A New Deal with the Old Iran: Opportunities and Challenges for India

In the spirit of the saying, Jaw-jaw is better than war-war, Iran and a group of six nations led by the United States announced a historic agreement aimed at restricting Tehran's nuclear weapons program for at least a decade in return for a phased lifting of sanctions. The deal requires Iran to scale back its sensitive nuclear activities and bring it under international supervision. In return, the Gulf nation will get access to $100bn in frozen assets and its central bank and industries will be free do business with the world. Consequently, the investors are beginning to size up the potential of an economy that has been isolated for three decades.

Since the Islamic revolution in 1979, ever expanding sanctions, on one pretext or the other, by the United Nations, United States and the European Union has been a regular feature of contemporary geopolitics. The embargo on wide swatches of the Iranian economy stymied its industries and resulted in its economy being 20% smaller than it otherwise would have been. Its oil exports that account for 85% of export revenues and a half of government expenditure plummeted drastically. And isolation from the international banking system caused rial (i.e. Iran's currency) to lose two-thirds of its value against the US dollar which in turn sent inflation soaring to 40%.

Crushed by economic hardship, Iran opened up negotiations, in 2013, on the nuclear and other broader set of issues with the world powers, and after twenty months of arduous talks a landmark deal was concluded. Effectively, the agreement will end Iran's international isolation and will bring it back into the global economic fold.

Opportunities and challenges for India post easing of the sanctions on Iran

Despite crippling sanctions, India was among a handful of countries that continued to trade with Iran, though it dragged its feet on many agreed investments. The easing of sanctions is expected to reinvigorate India’s economic and strategic engagement with Tehran, but many fear that the Gulf nation may now strike a hard bargain, or even turn to more competitive players. However, given India’s goodwill in Iran due to its continued engagement, it is likely that Indian companies will gain in the future.

Crude prices:

With unbalanced fundamentals (demand-supply mismatch) and no major geopolitical disruption in sight, it is expected that crude prices will remain soft in the foreseeable future. Not only that, with oil markets well supplied, exporters are offering sweeter deals in terms of increased credit period, nominal discount and free shipments to grab a bigger slice of the Asian markets. Cumulatively, these developments suggest a benign impact on the financials of Indian oil companies, and on country’s macro fundamentals.

As per the data from the Organization of the Petroleum Exporting Countries (OPEC), daily world supply of crude exceeded demand by almost 3mn barrels per day (bpd) for the period April to June 2015 on account of record production by the United States, OPEC and Russia; as also due to slowdown in global economy that has stymied crude demand. However, despite the glut, Iraq has added 0.1mn bpd to its exports since June, and post easing of sanctions, Iranian officials predict a quick rebound of up to 0.4mn bpd and an additional 0.6mn bpd after six months. Iran, as number two producer within OPEC, exported around 2.5mn bpd until 2011 before stringent sanctions halved its shipments in last couple of years, and it will push hard to regain its position and market share.

As for shale drillers in the United States, production primarily depends on productivity of wells, efficiency gains in production and breakeven price (that ranges anywhere between $25 to over $100 per barrel). On an average, just 25% of wells account for about 80% of the initial shale oil production. Moreover, the sector has been witnessing 20-30% efficiency gains every year resulting in steady reduction in the actual cost per barrel. It is, therefore, not surprising that with fall in global crude prices, rig counts have decelerated but production has continued to grow as drillers concentrate on more productive areas. The phenomenon is similar to the US natural gas industry where operating rigs currently are down by 80%, yet total production has grown 40% since 2009. Consequently, excess global supplies and tepid demand growth for crude is expected to keep a lid on prices which in turn will have a positive impact on India’s macro fundamentals.

  

Infrastructure Investments:

India has interests in railways, port, aluminium, steel, fertilizer, and oil & gas sectors in Iran. However, China too enjoys a healthy relations with Iran and has entered the country in a big way, the first of many projects being a high-speed rail line between the cities of Tehran and Isfahan. Given that Indian companies have already made inroads into the Iranian market, they will now have to match China’s speed and scale of project execution.

Iran has about 10% of oil, 18% of gas and 3% of the world's mineral reserves and the country needs significant investments in these sectors. With embargo gone, the government is said to be working on new oil and gas contracts, by some estimates worth $100bn. ONGC Videsh is expected to make renewed pitch to invest nearly $7bn in its biggest gas discovery that holds 12.8 trillion cubic feet of gas. Though it has already spent around $100m to develop the facility, production was stalled due to sanctions. New Delhi is currently engaged in lengthy negotiations as Tehran intends to auction the site instead.

In addition, India has also signed a memorandum of understanding (MoU) in May this year to invest in the Chabahar port in Iran to have an unhindered access to resource-rich Afghanistan and Central Asia. The port will be developed by an Indian joint venture company at a cost of $85mn and a fertilizer plant is expected to come up in its vicinity as Iran has promised to supply natural gas at $2.85 per unit for urea production. Importing this urea to India will be 50% cheaper than the domestic output, thus leading to a drastic reduction in the fertilizer subsidy. On top of that, Iran has also offered preferential tariffs for Indian exports passing through the aforementioned port and headed to Afghanistan and Central Asia.

Other major investments, where talks are currently underway, are expected to be in steel, aluminium and railways. The National Aluminium Company Limited (NALCO) is considering a $3bn aluminum smelter complex along with a thousand megawatt captive power plant to produce 5 lakh metric tons of aluminum per year. In the railways sector, Indian companies led by the Steel Authority of India Limited (SAIL) have signed a $233mn contract to supply more than 1.5 lakh tons of rail tracks to develop Iranian railways. Tehran wants to spend up to $8bn over the next six years to revamp and expand its railway network, and to this effect will require about 3mn tons of steel rails.

Trade:

Post easing of the sanctions, Indian exports of many items (corn, soyabean, sugar and engineering products) are likely to go down due to international competition whereas shipments of rice and other products like tea, iron ore, steel may either increase or remain flat. On the import side, India has already stepped up oil purchases from the Gulf nation by over 50% on year on year basis. Therefore, although it is expected that Indian exports to Iran will jump by over a third to $6 billion this fiscal year, overall trade deficit with the Iran is likely to widen in the coming months. Nevertheless in years to come, new opportunities could open up for Indian pharmaceuticals and IT sector to boost their business in Iran.

Current bilateral trade between India and Iran is about $14bn with the balance heavily in Tehran's favor due to oil imports by India. Indian exports to Iran were around $4.2bn last year, comprising mainly of food items. To circumvent payment settlement complications arising from the sanctions, India started a rupee-denominated trade with Iran in 2012 whereby Indian refiners settled 45% of payments by depositing rupee in the Iran Account in Mumbai. Iran then used these funds to import various goods from India, leading to doubling of Indian exports to Tehran in past two years. India, consequently, became Iran's top rice supplier, accounting for about 90% of its basmati rice requirements. And shipments of commodities such as corn, sugar, soybean, tea, iron, steel, chemicals, machinery, and vehicles too soared as India faced little competition against the backdrop of sanctions.

With embargo relaxed and new avenues for trade available, Iran will return to conventional deals with India and thus agri-exports are expected to face intense competition. The South American countries will out-price India in products such as soyabean, sugar and corn. And a 20% depreciation of euro over the past year will help European firms win market share from India in automobile parts and machinery tools.

Nevertheless, it’s not all gloom and doom for Indian exporters. The Federation of Indian Export Organizations (FIEO) expects shipments of products such as rice and tea to continue on an upward trajectory, given India’s monopoly in basmati rice and abundance production of many food items. In fact, the All India Rice Exporters' Association anticipates 10-15% rise in basmati rice exports to Iran. In addition, opening up of Iran also provides future opportunities for Indian pharmaceuticals and IT exports.

Rupee:

Bullet payment of about $6.5bn to clear past oil dues of Iran is expected to bring rupee under pressure. But oil companies were advised by the finance ministry, in advance, to make staggered purchases of dollars from the market for the aforesaid purpose, hence no significant depreciation is expected.

India is the second biggest buyer of Iranian oil after China, though it was forced to drastically cut down its imports from Tehran on account of the sanctions. Under the payment settlement mechanism devised to beat the embargo, Indian oil companies have to clear past dues of Iran to the tune of $6.5bn for crude oil purchases. With sanctions gone, many fear that a bullet repayment would put pressure on the rupee and impact overall imports. However, expecting this development, the oil companies were advised by the finance ministry, in advance, to make staggered purchases of dollars from the market for the aforesaid purpose.

A-Greek-ment in Europe

After five months of drama and yesterday’s nail-biting negotiations that lasted for seventeen long hours, Europe finally has an ‘a-Greek-ment’. The decision secured a three year €86bn bailout programme for Greece that will help the country avoid the social, economic and political consequences of a negative outcome. But there are harsh conditions to be met. The draft agreement demanded Greece to immediately take the following steps:

• Streamline the VAT
• Broaden the tax base
• Actions on non-performing loans
• Full implementation of automatic spending cuts
• Reforms to make the pension system sustainable
• Safeguard the legal independence of its statistic office
• Reform labor market policies to align it with European best practices
• Liberalize the economy through a scaled up privatization programme (e.g. privatize the energy transmission network)

One of the newest additions to the list of reforms was the transfer €50bn of Greek assets to a new fund, 50% of which will be used for bank recapitalization, another 25% for debt repayment and remaining 25% for investments in the economy. As for Greece’s most important demand regarding reduction in country’s overall debt load is concerned, French president Francois Hollande and German chancellor Angela Merkel confirmed an eventual re-profiling of Greek debt by granting longer grace period and extending maturities, but a nominal debt haircut was completely ruled out.

Greek prime minister Alexis Tsipras now heads away from Brussels and straight into a political battle in Athens, where next few days are expected to be tensed, as the Greek parliament approves the entire set of conditions. Once passed, the third bailout package will then be approved by the national parliaments of other Eurozone countries. Also on the agenda was Greece’s urgent financing needs of around €12bn to help cover its debt repayments in July and August, while the third bailout is implemented. This means that Greece will have to get reforms through the parliament by Wednesday to access bridge financing. And hence, a national unity government (i.e. government of broad coalition consisting of all parties formed during a national emergency) is expected to be formed to push through aforementioned legislations in a tight time-frame.

The political agreement reached in Brussels means the European Central Bank (ECB) will not terminate the emergency liquidity assistance (ECB) provided to Greek banks. Athens has conveyed to the ECB that it requires an additional €2bn of emergency liquidity assistance (ELA) for the banks to open on Tuesday to provide other services, meaning that €60 withdrawal limit is expected to stay for some more time. But the ECB is yet to decide on this matter. The Greek prime minister termed bridge financing and debt re-profiling as his twin wins, but added that the package was tough on the Greece economy. However, he hoped that an agreement will help stabilize the economy after months of turbulence, and inward investments would negate the recessionary impact of austerity.

The European equity markets surged on the news of an agreement, Euro jumped and bond yield eased for Greece as well as other indebted countries like Italy, Spain and Portugal.

The Final Proposal

The Greek government finally surrendered to demands of its creditors for severe austerity measures and comprehensive economic reforms that are largely in line with creditors’ long demands, thus raising questions as to what did prime minister Tsipras achieve in five months of deadlock, angst and the lock-down of his banking sector? 

This was well explained by Greece’s former finance minister Yanis Varoufakis who argued that while previous negotiations were being conducted to unlock the final tranche (equivalent to €7bn) of Greece's second bailout programme, the current dialogue is being undertaken to finalize a third bailout package worth €53.5bn that is expected to run for three years. In addition, Greece has managed to get the International Monetary Fund  

(IMF), European Union (EU) and United States (US) to take a hard look at its debt burden and consider measures to make them sustainable, which was previously not the case. 

Although the final proposal does not explicitly cover debt relief, Athens has sent a release to the media stating that they are in fact seeking regulation of their debt (i.e. haircut and restructuring) and the €35bn investment package earlier promised by the president of the European Commission, Jean-Claude Juncker. Given the punitiveness of the proposal, international observers have argued that some form of humanitarian aid to Greece cannot be ruled out too. President Juncker had mentioned aid as part of the Grexit plan, but diplomats in Brussels have hinted at some form of assistance even if an agreement is reached in order to tone down the social strife in Greece that may arise in reaction to the harsh austerity measures that are on cards. The detailed Greek proposal that entails public spending cuts worth €13bn subsumes among other things, 

• Fiscal measures to achieve a primary surplus (i.e. government income minus expenditure, excluding interest paid on government debt) target of 1%, 2%, 3%, and 3.5% of GDP in FY15 and beyond,
• VAT reforms and tax policy measures to address shortfall in tax collection,
• Pension and public administration reforms, and 
• Privatization

A last minute compromise?

The detailed reform proposal forwarded by Greece on Thursday has raised hopes of a compromise deal being signed at the emergency meeting of EU leaders on Sunday, with Irish finance minister Michael Noonan stating that Greece can strike a third bailout deal this weekend as mood at the negotiating table has improved drastically since the arrival of its Greece’s new finance minister Euclid Tsakalotos.

But equally important is the position of creditors on the issue of debt haircut in return for the bitter austerity bullet that Greece has accepted to bite. The president of the European Council Donald Tusk has already argued that it is imperative that a convincing proposal from Greece is matched by an equally realistic proposal on debt sustainability from the creditors. And this sums up the basis for a compromise to keep Greece in the Euro Area. Though France, Italy and Spain had no objection with debt relief being granted to Greece, the largest economy in the Eurozone (i.e. Germany) had flatly refused any concessions on the same. However, there seems to be some positive movement from all quarters as we head to the fateful EU Summit on Sunday. Germany seems to have softened its opposition to debt relief in last 24 hours following strong pressure from many quarters including the IMF, US and France. Thus a commitment to extend maturities and reduction in interest rates looks likely, if not nominal debt haircut.

The Greek proposal has been sent to the Eurogroup finance ministers and has been voted by majority in Greek Parliament today as a prior action and mandate for Sunday’s negotiation. Although Greek prime minster Alexis Tsipras has urged his countrymen to rally behind him and back the austerity proposal, but only time will tell whether creditors consider these measures as sufficient in light of the sharp deterioration of the Greek economy in recent weeks. The Eurogroup finance ministers are scheduled to meet on Saturday, ahead of the EU Summit on Sunday, to decide on Greece's third bailout request and temporary financing arrangements from the European Central Bank (ECB) to keep Greek banks afloat. And in a major boost to Greece before the aforesaid meeting, France has already deemed the proposal as being credible and comprehensive. 

A deal may bring to an end five months of agony for the Greek citizens but a negative outcome would launch a long and messy process of Grexit. Nevertheless, with a compromise deal looking to be in sight, markets in Europe and US surged as investors sensed a glimmer of hope. Bond yields for indebted European nations declined too with Italian 10-year bond yield falling by 0.05% to 2.17%, while the Spanish 10-year yield declined 0.06% to 2.16%. Signs of Greek progress also had a positive impact on the EUR/USD pair which witnessed a minor spike to 1.12 in the early European session.

The Greek reform proposal in detail

Fiscal Structure measures:

The proposal seeks to increase corporate tax rate from 26% to 28%, phase out the preferential tax treatment for agriculture income, abolish subsidies on diesel oil for farmers, eliminate cross-border withholding tax, reduce prices of off-patent and generic drugs, limit the prices of diagnostic tests, strengthen framework for independent agencies to strengthen tax collection and oversee government finances, introduce tax on television advertisement, increase the rate of tonnage tax, and phase out special treatment of shipping industry. The reform list also includes reduction in military spending to the tune of €300mn over next two years, increase in luxury tax on recreational vessels from 10% to 13%, taxation on video lottery terminal (VLT) gaming, and auction of 4G and 5G licenses to generate revenues.

While many of the aforesaid steps are positive, others may result in squeezing the economy even more, particularly additional taxes on corporate sector and shipping industry. For an economy whose nominal GDP has shrunk by almost 25% in last eight years, increased taxation on the corporate sector might end up making the economy further uncompetitive. Similarly, Greece has long maintained the leadership in the international shipping industry and levying further taxes on a highly cyclical industry that is marred by a slowdown in global economy could put it under further strains. Equally punitive is the withdrawal of subsidies to farmers who are generally the poorest lot. Abolition of withholding tax could be beneficial though, as it will incentivize the flow of private capital in a highly strained economy.

Tax reforms:

On the taxation font, the VAT reform will target a net revenue gain of 1% of GDP on an annual basis by levying a unified rate of 23% on all good and services including restaurants – a key battleground before. A reduced rate of 13% will be applicable on basic food, energy, hotels and water, and a super-reduced rate of 6% on pharmaceuticals, books and theater. Corporation tax will be levied at 28% and measures will be introduced to broaden the tax base and crack down on tax evasion to improve collections. Various tax exemptions will also be eliminated, particularly on islands with high incomes which are popular tourist destinations.  

The VAT reforms are amongst the most desirable which were long overdue. Greece has one of the largest gaps in the EU on VAT revenues because of a highly complex structure with myriad preferential tax treatment and exemptions, thus leading to significant leakage in the system. On the other hand, additional taxation on restaurants, tourist islands and other tourism related amenities will only harm an economy that is heavily dependent on tourists for revenues.

Pension and public administration reforms:

The proposal recognizes that the pension system in Greece is unsustainable and needs fundamental reforms and proposes to undertake steps that will deliver savings upto 0.5% of GDP in FY15 and 1% in years thereafter. The proposal also seeks to extend the retirement age to 67 years by 2022, create strong disincentive to early retirement, better target social pensions, gradually phase-out solidarity grant by 2019, and post June 2015 provide to people, first contributory pension only at the attainment of statutory retirement age, and second link retirement benefits with the contributions. Also subsumed is rationalization of public sector wages and benefits in line with skill, performance and responsibility of the staff. 

Greece’s overburdened pension system, endemic tax fraud, widespread corruption and the frequent complicity of the government drained the treasury with devastating consequences. In this context, streamlining the dysfunctional pension system is a step in right direction. But what is bizarre is the increment of retirement age to 67 years in a country where youth unemployment has reached an alarming level of 50%! 

Privatization and miscellaneous:

The final list of reforms pertain to privatization whereby steps will be initiated to privatize regional airports, ports and other assets listed under the Hellenic Republic Asset Development Fund (HRADF). Some other initiatives listed in the proposal include steps to modernize corporate and household insolvency laws, liberalize closed sectors like wholesale trade, construction, e-commerce and media, open up restricted professions like engineers, notaries, and actuaries, setup one-stop shop for business clearance, reform the gas market and initiate steps to privatize electricity transmission companies.

The Greek Referendum

The No camp decisively won Sunday’s referendum in Greece over the terms of its debt bailout, a vote which creditors deemed an in-out choice on euro membership. Results published by Greece’s interior ministry showed that about 61% of ballots polled voted ‘No’ against approximately 39% ’Yes’ votes. A breakdown of the results by region in Athens showed astonishing class differences in voting. In poorer areas of Athens (Aspropyrgos, Perama, Keratsini etc) more than 70% voted 'No' while in rich areas (such as Ekali) 85% voted 'Yes'! 

Although prime minister Alexi Tsipras reiterated that a win for No camp – technically a rejection of creditors’ bailout offer – would strengthen his hand in renewed bailout talks, experts think otherwise. According to them this would plunge Greece deeper into turmoil as it tries to prevent the collapse of a financial system that is rapidly running out of cash, “This could mark the point of no return. Greece and the euro have now entered totally uncharted waters,” said an analyst. The president of the European parliament, Martin Schulz, too had said ahead of the Sunday vote that, “If they say No, they will have to introduce another currency after the referendum because the euro is not available as a means of

payment.”

Liquidity crunch continues but banks expected to open on Tuesday

According to the reports, the Greek central bank governor, Yannis Stournaras, called the European Central Bank (ECB) president Mario Draghi on Sunday evening to request for more emergency loans. With banks fast running out of cash, the Greek central bank also called in a meeting to discuss the liquidity crisis and whether to reduce the daily withdrawal limit from €60 to €20. On the other hand, members of the Syriza government reassured voters that banks would reopen by Tuesday regardless of the outcome of the referendum. The ECB governing council is scheduled to hold a conference call today to decide on more support for Greece’s financial system and it may also choose to step up purchases of Eurozone government bonds if events in Greece drive up yields of other indebted countries like Italy, Portugal and Spain. 

Investors nervous because of unknown political and/or economic contagion

As rallies in support of Greece were held in several European capitals, experts feared of political contagion, if not economic. Enrico Letta, Italy’s former prime minister said that the Greek crisis could potentially pave a motorway for the affirmation of populism in Italy. Likewise, Spain’s economy minister Luis de Guindos reiterated that Greece should remain part of the Eurozone as the membership is irreversible while also adding that his government was open to negotiating a third bailout with the creditors. 

Economists also warned that a stalled negotiations process could have detrimental impact on financial markets in Europe, especially against a background of growing problems in China. The top securities brokerages in China have announced that they will buy at least 120 billion yuan of shares in an effort to stabilize the market which has slumped by almost 30% since the middle of last month. This announcement follows a slew of policy actions undertaken by the Chinese central bank last week including a cut in the interest rate. But none of the initiatives has so far succeeded in halting the slide.

Leader to hold talks on future strategy

Meanwhile conciliatory voices have started to make some noise again. Emmanuel Macron, French economy minister, said that talks needed to resume between Greece and its creditors. French president Francois Hollande and German chancellor Angela Merkel will hold talks in Paris today evening to discuss the future strategy amid Mr Tsipras announcing that he will move towards rapprochement. In another development, while a spokesman for Eurogroup chairman Jeroen Dijsselbloem said that the group of Eurozone finance ministers will meet later this week, France and Germany are pushing for an urgent summit on Tuesday and are likely to discuss a new Greece bailout proposal. 

The biggest sign that all parties might head back to the negotiating table is the blinking of Germany’s finance minister Wolfgang Schäuble, one of the most hawkish and prominent leader, along with the resignation of Greek finance minister Yanis Varoufakis. The embattled Greek finance minister resigned after lenders apparently expressed preference for his absence from the Eurogroup meet on Tuesday.  He resigned saying the move could potentially help prime minister Tsipras reach an agreement with creditors, in a clear sign that both sides are willing to cede some space now. 

On the other hand, Mr Schäuble, who was until now a hardliner, suddenly turned a more conciliatory face towards the Greek people. With pharmacists in Athens reporting that the government had rationed the distribution of drugs, and fears being raised of food shortages within weeks, the finance minister of Europe’s biggest economy said that they would not leave the Greek people in the lurch. But the Greek prime minister and finance minister continue to keep up the pressure with former scheduling a call with Russian president Vladimir Putin on later today and the latter  by accusing European leaders of scaremongering and spreading fear in Greece people. 

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