INSTITUTIONS OF INVESTMENT

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Overall, since the early 1950s until 1979, the development plans concentrated on structural reforms, interactions between the public and the private sector, their investment needs as well as stabilization policies to support investment and development in the Iranian economy. However, following the revolution and particularly during the 1980s, the role of the state sector strengthened, the activities of the private sector weakened.

After the war, the government gradually promoted privatization so as to strengthen market mechanisms in the economy. Nevertheless, because of the presence of a large number of semi-SOEs and semi-SOEs in the country, the boundaries between the public and the private sector became vague. Therefore, because of the institutional, political and economic setup in Iran, market forces became only partially effective. In this setting, banks played a crucial role in facilitating investment in Iran and, as largely determined by the government, they channelled financial resources to various economic sectors (Taghipour, 2009). The next section, therefore, provides an overview of the role of the banking system and investment institutions in the country.

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context of the Islamic Constitution and the Monetary and Banking Act. Each year, after the government’s approval of the annual budgets, the CBI presents its monetary and credit policy to the Money and Credit Council (MCC) for approval.¹⁴ Major elements of these policies are then incorporated in the development plans. The sectoral credit allocation is set by the MCC which is the highest banking policy-making body of the CBI. Since the 1990s, the MCC also sets annual targets for credit allocation to the private sector (CBI, 2002). The CBI implements monetary policies, both directly through its regulating power and indirectly through its effects on money market conditions (CBI, 2002). Direct instruments include banking profit rates and the setting of credit ceilings. The MCC determines the profit rates (the expected rates) of return on banking facilities and the minimum and maximum profit rates of return within the framework of the Usury-Free (interest-free) Banking Law. Based on the Usury-Free Banking Act (passed in 1983), the provisional rates paid to depositors or received from borrowers should reflect the profits or losses of a business (Jalali-Naini and Khalatbari, 2002). The CBI can intervene in determining these rates both for investment projects or partnership and for other facilities extended by the banks. In accordance with the Monetary and Banking Law of Iran, the CBI can further intervene in monetary and banking affairs for instance by restricting banks via setting sector-level ceilings for loans and credits (CBI, 2002).

The CBI’s indirect instruments consist of the reserve requirement ratio, issuing participation papers (bonds) and opening deposit accounts. The CBI determines the reserve ratio for all the banks, and on this basis, the banks are required to deposit part of their liabilities in the form of deposits with the CBI. According to the Islamic Sharia, the use of bonds is illegal because of their fixed rates nature. Instead, the utilization of participation papers or payment of profit is encouraged. Since the implementation of the third post-revolutionary plan, the CBI has been authorized to issue participation papers as an instrument to affect the level of broad money (M2) and to control the inflation rate. Additionally, since the late-1990s, within the framework of the Usury-Free Banking Law, the banks have been allowed to open a special deposit account with the CBI to control liquidity through absorption of their excess resources (CBI, 2002).

14 The MCC’s permanent members include the governor of the CBI, the Head of the Chamber of Commerce, the Finance and Economy Minister and some members of the parliament. [Online]. Available at: http://www.icccoop.ir [Accessed 30 July 2014].

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In theory, the economic independence of the Central Bank depends on its ability to control the quantity of credit it lends, and its freedom to set the expected rates of return on facilities that is charged on credits (Grilli, et al., 1991). It has been argued that higher levels of Central Bank independence have positive effects on investment (Pastor and Maxfield, 2000). This independence can further enhance investment efficiency of the financial sector by mobilizing savings to finance capital accumulation (Shaw, 1973). Iran’s Central Bank is formally an independent institution. In practice, however, the CBI is not able to formulate or implement proactive monetary policies and has no power over fiscal policies. It is the government that has direct control over the lending and investment activities of commercial banks (Jafari-Samimi, 2010).

According to the Islamic Banking Law, liabilities incurred by the banks are of two types, (i) current and saving Gharz-al-hassanh deposits, and (ii) short- and long-term investment deposits.

In using current Gharz al-hassanh accounts, similar to demand deposits in conventional banks, customers make transactions and payments. For the saving Gharz al-hassanh accounts, non-fixed bonuses and prizes as well as priorities in using bank facilities are given to depositors. For short-term deposits, the minimum time limit is three months and for long-term deposits time limits vary between 1 and 5 years. In theory, no fixed rate of return can be guaranteed to the depositors in advance and the term ‘provisional’ rates are officially used to reflect that the rates that are paid indicate the profits or losses of a business. Yet, in practice, deposit rates or

‘dividends’ have become pre-determined (rather than being dependent on the banks’

profitability) and the depositors have never lost their savings or gained higher returns than the pre-set provisional rates.

Moreover, various modes of contact financing include (i) Mudarabah (profit sharing); (ii) Musharakah (partnership); (iii) Direct Investment; (iv) Murabahah (differed payment sale); (v) Salaf (purchase with differed delivery); (vi) Ijrah be shart-e-tamlik (lease purchase); (vii) Jualah (transaction based on commission); and (viii) Gharz-al-hassanh (benevolent loan).¹⁵ Since, in

15 (i) Mudarabah: banks provide credits to the commercial sector, and business profits are shared based upon previous agreement; (ii) Musharakah: this is of two forms of ‘civil’ and ‘legal’ partnership. The former is project-specific for short and medium periods. Capital is provided both by banks and their partners on a joint-ownership basis for the conduct of a specific job. The latter is a joint venture concerning longer term projects and banks provide a portion of total equity of a newly established firm or purchases part of the shares of the existing companies; (iii) Direct Investment: banks can invest directly in any long-term economic activity in the public sector except for projects involved in the production of luxury products; (iv) Murabahah: banks are permitted to purchase

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these practices, the lenders and the borrowers are to share the profits and risks of projects based on previous agreement, the actual size of the profits to the lender could be known only after the completion of the projects. Such a risk sharing approach has encouraged borrowers to take on riskier projects, which in turn has made the loan portfolios of the banks riskier. As a result, banks have rationed their credits more strictly and have diverted a large share of their assets to commercial and short-term investments (Hassani, 2010).

In theory, interests charged on loans are considered as fees or shares of business profits and the transactions are operated through the modes of financing contracts as mentioned above. In practice, however, banks charge fixed pre-set amounts at rates that are approved by the CBI at least once a year. During the last two decades, for instance, from the above eight most commonly used methods of contract financing by commercial banks, on average about 40% of the contracts have been under the installment sale category, the closest to interest-rates based conventional banking (Hassani, 2010). Also, banks’ commercial risks are minimized as at the time of defaults, the principal amount, the expected rates of return on facilities and the late fees are collected through possession and or sale of secured high value collateral items such as real estate or machinery.

During the first two pre-revolutionary plans (1949-1962), the Plan Organization (PO) formulated and executed its investment projects independent of the government. However, since the formulation of the third pre-revolutionary plan in 1963, and with the establishment of the Supreme Council, the Prime Minister became in charge of the PO as a means to coordinate the government’s economic policies. Accordingly, the responsibilities of the PO were revised and since then it became responsible for national planning, execution of governmental projects, and raw materials, machinery, equipment, spare parts and other needs of businesses in industry, agriculture, mining and services. Banks can then resell these items based on short-term installments. Prices in these transactions are expected to cover costs as well as profits (under certain regulations); (v) Salaf: banks can purchase goods from productive businesses to provide them with capital. Therefore, banks do not lend money; instead they buy parts of the future products at an agreed-upon price which must not surpass the market price of the product at the time of the contract; (vi) Ijarah be shart-e-tamlik: banks buy real property or other assets required by businesses (or individuals) and lease the assets to them. The price of the asset is set on a cost-plus basis and its ownership is transferred to the lessees at the end of the contract; (vii) Jualah: projects related to the expansion of production, commercial and service activities are undertaken by banks or customers on a short-term basis to pay a specific sum in return for a service and the fee to be charged must be set at the time of contract formation; (viii) Gharz hassanh: it is a non-commercial facility without any expectation of profits. The loans are financed by Gharz al-hassanh saving deposits and are often given to small producers, farmers and small-scale businesses. In the agriculture sector, there are also other financing methods such as Muzarah and Masaqat which are employed when the other financing methods cannot be used (see the Law for Usury (Interest) Free Banking. [Online]. Available at:

http://www.cbi.ir [Accessed 1 May 2015]; see also Hassani (2010).

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financing of investment schemes via the plans’ budget. During 1956-1972, about 71% of total oil income was allocated to the PO and its role in the process of capital accumulation became central.

With the implementation of the fifth pre-revolutionary plan (1973-1977), the current and development expenditures of the government were combined and the PO lost its financial independence. During these years, the oil income-bred substantial liquidity expansion in the economy resulted in a rapid growth of investment. Following the oil boom of 1973, and due to the consequent oil-financed expansionary monetary effects, Iran’s monetary base and domestic liquidity rose considerably. Coupled with a rapid rise in deposits and the expansion of financial resources, all the banks increased their credits, which intensified inflationary pressures in the economy. As a result of a high inflation rate, the real expected rates of return on facilities became negative and the real cost of capital decreased which in turn stimulated the demand for credits in all sectors of the economy. With increased lending capacity and low costs of debt, companies borrowed extensively, and consequently the ratio of bank-financed capital investment including private investment rose significantly (Jalali-Naini, 1985). During this period, the government revised the sectoral loan rates in its development plan, and based on the revised plan, the share of credits in low productive sectors such as agriculture declined, whereas sectors with higher productivity such as industry and construction enjoyed a greater share of credits.

The Iranian banking system consisted of six banks in 1950, four of which were state-owned. The number of banks increased to twenty-six by 1960, of which seventeen were private banks and four were specialized banks. By 1976, the number of banks rose even further to thirty-five, of which ten were specialized banks (Karshenas, 1990, p.98). Over the 1960s and the 1970s period, the government in particular pursued a policy of financial aid to the private sector through two banks, the Industrial Credit Bank and Industrial and Mining Development Bank.

In the post-revolutionary era, the banking system and the credit market underwent substantial structural changes. Soon after the revolution, all the commercial banks and insurance companies were nationalized and consolidated, and banking regulations changed with the approval of the Islamic Banking Law of Iran. The formulation of guidelines for monetary and credit policies remained in control of the MCC. In 1979, any fundamental market-oriented reforms, such as

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privatization and market-liberalization, became greatly constrained because of Article 44 of the Constitution. Following the war, the role of the state and the scope of government operations increased significantly. The state nationalized large-scale industries and the entire banking system. By the end of the war, the SOEs and Bonyads (semi-state-owned charitable foundations) were the major players in the economy of the country and in charge of all the large scale economic activities in the energy and strategic sectors. The role of the private sector during this period was limited to small-scale agriculture, mining and manufacturing, and domestic trade and services. By 1982, in line with the Banking Nationalisation Act, the number of banks decreased to six commercial and three specialised banks (Jalali-Naini and Khalatbari, 2002).

Consistent with the Islamic banking practices, after the revolution, the Iranian government played an important role in converting the banking system, which until 1979 was dominated by conventional banking practices, into Islamic banking. The law of Usury-Free banking was passed by the Majlis (the parliament) in 1983, and started being implemented by the banks in 1984. Under the Usury-Free Banking Act, the charging of interests on all borrowing and lending activities was banned and banks were obliged to engage only in interest-free Islamic transactions and commercial transactions that involved the exchange of goods and services in return for a share of the expected profit.

Overall, the years from 1979 to 1988 were characterized by the complete state ownership of the banking sector, strict government restrictions on banks’ deposit and lending ceilings, high reserve ratio requirements, extensive control of capital flows, and state-led credit allocation programs. In 1989 and during the first plan, the government re-opened the Tehran Stock Exchange (TSE) in order to find new domestic and foreign investors in the capital market.

Fueled by favorable oil prices, financial resources of the banking sector increased during this period. Since the financial sector was state-owned, most of investment funds were channeled to the public sector.

Limits on sectoral credit allocation and control of the return rates of state-owned banks were gradually relaxed. Participation shares were introduced as securities for medium-term financing of investment projects, and deposits and lending rates in the banking sector were further

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adjusted (Jalili-Naini and Toloo, 2001). Sector-level lending rates, which had been kept significantly below inflation, were revised upwards and deposit rates were increased. Initially, as a result of these policies, deposits relative to cash holding increased (Jalali-Naini and Khalatbari, 2002). However, with the significant rise in inflation during the early to mid-1990s, deposit and lending rates in real terms began to fall again.

During the fourth plan, the government obliged all the banks to reduce deposit and lending rates of return (CBI, 2003). The government further imposed different rates and conditions on public banks to give high priority in their lending operations to technology-driven projects, small and medium enterprises, and to housing projects for low income earners (Amuzegar, 2010).

Consequently, the level of non-performing loans (NPLs) of state-owned banks increased dramatically after 2006. According to the CBI (2006), the annual growth rate of state-owned banks’ NPLs was less than 30% before 2005, while it significantly increased to 129% in 2006.

CBI (2006) also stated that the highest share of the NPLs belonged to the manufacturing and mining (20.1%), and the construction (19.5%) sectors.

In brief, with the establishment of the Central Bank and the Credit and Currency Council in 1960, the government exerted a tight control over the amount and distribution of funds in the country’s formal credit market. This was mainly realized through different forms of credit controls and a policy of differential rates. The system of differentiated rates was set up to encourage investment in the state’s favored sectors. For instance, over the period 1973-2010, the lending rates for the agriculture sector were the lowest in comparison to other major sectors of the economy, whereas this rate was the highest in the services and commercial sectors.

Appendix 2B reports the expected rates of profit on facilities provided by the specialized bank during 1973-2010. Seemingly, the expected rates of return on facilities instruments were not used to combat inflationary pressures in the Iranian economy since this would have required the government to set higher rates, which in return would have had adverse effects on investment and growth. On the deposit side, the rates paid on investment deposits were lower than the inflation rate. Hence, the real expected rates of return on facilities were negative. This adversely affected the economy partly because considerable resources were invested in financial assets, like foreign currencies, or in durable goods such as gold, houses and cars, rather than in savings with the banking system. Appendix 2C illustrates the term-investment deposit rates over the period under investigation.

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Overall, during the years under consideration, the government determined the official rates of return in the banking system. To stimulate economic growth, the official rates in real terms were set at a low or even negative level. Because of the low costs of official loans, the demand for credits always surpassed the banking system’s supply. In addition to the control of rates of return, the government regulated the quantities of credits allocated to the economy through different methods. Firstly, the government determined the credits that were to be directly distributed in its annual budgets. Secondly, the government controlled the supply of credits made by banks through a system of quotas (CBI, 2002). Similarly, the government determined the quantity of credits allocated for the major economic sectors including agriculture, manufacturing, construction, exports, and services in order to give priority to its preferred sectors.

Hence, the Iranian government played an interventionist role in the size of real investment and in the allocation of oil-driven financial resources to various sectors of the economy. Under the state’s interventionist stance, the Iranian banking sector became the core domestic vehicle for financing the country’s development projects and its growing public sector.

Yet, interestingly, the private banking system was re-introduced in 2001 and since then private banks’ ratio of deposits to total banking deposits has been on increase. Also, rather than being dependent on the banks’ profitability according to the Usury-Free Islamic Banking Law of Iran, deposit rates have become pre-set and the depositors have never gained higher returns than the pre-determined provisional rates or lost their savings (Hassani, 2010; Jafari-Samimi, 2010).

Hence, as discussed above, it appears that the Iranian Usury-Free Banking Law has established a context within which the Iranian banking system functions similar to other systems in developing or planned economies with non-Islamic banking systems. Therefore, it is of interest for this thesis to investigate the extent to which

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aggregate and sectoral investment patterns in the context of the Iranian economy are consistent with neoclassical-accelerator type investment models which were developed for competitive open-market economies.

2.4. MACROECONOMIC PERFORMANCE AND OIL DEPENDENCY