Following the initial posting about Iranian Credit Markets, Borghan Nezami, one of my colleagues posted A Note. In his note, my views, as expressed in A Case for an Iranian Asset Bubble and the Role of Iranian Credit Markets are misrepresented. His note mentions a list of underlying assumptions in my article, whereas I never made those assumptions, either explicitly or implicitly; he then refutes the article and considers it misleading based on that list. Since his interpretation of the underlying assumptions and the conclusion in that article are not correct, it will be beneficial to all of us if I clarify them. I start by summarizing the main theses behind my original post and then respond to Borghan's claims about my article.
My views about the Iranian credit market are:
1- The lending policy in Iran encourages too much risk taking by the borrowers (for example low interest rates on directed loans for people with connections or the checking system)
2- Concentration of credit risk and poor risk management in Iran, rather than the size of private debt, is dangerous (In case of directed loans the risk burden is on the banks and for the checks it is with people who have accepted the checks)
3- The credit policies favor speculative activity financed by reckless borrowing (for the lucky few who can get credit at low rates and without limit)
4- People can access unobservable amount of credit via the checking system (I hope to explain in another posting how you can trick the checking system in Iran to gain literally unlimited amount of credit).
5- Most of this speculative activity is concentrated in the real estate market (many of the big construction projects like Atisaz by Bonyad Mostazafan are financed by directed lending), which has created a bubble.
In summary, my biggest concern is about the credit risk and how it is managed.
A review of Borghan’s claims about my assumptions and why his claims are not true:
Before I go to the details, I believe the biggest misunderstanding about my article is that he thinks I view checks as the only or the single major factor in the bubble. Nothing can be further from the truth. I mentioned directed lending and sandough-e-gharzolhasaneh along with checks as credit instruments in Iran.
1. He claims I assumed “Checks are always accepted as a form of payments:”
I never made such an assumption. All I said was that some of the checks in Iran are used as a form of credit instrument similar to credit cards. Furthermore, checks are only one example of what I mentioned in the article. I specifically mention three items as unhealthy debt instruments:
a. Directed Lending: The government forces banks to finance certain companies that have close ties to the government. Also, the government is using directed lending to finance its own debt.
b. Sandough Gharzol Hasaneh: I guess we both agree that these are mainly a scam by bazzari’s and the religious rulers to borrow money without paying transparent interest rates.
c. Dated Checks: The way these checks are treated enables some people to use them as an unlimted sources of credit. An example of such an abuse happened during what became known as the "123 Milliard Toman" scandal (the case was prosecuted by Mohseni Ejei and during which some reports of credit abuse by certain institution emerged).
I cannot understand why Borghan thinks my arguments are based solely on checks.
2. He claims I assumed “The Interest Rates on Checks Are Almost Zero:”
For many short-term purchases, this is basically true. If you are not buying a big-ticket item, you can get away with “zero percent financing.” For larger purchases, even though the checks are discounted against the interest rates, the person receiving the check cannot verify the amount of borrower’s outstanding debt.
In addition, in the financial markets, what counts is the difference between interest rate that you pay and the risk free interest rate. Again, given that the risk free interest rate in Iran is about 20% (or somewhere around that), any discount rate below 20% encourages borrowing by financial arbitrage: people can borrow money at below 20%, put it in the bank and receive the 20% interest and make a profit in the process. So risk premium in Iran = interest rate – 20%; as opposed to 13% inflation rate that Borghan refers to. (a more detailed discussion can be find in books and articles about CAPM).
Furthermore, in the article I once mentioned that what counts (in the goods market) is the real interest rate: the difference between nominal interest rate and inflation. With that in mind, in many instances of directed lending, actually people are paying negative real interest rates which encourages reckless borrowing by those who have access to directed loans.
For a financial perspective, I refer the readers to Asset Pricing by Cochrane (a University of Chicago guy) and Principles of Financial Economics by Stephen F. Leroy and Jan Werner. For a more macroeconomic perspective, you can look at Macroeconomics by David Romer (Berkeley guy) or Lectures on Macroeconomics by Fisher and Blanchard (MIT).
3. He claims I assumed “Banks are responsible for paying checks:”
I never said that. The danger to banks comes from the directed loans. As for the checks, the defaults do not affect the banks but the potential ripple effects destabilizes the whole economy.
4. He claims I assumed “There is no punishment for default:”
Again, I never said that; what I said was that people with default history have the same level of access to credit market that people without default history. Yes, you will go to jail for not paying your checks, but after you come out, you can open another checking account quiet easily. In America, a trace of bankruptcy will haunt you for at least 15 years; your life will be very miserable because you may even have difficulty finding a job with a bankruptcy history.
5. He claims I assumed “Banks easily lend to individuals at low interest rates”:
First, in my article I did not restrict myself to individuals; but many individuals and government-sponsored companies have access to low interest rates via directed lending. Furthermore, what counts in financial markets is the difference between corporate (or individual) interest rates and the riskless interest rates (basic CAPM). As I mentioned, the riskless interest payments are about 20%; so actually, if you are borrowing money at 25%, you are paying a 5% premium. A 5% premium is very close to the premium that corporations with a BB rating pay in the US. So yes, I believe that there is an imbalance in the interest rate markets; though I am not sure if this is because the 20% riskless rate is two high or 25% interest payments are two low.
* * *
Then, after alleging that I make these five assumptions (and as I mentioned, I do not make at least the first four assumptions), Borghan says that I conclude the private debt level is two high. Nothing can be further from the truth; all I concluded was that the structure of credit markets in Iran has encouraged reckless borrowing by high-risk economic entities, which has resulted in speculative market activity. But I believe that since the credit risks are concentrated among very few economic agents and is not properly managed, the consequences of a bubble burst for the economy can be very severe.
Borghan is very correct that the level of debt in the US is much higher than that of Iran (compared to GDPs of course). But the credit risk is far better managed in the US. Alan Greenspan this week mentioned that in the 1990’s, telecoms issued about $1Tr in debt and they defaulted on most of it; but since the risk was diversified through use of credit derivatives the US economy and the banking system was able to survive the aftermaths.
I think we both agree about the necessity of maintaining credit histories and default records to have a sound financial system.
One last thing, I had a different (and narrow) view about the definition of moral hazard; to give an example, my understanding was that if people buy insurance and as a result of having insurance engage in risky activities, this would constitute moral hazard; according to Pindyck and Rubinfled (2001, page 669) is:
"When an insured party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event".
In their book, when they talk about markets with asymmetric information they treat Quality Uncertainty(market for lemons), Market Signaling, and Moral Hazard as three different but closely related topics.
As Borghan pointed out, this definition is too narrow. As he points out:
" Moral hazard comes from 'Hidden Action' in any Principal-Agent relations, and
not only insurance. For example in the case of banking in Iran it's very common that sometimes some people take a loan for building their house, which is very low risk activity, and then invest the money in a risky business activity; This is called 'Moral Hazard' as well".
Thanks for pointing this out Bourghan!
In the end, I hope that we all have gained something from these discussions.