Tyranny of numbers

Understanding the rial’s strength

Posted in General, Inflation, Macroeconomy, Sanctions by Djavad on January 18, 2016

Last month a headline (link in Persian) in Eghtesad News read: “Do not buy dollars, it will get cheaper”!  More surprising than the headline was who said it: Iran’s Central Bank Governor, Valliollah Seif.  As his critics were quick to point out, it was unwise for the one official whose economic predictions should be muted and very general — the US Fed’s statements about the future need expert decoding — to claim to know which way the exchange rate will move in the future (you can read here — in Persian — the CBI’s lengthy explanation for the controversial remarks).

Well, that future has arrived and the Governor’s prediction did not come true. If he was trying to stop the slide of the rial, he did not succeed, for as the “implementation day” for the Joint Comprehensive Plan of Action (JCPOA) approached and the prospects of the $30 billion return to the Iranian economy strengthened, the dollar actually gained in value and the rial weakened (see nominal rates in the chart below).  This not to suggest that Mr. Seif was actually mistaken about the course of the rial, only that his statement may not have reflected his own beliefs.  In any case it is foolish to trust the advice of a central banker about the exchange rate, even one that supplies more than half of the foreign currency, when he is trying to stabilize the exchange rate with little foreign exchange in his coffers.  The Economy Minister, Ali Tayyebnia, quoted in the same news item, was more philosophical in his advice to investors: “price determination is God’s work.”  His attempt at dispelling the notion that the Central Bank was manipulating the exchange rate, was contradicted by a former governor of CBI, also quoted in the same place, that the dollar would be stronger were it not for the government’s injection of dollars into the free market.

From a simple supply and demand perspective the rising value of the dollar is easy to understand because oil, Iran’s main export, lost one-third of its value in January, falling to less than $30.  Given the collapse of oil prices, the question is, why the rial has stayed so strong?

A little more than three years ago, the rial was the most closely watched currency in the world, its value was plummeting and pundits were predicting hyperinflation followed by economic collapse.  Sanctions seemed to be finally doing their crippling thing, pressuring Iran to make concessions on its nuclear program.  The widely predicted hyperinflation and economic collapse did not happen but Iran was at the negotiation table a year later.  Without any actual removal of sanctions, the rial stabilized and even recovered some of its lost value.

If you stopped watching the Iranian currency since its big crash in 2012, you may have missed this surprising recovery, in real terms.  The surprise is that the rial has been fairly stable in nominal terms while Iranian prices have been rising nearly twice as fast as prices in OECD countries, meaning that since 2012 the rial has appreciated in real terms (and relative to the dollar) by 100%, all the while the price of oil has been falling.

Here is a quick review of the data.  In late 2012 the rial was trading at above 35000 rials to the dollar, having depreciated by over 200% in October of that year, but in subsequent 12 months it rose in value, reaching less than 30,000 rials to the dollar in the aftermath of the interim agreement between the P5+1 and Iran known as the Joint Plan of Action (JPOA) in November 2013 (the red line in the graph below).  A year later, with oil prices crashing and the prospects for quick gains from JPOA fading, the rial started to lose value again and the exchange rate (ER) went back up to 35000.

Despite the recent drop, over the past three years the rial has been gaining in value, as indicated by the falling real exchange rate since early 2013 (shown in blue in the graph below). In the last three years the rial has risen by about 38% relative to the dollar.

Figure.  Nominal and real exchange rates, 2010-2015 (rials per USD)


Note: the real ER is calculated by deflating the nominal ER by the difference between the inflation rates in Iran and OECD.
Source: The Central Bank of Iran and OECD.

This is the exchange rate stabilization that the Rouhani administration is quick to take credit for.  Of course, much of the rial’s recovery came after Rouhani’s election, in June 2013, which increased optimism about an end to the sanctions.  At the time, oil prices were still high (they would dive a year later) but sanctions had cut Iran’s oil exports by half.  At the same time, given the expectation of the lifting of the sanctions, capital flight has been low, accounting for the strength of the rial.  The part that Rouhani would not like to take credit for is that his policies of austerity, which I wrote about here, have so depressed the demand for imports, and hence foreign currency, that the ER cannot rise.

Whether a strong rial is a good thing for Iran’s economy is a different issue.  I happen to think not.  Iran can only grow now by encouraging local production — increase its non-oil exports and reduce imports — and to do so the rial needs to reflect the productivity of Iranian workers relative to the rest of the world.  I see no reason why that should have increased by 38% in the last three years.



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