Robert Powell Iran Special.Indd

All that glitters Assessing opportunities and risks in post- sanctions Iran A report by The Economist Intelligence Unit All that glitters Assessing opportunities and risks in post-sanctions Iran

Contents

Introduction 2

Background 3

Economy 6

Sectoral analysis 8

Business environment 18

Introduction

January 16th 2016 will forever be viewed as a watershed for Iran. On that day, the International Atomic Energy Agency (IAEA) judged that Iran was fully compliant with its internationally agreed nuclear obligations—a ruling that in effect restored the Islamic Republic to the global community of nations and removed a mass of international sanctions that had been piled on the country since 2006. Keen to make up for lost time, Iran’s president, Hassan Rowhani, has been urgently seeking to drum up new business. On January 23rd he hosted a summit for China’s president, Xi Jinping, in Tehran, at which the two sides agreed to boost bilateral trade to US$600bn within a decade. This was swiftly followed by a trip to Italy and France, where some €50bn (US$55bn) in contracts were signed. However, even with Iran’s doors thrown open, it would be wise for businesses to keep in mind the ancient Persian proverb: “He who wants a rose must respect the thorn”. Iran’s economy is unusual among the region’s oil exporters; it boasts the largest natural gas reserves in the world and the fourth-biggest oil reserves, and yet it has a diversified economy (including a significant manufacturing sector), all backed up by a large, youthful, well-educated and welcoming population. But the business climate is less welcoming. Vested interests still permeate almost every aspect of the economy, typically operate outside the parameters of international commercial law—especially those businesses connected to the Islamic Revolutionary Guards Corps—and will jealously guard the gains they accrued during a decade of sanctions. And the finger of blame for Iran’s tricky operating environment should not be pointed solely at Iran; an array of residual US sanctions can snare the more unwitting investor, and Iran’s economic momentum is still too dependent on the vagaries of the global oil market. In this white paper The Economist Intelligence Unit will sketch out an economic road map of Iran’s future, outlining the most promising economic sectors within the world’s most exciting emerging market, but also detailing the country’s regulatory impediments to business. We will also provide lessons from the past, and reveal where Iran sits among the world’s major economies in our business environment rankings.

2 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

Background

ince 1979 Iran’s economy has been buffeted by the chaos of the post-revolutionary environment Sand the demands of the eight-year war with Iraq (1980-88), and more recently by international isolation, fluctuating oil prices, sanctions and a fierce power struggle within the country’s political institutions. As a result, economic policymaking has been haphazard for much of the post- revolutionary period; no consistent strategy towards economic development has been pursued, and the commitments of successive five-year plans to support market-oriented reforms, boost the role of the private sector and diversify the economy away from its reliance on oil exports have not been honoured.

Iranian real GDP growth (at factor cost) (%)

16 16

12 12

8 8

4 4

0 0

-4 -4

-8 -8

-12 -12 1982 84 86 88 90 92 94 96 98 2000 02 04 06 08 10 12 14 Source: The Economist Intelligence Unit.

Ahmadinejad squanders his inheritance The country’s first concerted economic liberalisation drive and global outreach effort occurred during the presidency of Mohammed Khatami (1997-2005), during which time Iran used windfall oil revenue to pay down most of its rescheduled foreign debt, abolished the country’s multi-tiered exchange

rate, relaxed import restrictions, launched a conservative privatisation drive and established an oil stabilisation fund (OSF). However, all the gains that were made during these years were largely squandered during the presidency of Mahmoud Ahmadinejad (2005-13), whose highly divisive presidency saw huge cash pay-outs and massive social housing programmes directed at the country’s poor, but also rocketing inflation, a collapse of the exchange rate and the depletion of the country’s OSF. It was also during his presidency that Iran’s efforts to establish a civil nuclear programme with international acquiescence were abandoned and a more nationalistic and confrontational approach to the nuclear issue was adopted. The consequent swathe of international sanctions led to the halving of Iran’s oil exports and the country’s financial sector being almost entirely cut off from the rest of the world. Not surprisingly, amid the tanking economy, the public yearned for change—culminating in the thumping presidential election victory for a moderate cleric, Hassan Rowhani, in the 2013 presidential election on a simple promise of diplomacy, dialogue and, ultimately, the ending of sanctions. Rowhani finds a receptive audience in the White House With a receptive audience in the shape of the US president, Barack Obama, talks made rapid progress, and an interim agreement was signed in November 2013 that provided for a halting of new sanctions and the release to Iran of over US$4bn in frozen funds. However, the short-term boost this provided to the economy soon dissipated as oil prices began their long downward lurch from September 2014, causing the Iranian delegation to redouble its efforts to reach a final deal. Eventually, after numerous postponements, on July 14th 2015 a final agreement was reached, the Joint Comprehensive Plan of Action (JCPOA). The JCPOA immediately provoked outcries from hardliners on all sides, with Iranian conservatives decrying the neutering of the country’s nuclear programme and the perceived violation of Iran’s sovereignty; in the West, meanwhile, Republicans in the US banded with Israel to denounce the deal as being too favourable to Iran, arguing that Iran could not be trusted to keep its side of the deal. Yet despite the scepticism, on January 16th the IAEA confirmed that Iran had implemented its commitments, including the shipment of 11 tonnes of Iran’s enriched uranium to Russia in late December, followed in early January by the redesign of its Arak heavy-water reactor. With the onset of “Implementation Day”, the sanctions that had hobbled the economy for a decade were finally lifted.

4 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

Timeline of sanctions freezes the assets of the Islamic Revolutionary Guards Corps and Islamic Republic of Iran Shipping Lines, recommends that states inspect Iranian cargo and August 2006 imposes financial restrictions on individuals and The UN Security Council passes Resolution 1696, entities connected with Iran’s nuclear and missile which threatens economic sanctions against Iran, programmes. after the Islamic Republic fails to respond definitively January 2012 to a compromise from the P5+1 (the five permanent The EU introduces a phased ban on imports of Iranian members of the Security Council plus Germany) oil, and, under pressure from the US, several Asian allowing it to conduct part of the nuclear fuel cycle countries agree to reduce their imports of Iranian in-country, in return for re-suspending uranium crude. Subsequently, Iran is cut off from the Society enrichment. for Worldwide Interbank Financial Telecommunication December 2006 network. The Security Council passes Resolution 1737 November 2013 introducing limited sanctions. Iran and the P5+1 agree to the Joint Plan of Action, March 2007 allowing for a partial freezing of Iran’s nuclear A second round of sanctions is agreed by the Security programme in return for an easing of sanctions on Council following a unanimous vote in support of Iran’s automotive and air sectors and the unfreezing Resolution 1747, which seeks to block Iranian arms of funds held abroad. exports and to tighten sanctions against Iran’s July 2015 nuclear industry. The Joint Comprehensive Plan of Action (JCPOA) is March 2008 signed between Iran and the P5+1. Iran agrees to The Security Council passes Resolution 1803, which limit the capacity of its nuclear programme, meeting includes an outright travel ban on Iranian officials US demands for a minimum “breakout time”—the engaged in Iran’s nuclear and missile programmes. time it would take Iran to produce enough weapons- September 2009 grade uranium for a single nuclear weapon—of a year The US president, Barack Obama, reveals that Iran or more and a tighter inspection regime by the IAEA. has been building a nuclear facility in the side of a In return, all nuclear-related sanctions will be lifted, mountain in Qom. Iran counters that it had informed once Iran abides by its requirements. the International Atomic Energy Agency (IAEA) of the January 2016 plant a week before. “Implementation Day”. The IAEA confirms that June 2010 Iran has met its obligations under the JCPOA and The Security Council passes Resolution 1929, which sanctions are lifted.

Economy

Real GDP growth After five years of sanctions-driven stagnation—during which the Iranian economy shrank by an aggregate 4%—The Economist Intelligence Unit expects Iran to witness a major turnaround in 2016- 20, as the lifting of nuclear-related US and EU sanctions propels the country to the top of the regional growth rankings. The most immediate driver of this growth will be a rapid recovery in oil exports (including oil long stored in tankers offshore), which, having been roughly halved by sanctions, are set to rise by around 700,000 barrels/day (b/d) by the end of 2016. There will be further increases in 2017- 20, but the size of these will depend in part on whether Iran can persuade technologically advanced international companies to invest in the sector. (An agreement with Total in January under which the French energy giant will explore development and exploration opportunities in Iran offers some early encouragement.) Investment in Iran’s underexploited natural gas reserves, in particular, could increase dramatically. The lifting of sanctions on the financial sector—which will see Iran’s reincorporation into the Society for Worldwide Interbank Financial Telecommunication (SWIFT) network—will help to ease general trading and investment conditions, and will therefore provide a big boost to Iran’s sizeable non-oil sectors. With rising inward investment and an improvement in the public finances, private consumption will also strengthen (as will import growth). Overall, given Iran’s hydrocarbons wealth, demographics and economic diversity, the comprehensive nuclear deal could herald a return to trend real GDP growth rates of around 5%. However, growth will remain below potential given the challenging business environment and the ongoing slump in oil prices (which will prevent any post-sanctions budget giveaways). Equally, the positive outlook all depends upon the Joint Comprehensive Plan of Action sticking; the provision for a “snap-back” of sanctions should Iran renege on its commitments will remain a persistent risk to this brighter outlook for some years to come.

Economic growth % 2015a 2016b 2017 b 2018b 2019b 2020b GDP 0.9 4.5 5.4 5.2 5.1 5.5 Agriculture 0.5 1 2 1 1.5 1.2 Industry 2 4.8 5.9 5.4 4.4 4.6 Services -1.5 1.9 5.4 5.6 6 6.5 a Economist Intelligence Unit estimates. b Economist Intelligence Unit forecasts.

6 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

Exchange rate and inflation Years of fiscal incontinence during the presidency of Mahmoud Ahmadinejad (2005-13), followed by the 50% devaluation of the Iranian rial in 2013, drove a surge in Iranian inflation, which peaked at 45% in mid-2013. However, with the administration of Hassan Rowhani restoring fiscal prudence and global commodity prices slumping, consumer price growth fell to a five-year low in 2015. We expect consumer price inflation to fall further, to 12.5% in 2016, as the onset of sanctions relief eases bottlenecks and services costs (insurance) on imports moderate—a trend that will allow average consumer price inflation to drop below 12% in the latter part of our 2016-20 forecast period. Falling inflationary pressures will be supported by a more stable exchange rate, including a narrowing of the gap between the official and the black-market rates (the latter of which is currently about IR35,000- 37,000:US$1), as the lifting of sanctions and the subsequent uptick in inward investment boost confidence in the rial. The ability of Bank Markazi (the central bank) to manage the exchange rate should improve as it gains access to foreign reserves currently frozen abroad.

Forecast summary (% unless otherwise indicated) 2015a 2016b 2017 b 2018b 2019b 2020b Real GDP growth 0.9 4.5 5.4 5.2 5.1 5.5 Crude oil production (‘000 b/d) 2,862 3,349 3,426 3,529 3,620 3,801 Oil exports (US$ m) 41,615 48,672 63,749 73,540 75,304 78,720 Consumer price inflation (av) 13.7c 12.5 12.9 12 11.5 11.5 Consumer price inflation (end-period) 9.4c 12.7 12.5 11.8 11.5 12 1-year deposit rate 16 13.6 13 13 12.5 13 Official net budget balance (% of GDP) -3.5 -2.9 -2.7 -3.1 -3.5 -3.8 Exchange rate IR:US$ (av) 29,011c 31,187 33,059 34,877 38,016 41,095 Exchange rate IR:US$ (end-period) 30,130c 33,032 35,537 37,986 41,125 44,204 Exchange rate IR:¥100 (av) 23,762c 25,075 26,877 28,588 31,680 34,795 Exchange rate IR:€ (end-period) 32,239c 35,840 41,045 45,013 49,761 53,929 a Economist Intelligence Unit estimates. b Economist Intelligence Unit forecasts. c Actual.

Sectoral analysis

Energy sector

Introduction Until a raft of US and EU sanctions on Iran’s oil and gas sector was imposed in 2012—as part of an effort to curb the Islamic Republic’s nuclear programme—Iran had long been OPEC’s second-largest oil producer. Iran was producing 3.6m barrels/day (b/d), of which 2.3m b/d was exported, just prior to the imposition of those sanctions. By the time “Implementation Day” occurred on January 16th— the day nuclear-related sanctions were lifted—Iran had been overtaken by Iraq as the number two producer in OPEC, with its oil production falling to 2.9m b/d and its exports more than halving to 1.1m b/d. Iran is now set, however, to witness a major recovery in its oil and gas sector in a post-sanctions environment. In addition to restoring oil production and exports to pre-sanctions levels in the short term, Iran also hopes to attract significant foreign investment in the long term, of tens of billions of dollars, in order to boost oil production to nearly 6m b/d in five years. Besides oil, Iran is also seeking to exploit its hugely underexploited natural gas reserves in order to become a major global exporter of natural gas as well. Iran will struggle to reach its longer-term production targets The Economist Intelligence Unit considers it entirely realistic for Iran to return to pre-sanctions production levels of 3.6m-3.7m b/d; however, its goal of reaching output of 5.7m b/d—a production level not achieved since before the 1979 revolution—will not be realised until well into the future, if ever. Nonetheless, sanctions on energy investment in Iranian oil and gas have been lifted (apart from some US prohibitions, which have been kept in place), and Iran will be able to export crude oil to all customers (except the US) without restriction, resuming sales to the EU and increasing sales to Asia. Low oil prices and a supply glut make the timing of Iran’s return to the oil market difficult, but it can be expected that production and exports will be able to creep up to pre-sanctions levels. Iran is also a major natural gas producer, although it mostly supplies the large domestic market. With additional investment Iran could become a more significant exporter of natural gas, especially given its huge resource base, although this is likely initially to be restricted to supplying nearby

8 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

Iran oil production ('000 b/d)

4,500 4,500

4,000 4,000

3,500 3,500

3,000 3,000

2,500 2,500

2,000 2,000

1,500 1,500

1,000 1,000

500 500

0 0 2000 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15(a) 16(b)17(b)18(b)19(b)20(b) (a) Estimate. (b) Forecast. Source: The Economist Intelligence Unit.

Iran gas production (bn cubic metres)

250 250

200 200

150 150

100 100

50 50

0 0 2000 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15(a) 16(b) 17(b) 18(b) 19(b) 20(b) (a) Estimate. (b) Forecast. Source: The Economist Intelligence Unit. markets in the region (such as Oman and Pakistan). In the longer term, however, Iran could be a supplier of natural gas to other markets such as Europe. Yet even after its return to the global energy scene, Iran will not be receiving an early windfall. The state of the oil and gas markets is quite different from what it was four years ago, when energy sanctions against Iran were tightened. In 2011 dated Brent Blend averaged US$111/barrel and Iran’s oil revenue was US$120bn; in contrast, today oil is struggling to stay higher than US$30/b owing to a glut in supply. Nevertheless, over the next decade Iran will play a greater role in the global oil and gas market, but the extent to which it does will depend on a host of factors. Most notably, its continued

commitment to limit its nuclear activities as outlined in the Joint Comprehensive Plan of Action is vital, as failure to do so would result in energy sanctions being reimposed, or “snapped back”. Another key factor will be Iran’s domestic business environment and its ability to attract foreign investment. Iranian oil exports With Implementation Day completed, Iran will resume oil exports to EU buyers. Iran was exporting 600,000-700,000 b/d before the EU imposed a ban on Iranian oil imports in early 2012. Iran will also be able to export oil to other markets, such as China, Japan, South Korea, India and South Africa, without restriction. Some US and EU sanctions were aimed at discouraging non-EU customers from buying Iranian oil, such as preventing them from insuring tanker deliveries or paying Iran for oil through the international financial system. What has not changed, however, is the US ban on Iranian oil imports, which has been in place since the 1980s. Iran aims to boost output by 1m b/d within 12 months Iran has said that it will boost output by 500,000 b/d now that sanctions have been lifted and, more optimistically, that it will increase output by a further 500,000 b/d six months after that. However, with the oil market well-supplied and weaker demand growth expected this year, the global environment is hardly ideal for Iran’s attempts to regain market share. With this in mind, Iran is likely to offer very competitive pricing, as well as crude for product swaps or deferred payments to encourage further sales. At any rate Iran is unlikely to flood the market and risk contributing unnecessarily to a prolonged period of depressed prices; the process of lifting Iran’s oil output will therefore almost certainly be gradual. Iran has also placed tens of millions of barrels of crude oil and condensates in storage, because its ability to sell oil under sanctions was curtailed. According to Platts, an energy information provider, Iran could be holding anywhere between 30m and 50m barrels of condensates and 10m-15m barrels of crude oil. Iran will focus on offloading its condensates and crude oil from storage in vessels in the Gulf, if for no other reason than to make additional vessels in its tanker fleet available for greater levels of crude oil deliveries. Iranian energy investment Given its substantial reserves of oil and gas, Iran has the potential to be a much greater player in global energy markets. Iran has 157bn barrels of oil in proven reserves (the fourth-largest in the world) and 1,201trn cu ft of proven reserves of natural gas (by some measurements the largest in the world). Iran produced over 6m b/d of oil in the mid-1970s, but since the revolution its crude production has been affected by conflict, sanctions and economic isolation. Iran is also a major natural gas producer, but the vast majority of its gas output is focused on supplying the domestic market (Iran is the fourth- largest gas consuming economy). Only small volumes of gas are exported via pipeline to neighbouring Turkey and Armenia (although Iran plans to export gas to Iraq, Pakistan and eventually Oman). On paper Iran, with its substantial resource base, is a potentially bright prospect for energy investment, but the extent to which the country is able to capitalise on this will depend on its ability to attract the necessary investment.

10 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

On Implementation Day, EU sanctions on investment in, and the provision of technology to, Iran’s oil and gas sector were lifted. US energy investment sanctions, which date back to the 1990s, are still in place, although secondary sanctions aimed at non-US entities are no longer in force. (US financial sanctions are still in place, however, which for example would prevent a US bank from financing investment in Iran’s energy sector.) The lifting of sanctions thus reduces some of the risk of investing in Iran’s energy sector, but by no means all. In reality, a number of legal grey areas—relating to financial transactions and technology transfer—still persist even after Implementation Day, and, in any case, Iran’s investment environment has long been unconducive to significant foreign participation. The post-revolutionary Iranian constitution prevents the awarding of concessions to foreign interests, but in the 1990s “buyback” contracts were devised by the Iranian authorities. Under buyback contracts, companies were rewarded for their investment with a share of production from the field that was being developed with their help. These models were not particularly attractive to foreign energy companies, and Western interest in Iran’s energy sector (apart from the key South Pars gas project) was fairly limited even before sanctions were imposed. Transparency over new Iran Petroleum Contract is still lacking As a result, in 2015 Iran released the outlines of a new contract, called the Iran Petroleum Contract (IPC), to replace the buyback model. Although the details of the contract have not yet been released, the IPC would offer more attractive terms than the buyback contract, allowing for longer contract durations and a fee paid per barrel based on the amount of risk involved by the contractor. Foreign companies would be required to form a joint venture with a local partner approved by the National Iranian Oil Company. At a conference in November in Tehran, Iran announced that it would offer 52 oil and gas development projects and 18 exploration blocks under the IPC. It is clear that industry interest in developing Iranian oil and gas reserves is huge, as is Iran’s need for outside capital and technology. However, a conference that was to be held in London at the end of February, which would have shed more light on the details of the IPC, has been cancelled, reportedly because Iranian officials were unable to get visas to enter the UK. The postponement of the London conference is symptomatic of the uncertainty that persists over Iran’s business environment, which will need to be addressed if there is to be a flood of investment to develop Iran’s energy sector. Some elements within Iran are sceptical of allowing foreign participation in the energy sector, and there is always the chance that sanctions could be reimposed. Even if all goes well, however, it will not be until the next decade that Iranian oil production rises significantly above its pre-sanctions level of just under 4m b/d. Automotive Iran has the largest automotive industry in the Middle East, and it is the country’s second-largest economic sector (after oil and gas), currently accounting for 10% of GDP. It has been deemed a priority industry by the Iranian government over the past 15 years and was growing strongly until a dramatic slump in 2012-13 as international sanctions affected companies, consumers and foreign investors.

The country produced over 1m cars and commercial vehicles in 2014 (protected by high import tariffs), according to the International Organisation of Motor Vehicle Manufacturers. However, with foreign investment set to return, production could revive to its 2011 levels of 1.5m vehicles by 2020. Iranian vehicle sales, which have already rebounded rapidly since the interim nuclear deal of November 2013, should also be set for strong growth. Even under sanctions, the Iranian market was about one-third the size of that of Germany, which is the largest in Europe, and it has the potential to grow quickly during our 2016-20 forecast period, as the economy improves. We expect pent-up demand to spur car sales, particularly in 2016-18, since even the partial relaxation of sanctions in 2014 has resulted in strong growth. As a result, we expect annual average growth in new passenger car registrations to reach 10.6% in 2016-20, pushing annual sales up to 2m in 2020—almost double their 2013 level.

Passenger car registrations ('000)

2,500 2,500

2,000 2,000

1,500 1,500

1,000 1,000

500 500

0 0 2011 12 13 14 15 16 17 18 19 20 Source: The Economist Intelligence Unit.

The battle among the automotive manufacturers to reap the rewards of this rapid growth will prove absorbing. Before 2012 European producers, alongside their Iranian partners Iran Khodro and Pars Khodro, had dominated the market, with France’s PSA Peugeot Citroën the market leader. However, after their French peers were forced by sanctions to withdraw, Asian manufacturers have sought to fill the gap. In particular, Chinese marques such as Chery, Changan and Lifan have made substantial inroads, while the South Korean manufacturers Hyundai and Kia accounted for 60% of imports into Iran in the first quarter of 2015. Peugeot Citroën is set to return to Iran Yet, with the lifting of sanctions, the market is set to become crowded once more. Iran’s president, Hassan Rowhani, visited Italy and France in late January, and one of the many business announcements made during the trip was about the much-anticipated return to Iran of Peugeot

12 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

Citroën, with the French firm agreeing to produce 200,000 cars a year with Iran Khodro. Peugeot Citroën will no doubt be keen to act fast, aware that another French firm, Renault, had resumed the shipment of car parts to Iran as far back as January 2014 (in the wake of the interim nuclear deal of November 2013). Intriguingly, the presence of Fiat Chrysler’s chief executive, Sergio Marchionne, at a dinner for Mr Rowhani in Rome on January 25th raised speculation about the possibility of Italy’s Fiat also building an automotive production facility in Iran. Nevertheless, returning foreign firms should not expect a rapid windfall—local vehicles are based on foreign models developed as much as half a century ago, and their domestic production partners will therefore require revamping, which will take time and considerable expense. Consumer goods One of the early visible changes that will accompany the lifting of sanctions will be the reappearance of Western goods on shop shelves. The availability of goods, and consumer spending more broadly, had been constrained by the impact of sanctions, but now that financial, trading and investment restrictions are to be lifted, the Iranian consumer market is likely to show vigorous rates of growth. This growth will be supported by the youthful demographic profile in Iran, where the median age is 27 and 43% of the population is aged below 25. Iran’s population is forecast to reach 83.4m by 2020, making it the second-largest consumer market in the Middle East and North Africa region. However, cracking the Iran consumer market will not be an easy task. The market is fragmented and underdeveloped, dominated as it is by small and medium-sized independent traders, typically operating in traditional bazaars. Equally, a significant portion of Iran’s consumers live in villages or small towns, with the rural population accounting for just over one-quarter of the total population. Foreign retailers form an orderly line Nonetheless, the lifting of sanctions should accelerate the shift towards larger retail units, including the entry of international operators and brands. Dubai-based retailers are likely to feature prominently in the first wave, with Majid Al Futtaim Group, which in 2009 opened its first hypermarket in the country, well-placed to benefit. Other Dubai-based players are also likely to be early movers, including the Al-Futtaim Group, which has set up a number of malls and Ikea stores across the region. Turkish retailers will also seek to set up stores in Iran. However, displacing the Iranian incumbents will not be easy. In the face of sanctions, Iranian consumers have grown accustomed to local versions of international brands, with, for instance, hundreds of copy-cat restaurant establishments that imitate brands such as McDonald’s, Starbucks and Chipotle. With this in mind, foreign brands will have to advertise their edge in terms of quality, while others may be forced to make an uneasy accommodation with some of the bootleg operators, given the difficulty in taking legal action. However, do not expect US companies to share in the windfall; in November 2015 Iran’s government introduced a blockade of US consumer goods, on the direct orders of the supreme leader, Ayatollah Ali Khamenei, who was apparently concerned about shielding national producers from competition. The ban on US consumer brands highlights one of the primary risks associated with entering Iran’s

market. Although we are upbeat about Iran’s prospects, with retail sales expected to reach US$167bn in 2020, if the pent-up demand and increased prosperity result in a flood of imports, the government may introduce tariff and non-tariff barriers, to protect both local suppliers and the balance of payments.

Consumer goods at a glance 2011 a 2012a 2013a 2014a 2015b 2016c 2017 c 2018c 2019c 2020c Retail sales (IR trn) 1,360.80 1,657.80 2,225.00 2,538.00 2,784.60 3,284.30 3,967.30 4,782.60 5,694.20 6,888.40 Retail sales (US$ bn) 128.2 136.2 120.8 97.8 95.4 104.7 119.3 136.3 148.9 166.6 Retail sales, volume growth (%) 4 -3.3 -3.6 -2.7 -4.3 3.5 6.3 7 6.8 8.1 Retail sales, US$ value growth (%) 21.2 6.2 -11.3 -19 -2.5 9.7 14 14.3 9.2 11.9 Non-food retail sales (US$ bn) 55.2 59.3 53.4 43.7 42.1 46.7 54.3 62.8 68.8 77.3 Food retail sales (US$ bn) 73 76.9 67.4 54.2 53.3 57.9 65 73.5 80.1 89.4 a Actual. b Economist Intelligence Unit estimates. c Economist Intelligence Unit forecasts.

Infrastructure During Mr Rowhani’s high-profile tour of Italy and France in January, his investment push focused primarily on one area: infrastructure. This was no surprise; Iran requires massive investment in, primarily, power generation, water supply, air and rail. In the three-and-a-half decades since the Islamic revolution, Iran’s government has spent considerable sums on its infrastructure, most noticeably roads, public housing, airports and rural electrification, but improvements have failed to keep pace with official plans or population growth. The sky’s the limit The biggest single deal during Mr Rowhani’s tour was Iran’s purchase of 118 aircraft from the pan- European (but French headquartered) Airbus, including 12 A380s (or Superjumbos), at a total cost of US$25bn. Since the US’s imposition in 1995 of a ban on aviation companies selling aircraft and spare parts to Iran—a ban that also affected Airbus, given that its aircraft incorporate US-built parts—state- owned Iran Air’s fleet has suffered worsening maintenance problems. As a result, reaching agreement on updating the country’s fleet has been a priority, and more such purchases, potentially even from US-based Boeing, are possible. Iran’s transport minister, Abbas Akhoundi, has remarked that Iran is in the market for some 400 medium- and long-range aircraft, as well as 100 short-haul aircraft. The first vice-president, Eshaq Jahangiri, has revealed that, in addition to updating the fleet, Iran is planning to build seven new international airports over the next decade. As part of this drive, Memorandums of Understanding (MoUs) to upgrade the country’s major airports were also signed during Mr Rowhani’s tour, with Italy’s Vinci signing a deal to build and operate new terminals at the Mashhad and Isfahan airports, and Aéroports de Paris and Bouygues of France agreeing to build a new terminal at the Imam Khomeini International Airport in Tehran. As well as plans to improve the country’s air infrastructure, Iran intends to invest some US$25bn to modernise and expand its rail network (although it has also made it clear that air infrastructure will be the priority). During his tour of Europe, Mr Rowhani reached deals with a slew of companies and

14 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

state departments, including France’s state-owned rail operator, SNCF, and Italy’s Itinera, to look at overhauling the Iranian rail network and providing new rolling stock and engines for the Islamic Republic of Iran Railways. However, all of this will be fruitless without sufficient electricity to power the country’s transport network. The head of Iran’s Power Transmission, Generation and Distribution Company, Arash Kordi, has said that Iran needs to invest some US$7bn-8bn a year in its power generation and distribution

Selected deals announced during Mr Rowhani’s EU visit (€, unless otherwise indicated) Description of deal Company Country Value Purchase 118 passenger aircraft Airbus France 22.8bn Build pipeline and upgrade two refineries Saipem Italy 4.6bn Metals joint venture and delivery of equipment Danieli Group Italy 5.7bn MoU to jointly develop infrastructure in Iran, notably in transport Itinera Italy 4bn Iran to repay monies owed to Italian companiesa; SACEb Italy 564m Produce 200,000 cars a year in Iran Peugeot-Citroen France 400m Provide Iran with 70 rail locomotive engines & 600 marine engines Isotta Fraschini Italy 400m Study into modernising three rail stations Arepc France 7m MoU to import 200,000 b/d from Iran Total France N/A MoU to operate and expand Mashhad and Isfahan airports Vinci Italy N/A MoU to renovate and expand Iman Khomeini International Airport in Teheran Aeroports de Paris & Bouygues SA France N/A a Payments had been frozen during sanctions, requiring SACE to reimburse the affected Italian firms.b Export credit agency. c Subsidiary of French state-owned rail firm, SNCF. Source: Press reports. sector—a sum that will require significant private and foreign finance. Although China has floated the idea of financing two nuclear plants, the overarching need for greater investment is likely to see the revival of the build-own-operate (BOO) and build-operate-transfer (BOT) contracts that were favoured during the presidency of Mohammed Khatami (1997-2005), and have also been popular in the Gulf Arab states. The BOT model allowed private firms to build a power plant and operate it for some 15-20 years, before finally handing it over to the Ministry of Energy. The BOT approach is also likely to be adopted for desalination plants—a major priority, in light of Iran’s worsening seven-year drought (20 of the country’s 32 provinces are now listed as having a “water shortage” or being “water critical”). Indeed, so acute has the country’s water shortage become that the government is seeking foreign investment to part-finance a plan to filter and transfer 200m cu metres/year of water from the Caspian Sea to the middle of the country. Financial sector Battered by years of state-directed lending—especially during the presidency of Mahmoud Ahmadinejad (2005-13)—and international sanctions, Iran’s banking system is a mess. Although

Telecoms and technology Iran has advantages that other countries lack; notably, the Shetab electronic clearing and payments system, introduced in 2002 for domestic banks, has Like other countries in the region, Iran has a proven a boon for e-commerce by raising public trust young and technologically savvy population, but in making purchases online. a government that is keen to control access to the However, the upcoming launch of another Internet and social media. And, again as in other uniquely Iranian service, referred to as the “Pure” countries, the censors are losing the battle for Internet (known as Internet-e Pak, or SHOMA in control; according to UAE-based Edoramedia, some Persian), will see the state seek to reassert some of 35% of the population uses Facebook (despite the its authority over the Internet. SHOMA will act as a fact that it is banned), and Instagram has witnessed national Internet service, and will be separate from an explosion in growth. In part, the authorities’ the global Internet. Although use of SHOMA is not failure to control Internet usage is an indirect expected to be mandatory, the government plans to consequence of their own success; Internet capacity reduce regular Internet connections and increase in Iran has been boosted by the launch of the Europe- the cost of Internet service providers to encourage Persia Express Gateway, a 5,000-km fibre-optic individuals to move to SHOMA. In reality, Iran is not cable system, and the country has had 3G and 4G going to be a friendly market for technology firms, since 2014 (which helps to explain why some 55% of especially Western ones, for some time yet. Iranians have smartphones). And in some instances

19 technically private banks now operate branches around the country, under a law passed in 2002 allowing their formation, state-owned banks, in particular Bank Melli and Bank Sepah, still dominate the domestic banking sector. Banks are saddled with large numbers of non-performing loans (NPLs)—Bank Markazi (the central bank) estimates that NPLs make up around 16% of total loans—and the difficulty of reducing the banks’ stock of bad loans is increased by their nature. According to a presidential adviser, quoted in mid-2o15, half of overdue loans (almost US$40bn) are owed by the government and state-owned companies, US$30bn by private and quasi-private enterprises and US$17.5bn are related to Mr Ahmadinejad’s Maskan-e-Mehr social housing scheme. Meanwhile, foreign banks have avoided the country, wary of the fines levied on HSBC and Standard Chartered, among others, by the US for breaking Iran-directed sanctions. The impact of Iran’s financial isolation is evident in the huge fall after 2012 in Iran’s short-term debt stock (which primarily comprises trade finance), which declined from US$10.3bn in 2011 to just US$486m in 2014 according to the World Bank. Iran makes a SWIFT return Yet, with the lifting of sanctions, the tide is turning. On January 19th the Society for Worldwide Interbank Financial Telecommunication (SWIFT) announced that, after talks involving Iranian, EU and SWIFT officials, Iranian banks would shortly be reconnected to the SWIFT international electronic clearing system. In addition, although foreign banks will remain wary about entering the country (given that a welter of US sanctions on Iran remain), non-Western banks may be less nervous, with Hossein Yaqoubi-Miab, an official at Bank Markazi, saying on January 21st that the Industrial and

16 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

Commercial Bank of China (the world’s biggest bank by assets) has applied to open a number of branches in Iran. Nevertheless, trade finance is likely to be the most promising early area for foreigners considering entering Iran’s financial sector; rules on retail banking remain stifling, and the appeal of investing in the stockmarket, although open to foreigners, is limited by the low number of listings and the risk of inadvertently purchasing equity in a company that is sanctioned by the US.

The pitfalls of investing in Iran an important strategic asset. The then transport minister, Ahmed Khorram, was subsequently impeached by the Majlis (parliament), and the airport International companies seeking to take advantage eventually opened one year later under Iranian of the array of opportunities presented by Iran management. following the lifting of sanctions need to weigh up Another notorious case in 2004 related to the the risks of dealing with a political and administrative award of a second mobile-phone licence. Turkey’s system that has undergone some significant changes, Turkcell was initially adjudged the winner in but that also has powerful currents of continuity. the tender, which specified a fixed fee of €300m Among the deals signed during a visit to Europe (US$328m) and was evaluated on the basis of the by Iran’s president, Hassan Rowhani, in late January investment plan and projected revenue streams. were Memorandums of Understanding (MoUs) with According to a law passed in September 2004, all French companies to develop and operate Iran’s contracts in which foreign companies held a majority airports: Vinci for Isfahan and Mashhad; and a stake required Majlis approval. This applied to partnership of Aéroports de Paris and Bouygues for a Turkcell, as it proposed to hold a 70% stake in the new terminal at Imam Khomeini International Airport venture. The Majlis blocked the deal, and the licence (IKIA) in Tehran. was instead awarded to South Africa’s MTN, the These airport projects could reveal how much second-placed bidder, after it agreed to lower its Iran has changed for international business. The stake to 49%. Turkcell tried various legal means to first terminal at IKIA was completed in 2004 by contest the decision, but to no avail. a local construction group. It was to have been In light of these and other cases, investors are operated by Tepe Akfen Vie, a Turkish-Austrian likely to watch closely the course of the new MoUs, consortium, as part of a deal that included building and the forthcoming elections for parliament and a second terminal, but its opening was delayed the Assembly of Experts, for indications of how by the intervention of the Islamic Revolutionary powerful vested interests in Iran will react to greater Guards Corps, after objections were raised to a involvement of foreign companies in the Iranian foreign consortium being involved in managing such economy.

Business environment

Business environment rankings Value of index Global rank Regional rank (out of 10) (out of 82 countries) (out of 17 countries) 2011-15 2016-20 2011-15 2016-20 2011-15 2016-20 Overall position 3.86 4.81 80 78 15 14 Political environment 3.6 4.3 75 70 13 13 Political stability 4.0 5.1 75 60 14 6 Political effectiveness 3.3 3.6 74 71 13 13 Macroeconomic environment 5.2 6.6 73 59 13 6 Market opportunities 4.4 6.7 57 14 11 2 Policy towards private enterprise & competition 1.8 2.8 82 79 17 15 Policy towards foreign investment 1.9 3.7 82 77 17 15 Foreign trade & exchange controls 2.8 4.2 81 77 17 14 Taxes 5.1 4.4 69 80 12 16 Financing 2.5 3.6 80 77 15 15 The labour market 5.2 5.8 65 63 9 8 Infrastructure 6.1 6.1 53 61 8 7

According to The Economist Intelligence Unit’s business environment rankings, Iran is ranked the fourth-lowest of the countries in the Middle East and Africa for the forecast period (2016-20). Iran is 78th (out of 82 countries) in the global rankings, although this is higher than its ranking for the historical period (201115), reflecting the beneficial impact on the country’s business environment of the implementation of the Joint Comprehensive Plan of Action. The removal of sanctions will ease trading and payment conditions substantially and allow for higher levels of foreign investment. Positive trends also include a demographic shift heralding a decline in Iran’s surplus-labour dynamic, a more responsible (less populist) government and a realisation by the government that Iran can no longer rely as heavily on revenue from oil exports as it has in the past. However, structural impediments to progress in the business environment will take a long time to overcome. We expect some reform efforts, but these will be limited by vested interests. Hence,

18 © The Economist Intelligence Unit Limited 2016 All that glitters Assessing opportunities and risks in post-sanctions Iran

although we expect some improvements to policies towards the private sector and foreign investment, these will remain areas of weakness in the business environment. The tax system remains complex and inefficient, and financing options are currently limited. Infrastructure is facing serious capacity constraints and needs substantial investment. Regulatory environment

Organising an investment Iran has two types of laws concerning foreign companies. The first type, such as the Foreign Investment Promotion and Protection Act (FIPPA) of 2002, addresses issues that directly concern foreign companies. The second type includes general laws with specific articles or bylaws that address foreign companies, such as the Direct Taxation Act of 1988, amended in 2002, and the Labour Law of 1979, amended in July 1989. Although FIPPA limits the market share that foreign investors allowed to have, it also provides, among other things, the following protections to foreign investors in Iranian companies: l equal treatment with local investors; l no licences are required for foreign investments, other than the FIPPA investment licence; unless stipulated in the investment licence, there is no limit to the proportion of foreign capital in an investment; and l in the event of nationalisation or expropriation, the foreign investor is entitled to compensation in an amount equal to the real value of the investment immediately prior to the event; Labour market The labour force is generally well educated and highly skilled. Nevertheless, wealthier Iranians have opted to send their children abroad for education since the 1979 revolution, which has created a brain-drain problem for the country. Government social policies encouraged a massive “baby boom” after the revolution and especially during the Iran-Iraq war (1980-88). As a result, the country has a very young population, with a median age of 27.4 years in 2012, according to the latest estimates by the US government. As the birth rate has plummeted in recent years, the median age is expected to rise significantly. There is a large differential in employment between males and females; in the fourth quarter of 2014 the economic participation rate of the population aged ten and over was 62.9% for men and only 11.8% for women. Of the total employed population of 21.4m, the agriculture sector accounts for 16.8%, manufacturing for 34.4% and services for 48.8%.

Labour law minimum wage (IR7.124m, or US$240, a month, in 2015/16). It stipulates that employees are entitled to paid leave and holidays, as well as an additional 40% of their usual pay for work completed on The Labour Law of 1991 covers all labour relations in Iran, including Fridays, official holidays and during paid-leave periods. the hiring of local and foreign staff. The Labour Law provides a On paper, current labour regulations in Iran are fairly well- very broad and inclusive definition of the individuals it covers; it disposed towards the concerns of workers. However, the trade union recognises all written, oral, temporary and indefinite employment system is highly undeveloped, and there is no legal room for the contracts. A 1991 regulation under section 35 of the Labour Code emergence of truly independent unions. prohibits employers from paying employees less than the authorised © The Economist Intelligence Unit Limited 2016 19 All that glitters Assessing opportunities and risks in post-sanctions Iran

Taxes There is a flat corporation tax rate of 25% on all taxable income, with no distinction made between local firms and those that are partly, largely or wholly foreign owned. Personal taxation rates are progressive, with the maximum rate at 35%. There is no separate capital gains tax. Value-added tax (VAT) was raised in March 2015 from 7% to 9% to offset the fall in revenue resulting from the collapse in oil prices during 2014. Foreign companies “residing abroad” that are contracted to work in Iran in areas such as construction, installation, transport, design and training are taxed at a rate of 12% of annual profits. However, overall, the tax system in Iran suffers from rampant non-compliance, owing to its complexity, often arbitrary nature and lack of a comprehensive, accurate national tax information system. As a result, the tax burden, measured as a percentage of GDP, is a very low 9.3%, compared with 35.5% in the UK and 44.2% in France, according to figures compiled by the US-based Heritage Foundation. Trade policy Iranian tariffs are high, in order to protect domestic producers—a state of affairs that will require many foreign firms to either set up production facilities within Iran or seek domestic partners. According to the World Bank, Iran’s simple mean applied tariff rate for all imported products was a high 25.36% in 2011 (latest data available); primary goods attract slightly lower rates. Medicines, wheat and “strategic” goods are zero rated. Tariff rates and customs levies are subject to frequent change, often at the whim of state-owned producers. Therefore, it is imperative to verify specific information on a regular basis.

Remaining US sanctions after the JCPOA l Foreign financial institutions will still be sanctioned if they do business with any Iranian person or entity on the US’s SDN (Specially Although the bulk of the US’s nuclear-related Designated Nationals) list. This list typically sanctions are being lifted after the full includes firms and individuals with links to the implementation of the Joint Comprehensive Plan of Islamic Revolutionary Guards Corps. It also includes Action (JCPOA), which was signed on July 14th 2015, 11 individuals and entities, including UAE-based a range of others, related to human rights, terrorism Mabrooka Trading, that were sanctioned in January and weapons of mass destruction, remain in place. after Iran conducted two ballistic missile tests in late These include: 2015. l US financial institutions are prohibited from l Even after the JCPOA, all US firms will have clearing US dollar transactions involving Iran. to apply to the US Treasury in order to receive This also applies to non-US financial institutions permission to do business with Iran. As the assisting US citizens or entities in clearing US dollar US Treasury itself said on its website: “The US transactions. embargo will generally remain in place, even after l US firms cannot do business with the Iranian Implementation Day, because of concerns outside of government or Iranian financial institutions. This Iran’s nuclear program”. prohibition also applies to the bulk of Iranian state- owned firms.

20 © The Economist Intelligence Unit Limited 2016 While every effort has been taken to verify the accuracy of this information, The Economist Intelligence Unit Ltd. cannot accept any responsibility or liability for reliance by any person on this report or any of the information, opinions or conclusions set out in this report.

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