Iran Sanctions Bite, but Will They Work?

Iran drew the attention of the world last week, with threats to obstruct the export of approximately one-fifth of the world’s oil trade in response to harsh new U.S. sanctions against its financial system.

Tehran’s long-standing proclivity for bellicose rhetoric muted the impact on energy markets, where oil prices rose only modestly. But the episode highlighted the prospect of a new round of instability and conflict in the Middle East, at a time when the global economic recovery remains precarious.

The Obama administration will implement the new U.S. sanctions gradually over the next six months, with a keen election-year eye on petrol prices and considerable flexibility, at least on paper, to avoid undercutting the global economic recovery.

However, the American measures, combined with a pending European ban on importing Iranian crude, will wreak havoc on Tehran’s energy exports, which generate the overwhelming majority of the regime’s foreign exchange.

Beyond Europe, major Iranian customers such as Japan and South Korea will co-ordinate carefully with Washington. China is already cutting back its purchases in a bid for considerable price discounts.

For the oil markets, the net effect of the sanctions and the tensions will bring intensified volatility and sustained higher prices.

Repercussions

For Iran, the crisis could be catastrophic. Already, the country’s currency has plummeted sharply as part of a decline that has nearly halved its value from a year ago.

The swift and severe impact that the mere anticipation of new U.S. sanctions had on Iran’s domestic economy underscores a significant uncertainty that has gone largely unnoticed amid the uproar over Tehran’s sabre rattling, namely: will the latest round of sanctions accomplish the objective set out by one of its architects in the U.S. Congress—the explicit collapse of the Iranian economy?

Washington and the world are currently fixated on whether and how the sanctions will reshape Tehran’s nuclear calculus, but the repercussions on Iran’s economy and society will ultimately have greater consequences for regional stability.

Iran benefits from an incredibly fortuitous endowment of resources, including the world’s second-largest gas reserves and third-largest conventional oil reserves.

It also has a young and well-educated population, a temperate climate and strategic location at the crossroads of Asia and Europe, and a historically diversified economic base that has been eroded but not wholly eliminated by reliance on resource rents.

And yet more than three decades of internal upheaval, regional conflict, government interference and mismanagement, and economic sanctions have exacted an enormous toll on this latent economic powerhouse.

The net result has been a profound deterioration of Iran’s status in the world economy over the course of the past three decades.

Iranians have watched as their once peer middle-income countries, such as Turkey and South Korea, have rocketed ahead in terms of per capita income, growth rates, productivity, access to technology and foreign investment.

Spending Spree

Over the course of the past decade, as other major energy producers took advantage of the epic oil price hikes to pay down debt and invest in infrastructure, Tehran has gone on a spending spree.

This was in part a means of buying off political dissatisfaction, with billions squandered, much of it on unsustainable import bills.

Iran’s current economic morass reflects a number of contributing factors: the legacy of populist economic grievances, factional infighting among the deeply divided post-revolutionary elite, the volume and inherent volatility of resource rents and a deeply contested relationship with the outside world.

Both for Washington and for Iranians themselves, it may be tempting to emphasize the impact of sanctions, if only for political purposes.

The United States trumpets the effect of sanctions to demonstrate that its pressure is working, while Iran stokes the same issue to cultivate international sympathy and dodge responsibility for its disastrous domestic track record.

It is fair to say that these measures, primarily imposed by Washington but broadened over the course of the past five years to include significant international participation, have imposed a high price on Iran’s development, particularly its energy sector and access to international finance.

Ultimately, however, sanctions represent one only dimension of an economic landscape that is profoundly problematic.

For decades, Tehran has managed to live with an increasingly draconian array of restrictions on its economic relations with the world through a variety of mechanisms.

These include domestic investment and development, efforts to insulate strategic sectors and vital constituencies, inducements to attract alternative investors and of course smuggling and evasion.

Iranians from a wide variety of political persuasions resent sanctions and frequently express bitterness about the American reliance on a tactic that is more easily evaded by its intended targets in the leadership than the broader population.

But ask any Iranian to name the foremost issue confronting the economy today, and from the highest echelons of the technocracy to the individual on the street, they will denounce government policies as the principal basis of their predicament.

This does not imply sanctions lack impact, but rather that they are merely contributing factors, exacerbating the underlying distortions and official malfeasance in the Iranian economy.

And so it goes with Iran’s recent currency crisis. While most of the headlines have linked the slide of the rial to a panic over sanctions, the reality is probably much more complicated and multi-dimensional.

Many Iranians surely rushed back to the black market for foreign exchange out of concern over the sanctions or the prospect of conflict, as was the practice for the first two decades of the revolutionary regime prior to the official unification of the exchange rate a decade ago.

However, the resources at Tehran’s disposal are more than sufficient to stabilise the currency, at least temporarily, and its handling of the crisis suggests the regime saw some benefits in an abrupt devaluation.

Government revenues from any continuing oil exports will go further in the local economy, while higher import prices will quickly curb the flood of imports, mainly from Asia, that have ravaged domestic production in recent years.

Still, the scope of the measures targeting Iran’s crude exports will take an enormous toll on the regime’s revenue stream.

As is often the case with the Islamic Republic, the price of the regime’s standoff with the West will be paid disproportionately by the Iranian people.