Avoiding a Persian Flavor of Dutch Disease

January 25, 2017

Since 2006 international institutions and Western governments have continually placed economic sanctions on Iran to stop nuclear and ballistic missile programs. A total embargo on oil and petrochemical products, a freeze of all assets held by the Central Bank of Iran in 2012 and trade sanctions have profoundly damaged the Iranian economy.[1] After the P5+1 and the EU reached the nuclear deal with Iran in 2015, the International Atomic Energy Agency verified Iran’s compliance with the conditions in the beginning of 2016. On “Implementation Day”, the 14th of January 2016, the previously negotiated part of the sanctions were lifted and Iran started to move toward liberalization of its markets.[2] Even so, sanctions on domestic trade and trade with certain materials have been upheld.[3]

The potential gains from reintegrating with the global economy are vast, if managed well. Through good policies, Iran’s government and central bank must minimize the dangers of re-exposure to the world economy. Paradoxically, resource-rich economies tend to grow more slowly and have weaker development,[4] especially when opening to trade is paired with low national wealth, institutional capacity, and economic diversity,[5] as is the case in Iran.

Iran’s strong reliance on oil exports poses a threat to its economy. There is a risk that Iran could fall victim to the so-called ‘Dutch Disease’, meaning that an export boom and rising aggregate income could lead to real appreciation of the local currency. When parts of the new income are spent on local non-tradable goods their price relative to tradeable goods rise, as the latter are set by international markets. Labor then shifts from exporting sectors to the non-tradable sector, making exports even less profitable. This is what economist Max Cordon calls the Spending Effect.[6] In the case of Iran, trade liberalization and massive international oil purchases could lead the local currency, the Rial, to undergo upward pressure.

An overvalued currency poses problems to domestic non-oil sectors in two ways. Firstly, as the value of the Rial rises, the price of all Iranian-produced tradeable goods on foreign markets will rise and experience a loss in international competitiveness. Secondly, Iranian citizens will import more as foreign products become relatively cheaper. This happened to the Colombian peso in 1975-1977, for example, as rising coffee prices led the currency to increase over 30% in value to the US Dollar. As a result, all other trade-affected sectors greatly suffered.[7]

The World Bank estimates that lifting the sanctions will allow Iranian oil production to increase by a million barrels per day. Iranian revenues are set to increase by more than $15 billion per year, an equivalent of 3.5% of GDP.[8] This will generate a large fiscal expansion that should be carefully managed, as currency appreciation must be minimized to avoid the ‘Dutch Disease’. As the World Bank noted, “whether this windfall translates to sustained economic growth and employment depends critically on the underlying policies and institutions of the government, especially those that support exports and diversification”.[9] Accordingly, we propose the following mix of fiscal, structural and monetary policy to smooth Iran’s transition to an integrated economy.

First, Iran should use the “National Development Fund of Iran” (NDFI), its sovereign wealth fund, to manage the inflow of investments and invest in economic diversification. The fund can be used to simultaneously control liquidity injected into the economy and invest in strategic assets. Through extended and more effective use of the NDFI, Iran would essentially direct and control the demand surging into the economy, and use capital to build capacity in non-oil sectors.[10] In doing so, Iran would avoid declining competitiveness in non-oil sectors and promote long-term sustainable growth.

Although picking ‘winners’ – that is, successful industries – is challenging for a government to pull off successfully,[11] Iran will be aided by the fact that it already started building promising advanced technology sectors prior to the sanctions, such as automobiles, pharmaceuticals or information technology.[12] Increasing expenditure on education, research and development (R&D) in non-oil industries, and infrastructure improvements can further facilitate development in these sectors. This could be achieved by encouraging Iran’s well-educated population to engage more internationally, for example through targeted education and training possibilities, and the use of diaspora networks. Iran can also achieve this by increasing capacity in physical infrastructure (roads, ports, and airports) and technological (internet and telecommunication), thereby minimizing the difference in purchasing power relative to the oil sector, which can finance higher trade costs and tariffs.

Second, structural reforms are another vital way to diversify Iran’s economy. Iranian authorities should aim to
provide a thriving business environment to attract new sources of foreign direct investment that further strengthen non-oil industries. Adapting financial legislation and industrial and trade policies would increase the economy’s attractiveness to international investors. Well implemented structural reforms could also increase access to capital, technology, and market opportunities. They would significantly improve the competitiveness of Iranian industries in global competition, thereby contributing to economic growth and jobs creation in the non-oil sector.[13]

Third, upward pressure on the exchange rate should be balanced by expansionary monetary policy with the goal of allowing the currency to appreciate within a reasonable limit. As Nobel laureate Paul Krugman noted, expansionary fiscal policy must be accommodated by expansionary monetary policy, which, if used effectively, can create major benefits for an open economy.[14] Providing the market with more currency would slow the Rial’s rise in value. An increase in monetary supply threatens to increase price levels, so the Central Bank must find a ‘middle way’ in their use of monetary policy and inflation rate targeting.

In summary, the lifting of sanctions is a turning point for the Iranian economy. Pressure on the Iranian Rial is expected, with a potentially destabilizing impact on the economy. Iran’s relatively high levels of human capital, recent macroeconomic stabilization processes, and lessons from the past can ensure that the sovereign wealth fund, intensified structural adjustments, and complementary monetary policy act as successful tools to prevent Dutch Disease.

If managed well, vital industries could benefit from access to capital, technology, and market opportunities, thereby ensuring sustainable growth and preventing over-reliance on oil. The use of this policy mix could prevent a ‘Persian Flavor’ of Dutch Disease and, as the World Bank recently put it, transform non-oil sectors into “dynamic export oriented industries that act as engines of growth”.

 

References

[1] Zachary Laub, “International Sanctions on Iran,” Council of Foreign Relations, 2015, accessed November 29, 2015, http://www.cfr.org/iran/international-sanctions-iran/p20258.

[2] Maloney Suzanne, “Un-sanctioning Iran: What the Nuclear Deal Means for the Future of Sanctions”, Brookings, (2015), accessed November 29, 2015, https://www.brookings.edu/blog/markaz/2015/08/03/un-sanctioning-iran-what-the-nuclear-deal-means-for-the-future-of-sanctions/.

[3] Information Brief, Treasury of the United States, https://www.treasury.gov/resource-center/sanctions/Programs/Documents/jcpoa_faqs.pdf

[4] Sachs D. Jeffrey and Warner M. Andrew, “The Big Rush, Natural Resource Booms and Growth”, Journal of Development Economics 59, no. 2 (1999): 43-76.

[5] Chris Geiregat and Yang Susan., “Too Much of a Good Thing?”, Finance and Development 15, no. 3 (2013): 8-11.

[6] Warner Max Corden, “Booming sector and Dutch disease economics: survey and consolidation.” Oxford Economic Papers 36, no. 3 (1984): 359-380.

[7] Christine Ebrahim‑Zadeh, “Dutch Disease: Too Much Wealth Managed Unwisely”, Finance and Development, 40, no. 1 (2003): 50-51.

[8] World Bank, “Economic Implications of Lifting Sanctions on Iran”, World Bank Middle East and North Africa Region, MENA Quarterly Economic Brief, Issue 5 (July 2015): 1-28.

[9]  Ibid.

[10] Ibid.

[11] Robert E. Lucas, “On the Mechanics of Economic Development,” Journal of Monetary Economics 22 (1988): 3-42.

[12] World Bank, “Economic Implications of Lifting Sanctions on Iran”, World Bank Middle East and North Africa Region, MENA Quarterly Economic Brief, Issue 5 (July 2015): 1-28

[13] Ibid.

[14] Paul Krugman, Obstfeld Maurice, and Melitz Marc J., “International Economics: Theory and Policy,” (New York: Pearson Publishing, 9th Edition, 2012).

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