The head of the Central Bank of Iran recently said that the root of all the economic challenges facing Iran is the excessive money supply caused by domestic banks’ heavy borrowing from the central bank. Money supply, its link to inflation, and its impact on the foreign-exchange market have created an intense national debate in Iran because of widespread negative impacts on the livelihood of the average citizen. Renewed U.S. sanctions on Iranian sales of oil and petrochemical products come into effect in November and are expected to add to the economic hardship in Iran, which included a historic currency crisis over the summer. Nevertheless, in the eyes of the public, the ill-advised policy choices of the Central Bank of Iran are considered to have a much greater negative impact on the economy than international sanctions, at least those imposed to date.

Over recent decades the Central Bank of Iran has constantly increased the money supply as a policy response to manage the pressure caused by domestic banks’ borrowing habits. Despite some of the fundamental differences between the economic policies of different administrations in Iran, increasing the money supply has been a common policy decision for all administrations. For example, the government of former President Ayatollah Ali Akbar Hashemi Rafsanjani, which was known for pro-market and liberal economic policies, had the same approach toward the money supply as the populist administration of former President Mahmoud Ahmadinejad. The administration of President Hassan Rouhani has also continued the money supply strategies of its predecessors.

In July, the central bank announced that Iran’s monetary base increased by 19.1 percent from March 2017 to March 2018. In theory, increasing the monetary base can boost economic growth because more cash in the hands of consumers can increase consumption and generate economic growth. However, although money in circulation has increased, the purchase of goods and services is not increasing proportionately due to high inflation. Inflation, therefore, has become one of the direct negative impacts of the increasing money supply in Iran.

The key driver of the constantly increasing money supply in Iran has been the rising debt owed by domestic banks to the central bank. Year-on-year bank debt grew in 2016 by more than 19 percent. It continued to increase between March and September 2017 by 16 percent (year-on-year). This has been caused by a growing number of nonperforming loans on banks’ balance sheets. From the 2011-12 fiscal year to 2017-18, the volume of nonperforming loans increased by 240 percent. More than half of Iran’s nonperforming loans are highly doubtful or lost funds. Widespread corruption in the banking and political system and a weak banking audit and accounting structure have created a favorable environment for a growing volume of nonperforming loans in Iran.

There is also the issue of “obligatory lending.” Iranian banks are often obliged to lend to certain borrowers, even when the borrowers do not meet the requirements to qualify for a loan, for example, when an applicant (an individual or organization) is recommended by another government organization or a senior political or military figure.

Nonperforming loans are often linked with projects that in some cases are ultimately abandoned. In many cases the loan applications (even those that come with strong recommendations) are fraudulent (i.e. the funds that are received from the banks are not invested in the projects described in the application). In a highly politicized environment the banks do not have appropriate auditing and monitoring mechanisms to perform due diligence and oversee the project development – and are unable to recover the debt. The central bank also has a relatively weak position in such a system because it lacks political independence from the government, does not have the technical capacity to carry out appropriate monitoring and auditing procedures, and lacks authority to implement much-needed financial discipline in the country’s banking system.

In theory, commercial banks are allowed to borrow from the central bank to meet reserve requirements when their cash in hand is low. However, inflation-control mechanisms are also important to control the inflationary pressure of a rising money supply. As noted, for decades the Iranian government’s response to bank reserve shortages has been to print money, without any solid inflation-control mechanisms, to maintain the required level of reserves for the central bank. They have particularly done this when money has been tight and government revenue has been low due to fluctuation of global oil prices and international economic sanctions.

The stability of the banking system has been a significant concern in Iran. The central bank announced that a high number of state-owned and private banks have been struggling with the issue of excessive borrowing from the central bank. To address the issue, the central bank began to restructure the banks’ debts in 2017 by reducing the interest rate due on the debts from 34 to 18 percent, or 16 percent if they put down collateral. Under the restructuring scheme, state-owned commercial banks managed to reduce their debt to the central bank.

In September, the central bank announced that its top priorities were controlling money supply and helping banks reduce their debt to the central bank by maintaining healthy balance sheets. For years, the Iranian banks have been caught in a cycle of accumulating nonperforming loans on their balance sheets and knocking on the central bank’s door to meet their reserve requirements. High interest rates due on savings deposits held by the banks as well as that of the central bank loans have also contributed to excessive bank borrowing. The government never allowed any of the banks to default on their debt or become bankrupt. Instead, the central bank kept rolling over the banks’ debts and continued its lending. The government would therefore either need to write off some of the banks’ debts or let them default, which would inevitably require some banks to close down. Closing down banks would in turn have negative social and political consequences that the government wants to avoid, particularly as the return of the U.S. sanctions is expected to add to existing economic hardship.

In response to concerns over the impact of high interest rates, the central bank started to enforce interest rate reduction policies over recent years. As a result, the interest rate on savings deposits was reduced from over 20 percent to a maximum of 15 percent for 1-year deposits. Despite the interest rate reduction, for a long time the rate of return on savings remained significantly higher than the rate of return on investment. In other words, for Iranian citizens it was safer and more profitable to park their assets as savings deposits in banks to generate income as opposed to investing those assets in productive economic activities. Over recent decades, it has become a social trend among Iranian citizens, regardless of level of wealth, to deposit liquid assets in commercial banks to earn a living. The cycles of quick currency devaluation, however, encouraged Iranians to move away from rial savings and rush to buy gold and foreign currencies. Reducing interest rates to single-digit numbers would be a crucial step for the government in solving the banking and liquidity challenges in Iran. Considering interest rates will have to be linked to inflation, the government must introduce inflation-control mechanisms prior to further bank rate reductions. Controlling the inflation would, however, remain a challenge in the aftermath of the return of U.S. sanctions.

The issue of money supply stemming from domestic banks’ debts to the central bank, and causing high inflation, is now having a comparable, if not worse, impact on the Iranian economy than the international economic sanctions currently in place. The government has acknowledged the issue recently and its strategy to tackle it is now the topic of heated public debate. The country’s banking system is in urgent need of what the International Monetary Fund summarizes as an asset quality review, a related-party lending assessment, and the recapitalization of banks. However, the renewed international sanctions and the government’s strategy to cope with them will not leave much policy space for the government to focus on banking reforms in the foreseeable future.