Iran's pivotal moment

Iran is at a crossroads. The year ahead will determine which path it takes: a resource-rich, rejuvenated success story, returned to the international fold and relied upon by western states as a stable force in an increasingly troubled region; or a recession-hit, bad loan-addled failure still barred from western trade and getting steadily, inexorably worse. The view in Tehran is that it could go either way.

Geopolitics, the most unpredictable of forces, are slowly shifting in Iran’s favour, largely for external reasons. One would never have imagined it a few years ago, but Iran is suddenly a natural ally to the US, which badly needs a stable government in a region where Islamic State (ISIS) – which, being Sunni in its ideology, is never going to be a friend of Shi’ite Iran – is gaining worrying traction, particularly in neighbouring Iraq.

The aligning of the stars feels like a once-in-a-generation opportunity: a leader in Hassan Rouhani who wants to reach out to the west coinciding with a US president who wants to make peace and who badly needs a foreign policy success.

Further reading

• Modern Middle East Bank shows there is no escape from sanctions • Ayandeh's DIY mega-merger sets template for Iranian bank consolidation • The long business arm of the Iranian state

At the same time, Europe has good reason to want better relations with Iran as its own relationship with Russia deteriorates. European reliance on Russian energy, chiefly gas, is clearly problematic; Iran has vast fields of the stuff and pipelines that already reach the Caucasus.

All of these things are bargaining chips for Iran as it tries to negotiate an end to nuclear sanctions in Geneva, and they raise the prospect of a sanction-free Iran ready to resume global trade and to make the most of its many advantages.

“I know that there are a lot of foreign entities – companies, contractors, investors – who are scrutinizing the situation,” says Mohammad Amir Davoud, general director of international affairs at Bank Pasargad, one of the biggest and strongest private banks in Iran. “They are waiting to see the results of the negotiations between Iran and the P5+1 [the five UN Security Council states plus Germany with whom Iran is in negotiation around its nuclear programme, the initial cause of the sanctions] so they can rush back to Iran for further investment. History shows the Iranian market has always been a secure and positive haven for investors.”

Indeed, Euromoney hears frequently of European businesses and banks that have informally visited Iran lately, assessing opportunities for when the right moment arises.

Such visits, and indeed the hopes of many in Iran and beyond, might have appeared premature when at the end of August the US Treasury announced a new range of sanctions-related actions against five Iranian banks. These included Bank of the Middle East, until then the biggest private Iranian bank to evade US sanctions.

But those inside Iran hope this is the last blow of the iron fist before the velvet glove of rapprochement is slipped on. They hope that sanctions relief could come as early as November.

And if that moment comes, what will the international financial community find when it gets to Iran? It is a mixed picture indeed. There is vast resource wealth, not just in hydrocarbons but minerals; a highly educated population keen to work hard in renewed international commerce; and a reformist government.

But there is also a bloated banking sector that is riddled with bad debt, odd accounting and a shortage of deployable capital, and an economy within which your business partner might well turn out to be the Revolutionary Guards. Nothing is simple in Iran.

First, the positive view.

Demographically, Iran has a lot going for it. Its population of 78 million is well-educated, it holds 9% of the world’s oil reserves alongside a broad-based manufacturing sector, and has a stock-market capitalization that stood at $170 billion earlier this year, similar to Poland’s and with a free-float bigger than Kuwait or Nigeria. It has a reformist president, Rouhani, who wants to engage with the rest of the world.

“We have a lot of competitive advantages,” says Hojatollah Saydi, managing director of Kharazmi Investment Co, one of the vast investment conglomerates that dominate the Iranian stock markets and economy. “Firstly there’s the population: not only its size, but its youth. Secondly, there is our geopolitical position, [between Europe, the Persian Gulf and the growing resource-rich markets of central Asia] Then there is the level of education, very different from other countries in the region.”

This is a huge source of pride: they say locally that the engineering graduates from Tehran’s Sharif University of Technology are right up there with the best of MIT. “And there is the potential: not just the oil and gas reserves, but our reserves of minerals.” He lists a long and bounteous inventory: copper, gold, nickel, zinc, cobalt, phosphate, gypsum, limestone (he doesn’t mention the uranium, but that’s another story.) “For a young population, if some doors open for us, we can do many things.”

It’s not only the locals who feel this way. “Tehran feels like Ankara did in 2004,” says Charles Robertson, global chief economist at Renaissance Capital, who launched a benchmark report on Iran in March following a visit to Tehran. “This looks to us like a potential re-rating play that could – in an investable scenario – attract those investors who have recently invested in Saudi Arabia, like those who invested in Turkey after 2001 and Russia since the 1990s.”

To reinforce the point, Robertson adds: “No other country is as large or as untapped.”

It is said that more was earned from oil under the administration of Mahmoud Ahmadinejad than in all previous administrations. If that’s true, the money doesn’t seem to have gone to the right places

It’s untapped, of course, because of the sanctions, and that’s the problem: none of that potential can be realized in anything other than a domestic sense so long as western enterprises are forbidden from trading with Iran in most sectors, and foreign banks from funding their trade. “Now the world is flat,” says Saydi, “and no company can grow without international cooperation.”

But – and here we get to the bad news – sanctions are only part of the problem.

Iran’s economy is in a perilous state, experiencing a deep recession of -5% last year at the same time as high inflation, with a devaluing currency, rampant unemployment, a banking sector addled by non-performing loans and a manufacturing base throttled by imports of cheaper goods from places like China.

At the moment, arguably it is getting modestly better: according to the central bank, inflation stood at 45% last year, is now down to 35%, and is projected to drop to 20%-25% by March 2015, the end of the Iranian year.

But it’s impossible to do this at the same time as growing an economy. “We have to squeeze liquidity to fight inflation, but we must also inject liquidity to let the economy grow,” says one senior policy official in Iran. “And you cannot really do both.”

It’s a common misconception that Iran’s economic woes are a function of sanctions. Sanctions certainly haven’t helped. But Iran’s economic problems were largely self-inflicted under the administration of Mahmoud Ahmadinejad, who ruled from 2005 to 2013. It is said that under his eight-year tenure more was earned from oil – at a period of high prices and largely before sanctions kicked in – than in all previous administrations, but if that’s true, the money doesn’t seem to have gone to the right places.

“We did not suffer from sanctions so much as we suffered from mismanagement,” says one banker. “We could have had a stable economy with low inflation.” He raises his hands with a wry smile. “But we do not.”

A word about sanctions. They apply at three levels – European Union, UN and US – but the American sanctions are by far the most influential, partly because they go a lot further than the others. They cover almost the entire banking sector, for example. They don’t just preclude trade with the US but anything in US dollars no matter where it is conducted, and the Obama administration’s vociferousness in pursuing sanction breaches has scared off many companies and banks from conducting even legitimate business. The almost $9 billion fine levied against BNP Paribas by US regulators in July has had quite an impact on the attitude of potential correspondent banks.

Sanctions do not cover a particularly broad range of industries – particularly since concessions in July removed the automotive industry and part of the petrochemical sector from the list – and humanitarian sectors such as food and beverages, medicine and medical devices have always been exempt. It is a surprise to many visitors to Tehran to find many household names of western commerce, such as Nestlé, Vodafone and Carrefour, operating successfully (and perfectly legally) in Iran.

But because financial services are still blacklisted, very little trade can be financed. Also, it means there’s no scope for hedging, although in truth the central bank has never had a mechanism for it to take place anyway.

The key sanction, therefore, is financial services, because so long as it stays on the sanction list, everything else might as well be too. There are labyrinthine methods through which European companies in non-sanction areas can legally trade with Iran, but they involve, for example, setting up accounts in Japan and transacting through there. That might make economic sense for a big grain shipment, but it won’t be economically viable for a supply of a relatively small amount for a particular medicine, even though pharmaceuticals are not on the sanction list.

“The practical result of sanctions,” says the principal of a London-based boutique advisory specialising in emerging and frontier markets, “is that a man who needs a cancer pill from Pfizer can’t get it.”

Indeed, as is common in sanctioned nations, there is widespread local resentment, a feeling that a political issue has yielded a punishment on ordinary people instead of politicians.

Euromoney’s visit to Tehran coincided with a fatal air crash there, and even as news broke over the city’s radios, taxi drivers were blaming it on sanctions. Why? Because until very recently, spare parts for aircraft were on the sanctions list, meaning the local airlines – upon which Iranian politicians surely never fly – have been unable to repair their fleet without going through the black market. And although aircraft parts were recently relieved from sanctions, still nobody’s selling them because of the stigma that now attaches itself to Iranian trade.

The key point about sanctions relief is not so much when it happens as in what order. Clearly, for example, nobody is going to be allowed to ship arms to Iran in the near future, which doesn’t bother ordinary people (or the economy) in the slightest. But if, as seems likely, the next step is a few more removals from the sanctions list, the clincher is whether financial services is included.

"This looks to us like a potential re-rating play that could – in an investable scenario – attract those investors who have recently invested in Saudi Arabia, like those who invested in Turkey after 2001 and Russia since the 1990s. No other country is as large or as untapped" Charles Robertson, RenCap

“If banks cannot have active communication with the international world and other banks, it’s like a one-way street: you’re just going down one side and cannot come back the other way,” says Jalal Rasoulof, CEO of Ayandeh Bank. “If they open to the banks, it would be very fruitful for the people.”

Iran’s banking sector is complicated. There are a handful of big state-owned banks, then around 20 others that call themselves private. This latter group varies between largely state-backed enterprises that sold some stock on the Tehran Stock Exchange during the privatization process of the last decade, to others that have no government ownership and in some cases have surprisingly diversified private shareholder bases. Beyond them are other financial institutions, credit cooperatives and several very large investment companies, some of which have their own banks within their holding company structure.

When sanctions start to lift from financial services, they are likely to do so in phases. Bank Sepah, which is owned by the armed forces (Sepah means army in Persian), should probably not hold its breath waiting to be permitted to do business with the west. But most of the private banks are already off the European and UN sanctions lists, and would expect to be among the first to come off the US one too.

And that’s the crucial point. The impact of US sanctions is so pervasive that it often doesn’t make any difference if a bank is free of EU constraints.

“Even though humanitarian items are exempted from sanctions, there are still fears of future punishment by the US against them,” says Davoud at Bank Pasargad. “So as a cautious gesture, they have decided not to work with the Iranian market at all. They are watching until all the sanctions are removed.”

Sanctions consequently do have a number of knock-on effects, perhaps broader than their intentions. Consider London-based Persia International Bank (PIB), a largely autonomous institution in London owned by two of the largest state owned banks, Mellat and Tejarat (Mellat successfully got itself removed from EU sanctions by the European courts, but Tejarat is still on the list, and consequently Persia itself is also barred).

PIB has a staff of 21 in a grand Georgian building on Lothbury just across the road from the Bank of England, doing pretty much nothing; the bank cannot even cash in its VAT refunds from HM Treasury – payments that have been clearly marked as legal by the British state itself – since no London bank will touch it for fear of being accused of improper behaviour.

It is a common lament that the BNP Paribas fine was not chiefly about indiscretions in Iran, but Sudan; likewise HSBC’s $1.9 billion money laundering fine was mainly about Mexico, with Iran something of an afterthought. “But when it says Iran first…” says one banker. “All foreign banks are scared and conservative. They avoid us even in areas that are perfectly legal.”

When sanctions do lift, there will be a flurry of Iranian banks reaching out for correspondent relationships with western counterparts, and westerners leaning in to do the same. It’s not exactly ancient history: a great many big western banks were represented in Iran before sanctions, from Chase to HSBC to ABN Amro. In one meeting, Euromoney spots a Merrill Lynch bull sculpture on an office shelf, sitting there like a museum artefact.

If and when they do return, foreign banks will find an Iranian financial services sector that faces two considerable challenges: one about past lending, one about funding for the future.

Iran is blighted by bad loans for sundry reasons. One is the collapse in Iran’s exchange rate earlier this year from just over 10,000 rials to the dollar to almost 30,000, which caused many clients to be unable to meet payments to banks. Another is the decline dating from the Ahmadinejad administration in the competitiveness of Iranian manufacturing – particularly the automotive sector – in the face of cheap Chinese imports. There have also clearly been problems with credit assessment.

One reason Iran is blighted by bad loans is the decline in competitiveness of Iranian manufacturing – particularly the automotive sector. “You tell me a bank that has less than 15% NPLs,” says one banker, “and I’ll tell you which bad debt he’s not showing in his books”

Most bankers talk about a system-wide NPL level of about 15%, but none of them believe it. It might well be double that. “You tell me a bank that has less than 15% non-performing loans,” says one banker, “and I’ll tell you which bad debt he’s not showing in his books.”

One bank that has had a particular challenge in NPLs is the otherwise impressive Saman Bank, which found itself a victim of one of the worst business scandals ever to hit Iran. In 2011, it became clear that almost $3 billion-worth of letters of credit had been fraudulent, affecting seven state and private banks, most notably the state-owned Bank Saderat.

Forged letters of credit were used to acquire assets – including state-owned or privatized assets such as the Khuzestan Steel Company – and it took four months for the fraud to become clear. When it did, at least 20 people were arrested, and four – including Mahafarid Amir Khosravi, an Iranian businessman once thought to be the richest man in Iran and judged to be the mastermind – were sentenced to death. Khosravi was hanged in May.

The former managing director of Bank Melli, Mahmoud Reza Khavari, resigned after the bank was implicated and his whereabouts today are unknown.

Saman found itself on the sharp end of this. “Basically, we had discounted LCs of Bank Saderat, and they defaulted on making the payments,” explains Vali Zarrabieh, Bank Saman’s chairman. The two banks have been in the courts ever since, and Saman has won every single case, but while it waits to get the money back its balance sheet has been crippled.

“At the time almost $600 million of deposits [based on a $/IRR rate of 10,000, as it was at the time] were locked up in those assets that are not performing,” Zarrabieh says.

Still, the story also demonstrates a level of equanimity and sense that one might not have expected. “How we managed it was nearly a miracle,” Zarrabieh says. “Very hard work, micromanaging everything, and daily meetings of the asset-liability management committee, not monthly or weekly. Also, one or two banks that tapped into the interbank market helped us greatly, and I’m always grateful for their help.”

Not everyone came through, however. “We never received any help from the central bank, and it was a pity,” Zarrabieh says. “I believe it was their responsibility to help as a bank of last resort, but they never did, and we never borrowed from them. The private banks had the decency to understand that what we had done was nothing out of the ordinary – and they knew if we went into trouble, there would have been a domino effect in the market.”

Once the remaining LCs are repaid (there’s about $100 million outstanding now), Zarrabieh says Saman’s NPL ratio will fall to below 11%, “which is basically normal in this market,” Zarrabieh says. “This rather high NPL is all because of macroeconomic issues that need to be addressed collectively.”

Most NPLs, he says, are collateralized mainly with properties and listed shares, “which take longer than expected to liquidate in order to circulate the cash into operation.”

Others have different challenges. Parsian Bank has as its biggest shareholder the Iranian car manufacturer Iran Khodro, which sometimes has been a great benefit to the bank in funding the automotive sector, but is likely to have led to bad loan problems in recent years when the sector, battered by imports, has been running at as low as 40% capacity.

Asked about this, Parsian responds: “We cannot say bad loans, because they are our main shareholders. If we have given a facility to them, their facilities are secured and safe.” In Parsian’s case, it probably won’t matter because the automotive industry is improving – Khodro has doubled production, it says – so that anything non-performing on the books has the potential to be revived, but it does speak to the difficulty in seeing just what’s happening inside a bank.

One problem that has to end is the accounting practice of banks raising their level of capitalization not by actually raising capital or attracting deposits, but by repeatedly revaluing their own property portfolios, which are often vast: some banks have as many as 3,000 branches, and they tend to own them outright. Tehran has a preposterous surplus of branches; there is a particular streetside location from which it is possible to see 13 without moving.

Zarrabieh believes the only solution is for the government or central bank to create a bad bank structure to shift all the troubled assets in to. “This is the most feasible solution to address this issue efficiently,” he says. “But having had many meetings and discussed this many times, they have not yet come to a single solid solution.”

Others have similar ideas. Parviz Aghili is founder and CEO of Middle East Bank. He has put forth a proposal for the restructuring of the banking system and improving the quality of financial statements, properly audited. “Their records should represent the actual facts,” he says. He then wants their capital adequacy tested under Basel III, with the results listed. “Those who are below 5% should be closed down. Between 5% and 8%, give them time to raise good cash. I don’t mean some of the stupid arrangements many of the banks do, reappraising the value of properties they own to increase the capital. That’s ridiculous. What I’m talking about is clean cash coming in, in the form of equity.”

The situation might not be quite as bad as it seems, he says, because of the level of security banks hold in real estate, which has at least benefited because of inflation. “Under normal circumstances when you have such bad loans, you should be in deep trouble, but they may not be if we have a good bank-bad bank model to separate the bad loans.”

But he believes beyond that, a change in attitude is necessary. “It is not understood that a bank has to operate as a bank. A bank cannot be an investor in a project like the chaebols did in Korea. Banking is an intermediary: you receive deposits, you provide loans and facilities, and that’s it.”

Aside from bad loans, there is another common lament in Iran: that there is just not enough money available for corporates to grow. Although there are a large number of banks – arguably too many – several of the private sector ones are modestly capitalized and in no position to advance the funds Iranian businesses need. 

The government is understood to be planning a restructuring of the balance sheets of state-owned banks to put them on a better foundation and make them better able to fund the troubled manufacturing sector of the economy, but that is scarcely underway and the bad loans have to be digested for that to happen.

“There are insufficient funds for companies that are trying to complete projects,” says Mansour Tafazoli, vice-president, international, at Parsian Bank. “They are facing problems raising the money they need.”

What else can borrowers do? They can’t raise funds in a local bond market, because there isn’t one, or at least not one that any issuer elsewhere in the world would recognize; there are something like retail bonds, issued and guaranteed by banks, but they are not tradable, and are instead generally sold back to the bank eventually at par (creating a further encumbrance for already-troubled bank balance sheets). These are known locally as participation papers or PPs, and the central bank acknowledges that they would be more useful if there was a secondary market for them.

The central bank, in fact, is not ill-equipped: it has a scripless securities trading system in place, ready and waiting. But it isn’t used because nobody wants to use it. Probably new rules and regulations would help, but there are bigger issues too. “You have to change the mood of the people,” says one Iranian policymaker. “They are used to PPs. They see them as like bank notes.”

Aghili at Middle East Bank has proposed a method of helping capital market development through murabaha, by providing a sort of subsidy based on future tax credits.

“If they go to the market right now, they won’t be able to raise funds below 25%, but half of it could be subsidized by tax credits and future earnings, to get the economy moving,” says Aghili. “That way we can get markets to provide a substitute for bank debt, to provide working capital and assist our private-sector firms. We could take the pressure off the central bank. Then we don’t have to increase liquidity as we did in the past.”

There is a modest sukuk market in Iran too, and at the time of writing the Sina Financial Services holding company, part of the enormous Mostazafan Foundation, was preparing an issue for a steel company within the group that should raise the equivalent of $80 million. But issues are still reasonably rare.

There’s also a big and vibrant stock market, but it lacks proper market makers and since there is only one class of share – a voting one – companies think twice about using the exchange to raise funds and issue new stock. “Shareholders cannot easily make a decision on raising capital because they will be diluted and lose control,” says Zarrabieh.

Despite their challenges – and perhaps because of them - banks are preparing themselves for brighter days when sanctions are lifted. Bank Mellat, for example, which styles itself as the largest private bank since a privatization five years ago but is still state-backed, is several years into an overhaul of business practices that among other things wants to get everything ready for when foreign banks and investors come calling again.

Pasargad has a series of action plans in place – one for worst case, one for an end to sanctions – and plans to increase its capital base from $1.5 billion to $2 billion within the next three years in order to have a base to grow from.

International business hasn’t gone away completely. Trade today is chiefly with five or six countries – especially China, India, Korea, Turkey and to an extent Japan – which can accept oil exports from Iran; Iran must then try to source all its import needs from the same country, though even then, payment and settlement is very difficult.

Still, there’s business to be had: Parsian, for example, still derives up to 25% of its profits from international banking, and has correspondent bank relationships with UCO Bank in India, Konlon Bank in China, Woori in Korea, Megabank in Taiwan and Halk in Turkey. “After sanctions are lifted we hope to start helping customers to hedge their obligations and contracts faster,” says Tafazoli.

And there are some successful businesses that have focused on the sectors that have never been covered by sanctions. “We focused on food and pharma because we saw this would be a door that stays open,” says Zarrabieh at Saman, an institution that would have sold more than 40% of its shares to a Middle Eastern bank in 2005 had it not been for the arrival of sanctions. “Today, we do about $6 billion of trade finance per year with a focus on food and pharma. We handle about 20% of the market share in food commodities and 50% of total pharmaceuticals.” But clearly, the potential is far greater, in terms of the obvious quick gains like trade finance, but also in areas such as private banking, asset management and offshore capital raising.

When the doors open, what should we expect from capital flows? Renaissance Capital expects lots of interest in Iran’s stock market, arguing that its rehabilitation into the west will create a re-rating play almost by definition. “We believe the reform drive might justify an overweight stance for EM strategists – if Iran was tradeable,” Robertson says.

The Tehran Stock Exchange is a surprisingly big and diversified market, with a market cap of about $130 billion even taking into account the currency’s devaluation, and 320 listed companies covering most of the sectors one would expect to find on a mature bourse. On an average day, 50,000 trades will move 500 million shares worth $100 million.

In the Tehran Stock Exchange lobby, where stock prices flash on screens, there is an eager audience of grey-haired men in their 60s, watching their shares move and generally enjoying the social side of it all

There is a futures market here, and Hassan Ghalibaf Asl, the exchange’s CEO and president, tells Euromoney an options market is under development, though short selling is not permitted at this stage. Online trading accounts for 15% of volume, Ghalibaf Asl says, and there is an exchange-traded fund, as well as more than 130 mutual funds. Euromoney is aware of an online educational share-trading programme under development to help individual investors – of whom some 7 million are licensed – to gain a better understanding of how markets work.

A visit to the Tehran Stock Exchange, its dismal downtown building notwithstanding, is interesting: downstairs in the lobby, where stock prices flash on screens, there is an eager audience of grey-haired men in their 60s or older, watching their shares move, looking for tips, and generally enjoying the social side of it all.

Retail is, in fact, the biggest part of exchange turnover. Institutional investments come from the banks, from a reasonably developed mutual fund industry, from insurers and the big investment companies one finds in Iran.

Then there’s foreign direct investment.

Zarrabieh at Saman says “without any doubt” there will be funds wanting to come into Iran in one form or another. “This country can absorb everything now with respect to investment,” he says, “from mining to oil, trade finance up to project finance. In my opinion, the best way would be for strategic investors to come and buy into the insurance and banking industry because that would be a doorway to invest into other sectors through them.”

Iran’s currency has devalued heavily in recent years, but one can make a positive case for this, both in terms of competitiveness of exports and the allure to foreign investors who will get more for their money.

“I believe that since the change in the exchange rates, prices are much more real in this country,” says Davoud at Bank Pasargad. “For investors who wish to bring in foreign currency, it’s much better now, and a much more secure environment for the conversion of riyal back to foreign currency again. They can feel much more confident that such a change in the exchange rate will not occur again.”

That said, the foreign investor on the FDI side will face a number of uncertainties and challenges. The accepted way in, much like China’s early days of openness, will be through partnership and joint venture, and that raises the question (also like China) of exactly who one is dealing with.

“It can be quite difficult in Iran to know if the entity you are looking at is linked to the Revolutionary Guards or not,” says Henry Smith, senior analyst at consultant Control Risks. Since the early 2000s, he says, the Guards – who started out as the militia for the Ayatollah after the Iranian revolution – have taken a more overt role in business and the economy, and in many cases gained stakes in companies during the opaque privatization process through that decade.

“It can be quite difficult in Iran to know if the entity you are looking at is linked to the Revolutionary Guards or not. Anyone dealing with them automatically poses legal and regulatory risks for themselves”

“There are implications for a company considering Iran, given that the Revolutionary Guards are in some sense enemy number one for the US. Anyone dealing with them automatically poses legal and regulatory risks for themselves.” Corporate records, he says, will only help to an extent, because often the principal of a company is a front for a retired general or his family members.

When banks find their way back in and once again navigate the immigration lines of Tehran’s Imam Khomeini Airport and the madness of everyday traffic, they will find opportunity for sure, but also the scars of an economy whose isolation and past mismanagement have left it brittle. Buyer beware.