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Iran: dealing with the deal

Economic Report

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  • The nuclear deal will have a clear positive impact on Iran’s economy
  • But the global impact is limited since Iran’s economy is not a very large part of World GDP
  • However, the deal could lead to increased oil production, which will put downward pressure on oil prices
  • Lower oil prices could potentially have a major impact on the global economy, although the largest part of the deal’s effect on oil prices has already been priced in
  • Geopolitically, the deal will lead to a more powerful Iran, increased rivalry between Saudi Arabia and Iran and possibly to increased tensions within the Middle East

On 14 July, Iran and the so called P5+1 countries (US, France, China, Germany, UK and Russia) reached an agreement (hereafter, the deal) to relieve economic sanctions on Iran in return for winding down in its nuclear program. This deal is historic. It has a wide range of implications, which range from (moderately) positive from an economic perspective to (quite) negative from a geopolitical perspective. In this piece, we briefly describe the deal, and shortly discuss the impact for Iran, its trade partners and the global economy, oil prices and geopolitics.

Deal basics

The deal entails that, in exchange for Iran winding down its nuclear activities: (i) United Nations (UN) and EU sanctions on Iran (in place since December 2006 and January 2012 respectively) will be lifted, (ii) Iran will gain access to about USD 100b in frozen assets it has abroad and (iii) Iran can make use of SWIFT , the international communication system for financial transactions[1]. Importantly, this does not mean Iran will be able to trade with the US. US entities cannot trade with or invest in Iran despite this deal because US sanctions on Iran are not based on Iran’s nuclear program[2].

The wind down of Iran’s nuclear activities broadly entails that Iran will reduce the number of centrifuges it has for enriching uranium, reduce its stockpile of enriched uranium and (iii) can no longer engage in unconstrained Research and Development (R&D) of centrifuge technology. The result of these restrictions is that Iran can make less nuclear bombs and the amount of time needed to make such bombs will increase. Namely, this so called “break out time” will increase from the current 1-2 months to 1 year.

Sanctions will only be lifted after the International Atomic Energy Agency (IAEA) verifies that Iran has actually taken steps to wind down its nuclear program, in a report expected in December 2015. If this report is positive, Iran will be able to trade goods (including oil) and services again with non-US entities.

Iran’s economy: clear positive

The deal is a clear positive for Iran’s economy and via multiples channels. The first channel is trade. Iran will be able to trade again with the rest of the world and thus also export more oil, which it was unable to do since 2012. The increased oil production provides a boost for the economy, although it is not yet clear how much the additional GDP will be (estimates range from 1% to 5% 2016). Increased general trade will also lead to a higher demand for Iran’s currency, the Iranian Rial (IRR), since importers of Iranian goods need to acquire IRR to pay for the goods. The IRR is likely to be quite undervalued, having depreciated by more than 50% in 2013 (from 12,073 IRR/USD in January 2013 to 24,722 IRR/USD in December 2013[3]). Moreover, this depreciation was mostly driven by an outside shock to the economy, namely sanctions, rather than being driven by less demand for Iranian products for other reasons. The Central Bank of Iran controls the value of the IRR, so an appreciation of the IRR might not be as large as it would be if it was a free floating currency. Nevertheless, the IRR will likely appreciate in value against major currencies. A stronger IRR makes Iranian products more expensive, which is bad for exports. But the overall effect will be positive since higher economic growth in Iran likely will likely lead to higher imports from the world, which will become cheaper as the IRR gains value. The IRR appreciation will also keep (imported) inflation in check, which surged to 26% per year in 2012, after major sanctions were put in place and was still high at 14% last year (Figure 1).

Figure 1: Depreciation leads to inflation
Figure 1: Depreciation leads to inflationSource: EIU

Importantly, Iran is well positioned to benefit from the deal more broadly than just through increased oil exports. For example, unlike many Gulf Cooperation Council countries, Iran has a well-educated and young population with a decent per capita income but an infrastructure deficit. These features are attractive for foreign investments since they imply a large retail market and a demand for infrastructure. Moreover, Iran’s educated workforce should be able to supply the additional high skilled labor demand created from potential infrastructure investments. In the longer term, Iran will also benefit from less brain drain, which is currently a major problem as about 150,000 Iranians with tertiary education move aboard to find a job each year. However, corruption, excessive red tape and medium term uncertainty about the actual implementation of the deal remain major impediments to foreign investments. Especially given the uncertainty, we do not expect a major inflow of foreign direct investments in Iran in the short term. But this might very well materialize if Iran abides by the terms of the deal and stays politically stable over the coming few years.

World economy: globally insignificant but regionally positive

Iran is the final untapped large market to enter the global marketplace in recent years. It has the 29th largest economy in the world with a (nominal) size of USD 420b in 2014 and a sizable population of about 80m people. Comparing this with other emerging markets, Iran’s economy is about as large as Thailand and about half the size of Turkey’s economy. However, the direct effect of Iran’s deal on the global economy will be limited. Because, when measured in USD, Iran represents only 0.5% of world GDP[4]. As a comparison, the USA and China represent about 23% and 14% of world GDP respectively on this basis.

That said, regionally, Iran’s trade partners will likely benefit strongly. The most notable beneficiaries of this large market are the United Arab Emirates (UAE), and Turkey since they already have trade and investment ties with Iran. But also Oman, which recently agreed to import gas from Iran. Of these countries, UAE (Dubai) is likely to benefit the most because it has traditionally acted as a hub for trade with Iran and also hosts a large Iranian diaspora. Currently, about 39% of all Iranian imports are from UAE. In that sense, China is also likely to benefit from a growing Iranian economy, as 19% of Iranian imports are from China.

Oil prices: lower, but largely priced in

Arguably the most important short term effect of the deal is further downward pressure on oil prices. Namely, about an additional 600K barrels of oil will be produced (exported) per day by 2016 if the deal goes through, which is about 0.7% of current daily world production. This might not seem much, but it is a significant increase of the current oil oversupply of about 3m barrels per day (according to Q2 2015 figures by International Energy Agency, IEA). As we have argued before, lower oil prices are a net positive for the global economy since most countries consume rather produce oil.

The largest part of the deal’s effect has been priced in. Oil prices, hardly reacted to the news on 14 July (Figure 2), having already declined by about 7% in the two weeks before the deal and partially also when the deal was announced in early April this year. More recently, oil prices have gone down further (to USD 49/bbl in mid-August), but this may also be related to China’s economic slowdown (China is the second largest net oil consumer in the world). Further pressure on oil prices might come about if the deal actually leads to sanction relief and additional oil production in Iran. Whether this will happen is still uncertain due to three factors.

Figure 2: Deal already priced in oil prices
Figure 2: Deal already priced in oil prices

First, the US Congress still has to approve the deal. This is likely though as Obama has said he will veto the approval if Congress does not approve, which can only be overturned with two thirds of the Congressional votes. Second, Iran’s parliament still has to approve the deal. This is also likely since the supreme religious leader (Ayatollah Ali Khamenei) has voiced his approval for the deal. Third, will the deal hold after 2017? Presidential elections are planned in Iran in 2017 and in the US in late 2016. The outcomes of these elections have a sizable chance of breaking up the deal after 2017. From the US side, this could happen if a hard-liner Republican candidate against the deal like Jeb Bush or Rick Perry wins the presidential elections (both have explicitly stated they do not like the deal). From Iran’s side, this could happen if a hard-liner against the deal wins the elections (for example someone from Iran’s Revolutionary Guard). The chance of this happening in Iran is high if the deal does not lead to a strong (perceived) increase of Iranians’ wellbeing. The population would then be likely to vent its discontent by opting for a new conservative anti-US president again.

Geopolitics: negative due to increased rivalry between Saudi Arabia and Iran

The geopolitical implication of this deal is that Iran will gain regional power, at the expense of Saudi Arabia and Israel. Iran might use its increased power and importance to exert more influence in regional conflicts. Most notably, Iran might increasingly back (financially as well as with military aid) Hizbullah in Lebanon, Houtthi rebels in Yemen and president Bashar Al-Assad’s regime in Syria. These are all Shia parties (Iran’s population is consists mainly of Shia Muslims), while the predominantly Sunni Muslim Saudi Arabia opposes all these parties. This Sunni Shia divide is at the heart of possibly increasing tensions that might arise due to Iran’s increasing power in the coming years. Saudi Arabia nor Israel want Iran to become more powerful, as this hurts their importance to the US. As a result of their discontent, the relationship between Saudi Arabia and Israel and the US will suffer.

Iran’s increased importance also might spark unrest between Sunni’s and Shia’s in other Middle East countries. A clear example is Bahrain, which hosts a Shia majority, while an elite Sunni minority controls the government (to the dismay of the Shias). This has already led to protests before (in 2011), which were fiercely suppressed by the government. Such uprising could happen again as the Shia population gets a sense of implicit backing from a regional power like Iran.

Footnotes

[1] Sanctions on arms trade will remain in place though for five years and on ballistic missiles for eight years.

[2] US sanctions on trade with Iran date back to 1979 as a result of the Islamic Revolution. These sanctions were intensified in 1995 to include virtually all trade with and investment in Iran. 

[3] The undervaluation of the IRR is also apparent in the difference between Iran’s real GDP per capita (USD 3,500) and the real GDP per capita on a Purchasing Power Parity adjusted basis (USD 22,000). Namely, the former underestimates purchasing power by a factor of 6. This is mostly because the IRR has depreciated so much against USD that it looks like Iranians have a relatively low income per capita in USD, while the PPP adjustment indicates that Iranian’s can buy a decent amount of goods with their annual income.

[4] Measuring Iran’s GDP in USD understates its size due to the heavy depreciation of IRR against USD. If sanctions relief leads to a higher value of IRR against USD than Iran’s share in world GDP will also increase as its purchasing power increases. As an indication, Iran’s GDP on a Purchasing Power Parity (PPP) adjusted basis is 1.2% of world GDP, which is still limited (although indeed much larger than based on USD).

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Author(s)
Raphie Hayat
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 51295

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