Last week, I wrote about some of the key questions surrounding the U.S. withdrawal or rather violation of the JCPOA which focused on the responses of Iran (production, discounting, regional policy), Europe (blocking measures), and Asian buyers of Iranian goods. Since then the focus has been on the European counter response to the U.S. decision, and on assessing the energy market impact, and the potential risks to the use of sanctions as a policy tool. I provide a few follow up thoughts here.
Exit first, protection later: Many European companies seem to be preparing to freeze or reduce their investment, worried about the risks of future fines, despite pledges of blocking statutes. Developed markets in Asia are likely to be more cautious Meanwhile at the same time, European leaders are rushing to implement blocking legislation that would shield European companies from fines, and would forbid some companies (banks?) from implementing measures lest they face other fines. These measures have exposed divergent views between and within key European countries (notably France and Germany in recent days).
The blocking statute and other moves are in part one of principle in which the Europeans look to establish their concern about U.S. extraterritorial sanctions for the current and future cases, especially where U.S. and Europe have diverging views on the goals. Companies may choose to be cautious implementing cuts or freezing new deals given their concerns about the limited upside from trade in this environment, and fearing to loose access to U.S. markets. The net result is likely one of confusion, broader derisking as some companies scaling back activity won’t scale it back up without assurances from Iran. As others have noted, the imposition of sanctions may be the nail in the coffin for investments that were already on edge due to questions about the investment terms including some oil and natural gas contracts.
Oil: Oil volumes will be a major indicator for all to assess whether the process of undermining or stabilizing the deal is a success. The Trump administration is likely to look for reductions to show that sanctions are being implemented, while Iran would likely see volume drops as a sign of bad faith from trading partners, leaving European and Asian buyers in the middle. One key difference from 2012 is that EU member states quickly eliminated oil imports, leaving key Asian buyers and Turkey to take part in the “significant reductions” in imports. Europe is unlikely to do so this time given the political goals. Expect there to be greater uncertainty and debate around the metrics to use in tracking compliance. As noted, last week, OPEC+ may well act slower and less extensively than buyers hope, increasing price spikes and overall volatility.
The chart below highlights some of the countries that will be pressured to reduce imports. While it includes non-oil exports as well as fuel, it provides a useful breakdown. One thing that stands out is that Iranian exports to Europe and India experienced the greatest boost post-JCPOA, with volumes increasing more modestly to South Korea, Turkey and China, as these countries tried to balance their regional trade. Japan notably, barely increased trade from the pre-JCPOA levels (though the change in energy prices partly obscures the trend.
Iran exports have been increasing along with hydrocarbon prices (rolling 3 month sums, USD billion)
Source: IMF (via macrobond)
The OFAC guidelines suggest waivers would only be granted to those companies that show “significant” reductions in the coming months ahead of the November deadlines. Market analysts estimate export declines of 200-700 thousand barrels in the coming months, and more in 2019, quite a wide range in scope.  complicating this, the definition of significant reductions is less than clear as the Trump administration hasn’t signaled whether they share the Obama administration definition of 10-20% declines over each six month period, or how they consider market price dynamics. Given the timing of decisions may continue to boost oil prices in the summer and fall as the mid-terms approach, these signals could be very important.
This suggests that companies looking to play it safe may reduce volumes, especially if the Iranians are unwilling to discount as Chinese and Indian buyers are likely asking for. Those countries that have already negotiated insurance or set up vehicles to do so in 2012-14 may be better positioned to maintain their market share or engage in barter agreements with Iran. Many Asian countries had to learn quickly to navigate the system to make sure their payments reached the Iranians in that period. European insurers or banks are likely to be much more worried than some of their EM Asian counterparts. This suggests that Chinese, Indian and Russian influence may increase.
Shares of Iranian Exports by Countries (% of total exports in USD terms)
Source: IMF (via Macrobond)
Impact on OPEC+ agreement: Many analysts see the sanctions decision as a risk to the OPEC+ (Vienna group) agreement which seeks to restrict output. Its definitely a test, and one likely to tighten the market further, particularly coming after massive declines from Venezuela and more moderate ones from Nigeria. The former’s almost 1mbd decline was partly absorbed by other countries cheating, but still resulted in quicker rebalancing of the market. In Iran’s case, other countries, most likely GCC countries like Saudi Arabia might respond by just directly selling more, rather than formally changing the deal. Recent statements from OPEC+ members don’t seem consistent with a group ready to start adding a lot more capacity – adding to uncertainty and the risk that new suppliers are slow and lower volumes than expected.
The ongoing trade threats and negotiations likely complicate oil decisions, amplifying the incentive for some actors to maintain their imports, and reducing it for others. Japanese and Korean companies, mostly government owned, may have high incentives to temper purchases to avoid fines, and perhaps to avoid retaliation in other ongoing trade negotiations and the planned DPRK discussions. Similarly, divergence in interests between European countries (Germany and France) may reflect ongoing negotiations on planned tariff implementation as well as the spillovers from Russia sanctions, not to mention different views on industrial policy (government support of companies) as well as the divergent sectors of interest in Iran. The net result is likely to be one in which China, already a dominant player in Iran (as a supplier, buyer and investor) increases its involvement. Meanwhile Russian interests could also increase, though its increased reliance on China and GCC as a source of long-term investment could muddy the waters there.
Impact on Iran’s economy: Many analysts believe that export declines might outpace that of production as Iran might seek to fill its relatively empty floating storage and might look to refine more products in the hopes of selling. While Iran might initially look to use a loophole and continue exporting products, such a loophole is unlikely to exist for long.
The overall impact on Iran’s economy is likely to be painful, especially coming in the midst of the ongoing currency crisis. A lag between production and export declines would shift the impact on Iran’s economy as oil sector contribution to GDP might slow more gradually (if at all) in the near term as output remains steady. However a reduction in sales would hit revenues and liquidity and likely constrain domestic demand via reduced government spending and lower domestic liquidity. FX shortages might reinforce these trends especially if the central bank continues its tight policy to temper inflation. Eventually, both exports and production might fall, hitting both oil and non-oil growth, as higher oil prices don’t offset for the volume losses. The concurrent reduction in (albeit limited) long-term investment would add to the drag, suggesting Iran’s growth could slow or even move towards recession.
Related imports (either for auto manufacture), energy projects or broader infrastructure are also likely to slow, especially if Iran struggles to make payments. This implies that Iran may become even more of a price taker on its imports, relying more on countries that buy its fuel. The full “escrow” account system that was much criticized in 2012-5 (it allowed for accrual of funds in local currency within oil consuming nations to purchase only approved goods), is unlikely to resume in the same degree, with financial transactions more leaky than at that point. Still, key consumers of fuel are likely to be direct or indirect suppliers, even as overall imports and the ability to pay for them declines.
Imports have been trending up, especially from Europe and UAE (rolling 3 month sums, USD billion)


Source: IMF (via macrobond)

I’ve been spending a lot of time (maybe too much time) in the last few weeks thinking about the Iran deal and economic and political impact of the U.S. exit.  I’m not alone, judging by the sheer number of quickly organized JCPOA exit panels in D.C. last week. If people seemed insufficiently worried about the risks a month ago, now the related topics are front and center, including concerns about the way the decision making process and U.S. isolation might undermine future sanctions, U.S. influence and regional security.

Having written at some length about the macro, energy and policy impacts, it seems a good time to highlight in this post some concerns about possible negative risks to the sanctions apparatus, a topic treated well by Elizabeth Rosenberg (with whom I’m lucky enough to do some work at the Center for a New American Security).

Interlocking sanctions confuse the targets and make it hard to imagine an eventual lifting: U.S. sanctions targeting Iran on different grounds are now becoming intertwined. The U.S. has long had sanctions against Iran for support of terrorism, the nuclear program and ballistic missiles among others. These are now becoming intertangled, blurring the lines for those looking to identify  policies or behavior that might result in sanctions relief or an eventual deal. That is, its becoming harder to isolate the behavior that the target is being asked to change. While premature at this point, it increases risks the sanctions are merely punitive rather than being linked to a policy change Its worth noting that U.S. Russia sanctions too have converged towards to a focus on a wide-range of “bad actions” suggesting they too could be near-impossible to lift or to prove a policy change. Doing so may make it even harder to gain broader support for future sanctions decisions, which risks their effectiveness in their broader goal which is to prompt policy change, contain the target and avoid an escalation to direct conflict.

U.S. policy seems focused on driving regime change rather than specific policy changes.Many U.S. officials now seem focused on inflicting economic pain on Iran to stress the regime in the hopes it will be toppled. I remain concerned that inflicting pain may not lead to policies supportive of regional and global security  and U.S. interests and may actually backfire, especially if they empower those focused on domestic resilience and resistance. While cutting off cash flow may result in a less free hand regionally, and less ability to support proxies, the focus on regime change is likely to disempower any pragmatists. Moreover it risks undermining the deal and making it more difficult for global cohesion.

Challenges to global financial plumbing and dollar funding system: The recent re-imposition revives key questions around the impact on the SWIFT system, which was key to cutting off dollar funding and broader funding in 2012. While a European system, the coordination was key to the depth of the sanctions, cutting off Iran from the global financial system. It also contributed to a further interlinkage between U.S. and European systems.  The tug of war between the U.S. and Europe could add to the confusion for those processing payments and could lead to alternatives to SWIFT and existing payments systems, adding interest for creation of new tools in Russia and China, and even Europe. There may be a cautionary tale from the recent round of Russia sanctions which resulted in several exchanges freezing transactions for a period of time, lest any deals violate sanctions. While targeted to one designated entity, the moves by the LME and Euroclear, while individually rational could pose risks to the exchanges themselves. While not a real challenge to the system any time soon, they may reinforce other structural drivers of competition including new stores of value in non-dollar assets . They could also shift more transactions underground, making them harder to track, collect taxes and fees on and undermine a wide range of policies.

Transactional bargaining between enforcement decisions and trade/security policy: The recent tweet from President Trump that seemed to offer relief for ZTE (a sanctions violator) as part of a broader U.S.-China grand bargain raised concerns for many reasons, not least the willingness to undermine previous legal processes  in exchange for possible trade/foreign policy gains at the executive level. Selected members of the  Trump administration have rhetorically used sanctions relief as a bargaining chip in trade negotiations on several occasions in the last year including offers to China if they imposed tighter sanctions, negotiations with the EU on trade and Russia links to name a few.  The willingness of the Trump administration to (at least rhetorically) use sanctions and sanctions relief for particular corporate entities as a bargaining chip for security and trade policy negotiations raises several issues around consistency of policy, industrial policy (of picking winners and losers at home or abroad).
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There are no doubt many more..

To read the whole post with graphics, please download here. Last week many Emerging market assets came under pressure following the rise in the US 10 year yield. The sell-off was concentrated in Turkish and Argentine markets, whose FX and thus other assets fell sharply, and in USD sovereign debt more generally, but some other assets came under pressure, admittedly falling just outside recent trading ranges. The sell-off prompted a lot of questions about whether this is a broad-based crisis. I don't think it is? Rather it should be a reminder to look closely at national balance sheets, the quality of growth, fiscal space and resilience. 

I’ll try to answer (briefly!) a few key questions in this post: What happened? How have affected central banks responded? How strong are EM fundamentals?  Is this another EM-financial crisis (hint: probably not), What would it take for a broader sell-off? what might be the vectors of contagion if it escalated? should we be worried about pegs?

As one would expect given the portfolio effects, which are higher for hard currency debt and equity than local, some other liquid EM saw outflows including Mexico (NAFTA risk), Brazil (election), India and Indonesia (oil and some modest financial contagion) but these seemed modest and are likely to remain so unless there is a meaningful macro risks emanating from China or the U.S. These risks are likely to stay isolated, but add to some growth challenges across relevant regions. Other stronger assets caught in the cross-fire (and even some of the affected assets) may present buying opportunities. 
This is unlikely to be the last such bout as investors test the resolve of the Fed to continue normalizing, the significant wave of US bond issuance is absorbed and growth rates stagnate or weaken due to the waning of stimulus and trade policy risks. Higher and rising oil prices – driven by the uncertainties about the Iran deal, continued implosion in Venezuela and profit seeking in Saudi Arabia, only complicate the outlook, causing concerns for oil importing regions and countries, and their consumption and external balance. 

Early last week I wrote about my concern that the risks Iran deal were not on the radar of many global investors and policy makers, one of the surprises from my last DC trip. I needn’t have worried – its now top of the agenda, or at least sharing it with China trade, Nafta and DPRK - a very busy agenda. If the U.S. were a Muslim country, I would be accusing policymakers of trying to get things done before Ramadan begins, but election timelines and a desire for continual pressure on negotiating partners seem to be a more realistic explanation. 
 
With the Iran deal front of mind seems a good time to expand on a few points from my ongoing analysis of Iran’s economy, including what’s happened since the passage of the JCPOA. While the economy has had some breathing space, focused around the revival of the energy sector, local policy choices and limited foreign investment kept domestic demand weak and challenged any private sector credit revival, all trends that are likely to be even more complicated in the coming months.