Investing in Iran, Post-Sanctions
This past year has seen some good economic and political news: a longstanding source of friction between Iran and other world powers was resolved peacefully in a victory for diplomacy, which leads consequently to a second piece of good news, the re-opening this year of a growth market for various businesses at a time when Sovereign Wealth Funds and other institutional investors are starved for yield. With US equity markets pushing further into over-valuation by historic measures (such as the Shiller PE Ratio), and a looming interest rate hike by the Fed creating uncertainty for fixed income markets that are even more over-valued, what alternatives lie in store for 2017?
Consider Iran’s demographics. Iran has a large population of 80 million, more than 60% of whom are younger than 30 years of age and in a stage of life characterized in economic terms by consumption. Consider also the pent-up demand due to the long history of economic sanctions on Iran, and it can be seen that the Iranian market is poised for growth well above the trend rate for developed markets and many other emerging markets. The IMF estimates Iran’s GDP growth at more than 4% per year. Consider Iran’s economic profile. Estimates of GDP for 2014 show that Iran exported approximately $96 billion of goods and services and imported approximately $61 billion of goods and services. With (1) a balance of payments surplus like that, in (2) a growing market with pent-up demand and (3) low external debt of approximately $10.2 billion on a $416.5 billion economy with (4) $68 billion of foreign exchange reserves, investments denominated in Iranian rials look to be a one-way bet (in the right direction). Taking risks into account, such as country risk and ease of doing business, affects the calculus but not the conclusion.
Who are Iran’s primary trading partners, and where might capital flows go? Currently China accounts for approximately 29% of Iran’s exports, India approximately 12% and Turkey nearly 10.5%. South Korea and Japan account for 5% to 6.5% of Iran’s exports. Poised for growth from suppressed levels will be exports to EU countries, no matter what the US does following the inauguration of Donald Trump as president. Industry accounts for nearly 41% of Iran’s economy, and services account for slightly more than 50%. Exports of goods and services account for nearly 21% of Iran’s GDP. But the Iranian opportunity appears to some people as a pot of gold on the other side of a minefield of sanctions. How to reach it?
The Joint Comprehensive Plan of Action (or JCPOA) was the culmination of years of hard bargaining between the government of Iran and the P5+1 (the five permanent members of the UN Security Council plus Germany). (Incidentally, the EU uses a different naming scheme to identify these negotiation parties. No matter when or how these different naming conventions arose, it is a testament to the ability of international bureaucrats to take the simplest task – here, the identification of who exactly was present in a meeting – and make it unnecessarily complicated.) The primary effect of “Implementation Day” on 16 January of this year was to significantly ease restrictions on various trade activities with Iranian companies. Note however that “easing” restrictions is a diplomatic way for each party to convey to its domestic audience what is in it for them. In reality, many opportunities are opened but are also subject to qualifications or prior authorization, and many remain closed.
Iran has been subject to an increasing number of sanctions for years, first by the US for decades as a consequence of the Iranian Revolution that deposed the US-backed Shah, to sanctions by the EU and the UN relating to various issues such as disagreements over human rights, matters relating to international terrorism, the development of ballistic missile technology and nuclear proliferation. The maze of economic sanctions applying to Iran is so extensive, and arises from so many disputes, that the putative “easing” of sanctions can be claimed by all sides as an example of successful negotiation, on the one hand by Iran who will undoubtedly see economic benefit from increased trade and investment, but also by the various parties that still have sanctions in place, for whom “easing” is in reality a new licensing regime for doing business with Iran. Those of us trying to navigate the sanctions regime will find that it is still a maze, and has not become a meditation circle.
Since 16 January of this year, we are in a state of “suspended sanctions;” technically many of the sanctions have not been terminated, but in fact could be reinstated if events do not go according to plan. Assuming everything goes as planned by the various parties, then the EU, US and UN sanctions will be terminated in two phases, from 8-10 years after the time the JCPOA was adopted on 18 October 2015 (this is called “Adoption Day”). Let’s take them step-by-step in turn.
“Transition Day” will be the day that all EU and US proliferation-related sanctions that were suspended in January of this year will be terminated. “Termination Day” will be on the eighth anniversary of Adoption Day, or it can occur earlier based on a report by the Director General of the International Atomic Energy Agency to the IAEA’s Board of Governors (and in parallel to the UN Security Council) stating that the IAEA has concluded that all nuclear material in Iran remains in peaceful activities. This is called the “Broader Conclusion.” On Transition Day, the EU and US will lift proliferation-related sanctions, including arms and missile technology sanctions.
“Termination Day” is the name given to the date when UN Security Council resolutions will be terminated, and it falls on the 10th anniversary of the Adoption Day, which will be 18 October 2025. The EU will also lift all remaining nuclear-related sanctions and terminate legal acts relating to them.
One issue to be aware of in deal-making during this transitional phase while sanctions are “suspended,” or rather are in a less restrictive mode, is that a failure of Iran and the P5+1 to agree that everything is going according to plan can result in what is called “snapback” of the sanctions, i.e., a restoration of the status quo ante. The view of both the EU and the US is that – if sanctions do snap back in the future (bearing in mind the possible change of course by the US following Trump’s inauguration) — conduct will not be subject to sanctions retrospectively if the conduct were permissible during the time that it occurred, and that an orderly period will be granted to allow the contracting parties to wind down their arrangement. Of course, your view of an “orderly wind down” may not be the same as the view of unionized bureaucrats in the US government, or of the Republican party’s majority in the US Congress.
It is advisable to take precautions in contracts against the risk of “snapback.” Under common law systems such as the UK and the US, it is possible that snapback could mean that performance of the contract is illegal, and this would excuse each party’s performance of the contract, as well affect enforceability of the contract. Whether or not Iran’s contract law and legal system would reach the same conclusion, it would be preferable to anticipate this contingency in the contract and provide expected steps to deal with the contingency as well as a mediation or arbitration clause for unexpected developments. The circumstances of snapback in the future indicate an environment of renewed tensions that would not work in favor of a foreign investor; deal protection measures would be especially important.
Newly Unsanctioned Sectors and Persons
The US sanctions were always the most extensive, so we can begin with a review of what has changed. The three most salient points to understand with respect to the US sanctions are (1) only the nuclear related sanctions have been lifted, (2) US sanctions lifted to date are primarily what the US calls “secondary” sanctions, which in the words of the Guidance circulated by the Departments of State and Treasury are “directed toward non-US persons for specified conduct involving Iran that occurs entirely outside of US jurisdiction and does not involve US persons,” and (3) in all events, transactions of any kind are still prohibited with anyone on the various lists of sanctioned persons. Yes, the US government’s guidance actually makes the statement that a legal sanction applies to conduct “outside of US jurisdiction.” Aside from the pedantic legal point that US sanctions ought not apply to conduct outside the legal jurisdiction of the US, the succinct explanation as to what the term “secondary sanctions” mean is that the US sanctions that have been lifted relate primarily to non-US persons, which includes foreign subsidiaries of US companies.
The US easing of secondary sanctions relates to the following seven industry sectors:
1. Finance, banking and insurance;
2. Oil, gas and petrochemical;
3. Shipping, shipbuilding and transport;
5. Iran’s port operators;
6. Gold, other precious metals; and
7. Graphite, raw or semi-finished metals such as aluminum and steel, coal, and certain software.
The EU did not have specific restrictions on the automotive sector or port operators, and the EU additionally lifted sanctions relating to banknotes and coinage. Otherwise, the categories on which sanctions were eased are broadly similar to the US.
In connection with Implementation Day, the US removed more than 400 individuals and entities listed on the three following OFAC lists of sanctioned persons:
1. the “SDN List” (the “List of Specially Designated Nationals and Blocked Persons”),
2. the “FSE List” (the “Foreign Sanctions Evaders List”), and
3. the “NS-ISA List” (the “Non-SDN Iran Sanctions Act List”), which was discontinued.
More than 200 persons remain on the US lists. It happens to be the case that the US identified, in an attachment to the JCPOA, the individuals and entities removed from the SDN List, FSE List, and NS-ISA List, and your Compliance team could check that list to confirm who is newly eligible from Iran for international trade. Among the parties now removed from the lists are the Central Bank of Iran (“CBI”) and other specified Iranian financial institutions; the National Iranian Oil Company (“NIOC”), the Naftiran Intertrade Company (“NICO”) and the National Iranian Tanker Company (“NITC”). The EU also removed these entities from the EU’s register of listed persons, and the EU also maintains a register available on an EU website for due diligence purposes.
However the reality is that the OFAC lists are updated periodically on OFAC’s website, and as the name of one list makes clear – the Foreign Sanctions Evaders List – a legal person may be added from time to time in response to newly acquired information that the US government believes will warrant adding that person to the FSE List. The action item for your Compliance function is a KYC check of whomever you intend to deal with against the current lists maintained by OFAC. Because of the KYC exercise and the periodic changes to the lists, you may find it prudent to subscribe to one of the third party vendor services that confirms eligibility of trading partners.
The sanctions easing described in the JCPOA do not apply to transactions that involve persons who remain or are placed on the SDN List. Transactions involving such persons remain sanctionable after Implementation Day. In sum, there are various industry sectors where opportunities are opened up, but only with persons who are not sanctioned.
Activities Allowed by US Persons
All of the preceding relates to secondary sanctions (i.e., sanctions on activities by non US-persons). The US government also eased sanctions on US persons who want to trade with Iran, but in only three product categories generally (commercial airliners for civilian use, and Iranian carpets and foodstuffs), and, notwithstanding the current US administration’s pretensions to liberation street cred, it has established an old school, neo-imperialist License Raj, which will license non-US entities that are owned or controlled by a US person (“US-owned or -controlled foreign entities”) to engage in activities that are consistent with the JCPOA. If business prefers clarity and predictability, then at least the implications are clear: make a large enough donation to the right political party or putative charitable foundation of a prominent politician’s family, and one can reasonably expect a license to trade with Iran. Just don’t call it a “bribe,” which makes it sound tawdry.
2017 and Beyond
This will only get more interesting after 20 January 2017, when Trump is inaugurated. Will he follow through on threats to rip up the agreement? Will he and Republican colleagues in the Senate insist on submitting the agreement to the US Senate for ratification as a treaty (President Obama called it an “Executive Agreement” to avoid submitting it to the Republican-controlled Senate), and risk rejecting it? Or are the most recent developments over his selection of ExxonMobil CEO Rex Tillerson as Secretary of State (who is on friendly terms with Russia’s President Putin) be the indication of where relations are going with Iran? Take up has been slow on investing in Iran this year. The election of Trump gives the Fed all the cover it needs to finally end its Zero Interest Rate Policy, hiding behind the excuse that the Trump administration brought on any ensuing meltdown in financial markets. Financial market developments in the coming year may lead many investors to re-consider why they stayed out of Iran.