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Is Iran Moving Toward Financial Instability?

A money changer poses for the camera with a U.S dollar (R) and the amount being given when converting it into Iranian rials (L), at a currency exchange shop at Tehran's business district, January 20, 2016

In recent weeks, Tehran’s foreign exchange and gold markets have experienced instability as the local currency has declined in value and the price of gold has risen.

The Iranian currency, Toman has lost around 12% of its value.

Hadi Ghavami, deputy chairman of parliament’s Budget Commission has said that the instability has several reasons, but the main culprit is lower oil prices creating a sudden budget deficit for the government.

In the government’s current fiscal year budget, oil income has been set at $50 a barrel. According to Ghavami, Iranian oil now fetches just $43, creating a considerable budget gap for the government.

Ghavami predicts that by the end of the Iranian fiscal year, next March, the country will face roughly a $30 billion deficit. This leads to less foreign currency entering the local economy and more decline in the value of the Iranian currency.

There are also other factors contributing to the budget deficit.

During the budget determination process some economists were warning not to be too optimistic about the windfall from the nuclear deal.

It is possible that the government was expecting the lifting of international sanctions to lead to more foreign investments and was optimistic in its budget projections.

But when budget projections don’t come true, why the government cannot slash spending?

The truth is that a big chunk of the budget goes to thousands of institutions and state owned industries, which have political sway in the country and expect to receive their share of the budget, no matter what. They are also notoriously wasteful and contribute very little to economic productivity.

Iran -- 1000 Toman bank note which was used just before the Islamic revolution in Iran.Its value was around $150.
Iran -- 1000 Toman bank note which was used just before the Islamic revolution in Iran.Its value was around $150.

Iran -- 1000 Toman bank note which is used since 90's in Iran. It is wroth less than 30 cents.
Iran -- 1000 Toman bank note which is used since 90's in Iran. It is wroth less than 30 cents.

Some observers call these budget allocations in Iran, political ransom.

What are other means remaining for the government to increase its income when oil prices decline?

One way of bringing in money on a day-to-day basis is profiting from the sale of foreign currencies on the local market. When the government faces a budget deficit it raises the exchange rate and the Iranian currency loses value.

This in turn contributes to inflation and reduces confidence in the economy, hampering internal investments and putting more people out of work. Eventually, instability in financial markets harms the economy, which can lead to a bigger budget deficit in the future.

The other tool in the government arsenal is a simple, but dangerous one. It borrows money from the central and commercial banks. This also leads to higher liquidity in the country and more government debt, which is a recipe for inflation.

For now, inflation seems to be stable at a high rate. The reason is that the dire situation of the economy has led to a drop in money circulation. According to the Central Bank, 45% of bank assets are currently sitting idle, with 15% bogged down as government debt.

Liquidity is high but almost half of it is not circulating.

Another reason for instability in the forex markets in Tehran is the migration of money from deposits in Iranian banks into cash holdings in foreign currencies.

Recently, Iranian banks reduced the rate of interest on deposits. Small and big investors decided to convert some of their money into foreign currencies and gold.

There is no doubt, that in comparison with stable economies, Iran’s higher inflation rate inevitably leads to loss of value for its national currency.

When the government had sufficient foreign currency income, it kept the exchange rate artificially favorable. But when oil prices decline, the government’s ability to intervene is curtailed.

It is not clear if the government can use short-term tools to stabilize the financial markets. It is possible that Iran’s currency will decline further and instability will grip the markets.