What investors should know about the collapse of Iran's currency.
A version of this article originally appeared on our US site, Fool.com.
In a recent two-part series on the tensions between the United States and Iran, my colleague David Lee Smith provided readers with a broad and insightful overview of the unfolding crisis. He discussed the European Union's newly implemented embargo against Iranian oil, the contentious relationship between Shiite Iran and its Sunni neighbours, and the growing divide between the leadership of Iran and that of Turkey, among other things.
Despite this comprehensiveness, aspects of the crisis remain muddled. And one of these aspects involves the recent and sudden collapse of Iran's currency, the rial. While David described the issue in the first article of his series, I've decided to expand on it here by discussing why it collapsed, and the implications of its doing so.
When currencies collapse
The collapse of a currency is typically a well-publicised event that reverberates throughout the world's equity markets. The domino-like capitulation of East Asian currencies in 1997, for example, sent equity markets hurtling downward, leading to one of the largest single-day drops in the Dow Jones Industrial Index in history. And the 1998 devaluation of the Russian ruble triggered the demise of hedge fund Long-Term Capital Management, immortalised by Roger Lowenstein in When Genius Failed.
Yet this didn't happen when the Iranian rial collapsed at the beginning of this year. And the question is: why? National Security Advisor Thomas Donilon shed a slender ray of light on this in an interview last week. Donilon tacitly implied that the collapse was anything but a mistake. And this would make sense, of course, as the United States is currently using economic measures to pressure the Iranian regime to abandon its nuclear program.
So why should we, as investors, care?
The answer to this question is two-fold. In the first case, the collapse of the rial provides an insightful case study into the vulnerability of exchange rates. How is it possible, for instance, that the currency of a major economy could lose half its value in a matter of weeks? In the second case, investors should care because it portends that a resolution to the crisis will occur sooner rather than later -- whatever that resolution may or may not be -- as a country that relies on imports as Iran does simply cannot function without an internationally marketable currency.
To illustrate the magnitude of the rial's collapse, I created the following chart, drawn from both official and unofficial sources of the rial's value. The official rate is the rate at which Iran's central bank will exchange rials for dollars. The unofficial or market rate is the rate rials change hands on the open market in Tehran.
As you can see, the rial departed from its official exchange rate at the end of last year. The timing was associated with the European Union's announcement that it would ban imports of Iranian oil, and the United States' decision to prohibit companies from interacting with Iran's central bank.
This sent holders of the rial scrambling to exchange them for dollars just as the proverbial door to do so was slamming. And because the forces of supply and demand determine a currency's value, the pressure on supply sent the purchasing power of the rial throttling downward. Last October, it cost roughly 11,500 rials to buy $1; today, it costs upwards of 23,000.
The impact of this on the average Iranian is severe. A Tehran-based importer of semi-precious stones told The Wall Street Journal that "the economic situation in Iran is a disaster. Trade is at a minimum, and everyone is in a state of panic". He's now averaging less than $100 a day for a store that costs $400 in rent and expenses.
And the owner of a carpet-weaving factory in the northeastern city of Mashad told the Journal a similar story, saying that she has had to lay off several workers and cut production in the past two months as the market has fluctuated and inflation increased. The businesswoman and mother of five went on to note that her purchasing power has dropped 30% in the last two months alone.
Get your house in order
What all of this suggests to me is that a resolution to the crisis is approaching, as the Iranian regime is being backed into a corner that its citizens will demand to be extricated from. And the fear around the world is that this could ignite a conflict with Israel and the United States, leading to a closure of the Strait of Hormuz, through which 20% of the world's oil passes.
Whatever happens in the short run, however, it seems likely that the price of oil will remain elevated as uncertainty around the situation affects the market.
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