Prospects for Iranian Integration into Global Capital Market

With a capitalization of about $170 billion as of March 2014, the Tehran Stock Exchange is the second largest in the Middle East region. For the last few years, its stock market has surged despite the burden of Western sanctions. Under the recent nuclear framework agreed to in Lausanne, Iran is expected to be freed from almost all economic and financial restrictions upon fulfillment of a list of stringent tasks. Capital mobility and further global integration are within view for investors. However, policymakers in Tehran need to navigate the benefits and costs of sudden capital inflow with caution.Since 2010, four major factors have fueled the rapid growth of the Iranian capital market. First, widespread sanctions limited capital outflow, which drove large amounts of investment into the domestic equity market. The second driver was a low rate of return on domestic assets. The country’s GDP failed to achieve its full potential due to a decline in commodity exports. As a result, the stock market seemed more promising in times of low yields and high inflation. Thirdly, other asset classes including currency and real estate presented practical challenges. A weak dollar from 2010 to 2013 appealed little to investors in the foreign exchange market. Even when the dollar regained its strength, banking sanctions continued to impede foreign exchange. Concurrently, the real estate markets within Iran and Saudi Arabia, a historical destination for real estate investment, remained stagnant as consumers doubted future growth. The last contributor to the growth of Tehran’s stock market was the privatization of previously public-held assets that evoked renewed confidence in the stock market. One significant case involved the Iranian automobile giant Iran Khodro. From 2008 to 2010, the Iranian government reduced its share to about 20% and created an attractive space for non-governmental entities to invest.Looking forward, the progress of nuclear talks and Iran’s continued efforts in privatization will lead to a large sum of capital inflows into the Tehran Stock Exchange. With an ongoing Eurozone crisis and constantly under-performing emerging markets, investors are likely to heavily prepare for the day that all sanctions are finally lifted. The voices of those hoping to break into the hottest-market-to-be currently prevail in major news sources. At this time, it is too early to speculate on which asset classes will gain momentum. However, investors’ eagerness and the growing consensus that Iran represents a “compelling combination of frontier and developed market characteristics” matter more than technical details. Equity research and fixed-income analyses could be easily achieved once the market is open and a wave of chief investment officers enters the arena. For now, more comprehensive analysis of macro-economic prospects is recommended for foreign investors.Iran should balance the advantages and challenges that capital mobility presents. The benefits of an inviting environment for capital inflow include the stimulation of growth, the smoothing consumption over time, and the diversification of the market. These aspects are vital in strengthening the economy’s fundamentals, especially as Iran comes out of decades of isolation and economic slowdowns. On the other hand, deeper financial integration and open capital markets can induce higher volatility of the exchange rate, inflationary pressure from associated economies, unpredictable monetary expansion, and a risk of widening current account deficits. These downfalls can be counter-balanced with appropriate fiscal policies and capital controls to some extent.While a high degree of central bank intervention (i.e. sterilization) on top of strict exchange rate policy could give Tehran more costly control over sudden capital inflow, direct policies of capital controls are unlikely to mitigate risks related to international integration. Furthermore, putting a cap on capital inflows acts as a kind of self-imposed financial sanction, which is contradictory to the goals of nuclear talks – to restore the export sector and to promote global integration. Another possibility is to impose a certain form of tax on capital inflow. However, similar capital inflow restrictions in Chile in the 1990s failed to curtail a rising volume of capital flows and a real exchange rate appreciation. These negative effects could exacerbate the upward pressure inherent to the currency of an oil exporter. Double forces on exchange rate appreciation could hurt the Iranian export sector profoundly and drastically decrease the country’s competitiveness within a few years of trade openness. Despite its lack of effectiveness on the macro scale, such capital controls helped Chile to reduce the instability of stock market returns and protected its economy from relatively small external shocks – a comforting correlation to Iranian financial sector. If the volatility of a surging and potentially high-demand capital market is the main concern of both Tehran and prospective investors, then moderate capital control measures combined with a continuation of privatization will prepare Iran for its return to the global market.