The Fractured Power
How to Overcome Tribalism
Over the past few years, the nuclear issue has dominated news about Iran. The landmark deal recently agreed to 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. One of the most fundamental questions is what path Iran will follow after the sanctions have been lifted: Will it open itself up to the world, fulfilling the country’s economic potential, or will the country’s influential conservative elite thwart global engagement? Iran’s choice will have profound geopolitical implications and will shape the country’s role in the world over the coming decades.
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. 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—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.
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.
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 corruption and intellectual property rights will continue to give pause to global investors. And even when foreign companies are willing to invest, powerful conservative forces within the Iranian governing elite are likely to cast doubts on their motives, hindering true engagement.
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.
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 second-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 percent 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 percent, among the lowest in the world.
Moreover, despite the large size of Iran’s energy resources, its economy is relatively diverse: roughly 50 percent services, 41 percent industry, and nine percent 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 percent of Iranians are below the age of 35. The population is 73 percent urban, a percentage similar to those of most industrialized countries.
And that urban population is well educated. Iran’s literacy rate is 87 percent overall and 98 percent for those between the ages of 15 and 24. Of the roughly 4.4 million students enrolled in universities, 60 percent were women as of the 2012–13 school year, and some 44 percent are majoring in one of the STEM fields (science, technology, engineering, and mathematics). 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)—although the education they receive in Iran is not always of the highest quality. Still, some 7.5 million Iranians, or about 13.3 percent 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 percent of its working-age population; Brazil’s, 11.7 percent; and Indonesia’s, 6.9 percent.
But Iran cannot take full advantage of these strengths without foreign investment. 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 international 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 ten years.
The need for foreign investment is hard to dispute. Iran’s young demographics and high unemployment levels, coupled with inflation in consumer prices of 17 percent in 2014 (down from 39 percent in 2013), indicate that its domestic savings rates will likely be too low to sustain sufficient domestic investment. And state investment is a poor alternative, as the Iranian government has tended to allocate capital inefficiently. The potential impact of foreign investment in Iran is therefore enormous.
But attracting foreign capital may prove difficult. Investors will be wary of Iran’s lackluster attempts at market liberalization, and those who decide to invest will have to overcome a deep strain within Iranian political thought that is hostile to the very idea of foreign engagement.
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, Ali Akbar Hashemi Rafsanjani, sought to rebuild the economy through privatization. In 2004, Iran’s Expediency Council, which advises Iran’s supreme leader, Ayatollah 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 percent of their shares.
But this was privatization in name only. Of the shares that were privatized, roughly half were distributed by 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.
Investors will be wary of Iran’s lackluster attempts at market liberalization, and those who decide to invest will have to overcome a deep strain within Iranian political thought that is hostile to the very idea of foreign engagement.
The remaining half of the shares were transferred to three types of quasi-governmental bodies: revolutionary and religious foundations, military and paramilitary organizations, and state-run pension funds. Although nominally private, these institutions are closely connected to the Iranian state; former government officials often serve in supervisory or management positions.
Thus, the net impact of privatization has been to transfer ownership of state-owned assets to entities directly or indirectly associated with the state, but with reduced transparency and accountability. Privatization has brought neither a cadre of skilled management nor better corporate governance; unsurprisingly, most of Iran’s privatized companies are believed to be unprofitable.
Investors may also balk at Iran’s many troubling economic indicators. For one, Iran performs poorly in international ratings of the economic and legal institutions necessary for development and growth. On the World Bank’s 2015 Ease of Doing Business Index, for example, Iran ranked 130th out of 189 countries—not prohibitively low, considering that Brazil and India were 120th and 142nd, respectively, but far from optimal.
Iran is also a poor protector of intellectual property rights. According to a 2013 worldwide ranking of property rights regimes by the U.S.-based advocacy group Property Rights Alliance, Iran ranked 111th out of 131 countries. In comparison, Brazil, China, and India were all in the top 60.
Iran fares just as badly in corruption rankings. Iran ranked 136th out of 174 countries on Transparency International’s 2014 Corruption Perceptions Index, a standing comparable to Russia’s and Nigeria’s.
Finally, the shortcomings in Iran’s institutions and business culture are also evidenced by the World Economic Forum’s 2014–15 Global Competitiveness Index, where, overall, Iran ranked 83rd out of 144 countries. Iran fares particularly poorly in the areas of business sophistication, financial-market development, institutions, and labor-market efficiency.
All these weaknesses will give foreign investors pause, even once sanctions no longer prevent them from doing business in Iran. And even if investors decide to bet on Iran, a different obstacle might stand in their way: Iran’s conservative elite, which harbors a deeply ingrained ideological opposition to the idea of foreign involvement in and influence on Iran. Iran’s conservatives have fostered a narrative of the country’s history centered on the idea that foreign powers have always tried—and will always try—to dismember Iran and to keep it militarily and economically weak and dependent. Although there are many dimensions to this narrative, a large one focuses on several historical episodes of apparent economic exploitation or political meddling at the hands of Western powers.
Consider two concessions that the Iranian government granted to European businesspeople in the late nineteenth and early twentieth centuries. In 1872, Iran’s monarch, Naser al-Din Shah, faced with a dire need for funds to support the central government, granted a concession to Paul Julius von Reuter, the founder of the news agency Reuters, giving him development rights over the country’s factories, mills, natural resources, roads, telegraphs, and other public works, in exchange for a fixed sum payable for five years and a profit-sharing arrangement for 20 years. The deal met significant domestic opposition and was revoked a year or so later, but the story remains an infamous example within Iran of unworthy monarchs ceding the country’s wealth to foreigners.
Although the Reuter deal never gained traction, another concession, granted to the English businessman William Knox D’Arcy in 1901, proved in many ways to define twentieth-century Iran. Already wealthy from mining exploits in Australia, D’Arcy secured a concession from Iran’s monarch, Mozaffar ad-Din Shah, for the right to explore for oil. The arrangement was to last 60 years, and it covered all of Iran save for five provinces in the north. In exchange, D’Arcy promised to give Iran 20,000 pounds plus 20,000 pounds in stock and 16 percent of his annual profits. D’Arcy at last struck oil in May 1908 and, a year later, founded the Anglo-Persian Oil Company, subsequently known as British Petroleum. The company’s operations in Iran were a source of domestic resentment and ire throughout the twentieth century, until Iran nationalized the company in 1951, canceling the concession and expropriating the company’s assets.
Finally, the overthrow in 1953 of Iranian Prime Minister Mohammad Mosaddeq, a plot orchestrated by the United Kingdom and the United States, convinced many Iranians that whenever foreign powers become dissatisfied with how Iran is being managed, they simply replace the offending leadership with one that will readily implement their designs.
If Iran genuinely wants to attract investment, it will need to implement a broad spectrum of reforms.
These encounters with foreign powers and capitalism created the prism through which the revolutionaries of 1979 viewed the economy. They argued that because foreign powers and capitalists could not be trusted, all major industries would be under state control. Any grant to private enterprise risked Iran’s independence, territorial integrity, and national prosperity. The scope of private enterprise was constrained, and it was consigned to serve the needs of the nation. And when it came time to relax state ownership, various constraints on foreign ownership persisted.
The economic calculus is indisputable: without foreign investment, Iran’s domestic economy simply doesn’t have the wherewithal to meet the aspirations of a well-educated, young population. But the burden of history weighs heavily on the minds of conservatives in the leadership who see such investment as a slippery slope leading back to an era of dependency and economic exploitation.
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. If even a few of its economy’s massive sources of inefficiency were removed, Iran could see immediate and substantial growth, becoming a premium investment destination. With greater economic opportunities at home, its brain drain may stop or even reverse, allowing Iran to 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 continue to stymie investors who may wish to participate in Iran’s privatizations or invest in the Tehran Stock Exchange. Not only will investors have to figure out the complex and opaque web of partial state ownership in companies, but they will also have difficulty accepting Iran’s unsophisticated corporate governance rules. 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. On balance, however, countries with stronger legal regimes have lower levels of corruption and better business environments. 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. The Ahmadinejad administration (2005–13) eroded the integrity of Iran’s banks. It imposed savings and lending rates that compromised the ability of banks to generate adequate spreads, and it directed state-owned banks to lend to state-owned enterprises, which led to a glut of nonperforming loans. At the same time, many banks started to engage in speculative activities, such as real estate and private equity investment, for which they were poorly equipped. And a shadow banking system emerged outside of regulatory oversight, often a harbinger of financial instability. Investors will be hesitant to invest in an economy with a closed financial system that misallocates and misprices capital. 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. As postcommunist countries all over the world have learned, 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. And once those entities have been truly privatized, Tehran will need to avoid the temptation to influence their corporate management—since governments that meddle in recently privatized companies do not attract investment or foster stable growth.
Without foreign investment, Iran’s domestic economy simply doesn’t have the wherewithal to meet the aspirations of a well-educated, young population.
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. But 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. In part due to that decision, Turkey’s inflation level fell from 30 percent in 2002 to eight percent in 2005, and its GDP growth increased from six percent to eight percent. If Iran follows Turkey’s example, it will give investors significantly more confidence.
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—and without fear that Iran would refuse to acknowledge their non-Iranian citizenship and the rights and protections that entails. Such an act, by itself, would be a powerful signal and could attract large amounts of capital.
BEFORE IT'S TOO LATE
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.
Economic reform is never easy. Opposition can coalesce quickly and add resistance to the already formidable obstacles to growth and efficiency. It is difficult to know exactly what the broader implications of reform will be for Iranian politics and society. If Iran wants to reap the economic benefits of sanctions relief, however, reformers must persuade those skeptical of free markets and foreign investment that reform can be a win-win opportunity, allowing for national wealth creation. If the Iranian leadership wants to reap the benefits of membership in the global economy, it will have to encourage its people—elites and ordinary Iranians alike—to accept that the world has changed and that outdated narratives of foreign meddling and exploitation should not hinder pragmatic decisions about the country’s economic future.
Iranian elites must also overcome their fear that market liberalization entails a decrease in state authority. 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. If not, there are plenty of other places it can go.