BMI's Executive Summary

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From Q108 we will be calculating the Commercial Banking Business Environment Rating (CBBER) for each of the countries surveyed by BMI. This will permit a more systematic and comprehensive comparison of the conditions within the banking industries of the various countries than was possible in the past. For each country, it will also facilitate a comparison of the conditions within the banking sector and conditions prevailing in other sectors.

Iran's overall CBBER at 46.0 is towards the lower end of the countries in the Middle East and Africa region that are surveyed by BMI. This score is underpinned by a solid if not spectacular score of 54.4 on the heavily weighted banking market structure element of the limits of potential returns element. This reflects the scale and entrenched position of the Iranian banking system within the economy, which is comparatively large for the region rather than at a high level of development.

In particular, the banking market structure elements of the limits of potential returns have a considerably higher score than the country elements (54.4 versus 38.7). On the other hand, the banking market elements of the risks to the realisation of returns are much less than the than the country risk rating (13.3 versus 59.4). In other words, although well-positioned within an economy that is strong on account of the currently high price of oil, the banking sector, rather than the economy more generally, is the primary locus of risks to its own further development. This is because the banking system is both not well regulated and very underdeveloped, constrained in particular by a small deposit base – a large portion of the domestic deposit base being held abroad - and under-used asset base on account of a low loan to asset ratio. Hence although Iran is a country that is comparatively large and experiencing strong growth, there are nonetheless not particularly high prospects for banking system growth. This is reflected in the comparatively low scores for the region for each of the non-market structure scores, in particular market structure based risks to potential returns.

We maintain our bearish outlook for the Iranian economy, and see no improvement in policy under the current administration. External pressures, domestic policy imprudence will continue to take a toll on the economy. The economy should expand by 5.3% in 2007 in real terms, backed by government spending, slowing to 4.8% in 2008 as inflationary pressures, ongoing political uncertainty, and macroeconomic mismanagement under the Ahmadinejad administration take their toll. High crude oil prices should help cushion the blows to the economy from the domestic and external forces mentioned – we see the OPEC basket averaging US$58.5/bbl in 2008 – by providing ample funds with which to stimulate activity, although this is by no means a sustainable policy course. As such, we see growth beginning to slow from 2008, dipping below 5%. At this point, the risks to our forecasts are to the downside, at least under the current administration.

While the oil sector contributed 11.0% of GDP in 2005 (2006 figures are yet unavailable, although our estimate is 10.3%), it accounted for around 80% of total exports and a significant proportion of budgetary revenues. As such, slower growth or contraction in the sector is likely to reverberate across the economy, particularly if it translates into lower government spending levels. It is not just external pressures that are affecting the oil economy. Given the President's penchant for populist policies such as decreeing interest rate cuts in order to provide cheap credit, as well as his use of Oil Stabilisation Fund money to finance his spending splurge, this does not bode well for the future of the economy. Inflation is another source of risk given the negative impact it has on demand as a result of higher costs. The consumer price index measure of inflation eased slightly in the month of Khordad (May-June 2007) to 16.1% year-on-year (y-o-y) while producer prices also fell slightly to 15.2% y-o-y. Still, we maintain our end-year 2007 estimate of 20% on account of robust money supply growth, 39.4% y-o-y in 2006, according to reports, the recent cut in gasoline subsidies and rising rental and food costs. While Iran has lived with high inflation for an extended period, price rises will increasingly take a toll on consumer and business sentiment, particularly given dire trajectory the economy is taking under the current administration.