For more on the Kurdistan Region’s debt crisis, see “Kurdistan Region’s Debt Crisis Threatens Iraq’s Economy.”

While it’s understandable that Baghdad is reluctant to help the semi-autonomous KRG dig out of its financial problems, Iraqi leaders might draw inspiration from financial leadership of Alexander Hamilton in the early days of the United States.

Hamilton, the first U.S. treasury secretary, convinced Congress to assume the unsustainable debts of the individual states—debt incurred to fight the Revolutionary War. The move helped bind the new country together and signaled to foreign and domestic lenders that the U.S. would be a good credit risk. Similar to Iraq today, the states’ debt levels varied widely and the decision of the federal government to assume their burden was bitterly contested by those with relatively smaller obligations.

The KRG is saddled with at least $17 billion of debt, probably more than the region’s GDP, as a result of economic blows since 2013 that include tumbling oil prices, fighting the Islamic State, and the central government retaking oil wells around Kirkuk that the KRG had seized in 2014 to block their capture by the Islamic State. Baghdad also sharply reduced revenue sharing with the KRG in a politically charged dispute over the calculation of the KRG’s share. So far Baghdad has disavowed any responsibility for creating or resolving the Region’s debt problem.

Economic Implications

Yet it is virtually impossible that the KRG can handle payments on debt of that magnitude, and a KRG bankruptcy would have serious implications for Iraq’s economy at large. It would undermine foreign investment, the business climate and Iraq’s improved perception as a sovereign risk—all coming as Baghdad seeks to finance recovery from the enormous damaged caused by the war against the Islamic State.

Baghdad would not necessarily need to take full responsibility for the KRG’s existing debts to conclude an agreement with KRG creditors. Iraqi authorities might consider helping the KRG reach a grand bargain that benefits the regional government and Baghdad, and gives creditors an incentive to accept a substantial write-down and rescheduling of the debt.

Baghdad could, for example, offer partial debt guarantees, particularly if the KRG were willing to adopt more transparent budget and revenue policies—a sore point with the central government. The KRG would still need to service the debt from its own funds, but that would be more feasible after a restructuring and having the KRG’s revenues buoyed by KRG-Baghdad compromises on fiscal transfers and oil. The creditors might accept such a deal: It’s highly unlikely the KRG will ever pay 100 cents on the dollar and a Baghdad guarantee would substantially improve the creditworthiness of their debts.

Negotiating with Creditors

To find a way through the KRG’s labyrinth of creditor claims, the best approach for the KRG—hopefully with Baghdad’s support—would be to negotiate separately with each class of creditor, particularly given the varying degrees of leverage they have on the KRG and Baghdad.

KRG Employees: The most compelling creditor class may well be KRG employees; paying their back wages will promote political stability and national unity. The political moment may be propitious for enlisting Baghdad’s assistance here: As the parties maneuver to form a new ruling coalition, they will likely need Kurdish allies, putting the Kurdish lawmakers in a strong position to bargain for Baghdad transfers to cover unpaid KRG salaries. Though Baghdad may insist on additional auditing to justify the KRG’s payroll, the new government would earn considerable goodwill and ease the hardships of ordinary Kurdish citizens by making these employees whole.

Rosneft: Baghdad’s reported talks with Rosneft reflect the Russian oil company’s position as probably the most powerful of the KRG’s creditors. Rosneft, which has considerable international clout, is now the primary shareholder in the Kurdistan Region section of Iraq’s only functioning pipeline to Turkey. Additionally, the company is close to Russian leaders who Baghdad would like to cultivate.

Turkish Creditors: Baghdad also cannot easily ignore the KRG’s Turkish creditors, which include a state-owned company owed transit fees for oil shipped through the Turkish part of the pipeline. The KRG has debts to other Turkish oil-sector companies that have close ties to the Turkish government. Only by working with Rosneft and Turkish creditors will Baghdad be able to ensure that oil exports from the Kurdistan Region flow to market and produce revenue for the Iraqi government. Analysts recently estimated the pipeline carries about 330,000 barrels a day. An agreement between Baghdad and the KRG on transit fees would allow an additional 300,000 barrels of Kirkuk oil to flow through the KRG-controlled pipeline. Reaching a compromise on Kirkuk oil transit fees would benefit the central government, the KRG and Rosneft.

International Oil Traders: The KRG reportedly pre-sold billions of dollars of oil exports to major international oil trading companies such as Glencore and Trafigura. These companies may be forced to settle for a less attractive restructuring of their claims, as they lack the Turkish creditors’ control of a pipeline or Rosneft’s Russian-backed heft and shares in the Kurdistan pipeline. However, Iraqi authorities may wish to play a role in assisting the KRG reach an understanding with this class of creditors since they are major players in international oil markets.

Central Bank Branches: Another class of KRG debt is owed to the Erbil and Sulaimaniyah branches of the Central Bank of Iraq, which the KRG pressured into extending credit without agreement from central bank headquarters in Baghdad. Despite this history, the central government will need to plug the hole in the central bank’s balance sheet arising from these uncollectible loans, reportedly well in excess of $4 billion. Unlike the other types of debt, both sides here are Iraqi public-sector institutions. Resolution may best be achieved through a restructuring that commits the KRG to repay the central bank over time

Power Company: The KRG has reportedly run up considerable arrears to Mass Global, the independent power producer that serves most of the Region and Kirkuk. If Baghdad does not work with the KRG to reach a financially sustainable arrangement with Mass Global electricity service could be jeopardized. With the KRG’s public-sector employees already demonstrating in the streets over unpaid salaries, is it really in Baghdad’s interest to further destabilize the Kurdistan Region and Kirkuk—and risk additional power cuts??

Oilfield operators: Foreign, private oil companies operating in the Kurdistan Region have far less influence in Baghdad. The central government considers these companies’ contracts in the Region illegal and is unlikely to be sympathetic to their claims as creditors. At the same time, the KRG has managed to maintain financial relations with these companies through an agreement reached in August 2017 by which the KRG ceded its own share in oilfields and eased other conditions for the operators.

Other private creditors: The remaining creditors, especially Kurdistan-based firms in sectors less critical than oil or power, may have the least influence with Baghdad and be vulnerable total write-offs by the KRG. Nevertheless, for the sake of stability and to avoid damaging the business climate and economy of the Kurdistan Region—and, by extension, Iraq as a whole—these creditors, too, should receive at least a percentage of their claims. In the case of these creditors responsibility would probably fall entirely to the KRG.

Iraqi Financial Successes

By working with the KRG to resolve the region’s debt crisis, the new government in Baghdad can continue improving Iraq’s standing as credit risk.

Iraqi authorities managing the country’s finances can take pride in their accomplishments over the past two years. Even as Iraq faced sharply lower oil prices from 2014 to 2017, the government won approval of an IMF lending facility in December 2016, a key signal of macroeconomic stability and credibility. In February 2017, Iraq issued $1 billion in U.S.-guaranteed debt, the country’s first international bond in memory. Six months later came a second $1 billion bond issue, this one relying solely on Iraq’s own credit.

Iraq’s credit standing today represents a dramatic turnaround from the Paris and London club agreements of 2005, which forgave most of Iraq’s Saddam-era debt. It can be attributed to both sides of the ledger: oil production and restraint in borrowing. According to IMF estimates, in 2016—at lower oil prices than at present—Iraqi government debt totaled 66.9 percent of GDP with external government debt at only 39.3 percent. These are manageable levels by international standards, particularly given Iraq’s large proven oil reserves.

If combined with resolution of disputes over oil and fiscal policies, Iraq can afford to help pull the KRG out of its financial hole. It’s in the national interest to do so. Having done the hard work of boosting Iraq’s standing as a sovereign credit, the new government should make every effort to prevent the KRG’s debt from tarnishing the country’s much-enhanced financial reputation and turning into a drag on Iraq’s economic promise.