Responding to Sanctions from the Supply-Side

One of the fundamental asymmetries of sanctions policy is that countries that apply sanctions have many opportunities to do so. Countries targeted by sanctions are usually only targeted once. Those using sanctions get to practice their economic statecraft. Those facing sanctions get a single shot to try and secure their economic survival.  

The question of how countries use their one shot has been little studied, especially since the emergence of financial sanctions as the primary tool of Western economic statecraft. This is a fundamentally important area of study. The efficacy of sanctions is a function of the resilience of the target. If a target can resist the coercive effects of sanctions in the medium-run, it is less likely that the sanctions will lead to the intended change in behaviour, particularly if the intended behaviour change is significant. Being able to estimate the resilience of the target is therefore a requirement for the judicious use of sanctions.

In a recent essay, I discussed how the Russian economy might respond to sanctions. My analysis drew on the experience of Iran, a country that has proven remarkably resilient in the face of the most expansive sanctions ever imposed. President Trump’s Iran envoy, Brian Hook, once stated “Because of our pressure, Iran’s leaders are facing a decision: Either negotiate with us or manage economic collapse.” We know that Iran managed to stave economic such a collapse. But was Iran’s response to the sanctions-induced economic crisis a good one?

Iranian economic policymaking is about as deft as in most middle-income countries. The grit of firms and households, which fought hard to prevent their own financial ruin, flattered Iranian policymakers. There were some successful policy interventions, such as a move to better regulate foreign exchange through the creation of a new parallel market, and the limited use of cash transfers to soften the blow of the economic downturn on households. But overall, it is difficult to conclude that Iran is a case study for an effective policy response to a sanctions crisis.

This is not to say Iran lacks sharp minds. But in the fog of economic war, a misunderstanding of the nature of the economic crisis and a reliance on textbook economics, combined to prevent a more nimble and effective policy response. The policy failure reflected an inability to respond to the key economic impact of sanctions—higher rates of inflation—with the correct set of policy tools. The Iranian government responded to persistent high inflation through a combination of monetary and fiscal interventions. Absent was any active industrial policy. This may come as a surprise. Helmed by a “revolutionary” government, Iran might have been expected to favour economic centralisation and public investment in its response to economic crises. But as a review of the statements and commentary of leading economic policymakers and economists makes clear, whether the interventions were monetarist or Keynesian, they have generally been focused on shielding aggregate demand from the sanctions pressure by seeking to control inflation or to compensate for its effects.

In a recent op-ed in the Financial Times, Iran’s finance minister, Ehran Khandouzi declared that the Raisi administration is seeking “to change the course of fiscal policy,” by aiming to “promote economic growth, price stability, and inclusive growth.” As part of this plan, Khandouzi called for “increasing government investment,” noting that the “public sector must play a more active role in investing in physical capital.” The timing of the op-ed was curious—talks over the future of the Iran nuclear negotiations have languished. By publishing his commentary in a leading international newspaper, Khandouzi may have been aiming to signal the Raisi administration’s readiness to engage with the global economy. Even so, the message of the op-ed was calculated. While Khandouzi notes that the negotiations in Vienna “could potentially lead to positive economic outcomes for Iran,” he concludes by explaining that the country is “ready for whatever scenario emerges — pessimistic or otherwise.”

In recent years, supply-side responses to inflation have come to the fore, particularly after the COVID-19 pandemic during which Western governments experienced inflationary pressures directly related to supply chain disruptions. As Yakov Feygin has written, the COVID-19 crisis “created bottlenecks in the production of practically every commodity.” For Feygin and other supply-side economists, the pandemic was a clarifying moment that “an active industrial policy” was a necessary part of any response to the “upward pressure on prices” that emerged as households continued to demand consumer goods and durables at a time when factories were forced to cut back production. Such an industrial policy would see policymakers “use the spending power of the government to issue long-term capital to vital but low-margin sectors.”

Could Khandouzi’s call for a “change in fiscal policy” see the emergence of an active industrial policy and a true supply-side response to inflation? Iran’s Supreme Leader, Ali Khamanei, has frequently cited the need to increase domestic production, which has been interpreted as a nod to import substitution. In an address given in March marking the start of the Iranian new year, Khamenei declared that “Production is the key to solving economic problems and the path to pass through economic difficulties.” However, looking beyond the Supreme Leader’s slogans, it is notable that more economic policymakers in Iran are increasingly connecting the specific problem of high prices to the challenge of low production. In a 2020 interview, Ali Salehabadi, now serving as governor of the Central Bank of Iran, expressed a decidedly supply-side outlook. “It goes without saying that the root of inflation in our country is not only monetary, but also related to real variables such as production. That is, increasing production in the long run will reduce inflation. Therefore, the growth of production will make the preparations for improving the living and economic conditions of the people,” he said. For his part, Khandouzi highlighted how “negative net investment in recent years” is “severely undermining future production and household welfare.”

There is no doubt that sanctions induce monetary and fiscal shocks that explain a significant portion of their inflationary impact. Moves to freeze Iran’s central bank reserves led to a shortage of foreign exchange. This weakened the Iranian rial. The Iranian government also printed money to finance budget deficits caused by the impact of sanctions on government revenues, principally oil revenues. But to fully capture the macroeconomic impact of sanctions it is important to look at goods, and not money alone. Financial sanctions hurt because they are the most effective means to determine what goods a target country can buy and sell in global markets. Sure, sectoral sanctions and export controls impact trade, putting pressure on the target country’s balance of payments. But countries have a knack at finding new buyers and suppliers (and intermediaries) who are willing to skirt these measures. What proves harder is finding banks willing to facilitate payments to those buyers or suppliers. It was not until financial sanctions cut Iranian banks, including the country’s central bank, from the global financial system in 2012, that there was a major impact on Iran’s current account. If an economy is highly import dependent, these disruptions have a direct inflationary impact. If the targeted country is relatively industrialised, producing more of the goods it consumes domestically, then the impact is less direct. This is the case in Iran and likely for Russia. In Iran, a decade of diminished imports of raw materials and intermediate goods have suppressed industrial output, in turn creating upward pressure on prices. In other words, consumer prices rose because producer prices rose. Iran experienced a supply-side shock.

As the short-run shock gives way to medium-run stagnation, persistent inflation and other economic impacts, such as unemployment, will lead to reduced demand—this is demand destruction. But in the immediate period after the imposition of sanctions demand remains mostly unchanged, even as inflation mounts. Households are inherently reluctant to cut back on spending in ways that will appreciably reduce quality of life and will therefore dip into savings. As prices rise further, families will increase the proportion of their expenditure on key categories, such as food and other consumer goods, including durables—demand for these goods is relatively inelastic. These are also the goods that Iran’s manufacturing sector tends to produce, given the large domestic market. This is partly why the supply-side challenge emerges. Consider the spending behaviours of a middle-class family in the aftermath of a sanctions shock. As the economic outlook worsens and as inflation expectations rise, that family will cut back on discretionary spending. They may delay the purchase of a luxury car or cancel a planned vacation abroad. But those decisions do not alleviate broader, society-wide price pressure because that consumption was either met through imports or facilitated by the Iranian services sector and not underpinned by domestic industry.

In more formal terms, under a major sanctions programme, aggregate demand in the targeted economy will fall. But in a relatively developed economy with a large domestic manufacturing base, the contraction in aggregate demand will be smaller than the contraction in aggregate supply for two reasons. First, uncertainty over future demand will see producers reduce investment. While sceptical of government interventions, Iranian private sector business leaders have sounded the alarm that a decade of low-investment is hitting production. Second, even when firms do have the means to invest, they may not be able to do so. Sanctions can prevent firms from acquiring the needed machinery and equipment, leading to the degradation of the capital stock and a drop in output. For example, sanctions on the Iranian oil sector made the acquisition of equipment more difficult, leading to concerns over the productive capacity of oil and gas fields.

Implicit in this analysis is the assumption that in the medium-run, sanctions will be lifted. Even so, the effects of reduced investment are significant. In the short-term, as producer prices rise, aggregate supply falls faster than demand, adding to inflationary pressure. But the nature of this contraction is where the real pain of sanctions lies. The shift in aggregate supply is not temporary, and it cannot be fully reversed through the lifting of sanctions because of a change in the elasticity of aggregate supply. In other words, enduring sanctions makes it fundamentally more difficult for an economy to bounce back when sanctions are eventually lifted in the medium-run. The relationship between the elasticity of aggregate supply and extended economic recessions has not been well-studied. This may be because a normal recession, even if lengthy, does not inherently impact the components of long-run aggregate supply—land, labour, capital and, productivity. But sanctions do not cause normal recessions. Sanctions prevent investment in capital goods by prohibiting or complicating the import of machinery and equipment. In this way, the prolonged lack of investment leads to a degradation of the capital stock. Mothballed facilities can be difficult to recommission and those assembly lines that do restart may be using obsolete technology. Iran’s leading automaker still produces the Peugeot 206, which was first introduced in France in 1998. In this way, while the lifting of sanctions may lead to a recovery of demand, particularly as restored foreign exchange revenues serve to strengthen the currency and boost purchasing power, producers may not be able to rapidly increase output in response to the expansion in demand.

The implication is that policymakers ought to think about major sanctions programmes—those that induce several years of high inflation—from the supply-side. In the short-run, the primary economic impact of sanctions is higher inflation, but in the medium-run, even after the lifting of sanctions, the pain of sanctions lingers as supply remains constrained. This is also why the beneficial impact of sanctions relief on the monetary and fiscal situation of the target country may not be sufficient to lead to a normalisation in price levels. On one hand, the upfront capital expenditure necessary to overhaul productive sectors may be prohibitively high after an extended period of underinvestment—in the aggregate, the targeted economy will struggle to ramp-up production at pre-sanctions rates. On the other hand, turning to imports to compensate for the new inelasticity of domestic supply will introduce its own price pressures, particularly given the lingering effects of sanctions on foreign trade, such as higher transaction costs. Under these conditions, sanctions relief is insufficient to deliver growth. As Nicholas Mulder and I have argued, countries ravaged by sanctions require sanctions reconstruction.

This analysis suggests that true sanctions resilience requires supply-side interventions. Finding ways to prevent the contraction in output is more important than trying to shore consumption, especially given the ways in which greater inelasticity in supply will diminish the prospects for the sanctioned country to recover under conditions when sanctions are eventually lifted. Taking this view, the response of Iranian policymakers to the inflation problem is peculiar. The focus on monetary policy reflects a textbook approach. Even in the aftermath of sanctions that obviously degraded supply chains and limited production, Iranian officials primarily viewed inflation as a phenomenon related to the growing money supply, which needed to be addressed through tighter monetary policy and higher interest rates. To put it another way, the response to the crisis focused on the production of money and the price of money, even though the sanctions crisis was largely, if not predominantly, about the production of goods and the price of those goods. This is why the rise of supply-side rhetoric among Iranian economic policymakers is so intriguing.

Beyond the economic significance of any forthcoming change in Iran’s policy response to sanctions, there are political implications that ought to be considered. If belated supply-side interventions make countries like Iran more resilient to sanctions, beyond the levels of resilience currently observed following faltering and orthodox demand-side interventions, sanctions may become less effective over time, especially as those countries yet to be targeted with economic weapons learn from the experiences of those that have.  

Counterintuitively, greater economic resilience among sanctions targets may also benefit those states imposing sanctions. If targeted countries can successfully devise an industrial policy that minimises the negative impact on the elasticity of aggregate supply, for example through financial support for productive firms and greater efforts to protect supply chains for machinery and equipment, it will make the economy more responsive to sanctions relief and reduce medium-run price distortions. Policymakers applying sanctions tend to do so under the false impression that sanctions can be imposed and lifted with the flip of a switch. Sanctions can certainly be imposed quickly—the sanctions imposed on Russia were applied with record speed. But their rollback is laborious, and the economic benefits can be slow to materialise, in large part due to the changes in the components of aggregate supply. Good sanctions policy requires maximising short-run pain while minimising medium-run harms. For both policymakers applying sanctions and those seeking to resist sanctions, better policy outcomes require supply-side thinking.

Photo: IRNA

Will Foreign Investment Return to Iran’s Automotive Sector?

Iran produced just 770,000 automobiles in 2019, down from 1,418,550 just two years prior. The re-imposition of U.S. secondary sanctions interrupted new investment in Iran’s automotive sector, particularly by European automakers such as Renault, Peugeot, and Volkswagen.

The median age in Iran is just 32. Limited public transport options and cheap petrol make car ownership attractive and even necessary—under normal circumstances, the Iranians would purchase up to 2 million cars each year, with a total sales value of up to $20 billion. 

The rising cost of manufacturing inputs and a shortfall in production has contributed to a sharp increase in the price of automobiles, particularly in the secondary market. While Iranian policymakers consider the automotive industry as a “strategic sector,” with state-owned firms Iran Khodro and SAIPA among the country’s largest employers, the hit to output over past two years has made clear the limits of the government’s ability to grow the automotive sector without foreign partnerships. 

Over the last year, companies linked to Iran’s defense ministry have stepped in to support production at the Iran Khodro and SAIPA in an attempt to localize the production of more parts and shield automakers from the rising cost of imports. At a signing ceremony in December of 2019, SAIPA CEO Seyyed Javad Soleimani told reporters, “With Defense Ministry’s help, domestic substitutes for 35 key auto parts are to be produced in Iran to curb the industry’s reliance on the global supply chain.” 

The cooperation between automakers and defense contractors is best understood as a stop-gap solution for the automotive industry. In the short-term the goal is to raise output. In the medium-term, the automotive sector will still require the transformative investment that only foreign automakers can provide.

Foreign automakers have long understood the potential of Iran’s large domestic market and the combination of low labor costs and local parts production. Iran’s industrial workforce is skilled and experience, particularly relative to their compensation. The monthly minimum wage is IRR 18.34 million for the current Iranian calendar year—now equivalent to less than USD 100 per month at current exchange rates. Between 2009 and 2011, two out of every 100 cars and commercial vehicles produced worldwide was manufactured in Iran.

These dynamics led numerous European, Korean, and, more recently, Chinese car and truck manufactures to establish license manufacturing agreements and even full joint ventures with Iranian automakers. Iranian auto parts makers developed the supply chain to provide the local parts content on which Iranian policymakers insisted. The manufacturing of the Renault Tondar, known as the Dacia Logan in most markets, saw Iranian spare parts manufacture obtain “Grade A” certifications from Renault. Following the new investments committed after the implementation of sanctions relief in 2016, there were growing expectations that Iran would become an exporter of European-branded automobiles to regional markets. 

Notably, the new post-JCPOA investment was intended to facilitate the partial privatization of the state-owned manufacturers. Through the Industrial Development and Renovation Organization (IDRO), the Iranian state was set to become a minority shareholder in the new Renault joint venture. A similar deal was struck between Daimler and Iran Khodro Diesel for the manufacturing of Mercedes-Benz trucks in Iran. 

Allowing foreign firms to be the majority shareholders of their joint ventures was an important shift in industrial policy for the “strategic” automotive sector. Such policy was also intended to address the long-running issue of inefficiency and poor productivity among the state-owned automakers. There were also a number of deals between foreign automakers and private sector firms in Iran, such as the agreement between Volkswagen and Mammut, which has produced Scania trucks in Iran since 2008. Scania’s persistence in the Iranian market has earned it a commanding market share of over 60 percent.

Clearly, prior to the re-imposition of sanctions, Iran was set to deepen its dependence on foreign investment to drive growth in the automotive sector. In the case that sanctions are once again lifted, that drive for foreign investment would no doubt resume. Iran’s automotive market will remain attractive, but foreign automakers will want to be sure that any new round of sanctions relief will be durable.

Photo: IRNA

For Iran’s Economy, the Price of a Car Matters More Than the Price of Oil

The combination of reimposed sanctions, a slowing economy, and a devalued currency have put Iran’s automotive sector under severe pressure With nearly 1 million jobs linked to the automotive industry, the price of a new car could be even more important than the price of oil for the Iranian economy.

In an interview with Bourse & Bazaar, Saeed Madani, the former CEO of SAIPA, Iran’s second largest automaker, warned that price controls are squeezing state-owned automakers as sanctions effect the overall economy.

State-owned firms Iran Khodro and SAIPA, account for 90 percent of the 1.5 million vehicles manufactured in Iran each year, but are in many respects these firms are least prepared for the bumpy road ahead.

Madani, who led the SAIPA for three years during the height of sanctions from 2012 to 2015, warned that dependence on imported raw materials and parts leaves Iranian automakers vulnerable as the economy slides into a recession.

“With the rial weakening, carmakers’ purchasing power has been slashed. The input costs of auto parts industry have also increased significantly,” Madani explained. The rial has lost 70 percent of its value against the US dollar since the current Iranian fiscal began in March, making manufacturing inputs significantly more expensive.

Automakers Face Pricing Squeeze

These costs cannot always be passed onto the consumer. Presently, Iran’s Competition Council retains the power to set prices for many domestic products, including cars that are categorized as affordable, meaning their sticker price is less than IRR 450 million.

Madani believes that even if the state is reluctant to deregulate the auto market at large, authorities must give a green light to the carmakers to increase prices. “The upgraded prices need to be set for each model depending on the share of imported auto parts in its production,” he said.

The price increases are especially crucial for models assembled from imported completely knocked-down (CKD) kits, as these vehicles have a higher foreign parts content than those designed locally. Madani thinks prices for the vehicles assembled from CKD kits should be “at least doubled.”

SAIPA’s most popular model is the entry-level Pride, based on a design from Korean automaker Kia. The Pride is the cheapest car made in Iran. To manufacture each Pride, “it is necessary to import USD 1,500 worth of parts and raw materials,” Madani explained.

But while earlier this year, automakers were receiving foreign exchange at the subsidized rate of IRR 30,000 per dollar, today their currency is purchased through the NIMA system, established by the Central Bank of Iran to coordinate foreign exchange purchases and to track forex transactions involving banks, exchange houses, importers and exporters in real time. Over the last month, the average NIMA rate was IRR 92,304 per dollar.

In Madani’s estimation, looking just to cost of inputs, and ignoring increased overheads facing SAIPA, the price of the Pride needs to be raised by IRR 90 million (USD 600) to bring its sticker price to IRR 320 million (USD 2200).

The official price of the Pride was last raised in June, bringing it to IRR 227 million (USD 1,500). Today, the Pride is regularly selling for IRR 340 million (USD 2,300) in secondary markets, demonstrating the heavy subsidization enforced by the government.

Failing to readjust prices could have dramatic consequences for the auto industry, warned Madani. “If the government does not let carmakers increase prices, they will go bankrupt. Firms will be forced to shut down many production lines and output rates will nosedive,” he said.

Faced with this dilemma, the government will be tempted to throw the automakers a lifeline by providing financial aid and loans. But Madani considers such aid to be a burden for manufacturers, which will struggle to pay back debts in the future.

Uncertain Government Response

In recent weeks, government figures have repeatedly signaled that they are considering giving carmakers the green light to increase car prices. Financial newspaper Donya-e Eqtesad recently reported that industry stakeholders and officials are well aware that the car prices need to be increased, but are afraid of the political cost of such a decision as it will be seen as placing pressure on Iranian consumers.

On October 31, Iran’s newly appointed industry minister, Reza Rahmani, told IRNA, “Automakers are not permitted to change car prices [on their own]. There is a designated legal mechanism for introducing new car prices. No decision has been made yet about changing car prices.”

In the interview, Rahmani also questioned the credibility of the unaudited financial statements reported by the local media, which suggested that Iran Khodro and SAIPA had made losses amounting to IRR 21 trillion (USD 142 million) and IRR 29 trillion (USD 196 million) respectively in just the last six months.

“Iranian automakers are not loss-making. By producing certain models local carmakers may incur losses. However, this is not an issue which cannot be resolved by better management of resources,” the minister countered.

Rahmani revealed that a “specialized task force” had been established in coordination with industry executives “to study the problems which have hindered auto production over the past few months.”

But time is short. “With every day passing carmakers’ loses will further pile up… Automakers should not be forced to foot the bill for subsidizing car prices in Iran,” Madani said.

His assessment is shared by Maziar Beiglou, a board member of the Iran Auto Parts Makers Association. Beiglou recently stated in an interview that the “The situation has been worsening by the day,” pointing to the rising price of inputs such as iron ingots used by companies that produce automotive steel. In Beiglu’s assessment, more than 300 auto parts makers have been forced to stop production.

Total vehicle production in Iran is down 15.1 percent looking to the first half of the current Iranian fiscal year, which began in March. Already, economic headwinds and slowing production have led to mass layoffs.

Sate-owned companies such as Iran Khodro and SAIPA are unlikely to “resort to laying off workers” given the difficult optics for the Iranian government, Madani predicted. But private sector auto parts companies have already been forced to layoff “100,000 to 150,000” workers because of the deteriorating situation.

Photo Credit: IRNA

Unilever and Golestan Strike New Joint Venture As Iran’s FMCG Market Accelerates

Unilever, acting through its Iranian subsidiary, has signed a joint venture partnership with Golestan Company, the makers of Golestan tea and one of Iran’s best known consumer goods companies. The agreement was signed on November 29, but was formally announced this week.

The new partnership will see Unilever and Golestan join forces to locally manufacture and sell food products in Iran. The company’s announcement emphasizes that “the new joint venture company will develop, manufacture, market and sell new brands and line of food products in Iran.” This suggests that more than simply an agreement to locally produce brands from the Unilever stable in Iran, the companies will create new offerings that best suit Iranian tastes. 

Özgür Kölükfakı, General Manager for Unilever in Iran, Central Asia, and the Caucuses, noted Golestan’s “local manufacturing and distribution capabilities” as the basis for a partnership that “strengthens [Unilever’s] contribution to Iran.” The announcement did not include details as to the amount of new investment earmarked for the joint venture company.

Though it has diversified into other foods, Golestan Company is best known for its eponymous tea. The ubiquity of Golestan tea in Iran reflects the company's early innovation in distribution and marketing. Golestan was one of the first Iranian FMCG companies to bring distribution in house, allowing greater end-to-end control of the supply chain, with an impact on everything from pricing to brand positioning on store shelves.

Unilever’s commitment to Iran has intensified since 2016, when global CEO Paul Polman made a visit to the country to meet with the expanding local team. Unilever sees Iran as an battleground as it competes in detergents and personal care with the likes of German Henkel and the American Procter & Gamble, and in food and beverage with the likes of Swiss Nestle and French Danone.

That Unilever will now operate not just its local representative office in Unilever Iran, but also a full manufacturing joint venture, reflects a trend among FMCG multinationals working in the country. While Unilever has owned a production facility in Qazvin since 2003, most FMCG companies have typically partnered with Iranian companies within licensing or contract manufacturing models, which saw globally recognized brands produced in Iran but without direct ownership or operation by the international partner, who would instead receive revenues in the form of a fee. This approach exposed multinationals to less risk, but also limited their ability to create value in the Iranian market.

Since the lifting of international sanctions on Iran in 2015, several forces have combined to further push companies towards joint venture partnerships or outright control of their Iran-based manufacturing interests. Not only has the Iranian and regional market matured in the two decades since many international brands began to be locally produced in Iran, offering greater opportunities at scale, but improvements in foreign investment protection and greater political comfort with foreign-owned local enterprise, have made joint ventures more appealing for international firms. This trend has led to new ownership-centered partnerships in the automotive, steel, pharmaceutical, and FMCG sectors, among others.

Consumer preferences have also driven the shift in strategy. Data from market research firm IranPoll indicates that 55% of Iranians believe that European products sold in Iran are “mostly counterfeit.” Iranian consumers still have a strong affinity for local brands, in part because nearly half of Iranians believe that European companies “do not have a good understanding of the needs and the taste of the Iranian people.”

To address these concerns and build local trust, multinational companies need to become more deeply engaged in the Iranian market. A significant 58% of Iranian consumers believe that “opening an official representative office in Iran will increase confidence in the quality of European producers’ products in the Iranian market.” In this context, Unilever’s move to establish a local joint venture with a trusted Iranian partner, and to focus on the development of new product lines tailored to local tastes is a smart response to consumer demands.

Today, in the Iranian FMCG market, the likes of Danone, Groupe Bell, Nestle, and Henkel are either operating with or actively exploring the potential for direct ownership of their local manufacturing interests. The most advanced company in this regard is Henkel, which brought out its Iranian shareholders in 2016 to convert its extensive manufacturing joint venture into a fully-owned subsidiary.

The determination with which FMCG multinationals are investing in the Iranian market is bearing fruits for Iranian consumers. The availability of consumer goods is one of the few areas where Iranians have seen improvements first-hand since the nuclear deal was implemented two years ago. In a recent survey conducted by Bourse & Bazaar in partnership with IranPoll, 43% of Iranian consumers have noted an increase in the “availability of goods made by multinational companies” for sale in Iran.

Said Ahmad Nasiripour, Managing Director of Golestan, relayed his hope that new partnership with Unilever points to a “much brighter future” for the company and its consumers. Expectations will certainly be high.

Photo Credit: Unilever

In the Future, Iran's Biscuits Will Be Made by Robots

Some of Iran’s most popular biscuits are manufactured in a facility about an hour south of Tehran. In the tea drinking country of Iran, biscuits are a staple, served to guests in living rooms and boardrooms alike. The biscuit company in question has been in business for over 50 years and occupies several buildings which house production lines for butter biscuits, chocolate cookies, and flavored wafers. 

While the scents are those of a bakery, the factory’s sights and sounds are completely industrial. Conveyor belts whir on several parallel production lines, arranged in the long central hall. The oldest equipment in operation was made in 1961 by English equipment maker Simon-Vicars and can bake 500 kilos of biscuits per hour. The majority of the equipment is made by Germany’s Werner & Pfleiderer, with two lines installed in the 1970s and a third line installed in the 1990s. These ovens can bake up to 900 kilos of biscuits per hour. The most modern equipment in the factory are the two Italian Imaforni ovens, purchased second-hand, which can bake up to 600 kilos of biscuits per hour. However, the Imaforni machines are often dormant.

Across the production lines, only the mixing, baking, and cooling processes are mechanized. Packaging of the biscuits is done by hand by teams stationed at the end of each line.

In a building next door to the main factory, the baking of more complex wafer cookies requires even more human input. Not only is packaging completed by hand, but the assembly of the wafers requires the sheets of pastry to be manually fed into the machine that applies the filling.

Altogether the factory employs just under 200 people and boasts a maximum production capacity of 11,000 tonnes per year. With dormant production lines, the output is really about half that figure. By way of comparison, Mondelez International’s factory at La Haye-Foussiere in France produces 45,000 tonnes of biscuits per year with just 450 employees. With greater automation, the La Haye-Foussiere factory employs just twice the number of workers to produce at least four times the biscuits each year.

The owners of the Iranian biscuit factory had one emphatic answer when asked what they would do a new injection of capital: “We would invest in automation.”

Last week, I wrote about the importance of the blue-collar workforce to Iran’s economic recovery, and how post-sanctions growth needs to serve this stakeholder group. While in the short-term, there is clear evidence that foreign direct investment will support the type of economic growth that drives job creation, in the longer-term, the relationship between investment and job creation is less linear. Workers know this and it explains lingering doubts among the working classes about the trajectory of Iran's economic development.

Automation looms large over industrial sectors around the world, and Iran is no different. The arrival of what is being called the “Fourth Industrial Revolution” was the focus of the 2016 World Economic Forum in Davos. The “Future of Jobs” report published during as part of the annual gathering made waves for its prediction of rapid and dramatic shifts in the composition of workforces worldwide. The report predicted over 1.6 million lost jobs in the manufacturing sector by 2020 across a sample of 20 countries that included developed economies such as the United States, Germany, and Japan, as well as rising economies such as China, India, Brazil and South Africa.

While Iran was not one of the country’s sampled in the report, the findings did cover Turkey, which is a strong proxy for Iran given the similar size and composition of its labor force. Employment in the manufacturing sector will actually increase in Turkey through 2020. Similar increases are forecasted for Mexico and South Africa. The report evidences how the pace of economic growth in emerging markets in the next 5-10 years will mean an expansion, rather than contraction in blue-collar jobs. The trend should hold true for Iran.

However, the report’s authors also note that the implementation of automation technologies will only begin to gain momentum globally between 2018 and 2020, when “Advanced robots with enhanced senses, dexterity, and intelligence” which “can be more practical than human labour in manufacturing” begin to account for a greater number of the roles on the production line. Realistically, the adoption of these expensive technologies in less-developed economies such as Iran will take place later, but as adoption increases the next generation of automation technologies will become less expensive in the same period when Iranian labor begins to grow more expensive as wages rise during the post-sanctions economic recovery. This combination of events will make automation even more appealing. Inbound investment will be used to improve efficiency and productivity in the manufacturing sector and capital intensive automation will be justified based on economies of scale made possible as Iran’s exports rebound.

Already, companies like German robotic arm manufacturer Kuka have helped modernize the assembly lines at Iran Khodro and other Iranian automakers. While such improvements to efficiency have helped Iran’s auto-industry become more competitive by international standards, thereby justifying the new wave of potential investment from the likes of Renault, Daimler, and Volkswagen, the long-term profitability of these sectors could depend on reductions to the workforce.

The experience of European automakers in their domestic markets is instructive. On average, a European Union auto worker produces the equivalent of 7 vehicles per year. In Iran, which has approximately 500,000 autoworkers and an annual vehicle production of about 1 million, the worker-to-vehicle productivity ratio is just 2. In the medium-term, an improvement in Iran’s productivity ratio would necessitate both increases in automation and also reductions to the workforce.

For the Rouhani administration, this presents a stark dilemma. How do you usher in an economic agenda to serve the people, if the new agenda will also usher in technologies that could upend employment opportunities for the working classes?

Over the last few years, many of Rouhani's critics have taken to labeling him a neoliberal, the implication being that his pursuit of economic growth will come at the expense of blue-collar workers. Rouhani's ability to address the concern will depend on his ability to ensure that "knowledge transfer" follows investment. 

When asked how they intend to manage impending shifts in labor markets, 65% respondents in “Future of Jobs” report cited “reskilling current employees” as the fundamental strategy for basic industries, including blue-collar work such as manufacturing and construction. But while rich countries like Switzerland and Sweden that face this dilemma can experiment with ideas such as universal income or mass retraining of the workforce, for Iran, these issues are far more delicate. 

As World Economic Forum founder Klaus Schwab and board member Richard Samans write in the preface of the report:

It is critical that businesses take an active role in supporting their current workforces through re-training, that individuals take a proactive approach to their own lifelong learning and that governments create the enabling environment, rapidly and creatively, to assist these efforts.

For the biscuit company, the opportunities to retrain staff for new roles are numerous. Whereas 200 individuals work in the company, just a dozen are involved in the distribution and sales of the company's products. There are essentially no formalized teams in sales and marketing, business services, retail partnerships, human resources, or corporate and legal affairs despite robust annual revenues. So while the overall proportion of manufacturing labor may decline, the growth of companies like the biscuit maker, should also open the door to opportunities in other job roles.

Looking to the breakdown of the Mondelez workforce in the UK, of the 5000 total employees, two-thirds are directly involved in manufacturing. By this standard the Iranian biscuit company should have nearly 10 times the current number of commercial staff given the size of the manufacturing staff. 

Indeed, the "Future of Jobs Report" forecasts job growth in business and financial operations, management, and sales functions across the sampled countries. For Iran, the challenge will be to make sure blue-collar employees are empowered to make the leap into these new roles. 

Photo Credit: Bourse & Bazaar

Masters of Montage: Peugeot and Iran's Auto Industry

Earlier this month, Iran's leading auto manufacturer, Iran Khodro (IKCO), announced the re-entry of its French joint venture partner PSA Peugeot Citroen into the Iranian automobile market. The new deal carries special significance as it brings with it the potential for new models to be introduced into an Iranian market where designs created in the 1980s are still produced and sold. Additionally, the announced deal would see 30% of Iranian produced Peugeot cars exported to regional markets. As Iran Khodro’s managing director Hashem Yekke-Zare emphasized, the deal promises to create a regional auto manufacturing hub in the Persian Gulf.  

Speaking to the breadth of the deal, Yekke-Zare said "the terms and conditions of the contract are not comparable with any of the previously signed agreements with Peugeot." The news of the revised auto-production deal even managed to get Iranian investors excited as shares of Iran Khodro nudged up despite a stock market still sluggish given the lack of positive indicators from the ongoing nuclear negotiations.

While news of the new joint-venture was only reported in the Iranian press, leaving its veracity unclear, the importance of a possible nuclear agreement to a resurgence in automobile manufacturing in Iran, particularly by Renault and Peugeot, has been long anticipated in the international business press.

As part of the new deal, Iran Khodro would be expected to meet Peugeot's production guidelines in an effort to bring the Iranian-made cars in line with the overall international standard. The Peugeot 405 GLX and Peugeot Pars (405 variant) remain big sellers among locally produced cars for their low price and plentiful supply of locally produced spare parts. But the overall build-quality lags behind the French-made versions, and a new manufacturing agreement would seek to remedy this.

Iran’s auto industry has typically relied on the domestic assembly of foreign models, a process known locally by the French term montage. In the mid-twentieth century, Iran Khodro democratized car ownership in Iran by producing the tough and affordable Paykan, which was based on the British Hillman Hunter design. In subsequent years, French brands became more popular.

After the Islamic Revolution of 1979, both Iran Khodro and its main competitor Saipa, struggled to sign contracts with foreign joint venture partners. Eventually, Saipa would begin the domestic assembly of the much maligned, but now ubiquitous South Korean designed Kia Pride. Iran Khodro produced a more premium product in the form of the French designed Peugeot 405 sedan and 206 hatch. All three of these models have been produced in their millions in Iran (IKCO's top year of production was 2011, with 1.7 million vehicles produced).

The sanctions relief permitted for Iran’s automotive industry as part of the 2013 Joint Plan of Action agreement did enable a 43% rise in production in 2014 (after an effective industry shut down in 2012-2013), supported by increased demand due to a stabilizing economy. In terms of market share, available figures from January 2015 suggest that the Peugeot 405 was the top selling car in Iran, outpacing the much cheaper Saipa Pride. The higher-end version of the 405, the Peugeot Pars, was also a strong seller, with a 54% increase in production.

Usually, such strong sales figures would be a signal of a healthy auto industry. But in Iran, the huge demand for these dated models speaks more to an overall dearth of options. 20 year old designs continue to roll off assembly lines, having had only minimal upgrades. Iranian consumers are ready for newer, safer, and more efficient models.

For this reason, excitement over a new deal with Peugeot serves as a reminder of the tough times that had befallen the Iranian automotive production industry over the last decade. If the reports in the Iranian press are to be believed, Peugeot is angling to take advantage of their market dominance by offering new models for montage. Yet, despite the fact that the Peugeot lion logo is affixed to so many cars in Iran, it is hard to say whether Iranians will remain brand loyal when more options arrive in the market. Already, Chinese, Korean, and even domestically designed IKCO models are chipping away at Peugeot’s traditional market share.

Time is not on the company's side. Sooner or later a nuclear deal will be reached, and Iranian car companies small and large, new and old are likely to be offered a wide variety of contracts to produce a wider range of models. How will the Iranian car auto manufacturing look in five years? The jury is out on the direction of the industry, but a look into the state of the competition serves as a potentially useful guide.

Renault, Peugeot's largest competitor in both France and Iran, has also prepared itself for an eventual easing of sanctions. The company recently offered two new "affordable" models to Iranian consumers in the way of the latest versions of the Renault Clio and Captur models.

Renault is actually the French company to most recently introduce a new model to Iran, providing complete knock-down-kits (CKDs) of its Tondar model, sold in Europe as the Dacia Logan. Significantly, Renault’s strategy offers a different look into how cars are produced and sold in Iran. Renault has not employed the same JV tactics that Peugeot has favored, rather licensing its Tondar model for production by three Iranian companies.

Further, the Wall Street Journal reported in January that Renault last year wrote off about €500 million (roughly USD $580 million) that it had accumulated over the years from sales in Iran, stating that under current banking restrictions it cannot repatriate the money. In what would be a bold strategic move, Renault executives have discussed buying a stake in Iranian manufacturer Pars Khodro using some of those stranded funds, according to people familiar with the matter.

Saipa, Iran's second largest producer has also been on the offensive in recent years. The company most notable for the multiple iterations of the 1980's boxy Kia Pride or Saipa 131 has begun producing knock-down-kits from a range of Chinese car manufacturers–nine models in all–along with a four locally produced small cars. The jump in the number of models with Chinese automotive makers underscores the tenuousness of Peugeot’s market advtantage.

Consumer reports suggest that Iranian car buyers will quite happily make the jump to other car brands, and increasingly to Chinese brands. Iranian car buyers have tired of the cars offered by the oligopoly of local producers and yearn for newer models (updated dashboard and facelifted headlights no longer suffice). Moreover, apprehensions of the quality of Chinese cars are slowly diminishing due to the continually improving safety ratings of the updated models.

Modiran Vehicle Manufacturing (MVM) produces local versions of popular low cost models of China's Chery Automobiles. MVM sought to compete directly with IKCO and Peugeot with inexpensive cars for Iranian consumers. Appreciating the up-to-date styling and features, Iranian drivers took up their offer in their droves. These days, many of the smaller vehicle manufacturers in Iran have either started producing or hope to produce  variants of Chinese cars. This is likely the largest threat to Peugeot and Iran Khodro in the next 5 to 10 years. This also explains Saipa’s stance of doing away with expenditure on R&D and throwing its lot in with Chinese manufacturers.

The future of Iran’s automotive industry will drive the country’s manufacturing sector at large. Iran’s ability to both diversify its economy, and capitalize on its strong consumer base will depend on the capacity for companies like IKCO and Saipa to produce desirable cars. The principal question is whether the bulk of those cars will be of French, Korean, Chinese, or even domestic designs. The longstanding prevalence of Peugeot may be fortified in the aftermath of a nuclear agreement, but inroads by France’s Renault, Korea’s Kia and Hyundai, and Chinese brands like Chery, may change the composition of Iran’s streets and highways for good. 

Photo Credit: Ran When Parked