Tyranny of numbers

Living with lower oil prices

Posted in Macroeconomy by Djavad on April 8, 2009

Iranians are more likely to complain about the prices of cucumber and watermelon, but if you ask economists what are the two most important prices in an economy, they would say the exchange rate and the interest rate.  The exchange rate is the price that links Iran to the rest of the world, and the interest rate is the link between the present and the future.  If a government can get these prices right, it has done half of its job in economic policy. 

These two prices happen to be the two that are most wrong in Iran.  The rial (at present about 10,000  per US dollar) is highly overvalued and the interest rate (averaging about 15 percent) is well below where it should be.  Iran’s exchange rate has remained basically the same in the last five years while prices in Iran have outpaced prices in its trading partners by about 100 percent!  So, to keep Iran’s non-oil exports competitive, a devaluation of about 100 percent is needed.  The interest rates charged by government banks is about ten percentage points below the rate of inflation of 25 percent, making the real interest rate a whopping negative 10 percent, which is why banks are not inclined to lend these days. 

Iran has done seemingly all right with these rates being out of whack because abundant oil money has covered up over these (and several other policies) mistakes in the past.  But with oil revenues in 2009 (1388) expected to be about half of what they were a year ago, the problems with an exchange rate that makes Iranian goods expensive and foreign goods cheap and an interest rate too low for anyone to lend will soon flare up. Earlier this week I wrote in more detail about Iran’s adjustment to lower oil prices, and complained that presidential candidates have not said enough about their plans to deal with lower oil prices.  But do they know and are not telling us? 

No one knows enough– especially the government– about what these rates should be, which is why economists prefer to let the market –that is, people who actually deal with these things– to set them.  The first problem with this option is that many economists in Iran do not believe in markets, period, while others would say that these are too important to leave to the market.  You will find economists of both persuasions in the inner circle of all of the three leading candidates.  The second problem is that Iran’s government is de facto involved in setting both the rate of exchange and interest.  The former because it is the main supplier of foreign exchange to the market, so its expenditure decisions affect the supply of dollars and the rate of exchange.  And when the government does too much spending backed by selling oil dollars,  it causes the Dutch Disease.  

Regarding the rate of interest, the government is constitutionally and ideologically bound to eliminate it, which is not the same as setting it to zero, but prevents interest-based transactions.   This gives the state a large window for interference in the banking sector, through which Mr. Ahmadijead’s government has driven the proverbial truck.  Early in his administration, he announced that banks should lower interest rate, an order that government-owned banks –which comprise more than 90% of Iran’s banking sector– had to obey.     

A third problem is with the professional advice that the government gets about where these rates should be.  Among the 1100 economists that Mr. Moussavi plans to call for help with economic policy are many who actually prefer a lower exchange rate (cheaper dollars) as a way to fight inflation, and to help –who else?–importers.   Though the most sensible of Iran’s economists have pointed out the plight of exports under the current policy, no one of the presidential candidates has taken up the issue yet, and may avoid doing so as long as they can, fearing the wrath of  Iran’s middle class.  In recent years, the middle class is accustomed to the predictable exchange rate and the cheap dollar, which help it finance its appetite for foreign durable goods and pay for its children’s education abroad.

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10 Responses

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  1. Majid S said, on April 21, 2009 at 4:23 pm

    Thanks a lot for the interesting post and blog. I had e comment on the oil price prediction. I think there is factor that you are not taking into account. I remember I had the same discussion with Dr. Nili a couple of years back in Sharif U.
    I am a petroleum engineer working in Calgary, Canada. One factor that I have seen is sometimes forgotten is the fact that almost all of the major world oil reserves are in their decline period; in some cases it is a steep decline. The problem is that with a $50 oil outlook for the next 2 years, oil companies would not invest big bucks. As a rough estimate, I can tell you that for a 50,000 bbl/D project you would need to spend ~$1B and a 2-3 yrs EPC time. So, when the economic recovery comes, say in two years, none of the major oil producers (except for Saudi Arabia – in some extent) can open the valves and flow oil to the market since they have not invested much during the down-turn.
    Because of that, I believe we’ll see another oil price bubble in the matter of 2-3 years.
    Speaking about Canadian oil sands, as an example, they’ve shed ~$100B worth of development project and the current decline rate of the producing reserves is at least 25% per year.
    I would be happy to read your opinion on this issue.
    Thank you again for your interesting blog.

  2. dsalehi said, on April 21, 2009 at 9:44 am

    No, I do like your question. It helps clarify something important. What good are exports? The create jobs. Is something you are producing –apples, tomatoes, or a work of art–for which local demand is weak but someone abroad is willing to pay more, why not let them buy it? It would provide incentives for more production, more investment in learning and pay for someone’s medical bills, college tuition, or help pull a family out of poverty.

  3. Kaveh said, on April 21, 2009 at 12:14 am

    I predict that you will not like my question, but here it is: I agree that if goverment follows what you say about rial, then export will increase, but so what? Is increasing export the only goal of a goverment?

  4. hamid reza said, on April 19, 2009 at 3:48 am

    Number 1-Thank you for the blog and this very interesting post , But I think the main postulate of this piece is that the oil price will deppreciate more or at least will stay below $ 50 in the coming months.So if the prices goes up as some guys in GS and IEA suggest ,then the next goverment in Iran wouldn’t face these difficulties you say,and we will see the continuation of the same old trends i.e, Cheap Oil Money (COM) in the form of cheap dollars in exchange market ,Low Interest Rates (LIR) by the help of subsidised resourses of Gov banks and of course high inflation and and high unemployed throngs of youngs , and who cares about the last two ones as far as you can give’em access to the coffers?
    Number 2- You have tied the first part which is pure economic to the 2nd which is politics and I find it even more interesting. I think the main trend which energize other realms of Iranian Economy as well as politics is through oil revenues ,then if oil prices goes up there will be a replica of the same raising voices of populism ,the one we witnessed in the last 4 years .Then Mr.Ahmadi nejad can generously distribute more subsidised loans to low income poeple (of course by a loose supervisory policies on banks ).
    Number 3- If oil prices deppreciate or even stay constant in the same level of about $ 50 for a barrel then we will have some real problems and sadly for Mr.Ahmadi nejad and his circle it would be a signal for him to leave the podium .
    Despite of the reports of IEA or Goldman Sachs it seems the prices will stay there for a midterm period (untill 2010 or even 2011 ,the time guys like Paul Krugman imply as the first signs of U.S recovery from this recession).
    Thank you

    • dsalehi said, on April 21, 2009 at 9:49 am

      You are right about the future of oil prices, but I hope you are not right about its consequences. I hope we have learned something from the last four years. The price of oil going up much above 50 is a big IF. Guesses or wishes about higher oil prices is not a good reason to postpone the adjustment, which is to risk a more difficult adjustment down the road. I made some predictions about the price of oil in October, which unfortunately came true (www.brookings.edu/opinions/2008/1021_middle_east_oil_salehi_isfahani.aspx). My feelings about a soft oil market for the next two years have not changed since then. In addition, prices may recover some, but it may take another 5 years before prices reach anything close to last year’s.

  5. nassim said, on April 18, 2009 at 8:23 pm

    I have read your article a couple of time to understand it. But I am sorry to find myself so dense as to imagine that if you set a higher interest rate, you will increase the value of the rial. If the dollar can fetch 4% and the rial 25%, wouldn’t this have a countering effect to depreciating the exchange rate to 20,000 rls/$?

    Perhaps given that there is no “market” economy in Iran one could accomplish these two contradictory goals. Is that what you are assuming?

    Also, don’t the “sarraf’s” set the unofficial exchange rate? I would guess that they do, and as it is close to the government rate, I guess it is the natural rate for the circumstances.

    Of course, the government controls million dollar transactions, and the sarraf level of exchange may be anecdotal, usually in low thousands of dollars.

    Feel free to email me if your answer is going to embarrass me! Thanks.

    • dsalehi said, on April 21, 2009 at 9:52 am

      You point that higher interest rates in Iran are supporting a strong (and overvalued) rial is correct. The rates still are much higher than the government wishes them to be (I am glad that it has decided not to enforce its interest rate ceilings with credit rationing).

      In my post I was more focused on the lending rate however, which the government does control. There is a large gap between the official lending rate and other private lending rates that reflect, among other things, the high rate of inflation.

      Finally, sarafs do not set exchange rates; for the most part they are price takers.

  6. ali said, on April 18, 2009 at 2:37 pm

    Many thanks for the job you are doing and your pioneering website. I’ve got a question: what if depreciating rial leads to even higher inflation rate in this period of downturn in Iran? which one is more important at the moment: raising not-so-much great Iranian non-oil exports a little bit, or avoiding a very likely inflationary depression?
    thanks in advance.

  7. Hossein said, on April 10, 2009 at 1:06 pm

    Excellent, clarifying post. Just a question. Does trade policy, tariff for instance, play any role here?

    • dsalehi said, on April 11, 2009 at 12:20 am

      Thanks. Yes, trade policy can play a role. Raising tariffs reduces imports, which is superior to imposing import quotas. Several years ago Iran removed all non-tariff barriers –ie quotas– to trade, so the more likely policy option is raising tariffs. However, raising tariffs does not help exports, which a depreciated rial would.


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