Iran's Exchage Rate Freeze:
Is it Appropriate? Is it sustainable?
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The Iranian government has managed to keep the exchange rate stable at around 8000 rials per U.S. dollar ever since March 2000. Looking at the history of exchange rate behavior this stability is a great success. This is by far the longest period of exchange rate stability after the Islamic revolution. However, in light of the government.s other economic policies and the current economic conditions, two important questions about the current policy of fixing the exchange rate against U.S. dollar must be raised. First, is the current exchange rate sustainable? And second, if the government has enough resources to sustain this rate, is it appropriate to do so?
What has made the current episode a success is that the central bank has been able to reduce the gap between the official exchange rate and the free market exchange rate to an insignificant level. The government achieved this goal by choosing an official exchange rate that was close to the free market rate in year 2000 (8000 rials per dollar). Ever since the Central Bank has continuously injected hard currency (dollar, euro, yen,..) into the exchange market to meet the public.s demand for foreign exchange at the official rate.
I argue that unless the government is capable of stabilizing the domestic economy and reducing the inflation rate, the current exchange rate policy is neither sustainable nor beneficial. When the government initiated the current rate of 8000 rials/$ in 2000, it simultaneously showed a commitment to reducing the government deficit and excess liquidity. As a result the inflation rate fell from more than 50% in 1994/5 to 11% in 2001. The stable exchange rate itself played an important role in reducing the inflation rate. Thanks to its high oil revenues in 2000-01, the government was able to provide more hard currency for imports and help stabilize the cost of imported products, which in turn helped reduce the inflation rate. However, the situation has changed in recent months and it appears that because of political pressures for job creation and opposition to reduction of government subsidies, the government expenditures and fiscal deficit are rising again. The growing deficits are causing the inflation rate to increase. By February 2003 the annual inflation rate rose to 17%. For reasons that will be listed below, it will be very costly if the central bank insists on keeping the exchange rate constant despite continuing high inflation rate.
In order to sustain the current exchange rate the government must be prepared to sell as much hard currency as the public is willing to buy at this rate. People and economic entities purchase foreign exchange primarily for two reasons: a) to pay for imports, b) to keep a portion of their wealth in hard currency. If government keeps the nominal exchange rate constant but fails to control the domestic inflation, the price of domestic goods becomes more expensive compared to imports and consequently the demand for imports will rise and importers will demand more dollars. At the same time, because of rising domestic prices, the costs of production will increase and lead to an increase in price of non-oil exports. This makes it harder for Iranian exporters to compete in international markets. The weak export sales of Iranian carpets in the past two years, offers a good example.
Similarly, when people feel that the government is unable to reduce the inflation rate they lose confidence in national currency and prefer to preserve the value of their savings by converting them into hard currency, gold or any other asset that will appreciate in value during inflationary periods. However, if despite the high inflation the government keeps the exchange rate constant and shows that it has enough reserves to continue this policy in the future, people have no incentive to convert their savings into dollars. Instead they channel their wealth into real estate, and other durable goods that are perceived to be inflation proof. (It is therefore no surprise that the price of real estate in Iran rose sharply in the second half of 2002 and the first quarter of 2003.)
The situation changes when people lose confidence in the government.s ability to preserve the exchange rate. There are many developments that can cause public concern. Lower oil prices could signal a decline in oil revenues and international reserves. Similarly an increase in trade deficit and international debt could increase the demand for foreign exchange and hence increase the risk that the government will not be able to sustain the current fixed exchange rate. Any of these signals could lead to a sharp increase in demand for foreign exchange as people and firms try to convert their assets into dollar before the government runs out of reserves and abandons the current rate. This anxiety itself will deplete the central bank.s reserves even faster, which, in turn, will cause more panic in the exchange market. This scenario has occurred several times in Turkey in recent years. Iran experienced this type of exchange market crisis in the second half of 1993, when despite injecting large sums of dollars into the free market, the central bank could not stabilize the exchange rate and was forced to abandon its plans for a freely floating exchange rate.
In light of the above explanations, and the current economic and political challenges that Iran is confronted with, the government.s insistence on keeping the exchange rate fixed at the current rate might not be an appropriate policy. Over the next two years the public demand for hard currency will rise sharply. The fixed exchange rate is partly to blame for this increase. First of all because of the continuing high inflation non-oil exports are becoming less and less profitable and government has to offer large amounts of export subsidies to compensate for the unprofitable exchange rate. Second, despite various restrictions, imports are on the rise. The import bill rose by more than $5 billion in 2002. Fortunately the foreign dept is still below $10 billion dollars but the debt has also increased in the past 12 months and according to the central bank the debt service (the annual repayment of principal and interest on current debt) will increase from $1.37 billion in 2003 to $2.47 billion in 2004. Therefore the demand for hard currency is on the rise.
At the same time the international price of oil is likely to decline by 20% in 2004. In addition OPEC might be forced to impose additional output cuts in reaction to the resumption of Iraq.s oil exports. As a result Iran.s oil export revenues might decline by as much as 20%-25%. Furthermore Iran.s international trade relations might be disrupted by the continuing U.S. hostility towards the Islamic regime. In order to modify Iran.s foreign policy and deny it access to nuclear technology, the United States might impose new sanctions on Iran and pressure other industrial nations to join in. Such sanctions will affect Iran.s exports, imports and prospects for attraction of foreign investment. In June 2003 the U.S. pressured Japan to withdraw from a $2 billion gas and oil development project in Southern Iran. The EU nations have also increased their pressure on Iran to accept more intrusive inspections of its nuclear facilities.
The Bush administration might go even further and try to destabilize Iran.s economy in order to put more pressure on the regime. In deciding whether to maintain the current exchange rate or allow for a gradual (controlled) devaluation, the Iranian policy makers must take these political and security risks into account. The hostile international environment implies that Iran.s economy will be highly vulnerable to external shocks to both its exports and imports. Most economists believe that a more flexible exchange rate will be more effective in protecting the domestic economy against such external shocks. For example if there is a sudden drop in oil revenues the exchange rate (price of dollar) must increase to reduce the demand for imports accordingly and encourage more exports. These changes will help prevent large trade deficits.
Some might argue that a fixed exchange rate is necessary to fight against inflation. As was described above, when the government is incapable of maintaining fiscal and monetary discipline (in other words controlling the liquidity,) a fixed exchange rate does not reduce the inflation rate. It only depletes the country.s international reserves, which will be followed by a sharp increase in price of dollar in the free exchange market. Currently Iran.s international reserves are adequate and there is still time for the government to either reduce the inflation rate or adopt a more flexible exchange regime and choose a more realistic exchange rate (11000-12000 rials per US$). By mid 2004 the economic conditions might be less favorable and it might be too late.
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