Iranian Economy: Difficult Times Ahead

By Nader Habibi

Dr Habibi is Professor of Middle East Economics at Brandeis University, Waltham, Massachusetts, USA.

How will Iran’s economy perform in the next two years? It will remain hostage to the Western sanctions and will suffer as a result. The government is trying hard to shield the domestic economy against the sanctions but with the new measures against the Central Bank of Iran (CBI) and potential boycott of Iran’s oil and gas exports in the next few months these efforts will not be enough. No matter how hard the government tries to stimulate the economy and support the productive units, sanctions will take a toll and Iran can suffer an economic decline of unpredictable magnitude. Three strong forces will influence the direction of Iran’s economy in the near future: sanctions, government economic policies and international oil prices.

Among these three, sanctions will exert the most influence in the near term. Oil prices are expected to remain high (above $80/B), which is good for Iran as long as it can sell its oil and collect the money. Iranian government’s economic policy will focus on direct subsidies to consumers and producers. Government willalso provide logistical support for import and export flows that are interrupted by sanctions. The effectiveness of these policies, however, will be adversely impacted by factionalism and lack of cooperation between the president and the parliament. Yet the influence of oil and economic policy will be overshadowed by the impact of sanctions and geopolitical risks in the near term.

The Iran-West nuclear dispute has escalated in recent weeks with the introduction of sanctions against the CBI and saber rattling over the Strait of Hormuz. The European Union is also moving toward banning Iran’s crude oil at a much faster pace than anyone had anticipated. The course of events has become less predictable and while both Iran and the United States have an incentive to avoid an all-out military confrontation, the risk of accidental military exchanges that can lead to rapid escalation has increased. It is therefore impossible to speak about near term economic prospects without making assumptions about geopolitical and military conditions. Three geopolitical scenarios can be imagined.

Three Geopolitical Scenarios

The first scenario is that the cycle of threats and counter-threats between Iran and the West will continue but a military confrontation will be avoided. In this case, it is highly likely that the US and Europe will intensify the economic pressure in hope of convincing Iran to halt its nuclear program. Since they feel that Iran is getting close to the point of no return (a point of technological advancement in development of nuclear weapons beyond which the program cannot be stopped by external pressure) the economic pressure is likely to intensify rapidly in the next 12 months. Hence moving forward the sanctions are expected to get more intense and cause considerable disruption in Iran’s international trade and oil revenues.

If Iran concedes to Western demands in response to these sanctions it is likely that the sanctions will continue for at least one more year and Western countries will keep up the pressure during the negotiations that will follow. After that they are likely to be lifted gradually in response to the speed of Iran’s compliance with the Western demands. If, on the other hand, Iran reacts to these sanctions by accelerating its nuclear program and possibly testing an underground nuclear explosion as an act of defiance, the sanctions will also intensify and might last for several years as Western nations try to contain Iran and force it to abandon its nuclear weapons (similar to how it has reacted to North Korea in recent years). Experience of India and Pakistan suggests that such sanctions will be partial and after several years they will be lifted as the international community eventually comes to term with Iran’s nuclear status. Under this scenario the sanctions might be accompanied with some forms of covert military operation against Iran’s nuclear facilities and infrastructure, which will inflict additional damage to the economy. Attempts by Western governments to promote ethnic and sectarian strife are also likely as a destabilization strategy. These covert interventions will also have an adverse effect on Iran’s economy.

What can partially diminish the pressure of sanctions in this scenario is potential lack of cooperation from China, Russia and Turkey. The US has sufficient political and economic leverage over Turkey and China to bribe or coerce them into scaling back their economic relations with Iran. But it is unlikely that they will be 100% cooperative. Turkey relies on Iran for a large portion of its oil and gas imports and benefits greatly from serving as an export and re-export hub for products that Iran cannot purchase from other countries because of the sanctions. However, Iran-Turkey relations can deteriorate in the next few months because of their opposing interests in Syria.

For China, Iran is a smaller trade partner but China has a geopolitical interest in weakening the sanctions and enabling Iran to partially bypass them. It wants to deny the US an opportunity to subdue Iran and hence consolidate its hegemony over the Persian Gulf region. China also uses its economic and trade ties with Iran as a bargaining chip in her wider geopolitical competition with the US (an ‘if you help Taiwan I will help Iran’ argument). Russia, which has its own geopolitical ambitions in the Middle East and has aspired to reassert itself as a superpower since 2000, is less likely to be co-opted or coerced by the US to join the Western sanctions against Iran. The ease of Russo-Iranian trade through the Caspian Sea will also increase Russia’s ability to help Iran partially offset the sanctions. Russia’s role, however, will be constrained by the fact that Iran’s economy is highly intertwined with Western and Asian imports, which cannot be easily imported through Russia.

A second possible scenario is that while the sanctions continue, the tensions lead to a military strike against Iran or an accidental military exchange. This would be an even worse scenario for Iran’s economy. It is very likely that any military confrontation will escalate into a wide and prolong conflict. The US and its allies will target military installations and key infrastructure of Iran such as bridges and power plants. The damage to the economy will be very severe and all types of economic activity will be disrupted. Trade through most borders of Iran will come to a halt and many goods and commodities will be in short supply. Under these conditions the government might have to resort to rationing of necessities and impose severe regulations on producers and consumers.

A third geopolitical scenario is that a military confrontation is avoided but economic pressures and political discontent lead to social and political instability. The uprisings that followed the 2009 presidential election exposed a widespread political discontent among Iran’s urban middle classes. That uprising was successfully suppressed and its leaders (presidential candidates Mir Hossein Mussavi and Mehdi Karrubi) remain under house arrest. The middle class are apolitical and quiet at present but they remain alienated. As the economic pressures intensify and standards of living decline (as a result of sanctions) the risk of social and political protests will increase. The ruling regime is strong and enjoys its own support base. As a result, a new round of political protests is unlikely to cause substantial political change but it can lead to urban violence and disruptive mass protests. Under this scenario, political unrest will put added pressure on the economy as normal retail activity might be disrupted and some labor groups might cause slowdown or disruption in production units. The segments of the bazaar might also close their shops collectively to express their anger at economic conditions. The unrest and stoppages will add to business uncertainty and put additional downward pressure on the economy.

Most Likely Outcome

These three scenarios all point to difficult economic times ahead for Iran in the next two years. No doubt the government of Iran will implement countermeasures to protect the domestic economy against the sanctions. The government will mobilize its resources to prevent the economy from being destabilized. One of the major challenges it will face is to maintain public confidence in the domestic economy and financial system. Since mid-December 2012 Iran’s currency has sharply depreciated against the US dollar and euro. Investors are worried about a shortfall in country’s oil revenues as a result of sanctions and fear that this will lead to a shortage of hard currency in the near future. This fear has encouraged many investors and ordinary households to convert their savings into gold and foreign currency. If government fails to stabilize the exchange rate this lack of confidence can prove very harmful for investment and financial stability.

Of the three scenarios discussed above the first scenario (escalating sanctions and no military confrontation) is the most likely scenario. The US and Europe are in no mood for another costly war in the Middle East. Yet at the same time they are determined to stop Iran’s nuclear program at all cost. Since the military option is undesirable Western powers will try to maximize the economic pressure on Iran and perhaps combine it with a barrage of sabotage and covert operations. The earlier policy of targeted (smart) sanctions aimed at hurting the ruling government, without causing any harm to the civilian population, has given way to comprehensive sanctions that are intended to cause maximum damage to the entire economy of Iran. The new goal is to put so much pressure on the economy that government cannot finance the nuclear program and/or the public feels so much pain that it will put pressure on the government to stop it. Difficult times are ahead for the Iranian economy.

© Copyright MEES 2012.