Economy, Business And Markets

Monetary Expansion Inevitable

Monetary  Expansion  InevitableMonetary  Expansion  Inevitable

What do you do when you fall into a pit full of mud? Wipe the mud off your face with your muddy hands first, or do you start climbing without hesitation? The answers to crises are rarely simple.

The Iranian government’s answer to its current predicament—stagflation, as economists call contraction that joins hands with very high inflation—was born out of pragmatism and in terms of execution is unprecedented in Iran’s history, according to Presidential Advisor Masoud Nili.

“Conditions are such that there is no solution apart from a short-term reversible easing of monetary policy,” Nili wrote in a note published by many Iranian news outlets.

During the past five years, Iran has been hit by sanctions and seen years of mismanagement catch up with it in the form of unintended currency devaluation, overdue government debt and accumulation of toxic debt in the banking system.

Despite a 3% expansion in the economy in 2014, after annual economic contractions of 6.6% and 1.9% in 2012 and 2013, respectively, according to World Bank data, a return to contraction is possible this year.

The government’s response, unveiled last week, is a short-term easing of monetary policy with tools mainly aimed at stimulating consumer demand.

During the past two years, falling crude oil prices have halved the government’s main source of revenue.

According to the Governor of the Central Bank of Iran, Valiollah Seif, oil revenues dipped from $119 billion in the 2011-12 fiscal year to $55 billion in the 2014-15 fiscal year.

The lost revenue forced the administration to halt many investment projects, exacerbating a slump in construction and pushing the economy towards contraction.

Furthermore, Iran’s non-oil exports are also chiefly petroleum-related. Falling crude has hit them, too. Sales of publicly listed companies slumped in the first two quarters of 2015. Private investment also retreated in the first quarter, while private consumption was on the verge of contraction.

“The economy has moved to a recession in demand in 2015 from a recession in supply during 2012-13,” Nili wrote.

The advisor notes that suppressed demand has been long in the making. Real income in urban households has consistently declined since 2007—two years after Mahmoud Ahmadinejad’s team took office.  

The trend steepened after 2011, and despite a 1.7% increase in average per capita income, it is 13% lower than its level in the 2011-12 fiscal year. The damage will take a long time to reverse.

“A return to 2011 levels of per capita income before mid 2018 may be optimistic,” wrote President Rouhani’s Economy Minister Ali Tayyebnia.

In the government’s new plan, the central bank’s reserve requirement—money a central bank mandates lenders to deposit with it for rainy days—will be cut 300 basis points to 10%, for healthy banks.

Loans will also be funneled from the central bank to car buyers and consumers of Iranian-made durable goods, at discounted rates.

With banks getting new funds, the central bank will also move to lower its cap on deposit interest rates, in turn lowering the cost of money for borrowers.

“The focus on domestic demand as opposed to exports has two reasons,” Nili says.

“Firstly, exports account for 15% of gross domestic product, as opposed to domestic consumption’s 50%. So, stimulating consumer demand would have a greater impact. Secondly, sanctions mean expanding exports are not really an option, for now.”

Pundits are worried that the increase in money supply will undo all that the government has achieved in controlling inflation. The inflation rate declined from a year-on-year peak of 45.1% in 2012 to 15.6% in June 2015 in line with the lifting of sanctions and the tightening of monetary policy by the Central Bank of Iran, according to the World Bank.

However, Nili assured in his letter that a look at year-on-year inflation’s pattern points to it “falling to a single digit at most by Dec. 21”.

Weak global commodity prices help keep inflation lower. Furthermore, the central bank will be monitoring prices on a weekly basis. The bank is authorized to increase money supply as long as monthly inflation does not exceed 0.8%--a limit set by the government.

Money, which has the most inflationary effects, will not be printed and the growth in money supply will come from money created by bank lending, which will put less pressure on consumer prices.

However, he reminded President Hassan Rouhani’s critics that short-term monetary policy changes should not be expected to address structural issues in the economy.

“As long as banks can transmit their financial imbalances to the central bank, continuous control over money supply is not attainable, and until such a time as fiscal imbalances are passed on to the banking system, one cannot hope for a sustainable single-digit inflation,” he said.

Iran’s financial system is heavily bank centered, with 90% of financing coming from them in the past three years, a government study shows. Banks have been grappling with mounting debt from the government, now over 1.46 quadrillion rials ($41.9 billion at market exchange rate), and close to one quadrillion rials ($28.5 billion) of overdue debt from their borrowers.

However, when you account that 75% of the 3.42 quadrillion ($97.7 billion) lent by banks last year were used to reschedule existing debt because debtors could not repay their loans, one realizes the depth of the hole banks are in.

As bank’s assets get stuck, the need for attracting depositors rises, increasing borrowing costs and forcing more companies to default on their debt or avoid borrowing. The race for deposits is worsened by illegal lenders that can offer higher interest rates because they operate outside of the central bank’s supervision and keep no reserves with it.

The aggregate result has been a credit crunch and high interest rates, which are a menace to economic growth in current conditions as much as they threaten to fuel inflation in future.