Amy Kaslow
Gulf News
September 24, 2003

In high-stakes Iraq, where reconstruction is riddled with risk, one banker’s obstacle is another’s opportunity. But while finance specialists consider forgiveness or fresh credit, pressing questions go unanswered. Who are responsible parties, as Iraq undergoes a regime change?

What are the prospects of Iraqi oil output financing reconstruction costs and payments to creditors?

Saddled with Paris and London Club debt, offset trade balances and unpaid export credits, Iraq’s balance sheet is a very complicated picture.

Rough estimates

Estimates of the country’s debt swing widely. But round numbers look like this: $100 billion – the future reconstruction funding over the next five years or so at $20 billion a year. This is not a current creditor claim – it is a funding priority. But the money is urgently needed and it is going to have to come from somewhere.

Legacy commercial debt owed to non-Iraqi banks and companies weighs in at roughly $50 billion. They see themselves as true creditors. Some $21 billion in principal sovereign debt and $40 billion in interest owed to western countries and Russia in the Paris Club.

The IMF is currently collecting data, to calculate the sum owed to Arab creditors; it is known that Kuwait is owed $8 billion.

A whopping $300 billion in reparation claims related to the invasion of Kuwait has been submitted to the United Nations Compensation Commission.

By October last year it had awarded $44 billion; by this spring more than $16 billion had been paid out of the compensation fund – which receives a share of the revenue from Iraqi oil sales. Many claims remain outstanding.

Many – but not all – of those relating to losses by Kuwaiti individuals and small businesses have been dealt with. Clearly, claims relating to big government and business may be easier to cancel or reschedule.

General wisdom is that the reconstruction funding claim tops the priority list. The legacy commercial debt will be subjected to negotiated solution.

Some of the legacy sovereign debt will be repudiated or forgiven because those countries have other geopolitical relationships with the United States. (Of course, the Paris Club is a protocol that helps sovereign to sovereign debt get worked out. And those negotiations don’t start until the International Monetary Fund helps develop and bless an overall recovery program. The IMF is a long way from putting together a blue-print.) Finally, the Kuwaiti reparation claims may fall toward the end of the line.

Different views

Seasoned debt watchers bring dramatically different views to Iraq, and the debate has spurred some innovative approaches. Duncan Darrow is a specialist in financial and bankruptcy law at New York’s Orrick, Herrington & Sutcliffe. Orrick is among the world’s top securitization firms.

For Iraq, Darrow expects a “multiple solution” including: an element of debt forgiveness – a wiping away of debt; a small cash payment by monetizing a percentage of future oil revenues; and a rolling over, or conversion, of the current debt into some kind of new debt instrument. It is the latter that Darrow is positioning his firm to pounce on as a financial opportunity.

Darrow hopes to soon trade in the form of “Freedom Bonds” – debt securities created from future cash flow of Iraq’s oil business. This form off securitization banks on performance in Iraq’s oil sector that defies the current state of major resistance to the U.S. occupation in Iraq and the constant threats and setbacks to the recovery of the oil sector.

But he hopes to soon introduce the Freedom Bonds to the market in three tranches. Series A would be $20 billion in rated debt; Series B would be $30 billion in unrated debt; and Series C would be $50 billion in unrated debt with a contingent payment feature, depending on Iraq oil revenue topping a specific mark determined by increased production and/or price.

Complicating things for Darrow and others looking to bundle Iraqi debt and trade it on the secondary market are the proponents of the odious debt doctrine.

“This has an intellectual genesis, and revolves around the concept that either be it countries or banks – whoever lent money to Iraq – if the lent funds were used to support Iraq’s military activities – that somehow those monies are tainted,” Darrow says. He exhales slowly and adds: “And they have been spoken of as prime candidates to simply be wiped out.”

Some of these claims date back to the eight year long Iran-Iraq war when the Iraqis made it plain to their creditors that if they had any hope of winning supply, reconstruction or oil contracts, the first order of business was to extend Baghdad three to five year deferred payments.

The race was on between France’s Coface, Germany’s Hermes, Britain’s ECGD, the United States’ Export-Import Bank and other leading export credit agencies (ECAs).

By 1989, debt accumulated to a point where the ECAs were unable to recover, and they were going to their respective governments and asking them to lean on the Iraqi government for repayment. Saddam Hussein, of course, was impervious to this bilateral pressure.

Now it is the creditors’ turn. Some US observers believe that the French, for example, will not forgive that official debt or export credits very easily unless they have a big bite of the reconstruction contracts.

So forgiveness and extension of new credit are inextricably linked to reconstruction prospects.

“There is a trade off here for both France and Russia,” says James Steinberg, director of foreign policy at the Brookings Institution and deputy national security advisor at the Clinton White House “The more that we open the door to them to participate in going forward, the more flexible they’re going to be about the past debt because their interest is obviously going to be greater in the future contracts, and they also recognize that under these circumstances, one never recovers very substantially debt that was contracted under questionable circumstances.”

As a practical matter, Steinberg adds, it’s “very difficult to force collection after the fact on arms transfers.” However, Paris sources have indicated that the position could be quite different.

Since the early 1990s, France has assumed that it would never recover the debt and it did not even bother to keep a tally of the theoretically accumulating total of interest and late payment penalties.

UN recognition

The key issue for Paris is UN recognition. If an agreement is reached within the UN Security Council over the status of Iraq’s interim government, France will feel much more willing to take a flexible line.

Assuming there is going to be any recovery of the debt, it will be difficult to determine just who is the responsible party. “There’s a long tradition of successor states assuming the debt of the predecessor governments, no matter how bad the government was before.

The classic example of course, is the Soviet Union and Russia. And most countries have chosen not to fully relieve themselves from it because they are concerned about going forward, whether they will have access to credit markets or not.”

Pressing questions for the emerging Iraqi government: Is it better off with debt cancellation, or is it better off coming to terms with creditors who will give it better access to credit markets going forward?

Much of the debt is owed to governments highly critical of the United States invasion of Iraq and equally displeased with its present occupation. To what extent can the U.S. effectively lean on these countries to forgive the debt – both official and commercial?

“Again we’ve seen this in other contexts,” Steinberg says, recalling recent war and post-war economic reconstruction scenarios he helped to negotiate during his years as chief of policy planning at the State Department and then later at the Clinton White House.

Debt forgiveness

“The United States unfortunately has tended to be enormously generous in offering to forgive debt owed to other countries. And that’s certainly been true with the Russian debt and other cases. I am sure that because there isn’t debt owed to us, we’ll have an interest in trying to minimize the burden on the Iraqi government.

“But we also have to recognize from our other experiences that jamming our friends is not necessarily in our interest. It’s certainly easier to do with official debt than with private sector debt, but even there, you don’t want o presume for others, particularly given the difficult relations we’ve had already going into Iraq to somehow suggest that in addition to ignoring their interest and their views going into the war that we’re now going to ignore their economic interests in trying to recover.”

The U.S. would do well, Steinberg says “to have a non-coercive, no pressure conversation” with the holders of Iraqi debt.

In the meantime, policymakers and debt watchers are considering a scheme that two economists have drawn up to eliminate lending to odious regimes, such as Saddam Hussein’s Iraq.

Michael Kremer, a senior fellow at the Brookings Institution and professor of economics at Harvard University, along with one of his graduate students, Seema Jayachandran, suggest two enforcement mechanisms.

First, to make odious debt contracts legally unenforceable by changing laws in creditor countries to disallow seizure of a country’s assets for non-repayment of odious debt. Second, to make foreign aid to successor regimes contingent upon non-payment of odious debt.

Donors, in effect, could refuse foreign aid to a country that is handing the aid over to banks that have illegitimate claims. Assuming the foreign assistance were substantial enough, this effort would give the successor governments the incentive to repudiate odious loans; banks would quickly see the deterrent and refrain from making the loans in the first place.