Iran: Paying the price for removing subsidies

Tehran’s decision to axe subsidies at the end of last year was both necessary and brave, but the new system of direct payments to the public may not prove any more sustainable. Published in MEED, 19 August 2011

Eight months have passed since Tehran introduced one of the most sweeping economic reforms the Middle East has seen. The removal of swathes of government subsidies was a risky policy, but initially everything seemed to go well. Now, however, some significant problems are emerging, creating fresh challenges that the government may struggle to cope with.

It was 18 December 2010 when President Mahmoud Ahmadinejad appeared on television to announce the end of subsidies for fuel and other basic commodities. He promised to introduce a system of cash payments to help people cope with the higher prices.

There had been a consensus that the system had to change. Artificially low prices for fuel in particular encouraged consumers and companies to be wasteful. With international sanctions undermining the government’s ability to export crude oil and import refined products, the position was also becoming untenable.

Ahmadinejad’s daring move on subsidies

Reforms to the system had been discussed in Iran since 1988, so in one sense the new policy was not a surprise. But the extent and speed with which the changes have been carried out has been remarkable. Overnight, some $60bn of subsidies were removed, equivalent to around 15 per cent of the country’s gross domestic product (GDP).

“It was a daring move,” says one Iranian economist. “It’s something a lot of governments in Iran have thought of doing and didn’t manage to do. Very few people other than Ahmadinejad would have taken this on. It’s a risky policy and it needed somebody who wouldn’t think a lot about it before doing it and Ahmadinejad is that kind of person.”

The removal of subsidies had an immediate impact on prices. According to figures compiled by local investment firm Turquoise Partners, the cost of gas oil rose 900 per cent from 1.5 cents a litre to 15 cents a litre. Fuel oil increased from 1 cents to 20 cents a litre. Water bills for households increased from 9 cents a cubic metre to 25 cents, and the cost of wheat flour leapt from less than 1 cent a kilogramme to 28 cent a kilo.

Despite such dramatic rises, the new system appeared to work smoothly in its early days. The payments of about $45 per person a month were made into people’s bank accounts as the government had promised and there was little sign of any public anger. There were no large protests on the streets of Tehran or other cities to complain about the policy.

The government also went out of its way to placate the public. In particular, it decided against introducing any means testing for the payments. As a result, according to the official statistics, around 73 million citizens, out of a total population of 75 million, are now receiving the cash payouts.

Initial success in cutting subsidies

“In terms of the ability to implement it without facing any significant upheaval you could say it’s been successful,” says Nader Habibi, the Henry J Leir Professor of the economics of the Middle East at Brandeis University in Massachusetts in the US. “Usually in developing countries when governments try to remove subsidies they face considerable social unrest.”

The IMF for one was impressed. A delegation travelled to Iran in late May and early June and issued a glowing report within days of returning to Washington. In its statement, the IMF team applauded the authorities “for the early success in the implementation of their ambitious subsidy reform programme”.

Some critics now say the IMF was too quick and too enthusiastic with its praise. One problem is the failure by the government to help businesses cope with the higher costs. Tehran had promised to give some $10bn-15bn in financial assistance to companies, but these payments have not been forthcoming. This has put huge pressure on local firms, particularly as many are barred from passing on all their higher prices to consumers.

“The way the reforms have been implemented has left many questions and problems,” says Habibi.

“The promised assistance to industry has not been realised. In that sense the implementation has not really gone according to plan and if this goes on it could lead to significant problems. The government has promised them loans instead of direct subsidies, but it has not materialised as fast as it should.” Inflation is another key concern. Prices were always going to rise as the cost of goods climbed closer to market levels and more money was pumped into the economy through cash handouts. The consumer price index rose from 12.5 per cent in November 2010 to 21.2 per cent in May. Some suggest that inflation could rise to as high as 30 per cent by the end of the year.

Critics say the problem has been exacerbated by the government’s expansionary fiscal policy. In May, Iran’s parliament approved a $508bn budget for the current year – a 38 per cent increase on last year. In addition, the authorities have failed to ensure that households actually pay the new, higher prices. Reports in the local press suggest that at least a third of consumers are still refusing to pay for gas and other goods.

Deficit concerns

“Some households have not paid their bills on time,” says Hadi Salehi Esfahani, professor of economics at the University of Illinois in the US. “People are reluctant to pay and the government has not shown the resolve to cut the gas and electricity from people’s homes.

“Eventually they’ll be forced to pay, but there may be a year’s lag and in this period the government will have to run a deficit to pay the cash subsidies, while collecting only part of it back through utility bills. That’s one of the factors that seems to be fuelling inflation.”

This could store up political problems for the future. “If the government gives something to someone and they then discover that it is being eroded because of inflation created by economic policies, they’re not going to be as grateful,” says Esfahani. “In fact, at some point they may become mad at the policymakers.”

There are other structural issues that are also causing concern. Some suggest the Iranian economy is not well placed to cope with the challenges that a free market in these goods will create and that it has failed to put mechanisms in place to prevent abuse.

“The remarkable social and economic consequences of the way that subsidy reforms have been carried out have been completely overlooked and I think they’ll be devastating,” says Kaveh Ehsani, an assistant professor at DePaul University in Chicago in the US.

“The way the subsidy reforms are being carried out has very negative effects for the economy and the population.

“If you look at the economy at large, you need strong and impartial institutions and a competitive market economy that would benefit from the lifting of the subsidies. Those institutions have been weakened systematically since Ahmadinejad has come to power. The potential for graft and corruption across this whole line of economic activities that are being opened up is tremendous. Who’s going to oversee the companies and corporations that are going to come and take care of all these services? There is no institutional oversight or regulatory processes overseeing this.”

The IMF statement in June suggested that the subsidy reform programme should “considerably improve Iran’s medium term outlook by rationalising domestic energy use, increasing export revenues, strengthening overall competitiveness, and bringing economic activity in Iran closer to its full potential”.

Indeed, there was a notable drop in use of the newly unsubsidised goods in the immediate wake of the reform programme being launched. Yet, unless the government can stabilise inflation, enforce bill payments more effectively and ensure that corruption is kept to a minimum, many of the potential gains may never be realised.

“Businesses see this as a chance to say ‘my costs have gone up, so my prices should go up’, sometimes much more than the costs,” says Esfahani.

“If many businesses manage to push up their prices in this way, inflation is going to rise and feed into itself, becoming a vicious circle. Whether the government can control and stop this process in the next few months and bring down inflation remains uncertain.”

The government has shown itself able to bring down inflation in recent years. According to the IMF, Tehran successfully reduced the annual average rate of inflation from 25.4 per cent in 2008/09 to 12.4 per cent in 2010/11. But other aspects of its economic policies have been less successful and overall economic growth has been meagre, at just 1.5 per cent last year. Unemployment was officially running at 14.6 per cent in early 2011, but in all likelihood is far higher.

Subsidy handouts unsustainable

The subsidy reform programme is not yet at an end. The changes made in December were only one element of a wider plan to eliminate all subsidies by 2015, but the new system of cash handouts that has replaced them may yet become unsustainable.

The payments are currently being made at a rate of about $3bn a month, meaning the annual cost to the government will be around $36bn – some 20 per cent higher than originally expected. The government’s finances may become over-stretched if there is any decline in its all-important oil revenues, whether because of a fall in the price of crude on international markets or an inability to sell its oil because of sanctions.

“The cost is far above the initial estimation and the system might not be sustainable going forward,” says Habibi. “Eventually they might switch from a universal payment to a system of need-based or income-based assistance. If the government reaches the point where it cannot sustain these payments it will have to either abandon the payments or limit the number of people who receive it.”

Limiting the provision to only the most needy might make economic sense, but it will require a brave government to take away a benefit that so many people are rapidly getting used to. While the previous system of subsidies did require a radical overall, the government may find that it has simply replaced one major financial headache with another.