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January 13, 2004

A Case for an Iranian Asset Bubble and the Role of Iranian Credit Markets
Ali Meli  [info|posts]


The lack of transparency in credit markets is a major problem in many developing countries. In many cases, most notably Southeast Asia in the 1990's, credit and credit markets were central to creation and demise of economic bubbles.

The dynamics are very simple: people borrow money (against promises of giving back their future income); and in a low interest rate environment (low compared to the inflation rate) people will borrow recklessly. This reckless barrowing increases the short-term welfare of the society, and more importantly increases the price of many long term assets, enabling and encouraging people to borrow and spend more. But, eventually households have to repay their debt and more often than not, they end up selling or at least trying to sell some of their assets to settle their debt. Often it is the case that many households try to sell their assets at the same time, which depresses asset prices and results in a bubble burst in the overall economy.

One can make a case for such an asset price bubble in Iran. Anecdotal evidence from Iran indicates that the real estate market in Tehran is significantly over priced ($4,000/sqaure meter in certain areas means that a home will cost about $1 Million, very comparable to the high end housing market in the US, while the per capita GDP of Iran is much lower). Also, automobile prices (which are considered an investment in Iran) are well above international levels. Furthermore, Iranians are able to borrow money fairly easily and through means that are not available in many other countries: they can use their checking accounts to obtain credit by use of post-dated checks or "Check-e-Tarikhdar;" a check that can only be cashed after a certain date. As I will explain later, these checks enable people to obtain easy credit at dangerously high levels.

All over the place, there are signs that many assets in Iran are over priced and that people are spending beyond their means; very much like Asian economies in mid 1990’s. Moreover, the government is maintaining a fixed exchange rate that creates structural inefficiencies in the economy and further encourages reckless spending (again similar to Asian Countries in the 1990's).

If the above diagnosis is correct (a more rigorous study of major economic indices is required to use a more certain tone), the outlook for the Iranian economy is very gloomy. Eventually, credit will dry up and foreign exchange reserves will diminish (as the crisis in Latin America, Asia, Mexico, Russia, and many other places have shown). The result will be depreciation of the real estate and other assets (an asset bubble burst), increase of inflationary pressures, and a currency meltdown.

The basic rule of macroeconomics is very clear: you cannot borrow and spend beyond your means indefinitely.

Unfortunately, there are many factors that increase the risks and potential severity of a credit crisis in Iran. Here are a few:

1- Ideological issues that the clerics have with interest rate: Khomeini, in a statement that shows his backwards attitude toward sound policymaking, once said "economics belongs to donkeys." Many clerics and wannabe clerics (like Basij and Sepah) have a firm belief that interest rates are against the wish of god. This prevents the government from having a sound monetary policy and controlling the credit markets; indeed it is hard to understand if the government is actually feeling responsible for making economic policy.

2- Since most of the economy is controlled by the governments, many banks are involved in directed lending. Directed lending is the practice of governments forcing banks to lend money at low interest rates to high-risk customers. Directed lending results in non-performing loans and eventual balance sheet loss for banks, but banks are obliged to do it anyway because of political reasons. Directed loans where very costly for countries like South Korea and China. The Chinese government recently had to spend $45 Billion to compensate the negative effects of directed lending by two of its largest banks.

3- There exists no system for maintaining credit controls: As Kaveh Khojasteh mentioned is his recent entry, credit in Iran is based on face to face "trust." In economies Western use of credit markets and credit instruments (like credit cards and mortgage loans) is quite common and increases the market efficiency and the overall health of the economy. However the Iranian credit system is different from lines of credit in three regards:

A. First, there is no central system for keeping track of credit history of people in Iran. It is fairly easy for people with negative records to get a checking account and use dated checks. But for example, in the US when people apply for credit cards or any credit product, they undergo a thorough investigation on how they have used credit before and a decision is made based on their “credit score”. Of course, there are also organizations that perform credit analysis for corporations (Moody’s, S&P, and Fitch).

B. Second, there are no nominal limits on the amount of credit in the most common Iranian credit system, the dated checking system. Account holders can write a dated check as high as they want and there is no way that the bank can estimate or limit the total amount of checks outstanding for a customer. So people with bad credit are essentially able to use large amount of credit.

C. Third, in the Iranian system, mainly due to lack of credit history, people pay the same interest rate regardless of their credit history. In case of dated checks, people are basically paying zero interest rates. In the Western system, higher interest rates are applied to people with high credit risk as a deterrent against having a bad credit history. However, in Iran high risk people have access to the same levels of interest rates as low risk people, which creates incentives for reckless borrowing.

4- Because of the above mentioned lack of transparency in the Iranian banking system; there are no mechanisms to measure the total amount of consumer debt outstanding in Iran. For example, no one knows for sure the amount of dated checks outstanding as of now because there is now method for banks to know how much their customers have issued checks. This situation can never happen in a credit card system. Therefore, the policy makers and researches, along with potential international lenders, are kept in the dark about the severity of the consumer debt bubble in Iran.

5- Many organizations, outside the official banking system, are in the business of borrowing and lending money. The most dramatic examples are a form of drift funds known as “Sandough-e-Gharzolhaseneh.” The official banking system is trying to crackdown on these unregulated thrifts but since the thrift funds have strong connections to certain political groups, chances of a regulatory intervention is very low. Since these thrifts are unregulated, they have a propensity to take high levels of risk through speculation on real estate markets, and as the history has shown, they also engage in fraudulent activities. There are no official statistics about the amount of assets controlled by these thrift funds.


Based on the above considerations, the consequences of a potential credit meltdown in Iran are hard to predict; but unless a bailout by IMF or World Bank does not happen, it is very difficult to maintain a positive outlook about the Iranian economy.

* This entry was motivated by the previous entry by Kaveh Khojasteh

Hamed at January 13, 2004 09:13 AM [permalink]:

A very nice post. After I read your article, it comes to my mind it might be the reason that bazaari's are so conservative. This can help to avoid the meltdown, probably.

hazhir at January 13, 2004 01:27 PM [permalink]:

Nice and informative post Ali, putting the facts together, your hypothesis makes a lot of sense, and is fairly troubling.
Two questions:
- Is the amount of barrowing in Iran higher than similar countries around. Ten years ago, I think it was very hard to barrow money from any bank(the dated check thing is of less concern, as the delays are shorter and therefore the bubble can not grow too far) and the interest rates in free market for money were much higher. How is the situation today?
- Related to the first question, what makes the situation worse today? I think many of the structures are similar to what we have had in the past 25 years, and eventhough we have had some cycles in the asset markets, I don't remember a very serious bubble bursting (except for peace deal after Iraq war).

yahya at January 14, 2004 11:55 AM [permalink]:

I guess someone can start a great business by creating a credit history company in Iran. It can try to collaborate with banks, but if banks didn't collaborate, it can work with businesses and their reports of fraud. It could charge businesses each time they ask the company about the credit history of someone.