The Stunning Collapse of Iran's Currency

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 neighbors, 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-publicized 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, immortalized 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 with Charlie Rose 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 rial's for dollars. The unofficial or market rate is the rate rials change hands on the open market in Tehran.

Sources: Official rate data from OANDA.com. Market rate data from NPR's "Iran Currency Tumbles" and "Growing Pressures Prompt Plunge in Iranian Currency," and AFP.com's "Iran Currency Tumbles."

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. (more)