The current debate over how to finance Greece has again put the spotlight on the unsustainable buildup of sovereign debt in the periphery and led to calls for a comprehensive strategy for official sector involvement (OSI). Until now, creditor countries have resisted OSI, establishing “red lines” that lead them to ad hoc and temporary efforts to reduce debt levels and fill financing gaps. These efforts buy time, but don’t address fundamental concerns about debt sustainability, build market confidence, or maintain public support for painful austerity. Resolving the European crisis will require concrete measures to deal with the large and growing European sovereign debt overhang, sooner rather than later.
Fortunately, we have a model for dealing with a debt overhang that has worked well--the “Paris Club”, the informal group of official creditors that since 1956 has met to deal with payment problems of emerging market debtor countries. For countries in crisis, the Paris Club provides rescheduling of sovereign debt owed to official creditors for either a defined period (a flow rescheduling) or a set date (a stock approach).
While the Club’s operations, geared as they are to low and middle-income countries under International Monetary Fund (IMF) programs, will on the surface seem ill-designed for large, complex industrial economies of Europe, I would argue that the Paris Club has three principles that should be central to the European approach.
First, it has a set of rules for the terms of restructuring based on the countries’ income and debt level that is known in advance. These rules are named for the city where they were agreed–-Houston, Naples, Cologne--though in practice the scale of debt relief will depend on a case-by-case assessment of the financing need of their program.
Second, Paris Club restructurings are conditional on a proven record of performance under an IMF program. In the European context, there is an unfortunate but real stigma associated with IMF programs and conditionality, but nonetheless making relief conditional on performance (in this case under an EU program) is essential to address legitimate moral hazard concerns.
The third key principle is seniority for new lending and for trade finance. The Paris Club sets a “cutoff date” and the restructuring, as well as any future restructuring, will apply only to debt originally contracted before that date. This means that new lending is, in practice, senior to old debt, which is critical to creating an environment for capital to return to the country.
If such a framework were in place in Greece, the IMF would not be in the unenviable position of approving a review that so clearly fails its financing assurance and debt sustainability tests, and the troika would not be deadlocked over OSI.
European leaders understandably are concerned about the costs of setting precedents when dealing with the crisis of the moment, as well as associating with a crisis management approach known for low-income emerging markets. But the costs of inaction are growing too large. Europe needs a Paris Club for European debt. Call it a consultative group if needed; hold it in Berlin, Amsterdam or Brussels (though it would be a shame not to take advantage of the French existing expertise and infrastructure). But the sooner these rules are established, the sooner we can see a return to voluntary capital flows.