Dubai: Unstable public finances of Iran are slowly translating into deterioration in asset quality of banks besides causing capital erosion, according to the Institute of International Finance (IIF).

“Continued public payment arrears, connected lending, and poor management of the banking system have weakened the balance sheets of Iran’s banks, underscoring the need for large capital injections, management restructuring, and governance improvements,” said Garbis Iradian, Chief Economist, Middle East and Africa, IIF.

IIF data on Iranian banks show, poor management and sanctions over the past few years have led to a sharp increase in non-performing loans (NPLs), which reached 13 per cent of total loans in 2017, well above the average of 3 per cent for the GCC banks. The capital adequacy ratio has continued to decline from 8.5 per cent in 2012 to slightly less than 6 per cent in 2017.

“With higher cost of funds, profitability remains constrained. With local banks confronting limited liquidity and maintaining a cautious lending stance, most private businesses still face difficulties in accessing or servicing loans,” said Iradian.

Total debt owed by state and private banks reached $340 billion (Dh1.24 trillion) in 2017, up more than 25 per cent from the previous year and increasing the risk of forcing large write-offs at some point in the future.

While domestic banks are already feeling the heat of deteriorating government finances and a potential slowdown following the collapse of the nuclear deal, international banks are already cautious about doing business in Iran because US dollar clearing restrictions remain, posing a major challenge for global banks to re-establish correspondent banking relationships.

Even if foreign firms facilitate financial transactions with designated Iranian institutions, they may remain subject to US secondary sanctions. On the political front, hardliners may undercut the government on the grounds of national security and tensions between Iran and Saudi Arabia could escalate.

Forex markets have been quick to react to the uncertainties surrounding the nuclear deal. The spread between the official and the parallel (black market) exchange rates widened in the past few weeks in anticipation of new sanctions by the US. The average monthly spread between the two rates increased from 13 per cent in October 2017 to 20 per cent in the past two weeks. As of January 15, the official exchange rate was 36,511 Iranian rials/dollar while the black-market rate was 43,950 rials/dollar.

A significant portion of foreign currency has recently moved out of the formal banking system to trade at the black-market rate. The authorities still intend to unify the two rates to make the economy more efficient and create a level field for the private sector to compete with public institutions with access to foreign exchange.

In a scenario, where the nuclear deal survives the current impasse, a pick-up in foreign capital would facilitate domestic investment in all sectors, leading to meaningful job creation. With a more efficient and trusted financial system, the spread between the official and the black-market rates would narrow, which in turn would support a gradual disinflation and spur consumption. With the economy on stronger footing, the government might be better able to fend off attempts by hardliners to undermine its agenda.