Government's behavior towards unprofitable state-owned enterprises and development projects can be a function of revenue expectations especially in an economy dependent on oil revenues.

According to a recent WB report, entitled: Iran’s Economic Growth: Opportunities and Limitations, based on national accounts during 1988-2004 reveals variable changes in economy inventories averaging 7.3 percent GDP if calculated at current prices.
In a vibrant economy, inventory changes should be zero on average for a sufficiently long period. Due to inefficiencies and statistical errors in developing countries it falls between 1 and 2 percent of GDP.
In Iran the figure exceeds this range and also the economy’s real GDP growth which averaged 3.3 percent for the period, the Persian daily Iran reported.
This is due to the impact of cost of capital effect and supply shock expectations because of high dependency on oil revenues and imports of capital/intermediary goods; periodical softening and hardening of budget constraints of public enterprises; varied statistical errors in PPI/CPI inflation differences; and shifting financial limits binding on private purchase of goods and services.
The report attempts to understand the puzzle of large inventories but the government’s dominating role and competitive general equilibrium models of inventory accumulation render it inapplicable.
Evidence suggests the average change in inventories is high in Iran due to certain behavioral patterns reflecting the economy’s tendency to supply shocks.
In 1990s, the average change in inventories in lower-middle income countries was 1.2 percent GDP, in Mideast and North Africa 1.7 percent and in world economy 0.6 percent.
The figure for Iran exceeds GDP growth by 4.3 percent while correlation between the two variables is high (0.82).
Evidence of post-war economic growth is stated less in national statistics.

World Development Indicators
Public enterprises facing soft budget constraints fail to use over-accumulated inventories efficiently.
In an economy that imports huge shares of its investment goods, prices and exchange rates vary in effective capital costs. The external political risks raise uncertainties causing over-accumulation of imported inventories by risk-averse economic agents. Hidden capital flight through over-invoicing of imports is an alternative for insurance against risks.

Inventories change
Inventories are stocks of goods held by firms to meet temporary or unexpected fluctuations in production or sales and “work in progress.“
Change in inventories is a balancing item on total expenditure side and equals difference between total supply and demand. Discrepancy between actual and estimated value of sources and output use is so extent that its value is reflected in inventory numbers.
Inventories are volatile components of aggregate demand. Business cycles studies show inventories have significant co-movements with GDP and over the business cycle inventories are pro-cyclical with sales.
Normally, change in inventories is large and positive during business cycle peaks and large and negative during trough.
Firms hold inventories in presence of frequent unforeseen demand and supply shocks because modern “on the spot or just-in-time“ management techniques cannot always deal with such shocks satisfactorily.
The choice-theoretic approach to inventory investment suggests that the relationship between inventory investment, sales and production depends on the prevailing type of economic shocks.
Two basic models in this approach imply two types of association between inventory investment and sales. If supply shocks are predominant, production is more unstable than sales and inventory investment and production tend to be positively correlated.
Consider a representative firm which faces frequent supply shocks in the form of a changing marginal cost schedule. To minimize costs, the firm increases production and accumulates inventories depending on circumstances, in form of finished goods or investment/intermediary goods, or both in that period when marginal cost is low.
Conversely, the firm decreases production and reduces inventories when marginal cost is high.
If a firm experiences mostly demand shocks, its production is less volatile than sales while its inventory investment and sales tend to be negatively correlated.
If the representative firm’s marginal cost is constant but faces a frequent changing demand, it minimizes costs by smoothing production and reducing inventories every time sales exceed production level and vice versa.

International Evidence
Other explanations for excessive accumulation of inventories not covered by standard theories are that it might be undertaken by mostly public-owned firms, which do not maximize profits, because it may not be their only objective or they lack appropriate incentives.
Or the inventories statistics in Iran’s national income data by design includes error terms.
The report says it might be also due to soft budget constraints. For economies with a large state sector it has long been observed that chronic loss making state-owned enterprises are provided with on and off budgetary resources to hang on.
Similarly, in economies where the government is involved in financing and/or managing development projects, the projects tend to take longer time to complete and state often pays for cost overruns.
Furthermore, government’s behavior towards unprofitable state-owned enterprises and development projects can be a function of revenue expectations especially in an economy dependent on oil revenues.
For example, during high revenue periods, organizations are able to approve many new development projects and provide more subsidies to ongoing ones, but during low revenue periods they are under pressure to limit fiscal expansion, limiting such allocations in the process.
This often results in many unfinished projects which are accounted as inventories in national accounts system. Volatility of commodity prices is a major shocks-producing factor. Commodity price volatility increases consumption instability and production resulting in market agents wanting to hold greater inventories to buffer fluctuations.
These imbalances are caused by different shocks in various countries, such as impact of a war, large negative swings in terms of trade leading to explosive price changes of inputs and finished goods.
High inflation may affect change in inventories statistics when no organized future markets exist to hedge against adverse movements in input prices.
Secondly, in economic environment where inflation varies highly while nominal interest rate is more rigid-which prevailed in Iran during the period under the study-the user cost of capital for inventory accumulation declines, raising inventories demand. Thirdly, high inflation may cause rising pressure on level of statistical errors.
In surveys used for compiling national accounts, gross income is initially calculated at producers’ prices, gross expenditure at consumers’ prices.
The greater the difference between CPI/PPI inflation, which tend to increase during high inflation, the larger the statistical error in national accounts.
Furthermore the report uses 1990s rather than 1988-2004 as the period for international comparisons because data for transition economies which were important for the analysis were only available for 1990s.

Economic Developments
After end of the Iraqi-imposed on Iran in 1988, the country embarked on a large infrastructure reconstruction program, which pushed gross fixed capital formation to levels consistently above 30 percent GDP.
Fiscal expansion increased by implementation of a social program. Iran pursued economic reforms including elimination of some trade restrictions, partial liberalization of foreign exchange system and narrowing the range of goods for which domestic prices were controlled.
While early effects of reforms were positive, they did not prevent expansionary fiscal stance from causing macro imbalances. Import of capital and intermediary goods were rising with major peaks in 1991-92, when both public and private companies which had access to foreign finance acted in anticipation of higher exchange rates after liberalization. The cost of capital effect on accumulation of inventories was at work.
As Iran’s access to longer-term external financing was limited at the time, large account deficit was financed through surging short-term debt and excessive drawing on foreign exchange reserves.
In 1994 several short-term debt repayments coincided with falling oil prices causing a severe balance of payments crisis. This led to reversal of many policy reforms.
To achieve account surpluses needed to avoid default on external debt, the government imposed tight import restrictions and reinstituted multiple exchange rates. The lowest positive change in inventories in post-war period was observed in 1994.
The early 1990s events highlighted dependency of economy on imports of capital goods. Positive correlation between imports and gross fixed capital formation expressed as a share of GNE in Iran is quite substantial-correlation coefficient 0.49 and correlation between imports and change in inventories, which is even stronger 0.79).
Inventories change was negative in 1988, but war with Iraq was continuing for that part of year.
In the following years, trade and exchange controls were slowly and selectively relaxed, but oil prices kept falling simultaneously while illegal economic sanctions were tightened, producing supply shocks for firms.
These developments produced huge confidence losses, a run on foreign exchange in 1995, rapid depreciation of nominal exchange rate and high inflation.
Inflation
Continued macroeconomic and political instability encouraged currency substitution and reinforced Iran’s chronic problem over the last thirty years capital flight.
In 1998-99, the depression in oil prices coincided with repayment of rescheduled debt which further delayed economic liberalization.
Even though the Central Bank if Iran (CBI) increase rates on domestic bank deposits, particularly those with longer maturities, to make holdings of rial more attractive, it could not possibly outweigh consequences of currency shocks.
The financial sector witnessed some policy reforms in the second half of 1990s. Since 1995 several private non-bank monetary institutions-which are credit and saving institutions having no permission to issue checks-had been officially authorized by CBI to enter the credit market.
Allocation of credit by public banks was also partially decentralized. The monetary authorities were given clearance to issue permit for private banks and since 2000 many such banks have been permitted to begin operations, though their share in total assets of banking system remained low, about 7 percent.
On the verge of the new millennium, national economy saw an acceleration of reforms. Oil prices started increasing, external debt to GDP ratio declined to a single-digit and international reserves have increased.
The government has established Oil Stabilization Fund (OSF) which includes two parts with dual purposes: Stabilizing economy by protecting it from oil prices volatility and providing foreign exchange needed to finance imports of intermediary and capital goods by potential exporters.
Inflation has declined compared to 1990s, though stabilized at a high level of around 15 percent since 2002.
Imports surged as firms having access to cheap foreign currency responded to incentives generated by cost of capital effect reinforced by fears of imports rationing because of political risks related to the Second Persian Gulf War.
In addition to adopting a managed floating exchange rate, the government reduced import registration deposits, simplified licensing procedures for imports, eased currency rationing and relaxed restrictions on money transfer by domestic residents abroad.
Low interest rates on loans from OSF have reduced cost of capital for financing imported intermediate/capital goods.
The volume of foreign currency loans granted to the private sector from OSF funds rose from $1.179 billion in 2002 to $2.587 billion in 2004.
Generally economic environment prevailing during 2000-2004 has been less conducive to capital outflow than during the previous decade. However, low OSF lending rates may have created some temptation for importers to over-invoice.

Low OSF lending rates may have created some temptation for importers to over-invoice.

Change in Inventories
Over-invoicing augmented national debt volume by borrowing firms and increased their cash holdings simultaneously. The difference in effect equals a low-cost credit line which firms can use for financing other activities.
During 1990s, change in inventories to GNE ratio experienced two periods of precipitous declines corresponding to two periods of debt crunches, with troughs in 1994 and 1999. These troughs could partly be explained by foreign currency shortage and import compression.
But soft budget constraints of publicly-owned firms, which represent a large portion of Iranian economy, might have been its cause.
During the period of high oil prices, bail-outs which soften budget constraints are administered variously, including heavily subsidized loans from public financial institutions conditioned on purchases from enterprises which accumulated large stocks of finished-goods inventories.
Unfinished development projects provide some anecdotal evidence on hardening budget constraints during crisis periods. The government estimates, there are currently about 9,000 such projects. Development projects have perceived soft budget constraints extent but have proved hard ex-post.
The debt crunch and tight fiscal space left the government no other alternative but to harden constraints which caused a downward pressure on change in inventories statistic.

Suggestions
Iran has the second largest population, after Egypt, in Mideast and North African region. Its population is mostly young. Well-educated women seek opportunities to participate at all levels of labor market and civil society.
The health and education indicators are among the best in region. This implies Iran has potential and human resources for economic growth.
More investment from private sector could lift some trade, credit and ownership barriers.
Reforms are needed in current laws and reducing bureaucracy. Optimum use of OSF management should be made by devising operational rules more transparent and in line with fiscal plan objectives.
Other measures include boosting public sector performance by limiting their budgets and introducing principles of writing operational budget plans while processing resources allocation. Ground must be paved for participation of private banks and their development to facilitate and increase financial resources allocated for economic agencies.