The fall of the Iranian rial: too much of a good thing?
In Tehran’s volatile currency market the rial fell to its lowest level ever today (January 2, 2012), the US dollar closing above 17,000 rials. The devaluation of the rial that started at a gradual pace over a year ago, and was largely expected and welcomed by economists, accelerated, going from less than 11,000 to around 15,000 rial per dollar in a matter of weeks. The additional fall in rial of about 10% in the last two days raises the question if the correction has gone too far. To answer this question one needs to have some idea of what is the right rate of exchange for Iran’s currency, something that you are unlikely to find in standard economics textbooks. There are two reasons why the market clearing price is not a good guide to the value of the rial: sanctions and oil.
Financial sanctions against Iran, which intensified this week with the signing into law of the latest bill by President Obama extending them to transactions with Iran’s Central Bank, essentially create a segmented market for foreign exchange in Iran. One market is for foreign currencies held in various accounts belonging to Iranian banks, and the other is for foreign currency notes or paper money. Because of the sanctions, there is demand for paper money for certain transactions for which dollars or euros in foreign banks are of little use. Iran has reportedly about $80 billion in bank accounts around the world, which it cannot easily spend. So, for most transactions people are forced to buy paper currency in the Tehran market, or buy it in Dubai and have it shipped in. For example, to send money to your daughter in Malaysia, these days you have to find a trustworthy traveler to take it for you because the Central Bank cannot make the transfer. So much for smart sanctions.
This market is relatively small, however, so its price can fluctuate rapidly. Some of the increase in the value of foreign currencies reported in recent weeks is probably of this kind, reflecting the tightening of sanctions. As more people in need of dollars enter this market — manufacturers in need of imported parts, parents needing to send money to their children studying abroad — the price can shoot up quickly.
So, the two-tier exchange rate system that has recently emerged is in part the result of sanctions, not Iranian government policy. It is therefore not to be confused with the policy-induced multiple exchange rate system that existed before 2000-2001. At least a part of the current gap between the official and the free market rate is because there are two types of foreign currencies, paper money and electronic bank accounts. The government has little control over this gap, unless it can find a way to bypass the sanctions and enable Iranian importers to use its holdings of foreign currency. We do not know what the equilibrium exchange would be if sanctions did not exist because we do not know the size of the market for paper currency.
The second reason why it is difficult to determine the right exchange rate lies at the heart of Iran’s oil-based economy. Roughly speaking, and ignoring capital accounts, in a normal economy the exchange rate reflects two productivities, the productivity of workers producing for exports at home relative to the productivity of workers in countries from which imports originate. Since in a balanced economy productivity in the export sector is close to the average level of productivity in the economy, the exchange rate reflects relative productivity levels in the two countries. So, if in one country demand for imported goods expands in line with increase in productivity, its currency need not depreciate; higher productivity would help pay for the additional imports because it would make the country’s exports more competitive.
But if exports are mostly oil or oil related products, this mechanism would fail to work. (Iran’s non-oil related exports amount to less than 5% of total exports.) The oil sector produces a lot of value with relatively few workers, as if these workers were much more productive than their fellow workers in the rest of the economy. But “productivity” in the oil and oil-related sectors such as petrochemical depends on the price of oil and on how much the government decides to extract from its reserves, two variables that have nothing to do with average productivity. The world price of oil is beyond government’s control, but how much it decides to extract (or more precisely how much of its oil revenues it decides to inject into the economy) does affect the exchange rate. The fact that governments of oil-exporting countries can influence the equilibrium exchange rate by merely selling more oil suggests that the textbook case of supply and demand is not all that relevant. The market for foreign exchange is dominated by a monopolist –the government — which has to decide on its oil exports and the exchange rate simultanously.
I do not know how one would go about finding the optimal level at which the government should set the exchange rate (by extracting more or less oil or by brining more or less of the oil money into the economy). But I do not need to know the optimal rate to know that, until a few weeks ago, Iran’s currency was highly overvalued. The oil boom of the last decade that brought $80-$100 billions a year in oil revenues prevented the rial from falling in value despite rising inflation in Iran. As a result, imports became increasingly cheap, undermining domestic production.
The figure below shows that while Iran’s price level was rising fast (the line in green) its exchange rate remained rather steady (red), causing the real effective exchange rate (EER, in blue) to increase; that is, Iran’s currency appreciated relative to the currencies of its main trading partners. Iran’s consumer price index more than doubled during 2005-2010 while the rial lost less than 15% of its value, causing the EER to increase by 50%. If we take these numbers as our main guide for deciding how far is too far for the rial to fall, 50% would be about right. This simple analysis then suggests a band between 15,000-16,000 rials per dollar.
This adjustment is long overdue and the impact of the real appreciation of the rial on the real economy has been quite severe. Because Iran’s economy is rigid and workers move slowly between sectors, the shock to the tradable sectors has caused loss of output and increased unemployment in tradable sectors, such as textiles. If the oil boom hurt Iran’s tradable sectors, can sanctions do the opposite by protecting domestic production from foreign competition? The answer is yes and no. Yes, because as Iran finds it increasingly difficult to pay for imports using its oil money deposited in foreign banks, and has to resort to barter and other special arrangements for tis import, domestic production will gain shelter from foreign competition. No, because much of domestic production depends on imports of intermediate goods, which will be also cut as a result of tougher trade conditions.
The fall in rial is just one part of this process of adjustment. As it falls it sets both forces into motion: the good (more protection) and the bad (costly inputs for industry and agriculture). To answer the question that I posed at the outset for this post more accurately — has rial fallen too much? — requires knowing which of these two factors is stronger.