The Economy That Diplomacy Couldn't Fix

As Iran's President Hassan Rouhani embarks on his first visit to the U.N. General Assembly in New York, the world's eyes are on the political handshakes that may or may not occur on the sidelines. Iranians, for their part, are hoping for a breakthrough in the nuclear stalemate, which would in turn help revive the country's  parlous economy.

For ordinary Iranians living with high inflation, unemployment and shortages in medical supplies, any diplomatic overtures will only be meaningful if translated into significant change in their daily circumstances. Everyone from central Tehran moneylenders to prominent businessmen is monitoring the currency exchange market in Iran for a sign of such a change.

The currency exchange market will be the first market to react to any opening in Iran’s relationship with the West, and indeed, with news of possible high-level meetings in New York, the Iranian made a steady gain agains the dollar, trading at 28,800 IRR to one USD.

As a matter of course, the dollar-rial exchange rate is the first index many Iranians check as a measure of whether the news is any good. After all, Iran’s oil exports pay for much of subsidies and public spending, and sanctions have reduced oil revenues by half.

Sanctions also have significantly limited Iran’s access to its revenues. Iran has the money to pay for imports but it cannot use its reserves because its banking sector is cut off from the global banking system. The Central Bank's ability to supply foreign currency has also decreased, causing the Iranian Rial to lose its value drastically.

For an economy which relies on imports to supply commodity markets, this means the average Iranian is paying far higher prices for several items in his or her consumption basket. The most immediate concern for many is that sanctions will be eased in a manner that strengthens the domestic currency and reduces inflation.

It's arguable whether such an expectation is realistic, but Iranians well remember another dramatic currency shift in their recent past. In the summer of 1988, after Iran accepted a Security Council negotiated end to the war with Iraq, the guns on the front went silence, and Iran's currency exchange market experienced a sudden shock. This shock was severe enough that it sent a number of currency speculators to intensive cure units in Tehran’s hospitals.

The day before Iran accepted the ceasefire, the USD-IRR exchange rate stood at  1450 Rial per USD. The first day after the official announcement it fell to 750 Rial per USD. And in four days, after Iraq agreed to the ceasefire, it reached 670 Rial and by the time ceasefire was in place, the US dollar was being traded at 590 Rial per USD.

The question today is whether a shock of this magnitude is still possible. The psychological shock of the end to a seemingly endless war was not comparable to anything Iranians had experienced before. But soon the grave realities of Iran’s economic circumstances caught up with them. ‫ The country's war-torn infrastructure needed reconstruction, oil revenues were at an all time low and the government had to pay subsidies on almost every single item in the marketplace. The Iranian Rial soon lost much of its gain. The US dollar appreciated 300 percent in the following eight years. The currency exchange rate began an upward trend in Iran that has not changed for the past 25 years.

Today every US dollar in Tehran’s exchange market can be traded for more than 30’000 Rials. The exchange rate has experienced an erratic year. The Ahmadinejad administration's lack of fiscal discipline and spending extravaganzas destabilized the market such that  the US dollar exchange rate against the Rial reached 40’000 Rial per USD. The Central Bank’s intervention brought the exchange rate back to 35,000 Rial per USD.

President Rouhani’s victory in the last presidential election brought the exchange rate down to less than 32,000, but the crisis with Syria pushed it back up to 33,500 Rial per USD. As of Saturday the exchange rate declined to 28,800 Rial per USD following the agreement with Syria and the recent indications from Tehran about a diplomatic overture.

This decreasing trend shows that currency exchange market does expect good news, however because the adjustments it might not be caught offguard. Of course not all possible outcomes will have the same effect on the market. A détente with the United State including a timetable to end all the sanctions will have the most significant effect on the market in the short run with the long run adjustments to follow. The exchange might drop to as low as 20,000 Rials.

However a limited agreement on negotiations framework might have a small impact, reducing the exchange rate to less than 30,000. The short term effect will be ignorable. An agreement between Iran and 5+1 to continue negotiations as before will not change the economic reality of Iran and the market continue to await further developments.

Independent of what happens this week in New York, Iran’s economy still suffers from an inflation rate of more than 40 percent, a large unemployed population and negative economic growth. These realities will not disappear with a diplomatic détente with the United States. Any shock will finally wear off and Iran’s economy will be left facing its own considerable issues and challenges.