Special report researched and written exclusively for The Middle East Online by international economist Moin Siddiqi
The Islamic Republic of Iran has made progress toward stabilizing its economy and improving diplomatic relations with the western powers, but the country needs to pursue comprehensive reforms to lay the basis for a return to robust growth, which, in turn, requires final agreement on a nuclear programme. Iran, the Middle East’s second-largest economy (after Saudi Arabia), should now focus on domestic reform agenda to fully benefit from its large economic potential.
The intensification of trade and financial sanctions brought about by political differences, has inflicted severe damages on Iran’s economy. Real GDP contracted by 6.6% in FY2012/13 and by 2% in FY2013/14. Oil exports have averaged 1.1mn barrels per day (b/d) since the US and the European Union (EU) sanctions of July 2012, compared with 2.1m b/d in fiscal year 2011/12. After factoring the steep depreciation of the official and black market exchange rates, Iran’s nominal GDP fell one-third from its peak of $514bn in FY2011/12 to $342bn in FY2013/14 (ending March 20, 2014), according to the Washington-based Institute of International Finance (IIF).
The foregone annual economic output (the average annual difference between nominal GDP in dollars in the absence of international sanctions and hefty currency devaluation as compared to actual outcome of the last three years) is estimated at $57bn, equivalent to $712 a year for every Iranian citizen. While the balance of payments has remained in surplus, albeit at lower levels than in previous years, sanctions have effectively blocked access to foreign exchange earnings. More than half the country’s official reserves (estimated at $92bn) are frozen as the US sanctions prevent Iran from repatriating assets accumulated from oil exports, plus other earnings from overseas investments.
Government oil receipts (which prior to sanctions accounted for about 50% of total revenue) have halved, leading to sustained budget deficits – averaging 2% of GDP – since 2012. Iran’s economy will continue to stagnate if oil prices remain within the range of $60-70 per barrel throughout 2015. The fiscal ‘break even’ price of oil (which balances the budget) stands at unrealistic levels of between $130 and $148/barrel for FY2014/15, mainly due to depleting oil exports in volume terms and swelling government spending.
Sanctions are also being imposed on the supply chain in key sectors of the economy, such as in the automobile industry and transactions of international and domestic banks. The banking sector has been denied access to the global payments systems, especially SWIFT, since early 2012. State-owned banks remain highly undercapitalised, poorly regulated, and nonperforming loans (i.e. bad debts) are reportedly at 14.4% of total loans, reflecting acute cash flow problems in the corporate sector. Many businesses face difficulties in accessing loans due to limited liquidity and the cautious lending stance by financial institutions as credit conditions have deteriorated. There is a severe shortage of hard currency.
A gradual trend towards economic liberalisation under the administration of President Hassan Rouhani (in office since August 2013), combined with some relief from the two interim agreements (November 2013 and November 2014), with P5+1 group of countries – the five permanent U.N. Security Council members, plus Germany – should help to revive a modest growth in FY2014/15 thanks to higher government investment and growth in non-oil exports. The sharp depreciation of the Iranian Rial has improved the competitiveness of manufacturing and non-oil exports sectors, as well as of the hydrocarbons industry and provided some cushion from the impact of sanctions.
The Joint Plan of Action between the Western powers and Iran (after the latest Vienna talks) provides for a limited, temporary easing of sanctions to enable Iran to stabilise oil exports, allows some access to frozen external assets and temporarily waives sanctions on petrochemical exports and the automobile industry. Under the terms of the six-month deal, Iran and the P5+1 agreed to a series of measures to be carried out while a conclusive accord is negotiated.
Tehran has pledged to:
*Halve enrichment of uranium above 5% purity;
*Neutralise its stockpile of near-20%-enriched uranium, either by diluting it to less than 5% or converting it to a form that cannot be further enriched;
*Not building any more enrichment facilities;
*Not increase its stockpile of 3.5% low-enriched uranium;
*Provide daily access to Natanz and Fordo sites to International Atomic Energy Agency (IAEA) inspectors and access to other facilities, mines and mills.
The P5 + 1 group has agreed to:
*Provide “limited, temporary, targeted, and reversible [sanctions] relief”;
*Not impose further nuclear-related sanctions if Iran meets its commitments;
*Transfer $4.2bn to Iran in instalments from sales of its oil. In some ways the financial sanctions on Iran have proven more effective than the oil embargo. Half of Iran’s foreign exchange reserves remain frozen in foreign banks.
A final accord with P5+1 – in which existing sanctions are lifted gradually starting July 2015 – would restore oil exports to their pre-sanction levels by 2017 or earlier and reopen access to the global financial system. Foreign direct investment (FDI) into oil/gas industry, long starved for capital spending and sophisticated technologies could return and eventually help Iran raise oil output, potentially beyond 4mn bpd. Iran, the world’s largest and second-largest holder of natural gas (1192.9 trillion cubic feet) and conventional oil reserves (157bn barrels), respectively, according to British Petroleum, could easily expand its role in the global energy markets, with implications for other major regional producers, notably Saudi Arabia (crude oil) and Qatar (liquefied natural gas).
The economy could rebound strongly for the first two years following an agreement. The Washington-based IIF envisages real GDP growth rates in fiscal years 2015/16 and 2016/17 reaching about 5% and 6%, respectively, underpinned by increased volumes of oil exports and private investment. However, the Obama administration, under pressures from Republican-dominated Congress, will ease sanctions only gradually, pending evidence that Iran is fulfilling its obligations.
A sanctions-free Iran holds out many possibilities, including resuming global trade and developing its huge natural gas resources for both power generation and exports. Iran’s youthful population of about 80 million people is well educated and unlike most regional oil exporters the country’s manufacturing sector is relatively diversified. However, the petroleum and non-oil industries require substantial FDI, along with renewed access to the OECD markets and import of new technology, to enable the country reach its optimal potential as a global energy leader – in both upstream and downstream sectors (including petrochemicals).
Without an agreement, Iran could suffer from stagnation or even protracted depression – with a heightened risk of political instability. In such a scenario, sanctions could be intensified on trade and financial transactions, leading to further reductions in oil exports and a significant currency depreciation along with stalling output and soaring unemployment and inflation, thereby resulting in a significant drop in living standards. “If the sanctions stay, they could bring the Iranian economy to its knees in two years,” warned Garbis Iradian, deputy director of the IIF. Recent plummeting oil price has further added to Iran’s woes – with serious implications for national budget and balance of payments.
The domestic agenda
The authorities need to tackle some of ‘deep-rooted’ deficiencies in the structure of Iran’s state-run economy, where large public and quasi-public enterprises partly dominate the manufacturing and commercial sectors. Public banks also control the financial sector. Aggregate GDP and government revenues are heavily reliant on oil revenues and are therefore intrinsically volatile.
The demographic profile of Iran is characterised by a disproportionately high youthful population (with over 60% of total population estimated to be under the age of 30). Consequently, some 750,000 youth are estimated to enter the labour market every year, with a large portion becoming unemployed, abandoning their job search and joining the ranks of the economically inactive population. It is estimated that around 150,000 Iranians with tertiary education leave the country every year. The government estimates the country must create some 8.5mn jobs over the next two years with an overarching goal of reducing joblessness rate to 7% by 2015, which appears a highly ambitious (some would say unachievable) target.
There is ample scope to improve the business environment. Iran has traditionally ranked low in competitiveness surveys, such as the World Economic Forum’s Global Competitiveness Report 2014 that ranked Iran 83rd out of 144 countries, behind most middle-income economies. It identified access to financing and policy instability as the main bottlenecks. Iran ranked 130th out of 189 in the World Bank’s Ease of Doing Business report for 2015 – reflecting continuous problems of red tape in “registering property,” “protecting investors,” and “resolving insolvency”. Only Algeria, Syria, Yemen and Libya rank below Iran among Middle East & North Africa countries on World Bank’s business data.
Tackling stiff obstacles in the business environment and financial sector development could revive much-needed private investment, whilst deeper international trade integration would complement the structural reforms in boosting lagging productivity and growth in ensuing years. High unemployment of about 24% among youth requires reforms to the labor market.
With a view to revivifying the economy, the Iranian government has unveiled several measures including: raising the productive capacity of the non-oil sectors, giving greater autonomy to the Central Bank, broadening the tax base, stabilising and unifying the domestic currency in the market, reinstating the Management and Planning Organisation, which was responsible for drafting the budget and the country’s five year development plans, and opening up the petroleum industry to oil majors for investment and technical assistance.
In sum, energy-rich Iran is now at a cross roads. A final accord on its nuclear programme would inject fresh momentum in terms of FDI and new export markets, whilst supporting increased consumption and improved business investment through heightened consumer and business confidence. Conversely, conditions will likely worsen if Iran remains shut to global business over the medium-term. Future growth prospects also depend on the degree of political liberalisation in Tehran and reforming the country’s labyrinthine bureaucracy. “This window of opportunity to advance comprehensive reforms should not be missed,” as Martin Cerisola, Assistant Director of the IMF’s Middle East and Central Asia Department, observed.