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Iran: Follow the (Oil) Money

By Rachel Ziemba

Many view today’s Iranian parliamentary elections as a referendum on the tenure of President Ahmadinejad, especially the economic policy management. Despite its oil windfall -oil export revenues likely neared $69 billion - in the year starting last March - and Ahmadinejad’s populist promises, Iran suffers rising unemployment, inflation and slowing growth. There are questions about how the oil savings have been spent though.

But the election results are unlikely to prompt a foreign policy shift - almost all policy makers seem committed to Iran’s nuclear policy agenda, if not necessarily the approach.

Although a loss by the group most closely tied to Ahmadinejad might weaken his position though, the net outcome may be little changed. A real question is whether the electorate will turn out to vote. Those in Tehran are thought to be jaded and have received fewer populist goodies than those in the country. But despite the loss of the party tied to the president in the local elections last year, little weakening was evident. Perhaps it is partly a result of those outside Iran attempting to read the tea leaves of policy choices. But perhaps fearing an electoral surprise, as many as 1/3 of candidates were rejected, leaving the choice between conservative and ultraconservative, to quote the economist.

Earlier this week, Karim Sadjadpour of the Carnegie Institute of International Peace released a paper surveying the writings and thoughts of Ayatollah Khamenei, the real power in Iran. Given his importance and that of Iran in resolving key standoffs in the region, there is no time to waste. understanding the thoughts of Khamenei are necessary to crafting a US policy to respond to Iran both concerning its nuclear ambitions and increasing prominence in the region.

Separately, Sadjadpour suggests that the election while not free nor fair nor predictable is significant for highlighting national debate. Ultimately it is the views of the Ayatollah that determines ultimate policy rather than the parliament or of the succession of presidents. Although the parliament may be a venue for public debates, its decisions can be overridden by the Council of Guardians. However, he suggests (as did Vali Nasr some time ago) that Khamenei might not necessarily appreciate the President’s confrontational approach which might explain some of the subtle and not so subtle promotion of his rivals. The latter may also be an attempt to manage squabbling factions.

This note though focuses on Iran's economy.

State of Iran’s economy

Economic policies are a weak point. Iran is one of few oil-exporting countries where economic conditions are worse, with slowing growth, inflation– low real interest rates triggering asset boom (property). Unemployment is high (over 20%?) Wage rates are not rising and to counter inflation, Iran uses a extensive system of subsidies.

Sanctions are having an effect on Iran’s trade and investment. Iran has had trouble securing letters of credit for energy exports. but oil revenues are offsetting some of the pain as has the ability to circumvent some but by no means all of the restrictions. Yet some analysts suggest that the need to shift financial transactions to back channels might add in part it is shifting trade away from Europe to Asia. China topped Germany as Iran's largest supplier last year.

And there are plenty of countries interested in investing in Iran - negotiations with Russian, Indian and Chinese companies are in the works. though several obstacles remain. and even Chinese banks reportedly cut ties with Iranian banks.

It has also cut trade and savings in dollars - it no longer accepts dollars for oil trade and the dollar apparently makes up only 20% of its reserve stock.

Iran’s fiscal policy has been expansionary from the beginning of the oil boom. In part this could be explained by simple population ratios. Iran has a larger population than Saudi Arabia but produces half the oil – and exports even less. Oil exporters with lower oil to population ratios face more spending pressure. Its no surprise that countries like Kuwait with some of the highest hydrocarbon per head ratios have been among the most abstemious. In fat more recent budgets have been spending even more. the most recent budget calls for spending $65 billion of the oil revenues rather than the $15b which is apparently allocated in the five year plan - as one of the presidents supporters turned critic attests.

Iran’s spending has been reined in somewhat by the lessening of gas imports, though it has perhaps only been reallocated. In 2006, domestic production accounted for only 60% of gas needs, making Iran's import bill balloon as it was forced to import supplies at rising global prices. In mid 2007, Iran introduced rationing and ever so slightly raised the price (it is still the third cheapest in the world. So far, imports do seem to be falling – though smuggling of the still cheap fuel continues. Iran of course is not the only country so restricted. Disruptions of pipelines and refineries have lowered Nigeria’s net oil imports and required it to import gas. All the more reason that any plans for developing Nigeria’s oil and gas sector insist upon a) capturing some of the gas that is flared off and b) ensuring that a significant share of gas is reserved for domestic use.

In the 1990s, Iran was able to boost its non-oil economy though and trade in non-petroleum products has increased. The IMF notes in a paper that the Iranian rial’s depreciation accompanied by emergence of the non- oil sector has been expansionary). But oil accounts for the vast majority of oil revenue. Like in several other countries, the availability of oil rents has meant a lower reliance on tax revenues.

One of the more remarked upon economic policies of mid 2007 was the decision to cut interest rates charged by the banks and other private lenders in April. Differences over monetary policy were one of the reasons that the central bank governor was replaced. Recent reports suggest that the government may stop cutting interest rates – allowing the banks perhaps to stop losing money. A property bubble - fueled in part by very negative real interest rates adds to inequality as many Iranians are unable to access housing. The FT suggests that this very bubble and the ability to flip apartments (prices have doubled in the last two years) are benefiting the elites. But Iran is not alone as a oil exporter suffering from high inflation triggered by supply constraints, negative real interest rates and rising global food prices (GCC countries, Russia, Central Asia face a similar conundrum)

UPDATE: Recent IMF data (hat tip the Economist Intelligence Unit) show a dramatic drop in Iran's money supply and Iran's net foreign assets from March to April 2007. Over a one month period, Iran's money supply dropped by as much as $35 billion and net foreign assets fell by almost as much. As seen below this drop contrasts sharply with the steady upward movement of Iran's money supply for the last few years.


Source: IMF International Financial Statistics

The April date coincides with the interest rate cut decision but while the interest rate cuts had the expected effect of further withdrawing funds from the money supply by shifting them from savings to the property market, the cuts only accelerated an ongoing trend - Iran's interest rates were already negative in real terms. Cuts just made them more so.

Similarly, the data show a significant drop in net foreign assets. The EIU wonders if funds were sent abroad in expectations of further sanctions. It was in March and April that Iran began pressing all of its clients to settle their oil trade in currencies other than the US dollar. In mid-2007, US stepped up pressure on foreign banks to cease doing business with Iran in dollars. By the summer German and Japanese banks had cut most ties - the Chinese did so later. Yet if Iranians and the state entities sent money overseas, it must have been sent through very opaque channels that did not register as Iranian assets. Either way it is a significant contraction - and it makes understanding the macro policy management even more puzzling. End UPDATE

Iran’s oil stabilization fund

Iran's OSF, created in 2000, receives oil revenues above a certain price point (rumored to be officially $39 a barrel) which are saved to reduce the effect of volatile inflows on the budget. As much as 50% can be each year loaned to private entreprenueurs in foreign exchange in sectors highlighted as a priority in the most recent five year plan. See Iran daily for how it could improve oversight, integration with the budget, transparency and governance – though it is unclear what it any of these guidelines it follows.

As one might expect, there is little information on the holdings, and management of the stabilization fund. Reports indicate Iran’s windfall has largely been spent. the IMF Article IV (2006) has some past estimates. The latest statement from the economy minister suggested that it had $7-8 billion in the fund at the end of 2007. Earlier in the year it had holdings of around $10 billion. Reports in the media have it bobbing around 10 billion for much of the last few years. It is likely that it receives and then spends a large share of inflows. Separate reports suggest that Iran’s central bank has around $60 billion in foreign exchange reserves, though this is not confirmed.

Spending the funds is not a bad thing – in fact investing to increase long-term productive capacity is beneficial in the long-run and helps promote diversification from oil. Also, it is not as if Iran could start a sovereign wealth fund to invest in companies abroad. But concerns have been raised that loans have been politically motivated -or serve to reinforce oil dependence.

So what has it been spent on?

Infrastructure projects including several refineries – which accounted for most of the $4.7b withdrawn in mid 2007.

Loans were issued to the private sector who had difficulty accessing credit.

Amuzegar worries that the speed at which the money was spent eliminated the chance for due diligence of projects and ensuring that they would serve the most good to the population. Instead he suggested big flagship projects are just reinforcing energy- guzzling that might not make a profit or employ many people.

He does agree that the fund should be a capital source for Iranian companies. Ensuring that it has available funds should the oil price sink, the fund could serve as a venture capital fund, supporting entrepreneurship.

Zahra Karimi suggests that a share of the fund should be allocated to seed employment creation schemes to reduce unemployment and the possibility of social unrest.

Iran is also seeking investment in its energy sector. In part difficulty in attracting investment is a result of sanctions – though not all foreign firms have been scared off. In fact global insight suggested that those firms bold enough to remain in Iran stood to benefit, but there are many obstacles and negotiations over pricing have stymied some discussions. Rising domestic demand and plateauing supply mean that Iran’s oil output could become a limitation to domestic development - Stern had suggested that rising domestic consumption and falling output could erase Iran's oil exports in the near future - a strange outlook for a country sitting on large oil reserves.

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