More on Iraqi Bonds and the Surge

A couple of heavyweights share their thoughts on Michael Greenstone's Iraqi bonds research which showed that investors seemed to believe the prospects for Iraq's post-war government had grown dimmer since the surge.

Here are excerpts from Richard Posner, an appeals court judge, and Nobel laureate Gary Becker via their blog.

Posner:

It seems unlikely that the surge itself would increase the risk of default, though it might, by enabling both the Sunnis and the Shiites to rest and augment their forces for the eventual showdown, taking advantage of a kind of truce imposed by the additional American troops. More likely, the bond traders see the surge as a desperate last gamble by the United States; as a preclude to U.S. withdrawal and specifically as a sign that the United States will withdraw soon after the next Presidential election, whoever wins the election; as a political gimmick; and as a failure in the aim of the surge of promoting progress toward a political settlement that will enable Iraq to be a functioning nation when we leave. If, as the bond traders fear, Iraq is likely to be divided well before 2028 into three separate nations (Kurdish, Sunni, and Shiite), a default is likely.

And more:

The only (though major) significance of Greenstone's bond market study, so far as our situation in Iraq is concerned, is that it is evidence that the surge, while it has reduced the number of deaths in Iraq, has not increased the viability of the Iraqi state, but instead has revealed (possibly even contributed to the prospect revealed) that the attainment of viability is increasingly unlikely.

Becker:

The additional evidence available since Greenstone's September study provides a more optimistic assessment than at that time of how the surge is going. Both American military and civilian casualties are way down during the past two-three months-Greenstone also refers to such data up until the end of August- and civilian life in Baghdad has returned to a semblance of normality for the first times in a few years. Explosions, mortar attacks in Baghdad, and bombings all declined by a lot in recent months. As a result, Iraq bond prices have also rallied significantly, so that their yields are down to about 10.5 percent recently. This is still about 10 percent above yields in February, but the additional premium has been reduced from almost 2 to a little less than 1 percentage point.

Several commentators have emphasized that the steep decline in Iraqi bond prices and corresponding increase in yields that began in August coincided with the beginning of the credit crunch, which significantly raised interest rates on all bonds. The crunch especially raised rates on riskier bonds, so it is not surprising that highly risky bonds like those issued by the government of Iraq should have fallen greatly in value starting in August. To correct for this, it would be valuable to compare Iraq bonds with bonds of comparable risk. Some traders have suggested comparisons with bonds issued by the government of Lebanon since that government's stability is also highly uncertain. Apparently, Iraqi bonds have outperformed Lebanon's since the beginning of the surge.

This would suggest that the surge may be having a positive effect on investor's expectations about the viability of the Iraqi government, at least relative to the viability of other governments with questionable stability in that most unstable region. However, Greenstone in his paper, and in some updated calculations of his that he sent me, prefers to use not a single country's data (a single country could be biased by choice of country), but an index of emerging market bonds. The gap between Iraqi yields and emerging market yields did decline noticeably from September, but the gap is still much larger than in February.