Western policy toward Iran relies heavily on economic pressure, and Iran's political trajectory is shaped in large part by its economic prospects and constraints. A toughened regime of UN Security Council sanctions against Iran and uncertainties about the viability of its petroleum sector—compounded by deep structural distortions caused by a history of economic mismanagement—raise real questions about the state of the Iranian economy. The Iran Policy Forum at the United States Institute of Peace convened a meeting to discuss the status of Iran's economy and energy sector; the effect of Iran's uncertain political climate and concerns over its nuclear program on the economy; and actions the government should take to avoid future economic troubles. This USIPeace Briefing summarizes the discussion.

Iran's Macroeconomic Performance

Iran's economy suffers from myriad problems, but it has not yet reached the point of crisis. In fact, the belief that Iran suffers from dire economic conditions is one of four myths circulating about Iran's macroeconomic performance. Iran's economy has actually performed well in aggregate terms, with a moderate rate of growth in the last ten to fifteen years, including healthy GDP and per capita growth in investment. In the last three years, Iran's actual growth rate has averaged 5.8 percent. ¹

Nor do economic indicators support assertions by some observers that inflation is much higher than the rate stated by the Iranian government. In the last fifteen years, the consumer price index (CPI) has increased by a factor of forty-two; if the inflation rate were actually twice the reported rate, the CPI would have increased by a factor of 950. Prices have increased by a factor of five in the last ten years, not twenty, as some claim. While this rate of inflation is cause for concern, it is in line with the depreciation of the exchange rate.

The third myth is that Iran suffers from widespread poverty and rising inequality. The poverty rate actually declined throughout the 1990s and continues to fall, and is low by international standards—especially when compared to that of other developing countries. Government public service and social assistance programs have helped to reduce poverty, particularly in rural areas. In addition, economic inequality throughout Iran has remained fairly stable and does not appear to be increasing.

The final myth is that unemployment in Iran is twice the official rate. Although the unemployment rate is high, it has declined since 2000 and reached 11.2 percent in 2004.² While official statistics match World Bank estimates, the current government has failed to generate sufficient job growth to meet the needs of Iran's young, educated population. For these youth, unemployment often lasts two to three years, which has resulted in more young Iranians living with their parents well into their twenties. It is estimated that every year between 700,000 and one million people enter a job market that creates only 300,000 to 500,000 decent jobs for them.³ The high unemployment rate, combined with the current youth bulge, puts significant pressure on Iran's economy and government.

Since President Mahmoud Ahmadinejad has taken office, economic, political, and legal reforms initiated by the two previous administrations have stalled. In particular, the government has made little progress reforming Iran's restrictive Labor Law, privatizing publicly owned industries, and generally shaking up Iran's rigid economic structure. Instead, it has focused on the nuclear issue. Ahmadinejad has also embraced a wide array of regional projects, mostly outside and in addition to the approved annual budget, making Iran even more reliant on oil income. The World Bank estimates that more than 28 social assistance programs reach approximately 4.5 million of Iran's poor. ⁴

Iran is experiencing growth in the non-energy areas of its economy, particularly in the manufacturing, agricultural, and service sectors. However, the government has not taken the steps needed to diversify its economy by producing consumable goods for export. Iran has the infrastructure and educated population it needs to succeed economically, but the country must resolve its political problems and implement economic reforms. This includes increasing transparency and easing government pressure on certain private sectors of the economy, such as private banks.

Iran's energy sector

Iran's crude oil production appears to be declining, which stems from three broad factors: poor maintenance of current crude fields and a lack of new project development; rising domestic demand and consumption; and Iran's political and investment climate.

Maintenance of current crude fields and lack of new project development

Most of Iran's oil comes from six aging crude fields. Although their recoverable reserve estimates are high, the fields are not well maintained. The National Iranian Oil Company (NIOC) does not have the necessary capabilities or access to the necessary technology or financing it needs for proper field maintenance. Much of the NIOC leadership was removed and replaced by appointees when Ahmadinejad's government came to power, decreasing expertise and decision-making skills at NIOC. Moreover, NIOC lacks the information on the fields necessary to create an effective production maintenance strategy. Despite its desire to handle Iran's crude fields on its own, NIOC is beginning to struggle with properly maintaining them and with developing new exploration and exploitation projects, primarily because of constraints placed on the company's finances by the government. Such problems with NIOC have limited the development of new energy projects in Iran by international oil companies (IOCs) and national oil companies (NOCs). These companies possess the capital and technology needed to fund and carry out new exploration and exploitation projects, which are keys to maintaining production.

Iran has a substantial supply of natural gas. The gas can be used for reinjection, a process by which it is used to pressurize the oil wells to ease extraction and stimulate crude production, thus increasing revenue. However, there is currently a debate within Iran about whether reinjection is the best use of its gas resources; they could also be exported in the form of liquefied natural gas, which would also generate revenue. Alternatively, Iran could use natural gas to meet its growing domestic energy needs. This would require advanced technology and funding, and the investment of IOCs, both of which Iran currently lacks.

Rising domestic demand

Iran's domestic energy demands and consumption have increased significantly, and will continue to rise. While this is in part an unavoidable result of Iran's developing economy, rising demand also stems from fuel subsidies from the government. These subsidies cost Iran about ten percent of its GDP annually, which leads to inefficiency and drives consumption. The NIOC receives only a fraction of this amount in investment. Rising consumption has increased the amount of gasoline that Iran imports and has increased pollution, especially in Tehran.

Iran's political and investment climate

Although Iran is one of a few oil-rich states open to investment by IOCs and NOCs, the current political climate limits the amount of foreign investment in Iran's energy sector. Additional sanctions placed on Iran could prevent future investment by IOCs. Iran's unpopular buyback system of project funding also impedes investment by imposing additional constraints on foreign companies and lengthening the duration of project negotiations.⁵ Iran has discussed reforming this system to make it more attractive and encourage companies to invest in exploration.

Actions by Iran's government also hinder development of the energy sector. Government spending is rising, and Iran needs oil prices to be high—around $50 per barrel—in order to break even. The government is also dipping heavily into the Oil Stabilization Fund (OSF), which is supposed to be set aside as a reserve fund. Spending this money, combined with Iran's declining production, could have extremely negative repercussions on the economy should oil prices fall suddenly.

Implications for Iran's future

Iran's economic and political future will depend on at least three factors: the willingness of foreign entities to invest in Iran; the manner in which the nuclear issue is resolved; and the government's ability and willingness to implement needed economic reforms.

As Iran's oil fields remain open, foreign governments and companies will continue to pursue investment opportunities. However, much of Iran's future successes in the energy sector will depend on its ability to fund new projects. Iran needs to reinvest an estimated $9 billion to $10 billion in its energy sector every year to maintain current output, but it currently allocates only a third of that amount. Iran also lacks sufficient foreign direct investment for economic growth. There is some concern about capital flight from Iran to Dubai, but one speaker indicated those fears are exaggerated, as such flight has not affected Iran's exchange rate. Finally, the possibility of additional sanctions imposed on Iran by the European Union or others in the international community may dissuade some IOCs from investing in Iran's energy sector, which would delay Iranian access to necessary technology and expertise.

If additional sanctions are imposed on Iran, it would add to the price of an already costly nuclear energy program. While such a program may make sense for Iran in the long run, if faced with a choice between pursuing such nuclear energy and adopting a more rational energy consumption policy, Iranians may benefit more from the latter. Iran could develop the infrastructure to use its natural gas to meet its own energy needs, which would be significantly less expensive than developing nuclear power. Speakers agreed that nuclear energy is not a necessity for Iran: instead of dealing with inefficient gas exploitation and taking other actions that could address Iran's energy problems, the government is creating circumstances that are harming the economy and leading Iran toward energy dependence.

The government's unwillingness to reform Iran's energy sector and its broader economic policies negatively affects the country's economic outlook. Iran needs to reduce welfare spending and its reliance on energy revenues and reform its domestic energy sector to enhance the efficiency of NIOC. The government also needs to increase economic growth in non-energy sectors, since Iran's energy industry brings in 80 to 90 percent of Iran's export revenues—a large gap for other industries to fill if Iran's crude production continues to decline or if oil prices fall. Iranians seem to be waiting to see how the nuclear issue is resolved before they have a serious internal debate about Iran's various economic problems.

Notes

1. "Iran Country Brief," The World Bank, September 2006, http://go.worldbank.org/1QTWSY93G0

2. Ibid.

3. Ibid.

4. Ibid.

5. Roger Stern, "The Iranian petroleum crisis and United States national security," Proceedings of the National Academy of Sciences of the United States of America, v4, n1, pg. 377-382, January 2, 2007.

This USIPeace Briefing was written by Kelly Campbell, senior program assistant in the Center for Conflict Analysis and Prevention. The views expressed here are not necessarily those of the Institute, which does not advocate specific policies.

The United States Institute of Peace is an independent, nonpartisan institution established and funded by Congress. Its goals are to help prevent and resolve violent international conflicts, promote post-conflict stability and development, and increase conflict management capacity, tools, and intellectual capital worldwide. The Institute does this by empowering others with knowledge, skills, and resources, as well as by directly engaging in peacebuilding efforts around the globe.