Economy, Business And Markets

Iran’s Economic Dilemma

Domestic Economy Desk
Iran’s Economic Dilemma
Iran’s Economic Dilemma

The Iranian government’s approach in handling soaring inflation over the past two years has divided economists over President Hassan Rouhani’s economic policies.  

Critics argue that by focusing all efforts on reining in the inflation, the government has failed to address another major issue afflicting the economy, namely recession. This is while supporters believe the administration should continue the current policies until it achieves lowers inflation under 10% and tackles the recession from other pathways.

The 25% drop in inflation since President Rouhani took office two years ago has been achieved through the adoption of strict policies by the Central Bank of Iran that controlled major inflationary factors such as fluctuations in foreign exchange rates and liquidity growth. Nonetheless, the latter was realized by implementing contractionary monetary policies to lower the money base.

Since one of the main contributors to the monetary base in Iran is the government’s dues to contractors and banks, the government hesitated to fulfill those obligations and tried to keep the money base down so as to control the inflation rate. The result, according to critics, would be a slump in industrial and manufacturing output caused by shortage of liquidity and lack of credit facilities.

Critics claim state policies have created a vicious cycle in which the government, due to shortage of financial resources, would have to take loans from the CBI to pay over the roof to contractors and banks, which would in turn increase liquidity and eventually push the inflation back up.

Some explain that this manifests a theory called Philips curve, referring to an inverse relationship between inflation rate and unemployment, which is the most outstanding upshot of industrial and manufacturing downturn.

They suggest that the government focus on one issue at a time: either to set the inflation rate free and inject money into job-creating industries to prevent economic recession, or get a hold of inflation rate at the expense of a slowdown in industries, resulting in high unemployment rate and its many economic and social consequences.

But is that the fundamental dilemma the government is bound to resolve? Many economists disagree.

“Philips curve does not necessarily apply to Iran’s economy at this point,” says Mohammad Hashem Pesaran, emeritus professor of economics at the University of Cambridge.

He believes that there are possible ways the government could pursue its inflationary policies without causing harm to industries.

He refers to how Washington managed to save the US economy from the 2008 recession as an example. While the US success in increasing GDP growth from a negative 2.8% in 2009 to 2.4% in 2014 signals that the economy had moved out of recession, the inflation rate was administered to remain under 3% during the period.

The key to US success, according to Pesaran, was “utilizing unexploited capacities” in the economy.

That model could also be used to address the current recession in Iran whose industries are, according to many experts, working at 50% capacity.

The unexploited capacities lie mostly in the supply chain which, most economists believe, constitute the major factor contributing to the current recession in the manufacturing sector.

In fact, the government should keep its focus on its top monetary priority–achieving single-digit inflation while removing hurdles to doing business--which would lead to exploitation of unused capacities.

That is the opposite of what critics suggest. They attribute the recession mostly to obstacles in the demand sector, arguing that since the inflation has generated problems on the demand side, policymakers should take measures to increase demand. Nevertheless, many find that argument illogical.

“There are many supply-related infrastructure problems, such as cumbersome bureaucracy and lengthy procedures in issuing permits, that the government should resolve at this point, instead of shifting focus to demand-boosting policies such as raising the interest rates,” says Pouya Jabal-Ameli, senior economist at Financial Tribune.

The critics point to the new decline in demand manifested in recent increases in the inventory of companies listed in Tehran Stock Exchange.

The phenomenon, driven by the downward inflation rate, has turned into a matter of concern for some, given its similarity to challenges experienced by countries such as Japan.

There is a general consensus that the glut Japan’s economy is struggling with, regardless of economists’ disputes over how it started, is triggered by deflation.

As prices show a downward trend, Japanese hesitate to spend, waiting for goods to get cheaper, which in turn results in a sharp fall in demand.

However, these concerns, many economists believe, should not give the government second thoughts about its single-digit inflation target, since there are many problems associated with double-digit inflation.

“A double-digit inflation gives rise to economic risks,” says Jabal-Ameli.

In a high-risk environment, investors tend to be reluctant to fund businesses, which adversely affects industries and causes concerns in the first place.

Moreover, he says that in the face of high inflation rate, the government has no choice but to manipulate the prices either in upstream or downstream industries.

The government’s interference with free price mechanism, which impacts the supply-demand matrix, causes turmoil in markets and ultimately a slowdown in economic growth.