Iran Plots Path From Sanctions to Action

Euromoney, September 2015

We don’t want to rain on anybody’s parade, but the expected removal of sanctions from Iran – probably between the end of the year and Easter – is not going to lead to a flood of immediate investment and a warm welcome back into the fold of international finance. Those things will happen. But they are going to take years.

The mood in Tehran is cautiously optimistic. After years under sanctions, there is a palpable fear that something could still go wrong to derail sanction relief – most obviously a vote against it in Congress so overwhelming that Obama can’t veto it – but nevertheless, people are planning ahead for brighter times. And as they plan, financiers realize that a great many further challenges await, some of the real, some a function of misperception or fear.

“If developments go according to expectations, then the impact will be enormous,” says Ahmad Azizi, senior advisor to the governor of the Central Bank of the Islamic Republic of Iran. “But I very much doubt we will see things along those lines. Although the JCPOA [the Joint Comprehensive Plan of Action struck for sanctions relief] is a tremendous development, it can’t be translated overnight into contracts, mechanisms, processes and procedures for the infrastructure of the financial system to be available for general trade and investment in the normal way.” Azizi counsels people to plan on twin tracks: “one that things move forward on a positive footing; the other that it’s bumpy and takes time.”

There’s no question Iran really needs the economic revival that should come from sanction relief. The situation is better than a year ago – after three years of recession, Iran has turned to modest growth, and inflation has dropped from disastrous (often over 40%) to merely alarming (about 14%) – but still there are problems everywhere you look, from youth unemployment to a dismal, and largely unknown, situation around corporate health and therefore the asset quality of the banking system. It’s not uncommon to hear an assumption that 30% of bank assets are non-performing, and some say even higher, though numbers like that never seem to appear in published bank data. The stock market has been bearish for 18 months now and real estate is struggling too, which would be a drain at the best of times but creates a deep problem when banks and pension funds have heavily committed to both. Pension funds are believed to be borrowing from banks just to pay their pensions out, and the problem gets worse as their existing assets decline in value. This can’t continue.

A flood of foreign investment would fix a lot of problems. If it went into the stock market, and caused it to rise, that would help the pension funds and to an extent the banks. If it prompted an increase in real estate values, even better: suddenly a lot of non-performing assets turn performing.

But that shouldn’t stop some hard work taking place to remedy bad practices. “When you are unwell, you go to a surgeon,” says the head of an Iranian brokerage. “Banks need surgery for two years or more: surgery on their balance sheet, on their investments. Surgery hurts, but it makes you better.”

Without it, there are questions as to just how likely major foreign banks are to want to come and partner with, or invest in, local banks anyway. At least one major bank admits (and probably many others think the same way) of a long-term dream that a foreign heavyweight like HSBC might one day take up a stake of perhaps 40% of the bank – the existing limit, and the central bank stands ready to lift it should there be appetite for more – with wonderful benefits flowing in either direction. But, notwithstanding the fact that the likes of HSBC are shedding rather than expanding in the region, there are just so many things in the way of it happening quickly.

To list a few: the fact that banks who have been burned for previous engagements in Iran (so that’s HSBC, Standard Chartered, BNP Paribas and Commerzbank for a start, plus anyone who’s watched them get fined) are going to be in no rush to go back; that probably no multinationals will until they have it written in black and white, ideally on US State Department letterhead, that it is unequivocally OK to go back; that for up to eight years, there will be the prospect of snapback provisions putting sanctions right back where they were in the first place, undermining effort and expense; that no major international rating agencies or auditors operate today in Iran, no matter how good locals say the Iranian equivalents are; and that it will take banks years to develop sufficient confidence on who the right partner should be and how they should work together. And that’s before considering the Iranian side, which would equally have a right to be apprehensive after having been frozen out of the international world for years. “These negotiations took a long time,” says Amir Mehran, advisor to the CEO at Bank Pasargad. “These are probably the longest negotiations in the history of the world. Even post-World War Two, the negotiations didn’t take this long.”

So nobody’s suggesting HSBC and Citi are going to be buying a bank on the day Swift gets turned back on, and instead foreign financial services will return to the Iranian fray in a series of steps. “I believe it is going to happen in phases,” says Mehran. “Smaller banks who do not have a US presence and have not been touched by US Treasury penalties will be the ones who come back to the market first.” Many expect UAE and Turkish banks to be first movers here. “The second phase will be larger European, Japanese and Chinese banks. And third, we will see at the end if US banks will ever come back to this market. Most of the JCPOA regarding banks talks about non-US entities, so the likelihood of large American banks coming at this point is not very high.”

Indeed, there is some uncertainty about who exactly is permitted or not permitted to do business together even after the sanctions come off. Pasargard, for example, believes that since it is one of eight Iranian banks that was blocked but never specifically designated for sanctions, it should be fine to return to normal as soon as the market opens, but that designated banks may not; not everyone is quite so sure, partly because some specific sanctions came under Presidential order rather than the areas touched upon by the sanction deal. Any lack of clarity will be seen by internationals as a reason to stay out, and the proof of that can be found by the reaction to the Joint Plan Of Action decision in December 2013 that it was perfectly legal to finance the export of humanitarian goods to Iran. Most banks still refused to handle Iranian letters of credit even in humanitarian, permitted areas, and readers of last year’s study of Iranian banking in Euromoney may recall one Iran-owned UK institution that couldn’t even cash its tax refund from the Inland Revenue, banks were so shy of going anywhere near it.

Ali Akbar Ahsan at Magellan Capital has been trying to explain the intricacies of the agreement to clients since it came out. On implementation day, he says, UN and European sanctions will be lifted, US sanctions waived; US secondary sanctions will be relieved in some areas, including finance, banking and insurance. “US Treasury officials have testified that Iran will not have access to the US financial system,” he says. “With the exception of four international subsidiaries of Iranian banks, US persons, or entities controlled by US persons, will be prohibited from transacting with Iranian banks.” Bank Saderat, one of the biggest in Iran, will continue to be designated under terrorism financing sanctions, he adds.

“Given that a large number of global banks have been, or currently are in, litigation with US regulators or in danger of being probed for previous misdemeanours, it would be safe to assume that they would not be at the vanguard of banks entering Iran in a post-sanctions era.

“Banks which do engage with the Iranian banking sector will face an initial minefield in regards to due diligence, anti money laundering and compliance.”

Still, just because banks don’t immediately go flooding in doesn’t mean portfolio investment can’t be quick off the blocks. As reported in our August edition, investment vehicles are already appearing even before sanctions are lifted – a recent example, from Mandalay Capital Management, is headquartered in Malta and gains its exposure through offshore participation notes and equity investments in Iran’s neighbours – and there is no question that fund managers are getting ready to engage. Turquoise Capital, which accounts for most of the (minimal) foreign capital invested in the Tehran Stock Exchange today through an investment fund it set up 10 years ago, says it has hosted 120 foreign investor delegations in Tehran in the last 18 months. “Everyone is coming, most of them European and most of them financial investors, but also industrial investors,” says Ramin Rabii, Group CEO at Turquoise. “Some delegations have two people, some have 30. Some are high net worth individuals, some are family offices, some are investment banks and some are emerging market funds. And they are all positive.” Akber Khan at Qatar’s Al Rayan investment group calls Iran “the most exciting investment destination in the world. No other country comes close.” [NB LINK TO MIDDLE EAST ASSET MANAGEMENT STORY HERE]

The investment case is easily understood: natural resources of every kind, a highly educated population of almost 80 million, and the likelihood of a boom in sectors that have been held back by sanctions, notably tourism, trade and infrastructure. Better still, valuations are around six times earnings, compared to 15 or 16 times in many other emerging or frontier markets. And the market has 550 listed companies, acceptable liquidity, and over 90 brokers in place to handle orders.

Granted, not all of these are world-leading companies, and many are convoluted holding companies of mixed merit. Iranian brokers say there is so much room for improvement in many areas of business and manufacturing that some locals mock the idea that Iran could ever have developed the nuclear wherewithal the West feared anyway. “How can we produce a nuclear programme when we can’t even make a good car?” asks one. But they offer considerable potential and market reach.

Instead, bigger investors are more likely to be given pause by the question of their co-shareholders. One subject of profound irritation to many Iranians is a perception that seems to have taken hold in the west over the last 12 months that all Iranian business is run by the Revolutionary Guard and its affiliates. It’s not that people deny their involvement: it would be crazy to do so, as the Guard and its contracting arm, or the Seal of the Prophets Construction Headquarters, or the Office Fund of Leader and Supreme Jurist Ali Khamenei, and others like it, are indeed everywhere. Iranians are instead riled firstly by any sense that this is sinister under-the-radar stuff – in fact, there are bits of the Revolutionary Guard that are so corporatized and visible you could probably sell them consultancy services – and secondly, the idea that there’s no way of knowing when they’re in the ownership structure of a listed entity.

“The role of the Revolutionary Guard in the Iranian economy is heavily exaggerated in western media,” says Rabii. “They are active in large multi-billion dollar oil projects, or building dams or roads, maybe the development of oil and gas fields and pipelines, that kind of large infrastructure project. But on the stock market their role is much smaller.” It’s also, he says, misunderstood. “The companies that are affiliated one way or another to the Revolutionary Guard are usually owned by, for example, the pension fund of the armed forces – which is a pension fund, at the end of the day. You don’t have somebody with a gun sitting across the table from you.”

He says many investors who come to see him remember Russia in the 90s, and find Iran more transparent and clean. “We have one share, one vote here. People show up at AGMs, and you get old pensioners yelling at a CEO appointed by the government. We don’t have that mafia behind-the-scenes wheeling and dealing.”

Princeton University’s Center for Iran and Persian Gulf Studies has been mapping out Iran’s economic structure using available TSE data and the various state, quasi-public and private ownership involved. Kevan Harris, its associate director, recently presented at a symposium on Iran and dissected Iran Khodro, the largest automotive manufacturer in Iran and an example of one of the big state-owned companies that was required to sell shares in a partial privatization under the previous government. Its list of main institutional shareholders goes like this:

• Negar Nasr Investment Co, which is linked to the Basij Cooperative Fund [Basij being another militia, like the Guards, which reports to the Ayatollah]
• The Civil Servant Pension Fund, an investment company for state employee pension contributions
• The Industrial Development and Renovation Organization, a public conglomerate that pre-dates the 1979 revolution
• Mellat Bank
• Tadbir Investment Co, which is linked to the Imam’s Order, or the Leader’s Office of the Ayatollah
• The Social Security Investment Company, the biggest investment company in the country, which represents private and semi-public sector employee pension contributions
• Two private sector investment firms
• Iran Khodro’s investment company, Samand.

Some of these might be uncomfortable bedfellows for foreign institutions, but it’s also possible that the semi-state institutions that turn up on shareholder registers might be willing sellers. This has to do with a halfway house that the Iranian privatization process got becalmed at. “The Iranian privatization programme has been going on for nine or 10 years now, but unfortunately it did not result in private sector management of these large companies,” says Rabii. “When the state started to sell all its large assets, the private sector was very small, banks were not given any financing for large purchases of shares, and foreign investors were non-existent. The buyside had nobody, and the only people who had money at the time were quasi-government institutions and pension funds. So we just had a transition of ownership from government to semi-government.”

That was not without benefits, as it led to listing and a level of transparency and accountability, “but you’ve never had the private sector management experience which can lead to efficiency and the creation of value. Once sanctions are fully lifted, we are going to see the second round of privatization, where these quasi-governments sell to real private sector of foreign investors. And they are all, by the way, huge potential sellers.”

Perhaps this tells us who will thrive in an opening Iran: those with due diligence but a strong stomach, an appetite for risk and a decent amount of patience. And eventually, that will be true not just of portfolio investors but of the banks too. “Non-performing assets are deteriorating, inflation has been high, and the previous government imposed almost eight years of financial suppression which left its impact on the health of the banking system,” says Azizi. “But from the perspective of a potential major foreign bank coming to bid for an Iranian bank, that would be reflected in the value. The potential of an entry to a market of 80 million people in the position that Iran is in would be tremendous, but the necessary financial investment would not be huge.” Seize the day or buyer beware? In Iran, it’s a bit of both.