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Analysis

Iran: Subsidy Cuts May Fuel Inflation and Civil Unrest

By Maya Senussi and Rachel Ziemba

On December 19, after a three-month delay, cuts in energy and food subsidies came into effect in Iran. This necessary measure, a means to mend the country’s fragile fiscal position and reduce excess consumption of fuel, will put an additional burden on residents by increasing costs of staple foods and fuel, which have been heavily subsidized. The plan phases in retail fuel cost increases over the next several years, offsetting the subsidies with social transfers, which will mitigate the overall effect. Even after the full plan is implemented, Iranians may not pay the entire cost of commodities. The country has one of the lowest retail fuel prices in the region and is only one of many countries in the MENA region trying to phase out subsidies. According to estimates, these subsidies absorbed between US$30-100 billion a year or about 25% of GDP.

Subsidies and other populist politics boosted Iran’s spending in 2005-08, forcing it to cut spending in 2009 as oil revenues fell. Like most OPEC members Iran’s government remains reliant on oil, though nonoil output represents a majority of its economic output. Iran has a rather low per capita oil output level (much lower even than Saudi Arabia’s). With low refinery capacity, Iran was forced to import much of its fuel, putting an extensive burden on the government. Efforts to phase in a value-added tax hike have met resistance from Iran’s merchant class. Iran’s 2010-11 budget has been narrowly expansionary, particularly through social transfers. Despite higher oil prices, Iran’s fiscal account should remain in deficit in 2011. Domestic borrowing, mostly from banks, has partly offset the deficit, as international markets remain closed and Iran needs funds and expertise to boost its oil and gas output. Neither are likely given the tightening of the sanctions regime.

The subsidy phaseout dropped the plan to means-test the recipients of the compensatory transfers and is thus less efficient than planned. As a result, the government may find it difficult to actually cut spending especially as the risk of civil disturbances, like those of 2007, remains high. Truck drivers in particular are very unhappy, and rumors of strikes persist. The recent shuffle of government ministers, yet another attempt to consolidate economic power, implies that the government is returning to populist plans, and that monetary policy will do little to counter inflationary pressures.

Even when the compensatory transfers are removed, subsidy reductions will also boost inflation, unofficially estimated to be as high as 20% even before the dismantling of subsidies. Recent disinflation (inflation fell below 10% y/y in mid-2010 well below the five year average) is at an end. Inflation picked back up to 12% by the end of 2010. We expect even the official CPI to average over 20% in 2011 as the subsidy change is priced in. The higher fuel prices and reports that domestically refined fuel has worsened in quality and exacerbated a seasonal smog issue could add to economic distress. Iran could well be in for a rocky year as inflationary pressures add to over 20% unemployment.

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