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March 2021, No. 96


Cover Story

Inflation and the Banking System Crisis


Monetary policymakers always need to respond to financial pressures, but the circumstances should not be such that these pressures overwhelm monetary decisions.


Controlling inflation is the main priority of the Iranian economy, but how will it be solved? A study examining the prerequisites of inflation targeting policy has described a way to reduce inflation in the economy.

According to this study, the preconditions for inflation targeting in Iran are not available at present, but with a policy package, the conditions for reducing inflation can be provided.

This package includes flexible foreign exchange, monetary and fiscal policies. Among the policies recommended by the report to control inflation, along with targeting, are the three steps of ďreducing unproductive costsĒ, ďmore flexibility in managing the foreign exchange market and eliminating unrealistic ratesĒ and ďmore active use of interest ratesĒ. However, the Iranian economy does not currently meet the conditions for inflation targeting, especially liberation from financial domination. But this policy can be an incentive to move towards fundamental reform.

Devastating Inflation

High inflation has long been the main and growing problem of the Iranian economy and society. Iranís economy has always seemed to suffer from a lack of a reliable anchor for inflation forecasts. In such circumstances, the Central Bank of Iran is confused between different goals and has no clear course of action. The countryís monetary policymaker has a variety of tools in this direction, such as limiting credit and determining bank interest rates. Intervention in the money market and the foreign exchange market are other activities of this institution.

In a situation where many inflation problems are the result of sanctions, economic institutions and monetary policy play a key role in the economy, and the mission of the monetary policymaker is very serious. Therefore, in order to plan and have a centralized and coordinated performance in different markets, in the spring of this year, the CBI announced a change in its monetary framework to inflation targeting. Emphasis is placed on trying to reduce inflation, but the question that arises is whether this inflation targeting is the best framework for reducing inflation in the short term or not.

Main Elements of Inflation Targeting

Given the current situation, the introduction of inflation targeting at best could be an incentive for the CBI to focus more on the necessary reforms in the future. But the main priority in the current state of the economy is the success of the policy of targeting in its main area, namely inflation. The key elements to achieving inflation targeting can be summarized in three headings. First, reducing the governmentís financial dominance; second, the CBIís lack of influence from other sectors and ending exchange rate control; and third, a sound financial system that does not hurt financial stability and does not force the CBI to take inflationary measures. In addition to these three conditions, the CBI has advanced data and analytical powers to predict inflation.

Governmentís Financial Dominance


A successful inflation targeting system depends on several factors, including foreign exchange rate flexibility and countering its effects on inflation through interest rates.


Monetary policymakers always need to respond to financial pressures, but the circumstances should not be such that these pressures overwhelm monetary decisions. Financial dominance is defined as a situation in which the budget structure restricts monetary policy and measures and completely impairs the CBIís ability to achieve its goals.

Monetary policy in Iran has historically been dominated by finance in several ways and has weakened the independence of the CBI. In the meantime, many of these financial pressures have been related to the economic policy framework.

The most significant shortcomings of the policy framework can be examined in a few cases. The first shortcoming is that the government has a direct role in determining monetary policy: For example, the strong presence of the government in the Monetary and Credit Council, which can be said that the level of credit is more the outcome of the decisions of the council rather than the CBI. The second shortcoming is the close relationship between government revenues and expenditures and oil and gas export revenues. As a result, monetary aggregates have generally been affected by fluctuations in oil revenues. The third problem is the significant role of the CBI in financing the government and state-owned companies. Also, the purchase of foreign exchange earnings from the National Development Fund, which is another legal function of the CBI, causes the expansion of the monetary base.

Public Debt Sustainability

Another important issue that can be added to the government pressure on the CBI is the sustainability of public debt. Although the debt-to-production ratio in Iran is not high by the standards of emerging countries, it does not include potential future debts or government arrears. If these elements are also taken into account in the volume of debts, it can put additional pressure on future inflation. Under the sanctions, declining oil revenues and the implications of the coronavirus pandemic are likely to increase the budget deficit. According to the International Monetary Fund, the budget deficit of the Iranian government will reach 9.6% next year. Also, as long as the severe financial dominance continues, an increase in interest rates can lead to public debt sustainability.

Exchange Rate Pressure on Targeting

A successful inflation targeting system depends on several factors, including foreign exchange rate flexibility and countering its effects on inflation through interest rates. In Iranís experience, the exchange rate is a key variable in causing inflation. In a way, it can be said that the main factor of inflation outside the economic framework has been the exchange rate. After the United States withdrew from the Iran Nuclear Agreement (formally known as Joint Comprehensive Plan of Action - JCPOA) in the spring of 2018 and imposed tougher sanctions, the exchange rate soared and there was a shock due to the outflow of current account capital. This year, too, the exchange rate rose sharply, mainly due to falling oil prices and disruption of international trade due to the corona virus. In such crises, the CBIís ability to intervene in the market is limited by two factors. One is the lack of active use of interest rates and the other is the reduction of foreign exchange reserves of the CBI and lack of access to blocked assets abroad.

Banking System Crisis

The unfavorable situation of the banking network is another problem in the field of inflation. The problems of the banking system can be summarized under two headings. The first is the weakness of the balance sheet and the lack of reliable estimates of interest-free loans. Bank arrears have also been very high over the years and have accumulated in the balance sheets. The second case is the lack of liquidity in banking operations and the need for the CBI resources. The borrowing of commercial banks from the CBI during these years has been one of the significant reasons for the increase in the monetary base. As a result, monetary policy remains largely influenced by the effects of the banking network.

Stagnation Limits

Cross-sectional components also sufficiently reduce the CBIís ability to contract, but do not make this impossible. These factors include the recession and the recent dramatic rise in stock prices. Iranís economy is shrinking sharply. The International Monetary Fund expects Iranís GDP to fall 6 percent this year. That would lead to an 18 percent drop in the three years since the United States pulled out of the Iran nuclear deal and re-imposed sanctions. On the other hand, if the second wave of the coronavirus pandemic intensifies, things can get worse and further limit the power of action. The public and private sectors, relying on bank funding, will thwart efforts to curb inflation. The private sector relies heavily on banks to finance current operations, thus limiting the range of monetary contraction needed to reduce inflation and inflation targeting.

The Path to ďInflation TargetingĒ

Controlling inflation is critical to Iranís economic and social sustainability. Achieving sustainable price stability first of all requires the CBI not only to have clear and flexible inflation targeting guidelines and operational independence to achieve it, but it must also be accountable for achieving the inflation target. The second point is greater CBI independence and a significant reduction in financial dominance. The third point is the unification of multiple exchange rates, the change of direction to a more flexible exchange rate, and putting an end to micro-level market management. Fourthly it is to take the necessary measures to correct the major problems of the banking system. The fifth step is to develop effective tools for monetary control (for example, the deep bond market), and most importantly, the reduction of foreign sanctions. Further efforts are needed to strengthen the CBIís technical capabilities, especially in data dissemination and inflation forecasting. In fact, most of this is needed for any successful domestic effort to reduce inflation.

It seems that another requirement for the implementation of appropriate monetary policy and good performance of transfer mechanisms depends on structural reforms in the banking network. In addition to the precautionary legal requirements, preventing the strong presence of the government and the public sector in the management of banks, as well as the extensive relationship of banks with companies in which they are major shareholders, are some of the factors needed to improve the banking network.

What Can Be Done about the Current Inflation?

Theoretically, in the short term, the CBI has three options: first, that the monetary policymaker can follow the status quo. That is, pursuing multiple goals with ineffective tools.

In the second option, it can move towards curbing inflation by setting a goal but without committing to a specific goal.

The third choice is to commit to a steady monetary growth path that is difficult given the increasing financial needs of the government or in the event of a deeper banking crisis.

 

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  March 2021
No. 96