Iran’s economy is in “shambles,” as President Barack Obama recently noted. Over the past two years, the Iranian economy has seen anemic growth, high unemployment, rising consumer prices, and a sharply deteriorating business climate. And it keeps getting worse.

Compounding those bleak economic prospects, “smart” economic sanctions imposed on the Iranian economy have been replaced by comprehensive ones, a subsidies reform program undertaken by the Ahmadinejad administration has backfired, and the value of Iran’s currency, the rial, has declined steeply. Still, Tehran has failed to decisively address these problems. Instead, it continues to funnel its resources into bolstering the country’s military capabilities while the economic pressure builds.

New Challenges

In the absence of regularly published information on basic economic indicators, a near consensus exists among domestic and foreign analysts that Iran’s average annual growth rate is less than 3 percent, its unemployment rate is about 15 percent, and its inflation rate is near 20 percent (with food price inflation exceeding 50 percent). On the brighter side, Iran has an ample balance of payments surplus, an external debt of about 6 percent of GDP, and a record $90 billion in foreign exchange reserves—equivalent to a year and a half’s worth of imports.

But this cushion will likely wear thin as Iran faces its most formidable challenge: a crush of sanctions imposed by the United Nations, the United States, the European Union, and countries aligned with the West. Limited in the early 1990s to trade restrictions on weapons, nuclear technology, and dual-use items, sanctions have grown increasingly comprehensive, targeting basic and vital economic activities including Iran’s oil trade, financial transactions, and foreign investment.

Beginning in June 2010, the United Nations Security Council put in place extensive restrictions on Iran’s international financial transactions and the activities of Iran’s elite military unit, the Revolutionary Guard Corps. Washington has imposed further sanctions, including a ban on the export of refined petroleum products to Iran and penalties for foreign banks and entities that conduct business with Iran’s major banks. The European Union, for its part, has frozen the Iranian central bank’s assets, restricted trade with Iran’s petrochemical industry, and halted the sale of gold, diamonds, and other precious items to Iran. Starting on July 1, 2012, the EU will also impose a ban on oil imports from Iran.

A failed subsidy reform program launched by the Ahmadinejad administration presents another major challenge. In December 2010, the president announced reform lifting the price of a number of subsidized items—including oil and gas products, electricity, water, bread, and milk—and placing them on track to eventually achieve parity with world prices. The purpose of this reform program was to discourage wasteful energy consumption and reduce public spending—while providing a safety net for the poorest in the form of cash grants. But none of these aims has been achieved. In fact, because the government did not have a practical way of determining who was in fact poor and thus eligible for the grants, what once were across-the-board price subsidies have merely turned into cash grants for almost the entire population of between 74 and 75 million.

Finally, the government has had to grapple with turmoil in the foreign exchange market. After nearly a decade of relatively stable rial-dollar rates in the “official” exchange market, and near parity between the official rate and the “free market” rate charged by private currency dealers, a gap between the two appeared in early December 2011. The official rate of 10,600 rials to the U.S. dollar gradually reached 11,200 rials in the open market. On New Year’s Eve, when President Obama signed into law new U.S. sanctions against Iran’s central bank, the exchange rate dam burst.

Failing to calm the currency market through a series of hysterical maneuvers, in January, Iran’s central bank was forced to officially devalue the rial by 18 percent against the dollar to 12,260 rials and pledge unlimited dollars for current transactions. It also authorized higher interest rates on savings deposits in order to divert liquidity from the exchange market back into banks.

When these actions failed to satisfy the rising demand for dollars, and parity between official and free market rates could not be maintained, the central bank finally recognized a “dual market” in mid-March and let private money changers handle the dollar demand for “luxury” imports. By late March, the rial was trading on the free market at the rate of 19,000 rials to one U.S. dollar, retaining just 55 percent of its average 2002–2010 value.

Dealing with the Effects

Iran’s economy may have been in turmoil in 2010, but now it is a mess. Tighter sanctions imposed on Iran’s trade, shipping, and banks are starting to take a toll. Difficulty in receiving foreign exchange, in particular U.S. dollars, has already begun to cause serious disruptions to vital Iranian imports. Iran depends on imports for more than one-third of its food supply and an even larger share of its industrial inputs—nearly all paid for by oil, gas, and petrochemical exports. Payments in gold, local currency, and barter deals have reportedly been arranged with China, India, Pakistan, and South Korea. Sanctions have also raised transaction costs, lowered public confidence in the rial, and encouraged smuggling.

The country’s daily oil production has declined slowly but steadily over the last two years by more than 5 percent due to poor maintenance of aging oil wells and a lack of new investment. Since Iran depends on oil and gas exports for 80 percent of its foreign exchange earnings and nearly 70 percent of its annual budget, a significant reduction in crude oil output is likely to affect the entire economy. Finding new oil markets to compensate for the likely drop in exports to Europe, moreover, may not be difficult, but it would be costly. Iran would have to offer various discounts to secure these deals, find insured tankers to ship the crude, and obtain payments in dollars through regular banking channels—steps that are more difficult to take now with tightened sanctions.

Still, Iran has yet to feel the full impact of the sanctions. A widely reported 300,000 barrels a day decline in the country’s daily oil exports has been offset by nearly 15 percent since crude prices increased at the beginning of the year—giving Iran its nearly highest price per barrel, largest annual oil receipts, and amplest ever gold and foreign exchange reserves. The pain of sanctions, moreover, has not been evenly distributed. Uncompetitive and unprofitable farmers and embattled medium-size local industrialists have actually benefited from falling imports and reduced foreign competition.

While the lifting of fuel and food subsidies has not led to disaster, as many expected, it also has not promoted energy conservation or lowered public spending. Many energy-intensive industries are, in addition, hard-pressed to operate at full capacity due to the unsubsidized higher cost of their inputs. Higher food and fuel prices have, moreover, reportedly increased the annual inflation rate by 50 percent. After the program’s first phase ended with an estimated $15 billion deficit, its second phase has been blocked by the Majlis, Iran’s parliament, and must be reauthorized in the current fiscal year budget once it is approved by the assembly.

The official devaluation of the rial and sizeable decline in the value of Iran’s currency has helped long-struggling exporters find new markets abroad. But due to Iran’s enormous need for imports, devaluation now serves as an unwelcome addition to current high inflation. Unless and until the authorities manage to close the large gap between official and free market rates, furthermore, the pre-2002 rent-seeking activities, widespread corruption, and payment chaos will soon reappear.

In sum, Iran’s economic situation is dire. A few factors seem to be in the country’s favor—high oil prices and decreased foreign competition, for example—but these hardly amount to a basis for sustainable growth.

Forecast: A Hot Summer in 2012

Last year, the supreme leader dubbed March 2011-March 2012 as the “Year of Economic Jihad.” In reality, hamstrung by these three developments, Iran’s economy limped along in 2011–2012, weighed down by a combination of inflation and unemployment, a deteriorating business climate, and a political outlook darkened by the shadow of possible military confrontation with the United States and Israel. Nearly all economic activity will be adversely affected in the coming year if sanctions bite deeper into oil exports and receipts.

But the Ahmadinejad administration is aloof from the practical problems facing Iran’s economy. In an uncanny resemblance to Soviet-era practices, the regime is following a dual-track policy of overlooking national economic setbacks while embarking on flashy technical and scientific projects regardless of the cost. These include completing an entire nuclear fuel cycle, installing some 3,000 new and faster centrifuges in Iran’s main uranium enrichment facility in Natanz, sending a third satellite into orbit on a domestically built rocket, and extending the range of Iran’s missiles.

The economy is now more state dominated, more oil dependent, and more vulnerable to external events than ever before. The loopholes, furthermore, that helped Iran avoid sanctions in the past are quickly closing up. Absent a quick, even if temporary, agreement on the nuclear issue, Iran is likely to face an intolerably hot summer soon.

Jahangir Amuzegar, former minister of commerce, minister of finance, and ambassador-at-large in Iran, is an international economic consultant. He has also represented Iran and several other member countries on the IMF’s Executive Board.