By Win Thin
Recent developments in Iran are worth discussing. We feel that with Middle Eastern political risk on the rise lately, Iran is more likely to have the largest impact on global markets, while escalating tensions between Syria and Turkey are unlikely to have as much lasting impact. News outlets have been carrying countless stories this past week about the collapsing Iranian currency, the rial (IRR). The rial is not used for international payments, making it both impossible and unnecessary to make any sort of currency call. Instead, we will simply state there seems to be a genuine shortage of dollars in Iran as sanctions appear to be very effective. We think the plunging rial is really just a symptom of the economic collapse under way there. As of this writing, media reports suggest that most money changers in Tehran remain shuttered after some street protests were seen this week.
Sanctions on Iran due to its nuclear program have been put in place under the auspices of the UN Security Council. Since the coalition agreeing to sanctions include the US, EU, Japan, Korea, and many others, the sanctions so far have proven effective in squeezing the Iranian economy. These sanctions have cut across many sectors. The EU has banned purchases of Iranian oil (the major EU importers are Italy, Spain, and Greece), and has also banned European firms from providing insurance or reinsurance to Iranian tankers. This has further crippled the country’s oil exports, though some of the importing governments have offered state-backed insurance for tankers. Iran too has offered to plug the insurance gap. Of course, oil is the most visible channel, but it is not the only one. Many global banks can no longer deal with Iranian banks and companies that have been identified as “fronts” for Iran’s nuclear ambitions. The US prohibits financial institutions from conducting or facilitating transactions with the Central Bank of Iran, while the EU has frozen some assets of the central bank.
Oil is of course the major driver for Iran, accounting for 80% of exports. International oil industry estimates currently put Iran’s proven oil reserves near 140 bln barrels (OPEC estimates are higher at around 150 bln), behind only Saudi Arabia (265 bln) within OPEC. Oil output had grown steadily from around 3 mln bbl/day in 1990 to over 4 mln in 2011. However, the sanctions have hit Iran hard, with reduced global demand leading Iran to slash output to around 2.85 mln in September. Domestic demand has risen from abound 1 mln bbl/day in 1990 to over 2 mln bbl/day currently. Before the embargo, Iran’s exports went chiefly to China (21%), Japan (9%), India (9%), Turkey (9%), Korea (8%), and Italy (5%), with these six countries taking almost two thirds of Iran’s total exports.
Iranian macro data is not readily available, but some numbers stand out. Nominal GDP stands near $500 bln, putting it just behind Saudi Arabia ($575 bln) as the largest within OPEC. Iran has foreign reserves estimated near $110 bln, while external debt remains low at around $22 bln. High oil prices have seen the current account surplus rise to over 10% of GDP in 2011, but that will likely fall back this year due to the sanctions. Inflation spiked to 27% y/y in July, and has surely gotten worse in light of food shortages and the plunging rial. GDP rose 6% in 2010 due to high oil prices, but growth subsequently slowed in 2011 to around 2% and is likely to stagnate in 2012. The IMF estimates total unemployment around 15% at the end of 2011, with youth unemployment seen near 25%. If sanctions are tightened further, Iran’s fundamentals will continue to deteriorate.
Israel has backed away from the threat of an imminent military strike on Iran. This could be for a variety of reasons, but it does seem that Israel may have been swayed by the problems that Iran is facing now. Tightening sanctions and also giving them more time to work should be seen as a viable policy, and is the tack that the US is taking. We believe an attack on Iran would very likely strengthen the position of the hardliners in Iran and blunt any recent progress by moderates there in regaining a measure of influence. Protests against rising inflation and shortages have sprung up this past week, and could signal a weakening of public support for the country’s rulers. As such, we are relieved to find Israel dialing back its bellicosity by a notch or two.
It is impossible to predict Iran’s political path ahead, but a free-falling currency amidst deteriorating economic fundamentals is simply unsustainable. Something has to give. We do note that Supreme Leader Khamenei has been the head of state since 1989, and that the clerics so far have shown no signs of any sort of political reform. The current head of government President Ahmadinejad has been in place since 2005, when then-President Khatami (a key moderate) was ousted. Ahmadinejad was reelected in 2009, and his current term ends in 2013. Candidates are vetted by the Guardian Council (led by the clerics), and so the choice of his successor will seen as a clear indicator of the country’s appetite for reform.
Rising social unrest may not lead to regime change, but one can hope that the leaders will take a step back from confrontation and take a step instead towards some reform. Any easing of Iran tensions would likely lead to lower oil prices. As it is, the removal of nearly 1.5 mln bbl/day of Iranian oil has been absorbed very well by the markets, with Brent oil prices currently near the year’s average around $112 per barrel. We cannot say how much of an Iran premium has been built into oil prices, but we not view it as insignificant. Lower oil prices would be a very welcome development for global oil consumers.
Editor’s Note: Also see Hyperinflation Has Arrived In Iran by Steven H. Hanke