Risk drivers and outlook

Iran has a relatively diversified economy and dependence on oil revenues has been reduced to one of the lowest among oil exporters in the MENA region. However, international sanctions severely impacted the Iranian economy. The intensification of sanctions in 2012 resulted in a higher budget deficit, deep economic contraction and a lower current account surplus. However, with the lifting of most sanctions the economy is expected to improve quickly in 2016.  Moreover, the country’s foreign exchange reserves stand at a high 17 months of import cover and external and public debts are very low, respectively about 7.3% and 15.9% of GDP at the end of 2014. For these reasons and as the international sanctions related to the nuclear programme were lifted, Iran´s political risk classifications are in category 6 for both the short term and the long term political risk on a scale from 1 (best) to 7 (worst).

The government under Rouhani has lowered inflation to 14% in 2015, a more enjoyable level than in 2012, when it stood at 41%. Also the availability of credit to the private sector at limited cost is perceived as a positive factor of the country’s systemic commercial risk. However, Iran has a relatively difficult business climate. The rule of law and accountability are weak, corruption is high whereas the exchange rate is overvalued. As a consequence, Credendo Group’s category for the commercial risk assessment is C (out of an A-C scale).

Facts & figures

Pros

  • Low external and public debt
  • Abundance of natural resources
  • High external liquidity
  • Relatively diversified economy

Cons

  • Dependence on energy for public and export revenues
  • Difficult business environment
  • Stagflation
  • Remaining international sanctions

Main export products

  • Oil & gas (57.2% of current account receipts), transportation, freight and insurance (5.1%), private transfers (0.6%)

Income group

  • Upper middle income

Per capita Income (USD)

  • 6,820 (2013)

Population

  • 78.5 M

Description of electoral system

  • Supreme Leader: appointed for life by Assembly of Experts
  • President: 4-year term, next elections in June 2017
  • Legislative (for unicameral Islamic Consultative Assembly or Majles-e Shura-ye Eslami or Majles): next election in February 2016

President

  • Hassan Fereidun Rouhani (since 2013)

Head of State

  • Supreme Leader Ali Hoseini-Khamenei (since 1989)

Country risk assessment

Stable but delicate political balance

Iran's political stability hinges on a balance of power between its different elite groups: the political elite, the military elite and the religious elite. The process of policy decisions involves extensive negotiation across multiple bodies and stakeholders, mostly behind closed doors. In the centre of the political system sits the Supreme Leader, who is the highest political and religious head. Ayatollah Ali Khamenei, who had been Iran’s president until the death of the first Supreme Leader Ayatollah Ruhollah Khomeini, currently holds this position. Khamenei, 76 and suspected to have prostate cancer, is appointed for life. He has significant power over several institutions and has the final say over all policy decisions. However, his way of operating is to wait for a consensus to form in debates and step in only when he has to break a deadlock. So Khamenei’s main task is to keep the balance between different power groups to ensure no single faction becomes too powerful.

However, this balance has been under increasing pressure as a part of the military elite, the Islamic Revolution Guards Corps (IRGC), expanded their political and economic influence. The IRGC is a combination of a military force and an intelligence agency, which owns a colossal business conglomerate in Iran. The IRGC plays a significant political role in the decision-making process by installing former personnel in elected or public posts. Through the Quds Force, a special forces unit, it also fights on Iran's behalf outside the country and is declared a terrorist organisation by the US. The IRGC’s reach in the Iranian economy has been growing since the Islamic Republic embarked on liberalisation in the early 1990s. After the war with Iraq (1980-88), former president Rafsanjani tasked the guards with assisting the government in reconstructing the country, which allowed the IRGC to expand into different sectors, a trend that continued under the Ahmadinejad presidency (2005-13). Also Khamenei’s reliance on the IRGC to quell protests in 2009 led to a substantial increase in the IRGC's domestic influence. Since president Rouhani took office in 2013, the pace of privatisation slowed down as the administration sought to reduce the financial influence of IRGC-linked corporations. It is important to note that sanctions on IRGC entities remain in place since only sanctions related to the nuclear programme are lifted. Hence, this can lead to significant counterparty risks for businesses partnering with Iranian companies.

Iran's regime has been relatively stable since its foundation after the 1979 revolution. It survived a major challenge to its authority during the 2009 'Green Movement' protests which demanded the removal of President Ahmadinejad. Protests were heavily repressed by the IRGC at the request of Khamenei but the latter and others in the elite recognised the need to respond to the popular demand for change in the system. In 2013 they allowed the election of Hassan Rouhani and gave him a mandate to negotiate a deal to end the nuclear dispute which had resulted in heavy international sanctions.

An island in the Middle East

Iran has a track record of tense international relations. Since the 1979 revolution, a core principle of the Islamic Republic is hostility to the West (chiefly the United States and Israel). The West, on the other hand, accused Iran of ‘rogue behaviour’ due to its support for militant groups in Lebanon, Palestine and Iraq. Iran’s international isolation was reinforced when the UN ratified several rounds of sanctions between 2006 and 2012 as a reaction to Iran’s refusal to halt uranium enrichment and cooperate with the International Atomic Energy Association (IAEA). The international agreement on Iran's nuclear programme in July 2015 has improved Iran's international status but the country has not abandoned its opposition to Israel or the US.

Iran found itself regionally isolated as well after the 1979 revolution and particularly during the costly Iran-Iraq war. With its majority of Shiite population, Iran is a Shia Islamic republic while most of its Middle Eastern neighbours have Shiite (minority) populations but are dominated by Sunni. Since the Iran-Iraq war, Iran has sought to develop a range of strategic alliances to end its isolation and project power in the region. Iran is now active in many neighbouring countries: in Syria, where it supports President Assad, in Lebanon with financial and military support for Hezbollah, and in Iraq where the IRGC fights against the Islamic State group (IS). The rising influence of a Shia Iran is perceived by Sunni countries as a severe strategic threat to their national security. Moreover, both Saudi Arabia and Iran are seeking for dominance in the region. This can lead to heightened tensions, particularly through a proxy war. This is illustrated by the current war in Yemen. Iran is (allegedly) supporting the Houthi rebels in Yemen, while Saudi Arabia is leading an international coalition against these rebels. Also, in the future, despite the nuclear deal, sectarian conflicts in the region cannot be excluded due to these regional dynamics.

Impact of international sanctions on the economy

Between 2006 and 2010, the UN ratified four rounds of sanctions as a reaction to Iran’s refusal to halt uranium enrichment and cooperate with the IAEA. The EU and the US even imposed further-reaching bilateral sanctions, including restrictions on the transfers of funds to and from Iran and a ban on entering into export credit commitments. Given the extraterritoriality of US financial sanctions, financial institutions cut ties with Iran and the transfer of funds, even for payment obligations on contracts signed prior to the imposition of sanctions. In January 2012, these sanctions were further broadened to include a ban on imports of Iranian crude oil and petroleum products. In March 2012, SWIFT had to discontinue its communications services to Iranian financial institutions. As a result, the country was cut off from the world financial system.

The intensification of international sanctions in 2012 brought shockwaves and pushed the Iranian economy into a deep contraction for two consecutive years (see graph below). Also, the current account balance was hit by the intensification of sanctions. It had been positive for years, but halved to 6.6% of GDP in 2012. In November 2013, the P5+1 (China, France, Russia, the United Kingdom and the United States; plus Germany), the EU and Iran signed an agreement for a short-term freeze of portions of Iran's nuclear programme while economic sanctions decreased on Iran, as the countries work towards a long-term agreement. This agreement provided a significant but short-lived impulse on the economy in 2014 as the economy grew by 4.3%. The effect is less significant on the current account balance, as oil prices dropped since mid-2014.

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On 14 July 2015, Iran agreed to a long-term deal to curtail its nuclear programme significantly. In return, the UN, the EU and the US agreed to grant Iran relief from certain nuclear-related sanctions. Due to the agreement, economic growth slowed down to 0% in 2015 as consumption and investment decisions were postponed because economic sanction relief was expected. In 2016, as sanctions are lifted, higher oil production, lower costs for trade and financial transactions and restored access to foreign assets are expected to lift real GDP growth to about 4.3 %. The current account balance is expected to remain subdued as oil prices are expected to remain relatively low in the medium term.

The economic tailwind from the nuclear deal will be somewhat restrained by the challenges of doing normal business in Iran. First of all due to the snap-back mechanism that can reinstate all sanctions automatically if Iran violates the agreement. Secondly, there are sanctions that remain in place related to other aspects of Iran’s behaviour, such as human rights issues, support of terrorism and its ballistic missile programme. US companies and foreign companies with significant exposure to the US market in particular face further hurdles to doing business with Iran because of remaining sanctions. Finally, Iran’s business environment is rather difficult. The country ranks 118th out of 189 countries in the World Bank’s Ease of Doing Business 2016. The country is known to have bureaucratic red tape, opacity of state institutions and an uncertain regulatory environment. Moreover, the rule of law and accountability are weak and creeping corruption is high. Finally, Iran's legal system is also outdated and complicated. These factors impeded FDI inflows even before international sanctions were introduced. However, as sanctions are lifted, the authorities can have greater incentives to press ahead with reforms to improve the business environment, notably to attract new foreign investors.

Diversified economy

Iran holds the world's fourth-largest proven crude oil reserves and the world's second-largest natural gas reserves. Despite the country's abundant reserves, dependence on oil revenues has been reduced to one of the lowest among oil exporters in the MENA region (see graph). This can partly be explained by the economic structure which is relatively diversified compared to peers. First of all, Iran is rich in other natural resources. Excluding fuels, it is the 11th biggest mineral producer in the world and the biggest in the Middle East. It has, among other things, copper, iron, chromium, phosphates, salt, gold and silver. Moreover, Iran is the second-largest producer of petrochemicals in the Middle East, after Saudi Arabia. In addition, it has a well-established automotive industry with a considerable potential for growth. Over the last years the Iranian government tried to diversify the country even more due to the impact of international sanctions on the oil sector (see supra). The sanctions have profoundly affected Iran's energy sector and have prompted a number of cancellations or delays of upstream oil and gas projects. The recent sanction relief is likely to accelerate crude oil production and exports. Iran might be able to produce an additional 600,000 to 900,000 barrels of oil a day regardless of the oil price, and increase this number to around 4 million barrels a day in the medium term. However, to reach this goal, attracting foreign investment, technology and expertise will be of critical importance. Other key sectors as well can benefit from the lifting of sanctions as the automotive sector depends on imported parts and the petrochemical sector could resume its exports.

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The government pursues sound macroeconomic policies

The government under Rouhani has been focused on solving the country’s economic problems. His prudent macroeconomic policies helped to stabilise the Iranian economy. One of the priorities is inflation. Iran has a long history of high and volatile inflation as is shown in the below graph. Until a recent past, the government policy prioritised output over inflation. However, since president Rouhani’s election in 2013, the government has tried to bring down inflation. More recent data show that Iran advanced in this area with inflation being estimated to be 16.2% and 14% in 2014 and 2015 respectively, coming down from a huge 41% in 2012. Inflation is expected to decline further in 2016 into the single-digit territory, to about 9%.

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The government has also been tackling the fiscal balance which has been in deficit since 2011. The fiscal balance came under greater pressure in 2012 when sanctions were further broadened. However, the Iranian government has implemented reforms to tackle this problem. First, it began to broaden the revenue base away from oil. Oil accounted for 55% of central government revenues in 2011, putting the central government budget deficit under strain when international sanctions in 2012 targeted oil. As a result, the oil share fell to 39% of central government revenues in 2014. Also now, as sanction relief is granted, dependence on oil is not expected to increase as oil prices will remain low in the medium term. Secondly, the government also decided to restrain current public spending, with a focus on Iran’s elaborated subsidies system. The government announced in early 2014 that they would scale back energy subsidies, leading to a fuel price increase in March/April 2014 of about 30%. Recent reforms have eased pressure on the fiscal budget; yet more needs to be done. In 2016, thanks to the sanctions relief, the fiscal deficit is expected to narrow to 1.3% of the GDP, coming from 2.5% in 2015. Sanction relief also allows authorities to use more of their foreign assets, half of which have been frozen abroad. Access to international capital markets is restored as well, allowing the government to accumulate external debt (in 2015, external public debt stood at a low 8.9% of GDP). As a consequence, the sanction relief provides a better environment to sustain sound macroeconomic policies and advance needed reforms such as further revenue diversification and subsidy reform.

Large net external creditor position

Iran is a large net external creditor. External debt (less than 2% of GDP) and debt service ratios are very low which is partially explained by the fact that the country has no access to international capital markets. Foreign assets of the banking system are equivalent to about 50% of GDP. However, a large share of them is frozen and is not available for payment purposes, even after the recent sanction relief. The country has comfortable foreign exchange reserves which stood at 17 months of import cover in 2014. That is high compared to many MENA peers (see graph). Nevertheless, a significant share was inaccessible when international sanctions related to the nuclear program applied. This has led to external arrears because of Iran’s difficulty executing payments. Looking forward, as these international sanctions are lifted, Iran is expected to be able to pay back these external arrears.

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