February 19, 2013 | The Wall Street Journal

Targeting Tehran’s Euros

The ECB's Target2 payment system has become critical to the regime since US financial sanctions curtailed its dollar business
February 19, 2013 | The Wall Street Journal

Targeting Tehran’s Euros

The ECB's Target2 payment system has become critical to the regime since US financial sanctions curtailed its dollar business

The United States has blocked Iran from easily accessing greenbacks as a means to slow down the Islamic Republic's nuclear program. But those financial sanctions only go so far. With Iranian nuclear physics still outpacing Western economic pressure, Washington is looking to prevent the mullahs from accessing their second favorite currency: the euro.

The key to the U.S. strategy is Target2, or the Trans-European Automated Real-Time Gross Settlement Express Transfer system. As the European Central Bank's proprietary electronic interbank payment system, it's the euro-zone equivalent of the U.S. Fedwire.

If you've ever conducted a transaction in euros, you've probably used Target2—unless, of course, you're doing cash deals out of the back of your car. The system facilitates untold numbers of legitimate euro transactions each year. But it also can be used unwittingly to aid Iranian sanctions-busting schemes. If an Iranian trader, for example, wants to convert euros from his Chinese bank account into yuan, and then transfer those yuan to an account held by a Chinese producer of maraging steel (useful for building advanced centrifuges), the Iranian trader's bank will likely use the Target2 system. A regional bank in Asia or an Asian settlement platform, as well as a European bank, will also be involved in settling the euro transaction.

Target2 is crucial to Iran because U.S. financial sanctions have already curtailed much of Iran's dollar-denominated business. In response, Tehran has transferred billions of dollars in foreign exchange reserves into euros, the world's second largest and most liquid currency reserve holding. The regime also has denominated a substantial portion of Iranian international trade contracts in euros.

The Journal reported last October that the regime holds around a third of its foreign-exchange reserves in overseas banks, and government sources have told us that euros are increasingly the currency of choice. The euros are held in Chinese, Swiss, Austrian, Russian, Turkish, Romanian and other foreign banks. Iran has also converted some of these euro holdings into other currencies to facilitate the Islamic Republic's remaining trade relationships.

Since the implementation of U.S. financial sanctions, the euro has also become the currency of choice for the Central Bank of Iran, which maintains foreign-exchange reserves to address a “balance-of-payments crisis.” Euros are Iran's principal hedge against the impact of sanctions, which are designed to force the regime to make painful choices about its illicit nuclear program.

That's where the European Central Bank can play a role. The ECB's own guidelines bar access to Target2 by those engaged in “money laundering and the financing of terrorism, proliferation-sensitive nuclear activities and the development of nuclear weapons delivery systems.” This describes the Iranian regime to the letter.

However, numerous Iranian banks, and foreign banks handling euro transactions on behalf of the Islamic Republic, can still access the Target2 system, as either direct or indirect participants.

This is neither new nor shocking. At the beginning of last year, some 44 Iranian banks and financial institutions were still using the Swift system, a member-owned Belgian cooperative that provides secure financial-messaging services that plug into Target2.

In February 2012, the U.S. Congress teed up new legislation that authorized the Obama administration to sanction Swift if it didn't expel Iranian banks. The following month, European regulators complied, ordering Swift to expel all EU-blacklisted Iranian users—about 30 in total, including the Central Bank of Iran. Swift's unprecedented action was a punishing blow to Iran's trade relationships.

At the time, Target2 was left out of the discussion. But now, in light of new evidence that Iran is accessing euros via Target2's payment system, some ECB officials have indicated that they are prepared to bar Iran from the system for violating the explicit prohibitions in the central bank's guidelines.

Such a move would comport with efforts by European policy makers to maintain the integrity of the euro. As was the case with Swift, the U.S. Congress is prepared to use an upcoming Iran sanctions bill to give European regulators a legislative push to do what they know is right.

Target2 takes on even greater importance in light of new U.S. sanctions that came into effect Feb. 6. The measures lock up billions in oil revenue in local-currency accounts in countries that buy Iranian oil, such as China, India, Japan, South Korea and Turkey. These local-currency funds can't be repatriated back to Iran, nor can they be used to finance trade outside these countries. Iran must spend the local currency on goods from local exporters.

While furnishing Iran with ample local currency to buy, for example, top-quality medicine from Japan, medical equipment from South Korea, generic drugs from India and consumer goods from China, these sanctions severely curtail Iran's ability to earn more euros (and dollars) from oil sales. As a result, Tehran's euro assets are even more critical for it to maintain the foreign-exchange reserves necessary to weather the impact of sanctions.

But time is short. A recent report by the Project on U.S.-Middle East Nonproliferation Strategy estimates that mid-2014 is when Tehran could reach the “critical capability” to produce enough weapons-grade uranium—or sufficient separated plutonium—for a bomb before such production could “reasonably be expected to be detected by the International Atomic Energy Agency or Western intelligence services.” Iran could reach this undetectable breakout earlier if it succeeds in operating the advanced centrifuges that it is adding to its existing enrichment facilities.

Before Iran achieves its nuclear objectives, the international community has a small window of opportunity to make one final push to make sanctions work. Target2 could play an important role in that success.

Mr. Dubowitz is executive director of the Foundation for Defense of Democracies, where he leads projects on sanctions and nonproliferation. Mr. Schanzer, a former U.S. Treasury terrorism finance analyst, is vice president for research at FDD.

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