It is ironic that Western pressure on Iran will be responsible for accomplishing the unthinkable: convincing the populist government of President Mahmoud Ahmadinejad to phase out costly subsidies and modernize the country's stagnant economy.
For decades, the high echelons of Teheran's political sphere have been debating on how and when to address the economy's Achilles' heel, but no leader has so far been willing to take the political blow, least of all Ahmadinejad.
The growing reality of "crippling sanctions", however, has finally lined up the respective powers-the Supreme Leader, Parliament (also known as Majlis), the Central Bank, and the government.
This month, Iran is set to begin the implementation of its five-year subsidy reform plan, with a particular emphasis on energy products.
The ultimate goal is to save up to $100 billion annually that should, if the policy that accompanies the plan is implemented correctly, help Iran modernize its economy and make it less vulnerable.
Geopolitics aside, the plan will no doubt be painful and risky.
Nevertheless, it remains a necessary evil that will serve to correct severe market distortions, strengthen a rising middle class, and diversify the productive sector away from oil dependence.
The plan is not new either.
The International Monetary Fund, the World Bank, Iran's Central Bank, and just about all economists have been advising Iran-and most other Middle Eastern countries-to do so for some time.
In fact, Iraq has already phased out most of fuel subsidies, regardless of its oil wealth.
If done correctly, this will no doubt strengthen and modernize Iran's economy, without abandoning the poorest to their fate.
The Economic Reform Plan, as it is known, became law in January after intense wrangling.
Implementation is expected at the beginning of the next Iranian year (March 21), along with the new budget and Iran's new five-year plan.
Subsidies on oil derivatives, natural gas, electricity, water, food, health and education will be phased out.
Savings of $20 billion annually, which will total $100 billion at the end of the five-year plan, will be managed by the government, but supervised by the Supreme Iranian Audit Court, which oversees government spending.
A portion of the saved money will be used to compensate low-income families with cash for their extra expenses, a form of explicit subsidies favored by the International Monetary Fund.
The biggest savings are expected from oil derivates, which make the bulk of government subsidies.
The cost of products such as fuel will be benchmarked to Gulf international prices, with a maximum 10 percent discount allowed.
Consumer prices of gas, water, and electricity will also be matched with production costs.
Until now the government has indirectly subsidized energy prices by regulating what consumers pay regardless of international market prices or production costs of state energy companies.
This has contributed to creating a huge hole the budget equal to more than 20 percent of the country's GDP.
It also promotes wasteful demand, especially from the largest consumers such as industry and wealthier households which squander resources because of their low cost.
Demand for fuel, gas, and electricity have soared, making Iran increasingly dependent on costly foreign imports, and creating disincentives to exports.
In the case of natural gas, for example, distortions in energy markets cause Iran to miss around 20 percent of its GDP in potential natural gas sales, according to the IMF.
This stands in stark contrast with Iran's ambitious foreign policy objectives given the significant geopolitical clout that would accompany higher natural gas exports.
Productivity is also imperiled as a result of subsidizing.
Unrealistic low industrial energy costs kill the need to improve industrial efficiency, thus making Iranians products generally of lower quality, despite at times being more expensive than foreign ones.
Iranian products thus loose international market appeal.
Low gasoline prices have also led to increased smuggling across borders.
Authorities estimate that as much as 17 percent of local fuel production-equal to almost 11 million gallons a day-is lost this way.
Urgency to phase out subsidies is also the result of Ahmadinejad's populist policies, which are blamed for rampant inflation and high unemployment.
Their exponential danger was exposed as the global economic crisis sent oil prices plummeting and the government was forced to use its reserves, without local demand being curtailed.
The subsidy agreement comes as the West-led by the U.
S.
-increased diplomatic pressure to ratchet sanctions on Tehran over its defiant nuclear program.
Ahmadinejad, who still faces strong internal dissent and turmoil over his reelection last year-believed to have been at least partially rigged-ordered uranium enrichment 20 percent above the threshold needed for scientific purposes.
Weapon grade uranium is over 90 percent enriched.
Ahmadinejad's subsidy reform plan has also raised skepticism within Iran, where it is seen as a ploy to garner more support for his faction.
He has fought for full control of the savings, even as the Majlis has tried to curb interventionism.
The budget proposal, which parliament still has to approve, is based on oil prices at $60 a barrel, significantly above the $37.
5 per barrel used last year.
The nearly $370 billion budget is almost 25 percent higher than last year's $298 billion.
The skepticism was refueled recently after Ahmadinejad surprised parliament by including $40 billion of expenditure in the budget that would be paid with savings generated through subsidy reductions, according to Iranian media.
While the president backtracked after the Majlis rejected the move-reminding the president that the plan called for $20 billion of savings annually-concerns that Ahmadinejad could mismanage funds appear well-rooted.
The issue is still uncertain, as many things are in Iran until their final approval.
The plan suggest that almost half of the savings will be redistributed as targeted subsidies to the most poor, another 30 percent will go to improving energy efficiency, and the remaining 20 percent will be kept by the government to offset losses in state-owned companies.
How the reforms are applied remains the question and ultimately a risk.
In terms of unrest, some 40 percent of Iranians are below the poverty line and at least 11 percent of the population is unemployed.
Mishandling the subsidy reform plan thus implies huge risks to internal stability.
Government mismanagement could be costly, especially in the current political environment.
But the biggest risk really is related to inflation.
Suddenly cutting subsidies means that prices will increase and that inflation will follow.
That is manageable if done correctly though.
Current inflation stands at single digits, a great accomplishment considering that only a year ago it fluctuated between 20 and 30 percent.
The IMF has also argued that inflation doesn't have to accompany the subsidy reform plan.
Malaysia, for example, increased prices of diesel more than 80 percent and kerosene almost 70 percent, accompanied by a 4 percent deflation.
There are similar examples, although not as successful, in Indonesia, and Turkey that reinforce the importance of policy when cutting subsidies.
If anything, that illustrates that proper handling of subsidy-cutting benefit to the economy.
In Iran's case, of course, this will depend on how reform will be managed.
Ahmadinejad appears to have a plan, at least on paper.
"Emphasizing a reduction of dependence on oil revenues and an increase of non-oil revenues, with a focus on industry, agriculture and housing -these are among the main attributes of the bill," he said when presenting his budget.
Public investment on construction accounts for $110 billion, for example.
The real challenge, though, is diversifying the economy as much as possible.
"I would not want to pass up a unique opportunity offered by a populist administration courageous enough to raise prices to market levels.
The icing on the cake will be if the government can combine price reform with achieving a greater equality in the distribution of income," wrote earlier this month in his blog Djavad Salehi-Isfahani, a Dubai Initiative research fellow at the Belfer Center for Science and International Affairs at Harvard University.
First published: Monday 15 March 2010, updated: Tuesday 16 March 2010.
For decades, the high echelons of Teheran's political sphere have been debating on how and when to address the economy's Achilles' heel, but no leader has so far been willing to take the political blow, least of all Ahmadinejad.
The growing reality of "crippling sanctions", however, has finally lined up the respective powers-the Supreme Leader, Parliament (also known as Majlis), the Central Bank, and the government.
This month, Iran is set to begin the implementation of its five-year subsidy reform plan, with a particular emphasis on energy products.
The ultimate goal is to save up to $100 billion annually that should, if the policy that accompanies the plan is implemented correctly, help Iran modernize its economy and make it less vulnerable.
Geopolitics aside, the plan will no doubt be painful and risky.
Nevertheless, it remains a necessary evil that will serve to correct severe market distortions, strengthen a rising middle class, and diversify the productive sector away from oil dependence.
The plan is not new either.
The International Monetary Fund, the World Bank, Iran's Central Bank, and just about all economists have been advising Iran-and most other Middle Eastern countries-to do so for some time.
In fact, Iraq has already phased out most of fuel subsidies, regardless of its oil wealth.
If done correctly, this will no doubt strengthen and modernize Iran's economy, without abandoning the poorest to their fate.
The Economic Reform Plan, as it is known, became law in January after intense wrangling.
Implementation is expected at the beginning of the next Iranian year (March 21), along with the new budget and Iran's new five-year plan.
Subsidies on oil derivatives, natural gas, electricity, water, food, health and education will be phased out.
Savings of $20 billion annually, which will total $100 billion at the end of the five-year plan, will be managed by the government, but supervised by the Supreme Iranian Audit Court, which oversees government spending.
A portion of the saved money will be used to compensate low-income families with cash for their extra expenses, a form of explicit subsidies favored by the International Monetary Fund.
The biggest savings are expected from oil derivates, which make the bulk of government subsidies.
The cost of products such as fuel will be benchmarked to Gulf international prices, with a maximum 10 percent discount allowed.
Consumer prices of gas, water, and electricity will also be matched with production costs.
Until now the government has indirectly subsidized energy prices by regulating what consumers pay regardless of international market prices or production costs of state energy companies.
This has contributed to creating a huge hole the budget equal to more than 20 percent of the country's GDP.
It also promotes wasteful demand, especially from the largest consumers such as industry and wealthier households which squander resources because of their low cost.
Demand for fuel, gas, and electricity have soared, making Iran increasingly dependent on costly foreign imports, and creating disincentives to exports.
In the case of natural gas, for example, distortions in energy markets cause Iran to miss around 20 percent of its GDP in potential natural gas sales, according to the IMF.
This stands in stark contrast with Iran's ambitious foreign policy objectives given the significant geopolitical clout that would accompany higher natural gas exports.
Productivity is also imperiled as a result of subsidizing.
Unrealistic low industrial energy costs kill the need to improve industrial efficiency, thus making Iranians products generally of lower quality, despite at times being more expensive than foreign ones.
Iranian products thus loose international market appeal.
Low gasoline prices have also led to increased smuggling across borders.
Authorities estimate that as much as 17 percent of local fuel production-equal to almost 11 million gallons a day-is lost this way.
Urgency to phase out subsidies is also the result of Ahmadinejad's populist policies, which are blamed for rampant inflation and high unemployment.
Their exponential danger was exposed as the global economic crisis sent oil prices plummeting and the government was forced to use its reserves, without local demand being curtailed.
The subsidy agreement comes as the West-led by the U.
S.
-increased diplomatic pressure to ratchet sanctions on Tehran over its defiant nuclear program.
Ahmadinejad, who still faces strong internal dissent and turmoil over his reelection last year-believed to have been at least partially rigged-ordered uranium enrichment 20 percent above the threshold needed for scientific purposes.
Weapon grade uranium is over 90 percent enriched.
Ahmadinejad's subsidy reform plan has also raised skepticism within Iran, where it is seen as a ploy to garner more support for his faction.
He has fought for full control of the savings, even as the Majlis has tried to curb interventionism.
The budget proposal, which parliament still has to approve, is based on oil prices at $60 a barrel, significantly above the $37.
5 per barrel used last year.
The nearly $370 billion budget is almost 25 percent higher than last year's $298 billion.
The skepticism was refueled recently after Ahmadinejad surprised parliament by including $40 billion of expenditure in the budget that would be paid with savings generated through subsidy reductions, according to Iranian media.
While the president backtracked after the Majlis rejected the move-reminding the president that the plan called for $20 billion of savings annually-concerns that Ahmadinejad could mismanage funds appear well-rooted.
The issue is still uncertain, as many things are in Iran until their final approval.
The plan suggest that almost half of the savings will be redistributed as targeted subsidies to the most poor, another 30 percent will go to improving energy efficiency, and the remaining 20 percent will be kept by the government to offset losses in state-owned companies.
How the reforms are applied remains the question and ultimately a risk.
In terms of unrest, some 40 percent of Iranians are below the poverty line and at least 11 percent of the population is unemployed.
Mishandling the subsidy reform plan thus implies huge risks to internal stability.
Government mismanagement could be costly, especially in the current political environment.
But the biggest risk really is related to inflation.
Suddenly cutting subsidies means that prices will increase and that inflation will follow.
That is manageable if done correctly though.
Current inflation stands at single digits, a great accomplishment considering that only a year ago it fluctuated between 20 and 30 percent.
The IMF has also argued that inflation doesn't have to accompany the subsidy reform plan.
Malaysia, for example, increased prices of diesel more than 80 percent and kerosene almost 70 percent, accompanied by a 4 percent deflation.
There are similar examples, although not as successful, in Indonesia, and Turkey that reinforce the importance of policy when cutting subsidies.
If anything, that illustrates that proper handling of subsidy-cutting benefit to the economy.
In Iran's case, of course, this will depend on how reform will be managed.
Ahmadinejad appears to have a plan, at least on paper.
"Emphasizing a reduction of dependence on oil revenues and an increase of non-oil revenues, with a focus on industry, agriculture and housing -these are among the main attributes of the bill," he said when presenting his budget.
Public investment on construction accounts for $110 billion, for example.
The real challenge, though, is diversifying the economy as much as possible.
"I would not want to pass up a unique opportunity offered by a populist administration courageous enough to raise prices to market levels.
The icing on the cake will be if the government can combine price reform with achieving a greater equality in the distribution of income," wrote earlier this month in his blog Djavad Salehi-Isfahani, a Dubai Initiative research fellow at the Belfer Center for Science and International Affairs at Harvard University.
First published: Monday 15 March 2010, updated: Tuesday 16 March 2010.
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