Solving the problem of subsidies in Iran

29 December 2009

In the face of civil unrest and falling living standards, US sanctions could offer Tehran an opportunity to implement unpopular subsidy reforms while blaming it on the West

The Iranian economy has endured a stagnant decade, and enters 2010 with yet another round of sanctions likely. The state of the economy hangs particularly heavy over the head of President Mahmoud Ahmadinejad, who came to power in 2005 as a populist leader yet has had his support eroded by falling living standards and rising unemployment.

Not all of the Islamic Republic’s economic problems are of its own making, at least not directly. Repeated international embargoes on the country have crippled industry and infrastructure, depriving Iran of both resources and foreign expertise.

With tighter sanctions approved by the US House of Representatives in mid-December and awaiting approval from the Senate, this year will prove even tougher than 2009 for the Iranian people.

If approved, the US sanctions will allow US President Barack Obama to ban foreign companies that supply Iran with oil from doing business in the US. Existing US sanctions ban foreign companies from doing business in the US if they invest more than $20m a year in Iran’s energy industry.

Key fact

2.25 million of Iran’s 3 million unemployed are aged under 30, and 800,000 people enter the job market each year

The Islamic Republic’s energy industry has been hit particularly hard by the global financial crisis. Despite having the world’s second-largest proven oil reserves – 138 billion barrels, according to UK energy major BP’s 2009 annual statistical year book, or about 11 per cent of the world total – Iran is in the unenviable position of having to import fuel due to an inefficient production and refinery infrastructure. About 40 per cent of refined petroleum products consumed by Iran are imported, and the new US ruling will give the White House greater powers to sanction companies selling fuel to Tehran.

The Iranian nuclear programme aside, attempts to move towards energy self-sufficiency have largely failed. The domestic refining industry is in a parlous state, and efforts to monetise the country’s enormous reserves of natural gas in the Gulf are still in their infancy.

Iran has negotiated gas-supply agreements with every country from Pakistan and India to its immediate Arab neighbours, yet a lack of equipment, expertise and foreign investment due to sanctions has prevented all but the most basic pipeline projects from moving ahead (see feature, page 30).

Despite the clear effect of sanctions on Iran’s ability to improve its economy, poor management has taken a far greater toll. Not only is fuel imported, but it is subsidised at the pump, crippling the public budget.

Rising unemployment

An estimated 38 per cent of Iran’s state spending goes towards gas subsidies. Still more money has been injected into the economy since 2007 in the form of state loans and bank credit. The theory has been to stimulate local industry, but the main result has been rising inflation, which reached a peak of about 30 per cent in December 2008 but has since fallen to about 12 per cent. 

Rising prices have also exacerbated social tensions within Iran. There are now more than 3 million unemployed, according to official statistics, of whom more than 75 per cent are under the age of 30. And the pressure from Iran’s young is mounting, with as many as 800,000 people entering the job market every year. Anti-government demonstrations have featured a high proportion of young, urban Iranians, and the government’s handling of the economy remains one of the most common causes of complaint.

Government infighting and the domestic political commitments of President Ahmadinejad make substantial changes to the budget unlikely in the near future. This makes Tehran heavily dependent on its oil income – which accounts for 60 per cent of government revenues – and in turn highly vulnerable to the movement of oil prices.

According to the US’ Energy Information Administration, Iran earned $49bn in oil revenues in the first 11 months of 2009, compared with $82bn in 2008.

The impact of these reduced revenues is already evident. Despite registering comparatively healthy economic growth during the era of high oil prices, growth slowed noticeably in the 2008-09 financial year, to 4.7 per cent from an average of 6.4 per cent a year in the first half of the decade.

Despite the recovery of the global economy, most analysts forecast Iranian gross domestic product (GDP) growth will remain subdued in 2009-10, at less than 3 per cent.

Much depends on the oil price. Prices appear to have recovered some stability, hovering above $70 a barrel in recent months, but this is still well below the $95 a barrel that Iran needs to balance its budget. With oil and gas accounting for more than 80 per cent of total exports of goods, any dip in prices will have a significant impact on the current account. A heavy import bill of nearly $70bn in the most recent fiscal year has added to the country’s problems.

“The issue of subsidies is all the more pressing as Iran appears to be emerging from a period of rapid inflation”

The other external factor is sanctions. Iran’s former allies, such as Russia and China, have been quietly backing away from their support for Tehran in recent months. Moscow has particular reason to feel aggrieved, having tried hard to negotiate a compromise deal over Iran’s nuclear programme.

Tensions with the West are clearly taking their toll on foreign investment. Of 17 oil and gas blocks tendered in early 2007, only three were awarded. And of 12 put up for auction in November last year, none has been awarded.

Past sanctions appear to have had less of an impact on exports, which Iran has directed towards Eastern markets. Yet they have been more effective at restricting inflows of goods, capital and investment.

“Sanctions have perhaps not been as effective as they could be, and the challenge is to make them not so raw, so they do not impact in a major way on those who are poor,” said William Cohen, former US defence secretary, at a press conference in December last year. “One route is try to prevent them acquiring credit from the international banking community.”

Subsidy reformThe Iranian leadership faces some tough choices in 2010. Not least of these is the question of subsidies, which cost Tehran an estimated $100bn a year. Plans to phase out the decades-old system have existed almost as long as the subsidies themselves.

But the internal and external political troubles of the past few years have persuaded a small group of politicians that by scrap-ping subsidies, Iran could wean itself off its oil and protect itself from the worst effects of sanctions.

Subsidies are a hot topic for debate. The vast majority of politicians, both conser-vatives and their opponents, have warned of everything from catastrophic price hikes to civil unrest. And these concerns are not without justification.

In May 2007, the government raised the price of petrol by a quarter, and shortly afterwards introduced rationing. While many economists supported the plan, it was executed poorly. Panic buying and anti-government demonstrations followed, and more than a dozen petrol stations were torched.

The issue of subsidies is all the more pressing as Iran appears to be emerging from a period of rapid inflation, with the cost of many goods leaping by as much as a third at its peak in 2008. This has not just stigmatised the rural and urban poor of Iran, the private sector has also suffered.

According to Mousa Vafayan, head of the chamber of commerce in the northern city of Sari, some 30 per cent of factories have been forced to suspend production, with many citing rising prices as the main cause.

This links to broader concerns about the structure of the Iranian economy. For such a heavily oil-dependent country, Iran has made much progress at diversifying. Services, agriculture and industry are growing sectors, while oil now accounts for less than 30 per cent of GDP.

Yet much of the economy is still in the hands of the government or its affiliates. An unusual feature is the large bonyads, or religious foundations, which dominate much of the economic life of Iran.

Many observers claim the combination of high inflation, price controls, inconsistent trade policies and more general hostility has prevented many private investors from gaining ground.

“Ahmadinejad should take some of the blame because he has not been supportive of the private sector, which creates the bulk of new employment these days, and whose outlook and willingness to invest is critical for economic growth and employment,” Djavad Salehi-Isfahani, professor of economics at Virginia Tech, said in a 2009 interview with US think-tank the Council on Foreign Relations.

President Ahmadinejad is in an invidious position. He rose to prominence as a defender of the poor and opponent of Tehran’s rich §middle classes, yet has been given the task by parliament of getting to grips with the subsidies system. The answer has been to present the reform of price controls as a populist measure, one that will punish the elites while freeing up government money to help the poor.

Whether this works in practice is another matter. After the chaos that followed June’s elections, the leadership will be wary of further alienating any interest groups.

Handled successfully, subsidy reform could help the government endure the siege it appears to crave politically. Ironically, sanctions could even make it more palatable. Reduced consumption would ease pressure on fuel imports, which in turn would ease pressure on public finances. And if the reforms stoke further resentment, there is always the West to blame.

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