Iran also ripe for change

Posted in Iran | 06-Nov-08 | Author: Hossein Askari| Source: Asia Times

An Iranian money changer holds U.S. dollars and currency with Ayatollah Ruhollah Khomeini's image in Tehran, Iran, Thursday, Oct. 30, 2008. The country has plunged into a bitter storm of recrimination, largely directed at President Mahmoud Ahmadinejad, as falling oil prices have hurt the Iranian economy.

United States presidents have understandably become gun-shy of dealings with Iran. Starting with Jimmy Carter, they have all had difficult encounters with the country. The 1979 hostage-taking at the US Embassy in Tehran defined Carter's presidency and cost him his re-election. President Ronald Reagan was preoccupied with US hostages in Lebanon and the bombing of the marine barracks in Beirut; both were blamed on Hezbollah backed by Iran. Reagan's presidency was also seriously tested by the Iran-Contra affair.

President George H W Bush oversaw the release of the last US hostage in Lebanon and indicated to Iran that Tehran's good will would lead to reciprocity, but he never followed through on the promise. President Bill Clinton tried all sorts of blunt sanctions to force Iran into submission, principally against the country's oil and gas sectors, but failed to get results. The outgoing President George W Bush worked with Tehran to throw the Taliban out of Kabul but went on to name Iran as a founding member of the axis of evil, where it now resides, its only remaining member; the others were Iraq and North Korea. Bush has also locked horns with Iran in Iraq and on the question of Iran's nuclear ambitions.

US presidents, not surprisingly, are increasingly hesitant to engage with Iran unless there is a relatively high probability of success. The initial attitude of president-elect Barack Obama, will, in all likelihood be similar. But Obama may be in a much better position than any recent president to succeed where others have failed - thanks to factors at play within Iran and the possibility that he might bring fresh insight, perspective and advise to the problems in dealing with the country.

Iran already has one strike called against it - it is on the verge of an economic implosion - and is facing a second and a third strike in rapid succession over the next six months. Indeed, for the first time since the early days of the Iranian revolution in 1979, regime change, more accurately a "velvet" regime change, in Tehran may not be out of the question.

If regime change occurs, it will be from self-inflicted economic failures, international economic developments and a thoughtful US response.

Strike one: Economic failure
Before the Iranian revolution, Iran's economy was heavily dependent on oil. Since then, an eight-year war with Iraq, low oil prices in much of the 1980s and 1990s, an influx of refugees, rapid population growth, US economic sanctions and ill-conceived policies have all adversely affected Iran's economic performance.

In addition to the heavy human toll, the comprehensive cost of the Iran-Iraq war was of the order of US$800 billion, amounting to about 60% of Iran's aggregate gross domestic product during the entire period of the war. As a result of regional conflicts, Iran became host to the largest population of refugees in the world, placing an added financial and social burden on the country.

Iran's economic performance continues to be determined to a significant degree by conditions in the international oil market. From the mid-1980s through 2003, oil export revenues were adversely affected by generally low oil prices. Yet when oil prices reached record heights, oil export revenues remained disappointing, due to declining oil output and to rising domestic consumption and smuggling of gasoline for export, both encouraged by low domestic prices that remain highly subsidized.
The inability of the United States to shape Iran's foreign policy has frustrated US leaders since the Iranian revolution. To show its displeasure and to further frustrate and keep pressure on Tehran, Washington has used indiscriminate economic sanctions as its weapon of choice, with limited effect.

Sanctions have served to reduce significantly foreign direct investment in the country, raised Iran's cost of capital and in delayed exploitation of Caspian Sea oil and gas. A second difficulty with regard to Caspian exploration has been Washington's efforts to generally reduce Iranian revenues by vetoing pipelines through Iran.

It is evident that these adverse developments, which were largely outside government control, have had an impact on Iran's economic performance. Yet the effects of Iran's own policies have arguably been the most detrimental.

In the immediate aftermath of the revolution, nationalization became widespread, reflecting the regime's political and social philosophy, continuing to the present day after much of the rest of the world has embraced privatization. The government created a number of new foundations to further its social and revolutionary agenda. These foundations manage the vast holdings inherited from the shah's regime, companies that were nationalized and private assets that were expropriated.

The foundations have had privileges and access to credit that have been denied to the private sector. Most of them operate outside government oversight and have at times frustrated government economic policies.

Under President Mahmud Ahmadinejad, enormous economic privileges have been extended to the Iranian Revolutionary Guards Corps. The guards have been favored for large government contracts and have received preferential tax treatment, especially with regard to import duties. The guards, though inefficient, are well on their way to becoming the single-largest business enterprise in Iran.

As is the case in the aftermath of many revolutions, the government attempted to improve working conditions by adopting restrictive labor laws and making layoffs costly. Indeed, under Iran's labor laws employers have to give workers lifetime employment contracts. Despite the government's best intentions, policies intended to protect labor have exacerbated the unemployment picture.

Iran does not have an efficient tax system and relies heavily on oil revenues to finance its expenditures. It is estimated that oil and gas revenues constituted over 75% of total central government revenues in 2006, with tax and non-tax revenues contributing the balance.

A modern government needs an efficient tax system to provide relatively stable revenues, a mechanism for effecting income distribution and a tool for macroeconomic management. In Iran, only government employees pay their complete income tax bill because the tax is taken out of their paychecks; the private sector does whatever is necessary to minimize its tax obligations and hardly anyone pays capital gains taxes. The absence of an effective progressive income tax and a capital gains tax have in turn been a major determinant of Iran's highly skewed income distribution, a large blot on the record of any revolutionary government.

Iran's economic shortfalls have been dramatically exacerbated by widespread and regressive government subsidies, and by administered prices. These were a legacy of the war with Iraq, but the subsidies have been continued for the sake of political expediency. The single largest subsidy, that for gasoline, was in the range of 11-22% of GDP during 1997-2006. Implicit and explicit subsidies typically have accounted for 15-25% of GDP.

In the 1990s, the Iranian government correctly realized that it needed to establish an oil stabilization fund (OSF) to cushion fluctuating oil revenues. Unfortunately, the government has not abided by its own legal terms for managing this fund. As a result, over the past three to four years, with record oil prices and at a time in which it should have built up the fund, the government has instead drawn it down.

While the government will no longer reveal the balance of funds in the OSF, by my estimate the current balance (at less than $20 billion) is lower than what was in the fund when Ahmadinejad took office over three years ago. Every major oil-exporting country has increased its level of financial reserves during these boom years, save Iran. Why?

Iran's macroeconomic policies over the past decade defy logic. With rising oil revenues, the Iranian government has increased government expenditures freely, resulting in inflation rates that have been in the 20-30% range and real interest rates on the order of minus 10-15%. At the same time, the exchange rate, although categorized as a managed float, has moved in a narrow range of about 10% to the US dollar.

Prices for imported goods have increased somewhat along with global inflation but prices of non-tradeables have increased at a much faster rate (with Tehran‘s real estate prices increasing by about 1,500-2,000% over the last 10 years), resulting in a highly overvalued currency and great damage to Iran's competitiveness.

The wealthy have gained beyond belief, through a real estate bubble that makes the US bubble look like a little blip. The wealthy have taken much of their capital out of the country, with oil revenues supporting their capital flight at an essentially fixed exchange rate, while the average citizen has suffered and received little benefit from oil depletion. Iranian citizens have essentially been fleeced. All along, the central bank has played an accommodating role (increasing credit by about 25-30% per year) as it has very limited independence from the government.

What is the result of these policy failures?

The most serious consequence of Iran's economic failure for the regime is an unemployment crisis. Over the last 10 years, Iran's unemployment rate has been in the range of 15-25% and is expected to become even more acute because of 800,000 new entrants into the labor force each year for the next four to five years, in an economy that may not create even half of the needed jobs to absorb new entrants and the increasing entry of women into the workforce.

The second serious consequence of Iran's economic failure is rapid inflation, which has been in the range of 15-30% over the last decade. If anything ravages the poorest segment of society, it is unemployment and inflation.

A third effect of government failure has been growing income inequality.

The fourth consequence is that Iran's financial reserves did not increase during the recent period of historically high oil prices. If oil prices continue their decline (see strike two below), then the regime in Tehran is in for the fight of its life. Iran would face a stark choice: impose capital controls (limiting people's ability to take money out) or allow the Iranian rial to float, possibly resulting in a rapid depreciation of 1,000 to 3,000% in the currency and inflation exceeding 50% per year. In either case, the regime would face an ominous political threat.

A fifth result of the government's economic failure is that the government has increased its dependence on oil revenues.

The sixth fallout of government policies has been capital flight on the order of $300 billion in the past six years to Dubai in the United Arab Emirates.

A seventh consequence, and the most comprehensive indicator, of failure is low per capita income growth. At the end of 1988, when the Iran-Iraq War had ended, Iran's real GDP was roughly what it was in 1977, and with a population growth of nearly 60% over the period since 1977, per capita real incomes had fallen by roughly 40%.

In the past five years, supported by oil prices that were until recently at record levels, GDP growth has been more robust, approaching an average 5.75% for 2001-2006. Still, even after these recent successes, real per capita GDP in 2007 was estimated to be about 1-2% below the levels of the mid-1970s.

As long ago as the end of the Iran-Iraq War (1988), Iran should have eliminated its subsidies, developed a just social safety net for the disadvantaged coupled with an equitable tax system, created a business-friendly environment embracing less restrictive labor laws and more flexible labor markets, embraced the rule of law, become credible in the eyes of its population to avoid social upheaval and reduce corruption.

Iran got a respite with the advent of high oil prices to embrace much-needed policies, but it did not act. It now finds itself between a rock and a hard place.

In sum, Iran can best be described as an economic basket case held afloat by oil revenues.

Strike two: Declining oil prices
What goes up must come down. Individuals caught in the euphoria of commodity booms, stock market, real estate and financial bubbles have a difficult time seeing beyond their noses. Iranian officials did not want to heed the warning that oil prices would fall and that people should really save during the period of high prices. The only question was how fast and how far oil prices would fall. Well, they have fallen from about $150 per barrel to about $60-$70 per barrel and they are expected to fall further.

With the global economy only now entering a recession, the demand for oil will drop further. The Organization of Petroleum Exporting Countries, as history clearly shows, will not be able to cut back exports to support prevailing prices. By my estimate, oil prices will fall to about $40 per barrel over the next year. How severe this will be for Iran will depend on how long prices languish at this low level.

If the length of the recession exceeds 12 to 18 months, a second strike will be called on Iran. The reason why Iran will be so acutely affected is that Iran has little or no access to financial markets, and its only source of external capital will be the International Monetary Fund. Iran will be reluctant to take this route, because Washington will be in a position to extract more than a pound of flesh given its influence on the IMF board.

If Iran tries to adopt policy reforms under these circumstances, domestic upheavals may follow. How can an Iran that did not embrace policy reform when it had room for maneuver adopt reform now when it means serious hardship for over 90% of Iranians? Under such circumstances, if the regime in Tehran wanted to be risk averse and maintain its hold on power, it would have little choice but to approach the US as a supplicant.

Strike three: A thoughtful US president?
Very soon after Iranian students took US hostages in Tehran, Carter froze Iranian financial assets in the United States. These sanctions were followed by a host of others imposed by the US. Most were blunt and ill conceived. They were imposed by people who had little appreciation for the workings of sanctions and little or no understanding of the Iranian economy, of economic policymaking in Iran, of the Iranian social system and the general circumstances of the country.

Many of the sanctions in turn adversely affected global, especially European, energy interests. Washington's desire for the United Nations to adopt such sanctions has also impinged on US foreign policy when it comes to China and Russia, while the Iranian hierarchy has largely, and rightly, dismissed the impact of most of the measures taken against the country.

The only sanctions that have made Iran scramble have been financial. Curbs on Iranian banks and the arm-twisting of financial institutions that do business with the country have taken a toll. The cost of letters of credit has gone up for Iranian businesses (when they can get them) and in many instances importers have had to pay cash, increasing Iran's cost of imports by around 15-20%. Moreover, the Iranian central bank has worried about the security of its own deposits; it has managed to survive up to now but uncertainties remain.

As bad as these financial sanctions have been for Iran, they are nothing compared with what could happen if Obama were to reject the "usual suspects" that previous administrations have listened to and instead goes outside the Washington Beltway to seek counsel from advisors who understand the workings of Iran and who can help him target Iran's economic and financial vulnerabilities. This could be a true game changer.

In the game of baseball, there are three strikes and you're out!

The lessons for the regime in Tehran are clear:
1. Immediately develop an economic and financial plan that assumes oil prices of $40 per barrel, with a clear eye and absolute commitment to urgent comprehensive economic and financial reforms. There is no time to waste. Get people who understand supply and demand on this project, not religious and political ideologues.

2. Be prepared to respond to thoughtful "sanction-like policies" that the new US administration might adopt - Iran should at least know its own vulnerabilities even if the US has not recognized them up to now.

3. Elect a president on June 12, 2009, who has little or no baggage, is thoughtful, intelligent and who could appeal to Obama and to the American people.

The regime in Tehran has taken a free ride for the last 20 years. It has put off needed economic reforms. As a result, the average Iranian has become dependent on wasteful subsidies and even then is still barely getting by, while a select few are amassing large fortunes, in the millions of dollars, in the hundreds of millions of dollars and even in the billions of dollars safely abroad.

A confluence of international economic developments and a thoughtful US president would severely test the regime in Tehran. Iran's leaders should keep a low profile, refrain from incendiary rhetoric and instead burn the midnight oil to come up with a viable economic, financial and social plan to face falling oil prices and a new American president.

The lowly forces of supply and demand and a new American president may achieve what the threat of mighty military force and high-profile economic sanctions did not achieve. In the end, Iran may no longer turn out to be the next US president's major foreign policy issue.

Hossein Askari is professor of international business and international affairs at George Washington University.