One of the old, chronic challenges of the central bank is the special structure of the foreign exchange market in Iran.
The forex market in most economic systems, in its conventional state, includes exporters of domestic goods and services who sell their currency in the forex market to the importers of foreign goods and services, as well as people who intend to convert their assets in domestic currency to assets in foreign currency or vice versa. Generally, commercial banks and brokers facilitate this process of buying and selling.
Central banks do not play a role in connecting buyers and sellers of currency; rather they apply policies related to buying or selling currency in the foreign exchange market with the aim of regulating the international competitiveness of the national economy.
Parviz Khoshkalam Khosroshahi, an economic expert, prefaced an editorial for the Persian economic daily Donya-e Eqtesad with this note. A translation of the text follows:
Problematic Structure
Central banks pursue their foreign exchange policy by buying or selling currency in the forex market. That is not the case in Iran; the central bank has been acting as the government’s banker for nearly half a century. Along with the conventional central banking, CBI buys the currencies of the super-exporter, the government, earned from the export of oil and gas.
In fact, the central bank has created a parallel forex market, which is several times bigger than the size of the conventional forex market. At times, the central bank has even replaced the conventional forex market, obliging exporters to sell their currencies to the central bank, or compelling importers to buy the currency they need from the central bank at the rate determined by the central bank (in fact, the management and control of currency supply and demand are entrusted to the central bank).
This mechanism has created major problems in the economy, as it has merged currency policymaking (macroeconomic area) and forex market activity (microeconomic area). In other words, the policymaker has become an agent of the forex market.
The purpose of foreign exchange policy is to regulate foreign exchange operations to pursue macroeconomic policies, especially when it comes to regulating the international competitiveness of the domestic economy, but the economic activity in the Iranian forex market is directly or indirectly aimed at making economic profit. In fact, currency policymaking is aimed at changing the direction of the current economic activity in the currency market. When these two opposing tasks (foreign currency policymaking and economic activity in the forex market) are assigned to a single entity, it is clear that the efficiency of both tasks will decline and if this single entity is the central bank, as it is in Iran, the credibility of the central bank will be hurt.
Another fault of this mechanism is the presence of conflicting interests that creates a contradiction between CBI’s macro and micro goals, which also leads to the lack of independence of foreign exchange policy from economic activity in the forex market.
Such a mechanism has tied monetary policymaking to financial policymaking. As a result, the monetary and currency policymaking becomes subordinate to the financial policymaking and the independence of the central bank will be practically ruled out. If the government sells the foreign currency from exports in the conventional forex market instead of selling it to the central bank, it will be very difficult for it to subordinate the monetary and currency policymaking to its financial policymaking, in which case, the chances of monetary policymaking losing its objectivity will be low (of course, the independence of monetary and financial policymaking is not synonymous with the lack of interaction and coordination between the two and the lack of accountability on the part of the central bank).
This structure has tied the government’s welfare and income distribution and development policies, as well as politicians’ electoral demands to monetary policymaking. Monetary and foreign exchange policies pursue both short- and long-term goals, but welfare policies and political demands target short-term goals. Therefore, the dependence of the monetary policies on short-term policies renders them ineffective (lack of independence of monetary and currency policies from politicization).
In such a mechanism, instead of the main exporter of the country, i.e., the government, selling the income from oil and gas exports to commercial banks in the foreign exchange market and collecting the rial resources it needs from within the economy, it sells petrodollars to the central bank and gets the rial it needs from the central bank’s resources, which leads to the growth of monetary base (printing new money). This is one of the main factors increasing liquidity, especially since the Third Five-Year Development Plan [2001-06] onward.
Of course, the central bank can sell the dollars in the forex market, but for various reasons, it doesn’t. This is one of the key factors leading to the natural and structural disconnection between the oil sector and, consequently, the currency and the rest of the economy, in addition to the fact that it continuously expands monetary base and liquidity, which lead to confusion and imbalance.
The currency shocks that hit the economy from time to time mainly happen through this phenomenon, directly or indirectly. By removing this phenomenon, firstly, the main source of conflict of interest between currency policy and currency trading in Iran’s economy will be weakened, and secondly, the forex market will gain significant depth that will act as an important lever for anchoring volatility in the medium and long term.
In this mechanism, policymakers sometimes decide to eliminate the conventional forex market, which is a strange move. All policymakers are concerned about how to create a market when there is no market for exchange (such as the market for public goods, foreign items and asymmetric information, among others). But at certain periods, the currency policymaker or the government surprisingly decides to eliminate the conventional forex market. The market is an efficient and low-cost tool for collecting information and reducing risk.
No Tools to Apply Monetary Policy
Another challenge of the central bank is not having the tools to apply monetary policy. Conventional tools of monetary policymaking are open market operations, legal reserve rate and discount rate.
At present, the most important and efficient monetary policy tool used by the central banks of the world is open market operations (buying and selling bonds), but in Iran, which is perhaps one of the few exceptions in the world, such a tool has only been used for a few years.
In addition, according to the law, the central bank is not allowed to buy debt securities in the primary market. Therefore, the volume of financial bonds in the central bank’s balance sheet is not so high to allow a significant impact on the real interest rate and serious monetary policymaking.
Some departments in the central bank still doubt the effectiveness of this monetary policy tool and continue to insist on the direct control of the monetary base. The central bank is not able to use such a policy given the regulatory and executive restrictions on monetary policy (asset purchase, liquidity provision and commitment to a specific monetary policy in the future). As a result, the central bank in Iran does not have the authority to control liquidity, curb inflation, boost economic growth and pursue the key goal of economic stability due to the lack of appropriate tools for implementing the monetary policy.
Monitoring the Banking Network
Monitoring the banking network is another challenge of the central banks. Basically, the main purpose of monitoring the performance of the banking system is to manage the risk of the banking system with the aim of controlling and reducing the two problems of adverse selection and moral hazard in banking operations.
Therefore, the central bank’s main regulatory task is to set regulations related to risk management and supervise the implementation of those regulations. However, it seems that instead of focusing on these goals, the Central Bank of Iran’s approach is to control banks (strong interference in the management of banks’ affairs) instead of supervising their operations.
Consequently, the cost of supervision for the banks as well as the central bank is extremely high, and on the contrary, its efficiency and effectiveness is extremely low. The predominance of such an approach has adversely affected the banking business environment.
If the central bank were to pursue the supervisory approach with specified goals, it will reduce the cost of supervision for itself and the banking network, and improve the efficiency and health of the banking system and the business environment of banks.
