Iran's Exchange Rate System and the Political Economy of Collapse

Written by Amaya Lilles, MSc Development Management, Applied Development Economics

The protests that erupted across Iran in late December 2025 were rooted in economic collapse ①—decades of inflation, a currency in sustained freefall, and the cumulative weight of international sanctions had eroded living standards ② to a breaking point. What may be less obvious is why a specific policy reform served as the immediate trigger, and why the merchant class at Tehran's Grand Bazaar ③, historically one of the regime's most durable political constituencies, was among the first to mobilise. The answer lies not in economics alone, but in the political architecture the economy had been sustaining.

The immediate trigger was a sharp collapse of the rial, which fell from roughly 1.07 million to the dollar in early November 2025 to 1.4 million by late December, its lowest recorded level, driving food prices up by over 70 percent and pushing small traders to the edge of viability. What began as a strike by shopkeepers quickly spread to more than 400 cities, drawing in students and the urban middle class, and prompting a violent crackdown that human rights organisations say killed thousands.

This article discusses the macroeconomic and political economy dimensions that sit beneath the surface of the crisis. It attempts to shed light on how Iran's multi-exchange rate system ④ functioned not simply as a failed subsidy policy, but as the mechanism through which the Islamic Republic sustained political loyalty after oil revenues declined. When President Masoud Pezeshkian eliminated that system last December, he removed a corruption mechanism that was economically indefensible and simultaneously severed a clientelist relationship between the state and its merchant base. Understanding that distinction between economic reform and political rupture is instructive both for reading what has unfolded since and for situating Iran's crisis within the broader geopolitical contest ⑤ now playing out over sanctioned oil flows, shadow financial networks, and the question of whether economic coercion produces political change or simply state collapse.

The Rentier Social Contract

A useful starting point is rentier state theory, a framework first developed specifically to explain Iran. In 1970, Iranian economist Hossein Mahdavy identified ⑥ the structural problem of states whose revenues derive overwhelmingly from external resource rents rather than domestic taxation. Economists Hazem Beblawi and Giacomo Luciani formalised this in The Rentier State (1987) ⑦: because rentier governments do not need to tax their populations, the conventional accountability mechanism (responsiveness in exchange for revenue) is inverted. The state purchases political compliance through distribution rather than earning legitimacy through governance.

Iran's government derived as much as 60% ⑧ of its annual budget from oil revenues as recently as 2009. This allowed the Islamic Republic to sustain a functional, if fragile, social contract that included subsidised energy, food, and housing in exchange for political passivity. Decades of oil dependency produced classic symptoms of Dutch disease: non-oil sectors atrophied, leaving the state exposed once sanctions began constraining the resource revenues it depended upon. As rounds ⑨ of U.S. and international sanctions progressively curtailed Iran's oil export capacity, that contract came under severe strain. The government faced the problem of how to maintain political loyalty when the resource base financing that distribution was collapsing. The multi-exchange rate system, formalised in 2018 following the U.S. withdrawal ⑩ from the nuclear deal and the reimposition of maximum pressure sanctions, was its most consequential attempt to manage that erosion.

Exchange Rate as Political Architecture

Introduced under President Hassan Rouhani in 2018, the preferential exchange rate fixed the dollar at a subsidised rate for approved importers of essential goods, ostensibly to shield domestic prices from sanctions-driven currency depreciation. Iran operated up to eight ⑪ distinct exchange rates simultaneously, with the open market rate reaching nearly five times the preferential rate by early this year. The gap between those rates was not a technical inefficiency, it was a transferable rent. Any actor with political access to cheap dollars could convert that access into profit, through import arbitrage or by redirecting foreign exchange toward capital flight rather than the essential imports it was allocated for.

This is clientelism enacted through foreign exchange allocation. The regime handed out access to a price distortion, and in doing so constructed a distributional coalition of commercially powerful actors whose interests were tied to the continuation of the system. The merchant class did not support the state despite the dysfunction of the Iranian economy; they supported it because the dysfunction was the source of their rent.

The outcomes were distributionally inverted. Between $15 and $18 billion ⑫ annually was channelled through the preferential rate system at its peak, resources flowing primarily to politically connected intermediaries, not to the consumers the system was designed for. Financing the gap between subsidised and market rates required the central bank to monetise the deficit (fiscal dominance), which drove chronic inflation averaging around 40% ⑬ annually. A 2025 World Bank forecast ⑭ projected this would push an additional 3 million Iranians below the poverty line by 2026/27. The rent flowed upward and the inflation landed on everyone else.

The Political Cost of Economic Reform

President Pezeshkian came to office in July 2024 ⑮ on a platform of economic reform. On January 1, 2026, he announced the elimination ⑯ of the 285,000-rial preferential rate, replacing it with a monthly direct transfer of 10 million rials (approximately $7) per person across roughly 80 million Iranians. An academic researcher at the University of Isfahan ⑰ concluded the reform was unavoidable in the long run, noting the system had "in practice become a driver of inequality and economic instability." Iran's Minister of Economic Affairs described ⑪ the preferential rate as "a platform for corruption, speculation and market instability."

By development economics standards, this was the correct policy direction. Exchange rate unification is a common prescription for economies suffering from capital flight, inflationary pressure, and productivity distortions that multiple rates produce. The problem was one of reform sequencing, or the principle that the order and conditions under which structural adjustments are implemented matter as much as the reforms themselves. The adjustment landed on an economy already experiencing 42% annual inflation ⑱ and a currency that had lost over nearly half its value in 2025 alone. The elimination of the subsidised rate caused immediate price increases on any good previously imported at the preferential rate. The $7 monthly transfer was a regressive compensation that was too small to offset the price increases that fell hardest on those least able to absorb them.

Under the multi-exchange rate system, inequality was mediated through opaque bureaucratic allocation. Ordinary Iranians knew the system was distorted but could not easily quantify their losses. When the subsidised rate was eliminated, market prices landed on household budgets visibly, making the inequality concrete and immediate rather than hidden and abstract. 

What makes Iran's case distinctive is the additional layer of elite political economy. The Grand Bazaar merchants who triggered the December protests were, for decades, beneficiaries of the distortion Pezeshkian removed. When he unified the exchange rate, he dismantled a corruption mechanism and stripped a politically influential constituency of its rent. The protests that followed were partly genuine economic despair among ordinary Iranians, and partly political backlash from commercial elites whose access to state-distributed rent had been cut off.

Pezeshkian initially called for dialogue, a position that collapsed once protests shifted from economic demands to calls for the end of the Islamic Republic. At that point, the distinction between reformists and hardliners became immaterial, as both depend on the same system for their power and survival. When Supreme Leader Ali Khamenei ordered ⑲ live fire on protesters in January 2026, Pezeshkian did not object. The crackdown, in which estimates of those killed range from several thousand to upwards of 30,000 ⑳, was not a hardliner operation a reformist president was powerless to prevent. Rather, it was a system protecting itself.

The Geopolitical Dimension

Iran's domestic crisis does not sit in isolation. The exchange rate system was one component of a wider shadow architecture that sanctioned states constructed to survive Western economic coercion. Iran, Venezuela, and Russia built an integrated network of approximately 1,000 shadow-fleet tankers ㉑ and parallel financial channels that allowed oil to move outside Western regulatory oversight. China was the principal beneficiary, absorbing roughly 80% ㉒ of Iran's 1.38 million barrels per day of exports at significant discounts last year. Venezuela supplied oil and commodities in exchange for Iranian fuel and technical support, with documents suggesting Iran's total financial exposure in Venezuela reached approximately $4.7 billion ㉓. This network kept Iran's sanctioned oil revenues moving and the preferential dollar system supplied with the foreign exchange it needed to function.

The Trump administration's moves in early 2026—capturing Maduro ㉔, blockading Venezuelan oil tankers ㉕, intercepting the Bella 1 shadow-fleet ㉖ vessel allegedly carrying sanctioned oil for Venezuela, Russia, and Iran, and reimposing maximum pressure sanctions—should be understood in this context. Venezuela's removal as a partner directly reduced Iran's capacity to route oil revenues through alternative channels. Israel's June 2025 military strikes ㉗ on Iranian nuclear facilities accelerated the rial's collapse and drained investor confidence. Three months later, the UK, France, and Germany triggered the UN sanctions snapback ㉘ mechanism under the expiring 2015 nuclear deal, reimposing the full suite of pre-deal sanctions, freezing Iranian assets abroad. By the time Pezeshkian's reform landed in December 2025, the foreign exchange reserves the preferential rate system depended upon had already been depleted by successive exogenous shocks.

The exchange rate reform, while economically necessary, was politically unsurvivable by the external environment. Pezeshkian lacked authority over security forces and had no credible path to the one intervention—a diplomatic settlement with the US and Israel—that could have provided meaningful economic relief quickly enough.

Iran's case illustrates that sanctions regimes and domestic governance failures do not operate in silos — the multi-exchange rate system, the shadow oil network, and the protests that followed were each simultaneously domestic and external in origin. The U.S. dismantled, over several administrations and with accelerating intensity under Trump, the parallel architecture Iran constructed to survive those sanctions: the shadow fleet, the Venezuelan partnership, the Chinese discount oil trade, and the 2015 nuclear deal, which had been the one viable path to sanctions relief. Iran's nuclear programme, the original source of that framework's collapse, remains the unresolved variable that makes a diplomatic settlement unavailable. The exchange rate reform was simply the point at which that accumulated pressure reached ordinary Iranians.

Writing in Forbes, Melik Kaylan ⑤ frames the human stakes plainly: “The supposed beneficiaries of the policies—the suffering populace of Venezuela and Iran—are seeing no rewards at all for their agonies.” History offers little evidence that economic collapse produces democratic transitions. More often it produces instability, contested power, and prolonged human cost. Iran is already losing the human capital any reconstruction would require, with educated youth emigrating, institutions weakening, and productive capacity declining. These costs, borne by Iranians, will outlast whatever political settlement eventually follows.

Sources 

① Maziar Motamedi, « Iran’s government budget reveals tough road ahead as currency hits new low », Al Jazeera, 26 December 2025.

② Simon Speakman Cordall, « Why is Iran’s economy failing, prompting deadly protests? », Al Jazeera, 16 January 2026.

③ Najmeh Bozorgmehr, « The historic bazaar where Iran’s protests began », Financial Times, 14 January 2026.

④ Maziar Motamedi, « Why does Iran have three foreign exchange rates? », Al Jazeera, 2 July 2019.

⑤ Melik Kaylan,« What Next For Iran And Venezuela? », Forbes, 9 February 2026.

⑥ Hossein Mahdavy, « The Patterns and Problems of Economic Development in Rentier States: the Case of Iran », Studies in the Economic History of the Middle East,1970.

⑦ Hazem Beblawi and Giacomo Luciani,« The Rentier State », Routledge, 1987.

⑧ Mohammad Reza Farzanegan and Gunther Markwardt,« The effects of oil price shocks on the Iranian economy », Energy Economics, January 2009.

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⑩ European Parliament,« US withdrawal from Iran nuclear deal », European Parliament, 18 May 2018.

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㉑ Max Lin,« FACTBOX: Shadow fleet expands to maintain sanctioned oil flows », S&P Global, 3 September 2025.

㉒ Reuters, « China's heavy reliance on Iranian oil imports », Reuters, 13 January 2026.

㉓ Umud Shokri, « What Iran stands to lose after Maduro's downfall », Iran International, 6 January 2026.

㉔  John Curtis,« The US capture of Nicolás Maduro », UK Parliament House of Commons Library, 6 January 2026.

㉕  Loulla-Mae Eleftheriou-Smith, « US intercepts tanker in Indian Ocean after it evaded Venezuela blockade », BBC, 24 February 2026.

㉖  Jaroslav Lukiv and Ana Faguy,« US seizes two 'shadow fleet' tankers linked to Venezuelan oil », BBC, 7 January 2026.

㉗  Al Jazeera, « Israel-Iran conflict: List of key events, June 20, 2025 », Al Jazeera, 20 June 2025.

㉘  Foreign, Commonwealth, and Development Office, « E3 joint statement on Iran: activation of the snapback », UK Government, 28 September 2025.