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March 06, 2013

View from Iran: how the country's economy came to crisis

View from Iran: how the country's economy came to crisis

An Iranian economist reports from the country, telling how the targeted US and UN sanctions have delivered a huge blow to the country's economy, an economy that was already overly dependent upon oil revenues and reeling from years of mismanagement.

For decades, drastic decisions followed by dramatic trend changes have become the norm for Iran’s economy. With the world’s largest energy reserves in crude oil and gas, 7% of the world’s natural resources and 1% of the world’s population, Iran’s economy represents one of the world's great growth opportunities; yet, it is arguably the world’s greatest under-achiever when it comes to sustainable development.

This viewpoint takes a closer look at the state of Iran’s economy and aims to explain the key causes and the drivers behind this inability to deliver on its potential.

Iran's revival
Shattered by eight years of war with Iraq (which ended in 1988), Iran’s economy was set on a path of rapid recovery. Economic reforms, the growing presence of multi-national corporations and privatisations during the presidencies of Akbar Hashemi Rafsanjani and Mohammad Khatami resulted in a major transformation from an isolated, wholly state-owned economy to an increasingly important industrial power and a major exporter of natural resources. Between 2000 and 2010, Iran’s gross domestic product (GDP) grew by an average of 5% year on year, putting the country on the verge of becoming a top 20 world economic power.

The economic growth of the previous decade was mainly fuelled by the gradual rise in the global price of crude oil, which in turn resulted in higher oil revenues. As the oil price went up, so too did Iran’s dependency on its petrodollars and the vulnerability of its economy.

And then came the international sanctions on crude oil.

Targeted sanctions
Iran is no stranger to sanctions. Shortly after the 1979 revolution, when the Pahlavi dynasty was overthrown, the US imposed widespread financial and trade embargoes on Iran. From 2003 onwards, and with the escalation of tensions over Iran’s nuclear programme, more sanctions were imposed by the United Nations and other Western states.

While these sanctions made international trade more difficult for Iran and increased the cost of cross-border businesses, they did little to hamper economic growth; needless to say that they also failed to achieve their intended objective of forcing Iran into suspending its nuclear programme. The US and its Western allies, however, revised their strategy and began to impose specific sanctions that targeted the heart of Iran’s economy; first, its financial system, and then, the country's oil revenues.

In early 2012, the US and the EU put sanctions on the purchase of crude oil from Iran. The psychological impact was immediate and severe. The foreign exchange market went into turmoil and the value of the Iranian rial, which was already under considerable pressure, dropped by 30% against major currencies within two weeks. The real impact of the sanctions have been wider reaching and have proven to be a significant blow to the economy as a whole. In a recent public speech, president Mahmoud Ahmadinejad openly admitted that the sanctions had impacted upon Iran's economy and blamed them for the currency devaluation. The so-called targeted sanctions have affected Iran’s economy in three ways:

First, with the EU halting its purchase of oil, Iran has lost a major customer base. In 2011, Iran sold 500,000 barrels of crude oil a day to Europe. With the embargoes coming into force in July 2012, this figure fell to almost zero. Additionally, the US has pressured major buyers of Iranian oil, such as China, India, Japan and Turkey, to reduce their purchase of crude from Iran. As a result, Iran’s sale of crude oil in 2012 averaged just over 1.2 million barrels per day, down from 2.1 million in 2011.

Second, the EU sanctions also prohibit the provision of insurance for Iran’s oil shipments. Given the scale of the risks associated with the shipment of oil, there are few entities around the world outside the Lloyd's market that are large enough to be able (and willing) to provide insurance for Iran’s oil shipments. This caused serious disruption to oil sales throughout 2012. In September, Iran’s daily exports fell to a 30-year low of 900,000. Since then, however, Iran has been able to make special arrangements with some of its buyers and sought help from domestic insurance companies. Daily sales of crude oil in January 2013 averaged 1.3 million barrels.

Third, sanctions on the Central Bank of Iran (CBI) have significantly limited Iran’s ability to access and mobilise its petrodollar revenues. This has led to a serious shortage of foreign currency for the country. In the case of some of its customer countries, Iran has had to resort to barter trade, whereby it exchanges its crude oil for essential (and sometimes non-essential) goods.

The dependency of Iran’s economy on oil has added to the severity of the impact of the embargoes. Its GDP is expected to decline this year for the first time since the Iran-Iraq war.

Unusual cause, usual effects
Over the past three decades, many countries have witnessed a devaluation in their currency. In most cases, this devaluation has been a consequence of fundamental economic problems. Though such devaluation in Iran is a result of political, rather than economic drivers, the effects and the behaviour of the market are similar to many previous cases.

A surge in speculative demand from ordinary Iranians trying to protect their assets against devaluation was probably the most expected reaction when the turmoil started. The CBI reports that in 2012, total demand for foreign currency was in the region of $100bn, almost 50% higher than that in 2011. This data also indicates that the additional demand was of a purely speculative nature.

In a report recently published by Iran's parliament, it is estimated that Iranians currently hold $18bn worth foreign currency, mainly in US dollar notes, in their homes. If this data is accurate, the Iranian 'house dollars' make up 2% of the world’s US dollar notes. This increased demand has accelerated the devaluation of the rial.

At the end of January 2013, the open market value of the rial against the dollar was one-third of the figure at the beginning of 2012. The foreign exchange market in 2012 was an extremely volatile one, and devaluation occurred through a series of shocks throughout the year. After a decade of the government maintaining a single exchange rate and controlling it, the open market rate now stands at an almost 200% mark-up to the CBI official rate. Foreign currency at the official rate is now only available to a very limited group of importers of essential food items, such as live cattle.

The great mismanagement
While the general consensus is that the sanctions are the main cause of the rial's devaluation and the stalling of Iran's economic growth, the government is also to blame. The aggressive expansionist policies of the past seven years, funded by windfall oil revenues, have not only increased Iran’s vulnerability to fluctuations in its petrodollar income, but have also led to a massive rise in excess liquidity in its economy. The stock of broad money has increased tenfold over the past eight years. This year, the government is also faced with a budget deficit of about $20bn and has resorted to printing more money. Inflation has also been on the rise for the past two years. The annual rise in Iran's consumer price index in January stood at 38%, its highest figure for more than 15 years. There are clear signs that the economy is now in the early stages of hyperinflation.

The CBI has also come under criticism for its inability to control the foreign exchange market. There is little evidence to suggest that the CBI has any long-term strategy for containing and stabilising the market. It has tried numerous short-term measures on a trial-and-error basis to calm the market, some of which have had the opposite effect.

The most notable step taken was the establishment of a new currency trading platform, known as the Centre for Foreign Exchange Transactions (CFET) in September 2012. CFET is aimed to be a platform through which foreign currencies of exporters are utilised to meet the demands of the importers, at rates set by the CBI (known as the trading, or semi-official rates). This was an effective measure for a short period of time. However, as the open market rates rose further, the exporters became reluctant to sell their currencies at the trading rate.

The government of Mr Ahmadinejad is expected to submit its final state budget bill to parliament shortly (as his presidency will come to an end in mid-2013). The official exchange rate, set in the budget, could have a substantial impact on the market. On the one hand, the government could be forced to devalue the official rate to increase the rial value of its foreign income (to compensate for the lost oil revenues) and to close the gap on the open market. On the other hand, there is considerable risk of further devaluation in the open market along with the official rate.

All doom and gloom?
At a glance, the picture looks a bleak one, and it certainly feels this way for ordinary Iranians. However, with a long-term perspective, the oil sanctions may well be a blessing for Iran's economy.

For decades, Iran has provided a classic example of the commodity curse. Iran has not only become dependent on its oil revenues, but the industry has also become unproductive and inefficient due to the generous governmental energy subsidies. The lower oil revenues will force future governments to cut spending, look for alternative sources of income, such as taxes, and also to pursue more sensible and disciplined economic and fiscal policies. Additionally, the long overdue plan for the removal of energy subsidies, the first phase of which was implemented in 2011, will be followed more seriously and with proper planning.

If Iran’s economy can withstand the current crisis (and that is a big 'if'), it may actually come out better off in the long run. In the short term, however, domestic and international political developments can completely change the equation for Iran.

This article was written by an Iranian economist who did not want to be identified due to the current political climate.

Image credit: www.ideastream.org

The Banker


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Comments (1)
syed abidiMarch 13, 2013 | 20:03
in fact this is a presentation based on the literal working but ground realities are that the sanctions have compell iran for self sufficincy in the feild of techonology where the west is worried if their monopoly on the techonology will be end hence they are playing this illegal games of sanctions the recent judgement by europian court calling the sanction illegal and unjustified. now if the world keep a blind eye hoping that this will not come to their way they are fools now iran then comes ksa then come uae and so on

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