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Laying Groundwork for FDI
Economy, Business And Markets

Laying Groundwork for FDI

The landmark nuclear deal reached between Iran and the United States and other world powers sets out arrangements for handling that issue, but it leaves open many other questions about Iran’s future course.
Conventional wisdom holds that the Iranian government will get a huge immediate economic windfall from the deal, thanks to the release of about $100 billion in frozen assets, and then continue to benefit as the end of the sanctions opens the floodgates to foreign investment, wrote the US journal Foreign Affairs.
But the windfall from unfrozen assets will not be as significant as expected. Iran’s preexisting financial obligations will likely reduce the amount of usable liquid assets to a figure closer to $50 billion. And given that Iran will need to keep a reasonable amount of that money in foreign reserves, the amount available for Iran’s immediate use will likely be closer to $25 billion.
It’s not a trivial sum, but far less than Iran needs given that the infrastructure investment levels required to rebuild Iran’s economy are estimated to be close to $1 trillion over the next decade.
Foreign investment will, therefore, be crucial for Iran, the last major economy not to have integrated into the global economy. Indeed, Iran is ripe for economic transformation. Unlike most countries rich in natural resources, Iran has a host of additional advantages, including a diversified economy, a trade surplus and a well-educated urban population. Foreign investment will allow Iran to capitalize on these strengths.
But the end of the sanctions alone will not be enough to attract investors. Although lifting the sanctions will remove a substantial impediment to Iran’s economic recovery, it will not automatically create the legal and regulatory framework necessary for sustained investment. Iran’s lackluster attempts at market liberalization and its undistinguished record on issues such as intellectual property rights will continue to give pause to global investors.
If Iran genuinely wants to attract investment, it will need to implement a broad spectrum of reforms, including strengthening property rights, transferring state-owned assets to the private sector and granting independence to its central bank. Only then can Iran reap the full economic benefit of the nuclear deal.

  Untapped Potential
Iran is the only country in the world blessed with massive amounts of both oil and gas; it boasts the world’s fourth-largest proven oil reserves and the world’s largest proven natural gas reserves. For that reason, many analyses of Iran’s economic potential focus solely on energy. But Iran’s economic advantages are numerous and varied.
With a GDP of approximately $1.4 trillion (converted to international dollars using purchasing power parity rates), or roughly 1.5% of global GDP, Iran has the 18th-largest economy in the world, between Turkey and Australia, according to the International Monetary Fund’s April 2015 World Economic Outlook.
Its GDP per capita, roughly $17,000, places it ahead of Brazil and China, even after its stagnant growth in recent years. And its debt-to-GDP ratio is around 12%, among the lowest in the world.
Moreover, despite the large size of Iran’s energy resources, its economy is relatively diverse: roughly 50% services, 41% industry and 9% agriculture. Oil and gas likely account for less than one-fifth of Iran’s GDP, according to unofficial estimates.
In 2011, before the sanctions, Iran was the world’s 13th-largest manufacturer of automobiles, producing 1.65 million cars annually, more than the United Kingdom. Since 2013, in part because of such diversity, Iran has enjoyed a relatively sustained annual trade surplus of about $35 billion from automotive production, chemicals, mining and minerals, utilities, and telecommunications.
But the most promising indicator of Iran’s economic potential is its human capital. Iran has a population of 80 million, comparable to Germany and Turkey. About 64% of Iranians are below the age of 35. The population is 73% urban, a percentage similar to those of most industrialized countries.
And that urban population is well educated. Iran’s literacy rate is 87% overall and 98% for those between the ages of 15 and 24.
After Russia and the United States, Iran is the world’s fifth-largest producer of graduates in engineering (reliable statistics for China and India are not available, but it is likely that they occupy slots one and two). Some 7.5 million Iranians, or about 13.3% of the country’s working-age population, have completed a university-level education, making Iran the most educated country in the Middle East. For the sake of comparison, Mexico’s university graduates make up 12.5% of its working-age population; Brazil’s, 11.7% and Indonesia’s, 6.9%.
Foreign investment can help Iran take full advantage of these strengths. Currently, the stock of foreign investment in Iran is estimated at $43 billion, which makes Iran the 58th-largest holder of foreign investment in the world. In light of the extensive western sanctions, this is a surprisingly large amount. In terms of relative potential, however, the investment is small, particularly when compared with that of a peer country such as Turkey, which has received around $209 billion in foreign investment, making it the 26th-largest holder of foreign investment in the world.
Indeed, current foreign direct investment in Iran falls significantly short of Tehran’s stated goal of attracting close to $1 trillion over the next five to 10 years.

  Challenges Ahead
But attracting foreign capital may prove difficult. Investors will be wary of Iran’s lackluster attempts at market liberalization. Although Iran has attempted to transition to a market-based economy, its efforts have largely failed.
Iran nationalized much of its economy in the wake of the 1979 Iranian Revolution. But after an eight-year war with Iraq, leaders such as Iran’s fourth president, Akbar Hashemi Rafsanjani, sought to rebuild the economy through privatization. In 2004, Iran’s Expediency Council, which advises the Leader of Islamic Revolution Ayatollah Seyyed Ali Khamenei, began advocating for greater private ownership of enterprises, a proposal the Iranian Parliament ratified the following year. Under the new law, many state-owned enterprises were permitted to privatize up to 80% of their shares.
But this was privatization in name only. Of the shares that were privatized, roughly half were distributed by former Iranian president, Mahmoud Ahmadinejad, to underprivileged segments of the population through a program known as “Justice Shares.” Instead of making the economy more efficient, this program has had the opposite effect, as the new shareholders have no meaningful business experience to help them manage or supervise the companies.
The remaining half of the shares were transferred to three types of quasi-governmental bodies that although nominally private, former government officials often serve in their supervisory or management positions.
All in all, privatization has brought neither a cadre of skilled management nor better corporate governance.

  How to Win Friends
Yet there is still cause for optimism. In deciding where to put their capital, investors take a country’s starting position as a given and look for the potential for dramatic gains. In this respect, Iran looks promising. It has the potential to see immediate and substantial growth, becoming a premium investment destination.
With greater economic opportunities at home, Iran can leverage its human capital. And if Iran is able to sustain growth beyond a decade, the country’s young people might find themselves in a position to provide domestic support for the country’s investment needs as they grow into adulthood.
If Iran wants to reap these benefits, however, it will need to foster an environment conducive to foreign investment. First and foremost, investment capital will need to be protected by laws that encourage certainty and stability in free markets.
At a minimum, such laws should secure physical and intellectual property rights, enforce contracts, reform the bankruptcy regime, encourage strong corporate governance and require transparent financial reporting based on internationally recognized accounting standards.
Without such laws, troublesome obstacles will stymie investors who may wish to participate in Iran’s privatizations or invest in Tehran Stock Exchange. Investors will demand risk premiums to compensate for the lack of transparency, effectively taxing the Iranian economy.
Corruption is also a significant challenge for Iran. Of course, there is no emerging market in which corruption is not a significant issue, and even advanced markets are susceptible to graft. If investors see that addressing corruption is a priority for the Iranian government, they will be more likely to invest, even if some level of corruption remains inevitable.
Investment capital also needs to be supported by a stable and credible banking system. Iran’s banks will need to be able to operate without government direction but with suitable regulatory oversight to promote sound risk management.
Aside from Iran’s oil and gas reserves, which will surely stay firmly under state control, most state-owned assets will need to be genuinely transferred to the private sector. Transferring state-owned enterprises to government insiders under the guise of privatization does not yield corporate dynamism or efficiency.
To achieve such gains, the Iranian government needs to hire independent experts to evaluate the performance of all companies that are majority-owned by the state and all quasi-state entities and then transfer majority ownership of underperforming entities to individuals or groups with no connection to the state.
Iran will need to reassure investors that the return on their capital will not be negatively offset by currency depreciations or price inflation, and those investors will look for a strong and independent central bank to mitigate these risks.
However, the Central Bank of Iran is not truly independent. A central bank cannot pursue price stability while financing its government’s budget deficits, as Iran’s is made to do. It was not until Turkey gave full operational independence to its central bank in 2001, for example, that it was able to restore financial stability and attract foreign capital.
Finally, Iran would benefit from encouraging its diaspora community to invest back home. Iranians living abroad share a cultural connection to Iran, making them more willing to take on risk; other investors will then be more likely to follow their lead.
Moreover, diaspora communities can introduce invaluable global networks of business, research, and technology to their countries of origin, thus accelerating their development. India’s experience and success in this regard is noteworthy, and one way Iran could follow India’s lead would be to issue identification cards to people of Iranian origin that would allow them to travel to and invest in Iran without a visa or dual citizenship. Such an act, by itself, would be a powerful signal and could attract large amounts of capital.

  Clock Is Ticking
Iran missed the golden era of globalization, from 1998 to 2007, during which foreign investment poured into the emerging economies. Today, all emerging economies must compete aggressively for their share of the available pool of capital.
Within the next few decades, as the advanced economies age, the amount of investment capital may be substantially lower and the cost of investing substantially higher. Having missed one era, Iran must race against the clock before another runs out.
As Iran opens up, investment capital will initially trickle in slowly. Investors will dip their toes into the water on the basis of hard facts, an analysis of long-term comparative advantage and evidence of policy shifts toward free markets. They will look for pragmatism over dogma, openness over isolation, and long-term foundation building over short-term cosmetic fixes.
If Iran wants to reap the economic benefits of sanctions relief, reformers must persuade those skeptical of free markets and foreign investment that reform can be a win-win opportunity, allowing for national wealth creation.
Fears that market liberalization entails a decrease in state authority also need to be overcome. In fact, successful transitions to free markets require not a weak government but a strong one able to preserve the rule of law and the market stability necessary for reform. The state’s power is not diminished; rather, the state simply reorients its role in the economy from dominant actor to guarantor of free markets.
Walter Wriston, the legendary former CEO and chair of Citicorp, famously said, “Capital goes where it’s welcome and stays where it’s well treated.”
If welcomed, the first wave of foreign direct investment in Iran will originate from those with a considerable appetite for risk and deep pockets. If they choose to deploy their capital, they will demand a high return for taking that risk. If their capital is well treated, more will follow.

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