WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

by Mahdi Ghodsi

• On 6 December 2019 a meeting of the Joint Commission of the Joint Comprehensive Plan of Action (JCPOA) will take place in Vienna after a recent bloody crackdown on protests in Iran.
• Iranian President Hassan Rouhani had an agenda to initiate structural economic reform and make peace with the United States. However, after the US withdrew from the JCPOA that reform agenda failed.
• To reduce sanctions-driven pressure on the budget, a high-ranking Committee of the Heads of the Three Branches of State appointed by the Supreme Leader introduced a hike in petrol prices. However, they underestimated its economic and political consequences.
• Iran is a long way from becoming a democratic state that does not suppress its own people brutally. However, that should be the goal of both domestic and international actors, in order to strengthen international security and regional peace, and ensure domestic prosperity. Within this, foreign countries and international institutions have an important role to play.

On Friday 6 December 2019 a meeting of the Joint Commission of the Joint Comprehensive Plan of Action (JCPOA) will take place in Vienna. This commission will be chaired by the Secretary General of the European External Action Service (EEAS) Helga-Maria Schmid and will be attended by the E3+2 (China, France, Germany, Russia, United Kingdom) and Iran. The main aim of this event is to discuss the survival of the JCPOA. It is important to note that this meeting comes after a bloody crackdown on protests by the Islamic Republic that killed at least 208 protestors. The final estimates of death toll may even rise higher in the coming days, as there was an internet blackout during the protests.

The protests started on 14 November 2019 when the Iranian government announced a cut in the subsidy on petrol, which led to a price rise of 50% for the first 60 litres per vehicle per month – and of 200% for anything exceeding that. The news sparked one of the biggest nationwide demonstrations ever seen in Iran. This led to a speedy and very sharp crackdown by the government. From day three to day seven of the protests, all internet connections to the outside world were severed. The protests led to rioting and to public buildings being set on fire. It is important to understand, first, why Iran’s policy makers opted to reform the fuel subsidy now; and secondly what went wrong.

Political background

The policy was adopted by the high-ranking Committee of the Heads of the Three Branches of State, appointed by the Supreme Leader Ayatollah Ali Khamenei. This Committee is not envisaged in the constitution and is established beyond the democratic norms of the Republic to counteract the US campaign of ‘maximum pressure’. It is important to note that for the first two days after the policy was implemented no official accepted responsibility. Members of Parliament were taken by surprise and sought an urgent meeting to reverse the price hike. Until the third day, the Supreme Leader defended the policy, because he himself had established the Committee of the Heads of the Three Branches of State. He asked the authorities to do their best to avoid any inflationary impact arising from the policy (practically impossible, as explained below). He also called the protestors ‘thugs’ and shortly afterwards the Supreme National Security Council imposed a nationwide internet blackout, during which it was disconnected from the outside world. This merely poured oil on the flames, and the protests developed into riots.

A long history of fuel subsidies

Back in the early days of the Islamic Revolution in February 1979, Ayatollah Khomeini had promised to transfer oil revenues directly to the people. That idea proved a winner then, and it has continued to be a popular slogan. Former President Ahmadinejad (2005-2013) undertook swingeing cuts to the petrol subsidy, and used the resulting massive increase in revenue to introduce a universal cash transfer, covering the entire population of 72 million people.

Rouhani halted the universal transfer in his first term as president. Nevertheless, now the Committee of the Heads of the Three Branches of State wants to resume payments, which again will be directly funded by the increased revenue resulting from the hike in petrol prices. The hike in the cost of petrol is likely to result in a rise in revenue by about a factor of 5 per litre (over the 2010 baseline figure) whereas total expenditure on the cash transfer is expected to rise by only 1.8% compared to 2010, thus constituting a significant income loss for the people

A cautious move towards structural reforms

International organisations such as the World Bank and the International Monetary Fund (IMF) have long advocated removal of the subsidies on energy and other commodities and liberalisation of the market. These were all recommendations made to Rouhani when he sought advice after he took office on 3 August 2013.

Ever since the Arab Spring, policy reforms similar to those mentioned above have been extensively implemented in many oil-rich Arab States in the Middle East and North Africa. Removing subsidies brings certain benefits and advantages, as many economists argue. First, such a policy can kick-start structural reforms, leading centralised economies to liberalise their markets. Second, such reforms reduce an economy’s dependence on the government budget and expand the fiscal space. They allow governments to concentrate resources on more productive activities and sectors, rather than on subsidising commodities. Third, subsidies on commodities encourage the export of the commodities in question (which is why export-oriented subsidies are prohibited under the World Trade Organization (WTO) Agreement on Subsidies and Countervailing Measures). However, when export of the subsided products is banned by the government (as is the case in Iran), the trafficking and smuggling of such commodities become major concerns, as the domestic government budget is actually subsidising foreign consumers. These issues provide the major motivations for the policies recommended by the international organisations mentioned above.

Iran, however, has one additional, vital problem: inequality and poverty have increased in recent years, as the Gini index shows. Under President Ahmadinejad, inequality was reduced by means of direct money transfers, funded by a similar reduction in the petroleum subsidy. However, from the beginning of the presidency of Hassan Rouhani, his government abandoned these universal transfers, opting instead for targeted money transfers to the bottom income deciles, while seeking to eradicate poverty through structural reforms. Rouhani’s technocratic government was prepared to reap the economic benefits of the Joint Comprehensive Plan of Action (JCPOA), by attracting foreign direct investment and improving the country’s productive capacities, thus creating new jobs and reducing the unemployment rate. Rouhani also managed to get inflation down to below 10% for a short period.

The stage was set for a broad structural economic reform, in line with the policy recommendations of the IMF and the World Bank. This would have promoted the private sector, liberalised the market (e.g. market pricing of subsidised commodities), improved conditions for doing business, harmonised the different exchange rates into a floating rate, improved the banking system by stepping up efforts to combat money laundering, tackled the financing of terrorism by joining the conventions of the Financial Action Task Force (FATF), etc. These steps would eventually have allowed the poor to find jobs and effectively have eradicated poverty. However, such reforms only work in the medium to long run and require a decent institutional environment.

Reforms have been interrupted by the abandonment of the JCPOA

However, the JCPOA failed after the United States withdrew from the deal and imposed fresh sanctions. Afraid of losing its foreign currency reserves, the Iranian government abandoned major structural economic reform. Instead of harmonising the exchange rates, it allowed the gap between the official and the market exchange rates to widen. Meanwhile, knowing what to expect after the previous rounds of sanctions under the Obama Administration, when the new sanctions were imposed Iranians adjusted their expectations on the financial market: people started to hoard foreign currency; dollarisation led to capital flight; excessive demand for US dollars caused the gap between the official and the market exchange rate to widen further; and imports became more expensive. As a result, inflation took off. The upshot was that the middle class got poorer, and the poor became even more vulnerable.

New US sanctions cause severe economic pressures

The pressure on the government’s fiscal space caused by sanctions is one of the main reasons behind the ill-fated policy, as was acknowledged by a government spokesperson. Exports of oil have declined from 2.6 billion barrels per day before the US withdrawal from the JCPOA in May 2018 to only about 300,000 barrels per day today. The corresponding fall in oil revenues has paralysed the government and prevented it from providing any expansionary stimulus to counter the recession in 2019 (the IMF estimates that the economy will contract by around 9.5% this year). The government may not be able to support its budget because it does not have any powerful friends from whom to obtain loans or credits.

Even the proposal by France’s Emmanuel Macron to offer Iran a USD 15 billion line of credit required the blessing of US President Donald Trump. In a four-point document, this support was made conditional on a fresh round of talks between Iran and the US (an initiative by Macron on the sidelines of the United Nations General Assembly in New York). However, Iran lost that card, too. The Iranian government is left without any foreign aid, and so now it needs to charge its own budget domestically, meaning that the pressure will fall on the Iranian population.

Instead of trimming budget costs at the expense of some public entities or boosting the budget via taxing semi-public companies (like bonyads (foundations) or the Setads^[1], which do not pay taxes, the hike in fuel prices are simply tapping the people. And the people see very clearly that their own government is again off-loading responsibility onto them.

Economic and political consequences of the petrol price hike have been underestimated

It would seem that an impact assessment was conducted to evaluate the costs associated with such a policy. However, the only cost analysed was the impact of the policy on inflation with a 2-3 percentage point rise in the rate of inflation being expected. It is however important to note that petroleum is the product of an upstream sector and is used in many other sectors either directly or indirectly. Its primary use, for instance, is in the transportation sector, which feeds into many other sectors of the economy. This makes petroleum an important source of shock, which impacts on costs of many other sectors and cascade down through the whole economy.

The government also seems to have assumed that, in terms of the inflationary impact of the energy price hike, the inflation expectations of consumers would be unchanged which proved to be a very big mistake. As mentioned above, the adaptive expectations of Iranians in the wake of the fresh sanctions caused inflation to soar – from 10% to 45%. A study by Moshiri (2015) and another by Salehi-Isfahani et al. (2014) indicate how delicate such a policy is with respect to inflationary pressure. When inflation expectations change or even become adaptive such policies can lead to strong price rises even in the short term.

Necessary longer term reforms are in conflict with short-term pressures

To calm the worsening economic situation longer-term structural reforms are needed. However, instead of undertaking the structural reforms mentioned above and countering US sanctions through diplomacy and further negotiations (an approach that was supported by the populace, which voted for Rouhani’s agenda), the populist policy of direct transfers re-emerged. The results made the public furious, and led to rioting. Similar riots occurred prior to the Islamic Revolution of 1979, as a result of which the Shah of Iran left the country, leading to the establishment of the Islamic Republic. Yet, four decades on, on the fifth day of another damaging nationwide protest, the Supreme Leader gave no positive sign to the demands of the protestors, but instead announced a victory over the enemy.

The recent episode indicates one of two things: either the Iranian rulers do not fully understand the true implications of their policies nor know their countrymen; or else they understand everything perfectly well and are quite prepared to quash any rioting. Whichever of these is the case, the correct path lies elsewhere. Moreover, it shows how the structural reform of a moderate government in Iran is blocked by the US withdrawal from the JCPOA with the danger to turn the Islamic Republic to once again into a hardliner State that brutally suppresses its own population.

Five world powers are gathering in Vienna to discuss the survival of the nuclear deal with Iran. These countries are meeting because they believe that international security and regional peace can be best achieved by prohibiting the Islamic Republic from obtaining nuclear weapons. However, recent events show that Iran is on the edge of re-enforcing its autocratic theocracy through non-democratic means. A move towards a democratic Iran that does not suppress its own people brutally will be very difficult to achieve, but any prospects of this will require a strong role for the international community and international institutions. This would also contribute to international security, regional peace and domestic prosperity in Iran.

^[1] See subsection 2.3.1 of an earlier wiiw report.