Capital Financiero

This section employs the generalized Impulse Response Functions (IRFs), developed by Koop, et al. (1996) and Pesaran and Shin (1998), to study the extent to which shocks from oil revenues and oil price volatility contributed to the shorter-run variability of investment and output in the Iranian economy.83 The use of the generalized IRFs is due to their invariant to the ordering of the variables in the VAR model (unlike the orthogonalized IRFs). The IRFs trace the dynamic effect of a one-time shock to one of the innovations on the current and future values of the macroeconomic variables. The innovation process ɛt is an unobservable zero-mean white noise

process with a time invariant positive-definite variance-covariance matrix.

It has been argued that the relationship between oil and the macroeconomy is non-linear (among others, see Mork, 1989; Lee, et al., 1995; Hamilton, 1996). Both linear and non-linear specifications of oil measures are used for the IRFs, where the models with linear oil measures are considered as the benchmark models. The IRFs are presented in Figures 5.3-5.4 and 5.6-5.7

82 _{The dummies associated with the above events have no explanatory powers when they are included in the}

models.

83 _{It has been argued that in the short-run, the unrestricted VAR model performs better compared to the cointegrated}

VAR model or VECM (Engle and Yoo, 1987, Clements and Hendry, 1995, Naka and Tufte, 1997). Hence, the unrestricted VAR models are used for the IRFs analysis.

143

for the years from 1974 to 2011. The middle dark lines in the graphs show point estimates of the responses to the level of each variable to a one standard deviation positive shock. The simulation horizon covers ten years and is shown on the x-axis. The y-axis plots the percentage change response to the shock. The IRFs analysis is conducted using EViews-7 software.

Figure 5-3 Incremental Responses to orevt Generalized One S.D. Innovations

Figure 5.3 shows the IRFs of the macroeconomic variables to a shock in the linear benchmark measure of oil revenues. The responses of investment and output variables to a shock in real oil revenues are positive until the fifth period, after which they return to the long-run level but stay above the equilibrium level throughout the period. Yet, the response of investment appears to be statistically insignificant. This indicates that, even though the Iranian economy is oil-based, oil revenues cannot be considered as an important driver of financing investment activities in the short-run. -.05 .00 .05 .10 .15 .20 1 2 3 4 5 6 7 8 9 10

Response of LNINV to LNOREV

-.04 .00 .04 .08 .12 1 2 3 4 5 6 7 8 9 10

144

Figure 5-4 Responses to dorevit and dorevdt Generalized One S.D. Innovations

The responses of investment and output to shocks to asymmetric measures of oil revenues are statistically insignificant (Figure 5.4). Such outcome, at first, might appear to be counter- intuitive. Yet, this can be (at least partly) explained through the structure of the government expenditures in Iran. Government expenditures can broadly be categorized into current and capital expenditures. The former relates to recurrent expenditures including subsidies and payments of the state’s employees, whereas the latter aims at adding to physical and capital assets of the economy. Since the early 1970s, an increasingly large share of the expenditures in the country is preliminarily used to finance the payments of the government’s sticky current expenditures and its external debt rather than investment spending. Interestingly, the reactions of investment and output to a shock to the differenced real oil revenue decrease appear to be very similar to that of oil revenue increase. This can be described through the inflationary effects of negative oil shocks. Due to the high inflexibility of the government’s current expenditures, any significant negative oil revenue shocks will adversely affect the government’s budget deficits, hence creating further inflationary pressures in the economy. Furthermore, such results appear to be consistent with the differenced real oil revenue variable being a stationary variable.

-.4 -.2 .0 .2 .4 .6 1 2 3 4 5 6 7 8 9 10

Response of LNINV to DLNOREVD

-.4 -.2 .0 .2 .4 .6 1 2 3 4 5 6 7 8 9 10

Response of LNINV to DLNOREVI

-.3 -.2 -.1 .0 .1 .2 .3 1 2 3 4 5 6 7 8 9 10

Response of LNY to DLNOREVD

-.3 -.2 -.1 .0 .1 .2 .3 1 2 3 4 5 6 7 8 9 10

145

Figure 5.5 illustrates gross domestic expenditure, public consumption expenditure and investment expenditure during the period under consideration. During 1965-2010, the average annual share of current expenditures in total expenditures recorded about 70 percent, whereas that of capital expenditures registered under 30 percent. Due to the high level of state engagement within the domestic economy and the rigidity of its current expenditures, the increased oil income has mostly been used to pay for the state’s sticky current spending. In this picture, subsidies have played an important role in the size and inflexibility of the current expenditures. The government, as the main recipient of oil windfalls, has tried to redistribute part of the windfalls through subsidies in the form of free or below cost provision of state services such as utilities, education, health, transport and inputs for specific economic sectors. Spending efficiency has consequently suffered due to high amount of unfinished projects and capital investments that could not be efficiently utilized because of inadequate recurrent resources. Hence, the presence of oil seems not to have contributed to the long-run sustainable investment spending in the country.

Figure 5-5 Investment, public consumption and gross domestic expenditures

Source: CBI.

Since the government’s revenue mainly depends on the oil sector, it is beyond the control of the authorities, thus the effects of oil-driven uncertainty have been profound on macroeconomic policies. That is, the evolution of monetary and fiscal policies has been dominated by the oil windfalls. Monetary policy involves printing money to convert oil revenues into the Iranian currency before being used by the government and is connected to fiscal policy through the monetization of the budget deficits. The government budget has been mostly in deficit, largely as a result of pressures in favor of expansionary expenditures. The current government

4 6 8 10 12 14 16 1975 1980 1985 1990 1995 2000 2005 2010 Investment Expenditure (Current Prices)

Public Consumption Expenditure (Current Prices) Gross Domestic Expenditure (Current Prices)

146

spending, on average, has been more than twice the level of the government development expenditures. Although the government has realized the importance of anti-inflationary policy, a tighter fiscal policy as scheduled in the development plans often has not been maintained. Negative real rates of return have further adversely affected the economy by altering the combination of assets held by the public since the financial resources have been mostly invested in durable goods (e.g., gold, cars and houses) or in financial assets (e.g., foreign currencies).

Figure 5-6 Response to volot Generalized One S.D. Innovations

Figure 5.6 presents the reactions of investment and output to a shock to oil price volatility, after which investment responds slightly positively and reaches its peak in the second period. It then decreases and remains below its steady state level throughout the period. Similarly, output shows a sustained negative reaction, indicative of the adverse effects of a shock to oil price volatility on output in the short-run.

-.16 -.12 -.08 -.04 .00 .04 .08 1 2 3 4 5 6 7 8 9 10

Response of LNINV to VOLO

-.08 -.04 .00 .04

1 2 3 4 5 6 7 8 9 10

147

Figure 5-7 Responses to voloit and volodt Generalized One S.D. Innovations

Figure 5.7 presents the responses of investment and output to innovations to oil price volatility increase and decrease. The responses of investment to a unit shock to both oil price volatility increase and decrease are statistically insignificant. The response of output to a unit shock to oil price volatility increase is initially negative, reaching its lowest point in the third period, respectively. Then it starts reverting to the steady state level from the fourth period. However, output appears to be insensitive to innovations to oil price volatility decrease in the short-run and remain very close to the long-run equilibrium level throughout the period.

The findings at large suggest that there are non-linear effects of shocks to various measures of oil on investment and output. Investment seems rather insensitive to shocks to various symmetric and asymmetric measures of oil. The response of output to one standard innovation in oil revenues is positive and tends to persist for a longer period, whereas its response to a unit shock to oil price volatility seems negative and rather shorter lived. Considering the asymmetric measures of oil, shocks to oil revenue increase and decrease seem not to stimulate or suppress output in the short-run. However, output responses negatively to a unit shock to oil price volatility increase relative to the insignificant effect of an innovation to oil price volatility decrease. -.2 -.1 .0 .1 1 2 3 4 5 6 7 8 9 10

Response of LNINV to VOLOI

-.2 -.1 .0 .1

1 2 3 4 5 6 7 8 9 10

Response of LNINV to VOLOD

-.08 -.04 .00 .04 .08 1 2 3 4 5 6 7 8 9 10

Response of LNY to VOLOI

-.08 -.04 .00 .04 .08 1 2 3 4 5 6 7 8 9 10

148

Overall, the rapid increase in government expenditures, stemming from the influx of oil windfalls, have affected spending quality and brought about unsustainable entitlements like recurrent cost commitments in the long-run. Fiscal and monetary policies have become expansionary and had obvious inflationary effects. Despite the government’s attempts to tame inflation, high inflation has remained a problem, creating economic uncertainty which has led to the lower level of investment spending. Seemingly, policies, in particular fiscal, seems to be one of the main underlying reasons for the presence of the natural resource curse in the Iranian economy chiefly through the inflation channel.

5.7. CONCLUDING REMARKS

This chapter, using annual data over the period 1974-2011, investigated the economic determinants of aggregate domestic investment in the oil-rich partial-market economy of Iran and the importance of oil in shaping investment patterns in the country. Two oil-based proxies, namely oil revenues and oil price volatility were used to explore the relationships between oil- driven constraint measures and investment in the long-run. Employing the IRFs, this chapter further examined the short-run impacts of shocks to oil income and oil price volatility on investment and output.

Some key findings emerge from this analysis. Firstly, the results are largely consistent with the modified neoclassical-accelerator theoretical framework used in this study for the mixed-market economy of Iran. The empirical results appeared particularly consistent in the estimate of the elasticity of substitution in a CES production function from the investment equation, which is typically less than unity and positive. Moreover, it is plausible to use a CVAR model, to assess the extent of the applicability of such a theoretical framework in the context of partial-market economies like Iran. Further to the empirical evidence, inferences could be made based on the theoretically motivated relationships within such a framework obtained by utilizing the integration and cointegration properties of the data in the sample, bearing in mind that the outcome of such an analysis depends on the market conditions prevailing in such economies. For instance, in the Iranian context, a variable such as the user cost of capital needs to be more carefully defined in the face of external and government influences which affect the economy through the regulation of the lending rates.

149

The empirical results further showed that investment is related to oil-driven measures in the long-run; the relationship between investment and oil revenues was found positive while that of between investment and oil price volatility was found negative. Surprisingly, the regime shift and dramatic political and economic upheavals during the period under study did not have determining effects on the underlying investment relationships in the long-run. This could be to some extent due to rigidities in government current expenditures coupled with persistent inflationary pressures throughout the years under study. Similarly, the IRFs of the macroeconomic variables to shocks to symmetric and asymmetric oil measures were found insignificant in most cases.

150