The Iran Primer

 

           In their annual health check of the economy, the first in 2½ years, IMF economists say that Iran’s near-term economic outlook remains uncertain. Facing continued constrained prospects for oil revenues and international transactions, Iran is expected to see its real GDP growth begin to stabilize in the current fiscal year after two consecutive years of sharp contraction. The still-weak recovery is expected to benefit from potential improvements in the external environment and some early signs of modest revival in growth in domestic demand.

 

           The new Iranian administration that took office in August 2013 has made some headway in improving the external environment and confidence in the outlook, the report notes. The authorities have reached an interim agreement with the P5+1 group of countries (the five permanent members of the United Nations Security Council plus Germany). This agreement (which took effect in January 2014 and provides for a limited, temporary easing of sanctions) allows Iran to stabilize oil exports, grants some access to Iran’s funds held abroad, and temporarily waives sanctions on petrochemical exports and the automobile industry.

 

           Iran now needs to focus on the domestic reform agenda to fully benefit from the country’s economic potential. “This window of opportunity to advance comprehensive reforms should not be missed,” said Martin Cerisola, Assistant Director of the IMF’s Middle East and Central Asia Department.

 

 

            Iran had achieved considerable progress in raising per capita income in previous decades, but large shocks and weak macroeconomic management in recent years have had a significant impact on macroeconomic stability and growth. A combination of shocks, associated with the implementation of the first phase of the subsidy reform, social-programs inadequately funded, and a marked deterioration in the external environment have weakened the economy. Inflation and unemployment are high, while the corporate and banking sectors are weak. The experience over the past several years has exposed structural weaknesses in the economy and in the

policy framework.

 

            The economic outlook remains highly uncertain. Facing continued constrained prospects for oil revenues and international transactions, the economy is expected to have continued to contract in 2013/14. With some positive tailwinds from the external side and incipient signs that the pace of contraction in domestic demand is slowing, economic activity would begin to stabilize in 2014/15. But the current outlook remains highly uncertain and subject to downside risks. The authorities are taking steps to make the regulatory framework for foreign investment in the oil sector more attractive, while the interim agreement with the P5+1 brings upside risks.

 

            The opportunity to advance comprehensive reforms should not be missed. There is a need to advance reforms to the product, labor, and credit markets to promote stability, investment, and productivity. The authorities should avoid postponing reforms and “muddling-through” in the hope of an improved external environment. Advancing reforms would lay the basis for sustained high growth and employment, especially should the external environment continue to improve.

 

            Dealing with stagflation requires several measures, careful sequencing and coordination. A three-pronged strategy should be centered on tightening monetary policy, some balanced fiscal consolidation, and structural reforms to boost the supply side. Staff welcomes the steps taken to remove the financing of the Mehr program from the Central Bank of Iran’s balance sheet, which bode well for stabilizing inflation in the future. The authorities are encouraged to find an alternative noninflationary source of financing for this program to minimize macro-stability risks ahead. Increasing profit rates gradually would help to firmly anchor expectations and contain second-round effects from the planned increases in domestic energy prices. The 2014/15 budget continues with the government’s decision to consolidate fiscal policy and would help balance the support for disinflation and needs of the economy. Staff welcomes the proposed measures to begin broadening the revenue base away from oil, most notably, the decision to bring forward and increase the scheduled VAT rate, as well as the reforms to strengthen tax administration and reduce exemptions. Staff sees scope to further increase the VAT rate in the years ahead—as it remains well below those of other resource-intensive countries—as well as to expand the taxation to specific activities that have experienced large gains. These measures would help to improve the quality of the fiscal adjustment and help lay the ground for a sustainable fiscal policy ahead.

 

            Reforms to the monetary and fiscal policy frameworks are also essential to entrench macroeconomic stability. The Central Bank of Iran’s mandate needs to be simplified and refocused toward price stability. To build a solid foundation for the future, it is essential to bring the institutional decision-making setup at the Money and Credit Council in line with those of countries that have successfully resolved high chronic inflation. Reforms to the fiscal policy framework should strengthen its countercyclical role, limit fiscal risks, and enhance macroeconomic coordination. The current framework supported by the Oil Stabilization Fund (OSF) and the National Development Fund of Iran (NDFI) could better balance the goals of macroeconomic stability, intergenerational equity, and development. For this, OSF resources need to be replenished soon to support noninflationary budget financing and build buffers for future shocks. Decisions on how to save and invest NDFI resources should be better coordinated explicitly with macro policies and underpinned by more explicit safeguards and transparency. Adopting a multi-year budget planning and expanding the coverage of the general government should enhance the operational conduct, monitoring, and accountability of fiscal policy, and thus limit fiscal risks. Staff encourages the authorities to review how best to bring quasi-fiscal activities into the budget to make them explicit so as to reform or discontinue them.

 

welcome. In the transition, the authorities should manage the exchange rate flexibly in light of external risks and still high inflation. The assessment of the official exchange rate is subject to an unusual degree of uncertainty. In the current circumstances, the official exchange rate would be moderately overvalued, with the bureau/parallel market rate closer to equilibrium. Staff recommends Executive Board approval of the retention of the exchange restrictions and multiple currency practices referred to in paragraph 20 since these are maintained for balance of payments reasons, are nondiscriminatory, and are temporary in light of the authorities’ commitment to unify the exchange rate regime and to remove the restrictions by mid-2015.

 

            The subsidy reform needs to proceed with the right supporting framework and macroeconomic policies. Iran’s design of the subsidy reform has been exemplary and the reform remains a priority. The implementation of the first phase has faced significant and varied difficulties and there is a need to make the lessons known to the public. Plans to increase domestic prices gradually are prudent but should be underpinned by an adjustment mechanism with strong political backing to support full implementation. The proposed distribution of resources among households and specific sectors presents a departure from the original design. The process for identifying and excluding less vulnerable groups requires criteria that are simple, transparent, and perceived as fair. In addition, the distribution of resources for supporting energy-intensive sectors needs to ensure a framework that fosters the adoption of new technologies and tighter budget constraints. In subsequent stages of the reform, transfers could be made more conditional on social goals and tilted toward private savings for the broader population.

 

            There is an urgent need to strengthen the Central Bank of Iran’s supervisory powers and enforcement capacity. The CBI should be able to swiftly take action in case banks fail to abide by regulatory standards. Staff welcomes the CBI’s initial steps toward a risk-based approach to supervision. Staff shares the view of some market participants about the scope for leveling the field of competition in the system through further privatization and reforms to government-mandated credit policies. Current proposals to deal with nonperforming loans and recapitalize public banks need to be supported by restructuring plans and reforms to enhance their risk management and accountability. In terms of crisis preparedness, it would be important to strengthen the bank resolution framework and putting the deposit guarantee fund on a sustainable financial footing.

 

complementary and essential to restore stability and boost employment and growth. The scope to improve the business environment is large and can provide a significant boost to productivity and growth in the years ahead. Enhancing the enforcement of the rule of law and property rights, maintaining policy and macroeconomic stability, and enhancing the transparency of policy making are fundamental pillars that would also pave the way for taking advantage of the growing foreign investor interest. Advancing reforms on AML/CFT would also help reinsert the domestic financial system into the global economy, lower transaction costs, and provide an important impetus to productivity. With large potential entrants to the labor force in the years ahead, reforms are needed to facilitate the reallocation of labor across sectors and lower nonwage labor costs. Staff encourages the authorities to review labor regulations to ease the rigidity of contracts and nonwage costs.

 

            There is a good opportunity to improve the timeliness of official statistics publication and to reaffirm the underlying methodology behind consumer price and unemployment data. In recent years, the quality and timeliness of price and unemployment statistics have come under increased scrutiny. The authorities have taken some steps under difficult circumstances, but there is scope for further improvement in the reporting and timeliness of official statistics. Technical assistance in these areas would help address these issues.

 

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            One of the first debates among the revolutionaries who overthrew the shah was about the legacy of the ancien régime. The royal heritage included the nuclear program, deemed by the revolutionaries as a costly Western imposition on an oil-rich nation. Yet, antinuclear rhetoric was not purely ideological. A pragmatic cost-benefit analysis indicated that while a gas-fired power plant would cost $300/kilowatt in Iran, the predicted costs of Bushehr would be between $2,500 and $3,000/kilowatt. Moreover, in the aftermath of the 1979 nuclear incident at Three Mile Island in the United States, safety concerns about the nuclear installations in Iran preoccupied the new authorities. Other arguments against the program included Iran’s limited uranium resources, earthquake-prone terrain, and lack of expertise.

 

            The death knell for Iran’s nuclear program was Ayatollah Khomeini’s pronouncement that the unfinished plants in Bushehr would be used as “silos to store wheat.” In July 1979, construction of all nuclear power plants came to a halt. The transitional government of Prime Minister Mehdi Bazargan abandoned all of the existing nuclear contracts. But the decision was not cost free.

 

            In retaliation and against the backdrop of the seizure of the U.S. embassy in Tehran, Western countries refused to deliver machinery Iran had already purchased at a hefty price. The United States—whose diplomats were taken hostage in Tehran for 444 days—ceased supplying highly enriched uranium fuel for the Tehran Research Reactor, which was forced to temporarily shut down. The halt of nuclear plant construction led to an exodus of Iranian nuclear scientists.

 

            The Kraftwerk Union also terminated its Bushehr contract, but Iran had already sunk $5.5 billion deutsche marks (nearly $2.8 billion in 1979 dollars and $9.6 billion in 2012 dollars) into the project. A bitter legal dispute ensued in several international courts. Based on a 1982 International Chamber of Commerce ruling, the German companies had to deliver some 80,000 pieces of equipment, but Iran’s efforts to obtain compensation for unfinished reactors and paid nuclear fuel came to naught. A German offer to provide Iran with modern gas-fired power plants to settle the $5.4 billion claim also fell on deaf ears.

 

            Lawsuits with the French over Eurodif were eventually settled in 1991; Iran was reimbursed a total of $1.6 billion for its original 1974 loan plus interest. To date, Iran is still listed as an indirect stockholder of Eurodif but under the 1991 settlement has no right to enriched uranium from the facility. This experience soured prospects of any future joint ownership of foreign facilities for Iran.

 

            In September 1980, Saddam Hussein’s Iraq invaded an Iran still in the throes of post-revolutionary chaos. What would become an eight-year war severely damaged Iran’s nuclear infrastructure. In retaliation for Iran’s failed raid on Iraq’s Osirak nuclear reactor, Iraqi air forces attacked the Bushehr power plant seven times during the war, leaving the plant in ruins. According to estimates by engineers from both Siemens and Technischer Überwachungsverein, the repair bill for the damages and environmental exposure of the two reactors in Bushehr ranged between $2.9 and $4.6 billion.

 

 

            By the mid-1980s, as revolutionary fervor in Iran began to subside while the country was still in a full-blown war with Iraq, Tehran’s leaders began to reconsider their nuclear program as a deterrence option. Iranian leaders felt isolated—a calculus that was exacerbated by the fact that Saddam Hussein was abetted by great powers with sophisticated weapons and (courtesy of the United States) crucial intelligence to locate Iranian military targets. Moreover, the drain of war had pushed the country into a severe energy crisis, evidenced by frequent blackouts.

 

            It was against this backdrop that Iran’s nuclear program, dormant since 1979, was resurrected. A nuclear program could potentially alleviate Iran’s dire electricity needs and serve as a deterrent against the Islamic regime’s foreign foes. In 1984, then President Ali Khamenei, the current supreme leader, obtained authorization from Ayatollah Khomeini to restart the nuclear program and allocated funds for the effort in the national budget. 

 

            Facing unprecedented international isolation, the Iranian government searched in vain for a partner to complete the Bushehr project, but due to U.S. opposition all efforts came to naught. Only one man provided Tehran with a promising response—the father of Pakistan’s nuclear weapons program, Abdul Qadeer (A.Q.) Khan. He visited Bushehr twice, in February 1986 and January 1987. But soon it became clear that the completion of Bushehr was beyond A.Q. Khan’s ability. Tehran grew convinced that the only option available to it was self-sufficiency.

 

            Their first step was to acquire nuclear fuel-cycle capabilities. A.Q. Khan had already offered assistance by providing enrichment technology to Iran. With the endorsement of the then prime minister, Mir Hossein Moussavi (who was put under house arrest, accused of “sedition,” in the aftermath of the 2009 disputed presidential election), a deal was struck between the representatives of the Atomic Energy Organization of Iran and A.Q. Khan’s illicit nuclear network. Iran’s uranium enrichment program was thus born in secret through the acquisition of technical drawings, manufacturing instructions, and samples of components for P-1 centrifuges (a 1970s Dutch design stolen by A.Q. Khan).

 

            With design information in hand, Iran started a wide-ranging procurement effort to obtain critical parts for building centrifuge cascades. For example, in 1988 the Iranian front company Kavosh Yar, a subsidiary of the Atomic Energy Organization, acquired centrifuge components and vacuum valves from the German company Leybold worth $500,000. In 1995, Iran revisited A.Q. Khan’s “nuclear Walmart” and bought parts and designs for the more advanced P-2 centrifuge.

 

            Iran also sought to upgrade the Tehran Research Reactor, the renovation of which had been pending since the shah’s era. In 1987, while renovating the reactor’s core, Argentina’s Applied Research Institute converted the reactor’s fuel from weapons-grade 93 percent enriched uranium to slightly less than 20 percent. The cost was $5.5 million. Argentina’s Nuclear Energy Commission also signed an agreement to supply 115.8 kilograms of the Tehran reactor’s required 19.75 percent enriched uranium, which was eventually delivered in 1993.

 

            By the mid-1990s, the nuclear program had once again become a national priority with more than $800 million allocated to it in the national budget. The nuclear technology center located in the city of Isfahan, south of Tehran, was inaugurated in 1990 and with it a wide-ranging quest to find additional nuclear partners. Despite generous offers from Iran, the government of Pakistan remained reluctant to share its nuclear know-how with its neighbor. But China was interested. Beijing conducted nuclear trade worth $60 million annually with Tehran, turning China into Iran’s primary nuclear partner. In 1991, Tehran secretly imported approximately one ton of uranium hexafluoride from China but failed to report the purchase to the IAEA, a requirement under its NPT safeguards agreement.

 

            U.S. pressure brought the Sino-Iranian cooperation to an end—another wakeup call that Iran would have to rely on native expertise. Thus began a renewed effort to bring Iran’s migrated nuclear talents back home and to train new experts. A group of 77 Iranian nuclear scientists were sent to study at Italy’s International Center for Theoretical Physics in Trieste, which was saved from financial crisis by a $3 million loan from Iran.

            Finally, a cash-strapped Russia took on the task of completing the Bushehr nuclear plant in 1992. Moscow’s impetus for entering the Iranian market was above all to rescue its post-Soviet nuclear industry from insolvency. A turnkey agreement was signed between the Atomic Energy Organization of Iran and AtomStroyExport, a subsidiary of the Russian Atomic Energy Agency. Moscow was to supply a 915 MWe VVER-1000 light-water reactor, which is suitable for power generation and not prone to proliferation. Tehran, in turn, agreed to pay 80 percent of the value of the contract in cash and the remaining 20 percent in kind. On the ruins of the crippled reactor, the Russians planned to build a sui generis nuclear plant—cobbled together with residual German equipment and scrambled Russian technology.

 

            From the outset, the project was plagued with problems. The design of the Russian VVER reactor was incompatible with the German foundations of the Bushehr plant. It cost Iran an additional $140 million to solve the problem. Due to American objections, Moscow also backed off from constructing a centrifuge-based uranium enrichment facility in Iran and instead agreed to supply the reactor’s nuclear fuel for a ten-year period with a price tag of $300 million. After a sixteen-year hiatus, the Bushehr reactor was once again a construction site. The initial completion date was set for 2001, but the estimate would prove off by more than a decade. But since construction began, between 250 to 3,000 engineers and technicians from Russia and other former Soviet Union countries have been working in Iran, reportedly earning $5,000 to $20,000 per month.

 

            From 1992 to 2002, Iran made steady progress toward an indigenous nuclear fuel cycle. Enrichment experiments were secretly conducted, contrary to Iran’s NPT safeguards obligations, on test centrifuges in a research and development facility installed at Kalaye Electric Company. Another vast clandestine enrichment facility was built underground near the city of Natanz. Buried under 25 feet of cement and concrete, construction of the gas centrifuge facility at one point consumed all of the cement produced in Iran. The Atomic Energy Organization of Iran had also started to secretly construct a heavy-water production plant and a 40 MW research reactor near Arak. 

 

 

            In August 2002, an Iranian opposition group, the National Council of Resistance (a front for the Mojaheden-e Khalq, a militant Marxist-Islamist cult that helped topple the shah and now calls for the overthrow of the Islamic Republic), revealed information about Iran’s undeclared nuclear enrichment facilities in Natanz and heavy-water production plant in Arak. The revelation ignited an international crisis. 

 

            Between 2003 and 2005—against the backdrop of the U.S. invasion of Saddam Hussein’s Iraq—France, Germany, and Britain (the EU-3) led a diplomatic effort to resolve the nuclear crisis. Iran, sobered by the fact that the United States had just defeated an Iraqi army in three weeks that they had fought to a standstill over eight years, initially agreed to suspend its enrichment program. It also voluntarily implemented the IAEA’s Additional Protocol, which allows for more intrusive inspections, for more than two years. But as the situation in Iraq began to deteriorate, turning in Iran’s favor, oil prices began to soar, and the EU-3 failed to bridge the gap between Iran and the United States, Tehran’s leaders grew emboldened enough to reject what they believed to be the West’s underlying objective: to get them to permanently give up their right to enrich uranium. On August 8, 2005, in the final days of Mohammad Khatami’s presidency, Iran restarted uranium conversion at its Isfahan facility.

 

            With the election victory of President Mahmoud Ahmadinejad in 2005, Iran adopted a harsher stance in negotiations. Eventually, in January 2006, it broke the IAEA seals and restarted uranium enrichment. On February 4, 2006, the IAEA’s Board of Governors voted to refer Iran to the United Nations Security Council for its noncompliance with its NPT safeguards agreement obligations. On July 31, 2006, Security Council Resolution 1696 was issued by unanimous vote, calling on Iran to stop uranium enrichment efforts within one month.

 

            Tehran continued to insist on its “inalienable right” to pursue uranium enrichment on its soil. Consequently, on December 23, 2006, the Security Council passed Resolution 1737, imposing international sanctions on Iran. This was the beginning of a mutual cycle of escalation. A third Security Council Resolution (1747) was adopted in March 2007. Several weeks later, Iran announced that it had reached industrial-scale uranium enrichment capabilities with the installation of 3,000 centrifuges in Natanz.

 

            Amid growing concerns about the possibility of a U.S. or Israeli military strike on Iran’s nuclear facilities, an unexpected U.S. National Intelligence Estimate was released in 2007, stating that Tehran had halted its structured nuclear weapons program in 2003. The report cooled temperatures, providing space for Iran and the IAEA to work on a “modality plan” for resolving outstanding issues within a year, and by February 2008, the IAEA closed the file on most of those issues. 

 

            But new evidence surfaced from a stolen laptop that allegedly contained information about Iran’s clandestine nuclear weapons program. The incident soured relations between Tehran and the IAEA and resulted in a four-year-long stalemate in talks about Iran’s pre-2003 activities. In March 2008, Security Council Resolution 1803 was passed, imposing further economic sanctions on Iran. The United States and its allies also started levying increasingly burdensome individual sanctions against Tehran. 

 

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