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Islamic Republic of Iran: 2014 Article IV Consultation-Staff Report; Press Release; and Statement by the Executive Director for the Islamic Republic of Iran

Summary: KEY ISSUES Context. Iran had achieved considerable progress in raising per capita income and living standards in previous decades. But in recent years, such progress stalled as both domestic policies and the external environment deteriorated. Inflation has increased sharply and non-oil growth is well below potential. Corporate and financial-sector vulnerabilities have emerged, and unemployment rates are high. A difficult external environment and domestic vulnerabilities raise the risk of entrenching the economy in a low-growth high-inflation scenario. The authorities are well aware of the challenges and the reforms needed, but face a highly-complex institutional set-up and socio- political context. Advancing reforms will require broad political commitment and needs to be supported by strong coordination and cooperation among key policymakers. A highly uncertain outlook. Facing continued constraints on oil revenues and to carry out international transactions, the economy is expected to continue to contract in 2013/14. With some positive tailwinds from the external side and modest incipient signs that the pace of contraction in domestic demand is slowing, economic activity would begin to stabilize in 2014/15. While the current outlook is subject to downside risks, the interim agreement with the P5+1 also brings upside risks. Were this progress to derail, the economy could be subject to new adverse shocks. Dealing with stagflation. The policy mix should support the economy while also gradually reducing inflation. Fiscal deficits should be contained at around 2–3 percent of GDP, by broadening the revenue base away from oil and by keeping a tight lid on spending. This should be complemented by reforms that boost the supply side (product, labor, and credit markets) as well as the demand side (to restore monetary policy credibility, reduce uncertainty, and better coordinate fiscal management). Subsidy Reform. Iran’s design of the subsidy reform has been exemplary and the reform remains a priority. Plans to increase domestic energy prices gradually are prudent but should be underpinned by an automatic price adjustment mechanism to ensure full implementation, by consistent macroeconomic policies, and by reforms to foster the adoption of new technologies and tighter budget constraints, particularly in energy- intensive sectors. Strengthening the Policy Framework. Fiscal reforms should empower the scope for countercyclical fiscal policy, better support macroeconomic stability, and be framed within a medium-term expenditure planning to limit fiscal risks. Priority needs to be given to price stability, by improving the mandate and operational autonomy of the Central Bank of Iran and by reviewing government-mandated credit policies. Work to unify the exchange rate should be initiated, while preserving flexibility ahead to ensure competitiveness. Reforms to Promote Growth and Jobs. There is a need to improve business regulations, advance effective privatizations, and reduce nonwage labor costs. Addressing weaknesses in the banking system is important, including by improving the supervisory and crisis preparedness frameworks.