Iran plans return to sukuk markets

12 October 2015

The potential lifting of international sanctions could awaken the largest sharia-compliant finance industry in the world

Special Report Contents

Iran’s financial sector is the largest sharia-compliant finance industry in the world, and its return to global markets cannot fail to make waves.

The Ministry of Finance took the first step to revive the country’s debt markets by reportedly issuing about $300m of short-term sovereign debt on 5 October, according to the local Securities & Exchange News Agency (Sena).

The effective interest rate is expected to be higher than the official bank deposit rate of 20 per cent, after the bills are sold at a discount. The first issuance since a €1bn Eurobond in 2002 will test appetite for government debt in an environment of overstretched banks and cautious private investors.

Increasing liquidity

The sukuk (Islamic bonds) are intended to develop Iran’s debt capital markets and increase liquidity in the banking sector.

“Iranian sovereign sukuk, assuming investors buy it, would help price a corporate yield curve,” says Khalid Howladar, global head of Islamic finance at the US’ Moody’s Investors Service. “If the sovereign bonds are widely accepted by the market, banks would be able to come to fixed-income markets on the back of that.”

Depending on investor appetite, Iran may issue another $600m of sovereign sukuk in the next few months. The central bank can issue up to $3.3bn in sovereign sukuk before the end of the financial year in March 2016.

Corporate potential

Iran’s banks had gross assets of IR14,107 trillion ($471bn) as of June 2015, according to the central bank.

Iran makes up 45 per cent of the global Islamic finance sector, according to Moody’s, and is the third-largest banking sector in the Middle East, after the UAE and Saudi Arabia.

Moody’s predicts that when Iranian banks re-enter international markets following the lifting of international sanctions expected in early 2016, they may boost global sukuk issuance volumes, which have fallen this year due to Malaysia’s financial worries.

Current volumes are very low in Iran, with debt issuance making up just 2 per cent of financing there, according to the local Securities and Exchange Organisation (SEO). However, Dubai-based Frontier Partners estimates there are 150-200 Iranian companies considering sukuk issuance.

“If Iran’s financial sector were to open up, and considering the relative size and needs of its financial sector, we might see $5bn-$10bn of sukuk issuance a year,” says Howladar. “Perhaps [these will be] hybrid structures as there is a significant need for new capital.”

Major obstacles

However, there are major obstacles to be dealt with before companies, especially in the petrochemicals and telecoms sectors, will feel confident issuing sukuk.

“The sukuk and capital markets are not liquid at all, and when you trace the transactions, it’s just a few organisations buying and selling to each other,” says Parham Gohari, a partner at Frontier Partners.

“There are significant issues with the system as a whole – lack of transparency and a proper framework.”

On 11 October on Tehran’s Fara Bourse, just 13,650 trades took place worth a total of IR412bn. The total market capitalisation of the securities market is IR762 trillion, or about 69 per cent of the sukuk listings on Nasdaq Dubai, the largest exchange globally, which is worth $36.7bn.

International investments

It is unclear if and when foreign investors will be allowed to buy Iranian debt under sanctions rules, and whether there will be investor appetite.

“Local currency issuances would be a tough sell, but if local banks issue [US] dollar bonds, there may be appetite,” says Howladar.

“It all hinges on the price. There is a demand for dollar yield, and Iranian debt would probably be quite high-yield, and so potentially attractive to emerging market investors.”

However, dollar bonds may be challenging commitments for Iranian companies due to high inflation and a riyal fast losing its actual value against the dollar. Iran’s banks follow the same broad sharia principles as other Islamic finance institutions, but do not tend to use international standards.

This will further fragment Islamic finance markets, predicts Moody’s. The sector is already hampered by a lack of standardisation of sukuk structures, although the situation had improved in recent years.

GCC banks

Iran will hope to attract excess liquidity from GCC Islamic banks, which are in the best position to take advantage of the Iranian market, if the political situation allows. However, with banking sector liquidity beginning to fall, Iranian issuers may find less appetite than hoped.

“Where are these investors going to come from?” asks Gohari. “There was a lot of liquidity in the Middle East and a lot of outbound investment, but now, as a result of oil prices dropping, it is being drawn back in. A lot depends on the regional economy.”

GCC banks have been tight-lipped on their plans for the Islamic Republic due to sanctions, which will not be lifted before the end of 2015, and rising geopolitical tensions.

Despite a lack of investment products and inadequate liquidity for Islamic investors, international appetite for Iranian debt, whether sovereign or corporate, is not expected to be strong.

Iran’s project finance prospects

Iran’s fully sharia-compliant financial sector will bring a renewed focus to Islamic project finance when sanctions are lifted early next year. The Islamic Republic is in dire need of investment to fund the rehaul of its ageing infrastructure, particularly in the key sectors of petrochemicals, energy and transport. Analysts and investors widely see funding and financing as the limiting factor on Iran’s ambitious investment plans.

Iranian clients are beginning to study contract structures and risk allocation with a view to convincing banks that projects are bankable, according to speakers at MEED’s Iran Breakfast Briefing held in Dubai on 29 September.

However, international banks will be cautious about exposure to long-term debt in Iran, even assuming that sanctions are removed as expected in early 2016.

Local banks are too overburdened by at least $30bn of non-performing loans and lack the capacity to finance investment on this scale. Government lending by domestic banks reached IR1066 trillion in June 2015.

Islamic project finance requirements could also discourage banks, as it remains a relatively new and untested area. In order to secure the level of financing demanded by investment programmes quickly, Tehran may have to compromise the sharia principles that govern its domestic banking sector.

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