From the Institute for Near East & Gulf Military Analysis
By Mr. Daniel Wagner, Non Resident Scholar, INEGMA
Mr. Fareed Mohamedi, Partner and Head of the Countries and Markets Division of PFC Energy, based in Washington, D.C.
The global debate on Iran's nuclear intentions and capabilities has been focused primarily on the role politics is playing in the process. Indeed, the Iranian Government's intransigence and hard political line are driving Iran's negotiating stance. Although there is sharp political division for and against Ahmadinejad in Iran, there is virtual unanimity among all political factions that Iran must have nuclear weapons in order to protect itself. Given this, even if Ahmadinejad and the hard line clerics were to be removed from power, the leadership that would follow would almost certainly support the continuation of Iran's nuclear weapons program.
As a result of Iranian intransigence, sanctions appear to be inevitable, even though the West continues to hope for a meaningful outcome. Although Russia's previous position against sanctions seems to be softening, it remains to be seen whether Russia will ultimate support robust economic sanctions. The Chinese are in any event unlikely to participate in a sanctions regime for two primary reasons. First, China wants to underscore its belief in the inherent rights of sovereign nations, and their own belief in non-interference in 'domestic' affairs. Second, the Chinese believe that the U.S. ultimately desires regime change, which stands in opposition to their own desire to strengthen their economic ties with, and derive future economic benefits from, Iran. Regardless of the relative success of future sanctions, they will have a net impact on all of Iran's trading partners.
The orientation of western Pundits toward the impact of politics on Iran's negotiating stance has drawn the discussion away from the rather serious economic situation Iran is currently experiencing. Given its over-dependence on oil and gas revenues, Iran's economy is already under moderate strain. Depending on the direction of future hydrocarbon prices, the economy could become severely strained. In order to balance its budget, Iran needs oil prices to rise above $95 per barrel and stay there. Projected oil revenue shortfalls in the current fiscal year will shift the budget into a large deficit position. As a result of conflicting budgetary demands and clashing political forces, the Ahmadinejad government lacks the political capital required to offset lower hydrocarbon receipts by cutting expenditures and/or raising non-oil revenues. If Ahmadinejad's political troubles deepen and capital flight accelerates, his ability to finance the looming budget deficit will become more limited.
Hydrocarbon exports account for more than 80 percent of Iran's total exports of goods and services, highlighting the current account's vulnerability to lower oil prices. In addition to price concerns, the physical volume of oil and gas exports is likely to decline over the foreseeable future due to the continuing lack of investment in the hydrocarbon sector. Iran's flexibility to run a current account deficit is therefore limited given its lack of access to international financing as a result of existing sanctions.
Source: PFC Energy
Ahmadinejad used record oil revenues from 2005-2008 to support expansionary fiscal and monetary policies. The non-oil deficit - a key measure of the fiscal health of an oil-producing country - widened sharply, as government expenditures ballooned beyond non-oil revenues. Ahmadinejad used his influence over monetary policy to promote imprudent fiscal measures. In mid-2007, he dissolved the Money and Credit Council and brought the key independent planning agency - the Management Planning Organization - into the presidential office, consolidating his control over economic policy. At the time, Ahmadinejad also insisted that the Central Bank lower interest rates below the rate of inflation. His unorthodox monetary policy directives contributed to spiraling inflationary pressures.
Source: PFC Energy
Rather than being used to build up the country's financial resources, as originally intended, Iran's Oil Stabilization Fund (OSF) has been tapped by Ahmadinejad to pay for populist programs. Unlike the Gulf Cooperation Council states, Iran failed to accumulate substantial monetary reserves during the boom. Oil revenues above the budget's oil price assumption (currently, $37.50 per barrel) are supposed to flow into the OSF. The deliberate setting of a low oil price assumption has led to greater discretionary spending via the OSF, which lacks transparency and provides a mechanism through which the government can channel funding to important constituencies.
The bulk of inflows into the OSF has been allocated to budget financing, or for domestic on-lending to the private sector. The use of OSF funds is partly compensating for the lack of international lending resulting from existing sanctions. It has extended credit to petrochemicals manufacturing and refineries, and pay for gasoline imports, among other areas of the domestic economy. Recent official statements about the amount of savings remaining in the OSF have been contradictory, ranging from below $10 billion to $25 billion. The government has stopped publishing data on the OSF balances, inflows, or withdrawals, making it difficult to ascertain the true status of the Fund.
The economic crisis and the decline in oil prices has also incited debate over replacing the country's byzantine subsidization system with targeted financial assistance to Iranians. Iran's explicit gasoline subsidies have accounted for 2 percent of GDP in recent years, while implicit petroleum and gas subsidies make up an additional 20 percent of GDP. While Ahmadinejad's 2009-2010 budget included a continuation of this state of affairs, the Majles rejected it on grounds that it would exacerbate inflation and increase poverty. The Majles recently amended its position by approving the outline of a bill to substantially reduce subsidies over the next five years.
While this is indicative of the extent of Iran's fiscal woes and Ahmadinejad's influence over the Majlis, the implementation of any reform would be a challenge practically and politically. Any relaxation of subsidies is likely to be gradual, with pressure in the immediate term on the country national oil company to cover the cost of fuel imports. Tackling the subsidy issue is important as demand continues to grow. Iran is boosting its refinery capacity and sophistication, though the impact will be marginal in comparison with the size of subsidization in the country.
Source: PFC Energy
Iran posted strong growth in FY 2006-08 in response to the government's loose fiscal and monetary policies. Non-oil and gas GDP has been the main driver of growth, as oil and gas GDP growth has declined in recent years. The pace of economic activity more than halved over the most recent fiscal year due to the impact of the global recession. Growth is likely to slow further in FY 2009/10.
Source: PFC Energy
Inflation has receded, but its rapid escalation during FY 2008/09 exacerbated social and political strains. Unemployment did not improve much even when non-oil growth was picking up. As the Iranian "youth bulge" enters the labor market, the economy will be hard-pressed to create the 600,000-800,000 jobs per year necessary to keep up with labor force growth. This can only strengthen opposition political forces and complicate Ahmadinejad's ability to govern.
Source: PFC Energy
Foreign Direct Investment continues to suffer as political tensions with the West continue to rise. Of 17 oil and gas blocks put up for tender in February 2007, only three were awarded. And of the 12 oil and gas blocks put for tender in November 2008, none have been awarded. China and Russia continue to be the dominant source of Iran's international commercial relations. Russia's tentative support for future economic sanctions against Iran may change that. Economically, Iran has few friends in the world.
All this points to a rather challenging economic environment in which Ahmadinejad is now forced to operate. Even if hydrocarbon prices were to stabilize above the level necessary for Iran to balance its budget and current account next year, many of the inherent contradictions associated with the country's economic and political process will continue unabated. As the timeline for a decision on whether to impose stricter sanctions on Iran draws nearer, Ahamdinejad and the hard liners in the Iranian government will undoubtedly dig in their heels in a more pronounced fashion, placing the economy under even more strain.
The impact of Iran's economic plight on the nuclear negotiation process is likely to be severe. As the government reckons with its unfolding economic reality and the ongoing vocal opposition to Ahmadinejad's second term as President continues, its inclination will be to reject any meaningful oversight of Iran's low-enriched uranium, to continue to bide for more time to complete the nuclear production cycle, and to continue to justify its past actions. The chance that there will be a sudden reversal in the government's approach to nuclear dialogue is close to zero. Iran is not bargaining from a position of strength, but weakness. The mismanagement of Iran's economy has only served to reduce the chance that further economic sanctions may be avoided.
The implications of all this for the Gulf region could be profound. Sanctions cannot and will not be air tight. There will be leakage through a variety of sources – official, black market, and otherwise. This will ultimately further enrich Iran's Revolutionary Guard, which already has extensive business interests in the country. It will also enrich Iran's trading proxies in the region, and embolden its military proxies (Hamas and Hizbollah), which Iran is estimated to spend up to $4 billion per year supporting.
The time for decisions – on the part of Iran, the U.S., and Israel – is fast approaching. If economic sanctions are deemed to fail and a military option is pursued against Iran by either the U.S. or Israel, Iran could benefit for a short time from a super-spike in the price of oil, to the extent that it is able to trade in the commodity. But whatever temporary economic benefit it may be afforded Iran as a result of its own actions will pale in comparison with the net economic price Iran will pay in the longer-term as a result of its mismanagement of its economic and political dilemma.
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