AN APPROPRIATE EXCHANGE RATE REGIME FOR IRAN
BIJAN BINESH AGHEVLI
The issue of an appropriate exchange rate regime for Iran is a crucial one. The recent move to unify the multiple exchange rates at a depreciated level was a critical step in removing entrenched distortions in the system and represented an important step towards economic reform.
While the importance of this move cannot be overemphasized, it would be folly to think that one single action can correct all the longstanding distortions of the previous system. It is clear that a difficult adjustment period lies ahead for the Iranian government.
Influence of Oil on the Economy
Iran’s economy is dominated by the oil sector, which is the main source of foreign exchange. Oil revenues have comprised about 90 per cent of total export earnings in recent years. The contribution of the oil sector to the budget had been substantially underestimated by the ex-official exchange rate, but, if converted into domestic currency at the parallel market rate, oil earnings would also account for the bulk of budgetary revenues.
To the extent that such earnings accrue directly to the budget, the government is the principal agent for the channelling of oil resources into the economy. However, the budgetary appropriation of oil revenues through a highly distorted system of multiple exchange rates has resulted in a significant misallocation of resources.
To gauge the magnitude of these distortions, it is important to review the previous multiple exchange rate system. Under this system, the total supply of foreign exchange was provided in the following proportions: three-fifths was provided at the highly subsidised official rate of about 70 riyals per US dollar; one fifth was provided at the less-subsidised competitive rate of about 600 riyals per US dollar; and the remaining fifth was supplied to the market where the floating rate moved in the range of 1,400- 1,500 riyals per US dollar. The average weighted exchange rate was, therefore, about 500 riyals per US dollar, or substantially below the floating rate.
The overvaluation of the official exchange rate was partly reflected in a simultaneous underestimation of government imports and oil revenues in terms of domestic currency. This aspect of the multiple exchange rate system was mainly an accounting phenomenon in the sense that a different exchange rate would not allow the overall fiscal balance, although the under-valuation of foreign exchange is likely to have encouraged excessive government imports.
A large amount of oil revenues, however, was allocated at the official and competitive exchange rates of public enterprises engaged in productive activities. These allocations represented an implicit subsidy that was not reflected in the budget. The implicit exchange rate subsidies provided to public enterprises have created serious structural imbalances in the economy. Sizeable financial resources have been shifted to those activities that have been eligible for access to the official exchange rate, regardless of their economic merit. As demand for foreign exchange was insatiable at the unrealistically appreciated official rate, the Government had to rely on non-price mechanisms for allocating foreign exchange. These mechanisms promoted rent-seeking activities and corruption. The scale of these unproductive activities increased rapidly as expansionist fiscal and monetary policies fuelled inflation.
Pressures on the Economy
The result was a widening of the gap between the official and the floating rates, which, in turn, raised the implicit real subsidies to public enterprises, further worsening the fiscal position and setting in motion an inflationary cycle. These macro-economic problems were exacerbated by the immense cost of the war with Iraq, trade sanctions and the freeing of Iranian assets, and the weakening of the oil market. Ultimately, increased pressure on the balance of payments and the associated short-term liquidity problems necessitated a fundamental reform of the exchange rate system.
Short-term Management of Exchange Rate Policy
An immediate decision that had to be made following the exchange rate unification was whether to devalue and then peg the rate, or adopt a flexible regime. The relative merits of these two options are dependent on a number of considerations. A pegged exchange rate regime, if supported by restrictive fiscal and monetary policies, has the advantage of providing an effective anchor for stabilising post-devaluation prices. A viable pegged regime, however, requires a comfortable level of international reserves to ward off speculative attacks on the currency. An under devaluation would result in a deterioration in the external position and require further devaluation that would undermine the credibility of the pegged regime. On the other hand, an over-devaluation would magnify the initial price jump and ignite a wage-price spiral.
In the case of Iran, given the difficulties in containing budgetary expenditures following the large devaluation, it would have been difficult to ensure that financial policies would be sufficiently restrictive to rule out any further exchange rate adjustments.
Furthermore, the uncertainties associated with the extent of the pass-through of the devaluation to domestic prices would make it extremely difficult to determine the market clearing exchange rate. In the absence of a large cushion of international reserves to defend the peg, the initial devaluation would have to err on the high side, with adverse inflationary consequences.
By contrast, a flexible exchange rate regime would obviate the need either for large international reserves or for having to decide on the correct initial exchange rate. Under this system, the exchange rate could be adjusted in response to market forces. A complete free float, however, would have the disadvantage that speculative capital flows would give rise to volatile exchange rate movements. Taking all of these factors into account, the policy makers’ strategy of adopting a managed float following the unification appears to have been the most pragmatic approach.
Depreciation of the Riyal
It is interesting to analyse rate developments following the unification. It could have been argued that the additional supply of foreign exchange directed to the floating rate market would exceed the additional demand, as many importers who previously had access to the official rate would have to purchase foreign currency at a much higher price.
Under these circumstances, there would be pressure for the floating exchange rate to appreciate. In the event, however, the floating rate depreciated after the exchange rate unification, as the government adjusted the rate in response to developments in the parallel market.
The initial downward pressure on the exchange rate reflects a number of factors. On the supply side, the removal of the official exchange rate has eliminated the incentive for a re-channelling of foreign exchange through corrupt practices. Consequently, the additional supply of foreign exchange to the floating market is partly offset by the decline in supply through unofficial channels.
On the demand side, there are indications that importers may have brought forward their purchases because of anticipated increases in tariffs owing to delayed adjustment of the exchange rate used for customs valuation purposes. Furthermore, demand for foreign exchange has risen owing to the concomitant relaxation of current account transactions, particularly for travel abroad. Finally, uncertainties regarding the new exchange rate system inevitably gave rise to speculative capital flows. These factors have contributed to the initial depreciation of the floating exchange rate.
The more recent appreciation of the rate, however, suggests that some of these factors, particularly speculative capital outflows, may have been transitory, leading to an initial overshooting of the rate.
Supportive Financial Policies
A crucial task following a devaluation is the formulation of fiscal and monetary policies designed to protect the improvement in external competitiveness. Unless the government is determined to establish financial discipline, the beneficial effects of devaluation are short-lived. On the fiscal side, the elimination of the official exchange rate has removed an important source of subsidies to public enterprises.
Consequently, many of these enterprises are likely to seek explicit budgetary support to offset their increased import costs (and foregone profits from foreign exchange transactions). To the extent that a major purpose of the devaluation has been to shift resources away from inefficient public enterprises, it is critical that such enterprises’ demand for budgetary support be strongly resisted.
More generally, the devaluation will greatly increase government oil revenues in domestic currency, as the conversion rate is changed from the official to the unified rate. Such a revenue increase will intensify pressures for increased government spending. To be sure, a significant increase in budgetary allocations will be required to meet the higher domestic costs of government imports.
However, every effort should be made to economise on foreign exchange utilisation on the basis of the more realistic pricing of imports. It should be remembered that the previous overvaluation of the exchange rate was a direct result of inflationary financial policies. The devaluation will, therefore, be successful only if it is supported by a significant improvement in Iran’s overall fiscal position.
Inflationary Pressures
A consolidation of Iran’s fiscal position will greatly facilitate the conduct of monetary policy. Nevertheless, the short-term formulation of monetary policy is complicated by the devaluation-induced rise in domestic prices. This upward adjustment in prices, which should be separated from the underlying rate of inflation, is the main conduit for channelling the desired effects of devaluation into the economy.
By raising the price of tradable goods relative to non-tradable goods, devaluation shifts aggregate supply in the direction of tradable goods and demand in the direction of non-tradable goods, thereby helping to improve the external position.
Given the extent of previous distortions in Iran’s exchange rate system and the size of the devaluation, the price adjustments are likely to be sizable. In the short term, monetary policy needs to strike a balance between alleviating the contradictory impact of devaluation and continuing inflationary pressures. The devaluation induced price increases, resulting in the decline in real balances, and domestic demand. The price adjustment must be taken into account to avoid either a credit crunch or an acceleration of the underlying inflation rate. However, it must be remembered that it is always easier to relax the monetary stance, should there be indications of a credit squeeze, than to dampen inflationary pressures, and so monetary policy should err on the conservative side.
The experience of other countries undertaking large devaluations suggests that some output contraction in the short-term may be unavoidable, given the need to maintain a tight monetary stance. However, the impact of a tight credit policy on the expansion of the private sector would be alleviated by ensuring that credit to the public sector does not preempt private demand. Strong fiscal discipline is, thus, a prerequisite for avoiding a credit squeeze in the private sector.
While financial policies should be geared to containing underlying inflation, it is equally important that the impact of devaluation be passed through to domestic prices so that the industrial sector can develop new and competitive industries and so increase employment opportunities. Unfortunately, such a restructuring of the economy cannot take place quickly, and at the same time there will be pressures on the government in the shape of an immediate increase in the cost of imports, and resistance from those who were reaping large rewards from the earlier exchange rate system.
The Fixed Versus Flexible Debate
Economic thinking on fixed versus flexible exchange rates has tended to concentrate on the relative effectiveness of the two regimes in meeting two objectives: maintaining international competitiveness and establishing price stability.
Proponents of fixed exchange rates have argued that this regime provides an effective anchor for price stability by imposing financial discipline on the government. Indeed, a case can be made that, when the authorities are genuinely determined to establish financial discipline, a public commitment to a fixed exchange rate enhances confidence and facilitates the task of stabilising prices.
However, it should be emphasised that a fixed exchange rate does not in itself impose financial discipline. There are many examples of countries, including Iran, which have maintained a fixed exchange rate, but have not adhered to the requisite financial policies. In these cases, the resulting deterioration in external competitiveness has retarded growth and worsened the balance of payments position, ultimately forcing a devaluation. The more expansionary the financial policies, and the longer the period of a fixed exchange rate, the larger the eventual devaluation.
A fixed regime, by definition, precludes the use of the exchange rate as an instrument of external adjustment. Consequently, when the economy is subjected to a shock, the only available course of action is to rely on financial policies to bring about the required adjustment.
Developing countries are particularly vulnerable to sudden shifts in their external terms of trade. To the extent that these countries are price takers in the market for both exports and imports, their external terms of trade are determined independently of their exchange rate. In the event of a sharp deterioration in the external terms of trade, an exchange rate adjustment would be required to alter the internal terms of trade so as to bring about the necessary shift of resources into the traded goods sector and correct the external imbalance.
To rely solely on contradictory financial policies to adjust the internal terms of trade through a reduction in the price of goods not for trading, would require considerable adjustment time and would result in a severe recession. In contrast, the correction of the relative process through an exchange rate adjustment would be considerably less costly.
A variant of this argument is that a flexible regime would free monetary policy to cope with domestic objectives, leaving the exchange rate to deal with external imbalance. This argument, however, has been challenged in recent years. First, the experience of the industrial countries with floating regimes has demonstrated that, in the presence of capital flows, it would not be possible to ignore the impact of domestic policies on exchange rate movements.
The second point that is particularly pertinent to the developing countries is that it is not at all clear that under a flexible regime, the authorities would effectively use their independence in policy-making to achieve their domestic objectives. Indeed, freed from external constraints, the authorities might rely even more extensively on large fiscal expansion financed through inflation tax.
A compromise would be to adopt a flexible exchange rate, but to implement restrictive financial policies to ensure that both the exchange rate and the domestic prices are kept relatively stable. This would provide a sound basis for sustained non-inflationary growth over the medium term and provide adequate flexibility to cope with external shocks.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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