Iraq woos bond investors as sovereign debt tightens

Iraq is beginning to open its doors again to international investors. With the country needing to raise capital to develop the infrastructure required to exploit its energy reserves, Credit looks at the role bond issuance could play in Iraq’s future.

Iraq recently came out of a destructive war, faces a political vacuum as parties try to forge a governing coalition after an election in March that produced no clear winner, and continues to suffer from major Sunni-Shia divisions. It also has no credit rating, large government fiscal and current account deficits and is hampered by inadequate infrastructure and widespread corruption.

“Iraq’s opaque bureaucracy, nascent financial institutions, widespread corruption and lack of business laws all combine to deter foreign investment,” wrote Anthony Cordesman, chair in strategy at the Centre for Strategic and International Studies, a Washington DC-based public policy research institution, in a March report entitled Economic Challenges in Post-Conflict Iraq.

“Iraq still relies on Saddam-era legislation to guide the process of investment, which brings the legitimacy of Iraqi contracts into question both abroad and at home,” Cordesman added.

To many international investors, any one of those risks would give cause for concern. But the multitude of problems cannot disguise Iraq’s potential. The country has proven oil reserves of 115 billion barrels, the third largest globally after Saudi Arabia and Iran, while analysts speculate that Iraq’s unexplored reserves could be just as large. Additionally, the current administration secured in March a $3.6 billion loan from the International Monetary Fund to help it implement a two-year economic plan.

The loan is conditional on Iraq putting in place the structural reforms it desperately needs; including improving public financial management, increasing transparency and accountability in the oil industry, and implementing reforms of the banking sector.

Assuming Iraq can make good on those plans, its future may not be as bleak as its recent past. “Iraq’s medium-term outlook remains favourable as oil production is projected to increase in the coming years, as domestic and foreign investment will start to bear fruit,” stated the IMF on granting the loan.

If Iraq is to finance the infrastructure projects it needs to exploit its wealth of oil reserves and restructure other sectors of the economy, it will likely need more funding sources than IMF loans. As well as attempting in the past 12 months – with limited success – to develop a domestic Treasury bills market, there has been speculation that Iraq could make a return to the international bond market for the first time since 2006.

Political risk

In the short term, investors will need to be convinced that the country is firmly headed along a path towards political and social stability. But, as the inconclusive result of the recent election highlights, achieving that objective is a pressing challenge.

For one thing, prime minister Nouri al-Maliki contested the election result, which saw the party of former prime minister Iyad Allawi win more votes and seats than anyone else. The result of the appeal was only a confirmation of the same result, although it also displayed the relative openness and transparency of the country’s electoral process.

“The process of forming a government could still take some time, possibly into September, and longer if the dispute over power continues,” says Julien Barnes-Dacey, Iraq analyst at Control Risks Group, a specialist risk consultancy based in London.

“The next government has to be a coalition and at this point it is hard to see who will join up with whom. Even now, more than four months after the election, the picture is no clearer.”

The prospect of political deadlock could impede the full implementation of Iraq’s economic plan. Yet a much bigger danger, according to Barnes-Dacey, is that a government is formed that excludes one of the main religious groups, sparking renewed violence. Although a unity government would be weak, it could be the least bad option.

“There’s a danger that the Sunni-dominated Iraqiya bloc, which secured the biggest vote in the election, could be excluded from power. The Sunni bloc did better than either of the two Shia-dominated blocs, but the latter two are talking about forming an alliance that would exclude Iraqiya,” says Barnes-Dacey. “That said, there is a deep-rooted dispute over who should be prime minister, which means any Shia alliance could collapse fairly quickly.”

It is, he explains, quite possible the Shias could try to exclude the Sunni bloc given their resentment of the Sunni domination of power during the Saddam years, when Sunnis held all senior government positions. Moreover, Iran, a major Shia sponsor of Iraq, would strongly oppose a Sunni-led government. Which begs the question, who would be the best leader for Iraq at this important, chrysalis stage?

“I don’t think there is a best answer at this time. The worst best answer could well be some kind of national unity government that brings everyone into the tent and doesn’t foment bitterness on the basis of marginalisation. But the result of that will be a weak government that is unable to rule effectively due to ideological divisions,” says Barnes-Dacey.

“The prime minister, Nouri Al-Maliki, and the head of the Iraqiya bloc, Iyad Allawi, are ideologically close. Both are looking for a strong, central, non-sectarian state, so in terms of a coherent, strong government they would work well together. But personal animosity will probably prevent them from unifying,” he adds.

Oiling the wheels

There is plenty of work for the new government to do. Iraq lacks sustainable provision of essential services such as electricity, clean tap water and sewage treatment. In the immediate years ahead, it will be utilities and infrastructure that receive special attention. Whether it can afford to get those basics working properly will depend on Iraq’s big asset, oil.

“Other than oil, I don’t think Iraq is exporting anything at the moment. It is importing from the likes of Turkey but oil exports could start increasing significantly in the next couple of years. The government says its want to increase oil production from 2.5 million barrels a day to 12 million barrels a day in six years,” says Barnes-Dacey.

At 2008 levels (and global production is not thought to have changed much since then), 12 million barrels would have accounted for one-seventh of global oil production. But Barnes-Dacey doubts whether Iraq’s goals are achievable without major improvements in the infrastructure of the petroleum sector and the arrangements it has with the oil-producing body, Opec.

“It’s not going to happen. Absolutely no chance. The best-case scenario is probably about seven or eight million barrels a day by 2020. But then you have to think about Opec too, so there’s a whole host of issues to be considered.”

Iraq is not currently operating under Opec restrictions. The cartel has given the country carte blanche to sell as much as it can to help build up the economy. But, notes Barnes-Dacey, that will change once Iraq’s production spikes to five or six million barrels a day.

One positive aspect for Iraq is that it has been able to secure favourable deals with international oil and gas majors in the past 12 months. Companies such as BP, ExxonMobil, Shell, Nippon Oil, Eni, Petronas and the China National Petroleum Company have all signed 20-year service contracts to develop Iraqi oil fields, and on terms that are favourable to Iraq.

“All the major companies agreed to sign service contracts, in which they accept a fee for each barrel produced, rather than production-sharing contracts, in which the company holds an equity stake in the venture,” wrote Cordesman in his March report.

The money Iraq generates from those deals could – if used prudently – have implications for the entire economy. “Those are huge contracts,” says Barnes-Dacey. “Iraq needs to rebuild its roads, ports and communication links. In terms of employment and investment this should dramatically transform the country. It is a disaster in the south of Iraq at the moment in terms of infrastructure, public services and the general shape of the country. That should be transformed by oil money.”

“Besides,” he adds, “there is a big population and traditionally a very educated middle class. There’s no reason why this oil surge should not mean a boom in other investments, whether it’s construction, telecoms or manufacturing. The whole country needs to be rebuilt and that goes from oil to schools to factories to electricity to bathtubs.”

With so many investment possibilities, and given the low base from which the country is restarting, ensuring a level of security that will allow the economy to develop and comfort international investors that their investment is safe is a major priority.

“Security is the number one objective and then Iraq needs a stable political system if you are going to attract wider investment. But oil companies are going in even without political stability because the returns are so huge. Those companies and the companies linked to them have good prospects,” says Barnes-Dacey.

Bond prospects

The bond market could yet play an important rule in supporting Iraq’s future funding needs. Currently the sovereign only has one bond issue outstanding: a $2.7 billion 2028 amortising issue completed in January 2006 that was part of the restructuring of Saddam-era debt. It was heavily discounted to allow for a yield of 10%, but despite the political insecurity, has performed relatively well in the secondary market in recent months. On August 18, the bond was yielding 7.06%, well inside the 8.28% yield the bond offered as recently as May 25.

That might seem rich when benchmarked against the likes of Pakistan, which has a 2036 bond trading at 10.24% on August 18. But according to Ahmad Alanani, an associate director in the fixed income sales and trading group at Exotix, a boutique investment bank in London, there is still good support for Iraqi bonds on the basis of its long-term prospects.

“People will tell you Iraq is high-risk but Venezuela and Argentina are much higher-risk in terms of their bond premiums on a relative basis,” says Alanani. He is not alone in his view.

“Iraq is lower-risk than many of these countries due to its high level of fiscal and international reserves that will serve as a cushion during periods of low oil prices,” says Ashok Parameswaran, emerging markets debt senior analyst at Invesco in New York. “Take Pakistan, whose discount to Iraq is justified given the higher level of headline risk in Pakistan due to the war there and rather ineffective political leadership. But Iraq, over the years, has been moving in the right direction.”

Iraq was reportedly in discussions with investment banks for a $5 billion bond issue last year. That deal didn’t come to fruition, largely because of issues related to the restructuring of its past debts, which have still to be resolved.

At the end of 2004, Iraq’s nominal public debt was $120.2 billion, of which $38.9 billion was owed to Paris Club members. The Paris Club, formed in 1956 in response to Argentina’s debt problems, is an informal group of official creditors whose role is to co-ordinate solutions to payment difficulties facing debtor countries. It agreed to write off 80% of the $38.9 billion its members were owed, while devising a restructuring plan – which included the $2.7 billion bond – for the remainder.

Non-Paris Club members, largely Gulf countries, were owed $60–65 billion, while commercial creditors accounted for the rest, about $15 billion. Debts owed to Gulf countries have yet to be cut to manageable levels. While the UAE has cancelled all its Iraqi debt and China and Japan have cut large chunks of their respective holdings, complications remain in achieving a workable debt restructuring agreement with both Saudi Arabia and Kuwait.

“The Paris Club debt is not the problem. Non-Paris Club creditors are bound by the principle of comparability to deliver debt reduction comparable with what the Paris Club has done. But those negotiations have been much slower,” says Stuart Culverhouse, Exotix’s chief economist and head of research in London.

His colleague Alanani sees Middle Eastern governments as the most likely purchasers of future Iraqi bonds. But it will be hard for Iraq to issue fresh debt in the region until Saudi Arabia and Kuwait relent over surviving Saddam-era debt – which Iraq still owes them.

“The UAE cancelled all their debt to Iraq in July 2008 and there’s talk of Qatar following suit soon, but the Kuwaitis and Saudis are holding this toughness and refusing to cancel. However, there are plenty of good noises coming out of the government in Iraq about its talks with the Kuwaitis and the prospect of potentially rescheduling or cancelling some of this debt,” says Alanani.

There is also, he adds, a question over the premium at which Iraq is trading relative to other Gulf countries. Iraq has been servicing its 2006-issued debt successfully thus far, but if it were to come to market again with a shorter duration bond, there might be questions asked over political risk.

A deficit of trust

And there are certainly new funding needs for Iraq to worry about. Its debt-to-GDP ratio is just over 60% and, if the imminent final leg of the Paris Club restructuring is agreed, that should shrink to 30%. But Iraq’s fiscal deficit (of close to 19% of GDP) and current account deficit are also major concerns.

“It’s the fiscal deficit that’s the big worry,” says Culverhouse. “And the current account deficit is of a similar order this year. The financing of that may possibly come through the foreign direct investment of the oil majors. But I don’t think we’ll see that for a couple of years while waiting for the political situation to calm down. So they need to bridge to that point.”

Culverhouse is encouraged by the recent rolling out of the IMF loan, but is nevertheless concerned over the size of Iraq’s financing needs in the near term. What may prove to be Iraq’s salvation in this area, he thinks, is the oil price, which is likely to be above what the government has budgeted for.

But there is fresh bond issuance to consider yet, given the size of the budget deficit. The government has already embarked on a domestic bond issuance programme, but there is a low ceiling on how much it can raise through that route, given the limited institutional investor base.

In its most recent issuance in June 2010, Iraq’s central bank was hoping to raise 200 billion dinars ($180 million) but the final order book only totalled 110 billion dinars. In fact, demand for dinar-denominated bonds issued by the central bank has tailed off markedly this year. After a 200 billion dinar deal issued last December was oversubscribed, an offering of the same amount in February only generated 100 billion dinars of orders.

Despite this, Culverhouse believes a new 10-year international offering is not beyond Iraq. While acknowledging that the ongoing political uncertainty and financing of its deficit present major challenges, he says investor concerns may be allayed to some extent by the conditions attached to the IMF loan, which “provides some external discipline”.

Moreover, there is evidence investors are increasingly encouraged by Iraq’s recent trajectory. “Over time we have seen levels of violence in Iraq steadily decline. The level of political uncertainty is high and transparency and governance need to improve if Iraq is to strengthen its investment profile,” says Invesco’s Paramasewaran. “However, Iraq’s political risk is offset to some extent by strong official reserves and fiscal savings. The yield on its sovereign bonds is attractive.

“It would make sense for Iraq to get a credit rating,” he adds. “As budget execution continues to improve, external debt issuance will likely grow. Having a credit rating will make it easier for investors to buy Iraqi debt. In addition, getting a rating will help to impose some market discipline on the authorities.”