Iraqi Bonds and the Effects of the Surge-Becker

Michael Greenstone of MIT had the excellent idea of using financial data to provide information on what global investors believe about the viability of this government. In an unpublished article revised on September 18th of this year, he uses data on movements over time in the yields on Iraqi bonds issued in 2006 by the present Iraq government to assess what investors believed about the prospects for success of the "surge" in American military personnel that began in mid-February, 2007. He shows that yields remained at about 9.6 percent from the beginning of the surge in February to midsummer, then climbed to 11.5 percent in August, and was at that level when he finished his study. What can one make out of this analysis? The bonds were issued with a 5.8 percent annual yield, which seems too low, given the high risks of a default by this government, and that high yield bonds (junk bonds) typically provide considerably higher yields. So not surprisingly, these Iraqi bonds have been priced in the marketplace at a considerable discount in order to yield to buyers returns that are much higher than 6 percent if the government manages to pay both the interest and principal (due in 2028). I agree with Greenstone and Posner that prices of these bonds offer a valuable way to determine expectations about the stability of the Iraqi government held by the savvy investors in the international bond market who are placing substantial financial resources at risk. This does not mean that these investors are never wrong, or do not change their views as the evidence unfolds, but rather that bonds prices offers relevant information about the assessments of Iraq's future by persons who have an important financial stake in whether they are right or not. 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. Another consideration relates to the ability of bond prices to accurately reflect what is happening to risk. Suppose investors and others believe that the surge has greatly improved the average financial and other prospects of Iraq, including the stability of its government. However, it is plausible that the riskiness of these outcomes has increased because of growing uncertainty about America’s commitment to continue its involvement, and the greater chaos that might follow if the surge failed. On this view, the surge could have improved by a lot the average outcome expected for Iraq in the future, while at the same time it would have increased the likelihood that the government would fail, and that bonds would go into default. Since the best that bondholders can do is receive interest and principal, while the worse is default on either or both these classes of payments, any increased risk produced by the surge would lower bond prices and raise yields even if expected outcomes greatly improved. A more appropriate way to assess the effect of the surge on expectations about the economy, and presumably indirectly about the stability of the government, would be to examine changes in valuations on the nascent Iraq stock exchange. Greenstone discusses trying to do that, but gave up because few stocks are traded, and trades are highly irregular. Since the market is very thin, it is hard to reach any strong conclusions, but I have the impression from a few reports that prices of stocks on the Iraq stock exchange have risen in recent months. Whatever the final conclusions about the evidence on the political future of Iraq provided by its bonds, financial markets are an underutilized source of information about the expectations of investors about political outcomes. To be sure, financial expectations can be very wrong. For example, Eugene Lerner has shown that the Confederate currency did not depreciate very rapidly (relative to the growth of the money supply) until only a few months before the end of the Civil War, even though historians are unanimous that the South had effectively lost the war long before that. Still, I generally would have more confidence in the accuracy of the expectations of persons with a serious financial stake in outcomes than in the forecasts of most others who express their views on future political outcomes.

Comments

[Rick Chaney, Ph.D.]

"Michael Greenstone of MIT had the excellent idea of using financial data to provide financial information on what global investors think about the viability of this government" is not accurate.

A review of Professor Greenstone´s paper will show that the "excellent idea" came directly from an earlier piece written by a graduate student in economics at U.C. Berkeley, Eric Chaney (see http://ericjustin.chaney.googlepages.com/iraqpaper2.pdf.). The first version of this paper dates from November, 2006, and was presented at the NBER conference in July, 2007.

[owinok]

This is an informative post for the reason that it recognizes the real value of information markets but urges caution regarding the interpretation of that information. There's the tendency to overstate the utility of information markets and this would be a dispassionate reading to advise that the results may not be amenable to accurate interpretation at a given moment.

[Anonymous]

Professors Becker and Posner,

what do you think about banning private possession of handguns?

Most of the countries have these kind of laws.
And probably as a consequence they have less students killed by them. Economically it seems that the USA as a whole would benefit from banning handguns.

Thanks

[DGG]

I like the paper, I like the idea, I like the post. It's just kind of funny that the paper gets so much attention from academics. The idea is really old. It's just an application of the event study methodology first used, 20 years ago? Not that innovative.

[BD]

The time series of Greenstone's calculated default risk on Iraq's bonds doesn't show a sudden uptick immediately after the beginning of the "surge," but rather a rapid increase starting at about 4 months later. What were the important news developments in that period of time? Casual observation suggests that much more news was being made by Congressional calls for a timetable for withdrawal of US troops than was being made by actual reports from Iraq.

The great potential weakness of any event study is ambiguity about the actual information content of the alleged event. In this case, it seems impossible to disentangle the expected strategic impact of the "surge" as a purely military action from its expected effect through the channel of US politics. What would any bond-market participant think about the prospects for medium- and long-term US military involvement in Iraq after observing Gen. Petraeus's congressional hearings?

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