Oil Dependence and Economic Development: Development Challenges to the Islamic Republic of Iran

Preface

“Oil Dependence and Economic Development” was originally written April 27, 2009 for an international political economy course at California State University – Sacramento.  It analyzes Iran’s growing dependence on oil revenues since the 1979 Revolution and why the regime has been unable to implement sufficient economic reform.  In it I explore Iran’s quasi-governmental, heavily subsidized state run industries as a cause for Iranian industry’s inability to compete internationally.  The subsidies are not given to make the industries more competitive, like is done elsewhere, but to create jobs given to regime supporters.  While it seems the government of Iran is aware that their system of patronage is economically debilitating, they dare not dismantle the system lest they alienate their supporters.  My concluding remarks about the reform candidate Mir-Houssein Moussavi in retrospect seem unduly optimistic.  In my defense I must confess that in the weeks leading up to the June election I was swept up by the momentum generated by the escalating campaign and the tantalizing promise of substantial reforms.  Needless to say, the last several months have been sobering.

Recent events, notably the buy up of Iranian Telecommunications by the IRGC in October this year coupled with announcement of cuts in consumer subsidies, indicate that the regime’s economic policy that is the focus of “Oil Dependence and Economic Development” is undergoing changes.  The regime recognizes as always that state control of the economy, particularly sectors promising high growth like telecommunications, confers political power.  The difference is that the Iranian government now seems more determined than ever to make the system profitable.  Until accurate estimates of how government revenue is distributed among the new acquisitions is made available, we can only speculate at the possibility of larger policy shifts.  My feeling is that the IRGC are ultimately not interested in managing competitive industries but quickly enriching themselves and spreading their influence.  Impending mismanagement of the Iranian telecommunication industry bodes ill for Iranians who have made up a impressive percent of internet users given the country’s population.

Dana Alexander Gray, November 20, 2009

Oil Dependence and Economic Development:

Development Challenges to the Islamic Republic of Iran

Introduction

In 1963 Mohammad Reza Shah Pahlavi announced the White Revolution, an ambitious set of social and economic reforms that aspired to modernize Iran and bring the country to par with Western Europe. The top-down restructuring of the White Revolution had the dual purpose of heading-off a potential revolution from below by granting Iranians greater political freedoms and more economic opportunities1 while concentrating the monarch’s power by aligning with business and cutting traditional landed elites out of politics.2 But the the high oil prices generated by the 1973 OPEC embargo changed the pace and nature of reforms as the monarch believed he was leading Iran towards a “great civilization.” The Pahlavi state based national growth expectations, officially predicted to reach an inconceivable 41%, on an unrealistic assumption that pouring huge amounts of money from oil sales would translate into growth.3 Uneven and erratic growth of Iran’s economy resulted in shortages of food and essential services, urban overcrowding, and heightened income disparity.4 While Iranians were subjected to the fluctuations of the international market, high oil revenues provided the state a financial buffer that increased its autonomy and halted democratic reforms.5 Resulting social pressures and an unresponsive state contributed directly to the 1978-79 revolution.

The Islamic Republic faces the same political and economic problems experienced by the Pahlavi monarchy because it too depends on oil. Fluctuations in the oil market make consistent economic growth impossible, the government is unable to fulfill its citizen’s economic aspirations and thus must contend with a disaffected populace. While it is unlikely social unrest will culminate in a revolution to sweep Islamic Republic, as shown by heavy-handed repression of student protests in 1999 compared to the Shah’s indecision when faced with a similar situation in 1978, its economic fragility keeps Iran from fulfilling its regional potential and becoming a valuable member of the international economic order. Instead Iran remains an unenergetic status quo power that must maintain an extensive security apparatus to ensure regime survival.

How Dependent on Oil is Iran?

Oil dominates Iran’s industrial sector, accounting for nearly half of all industry in 2001 and growing.6 Oil sales compose 85% of Iran’s exports and are thus by far Iran’s primary source of foreign exchange.7 Further, the Iranian government relies on oil revenue for most of its income. Because of the current low price of oil, $48.60 as of 27 April 2009, Iran can not make its balance of payments. Because of the recent spend-thrift populism of President Ahmedinejad, Iran lacks the financial reserves of other large oil countries like Saudi Arabia or the UAE to float the crisis and must borrow or radically change its fiscal policies to reduce imports and boost exports.8 The required fiscal changes would increase pressure on the rial and be very unpopular.

Figure 1 shows how highly correlated Iran’s gross domestic production and industrial sector have been over the last four decades. Oil revenue, while it does not encompass all of Iran’s economic activity, is the chief determinate of Iran’s GDP. As can be expected in an economy that depends on oil, fluctuations in the price of oil internationally have immediate repercussions on Iran’s economy. As shown in figure 2, all of the booms and busts of the Iranian economy have coincided with fluctuations in the international price of oil. This means as long as Iran relies on oil for its income, it can not control its economic future through through well-managed policies but will forever be at the mercy of volatile external forces.

Figure 1Figure 2

Attempts to Spur Economic Development, Rafsanjani and the Pragmatists

In 1989 Hashemi Rafsanjani assumed the presidency of the Islamic Republic on the promise of economic reconstruction and foreign policy pragmatism. In the wake of Khomeini’s death, Rafsanjani was the most powerful political player in Iran. He was able to change the constitution to expand the powers of the presidency and institutionalize and thus reduce the personal power of the supreme leader, now held by an under-qualified Khamene’i.9 Yet despite his political power, President Rafsanjani was unable to accomplish the two essential changes needed to move Iran towards a free-market economy. Iran could not attract foreign direct investment and Iran’s economy was dominated by inefficient para-governmental organizations.

As a result of the revolution, foreign investors had pulled out of the economy and Iran was considered unstable. Despite overtures to the West, including moderating Iran’s stance on Israel’s occupation and condemning Saddam’s invasion of Kuwait in 1991, Western investors and their governments continued to regard Iran with suspicion.10 Iran went from being considered the Japan of the Middle East in the early 1970s, only better because Iran had its own resources, to receiving the least foreign direct investment of its Middle East and North African peers: only 0.34% of FDI among MENA countries went to Iran compared to Turkey receiving 35%.11

Since the revolution Iran’s domestic economic character had changed as well, but mostly because of the war with Iraq. Numerous state owned enterprises, as well as unregulated para-governmental organizations called bonyads, dominated the economy. All were inefficient, yet so heavily subsidized, explicitly or indirectly, by the state that the private sector can not compete.12 The bonyads were too heavily entrenched in Iran for even Rafsanjani to eliminate, they had developed as a means for the government to reward supporters and doing away with them would likely do away with what little popular support remained for the regime. And so when Rafsanjani attempted economic regulations to attract foreign investment, the bonyads were exempt and the costs of reform fell entirely on the private sector, weakening it further vis à vis the para-governmental organizations.13 While figure 3 seems to show Iran’s economy becoming less dependent on oil after the revolution, one must keep in mind that the the other sectors of the economy now rely on government subsidies. Since Iran’s government uses its oil income to subsidize, the net effect has been to make the entire economy vulnerable to oil fluctuations. Additionally, the apparent diversity has been into services, instead of sectors with higher growth potential, such as manufacturing.

Figure 3

While lack of transparency and authoritarianism has not stopped foreign investment elsewhere, China being the paramount example, bonyads are the structural failing of Iran’s economy that makes it unfavorable to export-oriented growth. Iran’s oil revenue subsidies encourage rent-seeking and redundancy instead of a competitive private sector.14

What about Democracy?

To be clear, Iran is not a democracy and no amount of foreign investment can change that. Although recent US administrations have expressed dissatisfaction with Iran’s democratic record, the justification for American-led sanctions again Iran is not to coerce Iran to make democratic reforms, as was the case for South Africa, but to make behaving outside the norms of the international system too costly for Iran. 30 years of sanctions have not changed Iran’s behavior, quite the opposite, they taught Iran to work around sanctions and have strengthened alliances between Iran and America’s rivals.15 As I have argued elsewhere, since the revolution, Iran’s behavior has changed to abide by many of the international norms America claims it flaunts. As shown by multilateral ventures such as water exports to the Gulf States, revolutionary ideology no longer dominates Iranian foreign policy and Iran abides by international norms for the obvious benefits that come with being a member of the international economic community.16

While there is little doubt Iran would be better off if the sanctions were lifted, as it is, the greatest challenges to the Iranian economy are endogenous.17 Iran’s economic woes, including unemployment, underemployment, inflation, and inefficiency, stem from government dependence on oil and misuse of oil revenue. Proposed economic reforms may be difficult, but in the aftermath of Ahmedinejad’s presidency, fiscal responsibility has never appeared more attractive in Iran. To encourage the level of saving needed for faster growth, Iran needs to raise interest rates, kept low by Ahmedinejad to make borrowing easier for the poor. To free itself from oil dependence, the government needs to promote competitive exports, impossible in an economy dominated by state owned enterprises and bonyads. To achieve competitive exports, subsidies must be cut in order to force the public enterprises to compete with the private sector.18

While Iran is not a democracy by any stretch of the imagination, it is not a clear-cut dictatorship either. Some of Iran’s institutions are democratic and greater control of the economy by private individuals will increase the potency of those democratic elements because the authoritarian elements derive their support from patronage. Conversely, should the Islamic Republic come to legitimize itself through its president and legislature rather than government charities, economic reform would be a natural next step. This connection is why Rafsanjani failed to transition Iran to a market economy. Rafsanjani was unable to break the state control of the economy because he was unwilling to reform the political system to legitimize the regime through its democratic institutions and thus had no choice but to keep the patronage system. His successors have shown less reluctance towards political reforms, particularly the 2nd Khordad movement of Sayyid Mohammad Khatami. Though he is not running, Khatami’s reform agenda is championed by former prime minster Mir-Houssein Moussavi in the 2009 presidential race. Should reformists again come to power in Iran, it seems likely that this time they will succeed in dismantling the inefficient patronage system with the abuses and failures of Ahmendinejad’s administration fresh in the minds of Iranians.

  1. Ali M. Ansari, “The Myth of the White Revolution: Mohammad Reza Shah, ‘Modernization’ and the Consolation of Power,” Middle Eastern Studies 37, no 3 (2001): 2.
  2. Ibid., 9.
  3. Ali M. Ansari, Modern Iran Since 1921: The Pahlavis and After (New York: Pearson Longman, 2003): 184.
  4. Nikki R. Keddie, Modern Iran: Roots and Results of Revolution (New Haven: Yale University Press, 2006): 163.
  5. Ali M. Ansari, Modern Iran Since 1921: The Pahlavis and After (New York: Pearson Longman, 2003): 182.
  6. Ahmad R. Jalali-Naini, “Capital Accumulation and Economic Growth in Iran: Past Experience and Future Prospects,” Iranian Studies 38, no. 1 (2005): 96.
  7. Ibid., 110-111.
  8. Djaved Salehi-Isfahani, “Tough Times Ahead for the Iranian Economy,” The Brookings Institute, April 6, 2009, http://www.brookings.edu/opinions/2009/0406_iran_salehi_isfahani.aspx (accessed 26 April 2009).
  9. Nikki Keddie, Modern Iran: Roots and Results of Revolution (New Haven: Yale University Press, 2006): 263-64.
  10. Ali M. Ansari, Modern Iran Since 1921: The Pahlavis and After (New York: Pearson Longman, 2003): 246.
  11. Massoud Karshenas and Hassan Hakimian, “Oil, Economic Diversification and the Democratic Process in Iran,” Iranian Studies 38, no. 1 (2005): 72.
  12. Ibid., 76.
  13. Ali M. Ansari, Modern Iran Since 1921: The Pahlavis and After (New York: Pearson Longman, 2003): 245.
  14. Massoud Karshenas and Hassan Hakimian, “Oil, Economic Diversification and the Democratic Process in Iran,” Iranian Studies 38, no. 1 (2005): 80.
  15. Jahangir Amuzegar, “Adjusting to Sanctions,” Foreign Affairs 73, no. 3 (1997): 34.
  16. Kamran Taremi, “The Role of Water Exports in Iranian Foreign policy towards the GCC,” Iranian Studies 28, no. 2 (2005): 320.
  17. Jahangir Amuzegar, “Adjusting to Sanctions,” Foreign Affairs 73, no. 3 (1997): 33.
  18. Ahmad R. Jalali-Naini, “Capital Accumulation and Economic Growth in Iran: Past Experience and Future Prospects,” Iranian Studies 38, no. 1 (2005): 115-116.
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