IHS Global Insight economist Alyssa Rallis has said that the slump in oil prices, to a near one-year low, poses a major threat to Iran’s economy.
Strong foreign-exchange earnings from high oil prices on top of a large cache of foreign-exchange reserve holdings have helped insulate Iran’s economy from the effects of sanctions; with oil prices having pulled back sharply in recent weeks and the euro—which reportedly now makes up the bulk of Iran’s reserve holdings—sliding rapidly against the U.S. dollar, this cushion is under threat.
The price of Dubai crude has fallen back to US$70/barrel in recent days, compounding the potential impact of the multiple threats to Iran’s economic recovery—including a weakening euro, additional economic sanctions, and economic mismanagement at home.
Implications
As the United States and its allies push ahead for a fourth round of sanctions through the UN Security Council and more than likely additional, tougher sanctions outside of it, sliding crude-oil prices will exacerbate the impact of these sanctions on Iran’s economy, threatening to derail hope for a mediocre recovery this year.
Outlook
Although Iran’s leaders have grown used to operating under tough external and domestic economic conditions, if oil prices continue their rapid plunge and remain below US$70/barrel for an extended period low oil prices and additional economic sanctions will put severe downward pressure on Iran’s internal and external balances, potentially derailing investment, trade, and the Islamic Republic’s recovery.
IHSÂ Global Inisght analysis:
From a 2010 high of near US$88/barrel at the beginning of the month, spot prices for Dubai crude have plunged nearly 20% to US$70/barrel on Friday (21 May), hovering around the mark this week as well. Officially, oil revenue accounts for around a third of central-government revenue and brings in roughly 80% of the country’s foreign-exchange reserves, but Iran’s economy is practically almost entirely dependent on oil income to maintain investment and growth in nearly all sectors. Oil income has been used by Iran’s ruling elite as a crutch for decades, with income from the lucrative export being used to finance regime supporters, buy public support through generous subsidy programmes, fund weapons development, and support allies abroad with aid and investment.
Nonetheless, profligate spending of oil revenue, economic mismanagement, and sanctions left Iran vulnerable to the global economic downturn; its government was the only oil producer in the region not to announce widespread stimulus measures to support growth. Already under pressure from state-directed lending and administrative interest-rate reductions, as the global economic slowdown accelerated Iranian banks quickly pulled back on lending to the private sector while Iranians simultaneously halted nearly all investment. Hit with widespread protests over the June 2009 presidential election results, the government also postponed or halted a significant number of its projects. Due to numerous structural inefficiencies, Iran has come to rely on an extremely high oil price per barrel to maintain spending and investment and does not have the same flexibility as many countries in the Gulf to ride out a prolonged period of low oil prices.
If oil prices continue to slide, or remain below US$70/barrel for an extended period Iranian authorities will need to further postpone crucial planned investments in the oil and gas sector and cut back on infrastructure and other development spending. Although a prolonged period of lower oil prices will likely not be enough to change Iran’s entrenched attitudes toward its nuclear programme, it will take away some of the country’s ability to continue financing expensive third-party transactions for banned materials and skirting U.S.-imposed limitations on conducting transactions in U.S. dollars.
In recent years Iran would have been able to fall back on its substantial cache of foreign-exchange reserves at times when foreign-exchange earnings were reduced, but the government’s decision to convert its U.S. dollar holdings to euro as tensions between the two countries intensified is taking away some of this cushion, with the euro depreciating substantially against the dollar so far this year.
Desirous to maintain an adequate foreign-exchange buffer against additional, tighter sanctions and threats to Iran’s lucrative oil and gas exports, the Central Bank of Iran amassed a significant stock of foreign-exchange reserves during the last oil price boom. At the end of 2009, official foreign-exchange reserves stood at nearly US$78 billion. However, the cushion that these foreign-exchange reserves have provided—in allowing Iran to finance expensive third-party transactions to skirt international sanctions—has been reduced substantially in recent months as the euro has lost ground against the dollar.
As tension between Iran and the West over its nuclear programme rose and pundits espoused the potential of the euro to take over from the dollar as the world’s next reserve currency, President Mahmoud Ahmadinejad ordered his government to convert all U.S. dollar foreign-exchange holdings into euro. Although estimates vary on whether or not the central bank now holds all or just a portion of its foreign-exchange reserves in euro, the currency’s 16% drop in value against the dollar since the beginning of the year has likely had a significant impact on Iran’s reserve holdings.
Based on foreign-reserve holdings of US$78 billion in December 2009, a 50-50 U.S. dollar-euro split for Iran’s foreign-exchange reserves would have yielded a US$6-billion drop in the country’s foreign-exchange earnings at the current 0.81euro/US$ exchange rate. If the Iranian authorities have successfully converted all U.S. dollar holdings into euro as mandated by Ahmadinejad, Iran would have lost US$12.5 billion, or 16%, of its year-end reserves. This loss would essentially remove two months of import cover at 2009 trade levels.
Outlook and Implications
On 18 May, the United States released a proposal for a fourth round of UN sanctions on Iran. Sanctions proposed in the draft include further restrictions on arms sales to Iran, more stringent shipping inspections, additional financial restrictions, foreign banking limitations, and additional restrictions on the movement and assets of the entities and individuals connected to the Revolutionary Guard. The three rounds of economic sanctions already passed by the United Nations—as well as bilateral sanctions originating in the United States and its Western allies—have significantly increased Iran’s economic risks and held back growth.
As the United States and its Western allies in Europe in particular tightened the financial noose around Iran, Iranian authorities had been able to avoid traditional avenues of international financial transactions, essentially funding their own trade activity and using their large stock of foreign-exchange reserves to pay a premium for third-party countries and smaller financial institutions to clear transactions on its behalf.
Although official economic data releases have been delayed significantly, purportedly to mask the severity of Iran’s economic downturn, anecdotal evidence suggests that economic activity in Iran had begun to pick back up as oil prices rebounded in recent months, giving the authorities there more confidence and flexibility to pursue controversial policies at home, like subsidy reform, and defy international demands to end its nuclear programme. Although a temporary slide in the euro or drop in oil prices separately would not have a severe impact on Iran’s economy the two events occurring simultaneously will curtail the country’s ability to ignore the impact of sanctions in the near term.
About the Author: Alyssa Rallis is IHS Global Insight’s economist
