Promise and Risk in Iran’s Emerging Market

EghtesadOnline: The announcement of Iran’s preliminary nuclear deal in July 2015 and the subsequent easing of sanctions augured a brighter economic outlook for the country.

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23 October 2017

Commentaries hailing Iran as “the billion dollar growth opportunity” and “the best emerging market for years to come” have proliferated alongside the wave of commercial and government delegations heading for Tehran to explore prospective investments.

Although it has been dampened by low prices in global hydrocarbon markets, this is now being translated into economic growth.

In the long run, however, Iran’s anticipated economic bonanza is predicated on cultivating a market-oriented business environment conducive to foreign investors and maintaining the goodwill of the western powers and its immediate neighbors, reads an article authored by a senior lecturer at Coventry Business School in the UK, Richard Woodward. According to Financial Tribune, below are excerpts:

Justified Excitement

At first glance, there is plenty to justify the excitement surrounding Iran’s rewiring into the global economy. Despite its years of relative isolation, Iran remains the 18th largest economy whose productive capacity and consumer markets have huge potential.

According to McKinsey, 56% of Iran’s households have an annual income exceeding $20,000. The country’s population is young (60% are under 30), urbanized, well educated (possessing high rates of literacy and enrolment in tertiary education), technically proficient (boasting the world’s fastest growth of scholarly scientific outputs and the fifth highest numbers of students graduating from engineering degrees), and entrepreneurial.

Iran is also blessed with natural advantages. The country possesses the world’s largest natural gas and the fourth largest oil reserves. Although petrochemicals account for 80% of the country’s exports and around a third of government revenues, its economy is much more diversified than many of its regional counterparts.

Significant exports of fruits and nuts, cement, plastics and other chemicals reveal the proficiency of the country’s farmers and manufacturing enterprises.

In fact, reintegration into the global economy is expected to revitalize the automobile, pharmaceutical, mining and tourist sectors. Iran’s location, including sea channels on its northern and southern coasts and borders with seven countries straddling Europe and Asia, leave it conveniently placed to play the role of a regional entrepot, especially given China’s enthusiasm for a New Silk Road aimed at resuscitating ancient trading routes between the two continents.

Challenging Economic Environment

This good news notwithstanding, Iran remains a challenging economic environment, especially for outsiders.

“Institutional voids”, the absence of an ecosystem of independent regulatory bodies and intermediary companies that support market operations, are a serious hindrance.

Although some western professional services firms have started to return, the shortage of recruitment and real-estate companies make it difficult to hire appropriately trained staff or rent office space, the shortage of credit reference agencies inhibit efforts to obtain or extend credit, and the shortage of market research and end-to-end logistics providers make it virtually impossible to identify and deliver products to consumers.

Iran’s lowly position (120th out of 190) in the World Bank’s Doing Business Index and the World Economic Forum’s Competitiveness Index (69th out of 137) likewise reflects a lengthy list of grievances, including corruption, tedious border procedures, restrictions on capital movements, inadequate infrastructure and erratic policymaking driven by the whims of state-owned companies. Topping this list is the difficulty of obtaining finance.

Iran’s financial system is relatively unsophisticated and budding entrepreneurs rely heavily on bank lending. Unfortunately, many of Iran’s banks are saddled with non-performing loans and are forced to channel much of their available credit to public enterprises.

The upshot is that the private sector is starved of capital or can only borrow at steep interest rates. To plug this shortfall and attain the ambitious 8% growth rate stated in its current Sixth Five-Year Development Plan (2017-22), Iran has pinned its hopes on attracting foreign investment.

The preliminary accords announced by Shell, Total, Airbus, Boeing, Orange and PSA Peugeot Citreon are among hundreds of contracts signed between foreign companies and their Iranian counterparts during the last two years.

Nevertheless, on closer inspection, many of the deals signed with companies overseas are nothing more than memoranda of understanding that put no capital at risk. The hesitance of prospective investors to commit to Iranian operations has many roots, but two in particular stand out.

First, doubts persist that the Iran can deliver thoroughgoing reform in the face of entrenched longstanding interests of entities inside the country. Second is the lingering threat from sanctions against Iran.

The recent decision by US President Donald Trump will inevitably put the focus on the “snapback” mechanism for reimposing sanctions related to the nuclear agreement.

Arguably, however, an equal threat comes from existing sanctions unrelated to the nuclear deal. Over 200 Iranian entities remain subject to US sanctions for non-nuclear related reasons. Given the opacity of company ownership structures in Iran, foreign companies run the risk of stumbling unwittingly into an alliance with an entity on the US sanctions list.

The advice on the US Treasury’s website is unequivocal: “US persons–including US companies–continue to be broadly prohibited from engaging in transactions or dealing with Iran or its government.”

To this end, the US does not permit its financial system to be used to facilitate economic activities with Iran. Washington also insists that non-American companies selling to Iran must obtain an export license if their products include US manufactured materials.

Foreign companies with significant US operations or which make extensive use of the US financial system have also been reluctant to engage with Iran.

Many larger European banks, mindful of the multibillion-dollar fines previously meted out, still refuse to handle transactions for clients undertaking Iranian operations.

Filling the Void

Companies from countries (especially China) that are less squeamish about dealing with Iran or are able to bypass the US financial system are currently filling the void.

While these companies may be able to match the financial wherewithal of their western equivalents, they ultimately lack the technical expertise and modern management practices needed to transform Iran’s solid domestic producers into internationally competitive industries.

Iran is regularly referred to as a final frontier for foreign investors. As with all frontier economies, their huge potential comes with attendant risks.