Tough Times Ahead for the Iranian Economy

Djavad Salehi Isfahani
Djavad Salehi Isfahani
Djavad Salehi Isfahani Professor of Economics - Virginia Tech

April 6, 2009

Iran’s oil-dependent economy is in for tough times as slack conditions continue in the global oil market. Oil prices averaged over $80 a barrel last year but in 2009 they likely will be half as much. Despite assurances from President Mahmoud Ahmadinejad (who recently asserted that even with oil prices as low as $5 a barrel, “nothing important” would happen, implying that the country’s economy would remain strong) and steady silence from presidential candidates about the looming economic crisis, the business mood in Iran is very grim as consumers and businesses brace themselves for a serious downturn.

Post-oil boom adjustments are not new to Iran. Similar, if not greater, declines in oil revenues took place in the mid-1980s, as a result of the intensification of the war with Iraq and the oil price collapse of 1986, and then in the mid-1990s, as a result of overindulgence following the brief oil boom of 1990-91. On the first occasion, the state of the economy was already dire and characterized by extensive rationing, so the adjustment was just greater restraint on consumption and investment enforced with more rationing. However, the experience of 1993-95 is more relevant because it resembles the current crisis more closely: market forces played a greater role and the country was experiencing economic growth. As a result, when the Rafsanjani government switched from a liberal import policy in 1990-92 to import restrictions that cut imports by half during 1993-94, consumers were shocked and unprepared.

The problem during the mid-1990s was not that oil prices had collapsed suddenly. As hostilities in the first Persian Gulf War came to an end in early 1991, what made the adjustment much worse was that Iran had to pay back about $20 billion in short-term loans that it had borrowed. The effect of the adjustment on ordinary Iranians and the poor was severe. Inflation soared to 50 percent in 1995, real wages fell by about 20 percent in just two years during 1993-95, and poverty increased.[1] Widespread dissatisfaction with the economic adjustment led to a revival of populist politics, which forced President Rafsanjani to abandon his market reform program and institute controls on prices and imports.

A harsh lesson was learned by the average person, who felt they had seen little of the gain but had to bear the brunt of the adjustment: get your goodies early in an oil boom so you are not left empty-handed when it comes to an end. This was felt especially by the young, who were last in queue to share in the benefits of the boom. The candy store had closed too quickly and without warning, leaving the more patient customers with baskets yet to be filled. It took barely a decade before this theory was put to test. In the middle of the latest oil boom — in 2005 — Iranians voted for a president who promised to “bring the oil money to their dinner table.”

The lessons learned by Iranians during this most recent populist-managed oil boom may become clear in June, when the outcomes of the election come to light. The precise course the economy will take in the next few years depends on who is elected, but choices are limited. Not surprisingly, the candidates are not talking about what they will do if elected, and the current Ahmadinejad administration is postponing adjustment until after the election.

Iran’s economy is facing at least three large imbalances. The most acute is in the balance of payments. Unlike Saudi Arabia and the United Arab Emirates, Iran does not have enough in reserves to finance its way out of the crisis. Oil exports are not responsive to domestic policy actions, so the foreign exchange gap will have to be met in part by cutting imports, through foreign borrowing, or by increasing non-oil exports. The last option is the most desirable from the perspective of jobs and growth, but it will not be the most likely if a populist president is elected. Already some candidates are whispering that they favor lowering the exchange rate (increasing the value of the rial relative to other currencies) in order to fight inflation. These candidates would lead voters to believe that they can have their cake and eat it too — that is, have access to more jobs while keeping domestic supply for domestic consumption. Yet, to boost non-oil exports the rial must depreciate in value, which will cause prices to rise but will also make exporting more profitable. When the exchange rate was raised to help exports during the last adjustment in the early 1990s, I recall reading in Iranian newspapers about the heroic citizens of the northern agricultural province of Gorgan who stopped the trucks taking “their” produce to Central Asia. So much for the national desire to promote exports and lower dependence on oil!

In these times of frozen international credit markets and economic sanctions against Iran, the second option of foreign borrowing is less likely than it was in the 1990s, but the risk of state-owned enterprises racking up foreign debts using short-term credit from eager overseas suppliers is not altogether gone. This is precisely what they did in the early 1990s, which deepened the post-oil boom slump and halted Rafsanjani’s reforms. Anticipating devaluation and government bailout, these enterprises incurred $10 billion in new short term debt alone between 1991 and 1993. Their actions forced the highly anticipated devaluation of the rial by a factor of 27 during the same period and forced the government to accept this debt as its own. If lessons from the past do not save Iran from repeating this scenario, the sanctions might, ironically, do so by making it harder for state enterprises to borrow abroad.

Repeating the past is more likely to come in the form of the politically more palatable option of simply cutting imports. Such a policy will be costly in terms of jobs and growth, but will unfortunately appeal to any one of the current leading candidates (Mehdi Karroubi, Mir Hossein Moussavi, and Ahmadinejad), all of whom have strong dirigiste tendencies and would welcome the power over the private sector which comes with overseeing the allocation of the anticipated $40 billion of oil earnings to industries and individuals. Mr. Moussavi is most familiar with this scenario because, as prime minster in the 1980s, he presided over a rationing system (of goods and foreign exchange) that humbled many industrialists and wealthy individuals who had to lobby for their allocations of foreign exchange or line up outside mosques for durable goods. That system was abandoned in the 1990s because it caused corruption and discouraged private investment. Will those lessons keep the country from going down that path again?

The second imbalance is in the government budget. Imposing more taxes will be politically costly and printing money inflationary. There are no good options here except cutting back on public expenditures and, if the past is any guide, investment will take the biggest hit. By 1995, economic contraction had brought investment down by 29 percent compared to 1992, while consumption actually increased by 8 percent. If this scenario is repeated in the next couple of years, economic growth, and thus jobs, unfortunately will suffer.

The third imbalance is in the country’s financial markets. President Ahmadinejad reduced interest rates as a way of helping borrowers, especially young people, who were targeted in an ambitious lending program for so-called “quick return projects.” Banks were pressured to lend, which they did to the tune of $18 billion during the first year of the program. However, returns were not quick enough and domestic supply did not respond as anticipated, causing prices and imports to rise. During the summer of 2008, inflation reached annual rates above 30 percent. The Central Bank intervened to limit the lending program and the resulting expansion of the money supply. This intervention has lowered inflation and inadvertently caused the economic adjustment to arrive earlier in Iran than in other oil-rich parts of the region, such as Dubai.

There are several parallels with the previous episodes of adjustment, but there is also one important difference ― demography. Whereas in 1986 and 1996, in the aftermath of the last two great downturns, youth (ages 15 to 29) comprised 26.4 percent and 28.4 percent of the population respectively, in 2006 they accounted for 35.4 percent of the population and 70 percent of the unemployed, both ratios being the highest in the Middle East and among the highest globally. Furthermore, most of these young men and women are well educated and, lacking stable employment, unable to marry, likely engendering feelings of disappointment and alienation. Had the oil boom lasted another 5 to 10 years, most youth would have “survived” their twenties and reached the glorious age of 30, when most Iranians finally find a stable job and many get married. (Unemployment rates drop from 25 percent for men and 45 percent for women in their twenties to less than 5 percent after age 30.) The onset of the economic slowdown at this time will likely inflict more damage on youth than any other age group.

There is never a good time for an economic downturn, but this is a particularly bad period for Iran and its youth to face adjustment, especially if it is administered the old fashioned way — that is, by contracting the economy to limit imports and causing investment and industrial production to fall. Most young people who are lucky enough to be employed are on short term contracts, as Iran’s labor law protects jobs for older people and those with less than three months on the job.[2] These youth will be the first to lose their jobs, and those who do not have a job to begin with will have to wait longer to find one.

The alternative to such a policy is to increase the scope of activity for the private sector to enhance its ability to create employment by shifting from contracting sectors (mostly services) to sectors that can expand (agriculture and manufacturing). On the macro side, this entails allowing the rial to depreciate and interest rates to rise so financial markets can provide the necessary credit. On trade, it implies resisting the impulse to protect unproductive industries, but rather to restructure them through privatization, greater competition, and prioritization of exports. Restructuring should also be extended to institutional reform of the labor market to make it more flexible. These are hard steps to take during a time of increased uncertainty but, if these reforms are not pushed forward now, the opportunity will disappear and “business as usual” will return once oil money begins to flow again.

It would be a brave — some would say foolish — presidential candidate to run on such a platform. Iran’s electorate is sadly focused on distribution during election times but, interestingly, in their own decisions, they are focused on the long term. Their erratic political behavior was demonstrated by the overwhelming victories of the liberal Mr. Khatami in three national elections, followed by a landslide vote for the conservative Mr. Ahmadinejad in 2005. In both cases they were wishing for redistribution, which neither delivered.[3] Yet, in their daily lives, as parents, the same voters are focused on the future of their children and therefore the longer term, as evidenced by their decisions to opt for small families and high investment in children. The nice thing about this schizophrenia is that a forward-looking electorate can be persuaded to give up on the short term gains from redistribution in favor of long term growth. It is time for Iran’s political leaders to stop pandering to the desire for redistribution, which in any case they cannot deliver, and instead promise reforms that will secure a long term future for the next generation.

[1] See: Djavad Salehi-Isfahani, “Poverty, Inequality, and Populist Politics in Iran,” Journal of Economic Inequality 7, no. 1 (2009): 5-24.

[2] See: Daniel Egel and Djavad Salehi-Isfahani, “Youth Education, Employment and Marriage Transitions: Evidence from the School to Work Transition Survey” (forthcoming 2009).

[3] See: Djavad Salehi-Isfahani, “Poverty and Inequality Since the Revolution,” in Viewpoints Special Edition: The Iranian Revolution at 30, Middle East Institute, 2009.