Middle East Economic Survey
VOL. LI
No 1
Iran’s Emerging Economic Threats
By Jahangir Amuzegar
The following article for MEES was written by Jahangir Amuzegar, a distinguished economist and former member of the IMF Executive Board.
The West’s inordinate preoccupation with the Islamic Republic’s nuclear program in recent months has diverted world attention away from two other issues that threaten the management of Iran’s frail economic structure. These internal challenges are perhaps of much greater potential impact on the economy than any unilateral or selective external economic sanctions.
President Ahmadinejad’s faith-based, populist, and “justice-driven” administration has come under fierce attacks by its critics (including ex-presidents Mohammad Khatami and Hashemi Rafsanjani) for its ad hoc, arbitrary, and whimsical economic policy decisions. The president’s obstinate rejection of expert economic advice and stubborn resistance to accepting economic realities, in the opinion of his growing detractors, have exposed the Iranian economy to a double whammy of what economists call “stagflation” (a mixture of slow economic growth and high inflation) and the “Dutch Disease” (a disequilibrium among domestic economic sectors caused by a sudden foreign exchange windfall).
The Stagflation
The ninth post-revolution Islamic government under the Ahmadinejad presidency – promising to “put the oil money on everyone’s table” – has, in the opinion of foreign and domestic analysts, embarked on a hazardous expansionary monetary and free-wheeling fiscal policy conducive to dire consequences. Accused
of ignoring both the guidelines of “Iran’s 20-year Perspective” (ratified by the Expediency Council and endorsed by the Supreme Leader) and the mandates of the Fourth Five-Year Economic Development Plan (2005-10), the Ahmadinejad government is taken to task for adopting such ill-advised economic policy measures as sudden increases in workers’ wages and retirees’ benefits, raising subsidies to more than 20% of GDP, doubling the perennially deficit-ridden national budget, reducing bank lending rates arbitrarily below prevailing inflation, promoting sub-prime marriage and housing loans to young and often unemployed couples, making credits available to the so-called “quick-returns businesses,” appropriating funds on the spot to hundreds of unplanned and questionable local projects (eg, sport stadiums, covered swimming pools, libraries, roads, etc) requested by people welcoming the president on his nationwide tours.
More troubling still, Mr. Ahmadinjad’s ill-concealed and enigmatic suspicion of banks and bankers has not been shaken, despite the failure of mandated lower bank lending rates and other cheap credits to unaffordable borrowers to: increase domestic investments; help GDP growth; reduce unemployment; and lower inflation, as the president promised. And his genuine and yet bizarre obsession that “high” loan rates are the cause of all domestic economic woes, led him to insist on pursuing the same course. Rejecting experts’ advice and disregarding what his detractors call the most elementary economic principles, he countermanded the decision by the Council on Money and Credit in mid-2007 to keep bank lending rates unchanged, and ordered the Council to further lower the rate – despite a near revolt by bankers.
The government’s largess through its expansionary monetary and fiscal policies, despite ample warning from more than 50 private economists, inevitably resulted in a spectacular and unprecedented rise in liquidity. Thus, between June 2005 and June 2007, the broad money supply (M2) registered a rise from IR730 trillion to IR1,400 trillion – an expansion which a critic claims was equal to the entire money stock accumulated since 1890s. As a result of injecting this increased liquidity into the market through the banking system, the consumer price index (CPI) that had been kept in check (partly through keeping prices of 10 major staples fixed at the September 2004 level) began to creep up. According to Central Bank data, the index climbed steadily from 11.7% in the second quarter of 2005 to 15.8% in the third quarter of 2007, and is forecast to reach 17.5% by March 2008 – or nearly twice as high as the planned target. Other official agencies (eg, the Ministry of Commerce and the Majlis Research Bureau) put the current inflation figures at 20% and 22.4% respectively. Most private economists at home and abroad also express doubts about the accuracy and reliability of Central Bank figures.
Contributing to the CPI rise have been several factors in addition to the government’s expansionary policies: commercial banks’ heavy borrowings from the Central Bank for their own lending, high denomination cashiers’ checks issued by banks without corresponding reserves, increases in the prices of some public services, higher import tariffs to protect troubled domestic industries, larger exports of domestic consumer goods to take advantage of government’s non-oil export prizes, considerable hoardings of popular items in anticipation of higher prices, and rising popular inflationary expectations. Curiously enough, price controls on major staples, while countering the immediate effects of the inflationary trend, eventually have worsened the situation as the Treasury has been forced to raise subsidies to producers of controlled items – thus adding to budget deficits, more liquidity, and still higher inflation.
But surprisingly, despite all the fiscal and monetary stimuli, gross domestic product (GDP) has remained somewhat sluggish, and went up by only 5.1% a year in real terms – far below the targeted 8%, and less than the actual 5.4% a year during the Fourth Plan (2005-10). A number of related elements – low total factor productivity, unprofitable public development projects, inadequate private investments, lingering private sector doubts about the government’s ultimate intentions, the slow and unpromising process of privatization, the depressed Tehran Stock Exchange, increased UN and US economic sanctions, and rumored flight of capital – have been identified as major causes for the slow growth. The outcome of faster price inflation combined with sluggish growth has been the current stagflation.
The Dutch Disease
Under the Third Development Plan (2000-05), the Iranian economy experienced an average annual real GDP growth of 5.4% (close to the 6.2% target), and an average yearly inflation rate of 14.1% (lower than the anticipated 15.9%). The average price of Iranian crude fluctuated between $21 and $44/B during the five-year period. The average oil export receipts were $26bn a year. For these and other country-specific factors, Iran was on an upward growth path, and thus relatively immune to both stagflation and the Dutch Disease. By contrast, in the first 2.5 years of Ahmadinejad’s rule, according to official data, the oil price of Iranian crude ranged between $51/B and $85/B – the highest in Iran’s 100-year oil history. The oil receipt rose to $46bn in 2005, $51bn in 2006, and is expected to reach $60bn in 2007. According to a high-ranking Majlis deputy, the more than $120bn receipts from oil exports during the 2.5 years of Ahmadinejad’s presidency have been equal to the total oil income during six years of the Khatami and eight years of the Rafsanjani administrations.
In market-based economies with no exchange controls, any such windfall in foreign currency earnings would tend to increase the exchange value of the local currency and alter relative prices of the so-called “tradable goods” (ie, imports and exports). Foreign products would become cheaper and more attractive, and locally produced wares lose their relative international competitiveness. Domestic capital and investment would thus be attracted to the “non-tradable” sector (eg, land, housing, and local services), raising their relative prices. In countries like Iran, where the foreign exchange rate is not floating but “managed” by the central bank, the process would be somewhat different, but the results would be the same. Conversion of petrodollars into rials by the central bank would increase domestic liquidity, raise aggregate demand, and lead to rapid inflation. But again, price rises in the “tradable goods sector” would be much higher than those of imports and import substitutes. And higher inflation at home compared with those of the country’s main trading partners would make “the real effective value” of the rial higher in terms of foreign currencies, thus fulfilling the same task, ie, making imports cheaper and exports more expensive. In Iran’s case, according to the IMF estimate, “the real effective exchange rate” of the rial in the 18 months ending in September 2006 appreciated by 11%. Since the nominal exchange rate of the rial since then has been kept between $1=IR9,200-9,300, while inflation has been in rapid rise compared to those of major trading partners, the real effective rate has appreciated correspondingly further. And the Dutch Disease symptoms have become more transparent.
The spectacular rise in oil export revenues has allowed the Ahmadinejad government to go on a spending spree by converting dollar windfalls into the rial, doubling domestic liquidity and fueling the inflationary fire. The inflationary tide has been the subject of widespread public complaints, critical Majlis debates, daily newspaper editorials, and warnings from the Supreme Leader and even the president’s own Islamic Revolution Devotees party. In order to stem the tide the government has taken advantage of the oil windfalls, reduced import tariffs on consumer products, and opened the import gates. The average annual imports of some $28bn during the Third Plan (mostly consisting of capital and semi-processed goods) have been allowed to rise to $41bn in 2005, $46bn in 2006 and an estimated $55bn in 2007 (including larger volumes of manufactured goods, and even certain agricultural products for the first time on record).
Symptomatic of the Dutch Disease, the tripling of imports from their 2002 level has resulted in altering the GDP components. While the abundance of cheaper imported goods from low-inflation countries has helped check domestic price rises to some extent, it has had two pernicious side-effects. On the one hand, domestic producers of “tradable goods”, ie, goods competing with imports (or ready for exports) have lost their international competitive power due to rising domestic production costs. On the other, abundant domestic liquidity has been drawn towards “non-tradable” items (eg, land, real estate, and non-competing services). Not unexpectedly, property values and house rents have reportedly doubled in some parts of Tehran and other large cities within a short time. Unable to compete with relatively cheaper imports, many domestic manufacturing enterprises (eg, textiles, clothing, shoes, furniture and others) and even some agricultural businesses (eg, tea, sugar, and fruit) have, according to the Minister of Social Affairs, faced losses and even bankruptcy. By some private estimates, each $1bn of additional imports into Iran has resulted in 20,000 job losses. “Unlawful” strikes by workers who have been laid off or not paid for months because of their companies’ financial troubles are now regularly reported even by the self-censored newspapers. Interestingly enough, even the ministers of Labor and Commerce have openly complained about excessive imports.
The Outlook
Apart from unforeseen calamities – a drastic decline in oil prices, effective new UN or US economic sanctions, or possible military entanglements – the remaining 20 months of Ahmadinejad’s lame duck administration will have to face the increasingly difficult challenges of harnessing inflation and creating new jobs. These problems cannot be solved by the methods adopted thus far. Inflation can no longer be denied or explained away by calling it “imaginary, inherited from the past, exaggerated by the opposition, or a natural phenomenon experienced by all countries”, as the president and senior government officials have so far maintained. Nor would price controls, rationing, and other administrative measures be of any major help as they would create new black markets, and encourage further smuggling. Neither can high youth unemployment be effectively and enduringly reduced by making low-cost credits available to the so-called “quick-returns” businesses. The outcome of this policy thus far, acknowledged by senior government officials, has been rising non-performing loans, a growing number of jobless debtors, intensification of rent-based activities, and other abuses.
An effective and enduring solution to both inflation and unemployment seems to require (1) a change in the government’s ideological mindset, and (2) a political determination to deal with causes rather than addressing the symptoms. President Ahmadinejad and his government must accept the fact that private gain is not always the enemy of social good. They ought to create a level playing field where the private sector can thrive, free from government intervention and unfair competition. They also must be convinced that those who disagree with them are not always their enemies but their adversaries. Politically, too, there is a need to realize that due to the country’s limited productive capacity, low factor productivity, and the precarious nature of imports, the problems cannot be tackled by increasing supply alone. The ever growing aggregate demand, fueled by high government spending, a budget deficit and subsidized low prices, has to be contained. Delivering the contractionary budget promised for 2007-08, and replenishing the over-drawn Oil Stabilization Fund (OSF), might be a good start.