Another October Surprise Coming?

10/18/2012 10:21 am EST

Focus: GLOBAL

It looks like Iran is becoming a centerpiece in this election, much as it was during the Reagan–Carter election. Except this time it isn't hostages, it's about nuclear ambitions and unstable leadership, warns Dr. Kent Moors of Money Morning.

Matters are beginning to come to a head in Iran.

So far, the impact of Western sanctions—an EU embargo of oil purchases, European and US restrictions on Tehran's access to international banking, and a new move to intensify the trading restrictions even further—have had a devastating impact.

Iran's currency, the rial, has collapsed. Riots have begun. Its government has rapidly lost its authority. And the Iranian economy is unraveling.

This has all the markings of a full–blown crisis. It will have an uncertain impact on the region and the wider oil market. This could get very unpredictable and very nasty. Let me explain…

Sanctions Paralyze Iran's Economy
Indications are emerging from several quarters that the current sanctions have dealt a major blow to the Iranian currency. The developments are prompting foreign initiatives to paralyze the regime in Tehran.

"The current perception is that the sanctions may have to be increased before Tehran will show clear signs of relenting," a source in the EU Energy Commissioner's office told me on October 6.

It remains too early to determine how far EU members are prepared to go in strengthening anti–trade restrictions. Nonetheless, several policy sources in Brussels, London, and Paris confirmed last week that a rising consensus believes something additional is warranted.

A complete EU embargo of Iranian oil imports took effect July 1. That action had widely been expected to put upward pressure on Brent prices in London. While some of that pressure has materialized, continuing demand concerns from the ongoing credit crisis and sluggish employment data have dampened the impact.

Still, a widening of the rift with Iran, coupled with the deteriorating situation on the Syrian–Turkish border, is certain to bring the problem to center stage.

Should Brussels and Washington orchestrate a new stiffening round of sanctions that expands beyond limitations on oil trade with Iran, a far more difficult environment for Tehran would emerge. It would comprise nothing less than an attempt to collapse the domestic Iranian economy, generate an escalation in internal popular unrest, and oblige the religious leadership to step in and delay the nuclear program.

There is now no doubt that the financial collapse has intensified. By the end of the trading week on October 5, the Iranian rial lost almost a quarter of its value. The plunge was due almost exclusively to the Western sanctions.

The list of moves against Iranian has been significant. It includes limitations on oil exports, including those against shippers, insurance underwriters, and financing entities. Next, Iranian access to international banking has been limited. And more recently, the US added sanctions against Bank Markazi (the Iranian Central Bank) and its network.

These events have had two overarching results. And neither has been positive for Tehran.

First, sanctions have made it much harder to raise capital from foreign trade, and have hurt Iran's foreign currency reserves. The second has obliged Iranian reliance on ad hoc and indirect methods of financing trade and repatriating proceeds. Both have markedly increased the cost of trade and dramatically lowered returns.

A Currency in Sharp Decline
The overall impact is now clearly displayed in the currency freefall, a result that the Iranian leadership can no longer hide. By October 6, the rial collapse had accentuated. It fell 9% against the dollar on the previous day alone, exceeding the record low of 37,000 to the dollar set less than a week earlier.

Even that estimate, however, may not tell the full story. Traders say that the exchange rate had actually declined even more, approaching 40,000 rials to the dollar.

"The currency has lost about a third of its value since Monday of last week, when the government launched an 'exchange center' that was designed to stabilize the rial by supplying dollars to importers, but this appears to have backfired," a source reported on October 2.

Iranian President Mahmoud Ahmadinejad has often referred to the dollar as "a worthless piece of paper," but must now contend with his own currency having dropped at least 80% in value against the dollar since earlier this year.

Acquiring reliable base figures from which to determine the real market fall of the currency has been difficult. According to the Iranian Web site Mesghal, generally regarded as a relatively objective source, the rial traded at 24,600 against the dollar on October 1.

What seems beyond question, however, is the observation that the currency's collapse is indicating that the sanctions are affecting Iran's ability to earn foreign currency, and that its hard currency reserves are dwindling.

To emphasize the point, Iran's deputy Majlis (Parliament) Speaker Mohammad–Reza Bahonar announced that national crude oil exports have dropped to around 1 million barrels per day during the first half of the Iranian year (starting on March 19) on average. This figure in June and July fell to around 800,000 barrels per day. Iran's oil export volume in 2011 was 2.3 million barrels per day, 18% of which was sold to European countries.

The announced total of 800,000 was lower than the International Energy Agency (IEA) estimate of about 1 million barrels, made only a few days earlier.

Iranian official statements are prone to discount the effect of Western sanctions on the oil industry. The Oil Ministry still maintained that crude production for the remainder of the year would hold steady. But Bahonar was noticeably taking a different, and unusually frank, route in his comments this time around, especially following a higher (though still dramatically reduced year–on–year) figure already public from the IEA.

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New Round of Sanctions Against Iran
Tehran on October 6 indicated it might be prepared to renew talks, but the trial balloon went nowhere. "Been there, done that," was the way one veteran of the previous fruitless "six plus Iran" talks put it.

The British, French, and German governments are pressing for new measures that will be agreed upon by the EU, possibly by the foreign ministers' meeting on October 15. To emphasize their determination, the foreign ministers of France, Germany, and the UK issued a joint communiqué requesting their EU counterparts to agree on new measures against Tehran. "We must let Iran know that we have not exhausted our options," Laurent Fabius, Guido Westerwelle, and William Hague wrote in the letter, a copy of which was seen on October 6.

Versions of what will be proposed vary, depending on the source. However, the following appears to be the substance of the proposal coming from London. British diplomats have indicated that the three countries were discussing new sanctions ahead of the October 15 ministers' session to include additional financial, trade, and energy sanctions.

These would include heightened measures to ban transactions with Iranian banks to include exchanges beyond either those directly with the central bank network of subsidiaries and surrogates or those related only to oil/gas sales and purchases.

Primary targets here are expected to be private banking avenues (similar to the alleged $250 billion plus channel using London's Standard Chartered Bank) and "gray area" transactions on the fringe of the Dubai Exchange that still require bank client activities through European banking houses.

On the trade side, the three countries will push to restrict an expanding category of EU trade with Iran. This would intensify the difficulty of obtaining equipment and material that could constitute dual usage, thereby impairing the ongoing nuclear development program.

Yet there are increasing signals both London and Paris (and perhaps Berlin too) are now viewing an increasing trade ban as a more concerted attempt to use domestic economic instability as a way to destabilize the existing leadership structure.

On the energy front, the proposed approach, labeled "a significant new departure" by one British source, is intended to ensure that Iran cannot bypass the oil embargo and continue obtaining finance that could be directed to the nuclear program.

As the opposition grows in the legislature, divisions were beginning to be seen publicly among the ministers over the best course of action to combat the currency crisis.

On October 2, Minister of Industry, Mines, and Trade Mehdi Ghazanfari called on security forces to intervene in the open foreign exchange market and control foreign exchange market fluctuations. Ghazanfari said that the currency trading price fluctuations are not just an economic matter, but a cultural, security, and political issue.

Iran Takes Defensive Action
While attention is currently focused on the recent sharp drop in the rial's value, the problem has been recurring for over a year. To combat it, Tehran established a Forex Trade Center (FTC) on September 23 to prevent a continuing drop against foreign currencies, providing dollars to importers of essential foodstuffs, medicine, and fuel at a fixed price.

The official version puts the rate at 2% below the open market's figures. However, sources have confirmed that market irregularities have forced regulators to exceed that level, straining Bank Markazi hard currency reserves and pressuring the rial even further.

In less than the first week of FTC operations, the currency's effective market rate declined by more than 30 %. Ghazanfari said that security forces should have a more direct role in controlling the open forex market, all but acknowledging the failure of the FTC and the dwindling options of the government. Earlier, the chief of the Iranian Revolutionary Guard Corps (IRGC) Major General Mohammad Ali Jafari said that the IRGC would intervene in the market to battle against illegal profiteers.

This was followed in quick succession by a complete disintegration in the administration's ability to control the currency situation. Late on October 2, Tehran moved to suspend all gold and foreign exchange trading as a result of uncontrollable pricing fluctuations, Iranian media outlets quoted head of the Gold and Jewelry Union Mohammad Kashti–Aray as saying.

Punctuating the volatility, Iran's Majanex Web site, which covers gold and foreign exchange prices, has gradually eliminated the price of the dollar since the evening of October 1, explaining that it has not been able to get accurate and reliable information about the dollar exchange rate.

In contrast to the value of gold, on the other hand, the rial is virtually disappearing. Where it can still be obtained, a single Bahar Azadi (a gold coin minted and sold by Bank Markazi) was going for at least 10.35 million rials on October 6, up from 10.25 million only one day earlier.

We are now rapidly moving into a very tense crisis environment.

Read more from Money Morning here…

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