Iran’s economy: FX, Energy and Domestic Policy Choices

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. 

Firstly on the deal risks; I continue to worry about the seeming lack of coordination for the outcomes that might occur on “May 13” and beyond and the differing views I was hearing about the impact of sanctions on Iran’s economy. U.S. policy seems still focused on pressuring allies to “fix the deal”, a positive sign, but at the same time, there seems to be less concern to what lifting the waivers and attempting to reimpose secondary sanctions might imply. There seems to be a growing risk that the U.S. will try a middle solution of looking to up-end the deal, but figuring out new sanctions measures and new energy supply patterns as it goes. The contrast with the 2010 period of sanctions preparation is palpable - at that time U.S. officials spent a considerable period of time looking to allies and adversaries to generate a unified front to avoid oil market disruptions. This does not (yet) seem to be the case. Uncertainty around the implementation of sanctions will likely encourage buyers to look on the margins for other supplies, making it difficult for a range of businesses to plan. As many in the press have noted, within European countries, the views on the next steps remain uncertain, meanwhile there seems to be little effort to work with Asian buyers to create a united front. All of this, coming at the same time as difficult trade negotiations likely increases volatility of oil products and makes it harder to plan for supply chain risks. 

Iran’s currency crisis: Many people have been writing about and asking about the decline in the Iranian rial. Given that oil market trends (global price and lack of Iranian discounts) suggest that there should be appreciation pressure, the pressure suggests there are sizeable capital outflows. This puts Iran (and Russia for that matter) at a contrast to the broader trend of oil producers who are facing Fx appreciation pressure as external balances improve and breathing space widens. 
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FX adjustments tend to have multiple causes and then take on a life of their own. In this case, as best as I can tell, it was driven initially by the crisis in the nonbank financial institutions that contributed to the protests in December and thereafter. Uncertainty about jcpoa was a major contributing factor but in my view, not the sole factor of the Fx slide. 

The failure of those financial institutions contributed to a search for hard assets, gold Fx and when the government was reluctant to provide it, the currency fell further, exacerbated by sanctions uncertainty and the limited access to foreign finance. That global banks were unwilling to provide liquidity was nothing new, they have long been cautious about the wide range of counterparty risks… and worry about snapback. However some regional sources of liquidity have been less available. Contacts in Dubai suggest that UAE-based institutions have been restriced in providing FX to moneylenders in Tehran, consistent with the AML rules of the UAE central bank.
 
What has the government done in response? -  keeping interest rates high to try to avoid further outflows.
- restricting the size of transactions (capital controls) – some commentators suggest this has had the silver lining of progressing on some of the anti-moneylaundering goals.
- unifying exchange rates. Allowing official rate to converge to unofficial one. Usually this helps since it avoids arbitrage, but may need to be accompanied by other policies such as providing Fx to locals who want it and  clarity on jcpoa. Iran still has significantly less foreign currency liquidity than many of its oil exporting peers, though foreign curency liabilities are even smaller (watch for an upcoming post. 
- they also seem to have adopted another policy which may be more symbolic - a swap line with turkey aiming to help Iranian banks get access to funding in Turkey for trade purposes - similar lines (from China mostly) finance imports from the country that provides it.  I am not yet aware of the details including size and scope of the mechanism, which will likely be small. 

The irony shouldn’t be lost though that Turkey’s currency and external balance is its own weak link - with inflation just into double digits, real rates modest (adjusted for inflation) and the current account deficit widening due in part to higher energy costs and the impact of massive quasi-fiscal expansion in the last year. Reserve adequacy is lower than other comparable countries - and Turkey's central bank is again calling in private sector gold reserves which it tends to do when there are significant FX concerns. Even comprared to IRR, TRY does  not look like a good store of value by any means. 

However, it raises an interesting question if other countries will route trade through Turkey. I would expect a greater proportion of trade to come from countries where government guarantees to trade are in place (some asian countries) taking on that risk instead of the bank. 
 
How is Iran’s Economy doing? How does it compare to the pre-JCPOA?
 
Despite the challenges, which are meaningful, Iran’s economy, still seems healthier than pre-jcpoa when the economy not just Fx but domestic demand and imports were in free fall. However, it’s still an economy which is weak and where there is little private investment and private consumption remains constrained. Credit growth is negligible reflecting to supply and demand issues and high cost of credit. The. Economy started to stabilize post Jpoa. But the bouncebank was almost entirely driven by energy sector (output and natural gas exploration), with construction and manufacturing providing only some offset. Domestic demand remains weaker than pre 2010 levels in part because some of the balance sheet damage from the Ahmadinejad years is only slowly being repaired. 
 
There are several reasons for this growth trend
- lack of major investment from IOCs, which are a reflection both of deal uncertainty and some domestic legal contracting issues and issues from the legislature. There have been many more MOUs than actual investment
- lack of global financial flows including banks (no surprise there). It has meant that those investing in Iran have needed to self insure, either internally (oil companies) or from sponsor governments (asia).
- government choice to prioritize reining in inflation (something that is even harder after the Fx crisis given the pass through from weaker currencies) and being fiscally conservative rather than boosting overall growth.
- inefficiencies in the domestic economy and challenges with vested interests. 
 
Thus, the government was reluctant to redistribute the additional (moderate) oil revenues post jcpoa, which of course were not massive, they also restricted bank credit which mean that household wages didn’t rise much and tended to fall in inflation adjusted terms. Despite some efforts to clean up the banking systems, local banks still have significant non or underperforming assets, related party lending to past cronies – measures which are hard to clean up. 
 
All of these factors might amplify the impact of the uncertainty from the future of the deal, a topic we will no doubt be discussing in more detail in days and weeks to come. For more on this or to see a fuller report, get in touch.