Nuclear deal vital to Iran's economy

Despite Rouhani’s best efforts, the fiscal outlook for Iran is bleak, with falling oil prices and ongoing sanctions eroding government revenue. Published in MEED, 5 January 2015

The failure to agree a compromise deal on Iran’s nuclear programme in late November means any hope of sanctions being lifted have been pushed back until 1 July this year at the earliest. But sanctions are not the only issue facing the Iranian economy. Even as talks with the P5+1 group of countries were approaching the November deadline, another problem was brewing.

The huge drop in oil prices in the second half of 2014 - from more than $110 a barrel in June to less than $60 a barrel in December - is also undermining government finances. The combination of the two elements means the outlook for Iran’s economy is rather bleak these days.

Of course, policymakers in Tehran are already used to tough conditions. As sanctions have been ratcheted up by the US and the EU, the pressure on the economy has steadily risen. According to the Washington-based Institute of International Finance (IIF), Iran’s economy enjoyed an annual average growth rate of 5.1 per cent from 2000 to 2011, but it then contracted by 6.6 per cent in 2012/13 and a further 2 per cent in 2013/14. The IIF estimates that the country’s nominal GDP fell from a peak of $514bn in 2011/12 to $342bn in 2013/14.

Signs of how much the economy is suffering are not hard to find. Oil exports have fallen from 2.1 million barrels a day (b/d) before the sanctions targeting oil sales were imposed to less than 1 million b/d and the Iranian rial lost 65 per cent of its value in 2012/13 against the dollar, according to local broker Mofid Securities. Unemployment is running at about 24 per cent among young Iranians.

Despite all that, the situation could in fact be far worse. The policies that have been adopted by President Hassan Rouhani since he took office in August 2013 do appear to be having a positive effect in some important areas.

Perhaps the most significant is the engagement with the US and others over the nuclear programme. While there has not yet been a breakthrough, there was at least an interim deal in November 2013, which has meant that some sanctions have been temporarily eased. As a result, Iran can more easily sell oil to key customers in Asia and restrictions on the export of petrochemicals and automobiles have also been toned down.

The government’s domestic policies are also helping, with inflation almost halving in the past year. According to Economic Affairs & Finance Minister Ali Tayyebnia, inflation fell from 40 per cent to 21 per cent in the 12 months to September 2014 and the economy should post growth this year.

“We are witnessing many indicators reflecting positive growth in the current year,” Tayyebnia told the annual meetings of the IMF and the World Bank in Washington in October. “The commencement of positive economic growth, along with a significant reduction in the inflation rate, shows Iran’s economy has followed the right direction since last year.”

Government ministers and senior officials these days often use the term ‘economy of resistance’ to describe how they are coping with the international trade embargoes. But while they may be able to point to improvements in some areas, the situation is still far from ideal and failure to reach a deal on the nuclear programme in 2015 would add substantially to the pressure on the economy. The US and its allies will not continue negotiating indefinitely unless there is a genuine prospect for a deal. If the talks collapse, the interim agreement will lapse and the sanctions could be tightened even further.

“If an agreement is reached, Iran could see GDP growth of 5 and 6 per cent in fiscal years 2015/16 and 2016/17 respectively,” says Garbis Iradian, deputy director for Africa and the Middle East at the IIF.

“Without an agreement, the Iranian economy would likely weaken further and unemployment would continue to rise. In this scenario, sanctions could be intensified on trade and financial transactions, leading to further reductions in oil exports and a significant depreciation of the black market exchange rate, along with higher inflation. The harsh economic and social consequences of a failure to reach an agreement would deepen the malaise and could even pose risks to the current political order.”

These are the medium- and longer-term risks for Iran surrounding the sanctions regime. In the shorter term, some of the economic gains made since Rouhani was elected could also be undone by the recent dramatic collapse of the oil price on international markets.

“After several years of recession, the Iranian economy has shown some stabilisation,” says Rajiv Biswas, Asia-Pacific chief economist for US research group IHS Economics. “However, the decline in oil prices will also have a significant impact on the Iranian economic outlook for 2015, delaying any significant rebound.”

The IIF estimates that Iran’s breakeven oil price - the level at which the government is able to balance its income and expenditure - has risen from $102 a barrel in 2012/13 to as much as $140 a barrel in 2014/15. That is more than double the current price of oil.

The problem for Tehran is multi-faceted. The international embargoes on the country have cut its oil exports in half in volume terms, but the government has also been increasing spending at a frenetic rate, with expenditure rising by 36 per cent in 2013 and by an estimated 25 per cent in 2014.

Adding to the problems, more than half of the country’s official reserves cannot be easily accessed by the government as they are held outside the country. As a result of US sanctions, Iran is effectively barred from repatriating its earnings from international oil sales.

The government has faced up to some of its challenges in its latest budget, which covers the fiscal year starting 21 March, and which was presented to the Majlis (parliament) on 7 December.

The total budget of IR8,370 trillion ($310bn) was just 4.3 per cent higher than the current year’s budget. Given that inflation is well into double figures, it means government spending is declining in real terms. Some areas of expenditure are benefiting from growth that is far closer to the level of inflation. Spending on government salaries, for example, is rising by 14 per cent, while spending on infrastructure projects will increase by 16 per cent to IR477 trillion.

Oil revenues for the coming year have been estimated at IR710 trillion, equivalent to a third of government revenues compared with 40 per cent for the current year. Mofid Securities says the lower income from oil sales will be offset by a combination of higher taxes and borrowing on the one hand, and lower public subsidies on the other. But “the shock of falling oil revenue gave little room for manoeuvre”, as the firm says in a review of the budget.

To try and offset the lower oil prices, the government would like to see a rise in non-oil exports. In a speech to parliament on 7 December, Rouhani stated that non-oil exports in the past eight months amounted to $31.5bn, a 20 per cent increase compared with the same period a year earlier. He suggested they might reach $50bn by the end of the current fiscal year, but as long as restrictions remain on the Islamic Republic’s banking system, increasing exports will continue to be a challenge.

Senior government officials have insisted that Iran can cope with far lower oil prices. “Even if prices slide to less than $40 a barrel, we are determined to manage the country properly by resorting to the terms of the economy of resistance,” Iran’s Vice-President Eshaq Jahangiri said in comments carried by the Ministry of Petroleum’s news agency, Shana, on 10 December.

Despite such fearless talk, in the end, every discussion of the Iranian economy must come back to the sanctions regime. The economy would clearly benefit from higher levels of foreign investment and the expertise of international companies. The government has been doing its best to encourage this, but until there is a nuclear deal it is unlikely that many large agreements will be signed.

At a recent international car show in Tehran, local media reported that automotive manufacturers and spare parts suppliers from Europe and Asia appeared keen to sign deals, but were stymied by the restrictions on working with Iranian banks.

The IIF estimates that without a nuclear deal the Iranian economy will fall back into recession, contracting by 0.6 per cent in 2015/16 and 0.9 per cent in 2016/17. In that scenario, the government would be running fiscal deficits of 4-5 per cent of GDP and the urban unemployment rate could rise from about 13.6 per cent today to 16 per cent by March 2017. Nominal GDP would be $351bn in the year 2016/17, lower than it was four years earlier.

The alternative scenario of a deal being successfully concluded would have a dramatic effect on the economy. Along with GDP growth of between 5 and 6 per cent, the IIF estimates that unemployment could fall back to 11.5 per cent, the government would be able to run a small fiscal surplus of 0.1 per cent of GDP by 2016/17 and nominal GDP would reach $434bn that year.

Despite the lure of such gains, Rouhani cannot agree to a deal at any price. Supreme Leader Ali Khamenei and his hard-line supporters in Iran will have to be convinced that it is the right thing to do. Unless that happens, it is ordinary Iranians who will continue to suffer most.

As Sara Bazoobandi, assistant fellow for the Middle East and North Africa Programme at UK think-tank Chatham House, says: “Sanctions are aimed to be targeted at governments but people pay the price of sanctions first and most.”