The currency market has many players and it is considered one of the most efficient markets in the world. When the value of a country’s currency decreases unexpectedly, the production sector of the economy has to endure higher prices of imported inputs and higher costs of production. While many companies in developed countries use the hedging instruments available in the market to plan against such risk, many companies in developing counties lack access to such instruments since the financial market has not matured in their home country and their access to global financial markets is somehow limited. In such circumstances companies rely on government subsidies – either a direct production subsidy or a guaranteed exchange rate – against other major currencies in the world.
In Iran, like some other developing countries, the central bank makes foreign currencies available to importers at a pre-determined rate. Historically, Iran, like other oil-producing countries, has pegged its currency to the U.S. dollar in order to stabilize oil revenues in the government budget. Even though Iran had formally abandoned the peg in 1992, the evidence points to significant interventions by the central bank to manage the exchange rate relative to the US dollar. Like many developing commodity-producing countries, Iran shares high dependency on oil exports and exposure to external shocks. Moreover, Iran is highly dependent on imports and has maintained an informal relatively stable target of the rial to the US dollar to insulate oil resources from currency fluctuations. By fixing the exchange rate, Iran also guarantees the stability of their currency to gain investor confidence.
When a country fixes its currency against another currency, officially or unofficially, the country has to intervene in the foreign exchange market actively to keep the value on the pre-determined or target rate. Iran, like other countries with fixed exchange rates, has to hold a reserve of foreign currencies. When there is a downward pressure on the value of the currency, the central bank uses its foreign currency reserve to buy rial in foreign exchange market in order to prevent depreciation. Alternatively, they will sell their own currency in foreign exchange markets if market forces push the value of their currencies higher than their targets. In this case, the country will accumulate more foreign currency reserves.
Exchange Rate and Dutch Disease
However, when higher oil prices lead to higher oil income and consequently higher inflow of foreign currencies to the domestic economy, in the absence of exchange rate adjustment, the impact is absorbed by higher prices and inflation in the country. This phenomenon is known as Dutch disease. As a result, while nominal exchange rates are fixed, the domestic currency appreciates in real terms as domestic inflation increases compared to inflation abroad. Higher inflation not only leads to appreciation of real exchange rate and hurts competitiveness of Iran’s non-oil export in the global economy, but also creates high inflationary expectation among general public which feeds into even higher prices or hyperinflation. As we can see in graph 1, consumer prices and producer prices have increased continuously since the 1990s.
Graph 1: Consumer’s Price Index and Producer’s Price Indices for different Sectors of Iran’s Economy
If we look at the rate of change in consumer price index since the 70s, we observe that the inflation rate is increasing in Iran after a period of decline.
Graph 2: Inflation, consumer prices (annual %), 1976-2013
Bypassing Dutch Disease
To reduce the dependence on oil, Iran like some other oil producing countries has aimed at boosting the competitiveness of its non-oil exports. In order to keep the competitiveness of non-oil production and remedy Dutch disease, many oil producing countries including Iran has created wealth funds to accumulate an additional inflow of funds during high oil prices and use them when oil prices decrease. The wealth funds are expected to neutralize the impact of fluctuations of oil price on the domestic economy by keeping the extra flow of foreign currency to domestic economy during high oil prices and also by using it as a cushion during oil price and revenue decreases.
A policy of fixed exchange rates, when successfully implemented, creates investor and broader public confidence, but when it fails, it can lead to an economic crisis. Specifically, if the fixed predetermined value is substantially higher that market equilibrium, the country risks running out of foreign currency reserves which will lead to currency crisis. In the era of high oil prices and before the recent global financial sanction against Iran, Iran’s central bank had enough available foreign reserves to hold the value of rial not only stable but also above its long run trend that corresponds to inflation differentials among countries. As a result of appreciation of the rial against its major trading partners, Iranian industries lost their competitiveness in the global market. However, the truth is that while currency appreciation makes Iranian goods more expensive abroad, at the same time, it will make it cheaper to import raw materials and intermediate goods, taking away some of inflationary pressure of increased liquidity.
Government Policy and Inflation
Higher oil price and higher oil revenue increases government revenues and domestic liquidity, resulting in demand expansion and higher inflation. An increase in government spending has reinforced the inflationary effects of higher oil prices through higher demand for goods. When the government uses expansionary monetary policy to finance its deficit, and at the same time uses the foreign currency reserves to defend the fixed exchange rate, the public expects depletion of reserves and eventual currency depreciation in future, and that leads to further inflationary pressure.
Iran’s public consumption expenditure accounts for 11.2 percent of GNP in 2010. At the same time, the shares of private consumption expenditure and gross fixed capital formation of GDP are 41, and 26.7 respectively. Private investment is less than 50 percent of total investment, reflecting the high share of public spending on capital. The government size has fluctuated with the oil price, booming during periods of higher oil revenues and shrinking during economic stagnation. Higher government spending on subsidies, wages and salaries, as well as on goods and services is likely to exert persistent inflationary pressures. In contrast, spending aimed at relaxing capacity constraints will ease structural bottlenecks and mitigate inflationary pressures. The recent removal of government subsidies on energy has also increased prices, generating higher inflation.
Impact of International Sanction
In the past, Iran’s ability to access financing for trade and investment has been limited due to investors’ lack of confidence. While the poor domestic business environment has been the main reason for capital outflow and lack of adequate foreign investment, the sanctions levied against Iran by Western powers have also been a contributing factor. For example, Iran’s oil production is suffering from inadequate investment. However, in the past few years, when financial sanctions were enforced on Iran, Iran’s access to global financial market was reduced dramatically; in some cases access to Western financial markets has been completely eliminated.
When global financial sanctions made it difficult for Iran to access its oil revenue, Iran experienced a currency crisis that led to sharp devaluation of rial. The graph below represents the number of rials that can buy one U.S. dollar. Increase in the value represents depreciation of the currency. As we can see, whenever Iran’s central bank was not able to supply enough foreign currency to the market to keep the value stable, an informal market was created for the currency at a higher rate. Then, consequently, the government had to devalue the rial in order to remove the black market. As we can see from the graph, recently, because of the optimism created by recent negotiations on nuclear issues between Iran and western powers, the value of official and non-official rates are getting closer but are still well below the rate prior to the recent currency crisis.
Graph 3: Iranian Rial’s Exchange rate against the U.S. Dollar, 1978 – 2012
The impact of sanction is not the main reason for the currency crisis in recent years. While financial sanction made it difficult for the government to raise foreign currencies for its import needs as demand for foreign currencies surpassed the supply, it generated downward pressure on the value of Iranian rial. In order to successfully hold the value of the currency stable, the government should not monetize its debt. Doing so not only causes inflation, but also raises public inflation expectation and reduces the demand for domestic currency. In this situation, the public moves its assets away from domestic money toward foreign currency and puts downward pressure on the currency. In such circumstances, if the government has access to abundant foreign reserves which happened during the high oil price era, the central bank will intervene in the market by increasing banks’ access to foreign currency as much as needed until confidence is restored. During the financial sanction, neither of the above exists. While the Iranian government was not completely out of foreign reserves when the currency crisis started in September 2012, it was facing major decline because of financial sanctions imposed on its banking transactions with foreign countries since summer 2012.
Stabilization of Iran’s Rial
A sharp decline of the value of the Iranian rial since 2012 led to a surge of inflation. In order to stop the free fall of rial, Iranian government has implemented capital controls on one hand and also restricted availability of foreign currency at a preferred rate only to imports of essential goods. For everything else, importers have to rely on the free market where the value is determined competitively. By maintaining multiple exchange rates, the government has introduced more flexibility in the exchange rate. They are also aligning their domestic policies to restrain demand growth. Containing credit growth and government spending would limit excess demand and upward pressure on prices.
Even having a fixed exchange rate via government intervention may not be desirable; achieving exchange rate stability has tremendous benefits. Predictability of the currency value increases confidence of domestic business and foreign investors. However, in Iran, years of high inflation because of expansionary monetary policy along with the recent removal of government subsidies on energy have been the main driving factor bringing the economy to current crisis while recent financial section worked as a detonator. Public confidence was at its all-time low when government reduced its supply of foreign currency to the market.
Currently, the Iranian government is gaining public confidence in taming inflation, by attempting to reach an agreement on nuclear issues to remove sanctions. As a result, the value of the rial in the free market and the government-set rate are coming closer. If the trend continues, Iran’s central bank will be able to reduce the current restrictions in the currency market and Iran’s rial will return to a single exchange rate.
Dr. Ida A. Mirzaie is a Senior Lecturer at The Ohio State University
Kandil, Magda, and Ida Mirzaie, 2013, Is There a Scope to Capitalize on Exchange Rate Fluctuations? Evidence for Iran, published in Exchange Rates in Developed and Emerging Markets: Practices, Challenges and Economic Implications, 4th Quarter, Nova Science Publishers, Inc.
Kandil, Magda, and Ida Mirzaie, 2008, Comparative Analysis of Exchange Rate Appreciation and Aggregate Economic Activity: Theory and Evidence from Middle Eastern Countries, Bulletin of Economic Research, 60:1, 45-96
Mirzaie, Ida, 2012, Navigating Currency Fluctuations, Inside Supply Management, March
Source of Data: Iran’s Central Bank
 An increase in the value of the exchange rate means depreciation of Iranian rial
 Investment in machinery accounts for 11.4 percent while construction makes 15.3 percent of total share of gross fixed capital formation in 2010.