Emad Mostaque, Strategist, Ecstrat
The last few years of negotiation following the freezing of Iran from the global system in 2012, co-ordinated with several regional allies to try to prevent the inexorable shift in the regional balance of power and baking of the Shia croissant, has shown that Iran is indeed a rational state, albeit one with irrational actors within it.
These irrational actors were, as in many countries, primarily driven not by religious fervour, but rather by political ideology (rather conservative) and the desire to maintain their privileged status in society – Iran’s elite controlled the reins to the sanctions economy and thus became inordinately wealthy from it, even as the middle classes suffered.
Economic factors to political sanctions
The erosion of the middle class and “bazaaris” was one of the most interesting elements of the recent sanctions regime, as this group had benefited dramatically from the easy monetary policy in Iran under President Ahmadinejad, who set real interest rates to -10% in a populist binge, causing a huge boom in the monetary supply base (almost four-fold pop) even as the currency was pegged to the dollar, resulting in a hugely overvalued rial and Iranian cash flooding the region and doubling imports to nearly $80bn.
This, combined with Iran undergoing subsidy reform (moving from $100bn a year on a $350bn economy to a basic income model) and GDP approaching $400bn made Iran a real threat from a soft-power basis in the region, particularly given its traditional “role” as supporting self-declared revolutionary groups such as Hamas and Hezbollah.
When sanctions kicked in in 2012, the Iranian rial simply corrected back to its real effective exchange rate, not a hyper inflationary collapse that some were warning of at the time. The currency has remained relatively stable in an EM context at around 30,000 rial to the dollar with interest rates at 20% and the Rouhani government steadily reducing inflation down to 15% from over 40%.
This move in the currency, which the elite could circumvent, halved imports and ironically crushed the increasingly influential middle class, who were effectively frozen out of the international market by SWIFT/banking sanctions. Indeed, the banking sanctions were the main spanner in the works for Iranian industry, as many industries were untouched by other sanctions but business just became too difficult to do for many others, particularly if focused on trade.
Recent sanctions and government action has led to some oddities in the Iranian economy in recent years, such as the savings rate dropping from 45% to 33% in the last few years with investment being squeezed, even as household consumption increased almost 10% to 52%. Real estate and luxury cars (particularly Porsches, which are oddly prevalent in Tehran) benefitted with imports at a quarter of consumption, but there is a significant gap in SME financing in particular.
While Iran will likely have access to over $100bn in frozen offshore reserves and assets, as well as 30m barrels of floating oil and increased oil flows, it faces a delicate balancing act if it is to avoid stoking inflation ahead of next year’s elections. The economy is moderately well diversified versus regional peers, with oil receipts under a third of GDP (with most of the receipts going on remaining energy subsidies and new social payments), but there is an increasing focus on economic diversification, with startup growth and accelerators actively encouraged and FDI, which currently stands at 2% of GDP, a key target. The opening of Iran should also change the political balance of power profoundly as the middle classes, who actually (mostly) pay tax, become the primary beneficiaries of increased trade and a reversal in declining investment.
Possibly the most interesting stock market in the world
The Tehran Stock Exchange has a market cap of $100bn and trades up to $200m a day, high in a frontier market context with a PE of around 6x and double digit dividends. Access should SWIFT sanctions be removed is surprisingly easy, but navigating the market is a bit harder as local knowledge is needed to separate the privately owned and controlled companies from those controlled by groups such as the Setad under Ayatollah Khamenei or under one of the myriad companies controlled by the praetorian guard of Iran, the IRGC. The bond market is nascent, but Shariah-compliant and growing
The stock market will be an essential means for Iran to encourage foreign investment and increase its profile, particularly as there are another potential $100bn of privatisations in the pipeline if current plans are kept to, ideally for the government at a higher valuation to the ones we’ve seen. We would expect inflows to be slower than one might think as foreign companies will be cautious of the web of sanctions that needs to be unravelled and many lack expertise in the region sufficient to navigate the opaque on the ground environment where corporate governance can be variable to say the least. The banking sector also doesn’t appear to be very healthy after years of economic mismanagement, but capital may suddenly become considerably cheaper to paper over the cracks.
Gradual sanctions removal
Back to the Iran deal, per the proposed text sanctions removal looks to be gradated but reasonably comprehensive, with the key banking sanctions being removed with IAEA verification, the major fillip to the economy that will allow it to resume its growth. We should expect a significant pickup in trade between Russia and Iran, with Turkey and China being the other major beneficiaries in this regard as the petrodollar nexus moves further East.
Certain sanctions focused on human rights abuses and related to Iran as a state sponsor of terror will stay in place, but the initial range of removed sanctions seems surprisingly broad. Iran has much more work to do to become a valued member of the global community, but trade goes a long way toward that. The most aggressive US sanctions have been codified by Congress and thus can only be waived by Congressional vote or waived on a short-term basis by presidential waiver. We don’t see this as being rolled back by future administrations, particularly as the likelihood of Iran adhering to the deal under our model is very high.
This also marks a massive success for President Obama and paves the way for an increased focus on Asia, where the rebalancing of China and Japan pose an uncomfortable problem with no clear solution. It is unlikely that the next President will roll back a nuclear deal or stop extending waivers regardless of the current rhetoric. The exception would be if Donald Trump wins, but that opens up a whole new barrel of worms. Congress will have 60 days to look at the deal but ultimately can’t block it. Big Oil will also lobby aggressively for the deal to be put in place.
The ultimate upshot of the deal however is peace as we avoid a distrous regional conflict.
Emad Mostaque is a Strategist at Ecstrat. This is an abbreviated version of his analysis of the deal between Iran and the P5+1 that was published on his blog on July 14th.
Disclaimer : The views and opinions expressed in this post are those of the author and do not necessarily reflect the official policy or position of ME Global Advisors.