Iran: The Risks May Outweigh the Rewards

Standard Chartered’s Iran predicament highlights a dilemma faced by Western banks: they need to expand into fast-growing markets. But this puts additional risk into their business models at a time when they desperately need to project stability and probity.

The allegations by New York State’s Department of Financial Services against U.K.-based, internationally-focused Standard Chartered, that it concealed $250 billion of illegal transactions between Iran-based banks, bring these two opposing goals into sharp relief.

“Investors are attracted to companies which are exposed to emerging markets,” said Emmanuel Cau, an equity strategist at JP Morgan Chase & Co. “But the risks are significant and they include high barriers to entry in terms of regulation, different consumer demand profiles and, in particular, issues with corporate governance.”

These risks are acute when it comes to investing in Iran, according to Edward Bell, a Middle East specialist at the Economist Intelligence Unit. The country’s economy is severely hampered by the U.S. and E.U. sanctions which, the EIU forecasts, will cause it to contract by roughly 1% in 2012-13. That’s before you factor in high inflation, a weak currency and a slow-moving and opaque legal system. Furthermore, President Mahmoud Ahmadinejad ‘s nationalist economic policies favor local entrepreneurship over partnerships with overseas investors.

If the sanctions weren’t in place, Mr. Bell says, Iran could be an attractive investment destination with a large and relatively well-educated middle-income population and strong demand from sectors like retail goods, car production and technology.

Gary Greenwood, a banking analyst with Shore Capital in Liverpool, pointed out that given some of the richest rewards can be made in difficult markets, financial services companies push at the limits of what is allowed.

He said:

“In situations where there are billions of dollars at stake, the rules get flexed. And if the rules at the top (of an organization) are being flexed, this will get exploited by people at the bottom. There’s an opportunity to make additional revenue by sailing close to the wind but this brings risk with it.”

Standard Chartered has put up a rigorous rigorous defense of its Iran business.

Chirantan Barua, an analyst with Sanford Bernstein in London, says it is difficult for investors to adequately scrutinize the risks of such places, because often companies operating overseas do so via partnerships with local businesses. As growth in the West remains under pressure, there’s been a recent tendency to overstate the benefits of operating in emerging markets and downplay the risks. Nevertheless, Mr. Cau reckons that historically, emerging market-focused stocks have been allocated a discount of between 10% and 15% by investors.

In particular, Mr. Barua argues that there’s a big difference in the risk profiles of large multinationals that have pan-global footprints and that operate under their own ambit-–and thus where there is transparency–and companies that operate with a large number of local partners and franchisees, which is more opaque.

He said:

“It’s impossible for investors to scrutinize the risks posed by operating in countries like Iran adequately, [so they discount the share price]. However, we seem to have forgotten the emerging markets discount in recent times given the [banking] troubles in the West. [The Standard Chartered situation] is a step in which that discount will likely come back.”

It’s easy to see why European corporates want to invest in far flung countries, despite the risks, given the rewards involved.

Here’s a sample of the OECD growth projections for 2012:

Brazil: 3.2%

China: 8.2%

India: 7.3%

Russia: 4.5%

Turkey: 3.3%

Indonesia: 5.8%

Versus:

European Union: – 0.1%

U.K.: 0.5%

U.S.: 2.4%

Germany: 1.2%

Spain: -1.6%

Italy: -1.7%

A quantum shift appears to be occurring, where the centre of economic strength is moving away from the U.S. and Western Europe.

The Standard Chartered debacle doesn’t make operating in any non-Western country inherently more risky.

And Iran, particularly with sanctions in place, is a very different proposition from some of the bigger developing nations with more sophisticated legal and regulatory systems. But investors in Standard Chartered are clearly starting to question the new truism that operating in high growth countries is enough to justify a higher valuation. The bank’s share price plunged by almost 25% to £10.92 in the wake of the Iran investigation. It’s gradually recovering, trading up 3.53% today to £13.63.

Source: http://blogs.wsj.com/source/2012/08/09/iran-the-risks-may-outweigh-the-rewards/