery 51,6 29,7 -10,1 17 0,28 8,1 7,3 13,3

Construction 26,8 22,9 -9,5 19,5 2,4 5,8 10,4 9,5

Agriculture sector 4 4 3,7 4,6 4,3 4,7 6,2 1,4

Manufacturing and mining secor 10,8 12,8 7,8 12,4 13 19,1 18,9 12,8

Oil sector 7,9 6,8 4,3 2,6 6,2 4,1 2,6 5

Services sector 53,04 48,5 56,8 50,4 44,5 45,5 47,4 50,3

Private sector 71,7 65 64,5 64,5 59,6 67 66,1 65,6

Public sector 28,2 34,9 35,4 35,4 40,4 32,9 33,8 34,3

Private sector

Machinery 61,8 65,4 39,7 56,2 62,7 71,8 72,8 58,7

Construction 38,1 34,5 60,2 43,7 37,2 28,1 27,2 41,3

Public sector

Machinery 26,3 32,6 45,8 38,2 33,6 33,3 34,7 35,7

Construction 73,6 67,3 54,1 61,7 66,3 66,6 65,2 64,2

Gross fixed capital formation - Annual average growth rates (% )

Gross fixed capital formation as % share in total investment (annual average)

Gross fixed capital formation as % share in private sector investment (annual average)

Gross fixed capital formation as % share in public sector investment (annual average)

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of structural shifts in the actual investment picture of the economy away from agriculture and even the oil sector towards services and manufacturing. This, in line with the empirical findings presented in Chapter Six, could suggest the presence of an ‘Iranian Disease’, which is a special case of the Dutch Disease. According to the Dutch Disease theory, one could expect that the relationship between oil revenues and investment in the sectors of oil and services to be positive, and that relation in manufacturing and agriculture sectors to be negative. Yet, the Iranian-type Dutch Disease is characterized by the expansion of capital formation as well as output in the sectors of services and manufacturing, but by their respective contractions in oil and agriculture sectors. In fact, these observations suggest that, chiefly through state-led investment expenditures for the promotion of industrialization in Iran which began in the early 1950s, oil income were invested in the sectors of services and manufacturing throughout the study period.

In document Economic Determinants of Domestic Investment in an Oil-Based Economy (Sider 55-62)