Why Iran's Government Will Bear the Weight of U.S. Sanctions

13 MINS READNov 21, 2018 | 10:00 GMT
On the eve of renewed sanctions on Iran's oil sector, an Iranian protester burns a U.S. dollar.

On the eve of renewed sanctions by Washington, an Iranian man burns a U.S. dollar during a demonstration outside the former U.S. Embassy in Tehran on Nov. 4. The demonstration marked the 39th anniversary of the embassy's storming by student protesters in 1979, which triggered a 444-day hostage crisis.

(ATTA KENARE/AFP/Getty Images)
  • Iran's economy will enter a sharp recession in 2019, but Tehran can capably manage any political fallout that may follow.
  • Economically, Iran will emphasize prudent management and protection of precious hard currency reserves while boosting domestic investment through its public sector and trying to continue financial sector reform.
  • While it focuses on economic survival in the face of sanctions, however, Iran will make only limited progress on much-needed longer-term reforms, such as strengthening the private sector.
  • Iran's squabbling political factions will try to take advantage of the economic environment, but in the face of the crisis, they will work together to prioritize regime preservation.

Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Annual Forecast. These assessments are designed to provide more context and in-depth analysis on key developments in the coming year.

A year ago on Iran's black market, one U.S. dollar would bring 41,000 Iranian rials. Today, it would take more than three times as many rials, about 125,000, to buy a dollar. One year ago, Iran was free to export as much oil as it was capable of producing. Today, the United States has reapplied sanctions related to both Iran's oil exports, which provide about a third of government revenue, and its financial dealings. And while the White House has granted sanctions waivers to a few of Iran's oil customers, the waivers are only temporary, ensuring that Iranian oil exports will fall further in 2019.

To put it bluntly, 2019 will be disastrous for Iran's economy, perhaps even precipitating significant economic and social unrest, much like the start of 2018. But while the Iranian economy will bend under the weight of sanctions, they will not break the Islamic republic. Iran's leadership has a long history of dealing with sanctions and economic isolation, and 40 years of practice has made the government particularly adept at survival.

The Big Picture

Iran currently faces sanctions as painful as any that it has ever experienced, but the country's tolerance for economic pain remains high. So while the pressure of sanctions will eventually force Iran to negotiate with the United States, it will not feel the need to do so in 2019. But to cope, Tehran has chosen insulating its economy from sanctions over continuing overdue reforms, leaving many of the economy's long-term economic issues unresolved.

A Long History of Economic Pressure

Iran has faced some level of sanctions since the Islamic Revolution in 1979 spawned the lengthy hostage crisis that led the United States to break off most economic ties and implement sanctions. Over time, the U.S. sanctions have become increasingly complex, and increasingly effective at disrupting the Iranian economy. When Iran's fledgling nuclear program was uncovered, sanctions intensified correspondingly, culminating with the United States and the European Union piling on particularly debilitating penalties in 2012. Those penalties sent the Iranian economy into a tailspin, driving the growth in its real gross domestic product down by 7.7 percent.

But even that sanctions-spawned economic collapse was not enough to bring Iran to its knees for a few reasons that apply to its current situation as well. First, Iran had become adept at managing U.S.-imposed sanctions by diversifying its ties to economies beyond the West, including Russia's, China's and India's. Russia and China in particular lent Iran political support in helping it develop its economy to operate outside the U.S.-dominated global financial system. Second, while oil exports were an important source of government revenue, the country's economy possessed enough diversity to be able to withstand short-term pressure. Third, in the face of the sanctions by a hostile power, the government's appeals to Iranian nationalism bolster support among the populace. And finally, rather than the chance that the sudden onslaught of sanctions will send the country into an economic tailspin, it is Iran's larger structural economic deficiencies that pose its biggest economic risk. Sanctions can increase the economic drag caused by its structural problems, but Iran has thus far coped by taking pragmatic steps to work around sanctions pressure and offering piecemeal concessions to reduce their impact.

Dealing with a Financial Crisis

Sanctions will force Iran to continue to focus on coping with a financial crisis in 2019. The rial's collapse in value has already caused inflation to steadily creep upward. The International Monetary Fund estimates it could approach a 40 percent annual rate by the end of the year, a stark reversal of President Hassan Rouhani's achievement of reducing inflation to below 10 percent in both 2016 and 2017, its lowest levels in 25 years. The increasing scarcity of hard currency in Iran and the continued outflow of cash from the country will force the government to enact strict capital controls. For example, Iran is demanding that exporters repatriate foreign cash they receive in payment for goods in a more timely fashion. In addition, the country will implement other controls designed to keep supplies of hard cash and gold inside the country and under the control of the government, including instituting limits on the amount of gold or cash that individuals are allowed to possess.

A graphic showing the value of Iran's currency under the weight of U.S. sanctions.

These rules will be backed by stiff penalties. In August, Supreme Leader Ayatollah Ali Khamenei authorized the creation of special courts to deal with financial crimes. Several Iranians already have been sentenced to death for financial crimes. Sentences were carried out Nov. 14 for two of them, including a currency trader dubbed the "Sultan of Coins," who had been determined to have possession of two tons of gold. The imperative for Iran to maintain the rial's value and control as much of its hard currencies as possible is clear: While Iran possesses more than $130 billion worth of foreign exchange reserves, sanctions have put much of that off-limits to the government, with less than $50 billion thought to be accessible.

Iran must maintain its supply of dollars and euros, which allows it to keep the official (and subsidized) currency exchange rate low enough to control prices of essential goods and staples like medical supplies, food imports and the like, and reduce the danger that rising costs will trigger widespread unrest. After all, memories of the famed "chicken crisis" of 2012 are still fresh in Iran. In July of that year, the price of chicken tripled, driving street protests that shook the government to the point that it even limited the broadcast of images of chickens for fear of further inflaming social unrest.

Iran's economic growth strategy — and, for that matter, its strategy to limit economic contraction — relies heavily on two things: continuing oil exports and fighting unemployment by providing jobs in the public sector (much of which is funded by oil revenue). Iran will need to do everything it can in 2019 to maximize oil sales and the revenue they provide (or, more likely, the inflows of bartered goods that its oil customers provide in exchange). While the United States has granted sanctions waivers to some of Iran's oil clients, it has required most to set up escrow accounts so that cash from oil sales does not flow back to Tehran. That structure will force Iran to essentially convert its oil revenue directly into goods imports. Iran, of course, will continue its efforts to smuggle oil in exchange for hard currency as it did when it faced similar sanctions.

Despite its efforts, Iran's oil income will remain severely restricted. While bartering will be somewhat useful in providing Iran with the goods it needs, the country would prefer to have access to its cash and to the global financial system. But the United States has forced the SWIFT system that facilitates international transactions to cut off most Iranian banks, leaving only a few connected to process humanitarian-related trade, such as for food and medical imports. It's not likely that Iran will gain greater access to the global financial system, even if the European Union follows through with a promise to set up a special-purpose vehicle to circumvent U.S. sanctions for trade with Iran. Even if it materializes, that mechanism would be relatively ineffective because of compliance risk issues that will inhibit companies from participating lest they run afoul of the United States. Still, the ability to barter for industrial goods plus the limited SWIFT access will be important for Iran.

The Resistance Economy

Although the term was not coined until this decade, Iran's economic strategy since the revolution has been establishing what Khamenei calls a "resistance economy." To Iran, that would be a self-sufficient one capable of withstanding international threats and pressure. This theme will be a key part of Iran's economic strategy next year.

Iran will be forced to rely more heavily on its domestic companies, particularly ones owned by the state and parastatal entities like the Islamic Revolutionary Guard Corps (IRGC). When Rouhani was re-elected in 2017, he called for the IRGC to get out of business, but its companies — including construction giant Khatam al-Anbia — will be a crucial part of Iran's domestic development strategy as it tries to weather the renewed oil sanctions. Iran will rely on investment by bonyads — state-backed charitable trusts — and the public sector to offset lost foreign investment and to maintain some economic activity in key sectors.

One bright aspect of the sanctions, at least for Iranian economic restructuring, will be the reduced demand for investment by the oil sector as compared with what it would need to maintain production growth or high production levels. The government will therefore be able to shift money away from oil (including what it would spend on the associated costs of supplies such as steel and concrete) to either the export market or other industries where needed.

It will not be enough for Iran to develop a self-sufficient economy based on domestic industry, however, considering Iranian dependence on critical imported technologies. Iran does have a relatively robust auto-manufacturing sector, but it is not capable of producing many of the parts it uses in complex components such as engines and gearboxes, relying instead on imports. The scarcity of hard currency not reserved for food and medicine will make importing those parts difficult for Iran's industrial base. Moreover, the increasingly lopsided unofficial currency exchange rate — which those importers would use — is increasing the cost of manufacturing considerably. Tehran wants to fix prices of key industrial goods like cellphones and cars as much as possible to placate the powerful merchant and middle classes, meaning that manufacturers will feel the pinch.

Despite the measures it will take to protect its economy, Iran will enter a sharp recession in 2019, with gross domestic product expected to contract by about 3.6 percent next year.

Not only will Iran's economy continue to depend on foreign inputs, it is beset with many structural inefficiencies. Ironically, the renewed U.S. pressure will force Iran to respond by making legitimate structural reforms that will aid its economy in the long run. Even as former President Mahmoud Ahmadinejad's populist economic policies drained the country's reserves, Tehran implemented a number of reforms under his presidency to reduce public subsidies, remove price controls on goods like gasoline and privatize some key industries (though his political allies were largely the beneficiaries of those deals).

Considering Iran's previous actions under economic pressure, it can be expected to make wholehearted attempts at reforming some inefficiencies this time around. Unlike Ahmadinejad, who didn't value the advice of technocrats, Rouhani has tried to empower a team of economic experts consistently throughout his term. Even though his previous economic minister lost his job in October and the head of Iran's central bank was sacked over the summer, Rouhani has not replaced them with political appointees. Instead, he has used them as scapegoats, but allowed each to retain informal power behind the scenes while filling their positions with other technocrats.

One central focus of Rouhani's government has been on reforming Iran's messy banking sector. The estimated rate of nonperforming loans in the sector is a whopping 11.4 percent. And even that may belie the true problems with most loan portfolios because of the sector's lack of transparency. The reform push has several facets, including strengthening the central bank's powers to regulate the sector. Another controversial aspect has been passing four transparency laws to strengthen the country's compliance with international rules designed to combat money laundering and the financing of terrorism in order to get off the Financial Action Task Force's (FATF's) blacklist.

Rouhani has expended a lot of political capital on the FATF issue, but Iran's hard-liners feel that reforming the terrorism-financing rules will limit Iran's ability to fund its allies abroad like Hezbollah. The moves to increase transparency also will run into resistance from Iran's politically connected elites, who will try to protect the patronage networks they have amassed.

The Economy May Break, but the Republic Will Not

Despite the measures it will take to protect its economy, Iran will enter a sharp recession in 2019, with gross domestic product expected to contract by about 3.6 percent next year. Due to perhaps more technocratic management by Rouhani's economic team, the economic decline in 2019 could be only half of what Iran experienced in 2012.

Nevertheless, the government will have to contend with several acute economic problems: rising rates of unemployment among both youths and the general workforce; growing food and medicine scarcity; and spiraling prices. But Tehran possesses sufficient means of political and social control to stave off disaster. There will be protests, including some that may be widespread and significant, but the state security apparatus has enough tools to deal with them so long as Iran's notoriously fragmented political leadership remains unified enough to protect the system. Among other levers, the government controls Iran's cyberspace and its media, has a near-monopoly on force, and can push ideological messages to shore up public support. Iranians themselves also have a high tolerance for privation: The older generation recalls the 1980-88 Iran-Iraq War, while the younger experienced sanctions-related difficulties in 2012-15. Their tolerance for hardship will reduce the political pressure that the hard economic times will bring. There would need to be prolonged economic decline to drive fragmentation in the political and security systems' cohesion.

While Iran's political system will remain united in the face of the threat, behind the scenes, its members will all be jockeying for power. Iran is at a crossroads politically and economically, and its political factions will push competing visions of the country's optimal path forward. Rouhani has tried to lead the country toward more economic engagement with the outside world. His fellow moderates and reformists want to continue down that path — and many of Iran's pragmatic conservatives, including potential presidential contender Ali Larijani, see merit in that position as well.

The political currents in 2019 will be influenced by Iran's conservative and moderate factions as they position themselves for 2020 parliamentary elections, where the reformists and moderates want to keep their gains, while Iran's conservatives want to make a comeback. The faction that makes the most gains in those elections will have a leg up in 2021 presidential elections, putting themselves in position to lead negotiations with the United States.

Between Sanctions and Reform

For 40 years, Iran's economic strategy and its political system has oscillated between circling the wagons to deal with economic crisis — many induced by sanctions — and strong pushes for wider structural economic and social reform. Iran has many long-term challenges ahead, including growing unemployment among youths and its highly skilled workforce. It also struggles with low female labor participation and an underdeveloped private sector.

But in times of crisis, Iran can only make so much progress on repairing its economic structure — and often reverts to past practices out of pragmatic need, as it is doing currently by empowering the public sector. While the short-term sanctions-induced crisis won't break the Iranian political system, continuing to push off solutions to long-term economic problems could.

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