Economy, Domestic Economy

Root Causes of Perpetual Forex Shocks

Root Causes of Perpetual Forex ShocksRoot Causes of Perpetual Forex Shocks

Foreign currency policymakers have always focused on maintaining the “nominal exchange rate” and have treated the “real exchange rate” with indifference. The latter, however, has gained relevance in recent years due to the structure of monetary policymaking and the previous administrations’ inability to curb inflation.

“Real exchange rate” is an inflation-adjusted “nominal exchange rate”. For instance, when the nominal exchange rate of the US dollar remains the same in a given year while the inflation rate and wages increase by 10 percent, it can be concluded that US dollar has invisibly depreciated. Such hidden depreciation hurts exports and benefits imports because when the rial gains against the dollar, exports become relatively more expensive while imported products will be cheaper compared to those offered by domestic rivals.

Despite sufficient evidence in favor of adjusting the exchange rate with the inflation rate, policymakers have been unable to take the necessary steps to adjust the rate and maintain the competitiveness of Iranian products against foreign rivals due to the following reasons investigated in the current edition of Tejarat Farda weekly.

  Inflation Rate

Over the past few years, inflation has played the most decisive role in deepening the gap between nominal exchange rate and domestic prices. In fact, inflation has been the very source of the gap. Central Bank of Iran (CBI) has always been under criticism for having failed to adjust the exchange rate accordingly in order to maintain the price competitiveness of Iranian products.

Thus, despite the need to observe the principle of purchasing power parity (which calls for the exchange rate to grow in proportion to the domestic and external inflation rate difference in order to avoid weakening of exports), curbing inflation seems to be the most important factor to be considered as part of any solution.

Political Pressure

In the 2000s when competitiveness of Iranian products weakened as a result of the deep gap between prices of domestic products and foreign rivals, even if the CBI had intended to maintain purchasing power parity and had the required tools for this purpose, political pressure on the administration would have prevented the measure.

Although the accumulated gap in the US dollar nominal and real exchange rate was finally fixed during the tenure of the then-administration in the 2000s, it can be concluded that administrations, in general, have always tended to care more about the “nominal” rate of the US dollar in order to safeguard their political popularity and have always lacked the required prudence to also think about the “real” exchange rate. That is the main reason why the principle of purchase power parity has been neglected all these years.

  Oil Dependency

Economists believe that the main obstacle in the way of adjusting the US dollar exchange rate with domestic prices is an external and unpredictable factor called “oil”.

The oil market has always been characterized by volatility in price and sales leading to significant changes in revenue in foreign currency for the country. Nevertheless, it is regrettable that the Iranian economy continues to suffer from the repeated impacts of oil market fluctuations and no effective mechanisms have been developed to counter its ripple effect across the economy. Although the establishment of National Development Fund of Iran (NDFI) has shielded the economy to some extent, its 30 percent share of oil revenues is not enough to fully protect the economy against the dire impacts of oil fluctuations.

In addition, oil-dependency negatively influences the balance of payments. For instance, in the period of March 21–June 20, oil exports (including the value of crude oil, oil by-products, natural gas, gas condensate and liquids) amounted to $16 billion while non-oil exports stood at $7 billion. In the meantime, the total value of import was $15 billion. Excluding oil, it is evident that the trade balance of the country (non-oil export vs. import) could not be shaped upon the existing US dollar exchange rate and the rate would naturally surge under market mechanisms.

Under such circumstances, the US dollar exchange rate would be different (approximately 50 percent higher than the existing rate) depending on the price elasticity of exports and imports with respect to the exchange rate. It is worthwhile to note that if the oil price in the period of March 21–June 20 is assumed to be $100 per barrel and the current price is $65, oil exports subsequently fall by 35 percent ($5.5 billion), which is still $2 billion higher than total import. This means that even the current US dollar exchange rate has the potential to create balance in the market but whether adopting such a policy is correct and sustainable under the assumed situation remains unclear and needs further study.

In brief, dependence on oil should end and high inflation rates should be curbed so that the Iranian economy can experience a more natural growth with domestic products becoming more competitive in terms of price and quality.