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Analysis | Sanctions Bite, Iran Scrambles

17 Oct 2012 23:00Comments

Islamic Republic could be moving toward Soviet-style command and control economic management.

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Q&A with Gary Clyde Hufbauer, the Reginald Jones Senior Fellow at the Peterson Institute for International Economics.

The European Union imposed new sanctions on Iran's financial, energy, trade, and transport sectors on October 15. What impact will these measures have on Iran's economy?

Oil and gas account for close to 90 percent of Iran's exports. Anything that interrupts the export of these commodities hits Iran hard. Oil shipments are already down by about 50 percent and Iran no longer has access to London's shipping insurance market.

As of 2010, gas accounted for less than four percent of Iran's export earnings, while petroleum accounted for 78 percent of earnings. But gas is one of Iran's few remaining exports. The European ban, coupled with the abundance of natural gas in the world market, is another peg in the coffin of Iran's economy.

The Iranian government is now taking desperate measures to deal with the crisis by applying drastically different exchange rates for purchasing imported goods. There are ten categories of goods linked with different exchange rates. For essential goods like medicine and basic foodstuffs, the exchange rate is 12,600 rials to the dollar. Nonessential goods, like consumer electronics and replacement car parts, are priced according to the black market rate of 35,000 rials to the dollar.

The broad thrust of U.S. and E.U. sanctions alienates middle and upper middle classes who are importing many types of goods. The economy is basically reeling from these sanctions.

How do international sanctions interact with the Iranian financial crisis?

The panic that took hold in September-October 2012 was likely sparked by the realization that sanctions may continue indefinitely. Iran's printing of additional rials probably contributed to the crisis.

Iran is short on reserves of foreign currency since its exports have been cut in half since last year. The government is also spending money on support for the Syrian regime. At the same time, it is trying to stave off the economic crisis impact on the Iranian people. It has drawn upon its foreign exchange reserves to make up the difference in export earnings to keep importing necessary goods.

But in September 2012, Tehran realized it would soon run out of foreign exchange. So the government cut back on imports in order to maintain funding for the security apparatus. As goods became scarcer and the rial's value plummeted, people began to panic. Middle and upper class Iranians observed the leadership's unwillingness to negotiate an agreement with the P5+1. They probably concluded that sanctions are not going to be lifted soon and that their holdings in rials will continue to lose value.

What additional measures can the U.S. or others take against Iran's economy?

There is very little wiggle room now but there are a few more ways to squeeze Iran. Asian countries could further reduce their purchase of Iranian oil since the world supply is not tight. But the United States would have to exert a significant effort to convince China, India, South Korea, and Japan to cut back further on their Iranian oil purchases. That effort, even if made, is not likely to reduce Asian imports of Iranian oil to a significant extent.

The United States could take additional actions against Iran's financial sector. It could launch a cyber attack on Iran's central bank to stop it from receiving or paying money electronically. This would be a drastic move likely to be construed as an act of war. The Pentagon has already stated that it considers cyber attacks constitute acts of war.

Alternatively, Western countries could warn that they intend to blacklist any tanker carrying Iranian oil. This would force Iranian tankers to ship oil only to secondary ports, making the tankers considerably less valuable. This move would not be regarded as an act of war on par with imposing a blockade of tankers.

Sanctions have been imposed on Cuba, North Korea, and Zimbabwe for extended periods of time. In each case, the state played a more prominent role in the economy and everyday life, and became more powerful. How does Iran's case differ?

Iran is a bigger country and has a more robust economy than Cuba, North Korea, or Zimbabwe. It also has a valuable natural resource -- oil. Although Iran is not a manufacturing power house, it is much more self-sufficient than those countries. Also, Iran's borders are long and porous so there are more opportunities for smuggling goods in and out.

In those other cases, the leaders decimated the middle classes of their countries. The middle class either fled, was killed off or lost its assets.

But this is not the case in Iran. There is a sizable group of middle and upper middle class families that have prospered for the last decade or longer. They are feeling the brunt of the sanctions, so their losses may make Iran more susceptible to economic deprivation.

Iran is similar to Cuba and Zimbabwe in its attempt to deal with sanctions. Countries pressed by sanctions tend to revert back to a command and control style of economic management, often rationing goods in a manner similar to the former Soviet Union. In this sort of system, money becomes less important. Instead, people with government connections and insider understanding of the system succeed. Rationing adds tremendous amounts of inefficiency into the economy and reduces overall output. But command and control systems consolidate power in the hands of the state.

The Iranian government is now assuming more control over the economy by placing items on lists linked to differing exchange rates. The government also permits certain individuals or companies to import the goods. There was not a high degree of freedom in Iran's economy prior to this recent crisis but now it is moving towards a Cuba- or Zimbabwe-style economy.

What will be the impact of international sanctions one year from now?

Sanctions have historically lost their efficacy over time because the targeted country scrambles to find alternative avenues to sell exports and buy imports. On the other hand, the countries imposing the sanctions will likely step up enforcement measures. In this case, the Iranians could step up their evasion tactics as the West ratchets up sanctions, resulting in an approximate standoff.

But a drastic change in the price of oil could be a game changer. If the price spikes for reasons unrelated to Tehran's nuclear program, countries that are lukewarm about enforcing sanctions could buy additional Iranian oil. India and China would be important players but other importers could also change the dynamics of the situation. The spike would need to be sizable though, perhaps a jump to $120 per barrel of oil from the current price of $90 (West Texas intermediate). On the other hand, Iran's economy would suffer more in the event of a price drop to $60 or $70 per barrel.

Maintaining international focus and cooperation on the Iranian nuclear issue for another year or two may prove increasingly difficult, as it did in Iraq during the 1990s. We will likely hear stories about Iranian infants and elderly citizens in dire straits. The outpouring of sympathy could prompt a relaxation of sanctions to help those vulnerable parts of society. Iranian state media may manipulate this picture as well.

This article is presented by Tehran Bureau, the U.S. Institute of Peace, and the Woodrow Wilson International Center for Scholars as part of the Iran project at iranprimer.usip.org.

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