After the Tsunami, Flexible Debt Relief is Needed

Lex Rieffel

The Indian Ocean tsunamis have generated a flurry of proposals to reduce the burden of external debt owed by the stricken countries. These proposals raise a host of public policy issues including conditionality, precedent and fairness. An especially thorny issue is burden sharing by commercial lenders.

The Paris Club group of rich creditor countries met this week for a preliminary discussion of tsunami debt relief. The statement issued on Wednesday and comments by officials involved in the meeting indicate that the Paris Club creditors are prepared to make an exception to their longstanding burden-sharing rule. The application of this rule in recent years has become increasingly problematic. Now is a good time for the Paris Club to adopt a more forward-looking approach to burden sharing by commercial creditors.

Rules for extending debt relief to developing countries evolved informally in the 1950s and 1960s when almost all of their debt was owed to aid and export credit agencies in the industrial countries. The rules were codified in the 1970s when many borrowing countries had problems meeting debt service obligations to commercial banks that had participated too eagerly in recycling petrodollars. One fundamental rule was “comparable treatment”: countries obtaining debt relief from creditor governments (through the Paris Club process) were required to obtain comparable relief from their commercial bank creditors.

This rule was enforced flexibly during the 1980s debt crisis. Although controversial at the time, in hindsight it was a sensible element of the work-out strategy that set the stage for the explosive growth of private capital flows to emerging market countries after 1990. Over the past 15 years, private lenders and investors have provided more than 90 per cent of the net capital flows to the big borrowing countries. Since 1998, 100 per cent of these flows have come from private sources because the borrowing countries have been making net repayments to institutions such as the International Monetary Fund, the World Bank and Paris Club creditors. In 2004, net private flows were in the order of Dollars 226bn (Euros 170bn) against Dollars 20bn of net repayments to official institutions, according to Institute of International Finance estimates. In the context of this reversal of official and private flows, strictly applying the comparable treatment rule no longer makes sense. The case for a new approach to burden sharing by commercial creditors rests on four observations.

First, the emerging market countries are increasingly dependent on private capital flows to fuel their economic growth, and these countries are increasingly the engines of global growth. Forcing Indonesia, Sri Lanka, and other tsunami-stricken countries to seek comparable debt relief from their commercial creditors will limit the private financing they will be able to attract for several years at least, and will raise the cost of borrowing for most if not all other emerging market borrowers. Ultimately it will also harm growth in the industrial countries.

Second, commercial banks provide less than half the net private lending to emerging market countries. The greater part comes from bond financing. Restructuring bond debt is much more complicated and costly than restructuring commercial bank debt. The process is a nightmare that every country should avoid if possible.

Third, unlike government aid and export credit agencies, commercial banks and bondholders do not lend for political or humanitarian reasons. They are part of a global market that directs private savings to where it can be used most productively.

Fourth, the strict application of the comparable treatment rule in the late 1990s was a political reaction to accusations that the US and other creditor-country governments were “bailing out” private investors and lenders in the financial crises that hit Mexico, Thailand, Russia and others. While these accusations were unsupported by rigorous analysis, they were hard to disprove. As a result, the official strategies for resolving these crises were confused and unbalanced. It is time the public sector re-asserted its leadership in crisis management.

Debt relief for tsunami-impacted countries is good medicine. Insisting on comparable relief from private creditors, however, would be like mixing aspirin and antifreeze. Over the years the Paris Club has shown commendable flexibility in response to changes in the international financial system. Let us hope its members take advantage of this opportunity to adopt a more sensible form of comparable treatment.