TEHRAN Tehran does not look like a city under siege.
Its shops and markets are full of goods and customers; signs that international sanctions are ravaging Iran's economy are hard to detect.
With global oil prices above $100 a barrel, the world's fifth biggest oil exporter is proving it can cope with trade and financial restrictions that the United States and Europe hope will force a halt to its controversial nuclear programme, which is suspected of seeking to build an atomic bomb.
That helps to explain the Iranian government's continued defiance as the West considers fresh sanctions that would take direct aim at the country's oil income.
"Sanctions do not turn off the money spigot, even while they may force re-routing of money flows through new third-party actors -- foreign banks unaffiliated with the U.S., for instance," said Kevan Harris, an Iran expert at Johns Hopkins University in the United States.
International sanctions imposed over the last five years have so far banned most U.S.-Iran trade, caused many shipping companies to cut back services to the country, and made it difficult for Iranian banks to do business with Western banks.
But in the vast majority of cases, that does not appear to have stopped Iranian factories from operating or everyday products from reaching shelves in shops. Imports can be obtained from new suppliers and ships run to different foreign ports, many of them in Asia, analysts say.
The sanctions are mainly being felt in the form of inflation, which is hitting some companies' bottom lines as well as consumers' wallets.
In a well stocked greengrocer's in central Tehran, the shopkeeper and an elderly customer exchange the obligatory courtesies known in Iran as "t'aarof".
"There's no charge" for her purchases, the shopkeeper tells her with customary politeness.
After she insists on paying and he reveals that the small bag of fruit costs more than $10, she drops the social niceties and exclaims: "How much? Are you sure?"
The official inflation rate stands at just under 20 percent -- up from a 25-year low of 8.8 percent in August 2010. According to an International Monetary Fund report based on government data, Iran can expect consumer price inflation of 22.5 percent for the fiscal year ending in March 2012.
Many Iranians believe the statistics grossly underestimate the true cost of living, which is eroding their spending power in a country where the average monthly household income in urban areas is just 10 million rials (around $750) and unemployment is estimated at 14.6 percent.
Most of the rise in inflation can be put down to President Mahmoud Ahmadinejad's decision to abolish billions of dollars of government subsidies that until one year ago had held down the prices of gasoline, food and utility bills.
But sanctions -- particularly those passed by the EU in July 2010 which made it difficult to transfer cash in and out of Iran -- have also pushed up prices, analysts say.
Because of the EU sanctions, Western banks no longer offer Iranian importers letters of credit, the common way of paying for products in international trade.
That forces importers to pay for their goods with other means, including through banks that have branches in countries in the Middle East and Asia where the sanctions do not apply, or through money exchange bureaus.
Not only does that deprive importers of good terms of credit, it obliges them to pay the free market exchange rate for foreign currency, making dollars or euros much more expensive than the official Iranian central bank rates indicate.
Dollars bought in the open market cost almost 20 percent more than the official rate posted by the central bank, which is struggling to maintain the value of the Iranian rial in the face of speculative buying of hard currency inside Iran.
Imported goods from Europe have become more expensive in Iran not because the products themselves are banned, but because of the added costs due to channeling payment for them through third parties.
A businessman who runs a paint factory near Tehran said sanctions had forced him to look elsewhere for a chemical additive that he once imported from Germany, but had now become too expensive to buy from German suppliers.
"It isn't a static situation, it's changing day-by-day," he said, adding that while all products would continue to find their way to the Iranian market, costs would continue to rise.
Some businesses are obtaining favourable letters of credit from banks in South Korea and China as exporters there seek to make up for waning demand in the economically weakened West.
"At the end of the days it's the people who are losing their buying power...They will feel it in six months, eventually they will pay the price, there's no doubt," the businessman said.
The ability of the Iranian economy to keep functioning in such adversity is at least partly responsible for the decision of the West in the last several months to consider additional sanctions, and for Iran's defiance in the face of the threat.
The European Union may stop buying the 18 percent of Iran's oil shipments that it imports. And the U.S. Congress is pushing for measures that would penalise foreign banks doing any business with Iran's central bank -- potentially a heavy blow against the body which takes payment for the 2.6 million barrels of oil that Iran exports per day.
The sensitivity of targeting the Central Bank of Iran was demonstrated two weeks ago after Britain, before any similar action by its EU partners, banned all its financial institutions from doing business with the country including the central bank. A mob stormed the British embassy compound in Tehran.
Iran's mild-mannered foreign minister, Ali Akbar Salehi, expressed "regret" at the violence but he said London only had itself to blame. "Britons angered the Iranian people with their stance," he said.
London's move was largely symbolic as few if any British banks have business with Iran or its central bank. The threat from Washington is far greater, as banks around the world would face being frozen out of the global financial system if they continued to trade with Tehran.
So far, however, Iranian politicians and media say they doubt the EU will ban Iranian oil or that Washington will push ahead with isolating the central bank completely.
"Greece, Italy and Spain are Iran's top oil importers (in the EU), and they have the most fragile markets as well. Any disruption of oil flow will cause an energy crisis in those countries," an Iranian Oil Ministry official said.
That analysis is to some degree shared by many Western diplomats and traders contacted by Reuters. Officials in the Obama administration have said they oppose hitting Iran's global oil exports or its central bank, because of the potential impact on the world's economy, although pressure for such a move has increased in Congress.
"Europe and America cannot seriously put the sanctions into practice and the Islamic Republic has the upper hand in the current situation and can take advantage from the existing circumstances," Parviz Sorouri, a member of parliament's national security committee, told the Fars news agency.
Oil Minister Rostam Qasemi said sanctions on Iranian oil would hurt the global market and that Iran would have "no problem to find a replacement for the EU".
(Editing by Andrew Torchia)
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