Iran has witnessed a turbulent year in regards to the value of its national currency. Between March and October, the rial lost about 70% of its value on the open market, leading to inflationary impacts and economic instability. While it has regained some of its lost value over the past few weeks, there are uncertainties about its future prospects — especially as US secondary sanctions will continue to limit Iran’s access to hard currency. In the meantime, debates surrounding the budget bill for the coming Iranian year (beginning March 21, 2019) have produced some hints about planned government policies. One key aspect of this will be the potential exchange rate decisions within the next budget cycle.
Historically, foreign exchange rates in Iran have been a function of the global oil price, the country’s ability to generate export revenues, the feasibility of repatriating hard currency proceeds into the economy and the overall financial position of the government. This explains why the reimposition of US secondary sanctions led to such a collapse of the national currency. While the Iranian rial has been appreciating in the past weeks, some have opined that the debates surrounding government policies in the coming Iranian year will reverse the trend.
So far, the market has been consolidating around the exchange rate of 100,000 rials to the US dollar — a 30% appreciation compared to the rates that seemed sustainable in October. Interestingly, in the meantime, the difference between the rate on the secondary market and the open market rate is negligible, leading to a scenario in which exporters will have no incentive to sell their hard currency on the latter. A sustained consolidation of both these rates around 100,000 rials per dollar will create a sense of stability that the business community needs moving forward.
Another important benchmark in the Iranian economy is the government’s reference rate in the state budget. The likely ratification of the planned rate of 58,000 rials per US$ in the parliament would mean a 38% rise in the base governmental rate (compared to 42,000 rials per greenback in the current Iranian year). This rate only indicates how the Iranian Treasury’s hard currency income will be converted to local currency. So for now, the rate does not mean that the government will immediately devalue the rial’s official exchange rate; rather, it is an indication. The question that experts are asking is whether the government will have to adjust the official exchange rate — which is only used for the import of basic goods — in order to compensate for its emerging budget deficit.
It is not a secret that the current inflationary environment will explode government expenses with an expansion of budget expenditures by a minimum of 20% compared to the current Iranian year. Calculations indicate that the government will have additional expenses of about 300 trillion rials ($7.1 billion at the current official exchange rate). At the same time, oil export revenues will decline in light of lower export volumes. Assuming that the Treasury’s share of oil export revenues would also decline by about $7 billion, the government will face a gap of $14 billion compared to the current budget. It is also evident that a reduction of government spending and infrastructure investments would be counterproductive, as such moves would worsen the unemployment situation. Therefore, the Treasury needs to increase its revenues. The big question is how the government will fill the gap. The established pattern for all Iranian governments has been to increase other government revenues, i.e., taxes and duties as well as privatization proceeds. However, under the current circumstances, such steps would also undermine the potential for job creation.
This is why the most likely move by the government will be a devaluation of the official exchange rate, which would address the budget deficit but also produce further inflationary impacts, as the proposed budget’s dependence on oil revenues will be 27%.
A rate correction along these lines won’t fill the entire gap, but it will be a needed remedy.
Another approach is to adjust the level of payments to the National Development Fund (NDF). By law, 32% of Iran’s oil export revenues have to be paid into the NDF, but some members of parliament are already considering an adjusted approach in the next Iranian year. In quantitative terms, if the country generates $50 billion from petroleum exports, by law $16 billion will have to be transferred to the NDF. But if the portion of oil revenues that need to be channeled to the NDF is reduced to 20%, then only $10 billion will be paid to the fund — making up for some of the expected budget deficit.
Alternatively, in the past, an additional budget position had been created allowing governments to sell some of their hard currency at rates closer to that on the open market. This tool had been removed by the Rouhani administration to increase budget transparency, but now there are calls to re-introduce the mechanism to make up for some of the gaps.
All key players will now have to wait for parliament's final budget decisions. But the dilemma is nonetheless clear: Will they opt to devalue the official rate and accept the inflationary impacts? Or will they resort to other means that will either undermine business confidence or reverse budget transparency? While an official devaluation will be politically undesirable, economic and political necessities compel the authorities to reduce the gaps between the various exchange rates, especially to remove a platform for corrupt practices. Considering that job creation will be an urgent priority, the government will be careful not to undermine exporters. Evidently, the growth and sustainability of export activity is a function of the exchange rate. Indeed, recent rate developments have underlined that Iranian exports will be competitive at a rate of around 100,000 rials per US dollar. In order to close the gap between the official and open market rates, the official rate will have to be adjusted upward eventually. A likely scenario is thus that an adjustment will take place in the second half of the next Iranian year, i.e., toward the end of 2019, based on the assumption that calmer economic conditions would make inflationary consequences more manageable.
The inflationary impact will nonetheless remain strong, partly due to the fact that there is an expectation of rising prices in the coming year. In this vein, prominent Iranian economist Hossein Raghfar has opined that even with an exchange rate of 80,000 rials to the US dollar, inflation would reach 80 to 100% by March 2019. Evidently, the question is what basket of goods is used as the basis for inflation calculations, but the past pattern of the impact of currency devaluation on inflation in Iran underlines that there is not a one-to-one impact. For example, in 2012, when the rial also lost about two-thirds of its value, inflation stood at 32%. Therefore, a more realistic prediction for inflation at the end of the current Iranian year will be between 30 and 40%.
At the end of the day, respected experts — including Raghfar — agree that a large segment of the undesirable foreign exchange and inflationary developments are a function of mismanagement by the government and the Central Bank of Iran (CBI). If the relevant institutions use this latest episode of turbulence to reform some of the structural weaknesses, such as the CBI’s dependence on the government, ongoing imbalances in the banking sector and the budget deficit, Iran may come out of this episode structurally stronger. If not, future exchange rate developments will continue to be affected by opaque, politicized and inconsistent decisions.
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