by Esfandyar Batmanghelidj
As Iran and the P5+1 look set to complete a historic nuclear agreement this week, the policy community in the US and Europe is very fearful that sanctions relief will provide Iran a dangerous windfall that it can use to expand its interventions in the region.
But these concerns fail to recognize that Iran’s post-sanctions windfall will be domestically driven, will generate private investment, and will transform Iran’s political economy for the better. A nuclear deal will actually help repair the broken relationship between consumption, savings, and private investment in Iran.
Since the imposition of broad financial sanctions on Iran in 2012, Iran’s gross national savings has fallen from 45% of GDP in 2011 to just 33% in 2015, according to data from the IMF. The drop in the savings rate has limited the capital available for business to invest for the future. The contribution of investment to Iran’s GDP fell 5% between 2011 and 2015.
To compensate, Iran’s economy has relied on consumption, particularly household consumption. Between 2013 and 2014, the share of household consumption as a proportion of Iran’s GDP jumped from 45% to 52%. Additionally, despite shrinking budgets hit by a sharp decline in oil revenues, government expenditures remained relatively stable, dropping slightly from 16% of total GDP in 2011 to 14% in 2015.
Consumption, however, does not help create long-term value for Iran, especially when the goods consumed include frivolous imports like foreign cigarettes and luxury cars. Imports were valued at 17.1% of GDP in 2014, equivalent to a fourth of consumption.
If Iran is going to mature into a diversified and competitive economic power, it will need significant investment to produce better goods and services domestically, especially in the private sector. To achieve this, Iran must grow its savings rate relative to consumption to free up financing that can spur private investment in capital assets and research and development.
Given that trade and foreign direct investment account for very small proportions of Iran’s GDP—a combined 2% in 2015—even large shifts in trade and FDI won’t have a major impact on Iran’s economic development in the near term. Even oil rents only account for 30% of Iran’s GDP, substantially less than household spending at the current time.
As such, the true engine of Iran’s post-deal economic growth will be the domestic shift from consumption to saving at the level of individual households. Households ought to seek long-term prosperity. Should they choose to save slightly more, either through bank deposits or through the purchase of securities or debt instruments, more capital would be available for enterprises, unlocking the second attribute of Iran’s nuclear windfall—private investment.
But if domestic macroeconomics trump capital inflows from the US and Europe, why is a nuclear deal important at all? How will sanctions relief affect the decision-making of Iranian households to encourage savings? The answer has to do with individual behavior.
The Short-Term Mindset
Years of economic stagnation, exacerbated by sanctions and intense domestic politicking, have conditioned most Iranians to think about personal finances with a short-term mindset. Iran’s high inflation means that money loses value over time. The country’s banking system had tried to counter this with interest rates that reached 22%. But this has had the effect of increasing the cost of financing for businesses, and inflation has remained high enough to still undercut significantly the expected return on savings for the average Iranian.
Weakness in the banking system is also reflected in the financial markets. Consider the Tehran Stock Exchange (TSE), which has a total capitalization of around $100 billion. This figure is dwarfed by the $600 billion capitalization of the Tadawul stock exchange of Saudi Arabia, a market with similarly low levels of foreign investment to-date. The GDP per capita in Saudi Arabia, measuring in purchasing power parity, is about $52,000. In Iran, the figure is $17,000 dollars. So while Saudi’s stock market is 6 times better capitalized, Saudi citizens exercise just 3 times more economic might. This suggests an untapped potential for corporate capitalization in Iran, long hampered by low levels of investor confidence.
Importantly, the Rouhani administration recognizes these structural problems and has worked laudably to introduce better monetary policy. Since 2013, the inflation rate has fallen from 42% to 15% and the administration recently agreed to lower interest rates from 22% to 20%. In 2013, the TSE reached historic highs on the basis of investor optimism around Rouhani’s economic reforms and the prospect of sanctions relief through the nuclear negotiations. This optimism has since cooled, and the TSE is down about a third over the last 18 months.
However, the conclusion of the JCPOA agreement in April of this year, which set the parameters for an eventual comprehensive nuclear deal between Iran and the P5+1, led to a 7% jump in the TEPIX index in just two days. A robust nuclear deal will no doubt kick-start trading on the exchange. The challenge will be to convert investor confidence into sustained behaviors—to temper wasteful consumption and support prudent savings.
The Opportunity Cost of Consumption
The key microeconomic issue that needs to be addressed is the opportunity cost of consumption. As seen above, there is currently little incentive for an Iranian individual or household to deposit or invest money. There are few options to turn cash into an asset that will generate a meaningful or reliable return. Even capital flight, a perennial problem for recessionary economies, has been thwarted by financial sanctions. Therefore, the tendency has been to convert cash into property or gold, which store value against inflation. But this kind of saving does not contribute to private investment.
Given the low opportunity cost of spending, individuals and institutions adopt short-term thinking. When members of the Iranian elite have $200,000 dollars, they might as well buy a Porsche. These elites have no reason to behave like the so-called “job creators” that a market economy relies on, investing in their own businesses or those of others. In this way, consumption suppresses savings, which in turn reduces the available capital for investment.
There is a corollary to this behavior among key institutional actors as well. Consider the Revolutionary Guard’s spending on its proxy militias, the same spending that policy analysts are concerned will increase following a nuclear deal windfall. The commercial monopolies operated by the military-security faction in Iran have no incentive to reinvest any profits from rents and revenues—there is no effective competition in the market. Without the need to grow its economic capital, the Guard and its affiliates focus on two activities. First, they spend within their own patronage networks in an aim to turn economic gains into political capital. The funding of foreign fighters is just a politically potent version of this consumption. Second, they entrench rent seeking through the control of grey market speculation that feed the unfettered need for Iranians to consume everything from cigarettes and luxury cars to real estate.
At a behavioral level, whether we look at the scion buying a Porsche or the general funding a militia, the inability to build true wealth leads to a fixation with appearing more powerful through prestige and patronage, the dominant currency of political capital in Iran. Yet, regardless of the purchased prestige, neither an armed fighter nor an imported Porsche makes society at large better off. This is perhaps the greatest weakness in Iran’s political economy, the way that the economic creates structural incentives for the country’s politics.
New Incentives, New Behaviors
But there is cause for optimism. The post-deal windfall will initiate a profound change in the current short-term mindset. As growth and investment begin to accelerate, the opportunity cost of consumption will increase. Every dollar spent in the present will forgo future returns. Consequently, in an environment where wealth creation is possible, individuals and institutions will change their behavior and begin to invest a larger portion of their wealth in order to secure greater economic power relative to other economic actors—the kind of competitive investment that creates jobs and drives further growth. Crucially, it will soon be savvy investment and value creation, rather than conspicuous consumption, which will define power and prestige in Iran.
The knock-on effects for Iran’s political economy could also be profound. The greater the degree to which the full range of Iranian citizens, who currently inhabit separate political and economic classes, invest in a marketplace like the TSE, the less reliant on patronage networks they become. Instead, everyone from schoolteachers to Revolutionary Guard commanders will become shareholders of a more political neutral type of capital. The segregation within Iran’s political economy, determined by the sources from which people earn their livelihoods and derive their wealth, will diminish as a prima facie, structural reason for political antagonism between citizens.
Iran’s domestic windfall should be welcomed as the first step in a post-sanctions era of new priorities and new possibilities. No doubt, foreign trade and investment will make its contribution. But Western political and economic analysts should understand that the creation of a more prosperous and productive Iran will be led from within through incremental but profound changes in the relationship between macroeconomic conditions, microeconomic behaviors, and the political economy as a whole.