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Apr 13, 2016 | 09:15 GMT

In Iran, Economic Reforms Hit a Hard Line

(BEHROUZ MEHRI/AFP/Getty Images)
Forecast Highlights

  • Now that sanctions have been removed, Iran's political factions over the next few years will fight over the direction of the economy and to what extent to open it to foreign investment.
  • Iran's hard-line conservatives, who have the most to lose in an open economy, will resist and undermine moderate President Hassan Rouhani's economic reforms.
  • The primary battleground will be the all-important oil and natural gas sector, since seeking investment to boost energy production is a cornerstone of Rouhani's reforms.
  • But Iran's weaker elected institutions — the president and parliament — will have difficulty overcoming opposition from unelected institutions, which Iranian conservatives and the supreme leader will use to blunt Rouhani's efforts.

With the nuclear deal between Iran and the West firmly in place, a struggle for economic power and influence within Iran is intensifying. The debate is over how much Iran should open its economy to the West and how the resulting gains should be distributed. Now that the February parliamentary elections, which resulted in a victory for many moderate politicians, have passed, Iranian President Hassan Rouhani will hope to move forward with his ambitious economic reform goals. Those goals are largely based upon economic re-engagement with the world, including the West.

But a dramatic shift in Iran's economy could undermine the economic strength and domestic power of those that benefited while Iran was under strict sanctions, including the Islamic Revolutionary Guards Corps. To maintain consensus, Iranian Supreme Leader Ayatollah Ali Khamenei will seek to bridge emerging political divides. This year — Rouhani's final year before the June 2017 presidential election — the supreme leader is even promoting the economic policy he first championed as the West was amplifying sanctions on Iran. Khamenei's goal is to remind Rouhani that Iran's conservative forces cannot be cast aside in policy decisions. It is also a reminder that he — as well as these hard-liners — will use all of the powers at their disposal to protect their economic interests.

Still, Rouhani would not be attempting to reform the economy without some support from Khamenei. But the supreme leader knows that a sudden political and economic change could offer an alternative to the policies that have long governed the Iranian people, jeopardizing the government's preservation. And much like previous attempts to liberalize the Iranian economy, opponents will slow Rouhani's progress.

A Shifting Economy

Before they were lifted, the West's sanctions on Iran led to inflation above 40 percent, pushed down oil exports at a time when oil prices were at record highs and blocked investment into the country. Despite Tehran's best efforts to convince the world otherwise, the West had crippled Iran's economy. In the eyes of many of Iran's conservatives, including the clerics, former President Mahmoud Ahmadinejad's eight years of populism and mismanagement did not help the country's industrial base or its debt situation.

Iran's economic problems and Ahmadinejad's attempts to undermine the supreme leader subsequently polarized Iranian conservatives, enabling the more pragmatic conservative Rouhani to win the presidency in 2013 with the promise of rehabilitating Iran's relationship with the West as a way to reinvigorate the economy. The first step was two years of negotiating over the country's nuclear program to relax sanctions.

Rouhani's task is comparable to that of one of his closest political allies, former President Ali Akbar Hashemi Rafsanjani, who attempted his own reforms to resurrect the economy following the destructive Iran-Iraq War. Rouhani's platform even mirrors that of Rafsanjani, promoting dialogue with the West, specifically the United States, to reintegrate Iran with the global economy. Specifically, Rouhani wants to partially liberalize the oil and natural gas sector, though the National Iranian Oil Company (NIOC) will remain state-owned. He plans to introduce an attractive licensing regime, the Iranian Petroleum Contract, to attract $130 billion in foreign investment for Iran's upstream oil and natural gas sector. Rouhani also hopes to privatize most of Iran's industry, including the automobile sector, to boost competitiveness. Finally, Rouhani will seek to reverse some of Ahmadinejad's populist policies, such as handouts and the vast subsidy systems. Rouhani will even try to advance measures that build up Iran's domestic technology and industrial capabilities, keep skilled workers in the country and streamline Iran's bureaucracy. 

Most of Iran's conservative factions stand to benefit from Rouhani's policies. As trade opportunities reopen, Iran's merchant class, the bazaari, will profit, especially those not deeply invested in the sectors that are to be reformed to attract foreign investment. However, Iran's hard-line conservatives stand to lose the most. Several hard-line conservative politicians recently lost their seats in Iran's parliament or in the Assembly of Experts in February elections. While the exact political balance in the parliament will not be known until after runoff elections in April, the parliament will almost certainly have fewer hard-line voices than before.

The hard-line conservative camp also includes powerful economic organizations. Many of Iran's bonyads — semi-private tax-exempt economic foundations that control much of Iran's non-oil industry — are close to the hard-liners, including allegedly the Mostazafan Foundation, Iran's second biggest conglomerate behind the NIOC and the biggest holding company in the Middle East. The other powerful group is the IRGC, which has significant economic influence in various sectors, including heavy industry, logistics and, most important, Iran's oil and natural gas sector.

Entrenched Economic Interests

The oil and natural gas sector is the heart of the Iranian political economy, and it is there that Rouhani and those that stand to lose from his economic reforms will clash hardest.

During Ahmadinejad's tenure, the IRGC entered extensive lucrative contracts in the energy sector. For example, with foreign investment closed off, the IRGC's engineering company Khatam al-Anbia was offered no-bid contracts on the South Pars natural gas field and a grand total of more than $25 billion in various energy contracts. Moreover, former IRGC members were placed in key positions in the sector, including in the post of oil minister and in many managerial positions with the NIOC and its subsidiaries. The IRGC, through its stakes in SADRA, one of Iran's largest shipbuilding complexes, also gained important contracts in offshore energy services.

Rouhani's plans for the oil and natural gas sector strike at many of these advantages. When Rouhani came into office, he and Oil Minister Bijan Zanganeh quickly moved to replace many of Ahmadinejad's appointees. Many in managerial positions at the NIOC tried to resist Rouhani, and it was not until his second term that he was finally able to remove them. Even then, Rouhani's attempts to restructure the NIOC were criticized by IRGC Maj. Gen. Mohammad Ali Jafari, forcing Khamenei to mediate the conflict and to limit Zanganeh and Rouhani's purge.

However, most of the IRGC's profits from the oil sector do not come from the NIOC or its subsidiaries, but rather from the contracts they perform in the industry, such as the South Pars development. And it is these contracts that are perhaps most at risk. Rouhani's call for outside investment is a plea for more capital but also for more foreign technology and expertise. The IRGC's competence in executing highly technical and complex oil and natural gas projects is questionable at best. IRGC contractors frequently had engineering problems, timing delays, financial shortfalls and other issues at the South Pars development so severe that they had to cease operations on certain projects.

Thus international oil companies view Iran's oil and natural gas sector as risky and understand that working with Iranian contractors will be difficult. Not only is their questionable competence raising the costs of investment, but the Khatam al Anbia headquarters are still under sanctions, limiting cooperation and making legal appraisals of deals hard to navigate. International oil companies are going to want to limit the extent of their involvement with IRGC-linked firms for these reasons and to bring in foreign-service companies instead.

Of course, technology transfer is crucial for Rouhani's plans, primarily through high local content requirements and regulations forcing international oil companies and service companies to partner with domestic providers. But Iran is prioritizing the state-owned NIOC and its subsidiaries, not the private and partially private contractors. Foreign investment will eventually reach the IRGC regardless, either directly through the oil and natural gas sector and its externalities or indirectly through other holdings. It is only a question of how much. The answer will depend on how much reform Rouhani will be able to pass while encountering stiff resistance through Iran's political system.

The President's Weakness

While the IRGC's role in the economy is extensive, its direct participation in the political system relies solely on politicians, both elected and unelected, that are closely linked to the faction. These representatives in the parliament often counterbalance the president (an opposition-led parliament blunted most of Rafsanjani's reforms). But now that parliamentary elections are over and the parliament is more supportive of Rouhani's economic policy, the president's road to reform has one less stumbling block that the hard-liners can exploit.

The first challenge to the hard-line conservatives may be Iran's 2016-2017 budget, which Rouhani presented in January. In it, the military budget was cut from $9.88 billion to $8.99 billion, and the IRGC's portion was cut 20 percent, from $6.1 billion to $4.8 billion. Artesh, Iran's regular army, was subjected to no such cut, its budget actually increased by 9 percent. But for now, Rouhani has put passing the budget on hold, at least until after the new members of the parliament take office in May, when there will be even less opposition.

Beyond the parliament, hard-line conservatives could block Rouhani's efforts using Iran's unelected institutions — mainly the Guardian Council, which can veto legislation; the Expediency Council, which mediates the Guardian Council and the parliament; the judiciary; and the intelligence services. The IRGC also controls Iran's missile program. While the West typically interprets missile tests as Iran flexing its military muscle, they are actually the IRGC's way of asserting itself against the Rouhani-led moderate camp, which has at times questioned the need for an extensive missile posture against Israel and the West. Iran's recent series of missile tests launched in March are the IRGC's way of reminding Rouhani of its control of military power. Similarly, the war of words that has erupted since parliamentary elections, especially statements by the IRGC disparaging Rouhani's economic record since being elected, is part of this factional competition. 

Rouhani's sudden cancellation of state visits to Austria and Iraq was likely due to this political tension in Tehran over the country's economic trajectory. The IRGC will continue to discredit Rouhani and his policies in the hopes of securing a more favorable presidential candidate next year. Stratfor sources suggest that the potential compromise candidate with the most support may be Ali Larijani, who not only believes that the economic reform needs to involve the IRGC but who also has conservative family ties to his powerful brother, Sadeq Larijani — Iran's chief justice who is on the short list of possible successors to Khamenei.

As supreme leader, Khamenei has a great deal of power to send the country in whatever political direction he chooses. But his primary way of managing the system has been to arbitrate disputes between different factions. If either the IRGC or the Rouhani camp gets too far out of line, he will step in to mediate. Right now he is taking a proactive stance, stressing his same economic plan that predated the nuclear deal to rebalance the political system so Rouhani's reforms do not diminish the IRGC.

And while the presidency is the second highest office in Iran, the president is still fairly weak in the country's political system. He has only limited control over foreign policy and the military. He lacks full veto power over the parliament. He does not have control over the media. The unelected bodies — the Guardian Council, the judiciary, the Supreme National Security Council — wield considerable power. And all presidents under Khamenei that preceded Rouhani became largely marginalized during their second term because they attempted to bolster the office's power to offset their institutional weaknesses.

But where his predecessor failed, Rouhani may be able to find more, albeit still limited, success. Unlike his mentor Rafsanjani, whose goals to stimulate the Iranian economy after the Iran-Iraq war came into direct conflict and were ultimately blocked by the entrenched socialist policies of the Islamic Left, the opposition that Rouhani faces is not necessarily ideological. Even though the IRGC, Khamenei and Rouhani have their differences over how much and how quickly Iran should open its economy to the West, they all believe the move is necessary. Many in the IRGC have even cautiously supported the nuclear deal.

It is more a question of balance of power and wealth between factions. Rouhani wants to dismantle part of the IRGC's economic prowess to promote economic development. To the IRGC, such a decision is a direct threat to its interests, and it will use all of its formal and informal powers to block him. However, the IRGC's efforts will have limits, and it will not go so far as to create an existential crisis. It will instead marginalize and shape reform efforts by complicating the president's foreign policy objectives through missile tests that irritate the West and by controlling militant proxies in the Middle East's many conflicts, including in Syria, Yemen and Iraq.

Despite the challenges, Rouhani will continue advancing his reforms. Khamenei has placed his trust in Rouhani — given his experience as a cleric, as a lead nuclear negotiator from 2003-2005, and his decades spent on Iran's Supreme National Security Council — to lead Iran in perhaps its most noteworthy engagements with the West since the Iranian Revolution. Clearly Khamenei has given Rouhani leeway on the nuclear issue and on the economy, but it remains to be seen if Rouhani's plans will succeed, making him an exception among his predecessors.

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