4. Fiscal Impact of Businesses of the State and Principles of State Support Introduction The fiscal implications of state ownership are significant. Businesses of the state (BOSs) are often tasked with providing services that generate important benefits (chapter 1). The fiscal costs of BOSs include regular fiscal injections from the budget, in theory to compensate BOSs for their social role. Fiscal risks from BOSs include explicit contin- gent liabilities—largely debt guarantees—and implicit contingent liabilities, such as when fiscal injections are needed to recapitalize state-owned banks.1 Liabilities gen- erated by BOSs are a major concern for the overall debt exposure of governments (World Bank 2022a, 2022b). Even before the recent COVID-19 crisis, many low- and middle-income countries had accumulated debt burdens, pushing them into high risk of debt distress and lead- ing to underinvestment and slow growth. During the financial crisis of 2008, govern- ments channeled resources into the financial sector and other hard-hit sectors to avoid an even worse economic downturn. The COVID-19 pandemic further expanded state support2 for specific sectors and firms, including BOSs, adding to the financial stress of governments (Freund and Pesme 2021). Today, countries find themselves with limited fiscal space and greater macroeco- nomic vulnerability, in part due to state support provided during the pandemic. This chapter examines the fiscal impact of BOSs and illustrates the extent of state support to BOSs as part of the fiscal response to the recent COVID-19 crisis. It  provides new evidence on state support and distills policy principles for the design of  state support. ■ BOSs can pose large fiscal costs and risks. BOSs in many countries have a sig- nificant share in public sector balance sheets, reflecting their important role in the economy and in development.3 Despite the significant fiscal risks posed by BOSs, measuring the scope, performance, and associated risks of BOS portfo- lios across countries is difficult, given the dearth of publicly available data and the heterogeneity of ownership structures and state support measures. 67 ■■ Examples of the fiscal impact of state support to BOSs and private firms during past crises show that such ­support comes with benefits but is also associated with costs and risks. When comparing the benefits of state support to BOSs and pri- vate firms, BOSs are more likely to maintain their employment during crises than private firms. The evidence is mixed about whether BOSs maintain invest- ment better than private firms d ­ uring crises. And there is little evidence that BOSs support growth, although the institutional e ­ nvironment affects whether BOSs have positive or negative impacts on growth. But state support to BOSs and private firms is costly and can exacerbate fiscal pressures; it can also hamper long-term growth by distorting competition, undermining corporate gover- nance, and leading to collusion, ­corruption, and moral hazard. ■■ State support to BOSs and private firms needs to be designed and implemented in a way that minimizes costs and mitigates downside risks and potentially dis- tortive impacts. Key policy principles of such state support include having clear objectives and prioritizing support, selecting the least distortive instruments, ­ improving targeting and transparency, and including explicit sunset clauses and exit strategies. Fiscal Risks Stemming from BOSs Estimating Fiscal Costs and Risks In countries where state-owned enterprises (SOEs) represent a large share of economic activity, they can pose risks to public finances (IMF 2021b). The important role of SOEs in those economies is reflected in their substantial portion of public sector balance sheets. SOEs account for the lion’s share (66 percent) of publicly financed infrastructure projects in low- and middle-income countries, making up 83 percent of the total financing for infrastructure projects (World Bank 2017).4 The net liabilities of financial and nonfinancial public sector corporations in public sector balance sheets are equiva- lent to an estimated 12 percent of GDP in El Salvador, 21 percent in Indonesia, and 33 percent in Kazakhstan (IMF 2020a). For 14 countries in Sub-Saharan Africa, SOE revenues average 7 percent of GDP, SOE assets average about 34 percent of public ­ sector assets, and SOE liabilities average about 20 percent of GDP (figures 4.1 and 4.2) (Harris et al. 2020). When risks materialize, they often have major and lasting implications for fiscal deficits and debt as well as for the conduct of fiscal policy, and they can lead to economic and financial crises.5 Of 230 contingent liability episodes during 1990–2014 ­ across 80 low-, middle-, and high-income economies, SOEs were the third most common source of contingent liability—with 32 episodes—that governments were ­ called on to cover (Bova et al. 2016). The fiscal cost was equivalent to 3 percent of 68 The Business of the State FIGURE 4.1  SOE Liabilities in Sub-Saharan African Countries and Other Regions 30 25 20 % of GDP 15 10 5 0 Low-income Emerging market Sub-Saharan Africa Advanced economies developing countries economies Source: Harris et al. 2020, 2. Note: Debt comprises loans and debt securities, while other liabilities comprise primarily other accounts payable. Data for anonymized countries are from unpublished sources. SOE = state-owned enterprise. FIGURE 4.2  SOE Liabilities in Select Countries in Sub-Saharan Africa Uganda Ghana Senegal Kenya Tanzania South Africa Mozambique The Gambia 0 5 10 15 20 20 30 35 % of GDP Debt Other liabilities Source: Harris et al. 2020, 2. Note: Debt comprises loans and debt securities, while other liabilities comprise primarily other accounts payable. Data for anonymized countries are from unpublished sources. SOE = state-owned enterprise. GDP,  on average, reaching as high as 15 percent of GDP in some cases (Bova et al. 2016). For 17 countries in the Middle East and North Africa, including Pakistan (and  excluding the Gulf Cooperation Council members), contingent liabilities amounting to 7.7 percent of GDP emanated from explicit or implicit government ­ ­ guarantees to SOEs, the financial sector, pension systems, and obligations under public-private ­ ­ partnerships (figure 4.3 and box 4.1) (Boukezia et al. 2023). Fiscal Impact of Businesses of the State and Principles of State Support69 FIGURE 4.3  Budgetary Impact of Contingent Liabilities in Middle East and North African Countries, Cumulative 1990–2018 8 0.5 7.7 0.8 % of GDP (cumulative, 1990–2018) 7 1.6 6 5 2.2 4 3 2.6 2 1 0 Financial sector Guarantees SOEs Pension PPPs Total Source: Calculations based on IMF 2020c. Note: Contingent liability realizations pertaining to SOEs include on-budget support measures and exclude off-budget subsidies. The impact of contingent liability realizations refers to the gross payouts associated with a contingent liability realization, which captures immediate budgetary pressures and excludes any asset recoveries that are associated with the realization. PPPs = public-private partnerships; SOEs = state-owned enterprises. BOX 4.1 Fiscal Costs and Risks of SOEs in Middle East and North African Countries Troubled state-owned enterprises (SOEs) can impose fiscal costs from budgetary transfers to com- pensate loss-making a ­ ctivities, poor dividend performance, nonrepayment of loans, calls on govern- ment guarantees, recapitalizations, or asset sales below book value. They frequently receive government support through the tax system, either through formal tax exemptions or through lax tax enforcement. Institutional weaknesses often exacerbate these risks via financial burdens stemming from uncompensated quasi-fiscal activities and poor governance and accountability. In the Middle FIGURE B4.1.1  Direct Fiscal Support to SOEs as a Percentage of GDP, 2019 8 7 6 5 % of GDP 4 3 Average fiscal support 2 1 0 a nia on an an . co ep isi roc n rd ist ita .R n ba Jo Tu k ur Mo Pa ab Le Ma Ar t, yp Eg Direct loans and on-lending Budget transfer Source: Calculations based on information from national authorities. Note: SOE = state-owned enterprise. (Box continues on the following page.) 70 The Business of the State BOX 4.1 Fiscal Costs and Risks of SOEs in Middle East and North African Countries (continued) FIGURE B4.1.2  SOE Debt as a Percentage of GDP, 2019 a. SOE debt 60 50 40 % of GDP 30 20 10 0 Djibouti Tunisia Mauritania Morocco Jordan Pakistan (2020) (2018) (2020) Domestic External Total b. Government guarantees to SOEs 60 50 40 % of GDP 30 20 10 0 Djibouti Morocco Tunisia Jordan Pakistan Iraq Egypt, (2020) (2020) (2020) (2020) (2020) Arab. Rep. Of which, FX Stock of government guarantees to SOEs Sources: Calculations based on IMF 2022; World Bank 2021c. Note: FX = foreign exchange; SOE = state-owned enterprise. East and North Africa, fiscal costs and risks associated with SOEs are sizable. In 2019 alone, the 17 Middle East and North Africa countries provided, on average, 2.1 percent of gross domestic product in direct budget support to SOEs through transfers, direct loans, and on-lending (figure B4.1.1). In addition, SOEs have received substantial government guaranteed loans, either directly or through state-owned banks (figure B4.1.2), some of which have been called over the years. SOEs often engage in risky projects on behalf of governments or charge below cost recovery for their services without being fully compensated from the budget. Although these types of activi- ties may improve the fiscal deficit, they often result in SOEs having difficulty meeting their pay- ment obligations to the government, social security funds, other SOEs, or private companies. They also lead to complex cross claims between government and SOEs, hindering transparency and sound fiscal management. Source: IMF 2021b. Fiscal Impact of Businesses of the State and Principles of State Support71 Despite the fiscal risks of BOSs, measuring the scope, performance, and associated risks of BOS portfolios across countries is difficult. Weak institutional capacity, report- ing, and oversight mechanisms are key contributors to the scarcity of data. Heterogeneity in ownership and the diversity in sectors where BOSs are present reflect the wide range of government economic and social mandates. In addition, explicit and implicit man- dates for BOSs may evolve and become ambiguous over time because of shifts in politi- cal and economic dynamics. For example, few countries have a formal state ownership policy that clarifies the state’s objectives for its BOS holdings. In the absence of clear objectives, it is difficult to assess their performance, especially with regard to public service delivery and value creation (PwC 2015). Governance challenges in state ownership can also carry significant risks. For exam- ple, central government oversight of BOS borrowing activities is weak in many coun- tries, especially in low-income countries.6 Because the legal framework is incomplete or is not being implemented, the institutional setup cannot capture liabilities stemming from BOSs, and limited institutional capacity constrains the ability to analyze and pub- lish BOS debt and financial data. Evidence from 13 debt management performance assessments during 2021–22 shows that 11 countries do not have a framework for ­ managing guarantees or on-lending operations, and the 2 countries with provisions have significant compliance gaps (World Bank 2021b). In 9 countries, reporting of borrowing activities to the central government by nonfinancial public sector entities is ­ not enforced. In 10 countries, the requirement to report on nonfinancial public s ­ ector debt is not applied; in 12 countries, the legislation is silent on the role of the central government when authorizing nonfinancial public sector bodies to borrow. Key Transmission Channels of Fiscal Risks Macrofiscal risks tied to BOSs can emerge from different avenues, both domestic (unfunded mandates, heavy subsidization) and external (shifts in external demand, supply disruptions). They can entail large contingent liabilities and poor oversight, sizable and poorly governed state-owned banks, and negative productivity spillovers (Böwer 2017; Melecky 2021). Cross-BOS ownership structures and connected lend- ing can lead to large payment arrears and systemic risks. Corruption can also pose sizable risks, given the close ties between BOS stakeholders and public officials and the size and scope of BOS services and balance sheets (Transparency International 2017a, 2017b). Key channels between public finances and BOSs include direct loans (including on- lending), loans across BOSs (for example, from a state-owned development bank to a state-owned utility), loan guarantees, recapitalizations, bailouts, subsidies, transfers, tax waivers, capital spending, dividends, tax receipts, payment arrears, and implicit liabilities (table 4.1). Governments, for example, can impair BOS finances by not fully funding public service obligations or by accumulating payment arrears to BOSs as ways to 72 The Business of the State TABLE 4.1  Potential Financial Impacts of BOSs’ Flows on Public Finances Type of flow Potential impact Receipts Dividends; guarantee fees; taxes Outlays Capital spending; subsidies, transfers; recapitalization, bailouts; tax waivers, arrears Assets Capital stock; technology Liabilities Loans; guarantees; accumulated losses Source: Original table for this publication. Note: BOSs = businesses of the state. manage fiscal liquidity pressures. Such practices adversely affect BOS and public sector balance sheets and, over time, can erode the delivery of public services. For example, a BOS that has a monopoly can generate substantial revenues for the government, but its overall economic impact can still be negative. If a country’s fiscal position is heavily bur- dened by its BOS sector—say, through large net transfers and b ­ ackstopping—interest rates for public sector borrowing could rise through a loss of confidence and elevated debt rollover risks. When BOSs are responsible for large capital outlays, they can also have macroeconomic impacts on employment and growth. If BOS policies crowd out the private sector, this crowding out weakens investment, job creation, and economic growth. Selected country examples provide a sense of the order of magnitude of potential risks and macrofiscal costs: ■■ Facing a range of issues—such as insolvency, conflicting commercial and socio- economic objectives, and inadequate oversight—SOEs in The Gambia have ­provided minor revenues in recent years but required significant budget support. At the end of 2020, their total liabilities were estimated at 19 percent of GDP (IMF 2023; World Bank 2021f). Risks from loan guarantees and on-lending have materialized in the past. For example, The Gambia signed a memorandum of understanding in 2018 that converted into capital SOE debt owed to the govern- ment (mainly pertaining to on-lent external loans) equal to about 4.5 percent of GDP in 2020 (World Bank 2020b, 2022a).7 ■■ In the Kyrgyz Republic, budget subsidies to SOEs roughly equaled their tax and dividend receipts, but energy sector BOSs entailed significant fiscal pressures and risks, given their high debt, large investment needs, and a backlog of reforms. Explicit risks included public investment on-lending equivalent to 16.9 percent of GDP at the end of 2018 (World Bank 2020a, 2021d). ■■ SOE cross-linkages contributed to Slovenia’s 2012–13 crisis, when the banking system dominated by three state-owned banks holding about 63 percent of the total banking sector’s equity (IMF 2016b, 2016c), faced widespread bankrupt- cies that ate up bank capital and resulted in government loss of market access (Böwer 2017). Fiscal Impact of Businesses of the State and Principles of State Support73 ■■ For 60 countries, infrastructure SOEs required average annual fiscal injections during 2008–19 of 0.25 percent of GDP to remain afloat, illustrating that govern- ment support to SOEs can weaken their fiscal position and increase the risks of sovereign debt distress (World Bank 2023a). Illustrating the Benefits and Costs of State Support to BOSs During crises, governments assign unique roles to BOSs and to private firms, usually to stabilize economies. During the global financial crisis and the COVID-19 pan- demic, many governments deployed vast fiscal responses that included support for  BOSs and private firms to keep people employed and sustain businesses and investment. Benefits During a crisis, economies at all income levels use state support to BOSs and private  firms alike to mitigate the impacts of the crisis. Governments are under pressure to provide fast relief and short-term stability and to stop the spread of the crisis (Pop and Amador 2020a; Qiang and Pop 2020). Governments resort to BOSs and private firms to provide relief, directing them either to provide emergency goods and services or to function as channels of government support to citizens and firms. They may also use BOSs or private firms to stabilize economies by countercyclically protecting their employment and investment and maintaining the demand for inputs and final goods and s ­ ervices. In addition, they use banks to inject liquidity into the economy. To enable BOSs or private firms to provide relief and function as economic stabilizers, governments often provide them with direct or indirect support. For past crises, the evidence for whether BOSs support economic stability is mixed. BOSs perform worse in productivity or profitability than firms in the private sector during crises, particularly during the global financial crisis (Beuselinck et al. 2017; Lazzarini and Musachio 2018; Vitoria, Bressan, and Iquiapaza 2020).8 But they typically are better able than private firms to maintain employment during crises (EBRD 2020; IMF 2019, 2021b; Kopelman and Rosen 2014; Vagliasindi 2022). Still, when BOSs maintain employment during crises, they may crowd out private sector employment during the ensuing recovery. Evidence of the impacts of BOS investment during crises is also mixed (García-Sánchez and Rama 2022; Jaslowitzer, Megginson, and Rapp 2018; Jie et al. 2021; World Bank 2023a).9 In regard to growth, there is little evidence of whether BOSs support growth, although there is evidence that the institutional envi- ronment affects whether BOSs are positive or negative for growth (Coleman and Feler 2014; EBRD 2020; Szarzec, Dombi, and Matuszak 2021).10 The World Bank Group Subsidy and State Aid Tracker shows that state support granted to private firms and BOSs during the COVID-19 period involved a wide 74 The Business of the State FIGURE 4.4  State Support to Private Firms and BOSs, by Type of Measure, April 2020 to June 2021 Other, 8% Equity, 4% Grants, 22% Suspension/rebates on input costs, 4% Wage subsidy, 6% Tax advantages, 10% Multiple measures, State guarantees 19% for loans, 11% Subsidized loans, 17% Source: World Bank Subsidy and State Aid Tracker. Note: The policy tracker includes a sample of announced or approved COVID-19-related measures directed to BOSs. BOSs = businesses of the state. instruments, including subsidized loans, capital increases, deferrals of taxes array of ­ and fees, direct grants, state guarantees of loans, and deferral in the payment of con- cession fees, illustrating the fiscal impact of BOSs and the extent of state support to them (­figure 4.4).11 New evidence comparing BOSs and private firms during the COVID-19 crisis shows that, although all firms lowered employment in 2020, BOSs shed fewer jobs and registered smaller declines in wages than private firms (box 4.2). There is also some evidence that BOSs registered smaller losses in revenue than private firms, but their productivity was the same as or lower than that of private firms. Costs and Risks State support to BOSs and private firms—during crises and normal times—comes at a cost and has risks. Such measures are costly and can exacerbate fiscal pressures when tax revenues fall and spending balloons. And they can bring higher inflation that hampers a speedy recovery. In addition to fiscal costs, other risks are associated  with state support to BOSs or private firms. State support can cre- ­ ate  inefficiencies in resource allocation and market distortions, unleveling the playing field. It can also undermine corporate governance and foster corruption, moral hazard, and waste. If emergency state support is not withdrawn promptly after a crisis and if there is no clear exit strategy, state support can weaken incen- tives for a healthy recovery. The potential risks for anticompetitive behavior, cor- ruption, and moral hazard due to state support arise when directed to both BOSs and private firms.12 Fiscal Impact of Businesses of the State and Principles of State Support75 BOX 4.2 New Evidence on the Role of BOSs during the COVID-19 Crisis New empirical evidence on the COVID-19 period that was compiled for this report indicates that businesses of the state (BOSs) maintained employment and wages in Brazil (Brolhato, Cirera, and Martins-Neto 2023); Ecuador (Ferro and Patiño Peña 2023); Estonia, Latvia, Montenegro, Poland, Serbia, and Slovenia (this report); Romania (Dauda, Pop, and Iootty 2023); and Türkiye (Akcigit and Cilasun 2023). The results hold when considering employment and wage trends for all BOSs com- pared with those of private firms and when considering BOSs operating in competitive sectors compared with private firms. The latter finding suggests that natural monopoly sectors are not driving the effect and that this trend may come at the cost of crowding out private sector employ- ment and reducing allocative inefficiency during recovery periods. For Türkiye (Akcigit and Cilasun 2023) and Europe and Central Asia countries (this report), the evidence is mixed for access to credit and investment behavior of BOSs compared with those of private firms during 2020. Of 14 Europe and Central Asia countries, BOSs have higher rates of asset growth in 5 countries, whereas the difference is positive but not statistically significant in 6 others. In Türkiye, when short-term and long-term credit growth of BOSs and private firms in 2019–20 are compared, BOS short-term credit growth was significantly lower, but there is no significant difference between long-term credit growth for private firms. In Romania (Dauda, Pop, and Iootty 2023), BOSs registered smaller losses in revenues than private firms. This revenue effect is more prominent for BOSs operating in competitive sectors than for private firms in those sectors. The result is driven by majority-owned BOSs (including BOSs with 25.0–49.9 percent state ownership), directly owned BOSs, and local BOSs, suggest- ing that these categories of firms may have been less vulnerable to the pandemic effects in Romania. In Ecuador (Ferro and Patiño Peña 2023), total factor productivity was lower for both BOSs and private firms during 2020. Total factor productivity growth was 41 percentage points lower for BOSs in competitive sectors than for private firms in those sectors. Although BOSs became less productive during the pandemic, workers employed in these firms were cushioned, as worker compensation grew. This finding suggests that, during economic downturns, BOSs are potentially competitive sectors. less efficient (and more distortive) in ­ In terms of fiscal cost, in high-income countries such as Australia, Germany, Japan, and the United Kingdom, support to firms during the COVID-19 pandemic accounted for more than 10 percent of GDP. In lower-middle-income and low-income countries, additional spending amounted to 3.4 percent of GDP, and equity, loans, and guarantees amounted to about 1 percent of GDP (figure 4.5) (IMF 2021a). The International Monetary Fund estimated in May 2020 that support by countries to their firms in the form of loans, equity, and guarantees totaled US$4.6 trillion (IMF 2020b). For example, the European Commission implemented a State Aid Temporary Framework for sup- port directed to firms mirroring the framework implemented during the global finan- cial crisis.13 Between March 2020 and September 2021, the European Commission 76 The Business of the State FIGURE 4.5  Discretionary Fiscal Responses to the COVID-19 Crisis, by Country Income Level, 2020–21 Low income Lower-middle income % of GDP Upper-middle income High income 0 2 4 6 8 10 12 Additional spending and forgone revenue Equity, loans, and guarantees Source: IMF 2021a. Note: Based on data for available countries, including 15 lower-middle-income and 5 low-income countries. approved more than 650 measures providing more than €3 trillion in state support to firms. Measures included creating new BOSs and granting state support to BOSs and private firms through cash transfers, tax reductions, payment deferrals, and access to finance. This extensive state support, increased state ownership, and control of BOSs can amplify fiscal risks (OECD 2020a). Besides fiscal costs, other risks are associated with state support to BOSs or private firms—during periods of crisis or normal times. State support affects the way firms interact with their competitors and reduces competition and economic efficiency. First, when resources are channeled to inefficient BOSs or private firms, state support may prolong their life span and help them to gain market share, while more productive peers face pressure to shrink and eventually exit the market. Second, support may distort their incentives to invest in productivity-enhancing activities, given the expec- ­ tation that the state would provide additional support to failing BOSs and private firms in the future (soft budget constraints). Third, state support might help a single BOS or private firm (or a group of BOSs or private firms) consolidate its market power or even take over (existing and potential) competitors. Through these channels, state ­ support can distort the market selection process, which in turn may hamper productivity growth while generating allocative, technical, and dynamic i ­ nefficiencies (box 4.3). In the long run, these distortions could reduce market competitiveness (see also Pop and Connon 2020). The type of state support affects the level of distortions. Using the example of state support during the COVID-19 period, the World Bank Subsidy and State Aid Tracker shows that state support targeted BOSs and private firms alike, but BOS support was Fiscal Impact of Businesses of the State and Principles of State Support77 BOX 4.3 Does State Support during Crises Distort Competition? There is limited evidence on whether support during crises is more or less distortive than during noncri- sis periods. For the global financial crisis, many studies review the effectiveness of liquidity injections in improving credit conditions, but there is limited evidence of the support’s distortions in markets. For example, studies find that the US Troubled Asset Relief Program had limited impact on the activities of firms or local economic conditions (Berger and Roman 2015; Sheng 2019).a But research also finds that the program allowed banks to obtain competitive advantages (Berger and Roman 2015), with politically connected banks being more likely to receive capital injections (Duchin and Sosyura 2012). For the responses to the COVID-19 pandemic, data are limited on the actual disbursement of support to firms, and it is hard to assess the possible competitive distortions with precision. The European Commission published a study suggesting that state support disbursed during the crisis had a limited effect on competition because support measures implemented by member states were proportionate to the economic damage suffered (Mathieu Collin et al. 2022). But the analysis did not cover sector or firm distortions. For COVID-19, fiscal measures to firms provide limited information about how beneficiaries were selected. Because the schemes were largely horizontal, covering all sectors (except financial services), the actual distribution could be expected to be demand determined and directed to sectors that suffered most. But World Bank (2021e) finds that 20 percent of firms that were not affected by COVID-19 reported receiving public support, compared with 26–29 percent of firms that were affected. a. The same result was found when studying the effects of subsidies for small and medium enterprises following the Great East Japan Earthquake of 2011. Kashiwagi (2019) finds that, although subsidies were effective in the retail sector, they made no significant difference in the manufacturing and service sectors. more likely to distort markets (box 4.4). BOSs were less likely to receive deferrals of fees, costs, taxes, and payments, which are less distortionary than other measures. BOSs were more likely to receive equity injections, which can be stickier than measures such as grants or loans, particularly if they are not linked to performance targets are not limited in time and are not accompanied by sunset clauses. In the provision of state support, there is always the potential for corruption. However, irrespective of the type of firm ownership, this risk is more acute during ­ crises, given the  large scale of fiscal stimulus being disbursed in a short period and with limited oversight. The resources allocated to crisis emergency response and recovery can offer significant opportunities for illicit gains, given the need for speed and flexibility.14 Although BOSs face corruption risks similar to those of private companies, the risks are compounded by the scale of assets they control, the considerable value of public con- tracts, and their proximity to governments. During a crisis, this privileged position also may put some BOSs in a  position to secure preferential support when bailouts are decided and funds are ­ limited. BOS procurement is vulnerable to corruption and collu- sion during crises, as it is in normal times. Crises exacerbate the corruption risk, 78 The Business of the State BOX 4.4 Support to BOSs and Private Firms during COVID-19 Governments most frequently purchased equity in businesses of the state (BOSs) as part of their support (32 percent of schemes), which can be more distortionary in the long term. Private firms, by contrast, received a wider variety of less distortionary measures, such as grants (about 22 percent of schemes) (­figures B4.4.1 and B4.4.2). Capital injections, share purchases, and debt alleviation were typically directed to BOSs with high state ownership. Loans and grants more often targeted BOSs with lower state ownership, with levels similar to those of private firms (figure B4.4.3). Some countries created new BOSs during the COVID-19 crisis. FIGURE B4.4.1 State Support to BOSs, by Type of Measure, April 2020 to June 2021 Suspension or rebates Other, 7% on input costs, 4% Subsidized loans, 4% Equity, 32% Not specified, 4% Multiple measures, 12% State guarantees for loans, 15% Grants, 23% Source: World Bank Subsidy and State Aid Tracker. Note: BOSs = businesses of the state. FIGURE B4.4.2 State Support to Private Firms, by Type of Measure, April 2020 to June 2021 Other, 10% Suspension or rebates Grants, 22% on input costs, 4% Wage subsidy, 6% Tax advantages, 10% Multiple State guarantees measures, 20% for loans, 11% Subsidized loans, 18% Source: World Bank Subsidy and State Aid Tracker. (Box continues on the following page.) Fiscal Impact of Businesses of the State and Principles of State Support79 BOX 4.4 Support to BOSs and Private Firms during COVID-19 (continued) FIGURE B4.4.3 State Support to BOSs, by Level of State Ownership, April 2020 to June 2021 Capital injection Closure and mergers of SOEs Creation of SOE Debt alleviation Government guarantee Grant Loan Loan or government guarantee Loan or grant Market provision of products Purchase of shares or participation Rebate Tax deferral 0 10 20 30 40 50 60 70 80 90 100 % of BOS support 10–24.9% state ownership 25–49.9% state ownership 50%+ state ownership Source: World Bank State Aid Policy Tracker. Note: The policy tracker includes a sample of announced or approved COVID-19-related measures directed to BOSs. BOSs = businesses of the state; SOEs = state-owned enterprises. particularly when oversight and accountability measures are limited during an emer- gency response or when coupled with weak institutional frameworks. State support can create moral hazards because it can raise expectations of future support, which may weaken market discipline. For example, recipients may take on more risk in the future if past support during crises leads them to believe that they will be bailed out in the event of a crisis. Particularly in the case of recapitalizations of banks, bailouts may encourage risk-taking behavior.15 Several studies find that bailouts result in higher risk taking.16 If state support is targeted toward larger firms that are deemed essential for systemic stability, they may have more access than smaller firms to other support. There is also concern that state support disbursed during the crisis may lead to “zombie firms,” which are economically unviable but continue to operate thanks to government support. So state support should not be available to firms that were failing or had structural issues before a crisis.17 80 The Business of the State Principles of State Support State support represents a significant amount of fiscal resources with a large ­opportunity cost, requiring a careful weighing of benefits against risks. Based on the ­implementation of state support during previous crises for which relatively good data are available, key policy principles for the design of state support to BOSs and private firms—especially during crisis periods—include the need to undertake the following:18 ■■ Prioritize competing demands. With scarce public resources, governments need to consider if support to BOSs and private firms is feasible. Given limited bud- getary resources, such support may result in fewer resources for other critical areas, such as health care. ■■ Clarify objectives. Support to BOSs and to private firms must have clear objec- tives. If the mandate is to provide public services or critical goods and services, BOSs must be properly funded to fulfill their objectives in the same way as ­private firms. ■■ Ensure proportional support and competitive neutrality. BOSs should not be over- compensated to meet specific objectives, because doing so could result in market ­ distortions, especially when BOSs compete with private peers in the same market. Governments should avoid soft budgeting and create separate budgets ­ for assigning temporary and special public policies for BOSs. Competitive neu- trality should be embedded in BOS governance and operations and be an overall requirement for targeting state support to maximize the effectiveness of public interventions given limited fiscal space and to minimize market distortions. It is important to identify BOSs’ commercial and noncommercial activities through separation of accounts, careful methodologies for calculating compensation for public service obligations, and requirements to earn market-consistent rates of return in line with those of the private sector under similar market conditions. ■■ Minimize selectivity and maintain incentives. Governments should consider clear criteria  for the design and disbursement of state support to minimize distor- tions, applicable in the same way to BOSs and private firms. At the same time, state support needs to incentivize the recipient of that support to meet stated objectives. For example, if the aim of the support is to protect jobs, the support can be tied to rules for maintaining a certain level of employment during times of crisis. ■■ Select the least distortive instruments. The level of distortion introduced by state support depends on the instrument. Governments should design support measures and associated instruments considering the objective pursued in conjunction with the risk of distortions. For example, deferrals (of taxes, contri- ­ butions, interest, or payments) are less distortionary than other measures. In general, one-off and time-limited subsidy measures are less likely to have harm- ful effects. A loan typically leads to less distortion than a grant because it will ultimately need to be paid back by the beneficiary (table 4.2). The risk taken by Fiscal Impact of Businesses of the State and Principles of State Support81 TABLE 4.2  Distortions of Different State Support Instruments Competition Additional transaction costs Type of financial support distortions Moral hazard required for unwinding Deferrals (of taxes, contributions, payments for inputs) Not required Low Low Guarantees Loans High High Grants Equity (or asset purchase) Required Source: Original table for this publication. the state in guaranteeing loans can be capped at a certain percentage, and a ­minimum premium can be required. Recapitalizations can generate market inef- ficiencies and are a sticky form of support. When situations require d ­ istortive measures, such as recapitalizations,19 governments can also provide incentives for p­ rivate sector buy-in to limit competitive distortions. For example, equity injections can be combined with bankruptcy proceedings. ■■ Target support based on viability and exposure to financial distress. Targeting beneficiaries, whether BOSs or private firms, is equally important to ensure ­ that support measures are effective (table 4.3). State support to BOSs can be more distortive if BOSs in competitive and partially contestable markets are targeted and if targeting is based on select firms rather than clear objectives. ­ ■■ Set sunset clauses, and articulate exit strategies. Support to BOSs should embed clear phasing-out mechanisms to prevent long-term sticky support that distorts markets. Sunset clauses for support can also minimize the cost of the interven- tion for taxpayers if they are transparent about the timing and process for termi- nating support, which may include reversing equity participation stemming from bailouts and BOS exits. If state support includes restrictions on long-term state ownership, an exit plan should detail how government will divest the ­ company over a specified period. Transparency can reduce distortions to competition, prevent misuse of public funds, and inform fiscal risk analysis (IMF 2016a; OECD 2016; Polackova Brixi and Schick 2002; World Bank 2023b). For example, during crisis periods, public aware- ness of state support facilitates take-up by businesses and reduces distortions when firms would o ­ therwise miss out on needed relief, particularly in rural areas. Data on beneficiaries and levels of support can limit the ability to target support unfairly or to ­onnected firms. Transparency can be combined with anticorruption politically c monitoring and  enforcement stipulations. Transparency measures are critical for strengthening public financial management of BOSs and include identifying BOS- related fiscal risks and mitigation measures as part of state ownership policies. Governments should require BOSs to publish financial statements and all support 82 The Business of the State TABLE 4.3  Targeting and Required Interventions, by Level of Financial Distress Type of BOSs or private firms Support needed Instrument Viable and not facing No targeted support needed to General business environment policies and regulations that financial distress address financial distress, but are competitively neutral (including, for instance, through the general development policies proper separation of BOSs’ commercial and noncommercial may still be relevant to achieve functions, requirements for BOSs to earn market-conforming certain objectives rates of return) and provide regular access to finance. Adequate compensation for BOSs (and private firms) if entrusted with emergency public service delivery (particularly in competitive markets). Viable but facing financial Targeted support to solve Support through grants and loans. Pre-insolvency procedures distress liquidity problems may also be needed. Viable but insolvent Debt restructuring (possibly Debt restructuring procedures that benefit BOSs or private followed by targeted support) firms and lenders. Nonviable and insolvent Liquidation Insolvency procedures that reduce the cost of bankruptcy and protect public sector balance sheets. Application to BOSs as well as divestiture, as required. Source: Adapted from World Bank 2021e. Note: The principles in this table can apply to BOSs and to private firms. BOSs = businesses of the state. given to various beneficiaries, both private and state owned. Information should be provided on the roles of state-owned banks and commercial banks in allocating credit. Transparency and clear communication of support measures also help to manage busi- ness expectations and build public support. Notes 1. Contingent liabilities can be either explicit (that is, legally grounded, such as government loan guarantees) or implicit, with a public expectation of government responsibility that is not estab- lished in law (for example, bailing out troubled subnational governments or state-owned enter- prises). Different contingent liabilities frequently are realized in tandem, either because they are caused by the same underlying shock or because the realization of one risk triggers that of another, for instance, if the financial troubles of a BOS firm put its lenders into difficulty. 2. State support can take different forms. Such support to BOSs and private firms can include access to credit through grants, loans, or guarantees and indirect support through payment deferrals and tax relief, cash transfers, fee reductions, or wage subsidies. Governments can also provide support through equity and debt finance, especially if companies are deemed strategically important. 3. Public sector balance sheets combine all of the accumulated assets and liabilities that govern- ments control, including public corporations, natural resources, and pension liabilities, and account for the entirety of what the state owns and owes. 4. State-owned banks often play an important role in the financial sector—for example, the Bhutan Development Bank accounts for 25 percent of total assets of the banking system, and Uruguay’s Banco de La Republica Oriental Del accounts for 43 percent. Some state-owned banks account for a significant share of their markets—for example, the Viet Nam Bank for Social Policies provides 60 percent of all the country’s micro loans, and Mexico’s Fideicomisos Instituidos en Relación con la Agricultura accounts for 67 percent of total lending to the agriculture sector (World Bank 2018). Fiscal Impact of Businesses of the State and Principles of State Support83 5. For example, given their dominance in network and primary sectors, BOSs are vulnerable to climate change risks, including decarbonization transition risks, that can affect public finances through dividend and asset losses (see chapter 5). 6. Most standard statistics and definitions of debt focus on the nonfinancial public sector debt, which would include BOSs and exclude state-owned banks. 7. In the past, two SOEs did not have the resources to repay their credits, and the government made payments on behalf of those two SOEs. 8. In the case of the European Union, the European Commission (2016) finds that, although the profitability and productivity of BOSs tend to be lower than those of private firms, the difference in performance between BOSs and private companies became smaller (or statistically insignifi- cant) during the global financial crisis, suggesting that BOSs were potentially stabilizing during the crisis. 9. Jaslowitzer, Megginson, and Rapp (2018) find that state ownership is associated with stability- seeking investment policies. García-Sánchez and Rama (2022) find that BOSs in Spain outper- formed other firms during the global financial crisis in their ability to cooperate with partners on innovation. However, Jie et al. (2021) find that investment fell more for BOSs than for other listed firms during the COVID-19 crisis, suggesting that they may have exacerbated the impacts of the crisis. Bortolloti, Fotak, and Wolfe (2022) find that government ownership did not ­mitigate research and development investment during crises. Further, the World Bank (2023a) finds that, although infrastructure BOSs that faced a negative shock received additional fiscal injec- tions equal to 3.5 percent of average assets, average capital expenditure declined by 40 percent of average assets the year after the shock. 10. EBRD (2020) finds that the presence of state-owned banks had a positive impact on income growth and other outcomes after the crisis in the Caucasus, Central and Eastern Europe, and Türkiye. Coleman and Feler (2014) find similar results in Brazil. Szarzec, Dombi, and Matuszak (2021) investigate the effect of BOSs on economic growth in 30 European countries in the period of 2010–16 and find that BOSs are per se neither positive nor negative for growth but that their impact on growth depends on the country’s institutions. With good (bad) institutions, the effect of BOSs is more beneficial (detrimental), turning significantly positive (negative) in the right tail (left tail) of the sample distribution of institutional quality. 11. The World Bank State Aid Tracker presents the state support schemes implemented by govern- ments across all continents in the context of the COVID-19 pandemic. The tracker includes a sample of 1,075 approved COVID-19-related measures in 167 countries from April 2020 up to June 2021 based on criteria that would qualify them as subsidies according to the World Trade Organization definition. A subsidy is a financial contribution by a government or public body conferring a benefit to its recipients, which are firms (not individuals or households). According to the World Trade Organization Agreement on Subsidies and Countervailing Measures, ­ ubsidies may include grants, tax exemptions, capital injections, loan guarantees, accel- Article 1 s erated depreciation allowances, and other in-kind benefits (https://www.wto.org/english/docs_e​ /legal_e/24-scm_01_e.htm). In the European Union context, state aid is defined as “any aid granted by a Member State or through State resources in any form whatsoever which distorts or threat- ens to distort competition by favoring certain undertakings or the production of certain goods shall, insofar as it affects trade between Member States, be incompatible with the internal market” (Article 107 (1) of the Treaty on the Functioning of the European Union). The tracker includes approved schemes but does not include data on the disbursement of funds at the recipient level. Data included in the tracker were collected through a desk research exercise using publicly avail- able information from countries’ ministries of finance (annual budget information for 2020/21; published lists of COVID-19-related measures and press releases), the European Commission, the European Free Trade Association, the International Monetary Fund, and other organizations, such as KPMG, Deloitte, White and Case, and Ernst and Young. They were updated regularly 84 The Business of the State during April 2020–June 2021. Overall, data from all the regions covered were publicly available and accessible, with some exceptions in a few countries from the Middle East and North Africa and East Asia and Pacific regions. 12. The role of state-owned financial institutions in a crisis warrants particular attention, separate from that of BOSs in the real sector (Gutierrez and Kliatskova 2021). 13. Although the 2008 and 2020 frameworks were similar regarding the type of aid (grants and soft loans) and the conditions for granting them (existence of a ceiling on the amount of subsidy per  company), the framework adopted during the 2008 crisis focused mainly on the financial sector—the 2020 framework largely concerned the real economy. 14. For example, an analysis of US congresspersons regarding the Emergency Economic Stabilization Act in October 2008 revealed that “higher campaign contributions from the financial industry increase the likelihood of supporting the Emergency Economic Stabilization Act” (Mian, Sufi, and Trebbi 2010, 1967). In the health care sector, approximately US$2 trillion of procurement expenditures are lost to c­ orruption globally per year, and rapid processes during crises likely exacerbate these losses. Single-source procurement, implemented by many countries during the COVID-19 crisis, created not only risks of corruption, but also risks of collusive behavior among all types of firms (United Nations 2021). 15. See, for example, OECD (2010, 34): “The financial crisis of 2008 is an extreme instance of the damage wrought by the existence of a soft budget constraint. One ingredient that contributed to excessive risk taking by banks was the implicit government guarantee they felt to be enjoying (and that they indeed were enjoying, as has been revealed by the various, costly rescue plans). The damage caused by the excessive risk taking was not caused by the granting of aid, but by the expectation that aid would be granted should the need arise.” 16. Dam and Koetter (2012) focus on German bailouts in which banks received capital injections from their responsible banking association’s insurance fund. Those authors find that a higher probability of bailout increases banks’ risk taking significantly, consistent with increased moral hazard. Hryckiewicz (2014) investigates the effects of bailouts on bank risk using data on banks rescued during 23 systemic banking crises in 23 countries, finding that bailouts increase bank ­ risk ­significantly and that blanket guarantees, nationalizations, and asset management companies contribute the most to increased risk. Using a sample for 53 countries, Brandao-Marques, Correa, and Sapriza (2018) also find that more government support is associated with more risk taking. In the case of the East Asia financial crisis, Poczter (2016) finds that recapitalization of banks in Indonesia increased the long-term risk taking of banks. 17. Under the European Union COVID-19 Temporary State Aid Framework, aid could be granted only to undertakings that were not already in financial distress before the start of the pandemic. Indeed, this was the case for the Portuguese €1.2 billion rescue loan in favor of a Portuguese ­airline (https://ec.europa.eu/commission/presscorner/detail/en/ip_20_1029). 18. This section builds on recommendations regarding the design of support and literature on the level of distortion of different support measures, including Blanchard, Philippon, and Pisani- Ferry (2020); Copenhagen Economics (2020); European Commission (2022); Freund and Pesme (2021); Manuilova, Burdescu, and Bilous (2022); Motta and Peitz (2020); ODI (2020); OECD (2009, 2020a, 2020b, 2020c); Pop and Amador (2020b); Qiang and Pop (2020); Vitale et al. (2020); and World Bank (2021a). 19. Criteria for recapitalization measures should include (a) evidence that the viability of the com- pany would be at risk without state intervention; (b) proof that no other measures were available to raise capital; (c) recapitalization measures that are limited in time; (d) establishment of appro- priate remuneration; and (e) adoption of structural or behavioral commitments, notably in the form of prohibitions on misuse of financial support. 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