Bourse and Bazaar | Esfandyar Batmanghelidj: On Monday, the Iranian rial sank to a historic low. But those Iranians who scrambled to convert their rials into dollars found it difficult to do so—as they have for months. Since April, reports on the accelerating crisis have consistently noted a lack of hard currency available at Iran’s exchange bureaus.

This important detail of the current crisis has gone largely unexamined in foreign reportage. While the determinants for demand for foreign exchange—widespread anxiety about the state of the economy and the return of sanctions—are well understood, the second determinant of market prices—foreign exchange supply—remains subject to mere passing mention. This is a mistake. Iran’s currency crisis is a supply-side story.

In the absence of data, it is hard to show quantitatively that the currency crisis is primarily a supply-side phenomenon, but there are numerous factors that make this likely. Iran has been prevented from repatriating its foreign exchange reserves held in Europe. Its regional neighbors have vowed to cease using the US dollar to conduct bilateral trade. Illicit networks that have long funneled US currency to the black market have been interrupted. Most tellingly, the Trump administration is being urged by its close advisors to “quickly exacerbate the regime’s currency crisis” by interfering with Iran’s foreign exchange supply.

While the government has no doubt failed to inspire confidence in its economic leadership, contributing to the ouster of both the central bank governor and economy minister, it is unlikely that expectations of rising inflation and economic recession alone would create so dramatic a rush to the safe-haven of the dollar.

In an interview with Euronews, economist Saeed Laylaz, offers more detail on how the historic exchange rate principally reflects a shortage phenomenon. “You might imagine that the dollar price of 12,000 or 13,000 toman accounts for 100 percent of the currency market, when in actuality we have various companies completing imports with a dollar at a price less than 8,000 toman in the secondary market,” Laylaz explains. In his assessment, while the 8,000 toman rate accounts for 80 percent of transactions on the secondary market, “the dollar bill is 12,000 toman.” Greenbacks are physically scarce and this accounts for the historic prices making headlines worldwide.

For companies with access to dollars at 8,000 toman and especially for those enterprises with access to dollars at the government rate of 4,200 toman, the price of the physical dollar bill offers an immense opportunity for arbitrage. The temptation for companies to divert a portion of their foreign exchange into the most lucrative and speculative parts of the free market has proven hard to ignore. One example can be seen in the petrochemical sector, where major companies, including state-owned enterprises, have been slow to make their foreign exchange available for sale on the secondary market through NIMA, the country’s centralized marketplace, despite instructions from the central bank and oil ministry.

Economist Hossein Raghfar described these companies as “accountable to no one” when it became apparent that they may have sought to sell their currency at the free market rate, rather than at the lower official exchange rate, despite the government instruction. Nonetheless, in the assessment of Masoud Nili, the government's chief economic advisor, this kind of arbitrage activity is a symptom of the rising premium and not its root cause. Nili comes close to acknowledging that the government's focus on profiteering in the early months of the crisis was an attempt to deflect from more consequential interruptions in foreign exchange supply.

It is likely that the primary cause of the currency crisis is a severe shortage in foreign exchange. This places the Rouhani administration in an especially difficult bind. It might seem straightforward that increasing the foreign exchange supply would help stabilize the rial and prevent the speculation enabled by the extreme scarcity of the dollar and euro. Mohammad Reza Farzanegan looks at some of these issues in his study of illegal trade in Iran from 1970 to 2002. He confirms that easing the ability of actors to “acquire more subsidized exchange” will lead to some part of the currency to be “sold in the black market of foreign exchange.” The actions of the petrochemical companies offer a perfect case study.

This is especially important at a time when the incentives for illegal import activity are increasing. Farzanegan writes that “whenever state intervention drives a wedge between international and domestic prices… there is an incentive for underground activities.” In subsequent research he has shown convincingly that the “wedge between international and domestic prices” can be applied externally—sanctions spur “underground activities.” In this way, making foreign exchange more readily available may stabilize the exchange rate, but it can serve to accelerate rent-seeking and smuggling, the agents of which have historically used their trading networks to take their profits offshore.

The specter of capital flight looms large over the administration. In a recent address, newly appointed central bank governor Ehsan Hemmati announced that the country would not use oil revenues in order to prop-up the currency. In a likely related move, Iran has decided not to seek to transfer EUR 300 million in cash from its funds in Germany to Iran to increase foreign exchange supply. A report in Shargh, a leading newspaper, suggests that the government had decided not to intervene to support the rial in order to prevent capital flight by allowing the dollar to become a scarce and expensive "luxury item."

A recent report by Iran’s Parliamentary Research Center estimated that capital flight in the year leading up to March 20 amounted to USD 13 billion dollars. By comparison, during the Ahmadinejad administration, that figure was possibly ten times higher, with reports suggesting that between USD 100-200 billion was taken out of the economy as sanctions tightened. Between 2005-2012 Iran generated USD 639 billion in oil revenues, with falling exports offset to a degree by historic oil prices. Yet Ahmadinejad left office with Iran’s foreign exchange reserves at only around USD 50 billion higher than when he entered.

To prevent capital flight on that order, the Rouhani administration can prioritize rate convergence and stabilization over interventions that would significantly lower the price of the dollar. The Central Bank of Iran has sought to "bridge" the two sides of the market that Laylaz describes, announcing that "authorized exchanges can sell foreign currency bought from exporters and other sources registered through the SANA system, in the form of banknotes in the open market." The banknotes would be purchasable upon request from the central bank. In this way, any increase in the supply of banknotes at the upper end of the market will be associated with reduced supply at the lower end, helping push the rate to convergence, even if the rate remains historically high. A high exchange rate may be a necessary evil in order to protect fragile economic growth.

In a study of the Iran’s economy from 1981-2012, Hoda Zobeiri, Narges Roshan and Milad Shahrazi of the University of Mazandaran identify a strong negative relationship between capital flight and economic growth in Iran. By trapping capital at home, even devaluing rials, the Rouhani administration might hope that wealth is committed domestically towards investments and capital formation that can sustain growth. Some evidence that this may be taking place can be seen in the fact that the Tehran Stock Exchange is on a historic bull run.

Laylaz and others have criticized the administration for “adding fuel to the fire of the market” by failing to curb the demand for foreign currency. But by focusing on demand, critics will miss important supply-side phenomena, such as how the currency shortage may slow the capital flight that has historically preceded the reimposition of sanctions. Whether or not this is an intentional outcome of the Rouhani administration’s policy, that the inability or unwillingness to increase foreign exchange supply may be consistent with attempts to limit illicit trade and capital flight is a surprising outcome and one that deserves to be formalized as part of wider efforts to manage and minimize rent-seeking in Iran.