Clingendael Articles 30 January 2025 Approaching the precipe: Near-term prospects of Iran’s economy - By Bijan Khajehpour, Managing partner at Eurasian Nexus Partners GmbH

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30 January 2025

Approaching the precipe: Near-term prospects of Iran’s economy

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In short

The Iranian economy is currently in crisis. This state of play shows in basic indicators such as high levels of inflation, low levels of growth and a depreciating exchange rate of the Rial

The root causes of Iran’s economic crisis are internal (corruption, mismanagement, budget deficits, a lack of investment and poor policies), as well as external (mostly sanctions)

Three transformations are required to set the Iranian economy on a more positive pathway, but each is fraught with difficulties: 1) initiating diplomatic engagement with Western governments to lift sanctions; 2) introduce reforms to existing fuel subsides; 3) break down barriers that make it difficult to shift gradually towards a digital economy

In the absence of successful economic reforms, more protests are only a manner of time.

By Bijan Khajehpour, Managing partner at Eurasian Nexus Partners GmbH

Editors’ introduction

In September 2022, the death of Mahsa Jina Amini marked a major turning point for Iran. The event sparked lengthy nationwide protests across socio-economic classes and population groups whose demands rapidly evolved from discarding controversial hijab regulations to calls for the overthrow the Islamic Republic. The Iranian government responded with repression, killing over 400 protesters in late 2022 and early 2023, according to human rights groups. 

The Clingendael blog series ‘Iran in transition‘ explores power dynamics in four critical dimensions that have shaped the country’s transformation since: state-society relations, intra-elite dynamics, the economy, and foreign relations. This blog post examines the prospects of a revival of the Iranian economy in the near-term.

The main push and pull forces of Iran’s economy for 2025

The Iranian economy is presently in crisis, which is reflected in a few basic indicators such as the inflation, economic growth and exchange rates. Official annual inflation has been above 30% since 2018, which has pushed a large segment of the middle class into poverty by undermining their purchasing power. Economic growth is mediocre and the free market rate of the national currency to the US$ devalued by 62% in 12 months (from IRR 520,000 on 1 January 2024 to IRR 845,000 on 27 January 2025). 

Iran’s economic performance is also heavily influenced by domestic politics, regional security issues and geopolitical developments. As to the latter, especially uncertainties connected with the second term of president Donald Trump, regional tensions and Iran’s pivot to the East weigh heavily. The interplay between politics, security, geopolitics and Iran’s economy will continue to unsettle the latter in the next 12 months and beyond. This article focuses on the key drivers of economic development and discusses the short to medium-term outlook.

The status quo goes downhill…

The past 12 months have been eventful for Iran. After the sudden death of President Raisi and snap presidential elections, the return of the moderate political forces to the executive branch created some much-needed optimism. However, this ended with the assassination of Ismail Hanieh in Tehran and the military tit-for-tats between Tehran and Tel Aviv. From a macro-economic point of view, the Iranian economy grew by about 4% in Rial terms in the 12 months that ended on 20 March 2024. However, in US dollar terms the nominal value of the economy stagnated with the country’s nominal per capita GDP decreasing from US$4,741 in 2022 to US$ 4,501 in 2023.  For the current Iranian year that ends on 20 March 2025, experts expect nominal, inflation-adjusted growth of 2%. 

It is expected that nominal GDP will drop below $400 billion in the current Iranian year (ending on 20 March 2025), which reflects continued weak economic performance. The economy is suffering from various imbalances caused by misguided subsidy policies, mismanagement, incompetence and corruption. The key phenomena undermining economic performance are the budget deficit, electricity shortages and financial sector deficiencies with the biggest sources of instability being high inflation and sanctions. These are interrelated and there are signs that resolving the sanctions challenge through diplomacy has become the government’s top priority as a result. This reflects in President Pezeshkian’s focus on achieving a new agreement with Western governments to reduce the impact of sanctions.  Also, in line with a more reform-minded approach, the government has restarted the process of passing the relevant legislation for Iran to be removed from the black list of the Financial Action Task Force (FATF). Figure 1 below shows the decline of the Iranian economy in real GDP growth, i.e. adjusted for inflation. 

 Figure 1: Real GDP growth 2019 to present

Figure 1: Real GDP growth 2019 to present - Source: Central Bank of Iran 

… but there are also sources of economic resilience

Economic diversity has been a key source of resilience of the Iranian economy, in particular the service sector’s dominance of the Gross Domestic Product (GDP).  In the Iranian year that ended on 20 March 2024, the service sector in fact contributed more than 50% to the overall GDP. As can be seen in Figure 2 below, the contribution to GDP of the petroleum sector was 16%, which represents a major increase compared to the previous year, while industry and mining contributed about 17%. The most significant decline occurred in the agricultural sector where many producers have withdrawn from traditional farming activities.

Figure 2: GDP composition for the year ending March 20, 2024

Figure 2: GDP composition for the year ending March 20, 2024 - Source: Central Bank of Iran

 

The economy is actually consolidating itself as a service-based economy and the growth of the service sector has generated substantial employment opportunities in the past 12 months.  Unexpected growth of the petroleum sector through additional exports also contributed to job creation. Table 1 below reflects the relative importance of the different economic sectors. 

Due to these developments, overall unemployment in Iran stands at a manageable level of the moment  (see Figure 3 below). However, youth unemployment remains high and exceeds 20%.

Figure 3: Unemployment in Iran 2019-2025

Figure 3: Unemployment in Iran 2019-2025 - Sources: Statistical Center of Iran, Central Bank of Iran

 

Yet, sources of instability threaten Iran’s economy

High inflation continues to be the key irritator for the economy (see Table 2 below). In fact, in the past seven years, average annual inflation has exceeded 30% - an unprecedented period in Iranian history. This level of inflation is massively eroding economic potential and puts pressure on all economic players. Experts agree that banks are being suffocated by inflation, but also by mismanagement, which has knock-on effects on many businesses and necessary investment.

Annual point-to-point inflation refers to the inflation at a certain point (usually at the end of a month) and measures the rate of inflation at that point compared to the same point in the previous year. This method accounts for seasonal adjustments.

The key driver of inflation is the recurring budget deficit that will continue to undermine the economic performance of the country. When the Iranian government has higher expenditures than revenues, it is forced to take loans from the banking sector, including the Central Bank, and to increase the money supply. Both are factors that create inflationary pressures. In addition, budget deficits lead to a lack of infrastructure investments that also undermine economic performance. An interrelated driver of inflation is the value of the national currency which is declining by the month. As Figure 4 indicates, the Iranian Rial has continued to depreciate. 

Figure 4: Free market exchange rate of the Rial to the US$ since October 2019  - Source: navasan.net.  Note that figures are in Iranian Rial. Some websites use the currency Toman which corresponds to the Rial by a factor 10. 

Many economic stakeholders are looking to the new government to see what policies it will adopt to stabilize the currency and contain inflation. There are indications that a restructuring of fuel subsidies is being considered for the new Iranian year to reduce their impact on the government budget. But here the government faces a dilemma. On the one side, the current level of subsidies is not sustainable. But on the other side, officials do not want to risk another wave of social unrest similar to the protests in 2019. Therefore, creative approaches are being discussed, such as allocating an amount of gasoline to each citizen that can either be used or converted to cash at a higher per liter price.

Another major source of instability have been the repeated electricity shortages caused by a lack of investment in various energy related subsectors. According to the Iran Chamber of Commerce, Industry, Mines and Agriculture, economic losses caused by disruptions to the production, transmission and distribution of electricity amount to $224 million per day. If these conditions continue, $80 billion (20% of GDP) will be lost next year.

Potential remedies

The root causes of Iran’s economic crisis are internal – i.e. corruption, mismanagement, deficits (e.g. due to subsidies), a lack of investment and poor policies – as well as external – i.e. chiefly sanctions. It will take concerted efforts on multiple fronts to raise the economy out of its current misery and generate better financial prospects for the average Iranian citizen. President Pezeshkian has underlined that he is prepared to tackle these root causes by addressing corruption, introducing structural reforms and pursuing an accommodating foreign policy. If he does so, three important transformations could be in the making over the next few years.

Transformation #1: Initiating diplomatic engagement with Western governments 

The most crucial transformation is the achievement of a diplomatic settlement with the United States. The Pezeshkian administration has openly advocated diplomatic engagement with Washington to reduce the impact of sanctions on the economy. There are already initial attempts to restore confidence in Iran-EU relations. Although the success or failure of EU-Iran diplomacy depends on President Trump and his administration’s agenda towards both parties, Tehran wants to prevent a snapback of EU and UN sanctions to which European countries are key. But the process of improving Iran’s relations with Western governments is a difficult balancing act.  On the one hand, Tehran does not want to appear weak. On the other hand, the economic situation is dire. To balance both, every diplomatic step needs to be planned and implemented shrewdly. 

From this perspective, the signing of an Iran-Russia strategic partnership agreement on 17 January 2025 was well-timed as it reminded domestic and international audiences that Iran has strategic options. It also showed more hardline domestic audiences that the Pezeshkian government is not submitting to Western demands to limit Iran’s interactions with Russia. On the downside, while the Iran-Russia partnership can create a modest economic momentum, especially in the transit sector, it will not address the massive investment and technological needs of Iran’s economy and lifting sanctions remains key. The strategic symbolism of the deal with Russia notwithstanding, many experts believe that the takedown of Hamas and Hezbollah has weakened Iran’s bargaining position. To an extent, it is therefore now up to the EU and the US to either view Iran’s weakened position as an opportunity to move towards a deal or to use its weakness to enter a path of escalation and confrontation. 

Transformation #2: Introducing subsidy reforms 

The second transformation required for an economic turnaround are meaningful subsidy reforms. Ever since President Pezeshkian took office, he and his ministers have hinted that such reforms will take place. However, experience has shown that a mere price increase will not solve the multiplicity of socioeconomic challenges that result from existing subsidies, such as rising inequality, corruption, financial imbalances and negative environmental consequences. But there is a lively discussion ongoing about how to restructure subsidies in a way that reduces the current financial burden on the Treasury without having the resultant inflationary impact of reform leading to additional poverty among lower income classes.  Even though preparing the necessary legal and structural frameworks takes time, urgency suggests reform might nevertheless happen already after the Iranian Nowruz holidays (likely in the second quarter of 2025).

Transformation #3: Moving towards a digital economy

Iran’s traditional economy is based on goods and raw materials, such as oil and gas, metals and commodities, which need to be processed and exported to generate value. Its ‘new’ economy is based on digital services for which Iran has the human resources even though Iran is far behind the technological level of advanced economies. There are strategists close to the Pezeshkian government that are promoting digitalization to dematerialize economic activity and reduce current economic imbalances. However, Generation Z can only leap towards greater digital value creation if the authorities remove existing regulatory and political obstacles, such as Internet restrictions, limitations on digital content and e-commerce. Additional issues are the fact that liberalizing the digital economy will create value only in the medium term and also requires a lifting of sanctions.

Conclusions

Compounding Iran’s economy being in crisis today is the fact that the economic outlook is not promising either. Even though the government is paying attention to the various imbalances, moving Iran out of its current crises will take time. Economic diversity and resilience as well as domestic private consumption are sustaining a reasonable level of economic activity and employment, but there are too many irritants such as sanctions, mismanagement and incompetence that lead to corruption, stagnation and despair.

The economy is in dire need of investment. Attracting foreign investment depends, however on successful diplomatic engagement that results in the lifting of sanctions. While Trump 2.0. makes a repeat of maximum pressure policies likely, there are also new geopolitical factors such as a positive dynamics in the Iran-GCC (Gulf Cooperation Council) relations that may pave the way for a positive engagement in 2025 and beyond. In addition to Iran-US diplomacy, other factors like regional tensions with Israel and domestic dynamics will influence the economic outlook. 

Inflation, shortages and short-term disruptions of the economy will persist until the transformations outlined above have been meaningfully undertaken. If the reformist zeal of the Pezeshkian government convinces society that the economy is on a positive trajectory, investment, activity and sentiment may improve. If it does not, the potential for social unrest will increase, especially if and when the government introduces fuel subsidy reforms. Such social tensions risk starting another negative interaction between political and socioeconomic demand that will produce more economic deterioration, social erosion and migration.