Iran: bracing for a backlash

Facing insolvency, Ahmadinejad will cut popular state subsidies

Since last summer, when demonstrators took to the streets to protest what they viewed as the fraudulent re-election of hardline President Mahmoud Ahmadinejad, Iran has faced its worst upheavals since the Islamic revolution of 1979. For weeks, until a bloody crackdown by the regime in large part quelled the disturbances, proponents of the so-called Green Revolution united in a show of defiance against the ayatollahs. The response—thousands were detained and dozens killed in clashes with police—brought harsh criticism from the West, as has the government’s recent announcement that it is ramping up its nuclear program, viewed by many as a means of gaining nuclear arms. Now, with Tehran facing the threat of new sanctions that could further hurt the country’s faltering economy, the regime is bracing for more unrest. But that may come at its own initiative: with his government facing insolvency, Ahmadinejad has proposed a radical overhaul of the system of massive state subsidies that have kept life tolerable for Iran’s citizens.

It could prove to be the mercurial leader’s greatest gamble yet. Last month, Iran’s highest legislative body approved a plan to claw back the profuse welfare state which, since the revolution, has held prices artificially low for all Iranians, while nearly bankrupting the oil-rich state. Iran first began doling out state subsidies for consumer goods in 1974, during the shah’s regime. In 1979, the system was expanded by the Islamic republic’s founding leader, Ayatollah Khomeini. He was already “socialist in orientation,” says Peter Wells, founder of the U.K.-based oil consulting firm Neftex. (Khomeini had promised the people, “We will build real estate, make water and power free, and make buses free.”) Circumstances only reinforced that bent. “Almost immediately after the revolution, Iran was invaded by Iraq, and the economy was put on a war footing,” says Wells. “Iran was also subject to a partial blockade by Western nations backing Iraq. The subsidy system became an essential tool to help the poor.”

Today, price supports are firmly entrenched, with Iran effectively a bastardized welfare state. They cover a broad range of goods, including gasoline, electricity, sugar, and water. BEDigest, published by a France-based energy consulting group, estimates that subsidies cost the government a staggering $100 billion a year, or about 30 per cent of GDP. Iranians pay just pennies for essential goods. It’s often cheaper to buy a litre of gas (which goes for just 10 cents) than a bottle of filtered water. And domestic businesses have been brought up with access to raw materials that cost them less than market value. Indeed, more than 30 years since the scheme was put in place, a whole generation of adult Iranians has grown up knowing only this artificial economy. “Iranians have become used to low prices,” Wells says, making it “hard to wean them off it.”

But the bill aimed at phasing out the subsidies has been passed. And though logistical details are still being hashed out, Iran will soon begin a five-year push to bring its prices in line with market values. By 2015, gasoline and oil derivatives will be brought up to 90 per cent of Middle East benchmark prices. Electricity and water will hit the free market target by 2014. The scheme, say experts, could save the government as much as $20 billion in 2010-11 alone.

In part, the bill is an effort to rein in a domestic economy rooted in unreality. Yes, distorted pricing has helped keep food on the plates of the Iranian people, around 19 per cent of whom live below the poverty line. But low prices have allowed consumption to become “unwieldy,” says Farideh Farhi, a World Bank consultant and a board member of the National Iranian American Council. Farhi sees that when she visits home. “I’m always shocked at the amount of waste,” she explains, “in terms of bread, gasoline. People don’t walk. They take the car everywhere, even if it’s five minutes away.” Waste and overuse are rampant everywhere. “If Iranians use their oil and gas at the present level,” wrote the Financial Times early this month, “there will be nothing left to export.”

The subsidy system has also created a perfect breeding ground for “smuggling opportunities,” Wells says. In particular, he notes, gasoline is bought cheaply in Iran and smuggled into Pakistan by the Iranian Revolutionary Guard Corps. By some estimates, up to 17 per cent of gas purchased in Iran is smuggled out of the country. Indeed, Farhi insists that getting rid of subsidies is about more than just saving money. It is a question of finally “creating an economy”: a real one where prices are allowed to fluctuate and independent industries are allowed to prosper or fail.

The more immediate reason, however, is that the current Iranian economy is in ruins, and the state can no longer afford to spend billions to keep prices low. Although a lot of economic damage was done during Ahmadinejad’s first term, when he squandered a steady supply of petrodollars, the crisis really kicked off when oil prices began to plummet (oil accounts for about 80 per cent of Iran’s total exports). By last November, a barrel of oil was down to $76.50, from $147 in July 2008. For a country whose GDP is linked so closely to oil exports, that’s a big hit. Meanwhile, inflation is rampant: while the state says that it has reached 13.5 per cent, others estimate that the rate could be twice that high. Businesses everywhere are floundering.

Cutting the subsidies can only add to Iran’s immediate problems. But Tehran must also deal with the huge long-term legacy of the subsidy system. The country imports a whopping 40 per cent of its gasoline—with prices for imported gas artificially kept low, there was little pressure to encourage a domestic industry, and the few refineries have fallen into disrepair. New sanctions could starve the country of much-needed imported gasoline, while cutting the number of states willing to shell out for Iranian oil. With that in mind, Iran has little choice but to develop a domestic gasoline industry—as fast as it can. Already moves are underway: with investment from China, Russia and India, in addition to some of the money saved when subsidies are cut, Iran believes it can be self-sufficient in gasoline by 2013.

Necessary or not, the transition to a free (or freer) market economy will not be easy. The Iranian parliament’s research wing, the Majlis Research Center, estimated that cutting price supports would push inflation up to 60 per cent, quadrupling the price of gasoline and other goods. Media outlets are hazarding their own guesses about how high prices could go. In January, a headline in the newspaper Bahar quoted “a Power Ministry official” as saying that “consumers’ electricity bills will be multiplied by 21.5 times.” If such price shocks materialize, they will be catastrophic—and will undoubtedly stoke unrest.

As they have in the past. Attempts made in 1992, 2000 and 2005 to slash subsidies were scaled back for fear of opposition. The last try was in 2007, when Ahmadinejad raised the price of gasoline by 25 per cent and introduced rationing. Panic ensued and hysterical crowds set fire to gas stations across the country. This time, Ahmadinejad may be trying to pre-empt violence by promising that a chunk of the projected savings from cutting subsidies will go to “targeted assistance” for the poor, to help them cope with higher prices. But that has also strengthened suspicions that in scaling back subsidies, Ahmadinejad is effectively taking a swipe at the middle class, which formed the core of last summer’s protesters. The poor will get aid, while the upper classes will, conceivably, be fine on their own. But the urban middle class will go it alone. “I personally do not worry about the poor as much as the lower middle class or the middle class,” says Farhi. Indeed, one hardline Iranian lawmaker has said that cutting subsidies would “eliminate the middle class.”

The regime may be hoping that its harsh response to last summer’s disturbances will discourage further unrest. Following the June election, says Farhi, Tehran “was engaged in this rather impressive crackdown of what it called hoodlums in the streets: arresting people and putting them in jail, bullying people.” In recent months, hundreds of alleged dissidents—journalists, students, and reform-minded politicians—have been jailed. A fraction of those have been made the object of elaborate show trials. Some have been handed death sentences—like the two young men who, last month, were hanged for “waging war against God.” (Both were arrested at opposition rallies.)

Such brutality can hardly win hearts and minds. But there is concern that new sanctions—which are being aggressively pushed by Washington—may well play into Ahmadinejad’s hands. In fact, they could provide him with a scapegoat when domestic prices go through the roof as a result of the subsidy reform. “He will blame the West,” Wells says. Writing in the Huffington Post last month, Matthew Sugrue put it most bluntly: “Tehran is about to shoot itself in the foot, and Washington is throwing itself in the way of the bullet.”

In that context, it’s still possible that, within some Iranian circles, Ahmadinejad could walk away the winner. Farideh Farhi has her own worries about the “incompetence” of the government. Still, she says, “If Ahmadinejad can pull it off, he has already done a tremendous service to the Iranian economy.” From the outside, cutting subsidies may appear to be putting Iran on the path to another blowout. But from the inside, Farhi says, “it has to be done.”