Developing countries face growing risks from financial fragility created by the COVID-19 crisis and non-transparent debt, according to a new World Bank report. As rising inflation and interest rates pose new challenges to recovery, developing countries need to focus on building healthier financial sectors.
According to World Development Report 2022: Financing an equitable recovery, the risks can be hidden because the balance sheets of households, companies, banks and governments are closely linked. Today, high levels of non-performing loans and hidden debt hinder access to credit and disproportionately reduce access to finance for low-income households and small businesses.
“The risk is that the economic crisis of inflation and rising interest rates will spread due to financial fragility. Tighter global financial conditions and shallow domestic debt markets in many developing countries are crowding out private investment and holding back the recovery,” said World Bank Group President David Malpass. “It is essential to work towards widespread access to credit and growth-oriented capital allocation. This would allow smaller, more dynamic companies – and sectors with greater growth potential – to invest and create jobs.
The global public health crisis triggered by COVID-19 has quickly turned into the biggest global economic crisis in more than a century, leading to major setbacks in growth, rising poverty rates and worsening inequality. . In response, governments have launched significant and unprecedented emergency support measures, which have helped to mitigate some of the worst social and economic impacts, and have increased sovereign debt levels – already at record highs in many country before the crisis. The response also revealed several private debt challenges that now need to be addressed urgently, including a lack of transparency in the reporting of non-performing loans, delayed management of distressed assets and less or no access to credit. for the most vulnerable households and businesses.
New world development report highlights several priority areas for action, including the early detection of financial risks. Since few countries have the fiscal space and capacity to address all challenges simultaneously, it outlines how countries can prioritize resources based on their context.
Surveys of businesses in developing countries during the pandemic found that 46% expected to be in arrears. Defaults could now rise sharply and private debt could quickly become public debt as governments provide support. Despite the sharp contraction in income and business income resulting from the crisis, the share of non-performing loans remains largely unchanged and below expectations. However, this may be due to forbearance policies and relaxed accounting standards that mask significant hidden risks that will only become apparent with the withdrawal of supportive policies.
“Before seizures, it’s often the things you don’t see that end up getting you. It is to be expected that many vulnerabilities will remain hidden,” noted Carmen Reinhart, Senior Vice President and Chief Economist of the World Bank Group. “Now is the time to prioritize early and tailored action to support a healthy financial system that can provide the credit growth needed to fuel the recovery. If we don’t, the most vulnerable would be hit hardest.
The report also calls for proactive management of distressed loans. Many households and businesses are facing unsustainable debt levels due to declining incomes and revenues. Effective insolvency mechanisms can help avoid the risk of long-term over-indebtedness and lending to ‘zombie’ firms that jeopardize economic recovery. Improving insolvency mechanisms, facilitating out-of-court arrangements, especially for small businesses, and promoting debt cancellation can help to enable an orderly reduction of private debt.
In low-income countries, dramatically increased levels of sovereign debt need to be managed in a proactive, orderly and timely manner. The historical track record shows that delays in dealing with sovereign debt overhangs are associated with prolonged recessions, high inflation and dwindling resources for critical sectors like health, education and social safety nets, with a disproportionate impact on the poor.
Finally, working towards inclusive access to finance is essential to support recovery from a historic pandemic. In low- and middle-income countries, 50% of households are unable to maintain their basic consumption beyond 3 months. The average business reports that it only has cash reserves to cover two months of expenses.
Households and small businesses are most at risk of being credit-starved, but access to credit improves the resilience of low-income households and allows small businesses to weather closures, stay in business, and ultimately , to grow and support the recovery. Digital financial tools and products can play a vital role in assessing borrower risk and providing recourse in the event of default, thereby improving credit risk management, enabling lending and fostering new economic opportunities.
The policy reforms needed to achieve an equitable recovery also provide governments and regulators with an opportunity and a roadmap to accelerate the transition to a more efficient and sustainable global economy. Climate change is a major source of overlooked risks in the global economy. Well-designed crisis response policies and longer-term reforms can encourage capital flows to greener businesses and industries.