Capital Expenditure Outpaces Capital Formation

EghtesadOnline: Iran’s economic climate is indicative of the pressure exerted by sanctions, says Mohammad-Qoli Yusefi, professor of economics at Allameh Tabataba’i University.

News ID: ۷۴۹۷۳۰

18 February 2020

“Under the sanctions regime, transfer of technology and capital goods does not take place and consequently capital expenditure outpaces capital formation,” he has been quoted as saying by the news portal of Iran Chamber of Commerce, Industries, Mines and Agriculture.

Capital accumulation primarily focuses on the growth of wealth through the investment of earned profits and savings. This investment is focused in a variety of ways throughout the economy, according to Financial Tribune.

One method of growing capital is through the purchase of goods that drive production, including physical assets such as machinery.

“We have to import the technology industries’ need from other countries if we believe that capital accumulation is one of the key issues for economic growth. However, neither capital formation, nor capital goods imports are happening at present,” Yusefi said.

“Our investments are usually directed toward unproductive economic activities and services. These are short-term investments that practically don’t help production-oriented economy and do not help increase capital formation. The decline in productive capital adversely affects employment rate as well.”

The economist noted that domestic production won’t increase and new factories won’t open, if the country fails to import technology, capital goods, machinery and industrial parts.

“Factories dating back to the 1960s are now operating overworked, vintage machinery on the verge of collapse; their industrial products can no longer cope with today’s demands,” he was quoted as saying by Otaghiranonline.ir.

According to the World Bank, unlike in 2016-17, the non-oil sector was the main contributor to the overall growth in the first half of 2017-18 (by 3.2 percentage points of the overall 4.5%).

Gross fixed capital formation recorded a positive growth rate for the first time since the second half of 2014-15, driven mainly by a pickup in investments in the construction sector. This was supported by a 20% growth in outstanding loans as of December 2017, compared to December 2016.

World Bank: Iran Not to Experience Growth Until 2021

The World Bank estimates that Iran's economy shrank 8.7% in 2019 compared to the year before.

The international financial institution's latest estimate in its January 2020 edition of "Global Economic Prospects" has been revised down by 4.2% compared to the June 2019 edition of the report.

World Bank's forecasts for Iran's GDP growth are 0% in 2020 and 1% each in 2021 and 2022.

The 2020 forecast has been revised down by 0.9% compared to the June 2019 edition of the report, but the 2021 forecast indicates no change compared to the previous report.

The report also shows Iran's economy contracted by 4.9% in 2018 after experiencing a 3.8% growth in 2017.

The contraction of Iran's economy in 2019 owes mainly to external shocks to oil and gas sector output. The plummeting exports come after the expiration of US waivers to major importers of Iranian oil and tightening of banking restrictions, in addition to new sanctions being imposed on the country’s petrochemicals, metals, mining and maritime sectors, the World Bank said in an autumn economic update released on Oct. 9. Excerpts follow:

The oil sector decline, coupled with international trade and capital flow restrictions, has negatively influenced economic activity in key non-oil sectors, including automotive, machinery and construction, which have faced supply chain challenges and higher operational costs.

In August 2019, the housing sector registered the lowest volume of sales in six years while prices rose by around 78% year-on-year. On the supply side, these developments, among other shocks such as floods and earthquakes, are likely to cause further stagnation in the services sector, the largest production component of GDP (56% share in 2017-18).

Similarly, the GDP expenditure components are to be strongly influenced by the shock to exports. However, the simultaneous reduction in imports is expected to moderate part of the downward pressure on trade balance and current account. Real government consumption is also expected to contract at a faster rate of 5.4% compared to the previous round of oil export embargos placed on Iran in 2012-13. The fiscal deficit is estimated to further widen to around 5.6% of GDP in 2019-20 as more than 30% (and as high as 63% in 2002-03) of the government budget is sourced directly from the sales of oil and gas.

The reduction in the tax base due to lower economic activity would also have a negative effect on current revenues and is likely to come at the expense of lower capital expenditures that have been under-realized relative to the budget approved levels in recent years.

The medium-term economic outlook remains challenging. The baseline assumption for the medium-term rests on continued oil exports of around 500,000 barrels per day on average.

In the coming years, the effect of the recent large exchange rate depreciation could allow the country’s goods and services to become more competitive regionally and help close the expected current account deficit gradually.

The fiscal deficit is projected to further widen in the next two years due to the legacy of the 2018-19 oil shock pushing government expenditures such as social protection measures upwards while receiving lower oil income and tax revenues.

Political and economic uncertainties make it difficult to project future poverty trends. However, a sharp decline in real GDP per capita and double-digit inflation are expected to have a strong negative impact on poverty rates through different channels, including the labor market, increasing costs of living and a further erosion of the real value of cash transfers.

Future poverty rates will also depend on the government’s public policy response. Any increase in the value of cash transfers, possibly along with introducing targeting mechanisms, could help the poor and vulnerable population cope with the socioeconomic shocks, but fiscal constraints may limit the scope for significant response.

The nature of uncertainties facing the economy means downward risks to the projected growth path remain in place. If oil exports were to be curtailed further, the economy could enter into a deeper recession and experience higher inflation rates. The challenge of protecting the vulnerable households would put additional pressure on government finances and potentially the value of rial.

Further restrictions on trade volumes and financial transaction arrangements with Iran’s neighbors could also pose a major risk to the current projections.

If they remain unaddressed, the ongoing liquidity and recapitalization challenges of the banking sector could further undermine banks’ ability to continue facilitating economic activity.

These important challenges highlight the crucial role of further economic diversification by focusing on non-oil sources of growth and government revenues.

Building on the economic base in the non-oil trade sector would improve resilience to external shocks and achieve a long-envisioned development plan goal that has been elusive to Iran and other countries in the region.