The Chronicles of Subsidy Reform

A paper recently authored by economists Roman J. Zytek and Mohammad Reza Farzin has reviewed the experience of Iran’s Targeted Subsidies Reform. The study addresses several criticisms of the key elements of the reform design, implementation record and broader economic and social impact, identifying and elaborating on the most critical design and implementation shortcomings. 

Zytek served as senior desk economist for Iran in the International Monetary Fund in 2006-11 and 2013-15. 

Farzin is a professor at the Allameh Tabatabaie University in Tehran. During 2008-11, he was Iran’s deputy minister of finance and was in charge of the subsidies’ reform headquarters.  

The paper has been divided into several parts, the first of which is presented below. Other parts will be published in the coming days.

  Background

In 2010-11, the Iranian government committed to an ambitious reform of subsidies. The reform envisaged replacing highly inefficient distribution of hydrocarbon rents through implicit subsidies to energy users with explicit cash transfers to the entire population. 

In the first phase of the reform, the government increased energy prices, though not up to the international level and distributed the revenue windfall from the increase to the entire population through periodic cash transfers. The transfers were set at a fixed monthly rate of 455,000 rials (about $45 at the 2010 exchange rate) per person. To ease the inevitable hardships, households and enterprises were to continue to benefit from limited and declining quotas of lower-priced fuels during an unspecified transition period.

A number of external events made the reform more difficult than it would have been in a more favorable environment. Iran’s external environment deteriorated severely during the course of the reform implementation. The surge in international food prices in late 2010 and early 2011 (FAO food price index reached an all-time high in February 2011) contributed to domestic food price inflation. 

The imposition of limits on oil imports from Iran by the international community severely undermined Iran’s oil exports and fiscal revenues, and led to a significant deterioration in external and internal macroeconomic stability. 

The decline in fiscal revenues and sanctions on Iran’s financial sector further complicated efforts to reduce energy intensity of the economy. Moreover, and more importantly, not all domestic economic policies were consistent with the design and demands of the reform. 

  Early Reform Impact

As expected, macroeconomic indicators deteriorated following the implementation of the reform on December 19, 2010. The rate of growth of the real Gross Domestic Product decelerated to 5.3% by March 2012, from 6.5% in the year ending March 2011. 

The non-oil and gas sectors expanded by a respectable 5.4% in the period, though down from the 7% growth in the prior year, all at constant basic prices of 2004-5. The overall Consumer Price Index jumped due to the massive step-like increase in energy prices. 

In March 2011, the CPI was 10% above its November 2010 level. Month-on month CPI inflation accelerated to an annualized rate of almost 50% in March 2011, from an annualized rate of 14% in November 2010. The higher energy costs increased production costs of Iranian manufacturers and farmers, and pushed transportation and retail distribution costs higher. In addition, the 40% increase in international food prices between June 2010 and February 2011 contributed to the increase in domestic prices for selected food items. 

However, the inflation rate decelerated rapidly by summer 2011. In US dollar terms, non-oil exports rose from $22.6 billion in 2010-11 to $26.7 billion in 2011-12. Iran’s current account remained in surplus that reached 11.5% of GDP and foreign exchange reserves increased by $20 billion in 2011. 

The rial remained relatively stable and well supported in the domestic official and parallel foreign exchange markets throughout most of 2011. Only starting in the last quarter of 2011, the spread between the two rates started to widen and reached 54% in January 2012, when new rounds of international sanctions on Iran gradually reduced Iran’s ability to export oil and draw on its international reserves to support the rial. 

The reform, at least initially, resulted in drastic improvement in income distribution among the Iranian households. The Gini coefficient declined from 0.411 in 2009-10 to 0.365 in 2011-12, as the cash transfers disproportionately benefitted the poorest households in relation to their income on the eve of the reform. 

In March 2014, the Iranian government began implementing the second phase of the subsidy reform. Most energy prices were raised, though the increases were relatively modest. In some cases, the nominal price increases were too small to restore the real—adjusted for inflation or exchange rate depreciation—price level of the energy products achieved in late December 2010. 

Prices of electricity, water, and gas were raised in March. On April 25, 2014, the remaining energy prices were raised. The price discount of gasoline sold under the quota system was reduced from 43% to 30%. The price increase brought the domestic price of gasoline to $1.10 per gallon compared to about $3.60 per gallon in the US retail market and $2.80 in the Persian Gulf coast’s wholesale market. 

Also, the government encouraged more affluent households to relinquish their cash transfers voluntarily and ultimately tried to de-register the more affluent from the list of beneficiaries. However, these efforts ran into both political and technical challenges. 

At the technical level, identifying and continuously updating the roster of upper income families proved next to impossible. Politically, such efforts were difficult to justify given the national ownership of Iran’s hydrocarbon resources. 

Therefore, most of the administrative efforts focused on minimizing fraud, identifying Iranians living abroad and encouraging the more affluent to donate their transfers to charities. 

Some of the additional revenues from the price increases were allocated in the 2014-15 budget to support reforms and expenditure in healthcare, support for municipalities and other local governments, as well as investment in oil and gas infrastructure. 

   Challenges

As expected, the reform exposed vulnerabilities in the corporate and banking sectors. The corporate profitability declined, reflecting the drastic increase in energy input costs, slowing economic activity, as well as the inability of enterprises to reduce employment or wages. 

In some cases, firms were unable to raise output prices due to administrative price controls. 

Vulnerabilities in the corporate sector spilled over into the banking sector. Companies unable to pay suppliers and employees were even less able to service their bank debts. The quality of bank assets and profitability deteriorated. 

The share of non-performing loans in all loans denominated in rials rose from 13.9% in March 2011 to 15.1% in March 2012. These developments set the stage for re-acceleration in inflation in 2012, when companies, unable to cover their cost from revenues, resorted to bank financing. 

The reform immediately improved the transparency and allocation of hydrocarbon rents, as intended. It turned the hydrocarbon rent into cash and transferred the cash into the hands of the Iranian population. The cash transfers initially shifted an estimated $30 billion per year into private hands. These empowered the Iranian citizens to spend a larger share of the country’s oil and gas rent as they desired, instead of forcing them to either buy cheap energy or forgo the benefit.

Thus, the allocation of final demand in the economy and consumer welfare improved, as households redirected some of their spending from energy to other goods or services, supporting the expansion of small- and medium-sized private enterprises in diverse sectors of the economy. 

Unfortunately, most of the benefits of the reform may have been diluted over the past five years. Though the size of the hydrocarbon rent collapsed with the decline in the international price of oil to their long-term averages, the efficiency of rent distribution inside Iran has improved by less than feasible. Most of the rent continues to accrue to less than optimally efficient state enterprises. 

(To be continued)