Tyranny of numbers

The anniversary of the subsidy reform, on December 20, 2011, arrived with fireworks, but not the kind the government had hoped for.  In a day that President Ahmadinejad was addressing a conference of the first anniversary of the subsidy reform in Tehran, the rial fell by more than 5%, breaching the psychological 15,000 rials per dollar barrier.  These two events are more than coincidentally connected.  The rial has been weakened by the inflation unleashed by the subsidy reform, a cost of the reform that was both foreseen and justified.  At the same time, the precipitous devaluation of the rial adds to uncertainty and macroeconomic instability that can undermine the subsidy reform.  The real benefit from the reform derives from reduced demand for energy, which can only happen if households and firms are willing to change their behavior and invest in energy saving equipment, which in turn requires confidence that the post-reform energy prices will not be washed up in some cycle of inflation and devaluation.  Remember, unsubsidized energy prices are equal their world prices multiplied by the exchange rate.  With 15,000 rials to the dollar, gasoline (at 4000 or 7000 rials per liter) is 50% cheaper than it was a year ago when the new price was set, and is once again subsidized.  

It is not as if Iranians are living in calm times.  There are threats of war, deepening of sanctions, and very strange behavior from the monetary authorities to contend with.  The Central Bank governor, Mr. Bahmani, was recently quoted as saying that he had “ordered” the reduction in prices of gold and foreign currency.  Before ordering so he had engaged in selling the same things cheap in order to lower their market price.  It does not take a genius to figure out that if the Bank is selling from a limited stock, every day selling diminishes its stock and therefore its ability to continue.  After weeks of fighting the speculative windmill, the Central Bank governor sounded a serious tone by acknowledging that with low real rates of interest (that is nominal rates some 10 points below the rate of inflation), it is very difficult to restrain asset price increases.

There is method in the madness of the rial gyrations.  The instability in Tehran’s foreign currency market is in part the result of past inflation that has gradually pushed rials out of alignment with other currencies.  Iran’s price level has jumped by about 50% in the last two years (despite price controls during the last 12 months) while the currency hovered around 10,000 rials per dollar.  This has made foreign goods cheap in the Iranian market and Iranian goods uncompetitive at home and abroad.  Local businesses were suffering from real appreciation (caused and financed by rising oil money) even before subsidy reform added fuel to the fire by raising inflation.   Parity between rial and foreign currencies is thus long overdue.  So a 50% devaluation, which has occurred with the dollar hitting the 15,000 mark, a previous wrong has been put right.

The subsidy reform was expected to worsen this imbalance in the short run by increasing inflation.  However, in the long run it can help.  Higher energy prices should encourage producers to adopt technologies that use less energy and more physical and human capital, which would boost productivity.  The cure for the worsening of the competitive disadvantage of Iranian producers as a result of higher energy prices is depreciation of the rial, provided that it takes place in an orderly fashion and does not add to uncertainty and macroeconomic instability.   The vents of the past few weeks have been anything but orderly.

The subsidy reform has survived its first year, and in a better shape than its critics were willing to admit.  Of all the programs introduced by the Ahmadinejad administration — marriage loans, quick returns projects, and low cost housing — this is the one that is most likely to outlast him and for which his administration will be remembered, at par with the reforms of the first Rafsanjani administration (1989-1993).  The latter hit the foreign exchange crisis of 1993-94 that forced President Rafsanjani to abandon his programs of economic reform during its second term.  Luckily, Khatami’s administration that followed (1997-2005) picked up the reforms where they had been left off, especially the reforms of the foreign exchange markets, banking. and foreign trade.

Saving the subsidy reform from the current turmoil should be easier because this time oil prices are high and at least this time the government is not broke.  But reliable information is in much shorter supply.  Governments tend to fight speculation by suppressing information or — worse — by supplying misinformation.  These tactics do not work well when investors are sophisticated and information flows fast.  Speculative bubbles are by definition the creation of bad information, rumors backed by no reliable data other than asset prices themselves.  While it is not at all clear to me that asset prices in Iran represent bubbles, or otherwise are unhinged from market fundamentals, I am willing to bet that reliable information about those fundamentals would calm the markets by reducing uncertainty rather than make them more unstable.  I also know that selling assets cheap or ordering their prices to go down is not what inspired confidence.

The government needs to come clean on the facts about the economy (publication of crucial data goes back to three  years ago), how external sanctions are affecting the economy and what it plans to do about them.  In terms of actions, unfortunately the government does not have all the cards; it has to contend with the parliament and other important players.  For example, even if it wanted to, it cannot decide on its own to raise the rate of return on bank deposits, something logical to do if interest rates are at record negative rates (minus 10%) and people are rushing to buy gold.  And then, if it did that, it would need to improve the business environment so that the funds that are redirected to banks can find their way into productive investments.  Interestingly, in this regard it is worth noting that the parliament is about to pass a bill, called behbood fazaye kasb o kar (improving business environment), that is surrounded by controversy and some in the private sector even claim they have not seen but are up in arms about.  The list of things to do is long and the place to start — increase transparency — is clear, but unfortunately, as always, not all policy actors are reading from the same script.