Middle East: Preparing for Iranian sanctions?

The past few months have seen a significant deterioration in relations between the international community and Iran. The International Atomic Energy Agency's (IAEA's) decision to refer Iran to the United Nations Security Council, after Iran removed UN seals on its uranium enrichment equipment, led to the downward spiral in relations.

Iran had already passed a law that any such referral would lead to a suspension of IAEA spot checks on its nuclear facilities - which Iran still stresses are merely for peaceful power generation purposes - and a restarting of moves towards uranium enrichment. The IAEA has since released a report indicating that efforts towards small scale enrichment have already begun.

Of course, one could easily argue that in a world and a region with nuclear weapons, Iran also has a right to possess nuclear weapons, let alone peaceful nuclear power generators. However, one could just as easily argue that President Ahmadinejad's comments about Israel illustrate the risks involved with such a stance. The focus of this article is the economic implications for the region rather than the rights or wrongs of the arguments being presented.

The first implication is clear. With oil markets so tight, any risk to Iran's 3.9 mbpd production (4.6% of global supplies) is unnerving. The rationale for such fears ranges from a total embargo on all Iranian exports, including oil, to the view that Iran could retaliate to any sanctions by reducing or halting oil exports. The former would likely be suicidal for the global economy and therefore is highly unlikely. The latter is more plausible and Iran is keen to highlight this leverage at any available opportunity.

Indeed, high oil prices may be one of the reasons for Iran's recent confidence when dealing with the international confrontation, both from a domestic financial standpoint and from an international leverage perspective. High oil prices mean that the country is benefiting from huge export revenues.

Meanwhile, markets get nervous when a mere 0.3mbpd is taken off the market in Nigeria due to militant attacks. Just think what the impact of losing a multiple of that amount would be. Therefore, it is conceivable that an Iran that is being threatened by the West, in the form of economic sanctions - or even worse military action - could feel inclined to threaten economic sanctions of their own in the form of reduced oil exports.

In the short term, this would be positive for the region as higher oil prices would boost further the export earnings of all the oil-producing nations. Of course, should this push the world economy into recession - a supply-side shock has much greater potential to do this than a demand-side phenomenon, which should be self-correcting in nature - then this would be damaging to the region's long-term prospects as it would undermine the current assumption implicit in commodity markets that oil prices will remain high in the indefinite future.

Our assumption that oil prices will average USD 40pb over the long run is very positive for growth in the region as it not only supports the oil sector, but it also allows for continued strong government spending aimed, presumably, at increasing efforts towards diversification. Once oil prices fall below USD 25-30 per barrel, then countries move back into budget and current account deficits.

What is less clear is the impact on the region of increased sanctions against Iran via trade and financial channels. Iran is the second largest economy in terms of GDP and also the second largest in terms of population size - behind Saudi Arabia and Egypt respectively. The country that appears most at risk from increased sanctions is the United Arab Emirates, more specifically, the emirate of Dubai.

Were the UN to pass a resolution in favour of UN sanctions then there would be great pressure brought to bear on any countries that may want to trade with Iran and the Dubai economy could be hit quite badly. However, we doubt that the UN will be able to pass such a resolution with Russia and China clearly having a significant interest in keeping trade ties open.

Therefore, the more likely outcome is that the EU impose sanctions along the lines of those already in place in the US. Clearly, this would mean the access to funding of any trade between the Europe and Iran would be sharply curtailed. However, this may benefit the region as Iran relies increasingly on imports from different sources. Thus, such a move could actually lead to a an economic boost to the region and, in particular, Dubai's small and medium-sized enterprise sector and its local banking sector.

Finally, some estimates have put Iran purchases of Dubai property in recent years at 30% of the total volume. While we doubt this figure is accurate and believe the real number is significantly lower, with many concerned about a housing bubble in Dubai - please see last month's edition of the Middle East Focus, 'Dubai's changing skyline II', for a detailed discussion of the Dubai residential property outlook - some are concerned that a tightening of the international noose around Iranian economy could lead to a dramatic decline in property prices in the emirate.

Again, the exact nature of any sanctions and who is trying to enforce them is crucial to this. If sanctions were seen as likely to be successful in forcing a shift in political power in Iran, with unknown consequences, this could actually encourage the local elite to look for places outside the country to invest in to protect their wealth. Of course, western markets are an unlikely target for such investments and therefore this could increase investment in both real estate and equity markets in the region, especially with the latter showing greater value in recent times.

Naturally, there is an incentive for the western authorities to get in the way of any such investment and trade flows as they undermine their efforts. Therefore, we would expect the US and EU to encourage the region to add their weight to the sanctions. However, absent a UN resolution, it is doubtful that the region will give into such pressure when the economic consequences of them doing so is so great. Meanwhile, the US may be unwilling to push too hard in case it decides that military action may be necessary at a later stage and does not want to undermine its ability to mount such an attack at a later date.

Therefore, while there are clearly risks to the region from the situation in Iran, and in particular Dubai, the reality is that unless the UN can show greater unity than it has in the past on this issue, the region could actually benefit from gradually increased tensions between the western world and Iran, in the short-term.

That said, given the potential for the Iranian economy to actively contribute to regional economic activity, in the long term an integrated and prosperous Iran is in everybody's best interest. The potential is there. Iran is home to the largest proven gas reserves in the world.

However, given a lack of financial resources domestically, this requires significant foreign investment and expertise. The payback period for such investments is measured in decades. Until people feel more comfortable with the political environment in Iran, such investments will not be considered. Therefore, expect it to be several years before such investments are made.