COMMENT: Solution to Iran’s banking problems starts at home

COMMENT: Solution to Iran’s banking problems starts at home
Northern business district of Tehran.
By Gary Kleiman of Kleiman International June 6, 2016

Since the January implementation of the nuclear deal that enabled the partial lifting of sanctions, Iranian officials from the supreme leader to the central bank governor have lambasted foreign banks for their so-called “Iranophobia”, mainly due to the US dollar and financial system curbs that remain in effect. These restrictions, directed particularly at the Revolutionary Guard with its pervasive economic control, are enshrined in domestic US legislation due to expire at year-end and have subjected major Asian and European banks to billions of dollars in penalties. However, Tehran’s political leaders and technocrats, joined most recently by the International Monetary Fund’s (IMF) deputy director on a maiden visit to the country, also acknowledge the pressing need for a clean-up of the state-dominated banking sector.

The Iranian banking system’s reported non-performing loan ratio stands at 15%, and businesses are starved for credit at mandatory near 20% “return” rates under the no-interest Islamic framework. President Hassan Rouhani’s advisers and local experts also emphasize the further development of the debt and equity markets, which contribute only marginally to savings mobilization and company financing, and have yet to attract much in the way of foreign investment, which is only 1% of the activity on the Tehran Stock Exchange. The lack of progress on a comprehensive financial sector reform agenda cannot be blamed on Washington or disappointing nuclear deal implementation, and Iranian policymakers and the just-elected parliament must reverse this state of affairs if they are to eventually earn global banking confidence.

The IMF’s number two, David Lipton, praised Iran’s economic stabilization strides during his brief visit in May, but cited a long list of unfinished fiscal, monetary and structural adjustments already taken by rival frontier markets. Less than 1% growth was registered in the Islamic year ended in March after a prolonged recession, and unless oil prices rebound the 4% post-sanctions growth forecast for this year is unlikely to be met. Agriculture was the best performer with a 5% advance, while services as a reflection of consumer strength was flat and industry fell 2%. The inflation decline was “impressive” with the latest annual headline readingcoming in at 9%, compared with over 40% two years ago, after monetary policy was tightened. The budget deficit was a modest 1.5% of GDP following an initial round of food and fuel subsidy cuts, while state enterprise losses remain a drain on the budget. However, President Rouhani unveiled a stimulus programme in late 2015 to support the auto, property and small business sectors, eroding discipline as discount loan facilities provided worsen bank portfolios, IMF analysts commented.

In the external accounts, the current account surplus almost vanished, but non-oil exports picked up. Foreign debt is negligible given the lack of borrowing capacity over the past decade, although Iran still owes Asian and European contractors billions of dollars in arrears to be taken from unfrozen accounts before normal supplier trade credit can resume. Iran issued Eurobonds in the early 2000s at a ‘B’ rating, and is in talks with the big three rating agencies as well as Chinese and Russian ones about obtaining an updated grade.

Exchange rate unification has long been promised, but inaction is an overriding international commercial and financial obstacle, with a 15% divergence between the parallel and official 30,000 rial/dollar level. Central bank representatives say the move could finally come in the next few months once they are able to fully access sequestered foreign reserves. It may be expedited to quell overseas bank hesitation now that the country is reconnected to the SWIFT network, since currency conversion entails loss from the higher government rate. Smaller European banks with active emerging market franchises, like Belgium’s KBC, have tiptoed into correspondent relationships despite the transaction risk. They have also been assured by domestic regulators of freedom from punishment as Iran works to adopt Financial Action Task Force-compliant anti-money laundering and terror financing guidelines.

However, the global banking community continues to shun direct local participation given dire balance sheet and supervisory conditions that President Rouhani flagged up early in his tenure, when he convened a conference to debate solutions. National accounting, auditing and classification norms, applied by a central bank subservient to the politically-influenced Monetary and Credit Council, mask the true extent of system bad assets, which are estimated at 20-30%. In capital adequacy terms the dated Basel I norms are used and the total rescue cost for the 20 licensed state and private banks, leaving aside dozens of unregulated intermediaries, could be in the $50bn-75bn range – around the size of the funds that could be released with the nuclear accord.

The government intends to pass stricter enforcement provisions in new laws, and may also assign sweeping restructuring powers to a “banking tsar” to shake up management, merge and close institutions, and restore profitability. It has debated the creation of a central “bad bank” as well, and the IMF has offered technical assistance to support these steps, but warned in its last Article IV report that “urgent repair” is overdue.

The Tehran Stock Exchange in turn has advanced 20% over the past year, with the market capitalization jumping to $100bn amid a low 7x price/earnings ratio. Several small London-based dedicated funds have opened with local partners targeting consumer plays in particular. However free floats are paltry with government pension funds and religious foundations locking up huge share blocks, and company financial information is thin. Retail speculative investors dominate trading, and many brokerages are unsophisticated operations tied to bigger family conglomerates with the associated contagion risks.

A privatization programme was initiated during the previous administration to increase offerings and buyer interest, but has since stalled. Pilot sukuk Treasury bill issuance was attempted last year, but considered a flop without supporting dealer networks and yield curves, and corporate bonds listed on the exchange are also state firm-dominated and illiquid. Supreme Leader Ayatollah Ali Khamenei touts the so-called “Resistance Economy”, which prioritises domestic production over imports, and in the banking and securities market modernization that phrase continues to apply.

Without serious internal accountability taking the place of external scapegoating, fears over a financial system meltdown and foreign investor fright will intensify over the next sanctions deal phase.