The interplay between exchange rates and inflation in Iran

Over the past few months, Iran's national currency has regained some of the value it lost in 2018. In fact, compared with its lowest point against the US dollar (146,000 rials in November 2018), the currency has regained about 30% of its value. Nonetheless, the high inflation that was brought about by the collapse of the national currency has not eased yet and still hovers above 40%. This article will identify the impulses that are pushing up inflation despite the relative stability in the foreign exchange market. 

In general terms, there is a direct relationship between the devaluation of any national currency and inflation. In the case of Iran, based on the studies carried out by the Statistical Center of Iran, each time the rial’s value is halved, 14.7% gets added to inflation. Using the so-called free market rate of the rial, the mentioned exchange rate in November 2018 (146,000 rials) was 3.5 times that in November 2017 (41,000 rials), justifying an inflation of close to 50%. However, the exchange rate on Sept. 2 (about 115,000 rials) is 27% lower than that of November 2018, but there is no sign of an easing of inflation. In fact, the country’s annual inflation as of June 21 stood at 69.5% compared with annual inflation of 47.5% on March 20, the end of the last Iranian calendar year.

In other words, while the authorities have managed to strengthen the rial, they have failed to contain inflation. The question is what other factors are contributing to this high inflation, which is eating into the purchasing power of Iranian families. 

The governor of the Central Bank of Iran (CBI), Abdolnasser Hemmati, has said there is always a delay for prices to fall once they have gone up. Nonetheless, he said he believes the stability of the exchange rate will eventually lead to price reductions. 

What Hemmati has not explained is that the CBI and the government have failed to contain liquidity growth, which is one of the main drivers of inflation. The latest statistics show the country’s money supply grew 25.1% in the 12-month period ending June 21. 

Al-Monitor outlined the interplay between the underlying inflationary pressures (money supply, subsidy reforms, budget deficit and currency devaluation) in July 2017. The same factors are at play today when it comes to pushing up inflation in Iran, but one — subsidies on the importation of essential goods (food and pharmaceuticals) — needs more in-depth examination. In the wake of the foreign exchange developments in the past two years, the government has quietly but sustainably reduced the number of goods and products that receive the subsidized exchange rate of 42,000 rials to the US dollar. Hemmati referred to this policy in a recent interview when he pointed out that since the beginning of the Iranian year on March 21, the CBI has allocated $62 billion to imports of pharmaceuticals and other essential goods, where some is bought at an exchange rate 42,000 rials but the rest at the so-called NIMA rate, which is almost identical to the free market rate. This means that, in essence, many imports of essential goods have been carried out at an exchange rate that is more than double the official rate.

It is conceivable that the government and the CBI are gradually preparing the ground for a unification of the exchange rates. To reduce the shocking impact of a sudden adjustment of the exchange rates, the authorities seem to be engaged in a gradual reduction of the list of goods and services that are entitled to receive the lower exchange rate. Evidently this has an immediate inflationary impact, while potentially reducing the likelihood of a future hike in inflation.

The process of unifying the exchange rates has been socially and politically challenging, partly because some powerful stakeholders benefit from the differentials between the various rates. There are even indications that some governmental bodies have tried to take advantage of the uncertainties in the currency market in order to use the differential between the official and the free market exchange rates to fill the agencies' coffers during a period of challenging government finances. Basically, the currency market engaged in what is known as spread betting on exchange rates and the government used the CBI presence in the market to benefit from fluctuating rates. This type of activity points to another main driver of inflation, the budget deficit. 

As usual, the government is financing its budget deficit by printing money and increasing its debt to the CBI. Incidentally, in the 12 months ending June 21, the government’s net debt to the CBI has grown by 62%. This leads to a number of inflationary impulses that have contributed to the current picture.

While Iran is trying to regain some degree of economic stability, high inflation remains the key issue. On Aug. 25, Hemmati said on his Instagram account, “Stability in different markets and decline in inflation means that the economy is moving toward stability.” However, the “decline in inflation” is not visible yet and will require a more comprehensive policy approach, especially in containing money supply as well as the growing budget deficit. 

For now, the emphasis of the authorities seems to be on the exchange rates, potentially with a plan to unify the rates within the next year. The expectation is that the Iranian currency traded on the free market would further appreciate. Fatemeh Moghimi, one of the directors at the Tehran chamber of commerce, has said the exchange rate would eventually drop to 80,000 rials to the dollar. 

At the same time, one of the main upsides of the current valuation of the rial is its positive impact on non-crude exports — an economic phenomenon that the country needs to compensate for low oil exports due to sanctions. A further appreciation of the national currency would undermine the future growth of exports. Furthermore, experts have no doubt that the current level of inflation will further undermine the value of the national currency. As such, finding a new balance will depend on many factors. 

A gradual process of unifying the exchange rates is a welcome step that in the short term will increase inflationary impulses. At the same time, while the authorities are focused on finding the new and sustainable exchange rate, there is an urgent need to increase the purchasing power of Iranian families. As such, one can expect a new wave of distributive policies to address the negative impact of inflation on society. This in turn will put pressure on government finances. This is why the authorities need to have a comprehensive approach that will prevent a vicious cycle where inflation, exchange rates and the budget deficit reinforce each other.