The Iranian rial lost 50% of its value in just the four months leading to the third week of July 2020. Certainly, this decline is nothing compared to the collapse of the rial vis-à-vis the US dollar in 2018-2019 when the rial lost more than 250% of its value. While sanctions and, in turn, the collapse of Iranian oil exports are seen as the main culprits in this continued decline of the Iranian economy and depreciation of the rial, we must not forget the other more important and persistent factors that have been responsible for Iran’s economic perils for decades. A primary factor is the absence of sound economic policy making based on solid economic theories and proven lessons from the economic histories of Iran and other countries.
Lawmakers and government officials in Iran repeatedly go back to the same set of failed economic policies that have been responsible for bringing the country’s economy to the brink of collapse over the past decades. Officials often dislike policies that require short-run sacrifices but are good for the health of the economy in the long-run, and instead favor populistic economic policies that are certain to harm the economy in the long-run but have some sort of small gains in the short-run. One example is the gasoline subsidies, which not only have been a huge waste of limited government resources but have also increased inequality in the country. Another instance of this policy mindset is the maintenance of an artificially high value of the Iranian rial by digging into the country’s limited foreign exchange reserve for a few years, only to then let go of the peg and allow the currency to collapse by hundreds of percent. This intense depreciation has happened several times in Iran’s economic history, dealing severe blows to the economy and market trust in the government’s exchange rate policies. Yet another example of an economic policy that has crippled Iran’s economy is the decades-long protection of the auto industry, which has managed to create a strong monopoly inside Iran and waste huge amounts of the country’s economic and financial resources. The list goes on.
Covering the Deficit by Printing Money
The monetization of the government’s budget deficit is the single most important factor for the fall of the rial against the USD and the high inflation rates in Iran. For the past year, the Iranian government has been running a deficit of around 200 trillion rials, or about $1 billion, on a monthly basis. Given the absence of a functioning debt market, the government has instead been borrowing from the central bank, which has little to no independence. This means that the government has been monetizing its deficit; in other words, the Iranian government has been printing money to pay for the gap between its revenues and expenditures. Economics 101 teaches us that printing too much money will lead to inflation which is the same as domestic currency losing its purchasing power vis-à-vis other currencies, goods, and services.
The Iranian government’s $1 billion monthly deficits is primarily caused by three crises: sharp declines of oil exports as a result of sanctions, declining oil prices as a result of the Saudi-Russia oil war and evaporating demand because of the pandemic, and the sudden and deep domestic and global economic contraction as a result of the pandemic. Over the past six months, it has sped up its printing money to cover this deficit. Hence, it is no surprise that after almost a year of stability, the rial has once again begun to free fall in the past four months from around 160,000 rial per USD to new lows of around 230,000 rials per USD. With the rial losing its purchasing power so rapidly, the US dollar and all goods and services are becoming more and more expensive, leading to overall actual inflation figures upwards of 50%. With Iranian economy contracting over the past year, such levels of budget deficits and high rates of inflation are posing serious threats to the long-run health of the economy and must be addressed immediately before inflation gets out of control and approaches triple digits. With higher inflation rates, the government’s budget deficit will only widen further, forcing the government to print even more money and leading to a vicious downward spiral toward hyper-inflation and a deeper economic crisis.
Time is of the Essence: Iran Must Act Now
What can the Iranian government do to stop this downward spiral? While there is no silver bullet, the government must try to implement a few simultaneous and mutually supportive strategies to buy more time until it is able to enact major structural changes in its economy. One such strategy is for the government to cover most of its deficit by borrowing in the bond market. Until a few months ago, Iran did not have a bond market for the government to go to finance its deficits. Recently, a primary bond market emerged and the government has been able to sell around $1 billion of bonds to Iranian banks. However, because of low interest rates on these bonds (around 15% while the actual inflation is on the upwards of 50%), long-term maturities (one to three years), and lack of secondary markets (these bonds cannot be sold in the market to other buyers), Iranian banks and financial institutions are not showing much interest in purchasing the government debt. To make the bond market more attractive, the government needs to offer bonds with short-term maturities to reduce their risks (such as three months and six months), increase the return (at least equaling that of inflation rate), and create a secondary market where bonds can be bought and sold in the market.
Second, the government needs to cover all or at least a portion of its deficit by improving its tax collection system. Positive steps have been taken in this direction but tax evasion in Iran remains estimated to be about the size of the government’s budget deficit, and the tax evaders are mainly from the higher income groups. Hence, not only can a more effective tax collection system substantially improve the finances of the government, it can also help in reducing inequality and promoting economic justice in the country, issues that are threatening its social fabric. In addition to this, the government should continuously look at its expenditure to reduce wastages and run a more efficient operation.
Third, the government needs to tackle the wide-spread systematic corruption. Corruption has become a pandemic at all levels of the Iranian governance structure, eroding the trust of economic actors in government policies, and has been costing the economy upwards of tens of billions of US dollars. Without effectively addressing corruption, other issues such as tax evasion, smuggling, inefficient monopolies, and many other economic ills and harmful policies will continue to exist.
The hyper-inflation cases of late 2000s-Zimbabwe and recent Venezuela are clear examples of what could await Iran’s economy if lackluster growth rates and monetization of budget deficits continue for a few more months. There are various efforts by the government and the central bank to change the current course. The success of these efforts hinge upon many factors but one thing is certain: if these efforts are not successful and the economy continues on the same course, Iran is running the risk of turning into another case of hyper-inflation that economists will refer to alongside Zimbabwe and Venezuela.
Amin Mohseni-Cheraghlou is an assistant professor in the Department of Economics at American University in Washington, D.C. He has also taught at the University of Tehran in the faculties of Economics and World Studies. His areas of expertise are Development Macroeconomics, International Political Economy, Economies of the Middle East and North Africa (MENA), and Islamic Economics and Finance. A research consultant for the World Bank Group since 2007, Amin writes frequently on topics related to development economics and economies of the Gulf and the MENA region. He holds a Ph.D. in Economics, an M.A. in International Development, and a B.S. in Electrical Engineering.
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of Gulf International Forum.