Restructuring debt is top priority
Litigation risk for years to come
NOT FOR THE first time, sovereign debt restructuring is likely to dominate the IMF/World Bank annual meetings. Most of the discussion this year will concentrate on Argentina: what the country should do, what the IMF should do, whether the debt exchange is going to be a success.
In the background, making far fewer headlines, will be negotiations on $100 billion of another country's debt. Representatives from all the big creditors will be trying hard to reach a solution and there's a good chance that progress will be made.
After all the emphasis on collective action problems and bond restructurings, the official sector has a tough nut of its own to crack. If a small group of countries can't agree on restructuring sovereign debt, they should think twice about lecturing a much larger group of bondholders on doing the same thing. Even if the bilateral creditors do come to an agreement, questions will remain on how and why the private sector should accept the terms of that deal.
The country in question is Iraq, the ultimate case of financial contracts running squarely into political realities. Which one wins could set the tone for sovereign debt relief at least as much as Argentina will.
In many ways, Iraq can be seen as the anti-Argentina: a case where the meetings are likely to generate more light than heat. Indeed, there are many ways Iraq is equal and opposite to Argentina. Both countries would love to reschedule their defaulted debt by the end of the year; both have in the region of $100 billion in such debt; both will essentially have to pay down that debt using commodity exports; and both countries' debt is currently trading in the 20s or low 30s as a percentage of par.
Abundance of goodwill
Yet the differences between the two countries are also striking. Argentina has over half a million creditors; Iraq has a mere handful. Argentina has antagonized and alienated virtually everybody to whom it owes money; Iraq's interim government is so new and overworked that the general attitude towards it is one of goodwill and sympathy. Argentina is seen as setting a hugely important precedent in terms of the international financial architecture; Iraq is seen in more geopolitical terms, a unique case that can't be viewed through a purely financial lens. Most important, Argentina's bilateral debt is negligible compared with the amount it owes the private sector; in Iraq, it's the other way around.
Between now and the year-end the world might be given a clear demonstration of what it means, in practice, for a country to owe tens of billions of dollars to other countries, rather than to bondholders. If Iraq can start moving towards a deal while Argentina remains in an unhelpful standoff with its own creditors, it's likely that the whole debate over some kind of formal mechanism to deal with private-sector sovereign debt will start all over again.
At least one senior London Club personage (albeit one on Argentina's payroll) has declared that whatever market-based solutions exist are clearly insufficient, in the light of what's been going on in Argentina, and what is needed is some kind of formal sovereign bankruptcy regime.
If Argentina's exchange offer is widely considered a failure, then such opinions are likely to start being heard more widely, and there's a good chance that the IMF might start dusting off its mothballed and widely hated proposal for a sovereign debt restructuring mechanism (SDRM).
But in order for people to start thinking along such lines again, it seems likely that another country, one without an enormous collective action problem, is going to have to show what a defaulted sovereign nation is capable of when there aren't lots of bondholders getting in the way.
Enter Iraq.
At the beginning of May, the UN Security Council unanimously passed Resolution 1546, endorsing the formation of an interim government in Iraq. The resolution gave clear legitimacy to the interim government, giving it a small number of clearly defined jobs. It has to hold elections by the end of the year, or in any event by the end of January; and it has to develop Iraqi security forces. Finally, there's paragraph 28. The UN, it says: "Welcomes the commitments of many creditors, including those of the Paris Club, to identify ways to reduce substantially Iraq's sovereign debt, calls on Member States, as well as international and regional organizations, to support the Iraq reconstruction effort, urges the international financial institutions and bilateral donors to take the immediate steps necessary to provide their full range of loans and other financial assistance and arrangements to Iraq, recognizes that the Interim Government of Iraq will have the authority to conclude and implement such agreements and other arrangements as may be necessary in this regard, and requests creditors, institutions and donors to work as a priority on these matters with the Interim Government of Iraq and its successors."
The bit about the government having "the authority to conclude" a debt renegotiation is crucial. After all, come the start of next year, the interim government will not exist any more. So if it's going to conclude a debt deal, it's going to have to do it quickly.
Linking debt relief to security
There are a lot of reasons why it is in the interests of Iraq's creditors – and Iraq itself – to do a deal sooner rather than later. The UN resolution is foremost among them: it erases any doubt about the legitimacy of the interim government to negotiate the country's debts, and expresses the goodwill of the international community towards writing down the debt stock.
Moreover, Iraq's interim government has been appointed rather than elected, which means that it has little in the way of rhetorical obligations to its constituents – it has no reason to hold up a deal for the purposes of political posturing, as some accuse Argentina of doing.
Iraq has $2 trillion of oil reserves, more than enough to attract investment in new infrastructure. But that investment won't come unless and until the sovereign debt situation has been worked out, which means that Iraq has a strong incentive to cut a deal as quickly as possible.