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 seeks to balance between:
- internal goals of sustainable economic growth while maintaining the political structure;
- external tasks to ensure a favorable regional strategic position.
If earlier these goals were achieved thanks to income from the sale of energy resources and religious zeal, today, when the assumption that Iran will flood the world with oil has not been justified, conflicts between these goals will become inevitable. Given the new economic constraints, despite the lifting of sanctions, the greater orientation of the Islamic Republic to internal growth in the long run will strengthen the country's national economy in a way that is compatible with an approach aimed at cooperation rather than confrontation in the Middle East.
Pursuing regional superiority, on the other hand, will be counterproductive, as it will result in inefficient use of resources. Such a scenario, in addition to deepening internal 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 its economic growth potential , rather than pursuing an expensive Middle East strategic advantage, will be more beneficial for most Iranians, as well as to achieve regional stability.
After the sanctions
Iran's economy is at a crossroads. Given the changing international situation and global prospects for oil, the country has to make a difficult choice. The lifting of sanctions after the signing of the nuclear agreement has the potential to resuscitate growth. The steps taken over the past few years have helped contain inflation, reduce subsidies and achieve exchange rate stability and even growth.
Nevertheless, the economy remains weak. Unemployment, especially among the younger generation, remains high. Prospects for the current year look better in light of the easing of financial restrictions after the release of large foreign exchange reserves, increased oil production, as well as increased confidence in the market, which lead to increased investment. The country's financial situation is likely to continue to strengthen if the planned measures to increase revenues, including increasing VAT, abolishing tax benefits and reducing subsidies, are implemented, which, combined with higher domestic production and imports, can further reduce inflation. .
The situation Iran is facing is unfavorable: oil is falling sharply today. This is compounded by the demand for long-term and costly investments in order to revitalize reaching the pre-sanction level of production of 4 million barrels per day and increase domestic demand. While growing oil production in Iran and related investments will increase GDP, lower export prices are likely to weaken the external position and budget. With limited prospects for any meaningful agreement to curb the supply of major producers, oil revenues over the next 3-4 years may be 30% lower than predicted by a strong recovery in 2016. In addition, the accumulation of foreign exchange reserves that would serve an airbag for an uncertain future will be negligible. In this case, there will be no room for an expansionary policy of boosting growth. Thus, the risks of further improvement have grown.
Restraining factors
At the same time, the Iranian economy is saddled with significant structural distortions that continue to restrain its growth forecast. Critical prices, including exchange rates and interest rates, have still not returned to normal; the financial sector is saddled with large non-performing loans; the private sector is faced with weak demand and inadequate credit availability; government debts have increased and subsidies remain large. Public sector entities 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. The increasing regional instability, as well as the uncertainty regarding the implementation of the nuclear agreement, further increase the risks.
Priorities: Domestic vs. Regional
In a broad sense, Iran seeks to accelerate economic growth within the existing political structure while strengthening its local strategic position. The political elite of the country, however, is divided into two groups. One of them is represented by reformists and the technocratic government of President Rouhani, who give 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, as well as reduce the role of the inefficient public sector, the course on internal development is likely to be outweighed in its favor.
The second force is represented by proponents of a tough line, the ruling clergy and the Islamic Revolutionary Guards Corps (IRGC), who would prefer to maintain the current economic structure, since they own a significant share in the economy.
Conservatives vs. Reformers
If additional resources are allocated to public sector entities, as well as in the broader sense of the IRGC and the clergy, with the structure of the economy unchanged, then the growth rate will fluctuate after the initial spurt. These forces will retain their main share in the national economy and their significant influence on Iran’s policies, thus leading to assertive regional and foreign policies through domestic economic development. Such a position will give rise to further instability in the region without increasing the country's welfare.
It is important to note that it remains unclear whether the current administration of Rukhani, who came to power in order to liberalize the economy, has sufficient capacity to carry out the necessary major reforms. He has succeeded in the recent election, but is confronted with the powerful and entrenched interests of hardliners. So far, he has achieved success in the following areas:
- stabilization of the foreign exchange market,
- reduction of some subsidies,
- containing inflation.
But the president may have difficulty expediting the process. For the authorities, the availability of space for promotion is important, which will allow public support for the continuation of reforms. International promotion and pressure could be crucial.
Iran, oil and politics
In the current environment, a country's authorities can pursue three broad strategies:
1) Preservation of the status quo.
2) Implementation of large-scale and coordinated reforms.
3) Carrying out 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 returns, but leaves the economic and political structure as a whole unchanged.
Maintaining the status quo will generate a surge in growth of up to 4-4.5% in 2016–2017. from almost zero in 2015–2016, when additional resources are used to reduce the deficit, pay for outstanding obligations, and launch suspended projects in the public sector. However, in an environment where oil prices are falling, the rise will slow down in the near and medium term to a level that will increase unemployment. The constant internal balance of political power will allocate resources in favor of regional strategic goals at the expense of domestic economic ones, and this will have negative consequences for growth.
The course for reform
According to the second option of a large-scale reform, economic liberalization and early correction of structural distortions will allow for sustainable growth, even with lower than expected income from the sale of energy resources, with a strong increase in the medium and long term. Such a dynamic development will increase the risk management potential of Iran. Oil has become cheaper and its price less stable. The success of this strategy will depend on a shift in the domestic balance of power from proponents of a commanding public sector economy to market-oriented stockholders. Experience has shown that long-term market exposure, in and of itself, helps create the necessary shift.
The third scenario, although politically the least destructive, will quickly move to the first option. Steps to tackle politically correct issues, such as budget consolidation at low incomes and easing barriers to private sector activity, 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 dwells on the first policy option, the United States will be forced to make it clear that regional aggression will be given a reliable rebuff from the United States and the region. In addition, if large players are forced out of direct investment in the country's oil sector, this can help persuade the authorities to change their strategy to a more adequate approach to domestic economic problems and maintain a balanced foreign policy.
In order to push Iran to the second option, the United States and international organizations must support this approach. Cooperation with other neighboring oil exporting countries will ensure a stable and realistic world oil price, restore traditional interdependence, helping to direct the Islamic Republic to pursue a foreign policy of regional cooperation and cooperation. Increased interdependence with the global market and increased inflow of foreign capital will encourage Iran to pursue a less confrontational policy at the local level, thereby contributing to the stability of the region.
In the case of the third option, local and global stakeholders may have to take measures to push the authorities to a more active political position. In particular, the relaxation of trade restrictions and non-oil investment cooperation may be due to domestic reform policies. Another way to influence Iran - freezing oil by large producers to support prices - could be an incentive for bold political changes.
Right choice
All actors involved in regional dynamics are interested in pushing Iran to choose a second scenario and pursue appropriate economic policies and structural reforms. Decentralization of decision-making and the increasing role of the market in the allocation of resources, along with the diminishing role of the public sector, are crucial. These steps will contribute to growth, increase employment opportunities, and support the integration of Iran into the regional and global economies. This will further expand the potential of the moderate part of society, which chose Rouhani in 2013 and won the recent parliamentary elections.
Key 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 a less-than-expected focus on oil revenues, external forces can influence the direction of resource allocation and help the state achieve a dual goal.
Areas where the need for external investment in Iran will continue - oil and the development of high-tech activities in other sectors necessary to address the growing unemployment of more educated young people. It is in the interest of foreign investors to maintain appropriate market policies in partnership with local investors less burdened by excessive regulation and control.
The international cooperation
Multilateral economic and financial institutions and the governments of major 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 in making private investment decisions. Accelerated WTO membership, 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 decisions 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 in the oil market. Closer coordination of policies with major 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 to follow.