IRAN

 


Summary
Iran has shown a strong determination not only to maintain Bank Markazi’s unblemished payment record, but also to demonstrate the creditworthiness of the state-owned commercial banks, since concluding reschedulings of external commercial debt payment arrears which arose in 1993-94.. Foreign debt has fallen sharply, and its maturity profile lengthened. New finance is emerging, particularly in the trade finance arena. The development of the energy sector provides fascinating opportunities for foreign financial institutions, some of which are already opening offices in Tehran.

The election of President Khatemi in May 1997 has, despite recent minor setbacks, strengthened the position of reformists and suggests further political reform to separate the powers of clergy and government. After years of international isolation, Iran’s relations with the outside world are beginning to improve. Relations with Gulf neighbours and the EU are now on a better footing and there are tentative signs that relations with the US are beginning to thaw after decades of open hostility.

Increasing numbers of international companies appear ready to ignore US sanctions legislation on Iran, raising questions about the long-term viability of the ILSA Act of 1996.

Short-term prospects have been hampered by the collapse in oil prices, and economic growth is expected to fall to 2% in 1998/99 as the government tightens fiscal policy and reintroduces tight restrictions on imports.

Creditworthiness has improved, thanks to the timely repayment of external debt obligations. Several export credit agencies have re-instated cover for Iran and the UK’s ECGD is understood to be reviewing its position.



Iran votes for change
Iran has come a long way since the Revolution of 1979. Euphoria following the overthrow of the Shah and the creation of an Islamic state has been replaced by frustration with the policies of a revolutionary government that has led the country into international isolation and hindered economic development. Pressure for reform and modernisation has been increasing since the death of Ayatollah Khomeini in 1989. This change in attitudes has been reflected in recent Parliamentary and Presidential election results. 1996 elections for the Majlis (parliament) proved an important barometer of the shifting balance of power - for the first time since the 1979 revolution conservatives were in a minority - but it was last year’s Presidential election which confirmed the full extent of public appetite for change. Moderate candidate Hojatoleslam Sayyid Mohammed Khatemi won a staggering 70% of all votes cast, while the conservative candidate and speaker of the Majlis, Ali Akbar Nateq-Nouri, who had been a one-time favourite and whose victory seemed a foregone conclusion, secured only 25% of the vote.


But right-wing remains powerful force
Khatemi’s term in office is expected to be marked by a new period of reform in Iran. However, the President will have to tread carefully for fear of antagonising Iran’s powerful religious right-wing which came to prominence after the formal creation of the Islamic Republic of Iran in 1979. Although Iran’s political system comprises executive, legislative and judicial branches with elections every four years for both the President and the Majlis, it is the religious establishment that has wielded power ever since Ayatollah Khomeini became Iran’s de facto leader following the Revolution.

Since Khomeini’s death in 1989, there has been a noticeable separation of powers between the clergy and government, but the religious establishment remains a powerful force. Iran’s current spiritual leader or Faghih - Ayatollah Ali Khamenei - is highly influential and the religious right-wing dominates the powerful Council of Guardians, Iran’s constitutional watchdog, screening all hopeful political candidates on moral and ideological grounds. Despite recent setbacks in Parliamentary and Presidential elections, the right-wing has been able to use its position on the Council of Guardians to undermine Iran’s liberals and moderates. The Council frequently uses its position to exclude Iran’s moderate groups from standing for office - most recently in by-elections for the Majlis when it rejected almost half the applicants, many of whom were Khatemi supporters.

The balance of power between the reformists and religious conservatives is expected to remain fragile. President Khatemi has made frequent references to political reform. Although no exact details are known it seems likely that any changes will aim at further separating the powers of clergy and government - something the right-wing is likely to resist.


International relations - a new era under Khatemi?
Following years of international isolation and sporadic failed efforts to reintegrate Iran into the international community, there is mounting evidence that Iran’s international relations are entering a new era. From Iran’s perspective, an improvement in international relations is critically important if it is to attract the foreign investment needed to support economic development. Former President Rafsanjani recognised this and took significant steps to improve Iran’s international relations, but it has been President Khatemi who has taken this a stage further.

Relations with the European Union are improving. A dispute with the EU, which had been triggered by a German court’s conviction of Iranian nationals for the assassination of Iranian Kurdish dissidents in Berlin in 1992, was finally resolved in November 1997, and most European ambassadors have returned to Tehran. UK Foreign Secretary Robin Cook’s recent comments that isolating Iran is "counter-productive" offers further encouragement, despite the unresolved fatwa against Salman Rushdie.

Regional ties with the Arab world have also taken a turn for the better since Khatemi took office. To some extent this is the product of the overtures made by Iran during Rafsanjani’s second term in office, but Khatemi can be expected to build on this.

Significantly, there are tentative signs that relations with the US are thawing. Although a huge divide still exists in perceptions and policies between Iran and the US, recent months have been characterised by more conciliatory statements from both sides. Further rapprochement is likely to be constrained by mutual mistrust and, from Iran’s perspective, by Iran’s spiritual leader Ayatollah Ali Khamenei who, in the past, has been a fierce opponent of improving ties with Washington. However, Iranian public opinion appears to favour closer ties and it may be this that allows Khatemi to continue with initiatives to improve Iran’s external relations.


Future of US sanctions policy in doubt
The future of the US’s controversial sanctions policy - the Iran-Libya Sanctions Act (ILSA) of 1996 - which mandates penalties against foreign companies investing more than $20mn a year in Iran’s oil and gas projects has been thrown into doubt following the decision of French oil major Total, in partnership with Malaysia’s state-owned Petronas and Russia’s Gazprom, to sign a $2bn deal to develop Iran’s South Pars gas field. The deal clearly breaches US sanctions policy, but so far the Clinton administration has stopped short of imposing sanctions because of fears of damaging relations with the EU. The apparent lack of US enthusiasm to impose sanctions against Total and its partners has cast doubt over the whole issue of US sanctions policy. Several other international oil majors have made clear their interest in investing in Iran. Congressional opposition probably precludes any immediate change in US policy, but US sanctions policy is clearly in disarray.


Economic policy and structural reform
Since the onset of the external debt problems of late 1993, financing of Iran’s substantial debt service obligations has been the main priority of economic policy. Measures to suppress imports have ensured that Iran has generated sufficient current account surpluses to cover debt payment obligations, and a combination of tight financial policies and fiscal consolidation has also enabled the government to reduce inflation to more manageable levels.

Despite the success in stabilising the economy since the onset of debt problems, deep structural imbalances have not been fully addressed. The public sector impinges on all aspects of the economy and has increased its control of the country’s resources, while the lending policies of the country’s commercial banks are primarily determined on political guidance rather than commercial feasibility. For a country like Iran, wracked by a ten-year war with Iraq and denied access to international finance over a prolonged period, this level of state intervention has been unavoidable. However, policy instruments have become increasingly inappropriate and the need for more comprehensive structural reform is mounting. Inefficient pricing policies, a weak tax system and a multiple exchange rate system have hampered economic development and performance. Some progress has been made on reducing price subsidies on domestic energy supplies and other basic items such as bread, but further progress is needed if Iran is to realise its full growth potential. There is also still a great deal to be done in terms of privatisation. The authorities are fully aware of the situation, but a broad political consensus in favour of such reform remains absent and there is therefore little prospect of radical structural reform in the near future. Instead the current policy of gradual adjustment is expected to continue.


Fiscal deterioration
The need for structural reform has become more apparent this year with the collapse in international oil prices. Following the improvements made in 1996/97 when fiscal consolidation and more favourable oil prices helped cut the fiscal deficit to 2.9% of GDP, Iran now faces fiscal difficulties. Weak oil prices thwarted plans to cut the deficit to 2.5% of GDP in 1997/98, and already government earnings projections for 1998/99 have been revised. The original budget, unveiled in November 1997, was based on an oil price assumption of $17.50 per barrel, but this was subsequently revised to $16 per barrel and oil earnings projections were adjusted accordingly, down to $16.2bn, in January, following the collapse in oil prices in late 1997. However, with oil accounting for over 40% of government revenue, and limited alternative sources of revenue, further budget revisions were inevitable, and in April 1998, the government set a new oil price of $12 per barrel, which implies oil revenue of nearer $12.2bn.

 

Oil Price movements

Source: Bloomberg

Growth prospects worsen
Economic growth is forecast to drop to nearer 2% this year as the full impact of weaker oil prices hits the economy. Fiscal tightening and import compression will depress industrial sector activity, while high real exchange rates will continue to undermine non-oil export growth.

The outlook contrasts sharply with the performance of the economy over the past two years when firmer oil prices helped mitigate ongoing tight financial policies. Real GDP growth accelerated to around 4.5% in the Iranian year 1375 (to end March 1997). The recovery was generally broad-based with strong performances from the construction, mining and manufacturing sectors, although the banking and insurance sectors continued to under-perform. The oil and gas sector also built on the recovery of 1995/96 as oil prices stayed firm. The outlook is very different for 1998/99. Public sector cutbacks will hinder oil and gas sector development as well as industrial sector activity. Several investment projects are already on hold and there is even some doubt about key projects.

 

Source: IIF, estimates

But inflation falls
Although it is difficult to ascertain the true level of inflation in Iran because of the host of price controls, subsidies and the distortions created by overvalued exchange rates, the official rate of inflation has declined owing to tight financial policies. Official consumer price inflation has fallen from around 50% in 1995/96 to less than 20% in 1997/98. Enforced public spending cuts associated with weaker oil prices together with weaker private demand should ensure inflationary pressures are contained at around 20% over the coming year, despite cuts in government subsidies on fuel and other items.

Source: Bank Markazi

Major energy developments
Iran’s proven crude oil reserves are estimated at 94bn barrels, equivalent to around 70 years’ production at current extraction rates. Iran’s quota in the Organisation of Petroleum Exporting Countries (OPEC) was increased to 3.942mn barrels per day (b/d) at OPEC’s Jakarta meeting in November 1997, prior to which it had been unchanged at 3.6mn b/d since 1993. The collapse in international oil prices since October 1997 (prices are down by almost 40%) has prompted Iran, along with other OPEC member states and non-OPEC producers, to cut production. In March 1998, at an extraordinary OPEC meeting in Vienna, Iran agreed to hold output, at 3.48mn b/d. Although this represents a cut of around 11% from its revised OPEC quota, it is less than 4% down on actual production in February.

 

Iranian crude output (mn barrels per day)

Mar 98

Feb 98

Jan 98

1997

Jakarta quota

3.59

3.62

3.60

3.48

3.94

Source: IIF

Production capacity is thought to lie somewhere close to Iran’s pre-November 1997 OPEC production quota. Output from mature onshore fields is declining following years of inadequate maintenance and it is not clear how much long-term damage has been done by recent water injection schemes aimed at restoring reservoir pressure. Increasing importance has been attached to developing offshore fields where production costs are cheaper and the National Iranian Oil Company (NIOC) is actively seeking foreign participation in several field developments on a buy-back basis. Political sensitivities have in the past precluded foreign involvement in Iran’s onshore fields, but economic realities have forced a re-think and a series of proposals are currently being prepared, offering upstream projects in both offshore and onshore fields to foreign companies. Oil majors have been cautious to invest in Iran, partly because of the threat of US sanctions, but also because of contract concerns. However, Washington’s inability to impose sanctions against French oil major Total over its involvement in the development of the South Pars gas structure is likely to lead to further foreign participation in oil and gas development in the future.

Iran has extensive gas reserves. Proven reserves of 20,000,000mn cubic metres represent 12.6% of global reserves and make Iran the second richest country in gas resources after Russia. Development of Iran’s gas, like oil, has been adversely affected by US sanctions policy, but foreign companies are now showing increasing interest.

Of huge significance is the work currently underway to construct a link between the Iran Gas Trunkline network and the border with Turkey. This infrastructure is being put in place as part of an agreement reached in 1996 between Turkey and Iran, which foresees more than US$20bn in oil being delivered by Iran over the coming years.

Further exchange rate liberalisation
Foreign exchange policy continues to rely on a multiple exchange rate system centred around an official "floating" rate pegged at IR1,750 to the US Dollar and an export rate of IR3,000 per US Dollar. The official rate applies to oil exports, essential goods imports, official capital inflows and debt service payments, while the export rate applies to all other exports and imports. Since 1995, a 100% repatriation requirement has been in operation and various surrender requirements applied to exports. In January 1998, however, the government dropped all currency requirements for exporters, effectively freeing non-oil exports from foreign exchange restrictions. The move, together with several devaluation schemes in recent months, is seen as a bid to reverse three years of decline in non-oil export earnings. By mid-April 1998, the Rial was trading at around IR6,300 to the Dollar in the black market. In view of current weak international oil prices, further falls are envisaged.

 


External position deteriorates
Following three successive years of improvement since 1993/94, the current account has deteriorated amid weakening international oil prices. Bank Markazi estimates suggest the current account surplus was running at half the level of the previous year in 1997/98. A further fall this year is inevitable given the collapse in oil prices. Non-oil exports continue to under-perform, but could pick up following the removal of currency repatriation requirements for exporters, in January 1998. Non-oil export revenue reached a peak of $4.8bn in 1994/95, but subsequently fell to $3.2bn the following year following the imposition of strict currency rules. With oil and gas accounting for over 80% of total export earnings, any recovery in non-oil exports will have a limited impact.

Given the need to maintain current account surpluses to cover external debt obligations, import growth will again be compressed. Following two years of compression in 1994/95 and 1995/96, when imports were cut to below $13bn, compared with over $20bn at the beginning of the decade, imports were allowed to increase to around $15bn as the external constraint eased. However, towards the end of 1997/98 it become apparent that import growth would need to be curbed again in order to maintain the current account position. Even if import growth is restrained the current account surplus looks set to narrow over the coming year.

Source: Bank Markazi

but external debt remains manageable
There has been a substantial improvement in Iran’s external debt position since the debt servicing difficulties of 1992/93. Short term debt, which had soared to $17.6bn, equivalent to 76% of total debt in 1993/94 was cut to $4.5bn (27% of total debt) in 1996/97. Since 1993/94, external debt has been cut from over $23bn to nearer $15bn, and therefore some $6bn in total debt must have been repaid in 1996/7 alone, according to Bank Markazi data.

Substantial current account surpluses have ensured that debt service obligations set out in ambitious rescheduling agreements in 1994/95 have been honoured. Bank Markazi data suggest that debt service obligations will peak at $5.4bn in 1998, but thereafter will ease back to nearer $200mn by 2002. Despite the collapse in oil prices and inevitable impact this will have on the current account, the government will meet its debt service obligations this year with reserves making up the shortfall in the current account.

Source: Bank Markazi


Creditworthiness improving
Iran’s success in covering external debt obligations has enhanced the country’s creditworthiness. Several export credit agencies have re-instated cover for Iran, and the UK’s ECGD is currently reviewing its position. However, Iran will have to continue to honour its obligations, despite current difficulties associated with the collapse in oil prices, if it is to maintain its creditworthiness. Assessments of Iranian sovereign risk reflect the country’s domestic political uncertainties, and as such its improved creditworthiness has been based on its professional approach to debt management and punctual repayment record.

Although foreign investor interest is picking up, actual levels of investment remain modest to date. According to official data, foreign direct investment is subdued at around $20mn. One of the main problems has been Iran’s international isolation and, in the case of the oil and gas sector, US sanctions policy. However, the election of President Khatemi and the increasing influence of the reformists offer some encouragement, and even some right-wing conservatives recognise the need for foreign investment.


Reserves set to fall
The Iranian authorities do not publish actual reserves figures on a regular basis, preferring to report changes in international reserves. However, it can be assumed that the country’s reserve position has improved significantly since the debt crisis of 1992/93, thanks to Bank Markazi’s policy of running large current account surpluses and small net inflows of private capital brought in by residents. According to Bank Markazi estimates, reserves (excluding gold, clearing accounts under special payment agreements, and holdings with international organisations) increased to $7.5bn in 1996/97, equivalent to approximately six months visible import cover. The reserves position is assumed to have deteriorated since then, however, owing to falling oil prices and declining current account surpluses, reflected in the declining trend in Iranian deposits with BIS banks, which by September 1997 had fallen to $7.5bn, from $10.7bn at the end of 1996.

 

Iranian deposits with BIS banks (US$ mn)

Dec 95

Dec 96

Jun 97

Sep 97

8,526

10,721

9,848

7,457

Source: Bank for International Settlements

Short term outlook
Iran faces a difficult year. In the absence of radical structural reforms which could reduce the country’s dependency on oil revenues, short term prospects will remain inextricably linked to oil prices. With world oil prices currently $5 below average 1997 prices, economic growth prospects have suffered. Further fiscal tightening appears inevitable, as does the re-introduction of import compression. Measures to revive non-oil exports, such as the removal of currency repatriation requirements for exporters, will enjoy some success, but will do little to alter the decline in the external and fiscal accounts. Most macro-economic indicators are forecast to worsen this year. Despite current problems the overriding priority of government policy will remain the repayment of external debt commitments.

 


Conclusion
There is no doubt that the Iranian economy has entered an important period. The collapse in oil prices will depress economic growth, but could encourage the government to accelerate economic reforms. The third five-year development plan, currently being prepared, is expected to contain proposals to diversify the economy, but Iran’s dependence on oil will continue well into the next century.

Iran displays a strong determination to maintain Bank Markazi’s unblemished payment record. Substantial efforts have been made to ensure timely payment of external debt obligations and although the forecast slump in oil revenues undoubtedly adds to financing pressures, we believe that Iran will continue to honour its external debt commitments. There is a concerted drive to lengthen the maturity profile of borrowings, which has greatly eased short-term debt ratios, and there is a strong desire to attract foreign investment. It is clear that Iran will become integrated into the international community once more. It is of vital strategic importance to the West and to Central Asia as a provider of energy (oil and gas) and petrochemicals. The need for integration is forcing the pace of policy change on the part of Western powers, which recognise the strategic importance of the country and its resources. For international financial institutions, the most interesting opportunities currently exist in the developing short- and medium-term trade finance market for Iran, and the financing associated with the developments of the energy and petrochemical industries, especially in the building of infrastructure which itself ever more closely links Iran with the rest of the world.

Key economic indicators

 
 

1995/96

1996/97

1997/98e

1998/99f

GDP growth (%)

3.2

4.4

3.0

2.0

Inflation (%)

49.4

23.2

17.3

20.0

Fiscal deficit (% GDP)

-3.5

-2.9

-2.5

-5.0

Oil production (mbpd)

3.6

3.6

3.7

3.7

Average oil price (Brent, $/b)*

17.1

20.4

19.2

14.0

Oil exports (US$bn)

2.4

2.4

2.4

2.0

Current balance (US$bn)

3.4

5.2

2.7

2.2

Reserves (US$bn)

5.2

7.5

5.1

3.5

External debt (US$bn)

21.9

16.8

13.6

15.0
* calendar year (95/96 = 95)
Source: Bank Markazi, IIF.


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