Return or Risk?

Iran should be able to exploit new financial tools if it is determined to develop its economy

The banking system, stock exchange, investment companies and credit institutes, together constitute arrangements and organizations which develop the financial sector of a country’s economy. This sector includes those institutions charged with the replenishment of savings and allocation of funds.
Investment is a vital necessity to economic growth. National revenues increase through sufficient investments, but the point is that investments necessitate the replenishment of financial resources. The latter is a function of financial sector in an economy given the fact that economic development largely depends on the financial sector. Empirical evidence confirms the link between the development of economy and that of the financial sector. Economic growth takes a faster pace in countries with a more developed capital market.
For each real flow of products or services, there exists a flow of money, and the financial sector, which includes various organizations, consists of monetary market and capital market. The main difference between the two is that monetary market deals with short-term prospects, while capital market is the long-term sector of economy.
Iranian economic profile in the past century shows that the only institutes or quasi-institutions in financial trade were currency exchange agencies. Shortage of money would make the business of these agencies more profitable. It is obvious that such a primitive and disintegrated structure cannot fulfill the needs for a growing economy.
As the experience of today’s developed countries shows, a country should be able to exploit new financial tools if it is determined to develop its economy. Foreign investors felt the need for an integrated financial system for their long-term activity in Iran at the start of their investment here.

When an organization enjoys a specific government budget, it hardly starts seeking new resources for investment

One objective of Iranian modernists was setting up national banks, by which the banking system was gradually established in response to a need for reconstruction of the Iranian economy. The main aim these banks pursued was to initiate a flow of financial reserves in order to replenish investment resources. On the other hand, industrial countries’ experience shows that commissioning a stock exchange and a developed capital market is an essential element of the economy. In mid-1960’s, the concept to establish a stock exchange was realized and Iranian financial sector was reshaped.
In order to have a bright picture of Iran’s financial sector, we should not overlook the role of traditional money market which has a monetary content rather than an investment one. This money market has been an inseparable part of Iran’s economy in the past decades. In this market, durable goods can replace money in some cases as a unit of value stock. In spite of ups and downs, today’s monetary market consists of the banking system, non-banking credit institutes and a large traditional and quasi-monetary sector, while the capital market is limited to a stock exchange center.
The quasi-monetary sector falls in the domain of unofficial and underground economy; therefore, it cannot be evaluated through official data. However, the weaknesses of Iranian capital market can be easily identified through official statistics. In March 1996 through March 1997, the volume of deposits in commercial and specialized banks in proportion to gross national product (GNP) was 45%, while in the same period, the volume of exchanges in the stock market in proportion to GNP was only 2% and the ratio of stock exchange volume to private deposits in trade and specialized banks was only 4%. In comparison, the current value of stock market in proportion to GNP was 121.7% in England, 259.4% in Malaysia, 194.8% in Singapore and 12.3% in Turkey. It can therefore be concluded that the status of Iranian monetary market is not satisfactory.
Like many other developing countries, Iran’s banking system and financial markets have dominance over the capital market. This dominance shows the impact of monetary and capital markets on each other. In order to find out the reason behind this dominance, we should first consider two basic concepts, i.e. “return” and “risk”, based on which both markets can be evaluated.
The most important tool offered in the monetary market is bank deposit, while in capital market the stocks of companies is the major tool. Bank deposits enjoy a high level of security. They can easily be turned into cash, and this gives them a privilege over the buying of stocks. Moreover, no tax is levied on bank deposits, while stockholders do not enjoy any tax exemptions. Therefore, making deposits in banks is a safer and more attractive option.
Is the return on investment in stocks more than interests received from bank deposits? The answer is positive, but the fact is that fluctuations in the stock prices overshadows the stock market to a large extent and this makes bank deposits more attractive for the investor.
Participation bond is another capital market tool which has been used widely in recent years. Bonds are released to attract public participation in development projects, undertaken by government organizations such as municipality.
Participation bonds have undeniable advantages: bonds help increase the variability of tools in the capital market; they are an effective means to control government mandates which would reduce the financial resources of private sector. Problems of participation bonds should not be overlooked: lack of variability in respect to return and the due date, secondary market, extra workload imposed on banks because of undertaking the management of these bonds.
There is not much difference between bonds and bank deposits in terms of security and benefits. Therefore, instead of being helpful in the replenishment of private savings, bonds are inevitably purchased by banks and lose all their potential benefits.
A significant factor overshadowing all economic activities in Iran is the short-term vision of authorities. Economic figures here have adapted themselves to the conditions governing the Iranian economy through making short-term, changing and flexible decisions. As said earlier, capital market has long-term prospects, thus in an economy where only short-term prospects can be seen by officials, financial tools are more heeded than capital tools. Therefore, under the current conditions, short-term monetary market is more attractive for people to invest comparing to long-term capital market.
Another structural constraint that serves as an obstacle on the way of capital market development in Iran, is the ownership system which is under the state control although private ownership can be seen only at a small scale. When an organization enjoys a specific government budget, it hardly starts seeking new resources for investment.
The ownership structure in two sections of Iranian economy — real and financial — gives momentum to the status quo in which the monetary market has dominance over capital market.
In the meantime, this shows that any endeavor to reform Iranian economic substructure, necessitates more comprehensive measures to reform economy as a whole. The structure of capital market escalates the current situation: capital market, as compared to monetary market, suffers from geographical while monetary market is expanded in a wider range. On the other had, Iranian capital market has witnessed more ups and downs comparing to monetary market.
Also, lack of competition and available information hinder the shaping of a developed capital market here. Moreover, the market’s restriction to secondary transactions, lack of secondary stock exchanges in addition to Tehran Stock Exchange has further put a negative impact on the role capital market can play in the economy. In addition to structural constraints, there are some other limitations related to the tools being used in the capital market, which has been a reason behind the little demand in this market. TSE only offers one or two financial tools.
Another constraint is the organizational one. Limited number of financial middlemen and financial organizations in this market indicates the above-mentioned fact. Above all these issues is absence of such developed markets as a specialized center for product exchange, which would help direct regular financial flow into the production sector of the economy. This shortcoming would increase the reliance of the country’s financial system on banking sector.
Undoubtedly, if there is variability in the ways and means of replenishment of financial resources, more options are available and more resources are attracted by national economy, and naturally, the volume of investments would increase and economic growth would speed up. Sustainable growth needs variability in the capital market.
If capital and monetary markets both exist independently from each other, the applicants attracted by the banking network are individuals and groups who willingly accept the conditions of money markets; while in the absence of a developed capital market, those who enter the monetary market do not choose this market as their primary choice, but they choose it because there are not other options.
Empirical and theoretical evidence shows these conditions are not to the benefit of the economy, because, as is expressed in economic terms, resources are absorbed at the sub-optimum level, and therefore, allocation of resources is also at sub-optimum.
The solution is to eliminate structural constraints in financial and real sectors of the economy and to create variability in monetary markets. Statistics show this variability does not reduce the deposits in the banking system, it even attracts some other groups toward this market. Therefore, the development of capital market is eventually to the benefit of the banking network and monetary market.

By: S.A. Mir-Motahari, President of Tehran Stock Exchange