Inflation blamed on Petrol

As the second round of cuts to the subsidies kick-starts, rationed and non-rationed petrol respectively experience 75 and 43 percent rise in prices. Some economists believe that the rise is too slow to generate the revenue forecasted in Article 21 of the National Budget Plan. There are also another group of economists who reckon that launching the second phase together with increase in the prices of energy carriers was unnecessary and that it does not serve the interest of the country as it may once again create ripple effect across the society. To investigate these opinions and examine the impacts of petrol price increase on the economy of Iran, Tejart-e-Farda organized a roundtable attended by Gholamhossein Hasantash, Senior Advisor for Institute for International Studies on Energy and Mehran Moeeni, Advisor to the Head of the said institute.

In the morning of Friday 25th April, petrol price was raised gently. What impacts such increase will have on the national economy? To draw a comparison, which one serves better: that steep climb in the first phase or this gentle slope?

Gholamhossein Hasantash: First of all, the term "gentle slope" needs to be defined clearly. Is 75% increase considered as gentle slope? I was not for the increase in petrol price. Not that I believe the old price was reasonable but that the whole pricing system in our economy is implausible. The minimum wage in Iran stands at 2000 USD while the dollar exchange rate against rial is 33,000 IRR. Drawing constant comparison with other countries in terms of different prices without thorough examination of other core indices such as minimum wage, public transportation, infrastructure, and quality of vehicles is not logical. In Iran, vehicles are of poor quality and are sold twice the world price, therefore, they must be fueled almost twice the amount needed in those countries to travel a distance of 100 km. This is what we are most critical of. There is no doubt that the petrol price in our country is not standardized.

Do you consider the petrol price illogical as an economist or from the view point of a firm?

Gholamhossein Hasantash: I am looking at this issue from the national macroeconomic perspective; imagine a product that can be sold at 1 USD in Persian Gulf countries is actually sold at 10 cents inside the country.

The first reason for my disagreement is the fact that you cannot choose only one product. The second reason is that petrol together with dollar exchange rate and gold coin have turned into indicators in the economy that can create fears of rising inflation and affect overall prices in the country.

Does "petrol" have the potential to work as an economic indicator?

Gholamhossein Hasantash: Like it or not, it already has. The general public currently do not justify the rise in prices with any other indicators but the petrol price. This is a clear proof that petrol is already serving as an indicator and therefore, should be treated with utmost care and caution.

As the third reason for my disagreement with raising the prices, I would like to refer to my meeting with Dr. Nili where I opposed any rise in prices despite the fact mentioned by Dr. Nili that the rise in inflation could already be minimized by a decrease in the price of fuel in real terms. While highlighting the value of the public trust in the new government to combat the rising inflation as an irreplaceable asset to invest on for the years to come, I suggested to delay the launch of the second phase for one year and pathologize the first phase closely in order to avoid the loss of public trust, curb the rising inflation and make careful plans for launching the second phase of cuts to the subsidies.

Mr. Hasantash believes the government could buy time and delay the launch of the second phase relying on the social capital behind it. However, there are several others who believe that the government has wasted the opportunities and could have started the second phase in 2013. What is your opinion?

Mehran Amir Moeeni: Apart from the political debates surrounding the launch of the second phase, the economic condition is of prime importance when implementing a policy. The first phase of the Subsidy Reform Act started in a totally different economic climate where dollar exchange rate was 11,000 rials; inflation rate was low, no sanctions existed; production was not as costly as today and therefore, an economic shock could be easily handled. The situation today is completely different. At that time, I was one of those for the increase in prices. To me, the Subsidy Reform Act reels with problems and needs to be reviewed. I do not really agree with this plan to continue.

But the legislators believe otherwise and think the Act is comprehensive but not implemented properly.

Mehran Amir Moeeni: It does not look like an efficient Reform Act as it requires the government to replace the energy subsidies with nationwide cash transfers among all classes of the society. It is undoubted that it is among the responsibilities of a government to create opportunities for people to increase their income but direct cash distribution is not the proper way. There is a proverb saying "Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime'. Unfortunately, this has created a new social issue and it should be investigated why certain individuals have decided to do nothing but to wait for this money to come to their doors. The new government had the chance to critically review the Act while presenting the Annual Budget Bill to the Parliament last year and shift their attitude towards the proper channels for subsidy provision but unfortunately the chance was not taken and what we see today is the repetition of the past although the new government is supposed to act logically and based on realities.

As to the petrol price, unfortunately, three different prices co-exist. According to many experts, having two price structures for petrol is poisonous as it feeds corruption and economic rent and does not serve the interests of the government. A substantial share of petrol sale is currently at the rate of 4,000 rials not 7,000 rials per litre. In the meantime, the basis for increase in the prices of other commodities will be the petrol price at the rate of 10,000 rials and as such inflation will be built upon the same while the government's revenue shall come from the petrol price at the rate of 4,000 rials per litre. The future reports by the National Oil Refining & Distribution Company will shed further light on the situation, although it does not seem that 7,000-rial-per litre petrol plays a visible role in revenues.

What is your prediction in this regard?

Mehran Amir Moeeni: Currently, there are three price structures for petrol in the market. As mentioned earlier, this will not generate any income or interests for the government. In fact, in the short run, those who sell their petrol quota to those who need it will gain the most. In other words, corruption is intensified. Even when 4,000 -rial-per-litre petrol quota ends, 7,000-rial-per-litre quota will replace and there will be little room for 10,000-rial petrol to sell and the trend will continue.

Given the three price structures for petrol, in your opinion where are we heading to?

Gholamhossein Hasantash: During a TV interview, Dr. Nili acknowledged that the increase in prices would result in stagflation; however, he further argued that given the air pollution issue, the increase was inevitable.

Academically speaking, most econometric analysis conducted on price elasticity of demand for petrol and other fuels in Iran and other regions of the world suggest that there is low price elasticity of demand for energy in general. For example, if energy prices are raised by 100%, energy usage is influenced by 10% or less. Econometric studies on petroleum products in Iran confirm the findings.

When speaking of environment pollution as the main reason for raising energy prices, it is expected that the government provide scientific and clear explanations based on mathematical and econometric models on how this is going to happen. For instance, for 5% reduction in air pollutants, how the increase and decrease in petrol price and usage should behave.

The problem is that such data gathering and systematic studies and researches have not taken place and the decision on the price of petrol lacks scientific grounds and justifications.

Another important issue is the real term prices versus nominal prices. The former as maintained by the neo-classic economists is the factor influencing the demand, usage and consumption pattern changes. Therefore, it is vital to work on calculating and reaching the real term prices. This is not possible unless a clear plan for curbing inflation is defined. When petrol price is decided at 7,000 rials per litre and it is intended to stabilize the inflation rate at X%, there should be clear explanation on the plan for curbing the inflation and the method by which real term price for petrol has been calculated.

Apart from that, it seems that the government cannot afford its expenses and is only seeking to find a way to fulfill its budgetary commitments. Looking from this angle, it should be noted that our government is large and can be adversely affected by the inflation.

Therefore, it is necessary for the government to study, well in advance, all possible impacts of such an increase within its own structure including the ministries. In my view, this was neglected in the first phase and the governmental organizations experienced an unpredicted surge in their expenses. As a consequence, they resorted to presenting fabricated reports. For instance, contrary to the agreements signed between the energy-related organizations and Subsidy Reform Act Organization as well as my own investigations, the former claimed that the margin of the revenue generated as a result of increase in energy carriers' prices was not sufficient for cash transfers to the public. To me, such false reports are justifiable as the situation was not predicted well in advance and it seems the same is happening once again in the new government. The situation will lead to inefficiency of the government. In other words, the increase in energy prices creates revenue expectations within the government while the resulting inflation and surge in its expenses may disappoint such hopes.

What is your forecast on the ensuing rise in inflation given the recent price increase?

Gholamhossein Hasantash: I have not come up with a model so far to answer precisely but given the areas affected by the increase namely taxation, minimum wage, bank interest rates and energy carriers, I think the inflation rate will not go below 30% by the end of the current year. In other words, the average inflation rate for this will be more than 30%.

So you do not believe in the WB and IMF forecast?

Gholamhossein Hasantash: I do not believe they can be realized. The recession will be intensified, as the manufacturers cannot afford the expenses arising from the surge in taxation, wages, interest rates and energy.

As published in our year-end issue, Dr. Nili maintained that 2014 would be a challenging yet deciding year in our economy that can heal our economy if passed successfully otherwise gloomy horizon looms ahead. Do you agree with this statement? Do you think implementing the second phase of Subsidy Reform Act can help us put the difficulties behind?

Mehran Amir Moeeni: I believe our main economic challenge is to implement the second phase successfully. I have also mentioned to my friends that this year is very decisive for our economy and that the government will be under serious pressure. In fact, the very challenge of the new government is the same. I believe the government could change the attitudes towards the Act by acting in a less sensitive manner and ignoring the reservations.

Could you elaborate further through some examples?

Mehran Amir Moeeni: The government has announced several times that it aims to curb the inflation. Energy carriers' pricing is a tool to realize the said goal. Given the pressure on the government to launch the second phase of Subsidy Reform Act, it could in fact control the inflation by choosing the best scenario with least impact on inflation while generating the most revenue. To this end, fixing the petrol price at 8,000 rials per litre could first of all mitigate the inflationary impact of 10,000-rial/litre petrol in the public eye and generate more revenue for the government. The very existence of a 10,000-rial/litre petrol price creates inflationary anxieties in the society and I believe all commodities' prices have already experienced increase based on that price not on 4,000 or 7,000 rial-per-litre petrol. The anticipation of inflation among the public is detrimental to the economy and intensifies the inflation. It was a good idea to supply the people with some information before the launch of the first phase. For instance, for the launch of the first phase, Mr. Rooyanian made an effort to rationalize the increase in taxi fares by providing some explanations to the public. In the second phase, the public had to be addressed again by the government officials as the conditions were even more complicated than before.

In economy all activities are chained together and changes immediately generate ripple effect. As to the justifications for the increase in taxi fares, it is noted that in addition to the petrol price increase, the rise in the price of automobile spare parts are mentioned by the taxi drivers. I believe the previous government succeeded to curb part of the anticipated inflation and may be we could even conclude that the first year went well although I was against the direct distribution of cash among people. My main point, therefore, deals with the way the prices are increased. As I believed the production sector would adopt immediately and the rise in wages would satisfy the workers. It was only the question of the vulnerable classes who could be covered by extending social security and providing cash or kind aids. However, further studies and research were required to identify the said target group.

As echoed both in the Fifth Development Plan and Subsidy Reform Act, one of the main concerns of the government is to reach Persian Gulf FOB (Fuel On Board) prices. Given your stance against the increase in prices, when do you think is ideal to reach FOB prices?

Gholamhossein Hasantash: The current approach does not take us to Persian Gulf FOB prices as they have to be converted into rials. Such undertaking demands stability in dollar exchange rate that can be achieved only when the inflation rate is controlled. Any rise in dollar exchange rate clouds the horizon to reach FOB prices. Dollar exchange rate constantly has the potential to fluctuate given the gap between the domestic and global inflation rates.

In the short run, when the new price of petrol is fixed, dollar exchange rate fluctuates by 10%. It is yet to see what will happen by the end of the period. Given that, I do not think targeting Persian Gulf FOB prices is a good idea unless the government defines a proper plan to stabilize inflation and dollar exchange rate against rial. This means we are living in a vicious cycle where reaching FOB prices seems possible and impossible at times.

Despite some oppositions and disagreements, the government finally decided to launch the second phase of the Subsidy Reform Act. As you know, this government has many critics and the prevailing rationality could be replaced with some intolerance. How should the new government move forward to utilize its social capital in the best way possible and restore the economy next year?

Mehran Amir Moeeni: The previous government had targeted revenue generation and energy saving that seem to have failed since it was launched 3 years ago. Countries enjoying economic stability like the US and European countries can well respond to price increase policies to save energy. Iran is still in the first stage. To control energy consumption, low-quality cars like Peikan should not be manufactured or imported.

Iranian cars consume much more fuel in comparison with international or even national standards. You cannot expect people to buy cars in order to keep the automotive industry alive and then expect them to leave it at home. Everyone who buys a car would like to use it, so the government has to create an enabling environment so that it could be used for certain purposes. To achieve energy-saving objectives, the government needs to design a policy package of which price increase is only the first step.

If the government increases the petrol price and force the domestic manufacturers to decrease prices by importing high-quality cars, then it could come under fire by domestic car manufacturers. Unfortunately, car manufacturers in Iran enjoy a strong rent at high levels of the state. Therefore, the objectives must be clear and standards need to be set. The government should supervise in a visible manner. Relative prices should work properly. Culture of the society should alter. It is necessary to foster the ground and combine pricing and non-pricing policies to achieve energy saving. Of course for any pricing policies to work, relative economic stability is the key.

For the second phase to be successful, do you think the inflation rate should stand at 10 to 12 % as in 2010?

Mehran Amir Moeeni: Yes. Although I wish to reiterate once again that I am for the increase in prices but not the way the Subsidy Reform Act is implemented.

Gholamhossein Hasantash: Even in the absence of precise sociometric studies and surveys, I believe the government did not treat the public properly. It was against the rules of transparency to increase the prices as of mid-February while spreading the rumors of possible increase in energy carries and at the same time asking people not to volunteer to receive cash payments.

The government could come clean on its budget imbalance and elaborate the two scenarios for people to combat the rising inflation: whether the prices are raised or people choose not to receive the cash payments would be to their best interest. In the absence of such an approach, we cannot expect people to wholeheartedly give up.

The second issue is the public trust towards the government. It cannot be overgeneralized to the whole society but I know a wealthy family of 100 people who are also big fans of Mr. Rouhani. In their discussions on whether to enroll for the cash payments or not, they finally concluded that it was better to enroll and receive the cash payment and open an account to help the poor. If they could trust that the government would spend the money in the right way to solve the fundamental problems of the society and develop the country, they would definitely choose not to receive the cash. Unfortunately that trust does not exist.

It seems that the new government has chosen to go with gradual increase in prices and is set to follow the provisions of the Third and Fourth Development Plan and apply a 20% annual increase. What is your opinion?

Mehran Amir Moeeni: Reaching FOB prices in 2 or 3 years is not attainable with the said 20% annual increase. In other words, such increase shall not reach 30,000 rials.

Gholamhossein Hasantash: With 20% annual increase plus the inflation rate of 20%, the real term prices of energy carriers would stay the same and as mentioned earlier, no changes in the consumption pattern would happen.

What about the 70% increase in petrol price at about twice the inflation rate as mentioned by you earlier?

Gholamhossein Hasantash: Such an increase can affect the consumption patterns only if the necessary infrastructure is in place and people are encouraged to use public transport instead of their own cars.

Can petrol be sold to people at higher prices?

Mehran Amir Moeeni: Raising the price is always possible but economic consequences should be predicted. At the moment it is not advisable. As the first step, it is essential for the government to implement economic stability plan and then take necessary measures to balance the prices so that the economy can cope with the shock. As to the petrol smuggling, the only way to address the problem is for the petrol price to reach a competitive level comparable with the neighboring countries.

Gholamhossein Hasantash: Doing so, there would be inflationary consequences for the economy resulting in the increase of the dollar exchange rate against rial. Therefore, pricing on this basis would not be logical. The issue of petrol smuggling must be dealt with as Iran is neighbored by a group of distressed countries with very different economies.

Mehran Amir Moeeni: In other words, unfortunately we are on the wrong path. I recall, at the time, I had a conversation with Dr. Farzin telling him that the Achilles heel of the Subsidy Reform Act was foreign currency exchange rate against rial. He believed there were no intentions as to balance the rate. He was attending the same conference where Dr. Nili mentioned that as the first step, the foreign currency exchange rate needed to be adjusted in order to implement the policies in the next step. Perhaps at that time such a statement was not considered as illogical since the pressure was on the foreign currency exchange rate against rial that had not been adjusted for years. Despite the aforesaid, it seems that having launched the second phase, the government intends to address the foreign currency exchange rate next.

We have attached ourselves to international markets and constantly talk of FOB and the necessity to adjust our prices based on FOB. It should be noted that FOB prices are under constant fluctuations and except for the US other countries choose to define a protective shield such as heavy taxation to encounter price fluctuations.

This is interesting to note that the US is the only economy that can remain sustainable while being flexible, even the Europeans cannot. Therefore, we should first think of distancing our economy from a turbulent environment. It is not possible to link our economy to the global economy with the current situation. The fluctuations in the foreign currency exchange rate against rial during the past 20 years is a good example as none of the problems of the country could be solved. Only a long-term phased plan independent from any governments can work out the problems.