Entrenched by Past Ghosts

The cold war was, in every sense, a battle between capitalism and communism—a fight for the merits of private business against the vileness of central planning. And in the end, it was won on the economic arena.

It became increasingly daunting for the crumbling Soviet economy to finance its armament race with the United States. In the 80s and 90s, more countries proceeded to open up their economies and reduce the state’s footprint in it.

Yet today, the legacy of neighboring the Soviet Union lingers in Iran’s economy, holding back development and fueling corruption.

Not only is the size of the state destroying productivity but it is also raising the allure of rent-seeking.

A study by Hamid Abrishami and his colleagues published in issue 67 of Economic Studies Magazine digs into “The Effects of Rent-Seeking on Iran’s Economic Growth”.

Unsurprisingly, it reaffirms the maladies caused by government intervention in business.

Strong growth in the Iranian economy has become a dream these days. In the 2000s, the economy inflated rapidly on the back of windfall petrodollars from record high crude prices. But the party could not continue, as revenues were wasted on profligate policies and money was printed incessantly to fund an ever-expanding state. Policymakers of the time mistakenly equated inflation with growth.  

The economy fell into disarray in the early 2010s, catalyzed by ever tightening sanctions and started contracting. The national currency lost its value, overdue debts soared and economic activity contracted, increasing unemployment. But these were ideal times for the select few who knew how to exploit rent opportunities.

The current administration has spent the past four years containing the fallout. Now the government, commercial banks and companies all have accumulated overdue debt, manufacturers are suffering and unemployment is ravaging the workforce.

Luckily, the government has succeeded in averting a nuclear standoff, getting most sanctions against Tehran removed, curbing inflation below 10%, and stopping rial’s freefall.

  Where Connections Are a Necessity

But the main issues holding back growth and fueling rent-seeking are still going strong. The state, which gradually took hold of every industry after the Islamic Revolution of 1979, has been augmented by a large quasi-state outfit, which gradually wrested control of many industries from the government in what was termed as “privatizations” since the mid 2000s. The only difference between the two is the quasi-state has little to no oversight.

The gigantic size of the state economy is the main culprit behind rent-seeking, according to the study. It makes double dealing and holding strong connections with state officials a must for surviving in Iran’s acrid business environment.

The Iranian budget has averaged 60% of gross domestic product in the past three decades, “twice the share of the US or Swiss governments from their GDP”. Reducing the budget’s share of economic output by 1% adds a whopping 0.2% to growth, the study found. So there is much upward potential for Iran.

Now, add the maze of government regulations, often constructed on the pretense of protection against foreign competition, to a hulking government.

“Tariffs, trade barriers and bureaucratic protocols,” are the name of the game in Iran and they do more harm than good. These overbearing regulations just reinforce established positions and create rent, redistributing resources from taxpayers to well-connected individuals. Cutting average import tariff rates, currently around 28%, by 1%, adds 0.02% to GDP. Yet, protectionism has strong political support, even among businessmen who try to insulate themselves by hiding behind tariffs instead of boosting productivity.

  The Tale of Markets and the State

As if a giant government and insurmountable trade barriers were not enough to halt an economy, Iran also has a multiple exchange rate regime. The previous government ditched a managed float and reverted back to a multiple exchange rate system in response to rial’s rapid devaluation in markets in 2012. The currency lost 70% of its value in a year and has not recovered, opening up a highway for the corrupt.

In a multiple exchange rate regime, the central bank offers cheaper foreign exchange, using its reserves, in quantities deemed necessary to purposes and businesses as it sees fit, while heavily controlling and hampering market transactions.

This current forex regime is opportune for rent-seeking, while complicating normal business, evident in surging corruption cases since the system was readopted.

According to Abrishami’s study, a percentage decrease in the gap between official and market exchange rates could boost GDP growth by 0.15%. The current gap for the US dollar is 14% and the central bank has promised to adopt a single exchange regime before the end of March.

Furthermore, the study found that reducing the gap between exchange rates will boost deposits in banks in the short term–deposits lenders badly need to sift out of the quagmire they are currently in.

Another fuel for rent is the large spread between interest rates in official and unofficial money markets. The interest rates advertised by banks for depositors are well shy of the rates that are agreed upon behind closed doors—one is dictated by powerful men sitting in their offices worrying about publicity and the other by economic necessity.

While rates for one-year deposits are advertised at 15% per annum, banks are more than willing to offer north of 20% per year for large sums of cash, let’s say something above $10 million, a source told the Financial Tribune on condition of anonymity.

“Recently rates have started climbing back up, highlighting lenders’ shortage of liquidity,” said the banker.

This spread provides people with a huge incentive to exploit the difference in rates and also discourages investment.

In short, “government intervention in money and currency markets has made foreign exchange and money market prices in the country unreal”, the study concludes.

The pity in all of this, as written in FT’s sister paper Donya-e-Eqtesad’s review of the study, is that: “A look at the literature of our policy makers reveals the good intentioned, yet destructive belief and assumption that actions taken along the said four points have increased production in the country.

Truly, Iranian politicians still carry the ghost of Soviet era in their heads, made terrifyingly evident in their lingo, and their propensity to look at markets as tools to carry out their bidding. Until this ghost survives, through policies, regulations and rhetoric, Iran’s future suffers, as it has for the past three decades.