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Iran’s Economy – Which Way Forward?

This article, published in an Iranian magazine, assesses the present state of Iran's economy and looks at how it should develop. It makes specific policy recommendations, and stresses that Iran's long-run economic success will require increased personal freedom.

Summary

This article was published in an Iranian magazine.

Iran's economy was severely damaged by the Iran / Iraq war, and by sanctions related to the nuclear dispute.

The resolution of the nuclear dispute is a major opportunity.

Iran is presently a middle income country, with very high levels of corruption.

Its future development depends on addressing some key issues.

The most difficult of these will be increasing personal freedom, which in the long run is economically essential.

15 February 2016

My website intentionally makes me easy to contact. In early December 2015 I received an intriguing email via my website. It came from someone I have had no previous contact with, Mojtaba Mousavi.

Mr Mousavi explained that he was International Editor of "The Age of Reflection" which he stated was an Iranian magazine covering issues related to the social sciences, culture and politics. He informed me that this is a relatively new Iranian monthly magazine which is published in English and French as well as the national language Farsi, and that it is distributed to all Iranian ambassaors and diplomats.

He wanted to interview me about the Iranian economy. We we agreed that I would write an article responding to some written questions from him. I can never resist new challenges!

The article has now been published in Issue 10, January 2016, in Farsi (which I cannot read) and in English. The English version in the magazine was slightly abridged for space reasons, but I have published my full original text below.

"The Age of Reflection - Journal of Culture and Humanities" has a website in Farsi. I understand that an English language website is being prepared and will have the same URL.

Iran’s Economy – Which Way Forward?

Mohammed Amin has a Mathematics degree from Cambridge University and is a Fellow of the Institute of Chartered Accountants in England and Wales and an Associate Member of the Association of Corporate Treasurers. Professionally Amin is a tax adviser, and in 1990 was the first Muslim in the UK to become a partner in Price Waterhouse. When he retired at the end of 2009, he was PwC’s UK Head of Islamic Finance and a member of PwC’s four-person Global Islamic Finance Leadership Team. He has presented on Islamic finance around the world as well as advising the UK Government. In retirement he is Chairman of the Conservative Muslim Forum which is part of the UK Conservative Party.

In 1979 the Iranian people overthrew the tyrannical regime of the Shah. The revolution led to a unique form of government under the oversight of Iran’s religious authorities led by Grand Ayatollah Ruhollah Khomeini. Only a year later the country was plunged into a devastating war after it was attacked by Iraq. More recently, Iran’s economy has suffered from severe external economic sanctions as a result of the nuclear dispute.

The recent resolution of the nuclear dispute with the impending lifting of sanctions offers new opportunities for the Iranian economy. Another consequence of the removal of external economic restrictions will be that Iran can no longer avoid confronting some key policy choices.

With the right policy choices, Iran with its young, highly educated population and generous natural resources has the potential to become a developed country. However as outlined below, these policy choices will be difficult ones to make.

Many of the economic challenges Iran faces are common to it and many other developing countries.

What should be the role of the state in the economy? As with many other developing countries, Iran has a large sector of wholly or partially state owned or state controlled companies. However, the successful economies of the OECD are marked by low levels of state ownership, since those countries understand that governments are almost always incapable of operating business enterprises successfully.

How does one control and then eliminate subsidies? These are often introduced for social welfare reasons, but then almost always become a burden on the exchequer while a disproportionate share of the benefit of subsidies often flows to higher income families.

How does the country reduce corruption to the relatively immaterial levels seen in most advanced economies?

Iran also faces a challenge which initially appears unique to the country. Is the system of government with the religious hierarchy overseeing democratically elected politicians compatible with an internationally open free-market economy?

However even here Iran’s situation is mirrored elsewhere. The People’s Republic of China faces the unresolved question of how long political power can be held solely by the Communist Party, while citizens are increasingly free to travel abroad and the non-state controlled segment of the economy becomes increasingly significant.

The article begins by looking at one economic sector where, in Iran, religion completely determines what is done. That is Islamic finance, since in Iran banking must be Islamic by law. As a result, Iran has the world’s largest Islamic banking industry with 40% of global Islamic banking assets.{1} The author points out however that the religious decision regarding whether banking is Islamic or conventional makes no fundamental difference to how the economy operates in practice.

The article then sets out a logical approach to determining what should be done by the state and what should be done by private sector agents:

The state must provide “public goods” (as defined).

It may be efficient for the state to provide certain other goods or services.

The state should not run commercial businesses.

After summarising certain characteristics which are common to most successful economies, the article considers how Iran measures up. On one key criterion, corruption, Iran’s performance is particularly poor. Iran does score somewhat better on “the ease of doing business”, albeit far below the levels of advanced economies.

Finally, the article makes some specific policy recommendations.

Societal impact of Islamic finance

The financial system matters for economic reasons. It also matters for religious reasons to those individuals who have religious beliefs, and the overwhelming majority of Iranians are Muslims.

With regard to the economics of finance, conventional finance has a very large debt-based fixed return component represented by the banking sector and the bond market, both corporate bonds and sovereign bonds, all of which use interest bearing contracts. Conventional finance also has a very large equity-based component represented by the market in quoted shares, venture capital, mutual funds, private equity etc. Debt-based contracts and equity based contracts are used in appropriate circumstances depending upon the requirements or preferences of the parties.

When it comes to religious matters, Muslims’ religious views regarding Islamic finance fall into three categories:

Some Muslims regard conventional finance as acceptable even if they are concerned about some unethical practices of some conventional bankers.{2}

Some Muslims regard conventional finance as prohibited for religious reasons. However, they regard Islamic finance as actually practised by the Islamic banks found in most Muslim majority countries, and in many countries such as the United Kingdom where Muslims are a minority, to be religiously acceptable.

Some Muslims reject both conventional finance and Islamic finance as actually practised. They seek the creation of other Islamic financial institutions which they regard as more religiously appropriate but which are not currently operated by anyone; perhaps because such financial institutions would be un-economic to operate.

In most countries conventional banks and Islamic banks operate side-by-side with individuals deciding which they wish to use. Some Muslim majority countries, including Sudan and Iran, have prohibited the operation of conventional banks and require all banking within their jurisdiction to be Islamic.

The religious aspects of finance and the economic aspects of finance are often conflated. That is a mistake and leads to misunderstandings. The distinction is explained below.

The many Muslim scholars who consider conventional finance as unacceptable base that opinion on conventional finance’s use of contracts that provide for the payment of interest. For example, a bank lends $10,000 to a customer today for a period of 1 year, and in 12 months’ time the customer must repay a total of $10,500, as there is an interest charge of 5%. Accordingly, their opinion is that Muslims should not be party to such contracts.

However, those same Muslim scholars generally have no religious objection to the use of murabaha contracts. For example, if the customer of an Islamic bank requires finance to acquire a car, he may identify the car that he wants, which a car dealer is willing to sell for $10,000. The Islamic bank will purchase that car from the car dealer for $10,000 and immediately sell the car to the customer for $10,500, agreeing with the customer that he does not need to pay the bank the $10,500 until 12 months have elapsed, although he may pay the full $10,500 sooner if he wishes. The fact that the bank paid the dealer only $10,000 is fully disclosed to the customer.

While the interest bearing loan contract and the murabaha contract which are illustrated above have basically the same economics, the Muslim scholars who advise on such matters consider the loan contract impermissible but the murabaha contract permissible. Such opinions are regarded as problematical by Muslims who fall into category (3) above who contend that the operations of Islamic banks using murabaha contracts are not truly Islamic. However as mentioned above there are no banking institutions which provide financial services acceptable to category (3) Muslims, presumably because what category (3) Muslims desire would be commercially unfeasible to provide.

The Islamic banking sector as actually operated in Muslim majority countries and in countries where Muslims are a minority primarily uses fixed return contracts, such as the murabaha contract above and ijarah contracts where fixed levels of rent are paid for the use of an asset. Islamic financial institutions also provide equity based financial services such as investment into quoted shares. Overall in Islamic finance one finds a spectrum of fixed return contracts and equity based contracts which is similar to the spectrum found in conventional finance.

Accordingly, the author considers that the introduction of Islamic finance brings no fundamental societal change compared with the operation of conventional finance. Whether banking is conventional or Islamic is purely a religious question and has no economic implications.

Some Muslims contend for religious reasons that only gold and silver can be money and that “fiat money” as used by almost all countries is religiously prohibited. However, the author rejects this opinion and is not aware of any Muslim majority country that follows it.

What states should do

There are some functions, referred to by economists as the provision of “public goods” that can only be performed by the state.

Examples are external defence, maintenance of internal law and order, the operation of a civil justice system, the operation of a monetary system, the regulation of monopolies etc. Most people would also include the operation of a social safety net so that citizens who suffer serious ill-health or are otherwise unable to support themselves do not die of starvation.

There are also other services, beyond the provision of strictly defined public goods, where it can be appropriate for the state to be involved. An illustration is the provision of healthcare where many countries, one example being the United Kingdom, consider that it is efficient for the state to provide universal health care rather than leaving it to the private market.

What states should not do

States are universally bad at operating commercial businesses. Example after example has shown that it leads to decisions being distorted by political imperatives.

It is even worse when the state prohibits the operation of private businesses. The experience of the USSR and the People’s Republic of China prior to the reforms introduced by Deng Xiaoping shows that the state is incapable of efficiently making all of the decisions required by a national economy. Economies operate much better when they contain a multiplicity of independent agents making separate economic decisions taking into account the information they gain from market-determined prices. That is why societies that practice free-market capitalism tend to be rich and societies that practice state socialism tend to be poor.

There are also many services which are often provided by states which can be better provided by the private sector. One example is the operation of schools and universities where cross-country comparisons show that it is most appropriate for the state to provide finance but the institutions operate best when they are independent decision-making units rather than units under the direct control of a central government ministry.

Characteristics of successful economies

Looking around the world, some countries have high levels of per capita income simply because they have high levels of natural resources income (mostly oil) combined with relatively low levels of population.

Putting that factor to one side, successful economies typically have certain characteristics in common:

The rule of law is strong. Laws are clearly drawn up, available to the public and only amended in accordance with clear and transparent procedures. Contracts when entered into can be enforced through the courts relatively swiftly and cost effectively. Even sovereign national governments abide by contracts that they have entered into. Corruption is low.

Transparency is high. Citizens are able to communicate freely with each other. There is a free media which can criticise the government and hold it to account.

Enterprise is free. Citizens are free to set up businesses without excessive requirements for permits from the government. It is easy to hire and fire employees. It is relatively straightforward to obtain capital from multiple sources, to buy and sell businesses and to close down businesses.

Monopolies are regulated. There is a high level of competition in the economy.

The economy is internationally open. It is easy to export and import goods. Foreigners are free to come to the country and establish new businesses or to acquire businesses from national citizens and to compete on equal terms with businesses owned by national citizens.

The state is limited. The government confines itself to the provision of a reliable legal system, the maintenance of internal order and the provision of public goods. In particular, the government does not get involved in the regulation of prices or wages.

Obviously there are many counter-examples at the level of detail. For example, the USA prides itself on its free-market system but many US states and cities have detailed rules even over such trivial matters as who can open a hairdressing business, which limit the freedom of enterprise. However, in overall terms it is clear that the USA has the above characteristics.

Similarly, the People’s Republic of China since the Deng Xiaoping reforms has enjoyed spectacular economic growth despite continuing with an excessive role for the state and having high levels of government corruption. However, it is clear that China’s future economic growth will be inhibited if these problems are not addressed.

Iran’s political system

Iran has a system of democracy overseen by a religious hierarchy at whose pinnacle is the Supreme Leader. Accordingly, it has some of the characteristics of a pluralistic society and some of the characteristics of an autocracy.

As indicated above, it is possible for autocratic systems such as that of China to achieve significant economic growth if they allow freedom of enterprise even while maintaining an unfree society. However eventually such systems hit limitations unless they evolve into truly free societies. China with its increasingly free internal social media and the freedom to travel overseas of its citizens is gradually evolving in that direction although it has yet to confront the illogicality of the Chinese Communist Party seeking to maintain total control of the state.

Iran will in due course face similar challenges as its economy develops. To a large extent these challenges have been hidden while Iran has had to operate a siege economy due to external economic sanctions being imposed due to the nuclear question. As well as inhibiting external trade and financial transactions, these sanctions have in practice inhibited the ability of Iranians citizens to travel abroad.

Evaluating Iran’s economic system

Iran is a middle income country. The following table is taken from the International Monetary Fund’s 2014 table of countries’ Gross Domestic Product based on purchasing-power-parity (PPP) per capita.{3}

Country

Ranking out of 187 countries

GDP per person PPP dollars

Taiwan

19

46,036

South Korea

30

35,379

Iran

70

17,443

Egypt

99

10,918

India

125

5,808

Unlike the other countries in the above table, Iran has oil and gas reserves which are very significant in comparison with the rest of its economy.

The non-governmental organisation Transparency International publishes annually an assessment of perceived government corruption. This gives each country a public sector corruption score on a scale from 0 (highly corrupt) to 100 (very clean). The countries are then ranked in order from 1 (least corrupt) to 175 (most corrupt). The table below uses data from the report for 2014.{4}

Country

Ranking out of 175 countries

Corruption Score

Taiwan

35

61

South Korea

43

55

India

85

38

Egypt

94

37

Iran

136

27

Iran scores very badly, far below even India and Egypt which are countries generally regarded as having high levels of government corruption.

Corruption typically distorts the economy, with economic rewards flowing primarily to a small clique of individuals closely associated with the government, who are granted favours such as licenses to operate monopolies.

While the rankings will always have some countries ranked towards the bottom since some country must be ranked 1 while some country must be ranked 175, the difference in corruption scores could be either small or large. The least corrupt country in the 2014 rankings, Denmark, has a corruption score of 92{5} (a perfect score would be 100) while Iran scores only 27.

Countries that score badly on corruption often also score badly on the “Ease of doing business.” Strictly that is not a logical necessity since a non-corrupt country could still decide to have very awkward, restrictive and hard to comply with business rules and regulations. However complex rules and regulations and corruption tend to go hand-in-hand since every additional restrictive regulation typically represents an additional opportunity for corruption on the part of the civil servants who are responsible for administering the regulation concerned.

The World Bank Group has an annual publication on this subject. The figures below are taken from “Doing Business 2016 Measuring Regulatory Quality and Efficiency” which measures a very large number of regulatory areas as well as combining them into overall national rankings.

To avoid excessive detail, the table below extracts only three numbers from the much more detailed information available in the full document.{6}

Country

Ranking out of 189 countries

Overall distance to frontier score (0–100)

Quality of land administration index (0–30)

South Korea

4

83.88

27.5

Taiwan

11

80.55

28.5

Iran

118

57.44

15

India

130

54.68

7

Egypt

131

54.43

7

As mentioned before, any ranking system will result in some country being ranked top and some country being ranked bottom. Accordingly, the “Overall distance to frontier score” provides a single score assessing how far each country is away from “perfection”. A country need not be troubled by its lower ranking if its absolute score is not too far below the score of the highest ranked country.

Gratifyingly, while Iran was ranked as the most corrupt country of the ones chosen for comparison, it performs significantly better on ease of doing business. This may be attributable to Iran’s unitary state (many complications arise in India from the power of the individual states) and from its relatively high levels of education. However, its absolute score is far below that of Taiwan and only slightly above that of Egypt.

The author noted that the World Bank Group specifically assesses the quality of land administration. The ease of proving title to land and buying and selling land, or using land as security for borrowing, is a critical factor in the development of capitalism. The book "The Mystery of Capital" by the Peruvian economist Hernando de Soto emphasises the importance of this factor and in particular mentioned the poor quality of land administration in Egypt. Fortunately, Iran performs significantly better than Egypt but is still significantly below countries such as South Korea and Taiwan.

Challenges for Iran and recommendations

After the 1979 revolution the Iranian economy had very high levels of state ownership. In recent years a privatisation programme has attempted to reduce this.

However, as the experience of many formerly communist countries has shown, privatisation can be difficult when one begins with an economy that has very high state ownership and limited individual wealth. At the simplest, there are very few potential national buyers of businesses to be privatised and many countries are (incorrectly) reluctant to sell state owned enterprises to foreign purchasers.

Some countries in Eastern Europe undertook “voucher privatisations” where the state gave vouchers to individual citizens that could be used for the purchase of shares in companies being privatised. However, in many cases entrepreneurial citizens were able to encourage others to sell them their privatisation vouchers at prices far below their true value.

In Iran many companies that have been privatised have remained significantly directly owned by the state while a significant proportion of those shares that have allegedly passed into private ownership are actually owned by quasi-state entities such as state retirement funds and companies associated with military entities.

Iran has also historically subsidised energy and food prices with the normal consequences found in all economies where such subsidies exist. These are the distortion of the market, over-consumption of that which is supplied below true market price and growing burdens of public expenditure. Accordingly, there has been a programme of replacing subsidies with direct cash transfers which is the normal technique for ending a subsidy program.

The extent to which Iran wishes to change its historic policies is fundamentally a political question. The policies outlined below would, over a relatively short period of time, dramatically improve the performance of the Iranian economy. However, they would at the same time weaken the control over the state and the population which is exercised by the present political structures.

Population registration

In recent years India has carried out a programme of registering its citizens and giving them an electronic identification. This enables them to identify themselves to banks for the purposes of opening bank accounts and for many other purposes.

Such a system of electronic identification would make it much more practical for Iran to phase out its remaining subsidies and to replace them by a programme of cash transfers to poorer citizens. It would also make it easier to introduce a system for electronic tax filings which would enable subsidies to be withdrawn as citizens’ incomes increased.

Ease of doing business

The government should systematically review all of its rules and procedures governing the formation of companies, tax filings, employment regulations, land registration etc. to improve its absolute score in the World Bank Group doing business assessment.

The easier it becomes for Iranian citizens to start their own businesses, the more will do so. Similarly, once external sanctions are lifted, the easier it is for citizens to import and export from Iran, the more will do so.

At the same time, the abolition of restrictions will reduce the scope for corruption. As mentioned above, one of the key reasons that corruption flourishes in some economies is the number of rules and regulations which give officials scope to demand bribes.

Increased personal freedom

National economic success requires increasing the proportion of citizens who are creative, who seek out new ways of conducting business activity and who create products or services that have not previously been supplied. An excellent paradigm for such activity is the creativity seen in the USA in “Silicon Valley” and in parts of London with the growth of high technology and “Fintech” (financial services technology) start-ups.

Individuals grow to be creative when they receive education that encourages them to think critically about all matters, when they are free to travel overseas, and when they are free to read any material which they wish and communicate with anyone they wish to communicate with. A key reason for the USSR falling further and further behind the USA in technology from the start of the space race in the late 1950’s to its demise in 1991 was that its people were not as creative as those of the USA because they lacked the freedoms mentioned above.

The economic success of the People’s Republic of China has shown that to a great extent strong economic results can be achieved alongside restrictions on personal freedom, although China has been gradually relaxing its system of restrictions. However, many of China’s apparently most creative businesses, such as Alibaba, have actually imitated forms pioneered in the USA where the real creativity took place.

In due course Iran will need to consider whether it wishes to prioritise government control over its people or to prioritise economic success requiring greater personal freedom.

{2} Figure 12 on page 20 of “The UK: Leading Western Centre for Islamic Finance” shows the percentage of banking that is Islamic for certain countries. Many countries which are almost 100% Muslim have 50% or less of their banking Islamic. This demonstrates that many Muslims are willing to bank conventionally, even when Islamic banking is available.

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