How Iran will respond to new sanctions

Editor's note:

This op-ed was originally published by Project Syndicate

Since December 2017, Iran’s currency, the rial, has lost one-third of its value. And on April 10, the exchange rate’s rapid depreciation prompted the government to halt domestic foreign-exchange transactions and outlaw foreign-currency holdings of more than €10,000 ($12,000).

This government’s move represents a radical change of course, following three decades of relatively liberal economic policymaking, during which the authorities have permitted private-sector foreign-exchange transactions and even capital flight. Iran is not just anxious about the reinstatement of U.S. sanctions after May 12, when U.S. President Donald Trump is expected to make good on his campaign promise to withdraw from the 2015 Iran nuclear deal. Rather, the country is already adapting to a new world in which the prospect of rapprochement with the West is fading.

With the threat of renewed U.S. sanctions having already created a rial crisis, the Trump administration is using the nuclear deal, formally known as the Joint Comprehensive Plan of Action (JCPOA), to try to force Iran to accept more restrictions on its nuclear program, as well as on its ballistic missile program. Given that Iran came to the table to negotiate the JCPOA less than a year after an earlier exchange-rate collapse—by 200 percent as of October 2012—it is not entirely unreasonable to believe that the government will bow to Trump’s demands.

But 2018 is not 2012. Iranians today are far less optimistic about repairing relations with the West, and particularly with the U.S. So, if the U.S. does renege on its commitments under the JCPOA, it would be difficult, if not impossible, for Iran’s leaders to justify further concessions.

Iranians are also less optimistic about President Hassan Rouhani’s ability to deliver greater prosperity, as large protests in December and January showed. With Rouhani’s hopes for market reforms and closer integration with the West dashed, he may be forced to change course, by adopting Iranian Supreme Leader Ayatollah Ali Khamenei’s “preference for the East over the West.”

That would certainly suit Iran’s hardliners, who have long railed against Rouhani’s pro-market, pro-globalization reforms. Their preferred strategy, which is now gaining traction, is to move toward a “resistance economy.” First proposed by Khamenei in 2012, this approach relies on import substitution and favors domestic over foreign investment, in an effort to reduce Iran’s reliance on Western economies and strengthen its resilience against international sanctions.

The need for a resistance economy had seemed to disappear with the JCPOA. After two years of negative growth, the Iranian economy rebounded strongly in 2016, as international sanctions were lifted. Owing largely to a doubling of oil exports, the economy grew at a rate of 12.5 percent. But the recovery has since slowed considerably. In 2017, the growth rate returned to about 4 percent, and is expected to remain low for the next several years.

Likewise, while the Iranian economy has created 600,000 new jobs each year since the JCPOA took effect, this has not been enough to absorb Iran’s massive youth bulge. In fact, unemployment is now at an all-time high, especially for young, college-educated Iranians. According to the 2016 census, among college-educated 20-29-year-olds, 36 percent of men and 50 percent of women are unemployed.

One reason for the inadequate supply of jobs is that Iran’s leaders have failed to improve the country’s environment for private investment. In 2018, Iran ranked 124th in the World Bank’s “Doing Business” rankings, which was unchanged from the year before. With powerful entrenched interests standing in the way of liberalizing reforms, Iran’s economy remains as anti-competitive as ever.

Still, much of the blame for Iran’s lackluster performance belongs to Rouhani’s economic team, which has proved no match for the economy’s mounting problems. If Rouhani ever held the key to the door of prosperity, as he was fond of saying in his 2013 presidential campaign, he failed to locate the keyhole in time.

Nearly five years after Rouhani’s election, Iran’s banking system is still insolvent. Burdened by non-performing loans accumulated during the 2000s real-estate boom, Iranian banks have been unable to lend for investment since 2012, owing to sanctions. To attract deposits, banks have been offering interest rates of ten percentage points or more above of the inflation rate, while using new deposits to pay previous depositors. The government has identified and closed a few of these Ponzi schemes. But for the rest of the country’s insolvent banks, the only option has been to wait for another real-estate boom.

Making matters worse, persistently high interest rates have pushed fixed investment down to around 20 percent of GDP, which is at least ten percentage points lower than what is required to bring down unemployment. Meanwhile, public investment, at less than 3 percent of GDP, is hardly enough to pay to maintain and repair existing infrastructure. And with prospects for substantial inflows of foreign capital dimming, there is little likelihood of an investment rebound.

Even before Trump’s election, foreign investors approached Iran cautiously, signing projects but holding back on actually committing funds. According to the International Monetary Fund, in 2016, $12 billion in foreign funding had been promised for various projects, but only $2.1 billion had been invested. And now that the government has imposed new restrictions on capital flows, the country’s attractiveness to foreign investors will fall further.

Capital controls are of course in keeping with the “resistance economy” favored by conservatives, one of whom recently stoked fears of capital flight by declaring that $30 billion had left the country in only a few months. In fact, a more likely figure is $10 billion.

In any case, depending on whether and how fast the JCPOA falls apart in the coming months, capital controls will be just the start of a great reversal. As economic decision-making shifts from markets to the government, Rouhani’s attempt to create a competitive, globalized Iranian economy will come to a grinding halt.