June 2018, No. 87

Banking

Central Bank Responsible for Maintaining National Currency Value

The realities cannot be ignored by the wrong policies that are aimed at fixing the exchange rate for a while.

Dr. Alinaqi Mashayekhi, Economist

A false idea about ​​the value of the national currency is created when we consider the price of the US dollar not the effect of depreciation of the national currency but its cause. Based on this false assumption, it is thought that if we lower the price of the dollar by injecting petrodollars into the market we will increase the value of the national currency. We may thus be able to maintain and even reduce the price of the dollar for a while, but due to the increase in domestic inflation compared to global inflation, the real value of the national currency will decline, and what is important is the true value of the national currency, not the price of the dollar to rial .

When domestic inflation is higher than foreign inflation and the real value of the national currency goes down, if the authorities, based on the above-mentioned false assumption about ​​the national currency prevent the price of foreign currencies from going up by injecting petrodollars into the market, the national economy would face a number of terrible consequences.

When domestic inflation is higher than foreign inflation, by fixing the foreign exchange rate a basket of goods purchased in dollars from abroad and converted into local currency at fixed foreign exchange rate its local currency rate will be less than the same basket of goods inside the country. Thus domestic production is reduced or shut down (such as footwear and domestic clothing), and the domestic market is put at the disposal of foreign products. Imports would happen from any channels. One is the official channel of IRI Customs Administration (IRICA) and the other is the smuggling channel. Part of the foreign currency that is supplied to the market to control the dollar price will provide the necessary hard currency to buy foreign goods and smuggle them into the country. Another part of the foreign currency injected into the market is purchased by travelers and tourists from Iran for tourism and leisure travels abroad. Some foreign trips may be cheaper than domestic journeys when the foreign currency is kept at fixed price for a long time and domestic inflation is higher than foreign inflation in that period.

On the other hand, when the price of domestic product is converted into rial or dollar (at cheap currency rate), the dollar price of the domestic product will be higher than the price of the same goods produced abroad. Consequently, Iranian goods in foreign markets cannot compete with foreign commodities price wise and this leads to decreasing exports. When domestic exports are not feasible and imported goods are smuggled or supplied through official channels cheaper than domestic manufactured goods, domestic plants are half-closed or shut down. When existing factories are half-closed or closed, there is no reason for investment to develop existing capacities and investment will decline. With the closure of factories and the decline in investment, the economy will face recession and unemployment will rise.

Moreover, when the price of the hard currency is kept lower than its real price with the injection of petrodollars into the market, some people are encouraged to buy hard currency and send it abroad. By purchasing cheap foreign currency they convert part of their assets in Iran into more valuable assets abroad. In fact, the injection of foreign exchange into the market facilitates the flight of capital from the country. As a result, a misconception of the value of the national currency and attempting to fix its price at a time that, due to an increase in domestic inflation compared to foreign inflation rate its price should increase, creates a lot of catastrophes for the national economy some of which are as follows:

·         Supply of hard currency used by smugglers through injection of petrodollars to the market to maintain the price of foreign exchange and smuggling of foreign goods into the country and cripple domestic production

·         Rendering domestic production uncompetitive inside and outside the country, which due to high inflation their price increases compared to foreign goods

·         Full or partial closure of the domestic industry due to the false and artificial price of the hard currency (which is kept down by the authorities) and unemployment of a large number of workers and employees of these industries

·         Decline in investment in industries that are closed or semi-closed

·         Escalation of the economic recession by reducing investment and closure of domestic factories resulting in rising unemployment

·         Increasing travel of Iranian tourists abroad due to cheaper foreign tourism services at cheap foreign currency compared to similar services in the country

·         To boost foreign companies in countries that trade with Iran, such as Turkey, China and Europe, at the cost of shutting down domestic factories and rendering Iranian workers jobless

·         Contribution to the withdrawal of capital from the country in foreign exchange

In addition to the aforementioned disasters, with the closure or reduction of domestic production, more hard currency will be needed each day to import and supply the country with goods and services. Of course, since the supply of hard currency is not possible anymore, the shortage of foreign exchange reserves will eventually trigger a price hike of the foreign exchange. The country has experienced foreign currency price jumps several times. But what is a matter of  more regret is that every time this happens the same misconception about the strength of the national currency is repeated and the policy of maintaining the power of the national currency (meaning maintaining the price of the dollar), and its destructive consequences, will again affect the country. What is more regrettable again is the plight of policymakers and authorities in order to stabilize the exchange rate. Everyone is on the wrong track and trying.

The misconception of the power of national currency is so embedded in the minds of some officials and decision-makers that the nation has to bear huge costs in order to eradicate that notion and reform the mindset of the decision-makers. Many producers go bankrupt, many families are afflicted with poverty, many young people get depressed under the pressure of unemployment and waste a lifetime in the hope that God will help change this wrong mentality about safeguarding the power of national currency based on the price of the US dollar and by injecting petrodollars into the market and providing the necessary hard currency for cheap imports and smuggling. In fact, when you look at the economy, you see that officials and decision-makers are unwittingly trying to destroy the national economy and help economic development of other countries because of sticking to that false mentality. The sooner that false idea is corrected the less the nation will suffer.

When the power of the national currency goes down in reality and as a result of macroeconomic mismanagement, we should let this depreciation get reflected in the price of foreign exchange, in order to avoid the above-mentioned disasters. The realities cannot be ignored by the wrong policies that are aimed at fixing the exchange rate for a while. It is only possible to hide the reality from ourselves which again is not rational. The exchange rate should change according to the difference in domestic and foreign inflation, as stipulated in the development plans frequently, indicating a real change in the purchasing power of rial. Exporters of non-oil products should sell the foreign exchange they earn from exports to the country’s banking system, and any importer, including the exporters of non-oil products who want to import goods or services, should transfer the foreign currency needed to import their goods by providing the required documents through the banking system to the seller. In fact, one of the sources of foreign currency used for smuggled goods, as well as the flight of capital, is the currency that non-oil exporters sell to dealers at a slightly higher price than domestic ones.

Maintaining the value of the national currency, which is a sign of good macroeconomic management of the country, is an important debate. Maintaining the value of the national currency is, in reality, an important task of the Central Bank. But the value of the national currency is maintained when inflation is controlled. If domestic inflation drops and stands equal to the average inflation in the trading partners of Iran, then the value of the national currency remains constant. In order to control inflation, the growth of monetary base and liquidity should be equivalent to domestic production growth. So the Central Bank and the government should manage the economy so that domestic production grows and liquidity growth does not exceed the growth of production. In that case, the value of the national currency will be preserved in real terms, and people will be protected from the misery of the costly preservation of the value of the national currency on the basis of a false idea.