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