Iran Resorts to New Financial Tools to Shore-Up Economy

The COVID-19 crisis has forced Iran’s government to turn to little-used financial tools to help stabilize the economy and address a widening fiscal deficit.

In the arena of monetary policy, the crisis is the first test of the new Open Market Operation (OMO) powers announced by the Central Bank of Iran (CBI) on January 18. To address the fiscal deficit, the Rouhani administration has pushed forward with long-planned privatization plans, conducting an Initial Public Offering (IPO) for SHASTA, the investment arm of the country’s largest social security provider. But the government faces hurdles as it resorts to largely unproven measures.

An underdeveloped interbank lending market will hamper OMOs. The interbank lending market in Iran was first established in June 2008. Despite the fact that the number and volume of transactions has grown substantially in recent years, with over 20,000 transactions registered in the last Iranian calendar year, the market remains hampered by the fact that Iranian banks do not maintain large reserves, meaning there are often too few banks with surplus liquidity in the market. As a result, it will be difficult for OMOs undertaken by CBI to influence the interest rate in the interbank market, limiting the central bank’s capacity to enact monetary policy through the bank-lending channel.

Iran’s interbank lending market also presents instrumental limitations. The most common mechanism by which needy banks secure liquidity is by direct borrowing from surplus banks, or, in times of emergency, turning to CBI as a lender of last resort. These loans are typically made without collateral and sometimes even without a formal contract. But given the prevalence of unsecured loans, there remains the possibility that the borrower might default.

While this possibility is generally understood to be low, it has likely increased given the current economic crisis. Iranian businesses will be seeking cheap financing to help them get through the difficult times. But given that Iranian banks struggle to determine the creditworthiness of their clients, any rapid expansion in lending could lead to greater issues with non-performing loans, particularly among the weaker banks.

The Central Bank of Iran had intended to use OMOs to adjust the inflation rate in accordance with its target for the current financial year, which is set at 20 percent—the annual inflation rate reached 41.2 percent in 2019-20.

On one hand, if the central bank aims to enable the country’s banks to lend to ailing businesses, the shift to the expansionary use of OMOs will be at odds with the inflation goals. On the other hand, now that the government is facing a record fiscal deficit, some Iranian economists are worried that the central bank may be pushed to use OMOs as a tool to generate government revenue, issuing bonds to finance expenditures. At a time when markets need clear leadership from regulators, the central bank’s priorities remain unclear.

While the central bank pursues new tools of monetary policy, the Rouhani administration has sought to tackle a fiscal deficit. The government’s IPO of SHASTA, also known as the Social Security Investment Company, was the largest IPO in Iranian history by market capitalization. The public offering of 10 percent of the company’s shares on April 15 generated USD 437 million in revenue for the government.

The strong performance of the Tehran Stock Exchange over the last year, despite the overall economic malaise, suggests that privatization of state-owned enterprises is a viable means for the government to generate much-needed revenues.

The Rouhani administration has long-pushed privatizations as a means to improve the finances of currently state-owned enterprises, to increase transparency, to improve corporate governance, and to reduce the footprint of the government in Iran’s economy. But any rush to privatize enterprises may lead to the loss of a “golden opportunity” as the government pursues public offerings to compensate for budget deficits without ensuring that the companies and their management become fully accountable to the public markets. 

Iran has been grappling with serious challenges in the areas of ​​fiscal and monetary policy in recent years. The Rouhani administration and the Central Bank of Iran have smartly sought to create new tools and establish new policies in response. But as the economy reels from the impact of COVID-19, these challenges have reached a point of crisis—the new tools may not be enough.

Photo: IRNA

Europe Can Use Local Currency Bonds to Sustain Economic Ties with Iran

For over a year, European governments have been struggling to determine how they can create a financing facility for projects in Iran. Access to external finance was a major expectation of the sanctions relief promised in return for Iran’s implementation of the JCPOA nuclear deal. With the full return of US sanctions just weeks away, the prospect that Europe will be able to contribute to Iranian economic development through project finance is growing slim.

The European Investment Bank has rejected calls to invest in Iran citing its reliance on global institutional investors, many of them American, to raise capital. A mooted European Monetary Fund, which would source its investment capital from European central banks, is still just a policy idea. Member-state financing vehicles, such as Italy’s Invitalia and France’s Bpifrance have proven unable to engage Iran, despite encouragement from government leaders.

But what if it is a mistake to focus on “external” finance? What if rather than try to source capital from outside of Iran to finance projects within the country, Europe sought to make use of the wealth already within Iran?

One underreported effect of Iran’s currency crisis has been the rapid expansion of liquidity in the market. Iranians are scrambling to convert their devaluing rials into safe-haven assets such as dollar and euro banknotes, gold, property, and even cars. But this scramble, which has seen Iranians draw down their vulnerable rial savings, has led to a rapid expansion in liquidity, which is itself creating inflationary pressure. The Central Bank of Iran is even considering raising interest rates in an effort to reabsorb some of over USD 350 billion floating around the economy.  

Perhaps surprisingly, as the currency crisis has unfolded, the Tehran Stock Exchange has hit historic highs. Iranians investors—particularly those whose wealth exceeds that which can be reasonably protected through the purchase of property and gold coins—are increasingly seeing securities and other forms of equity investment as a way to hedge against devaluation. The only problem is that this kind of reinvigorated investment is unlikely to help Iran avoid a recession, particularly in the non-oil sector. Investments on the Tehran Stock Exchange does not lead to the efficient and smart fixed capital formation the country needs to achieve real growth.

The demonstrable hunger for investment opportunities resulting from inflation fears and rising liquidity presents a valuable opportunity. In other emerging markets, such investor demand has been successfully use to source the capital necessary for impactful development projects. The best example can be seen in the financing methods of the European Bank for Reconstruction and Development.

EBRD was established in 1991 to support the liberalization of the Eastern Bloc economies after the fall of the USSR. Just a few years after its launch, EBRD began to tap local investors as a source for its project financing by borrowing and lending in local currencies. EBRD issued its first local currency loan in 1994, denominated in the Hungarian forint. Since then, the bank has issued 722 loans across 26 currencies valued at EUR 12.4 billion.

Local currency financing has been made possible through the issuance of local currency bonds. These bond offerings are issued under local laws and regulations, but are backed by the creditworthiness of ERBD and the steady strength of the Euro. Such “local currency Eurobonds” can be particularly useful to offer domestic investors a hedge against inflation.

In November 2016, EBRD issued a “pioneering” EUR 92 million “inflation-linked Eurobond” in the local currency of Kazakhstan. The bonds have a five-year maturity and “pay a coupon of 3-month Consumer Price Index (CPI) rate plus 10 basis points per annum.” EBRD is also seeking to have the security listed on the Kazakhstan Stock Exchange to make the bond even more accessible to local investors.

When the note was launched, Philip Brown, managing director at Citi Global Markets Limited, which managed the issuance, commented on the “demand for inflation protection from the increasingly sophisticated investor base in Kazakhstan. This trade highlights the useful role the EBRD can play in helping local investors meet their needs and in doing so, develop new markets.” While the likes of Citibank would not be managing such a bond issuance in Iran for obvious reasons, it is easy to see how Iran’s own sophisticated investor class would see a rial Eurobond as an attractive asset to guard against rising inflation.

A local currency bond offering would help Europe and Iran achieve several goals. First, European governments would finally be able to source and deploy the the billions of euros in financing that had been promised to Iran in various credit lines, only to be stymied by the hesitance of European banks to facilitate the underlying transactions in the project finance. Second, it would empower European governments to more directly influence regulatory reform in Iran’s banking and finance sector—a role EBRD has actively and successfully played in the markets in which it has investment since its inception. Third, the new bond would help the Central Bank of Iran reign-in excess liquidity in the market in a manner that is likely to create the greatest long-term value for the economy at large. Fourth, the establishment of a European-Iranian development bank would be a powerful political signal at a time when support for the JCPOA is wavering.

Like European Investment Bank, EBRD is too exposed to the United States in order to pursue projects in Iran itself—the US is a 10 percent shareholder of the bank. In order to pursue local currency financing, European governments would need to establish a new state-owned development bank in order to issue the rial-denominated Eurobonds.

Unlike EBRD and for reasons related to sanctions risks, this should be done through the creation of an Iran-registered financial institution owned by European governments, which would enlist the support of local investment banks and brokerages to bring the bond to market. This European-owned and Iranian-registered development bank would raise capital locally and invest locally, reducing the needs to engage in international transactions that are complicated by the returning sanctions. Conceptually, such an institution would be a kind of inverse of the Hamburg-based EIH Bank, but with a development finance rather than trade finance focus.

The creditworthiness of the new bank would be assured based on a sovereign guarantee for the bank and its liabilities from the European shareholders. The fact that the ownership of the bank will not overlap with its country of operation also limits risk. For similar reasons, no multilateral development bank worldwide has had to resort to its callable capital to date.

The envisaged bank would face several challenges including a lack of robust monetary policy in Iran, a relative lack of transparency within capital markets, and high domestic interest rates which could undercut the attractiveness of the bond offering. It would also need to conduct know-your-customer due diligence above and beyond that conducted by Iran’s own brokerages. But the myriad challenges in Iran are probably no greater than those faced in countries such as Kazakhstan, Georgia, and Ukraine where European financial actors have been able to successfully structure the credit facilities.

Encouragingly, the bond market in Iran has matured considerably over the last few years, and local companies and government agencies have developed capabilities in structuring debt instruments with the help of local investment banks and in compliance with the rules of Islamic finance. In the seven years since Islamic sukuk bonds were first introduced to the market, around USD 4 billion in debt has been issued.

Today, Iran’s leading companies regularly raise financing on the order of USD 100 million through individual bond offerings. A local currency Eurobond, which would be used to finance the transformative projects that had been envisioned for post-sanctions Iran, would easily raise amounts on this order. To bring this idea to fruition, European governments would simply need to combine a proven capacity for financial innovation and the commitments of their central banks, two contributions that cannot be sanctioned by the United States.

Photo Credit: Depositphotos

Iran’s Capital Markets: Securitizing the Future

The future of the Iranian financial sector might be vastly different to what we—those who work in the industry– can imagine today. With this in mind, the potential for making the financial sector a driving force for Iran’s economic reboot must considered as supremely important. 

For Iran to overhaul various aspects of the domestic economy, it must attract at least $1,000 billion dollars in investment during the next decade. If for any reason our economy fails to absorb the required level of investment, not only will we not achieve the goals of Iran’s 2025 Vision Plan, but we will also miss a historic opportunity to enhance our rightful position in the global economy.

Therefore, it is our obligation to obtain the much-needed investment for Iran. 

The unusual hurdles imposed on our economy have culminated in an unfortunate economic stagnation. This situation has adversely impacted a country with an enormous potential, which would otherwise be most appealing to the international investor. 

In order to ensure sustainable economic growth, Iran will need to divert considerable financial resources into infrastructure and large-scale projects. These projects may be unprecedented in size and complexity for Iran. 

The key point is that conventional methods for promoting investment in Iran, particularly foreign direct investment, have become less appealing and are insufficient to effectively address international investors’ concerns, especially after exposure to the world economic crisis. 

In the case of Iran, this is further aggravated by the harsh conditions imposed on investment due to sanctions. Knowing this, two factors have a crucial role in leading potential investors: transparency and the ease of exit from ventures, i.e. favorable exit strategies. 

Iran’s finance sector leaders will need to be flexible and innovative in financial engineering and offer a range of financial instruments to investors, either domestic or foreign. This leads to the conclusion that for those of us in the sector there is no strategy more important or effective than securitization. 

Securitization is the financial practice of pooling various types of debt, illiquid assets, and/or groups of assets into more liquid financial instruments in order to sell them to third party investors. Securitization promotes liquidity in capital markets by making it easier for investors to buy and sell (enter and exit) investments across sectors. 

During the last decade, various new types of project financing methods have been devised for infrastructure investments in Iran. Compensation Arrangements, ranges of Build-Operate-Transfers (BOTs), and, recently, Public-Private Partnership agreements (PPPs) alongside the issuance of participating notes, corporate bonds and Sukuks are examples of our endeavors for financing projects. 

Despite our achievements, we do not fully realize the imperative of giving potential investors even greater confidence through intelligent securitization.  I have to stress that investors are clever people, they know how to assess projects and how to control their business risks, but they need the right vehicles. 

By confidence I mean providing investors with transparent and reliable information as well as reliable platforms for transacting securitized projects and investments. Investors must be confident that whenever they decide, they are able to sell their investment at a fair price.

Therefore, I believe that securitization, though not the only way the only imperative to improve the investment climate, is nonetheless critical. Securitization offers the best and most efficient methods of financing the country’s projects in the post-sanctions era in the shortest period of time.

Now the question is what are the required grounds for new best-practices? 

Certainly, we need to review our legislative environment and implement the required amendments, remove the unnecessary barriers and in general, improve our “doing-business” indices. In addition to the above, Iran’s finance marketplaces remain a vital part of this development plan. Specifically, securitization needs markets where assets can be effectively valued and traded. 

A notable point is that Iran has the oldest capital market in the region, established in 1968. With almost 50 years of experience, Iran has a robust background in this area and thanks to the new Securities Market Act, ratified by the Parliament in 2004, the country has had the opportunity to modernize its financial market and establish almost all the frameworks required by global best-practice. 

I will not elaborate on the structure of Iran’s capital market here, but it is worth mentioning that during the past decade, we have observed tremendous developments in the fields of financing, financial markets administration, and related technologies. 

These changes include a notable portion of the privatization program within the framework of economic reforms, which was carried out through the Tehran Stock Exchange (TSE) and the Iran FaraBourse (over-the-counter market). 

The Iran Mercantile Exchange and Iran Energy Exchange, too, have had an important and constructive role in improving commodity markets’ efficiency and transparency in our economy, which deserves its own detailed discussion. However, it is noteworthy that the share of the contribution of the capital markets to Iran’s GDP is still unsatisfactory. 

Where the main impetus behind long-term sustainable economic growth is national and foreign capital investment, it becomes imperative that new methods based on securitization be devised, which at the same time make further development of the financial markets a necessity. We, therefore, need to introduce new players in our financial markets including new companies and entities, which can develop new and innovative methods, products, and instruments of finance based on securitization, educate a new generation of specialized experts, enter joint ventures with reputable international firms, obtain and develop new systems in the area of financial technology, and more.

International investors continue to recognize that the Iranian financial sector, with its great potential, will be one of the most active, (and hence profitable) industries in the region. But these investors will only act with confidence once sanctions are lifted and Iran’s new phase of securitization and transparent sector development begins. 

Photo Credit: The Iran Project