With Friends Like These…

How the sanctions might hurt America's potential allies inside Iran.

The collapse of the rial in Iran's foreign currency exchange in early October was a tipping point -- not so much for Iran's economy as for Tehran officials' efforts to deny that sanctions do harm. In a rare moment of agreement, President Mahmoud Ahmadinejad and analysts in Washington blamed the rial's collapse on Western sanctions, even as most of the president's political opponents in Tehran insisted that his handling of the economy -- not sanctions -- was responsible for the economic mess.

For his part, Supreme Leader Ali Khamenei dismissed the sanctions as "not a new issue" and said that "enemies are making efforts to blow the issue of sanctions out of proportion, and, unfortunately, certain people inside are assisting them."

As a lame-duck president with only six months left in his term, Ahmadinejad is an easy target. But blaming the crisis on domestic policy mistakes is also a way for the more radical politicians in Tehran to continue to deny the sanctions' negative impact and to suggest that the crisis will be brought under control by changes in economic, not foreign, policy.

In reality, both the sanctions and the government's inept response to them have contributed to the country's economic woes. But Western analysts have misjudged the severity of the crisis: Since the rial started to fall, the media has been full of tall tales of hyperinflation, economic collapse, and revolution. Much of this is based on a misunderstanding of how Iran's foreign exchange markets work.

Why didn't Tehran see this coming?

Economic mismanagement in Iran is nothing new. In the past, high oil prices have covered up policy mistakes and prevented economic crises. Oil couldn't save Iran this time, however, because sanctions have taken a large bite out of the country's energy revenues. Oil exports are down about 50 percent this year from their normal level, and they may fall further. Iran has also lost its access to part of its foreign currency reserves, which are frozen in foreign banks.

Iran should have known this could happen. After all, Western governments were not hiding their intentions to tighten the sanctions. The Iranian authorities had ample warning that maintaining the rial as a convertible currency would become infeasible once sanctions began to bite. They could have laid the groundwork for their current multiple-exchange-rate system -- which allows Iran's Central Bank to sell foreign currency at different rates to different users -- long before December 2011, when U.S. President Barack Obama signed the sanctions law that limits Iran's access to the oil market and the international financial system.

Tehran views the multiple-exchange-rate system as the right response to the sanctions. It offers the government, which earns all foreign currency, the tool to manage the economy and contain the political impact of the sanctions. There's logic behind this: The system has insulated the economy from hyperinflation, making its case different from those of other countries that have experienced large external shocks, such as East Asian countries, Turkey, and Zimbabwe.

A tale of two currency markets

Tehran still has tools to prevent the rial collapse from having uncontrollable political effects. The government can limit the devaluation to currencies that are privately traded, selling its own reserves at preferential rates and therefore keeping prices of critical commodities and wages from rising too much. It does not have to print money for its expenditures in tandem with devaluation, which reduces the risk of hyperinflation. Thus a large devaluation in the rial in the free market is much less significant than the same devaluation in countries where the government has to buy its foreign currency from exporters.

The economic signal from Iran's free market is not as significant as people think for yet another reason. Sanctions have segmented the foreign currency market in Iran into two relatively separate parts. One part is for transactions managed by the public sector, which can be conducted on a barter basis, or in the currencies of the countries that continue to buy oil from Iran, such as Indian rupees and Chinese yuans.

The other market is for paper foreign currency and hawala (a system of parallel transactions in two countries), which people use to pay for imports that the government considers luxury goods, to send tuition money to hundreds of thousands of Iranian students studying abroad, to take money out of Iran, or simply to seek protection from inflation. The supply of foreign currency to this market is much tighter than the limits set by falling government oil revenues, so its gyrations do not necessarily reflect the ups and downs of oil exports. Nor is the rial's value in this market relevant for the price of foodstuffs or manufactured items, which the government can purchase with its oil revenues.

The shock to production

This two-tier system hasn't been well suited for the goods that keep Iran's agricultural and industrial sectors running, which constituted about two-thirds of imports. The system's persistence indicates the government's lack of preparedness, which has frustrated Iran's productive sectors for months.

Iran's economy is highly globalized, and most sectors rely on some imported items for production. Sanctions have disrupted the supply chains for these sectors. This summer, a shortage of imported chicken feed caused the first sanctions-related political crisis in Iran. Several hundred ordinary Iranians protested the shortage in Neishabour, a medium-sized city where more than 75 percent of residents voted for Ahmadinejad in the 2009 election.

As a result of sanctions and the government's ineffective response, Iran's industrial production has fallen and thousands of workers either have lost their jobs or are not being paid. Car production, which had increased fivefold in the last decade, was down 42 percent from March to September compared with the same period a year ago, mostly due to a shortage of spare parts. This year, French car producer Peugeot shut down its operations in Iran.

To remedy this situation, the government in late September unveiled its new "foreign exchange center," which allows licensed importers and exporters to bid for foreign currency, mostly supplied by the Central Bank. Approval for access to this center is based on the priority that the Central Bank attributes to the commodity in question.

The new market has introduced a third exchange rate, where the rial is currently trading about 20 percent below the free market rate but twice the official rate reserved for essential imports. This large gap, as well as talk of unifying the exchange rate, fueled speculation that a large official devaluation was imminent -- and possibly caused the value of the rial in the free market to fall 40 percent the same week.

The foreign exchange center has helped producers because they no longer have to compete with speculators and those taking their money out of the country, but it has also sharply increased the power of the government vis-à-vis the private sector -- a risk that critics of Iran sanctions have been warning of for some time.

Why Ahmadinejad won't do the right thing

The blow to the productive sectors of Iran's economy has shrunk output at a time when Iranians are holding record amounts of cash. Liberal spending has expanded liquidity by more than five times since Ahmadinejad took office seven years ago. Too much money is chasing too few goods. Inflation, which was running close to 30 percent a month ago, is now probably closer to 50 percent.

Excess liquidity and high inflation have sent ordinary Iranians in search of safe assets that can protect the value of their savings. As a result, the small Tehran Stock Exchange rose 12 percent last month, real estate has been booming, and gold and foreign currencies have gone through the roof.

An effective way to absorb such liquidity and channel it to productive uses is to raise interest rates, but the government has avoided doing so. Opposition to raising interest rates to fight inflation is partly the result of Islamic teachings that ban interest altogether, but it is also related to powerful lobbies that prefer to borrow cheap from publicly owned banks. One of the first economic actions that Ahmadinejad took when he came to office was to lower the cap on interest rates to 12 percent in the middle of an oil boom, while the economy was overheating. Interest rates have been on average 7 percentage points below the rate of inflation during his tenure.

In a rare concession, Ahmadinejad agreed a few months ago to raise interest rates to 17 percent on one-year deposits, but this was too little too late. With real interest rates in the double-digit negatives, Iranian banks have been losing depositors in droves.

Spreading the economic pain

Despite everything, Iran seems to be weathering the storm better than advertised. Sanctions were intended to inflict economic pain on Iran's population, with the hope that Iranians would persuade their leaders to compromise with the West on the nuclear standoff. But these hopes have been dashed: Tehran may have fumbled its economic response to sanctions and failed to minimize their overall level of pain, but it does seem capable of dealing with their political fallout by managing the distribution of the pain. Its principal means in doing so is the multiple-exchange-rate system, which eases the sanctions' impact on Iranians below the median income -- Ahmadinejad's political base. Meanwhile, the system shifts the burden to upper- and middle-income Iranians, who have shown little affection for the controversial president in any case.

To protect lower-income people, the Iranian government will likely act conservatively in supplying foreign exchange for nonessential needs and make sure that it has enough reserves for critical imports of food and medicine. This will mean the value of the rial in the free market will continue to fall -- but such an event should not be interpreted as a sign of economic collapse.

Ironically, if this scheme succeeds, much of the pain will be borne by upper-income Iranians who are generally most friendly to the West and least likely to revolt, because they have more to lose. They will be the unintended victims of Western sanctions, which have so far proved a very blunt instrument of U.S. foreign policy. Upper-income Iranians have plenty to be upset about with their own government, but now there is a distinct possibility that they will also blame the West for their misfortune.

This is not only unproductive from the point of view of Western policymakers -- but it will also complicate relations with Iran if and when the country rejoins the global economy.


National Security

My Way Or the Huawei

The U.S. government's recent accusations against two Chinese companies are seriously overblown.

The U.S. House Intelligence Committee released a much-publicized report on Monday accusing two Chinese companies -- Huawei and ZTE, the world's second- and fourth-largest telecommunications-equipment suppliers respectively -- of providing opportunities for the Chinese government to spy on the United States. The report labeled both corporations national security threats and recommended that U.S. companies cease doing business with them.

Much of the media coverage of Huawei and ZTE is certainly eyebrow-raising. Yes, it's clear the Chinese government holds tight control over two of the countries' most successful private companies, and Huawei and ZTE executives have numerous ties to the government, like all companies in China in sensitive industries. The United States is also undoubtedly the victim of a huge volume of cyberattacks originating from the Chinese mainland.

Although the report -- at least the unclassified version -- is full of sound and fury, it is almost devoid of anything conclusively connecting Huawei and ZTE with the charges levied against them. The 11-month investigation, which Huawei requested, starts from the presumption of guilt and works backwards from there: All its conclusions are based on the suspicion of wrongdoing. As 60 Minutes reported two-thirds of the way into its segment on Huawei this past Sunday, almost as an afterthought, "[T]here's no hard evidence" that any of the espionage allegations are true.

It seems that the House intelligence committee's response to potential cybersecurity threats has been to circumvent the Bill of Rights using "national security" as an excuse, while the committee avoided the most effective solutions -- like examining the two companies' code and vulnerability testing all foreign-made communications equipment -- that would make the nation's communications infrastructure safer.

Even before the investigation started, the U.S. government has been unofficially pressuring companies to refuse business with Huawei, calling into question whether Huawei and ZTE have ever been afforded due process. According to Sunday's 60 Minutes report, former Secretary of Commerce Gary Locke called the head of Sprint in 2010 when they were close to signing $5 billion contract with Huawei and convinced Sprint to back out of the deal. (The Wall Street Journal has also reported on the phone call.) When the head of small U.S. telecommunications company, United Wireless, bought equipment from Huawei he couldn't get anywhere else, he received a visit from two federal agents who were "not pleased" with his business ties, according to 60 Minutes.

The consequences for ignoring the issues surrounding Huawei and ZTE are serious, and the U.S. government should prevent government agencies from entering into contracts that could harm the United States. And the U.S. government has good reason to fear the Chinese government's connection to Huawei and ZTE from past experience: Even if their equipment is perfectly safe now, it could be turned against the United States in the future.

But the U.S. government, along with House Intelligence Committee chairman Rep. Mike Rogers, have effectively blacklisted Huawei and ZTE, even though the two companies have not been convicted of -- let alone charged with -- any crimes. Rogers even called into question the patriotism of any company doing business with Huawei, telling 60 Minutes, "If I were an American company today... and you are looking at Huawei, I would find another vendor care about the national security of the United States of America."

In September, two other members of the House Intelligence Committee, Republicans Sue Myrick and Frank Wolf, went further, taking the extraordinary step of pressuring DLA Piper, one of the largest business law firms in the world, to drop ZTE as its client, citing the "threats your client may pose to the national security of the United States."

The tactic of aligning one's attorneys with the crimes its clients are accused of committing is antithetical to the legal traditions in the United States and the 6th Amendment of the Constitution, which guarantees the right to legal representation. It dates back to another conflict between two nations, when founding father John Adams insisted on representing in court the British soldiers accused of committing the Boston Massacre.

Incredibly, despite an 11-month investigation the committee did not actually test any piece of Huawei or ZTE's equipment, according to the House report. This did not prevent Committee members from accusing both companies of installing in their products "backdoors" -- bits of code that would allow China to monitor transmissions over the equipment. As Forbes writer Andy Greenberg pointed out, the most effective solution would be to test "for the backdoors and bugs that Congress believes Huawei and ZTE may have installed and apply those tests to all the networking equipment that comes through the door." ZTE even suggested that a third party conduct a "thorough review and analysis of software codes" and run "vulnerability scans and penetration tests" of their systems, similar to how the British government tests Huawei products. Yet the intelligence committee refused to even test the equipment as part of its investigation.

This is why that despite charges of "national security," the rhetoric of the Intelligence committee smacks of economic protectionism. While Huawei and ZTE have far closer ties to the Chinese government, U.S.-owned Cisco, the greatest likely benefactor from this report, manufactures many of its own parts in China. In fact, all major U.S. networking companies source from China and present many of the same "supply chain risks" the report warns about.

There is no doubt the installation of backdoors into communications equipment is a justifiable worry. They will not only facilitate privacy abuses and Chinese cyberattacks, but also give criminals an easier avenue of attack. Unfortunately, the United States is looking to the do same thing itself. FBI Director Mueller complained to Congress in September that Internet communications providers "are not required to build or maintain intercept capabilities" and asked Congress to pass a surveillance bill that would force telecommunications companies -- plus services like Facebook, Google, and Skype -- to install government-friendly backdoors in all its software.

As Wired's Kim Zetter explained, "In practice, this means that all carrier-grade networking equipment sold worldwide comes with built-in capabilities to wiretap citizens, no matter what country they live in. Computer security experts have long pointed out that such capability can be hijacked by others to intercept communications."

Former Commerce and State Department official James Lewis, now with the Center for Strategic and International Studies, argued on 60 Minutes that the real difference in Huwaei and ZTE's case is China's state control. In the United States, "companies are used to throwing their weight around, telling the government what to do," he said. "In China, a company is a Chia Pet. The state tells them what to do, and they do it."

Yet AT&T, Verizon, and Bell South -- at the time the three largest telecom companies in the United States -- showed all the spine of a Chia Pet and famously bowed to pressure in the aftermath of 9/11,when they handed over billions of phone and emails records as part of the National Security Administration's warrantless wiretapping program. The companies were in such clear violation of federal law that Congress later handed the telecom companies full, retroactive immunity for assisting the government.

This is why the report's final recommendation is its best one: transparency. More transparency from telecommunications companies, both in their equipment's capabilities and their policies and procedures for interacting with governments, is vital in keeping citizens' privacy, and in guaranteeing the safety of U.S. infrastructure. That principle should be applied to Chinese companies, American companies, and every company in between.