Iran Special: A Beginner's Guide to the "Currency Crisis"

An Iran analyst offers a guest commentary to EA on the possible "currency crisis" affecting Tehran:

It is no secret that the Iranian rial/toman is overvalued --- the real surprise in recent years is how or why the Iranian government has kept the rate relatively stable. The current foreign exchange crisis is not a planned move towards much-devaluation; instead, it is indicative of poor preparation by the Iranian Government for recent developments. 

Let's start by clarifying what has happened. It's important to note that the Central Bank of Iran has not changed the exchange rate by much. According to www.cbi.ir, the exchange rate for the USD is currently 10,198 IRR. [Editor's Note: It is now listed at 10,699 IRR after the Central Bank of Iran pegged its latest injection of dollars into the market at that level.] That is the rate that the Iranian government will give those who qualify to purchase dollars, and also the rate at which it pays out rials to the government in exchange for petro-dollars. 

Most people, however, including many private businesses, do not use this system or rate for their foreign exchange needs. Rather, they rely on informal currency exchangers (the famous hawala system), to procure their foreign currency, be it for travel, for money for their kids studying abroad, or for import goods to sell in the country.

What happened in the past two weeks is that the black market spread -- which was negligible up to now and even less than retail banking spreads elsewhere in the world -- started growing and reached around 20-30%.

So, if you want to change your rials for a USD, you're likely to pay close to 12,000-13,000 IRR for a dollar rather than the Central Bank's rate of 10,198. 

You would think that the money exchangers in Tehran are jubilant, but they aren't. Supply of dollars has dried up, driving up prices, so they don't have much volume to trade. 

Why?  It appears that Iranian officials truly wasn't prepared for the speed by which banks around the world, and particularly in Dubai, stopped moving money from Iranian banks and their branches abroad. (Some traffic still exists. The state-owned Iranian banks in the UAE are operational, but no one knows how long that channel will remain open.)

All this was predictable, and the Iranian government should not have been caught off-guard. However, because it was,  the money exchanger is now stuck trading low volumes. Matches have to be made, such as a son living abroad sending money to his mother back home set against a father who needs those dollars for his daughter's education in the US.

The over-valuation of the rial is costing Iran roughly the same amount as its entire bill for energy subsidies (about $30 billion). Keeping the rial artificially high essentially translated to subsidising every import item.

I always wondered why the Ahmadinejad government tackled the difficult direct subsidy issue, instead of the currency over-valuation, which would have had more support from industrialists and produced the same net savings.

The best answer I found to this question was that the value of the rial, especially versus the dollar, is a matter of pride and prestige. It's a visible benchmark and the current government simply didn't want to see the devaluation of the rial by at least 30% on its watch.

Devaluation of the Rial would have also a profound impact on the subsidy removal programme.  The price for energy, for example, is set against the benchmark of FOB [crude oil price] in the Persian Gulf. So the higher the exchange rate, the higher the price of your gas, electricity. and gasoline bill at home.  The subsidy removal plan is already ambitious and will probably be scaled back in implementation. The Government certainly could not implement the double whammy of subsidy cuts and devaluation together.

Planned devaluation takes place in a controlled and predictable manner. Waking up and finding the dollar costs you 20% more and waiting another few days to see it now costs you 30% more is disastrous. 

Consider, for example, government projects. Lots of work is contracted out to private sector players who generally win through a competitive bidding system (though there are certainly some aberrations to this rule). 

Now imagine you are the Iranian contractor who is supposed to build some sort of plant or factory for a government body. Your project will involve a lot of imports: building material, steel, equipment, etc. All of a sudden, your input costs have shot up by 30%. There is no way you can carry out the project. So, either the state contractor alters the project price, or you default and forget about the 10-20% project guarantee bond you put up. You can imagine the chain reaction.

So, now what?

The best way to understand the current foreign exchange crisis is by imagining that you are commuting back home from your job, driving on the same route you have been taking for the past decade. All the sudden, you see that the highway you take has been closed off. You immediately try the main road you know, but that is closed too. You go to the train station, only to learn that it not running.  You will feel very disoriented and may not know how to get to your destination.

That's where we are now with the Iranian banking system. Businesses and individuals are feeling disoriented because the banks and forex traders they have relied on for decades are suddenly unable to service them.

Over the next few weeks and months, they will start finding the side streets and figuring out how to move money again. It's unlikely that such a high spread will remain in place between the official and black market rate of the rial. I expect the spread to narrow, but it will persist at much higher levels than in the past. The traders will want to be compensated for the trouble of finding new routes and the few banks that do not worry about US pressure or their own government's cracking down will want a premium for their services.

My best assessment is that we can say with certainty that the sanctions are indeed "biting" and "painful", especially for ordinary Iranians and the private sector. But to say that sanctions are "working", we need evidence that they are contributing to their core purpose, which is supposedly to change Iranian behaviour on certain issues.

When assessing the impact of sanctions, we should also consider the other side of the story. Iran- watchers have been astonished to see the Tehran Stock Exchange reporting astronomical gains and billions of dollars worth of government bonds selling out in a matter of hours. 

There are a few reasons for that phenomenon; one of them is the lack of an alternative. In simple terms, there is high liquidity in Iran, and if this money cannot find its way out safely, it will chase domestic opportunities. As an Iranian citizen is likely to experience major problems holding even a simple savings account outside the country, many have little option but to keep their wealth inside. And let's face it, who wouldn't be tempted by the 16% interest rate offered by Iranian banks, when the foreign exchange rate has been stable for over a decade? 

Of course, if the rial starts losing its value in a rapid manner, that equation is likely to change, meaning the CBI's reaction over the next weeks will be extremely important in preventing major capital flight.