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Risk profile

Iran’s financial and macroeconomic indicators are strong thanks to high oil prices, but its governance indicators are weak. Overshadowing the country is the possibility of sanctions, even armed conflict, in response to the country's nuclear program. Over-dependence on the volatile oil market is another concern.

Recent developments – Negative

The victory of ultra-conservative Mahmoud Ahmadi-Nejad in June presidential elections has increased the likelihood of populist economic policies, a harder line on social and foreign policy, an increase in domestic political in-fighting, and more difficult foreign relations.

The president's economic program announced in August is vague and contradictory. It advocates marketisation, privatisation and bureaucratic downsizing, but also introduces a raft of new controls and regulations. It talks about strengthening capital markets but criticises banks’ profit-making. According to the blueprint, tourism should be boosted, but so should enforcement of Islamic moral codes upon visitors.
There is speculation that Ahmadi-Nejad may end foreign investment in the oil and gas industry, even though such investment is vital to arrest dwindling oil production from ageing fields. Oil production was down to 2.13m b/d in September from 2.74m b/d in May.
A speech by the president on 26 October calling for Israel to be ‘wiped from the map’ has earned him condemnation both at home and abroad (photo). In response, Supreme Leader Ali Khamenei has called for ‘statesmanlike’ conduct of foreign policy. And the president's opponent in the June presidential elections, the former president Ali Akbar Hashemi Rafsanjani, has said that the Israeli-Palestinian issue should be solved peacefully.

www.iranfocus.com

Khameini’s disquiet at Ahmadi-Nejad’s truculence has reportedly prompted Khameini to give the watchdog Expediency Council, led by Rafsanjani, oversight of all three branches of government to ensure that they stick to the government’s long-term goals.
Opposition to the president is also building among conservative and reformist deputies in the majlis (legislature). Complaining about lack of consultation, conservatives have rejected the president's choice of oil minister, proposed a new law to force the retirement of many senior petroleum industry managers, and conducted investigations into corruption in the industry. The result has been a state of ‘paralysis’ in the industry, according to consulting firm Oxford Analytica. Meanwhile, reformists, including previous president Mohammed Khatami, are holding exploratory talks about forming a ‘reform and democratic front’ to oppose the government.

The president's intemperate remarks over Israel will worsen the already-existing dispute over Iran's nuclear program. They are unlikely of themselves to prompt a US or Israeli military strike against Iran's nuclear facilities – Iran’s influence in Iraq and in the international oil market rules that out. But they will increase US/EU pressure for the UN Security Council to impose sanctions – pressure that Russia and China will continue to resist. The nuclear stalemate is likely to dog the risk outlook for some time.

According to the Financial Times, ‘concerns have been growing in corporate boardrooms across the globe about Iran’s alleged nuclear ambitions’. BP, General Electric and Halliburton have all recently said that they will either shelve new investment in Iran or refuse new business till the issue is resolved.

Rating comparisons

The OECD rates Iran 4 for country credit risk on a scale 1-7. Of the three major international credit ratings agencies, only Fitch rates Iran. Last December it upgraded Iran’s long-term foreign currency debt rating to BB- from B+ . BB- is equivalent to an OECD rating of 5. According to press reports, five Iranian companies are planning to issue international bonds this year with a total value of more than US$1¼ b. They are awaiting ratings from Fitch expected to be close to the sovereign rating.

The Economist Intelligence Unit (EIU) awards Iran an overall risk rating of D on an A-E scale. Security risk: B. Political stability risk: D. Government effectiveness risk: E. Legal/regulatory risk: E. Macroeconomic risk: B. Foreign trade/payments risk: D. Financial risk: D. Iran ranks last of 60 countries in the EIU’s business environment rankings.

World Bank governance indicators (see chart below) show a country in the bottom quartile of the international league table on four out of six indicators. The country has been going backwards since 1996 except for a negligible improvement in regulatory quality and a more marked improvement in control of corruption.

The Heritage Foundation classes Iran as ‘Repressed’ on measures of economic freedom. It ranks 148 out of 155 countries, between Uzbekistan and Cuba and seven notches ahead of the most lowly ranked country, North Korea.

Freedom House classes Iran ‘Not Free’, with a score of 6 for both political rights and civil liberties on a scale of 1 (freest) to 7 (most repressed). It says that the trend is downward ‘due to the hard-line clerical establishment’s obstruction of the electoral process and increased restrictions on freedom of expression’.

External debt default – Moderate risk

Thanks to record oil receipts, the short-term external payments outlook is good. The continuing strength of oil prices have given Iran the best of all worlds – the ability to increase government and import spending rapidly and to generate external current account and fiscal surpluses. Those surpluses have in turn allowed accumulation of substantial foreign exchange reserves and repayment of external debt. External debt is now less than 10% of GDP, and the debt service ratio is under 6%, according to the EIU. Foreign exchange reserves are many times greater than short-term external debt, providing a large cushion against liquidity or debt rollover difficulties.

Even so, a drop in oil prices could erode the economy’s strong financial position, especially given the very heavy dependence on oil and the risk that the government wouldn't cut spending as rapidly as it increased it beforehand. Oil makes up 80% of merchandise exports and hydrocarbon revenue more than 50% of total government revenue.

Because of strong exchange and capital controls, the economy is relatively immune to capital flight. Note, however, that a sudden and significant flight of capital to Gulf deposit accounts, in response to a deteriorating political climate, was reported in September. While this won't deplete official foreign exchange reserves suddenly, it will drive down the black market exchange rate and could over time lead to a steady drain of reserves.

There is a small risk that an escalation of the nuclear dispute could prompt either imposition of sanctions, or a payment standstill by the government, or both.

Inconvertibility – Moderate risk

Reasonable freedom to remit income and repatriate capital plus currently strong petrodollar earnings and high foreign currency reserves limit inconvertibility risk. Nevertheless, inconvertibility remains a concern for two reasons – ambiguity about the country's capital controls and demonstrated willingness by the authorities in the past to reach for capital controls when foreign currency inflows and reserves decline.

The Foreign Investment Promotion & Protection Act of 2002 (FIPPA) allows repatriation of capital by foreign direct investors, but adds that investors can repatriate only 'the foreign currency earned through the export of commodities produced and/or through the foreign currency resulting from services rendered by the corporation utilising the foreign capital and/or through the export of any other authorised commodities'. In plain English, income derived from sales in the local market isn't eligible for transfer abroad.
The authorities reached for exchange and capital controls on several occasions during the 1990s to eke out scanty foreign exchange reserves. If they were to do so again, it is unclear whether they would give priority in foreign exchange allocation to import spending or to obligations to foreign creditors and investors.

Expropriation – Low risk

A repeat of the wave of nationalisations that occurred after the 1979 revolution is unlikely. The FIPPA makes explicit that foreign ownership is allowed in a range of business assets and vehicles, including BOT, oil buyback and civil partnerships. It also guarantees compensation in the event of nationalisation. However, the act clashes with Article 44 of the Constitution ... 'The state sector is to include all large-scale and mother industries ... power generation ... post, telegraph and telephone services ... and the like; all these will be publicly owned and administered by the state.' Further ambiguity creeps in because while the act states that foreign ownership shall not exceed 25% in each 'economic sector' and 35% in each 'field (sub-sector)', the authorities have leeway to give 'due regard to the value of the services and commodities supplied in the domestic market' when deciding whether to permit an investment.

Legal/regulatory problems – High

The legal and judicial system does not do a good job of protecting property rights or enforcing contracts, according to many investors and analysts. It is biased against foreigners and liable to manipulation by local interests. Worse, the conservative-dominated majlis has retrospectively changed laws affecting foreign investors – to their cost. It has passed laws to retrospectively lower foreign ownership in a mobile phone licence and an airport. These have prompted the foreign investors to threaten withdrawal from the projects.

The majlis is proposing to give itself a right of veto over foreign investment ventures.

Political risk consultancies such as the EIU advise investors to take advantage of bilateral investment agreements where they exist to insert international arbitration clauses in contracts. According to the Australian Department of Foreign Affairs & Trade, Australia and Iran are currently negotiating such agreements on trade and investment promotion and protection.

Political violence – Low risk

Internal security is by and large good, and external threats low.

There are some provisos. A pre-emptive US/Israeli military strike against Iranian nuclear facilities would change things for the worse. So would a US military campaign to effect regime change.

The main threat to internal security is the continuing and intense power struggle between hardline conservatives and reformists. This has spilled over onto the streets on several occasions, notably in 1999 when students calling for reform fought pitched battles with security forces in Tehran – the students came off second best. For the present the hardliners have the upper hand because of their control of the security forces and willingness to put down dissent. But time is probably on the side of the reformists because of demography – the country's overwhelmingly young population yearns for political and social liberalisation. A clerical establishment bent on clinging to power facing a population crying for change is probably not a good recipe for peace and stability.

Typically, foreign commercial interests have not been targeted in street protests. Nevertheless, if the nuclear dispute with America escalates, popular anger could be directed at foreign interests. In that event, the usual suspects – embassies and iconic brand names – would be in most danger.

Roger Donnelly
Chief Economist
rdonnelly@efic.gov.au

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