The subject matter of this paper is "Iran Economy: Consequences of High Oil Prices", which fit within frame of "criticizing Iran’s economy". In this paper, we will focus on recent increase in oil price and analysis of the effects and consequences of this big change in international economy on Iran’s economy. Firstly, we will briefly review what has already happened in the international oil market. Secondly, we will present preliminary explanations about some economic mechanisms, which should be discussed to make the discussion more understandable. Thirdly, we will reach a conclusion about how increased oil price affects our economy.

In 1970s, the world witnessed remarkable increase in oil price. The first leap in global oil price pertained to 1973-74, which was a result of Arab-Israeli conflict. The next leap occurred as a result of the Islamic Revolution in Iran and subsequent war with Iraq in 1979-80. Afterwards, oil price fell moderately up to 1998, when oil price reached its lowest during those three decades; that is, the market witnessed the lowest oil price over 25 years that ended in 1998. However, oil prices increased again and, excluding inflation, they have currently reached the highest level over the past 30 years. Of course, if we include inflation rate and calculate places accordingly, the result will be somewhat different.

In general, recent developments in the oil market have only occurred once and in other instances fluctuations in oil price have not been such wide. These developments have greatly increased revenues of oil producing countries and we have also earned a lot of unexpected petrodollars through exports. OPEC’s annual earning through oil production from 1993 to 1999 stood at an average of about 150 billion dollars, which increased to about 230 billion dollars per year between 2000 and 2003. This figure rose to 380 billion dollars in 2004 and is expected to hit about 600 billion dollars in 2005. That is, OPEC countries are facing a great boost in their revenues due to current price conditions.

We aim to shed some light on dimensions of developments which are taking place in those countries as a result of increased oil price. If we compared the first six months of 2003 to 2003, we would see that revenue hike has been about 360 billion dollars in one and a half years and our excess revenues stand at about 47 billion dollars, with Saudi Arabia claiming the lion’s share of those revenues.

Part of those revenues is used in oil exporting countries and what is known as foreign exchange revenues is, in fact, the price of oil that those countries can export. Since OPEC members usually supply energy to their people through huge subsidies, therefore, energy consumption in those countries is constantly soaring. Of course, this is not the case for all of them. Nigeria is an example, where figures related to revenues and exports are very close while some countries like Venezuela or Kuwait have shown rapidly downward trends in this regard over the past few years. In the case of Iran, that part of oil revenues that was translated into foreign exchange revenues was constantly falling since early 1990s. The exception was concluding years of that decade when that proportion increased and the increase was owed to our limited refining capacity. Anyway, the trend has been generally downward. Overall, OPEC members have experienced good revenues in past years. The riddle is that why welfare situation in those countries does not match their revenues taking into account that per capita income in most OPEC members has been falling over a long period of time? (The exception is Indonesia which is different from other OPEC members and has turned into an oil importing state over the past 6 months because its economy is more similar to its regional neighbors and, as a result, its dependence on oil is lower and its economy is more diverse.)

The question, therefore, is whether the latest phenomenon in the oil market is positive, or negative? Perhaps this looks a strange question, because we generally want to earn more. We spend less than 2 dollars on every barrel of crude oil and earn over 50 dollars in return. What other business can be so profitable? Therefore, the question as to negative or positive nature of increased oil prices may not seem to be a correct one. As mentioned before, after a long period of downward oil prices, we have experienced a new surge in international oil price since the late 1990s. The question is "Can this phenomenon lead to activation of economic mechanisms, which will not be desirable under current conditions?" We will try to shed some light on this issue. What will be the consequences and effects of high oil price on our economy?

We must first refer to economic mechanisms before reaching a firm conclusion. First, we will explain four major mechanisms all related to the main theme of our discussion.

In 1984, we earned 12 billion dollars through selling oil and gas. The figure reached 18 billion dollars in 1990, 16 billion dollars in 1991, 16.8 billion collars in 1992, and 14.3 billion dollars in 1993.

If average inflation rate of a country is higher than the average inflation rate in countries which are its trade partners and possess a constant exchange rate, then that country will gradually experience increased demand for imports while its exports will lose competitiveness in international markets.

Let’s assume that foreign exchange rate remains constant at 800 rials over a whole year. We can even ignore qualitative differences between domestic and foreign goods and assuming that domestic products are of the same quality as their foreign counterparts. Let’s also assume that an imported television is worth 1,000 dollars and inflation in producing country is 2 percent while in our country, it is, in fact, 20 percent. In the first year, the television will be sold for 800,000 tomans inside the country and its price will be similar to the international price of the said television. One year passes and what happens is that the price of that television set would increase to 1,020 dollar in the country of origin due to 2-percent inflation rate there. At the same time, due to a 20-percent inflation in our country, its price will reach 960,000 tomans while price of the imported one will be 1,020 dollars or 816,000 tomans.

This shows that price of two television sets, which were similar in terms of quality and price at the beginning of the year has changed by the end of it because domestically made television set is worth 960,000 tomans, while the imported one is worth only 816,000 tomans. It is natural, then, for the consumer to buy the imported television set and this will threaten domestic television production. Many workers will lose their jobs, because their product cannot be sold in the country anymore.

Now assume that the same country exports carpets and uses the earned foreign exchange to produce television sets. Again, assume that its exported carpet is worth 300 dollars per square meter. At the end of the year, carpet price will reach 306 dollars per square meter (at an inflation rate of 2 percent). Inside our country, 300 dollars is equal to 240,000 tomans, which will increase to about 290,000 tomans at an inflation rate of 20 percent. If an oil exporter aims to keep his earning constant by the end of the year, he would have to sell his carpets at 350-360 dollars per square meter at international markets. Now, when Pakistani or Chinese producers sell their carpets at 306 dollars, the Iranian producer will prefer to sell his carpets inside the country instead of exporting them. As a result, our exports will diminish because our products lack competitiveness in foreign markets. On the other hand, competitive power of foreign goods in domestic markets will increase boosting likewise the demand for imports. The end result is that in a country which lacks oil, trade deficit is sure to happen. That is, if that country only imports television sets and exports carpets, as a result of what was explained above, people will be willing to purchase foreign exchange to import more television sets and demand for foreign exchange will increase. Therefore, foreign exchange rate will not remain constant and will increase to a level that will mean new equilibrium, just like what happened during the first year. This trend will go on in the following years. This means that if a country is dealing in ordinary industrial and agricultural items, there is a mechanism for correcting errors which will practically help the country reach a new equilibrium at a different level. Under the new equilibrium, foreign exchange rate increases tantamount to defense between two inflation rates (20 minus 2); that is, 18 percent. Therefore, foreign exchange rate should be increased from 800 tomans to make new equilibrium possible.

Therefore, considering logical trend, the foreign exchange rate should be changed equal to difference in domestic and foreign inflation rates to keep competitive capabilities at the same level. Interesting point is that many European countries establish punishments so that other countries will not increase their foreign exchange rates.

Now, if one of those countries enjoys a natural resource such as oil. That is to say all other assumptions are in place and only crude oil is added to them. The result will be that inflation will remain at 20 percent while foreign exchange rate remains constant. Under new conditions, demand also rises and exports lose in competitiveness and the only difference is that foreign exchange rate remains constant. Therefore, more pressure is put on foreign exchange rate and it rises. However, crude oil reduces that pressure and it is quite possible for error correction mechanism, which exists in other countries, to be absent here and as a result, that country may continue to make erroneous decisions without a reliable feedback to warn decision-makers. This is an important point, which explains why in our country decision-makers do not learn economic principles efficiently. Because learning occurs through effective feedback from realities and when those realities are covered by oil revenues, one cannot learn economic mechanisms in practice.

An oil exporting country may experience conditions when foreign exchange rate in that country takes an unnatural course. Foreign exchange rate may even decrease in the opposite to normal course. That country, therefore, will practically lose competition power with regard to its industrial and other products. Countries like Saudi Arabia, Kuwait, Qatar, and Venezuela, which are among the most important oil exporting countries, are not industrial states. Share of industry in Saudi Arabia is five percent and most of industries are oil related. Therefore, they will gradually lose competitive power. This situation is known as ‘Dutch Disease’ in economics. That is, a country that enjoys natural resources (which comprised gas in the Netherlands and oil in oil exporting countries) may lose its competition power in fields other than underground resources, and its economy will gradually become dependent on one product.

When inflation increases, our distance from international prices widens and in this way, we will again lose export markets.

A function for foreign exchange rate is that we have got to pay foreign exchange for importing needed goods; that is, foreign exchange is a means for transaction. Another function is that it can be used as an asset. That is, people can convert their deposits into foreign exchange, especially when inflation reduces parity rate of rial while dollar has gained in value in other countries. In fact, under these conditions, foreign exchange will not behave like ordinary commodities, but more like variables of capital market such as stocks. That is, foreign exchange rate may change with wide fluctuations.

Consequently, when people’s anticipation about future outlook of the stock market affects their current behavior, the same will happen to foreign exchange. If under special conditions, oil revenues are very high and it does not seem that oil prices will fall in the predictable future, then nobody will invest in foreign exchange because all know that Central Bank of Iran has a lot of money in possession and should foreign exchange rate increase, the Central Bank of Iran will powerfully oppose that trend. This is quite the opposite of what happened in our country in 1994 when foreign exchange reserves of the Central Bank of Iran had depleted and foreign exchange rate started to rise. People knew that the Central Bank was too weak to be able to reverse the rising trend of foreign exchange rate, and therefore, started to purchase foreign exchange. As a result, foreign exchange rate doubled in a few days.

Under current conditions, our country is experiencing opposing conditions in comparison with those years. When people are sure that foreign exchange market is secure and Central Bank of Iran has announced that foreign exchange rate will remain constant, there will be a downward pressure on foreign exchange rate. Even if the Central Bank of Iran does nothing to keep foreign exchange rate constant, the current conditions may still cause downward pressures on foreign exchange market. While inflation in our country is higher than other countries and demand for imports is higher than exports, foreign exchange can be a separate category and as time goes by, reduced competitiveness is intensified.

Let’s assume that the Central Bank buys foreign exchange from an exporter and sells that foreign exchange to an importer. Then the Central Bank will pay 800 tomans per dollar to the said exporter and takes it back from the importer in rials. The Central Bank works only as an intermediary in this case. For example, if oil prices increase from 30 dollars to 60 dollars per barrel, our foreign exchange revenues will suddenly double. Now, if the Central Bank purchases this surplus revenue from the government, it will give rials to the government and will purchase the surplus revenues to importers in dollar. The result is that, foreign exchange supply will increase and foreign exchange rate will be more prone to reduction without any change in the volume of liquidity.

There is also a second possibility; that is, the Central Bank may purchase foreign exchange without selling it to importers and keep it at its own coffers. In this way, money base will increase. That money will increase by about 3.7 times before it will reach the people.

Under conditions when Central Bank purchases more foreign exchange from the government, it will be offered with two options for either injecting it into the economy to activate the first mechanism and worsen unemployment, or keep the foreign exchange and inevitably increase inflation. On the other hand, when inflation is increased, the first mechanism is activated. When inflation increases, our distance from international prices widens and in this way, we will again lose export markets.

The process of the above three mechanism is that if the country’s foreign exchange revenues are increased, it should be either injected into economy, which will increase imports and reduce our competition power and exacerbate unemployment, or be converted into liquidity, which will exacerbate inflation. As long as we have no other place to use our foreign exchange, the situation will not be out of the said two conditions.

When the situation of oil revenues is good in our country, people’s expectations increase in parallel. Under that situation, people expect to witness improvement in their welfare status because when oil price falls, people are told that the government does not have enough money and they should wait until the situation improves. Therefore, when oil price rises, the public expectation is for improvement of overall situation. This will activate a mechanism in our political economy.

In a country, when an election is held every two years, oil revenues become a publicity tool for elections. That is, the government and those who want to garner people’s votes make promises. During past presidential elections, almost all candidates made promises above their capacities. All those promises were based on the analysis that there is a good revenue sources which can be expended. When the country is devoid of such a revenue source, they cannot make such promises because the people will immediately say that the money to fulfill those promises is to be collected through taxation. However, when taxes are not supposed to be increased, the mechanism which is activated in our politicized economy is that they make sweet promises about what is going to be done.

When oil price increases, governments usually expand in size and their expenditure increases as well. Under those conditions, more developmental projects are started, and sometimes salaries are raised. This clearly happened in 1976 and 1977. That is, after oil price hike in 1973, salaries of civil servants increased in 1976-77. The government also started a lot of investment projects. Therefore, state expenses usually rise under such conditions.

Another warning point is that since government’s expenses are usually related to big cities, shantytowns spread and population shifts from villages to big cities. As a result, surplus revenues resulting from high oil prices are circulated in big cities and this is what exactly happened in 1975-77. During recent years, this phenomenon has been repeating itself and statistics confirm it. We see embarrassing poverty in the outskirts of Tehran. Tehran enjoys the best welfare among Iranian cities. Therefore, this means that the governments spends its money in big cities and this is the main reason for spread of shantytowns around such big cities as Tehran, Tabriz, Isfahan, Shiraz and so on.

Taking all the above mechanisms into account, we will come to conclusion that with increased oil price, the country’s foreign exchange revenues rise and then, we will be facing threatening phenomena. Under such conditions, a group of mechanisms are activate which lead to reduced competitiveness, reduction of industrial activities and increased volume of liquidity, on the one hand, while giving rise to increased inflation, higher state spending, an oversized government, and unequal distribution of income, on the other hand. Many embarrassing events that hit newspaper headlines are spin-off of this vicious circle. If we handle this phenomenon passively, increased foreign exchange revenues may not be an auspicious event. These mechanisms are totally coordinated and can push us toward worse conditions because they will decrease competitive power of our products in international markets. In 1984, we earned 12 billion dollars through selling oil and gas. The figure reached 18 billion dollars in 1990, 16 billion dollars in 1991, 16.8 billion collars in 1992, and 14.3 billion dollars in 1993. Annual oil revenues have averaged 15 billion dollars after 1995 and it suddenly doubled in 2004 and hit about 36.5 billion dollars while the figure is expected to exceed 45 billion dollars during the current year. Accordingly, our imports stood at 37 billion dollars last year while average imports figure stood at 22-23 billion dollars during the years that we experienced the highest oil prices. Growth of liquidity hit 33 percent last year, which was one of the highest liquidity growth rates to be experienced in Iran. If those mechanisms are activated, we are prone to undergo worse conditions, which will not show themselves during the first year. Our per capita revenues will first rise before taking a nosedive and we will experience another period of reduced rates in the face of raging inflation. The Oil Stabilization Fund was meant to prevent this from happening. It was supposed to be a secure place which would prevent liquidity from expanding and foreign exchange from falling. Then it could be used to gradually increase foreign exchange revenues of the country. In practice, however, it failed to realize predetermined goals, because Article 60 of the Third Economic Development Plan Act, which pertained to Oil Stabilization Fund, was amended time and time again. The government withdraws from the Oil Stabilization Fund for any purpose. In fact, we are selling foreign exchange to the Central Bank, which will either be converted into liquidity or reduce competitiveness of our economy.