The rising value of foreign exchange against the rial has been a cause for serious concern in recent months.
Regardless of the inflationary consequences of this growth, public anxiety can lead to an increase in speculative practices and demand for foreign currency and gold markets. We need to acknowledge that the economy has seen a currency shock; policymakers need to give an appropriate reaction instead of just analyzing its origin. The same crisis happened during the terms of former presidents Akbar Hashemi Rafsanjani, Mahmoud Ahmadinejad and Hassan Rouhani. The response of all of them was similar and ineffective. It seems that the current administration is playing the same card, i.e., selling gold coins to each ID card holder in the hope of reducing gold prices and exchange rates at prices lower than the open market rate. This will be a costly move that will only empty the government’s coffers.
Ali Sarzaeem, an economist, prefaced his write-up for the Persian daily Donya-e-Eqtesad with these words. A translation of the text follows:
The government needs to think of varying measures for the short, medium and long terms. Introducing an interest rate hike seems to be the most immediate measure to control the consequences of this shock in the short term.
The interest rate is a policy tool that should not be regarded as a sacred or taboo issue. We need to increase the interest rate to a significant level (for example above 30%) in the current situation. Will such a course of action be effective in containing inflation and speculative practices? What are the costs of such a move?
The interest rate is a policy tool that should not be regarded as a sacred or taboo issue. We need to increase the interest rate to a significant level (for example above 30%) in the current situation
A significant increase in interest rate will curb demand for loans for speculative practices and reduce the pressure on the banking network to a great extent. In doing so, the pressure of banks on the central bank to overdraft will also decline and this will stabilize the economy. Undoubtedly, this move will witness a great deal of opposition. Many people will argue that the economic viability of projects will disappear with an interest rate higher than 30%. In response, we need to pay attention to two points.
Firstly, inflation rates are usually put at 25% when it comes to economic evaluations. However, if we intend to update these economic evaluations, not only should such an assumption be increased to 50%, but the scrap value [the worth of a physical asset’s individual components when the asset itself is deemed no longer usable] of factories and machinery also increases because the rise in exchange rates drives up the price of machinery. Therefore, in order to understand the economic value of a project, one should think about the income from the capital price growth as well as the source of the revenue.
Secondly, keeping inflation in check brings about a huge cost. The costs of inflation rates of above 50% outweigh the costs of implementing high interest rates. The interest rate of more than 30% is still tolerable for many large industries, but not for small industries and businesses.
To protect the industry, command pricing must be halted so that enterprises manage to adapt to the new interest rate. Many businesses will go bankrupt, if the government suppresses prices and increases interest rate in the same breath.
Some economists believe that increasing the interest rate cannot curb inflation in Iran because large companies will continue to default on their loans without the fear of consequences. I believe the main problem with this idea is that high interest rate can create an income effect in addition to the substitution effect and this will weaken the effectiveness of high interest rates for stabilization. It is unlikely that such an obstacle exists.
That a high interest rate could enhance purchasing power and in return create inflationary pressure is a valid concern but the solution to this problem is the gradual lowering of the interest rate after containing inflation in the medium term (two to three years) via meticulous implementation of open market operations and market management of the central bank in the debt market.
In the long run, the country needs to diversify its trade partners and look for a pattern of trade that matches foreign exchange resources and expenses to reduce the sanctionability of Iran’s economy. Of course, the removal of sanctions and the normalization of the country’s conditions in both foreign and domestic relations are an undeniable necessity.
