Rial devaluation and inflation — without the hype
For the past several weeks, the rapid fall of the rial has been linked to hyperinflation and a possible quick end to the impasse in nuclear negotiations with Iran. Inflation estimates of 196% per year in NYT, 70% per month in Boston Globe, and similar reports in Washington Post and Bloomberg, were all traceable to an article in the Cato website that had prematurely added Iran as the 48th worst case of hyperinflation in the world. Some commentators could hardly hide their joy in the prospect that sanctions were finally, and mercifully, about to spare the Middle East yet another war and the Iranian people years of suffering under sanctions. But these predictions have failed to materialize, and the media interest in the issue has waned. We are slowly hearing the other story of the rial devaluation, its positive effect on local production (see, for example, Jason Rezaian’s informative report in Saturday’s Washington Post).
Prices for most goods have been rising fast but at rates well below hyperinflation. The price of some key staples have hardly risen in the weeks since the fall of the rial: energy prices have remained unchanged (thanks to the parliament’s objection to the second phase of the subsidy reforms), bread is still selling at 5000 rials a loaf, and chicken at about 50,000 rials a kilo. The annualized inflation rate for the month of Shahrivar (ending on 20 September 2012) was about 30% according to figures released by Iran’s Central Bank (their annual rate for month on month was 24%). I expect the inflation rate for 2012 to remain below 50%.
As I have explained in this blog (and most recently in Foreign Policy), the hype about hyperinflation was misleading because it was based on a faulty analysis of how Iran’s foreign currency markets work. But while the hyperinflation story has lost its appeal, people still speak of “rial’s devaluation” and its size as if it were easy to measure. Let me explain why it is not, and why talking as if it is can be misleading.
The short answer is the multiple exchange rates system. The long answer requires the use of an example that explains the mechanics of Iran’s devaluation. The example involves some knowledge of arithmetic but no economics — and there is a short quiz at the end.
Suppose a college football stadium needs to undergo renovation removing half of the seats from the market. Ordinarily, ticket prices are $10 per game, and at this price half of the seats are occupied by students and the rest by townies and alumni. This year, with only half the stadium seats available, the college estimates that the (equilibrium) market price could be as high as $20, a price that few students will be able to afford. To keep students coming to the games to cheer their team, the college decides to sell 80% of the available seats to students at the old price of $10 and sell the rest in a “free market”. Suppose also that the free market price is $40.
The short quiz is to calculate the rate of increase in the price of tickets. If you answered 400% you can get a job at a prestigious international newspaper but you flunk the quiz. Why? Because there are two markets and 300% is the ratio of the new price in one market to the old price in another. Actually, this turns out to be a trick question because it does not have a simple answer. For students (80% of the market) there has been no price increase, while non-students (20% of the market) experience a price increase of 300%. If you had to give one number, you might say 60% (= 0 x 0.8 + 300 x 0.20). A more complex answer would take into account the cost of students waiting in line resulting in a higher average rate of the inflation. Compare these answers to what the price increase would have been — 100% — had there been a single price.
This is pretty much what happened this summer to Iran’s foreign currency market. Iran lost about half of its supply of foreign exchange because of sanctions, and the government decided to protect its population from the worst part of its consequences. It abandoned the unitary exchange rate regime that had brought a decade of economic growth to the country in favor of multiple rates. As in our example, there is a single supplier of foreign exchange — the government — which allocates a part of its forex to basic necessities (at 12260 rials per dollar) and sells the rest to licensed buyers in the recently set up Foreign Exchange Center (at about 25,000 rials per dollar). It may be supplying some of its forex to the so-called free market (at widely fluctuating rates, between 30,000 and 45,000 rials per dollar) but we do not know how much, if any. The latter price is equivalent to the price of auctioned stadium seats. So, as in the example, calculating the rate of devaluation by dividing the rate in the free market by the previous singular rate (say 33,000/11,000, or 200% increase) is incorrect.
A more reasonable estimate of the extent of devaluation in Iran should take into account (at least) three rates of devaluation: the official rate (10%), the Exchange Center rate (about 150%), and the free market rate (about 200%). But, unlike in the example, we do not know the shares of the forex going to these three markets, so even a simple weighted average of these rates is not available. If the share of forex allocated to the three markets are 0.40, 0.55, and 0.05, the weighted average would be 96.5% (= 0.40 x 10 + 0.55 x 150 + 0.05 x 200), which is much lower than 200%.
Any devaluation close to 100% is a huge shock to the economy, so the point of this exercise is not to minimize the gravity of the situation, nor to simply offer a formula to estimate the size of the devaluation. Understanding the mechanism is the important point. Even if we cannot quantify the rate of devaluation, we can still analyze its consequences if we have the right model. The consequences of a single-market devaluation are very different from one that involves transition from a unitary to a multiple exchange rate system. Put this together with the fact that the government is the main supplier of forex, and you can see why hyperinflation is a misleading account of post-devaluation Iranian economy.