The Collapse of Iran's Rial
"Wealth comes like a turtle and goes away like a gazelle." -- Persian Proverb
The Iranian economy has been imploding, at times even nudging news of Iran's nuclear program off of the front pages. In the first ten months of 2012, the Iranian currency, the rial, lost more than 80% of its exchange value. In a single day, on October 1, 2012, it dropped by 15%, and, after a brief reprieve, resumed its trend downwards in early 2013. At least one commentator has compared Iran's economic meltdown with that in Zimbabwe.
Although many, including in the media, have interpreted Iran's economic woes as proof that economic sanctions are at last "working," there are reasons to believe that the economic disaster inside Iran has little, if anything, to do with the sanctions, and -- more generally -- that sanctions cannot possibly "work" against Iran. The collapse of the Iranian currency is largely the byproduct of internal Iranian economic policy.
During the 1990s, long before the current bout of sanctions, the government found itself unable to service its debt, and there were debt "reschedulings" -- actually partial defaults. In 1993, a particularly severe balance of payments crisis was accompanied by rapid depreciation of the currency and large increases in money printing.
Under the Shah, the rial had been pegged to the dollar at a rate of 68.73 rials to the dollar. The current account of Iran's balance of payments was generally in surplus, with Iran earning more foreign exchange, including from US aid, than it spent. By 1978, with the Ayatollahs in control, the rate was 71.46.
Over the next twenty-one years, the rial lost 99.2% of its exchange value against the dollar, reaching 9430 rials to the dollar in July 1999. This massive loss had nothing at all to do with "sanctions," although a few half-hearted sanctions were imposed by the US in 1995, in response to Iranian terrorism. Once the 1978-9 hostage crisis was resolved, there were no sanctions to speak of against Iran. Even the long war between Iran and Iraq, during which Iran ran up $30 billion in foreign debts, produced none of the losses in the exchange value of the rial. The rial actually rose slightly in value during the eight years of the war, ending at about 68.6 to the dollar. The collapse of the rial came after the war.
What produced the massive depreciations was galloping Iranian inflation, produced by hyperactive printing of money by the Iranian government. According to the IMF, "The role of money (in Iran) is prevalent in determining the price level in the long run." The consumer price index, the usual measure of inflation, tripled between 2004 and 2011, and that is according to the distorted official statistics, which are clearly gross underestimates.
The immediate trigger to the acceleration in the rate of depreciation of the rial appears to be the change in the governmental subsidization program. Like other Middle East countries, Iran has attempted to buy domestic tranquility by subsidizing the prices of "basic" foods. Eventually the drain on the public purse becomes too severe and the government is forced to reduce subsidies and raise food prices. This invariably leads to political unrest. (The French Revolution was largely triggered by similar subsidization-then-cancellation financing schemes by Louis XVI.) The "Arab Spring" riots began in Tunisia when food subsidies were slashed; the unrest spread from there to much of the rest of the Arab world.
On December 18, 2012, the Iranian government eliminated food and energy subsidies (including to electricity consumption). Petrol prices before the reform were only about 40 US cents to the gallon. The government attempted to buy the cooperation of the public by granting almost all consumers in Iran a cash grant in lieu of the higher prices for food and utilities. 50% of the loss in purchasing power was supposed to be restored to consumers by the government in what it was calling "targeted subsidies." Close to 80% of Iran's population was granted unrestricted access to compensatory payments that had been deposited in specially created bank accounts. 7000 Iranian corporations also received the "targeted subsidy." According to Prof. Meir Litvak, director of the Center for Iranian Studies at Tel Aviv University, "Until two years ago, the Iranians spent $90 billion a year on subsidies for food and fuel. Today, they spend a similar sum on monthly compensation payments to low-income families. This compensation cancels out the savings achieved by the abolition of the subsidies."
Macroeconomics professors routinely conduct thought experiments with their students about what would happen if a giant helicopter were simply to dump cash money down upon all the consumers in a society, but it is doubtful any other country before Iran has tried to apply the idea literally. There is some evidence that the "experiment" has resulted in widening gaps in wealth and income across Iranian social classes. [ Possibly the wealthier and better-connected classes in Iran may be getting more than their fair share of the "compensatory payouts," and therefore are not as harmed by the cuts in subsidies .
Iranians also seem to have long had a fetish for gold, and in times of distress run to it. In September 2012, gold prices inside Iran jumped 7% in a single month. According to a report on Bloomberg, the central bank of Iran tried to stabilize the price of gold by auctioning gold reserves. Ali Alfoneh, an economist at the American Enterprise Institute, wrote: "After two weeks, they abandoned the strategy because they could no longer defend the currency. The price of gold was still going up, because there's no public confidence in the CBI."
Soon after that, the regime decided to seek more effective means to stop the run on the rial. "As the exchange rate for dollars skyrocketed from 29,000 Iranian rials to nearly 35,000, police used tear gas and batons to disperse money changers and traders outside the Central Bank demonstrating against president Mahmoud Ahmadinejad's mishandling of the economy."
Iranians have been pouncing upon gold from any source they can find, particularly gold imported from Turkey. World gold exports in the first seven months of 2012 were five times more than the total in 2011 -- owing to rising demand from Iran, which had accounted for only 4% of sales two years earlier. According to the Guardian, "In the wake of the currency crisis, many Iranians who have lost faith in the rial are now contributing to its instability by rushing to convert their assets and properties to foreign currency and gold. The government has repeatedly attempted to bring the currency under control, but with no success. Last week it launched an exchange centre aimed at stabilising the rates, but the rial's fall has since increased." The Iran government had made large gold purchases in 2011, but these were being rapidly lost in 2012 in the speculative attack by Iranians themselves against their own national currency. Alcoholism, which is not supposed to exist at all in Iran, perhaps as a result of the economic troubles, seems to be on the rise.
Further, to the extent that international tensions have affected Iran's markets at all, it appears that what matters is the growing talk of armed conflict, not "sanctions." Many Iranians may believe that any armed conflict would have a far more serious impact upon their standard of living than sanctions have had until now, where trade and supplies of commodities and even utilities could be disrupted. Sanctions can be bypassed by clever merchants. Cruise missiles, however, and their effect on the functioning of the economy, cannot.
Skepticism about Sanctions
Economic sanctions are not the cause of the collapse of the Iranian rial. Economic sanctions never "work." Rhodesia held out many years even with near universal sanctions against it. Sanctions can have some symbolic value and demoralize the targeted populations. But even nations seemingly subjected to the harshest sanctions -- Rhodesia, South Africa, North Korea, Cuba -- managed to function and trade in world markets quite well in spite of them. In Cuba and North Korea, their domestic poverty and misery are produced by rigid central planning more than by any sanctions.
Economic sanctions are more symbolic manifestations of anger or moral indignation than effective weapons of state. While economic sanctions have been used by various states for centuries, they have rarely, if ever, achieved much. They failed to change the behavior of Serbia, they failed to force Iraq out of Kuwait and they failed to mend human rights abuses in China. Any limited effectiveness economic sanctions have is usually when they accompany actual armed warfare, not when they substitute for warfare – for example, as in the sanctions that accompanied the two world wars and the Napoleonic campaigns.
Further, the timing of Iranian regime's economic woes pre-date economic sanctions. The sudden acceleration in the demise of the rial took place after years of sanctions, only when threats of armed intervention were being voiced and "red lines" were being drawn by Israel and the United States, lines that began to concentrate the mind of the average Iranian. Sanctions simply do not cause a serious enough loss in standards of living for countries targeted by them, and there are also too many ways to evade the sanctions. Sanctions have not stopped the trade in African "blood diamonds," and they are even less effective against moderately developed middle-income countries.
Some of the "sanctions" against Iran were clearly pointless and ineffective. For example, the US and Western allies announced in January 2012 that Iran was being cut off from the international payments and bank settlements systems, which are used to clear electronic payments and checks. More recently there have been calls to evict Iran from the payments clearing system for Euros. All Iran needed to do, however, to continue to participate in the world payments system was to find a single "correspondent" or representative bank willing to clear payments for the country, to accept payments coming in and use the proceeds to pay Iranian bills. To do this, it was not even necessary to choose from among the many banks from Islamic countries. There have been reports that the giant British bank HSBC has been providing Iran with correspondence services, and Russia also appears to have been providing clearing services. In other cases, the sanctions almost appear to be designed to solicit chuckles, such as those imposed by the UN in 2010 directed only against eight individual Iranian officials.
The most important reason for skepticism about the role of "sanctions" in the collapse of the rial, however, is the evidence that internal economic policy and regime incompetence in printing money and thereby devaluing was what produced the mess.
A superficial examination of Iran's economy would seem to point to its enormous potential, invulnerability, and capacity to withstand sanctions. It is the world's fourth largest petroleum producer and was until the recent downturn the second largest oil exporter in OPEC. Iran has estimated proven oil reserves of 137 billion barrels (as of January 1, 2011). Its standard of living was until recently higher than most other Middle Eastern countries, if not quite European levels. Until the current crisis hit, its per capita GDP, a common measure of productivity and wealth, was just behind the levels for Turkey and Brazil. By most standards of health, education, and well-being, Iran appeared to be well on its way into the international middle classes. Life expectancy in the country was close to European levels.
The Iranian economy nevertheless still manages to defy all indicators of health, steadfastness and cohesion. The culprits are not hostile Westerners, but rather incompetent Ayatollahs who have been handed a country to run. The latest form of environmental policy in Iran consists of calling on snipers to kill the giant rats that have taken over Tehran.
The Plummet of the Rial
Current popular joke in Iran: How many rials are in a dollar? Now, or… now?
The demise of the rial has been one of the most dramatic financial events in recent history. The currency, named after the old Spanish Real (similar to royal) coin, traded at a distorted and artificial "official" rate of 1750 rials back in 2002. It is difficult to pin down the exchange value of the currency for various dates, and there are in fact multiple exchange rates maintained by the Iranian regime, each for a different class of transactions. For example, foreign currency for imports is purchased at different exchange rates depending on how "essential" the regime regards the items imported. Recently the regime raised the price for buying foreign exchange used to pay for imported Basmati rice from India, evidently because rice was suddenly regarded as less essential.
Other countries have experimented with such multiple-exchange-rate systems; these not only always fail, but create economic havoc because imports and exports end up being determined and selected by the arbitrary pseudo-pricing, not by market considerations of profit and cost effectiveness. The different rates are assigned arbitrarily to different classes of transactions; smart traders find ways to redefine their transactions to get the better rates. Iran has repeatedly announced over the years the unification of its exchange rates, only to back-peddle and re-introduce the multiple rates all over again. The results were not long in coming.
The assignment of different sorts of transactions to different exchange rates in any multiple-exchange-rate system is arbitrary; clever traders always find ways to move transactions supposedly assigned to one rate to a better, more favorable rate, then pocketing the difference as "arbitrage" profits. Indeed, growing internal anger in Iran has focused on charges that insiders and cronies of the regime are making fast and easy riches by exploiting the inconsistencies in the system of multiple rates. The US has also condemned Iran for allowing such arbitrage profiteering by insiders. The Iranian exchange rate has long been characterized by high volatility and "over-shooting" of equilibrium levels.
The "official" exchange rate for the rial is an arbitrary and misleading non-market rate invented by the regime. Maddeningly, it is the only one cited by the CIA in its "World Factbook," and this is hardly the only economic "fact" the CIA gets completely wrong. The CIA, for example has a record of accepting at face value the "estimates" of Gross Domestic Product and standards of living of many countries, including those without market economies, where prices have no meaning. Before the collapse of communism, for decades the CIA accepted many Soviet "estimates" and statistics at face value. The Iranian government also manipulates the currency all the time by buying and selling foreign currency (and not just the currency market, but also the gold market). Along with all the confusion, by early October 2012 the rial had depreciated in the open market to about 35,500 per US dollar -- about 300% of the "official" exchange rate proclaimed by the government. By January 2013 the rial was trading even lower even than that. The Governor of the Iranian Central Bank was fired and an official "probe" of the Central Bank's malfeasance was announced.
The plunge in the value of the rial was accompanied by a massive loss in Iranian state foreign reserves. According to the International Monetary Fund, at the end of 2011, Iran held 106 billion dollars in official foreign reserves, mainly deposits in Euros and other European currencies, enough to cover 13 months of imports of goods and services into Iran. But these declined rapidly, so that by November 2012 Iran announced it plans to stop holding dollars and Euros as reserves.
Iran has already cut the portion of its reserves held in US dollars, no doubt out of fear that America will again freeze its funds. It has reason to worry. In 1979 the US froze $12 billion in Iranian assets in response to the hostage crisis. Later, in 2009, the American government froze another two billion dollars in Iranian funds held in the US. While Iran keeps its level of reserves secret, Nader Habibi, an economist at the Crown Center for Middle East Studies at Brandeis University, estimates that by September 2012, these had plummeted to 50-70 billion dollars from an estimated 100 billion dollars at the end of 2011. 
Galloping Inflation and Currency Depreciation
Hyperinflation and rapid depreciation always go together. Supply of foreign currency drops and demand for it increases when there is high domestic inflation. Hyperinflation is where a currency quickly loses its purchasing power in the domestic market; rapid depreciation is where the same currency loses its purchasing power in foreign markets. The Iranian central bank is not independent; it is tightly controlled by the regime. Iranian central bank official statistics concede that the amount of money in circulation more than quadrupled between 2001 and 2011.
No one really knows what the Iranian inflation rate is because the officially announced rate is fictional. The government claims it is "only" around 22% but one could probably not find a single Iranian consumer who believes that. The Wall Street Journal cites sources who put it above 50%. There is evidence that inflation in food prices is considerably higher than the overall inflation rate. To make matters worse, the Iranian Central Bank has traditionally been the source for (very incomplete) financial and economic data for the country, but responsibility for data has now been passed over to an official governmental Statistics Office. Many of the pages, however, that are supposed to contain statistical data for the country are blank or missing on all web sites. From what we can ascertain, it appears that Iranian real national income went into a downward spiral in 2007.
Fereydoun Khavand, a professor of economy at the Paris Descartes University and an Iran expert, claims that the economic downturn is now serious enough that it is threatening to destabilize the regime. "There is growth stagnation plus inflation, a dangerous combination that might make Iran compromise." It has not done so, at least not yet. Throughout history, stagnation and inflation have only produced belligerence, aggression and war -- and brought Hitler to power.
The rapid depreciation has been accompanied by a flight by Iranians to gold, to the dollar and to other foreign currencies. According to one financial report,
Financial Instability and Mismanagement
Ayatollah Khamenei recently urged Iranians to consume Iranian products and shun foreign goods in order to support domestic production. Why such policies produce poverty is the subject of the first week's classes in any freshman Econ course: international trade allows countries to produce more efficiently, and to obtain products in the world market for a fraction of what the products would cost to produce domestically.
The financial system of Iran is one in which financial transactions are supposed to be subordinated to Islamic law. Therefore interest payments are formally prohibited. The entire banking system is based on loopholes and escape clauses that allow banks to charge and pay interest, but without calling these payments of interest. The ersatz interest payments are generally well below inflation rates, implying that credit is ultimately directed administratively: bureaucrats determine which borrowers get credit and at which rates, based on whim and caprice, rather than markets assigning credit to the highest bidders in a market mechanism. In addition, Iranian households tend to seek alternative venues, foreign currencies and gold, in which to hold their savings, to avoid the losses due to the negative returns on bank deposits. Some bank savings have flowed out into the Iranian stock exchange. While shares there rose by 500% in the decade ending in 2011 in rial terms, this was virtually entirely a reflection of rial inflation.
Much of the credit allotted by the Iranian banks goes directly to the government; between 2000 and 2010, lending to the private sector, as a proportion of GDP, was flat. The government instructs the banks how to allot credit, which borrowers and which sectors must be regarded as "priorities," and to which clients the banks must direct most of their lending. According to the IMF:
The Iranian banking system is rife with corruption and embezzlement. The corruption seems to run all the way up the ladder; a former head of the Central Bank was recently detained in Germany with a suspicious $70 million check in his possession. Iranian banks have low levels of capitalization, and even that capital -- because they tend to set aside very small amounts against delinquent and non-performing loans -- is imaginary, erased by non-performing loans that are still treated as if they are performing. State-owned banks are in worse shape than private-sector banks; in 2010 alone, due to bad loans, most of their capital vanished.
Officially, over a quarter of bank loans are non-performing, but there are some indicators showing much higher rates of default. Bounced checks have also become something of a national plague. Of loans to public entities such as state owned utilities, enterprises and municipalities, over 90% are non-performing. While initially Iranian banks were state-owned, in 1979 private banks were permitted to operate. In recent years privatized banks have expanded their operations, although they are still closely controlled and micro-managed by the regime.
Incompetence is the Cake; Sanctions just the Icing
While they are not the main cause of Iran's economic implosion, sanctions against Iran have an effect at the margin, to use the favorite expression of economists to refer to critical small incremental changes. Iranian oil exports are thought to have dropped by half in the first part of 2012, and seem to have continued to decline into early 2013. Since oil prices decreased during the same period, revenue receipts for exported oil also dropped to an even greater degree. Much of the drop in oil revenues was caused by sanctions, although expansion in exports by other OPEC petroleum producers and the continuing world recession also contributed to the drop in Iranian export revenues. There are plenty of countries that are ignoring the international sanctions and expanding their purchases of oil from Iran. Some of these trades, especially for petroleum, are being conducted openly; others, discreetly, under the table. Some of the loss in Iran's export earnings was due to oil reserve revenue that simply mysteriously "disappeared."
The sanctions surely did not help the Iranian economy. But economic misery, because it is domestically produced, would be almost as bad even without them. "The free fall of the rial is due to a combination of President Ahmadinejad's economic mismanagement and the international sanctions regime," says Ali Alfoneh. "However, the Iranian public is first and foremost blaming the regime for economic hardships." The Iranian daily Jomhouriye Eslami's cited the speaker of the Iranian parliament, Ali Larijani, as saying that 80% of the country's economic problems were due to economic mismanagement. Iran's economic troubles are thought to have forced the country to pull troops out of Syria that were defending the Assad regime.
Talking heads in the Western media have been emerging in droves and patting themselves on their backs for the "success of the sanctions" in producing the collapse of the rial. The US Congress proposes capitalizing on the "success" of the sanctions by imposing more of them. The Iranian government characteristically blames Western "conspiracies" for the collapse -- that is, when it is not blaming domestic conspiracies. Dr Ghulam Ali Haddad Adel, former speaker of Iran's parliament, said that Iran would defeat the enemy's "conspiracy against its foreign currency and gold markets."
Iranian government actions seem to belie the claim that Iran really thinks the sanctions are what lie behind its economic sickness. Recently the government claimed 22 key Iranian "speculator ringleaders," sixteen of whom were arrested, were behind the run on the rial. President Ahmadinejad threatened massive additional arrests. Iranian police were assigned to stop the speculation by beating speculators and currency traders in the bazaar. Complain as they might about the conspiracy of the Zionist-Crusaders to undermine their economy, the Ayatollahs seem to understand that the real threat to their hold on power comes from Iranians on the street and in the bazaar -- people who understand that the government, not sanctions, has ruined the country's economy.
 "Iran Loses the Economic Battle," By John Allen Gay , National Interest, October 4, 2012
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