Following his recent re-election, Iran’s president Hassan Rouhani is keen to prioritise the economy in his second term, pushing for further softening of Western sanctions, encouraging investment, and promoting growth.
Some of that progress is already underway, as indirectly evidenced by the strong mandate the Iranian leader received from the population this month.
The long-awaited (albeit partial) easing of the US-led sanctions following the Obama administration’s nuclear deal with Iran was expected to open the floodgate of foreign investment in one of Middle East’s largest and most diversified countries in 2016.
The country, which holds the world’s second largest known natural gas reserves and fourth largest oil reserves, was able to hike production by nearly 4 million bpd, or around 20%, while keeping, for now, the advantage of being exempt from OPEC cuts.
According to a Euler Hermes report, inflation in Iran dropped to 10%, a 27-year low, down from 30.8% just four years ago, largely thanks to cheaper import costs. GDP growth remains healthy, dropping only 0.2% to 3.8% in 2017 from 4% in 2016.
It also boasts strong fundamentals, particularly impressive in light of the prolonged sanction-induced recession; these include a huge domestic market, US$70bn worth of currency reserves, low external debt and a continued current account surplus, which is expected to pass the 3% of GDP mark in the next two years.
The positive dynamic between Washington and Tehran emerging on the back of a hard-fought nuclear deal (under which Iran agreed to wind down its nuclear development programme) is bearing fruit. In 2016 Iran has attracted over US$12bn worth of foreign direct investment, making it the second largest FDI destination in the MENA region, according to FT’s FDI Intelligence report. Over half of that came from Germany and Spain, but a range of countries from the UAE and UK to China and Russia also contributed to this spike.
Iran ranked sixth in the region in terms of projects undertaken by foreign investors, with a total of 59 projects in 2016 representing an impressive 556% jump year-on-year. Tellingly, most of these projects and contracts were linked to energy markets, with France’s Total and Italy’s Eni dipping their toes in Iran’s gas fields.
Aberdeen Asset Management portfolio manager Kevin Daly admits some progress has been made, but is exercising caution.
“To turn that trickle into a stream, you need a strong lobby from US institutions to complain that other countries are getting an unfair advantage due to US sanctions, which is yet to appear. So for now, for portfolio managers like myself, Iran remains a no-go area.”
The continued reliance on oil and gas sectors, which account for 23% of GDP and over 50% of export receipts, while offering some short-term respite, may be detrimental to the economy in the long term.
Effects of that are visible already, under the surface. Unemployment remains high at 12%, and real interest rates have drifted above 10%, which has weighed on domestic lending. Outside Tehran, inflation-adjusted household expenditures fell during Rouhani’s fiscally austere first term, while poverty rose, with a million more people living below the poverty line than before he was elected, according to research by Cairn.
Part of that is down to a huge drop in state spending, which as a percentage of GDP has in previous years fluctuated around the low 20s, but has been closed to 5% under Rouhani. The deeper cause can be found in the structural issues within Iran’s economy, namely in the banking and the financial sectors.
While the need for economic diversification is on everyone’s minds in the Middle East, Iran is particularly hard pressed because the lack of a functioning financial sector and hard-currency -starved banks means capital has to come from abroad.
Iranian lenders are facing a squeeze from both sides, burdened with NPLs that are a legacy of the previous regime, and unable to return to international markets due to remaining sanctions.
According to Garbis Iradian, IIF’s Chief Economist in the Middle East, Iran’s nonperforming loans to total loans exceed 12%, well above the average of 3% for the GCC. The capital adequacy ratio has continued to decline from 8.5% in 2012 to slightly less than 6% in 2016. Profitability remains constrained by the high cost of funds.
“The banking sector in Iran is the weakest sector in the economy,” Iradian admitted. “Continued public payment arrears, connected lending, and poor management of the banking system has weakened the balance sheets of banks. Iranian banks need large capital injections, management restructuring, and governance improvements.”
“Without bank financing or access to hard-currency, there are limited financing options,” echoed Daly. “They can do project financing, in non-dollar currencies, securitisations – there are definitely things they can do outside the sphere of the dollar. But non-US domicile institutions are still fearful of dealing with the Iranians because they don’t want to cross the US.”
Another major drawback is the two-tier exchange system, under which the free market rate that stands at 37,600 rials, while the CBI’s official rate is 32,446 rials. While the government intended to tackle the FX issue last autumn, those plans were indefinitely delayed amid growing volatility in emerging market currencies and oil markets.
Still, Rouhani’s administration has made some progress. His administration began reforming the troubled banking sector, introducing new anti-money laundering and anti-extremism laws that ought to boost transparency, as well as bringing Iranian banks closer to compliance with Basel III regulations.
But this reform programme still lags behind commitments made to the Financial Action Task Force and its action plan, and more work needs to be done, particularly in encouraging the development of capital markets. Whether he can pull it off is still up for debate.
“President Rouhani may now be in a stronger position to push through laws needed to liberalize the economy, reduce corruption, attract foreign investment and raise productivity,” thinks Iradian. “While hardliners still control the judiciary, the security and military forces, and intelligence agencies, Rouhani and the reformists will gradually gain a bigger say in key decisions. A major challenge of Rouhani’s agenda is to open up Iran’s isolated economy to foreign investors.”
But Daly is unconvinced. “What is evident at this stage about Rouhani is that he is still not really calling the shots. The mullahs still wield a lot of power, even if he is still president in title. He was given the permission to negotiate a deal with the West, and it was in the theocracy’s interest, which received a lot of criticism from the US, because many saw Iran being given too many concessions, and the deal is still seen as being one-sided by some.”
As a result, Iran’s chances of entering international bond markets remain remote. Asked about a possible timeline for a bond issuance program by the Iranian government, the country’s Central Bank Governor Valiollah Seif recently told Fars News Agency that the country hopes to tap the debt markets, but refused to give any specific dates.
"That will be when the country must issue bonds in the international markets and that is when we become certain that there is demand for our debt," he responded vaguely.
...and the Ugly
Ultimately, US sanctions maintain a glass ceiling for Iran’s economy and their damage can only be managed or minimized, but not overcome, beckoning important questions about what US policy towards Iran will be going forward.
Trying to predict Trump’s future approach is an exercise in futility, but his first foreign trip to the region led to a US$110bn deal with Saudi Arabia and a flurry of smaller deals with others. Iran, on the other hand, was met with Trump’s trademark Twitter storms targeting the Islamic republic, seemingly in an attempt to strike a resonant chord with allies by targeting a common enemy in the region (Trump also visited Israel on the same trip).
Outside Iran, many saw the strong mandate given to Rouhani in the latest election as a signal of the population’s commitment to reform and a rebuke of its hardline image. But some fear that signal will fall on deaf ears.
“I don’t think the election is going to have any impact,” Daly conceded. “The economic sanctions from the US are still the decisive factor here, especially now that Donald Trump has put his cards on the table.”
“He’s backed away from his claims to tear up the agreement because he realised that there are other stakeholders in this deal, so the US would struggle to tear it up unilaterally. But as an investor, nothing has changed in terms of our ability to invest in potential bonds from Iran.”
Iradian also pointed to potential divergence of US policy from Europe’s and Asia’s.
“Rouhani must deal with an unpredictable Trump administration. And there is substantial pressure in Congress for tighter non-nuclear sanctions on Iran. However, new sanctions by the US may not be effective without the participation of Europe, China and Russia,” the economist noted.
Filling the Gap
As the recent anti-globalist sentiment emanating from the US continues to alienate the country from the rest of the world, it might be worth keeping an eye on other players willing to fill the void.
More than half of the 29 companies allowed to bid for Iran's much-anticipated first tender on oil and gas projects were from Asia or Russia. "They can get a cheap solution from the Chinese or an off-the-shelf one from the Russians," one EU diplomat told Reuters. "That's not a long-term solution, but it might be what they're left with."
Recently, Total became the first European energy major to put real money into Iran since sanctions were lifted, striking a US$2bn deal to help develop South Pars 11, part of the world's largest gas field.
Iran is also in talks with Britain's export credit agency to facilitate the financing of aircraft sales to state airline IranAir, according to senior Iranian officials. IranAir plans to buy more than 180 jets from Airbus and Boeing, with Trump’s silence on the latter deal indicating some inherent contradictions between his domestic economic agenda and foreign policy. The recently-inked deal with the KSA could make America’s easing up on Iran a more remote possibility than was the case previously.
“Iran needs to improve the business climate to attract international investors. Business discrimination, legal uncertainty, and widespread corruption continue to hinder a strong recovery in investment,” concluded Iradian.
“Iran is unlikely to become a big part of the US government agenda. Even someone who might replace Trump would not risk jeopardizing the trade deal with the Saudis, so we don’t expect the sanctions to be lifted anytime soon,” Daly added.
If Iran follows through on its promises and continues on path of reform, growing its economy and pushing to integrate with Western markets, US sanctions will be blocking a growing crowd of suitors. It may become increasingly difficult for the US to stand in the way of that crowd, and to see a potentially lucrative market fall into the hands of their biggest competitors.