The Islamic Republic’s strategy to tame the wild rial and evade US and EU sanctions

Following our previous post on the Islamic Republic’s deteriorating currency and economic situation, the regime appears to have come to a consensus on taking the first concrete steps toward addressing the issue, according to Mehr News.

President Mahmoud Ahmadinejad has agreed to raise Iran’s official interest rate to 21%, above the official inflation rate of 20.6%, in a bid to convince Iranians to hold on to the rial and stem the rush to alternatives such as the US dollar, euro, British pound, and gold. Some have argued that the official inflation rate does not reflect the actual inflation rate in the country, a claim that if true could mean that this move may not be as effective as the regime hopes.

The government has also attempted to stop arbitrage and currency speculation which could be sapping the state’s foreign exchange reserves and fueling the rial’s descent by setting a single exchange rate between the rial and US dollar, instead of the multiple exchange rates that exist today. The new official exchange rate has been set at 12,260 rial to one US dollar, with private currency dealers allowed to conduct transactions within a margin of +/- 3-5% of the new rate.

These new measures follow earlier steps which limited the sale of foreign currencies to public or private entities that could show a critical need, for example to purchase imports. These measures may be working, at least in the short term. The exchange rate used by private currency dealers fell from a high of over 20,000 rial last week to 17,300 rial for one US dollar yesterday. Despite this, there is still a difference of 5,040 rial between the official exchange rate versus the market rate, with no indication of whether this substantial gap will be bridged any time soon.

The precipitous downward spiral of the rial in the last month has followed the most recent round of United States multilateralized sanctions on third parties doing business with Iran’s central bank, an European Union embargo on the importation of Iranian crude oil, and similar sanctions by Canada, Britain, and Australia. Iran’s legislature, the Majlis, has responded to this week’s EU embargo by maneuvering to preemptively cut off oil exports to the EU in the apparent hopes of raising global oil prices and cause distress to a Europe already suffering from economic woes. The EU imports approximately 20% of Iran’s oil exports, and some of the Eurozone countries currently experiencing the most severe economic and financial problems, including Greece, Italy, and Spain, are among Iran’s main European clients. A sudden loss of oil supplies could result in a shock that worsens their condition.

As economists like to point out however, oil is a fungible good and Iran is currently in the process of diverting its surplus oil exports to different markets. Two likely candidates include China and India, but US and EU sanctions have made it increasingly difficult for these countries to pay for Iranian oil using dollars and euros. Iran is considering three possible solutions to this dilemma. First, clients could pay for Iranian oil using local currencies such as the Chinese yuan or Indian rupee. Second, Iran could directly barter its oil for commodities that it needs. Finally, clients could exchange gold for oil, as India recently suggested. This last option appears to be the most desirable for Iran, and may provide it the means to arrest the rial’s descent and escape from the clutches of sanctions. The solution that actually materializes remains to be seen, and important customers of Iranian oil, particularly Japan and South Korea, are still on the sidelines, hoping to convince Washington not to interfere with their historically strong energy relationship with Iran.