Iran is planning to launch a major sukuk issue followed by an even bigger China-centric offering to raise capital for oil and gas projects. Simon Watkins reports.
What: Tehran has passed a bill that will see Iran issue US$3 billion in a sukuk as a precursor to a unique bond issue.
Why: The resumption of US sanctions has hit Iranian oil exports, which in turn has reduced revenues for the country. As a result, its options are limited, but Iran still holds appeal in the sukuk market.
What Next: The Peoples Bank of China (PBOC) will underwrite and distribute the latter bond, which will be backed by Iranian oil flows.
Iran’s parliament last week ratified a bill that will open the way for a US$3 billion issue of Islamic bonds (sukuk). The move comes with the national budget deficit running at well over 3%, oil sales down by a half from a year ago and little Western interest in the local stock market.
The situation is likely to worsen on the back of ongoing US sanctions.
The capital raised from the Sharia-compliant issue will be used to fund various hydrocarbons projects in Iran. It will provide a further test in terms of pricing and diversity of investor coverage for an additional major bond issue of a unique structure executed through its bankers in China.
Iran currently has few options for raising any substantial capital amount, let alone the US$150 billion or so still required to complete its outstanding oil and gas sector projects.
There is no chance that its banking sector can come up with the capital, for a start. According to the Central Bank of Iran’s (CBI) vice governor, Akbar Komijani, around 60% of the Iranian banking system’s non-performing loans (NPLs) are ‘category three’ by international debt repayment standards. This means that they comprise loans that have yet to be repaid after eight months, suggesting that there is little hope of their recovery.
Moreover, an internal audit last year by the Ministry of Finance (MoF) showed that at least 70% of the country’s entire NPL burden was related to businesses directly run by – or closely associated with – the Islamic Revolutionary Guards Corps (IRGC), which remains under close US scrutiny. By extension, therefore, a large majority of all Iran’s private banks are actually bankrupt.
This feeds through into the Tehran Stock Exchange’s (TSE) inability to act in the usual way as a capital-raising mechanism for Iran’s oil and gas sectors.
First, it means that even non-IRGC associated companies find it extremely difficult to obtain funding, as the bulk of Iran’s banks are overextended already. Secondly, many international investors who might otherwise have an interest in investing in Iran – given its broad economic base and appealing demographics – will not do so.
According to Anthony Rapa, partner at Kirkland & Ellis, even before the US pulled out of the Iran nuclear deal, testimony to a sub-committee of the US’ House Committee on Foreign Affairs pointed to the IRGC having significant ownership shares in 27 companies that are publicly traded on the TSE.
The testimony further indicated that the IRGC had placed top commanders at the heart of more than 200 Iranian companies in sectors, including oil and gas.
Although Iran is in no position to raise capital through a Western-oriented traditional bond denominated in a mainstream currency, its prospects in the global sukuk market are actually good.
Middle Eastern countries have often used this model of bond issuance in the past when they have been uncertain of how a more traditional bond issue would go down with investors owing to negative economic circumstances, and this is the case with Iran.
Targeting such a specialised investor base as well has the advantage that the pricing for sukuk is generally lower than for a traditional bond issued by the same country and, given the rising interest rates trajectory in the US, the premium that such countries would have to pay over US Treasuries would be high.
“The appeal of the sukuk will be determined by its spread – nominal value – not against the usual benchmarks but rather against sukuk alternatives as well as high-yield bonds issued by Iraq, Mongolia, Kazakhstan and even Pakistan,” Mehrdad Emadi, head of consultancy Betamatrix, told NBI.
“However, US sanctions have inserted a significant additional discount in the computation of yield, spread and spot pricing,” he said.
The sukuk investment community ranges from the UK (the first Western country to issue a sukuk), through Germany and Turkey (key European hubs for sukuk) to Malaysia (the biggest sukuk centre in the world). This market has grown in size from around US$10 billion of total investable assets in 1975 to a projected US$115 billion in 2019, according to S&P Global Ratings.
Under Sharia law, a sukuk should avoid investment in activities that are speculative, involve uncertainty, pay interest, are unjust to participants or are connected to prohibited businesses (such as gambling, alcohol and the sale of certain foodstuffs).
Part of Iran’s appeal in this regard is that it is a truly Islamic issuer.
The investment universe of sukuk became a lot more sceptical about purported Sharia-compliant offerings during the financial crisis of 2008.
The Accounting Auditing Organisation for Islamic Financial Institutions – the Islamic finance standards watchdog – said in February 2008 that the repurchase undertakings found in around 85% of apparently Sharia-compliant bond and equity fund structures that were based on ‘mudaraba’ and ‘musharaka’ principles violated the Islamic duty to share risk.
After this, the issuance of these two types of bonds declined during that year by around 83% and 63% respectively, even at a time when these ‘less risky’ Islamic finance products should have benefitted markedly from chaos in Western financial systems.
Compliance and the Chinese
Iran, though, will issue fully Sharia-compliant bonds, in keeping with its Islamic republic status. Buyers of the bonds will share in the underlying asset of oil flows from selected oilfields, thus sharing risk and reward, and no interest will be made directly in the form of yield payments.
Instead, investors will receive periodic payments of their share of profits on the principal amount invested, as laid down in their certificates of ownership from the issuer and, when the bonds mature, the sukuk holder will also receive the principal amount invested.
The paper will also carry with it an implicit government guarantee, as they will be issued either by the government itself or by the National Iranian Oil Co. (NIOC). Because of these rigid strictures, Emadi underlined that the appeal of sukuk – as expressed in pricing and breadth of investor interest – transcended the issue of credit rating, which is normally central to the success and pricing of a conventional bond issue.
Sukuks are judged by their individual Islamic credentials and the underlying asset involved, Emadi said.
Given that the underlying asset will be a share in oil flows from some pre-announced oilfields, this mitigates any concerns over foreign currency credit ratings.
“There will be interest from state-clients of Iran as well as their corporations who will see a premium in participating in the scheme, most notable amongst them Chinese entities, the Qataris, Malaysia and India. They will see both the financial appeal and the political leverage holding the bond may offer them,” he said.
“Based on the dynamics of previous issuances, the spread needs to be around 10-15 basis points higher than Iraq has aimed for and perhaps even those realised by Kazakhstan,” he added.
In addition, there is a lot of investable money both in Iran and with Iranians abroad. Dubai alone is home to around 500,000 Iranians who saw their bank accounts shut down under the sanctions regime and who will not go into the stock market but are looking for better than bank deposit account returns.
As part of its ‘One Belt, One Road’ initiative, China has also seen a number of sukuk issues from state entities as a key part of its strategy of building a network into the world’s main centres of Islamic finance. Sharia-compliant assets in the Middle East and Southeast Asia account for as much as 25% of total banking assets.
China is due to act as a book-runner for this sukuk issue and, should it go well, it will also be the co-ordinator for a new bond issue, structurally designed between it and Iranian risk experts.
The Peoples Bank of China (PBOC) will act as sole lead underwriter and principal distributor of the bond. The structure will be that the Iranian government, or state vehicle, will issue a bond through the PBOC, which will be backed by the Chinese central bank, either in renminbi or another currency pegged at a specific rate to the renminbi.
The PBOC will then distribute the bonds simultaneously to the Central Bank of the Republic of China (Taiwan) in Taipei, and the Monetary Authority of Macao.
Crucially for broadening out its appeal to as wide a foreign investor pool as possible, the China-run bond would carry with it the option to be redeemed in rials and euros. The bond holder could decide on redemption day which currency is preferred, given the prevailing spot rate, thus eliminating much of the illiquid currency risk.
For the Chinese, the risks in running this bond would be minimal, as all of the international sovereign issues would be backed fundamentally by some of Iran’s oil flows.
The reward, though, is multi-faceted. It will promote the use of the renminbi as one of the world’s truly international currencies, which China regards as befitting its standing on the world stage, and will further compound China’s influence in Iran.
This latter factor it regards as absolutely vital to the success of its land route in the ‘One Belt, One Road’ project, as stressed by senior Chinese figures during the recent visit of Iran’s Oil Minister, Bijan Zanganeh, to Beijing.