RESTRICTED

LiuE coPY Report No. P-1003

This report is for official use only by the Bank Group and specifically authorized organizationsor persons. It may not be published, quoted or cited without Bank Group authorization. TheBank Group does not accept responsibility for the accuracy or completeness of the rcport.

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

EXECUTIVE DIRECTORS

ON A

PROPOSED SEVENTH LOAN

TO THE

INDUSTRIAL AND MINING

DEVELOPMENT BANK OF IRAN

WITH THE

GUARANTEE OF IRAN

December 8, 1971

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REPORT AND RECOMMENDATION OF THE PRESIDENT TO THEEXECUTIVE DIRECTORS ON A PROPOSED SEVENTH LOAN

TO THE INDUSTRIAL AND MINING DEVELOPMENT BANKOF IRAN WITH THE GUARANTEE OF IRAN

1. I submit the following Report and Recommendation on a proposed loanto the Industrial and Mining Development Bank of Iran (IMDBI) to be guaranteedby Iran, for the equivalent of US $50 million to help finance industrial lending.The initial amortization schedule provides for repayment over a period of seven-teen years, including two years of grace, but is subject to change in order toconform substantially to the aggregate of the amortization schedules applicableto the specific investment projects financed out of the proceeds of the loan.The interest rate would be 7¼ percent per annum.

PART I - INTRODUCTION

2. The status of current Bank Group operations in Iran was set out inparagraphs 2 to 7 of my Report to the Executive Directors on a proposed PipelineProject in Iran (No. P-995 dated December 2, 1971). A summary statement ofBank loans as of October 31, 1971 is attached as Annex I.

3. The Bank's first loan to the IMDBI was made in 1959 when IMDBI wasestablished in order to finance private industrial development through mediumand long term loans and investments in share capital. A further five loanshave been made to IMDBI bringing the Bank's total lending to T1DBI to $154.4million (net of cancellations). Although the rate of utilization of thefirst loan was somewhat slow, the subsequent loans have been rapidly utilized;as of October 31, 1971 the first five loans were either fully disbursed orfully committed, the sixth loan, extended on August 7, 1970, is expected tobe fully committed by the end of 1971. Disbursement of Bank loans by INDBIhas slowed down somewhat in FY 1971 due to a combination of factors, such assubstantial delays in machinery deliveries in 1970 and the increased sharein IMDBI's activities of large and complex projects that have relativelylong implementation periods. IMDBI has requested a seventh loan to meetpart of its commitments in foreign exchange to the end of calendar 1973.

h. The Bank is presently considering a proposed loan to the IndustrialCredit Bank (ICB), a Government owned institution, which is the only othersubstantial source of long term industrial finance in Iran.

PART II - THE ECONOMY

5. An economic report entitled "Economic Position and Prospects of Iran"(SA-23a dated May 18, 1971) was distributed to the Executive Directors onAugust 13, 1971. A Country Data sheet is attached as Annex II.

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6. A statement on recent developments in the Iranian economy is con-tained in my Report to the Executive Directors on a proposed Pipeline Projectin Iran (No. P-°95 dated December 2, 1971).

7. As background to the proposed project, the achievements, problems andprospects of Iran's industrial development are outlined in Annex III.

PART III - THE PROJECT

8. A report entitled "Appraisal of the Industrial and Mining DevelopmentBank of Iran (DB-82a dated December 2, 1971) is being circulated separately.A loan and project summary is attached as Annex IV.

9. IMDBI officially began operations on October 14., 1959 following twoyears of discussions and negotiations between the sponsors (Lazard Freres Companyand Chase International Investment Corporation) and the Government of Iran.The World Bank acted, by invitation, as an adviser to the parties during thisperiod. ThEDBI's share capital, which was initially lials 480 million, wasincreased in 1968 to Rials 960 million and again in October 1971 to Rials 1,500million. Share capital is wholly privately awned, with 2,000 registered Iranianshareholders who own 82 percent of share capital. The remainder of the sharecapital is held by foreign banks and companies with Barclays Bank (U.K.) beingthe largest foreign shareholder. In addition, IMDBI obtained a Governmentadvance, subordinated to share capital, of Rials 600 million at the time ofits establishment and has received long term loans from the Plan Organizationamounting to Rials 2.5 billion as of March 20, 1971. It also has recourse toan overdraft facility with the Central Bank of Iran up to Rials 1.0 billion,and managed funds from the Industrial Credit Bank, the Bank Melli Iran and fromthe Plan Organization, from which it receives agency fees. Six Bank loans totalling$154.4 million (net of cancellations) have been made to date.

10. The primary objective of IMDBI is the stimulation of private indus-trial development in Iran. Its Memorandum of Association states that it isto develop, encourage and stimulate private industrial, productive, miningand transportation enterprises in Iran and to encourage, to sponsor and tofacilitate the participation of domestic and foreign private capital in suchenterprises. As stated earlier, the only other source of long-term funds forprivate industrial development is the Industrial Credit Bank. Within the frame-work of the Government's industrial policy, which has as one objective therapid development of the manufacturing sector, IMDBI's operations have servedto achieve the primary purposes for which it was established. It has playedan important role as a source and mobilizer of industrial finance and a promoterof industrial projects, particularly in non-traditional fields, thereby con-tributing to the introduction and dissemination of new technology as well asof managerial skills in the private sector. flIDBI's contribution to financingprivate industrial investments has ranged between 12 and 17 percent of totalinvestment in recent years.

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11. Since its establishment in 1999 to March 1971, IMDBI has committedloans and equity investments amounting 'to Rials .22,880 million (US '$275million equivalent). Commitments have increased markedly in recent years,approximately 56 percent of the total commitments being in the period betweenMarch 1969 and March 1971 when approvals exceeded Rials 4.0 billion per yearfor the first time. Loans over Rials 75 million account for nearly 60 percentof the total amount committed, although only 20 percent of the number of loanscommitted. Some 90 percent of IMDBI's total commitments has been for loans,the remainder being for equity investments. IMDBI provides loans at an interestrate of 9 percent per year, including 1 percent service charge, which is anincrease of 1 percent since July 1970. In general IMDBI's loans are for tenyears, including 3 to 4 years of grace.

12. Most of IMDBI's equity investments have been made in the projectsit has promoted. IMDBI's equity portfolio has almost doubled in the pasttwo years. Equity investments subscribed out of its own funds for 49 invest-ments as of August 1971 amounted to Rials 1.8 billion. In FY 1971* the returnon investments in companies paying dividends (13 out of 49) together withprofits on shares sold was 26 percent of the original investments. The over-all return on the equity portfolio in Ft 1971 was 7.5 percent.

13. IMDBI has made a substantial contribution to the development of privateindustry in Iran. It accounted for about 80 percent of the total long-terminstitutional finance provided to private industry in 1969. The mobilizationof resources in Iran has been restricted by the limited market for borrowedfunds. However, DMDBI has been successful in raising equity through increasesin its share capital, now totalling Rials 1,500 million. The market forindustrial borrowing remains relatively narrow and lacks institutional arrange-ments. To facilitate the mobilization of private capital, IMDBI took theinitiative in establishing the Tehran Stock Exchange in 1968. Its DeputyManaging Director is the General Secretary of the Exchange and the rules andregulations have been formulated with IMDBI's assistance. This Exchange,however, still contributes little to resource mobilization for the industrialsector because only 13 companies are listed, of which IMDBI is the most active.The other main limitation on IMDBI's ability to borrow locally is the heavyGovernment borrowing on high tax free interest terms, with which IkBI cannotcompete. The Central Bank has requested IFC to undertake a capital marketstudy. An IFC mission is scheduled to visit Iran in January 1972.

14. As for foreign capital, new possibilities of borrowing from sourcesother than the Bank will open up when Parliament approves the legislationdesigned to enable the Government to guarantee IMDBI's other foreign exchangeborrowing. Two,,agreements for loans totalling DM 51 million from theKreditanstalt fur Wiederaufbau (KfW), which have been negotiated, are expectedto be executed when Parliament approves the legislation.

* IHDBI's fiscal year runs from March 21 to March 20. Thus FY 1971 wasfrom March 1970 to March 1971.

15. IJDBI has been successful in promoting about 50 projectsmainly for the manufacture of intermediate and capital goods. As of March1971, 55 percent of its total approvals was for such projects. In recentyears, IMDBI has become increasingly involved in large scale ventures basedon advanced technology in non-traditional fields. Financing of medium andsmall scale industry continues to be important but has declined in proportionto the total amount of comnitments.

16. As of October 31, 1971 loans totalling $79.3 million ave beenapproved for 93 projects under the last two Bank loans. These projects willinvolve a total investment of $293 million and will provide employment for19.,500 workers. The average investment per worker is therefore about $15,000.For projects promoted by IMDBI, investment per worker is about $26,700. Inview of this relatively high cost per unit of employment associated with IDBIprojects, it is apparent that the benefit of these projects does not lieprimarily in the creation.of immediate employment opportunities, but in theestablishment of more complex industries which form the basis on which sustainedindustrial growth is possible, which will.generate further employment opportunities.The secondary effects will evidently be beneficial from the employment pointof view, since IMDBI projects will help provide a basis for the creation ofother more labor intensive industries. Mbreover, the investment per workerin DDBI projects compares favorably with that of public sector projects,which is estimated at nearly $67,000. In view of the Plan Organization'sforecast that another 600,000 industrial jobs should be created in thepublic and private sectors in the next five years, employment generationshould become an important aspect of Government policy. The Bank is discussingthese policy matters with the Government.

17. IMBDI's Board of Directors consists of 15 members, three of whomare foreign. The Board elects five of its members to constitute an ExecutiveCommittee, to which all powers of the Board are delegated. The ManagingDirector is a member of the.:Board and of the Executive Committee, not exofficio but as a representative of a group of shareholders.

18. IMDBI is competently managed by the present Managing Director,supported by a small senior staff. However, with the rapid expansion ofits operations in recent years, more systematic organizational arrangementsand operational procedures have become necessary. IMDBI has recently decidedto implement, with the assistance of a consultant, a plan to strengthen theorganization, improve project appraisal and supervision and streamline opera-tional procedures. It is expected that the measures taken will result instrengthening the middle level management and extending the delegation ofresponsibilities, thereby allowing the senior management to devote more atten-tion to policy making and concentrate on major issues.

19. IMDBI's appraisal work has been generally satisfactory but there havebeen evidences of somewhat weak: economic and market analysis. Efforts arebeing made to improve the quality of this aspect of appraisal. The positionof the head of the Economics Department, which was vacant for some time, hasnow been filled. This should strengthen the Department. Measures are alsobeing taken to improve appraisal techniques and procedures and the format ofappraisal report.

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20. Project supervision is effected through, first, the Loan SupervisionDepartment, which is responsible for loans from the time they are committed,second, a Management Unit, set up in 1970, which supervises and assistsand, in some cases seconds staff to companies, and, third, IMDBI representa-tion on the Boards of companies of which it is a shareholder. IMDBI's regularsupervision work had not been well organized and the arrangements were inadequateto cope with IMDBI's rapid expansion, its high level of arreaxs and itsresponsibility for promoted projects. IMDBI's management recognizes theneed for organizational changes to ensure systematic supervision. The DeputyManaging Director has been entrusted with coordinating the supervision workand staff members have been assigned responsibilities for individual projects.Client companies have been classified in accordance with performance, and workschemes are being developed providing for regular reviews and plant visits.Standard reporting formats are being prepared and recordkeeping and managementreporting are being developed.

21. IMDBI's profits before provisions and taxes have increased at anannual average rate of about 23 percent between 1967 and 1971. Net profitas a percentage of net worth was 14 percent in 1971. A 12 percent dividendwas paid in 1970 and 1971, compared with 10 percent in the two preceedingyears, and 8 percent in 1967. Total assets have increased markedly fromRials 1.0 billion at the end of March 1961 to Rials 10.0 billion at the endof March 1971. Loans in arrears by more than three months amounted to 17percent of IMDBI's loan portfolio outstanding as of June 21, 1971. Effortsare being made to reduce the level of arrears, particularly by close super-vision of the 14 projects which are found to be facing serious difficulties.The total amount outstanding in respect of these projects is about Rials 450millior or 5 percent of loans outstanding. The conclusion of a project-by-project review of IMDBI's portfolio is that it is basically sound.

22. The growth prospects for IMDBI continue to be good in view of thehigh priority given in Iran to industrial development. It is expected thatthe volume of IMDBI's approvals will increase to about Rials 6.0 billion($80 million) in 1972, as compared with Rials 5.1 billion ($68 million) in1971, and increase thereafter by Rials 1.0 billion per year for the next fiveyears. These projections appear realistic in the light of expected demandand IMDBI's organizational capabilities. Promoted projects are likely toloom large in its operations, and possibilities of further project promotionin such fields as automobile parts and accessories, electrical and mechanicalequipment, steel alloys and other capital and intermediate goods are beinginvestigated.

23. On the basis of its projections, IMDBI would require new resourcestotalling about Rials 10.7 billion ($140 million) to cover its operations,on a commitment basis, through the end of calendar 1973. Of this, Rials5.1 billion would be needed for local expenditures and the equivalent ofRials 5.6 billion ($75 million) for imported goods and services. Require-ments for local procurement would be met by IMDBI's own cash generation,the recent share capital increase (Rials 540 million), and a further Rials

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1.0 billion loan for the Plan Organization. However, as of March 20, 1971,IMDBI had committed Rials 1.2 billion more than it had available in long-term funds. During negotiations IMDBI has agreed to bring its long-termresources into balance with its long-term conmitments. Thus DMBI musteither attract more long-term local currency funds or scale down its fore-cast increase in local currency commitnents.

23. The proposed Bank loan of $50.0 million would meet about two-thirdsof ID4BI's requirements for procurement abroad until the end of calendar1973. IMDBI must, therefore, seek additional sources of foreign capitalfor the remaining one-third.

21 As under previous loans, prior Bank approval would be necessaryfor each sub-project requiring Bank funds in excess of $1.0 million and thleaggregate free limit would be maintained at $17 million. The foreignexchange risk will be passed on by IMDBI to its borrowers. The debt/equitylimiit will remain 7:1. The proposed loan would be restricted to financingthe :cost of imported goods and services needed for investments supportedby DMDBI.

24. In summary, IMDBI is an effective and important institution in Iran,contributing substantially to the growth of the industrial sector. It hasdemonstrated its ability to use capital effectively and it is creditworthyfor the additional Bank financing proposed.

PART IV - LEGAL INSTRUMENTS AND AUTHORITY

25. The draft Loan Agreement between the Bank and the Industrial andMining Development Bank of Iran, the draft Guarantee Agreement betweenIran and the Bank, the Report of the Committee provided for in Article II,Section 4(iii) of the Articles of;Agreement and the text of a resolutionapproving the proposed loan are being distributed to the Executive Directorsseparately.

26.. The draft agreements conform to the normal pattern for loans fordevelopment finance companies.

27. I am satisfied that the proposed loan would comply with theArticles of Agreement of the Bank.

PART V - RECOMMENDATION

28. I recommend that the Executive Directors approve the proposedLoan.

Attachments Robert S. McNamaraPresident

December 8, 1971

ANNEX IPage 1 of 2

STATEMENT OF BANK LOANS TO IRANAT OCTOBER 31, 1971

Amount (US$ millioniLoan Number Year Borrower Purpose Bank Undisbursec

Seven loans fully disbursed 245.2 -

410-IRN 1965 Iran Roads III 28.0 9.8411-IRN 1965 Iran Roads (Feeder) IV 8.5 1.3517-IRN 1967 Iran Agriculture-Ohazvin 11.0 4.5539-IRN 1968 IMDBI Industry - DFC IV 25.0 3.1594-IRN 1969 Iran Agriculture-Dez

Irrigation 30.0 24.7602-IRN 1969 IMDBI Industry - DFC V 40.0 13.6662-IRN 1970 ADFI Agriculture Credit 6.5 3.2697-IRN 1970 Iran Roads V 42.0 41.7703-IR^T 1970 I1DBI Industry - DFC VI 50.0 42.7716-IRN' 1970 Iran Pbwer I 60.0 59.8717-IRN 1970 Iran Telecommunications I 36.0 36.0718-IRN 1970 Iran Education I 19.0 19.0

Total (less cancellations) 601.2of which has been repaid 150.1

Total now outstanding 451.1

kmount sold 22.6of which has been repaid 21.9 0.7

Total now held by Bank L04

Total undisbursed 259.4

ANNEX IPage 2 of 2

STATIBEIT OF IFC. INV3TS3 IN PRANAT OCTOBER 31, 1971

Amiount (US$ mniJllions)Year Comany Loan EAuity Total

1959 Sherk ate Sahami Kalhashan(Ceramic tiles) 0.3 - 0.3

1969 Sherkate Sahami N'avard vahuleh Ahwaz (Steel products) 3.0 0.9 3.9

1971 Sherkate Saharii Aliaf(Textiles) 4.5 - 4-5

Total 7.8 0.9 8.7

Less sold or repaid 1.5 0.2 1.7

,Now held 6 d O7.0

ANNEX IIPage 1 of 3

IRAN: COU,1'RY DATA

Area and Population

Area: 1,648,000 km2Population: 30 millionRate of Increase: total about 3 percent

urban about 5 percentDensity: about 19 per km2

National Accounts. oonstant 1959/60 Prices

igg2/ 196/65 19691702/ ~~~/ 0Rls.Y growth_ S1. gRIw '-s.

billion billion billion

Agriculture 85.1 1.6% 92.2 5.8% 122.1Manufacturing 27.5 8.8% 41.8 14.1% 81.0Public Administration and Defense 23.1 6.8% 32.2 13.5% 60.7Other Services 63.7 3.9% 76.9 9.5% 121.5Miscellaneous 34.0 6.5% 46.3 8.7% 70.0

Non-oil GDP 233.4 4.14% 289.4 9.5% 455.3Oil Sector Contribution to GNP 24.2 11.44% 41.6 16.3% 88.6

GNP at factor cost 257.1 5.1% 329.8 10.4% 539.5

1969/70 National Accounts, current prices

ials $ equivalent

GNP at factor cost, total 634 billion 8,370 millionper capita 21,130 280

Non-oil GDP, total 550 billion 7,261 millionper capita 18,300 242

1/ US$ = lis. 75.752/ Oompound average annual growth between years indicated.

ANNEX IIPage 2 of 3

Savings and Investmnentbillions of rials, current prices

1964/65 1969/70

Gross MTational Savings 72.5 112.3of which: Private 4o.4 84.4

Government 29.4 19.5

Gross National Fixed Capital Formation: 62.4 154.2of which: Private 40.1 73.5

Government 22.3 80.7

Government Financebillions of rials

1964/65 1969/70

Current Revenue 68.3 143.9Oil revenue 36.4 70.1N'on-oil revenue 31.9 73.8

Current Expenditures 1/ 54.9 113.5Defense and security l/ 19.1 51.5Others 35.8 62.0

1/ Not including defense expenditures financed directly by net foreignborrowing.

ANNEX 3Pae 3 f 3

Balance of P3yments$ milion)

1963/64 1264/65 1969/70

Net earnings from the oil sector 463.8 746.8 1099.0Nbn-oil merchandise ixports 138.2 153.1 244.7Merchandise imports 480.7 684.2 1675.7Interest payments on foreign debt 15.0 18.5 70.4Amortization of foreign debt 52.0 67.0 162.1SDR allocation - - 21.0Others, net - 26.8 - 64.2 -150.1Medium and long-term foreign capital 24.3 35.0 694.2Short-term assets, net - 24.8 -101.0 - 0.6

Monetary Surveybillions of rials

1964 1965 1970

Foreign assets, net 20.1 27.5 9.4Wret claims on public sector 11.8 4.1 65.5Net claims on private sector 72.9 88.1 197.9Assets = liabilities 104.8 119.7 272.8Money supply 48.9 53.8 90.5Time and savings deposits 32.5 38.5 117.1SDR allocation - - 1.6Othere (including capitil) 23.4 27.4 63.6

Prices, Annual average rate of change

1963/64 - 1969/70 1969/70

Cost of living index 1.46 3.4VIholosale price index 1.31 3.5Implicit price inflator, non-oil GDP 1.78 3.5

ANNEX IIIPage 1 of 6

INDUSTRIALIZATION OF IRAN

1. Industrialization in Iran during the 196 0's was extremelydyanmic. Real value added in manufacturing grew by over 11 percent a year,the growth rate rising from less than 9 percent during the first half ofthe decade to more than 14 percent during the second. Industrial employmentan estimated 1.6 million at the end of the decade, had nearly doubled, andits share in total employment had increased from some 15 percent at thebeginning of the period to some 18 percent at the end. The contributionof manufacturing to the gross national product in constant prices increasedfrom less than 11 percent to 15 percent at the same time, and manufacturingranked close behind oil as the leading growth sector.

2. More than half of the increases in value added in manufacturing incurrent prices resulted from increases in the light consumer goods industries.Both intermediate goods and durable consumer and capital goods industriesgrew much faster, by 18 percent; the former contributed nearly 30 percent tothe total value added increase achieved, the latter 12 percent.

3. Growth was due to both the very substantial increase in the sizeof the domestic market (domestic production plus imports minus exports) forma,nufactured goods and to the import substitution effected. The total valueof domestic manufacturing production at current prices more than quadrupledbetween 1960/61 and 1969/70; the value added at current prices approximatelytripled over the decade. Imports of manufactured goods increased at a muchslower rate and roughly doubled. Hbwever, because of a sharp decline inimports during the early years of the decade, the rise in import from 1963/64on was very swift. Practically all this increase was in imports of inter-mediate as well as capital goods, to provide the capital equipment and materialsrequired for industrial expansion. The share of consumer non-durables in totalmanufactured imports declined from 20 percent in 1960/61 to 12 percent in1969/70.

4. Another significant kind of structural change was also plainlyvisible. Modern, well-equipped new factories, though relatively few in number,have obviously made the major contribution toward the output increases achieved.Although data on oubput and employment by size of establishment are scanty,those available for the period 1964/65 to 1967/68 show that less than 3 per-cent of total manufacturing establishments, employing ten or more workers andaccounting for roughly one-third of industrial employment, increased theirshare of total output from 58 percent to 66 percent and accounted for nearly80 percent of the total output increase achieved. Thus, while the numberof small firms increased rapidly, their productivity lagged behind that of

ANNEX IIIPage 2 of 6

larger firis. There is no doubt that these data are typical. They are con-firmed by other data which show that the average capitalization of firmscommencing operations grew from some US $160,000 in the middle 196 0's to someUS $360,000 toward the decade's end, reflecting both the increasing scale ofoutput' ard the growing technological complexity of new investment. Whereasmany new industries, though relatively large in scale, were essentially simpleassembly operations in the early 1.960's, the industrial sector as a whole hadobviously begun a process of backward integration. This trend was apparentlyaccelerating toward the end of the 1960's. Assembly operations induced thebackward linkage manufacture by others of a broad range of interm6diate produii'&for their use. New intermediate products foroth'er sectors, notably forbuilding and construction, also came into production, and an emerging produc-tion of capital goods also became visible. Thus toward the end of its firstdecade of accelerated modern industrialization, Iran was already moving outof the. relatively simple and easy phase of import substitution into a m"C"hmore c6oiplex and demanding one.

5. Production figures alone cannot give a true indication of the changewhich the growth of modern industry has brought to Iran. The consumption require-ments of a significant, albeit still very small, upper income group are nowin large part supplied by locally manufactured products. The more rapidlygrowing and larger "middle income" group, comprising some 12 to 15 percent ofthe popiulation, receiVes annual incomes in the range of US $700 - US $1,300.While these too comprise a good part of the market for manufactured goods,individual family consumption of connsumer durables within this group mustbe still rather austere. Manufactured products are also entering the livesof people throughout the country. The bazaars trade predominantly in goodsof local manufacture. While the bulk of capital equipment is still imported,new telephone exchanges operate with domestically assembled automatic lines,and electric substations function with locally assembled transformers. Foreigntrade in manufactured products for the most part consists of imports, butexports have also been growing. Mechanical skills have been introducted through-out the industrial sector, and entirely new levels of technical kn6wledge and

managerial skills are spreading, not only within industry, but also to associatedactivities. New entrepreneurs have emerged from traditional importing andwholesaling activities of the bazaar to manage and develop great industrialenterprises. Industrialization has thus begun to make a substantial contribu-tion-toward the fulfillment of its principal objectives: economic growth,diversification and employment of the economy, as well as its modernization.

6. The prices of manufactured goods in relation to those of countriesproducing and trading similar products are a general indication of the overallefficiency with which industrialization has been accomplished arid of its

ANNEX IIIPage 3 of 6

costs. Such comparisons are not easy to make and they have to be consideredvery carefully. From the comparative price data available, it appears thatrelatively few products manufactured in Iran are cheaper than, or as cheapas, imported products. Many are 50 percent higher in price than the c.i.f.equivalent for imported goods, and some are more than 70 percent higher. Thec.i.f. import prices on which these comparisons are based represent theprices at which Iran could obtain such goods at present. Higher Iranianprices therefore represent a real economic cost. It must be borne in mind,however, that domestic prices in the exporting countries are frequentlyconsiderably higher than are their export prices. These provide a morerelevant basis for Judging the comparative efficiency of Iran's industries.They may also provide a better guide, over the long term, to the pricesat which Iran may be able to import such goods in the future, notably inthe intermediate products field. It should also be taken into account thatthe Iranian products which bear relatively the highest prices are semi-luxuryand luxury goods in the consumer durable goods field, which affect chiefly theupper and upper-middle income groups. At this stage of Iran's development,this may not be an unreasonable cost for these groups to bear. It seemsalso that some of the highest priced goods are those which have only recentlycome into domestic production. There has been a tendency for the prices ofsuch goods to decline as experience is gained in production, starting-updifficulties are overcome and increases in the volume of production areachieved. Prices also reflect prevailing rates of exchange. For purposes ofinternational price comparison, a notional exchange rate which would resultin a balance of payments equilibrium without protection should be taken intoaccount. This would suggest that price differentials between Iran and othercountries are less than have been indicated above.

7. The view that Iran's recent industrialization, as measured byproduct prices, has not been excessively inefficient is also borne outby price trends in the 1960's. These prices started, to be sure, from afairly high level, but during the decade the prices of domestic manufacturedgoods have risen less on average than either the prices of imported goodsor the price of foodstuffs, and price rises have been particularly smallfor many of the products which enter into the consumption of the commonpeople. Iran was thus able in this period to achieve rapid industrial growthand relative price stability for manufactured products.

8. These achievements in industrial growth would not have been possiblein the absence of several important contributing factors. The industriali-zation process begun during the 1920's had already made substantial progress.Some entrepreneurial and labor skills, as well as much basic infrastructure,already existed. Natural resources were available for many fields ofindustrial endeavor. Labor was abundant, disciplined and adaptable. Theremarkable expansion of oil revenues and other net capital inflows contributedto the means of finance and to foreign exchange availability, as well as to

ANNEX IIIPage 4 of 6

the rapid growth of the market for manufactured goods., while politicalstability and an appreciation of foreign technical and managerial capabilitiesstimulated foreign investment and collaboration. Of great strategic importancealso was the fundamental policy decision to spur modern industrializationand the pragmatic readiness to make available to prospective investorsan irresistible battery of investment incentives. These included most impor-tantly the readiness to protect new manufacturers from foreign competitionto the extent necessary to induce investment in desired enterprises, andgenerous tax, credit and other incentives. Promotional policy went beyondthe generous incentives extended to the private sector. The Government itselfhas undertaken vast new investment, notably in the basic petrochemicals, steel,machine tool and machinery industries, partly for reasons of public policyand partly because the sums required exceeded the financial capacity ofprospective private investors.

9. Industrialization has not been without its problems and itscosts. The most important problem now facing the industrial sector is thatof continuing structural change. This has several aspects. First, theimport substitution now substantially completed in consumer and relativelysimple producers goods needs to be carried progressively into the morecomplex intermediate and capital goods fields to sustain the sector'sdynamic growth rate. Second, because of the need for economies of scale inmany of these industries, which frequently exceed the capacity of the limitedIranian market to support them, a far greater degree of care and selectivity,and greater export efforts, will be needed, if excessively high prices are tobe avoided. The same need for economies of scale will limit the possibilitiesfor internal competition, and will therefore require reliance on only moderateimport duty protection (or only temporarily high protection) to protectconsumer and user interests. Third, the need to provid9 moderate levels ofprotection for these new industries will deny to existing user industriesthe low duties and duty exemptions they have till now enjoyed in meeting theirrequirements for such goods abroad. If the new import substitution is not toresult in a much higher cost and/or price structure for finished industrialgoods, the selection of new industries must give due consideration to their com-parative efficiency and cost, and to the cost, price and profit structure ofthe industries that use these products. If further growth is to be vigorous,it will be necessary to place great emphasis on efforts to improve efficiencythroughout the industrial structure.

10. Despite the rapid growth of the domestic market, limitationshave emerged and are becoming increasingly severe. Lagging agriculturaldevelopment and low rural incomes have constituted a basic limitation onthe growth of the market for manufactured goods. Although urban workershave been more prosperous than farmers, in absolute terms their incomeshave also been an important limiting factor. Although upper income and

ANNEX IIIPage 5 of 6

emerging middle income markets supported rapid growth in the consumerdurables during the 1960's, this growth was in important degreo an importsubstitution phenomenon. It has therefore tended to slow down as importsubstitution more fully exploited its potentials. Indeed, there are signsthat some manufacturers have already experienced difficulties as the rateof growth of their market declined.

U. Another serious problem has been the inefficiency which, underthe cover of high levels of protection, has characterized much recentindustrial growth. Protection and other incentives have induced investmentprematurely in some fields which contribute only little to national economicgrowth and welfare. *There has also been a tendency toward tho fragmentationof production in many lines at the cost of technical efficiency, withoutcommensurate gains in competition. In a number of product fields, a veryfew, relatively large and efficient units co-exist with a large number ofsmall and inefficient ones. This has been both an effect and a cause ofexcessive protection which has enabled inherently inefficient firms and/orpoorly managed ones to remain in business at a considerable cost to theeconomy. A shortage of skilUs at al levels, especially in middle manage-ment, and the lack of practical experience on the part of engineers,accountants, and managers in handling industrial problems, have also con-tributed to low levels of efficiency, particularly when firms first enterinto production.

12. At the same time, the duty-free importation of capital goods hastended to make the manufacturing industries more capital intensive than theymight otherwise have been. While factory employment grew by about 10 percentper year in the 1960's, the outlook for employment appears to be less favorable.A larger share of future industrial growth will of necessity have to be inthe more technologically complex, capital intensive intermediate andcapital goods industries, so that unless,-special efforts are made to engagein labor intensive capital goods industries like engineering goods, andunless the biases favoring capital intensity are removed, there is a realdanger that the rate of employment growth will decline.

13. Through most of the 1960's the emphasis on import substitutionwithin the domestic market led to a neglect of export opportunities. Theadvantages of scale and economy that come with specialization and tradewere therefore inadequately realized. And since the deepening and expansionof the industrialization process inevitably require large increases inimports of raw materials and of intermediate and capital goods, the failureto specialize and export weakens the balance of payments. Imports ofmanufactured goods contributed to the heavy reliance on borrowing abroadin recent years - much of it in short-term suppliers' credits - despite fastincreasing oil revenues. The new industries of the 1960's were much moredependent on imports than the resource-based light consumers goods industrieshad been. Thus any curtailment of imports hurts production and employment.

ANNEX IIIPage 6 of 6

14. This appraisal of the problems of Iran's evolving industrialeconomy should also be viewed in the light of the larger macro-economicissues which were examined in the Bank's 1971 economic report.l/ It isclear that Iran's dynamic economic growth in recent years has been achievedin ways which have strained her resources,and resulted in imbalances. Iranthus stands today at the threshold of a new stage of economic growth, inwhich these strains and imbalances must be corrected if the growth itself' isto be sustainable. It follows, moreover, that future industrial growthmust be brought into better balance with other sectors of the economy andcontribute to the necessary improvement in the use of resources and in thebalance of payments as well0 Moreovers examination of the longer termmacro-economic perspectives suggests the need, over time, to modify recentsavings-investment-consumption relationships and trends if rapid industrial,as well as overall economic, growth is to be sustained. However, witheffective policy support, continued industrial growth at a rate of some13 to 14 percent appears to be a reasonable prospect.

15. This assessment represents, in brief, the results of further workdone in the Bank on Iran's industrialization since 1968-69 when, as anoutgrowth of the Government's and the Bank's common concern over past per-formance and future direction of industrial development, the Bank firstundertook a comprehensive analysis of this sector. Its basie elementswere foreshadowed in the report then issued.?/ Moreover, policy statemientsand measures announced by the Government since early in 1970 are clearlybased on an appreciation of the essential aspects of the assessment presentedhere and in the earlier report. The question how Iran may most usefullycontinue to develop the major lines of strategy and policy is one of theimportant subjects being considered in conjunction with the preparation ofIran's Fifth Five-Year Plan, due to come into effect in March, 1973.

v/ IBRD, Current Economic Position and Proopects of Iran,SA-23a, May J19, 1971.

g/ IBRD, Industrialization of Iran: The Record, the Problem a,nd theProspects, SA-14, May l1, 1970.

ANNEX IVPage 1 of 3

Loan and Project Summary

Borrower: Industrial and Mining Development Bank of Iran

Guarantor: Iran

Amount: $50 million equivalent in various currencies

Terms andConditions: Repayable substantially in conformity with the aggregate

of the amortization schedules for sub-loans and investmentsfor which withdrawals from the loan account are approvedor requested; interest at 7½ percent por year; commitmentcharge of 3/4 of one percent on the principal amount of theloan not withdrawn from time to time

Purpose: To meet part of IMDBI's requirement for the financing ofthe import component of specific private productiveenterprises during the period January 1972 to December 1973

Final date forproject submission: December 31, 1973

Free limit: $1 million for individual sub-projects; $17 million aggregatelimit

Debt covenant: Maxinmm debt/equity ratio of 7:1 (as defined in the LoanAgreement)

Procurement: Through normal commercial channels

Terms of loans toINDBI's borrowers: 9 percent (including one percent service charge); amortization

depends on individual projects but generally does not exceedten years; exchange rate risk borne by the borrower; securitygenerally in the form of a first mortgage.

Bank loan: Years ending December 31, 1972 1973 1974 1975 15-in million US dollars-

Estimated commitments 35 15 - -

Estimated disbursements 1.6 12.1 22.6 11.8 I

ANNEX IVPage 2-of 3

Loan and Investment Commitments

Years ending March 20 1971 1972 1973 1974. 1975 1976(Actual) (Projected)---- in million Rials --------------

Projected total commitments 4,042 5,371 4,994 5,870 6,835 7,640

Financed by:Opening balance of uncommittedfunds 5,627 3.,36 4,027 2,229 4,117 1,548Increase in share capital - 541 - - - -

Internal cash generation 267 372 472 603 760 980Collections minus repayments 434 600 611 780 869 969Sales of investments 70 99 113 125 137 150Domestic borrowing 680 - 1,000 1,000 1,000 1,000Bank loans - 3,750 - 3,750 - 3,750Other foreign borrowing - 1,000 1,000 1,500 1,500 2,000Closing balance 3,036 4,027 2,229 4,117 1,548 2,757

Balance Sheets 1971 1972 1973 1974 1975 1976(Actual) (Projected) -------------- in million Rials --------------

Assets

Current assets, net ofcurrent liabilities -1,318 -1,685 -1,728 -1,742 -1,869 -1,986

Loan portfolio, net ofprovisions 8,318 10,713 13,131 16,413 20,093 24,098

Equity portfolio, net ofprovisions 1,297 1,642 1,777 2,077 2,467 2,847

Other assets 58 46 59 67 50 33

Total 8,355 10,716 13,239 16,815 20,741 24,992

Liabilities

Foreign currency loans 4,647 6,038 8,098 10,978 14,141 17,580Domestic loans 2,379 2,729 3,079 3,579 42079 4,539Equity 1,329 1,949 2,062 2,258 2,521 2,873

Total 8,355 10,716 13,239 16,815 20,741 24,992

ANNEX IVPage 3 of 3

Earnings 1971 1972 1973 1974 1975 1976(actual) ~ (Projected)

-in million Rials--------------

Gross income 784 1,010 1,295 1,674 2,110 2,651Financial expenses 401 534 704 935 1,195 1,495Administrative expenses 93 104 119 136 155 176Provisions 79 102 128 168 209 260Taxes 26 30 74 84 135 218Net profit 185 240 270 351 416 502

as % of year-endshare capital 19.3 16.0 18.0 23.4 27.7 33.5as % of averagenet worth 14.5 14.6 13.5 16.3 17.4 18.6

Debt/equity ratioas defined inLoan Agreements 4.3 3.7 4.3 5.4 5.4 5.6

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