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Fareed Mohamedi Headshot

Iran's Economic Vulnerabilities

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Although there is sharp political division for and against Ahmadinejad in Iran, there is virtual unanimity among all political factions that Iran must have nuclear weapons in order to protect itself. Given this, even if President Ahmadinejad and the hard line clerics were to be removed from power in Iran, the leadership that would follow would almost certainly support the continuation of Iran's nuclear weapons program.

As a result of Iranian intransigence, sanctions appear to be inevitable, even though the West continues to hope for a meaningful outcome. Although Russia's previous position against sanctions seems to be softening, it remains to be seen whether Russia will ultimately support robust economic sanctions. The Chinese are in any event unlikely to participate in a sanctions regime for two primary reasons. First, China wants to underscore its belief in the inherent rights of sovereign nations, and their own belief in non-interference in 'domestic' affairs. Second, the Chinese believe that the U.S. ultimately desires regime change, which stands in opposition to their own desire to strengthen their economic ties with, and derive future economic benefits from, Iran. Regardless of the relative success of future sanctions, they will have a net impact on all of Iran's trading partners.

The orientation of Western pundits toward the impact of politics on Iran's negotiating position has drawn the discussion away from the rather serious economic situation Iran is currently experiencing. Given its over-reliance on oil and gas revenues, Iran's economy is already under moderate strain. Depending on the direction of future hydrocarbon prices, the economy could become severely strained.

In order to balance its budget, Iran needs oil prices to rise above $95 per barrel and stay there. Projected oil revenue shortfalls in the current fiscal year will shift the budget into a large deficit position. As a result of conflicting budgetary demands and clashing political forces, the Ahmadinejad government lacks the political capital required to offset lower hydrocarbon receipts by cutting expenditures and/or raising non-oil revenues. If Ahmadinejad's political troubles deepen and capital flight accelerates, his ability to finance the looming budget deficit will become more limited.

Hydrocarbon exports account for more than 80% of Iran's total exports of goods and services, highlighting the current account's vulnerability to lower oil prices. In addition to price concerns, the physical volume of oil and gas exports is likely to decline over the foreseeable future due to the continuing lack of investment in the hydrocarbon sector. Iran's flexibility to run a current account deficit is therefore limited given its lack of access to international financing as a result of existing sanctions.

Iran posted strong growth in FY 2006-08 in response to the government's loose fiscal and monetary policies. Non-oil and gas GDP has been the main driver of growth, as oil and gas GDP growth has declined in recent years. The pace of economic activity more than halved over the most recent fiscal year due to the impact of the global recession. Growth is likely to slow further in FY 2009/10.

Inflation has receded, but its rapid escalation during FY 2008/09 exacerbated social and political strains. Unemployment did not improve much even when non-oil growth was picking up. As the Iranian "youth bulge" enters the labor market, the economy will be hard-pressed to create the 600,000-800,000 jobs per year necessary to keep up with labor force growth. This can only strengthen opposition political forces and complicate Ahmadinejad's ability to govern.

Foreign Direct Investment continues to suffer as political tensions with the West continue to rise. Of 17 oil and gas blocks put up for tender in February 2007, only three were awarded. And of the 12 oil and gas blocks put for tender in November 2008, none have been awarded. China and Russia continue to be the dominant source of Iran's international commercial relations. Russia's tentative support for future economic sanctions against Iran may change that. Economically, Iran has few friends in the world.

All this points to a rather challenging economic environment in which Ahmadinejad is now forced to operate. Even if hydrocarbon prices were to stabilize above the level necessary for Iran to balance its budget and current account next year, many of the inherent contradictions associated with the country's economic and political process will continue unabated. As the timeline for a decision on whether to impose stricter sanctions on Iran draws nearer, Ahamdinejad and the hard liners in the Iranian government will undoubtedly dig in their heels in a more pronounced fashion, placing the economy under even more strain.

The impact of Iran's economic plight on the nuclear negotiation process is likely to be severe. As the government reckons with its unfolding economic reality and the ongoing vocal opposition to Ahmadinejad's second term as President continues, its inclination will be to reject any meaningful oversight of Iran's low-enriched uranium, to continue to bide for more time to complete the nuclear production cycle, and to continue to justify its past actions.

The chance that there will be a sudden reversal in the government's approach to nuclear dialogue is close to zero. Iran is not bargaining from a position of strength, but weakness. The mismanagement of Iran's economy has only served to reduce the chance that further economic sanctions may be avoided.