The Financial Action Task Force places Iran on its blacklist: Possible implications and limits of the Iranian response

EPC | 12 Mar 2020

At its last meeting in February, Iran was placed on the blacklist of the Financial Action Task Force (FATF), thus becoming the second country, after North Korea, to be placed on that list. The placement of Iran on the list came after several stages of deferral of the respective decision and granting Iran a grace period to enact laws that ensure financial transparency, combating terrorism and anti-money laundering, after the Iranian government failed to enact those laws due to the objection of the hard-line current which prevented the adoption of the bills at the Expediency Discernment Council of the System.

While the decision was described by the Iranian Foreign Ministry as a political one that ignores the Iranian government’s action in this respect, it was welcomed by several countries, including the United States. President Rouhani blamed those who prevented the enactment of the laws in Tehran, declaring that they should be held accountable to the people, considering the implications of such a decision for the Iranian economy.

The effect of FATF’s decision on the Iranian economy

FATF’s decisions mainly target financial systems. In its decisions, FATF recommends that financial institutions exercise due diligence in dealing with the financial institutions of countries placed on the greylist and those placed on the blacklist. While its decisions are non-binding on the parties, experience shows compliance by the majority of financial institutions in all countries to those decisions. Thus, Russia and China were keen on Iran’s enactment of the laws necessary for its removal from the blacklist. The Russian Foreign Minister emphasized that placing Iran on the blacklist would add significant difficulties to trading with it, which was also emphasized by his Chinese counterpart.

Normally, placing Iran on the blacklist means the total collapse of its monetary dealings with the world since monetary exchange would be impossible with that country. Pakistan’s experience within this framework represents a prominent example of the extent of the effect of placing a country on FATF’s blacklist when the majority of its monetary dealings with the global banking institutions almost came to a halt. However, in the Iranian case, and under the sanctions imposed on the economy and the banking sector in particular, such a decision has a limited effect on the Iranian economy. The limited effect of the decision is manifested in the limited response to it by the currency market. Experts indicate that less than half the percentage of the fall witnessed in the value of the Iranian currency over the past two weeks (17 percent) could be attributed to FATF’s decision, while the remaining proportion is divided between a number of developments, including the domination of Parliament by hard-liners, the Coronavirus (Covid-19) affecting the whole country and its economic implications. The sectors that could be most affected by FATF’s decision are the following:

1- The Instrument in Support of Trade Exchanges (INSTEX)[1]: the European mechanism to support trade with Iran will be the most affected by the placement of Iran on the FATF blacklist since it would be impossible to implement the European mechanism under this procedure. Nevertheless, INSTEX remained a dead letter, which means that its effect on the Iranian economy will not be significant. Yet it represented a symbolic window that opens into the European Union (EU). Iran’s placement on the FATF blacklist amounts to the closure of that window and the impossibility of monetary exchange with the EU under any other precautionary mechanism, including the European monetary support system against US sanctions.

2- Banking trade system with Russia: although the volume of monetary exchange with Russia through the banking system is quite limited, not exceeding half a billion dollars (trade with Russia is based on barter), the decision remains important for several reasons, including  preventing the fulfilment of Iran’s desire to integrate with the Russian banking monetary trade system which constitutes an alternative to the SWIFT system which Iran has long strived to implement to open up a horizon for monetary trade with the world. The decision would also prevent interacting with the Eurasian Economic Union which Iran had hoped to compensate for its lack of trade by extending trade with its countries.

3- Trade relations with China and Iraq: with regard to China, Iraq and other partners, although most trade channels have not been affected, some important sectors will be affected by the FATF decision, including the oil and energy sectors. While Iranian experts hope that this would not lead to an interruption of work in those sectors, the procedure would certainly increase the cost of transferring the oil and energy receivables into the body of the Iranian economy, which would amount to a reduction (of up to 10 percent of those receivables) being paid to transfer money into the Iranian economy.

The decision has a symbolic importance in that it transforms sanctions on the Iranian banking system from US sanctions to international ones which other economies, including the EU, China and Russia, are committed to implement. Besides, the FATF decision to place Iran on the blacklist (unlike US sanctions which could end overnight once an agreement is reached between both countries) requires a period of time (at least three years according to expert estimates) to give up and remove Iran from the blacklist. This means that the banking system will continue to be banned even if the US sanctions are lifted due to agreement between both countries.

Iranian response: avoidance of the international banking system?

In spite of the strong effect that the FATF decisions normally have on global banking dealings, FATF’s decision to place Iran on its blacklist would continue to have a limited effect on the Iranian economy in its current shape. That limited effect can be seen not just in the limited response of the currency market (not exceeding 9 percent according to experts), but also in the reaction of Iranian officials. The Governor of the Iranian Central Bank, Abdolnasser Hemati, said that FATF’s decision, important as it is, would have a limited effect on the Iranian economy. Mesbahi Moqaddam, a hard-line member of the Expediency Discernment Council of the System, said that Iranian trade will not be significantly affected by the FATF decision and will almost retain its status.

Despite their differing viewpoints, both Hemati and Moqaddam indicated that the Iranian economy has tried to develop itself which made it far from being affected by the decision. While Hemati declared that the recent developments have shown that Iranian trade passes through monetary channels that are not affected by such sanctions, Mesbahi Moqaddam referred to third-degree banks and exchange companies that cooperate with Iran, in addition to friendly countries such as Iraq, China, Russia, India and Turkey.

In short, the Iranian economy remained far from being widely affected by the FATF decision, not due to US sanctions that targeted the Iranian banking system alongside other sectors, but due to Iran’s efforts to avoid the international banking system and develop a trade and monetary exchange system based on mechanisms that are distant from that system, which renders any procedures in this field of little effect on Iran’s trade and monetary exchange with the world.

The main mechanisms resorted to by the Iranian economic system to avoid the international banking system are “barter”, “exchange companies” and “local-currency exchange”, in addition to other less effective mechanisms such as the transport of banknotes (or the so-called “suitcase dollars” in Iranian literature). Below is more detailed information on each of these mechanisms:

1. The barter system: considered the most important mechanism available to the Iranian regime to detach itself from the global banking system, and to which the Iranian economy resorts to counter US and international financial sanctions. The Iranian economy uses barter in all its trade relations with its main non-European partners. Figures demonstrate a significant share of barter in trade with China and Russia. However, Iran exerts great efforts to develop the barter mechanism in its trade with countries with common land borders. Iraq, Turkey, Afghanistan and Pakistan account for nearly 40 percent of Iranian exports. According to that system, Iran attempts to barter its goods for the goods it needs without having to go through the banking system. Experts estimate the share of barter in overall trade with Iran by at least 60 percent.

2. Exchange companies: a mechanism resorted to by Iran to avoid the international banking system. The Iranian economy boasts a large network of exchange companies in southeast Asia, China, the Gulf region and Turkey along with Iraq and Afghanistan, that enables it to move money away from the international supervision imposed on the banking sector. While Iran relies on cooperation with small banks also in its monetary exchange with the world, the difficulty of dealing with the banking sector (especially that the norm assumes the establishment of small camouflage banks that are much more costly compared to the establishment of an exchange company) has driven the Iranian economy to rely on the network of exchange companies to carry out this exchange.

The network of exchange companies helps to move money into Iran, albeit on a small scale, and helps also to pave the way for barter transactions. No accurate figures are available on the amount of money exchanged over this network, although a close observation of the developments indicates a noticeable activity by the network of exchange companies even in European countries such as Sweden, Austria, Germany and Spain. A follow-up of the market also reveals that despite the remarkable reduction of the activity of exchange companies in some countries such as the UAE and Malaysia, certain important exchange companies continue to cooperate with Iran despite the sanctions (in addition to exchange companies set up by Iranians or their partners) by benefitting from the gap of the sanctions imposed on the banking sector.

3. Local-currency exchange: local-currency exchange remains one of the options of the Iranian economic system. The main areas of monetary exchange by local currencies from an Iranian perspective are exchanges with China, India and Russia where Iran attempts to sign contracts with those countries to drop the dollar and euro from the circle of transactions. However, the monetary trade volume in local currencies has so far remained limited despite official supportive positions in Iran. The is due to the lack of a strong corresponding official will, especially in the case of India, the weakness of economic exchange in the case of Russia, and because of the presence of significant alternative methods in the case of China. Nevertheless, the mechanism accounts for a remarkable proportion of monetary trade (estimated by some at 10 percent at most), and could be further developed to account for a greater portion of trade should Iran be compelled to it.

The above three methods account for the majority of trade volume between Iran and its major partners and fall outside the scope of the decisions covering the activity of the international banking system. This means that the FATF decisions cannot reach these aspects in a significant manner in spite of their general effect on the Iranian economy by ending the hope attached to the INSTEX and tightening the potential of trade with partners such as China and Russia.

Possible scenarios

It is difficult to speak of various scenarios leading to different results in this respect because the FATF decision, if put within the framework of the circumstances witnessed by the Iranian economy, would lead to a result that is close to that announced by the Governor of the Iranian Central Bank. However, the following cases could generally be assumed:

First scenario: developing the potential of the Iranian economy. This scenario assumes that the Iranian economy can develop its potential to avoid the global banking system through the aforementioned mechanisms. In such a case, any sanctions imposed on the Iranian banking system will not have a substantive effect on the economy, nor will they lead to further reductions in the trade volume between Iran and its partners. However, this scenario assumes that the Iranian economy will not develop, and that the Iranian trade volume with the world will not grow substantially, remaining at this limit, which has been its lowest limit over the past years. It also assumes the cooperation of Iran’s main partners with it in the upcoming period in spite of the placement of Iran on FATF’s blacklist. While the first assumption is quite valid, the assumption that Iran’s partners will continue to cooperate with it fully in spite of its placement on the blacklist is dubious in light of positions previously declared by officials in those countries warning against the consequences of the placement of Iran on FATF’S blacklist.

Second scenario: comprehensiveness of imposed sanctions: this scenario assumes that the sanctions imposed on the Iranian banking system, in terms of US sanctions and the restrictions resulting from the FATF decision, will be supplemented by new decisions or sanctions that include the field of monetary exchange outside the framework of the banking system or at least make that exchange more difficult. Such decisions could include surveillance systems over the exchange companies and the customs authority to restrict their cooperation with Iranian parties. While those decisions will not lead to termination of trade between Iran and its partners, they will limit the volume of that trade and raise its cost. This would clearly reflect on the volume of trade between Iran and the world. The greatest challenge in this respect lies in the surveillance of trade between Iran and its neighbours and imposing restrictions on the barter mechanism, in addition to decisions that would narrow the scope of work of exchange companies since both fields seem to be quite far from the possibility of surveillance.

 

[1] The Instrument in Support of Trade Exchanges (INSTEX) is a special financial mechanism established on 31 January 2019 by Germany, France and Britain to facilitate non-USD trade with Iran. The company is headquartered in Paris and is headed by German banker Per Fischer, the former Head of Commertzbank.

 

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