A year has passed since the Iran nuclear deal and the lifting of international sanctions — but where is the flood of inward investment that the economy expected to see? Rumors have emerged of dissatisfaction within Iran at the slow progress of economic change, while foreign investors remain wary of the market and uncertainty over US secondary sanctions continues to inhibit activity. LAUREN MCAUGHTRY takes a closer look at what is really happening in the world’s largest Islamic economy.
The Joint Comprehensive Plan of Action (JCPOA), an international agreement on the nuclear program of Iran, was agreed in Vienna on the 14th July 2015 and EU and primary US sanctions were lifted the following January. After an initial surge of excitement however, the optimism began to slow. US banks and citizens are still restricted from engaging with Iran, and the country remains unable to process international financial transactions or repatriate assets from overseas accounts. Uncertainty is rife and dissatisfaction appears to be spreading within the country — in April, US Secretary of State John Kerry met with Iranian Foreign Minister Javad Zarif to discuss concerns over the implementation of the JCPOA, after Iran voiced frustration at the slow pace of the financial sanctions relief promised by the deal. Iran’s central bank governor, Valiollah Seif, has already warned that the agreement could be at risk if the US doesn’t act to facilitate Iran’s reintegration into the global markets.
However, observers note that a transformation of this magnitude will always take time. “Upon the lifting of sanctions, the sentiment in Iran arguably was one of over-excitement, with expectations of immediate benefits,” explained Clemente Capello, the founder and chief investment officer of UK-based asset management firm Sturgeon Capital. “The reality is, these benefits take a while to play out, and as such expectations are adjusting.”
“What the European banks are looking for is clear guidance from the US as to what they can and can’t do,” agreed Kiyan Zandiyeh, the portfolio manager for Sturgeon Capital’s Iran Fund. “The Iranians see this as a stumbling block to getting benefit from the lifting of sanctions and they are exerting a lot of pressure to change the situation.” However, he warns that: “There still is a level of mistrust between the Iranians and their counterparts to the JCPOA, and vice-versa, with certain factions on both sides having an interest in the deal not being fully implemented.”
This divergence between expectation and reality has been reflected in the recent volatility of the market. “Between January (when sanctions were lifted) and April, the market rallied just above 30%,” noted Kiyan. “However since then till the end of June, it fell 10%. So from initial high hopes, we saw a dramatic lowering of expectations.”
Recent months have brought good news, however — and the market is looking optimistic. Foreign direct investment into Iran rose to US$4.5 billion in the first quarter of this year — the highest growth in over a decade, according to fDi Intelligence.
Although the volumes do not yet meet the stated government ambitions of US$30-50 billion in foreign capital per year, progress has been positive. KPMG recently released a report that found 12 sectors for inward investment worth an estimated US$250 billion, while inward FDI projects jumped from just three in 2013 to nine in 2015.
Siemens in March signed a preliminary rail deal for US$2.3 billion while Airbus and Boeing have reportedly received orders for US$27 billion and US$17.6 billion respectively; and talks this month with Japan’s Mitsui Chemicals and French oil giant Total are expected to bring in a further US$60 billion in foreign investment.
On the banking side, a report from the Financial Times claims that the financial services sector has also seen inward investment of over US$60 billion. “There are current liquidity issues but once these are resolved, banks will be the big winners. The Iranian economy is bank-based and when trade finance and LCs return, you will find the better banks will have a very high return on equity and will benefit from that growth story,” pointed out Payam Malayeri, the head of asset management at Griffon Capital, a Cayman Islands-registered asset management and private equity group and one of the few investment firms fully focused on the Iranian market.
A challenging market
All this sounds promising — so what’s the bad news? Most significantly, practitioners warn that Iran’s financial, legal and regulatory framework is simply not yet advanced enough to accommodate the influx. “The barriers to entry are notable — foreigners need handholding and guidance,” explained Payam. “The integration of Iran back into the global economy will take time. Currently, there is a rather [large] gap between Western regulatory standards and regulations in Iran. SWIFT is on, but correspondent banking relationships are a stumbling block today. There are a lot of challenges and most foreigners who want to work with or invest in Iran will need the help and guidance of local experts.”
A question of perception
While there are very real obstacles to development, much of the white noise in the market appears to be a question of perception. “There are two types of challenges — real and perceived,” commented Capello. “From an infrastructure standpoint the market is well developed. We have more than a decade of experience in frontier markets and Iran is the most developmentally sound, liquid, diverse market that we have dealt with, so concerns around that are misguided. The main concern for us is that western and international banks are still not keen to transact Iranian business because they are afraid of sanctions. Their compliance departments have not been updated and their internal regulations prevent them from having anything to do with Iran. That has been the biggest challenge for everybody. The most frustrating point is that it is not a rational conversation, but a dogmatic one.”
So how do you overcome these issues? Reputation is important, as is working with a local partner. One of the first things that Sturgeon Capital did in the asset management space was to set up an institutional grade, very transparent and scalable platform for governance and industry best standards. “We spend a lot of time on sanctions compliance and what that means in terms of how you invest,” noted Payam.
“It’s a very hard market for those that don’t have the relationships to penetrate,” agreed Abradat Kamalpour, a finance partner and head of the newly-created Iran desk at Ashurst. “However, those that have the relationships and the language and the cultural understanding are doing very well. We are already deeply involved in a number of transactions.”
As impetus builds, there is increasing pressure on the US to clarify the situation and remove uncertainty. “Right now the restrictions are just a self-inflicted disadvantage by the US,” said Capello. “It’s not getting anywhere in terms of its stated political objectives, which are to create better understanding between the west and Iran. The sanctions are really just making life difficult for banks.”
However, progress is gradually taking place. “There is a lot of momentum building up,” noted Abradat. “The expectation that it would take off overnight after sanctions were lifted was always unrealistic — these things take time. Any investor that wants to get in needs to go and understand the market first, meet people, understand the legal framework. No one is going to put half a billion dollars in tomorrow. But the due diligence trips and the compliance investigations are happening now.”
A land of opportunity
For those early movers brave enough to dip a toe in the waters, the rewards look to be worth the risk. Valuations are cheap, with average PE ratios standing around 7, according to Griffon Capital. “Average dividends for the broader market are around 11-12% — around 30-50% cheaper than emerging markets and frontier markets,” pointed out Payam. “We think this discount will close in the years ahead so first movers will have an advantage.”
The returns are already validating entry. Between its launch on the 4th April 2016 to the 28th June, Griffon Capital’s initial euro-denominated share series gained 3.6% despite a market correction of 8.2% in the TEDPIX (the main index of the Tehran Stock Exchange) and has thus far materially outperformed the industry benchmark. “We expect our AUM [assets under management] to be between EUR50-60 million (US$54.86-65.83 million) by December 2016 year-end,” noted Payam. Sturgeon has seen a similar trajectory. “Performance has been positive — from February to June, we are up 13% in euro terms while the market is up about 8%,” Capello told IFN.
The improving macroeconomic environment should only help matters — last month the country’s inflation rate dropped to single digits (9.7%) for the first time in 25 years, which means riskier assets like equity will benefit. The Tehran Stock Exchange in July announced its approval by the World Federation of Exchanges, which should bring another boost. But it’s not just the equity markets that are tempting foreign investors. “At the moment, you can also invest in government treasury bills, which are giving yields north of 20% — very attractive in a world where most sovereign bonds are bringing in zero,” said Payam. “It’s a great choice for yield-hungry investors and it also brings diversification to a portfolio.”
The key benefit of Iran is its already developed and diversified economy — only around 10-20% of its GDP comes from hydrocarbons, compared with around 45% for Saudi Arabia, for example. “Iran is not just an oil and gas story. There are deals being done on solar, rail, auto manufacturing, technology, mining and minerals, pharmaceutical, technology and aviation,” noted Abradat. “It’s just a matter of time before the big guys can start playing ball with confidence.”
So who has been brave enough to take the first plunge? Unsurprisingly, the first movers have been high-net-worth investors and family offices. “They are the more intrepid and nimble investors with less red tape and are faster to get comfortable,” commented Payam. However, the investor profile is already changing. “We do have institutional investors in our fund already and by the end of the year they will be the majority,” he noted. “They have taken more time to come online because their due diligence takes longer, but they are getting there slowly.”
And while the standard intelligence says that US citizens are banned from engaging in Iran, IFN has learned that the opportunities may nevertheless be too tempting for some investors to pass up. “We have seen dramatic interest from high-net-worth investors and family offices — including Americans,” revealed Capello. “Americans are not allowed to decide whether to invest in Iran, but there are ways around that — there are exceptions for certain types of investors. Without going into detail, we have found a lot of interest from investors that were a combination of two groups: [those with] 1) a certain amount of sophistication and 2) limited bureaucracy in their organization.”
The elephant in the room is of course the impact that all this interest and activity could have on the Islamic finance industry. There have been concerns that while Iran is ostensibly the world’s biggest Islamic economy, its systems are so different that this may not have a notable impact on industry development. However, Abradat believes that it is instead an issue of changing perceptions. “Everything in Iran’s financial market must be Shariah compliant. Shariah compliance is done based on the models developed in Iran and signed off by the relevant Shariah scholars in Iran. Other players in the market will need to adapt to understand their way of transacting,” he explained. “You have the GCC model and the Malaysian model. Now there is another model in the market, and Iran has the largest amount of Islamic banking assets in the world so it will behoove the industry to take notice. If people want to access the Iranian market, they will need to understand how it works.”
Investors are already aware of the specific requirements of the Iranian economy, and while not all funds investing into Iran define themselves as Shariah compliant to their investors, they believe that they offer a genuinely Islamic opportunity. “All investments in Iran are Shariah compliant. All the fixed income is Islamic, so they all tick the Islamic boxes. It is an Islamic country so there are no non-Islamic sectors,” Payam explained to IFN. “The majority of investors have been conventional investors looking for returns. However, we have also talked to investors who focus on the Islamic side, and want exposure to Iran because it complies with their requirements.” Even those asset managers who have not yet explored Shariah compliant options are, through the opportunities in Iran, learning more about the potential within the Islamic market. “Our mandate is more generic,” commented Capello. “We are at a stage where we would be interested to learn more about Islamic investors but we are still in the early stages.”
So where next? Instead of being a watched pot that never boils, Iran appears to be transforming before our very eyes into a vibrant and attractive investment destination — and key players are starting to sit up and take notice. “The bigger financial institutions are about six months to a year away from entering the market and a lot of them are just getting ready now,” said Abradat. “There is a lot of interest in the Iranian market from Asia — especially Southeast Asia as well as Japanese and Korean institutions — and these players are going in aggressively and signing deals. There are also a lot of European banks already doing business there, and since launching our Iran desk we’ve had a few global banks approach us to make plans. A few GCC entities are very interested but they are in the early stages.”
And of course, all this interest will only have a positive impact on the Shariah compliant financial framework. “These banks will have to develop Islamic finance capabilities to get involved in Iran, and that will act as a catalyst for the global industry,” Abradat confirmed. “The institutions that are getting in now and building the relationships and taking measured and calculated steps to move in will be in a very good position. The global Islamic finance industry could do with a bit more energy. Ever since the financial crisis, innovation has slowed and it needs a bit of impetus. Once Iran opens up, it will act as a catalyst for the market, and it will be a vital cog in the global wheel.”
At the end of the day, however, the appeal will be in the performance — and institutions will follow where investors forge a trail. “In a world where returns are going down and investors are hungry for yield, Iran looks very attractive,” concluded Payam. “It is a classic case of risk versus rewards — but the rewards are underestimated and the risk is overstated. With time, that will reverse.”