The agreement Iran has reached regarding its nuclear program could bring about its eventual economic rebound, and boost Islamic finance in particular, in Standard & Poor's view. Iran agreed the Joint Comprehensive Plan of Action (JCPA) with the P5+1 (China, France, Russia, the U.K., and the U.S. plus Germany) in July 2015. Standard & Poor's believes this bodes well for Iran's economy, if and when sanctions are lifted, and could boost Islamic finance. Iran is one of the largest players in the industry, contributing to around 40% of global Islamic banking assets
Iranian banking system leverage (measured as financing to total assets) remains relatively limited, leaving space for some financing of post-sanction infrastructure and investment projects. However, due to its low capitalization and weak asset quality indicators, we believe the banking system alone is unlikely to be able to absorb these investments: we expect Iran may need recourse to other forms of financing such as sukuk, both for infrastructural investment projects and overall economic regeneration in Iran. This assumes all the necessary regulatory adjustments are made, such as aligning the structures used for sukuk issuance with those widely accepted in the market. We expect that accessing the sukuk market might help Iran raise funding for its projects and be seen by global Islamic investors as a diversification opportunity. The Islamic financial market could also benefit from volume effects as post-sanction investment projects are reportedly high. This could support market growth in the medium term.
The flipside of sanction removals is the possible drop in oil prices. This could intensify pressure on some oil exporting countries that rely heavily on oil revenues, in turn curbing their spending and banking system growth.
None of this is a done deal yet. The agreement is still to be approved by the parliaments of some of the P5+1 countries and Iran has to comply with its obligations.
Sanction removal could create medium-term opportunities for Islamic finance
Iran has been under international sanctions for more than 35 years. These have intensified over the past five years and
have significantly undermined Iran's economy. Real GDP growth turned negative in fiscal years 2012 and 2013 before recovering slightly in 2014, while inflation spiked and the local currency depreciated by more than 50% (see chart 1).
Over the past few years, investments in key economic sectors have also declined due to the lack of available financing
sources as sanctions cut Iran's access to the international capital markets and prohibited foreign investments in most
of its economic sectors.
If the agreement is approved and Iran meets all deliverables, sanctions may start to lift in the first half of 2016. The World Bank estimates this would help Iran's oil exports rebound to pre-2012 sanction levels within 8-12 months.
Sanctions lifting could also restore Iran's access to the global financial markets. Under this scenario, Iran's GDP growth would hover around 6% annually in fiscals 2017 and 2018 according to market estimates, compared with less than 1% in 2015 (IMF data).
Post-sanctions, the Iranian economy is expected to be boosted by increased oil revenues (the World Bank estimates $15 billion in the first year); lower trade costs; higher foreign direct investment of around $3 billion in 2016 and 2017 compared to almost nil between 2012 and 2014; and reestablished access to frozen foreign assets (the World Bank estimates around $107 billion, of which about $29 billion will be released immediately after sanctions are lifted).
Significant investment projects that had been put on hold will also likely resurface and involve foreign, multilateral, and bilateral investors. Iran has recently said it will present to oil-sector investors alone projects worth more than $100 billion. On the flipside, oil prices could drop due to Iran's additional oil export capacity causing an increase in supply--estimated at about one million barrels per day.
While we think that investors might be cautious, Iran's investment needs are significant. Given the scale of opportunities--infrastructure projects or regenerating the country's already well-diversified private sector--Iran will likely seem attractive to many investors, especially compared to other oil-exporting countries in the region, and also because Iran benefits from a relatively well-educated labor force. The United Arab Emirates and China are likely to be the first beneficiaries from sanctions lifting given their existing relationships with Iran as they contribute to around two-thirds of Iranian imports.
Standard & Poor's believes that the free capacity available in the Iranian banking system might be used to meet some financing needs, possibly boosting growth for Iranian banks and the global Islamic finance industry. Nevertheless, we do not view the agreement as a done deal yet; the removal of sanctions is still not secured and has yet to be approved by some P5+1 parliaments. We consider it unlikely that the Iranian banking system and foreign direct investment alone can absorb the planned investments and we expect that recourse to other sources of financing--multilateral, bilateral, and sukuk issuance--might be necessary. In recent years, international sanctions have prevented Iranian entities from global sukuk issuance, while issuance in local capital markets was estimated at around $10 billion-$15 billion per year, over the past four years.
The Iranian banking system is one of the largest Islamic banking systems in the world
Iran operates under the law for usury-free banking approved by the Islamic Consultative Assembly in 1362 (Solar Hijri; equivalent to 1983/1984). Islamic financial products used in Iran are structured slightly differently than products used in other core countries of Islamic finance (Gulf Cooperation Council countries and Malaysia). For example, banks in Iran are allowed to remunerate their current account holders at their discretion, in the form of cash or in-kind bonuse and Musharaka is widely used.
Iranian banks contributed about $500 billion to the global Islamic banking system, or 40% of the industry's total banking assets, at year-end 2014, according to data provided by the Central Bank of Iran. However, we note that Iranian banks' and the central bank's financial data disclosures remain limited compared with more advanced emerging markets, as well as global standards, and the country is slowly healing from stagflation. In addition, the banking system in Iran remains local and lacks integration with other Islamic banking systems.
Iran's banking system has 30 players but is dominated by a top five that collectively control more than half the system's total assets. In our opinion, the overall creditworthiness of the banking system remains relatively weak, however. It has had significant asset quality problems, exacerbated by several years of sanctions and sluggish economic activity. Nonperforming loans are high at around 14% at fiscal year-end 2014. Moreover, the system remains underprovisioned and undercapitalized according to IMF data (see chart 5).
Nevertheless, the system's loan leverage remains relatively limited as shown by a loan-to-asset ratio of around 54% and a loan-to-deposit ratio of around 77% at fiscal year-end 2015 (March 20) suggesting that there is still some room to further expand credit to the economy.
The regulatory environment may be key to Iran's access to required funding
Given the relatively poor creditworthiness of the banking system, we believe Iran will likely need to seek alternative funding sources such as sukuk to finance its investment projects. We believe that Iran's current regulatory environment is likely to require further strengthening for the country to be able to make full use of structures widely used and accepted in the market. Iran has made a start: a 2008 regulatory change clarified the regulatory framework for Ijara sukuk; a 2009 regulatory change allowed for the fiscal neutrality (that is, no additional taxes as for conventional financing) of special purpose vehicles in sukuk issuance; and in 2012 the authorities enacted regulatory requirements for Murabaha sukuk. Additional regulatory changes to cover other types of widely accepted structures in the market and to clarify whether it would be possible to issue instruments under a foreign law (such as English law) in Iran would be key to attracting sukuk investors.
In addition, we believe further investor protection and contract enforceability will also help Iran's attractiveness to foreign investors. For the time being, these remain weaknesses; the World Bank ranks Iran at 130 of 189 countries for ease of doing business and ranks it even lower for investor protection (154) and insolvency resolution (138).
While Iran stands to benefit from a return to the global sukuk market, assuming sanctions are lifted, global Islamic investors are also likely to see a benefit in new diversification opportunities in a country with a growing economy and less dependence on oil compared with some other oil-exporting countries. We expect this could lead to an increase in global sukuk issuance in the medium term as Iran would likely have to finance a significant amount of projects that could support market growth in the medium term.
Mohamed Damak (Dubai), Benjamin J Young (Dubai), Bida Blume (Dubai) - Credit Analysts - Standard & Poor'sBLOG COMMENTS POWERED BY DISQUS