Monetary and Capital Market Exclusive, March 2004

Monetary and Capital Market in Iran

A Pragmatist Looks at the Iranian Capital Market

The major, and dominant, players in our capital market are commercial banks comprising of large government bureaucracies and very small private banks.

Ali Manavi Rad, Chairman & CEO Etebar Financial Management Consultants Co.

At a recent IMF seminar, Noble Laureate Douglas North of Washington University addressing the ever-present question of why some economies grow and others stagnate, emphatically reiterated what was not novel to the professional audience at the seminar; that underdevelopment of capital market is a major culprit in causing historical economic backwardness and low rate of growth. You did not need to be a top notch economist to appreciate that. We intuitively know that growth is like happiness. Money alone does not bring you happiness but you can hardly feel happy without money.

The concept of capital is, of course, more elusive than money. Growth depends not only on capital accumulation but also on capital allocation. Allocation is what capital markets are more expected to do, efficiently. And Iranian capital market is not efficient.

In recent decades nearly all elements of an inefficient capital market have been present in Iran;

• You (as saver or investor) can not easily and smoothly enter (and leave) our capital market at minimum cost and effort,

• The market does not give the right and timely signals on the price and availability terms of capital,

• The market does not distribute the available capital to the bidders (investors) with the highest price offered (return on capital) and transfer the price at a minimum cost to the suppliers (savers).

 As a result of this:    

• Financial resources available to the firms are not sufficient for renovations and technological improvements,

• Non-productive saving instruments (land, gold and foreign exchange) take the lion's share in the portfolio of the savers,

• Investment in new products and processes could not be easily financed,

• Limitations faced by creative entrepreneurs to put up tangible collaterals sharply reduces their ability to borrow, even when their ideas are economically feasible and profitable,

• The cost of borrowing is impossibly high,

• Financial products are practically dealt with as if they are considered "disposable". They are used once as they are produced and then remain idle throughout their life cycle. This drastically reduces the depth, volume and flexibility of the market.

• Financing potentials are basically limited to bank borrowings (with all its problems and shortcomings) and equity sale as a direct, cost-effective financing method depends on uncertain prospect of acceptance of the firm to the Tehran Stock Exchange.

• The possibilities to enter into international markets are very limited, time-consuming and inefficient therefore huge and relatively cheap resources in these markets could not be tapped to complement local capital.

This combination has largely translated itself into a very unfortunate situation in which other factors of production i.e. our labor force and our natural resources have come under destructive pressures. We use more and more of our non-renewable natural resources (soil, oil, air, woods and water) to sell them for immediate money. Our labor force, also in a technologically backward environment with low per capita added value, has to hang on to multiple jobs and long hours of sweating with depressive effects, to make a living. Private capital, available for the right projects in a timely way and at a reasonable cost, is the only vehicle to bring advanced technology to our production practices to lift this erosive pressures on our human and natural resources and to provide jobs for many more job-seekers to come.

Our capital market does not perform these very crucial functions, partly because for performing these, you need efficient financial intermediaries. These are agents acting between savers and investors to mobilize and channel financial resources towards the best uses. These agents are in two groups:

• The first group creates an indirect relationship between savers and investors, collects savings, pays the reward (interest) and sells these resources to the investors. These are the agents in the bank-based financial system.

• The second group establishes a direct link between savers and investors and plays the role of the facilitator, guarantor and advisor to both sides. These are the agents in the security-based financial system.

The major, and dominant, players in our capital market are commercial banks comprising of large government bureaucracies and very small private banks. The rest of our capital market players e.g. insurance companies, pension funds and even stock exchange are depressively dependent on and even controlled by big commercial banks. And commercial banks mired in their huge bureaucracies and rigid regulatory straight jackets could not possibly respond to our present capital needs let alone the huge demands of the future. They are largely incapable of analyzing proposed projects to quickly recognize profitable ones. Therefore their lending practice heavily relies on collaterals (basically real estate) to be put up by the investors. These banks are limited by credit ceilings, mandated to lend to public projects and forbidden to engage in new financial transactions to offer new and innovative financial products.

An alternative to this monolithic structure of our market is, seemingly, a development bank. Designed to deal with medium and long-term financing needs, these banks are supposed to have a better understanding of project lending practices. But where could they possibly get their resources from? They are not deposit collectors and they can not afford to be in a market where the competitors run thousands of branches offering a much wider spectrum of services to ordinary deposit makers. Therefore such a bank usually relies on subsidized government money, which nowadays is not easily available. And they also are banks, subject to all local and international regulations regarding adequacy of their base capital for their operations and again incapable to offer innovative products.

The dominant factor which over-shadows everything in our economy is a huge (more than 200 times) jump in the money supply during the last two decades which makes the financial resources potentially available. Then there are rapid institutional changes like the emergence of a large number of investment companies, usury–free (gharz ol-hassaneh) funds, leasing companies and expansion of pension, social security and charity organizations. These together with the large number of existing branches of the commercial banks have contributed to a very widespread network of deposit collectors able to mobilize huge amounts of savings. Therefore, possibilities—both institutional and personal—for capital accumulation are realistically available within our economy. And outside, in spite of the presence of some politico-economic problems, we can easily have access to markets which, after deregulations and globalization have reached levels of maturity enough for them to recognize lending-investment potentials in the far corners of the world, especially in a resource-rich country at the time when the advanced economies are offering, the historically, lowest levels of return on capital. But then comes the problem of efficient allocation where our traditional bank-based financial market has failed. Now more than ever we need to have independent and flexible allocation machineries to more directly channel funds to our potentials growth poles. Here is a gap which could only be filled by a non-bank institution.

An intermediary able to directly connect the saver and investors and, at the same time, give much needed support to the existing deposit collectors could perform three main functions:

a)   Recognize and promote economically profitable projects in all sectors of the economy.

b)   Enhance credit-standing of the entrepreneurs to borrow for financing their projects.

c)   Introduce new and alternative products and instruments to entice savers and make traditional financial products more varied, interchangeable and re-usable.

The aforesaid shortcomings of the traditional financial intermediaries i.e. commercial and development banks, to perform the role of the efficient allocator necessitates creation of a security-based entity to provide professional services to tap the available saving resources in and outside the country. The proposed entity could assume the form of an Industrial Development Fund (The Fund) to assist financing all investment projects (in industrial, agricultural and service sectors) with positive rate of economic return. Such a "Fund" shall be designed to provide four groups of services i.e.:

a)   Investigative services (project evaluation, financial, administrative and technical re-structuring studies)

b)   Advisory services (fund management, merger and acquisition and contracts)

c)   Supportive services (underwriting and guarantees)

d)   Transaction services (bonds, securities and derivatives)

The "Fund" is not a ''bank" so it enjoys all  the flexibilities of  a non-bank institution and basically focuses on identifying "projects" , supporting them with different techniques of "underwriting" and initially offering them to the public at large (including deposit collectors) inside and outside the country. Therefore the core business of the ''Fund" would be the supportive services i.e. issuance of guarantees to make the projects acceptable to the investors and bankable for the financers.

Considering the existing structure of our financial sector, the guarantor authority of the ''Fund'' could, at least at the first stage, only come from the government. So at the beginning the ''Fund'' will have to be a public entity, authorized to issue guarantees and underwrite initial public offerings. An act of parliament would allow the government to budget the amounts of guarantees issued by the "Fund'' and called upon by the beneficiaries. A sovereign guarantee like this opens the local, and more important, the international markets. The catch is, of course meticulous evaluation of the profitability of the projects to limit encashment of the issued guarantees and avoid failure of the underwriting operations.

The ''Fund'' could, in a very effective way, complement and enhance the quality of the financial resources now being offered by the Foreign Exchange Reserve Fund (FERF). FERF is using ''agent'' banks to evaluate proposed projects before they are accepted by the Ministry of Industries and Mines and the Trustee Board of FERF. Accepted projects then go to the Central Bank for final approval for foreign exchange loans with concessionary rates and complementary rial loans to the project owners for implementation of their projects. But all the while the resources of FERF are sitting in their ''accounts'' earning meager rates waiting to be used for payments to beneficiaries of letters of credit opened for machineries and equipments for the approved projects.

FERF reserves now kept as an ''account'' with the Central Bank are placed in the markets as part of the official reserves of the country. This, due to strict laws and regulations governing the management of the official reserves, very much limits any possibility for an active use of these reserves for credit creation in the markets. On the other hand, the dual use of FERF reserves for lending to private industrial projects as well as a ''buffer'' to absorb shocks of oil income drops, creates an uncertain character for FERF reserves which precludes use of these funds, or part of it, for a stable presence in the market.

A meaningful, and workable, alternative would be to transfer part of FERF foreign exchange reserves as the initial capital of the proposed ''Fund '' and then allow the ''Fund'' to borrow additional resources from FERF for further financing operations. The initial capital together with borrowing possibility for the ''Fund '' coupled with the underwriting authority of the ''Fund'' shall then be actively used in the international markets to raise credit facilities many times the dollar value of the existing reserves of FERF.

The proposed ''Fund'' armed with these credit enhancement potentials shall have a very effective presence in the market for a multi-dimensional operation of underwriting, IPO's and venture capital and financial engineering for all financing solutions including introduction of structured financing arrangements and derivatives. The ''Fund'' has to be structured in a way that with a professional core staff it could economically out-source the needed services to avoid becoming a new bureaucratic behemoth and benefit from the most advanced professional expertise available inside the country as well as in the more sophisticated international markets. 

The future challenges of the Iranian economy faced with new waves of baby-boomers of the last two decades, are huge. This also comes after decades of inadequate productive investments. A new approach to institutional arrangements of our capital market is a key to accelerate growth. Licensing private banks was a welcome development. Now there is a need for new solutions to make use of the existing potentials for financing investment projects.