by Hamid Zangeneh
Iran’s policy with respect to the exchange rate of the rial could be analyzed under either a short-run or a long run scenario. Assuming free competition, in the short-run, the exchange rate is determined in the market—by demand and supply. In the long–run, however, the exchange rate is roughly the ratio of domestic to foreign prices—the dollar value of rial determined by the ratio of the level of U.S. prices to price levels in Iran. The rise in either price level relative to the other would cause that currency to falter relative to the other. If Iranian prices double while American prices remain stagnant, the U.S. dollar/Iranian rial must appreciate proportionally.
Under a fixed exchange rate regime there is a de facto suppression of exchange rate volatility and incremental adjustments according to relative changes in other economic variables. So when enough pressure is built up, we see wild devaluations or revaluations when the government, through the central bank, decides to relent and give in to the legitimate or speculative attacks on a currency and allows the currency to reach a different, perhaps more appropriate, level.
Iran has never followed a truly free market approach to exchange rates. Rather, it has always followed variations of fixed and flexible exchange rate regimes—at times a single exchange rate, but mostly, a more difficult and harmful multiple exchange rate system. Effectively, the government uses different rates for imports and exports and even different rates for each category of imports or exports as well as different market mechanisms for different sources of foreign reserves. Therefore, Iran’s exchange rate policy has gone through several metamorphoses in advancing development policies as well as fighting inflation. But regardless of the intentions of the policy, legitimate or otherwise, oil revenues have been pivotal in determining the exchange rate regime and its par values. That is, the government’s ability to provide more or less foreign exchange at lower or higher prices when oil revenues are plentiful or scarce has been highly influential in decision making.
Sanctions have been a thorn in the side of Iran for decades. But in the recent months, tensions have been rising to the extent that financial institutions throughout the world especially in the Persian Gulf sheikhdoms have become wary of dealing with Iran, even in the form of non-sanctioned economic activities and financial transactions.
Until March 1993, there were three official exchange rates—the basic rate, used for oil exports revenues, imports of basic necessities, and official foreign debt repayment; the competitive rate, used for imports not eligible for the basic rate; and the floating rate, for other transactions. That March, all these rate were replaced by a single rate, which effectively depreciated the rial to Rls 1,750/US$, a rate similar to the parallel market rate. Six months later, the policy was abandoned and a new fixed rate of Rls 2345/$ US was established to discourage imports and promote exports.
In 1995, high inflation in Iran and US sanctions put a great deal of pressure on the Central Bank to change the parity rate of Rial to correspond to the parallel market rate again. These pressures led to devaluation of Rial to Rls 3000/$ US in 1995. The cat and mouse game between the parallel free market, effectively a black market, and the fixed government rate has been the story of Iran’s exchange rate policy. That is, the government allows the free market to function alongside the government-approved system until the discrepancy between the two reaches a boiling point. At that point, the central bank develops a new scheme to close the gap.
Currently, due to uncertainties created by elimination of subsidies for essential staples and tightening of international sanctions, individuals and many corporations are trying to cover themselves by hoarding foreign currencies and importing more than what they would normally, at the current lower exchange rates. However, many factors favor the short-run ability of the government to deal with higher than usual demand for foreign currencies in the market.
At this time, the government does have a reasonably high amount of foreign reserves (about $90 billion, large enough to deal with over $80 billion of annual imports), high world oil prices (again, above $80 a barrel), and high oil revenues (about $65 billion at today’s prices) to shield the country from much hardship in the short-run. Besides the local and international political reasons, these figures explain why both President Ahmadinejad and Mahmoud Bahmani, Governor of Iran’s Central Bank, came out with gusto in defense of the old parity of Rls10,300 per US$. President Ahmadinejad, with a bit of his usual flair and exaggeration, proclaimed on October 6, 2010 that there is “no crisis of foreign reserves” and the government can provide for the high demand even if they rise by “fifty-fold.” Bahmani supported the president by saying that the central bank will supply unlimited amounts of gold and foreign currencies to maintain stability and normalcy in the market. He also warned speculators about destabilizing activities and suggested that they would “definitely lose” this game.
Iran has probably learned a lesson or two from the way OPEC members have dealt with oil speculators. They allow financial speculators to push oil prices on paper to rise and if it goes beyond their desirable level, they raid the market and push the price down by taking profits on the paper oil supplies. The Iranian government could do the same in the market for currencies. They could allow prices to rise and then arrive to sell their holdings at the new par values and earn an enormous profit. Or, as they seem to be doing this time, they could let the money changers buy a great deal of currency and when prices reach an undisclosed point, suddenly begin underselling them to inflict catastrophic losses.
Even though the central bank is capable of inflicting short-run pain on speculators, or letting the market find a new equilibrium price before setting a new par-value, one key question remains. How long can the bank fight the deteriorating fundamentals of the economy and the international environment that creates uncertainty and calls for speculation on the currency? Obviously, it does not have the resources to go on selling currencies at low prices forever. It would be foolhardy to do so anyway. They question is when they would relent and allow the dollar to appreciate (hence the rial to depreciate) to a sustainable level corresponding to its purchasing power.
Hamid Zangeneh, is Professor of Economics and editor of Journal of Iranian Research and Analysis at Widener University in Chester, Pennsylvania.
Picture via Flickr, by f650biker.