griffon quarterly report - iran's macro economics dashboard - march 2017

Griffon Asset Management

Investor Quarterly ReportMacro Dashboard

March 2017

Asset Management and Private Equity


Figure 9: Quarterly GDP growth (y/y) by sector (supply side)

The data in Figure 9 above (supply side contribution toquarterly GDP growth) covers up to 20 December of Q42016. GDP growth for the nine months of the current Iranianfiscal year (Q2 to Q4 2016) reached 7.2%. The oil sectorrecorded by far the highest growth (85.4% in the ninemonths), fuelling 2.2% of the 7.2% GDP growth. The growthin the larger sectors of services, agriculture and industry allalso swung well into positive territory this year, broadeningthe recovery and contributing 3.1%, 0.8% and 3%,respectively, to the overall nine-month GDP figure.

The main sector that remains a drag on growth isconstruction, which contracted 11% in the nine months ofthe Iranian year 1395. Recent construction data (on thenumber of permits issued, projects in progress and projectcompletions) shows tentative signs of an uptick, and therecent increase in sales of construction materials appears tostem from a shift in demand for smaller housing units. Thereare also tentative signs of improvement on the demand sidein Tehran’s housing market (which has endured five years ofstagnation), aided by a growing mortgage market off a verylow base. House prices are still falling in real terms, however,and the supply glut in larger or luxury housing units and thesurge in commercial construction will likely minimise anyprice increases and limit new builds in these segments.

From the demand-side perspective (of GDP), consumptionand investments remained weak in 2016. However, given theample spare capacity (production and labour), expectationsof significantly higher FDI in 2017 (announced FDI projectstotalled ~$9bn in 2016), and slow but steady increase in theavailability of cheaper domestic credit, sustainable growth innon-oil sectors is probable.

Figure 10: CPI and PPI

The recent collapse in inflation – down from a peak of ~45%in 2013 to the recent trough of 8.6% in Nov. 2016 to Jan.2017 – resulted largely from better management of fiscalpolicy by the State and of monetary aggregates by the CBI.

As per Figure 10, recent PPI data – given its propensity tolead the CPI, as rises in production costs often reach retailprices with a lag – suggests inflation has bottomed out in theshorter term. Recent monetary easing by the CBI and theminimum wage increase (by 14.5%) further support this. ThePPI increased from 3.3% in Aug. 2016 to 4.5% as of the lastreading in Feb. 2017. The extent to which PPI can be a gaugefor CPI is also determined by the import make-up of the CPIbasket (PPI excludes imports), i.e. the greater the portion ofthe CPI basket that is domestically produced, the greater thecorrelation between the PPI and CPI. Thus one can also splitthe CPI basket into tradable and non-tradeable goods; thelargest two weights of the CPI basket are Food & Beverage(27.4% & tradeable) and Housing (31.1% & non-tradeable);both increased (6.3% & 9.8% resp. as of Jan. 2017).

Figure 11: PPI basket

Figure 11 displays the simultaneous and broad move higherin the PPI constituents that occurred as the producer pricesin the two sectors of industry and agriculture (69.1% of thePPI basket) accelerated. As it also shows, the servicescomponent has ceased its downward trend.

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Iran’s top-down update: Macro dashboard

Investor Quarterly Report

Sources: CBI, SCI, World Bank, IMF, SEO, Donya-e-eghtesad, McKinsey Global Institute, Griffon Asset Management.

0%

3%

6%

9%

12%

15%

CPI (point to point % chg)

PPI (point to point % chg)

Inflation (12months moving average)

The IMF projects that GDP growth will stabilise at around4.5% over the medium term as the recovery spreadsfurther to non-oil sectors, assuming oil production remainsat the current OPEC target.

sector Agriculture Industry Servicesweight 17.1% 52% 30.9%

-25%

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0%

5%

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15%

20%

Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016Agriculture Oil & gas Industry Construction Services Total GDP

50.0%57%

95% 109%

sector Agriculture Oil & gas Industry Construction Servicesweight 15% 5% 29% 3% 54%

-5%

0%

5%

10%

15%

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan FebServices Agriculture Industry


Figure 12: Unemployment

The pace of job creation, though impressive (1.06 million jobs created in Q2-Q3 2016), is still insufficient (1.67 million job seekers in the same period) to stem the rise in unemployment, which stood at 12.5% in Q1 2017. This is driven by the increase in the employment participation rate (since Q1 2016) as more Iranians seek jobs (see Figure 12). The increase in the participation rate is both encouraging and unsettling – encouraging, as it demonstrates that previously inactive individuals are now hopeful and active as the economy recovers; and unsettling, as it is a reminder of how many more jobs still need to be created in an economy where an estimated 1 million university students graduate every year. In particular it is private sector job creation that needs to accelerate. By comparison, labour participation rates in Turkey, Russia and China vary from 50% to 70%. Therefore the labour participation rate in Iran has material upside potential (i.e. spare employment capacity, which is disinflationary). In particular, with male and female participation rates at 65% and 16%, respectively, there is significant potential upside in the female rate.

The unemployment rate in Iran among the youth (defined as between the ages of 15 and 24), at 28.1% in Q1 2017, is particularly notable.

A final note is that underemployment – which includes (a)workers who are highly qualified and/or skilled but workingin low-paying or low-skill jobs and (b) part-time workers whowould prefer to be full time – has remained relatively stablein the last two years.

Figure 13: Iranian trade balance (cumulative, ex-oil), fiscal year 1395

As shown in Figure 13, the current account remains insurplus. Even ex-oil, the trade balance has been positive,with the largest portion of the non-gas exports beingpetrochemicals & condensates ($16.4bn in the 11 monthsfor this year). In the medium term, total exports will stilllikely more than offset any acceleration in imports toaccommodate future industry investments and growth, thusmaintaining a surplus. Including oil, Iran has been running anaverage monthly trade surplus of about $2.5bn, whichequates to a hefty current account surplus of as high as ~8%of GDP. However, given the pent-up demand for imports(due to sanctions and lack of financing), further gains in thecurrent account surplus should not be expected. A finalfactor worth noting is the size of the smuggling-driven blackmarket, which is perhaps $12-15bn; this may mean thecountry’s surplus is in reality lower.

Figure 14: Oil production and exports, Iranian fiscal year 1395

Expectations are for oil production to remain at the OPECtargets, which Iran reached in the second half of the currentIranian fiscal year (see Figure 14). So while the oil sectorcould provide some further growth year on year (particularlyfor the first half of New Iranian year), its positive impact onGDP will be much more muted compared to the boostalready provided in 1395 (21 March 2016 to 20 March 2017).

3


Sources: CBI, SCI, OPEC, IRICA, JODI, McKinsey Global Institute, Griffon Asset Management.

-

5

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$ bi

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Imports Natural gas exports Non -gas exports

11.5% 10.8% 10.9% 10.7% 11.8% 12.2% 12.7% 12.3% 12.5%

37.3% 38.0% 38.9% 38.1% 37.7%39.5% 40.4% 38.9% 38.9%

9.5% 8.2% 7.6% 9.4% 9.8%8.5% 8.3%

11.3% 10.9%

Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017

Unemployment rate Participation rate Underemployment rate

0

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mbp

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Daily oil production Daily oil export OPEC basket price


Figure 15: Government revenue, Iranian fiscal year 1395

The Iranian government forecasted a General Budget for1395 of $98bn, of which 35.3% was to be derived from taxesand 25.3% from oil. In the first nine months of the Iranianyear 1395, although oil and tax (and royalty) receipts wereexpected to be $58.5bn, only $42.1bn was received, ashortfall of $16.4bn (see Figure 15). This is mainly accountedfor by a lower oil price, settlement payments to the CBI foradvance oil payments, and the ongoing need to overhaul thetax base. Whilst tax revenues are up 28.9% year on year (ona nine-month basis), new taxation directives and codes willcontinue to increase the tax base (as opposed to increasingtax on those already paying) by improving data collection andaddressing those who have been evading or indeed beenexempt from paying tax.

Figure 16: Government budget deficit, Iranian fiscal year 1395

For the Iranian year 1395 (21 March 2016 to 20 March 2017)the government had anticipated raising $19.3bn fromfinancial asset sales. In the first nine months it has raisedabout $11bn, mainly through bonds, to finance its budgetdeficit, of which about $2.3bn (Islamic Treasury Bills) werelisted in the capital markets. This resulted in a “crowdingout” effect and – after further T-Bill listings were haltedtowards the end of the year – concern regarding the capitalmarkets’ ability to absorb further issues, especially as foreignportfolio inflow remains muted.

Government expenditure (including both current anddevelopmental/infrastructural spending) grew 18.6% (y/y) inthe first nine months of 1395, though remaining 24.0% lowerthan the legislated amount. As per Figure 16, this hasenabled the actual budget deficit ($8.1bn, 2.8% GDP, overnine months) to remain less than the legislated deficit($9.9bn, 3.4% GDP, over nine months).

Prudent fiscal policy and gradual fiscal adjustments – such asthe General Budget’s growth for 1396 being no greater thanthe expected inflation rates of ~10% – will be essential forthe following fiscal year, and will likely limit any significantgrowth in government expenditure. The historical and stillproblematic issue of State over spending on currentexpenditures and relative neglect of infrastructural spend,continues to cap longer-term productivity and economicupside.

The Budget Bill for the Iranian Year 1396 is based on theCBI’s USD/IRR FX rate of 33,000 and oil at $55 (with 2.42mbdof exports, including condensates). Government revenuesand expenditures are forecasted to grow 16.6% and 10.3%,respectively, with a legislated budget deficit of $7.1bn (<2%GDP forecasts).

Whilst Iran’s actual and expected budget deficit (as apercentage of GDP) is small by global or regional standards –compare Saudi Arabia at 11.7%, Egypt at 12.4%, Pakistan at4.6%, Brazil at 6.4%, or Russia at 3.7% – its financing is stillburdensome. The option of meaningful foreign financingremains sidelined whilst the State also has other domesticpayables (to banks, contractors, pension funds,municipalities and utility providers), estimated at 30-40% ofGDP. Hence with the high burden that the cost of localfinancing creates (>20% domestic interest rates), a relativelylow budget deficit becomes exponentially more difficult toachieve.

A more granular assessment of the budget deficit shows thatit is the non-oil deficit – currently hovering at around 10% ofGDP – that poses the biggest challenge for the State.Increasing tax collections from 7.5% to 10% of GDP will help(though requiring a broader tax base and more-effectiveadministration and regulations), but this will still fail to offsetmodest increases in State developmental (investment)spending and maintaining subsidies. Public debt could rise to~40% of GDP, given the plans to issue new debt to clear Statepayables.

In sum, the major factors adversely affecting the non-oilbudget deficit are interest payments and the need toincrease investment spending, whereas the main levers toalleviate some of the fiscal pressure are subsidies reform,prudent current spending and increased tax income.

4


Sources: CBI, World Bank, IMF, TSE, Financial Tribune, Bloomberg, The Economist, Financial Times, McKinsey Global Institute, Griffon Asset Management.

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$bn

Tax and others (actual) Tax and others (legislated)

Oil (actual) Oil (legislated)

(14.0)

(12.0)

(10.0)

(8.0)

(6.0)

(4.0)

(2.0)

-

$bn

Legislated balance Actual balance


Figure 17: Money Supply components

The monetary base (the powerful money multiplier) grew by11.2% over the first nine months of the Iranian year 1395(versus 18.7% and 21.1% growth over the comparable periodin the two previous years) and 19.4% year over year. Theprimary and secondary sources of growth for the monetarybase were increases in CBI net claims on the public sectorand the banks (driven by the government initiative for SMElending, at a time when the banks’ ability to lend waslimited), respectively.

In addition, M2 grew by 21.4% for the same period, versusgrowth rates of 19.7% and 26.4% for the previous two years.

Hence the loosening of monetary policy, as indicated by themonetary aggregates, does increase the risk of higherinflation going forward.

Figure 18: Money Velocity

As per Figure 18, money velocity (money supply x moneyvelocity = nominal GDP) has been trending lower for the lastthree years (acting as a counterweight to the money supplygrowth of about 30% year on year).

However, notably M1 (which includes cash and checkingdeposits) relative to the quasi-money components of M2(e.g. savings, time deposits, and mutual funds) can beconsidered a lead indicator of money velocity. The point-to-point percentage change (with data normalised toaccommodate seasonal influences) has in 2016 meaningfullyreversed what was an aggressive downward trend, and isnow approaching positive territory. This would suggest anincrease and reversal of the negative trend in money velocityis likely to happen in the Iranian New Year. In simpler terms,historical data (the last 10 years) shows term deposits as apercentage of money supply have been ~65% versus thecurrent ~81%. As and when real interest rates (currently~17%) revert closer to the lower-inflationary environment(~9%), one should also expect a significant outflow in termdeposits (probably to sight deposits initially).

Figure 19: Real interest rates

As Per Figure 19, real interest rates (using Islamic TreasuryBills YTM as the “risk free”) in the current Iranian year havefluctuated from a low of 11.2% (August and September2016) to a high of 19.2% (in February 2017). Part of thecurrent squeeze in rates at this time of year is cyclical (as weapproach year end, corporate seasonal imports andinventory levels increase whilst simultaneously financial firmstry to deleverage), so the squeeze should relax in the shortterm in the Iranian New Year. The remaining (and larger)factors for high real rates originate from the instability andcompetition for deposits in the banking system, Statepayables (soon to be debt) and the budget deficit (non-oil inparticular).

5


(a) Monetary Base = cash (public + banks) + bank required reserves + excess reserves.(b) M2 = M1 + term deposits.(c) M1 = cash (public) + sight deposits. Near money = short term deposits + long term deposits + saving (and other) deposits.Sources: CBI, IMF, Financial Tribune, Bamdad Institute, Griffon Asset Management.

-35%

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Money Velocity (LHS) M1⁽ᶜ⁾/ Near money (q/q % chg) (RHS)

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12% 11% 12% 13%11% 11% 11%

13% 12%15%

17%19%

-2%

3%

8%

13%

18%

23%

28%

Inflation T-Bill YTMs (ave.) Real interest rate


Figure 20: USD/IRR CBI & free market FX rates (Jan. 2016 – Feb.2017)

Figure 20 illustrates (for Q4 2016 to Q1 2017) the morerecent seasonal pattern for the rial, where weakness in Q4sis followed by recovery in Q1s (repeated over the last two tothree years- see Dec. factsheet). As we headed into Q1 2017the rial repeated this behaviour, recovering 8.0% from itsDecember 2016 low (41,100 on 27 December) to close at37,830 on 26 February 2017.

For the longer-term currency outlook, two of the mostimportant longer-term economic factors to consider areinflation and productivity. The sharp falls in inflation (CPI hasfallen from a peak of about 45% in 2013 to 8.6% in Q4 2016)and expected productivity gains (off an extremely low base,with Iran’s FDI stock a fraction of its EM peers) will likelymean longer-term currency support and stability (i.e. moreakin to gradual annual depreciation in line with inflationdifferentials to a global basket, as opposed to sharpdevaluations). In addition, the positive trade surplus(including and excluding oil) and capital account inflows willbe supportive of the local currency. As a counterbalance asthe economy fulfils its 4-5% GDP growth expectations in theyears ahead, many industries will increase their imports, andconsequently foreign currency demand will rise. Last but notleast, the CBI now has greater independence and authorityas well as increased tools (in policy and reserves) to achieveits core policy of price and currency stability.

Figure 21: USD/IRR free market FX rate and inflation differential

The CBI is also now allowing banks to operate at the freemarket exchange rate and has already shifted over half ofthe import categories away from the official CBI rate to thefree market rate (Figure 21). In other words, the CBI isalready “managing” the unification, and appears set toensure that it will not be an “overnight” event. With theState’s hard currency reserves again growing (sustainably),we believe the State will implement the unification and willdo it at a level close to the free market rate – that is, theofficial rate will face a “devaluation” to close (most if not all)the gap with the free market exchange rate.

Whilst the base case (as per repeated communication fromthe CBI) for FX unification may have been by Iranian year end1395 (20 March 2017) or just after, there will be a delay inthe unification of the FX rates. In our opinion, the delay couldbe up to 12 months. One of the fundamental causes for thedelay is the lack of sufficient correspondent bankingrelationships between Iran and the rest of the world (thuslimiting the CBI’s ready access to reserves and ability tosensibly manage and intervene in the FX market). Animportant prerequisite for the complete unification of the FXdual structure is fully operational banking channels betweenIran’s financial system and an adequate number of largerinternational banks; whilst the connectivity is improving,there is still work to do. The CBI’s efforts to reform andharmonise domestic banks with international standards arecrucial to achieve this. Other factors to assess, in relation tothe viability of FX unification, include the extent to which:

• The CBI has sufficient financial resources (net FX reservesare ~$59bn, the equivalent of ~17 months of imports),

• Inflation has been (sustainably) curbed,• A currency futures exchange is created (to enable

hedging and reducing volatility),• Fiscal discipline is continued so as to minimise the budget

deficit, and• The government again encourages banks to manage and

operate FX transactions by tightening the regulations onFX bureaus (which are much smaller and sometimeslightly regulated).

6


Sources: CBI, IMF, Bloomberg, Mirdamad Exchange, Royal Exchange, Parsi Exchange.

7%

12%

17%

22%

27%

32%

29,000

31,000

33,000

35,000

37,000

39,000

41,000

1-Ja

n

1-Fe

b

1-M

ar

1-Ap

r

1-M

ay

1-Ju

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1-Au

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1-Se

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1-Ja

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FX sp

read

(%)

USD

/IRR

USD/IRR (CBI)

USD/IRR (free market)

FX spread (CBI versus free market rate)

-80%

-60%

-40%

-20%

0%

20%

40%

60%

Inflation differential USA/Iran USD/IRR monthly year on year change


ABOUT GRIFFON CAPITAL

Griffon Capital is an Iran-focused asset management and private equity group established to unlock value from the country’s public and private equity markets. Among Griffon’s primary objectives is to allow local and international institutional investors the ability to seamlessly access and maximise opportunities in Iran through purpose-built vehicles and investment products spanning traditional and alternative assets.

The Group’s strength is rooted in a robust operating platform developed by leading international advisors and are supported by internationally recognised administrators and auditors. Our platform consists of a high calibre team with deep local market expertise and international financial pedigree blended at the board, management and execution levels. This includes a management team steeped in investment banking, wealth and asset management and corporate finance experience. Griffon is also distinguished by on the ground local research and primary thinking and a governance culture defined by global best practices in risk management, compliance and reporting.

Modaberan Homa is fully licensed and regulated by the Securities and Exchange Organization (SEO) of Iran.

7



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