Iran and the Global Economy

Petro Populism, Islam and Economic Sanctions

Parvin Alizadeh, Hassan Hakimian, Parvin Alizadeh, Hassan Hakimian

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781317963004
• Edition: 1
• Topic: Sozialwissenschaften
• Subtopic: Landeskunde

The relationship between religion and the state has entered a new phase ever since the Iranian Revolution more than three decades ago. The recent mass uprisings against autocratic rulers in the Arab world have highlighted the potency of Islamist forces in post-revolutionary societies in the region, a force arguably unlocked first by Iran's version of the 'spring' three decades ago. The economic ramifications of these uprisings are of special interest at a time when the possibility of the creation of Islamic states can have implications for their economic policy and performance again. A study of the Iranian experience in itself can offer rare insights whether for its own features and characteristics or for its possible lessons and implications for recent events in the region. This book is concerned with the economic aspects and consequences of the Iranian Revolution in general and its interaction with the international economy in particular. Many studies have to date dealt with Iran's economic challenges, policies and performance in the post-revolutionary period but its interaction with the international economy – although of growing importance – has not received sufficient attention. The contributions in this volume by experts in the field address ways in which in the span of three decades, Iran's economy has evolved from a strong aspiration to develop an 'independent economy' to grappling with debilitating international economic sanctions.

1 One hundred years of oil income and the Iranian economy

A curse or a blessing?

Kamiar Mohaddes¹ and M. Hashem Pesaran²

Introduction

This chapter examines the impact of oil revenues on the Iranian economy over the past 100 years, spanning the period 1908–2010. It begins with an overview of the history of oil exploration and development in Iran, and considers the quantitative importance of revenues from oil exports for the Iranian economy. Three sub-periods are identified.

In the first sub-period, 1908–1959, oil started to be produced in significant quantities, but Iran’s share of profits from exports of oil remained rather limited, despite repeated renegotiations over the oil contracts between the Iranian government and the international (mainly British) oil companies, the nationalization of the oil industry, and the subsequent establishment of the National Iranian Oil Company.

The second sub-period, 1960–1978, saw major changes in the international oil industry and expanding oil revenues for Iran. Iran’s revenues from oil exports started to become significant, more or less steadily, from 1960 onwards thanks to increased production and better royalty terms made possible partly due to the increasing importance of OPEC in contract re-negotiations between producers and host companies. But the main factor behind Iran’s huge oil revenues in the 1970s was price increases, which were modest initially but then became substantial after the quadrupling of international oil prices in 1973–1974.

The third sub-period, 1979–2010, coincides with the overthrow of the Shah’s regime in the February 1979 revolution, the halving of oil exports as an intended policy change by the revolutionary government, and significant volatilities in Iran’s oil revenues due to the eight-year war with Iraq (September 1980 to August 1988), US economic sanctions (targeting Iran’s oil and gas industry), and the vagaries of international oil markets.

In short, although oil has been produced in Iran for a long time, its importance for the development of the Iranian economy was relatively small until the 1960s. The quadrupling of oil prices in the 1970s and the Shah’s policy of spending almost all of the increased revenues domestically substantially increased the country’s dependence on oil income, which also happened to coincide with a much higher volatility of international oil prices. Revolution, war and economic sanctions, through their impacts on oil production and exports, have introduced further important sources of variation in Iran’s oil revenues. As a result, the Iranian economy has been subject to unprecedented oil revenue volatility. Annual oil revenue volatility has risen from 35.5 per cent per annum during 1960–1978, to 51.1 per cent per annum during 1979–2010, as compared to oil price volatility which rose from 11.3 per cent to 26.1 per cent over the same periods.

In this chapter we argue that it is the volatility in oil revenues and the government’s inappropriate economic and political responses to these volatilities that are the curse and not the abundance of revenues from oil exports in itself. To this end we review the literature on resource abundance and growth, as well as the recent macro-econometric evidence on the Iranian economy. Although the early literature showed the existence of a negative relationship between real output per capita and resource abundance, more recent evidence is not so clear-cut. First, the early literature used cross-country analysis that fails to take account of dynamic heterogeneity and error cross-sectional dependence, and this could bias the results. Second, the early analysis ignores the effects of oil revenue volatility on growth, which turns out to be important. Using appropriate econometric techniques and including measures of resource revenue volatility in the analysis, the evidence in fact points to resource revenues having a positive effect on growth, with resource volatility affecting growth negatively. Seen from this perspective, resource revenues can be both a blessing and a curse, and the overall outcome very much depends on the way the negative effects of resource revenue volatility are countered by use of suitable stabilization funds and other policy mechanisms that smooth out the flow of government expenses over time. There are also a number of political economy considerations that are highlighted, such as government accountability, generous subsidy policy, and general rent-seeking activities that often manifest themselves in higher inflation and reduced economic efficiencies.

Turning to the macro-econometric evidence, we first review the historical trends over the period 1937–2010. We show that there are strong positive correlations between growth of real GDP and real oil export revenues over the whole period and a number of different sub-periods. But, at the same time, we observe strong negative correlations between real GDP growth and inflation, again over the full sample period and the same sub-periods. These results are corroborated by the more formal macro-econometric evidence, also reviewed in the chapter. We note that, while oil revenues affect real output positively, inflation has a statistically significant negative effect on real output even in the long run. Based on standard economic theory we would expect inflation to have a significant positive effect on real output only in the short run (through the Phillips curve trade-off), and no effects on real output in the long run. We view the negative long-run relationship between real output and inflation as an indication of the adverse effects of a combination of factors (such as rentseeking, poor institutional arrangements for dealing with oil revenue volatility, and general economic mismanagement) on economic growth.

Econometric analysis also reveals additional insights into the way the Iranian economy functions, which is not apparent from a historical analysis. Using generalized impulse response analysis it is shown that the effects of oil revenue or foreign output shocks work themselves out through the economy within two years, which is much shorter in duration than what is generally obtained (three to five years) in the more developed economies. Such rapid responses to shocks could be due to the relatively underdeveloped nature of money and capital markets in Iran, and the country’s relative isolation from the global economic and finance community. Such a fast rate of response to shocks makes it even more important that appropriate stabilization policies are put into effect so that the adverse effects of negative shocks on output and consumption are dealt with in a timely manner.

We conclude that, in order to promote growth, policies should be devised to control inflation, serve as shock absorbers negating the adverse effects of oil revenue volatility, reduce rent seeking activities, and prevent excessive dependence of government finances on oil income.

The rest of the chapter is set out as follows: Section 2 discusses the history of the oil sector and its importance for the Iranian economy during the three sub-periods: 1908–1959, 1960–1978, and 1979–2010. Section 3 reviews the literature on resource abundance and growth, and discusses the relevance of the “Dutch disease” and the “resource curse” literature to Iran. Section 4 considers the macroeconomic trends and reviews the existing macro-econometric evidence on the relationship between oil income, inflation and economic growth, both over the course of a business cycle as well as in the long-run. Section 5 presents the evidence on oil price and revenue volatilities and discusses how they interact and influence the economy. Some concluding remarks are given in Section 6.

Importance of the oil sector in the Iranian economy

It is now over 100 years since oil was discovered in Iran in commercial quantities. But as we shall see, oil export revenues started to play an important role in the Iranian economy only after 1960, largely due to the low levels of royalties that the Iranian government received from foreign oil companies operating in Iran before 1954. The period post 1960 can also be conveniently split into the pre and post-revolution periods. More specifically, we group the years since 1908 into three sub-periods: 1908–1959, 1960–1978, and 1979–2010, and consider each of these periods separately below.

1908–1959

In 1901 William Knox D’Arcy signed an agreement (which became known as the D’Arcy Concession) with Muzaffar al-Din, the Shah of Iran, in which D’Arcy was given the exclusive rights to explore, develop and produce any oil and gas fields in an area that covered three quarters of the country. In exchange for this right, the Shah would receive a lump sum payment of £20,000 in cash and an equal amount worth of shares of the company that was granted the right to explore oil in Iran. More importantly, the Shah would also receive 16 per cent of net annual profits of the company (Article 10 of the D’Arcy Concession 1901 reproduced in Ferrier 1982).

A large number of test wells were drilled in Iran between 1901 and 1904, and while oil was discovered, the amounts found were not commercially viable. As D’Arcy was slowly running out of money, in order to finance further explorations, he was forced to find other sources of funding and finally in 1905 sold most of his right to oil exploration and production to the Burmah Oil Company. By 1908 the cost of exploration had reached over half a million pounds without any viable oil fields being discovered. Thus the decision was made to shut down operations in Iran. Although George Reynolds, the chief explorer in Iran, received a telegraph from London telling him to stop drilling, he continued exploring for oil until the order was confirmed by post (Kinzer 2003).

Before the letter from England reached Reynolds, large amounts of oil was found in Masjid-i-Suleiman on 26 May 1908. With this discovery a new corporation was formed later that year called the Anglo-Persian Oil Company (APOC). In 1913, in exchange for secure and cheap oil supply from APOC, the British government, on the initiative of Winston Churchill, injected £2 million into the company and in doing so acquired a majority ownership (51 per cent of total shares). Thus in effect APOC controlled all oil operations in Iran and the interest of the British government and APOC became aligned. This partnership made sure that the British government became an important player in the Iranian oil industry, enhancing her sphere of influence in Iran.

During the first few years of APOC’s operations a massive infrastructure of oil wells and pipelines were put in place. One of the largest oil refineries in the world (up until the first half of the twentieth century) was built in Abadan, which enabled APOC to become a major oil producer in the Pers...