Iran: Oil and the Economy

The choice made by Iran in the period after the signing of the nuclear agreement will entail a reassessment of US policy not only in relation to this country, but to the region as a whole.

Kill two birds with one stone

The Iranian strategy is aimed at a balance between:

• Internal goals of sustainable economic growth while maintaining political structure;
• External tasks of providing a favorable regional strategic position.

If earlier these goals were achieved through income from the sale of energy resources and religious zeal, today, when the assumption that Iran will flood the world with oil has not materialized, conflicts between these goals will become inevitable. Given the new economic restrictions, despite the lifting of sanctions, the greater orientation of the Islamic Republic on domestic growth in the long term will strengthen the country's economy in such a way that it will be compatible with the approach aimed at cooperation, rather than confrontation in the Middle East.

The pursuit of regional superiority, on the other hand, will be counterproductive, as this will result in inefficient use of resources. This scenario, in addition to deepening domestic political differences in Iran, requires a significant revision of the strategies of local players, as well as the policies of the United States. Actions that push the country to strengthen economic growth potential , rather than pursue an expensive Middle Eastern strategic advantage, will be more beneficial for the majority of Iranians, as well as for achieving stability in the region.

After sanctions

The economy of Iran is at a crossroads. Given the changing international situation and global oil prospects, the country faces a difficult choice. The lifting of sanctions after the signing of the nuclear agreement has the potential for resuscitation of growth. Steps taken over the past few years have helped to contain inflation, reduce subsidies and achieve exchange rate stability and even growth.

Nevertheless, the economy remains weak. Unemployment, especially among the younger generation, remains at a high level. Prospects for the current year look better in light of the easing of financial constraints after the release of large foreign exchange reserves, increased oil production, and increased confidence in the market, which lead to increased investment. The country's financial situation is likely to continue to strengthen if planned measures to increase revenues, including VAT increases, the elimination of tax breaks and the reduction of subsidies, will be realized, which, combined with higher domestic production and imports, can further reduce inflation .

The situation facing Iran is unfavorable : oil is falling sharply today. This is exacerbated by the demand for long-term and costly investments to revive the pre-sank production level of 4 million barrels a day and increase domestic demand. While growing oil production in Iran and related investments will contribute to GDP growth, a decline in export prices is likely to weaken the external position and budget. With limited prospects for any meaningful agreement to contain supplies from major producers, oil revenues over the next 3-4 years may be 30% lower than projected on the assumption of a strong recovery in 2016. In addition, the accumulation of foreign exchange reserves that would serve Airbag for an uncertain future, will be negligible. In this case, there will be no room for the expansionist policy of activating growth. Thus, the risks of further improvement have grown.

Constraints

At the same time, the Iranian economy is burdened with significant structural distortions, which continue to restrain the forecast of its growth. Critical prices, including exchange rates and interest rates, have not yet returned to normal; The financial sector is burdened by large non-performing loans; The private sector is facing weak demand and inadequate credit availability; The debts of the state increased and subsidies remain large. The subjects of the public sector control a significant part of the economy and access to bank loans. The management of the private sector and the business environment is inadequate and opaque, which undermines private investment. Strengthening regional instability, as well as uncertainty regarding the implementation of the nuclear agreement, further increase the risks.

Priorities: domestic versus regional

In a broad sense, Iran seeks to accelerate economic growth within the existing political structure while strengthening its local strategic position. The country's political elite, however, is divided into two groups. One of them is represented by the reformists and the technocratic government of President Ruhani, who gives priority to economic growth. Thus, it is more inclined to seek a regional strategic balance and closer cooperation with external forces for the sake of its economic program. If the authorities decided to liberalize the national economy through large-scale reforms, and to reduce the role of the inefficient public sector, the course toward domestic development is likely to outweigh in its favor.

The second force is represented by supporters of the hard line, the ruling clergy and the Islamic Revolutionary Guard Corps (IRGC), who would prefer to maintain the current economic structure, as they own a significant share in the economy.

Conservatives Against Reformers

If additional resources are channeled to the public sector entities, as well as in the broader sense of IRGC and the clergy, with the economic structure unchanged, the growth rate will fluctuate after the initial spurt. These forces will retain their major share in the national economy and their significant influence on Iran's policy, thus leading to assertive regional and foreign policies through domestic economic development. Such a position will generate further instability in the region without improving the country's welfare.

It is important to note that it remains unclear whether the current administration of Ruhani, who came to power with the goal of liberalizing the economy, has sufficient capacity to undertake the necessary major reforms. He excelled at recent elections, but faces powerful and entrenched interests of hardliners. So far, he has achieved success in such areas:

• Stabilization of the foreign exchange market,
• Reduction of some subsidies,
• Restraint of inflation.

But the president may have difficulties with speeding up the process. For the authorities, it is very important to have a space for promotion, which will provide public support for the continuation of the reforms. International encouragement and pressure could be decisive.

Iran, oil and politics

In the current conditions, the country's authorities can pursue three broad strategies:

1) Preservation of the status quo.

2) Implementation of large-scale and coordinated reforms.

3) Conducting moderate politically neutral reforms.

The third option will ease some restrictions on private sector investment and fiscal consolidation in a situation where Iran sells oil with lower profitability, but leaves the economic and political structure as a whole unchanged.

Preservation of the status quo will generate a surge in growth to 4-4.5% in 2016-2017. From virtually zero in 2015-2016, when additional resources are used to reduce the deficit, pay outstanding obligations, and launch suspended public sector projects. However, in conditions where the cost of oil is declining, the recovery will slow in the short and medium term to a level that will increase unemployment. The unchanged internal balance of political power will allocate resources in favor of regional strategic goals at the expense of intraeconomic ones, and this will have negative consequences for growth.

The course on reforms

According to the second variant of the large-scale reform, economic liberalization and early correction of structural distortions will allow achieving sustainable growth, even with lower than expected revenues from the sale of energy resources, with strong growth in the medium and long term. Such a dynamic development will increase the risk management potential that Iran has faced. Oil has become cheaper, and its price is less stable. The success of this strategy will depend on a shift in the internal political balance of forces from supporters of the command economy of the public sector to market-oriented shareholders. Experience has shown that the long-term impact of the market, in and of itself, helps create the necessary shift.

The third scenario, although politically the least destructive, will quickly move into the first option. Steps to address politically correct issues, such as consolidating the budget in a low-income environment and easing barriers to private sector activities, can temporarily calm down dissatisfaction with the state of the domestic economy. Uncertainty and increased competition for political power, which will affect the distribution of oil revenues, will be counterproductive.

Iran: oil and foreign investors

If Iran stops at the first version of the policy, the US will have to give it clear that regional aggression will be reliably repulsed by the United States and the region. In addition, if large players are ousted from direct investment in the country's oil sector, this can help persuade the authorities to change their strategy to more adequate to domestic economic problems and to pursue a balanced foreign policy.

In order to push Iran to the second option, the US and international organizations should support this approach. Cooperation with other neighboring oil exporting countries will ensure a stable and realistic world oil price, restore traditional interdependence, helping to send the Islamic Republic to conduct foreign policy of regional cooperation and cooperation. Increasing interdependence with the world market and increasing foreign capital inflows will encourage Iran to pursue a less confrontational policy at the local level, thus contributing to the stability of the region.

In the case of the third option, local and global stakeholders may have to take steps to push the authorities to a more active political position. In particular, the weakening of trade restrictions and investment cooperation, not in the oil sector, may be due to the internal policy of reforms. Another way to influence Iran - the freezing of oil by large producers to support prices - can be an incentive for bold political changes.

Right choice

All the actors involved in regional dynamics are interested in pushing Iran to choose the second scenario and conduct appropriate economic policies and structural reforms. Decentralization of decision-making and increasing the role of the market in the allocation of resources, along with the diminishing role of the public sector, are crucial. These steps will promote growth, increase employment opportunities, and support Iran's integration into the regional and global economy. This will further expand the potential of the moderate part of society that chose Ruhani in 2013 and won the recent parliamentary elections.

The main trading partners, with the support of the United States, international investors and multilateral lending institutions, can play an important role in this process. While internal forces will dominate disputes over less-than-expected orientation toward oil revenues, external forces can influence the direction of resource allocation and help the state achieve a dual goal.

Areas where there will be a need for external investments in Iran - oil and the development of knowledge-intensive activities in other sectors necessary to address the growing unemployment of a more educated young population. It is in the interest of foreign investors to maintain an appropriate market policy in partnership with local investors less burdened with excessive regulation and control.

The international cooperation

Multilateral economic and financial institutions and governments of the main investing countries can play an important role in the reform process. Organizations such as the IMF and the World Bank can and should advise the Iranian authorities on the necessary political reforms. Their position can have an important positive effect when making private investment decisions. Accelerated membership in the WTO, as well as access to world markets will complete the cycle of economic liberalization and integration. A decisive line to change the regional strategic balance will take a long way to influence the decision-making on the allocation of resources and changing priorities towards internal growth.

At the local level, Iran's interests include cooperation with other producers in order to stabilize the situation on the oil market. Closer coordination of policy with the main energy producers in the Persian Gulf will not only help improve Iran's economic prospects, but also reduce tensions in the region. The experience of informal cooperation with Saudi Arabia and other major producers of regional oil policy in the 1990s is a good example for imitation.