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May 2006, No. 40


Economy

Liquidity growth in Iranian economy started at 20 percent, then it reached 25 percent, and later even 30 percent was accepted as ordinary.

Picture of Iranís Oil-Dependent Economy

Dr. Masoud Nili,
Senior Economist

To review Iranís economy at present and its outlook, many factors which have undergone considerable changes should be taken into consideration.

Seven factors are more important than others and taking account of them as a group is more important than studying every one of them individually.

The first factor is the approved budget for the current Iranian calendar year (started March 21, 2006) as the most important economic phenomenon which has been followed and implemented within frame of governmentís decisions. In better words, it encompasses governmentís programs from January 2006 up to the end of the Iranian year, 1385 (March 20, 2007). The first external policies of the government were reflected in budget supplement for the past Iranian year (ended March 20, 2006) and another part of them has been manifested in the current yearís Budget Act. The second factor is changes in liquidity and its effect on the domestic economy. The third factor is related to new policies on performance of banks and forceful determination of profit rate of bank deposits.

The fourth factor is nuclear policies and their effect on Iranís economy with the fifth factor being energy price and situation of energy consumption.

Governmentís policy in stabilizing prices is the sixth factor while the seventh factor is foreign exchange rate and its determination.

Perhaps, we better compare todayís conditions with the situation in 1974-77 because current conditions are very similar to conditions of those years. Before 1974, Iranís oil revenue stood at 1.5-2 billion dollars a year, which increased to 10 billion dollars in 1974 and to 20 billion dollars in 1977.

Therefore, the country was faced with rapid growth in oil revenues and Iranís oil earning quintupled in two years and increased ten times in less than four years. In reaction to revenue hike, governmentís budget increased by 3 percent, but further rise in budget in the following years was less steep. Historical experiences show that developments in relation to increase in foreign exchange resources are usually bigger than developments under those conditions. For this reason, it is generally believed that Iranís budget in 2006 is the most expansionary budget during all post-revolution years.

In 1998, average oil price stood at 10.8 dollars per barrel and oil revenues grew fourfold in about 7 years. Meanwhile, state budget in 1998 was less than 71,000 billion rials, but Iranís budget for 2006 has been estimated at 600,000 billion rials; that is, while oil revenues have quadrupled over a 7-year period, state budget has increased eightfold during the same period.

The effects of liquidity growth resulting from budget supplement of 2005 and Budget Act of 2006 along with such a high growth rate for liquidity will be very detrimental to Iranís economy

Before 2002, government spent an average of 15 billion dollars in foreign exchange. The figure increased to 21 billion dollars in 2003, to 30 billion dollars in 2004, and to 36 billion dollars in 2005. It seems that the figure will reach 45 billion dollars in 2006, which is indicative of serious budgetary dependence on petrodollars.

The Third Economic Development Plan aimed at reducing governmentís dependence on oil revenues to less than 12 billion dollars, but it actually soared to more than 40 billion dollars in 2006. Therefore, the governmentís budget experienced such a great leap in 14 months from January 2005 to march 2006, when the government was determined to offer Majlis with a budget supplement. Considering this reality, one can conclude that the country witnessed one of its biggest financial developments in the Iranian year, 1385.

Although the government justifies increased size of government under the aegis of increase in developmental budget, it should be noted that every rial of developmental budget in later years should be considered at a higher rate than one rial in current budgets and, for example, if a hospital is built through developmental budget, expenses on physicians, nurses, staff and other parts of the hospital would be supplied through current budgets. On the other hand, if developmental budget grows 70 percent, but production of cement and iron beams, which are needed to implement developmental projects, only increases 10 percent, demand for such goods will increase and lead to higher prices and runaway inflation. When price of capital goods increases, it will reduce investment by the private sector. 

Increased Liquidity: Like physicians who are attentive to blood pressure and temperature of their patients, the first thing which is focus of attention in economy is volume of liquidity. Average growth of liquidity in the world is about 13.5-14 percent, but corresponding figure in Iran is, unfortunately, very high and it has even crossed the red line during the past three years. However, the inflation rate has not yet moved proportionate to such growth in liquidity and this has prevented decision-makers to think of a solution.

Liquidity growth in Iranian economy started at 20 percent, then it reached 25 percent, and later even 30 percent was accepted as ordinary. Liquidity growth rate reached 36 percent in 2005 with the volume of cash hitting 900,000 billion rials. Once experts were worried about a 40-percent growth in liquidity, but now it has reached 50 percent and is expected to exceed 50 percent in the current year with the main reason being proposed budget supplement according to which 8-9 billion dollars of foreign exchange was liquidated into rial. Conversion of that foreign exchange to rials will have a great effect on growth of liquidity, part of which will be belatedly experienced in 2006. Therefore, the effects of liquidity growth resulting from budget supplement of 2005 and Budget Act of 2006 along with such a high growth rate for liquidity will be very detrimental to Iranís economy.

Under this situation, we get close to Saudi Arabiaís conditions. The difference is that liquidity growth rate in Saudi Arabia is very high, but inflation is near zero. The reason for low inflation is lack of industries which has made Saudi Arabia vulnerable to imported inflation. Since imported inflation is not higher than 2 percent, excessive inflation growth does not happen in Saudi Arabia.  

Banking System: Perhaps we better liken decisions made by the new government and Majlis and the current situation of the banking system to tsunami. For many years, profit rate has been a central discussion by the Central Bank of Iran and the banking system. In all those years, debates always focused on three major rates: profit rate, foreign exchange rate, and energy price, which have taken a converging course over the past years. Those debates are still in full force. Advocates of lower profits rates believe high profit rate to be the main reason behind lack of competitiveness in the country and compared Iranís profit rate to corresponding figures in such industrial countries as the United States, Europe and China where profit rate is below 10 percent. Undoubtedly, lowering profit rate of bank deposits will not encourage people to deposit in banks, but reducing profit rate of bank facilities will increase demand for loans and those facilities and increased demand will, in turn, lead to establishment of parallel markets and make those markets even bigger.

Proponents of the plan remind difference between profit rate of facilities and deposits and currently mention their problems, but they think that by putting pressure on banks and lowering profit rate of bank facilities, the banking system will be improved.

Banking system is the most competitive industry in the world; that is, if one bank fails to perform efficiency, its share will be immediately taken up by another bank while the reverse is true here. In Iran, people are dependent on banks and when they form long lines in front of banks before working hours begin, it shows that banks will have no problem with regard to customers and their work is guaranteed. Meanwhile, state-run banks are seriously dependent on rules and regulation and inefficacy is inherent to governmental banks.

Banking system is the most competitive industry in the world; that is, if one bank fails to perform efficiency, its share will be immediately taken up by another bank while the reverse is true here.

When profit rate of bank facilities is reduced, demands for those facilities will increase in parallel and the bank should report to applicants on its performance and should increase the number of its branches and staff to be capable of handling increased demand. Therefore, the idea that reducing profit rate of bank facilities will not harm depositors is not true. Iranian economy is based on economic rents and if we wanted to mention two major characteristics of such an economy, they would be firstly, oil and, secondly, banking system.

The different between value of money which is taken from bank and its value in the market, is high and that difference leads to rent seeking. If we coupled this factor with growth in budget and liquidity, which are the most important reasons for increasing inflation, rent margin will increase and this is the main breeding ground for administrative corruption in the country, which adds to number of those seeking economic rents.

Iranian nation still remembers the story of low-priced dollars which were apparently used to implement developmental projects. They still see unfinished barns along the roads which should have been completed many years ago.

This is what is called a populist approach to the issue. People can be attracted under such conditions in the short term because they think it will lead to expansion of justice. However, when government spends a lot due to increase in oil revenues, people will not pay attention to large-scale consequences of that spending. In fact, we can continue to attribute inflation to a group of inconsiderate people and, inflation remains a strange phenomenon just as is the case with the Iranian economy. At the same time, inflation has been eradicated in the world and there is no inflation in advanced economies. For example, Turkey which was grappling with an 80-percent inflation rate for years will have one-digit inflation in 2006 or South American countries which were suffering from several-thousand-percent inflation rates are now experienced one-percent inflation rates. Only five countries remain with high inflation rates and Iran is one of those countries. Unfortunately, most people think that the government is treating price hike in a physical and punitive manner.  

Energy Price: We will import 7-7.5 billion dollars worth of energy most of which will pertain to gasoline. Nowhere in the world, has a government bought 6-7 billion dollars gasoline because most of their needed gasoline is produced inside their respective countries. The whole foreign exchange revenues of Iran reached about 7 billion dollars in 1988, part of which was spent on weapons and the rest, which amounted to about 3 billion dollars, was spent on importing gasoline. Our current gasoline imports are tantamount to all foreign exchange revenues of those years. Some have proposed that new refineries should be built inside the country, which is not very different from purchasing gasoline, because Iranian oil refineries have low production capacities and, in that case, a large part of oil will be used inside the country to produce gasoline instead of being exported. In this way, countryís oil revenues will take a nosedive. 

Foreign Exchange Rate: Oil exporting countries are generally vulnerable to Dutch Disease. It means, when we are faced with plentiful resources, selling those resources will affect foreign exchange rate inside the country by reducing it. This will increase inflation and price of imported goods falls in the face of rising price of exports. Finally, we reach a point where we are currently standing: that is, we import oranges from Egypt and foreign chocolates which can be even consumed by low-income strata. As a result, domestic producers lose their profits. This situation will lead to where Saudi Arabia has already reached; that is, a point where domestic production of no commodity is economically justifiable.

At present, there are 12 economic indexes to be controlled by the Central Bank of Iran of which 11 indexes are in critical conditions and only one index has resisted in the face of calamity and that index is proportion of liquidity to Central Bank of Iranís reserves.

After unification of foreign exchange rate, domestic production became economical. However, this will only last for a short time after which domestic production will not be economical anymore, goods are imported in lower prices, domestic industry is stifled and housing and service sectors prosper. Therefore, such growth is like a balloon, which has been inflated asymmetrically, showing a ridiculous shape. 

Price Control: State-run companies have been barred from changing price of their produced commodities, but inflation is still rising. The government accounts for the lionís share of domestic economy and gross domestic product is dependent on the state-run sector.

Governmental companies are not able to invest through such a price control mechanism. For this reason, they resort to banks and take loans, which will deprive the private sector from bank facilities and drive them to the brink of bankruptcy.

I showed through a research last year that foreign exchange rate can be kept constant against growing liquidity up to a certain time, but it will get out of control sooner or later. At present, there are 12 economic indexes to be controlled by the Central Bank of Iran of which 11 indexes are in critical conditions and only one index has resisted in the face of calamity and that index is proportion of liquidity to Central Bank of Iranís reserves. Since Central Bank of Iranís reserves is enormous, nobody is purchasing foreign exchange.  This will be to the opposite of past years when everybody was buying foreign exchange and when Iran accepted UN resolution 598, foreign exchange rate fell by half in less than an hour and many economic activists had a heart attack. In case of new sanctions, the situation will become unsafe and increased inflation and liquidity will get the country close to crisis.

Therefore, sanctions should not be looked upon as merely mechanical changes. The spring which has been compressed for many years, will be suddenly released. At present, 12 levers have been employed in the country, which are moving against one another. We are moving toward challenge in our diplomacy, but our annual budget is being directed toward abundance of resources. As long as wages and salaries are increasing, on the one hand, while limitations are being imposed in other fields, on the other hand, problems will not be harnessed. In case of new sanctions, higher inflation and increased foreign exchange rate will be inevitable.

 

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