FREE GEOPOLITICAL NEWSLETTER

Background:
Known as Persia until 1935, Iran became an Islamic republic in 1979 after the ruling shah was forced into exile. Conservative clerical forces subsequently crushed the westernising liberal element. During 1980-88, Iran fought a bloody, indecisive war with Iraq over disputed territory, which caused large-scale damage to its economy. The key current issue is how rapidly the country should open up to the modernising influences of the outside world, with a conservative faction in control of some key institutions, such as the Council of Guardians, and a reformist faction centred on elected President Khatami. 

US and Iran 
Despite the apparent improvement in the relations between the US and Iran, which had followed the 11 September terrorist attacks, by January 2002 the tension between the two countries had reached new peaks. President Bush accused Iran of being part of an "axis of evil" together with Iraq and North Korea and asked Iran to stop meddling in the internal affairs of Afghanistan and developing weapons of mass destruction. While the Iranian leadership had good reason to be worried about the intensification of American hostility, the Bush administration was clearly not planning any direct action yet. By July, however, with his call for "reform from below", President Bush appeared increasingly interested in fomenting a revolt against the Islamist regime. There are clear signs that the ruling elite felt seriously threatened and feared at least a tightening of the embargo. It seems that at least part of the several billion US$ that returned to the country during 2002 was made up of the gold reserves of the government, previously held by European central banks. By mid-May even the reformist President Khatami felt that he had to take a strong stance and warned the US administration against "threatening, insulting and humiliating" Iran. As a reaction to growing American pressure, Teheran strengthened its efforts to improve its relations with its Muslim neighbours, such as the Central Asian countries, Azerbaijan and even Saudi Arabia.
The reformist government of Iran remained in reality keen on improving relations with the US. During 2002 it gave out plenty of signals pointing in this direction. Among them, not only it stated that it was ready to accept a new, tougher resolution on Iraq and collaborated to enforce a stricter embargo, but also took the unprecedented step of declaring that a two-states solution is acceptable for Palestine, so long as the Palestinians accept it. Even the conservatives, who dominate a number of key institutions, first and foremost the Council of Guardians, and count among their members the Supreme Spiritual Leader, Ayatollah Khamenei, were not uniformly hostile to improving Iran's relations with the US, at least not at all times. Some of them argued that such an improvement would make it easier to maintain the status quo internally. Supporting a US war against Iraq could be a suitable way to buy American acquiescence for the lack of internal reforms. The majority of the conservatives, in any case, maintained at least on the surface a strong opposition to reconciliation with the US. 
Even if the reformists were willing to acquiesce to US war plans in neighbouring Iraq, they feared that in the event of a war its economy would suffer severely, not least because of a likely massive influx of refugees. The possibility of Kurdish nationalism being strengthened by a war in Iraq was also seen with apprehension in Teheran. On the whole, the Bush administration did not openly respond to hints coming from conservatives that a deal might be possible, but the press suggested that it might actually be considering to enlist some help from Iran. For sure, as the international attention turned to Iraq, from October Iran was spared the war of words that had afflicted it during the previous months. In any case, as the end of 2002 approached, the Bush administration maintained that it would welcome an internal overthrow of the Iranian regime.

Iran and the rest of the world
The main tool in the hand of the US administration for exerting pressure on Iran is increasing its isolation from the rest of the world, in particular Iran's neighbours and trading partners. During 2002, it appeared clear that the largest economies were the least likely to bow to the pressure. The European Union in particular decided to actually expand its ties to Iran. After some initial anxiety, the EU announced in July its readiness to develop closer commercial ties with Teheran, although conditionally on Iranian willingness to discuss such issues as nuclear proliferation, terrorism and human rights. There have been delays in the negotiation of deals with Russia and Japan in the oil, nuclear and defence industries, but in the end both countries looked intent on continuing their flourishing trade with Iran. The main danger to Iran could have been that Russia could soon be lured towards a more pro-American stance in exchange for economic concessions, which might include forgiving Russia's Soviet era debt in exchange for the termination of nuclear cooperation with Iran. The fact that Russia and Iran developed diverging ideas about how to deal with the resources of the Caspian Sea might have contributed to push Russia away from Iran. President Putin, however, opted instead to strike a delicate balance between continuing Russia's lucrative trade with Iran, while at the same time doing his best to appease American fears of Iranian interest in weapons of mass destruction. By December, Iran responded by showing some more willingness to tackle the issue of the Caspian Sea resources.

Economic performance
Apart from the international tensions, the economic and political situation of Iran remained highly uncertain throughout 2002. The development of oil extraction in Iran was negatively affected by project delays and by some flaws in the buy-back deals negotiated with the international investors and it increasingly looked doubtful whether Iran could succeed in increasing its production to the levels planned. A failure would have very negative consequences for the economic stability of the country, due to the rapid growth of internal consumption of oil, which was expected by some analysts to match the volume of exports as early as in 2002 itself. Petrol is sold within Iran at heavily subsidised prices, with a litre costing to the Iranian motorist just $0.063, which encourages therefore high consumption levels and waste, only makes the matter more urgent. The non-oil sector of the economy showed little sign of development in 2002. After having expanded rapidly in the early 1990s, following the adoption of an export-led growth strategy by the government, Iranian non-oil exports have stabilised at around US$5 billion. The economy, dominated by an inefficient public sector and by the notorious foundations, simply demonstrated that it lacked the dynamism to exploit the opportunities offered by the new policy. The free trade zones, set up in the past, have so far failed to generate productive economic activities and are mostly being utilised for import/export activities.

Economics and demographics of a latent crisis 
If the debate about the chances of success of Iran's plan to expand its oil production was still undecided at the end of 2002, there has never been any doubt that the Islamic Republic cannot afford a failure. Although the birth rate has been brought down to manageable levels in recent years, the baby boom generation is beginning to join the workforce, causing a terrible headache to the government. With 5.5 million high school certificate holders expected to join the job market in 2002-2005, the government needs to create more than 1,300,000 new jobs every year to prevent an increase in the unemployment rate and keep the population happy, but in 2000/2001 it succeeded in creating just 400,000. To generate the required amount of jobs, Iran's economy should grow at the yearly rate of 12%. Economic growth reached 4.5% in 2000/2001, short of the 6% target but still not a bad achievement when judged by the standards of Iran's performance over the last decade. In 2001/2002, which according to the Iranian calendar ended on 21 March, low oil prices and a cut in production ensured that growth was lower, around 3.5%. In 2002-2003 very favourable circumstances, including most of all an increase in oil prices, contributed decisively to strengthen economic growth, now expected to reach 6.4%. Many Iranian businessmen, faced with poor performances in the American and European markets, moved their assets back to Iran, which on the other hand has reduced taxes and has approved a more friendly foreign investment law. It is estimated that private funds account for a large part of at least US$7 billion which have gone back to Iran in 2002, underpinning among other things a very good performance of the Teheran stock exchange, which became one of the world's best performing, up by 30%. However, even such as performance will not be enough to cure Iran's economic ills. Moreover, during the early months of 2002 the negotiations with potential investors in Iran's oil and gas industry took a negative turn, although there were signs of improvement towards the end of the summer. In 2002 a wave of financial scandals hit executives of some Iranian oil companies involved in partnerships with foreign investors and Iranian officials showed a marked tendency to delay negotiations, fearful of attracting the attention of a judiciary which is closely aligned with the conservative faction. International investors, on the other hand, became increasingly wary of investing in the Iranian market, in particular as they began to feel that it might be possible to extract better conditions. Only state-owned companies, such as Norwegian Statoil, continued to sign contracts with the Iranian government. Starting from May there were indeed some signs of a growing willingness to offer more appealing conditions to foreign investors, as the chairman of the parliamentary energy committee, Hossein Aferideh, proposed to lengthen the buy-back contracts which represent Iran's approach to reaching agreements with international investors. At present, buy-back contracts last five to seven years, which is considered too short by many players in the oil industry. 
In 2002, the situation of the oil industry was compounded by an extensive program of well maintenance and by a series of strikes in the industry, which resulted in an estimated 8-9% decline in exports of crude Iranian oil. It is significant, however, that one of Iran's newest gas clients, Turkey, successfully bargained for lower prices after being offered a substantial discount by Russia. Russia's increasingly aggressive marketing practices might cause more problems to Iran in the future, as it continues its efforts to penetrate the European market.

Foreign investments and internal politics 
Investment in the oil industry is less controversial, because it tends to be easier to isolate from the mainstream of society and because the rewards are so obvious. But that will likely not be enough to inject enough dynamism in the Iranian economy. The opportunity to attract funds towards other sectors certainly exists. An important sign was the successful launch in July of the new euro bonds, the first denominated in a foreign currency since the Islamic revolution. Soon the government was planning new issues of euro bonds, while the Iranian parliament was asked to examine a proposal to receive oil payments in euros.
The attempts to reform the Iranian economy and political system were slowed by the opposition of the conservative faction. The Council of Guardians blocked the introduction of several laws, including the new foreign investment law, despite its approval by the parliament, forcing its amendment. Other such laws were still blocked by the Council of Guardians at the end of 2002, including a project to end the unaccountability of the foundations, which control a large part of the Iranian economy, a large-scale privatisation program, a new labour code and several others. There are however some signs that during 2002 a split began to emerge within the conservative camp, with some taking a more moderate stance. On the other hand, there were divisions within the ranks of the reformists too. At the beginning of 2002, the main item of contention among the reformists was the liberalisation of the economy, with some groups favourable to the liberalisation of the economy and others, such as the Islamic left, who were cold towards it. By the end of the year, however, the picture had been redrawn and the main fault line was now running between moderates, willing to accept Khatami's slow pace, and more radical reformers, who were clamouring for a final confrontation with the conservatives and were beginning to voice criticism of Khatami himself. The renewed pressure of the units of the "moral" police on an increasingly impatient youth, together with the ongoing repression against the reformist press, only contributes to the radicalisation of a part of the opposition. The death sentence against a reformist intellectual, Hashem Aghajari, guilty of having attacked the power of the conservative clerics during a lecture, unleashed in November a new wave of student unrest across the country, the largest after that of 1999. The resurgent student movement took most observers by surprise, as many had diagnosed its demise. 
On the internal political front, the main development in February was the apparent confirmation that the reformist front is slowly disintegrating. Three separate reformist lists will contest the 28 February municipal elections in Teheran, ranging from the pragmatic right to radicals who criticise Khatami for his lack of action. The electorate appears rather disillusioned and apathetic and in 2,000 municipalities there will be no elections at all because of the lack of candidates. Occasional arrests of dissidents continued in February, although the reformist front could claim at least a partial victory when a re-trial was ordered of outspoken reformist Aghajari, who had been sentenced to death because of his public statements against the regime. However, Aghajari will be re-tried by the same court which had sentenced him to death earlier and it might well be too early to say that his case is closed.
Even the 2002-2003 Iranian budget, approved during the spring, reflected the political constraints under which Khatami and his government had to operate. Spending went up massively on the previous year, with tax cuts and massive pay rises to civil servants, whose real income would increase by 17% in real terms. The government expected to pay for a large part of such increases in expenditures through the privatisation program, which however had been stagnating for a while and might well continue to do so in the near future. Most observers therefore believe that Teheran will soon be running a massive deficit, the more so since the 2003/2004 draft budget, presented to the parliament in December, shows a 21% increase in spending on the previous year. While promising to public employees salary increases to match inflation, the draft budget counts on privatisation to reduce spending and getting some extra revenue. Reflecting the compromise character of the budget, military expenditures are also going to increase. Observers estimate that the fiscal surplus of 2001/2002 will turn to a 2.1% budget deficit this year and might still double in 2003/2004. It should be considered, however, that Iran's government debt is comparatively low, at just 19% of GDP. By the end of 2002, on the other hand, there were signs the Iran's financial situation might be improving, with a buoyant stock exchange, growing interest among international investors for the domestic car industry and a more general consolidation of Iran's image on the financial markets.
Fearful of losing his own base of support, during September President Khatami finally decided for an all-out assault on the main conservative stronghold, the Council of Guardians. During September the reformist government presented a draft law, which would greatly reduce the powers of the Council, especially as far as its ability to disqualify election candidates is concerned. The government also presented other constitutional and administrative reforms, including greater powers for the president. President Khatami warned that he might resign if his projects were not approved, leaving the country in a state of chaos. By the end of the year there was talk of a conservative coup d'état against the reformists, while the security forces were stepping up indoctrination and "ideological training" of the rank and file, possibly preparing for taking part in a violent repression. Some conservative circles were increasingly promoting former President Rafsanjani as the right man to lead a coalition of moderates, aimed at addressing the economic difficulties of the country, without touching the institutional framework. 

Forecast 2003

Impact of war in Iraq
Neither the reformers not the conservatives were unanimous about the prospect of a war in neighbouring Iraq. Hard-liners are too hostile to the US to consider anything but complete opposition to whatever the Americans might do. Khamenei, a relatively moderate conservative, appeared to be ready to cooperate with the US, but only in exchange for substantial concessions, such as Iran's removal from the "axis of evil" and for the recognition of Iran's interests in Iraq. Former President Rafsanjani, a more pragmatic conservative, seemed to be ready to content himself with much less, such as a promise that the US will not attack Iran next. The reformist government, on the other hand, continued to focused on an alternative foreign policy, aimed at reminding to the Americans and the world how friendly Islamic Iran can be instead. In the end, the real issue will turn out to be Iran's attitude after the toppling of Saddam Hussein's regime, when Iraq might face chaos and anarchy. 
Russia's decision not to abandon its ties (and profitable trade) with Iran appeared in all its importance in January, when the Bush administration dropped its objection to the building of a nuclear power station in Iran, with the clear aim of softening Russia's opposition to the war against Iraq. However, by March the tension was up again, as US claims were for the first time substantiated at least in part by inspectors of the International Atomic Energy Agency (IAEA). If US fears about the nuclear reactor being completed in Bushehr continue to appear unjustified, the uranium processing plant in Isfahan, which is about to start operations, and the enrichment plant construction site found in Natanz look definitely more suitable for the development of nuclear weapons. There were unconfirmed reports that the organisation is worried about what it has found and that some violation of the non-proliferation treaty might have occurred. In February President Khatami had admitted for the first time that Iran is mining uranium. Some sources now estimate on the basis of the new discoveries that Iran might be just a couple of year away from producing an atomic bomb. It is possible that the climax of admissions and discoveries of the last two months is part of a plan to trade Iran's stricter adherence of the non-proliferation treaty against the lifting of the sanctions imposed by the US. In fact, Iranian officials have clearly hinted at the possibility of such a deal. 
While the hard bargaining with the EU on the issue of human rights will continue for a some time, the Iranian government could in January show at least an initial success in this regard, with the abolition of death penalty by stoning. In January important trade agreements were signed with India and Afghanistan, which are likely to greatly increase Iran's influence in the East. On the other hand, Teheran's position in the Caucasus and central Asia is likely to remain weak, as shown in March by the failure of the visit of Turkmen President Niyazov to Teheran to produce the expected consolidation of the alliance between the two countries.

Decline of the reformist coalition
Even when a war is over, an Iraq occupied by the Americans will inevitably affect Iranian internal politics. The more radical reformers and the extra-parliamentary opposition are likely to become emboldened, while it is much more difficult to predict how the conservatives might react. The trend which emerged during 2002, of a split between moderate and hard-line conservatives, might well strengthen in 2003, and there are signs that something like that might be taking place within the ranks of the reformists too. In March the defeat of the reformists in the administrative elections, especially in Teheran, highlighted the growing rift between the Islamic left factions and the right-wing reformists of the Executives of the Reconstruction group, which all support Khatami in the national parliament. Division exists also within the Islamic left between clerics, who tend to be more moderate and more supportive of Khatami, and secular members, who are increasingly becoming radicalised. Then, the two moderate factions might ally and form a centrist government, which would try to reform the economy and certain institutions, without challenging however the clerical nature of the Iranian state. Towards the end of 2002, Supreme Leader Khamenei's intervention against the judiciary, which had passed the death sentence against Hashem Aghajari, appeared a sign that Khamenei himself could have taken the leadership of the moderate conservatives. Other moderate conservatives, such as Hassan Khomeini, the Ayatollah's grandson, and Ahmad Takoli, who had challenged Khatami in the 2001 elections, also condemned the death sentence, while the judiciary, a stronghold of hardliners, resisted their criticism. However, among the reformers there seem to be little appetite for a compromise, mainly because their support base opposes it. In 2003 some moderate reformists will continue to argue in favour of a compromise, for example by dropping the proposal that the President should acquire the power to prevent the execution of a sentence delivered by the judiciary. However, the large majority of reformers will oppose such deals, because their constituencies are in risk of switching over to the anti-system opposition. 
For 2003, therefore, political developments within Iran might take three different turns. It appears very likely that Khatami's reform bills will not be approved by the Council of Guardians as they stand and they would have at least to be modified to an extent that would likely upset their nature. The conservatives might still refuse to concede any ground and, if faced with an increasingly militant opposition in the streets, stage a coup d'état. Some prominent conservative leaders, such as Khamenei himself and former president Rafsanjani, threatened openly the recourse to force already during the course of 2002.
It is also possible that the conservatives might succeed in attracting moderate reformers such as Khatami towards a compromise which stills increases his powers, although without weakening the capability of the conservatives to resist the reforms as much as most reformists desire. Khatami, a moderate himself, might find difficult to refuse such an offer. From the conservative point of view, the loss of power would be offset by a likely split in the reformist coalition and by the possibility of blaming future failures of the reforms on the newly enfranchised Khatami. The most likely outcome, however, is a new government headed by moderate conservatives and right-wing reformers, maybe strengthened through recourse to rigged elections.

A mixed economic picture
Whether the reforms accelerate or not, political and social tensions are not going to die down in 2003. faster reforms will in any case mean more hardship for some sectors of the population. The latest estimate of the inflation rate in 2002/2003 was 15.3%, up four percentage points on the previous year due at least in part to the abolition of privileged currency exchange rates for some Iranian institutions, which was one of the reforms of the Khatami government. By some estimates, inflation could exceed 20% in 2003/2004, due to the growing budget deficit and price hikes in a number of commodities.
A compromise between moderates on both sides, however, would at least be likely to unblock the development of the oil industry. Iran will need to invest $30 billion over the next 8-9 years to maintain its share of world oil exports. The ageing Iranian fields have lost production capacity at the rate of 250,000 barrels per day, 6.4% of annual production. At least $1 billion are needed every year to maintain production at the current levels. To maintain the level of exports in the face of rising internal consumption and to increase them to satisfy the needs of a growing population, much more than that amount will be needed. 
In the strategy of the Khatami government, gas is supposed to make up for the shortcomings of the oil industry. Since Iran has huge reserves of gas, which at present are largely under-exploited, it would make good sense to move the focus of the investments in that direction. After the blow of the re-negotiation of the deal with Turkey, which could have cost Iran as much as 20% in discounts on the previously agreed price, Iran will be looking east, having identified China and most of all India as potential major markets of the future. 
Despite the improved economic performance of 2002/2003, it appears obvious that it will be difficult to achieve significantly higher growth rates without attracting massive foreign investment. The forecast of the Economist intelligence Unit for 2003/2004 is 5.3%, lower than in the current year, although still comparatively good. Even in this regard, a successful compromise among moderates could play an important role in reducing the opposition among conservatives against foreigners playing a much larger role in Iran's economy. The Iranian government is quite optimistic, as shown by its 2003/2004 budget. The assumption that oil revenues will maintain the level reached in 2002/2003 (around US$15 billion), when the Iraqi and the Venezuelan crises combined to push oil prices upwards, appears doubtful indeed. The government, however, has the option of drawing resources from its stabilisation fund, which is expected to stand at US$7 billion by the end of the current fiscal year (20 March) and which is meant to compensate the fluctuations of oil prices. As a result, the government confidently predicts GDP growth at 6% next year, which would confirm the performance of 2002/2003. The Economy and Finance Minister Mahazeri also predicts that Iran will finally be able to attract significant foreign direct investment next year, in the range of US$4 or 5 billion, as opposed to the less than US$500 million invested in 2002/2003. Iran also plans to expand its oil production to 5 million barrels a day by 2004, up from the 3.6 million of 2002. The government is making natural gas available to most of the urban areas, in order to reduce internal consumption of oil and have more available for export. Moreover, the Khatami administration is going to borrow money to fund its many projects. It is authorising the issuing of bonds over the 2003/2004 financial year for a value of 5,400 billion rials (US$676 million), a 125% increase over the current year. The good news for the economic prospects of Iran is that the government also authorised the private sector to issue its own bonds as a way of making up for the inability of the banking sector to provide adequate funding. The level of foreign debt is at a relatively modest US$23.4 billion and the country's hard currency reserves are higher than ever.
During March the first signs emerged that the Khatami administration is trying to tackle the issue of the excessive subsidies to consumption, that are undermining the Iranian economy. After an official of the oil industry admitted that Iran will have to import 5.8 billion litres of gasoline this year to meet internal demand, up 2 billion on 2002/2003, the government proposed that the price of gasoline should go up by 30%, rising from US$0.06 to US$0.08 per litre. While the latter would still be a very low price by any standard, there is opposition even among reformist parliamentarians, who fear a backlash among the population and an upsurge in inflation. On the other hand, the uncontrollable increase in internal gasoline consumption represents a growing burden for Iran's economy and contributes to erode the country's oil exports, which fell by 7.6% in 2002, to just over 2 million barrels a day. 
Foreign businesses express a strong interest in the Iranian internal market, which at present is underdeveloped, due to restrictions to imports, which the government tries to maintain at around $15 billion, and to the inability of the domestic industries to meet demand. After achieving the first modest successes in attracting foreign investments in 2002, the Khatami administration hopes that 2003 will finally see the beginning of a massive inflow of foreign investment into Iran's industry and services. This might be rather optimistic, but there were some signs of growing interest in January and February. After FIAT and Peugeot had showed up in earlier months, in February it was the turn of DaimlerChrysler and Chinese manufacturer Chery to announce their plans for the Iranian car industry, whose annual sales of 300,000 are estimated to cover only half of potential demand. It is expected that in the foreseeable future most investments in the non-oil sector will come from Arab countries, but already some European companies are beginning to invest small sums. The government expects its privatisation program to finally take off in 2003. Before the end of the current fiscal year (20 March), several state companies are expected to be floated on the stock exchange, as a prelude to privatisation. Banks in particular figure prominently in the list of state firms to be privatised. At present, there is just a single genuinely private bank in Iran and its network of branches is still very limited. There are, however, a number of obstacles towards a successful privatisation campaign. State banks are largely overstaffed, often have been operating at a loss for some time and are burdened by bad debts granted to state firms, the foundations and privileged individuals. The overall approach to economic reform remains cautious. This caution is sometimes dictated by genuine political concerns, as in the case for example of the planned reduction of tariffs on imports. At the beginning of February the deputy minister of commerce stated that the elimination of tariffs on imported goods would be eliminated gradually, in order to safeguard the interests of consumers and producers. However, in other cases this "caution" is the consequence of divisions within the government and the state administration. The complex web of interests which grew over the Iranian economy over the past quarter of a century makes reforms objectively difficult. The laws and regulations of the Central Bank of Iran, for example, encourage investment in unproductive activities, such as import businesses, which benefit from tax holidays, while production goods are subjected to high tariffs and taxes.