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Gambling on convertibility.

As President Rafsanjani prepares to start a second four-year term as Iran's head of state, he has committed himself to far-reaching economic reforms. The centrepiece of his strategy is the freeing of exchange rates. The success of his programme depends on the credibility of the government's economic management, a long-term reduction of imports and an improvement in oil export revenues.

VOTING TAKES PLACE this month to elect a new Iranian head of state. President Ali Akbar Rafsanjani is certain to be voted in for a second four-year term and, as the law stands at present, he cannot seek further re-election. His reputation when he finally leaves office will depend very much on his handling of the economy over the next year.

In his first four years as president, Rafsanjani has laid the groundwork for reinvigorating Iran's postwar economy. He has sought to appeal to the interests of the middle class, cautiously adopting a free market approach and relying on Western-educated technocrats to push through reforms.

Inevitably, this has aroused the hostility of Iran's revolutionary purists, whether they are conservative clerics in the mould of Ali Khamenei, Khomeini's successor as Supreme Guide, or unreconstructed radicals. Both tendencies are suspicious of Rafsanjani's attempt to adapt the revolution to the unwelcome realities of the outside world. If the president is to prevail, his crash course in economic reorientation must show signs of success in 1993.

He has certainly been bold. Devaluation of the rial has been debated for some time, and in the process has become something of a symbol of economic redirection. Rafsanjani chose the start of the new Iranian year at the end of March to confront the issue head-on.

The official exchange rate of the rial was devalued by almost 100%, wiping out subsidised rates for everything except an estimated $3.8bn of essential imports. Within three weeks, Mohammed Hossein Adeli, the governor of the Bank Markazi (the central bank) announced that the rial was henceforth "fully convertible" and that the government was determined to "put the foreign exchange markets in order and harness prices".

Currency and price stability will be the criteria by which the success of economic reform is judged by the population at large. After the devaluation in March, the rial lost a fifth of its value on the unregulated free market. Several newspapers criticised the Bank Markazi for failing to intervene or give reassurances about its policy.

Adeli's announcement of full convertibility was accompanied by a further 6.7% devaluation of the Bank Markazi's floating rate. Importers have been promised that they will be able to purchase all the hard currency they need at the new rate of $1-IR1,648. On presentation of proper documents, banks will sell foreign exchange to Iranians studying abroad and patients going overseas for treatment. Anyone else will be free to buy up to $5,000 in hard currency. For the time being, the free market rate (which at one point seemed poised for a tail-spin) has remained steady.

Adeli insists that Iran's foreign currency situation is comfortable. Along with other senior officials, he has claimed that the Iranian economy is fundamentally sound and this is an opportune moment to liberalise rates. Nevertheless, he has recognised the importance of reassuring the markets. "Our foreign exchange regime is a regulated floating rate and the control mechanism is at work," he declared in April. "Although supply and demand is the main factor in determining foreign exchange rates, we should act in a way that hard currency rates can reflect our main economic indices."

Provided the Bank Markazi can fulfil its promise of providing hard currency to all-comers, the free market rate should be kept under control. The central bank governor says there are sufficient reserves available to meet all eventualities. Relatively liquid foreign exchange reserves are put at around $6bn. Earlier this year, bank and government officials were reported as quoting figures of $2bn to $3bn being set aside to support the currency after devaluation.

Inevitably, however, there are doubts. Iran has been suffering a cash squeeze since early last year. The most evident symptom is the mounting backlog of letter of credit payments. In March last year, Mohsen Nourbakhsh, the minister of economy and finance, made the startling declaration that short-term indebtedness had reached $30bn. He may have exaggerated to create an impression on Iran's none-too-disciplined spending ministries. Credit lines not taken up and an element of medium-term project finance seem to have been thrown into the total.

Nonetheless, Iran is behind by around $5bn on letter of credit payments from 1992 and a further $15bn will mature this year. There will be some relief as German, Japanese and French banks negotiate deferral of letter of credit payments. Medium term loans are also being discussed with Iranian banks to finance contracts and the World Bank has up to $1.5bn of project aid in the pipeline. However, none of this will basically alter Iran's long-term hard currency needs to support a fully convertible rial.

A serious constraint on hard currency availability is the shortfall in oil revenues. In the first nine months of the financial year ending last March, Iran is reported to have earned $10.5bn from oil exports. Extrapolated over the year as a whole, this suggests that the total revenues from oil will be at least $2bn lower than the forecast $16.7bn.

Immediate prospects for firmer prices are unpromising. At the same time, while Iran is producing at a level higher than its allocated Opec quota it still seems to be struggling to maintain output. Last October Iran pumped 3.8m b/d to show what it could do. Later, it even raised its production estimate for the month to 4m b/d. But produce in April was estimated to be 3.45m b/d, down 100,000 b/d from the previous month. Foreign industry experts believe that at present higher output levels cannot be maintained because of the poor condition of the southern fields.

Iran is currently completing a $2bn crash programme to increase capacity to 4.2m b/d by the end of this year. According to Mehdi Hosseini, a senior Oil Ministry official speaking at a conference in London in April, capacity will be raised to 4.6m b/d next year and is projected to rise to more than 5.5m b/d by the end of the decade.

His claims and projections have been greeted with some scepticism. Some Western oil observers feel that Iran cannot hope to achieve its capacity goal without bringing in international firms to handle field maintenance and secondary recovery programmes. Foreign companies have been asked to develop and maintain offshore fields since 1990, but the experience has been fraught with difficulty because of legal and political constraints.

The economic reformers are caught in a bind. They desperately need increased oil revenues to generate the hard currency income required to prove that the economic liberalisation strategy is worthwhile. But the revolutionary diehards and the immobility of the system militate against foreign involvement in the oil sector.

Putting a brave face on matters, Mehdi Hosseini claims that foreign oil companies are "welcome under the framework of service contracts". On the other hand, he points out guardedly, concessions and production sharing agreements are not "legally allowed".

If oil exports are unable to generate enough foreign exchange, Rafsanjani's government has no option but to tighten up on imports. After two years of largely uncontrolled buying from abroad (a stop to post-war euphoria), there are signs of a serious effort to limit imports. According to the Customs Office, imports during the year ending last March totalled $17bn, some $4bn less than the official target. Last year, the import bill was forecast at $20.8bn, itself a sharp reduction in the $25bn-$28bn recorded in 1991-1992.

The improvement should have just about brought imports into line with oil and non-oil exports, thus helping to relieve the pressure on letter of credit payments. But while oil revenues remain depressed, Iran's appetite for imports will have to be permanently curbed. In 1993-1994, the government is thought to be aiming at an import target of around $14bn.

The key to success is import substitution. Nourbakhsh has said he is confident imports can be kept down in 1993 and beyond without causing serious discomfort or dislocation. Since the start of the current Five-Year Plan (which will be completed next March), Iran has pursued a deliberate policy of industrial diversification and self-reliance, coaxing foreign sources to invest in development projects which will be financed from their output.

The strategy is sensible, given the volatile state of the oil markets, but it is still too soon to say whether it is proving a success beyond the government's understandable need to make propaganda out of it. Mohsen Nourbakhsh is quoted as saying that it has worked "perfectly well". That may be pitching matters too far. But if the cost of imports can indeed be reduced by $2bn in 1993 and twice that in 1994 (as the government hopes), there is reason to believe that import substitution is having an effect.

Particular emphasis is being placed on the reduction of imported oil products. Rafsanjani has predicted that newly installed refining capacity will permit Iran to cease product imports by next year, saving an annual bill of $1.4bn. The 150,000 b/d Arak refinery is due to start operating next month, while a similar amount will be contributed by the completion of the Abadan refinery rebuilding later in the year. An entirely new 250,000 b/d refinery is planned for Bandar Abbas, but construction will not begin until 1994.

Promoting local manufacturing and oil and mineral processing (two areas which have been emphasised) is one thing. Cutting the food import bill is another. With a rapidly growing (and, if Rafsanjani has his way, an increasingly affluent) population, the demand for foodstuffs will grow uncontrollably as most Middle Eastern nations have discovered to their cost.

But domestic food production is subject to natural hazards. Last year, Iran enjoyed a particularly good harvest and the food import bill was a mere $1.2bn. Annual wheat output rose by almost 4m tonnes to 10.3m tonnes in 1992, while rice output increased by 800,000 tonnes to 2.5m tonnes. Rafsanjani has expressed the hope that Iran will achieve self-sufficiency in meat and sugar production under the second Five-Year Plan. The outlook for 1993, however, is overcast by severe flooding earlier in the year.

A lower level of imports will probably not have a major impact on the buying public for some time to come, largely because stocks of wholesale and retail goods are still substantial after the import bonanza of the early 1990s. More to the point is the effect of continued cutbacks on business confidence and popular expectations. Belt-tightening has already depressed economic growth, which averaged 10% in 1990 and 1991.

The significance of these constraints for Rafsanjani's prospects of retaining political mastery over an unruly parliament and a combative opposition is public reaction to the inevitable inflation and unemployment which will follow currency devaluation.

Official figures underestimate the problem, but provide an indication of how serious it may become. Inflation may rise to 30% this year, half as high again as last year. Prices of many essential household goods have reportedly shot up by as much as a third since March. The government admits to an unemployment figure of 14%. The reality is certainly worse and the numbers out of work are bound to increase in 1993.

The big question is whether the government will successfully make the transition from a centralised war economy to a free enterprise system without incurring serious political disruption. Iranians optimistically hoped that the end of the conflict with Iraq would usher in an era of prosperity. The government's failure to deliver on such inflated expectations has caused widespread dissatisfaction.

But Rafsanjani can also turn disillusionment to his advantage. There is increasingly widespread acceptance that the shortcomings of economic management since 1979 must be rectified, and that the process will not be painless. Radicals in the hierarchy are eagerly exploiting discontent in the hope of embarrassing Rafsanjani in the presidential elections. Their efforts will not have any effect on the outcome, but could weaken the reformist leadership if the restructuring of the economy proves too unpalatable.

It will be important, therefore, to take note of the turnout at the presidential election. In effect, Rafsanjani is conducting a referendum on his economic policies and seeking a popular mandate to carry them through. If the electorate is too apathetic to turn out in force (and cast votes for what is a foregone conclusion), Rafsanjani's ability to maintain the momentum of reform will be imperilled.

There will then be a risk of the government feeling obliged to slow down the pace of change in order to avert social unrest. Rafsanjani's sticking power and his ability to manipulate Iran's convoluted domestic politics will definitely be put to the test.
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Title Annotation:Iran's economic reform program
Publication:The Middle East
Date:Jun 1, 1993
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