The Rial Saga

via Middle East Economic Survey

By Jahangir Amuzegar

*Dr. Amuzegar is a distinguished economist and former member of the IMF Executive Board.

During the last 12 months, and particularly since January 2012, the erratic and unhinged behavior of the Iranian currency, the rial, has been added to the Islamic Republic’s other thorny and protracted economic woes. After nearly a decade of relative stability in both the official and free market, the rial experienced a precipitous plunge in late December 2011, and subsequently lost nearly half of its value within a short time. With far-reaching effects not only on external trade, but also on domestic prices, interest rates, savings, investments and capital flows, the rial’s value has become the Mahmoud Ahmadinejad administration’s biggest daily economic headache.

While the explanations, reasons, and guesses so far offered for the upheaval have ranged from the probable (eg deteriorating business climate and political uncertainties) to the bizarre (eg sabotage by government “enemies”, manipulation by local currency dealers, and the administration’s own stratagem to make up for budget deficits), the real reasons are more numerous and far more complicated. This review attempts to seek the underlying causes of the recent events in a number of deeper-rooted and interrelated phenomena not so far sufficiently scrutinized.

The Unfolding Drama

The fall of the rial’s value has a long history. On the eve of the 1979 revolution, Iran’s domestic exchange rate for the US dollar was IR70.6. The revolution’s subsequent economic disasters – the bureaucracy’s massive upheaval, wholesale nationalization of banks, industries, and commercial enterprises, the exodus of nearly all experienced industrial managers, and massive capital flights exerted relentless daily pressure on the rial. The ruinous 1980-88 Iran/Iraq war and the drastic fall in Iran’s annual oil exports, accompanied by lower oil prices in the mid 1980s, imposed further heavy burdens on the Iranian currency. A series of misguided economic policies followed by Mir Hossein Mousavi’s left-center government during the 1980s, designed to control prices and wages, resulted in the rise of a multiple exchange rate system. So, by the end of the war, the Islamic Republic had 12 different official exchange rates for the US dollar. Subsequent attempts by the postwar government of President Hashemi Rafsanjani designed to cope with rent-seeking activities, spreading corruption, and economic injustices gradually reduced the exchange number to four. Under President Mohammad Khatami’s “reformist” government, the last four exchange rates were finally unified in 2002.

During 1978-2002 the rial lost its foreign exchange value steadily year after year. While the official dollar rate – announced by the Central Bank of Iran (CBI) under its so-called “managed float” system – started weakening from $1=IR70 in 1978 to $1=IR1,750 in 2001, the free market rate rose from $1=IR100 to $1=IR7,920 during the same 23 years. As the free market rate had reached $1=IR8,000 by 2002, the new unified rate was set at $1=IR7,950 and was periodically raised by small increments.

In the meantime, the free market rate’s difference with the official rate was virtually eliminated until September 2010 when a relatively modest difference of about IR1,300 began between the two rates, and repeated attempts to eliminate the daily difference were not successful. On 7 June 2011, the rial unexpectedly crashed on the open market and traded near $1=IR11,800. The CBI, moving to eliminate the difference and unify the two rates, raised the ongoing official rate from $1=IR10,590 to $1=IR11,740 – a 10.5% devaluation. In a matter of days, due to the CBI’s massive market interventions, a new stability was established. In order to minimize future rate differences, the CBI opened a “secondary” exchange window designed to deal with dollar demands for services (eg travel) at a third rate between official and free.

In early November 2011, while the foreign political climate became cloudier, the dollar rate in the secondary and free markets registered IR12,800, and IR13,300 respectively while the official dollar rate was fixed at IR10,850. By 30 November, while the official rate was $1=IR10,900 the free market rate climbed to $1=IR13,300. In the third week of December 2011, the free market rate climbed to $1=IR14,300 and by 30 December it reached $1=IR15,480. On 2 January the US currency sold at IR18,000 and climbed to $1=IR22,100 by 24 January. A series of panicked reactions by the CBI (eg frequently adjusting the official rate up and down) were of no avail, and market volatility intensified. Failing to calm the situation through monetary interventions and a sizeable injection of dollars in the market, the government resorted to a coercive policy. The Majlis passed legislation forbidding street venders (ie unlicensed money changers) from selling foreign currencies, ordering licensed dealers to sell dollars at no more than the specified rate, and blocking websites that reported hourly dollar prices. The Judiciary chief threatened execution of currency manipulators.

On 18 January 2012, failing to stop the currency’s continued decline, the central bank lowered the official rate by 8.5% to $1=IR12,260, and promised to offer unlimited dollars for current transactions. Then the Council on Money and Credit on 25 January 2012 changed its long-held policy of fixing deposit interest rates, allowing both government and private banks to set their own competitive rates. While the official rate was kept unchanged, the rial continued to slip and slide in the free market as the CBI was not prepared to meet all daily dollar demands. Powerless to maintain parity between official and free market rates, the CBI finally sanctified the coexistence of the “dual markets” on 14 March 2012, and let private money changers handle dollar demands for “non-essential” imports. The free market rate in late March 2012 fell to $1=IR19,000, or about 55% of its 2002-11 value. Five months after the previous high in January, the dollar rate was ranging between IR17,000 and IR19,000, surpassing $1=IR20,000 for a brief period. It has hovered around $1=IR19,000 since, with no particular direction and responsive mainly to current political events.

Leading Causes

The official explanations of the rial’s turbulence are few, far between and occasionally even bizarre. Despite reams of theoretical proofs, and decades of practical evidence to the contrary, President Ahmadinejad has linked the currency upheaval to a conspiracy between private exchange dealers, opposition politicians and the hostile press. The Central Bank governor has called it the reflection of a mob mentality, and the product of a “defective exchange market” where “hoarders, smugglers and soulless speculators” are trying to create “a false demand” for dollars as a “venue for investment”.

An objective and realistic look at the recent events, however, seems to show that the real factors behind the precipitous fall in the rial’s exchange value should be traced to: (1) a mistaken belief in the high value of the national currency as an economic desideratum; (2) a series of wrongheaded economic policies pursued by the Ahmadinejad administration to deal with both inflation and unemployment; (3) the perseverant pursuit of a national nuclear power policy, inviting the West’s wrath and resulting in a series of hardening economic sanctions; and (4) significant loss of  public confidence in the government’s ability to support the official exchange rate in the face of external pressures.

The ‘Strong Currency’ Myth

The strength of the national currency and the high exchange value of the rial has always been more of a political, rather than a monetary or market phenomenon, in Iran. A strong rial, in the eyes of both the man in the street and the seasoned politicians, has always been a clear sign of economic vigor, and a symbol of political power and prestige. The intensity of faith in this myth has also been related to the believers’ economic literacy. Keeping the dollar/rial rate deliberately (and artificially) low, while one of the clearest economic policy mistakes of the past decade, is still widely demanded and revered. A current Persian website – Asr-e Iran – nostalgically laments that while the Iranian national currency unit – the Shahi – was equal to one shilling or one-twentieth of the English pound in the 16th century, the value of today’s rial is officially equal to 1/19,500 of the British currency and its free market rate as little as1/30,000.

Due to the pervasive influence of this myth, there were neither any effective business demands, nor any urgent political will, to adjust the exchange rate to its proper level after the 2002 rate unification – although all leading economic indicators warranted such realignment. There were faint voices of advice by private economists, and desperate pleas by disadvantaged exporters for the rate adjustment. The first group was contemptuously ignored by the authorities, and the second was partly silenced through the so-called “export prizes” and subsidies.

Neglecting Realities

Handicapped by the nostalgic feeling about the high national currency value, and obsessed by certain “out-of-the-box” economic convictions, President Ahmadinejad began his tenure in 2005 by following a populist and welfare-oriented economic policy, promising to “put the oil money on everyone’s table.” His economic agenda included: (a) an expansionist fiscal policy aimed at “eradicating poverty;” (b) a distinctly overvalued rial to reduce imports’ cost; (c) a mandatory low interest rates policy to minimize capital costs of business; and (d) the use of bank loans, bond issues, and sale of state enterprise to finance budget deficits – instead of tax hikes or more efficient tax collection.

The expansionist binge began with: (i) extensive and poorly supervised loans to the so-called “quick-return projects” in order to increase employment; (ii) an immense nationwide housing project (Maskan-e-Mehr) to increase home ownership; (iii) hundreds of half-baked local development projects to satisfy the crowds who greeted the president in his countrywide tours; and (iv) a “subsidies reform program” involving monthly cash payments to nearly the entire population to make up for higher energy and bread prices. As a result, the national budget rose from IR1,590 trillion in 2005 to IR5,100 trillion in 2011 – or more than three times in seven years. With annual budget deficits running at more than 4% of GDP each year, total liquidity rose from IR921 trillion in 2005 to IR3,720 trillion in 2011, or nearly fourfold.

Protracted budget deficits and liquidity expansion during 2005-11 caused the average officialcost of living index to rise by nearly 17% a year – with the most conservative privateestimate showing 22%. During the same period, Iran’s main trading partners had price increases of 2-4% a year. By a simple calculation, the difference between Iran’s cumulated inflation during the seven-year period compared with those of its trade partners would have warranted some 90% devaluation of the Iranian rial. In actuality, the exchange rate only rose from $1=IR9,025 in 2005 to $1=IR10,445 before the December crash, or a total correction of less than 16%. Thus, the government not only ignored the facts; it also violated the clear mandates of both the Fourth and Fifth Economic Development Plans, requiring annual adjustments of the rial’s exchange rate in line with the differences between domestic and foreign inflation rates. Curiously enough, in December 2010, while announcing his subsidies reform program, President Ahmadinejad asked the head of the CBI to come up with a new and “realistic” exchange rate in view of Iran’s “ample foreign exchange reserves” – an order which  some of his aides at the time interpreted to mean revaluing the rial towards $1=IR5,000!

The same incongruous treatment greeted the government’s regulations of bank interest rates. During the first six years of the Ahmadinejad administration, the authorized interest rate on short term savings deposits frequently trailed the annual inflation rate, eroding the net value of the depositors’ wealth. The maximum interest rate (called “profit share” to comply with Islamic principles) payable by commercial banks on short term (less than five years) deposits during 2005-10 averaged 13% per annum, while the corresponding inflation rate registered 17-22%. In the highly inflationary year 2008, the negative spread reached 10%. As a result, there was a steady decline in the growth of savings deposits during the entire period. Despite these warning signs, however, and even ignoring the mandates of the Fifth Economic Development Plan (2010-15), requiring periodic adjustments of the deposit rates in line with the inflation rate, the Council on Money and Credit, chaired by the president, refused to budge. Even when faced with continued turmoil in the exchange market in early January 2012, the Council (in the absence of the president) allowed interest rates paid on savings deposits to be left at the individual bank’s discretion (in order to divert liquidity from gold and dollars markets). The decision was vetoed once the president returned from a foreign trip. It was only after strong public pressures that on 25 January 2012 the president finally approved the rate adjustments.

President Ahmadinejad’s third gamble with the teetering economy was to fight a virulent and cumulative inflation with the wrong weapon. Instead of controlling consumer prices through conventional means, eg balancing the budget, raising interest rates, reducing bank borrowings, controlling liquidity, or raising factor efficiency, he chose the easy way. Blessed by the best six years of oil export receipts from Iran’s 106-year-old oil industry, he opened the imports’ floodgate. Iran’s revenues during the first six years of the Ahmadinejad administration reached $560bn, compared to only $433bn by all the eight previous governments since the 1979 revolution. In the same six years, imports amounted to $330bn – three times those of the Khatami and Rafsanjani administrations. Yet, during the same six-year period, the government debt to the banking system rose from IR113 trillion to IR403 trillion – or four times. The pernicious policy of trying to fight domestic inflation through cheap imports required the rial to be kept highly overvalued.

Sanctions As Catalyst

The Islamic Republic’s nuclear development program has been the third factor in the exchange rate drama. Widespread suspicion in the West regarding the ultimate objective of Iran’s uranium enrichment activities initially led the United Nations Security Council to issue four consecutive sanctions resolutions. And the move was subsequently followed by the US, the European Union and others. Thus, the original “targeted” and “smart” penalties gradually morphed into the current “crippling” restrictions. They currently consist of stiff and extensive restrictions on travel, trade, banking, finance, shipping, insurance, investment, and transfers of nuclear technology involving hundreds of individuals, businesses, and agencies associated with the Tehran government. Their sole objective has been to dissuade Iran from pursuing its nuclear program – a program which Tehran claims to be for purely civilian energy research and production, but the “sanctioneers” suspect it to involve certain military objectives and possibly even nuclear weapons ambitions.

Although the current sanctions have not targeted the exchange rate in any direct way, their indirect impact on the rate’s movement has been notable. While the rial’s equilibrium exchange rate was due for a substantial correction and for a long time, the plunge would not have occurred without a catalyst. The currency could still have remained out of equilibrium for a while thanks to rising oil export earnings. The trigger for the precipitous plunge was supplied by the news of forthcoming new crippling American and European sanctions in early December 2011 – particularly the oil embargo. The exchange market was visibly rattled. And, on 31 December, when US President Barack Obama signed into law the new (and unprecedented) sanctions involving Iran’s central bank, the exchange dam burst, and the downward movement began.

In the same vein, while negative interest rates on bank deposits were not unique to the Ahmadinejad administration, and never a lever for a game change, two specific factors related to sanctions heralded a dynamic change. The first was a shift in the investment climate, shaken by the threatening sanctions. Prior to 2010, when there was relative political calm, the real estate market was flourishing, and rising liquidity would flow into land, apartment building, and the Tehran Stock Exchange. With the news of ominous times ahead, the funds started to invade the gold and foreign exchange markets as far safer and better havens. The second factor was a bewildering and untimely decision by the Council on Money and Credit, aimed at compensating the effects of sanctions, to lower short term interest rates from 16% in 2008 and 13% in 2009, down to11% in 2010 and 10% in 2011, at the very time that consumer prices had begun to rise from 12% towards 22%!

Loss Of Market Confidence

The fourth factor in the rial’s declining value has been the loss of people’s confidence in the CBI’s ability to cope with the crisis. The bank officials’ frequent empty promises, inadequate determination to follow declared policies, insufficient action to deal with the crisis, and inadequate supply of dollars to stem the growing speculative demand have all been major sources of popular disappointment. To wit, when the free market rate for the dollar dropped by more than 10% in less of a day in late December 2011, the CBI governor responded with a firm promise to bring it back even below the official rate. Yet nothing happened. On 5 January 2011, the bank ordered private exchange dealers to charge no more than IR14,000 for the dollar. The order was totally ignored. And the rate by the street vendors jumped to $1=IR16,250. The governor said he had firm plans to stabilize the market, but it was not in the public interest to reveal them. On 25 January 2012, the governor said the four demerged exchange rates (reference, official free, travelers, and open market) would be unified in 48 hours, and there would be no limitation in the dollar supply for various current transactions. It proved to be an empty gesture. And there was mistake after mistake. For example, one of the reasons for the people’s rush to buy dollars in the first days of the new year was their lack of confidence in the CBI’s claim of ample gold and dollar reserves. Yet, instead of reducing this skepticism by showing resolve to meet all dollar demands, the central bank on 6 January 2012 cut the travelers’ ongoing $2,000 allowance down to $1,000 – thus reinforcing the people’s conviction that the bank was running out of dollars. As a result, the public was convinced that due to hardening sanctions, Iran’s oil exports would be drastically reduced, and higher oil prices caused by global tensions would not be enough to compensate for total receipts, thus, sooner or later, forcing the CBI to ration foreign exchange sale.

The Ideal Exchange Rate

The hottest current economic issue in Iran is the proper exchange value of the rial in terms of the US dollar. In the absence of an objective determinant of the equilibrium exchange rate, suggestions about the right number abound. Private analysts, on the basis of rapid inflation and sluggish exchange rate adjustments in the last few years, argue for a rial devaluation towards the current free market rate of about $1=IR19,000. Government officials, aware of the devaluation’s effect on import costs and further domestic inflation, favor the opposite course and hope to bring the free market rate down towards the official rate. Traders are also divided on the basis of strict self-interests. Exporters and domestic producers of tradable goods are demanding a lower rial rate in order to become more competitive abroad. Importers, on the other hand, argue that since the bulk of Iran’s imports consist of raw materials and semi processed goods, a strong rial is in the national interest as it keeps down producers’ costs. Anti-devaluation groups also argue that since Iran is dependent on imports for 30% of its food consumption, any upward adjustment of the exchange rate would add to the already high domestic consumer living costs. They similarly allude to the low price elasticity of both Iran’s exports and imports as a significant disincentive for devaluation.

Private market analysts also argue for substantial devaluation, pointing to the fact that due to cheap dollars, Iran’s imports have increased from $18bn in 2001 to more than $64bn in 2010 (not including payments of $19bn for services, and an estimated $20bn in smuggling). The latest imports roster, mostly from China, comprises items that have never been on Iran’s import list. As a result, not only have traditional exporters been unable to compete in foreign markets due to the overvalued national currency, domestic producers have also lost their competitive power, gone bankrupt, or become packagers and handlers of foreign articles. Domestic industry has become increasingly hallowed.

Determining the right rate of exchange for the Iranian currency, however, is difficult due to the country’s heavily oil-based economy, and the unpredictable effects of sanctions. Iran’s oil industry – responsible for more than 85% of the country’s annual foreign exchange earnings – is state-owned. The government is the sole arbiter of daily oil extraction, and the sole dispenser of oil export receipts (ie injection into the economy). The government’s decision to sell more or less oil thus influences the exchange rate automatically. The small “free market” plays only a marginal role. In such a case, where the main provider of the foreign exchange is the treasury, and the major users of the foreign money are state enterprises, whatever rate the central bank might set would be arbitrary and not necessarily the “equilibrium” rate. The rate that is determined in the “free market” by private importers, travelers, students, smugglers, and capital movers is marginal. The free market’s difference with the official rate at any given time is only indicative of the fact that the official rate is “out of range” and that the government is not willing (or able) to meet the entire “discretionary” demand.

Searching For The Right Exchange Number

Already five months into the Persian New Year, there is still no clearly declared exchange rate policy by the CBI, and the dollar rate is drifting up and down with no clear direction. On 27 July 2012 the deputy director of Iran’s Export Promotion Organization announced a “consensus agreement” among the CBI and other government agencies to divide the entire imports list into 10 main categories, with the first five (comprising a list of specific consumer staples and industrial necessities) eligible to receive dollars at the official rate, and the other five (discretionary and luxury items) supplied with the dollars earned from non-oil exports and other free market sources. The secondary market is closed, and foreign exchange at the official rate will now be sold only for travel to religious destinations.

A successful and orderly administration of such a complex exchange regime is highly difficult in normal times. It would be extremely complicated and hazardous in the present domestic economic conditions. Under the strain of biting sanctions, Iran’s economy is experiencing an unprecedented anemic economic growth, disturbing double-digit inflation, worsening youth unemployment, falling oil output, reduced oil exports, and lower oil prices. GDP growth this year is estimated to be no more than 1%. Unemployment among 18-25 year-olds is officially 29.1%, with many analysts estimating much higher rates. Press reports point to a large portion of the production sector operating at half-capacity, with a wave of bankruptcies and business closures. The latest CBI data show wholesale prices up by 33.4% and the consumer price index by 22.4%, with certain food items (eg chicken, red meat, and milk) up by a staggering 30-80%. OPEC and other sources report Iran’s daily oil production (the economy’s life blood) at 2.9mn b/d, down from 3.9mn b/d last year. Oil exports (the country’s main foreign exchange source) are reportedly at 1.2mn b/d, compared to 2.3mn b/d prior to the oil embargo. Oil export earnings (the annual budget’s major source of income) are reduced considerably due largely to the European oil embargo, and partly to lower oil prices (from the record $126/B in March to $96/B in June). According to reliable estimates, the Islamic Republic needs a $117/B price to finance its current fiscal budget, while market prices have lately been running at $105-111/B.

The sanctions’ role in these setbacks is coming to light as days go by. After years of defiantly denying the stiffening results of universal restriction, and in fact welcoming them as a spur to national self-sufficiency, a chorus of influential voices is now openly showing concern. Supreme Leader Ali Khamenei himself still remains defiant, and claims that Iran is currently “100 times stronger” than before, and that “Westerners” themselves have “vaccinated” the country against sanctions through their 30 years of censure – arguing that an oil-less, and knowledge-based economy could well resist any sanctions. But a growing group of top civilian and military leaders, Majlis lawmakers, and even high-ranking clergy show clear signs of unease and openly bemoan current economic hardships.  President Ahmadinejad has recently acknowledged serious financial impact of what he called the “toughest” measures ever imposed on the Iranian economy. The Minister of Industry and Trade has called them “devastating.” The Majlis speaker has acknowledged the sanctions’ share in the current plight.

The Insoluble Dilemma

The central bank’s latest de facto acceptance of a multi-tiered official exchange regime has now reopened the old Pandora’s Box of economic rents, appropriation of cheaper dollars to insiders, and widespread corruption – reminiscent of the 1980s as a major source of ill-gotten wealth for the Islamic Republic’s current financial moguls. There are already press reports regarding industrial producers complaining about lack of access to the official rate, the necessity of bribing bank officials to receive cheaper dollars, and the growth of under-the-table deals. The current IR7,000 difference between official and free market rates, if continued, would promise to generate billions of new “rent” to materialize in the next few months to be grabbed by insiders.

However, despite strong verbal objections to the current multiple exchange system by certain influential groups in and out of the government, and strong popular demands for the return to currency unification, the dilemma continues insoluble. An early return by the CBI to a single rate around the current official rate would seem out of the question without prior easing of the crushing sanctions, eg the oil embargo and central bank operations. On the other hand, a more logical realignment towards the free market rate would also be nearly impossible at this juncture without first taming the intolerable high domestic inflation.

What seems certain is that in the next few months and beyond, the Islamic Republic is going to face its toughest and most troublesome economic challenge since the end of Iran/Iraq war, with unprecedented major headwinds. The fate of the rial also will, by more than any other factor, be directly tied to the course of Tehran’s relations with the 5+1 group, and the resolution of the nuclear issue.

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