By Jahangir Amuzegar
In the following article for MEES, Jahangir Amuzegar, a distinguished economist and former member of the IMF Executive Board, analyzes the performance of the Tehran Stock Exchange.
With its stunning performance in the last five years, the Tehran Stock Exchange (TSE) has astonished and fascinated global financial analysts. While the overall indices of the world’s five major exchanges – New York, London, Paris, Frankfort and Tokyo plunged by 40 to 70% between March 2001 and April 2003, the TSE index (Tepix) bucked the trend by going up nearly 80%. And, while none of the major exchanges has yet regained its 2001 high, the Tepix has more than tripled its record since then. Given this eye-popping record, some seasoned market gurus have been tempted to suggest that the TSE is really a place to be. A more sober and objective examination of the exchange’s history and its specific characteristics may suggest a more cautious conclusion.
The TSE’s Track Record
While the idea of establishing an organized stock market in Iran goes back to the mid-1930s, it took more than 30 years for an enabling securities law to be enacted by both houses of Iran’s legislature in 1967. The Tehran Stock Exchange began operation in early 1968, dealing in shares of a limited number of private banks, industrial companies, Treasury bonds, and state-backed securities. During the 1970s, and particularly after the 1974 oil price explosion, the market showed a dramatic rise in volume of transactions with modest share price rise. In 1977-78, the annual value of shares traded in the TSE reached IR44.5 billion ($628mn) – a record for the decade. On the eve of the 1979 revolution the paid-up capital of 105 enterprises (22 private banks, 2 insurance companies, and 81 industrial corporations) listed on the exchange was estimated at IR220 billion ($3.1bn).
After the revolution, the expropriation of industrial and business enterprises belonging to the Shah’s supporters along with the nationalization of all private banks reduced the number of listed companies to 56. Following the passage of the 1983 Islamic “interest-free” banking act, interest payments on debt securities were banned, and trade in the old debt certificates was reduced to a trickle. Shunned by Islamic Marxists in power as a capitalist tool, and affected by the Iran/Iraq war of 1980-88, the TSE experienced a period of relative standstill. Annual volume of trades fluctuated between a miniscule IR49mn in 1981-82 and IR1,690mn in 1987-88 – mostly involving equities of less than 40 companies.
The ceasefire with Iraq, the exit of a statist/interventionist administration, the start of a Five-Year Economic Development Plan, and a favorable new corporate income tax law gave a needed boost to the dormant equities market. More significantly, a “privatization program,” launched under the first five-year plan in 1991-92, to sell some 390 state firms to the public became a welcome boon to the exchange’s upswing. Under this initiative post-revolution public entities, and several Islamic “charitable” organizations (the bonyads) that had previously taken over the expropriated private properties were ordered by the government to offer shares of their enterprises to the public through the TSE. As a result, the total number of shares traded in that year reached 62.6mn worth IR478bn, and the Tepix registered 472 (1990=100) – a post-revolution record. Allegations of questionable accounting procedures, fabricated corporate profits before their initial public offerings (IPO), and other unsavory practices in the sale of public companies caused the Tepix to decline by 15% in two subsequent years – taking the gloss off the nascent market.
After the government put a stop at the badly botched privatization experience, and a new Majlis law on the subject in 1994 severely restricted its future resumption, the TSE began its new surge. The Tepix rose from 694 to 1,549 – striking 123% – in l995-96, and another 25% in 1996-97 -- raising the index to more than four times its previous record. As was feared, the bubble burst shortly thereafter, and the index fell by 21% in two subsequent years. From then on, a steady increase in annual money supply (largely due to the budget deficits financed by the Central Bank at no interest), combined with a mild recession in other investment alternatives (eg real estate, gold, foreign exchange, automobiles, and cell-phones) helped launch an unprecedented meteoric boom. In the first six months of 2002-03, the Tepix rose from 5,368 to 8,993, and in the next six months to 11,379 thanks mainly to the newly reorganized Privatization Agency’s initial public offerings. Thus, in a span of only four years between March 1999 and March 2003, the index rose from about 2,206 to nearly 11,400, and the number of shares traded in the market went up from 1.7bn a year to 7.9bn.
The astounding growth of the market within a fairly short period of time caused understandably high anxiety among exchange officials, and its Secretary General on several occasions warned the public about a possible new bubble burst. In mid-2003, failing to dissuade speculative traders, he took an unusual decision to ban any rise in the index for 15 days, and disallowed any price increase of more than 5% a day in any company’s share from then on. Nevertheless, the market continued its upward trend and reached an all time record high of 13,836 in mid-December 2004.
In the first three months of 2005 a number of factors began to stop the unrelenting upward trend. New rumors of stock price manipulations by sellers, suspension of some companies from the exchange, and possible criminal investigations of others caused renewed legitimate anxieties. Lukewarm reception of the Privatization Agency’s new IPOs reflected a decline in investors’ confidence. Exogenous factors such as Iran’s nuclear enrichment issue, rumored military threats from Washington and Tel Aviv, the region’s growing political turmoil, uncertainties about Iran’s June 2005 presidential election, and the conservatives-dominated, Majlis’ attempts at price and interest-rate controls increased the uncertainty factor. On the last day of trading on17 March 2004—before closing for the Iranian New Year 1384 -- the Tepix was down to 12,113. Despite this partial reversal, however, the market was still up 6.5% year-on-year, albeit down 12.5% from its mid-December peak.
Performance Puzzle
In the decade ending in March 2005, the number of companies listed in the TSE increased to 420 from 164, and the total number of tradable shares in the exchange skyrocketed from 149mn a year to about 12bn. The market value of listed shares reached $46bn compared to $8bn 10 years back. And the Tepix was up 17 times. This escalating pace of growth could hardly be explained by either fundamental or technical market criteria. During the decade, none of the principal economic indicators warranted such an upsurge. Gross domestic product was up barely 54%. Capital productivity reportedly declined by 2.2% a year between 2000 and 2003. Wages perennially lagged behind consumer price index. Price earning ratios steadily increased, signifying lower return on investments. Iran still remained one of the world’s closest economies, ranking 148 among 155 countries surveyed by the Heritage Foundation. And, the country’s investment risk, although slightly improved due to larger oil export earnings, was still higher than 80 other countries in OECD’s tabulation. Meanwhile, unemployment remained in the double-digit range. Industrial capacity was not fully utilized. State banks remained under-capitalized. Annual budget and budget deficit increases both exceeded the GDP growth rate. And one third of state-owned enterprises operated in the red. In short, the exchange’s striking turnout was largely independent of the economy’s performance, and basically a function of its own exclusive characteristics: insufficient liquidity, scant transparency, and particularly a built-in upward bias.
A Modern Day Financial Bazaar
The TSE’s phenomenal growth in the past, and its risks-laden future behavior, can best be understood and explained by a closer look at its salient features: state-dominated governance, majority public ownership, small size and narrow scope of operation, and perceived insiders’ manipulation. To begin with, the TSE’s governance structure makes it a virtual appendage of the state. Its main organs – High Council, Acceptance Committee and Arbitration Board – are almost totally manned by either incumbent government officials or government appointed public representatives. The governor of Iran’s Central Bank presides over the exchange’s High Council. The deputy governor heads the Board of Directors and the Acceptance Committee. And the seven-member Board of Directors elected by brokers is answerable to the Supervisory Commission that is appointed by the High Council.
Secondly, as much as 80% of the exchange’s current market value is reportedly owned directly or indirectly by state organizations (eg the Social Security Fund and the Pension Fund), or by semi-public agencies (eg state banks, state insurance companies, and semi-public bonyads). Dominated in its organization and management by the Central Bank, the Council on Money and Credit, and the state banking system, the exchange’s mission is diluted, and its interests ill served because the organs that are in charge of the country’s credit and money markets are in reality its competitors. For this reason, the TSE plays no significant role in providing venture capital. Nor is it a notable magnet for mobilizing private savings.
Third, the TSE is relatively small, lacking in both breadth and depth. It is insufficiently liquid, and largely inward oriented. With only about $46bn in total valuation, it falls far behind all major world exchanges in size, and in most cases as a ratio to total national product. (A comparison with the NYSE’s $20 trillion’s worth is indeed far fetched.) The TSE also deals in only a handful of instruments and products. Risks are high, not rationally differentiated among various financial papers, and nearly impossible to hedge. The TSE is similarly a fairly narrow market. Of more than 680,000 registered companies in the country only 420 are listed on the exchange – with more than 100 totally inactive, and less than 200 regularly traded. Daily turnover of shares is about 30 and among the world’s lowest – signifying the exchange’s lack of depth. By some estimates, less than 10 large corporations belonging to a handful of major industries own more than 50% of the exchange’s total value, and account for nearly four-fifth of daily transactions Of Iran’s estimated 68mn population less than 3mn own shares of stock of any kind – one of the smallest percentages among countries with Iran’s GDP. Individual participants in daily transactions typically number a few thousands. Small shareholders are mostly stock market novices with a very short investment horizon who dabble in the exchange not as savers for rainy days, but mostly as slot machine players or lottery enthusiasts. They typically show a strong preference for receiving regular dividends over capital gains.
Insufficient Liquidity
Fourth, of a much greater significance among the TSE shortcomings is its insufficient liquidity. There are as yet no professional market makers, and all orders must be individually matched – causing lengthy delays in orders’ execution. There is also an almost perpetual imbalance between demand for shares and their supply. Since the bulk of market securities belong to a few powerful public conglomerates, the shares offered in the exchange routinely lag market demands because majority shareholders have both the incentive and the clout to withhold supplies in order to elicit higher bids. By contrast, the demand for shares is relatively strong due to annual double-digit inflation, a steady 25%-plus annual increase in total private sector liquidity, rising oil prices, and the lure of making a quick buck. Thus while the market’s average price/earning ratio still remains fairly low and reportedly around 10%, it has gone up by 350% since 1998. Another reason for insufficient market liquidity is the small number of brokers and agents – namely, one broker for each 50,000 shareholders. Brokers are also in a position to prioritize transactions in their own favor, or in favor of those with inside information without the fear of being caught or punished. Similarly, state banks, as both indirect owners of the exchange (through their numerous investment subsidiaries) and the exchange’s designated agents to execute orders, are able to look after their own interests at the expense of the public.
Fifth, the TSE’ s transparency in terms of information, self regulation, and internal enforcement of rules also falls short of Western standards. The Islamic Republic’s economy does not yet have a comprehensive securities and exchange statute, and the TSE itself operates under an antiquated 40-years old law. There is also nothing resembling a securities and exchange commission to guide, regulate, supervise, and hold market operators accountable for their actions. The main exchange organs, lacking professional secretariats, sufficient budget, and full-time attendance are virtually controlled by brokers and agents with their own vested interests. The General Secretary, appointed by the Brokers Organization, wields enormous (and excessive power) over the market’s operations.
Sixth, individual share prices in IPOs often follow policies and decisions of the General Secretary, manipulations by rent-seeking vested interests, and other agents and speculators with special leverage. In the absence of professional analysts, bond-rating agencies, and independent sources of financial news, equal access to individual company performance is rare. And due the lack of proper supervision, investors’ rights are not adequately protected. Proxy statements and disclosure rules are largely absent or deficient. According to published reports, trading on inside information and a host of other unsavory practices are the norm rather than the exception.
Finally, the TSE remains almost totally a local exchange. Foreigners’ participation is fairly limited, and portfolio investments do not yet enjoy the legal protection and privileges accorded to foreign direct investments. According to the latest regulation approved by the exchange’s Board of Directors in mid April 2005 foreign investors are permitted to purchase no more than 10% of any listed company. Repatriation of principal, dividends, and capital gains are allowed only after three years. Foreign corporations are not allowed to list on the TSE.
The Outlook
In the first three weeks of the new Iranian year 1384 (2005-06), the Tepix has resumed its upward trend, although by early May 2005 it was still behind its December 2003 all time record high. A reduction of tension on the nuclear enrichment issue, upsurge of private liquidity by the banking system, and a return of investors’ confidence have all helped the new gains. An up-to-date and comprehensive securities and exchange statute is expected to be enacted by the 7th Majlis in a couple of month. New rules have also just been set by the High Exchange Council regarding establishment of market makers, regular availability of shares for companies listed on the Exchange’s big board, and other needed provisions to go into effect in a few months.. According to press reports, TSE officials now daydream about raising the exchange’s total value to $100bn by the end of 2005. Thanks to a recent liberal interpretation of the Constitution’s highly restrictive Articles 43 and 44 by the Expediency Council most key industries – the so-called “commanding heights” of the economy— thus far constitutionally reserved for the state are to be denationalized and offered for private investment. TSE managers also intend to install new facilities for buying and selling shares in all provincial centers, expand electronic transactions capable of handling up to 500,000 daily orders, and create a supplemental market for smaller companies. Rising historically high oil prices, mounting budget deficits, and increasing money supply are also bound to raise demands for shares this year. Nevertheless, the TSE still would not be a market of choice for the timid, the faint hearted, and the risk-averse investor.
