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Middle EastAugust 3 2003

Iraq’s soaring debt tests investor confidence

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As this beleaguered nation tots up its accounts payable, Mark Wallace asks whether debt forgiveness from the international community can pave the way to economic restoration.For the Coalition Provisional Authority that has occupied Iraq since the recent war, rebuilding the country’s financial and economic system will prove as difficult as putting back together any of the tattered country’s physical infrastructure. And it will have ramifications that are just as far-reaching – not just for Iraqis but for the international financial community as well.

While the bonds of trade and commerce that were severed by Saddam Hussein and UN sanctions have yet to be re-forged, Iraq remains linked to the rest of the world through its outstanding foreign debt. Dealing with that debt will be one of the thorniest issues that the occupying powers face. Even determining how much debt actually exists is proving difficult. From there, issues will have to be resolved such as who gets paid back in what measure, whose claims take priority, and how to carry the less heavy but still burdensome debt load that will remain after the wrinkles are smoothed.

The first steps toward answering all those questions now have been taken. In July, the Paris Club of government creditors met to add up what it is owed. As the International Monetary Fund (IMF) and the World Bank come to grips with the problem, more will be revealed. And as a creditable government is established in Baghdad, questions of outstanding contracts and other accounts payable also will begin to clear up. In the meantime, investors who want to dip their toes into one of the most exotic of exotic markets would do well to acquaint themselves with the developing picture as it now stands.

Sizing up the problem

Any estimate of Iraq’s total outstanding debt has to take into account several factors, including bilateral credits extended by creditor nations (including both the Paris Club and Arab nations), war reparations from the Iran-Iraq war and both Gulf wars, and commercial payments outstanding.

According to estimates from a variety of independent sources, Iraq’s total debt could stand at more than $500bn, including all types of obligations. At that level, the country has a debt burden of more than 15 times its estimated annual GDP of $30bn and almost no effective hope of even servicing the debt in a reasonable manner.

A closer look makes the situation seem more tolerable, though just barely. Iraq’s debt to the IMF is not urgently repayable. Almost half the total debt is war reparations, which may be delayed, reduced or even cancelled if creditor nations decide the Iraqi populace should not be held liable for the transgressions of Saddam Hussein. But even more reparations claims have yet to be adjudicated, meaning that the debt total could grow.

New trends in debt forgiveness mean that of the remaining total $154bn in bilateral and commercial loans from the Paris Club and other countries, anywhere from 20% to 80% of that may be forgiven under various debt rehabilitation doctrines.

But a substantial volume of loans will no doubt remain on the books. Most of the country’s outstanding commercial debt resides with China, France and Russia, and most of it concerns oil exploration and development contracts, according to an analysis by economist Dr Robert Looney of the US Naval Postgraduate School. These countries no doubt will be reluctant to forgive these obligations, especially given the uncertainty of building a business relationship with the coming American-sponsored regime.

Military debt is also a substantial factor, according to Dr Looney. Arab Gulf states claim about $55bn in loans and assistance provided during the 1980-1988 Iran-Iraq war. Kuwait, whose claims may carry more weight than most, is owed $17bn of this. European governments are also involved. France is owed $4bn for military equipment, including fighter planes and missiles, and Russia is owed $9bn for similar material. Germany is owed $4bn.

In short, Iraq’s debt burden means any investment in the country is an almost hopeless play, unless drastic measures are taken to make the debt more manageable. Fortunately, some strategies may soon bear fruit, though it will be some time before the country’s ongoing payments situation can be sorted out to investors’ satisfaction.

Forgiveness financing

One hope is that much of Iraq’s debt may be forgiven under programmes similar to the World Bank’s Heavily-Indebted Poor Countries (HIPC) programme, which seeks to relieve unmanageable debt burdens of the world’s most impoverished nations. This scenario, of course, counts on the goodwill of Iraq’s creditors and may make things difficult for investors until the question is settled.

Programmes such as the HIPC have helped countries overcome crushing debt burdens that would otherwise have choked off their economies and left them with little hope of development.

In places such as Nicaragua and Mozambique, debt forgiveness of more than 70% has freed up cash that is better used in developing commercial and social infrastructures than flowing straight out of the country in the form of debt service.

Another doctrine under which the burden might be reduced is that of “odious debt,” which holds that the Iraqi people should not be held responsible for bills run up by a dictator who held power by force and terror.

While it has been floated in many cases around the world, this idea thus far has had difficulty finding traction on the ground. For one thing, it would require bankers to become judges of character as well as financial soundness, and could, as some critics charge, make lenders far more reluctant to do business in any but the most democratic of nations. As Dr Looney points out, a regime change and sudden move to democratisation in China could leave international bankers holding a $200bn bag under a loose interpretation of the doctrine.

Still, estimates remain that the Paris Club will eventually forgive up to 70%-80% of the Iraqi debt it holds – an amount similar to that extended to Serbia and Montenegro for the former Yugoslavia’s debts after the Kosovo war – and may overlook interest that has accrued since Iraq stopped servicing its debts in 1990.

Paris Club debt deals are normally based on IMF estimates of a country’s sustainable debt level. But international politics may play as big a part as altruism here, with US interests weighing heavily. The more the US administration seeks to help US business interests in the country, the more it will push for European and Arab creditors to move to a substantial reduction of Iraq’s debt. This will reduce the country’s debt service and free up cash to flow to the accounts of American corporations doing business in Iraq.

France, Germany and Russia, however, who collectively hold about $8.85bn in Iraqi debt, may resist debt forgiveness more than most. Staunchly opposed to the US-led war, it is reported that they have resisted initial calls to forgive Iraqi debt. Should they dig in their heels, a Paris Club deal – which would require that all countries receive similar benefits – would be difficult to craft.

An added factor could be a payments moratorium, in an arrangement again reminiscent of Yugoslavia’s case. Putting off any debt service and reparations payments for five to 10 years would ease the country’s ability to get back on its feet and make subsequent investments in Iraqi debt or in the country in general more attractive.

The US will pressurise governments, especially that of Kuwait, to forgive much of the outstanding war reparations in the interest of regional economic health.

A moving target

Besides debt forgiveness and American whim, what other factors will affect the shape of Iraqi debt? An IMF mission to Baghdad will help the process along. The IMF plans an estimation of Iraq’s balance-of-payments situation and will issue a debt sustainability report that will become a bellwether for those doing business with the country.

The London Club of commercial creditors no doubt will follow closely any cues from the Paris Club, if only because they will come under popular and governmental pressure to offer similar terms.

The London Club and other private creditors owed under outstanding contracts are expected to be forced to repudiate about 80% of their claims. But London Club debt could be as low as $2.6bn, according to some, and Iraq’s total commercial debt has been estimated at less than $10bn by the UK government.

The progress of reconstruction will also affect the picture, based largely on the rehabilitation of Iraq’s oil sector, which is not progressing as quickly as had been hoped. Unless the oil sector begins producing real revenue soon, Iraq will not have enough money to service even the smallest portion of remaining debt.

Even if it does, things still seem doubtful. The costs of reconstructing and running the country are estimated at somewhere around $30bn a year or more, while oil revenues are put no higher than $25bn or so.

The political question will weigh heavily. Until a UN-sanctioned government is in place, it will be difficult to reach an international accord on the issue of Iraqi debt. Divisions in the Paris Club, a consensus body, also will delay the process. And the delicate issue of relations among Arab states, and between these states and Western governments, also must be negotiated.

The exotic play

Though it has been more than a decade since Iraq held any kind of well-defined position in the world of international finance, speculators here and there have continued to trade the country’s debt, even if only as an exotic among exotics. Dealers such as Aberdeen Asset Management, Ashmore Investment Management, East-West Debt, Exotix Ltd and Omni Whittington all have handled Iraqi paper in recent years.

Traded Iraqi commercial debt chiefly takes the form of two syndicated loans issued by state-owned Rafidain Bank for $500m each, dating from 1983 and 1987. With some traders optimistic that holders of this paper could fetch as much as 75 cents on the dollar, the Rafidain loans have traded at 15 to 20 cents.

Omni Whittington estimates that the volume of Iraq’s outstanding foreign trade debt, on the other hand, could be as high as $62.2bn. Some of this trades as low as 1.5 cents on the dollar, however. In any case, the market is hardly liquid, although there is enough interest in the instruments that the markets rise with speculative plays on eventual restructuring deals. Market participants agree that Iraqi paper will continue to trade, even if deeply discounted. In a highly uncertain international climate, all investors need is the stomach for it.

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