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Aug 17, 2012 | 10:32 GMT

Iran's Sanctions-Driven Currency Crunch

Iran's Sanctions-Driven Currency Crunch
TTA KENARE/AFP/Getty Images
Summary

The European Union implemented a new round of economic sanctions against Iran on July 1. The move is part of an international effort to pressure Tehran into returning to negotiations on uranium enrichment and, more generally, to contain Iran's growing regional ambitions. The Iranian economy has been hammered by sanctions, including U.S.-backed measures. Iran's oil exports and government revenues have dropped, reducing the value of the Iranian rial by half and adding to Iran's chronically high inflation.

The sanctions are designed to prevent Iran from acquiring and using U.S. dollars and, to a lesser degree, euros, both of which are critical for any country participating in the international economy. The lack of access to dollars has contributed to the depreciation of the rial and led to higher costs of imported products and even higher inflation. Iran is attempting to cope with the challenge in several ways such as instituting a multi-tiered exchange rate system, restructuring domestic subsidies and setting price controls. However, Iran's countermeasures will likely exacerbate the country's economic problems, and Tehran will be forced to rely on its security apparatus to enforce unpopular economic policies as pressure mounts.

As a result of the sanctions, Iran's crude exports in June declined to their lowest level in 20 years. Oil is the primary source of U.S. dollars for Iran, and the export drop has consequently made paying for Iran's dollar-denominated imports more difficult. Though the government's foreign exchange reserves are sufficient to cover its immediate expenses, Tehran has taken steps to cut spending.

To restrain outlays, the government is reducing or restructuring domestic subsidies for gasoline and other essential goods. Subsidies play a critical role in maintaining public support for the regime, but they also generate inflation. High oil prices in recent years have allowed the government to use crude export revenues to mitigate the impact of inflation and indirectly pay for the subsidies. However, the recent drop in oil exports amid growing inflation has made that approach untenable.

Inflation has also reduced the value of the rial. Since August 2011, its market exchange rate has dropped to roughly 22,000 rials per dollar. Internally, Iran uses an official exchange rate (recently set at 12,260 rials per dollar) for select products, although the Iranian Central Bank on Aug. 5 announced another unspecified devaluation set for mid-August. In July, the state-run Iranian Students News Agency reported that Tehran will introduce a third exchange rate to deal with the inflation problem.

Under the plan, importers of essential goods such as food would have access to the cheaper rate of 12,260 rials per dollar, while importers of capital, intermediate and non-essential consumer goods would have access to a middle rate of 15,000 rials per dollar. Importers of luxury goods such as cars would have access to dollars at the market rate. In April, in an effort to ration dollars, Tehran banned imports off 600 types of goods that have domestic alternatives. Iran's intent is to balance between the shortage of dollars, which causes inflation, and the need to keep basic goods affordable for the population. This three-tiered exchange system effectively is an attempt to subsidize Iran's import of strategically important goods.

Venezuela's Experience

Iran is not the first country to implement a multi-tiered exchange rate in an effort to save hard currency reserves for essential uses. In 2010, Venezuela enacted separate official exchange rates pegged to the U.S. dollar for essential and non-essential imported goods. But Caracas had difficulty ensuring that savings on goods imported at the preferential rate were passed along to consumers. In effect, people exploited the system by importing goods at the lower subsidized rate and then selling the goods at the market rate. The practice, known as illegal arbitrage, negated the intended effect of the subsidies.

Illegal Arbitrage Activities in Iran

Illegal Arbitrage Activities in Iran

The multiple exchange rates failed to stem inflation while costing the government money to maintain them, so Venezuela had no choice but to strengthen price controls. The move contributed to a secondary dilemma: Price controls made it unprofitable for suppliers to meet overall demand, leading to shortages of essential goods. This fueled black market trade of the goods, pricing out the the poor and undermining the political intention of the controls.

While Iran has not yet experienced such shortages, reports have emerged of Iranian merchants taking advantage of the subsidized rate. In response, Tehran has begun imposing fines on shop owners caught selling subsidized imports at higher prices. The government has also seized diesel fuel, food and other items being smuggled out of the country where they command higher prices in currencies more resilient than the rial.

As the Iranian economy deteriorates and inflation continues to rise, Tehran will likely emulate Venezuela and impose price controls. However, with price controls in force, Iran's supplies of various goods could quickly drain leading to the emergence of widespread shortages. While consumers might tolerate high prices, fuel or food shortages could spark protests or other forms of social instability that Tehran wants to avoid.

The potential for social instability would force Tehran to rely on internal security organizations to enforce the economic policies. Iran's Islamic Revolutionary Guard Corps and Ministry of Intelligence and Security form the core of Iran's security apparatus. These groups are at the center of Iran's conflicts with the West, including the Strait of Hormuz and the Iranian nuclear program, and the groups already hold significant influence over the Iranian economy. Implementing unpopular economic measures may further distort the country's economy, but such a move could give the Iranian regime time to devise alternative solutions while protecting its domestic position.

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