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Why Iran must seriously act to address rent seeking

While the top elites of the Islamic Republic are recognizing the need to address mismanagement of the Iranian economy, the core issue remains the rent seeking that is thwarting genuine reform.
President Hassan Rouhani speaks at the Iranian Parliament in the capital Tehran, on August 28, 2018. - It was the first time Rouhani had been summoned by parliament in his five years in power, with MPs demanding answers on unemployment, rising prices and the collapsing value of the rial, which has lost more than half its value since April. (Photo by ATTA KENARE / AFP)        (Photo credit should read ATTA KENARE/AFP/Getty Images)

The major economic downturn over the past few months poses the question of whether Iran will ever manage to exit the crisis mode within its economy. A number of remedies have emerged over the past few weeks to help decision-makers manage the current economic crisis. Yet there is a need to look at the core problem that has undermined sustainable economic development in Iran.

Recently, the Tehran Chamber of Commerce presented 12 strategies addressing the economic crisis, including the discontinuation of the lower exchange rate and an overhaul of foreign exchange and customs policies, a rationing of subsidized fuel and a new approach to protecting the lower income classes and liberalizing foreign trade, especially exports and imports of basic goods.

In August, a group of economists wrote an open letter to President Hassan Rouhani outlining the key issues in the economy. The economists offered a number of remedies and also underlined that the key issues are structural and the conditions have deteriorated due to the “public distrust in state institutions.” They pointed to the need for the government to reduce its role in the economy to that of a regulator as opposed to being a key economic player.

In May, internationally recognized economist Mohammad Hashem Pesaran advised Iranian decision-makers to focus on job creation through the promotion of “light industries, services and tourism” and also to create a competitive environment where the private sector can compete with semi-state institutions.

Another commentator, Nemat Ahmadi, also opined in May that fighting smuggling and the prevalence of dirty money would be the single most important strategy to reform the Iranian economy. He proposed that Iran could push back against dirty money by implementing legislation related to the Financial Action Task Force.

As can be seen, there are a number of macroeconomic and microeconomic remedies that are being presented. Incidentally, none of the current problems and proposed remedies are new to the discourse on the Iranian economy. The question is why past and present governments have never managed to address these issues efficiently.

The fact is, the Iranian economy has been subject to a set of spiraling vicious cycles that none of the governments have managed to get under control.

The first vicious cycle is the relationship between bank interests, money supply and inflation. As has been witnessed in the past five years, to control inflation, the authorities have to inject stability into the valuation of the national currency and gradually reduce bank interest rates. This set of policies succeeded in reducing inflation from 35% in 2013 to a single digit figure in 2017 under the Rouhani administration. However, low bank interests accompanied by political uncertainties and the threat of sanctions compelled Iranian society to look for other hedging mechanisms, migrating capital from banks to currency and gold markets. In response to the pressure on the currency value, the authorities increased the bank interest rates again, which pushed up money supply, put pressure on the currency valuation and led to higher inflation. Iran has seen this cycle many times over the past three decades — most recently this year, when inflation is projected to be above 23%.

The second vicious cycle emerges from instability in policies and the short-termism in economic decision-making. As explained in Al-Monitor in June, the push for quick gains and short-term economic cycles creates bubbles in the various markets and does not allow for medium- to long-term economic stability. Short-termism compels the authorities to control phenomena like inflation and foreign exchange rate through artificial interventions that backfire in the longer run. This is a serious governance issue and can only be resolved through structural reforms in how economic decisions are made and their implementation supervised.

The third vicious cycle is related to the government’s role in the economy. Since the initiation of Iran's first five-year plan in 1989, Iranian authorities have implemented privatization plans with the goal to reduce the size of the government. However, various studies have shown that the genuine private sector has not really benefited and that at best state assets have moved from the government to the semi-state sector. Now, the fact is that the state and semi-state sectors continue to seek rents in the complex market structure that is characterized by inefficiencies. These sectors secure the most lucrative economic interests for themselves at the expense of the real private sector. For example, the private sector’s need for financing is suffocated by the unrestricted access of state and semi-state sectors to financial resources, forcing the private sector to look for alternative capital markets at a much higher expense. This in turn leads to economic imbalances, especially unemployment.

No matter how one looks at the economic realities, rent-seeking activities and the resultant corruption are the core issues. All other challenges are a consequence of rent seeking. For example, the massive growth in money supply, which many have identified as the main cause of inflation and devaluation of the rial, is a consequence of an irrational growth in private and semi-state financial institutions that exploded the money supply by offering high interest rates on nonsecured saving accounts. It is also evident that the “public distrust” pointed to by the economists in their letter to Rouhani is a direct function of the level of visible corruption and mismanagement in the economy. Another example is smuggling. The latest statistics on the smuggling of subsidized fuel out of the country points to a staggering volume of 20-30 million liters of gasoline being smuggled. It is hard to imagine that this level of smuggling is happening without the complicity of some power centers in the country.

So, where does Iran go from here?

While the authorities will have no choice but to repeat the past pattern and engage in short-term remedies to address some of the imbalances, there needs to be a medium-term course of action. This course will have to recognize the governance issues, especially corruption and rent seeking and to create a more conducive business climate for private sector activity in Iran. Past experience has shown that this won’t happen as long as the government itself remains a key and unregulated player in the economy. Rent seeking elements within the power structure will always find reasons to expand their activities through direct or indirect government involvement, hence creating platforms for corrupt practices. The current multi-tiered exchange rate system is the best example for such a corrupt platform.

In a policy speech on Oct. 10, Supreme Leader Ayatollah Ali Khamenei confessed that the country’s problems had been caused by domestic shortcomings as well as sanctions. He then stated, “We need extraordinary efforts … to find solutions for those domestic economic challenges and to confront cruel American sanctions. Serious decisions should be made.” His reference to “serious decisions” seemed to hint at relevant reforms and the question is how far the Islamic Republic will go in structural and other reforms in order to exit the mentioned vicious cycles and present a sustainable path of economic development. There is no doubt here that the core issue is the fact that one is expecting the very authorities that have been penetrated by corrupt interests to come up with remedies to get rid of the same corrupt networks. Only time will tell whether this will ever happen.

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