Tyranny of numbers

Policy reversal on interest rates in Iran: Is it enough to revive the rial?

Posted in General by Djavad on January 26, 2012

After weeks of wrangling, on Wednesday, January 25, President Ahmadinejad has consented to the request from his Central Bank to sharply raise interest rates (officially referred to in Iran as “the rate of profit of banks”), from 12.5% on one-year deposits to over 21% and higher.   The argument for increasing deposit rates is simple macroeconomics: when interest rates are below the rate of inflation, as they have been in Iran for the last two years, people will try to protect their savings by shifting their money to other liquid assets, such as foreign currency and gold.  According to some reports, this theory was put to a quick test when the price of dollar and gold dropped on the same day that the hike in deposit rates was announced.  At the same time, the Central Bank has announced that it will unify the exchange rates at 12,260 rials per dollar, which is an official devaluation of less than 10%.    But, as welcome as these pragmatic steps are, they may not be enough.  Higher interest rates will do some good, but are unlikely to lower the market exchange rate to the new official rate.  These are complicated times in Iran and simple macroeconomics may not apply.

The policy change on bank deposit rates is significant, both because of its magnitude — banks are free to offer deposit rates as high as they want — and because of the lesson it entails.  When President Ahmadinejad took office in 2005, he promised to lower both the interest rate and the exchange rate.  Seven years later, he has to live with higher rates for both.  The lesson to be learned from this fiasco is that a bit of economic logic can go a long way.  Ideologists inside and outside the government who view markets with suspicion and confuse understanding and respecting how markets work with defending neo-liberal and free-market policies, do themselves and the nation disservice.   In this particular case, the simple logic of markets says that you cannot control both the rate of interest and the exchange rate: if depositors cannot at least maintain the value of their money while it sits at the bank, among other things, they will turn to foreign currency, putting pressure on the exchange rate.

How have Iranian banks been rewarding depositors lately? If you put 100 rials in the bank ten years ago, today you would have 370 rials, which is worth only 91 rials because of inflation.  The real rate of interest on one-year bank deposits (nominal interest rate minus the rate of inflation) has been negative in 7 out of the last 10 years.  Real rates have averaged -1.7% per year for the period, and, significantly, reached minus 10% in 2011 (see the graph below).

It is not clear that the sharp negative turn in interest rates is responsible for the sudden collapse of the rial this month.  As inflation picked up in 2007, causing real interest rates to plummet, money first moved into real estate, which was already hot because of the oil boom, causing a housing bubble.  When the bubble burst, in 2008, people started looking for other stores of value, mainly gold and the dollar, pushing up their prices gradually.  The higher deposit rates will solve this part of the problem because they will attract money away from these risky and volatile assets into banks, but the larger problem, the sudden increase in the prices of gold and foreign exchange, is harder to solve.   This is because, in times of a crisis such as Iran finds itself in, bank deposits are not good substitutes for gold and foreign cash.

As I noted in my previous post, the latest crisis is caused in large part by the harsh US and EU sanctions that prevent not just ordinary traders but also Iran’s Central Bank from moving money around.  If sanctions worsen, as most people seem to expect, money in the local bank is of little use for paying for critical imports or for education or medical care abroad, no matter what the interest rate.  It is quite telling that the run on the rial started when the US sanctions against Iran’s Central Bank passed the Congress with near unanimity last December.  Once sanctions become law they are very hard to remove (the sanctions against Iraq were only removed in 2009).

An Iranian official said recently that the sanctions are good for Iran.  I am not sure if using the international financial system for  political reasons, as the US and EU have done, is good for anyone.  But we know of one good thing that the sanctions have done already — encourage more sound economic policy in Iran.

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10 Responses

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  1. […] Salehi-Isfahani, un professeur américano-iranien de Virginia Tech University aux Etats-Unis a fait remarquer dans son blog que grâce aux sanctions « la politique économique s’est améliorée en Iran ». […]

  2. Ary said, on January 30, 2012 at 10:34 pm

    Thanks for the article. Very nice read.
    Interestingly, there is another country where the demand for gold is increasing these days. Perhaps for not exactly the same reason.
    http://www.ft.com/intl/cms/s/0/3941741c-481f-11e1-a4e5-00144feabdc0.html#axzz1l0022K53

  3. Tabatabaei said, on January 29, 2012 at 9:12 am

    I am glad that I came across your website.I enjoyed reading useful articles on todays Iran’s Economy.

    Many thanks.

  4. Djavad said, on January 27, 2012 at 5:56 pm

    It is difficult to judge things from a distance, but have to make do with what is at hand. I will try to write more on sanctions. thanks for the encouragement! Iran imports cell phone primarily because it is cheaper to do so. The reasons for why Iran cannot compete internationally are plenty, but one important reason is (or was?) the exchange rate.

    • Dr. Hamed H. said, on January 27, 2012 at 11:23 pm

      Thanks. I will wait for your article on the issues.

  5. arghami said, on January 26, 2012 at 11:56 pm

    Very well written, can’t beat the logic.

  6. Dr. Hamed H. said, on January 26, 2012 at 5:08 pm

    Another wonderful article I must say. I have the opinion that it is better if Iranian government just does not try to mess with exchange rate and let the market find the rate by itself. Trying to impose an arbitrary rate is more dangerous in long run than letting the market find let’s say 18,000 as the real rate. All state imposed rates are doomed to fail. It would be better if the state would go after fundamentals and encourage increased production instead of trying to fix the exchange rate. It is like if a doctor tries to impose how many breaths per minute a short of breath asthma patient takes as to rational treatment of asthma which is dilating the obstructed air passages using bronchodilators. Unfortunately Iranian state still thinks that they can dictate to markets and their policies instead of being geared towards helping the market has been trying to impose restrictions on it. Iranian officials really need to disengage ideological issues from economics and they would be well advised to take a trip to China and see how things are done there in this regard.

    My rudimentary question from the learned author is if making a technocratic monetary policy institute in Iran would be a good thing for Iran. Let’s say if Iran’s central bank become a completely sovereign entity, and its all powerful board members are elected by votes of only Iranian economists. Would it be a good idea? The other question is what Iran can do in its economic policies in order to minimize the effects of sanctions? Is there anything out there that Iran can do economically to off set sanctions?

    • Djavad said, on January 26, 2012 at 10:27 pm

      Thank you for your comment. I agree, governments often think they have more control over prices than they actually do. It is difficult to believe that the government can unify the two rates at 12600 rials per dollar because at this rate demand for dollars is very high, and the Central Bank will be just transferring wealth to private money changers.

      How to reduce the adverse effect of sanctions? I must confess that I have not thought much about this, but here are my two cents. Devaluation tilts the balance in favor of domestic producers, while at the same time sanctions make it hard for them to fill in behind diminishing imports. Under emergency conditions, governments usually lose patience with the private sector and step in to directly produce things or distribute them. The government woud do well to resist this temptation. The new policy to free up the interest rate is a good move because it will loosen credit (as difficult as it seems to believe). There are other policies that would improve the business environment, but more on that later.

      • Dr. Hamed H. said, on January 27, 2012 at 5:37 am

        Thank you for your reply. It is really good to get expert opinion and the opportunity to ask questions from an actual expert. I may use this opportunity to request you to write an article on sanctions and what their effects are going to be on Iranian economy and society even if it be just a theoretical or academic exercise. Also what correct policies Iran can initiate to reduce the effect of the sanctions. I would really appreciate it.

        Also as you had hinted in one of your other articles, I am still waiting for you to write about why Iranian society is not as productive as other societies eg. German or China. Why Iranian socio-cultural system does not produce any top notch corporations and companies, despite being relatively rich and having human resources. For example why Bazar always seem to be going back and forth between investing in housing and dollar and not in let’s say manufacturing smart cell phones or any other high value product even though Iran imports huge amounts of such products. I was just hypothetically thinking that even if 60 million Iranians use cellphones and the average life of a cell phone being 3 years in Iran, then Iran would need 20 million cell phones each year which currently imports all of them. Why Bazar never invests in such markets and even beyond exporting them even it be regionally if not internationally? Is there any macro economics involved here?

        Thank you once again.


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