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Iran economy could limp along under sanctions

Iran economy could limp along under sanctions

With Iran's oil earnings possibly dropping and sanctions may cut GDP by 10 percent, can the country's economic diversity and self-reliance be enough to cushion the blow?

February 7, 2012 5:07 by

Hufbauer estimated that at most, the sanctions against Iran would cut its GDP by 10 percent. That is about the same impact as North Korea suffered, and below 20 percent for Iraq, he said.

With oil providing about two-thirds of government revenues, the sanctions will undermine Iran’s state finances. The IMF estimated Iran would post a budget surplus of about 2.8 percent of GDP this fiscal year; the fall in oil revenues, combined with a 10 percent cut in tax receipts due to a slower economy, could convert that into a deficit of over 2 percent of GDP next year.

That could be troublesome for a highly indebted government. Iran’s government is financially strong, however; general government gross debt is just 9 percent of GDP, compared to levels approaching 100 percent or more for many EU countries.

Iran’s low debt means it could easily finance much sharper deterioration in the budget balance through selling domestic bonds or other measures, said Raza Agha, Middle East and North Africa economist at British bank RBS.

“The public finance impact seems manageable in the immediate future given the bulwark of public sector deposits and other domestic financing options available to the government.”

It is in the link between Iran’s balance of payments, currency and inflation that the economy looks most vulnerable. The IMF estimated Iran would post a balance of payments surplus of $31 billion this fiscal year; the drop in export earnings due to sanctions could wipe that out next year or even push Iran into an external deficit.

Normally, Iran’s foreign exchange reserves could cover the deficit comfortably; the IMF estimated the central bank’s net foreign assets at $104 billion this fiscal year. Although the EU has said it will freeze Iranian central bank assets under its jurisdiction, Iran has had plenty of time to move its reserves out of Europe and other US allies.

But a surge in Iranian inflation is complicating the picture. The official inflation rate has jumped from single digits to around 20 percent in the past 18 months; analysts think the real rate is higher. The rise is mostly because of economic reforms which cut energy and food subsidies at the end of 2010, but also because sanctions make imports more expensive.

High inflation is adding a collapse of confidence in the Iranian rial, boosting its black market rate to above 20,000 to the dollar last month from roughly half that level a year ago.

That threatens to accelerate capital outflows from Iran, which the IMF originally projected at $11 billion this fiscal year, and deplete foreign reserves much faster than would otherwise have been the case.

It could also boost imported inflation further. Iran has shown it can operate with high inflation — the rate was above 25 percent as recently as the 2008/09 year — and since imports are worth only about 16 percent of GDP, currency depreciation will not necessarily boost inflation drastically. But there is a risk that in the minds of Iranian businessmen and the public, expectations for a weak currency and rising inflation will become mutually reinforcing.

After months of hesitation, Iranian authorities acted aggressively in late January to try to stabilise the rial, raising interest rates on long-term bank deposits as high as 21 percent from a range of 12.5-15.5 percent. That may have eased pressure on the currency for now, but the pressure may mount again when the EU’s oil sanctions kick in later this year.

“The currency crisis will probably continue. Ahmadinejad’s political aversion to high interest rates, and the high level of disorganisation and inefficiency in the government make a comprehensive policy response to the currency crisis unlikely,” political risk consultants Eurasia Group said in a report. (By Andrew Torchia)

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