Europe Can Use Local Currency Bonds to Sustain Economic Ties with Iran
For over a year, European governments have been struggling to determine how they can create a financing facility for projects in Iran. Access to external finance was a major expectation of the sanctions relief promised in return for Iran’s implementation of the JCPOA nuclear deal. With the full return of US sanctions just weeks away, the prospect that Europe will be able to contribute to Iranian economic development through project finance is growing slim.
The European Investment Bank has rejected calls to invest in Iran citing its reliance on global institutional investors, many of them American, to raise capital. A mooted European Monetary Fund, which would source its investment capital from European central banks, is still just a policy idea. Member-state financing vehicles, such as Italy’s Invitalia and France’s Bpifrance have proven unable to engage Iran, despite encouragement from government leaders.
But what if it is a mistake to focus on “external” finance? What if rather than try to source capital from outside of Iran to finance projects within the country, Europe sought to make use of the wealth already within Iran?
One underreported effect of Iran’s currency crisis has been the rapid expansion of liquidity in the market. Iranians are scrambling to convert their devaluing rials into safe-haven assets such as dollar and euro banknotes, gold, property, and even cars. But this scramble, which has seen Iranians draw down their vulnerable rial savings, has led to a rapid expansion in liquidity, which is itself creating inflationary pressure. The Central Bank of Iran is even considering raising interest rates in an effort to reabsorb some of over USD 350 billion floating around the economy.
Perhaps surprisingly, as the currency crisis has unfolded, the Tehran Stock Exchange has hit historic highs. Iranians investors—particularly those whose wealth exceeds that which can be reasonably protected through the purchase of property and gold coins—are increasingly seeing securities and other forms of equity investment as a way to hedge against devaluation. The only problem is that this kind of reinvigorated investment is unlikely to help Iran avoid a recession, particularly in the non-oil sector. Investments on the Tehran Stock Exchange does not lead to the efficient and smart fixed capital formation the country needs to achieve real growth.
The demonstrable hunger for investment opportunities resulting from inflation fears and rising liquidity presents a valuable opportunity. In other emerging markets, such investor demand has been successfully use to source the capital necessary for impactful development projects. The best example can be seen in the financing methods of the European Bank for Reconstruction and Development.
EBRD was established in 1991 to support the liberalization of the Eastern Bloc economies after the fall of the USSR. Just a few years after its launch, EBRD began to tap local investors as a source for its project financing by borrowing and lending in local currencies. EBRD issued its first local currency loan in 1994, denominated in the Hungarian forint. Since then, the bank has issued 722 loans across 26 currencies valued at EUR 12.4 billion.
Local currency financing has been made possible through the issuance of local currency bonds. These bond offerings are issued under local laws and regulations, but are backed by the creditworthiness of ERBD and the steady strength of the Euro. Such “local currency Eurobonds” can be particularly useful to offer domestic investors a hedge against inflation.
In November 2016, EBRD issued a “pioneering” EUR 92 million “inflation-linked Eurobond” in the local currency of Kazakhstan. The bonds have a five-year maturity and “pay a coupon of 3-month Consumer Price Index (CPI) rate plus 10 basis points per annum.” EBRD is also seeking to have the security listed on the Kazakhstan Stock Exchange to make the bond even more accessible to local investors.
When the note was launched, Philip Brown, managing director at Citi Global Markets Limited, which managed the issuance, commented on the “demand for inflation protection from the increasingly sophisticated investor base in Kazakhstan. This trade highlights the useful role the EBRD can play in helping local investors meet their needs and in doing so, develop new markets.” While the likes of Citibank would not be managing such a bond issuance in Iran for obvious reasons, it is easy to see how Iran’s own sophisticated investor class would see a rial Eurobond as an attractive asset to guard against rising inflation.
A local currency bond offering would help Europe and Iran achieve several goals. First, European governments would finally be able to source and deploy the the billions of euros in financing that had been promised to Iran in various credit lines, only to be stymied by the hesitance of European banks to facilitate the underlying transactions in the project finance. Second, it would empower European governments to more directly influence regulatory reform in Iran’s banking and finance sector—a role EBRD has actively and successfully played in the markets in which it has investment since its inception. Third, the new bond would help the Central Bank of Iran reign-in excess liquidity in the market in a manner that is likely to create the greatest long-term value for the economy at large. Fourth, the establishment of a European-Iranian development bank would be a powerful political signal at a time when support for the JCPOA is wavering.
Like European Investment Bank, EBRD is too exposed to the United States in order to pursue projects in Iran itself—the US is a 10 percent shareholder of the bank. In order to pursue local currency financing, European governments would need to establish a new state-owned development bank in order to issue the rial-denominated Eurobonds.
Unlike EBRD and for reasons related to sanctions risks, this should be done through the creation of an Iran-registered financial institution owned by European governments, which would enlist the support of local investment banks and brokerages to bring the bond to market. This European-owned and Iranian-registered development bank would raise capital locally and invest locally, reducing the needs to engage in international transactions that are complicated by the returning sanctions. Conceptually, such an institution would be a kind of inverse of the Hamburg-based EIH Bank, but with a development finance rather than trade finance focus.
The creditworthiness of the new bank would be assured based on a sovereign guarantee for the bank and its liabilities from the European shareholders. The fact that the ownership of the bank will not overlap with its country of operation also limits risk. For similar reasons, no multilateral development bank worldwide has had to resort to its callable capital to date.
The envisaged bank would face several challenges including a lack of robust monetary policy in Iran, a relative lack of transparency within capital markets, and high domestic interest rates which could undercut the attractiveness of the bond offering. It would also need to conduct know-your-customer due diligence above and beyond that conducted by Iran’s own brokerages. But the myriad challenges in Iran are probably no greater than those faced in countries such as Kazakhstan, Georgia, and Ukraine where European financial actors have been able to successfully structure the credit facilities.
Encouragingly, the bond market in Iran has matured considerably over the last few years, and local companies and government agencies have developed capabilities in structuring debt instruments with the help of local investment banks and in compliance with the rules of Islamic finance. In the seven years since Islamic sukuk bonds were first introduced to the market, around USD 4 billion in debt has been issued.
Today, Iran’s leading companies regularly raise financing on the order of USD 100 million through individual bond offerings. A local currency Eurobond, which would be used to finance the transformative projects that had been envisioned for post-sanctions Iran, would easily raise amounts on this order. To bring this idea to fruition, European governments would simply need to combine a proven capacity for financial innovation and the commitments of their central banks, two contributions that cannot be sanctioned by the United States.
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