A World Bank Group Flagship Report WORLD DEVELOPMENT REPORT FINANCE FOR AN EQUITABLE RECOVERY A World Bank Group Flagship Report WORLD DEVELOPMENT REPORT FINANCE FOR AN EQUITABLE RECOVERY © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW, Washington, DC 20433 Telephone: 202-473-1000; Internet: www.worldbank.org Some rights reserved 1 2 3 4 25 24 23 22 This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Execu- tive Directors, or the governments they represent. 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ISSN, ISBN, e-ISBN, and DOI: Softcover ISSN: 0163-5085 ISBN: 978-1-4648-1730-4 e-ISBN: 978-1-4648-1731-1 DOI: 10.1596/978-1-4648-1730-4 Hardcover ISSN: 0163-5085 ISBN: 978-1-4648-1759-5 DOI: 10.1596/978-1-4648-1759-5 Cover and interior design: Gordon Schuit, with input from the Design team in the Global Corporate Solutions unit of the World Bank. Library of Congress Control Number: 2022930708 The cutoff date for the data used in this report was August 31, 2021, unless otherwise indicated. Contents xi Foreword xiii Preface xv Acknowledgments xix Abbreviations 1 Overview 1 Introduction 3 The economic impacts of the pandemic 6 The economic policy response to the pandemic: Swift but with large variation across countries 8 Resolving financial risks: A prerequisite for an equitable recovery 20 Conclusion 21 Notes 22 References 25 Introduction 26 Introduction 26 Impacts on households 33 Impacts on firms 38 Impacts on the financial sector 39 The short-term government response and its impact on public finances 44 Notes 46 References 49 Chapter 1: Emerging risks to the recovery 50 Introduction 51 Interconnected financial risks across the economy 54 From health crisis to financial distress: Emerging risks to the recovery 68 The global economy 71 Conclusion 72 Notes 72 References 74 Spotlight 1.1: Financial inclusion and financial resilience iii 79 Chapter 2: Resolving bank asset distress 80 Introduction 82 Why do NPLs matter? 83 Identifying NPLs: Asset quality, bank capital, and effective supervision 93 Building capacity to manage rising volumes of bad debts 100 Dealing with problem banks 108 Conclusion 109 Notes 113 References 118  potlight 2.1: Strengthening the regulation and supervision of S microfinance institutions 123 Chapter 3: Restructuring firm and household debt 124 Introduction 124 Why should anyone care about insolvency systems? 127 Strengthening formal insolvency mechanisms 134 Facilitating alternative dispute resolution systems such as conciliation and mediation 136 Establishing accessible and inexpensive in-court and out-of-court debt resolution procedures for MSMEs 141 Promoting debt forgiveness and discharge of natural person debtors 142 Conclusion 143 Notes 145 References 149 Spotlight 3.1: Supporting microfinance to sustain small businesses 155 Chapter 4: Lending during the recovery and beyond 156 Introduction 157 Solving the COVID-19 risk puzzle: Risk visibility and recourse 161 Improving risk mitigation 184 Policies to enable access to credit and address risks 189 Conclusion 190 Notes 191 References 199 Spotlight 4.1: Public credit guarantee schemes 203 Chapter 5: Managing sovereign debt 204 Introduction 204 The impact of COVID-19 on sovereign debt 207 The human costs of debt crises 211 New challenges in managing and resolving sovereign debt iv | CONTENTS 214 Managing sovereign debt and resolving sovereign debt distress 227 Looking ahead: Reforms to mobilize revenue, improve transparency, and facilitate debt negotiations 234 Conclusion 235 Notes 237 References 241 Spotlight 5.1: Greening capital markets: Sovereign sustainable bonds 249 Chapter 6: Policy priorities for the recovery 250 Introduction 252 Tackling the most urgent sources of risk 253 Managing domestic risks to the recovery 255 Managing interrelated risks across the global economy 256 Seizing the opportunity to build a more sustainable world economy 256 Notes 257 References Boxes 43 I.1 The interplay of fiscal and 106 2.5 Restructuring the monetary policy financial system in Ghana 57 1.1 Case study: Supporting 124 3.1 A short primer on the borrowers and the insolvency process financial sector in India 131 3.2 Comprehensive and 63 1.2 The unintended ongoing institutional consequences of insolvency reforms in regulatory forbearance India, 2016–20 69 1.3 External factors in the 150 S3.1.1 How Pakistani MFIs and recovery: Will this “taper regulators managed the tantrum” be different? crisis 84 2.1 International guidance 151 S3.1.2 Case study: A compounded on loan classification and crisis in Lebanon problem assets 163 4.1 Case study: Adaptive 89 2.2 The use of financial underwriting in Mexico technology in banking 165 4.2 Credit and algorithmic supervision during the biases pandemic 168 4.3 The COVID-19 digital 90 2.3 Bank supervision and shock state ownership of banks 172 4.4 Case study: Mobile money 97 2.4 Addressing problematic overdrafts in Kenya loans to micro-, small, 176 4.5 Case study: Pay-as-you-go and medium enterprises home solar systems in Slovenia CONTENTS | v 179 4.6 Case study: Doubling 222 5.3 The role of multilateral down on MSE finance coordination in the throughout the pandemic looming debt crisis: 182 4.7 The supply chain finance The G20 Debt Service response to the pandemic Suspension Initiative and the G20 Common 187 4.8 Case study: Use of Framework alternative data by credit bureaus during the 225 5.4 Case study: The social and pandemic economic costs of financial repression in 208 5.1 Case study: Debt relief to Argentina create space for social spending in Rwanda 230 5.5 Case study: The curse of hidden debt in 216 5.2 Case study: Seizing Mozambique market opportunities for better debt management 250 6.1 Evaluating the success in Benin of the crisis response: A research agenda Figures 2 O.1 Economic impact of 14 O.8 Quarterly trends in credit COVID-19 in historical conditions, by country perspective income group, 2018–21 3 O.2 Conceptual framework: 17 O.9 General government gross Interconnected balance debt, by country income sheet risks group, 2010–20 4 O.3 Conceptual framework: 18 O.10 Sovereign debt Vicious and virtuous restructuring and time cycles spent in default, selected 7 O.4 Fiscal response to the countries, 1975–2000 COVID-19 crisis, selected 27 I.1 Impacts of the COVID-19 countries, by income crisis on households, by group country income group 8 O.5 Fiscal, monetary, and 28 I.2 Global annual change in financial sector policy extreme poor, 1992–2020 responses to the 28 I.3 Global extreme poverty, pandemic, by country 2015–21 income group 30 I.4 Ways in which households 9 O.6 Capacity of coped with income losses banking systems from the COVID-19 crisis, to absorb increases in by country income group nonperforming loans, 32 I.5 Household resilience to by country income group income losses, selected 12 O.7 Share of enterprises in emerging and advanced arrears or expecting to economies fall into arrears within six months, selected countries, May–September 2020 vi | CONTENTS 33 I.6 Impacts of alternative 59 B1.1.2 Support for new lending COVID-19 policies and through partial credit coping strategies at guarantees in India, different time horizons, by firm size emerging and advanced 60 1.4 Fiscal constraints to economies the COVID-19 response, 34 I.7 Impact of COVID-19 by country income group on businesses, selected 61 1.5 Government arrears in countries Sub-Saharan Africa 36 I.8 Economic uncertainty and 61 1.6 Financial sector policies employment during the during the COVID-19 COVID-19 crisis crisis, by country income 37 I.9 Percentage of corporate group debt at risk after a 64 B1.2.1 Nonperforming loans simulated 30 percent in India, 2005–16 shock to earnings, 65 1.7 Government debt and precrisis, selected countries, by income banking sector fragility group during the COVID-19 crisis, by country income 40 I.10 Fiscal response to the group COVID-19 crisis, selected 67 1.8 Change in average countries, by income group government revenue, by country income group, 41 I.11 Fiscal, monetary, and 2011–20 financial sector policy 67 1.9 Average primary responses to the pandemic, by country government balances, income group by country income group, 2010–20 42 I.12 Global sovereign 70 B1.3.1 Impacts of the “taper downgrades, 1980–2020 tantrum” on the 43 BI.1.1 Asset purchase programs Indonesian economy, of central banks during 2005–15 the COVID-19 crisis, 81 2.1 Changes in by country income group nonperforming loan 50 1.1 Conceptual framework: ratios, by country income Interconnected balance group, 2020–21 sheet risks 86 2.2 Capacity of banking 53 1.2 Conceptual framework: systems to absorb Vicious and virtuous increases in cycles nonperforming loans, 55 1.3 Social safety nets and by World Bank region and income losses during country income group the COVID-19 crisis, by 92 2.3 Comparison of country income group accumulation of 57 B1.1.1 Use of monetary policy to nonperforming loans at reduce interest rates in public banks and private India banks after adverse shock CONTENTS | vii 95 2.4 Nonperforming loan 164 B4.1.1 Growth in loan reduction flowchart disbursements by Konfío, 99 2.5 Ratio of nonperforming 2019–21 loans to total loans, 165 B4.2.1 Share of borrowers who Serbia, 2010–20 appear more creditworthy 107 2.6 Financial safety net and when using a machine bank resolution powers, learning model than when by country income group, using traditional 2016–20 statistical methods 120 S2.1.1 Credit risk ratio and 170 B4.3.1 Impact of the COVID-19 restructured portfolio pandemic on adoption of ratio, by size of technology by businesses, microfinance institution by country income group and World Bank region, 173 B4.4.1 Growth of merchant 2019 and 2020 payments and mobile 125 B3.1.1 Insolvency process money overdrafts in timeline Kenya, 2019–21 131 B3.2.1 Insolvency backlog in 175 4.3 Impact of the COVID-19 India, 2018–20 pandemic on consumers’ loan approval rates, by 134 3.1 Share of enterprises in product type, Poland, arrears or expecting to 2019–21 fall into arrears within six months, selected 177 B4.5.1 Volume of off-grid lighting countries, May–September products sold as cash 2020 products and via PAYGo, 2018–21 137 3.2 Enterprise ability to survive a drop in sales, 205 5.1 General government gross selected countries debt, by country income group, 2010–20 138 3.3 Share of enterprises in arrears or expecting to 206 5.2 Level of risk of external be in arrears within six debt distress, low-income months, June–September countries, 2011–21 2020 209 B5.1.1 Poverty-reducing 138 3.4 Share of enterprises with expenditures in Rwanda lower monthly sales than versus other HIPC in the previous year, countries June–September 2020 210 5.3 The lost decade of 138 3.5 Nonperforming loans, development in countries selected Asian countries, defaulting on sovereign 1998–2005 debt 159 4.1 Quarterly trends in credit 212 5.4 External debt in low- conditions, by country and middle-income income group, 2018–21 countries, by creditor type, 1980–2019 161 4.2 Impacts of selected risk mitigation strategies on 212 5.5 Composition of creditors visibility, recourse, and in all countries and in risk low- and lower-middle- income countries, 1989 and 2019 viii | CONTENTS 220 5.6 Sovereign debt 233 5.7 Sovereign bond principal restructuring and time maturation in selected spent in default, selected low- and middle-income countries, 1975–2000 countries, by share and 222 B5.3.1 Participation of countries type of collective action in DSSI, by level of risk of clauses included in the debt distress bonds, 2021–33+ 225 B5.4.1 Poverty and financial 242 S5.1.1 Share of countries with repression, Argentina, government-issued 1995–2002 sustainable instruments, by country income group, 226 B5.4.2 Financial measures 2020–21 affecting savers during Argentina’s economic 244 S5.1.2 Correlation between share crisis, 2001–02 of green and social bond issuances and GDP per 231 B5.5.1 Mozambique’s external capita debt service projections (2015–27) before and after 245 S5.1.3 Regulatory coverage of the 2016 disclosure of sustainability factors in hidden debts capital markets, by country income group Tables 63 B1.2.1 Provisioning requirements 94 2.2 Nonperforming loan by loan category, India, reduction measures 2008 104 2.3 Principal bank resolution 66 1.1 Change in average central tools government debt stocks, 140 3.1 Principles for adapting by country income group, insolvency frameworks for 2010–20 MSMEs 85 2.1 Countries’ adoption of 217 B5.2.1 Benin’s debt profile and selected indicators of asset recent issuances in the classification systems, Eurobond market, by country income group 2019–21 CONTENTS | ix Foreword This new World Development Report focuses on the interrelated economic risks that house- holds, businesses, financial institutions, and governments worldwide are facing as a con- sequence of the COVID-19 crisis. The Report offers new insights from research on the interconnectedness of balance sheets and the potential spillover effects across sectors. It also offers policy recommendations based on these insights. Specifically, it addresses the question of how to reduce the financial risks stemming from the extraordinary policies adopted in response to the COVID-19 crisis while supporting an equitable recovery. The unfolding COVID-19 pandemic has already led to millions of deaths, job losses, business failures, and school closings, triggering the most encompassing economic crisis in almost a century. Poverty rates have soared and inequality has widened both across and within countries. Disadvantaged groups that had limited financial resilience to begin with and workers with lower levels of education—especially younger ones and women— have been disproportionately affected. The response by governments has included a combination of cash transfers to households, credit guarantees for firms, easier liquidity conditions, repayment grace periods for much of the private sector, and accounting and regulatory forbearance for many financial institu- tions. Although these actions have helped to partially mitigate the economic and social con- sequences of the pandemic, they have also resulted in elevated risks, including public over­ indebtedness, increased financial fragility, and a general erosion in transparency. Emerging economies have been left with very limited fiscal space, and they will be made even more vulnerable by the impending normalization of monetary policy in advanced economies. This Report highlights several priority areas for action. First is the need for early detection of significant financial risks. Because the balance sheets of households, firms, financial sector institutions, and governments are tightly interrelated, risks may be hidden. The share of nonperforming loans has generally remained below what was feared at the beginning of the crisis. But this could be due to forbearance policies that delayed debt repayments and relaxed accounting standards. Firm surveys in emerging economies reveal that many businesses expect to be in payment arrears in the coming months, and so private debt could suddenly become public debt, as in many past crises. The interdependence of economic policies across countries matters as well. Public debt has reached unprecedented levels. As monetary policy tightens in advanced economies, interest rates will need to increase in emerging economies as well, and their currencies will likely depreciate. Higher interest rates make debt service more expensive, reinforc- ing the trend of recent years, and weaker currencies make debt service more burdensome relative to the size of the economy. Liquidity problems could suddenly morph into solvency problems. The corporate–government nexus is another potential source of contingent liabilities and hidden debt. State-owned utilities have been asked to delay increases in tariffs and xi accept arrears in bill collection. Concessions and public-private partnerships have faced dramatic declines in revenue. Sooner or later, the losses could end up on the budget. Mean- while, borrowing from foreign state-owned enterprises often escapes the surveillance of debt management agencies. These contingent liabilities and parastatal loans can raise significant financial risks in low-income and some emerging market countries. Second is the need for proactive management of distressed assets. In the absence of effective resolution mechanisms for private sector debt, balance sheet problems last much longer than they should, with loan evergreening keeping “zombie” firms alive and under- mining the strength of the recovery. Formal insolvency mechanisms need to be strength- ened and alternative dispute resolution systems facilitated. Revamped legal mechanisms can promote debt forgiveness and help protect the long-term reputation of former debtors. Early detection of risks and proactive management may also reduce the risks asso- ciated with the servicing of sovereign debt. Reprofiling allows moving to longer maturities and smoothing out debt-related payments. And the time for it is now, while international interest rates are still low and accessing global financial markets is still an option. Debt management can also help hedge against exchange rate volatility and currency weakness. The biggest challenge is sovereign debt restructuring. The absence of a predictable, orderly, and rapid process for sovereign debt restructuring is costly, dampening recovery prospects and creating uncertainty. The historical track record shows that the longer the debt restructuring process takes, the larger the “haircut” creditors experience. For debtor countries, delay presents major setbacks to growth, poverty alleviation, and development. Unfortunately, negotiations on debt restructuring for the poorest countries under the G20 Common Framework are currently stalled. Finally, it is critical to work toward broad-based access to finance. Low-income house- holds are more likely to smooth out their consumption if they can save and borrow. Small businesses are better able to invest and create jobs if they have access to credit. Digital finance can play a critical role in enabling access to finance and fostering new economic opportunities. Emerging economies need to rebuild their buffers and avoid sacrificing the accumula- tion of capital—both physical and human—along the way. The path chosen for fiscal con- solidation is critically important in this respect. The composition of government spending affects economic growth, and more buoyant economic activity is critical to achieve devel- opment goals and debt sustainability in the longer term. As for advanced economies, they should carefully unwind the extraordinary stimulus policies and avoid creating global turbulence. While reducing the balance sheets of their central banks, they should also rebalance their composition toward shorter-term assets because short-term interest rates matter more for the small and medium enterprises that constitute the backbone of global supply chains. This new edition of the World Development Report charts a road map to tackle the finan- cial vulnerabilities created by the COVID-19 crisis. The World Bank Group will continue to work tirelessly to assist client countries in these efforts. David Malpass President The World Bank Group xii | FOREWORD Preface In the midst of exceptional uncertainty, policy makers around the globe are grappling with the delicate task of scaling back the economic support measures put in place during the early stages of the COVID-19 pandemic while encouraging creation of the conditions needed to restore economic activity and growth. One significant challenge is the lack of transparency—created or reinforced by the pandemic and (unintentionally) exacerbated by policy actions—about the risks in the balance sheets of the private and public sectors. What we do know is that the pandemic- induced recession of 2020 led to the largest single-year surge in global debt in decades. Before the pandemic, private debts were already at record highs in many advanced economies and emerging economies, leaving many households and firms poorly prepared to withstand an adverse income shock. Many governments were also facing record-high levels of debt prior to the pandemic, and many more significantly increased their debt burdens to fund vital response policies. In 2020, the average total debt burden of low- and middle-income countries increased by roughly 9 percentage points of the gross domestic product, compared with an average annual increase of 1.9 percentage points over the previous decade. Fifty-one countries (including 44 emerging economies) experienced a downgrade in their sovereign debt credit rating. What we do not yet know, however, is the extent to which governments and private debtors are harboring hidden risks with the potential to stymie economic recovery. In particular, increased complexity and opacity in sovereign debt markets (as to who holds the debt and under what terms) often make it difficult to assess the full extent of risks in government balance sheets. On the private side, common elements of pandemic response programs, such as moratoria on bank loans, general forbearance policies, and a marked relaxation in financial reporting requirements, have made it difficult to determine whether debtors are facing short-term liquidity challenges or whether their incomes have been permanently affected. For both, the risk is insolvency on a scale and scope that are difficult to gauge in advance. Within the context of uncertainty, the world is confronting the daunting challenge of continuing to navigate a global pandemic, while managing and reducing financial risks across household, business, financial, and government sectors. Problems in one area can and do reverberate across entire economies through mutually reinforcing channels that connect the financial health of all sectors. What at first blush appears to be an isolated disruption in one sector can very quickly spill over to the rest of the economy. For example, if households and firms are under financial stress, the financial sector faces a higher risk of loan defaults and is less willing or able to provide credit and support economic recovery. xiii As the financial position of the public sector deteriorates as a result of higher sovereign debt and lower tax revenue, many governments find that they are less able to support economic activity. Policies that facilitate the early detection and swift resolution of economic and finan- cial fragilities can make all the difference between an economic recovery that is robust and one that falters—or, worse, one that delays recovery altogether. Starting with an in-depth assessment of the severest and most regressive financial and economic impacts of the pandemic, this World Development Report puts forward a focused, actionable policy agenda that countries can adopt to cope with some of the harmful and potentially lasting economic effects of the pandemic. Some of these policies seek to reduce opacity in credit markets, for example, by ensuring that banks report accurate, timely indicators of loan quality or by increasing transparency around the scale and terms of sovereign debt. Other initiatives aim to accelerate the resolution of debt distress through improved insolvency proceedings for companies and individuals, and proactive efforts to reprofile or restructure sovereign debt. Because there is no one-size-fits-all approach to economic recovery, the appropriate policy mix depends critically on prevailing conditions and policy capacity. Few if any governments have the resources and political leeway to tackle simultaneously all of the challenges they face as the pandemic recedes. Countries will need to prioritize. The potential for policy to contribute to a lasting, inclusive recovery will depend on the ability of governments, working in partnership with international financial institutions and other development professionals, to muster the political will for swift action. Carmen M. Reinhart Senior Vice President and Chief Economist The World Bank Group xiv | PREFACE Acknowledgments The 2022 World Development Report (WDR) was prepared by a team led by its director, Leora Klapper. Martin Kanz served as deputy director, Davida Connon as manager, and Davide Mare as data manager. Laura Starita provided developmental guidance in drafting the Report. Overall guidance was provided by Carmen Reinhart, Senior Vice President and Chief Economist of the World Bank Group (WBG), and leader of its Development Eco- nomics (DEC) Vice Presidency, and Aart Kraay, Director of Development Policy of DEC and Deputy Chief Economist of the WBG. The Report is sponsored by DEC and was pre- pared in partnership with the World Bank’s Equitable Growth, Finance, and Institutions (EFI) Vice Presidency (Finance, Competitiveness, and Innovation Global Practice; Macro­ economics, Trade, and Investment Global Practice; and Poverty Global Practice) and with the Financial Institutions Group and the Development Impact Measurement Department of the International Finance Corporation (IFC). The core author team comprised Momina Aijazuddin, Alexandru Cojocaru, Miquel Dijkman, Juan Pablo Farah Yacoub, Clemens Graf von Luckner, Kathryn Holston, Martin Holtmann, Nigel Jenkinson, Harry Lawless, Davide Mare, Sephooko Ignatius Motelle, Rita Ramalho, Matthew Saal, Beniamino Savonitto, and Mahesh Uttamchandani, together with research analysts Sri Sravya Raaga Akkineni, Francine Chang Fernandez, Michael Gottschalk, Lingaraj Giriyapura Jayaprakash, Mansi Vipin Panchamia, Jijun Wang, and Nan Zhou. Selome Missael Paulos provided the team with administrative support. Members of the extended team and contributors to the Report’s spotlight features are Matthew Gabriel Brown, Pietro Calice, Nadine Chehade, Erik Feyen, Matthew Gamser, Wissam Harake, Meraj Husain, Kira Erin Krown, Christoph Lakner, Camilo Mon­ dragon- Velez, Stephen Rasmussen, Allison Ryder, Valentina Saltane, Alexander Sotiriou, Stefan Staschen, Robert Johann Utz, and Nishant Yonzan. Additional contributors are Pranjul Bhandari, Fernando Dancausa, Fiseha Haile Gebregziabher, Ashish Gupta, Alexandre Henry, Fernanda Massarongo Chivulele, Collen Masunda, Antonia Menezes, Rachel Chi Kiu Mok, Sergio Muro, Ugo Panizza, Albert Pijuan Sala, Tarun Ramadorai, and Guillermo Vuletin. Special thanks are extended to the senior leadership and managers of EFI and IFC for their partnership and guidance in preparing the Report, including Paulo de Bolle (Senior Director, Global Financial Institutions Group, IFC), Marcello Estevão (Global Director, Macroeconomics, Trade, and Investment, EFI), Issa Faye (Director, Development Impact Measurement, IFC), Dan Goldblum (Manager, Development Impact Measurement, Finan- cial Institutions, IFC), Cedric Mousset (Acting Practice Manager, Finance, Competitive- ness, and Innovation, EFI), and Jean Pesme (Global Director, Finance, Competitiveness, and Innovation, EFI). xv The team is also grateful for the guidance, comments, and inputs provided by Tatiana Alonso Gispert, Karlis Bauze, Buddy Buruku, Jennifer Chien, Krishnamurti Damodaran, Hugo De Andrade Lucatelli, Denise Leite Dias, Matei Dohotaru, Ismael Ahmad Fontán, Xavier Gine, Eva Gutiérrez, Samira Kalla, Pamela Lintner, Martin Melecky, Martha Mueller, Juan Ortiz, Alexander Pankov, José Rutman, Venkat Bhargav Sreedhara, Ekaterina Ushakova, and Carlos Leonardo Vicente. The team would also like to thank the many World Bank colleagues who provided written comments during the formal Bank-wide review process. Those comments provided invaluable guidance at a crucial stage in the Report’s production. The WDR team also gratefully received suggestions and guidance from the members of a technical advisory board for the Report: Viral Acharya, Muhamad Chatib Basri, Graciela Kaminsky, Odette Lineau, Atif Mian, Jonathan Murdoch, Tim Ogden, Raghuram Rajan, and Kenneth Rogoff. The WDR team also engaged with and received specific inputs, including policy guidance and data, from the following representatives of academia, international organizations, civil society organizations, private sector companies, and development partners: John Fischer, Jim Rosenberg, and Michael Schlein (Accion); Daniel Osorio (Banco de la República, Colombia); Marcia Díaz and Veronica Gavilanes (Banco Pichincha); Mariusz Cholewa and Paweł Szarkowski (Biuro Informacji Kredytowej S.A.); Nancy Silva Salas (Comisión para el Mercado Financiero); Andrée Simon (FINCA Impact Finance); Amrik Heyer and David Taylor (FSD Kenya); Rafe Mazer (Innovations for Poverty Action); Carlos Arredondo, Nadia Cecilia Rivero Morey, Jeffrey Sadowsky, and Gregorio Tomassi (Konfío); Zhenhua Li, Shi Piao, Xiaodong Sun, and Joey Zhang (MYbank and Ant Group); and Andreas Fuster (Swiss Finance Institute @ EPFL). The team consulted with and received input from the following IFC colleagues: Olawale Ayeni, Jessica Camilli Bluestein, Erica Bressan, Peter Cashion, José Felix Etchegoyen, Bill Gallery, Anushe Khan, Luz María Salamina, Leila Search, and Beatrix Von Heintschel. Data from the World Bank Business Pulse Surveys used throughout the Report, as well as related analysis, were collected and analyzed by Besart Avdiu, Xavier Cirera, Marcio Cruz, Elwyn Davies, Subika Farazi, Arti Grover, Leonardo Iacovone, Umut Kılınç, Ernesto López-Córdova, Denis Medvedev, Gaurav Nayyar, Mariana Pereira López, Trang Tran Minh Pham, Santiago Reyes Ortega, and Jesica Torres Coronado. The Report also draws on data collected by the World Bank’s High-Frequency Phone Surveys conducted during the pandemic. They were led by Benu Bidani, Ambar Narayan, and Carolina Sánchez-Páramo, with the assistance of Sulpice Paterne Mahunan Amonle, Miyoko Asai, Paola Ballon, Gildas Bopahbe Deudibe, Laura Blanco Cardona, Antonia Johanna Sophie Delius, Reno Dewina, Carolina Díaz-Bonilla, Fatoumata Dieng, Julia Dukhno, Ifeanyi Nzegwu Edochie, Karem Edwards, Kristen Himelein Kastelic, Lali Jularbal, Deeksha Kokas, Nandini Krishnan, Gabriel Lara Ibarra, Maria Ana Lugo, Silvia Malgioglio, José Montes, Laura Moreno Herrera, Rose Mungai, David Newhouse, Minh Cong Nguyen, Sergio Olivieri, Bhavya Paliwal, Utz Pape, Lokendra Phadera, Ana Rivadeneira Alava, Laura Rodríguez Takeuchi, Carlos Sabatino, Jeeyeon Seo, Dhiraj Sharma, Siwei Tian, Ikuko Uochi, Haoyu Wu (Tom), Nobuo Yoshida, and Maryam Zia. Data collected through Enterprise Surveys COVID-19 Follow-Up Surveys, made available by the Enterprise Analysis Unit of the DEC Global Indicators Department of the World Bank Group, were used to inform the Report’s analysis and recommendations. The team is led by Jorge Rodríguez Meza and coordinated by Silvia Muzi. Adam Aberra, Gemechu A. Aga, Tanima Ahmed, Andrea Suzette Blake-Fough, David Francis, Filip Jolevski, Nona Karalashvili, Matthew Clay xvi | ACKNOWLEDGMENTS Summers, Kohei Ueda, Domenico Viganola, and Joshua Seth Wimpey all contributed to the data c­ ollection and publication of indicators. The team consulted as well with World Bank Group colleagues, policy makers, and staff from other international organizations, civil society organizations, development partners, donors, financial institutions, and research institutions. Seminars were held with subject matter experts to discuss the technical details of the legal and policy rec- ommendations in the Report. Panelists and co-hosts were Scott Atkins (Chair and Head of Risk Advisory, Norton Rose Fulbright Australia, and President, INSOL International), Juanita Calitz (Associate Professor, University of Johannesburg), Zarin Daruwala (Cluster Chief Executive Officer [CEO], India and South Asia Markets [Bangladesh, Nepal, and Sri Lanka], Standard Chartered Bank), Matthew Gamser (CEO, SME Finance Forum), Juan Carlos ­Izaguirre (Senior Financial Sector Specialist, Consultative Group to Assist the Poor [CGAP], World Bank), Klaas Knot (President, De Nederlandsche Bank, and Chair, Financial Stability Board), Alexander Sotiriou (Senior Financial Sector Specialist, CGAP, World Bank), Lucia Spaggiari (Innovation Director, MicroFinanza Rating), Kristin van Zwieten (Pro- fessor, University of Oxford), and Romuald Wadagni (Minister of Economy and Finance, Benin). Special thanks are extended to CGAP and the SME Finance Forum for facilitating engagement with their networks. The team would also like to thank the German Federal Ministry for Economic Cooperation and Development (BMZ) and its convening author- ity, the Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ), for holding a stakeholder workshop on the Report and providing an additional opportunity for the team to collect feedback from development partners. The Report was edited by Sabra Ledent and proofread by Catherine Farley and Gwenda Larsen. Robert Zimmermann verified the Report’s extensive citations. Gordon Schuit was the principal graphic designer. Anugraha Palan, Shane Romig, and Nina Vucenik developed the communications and engagement strategy. Mikael Reventar and Roula Yazigi pro- vided web and online services and related guidance. Special thanks are extended to Mark McClure, who coordinated and oversaw formal production of the Report by the World Bank’s publishing program. The team would also like to thank Patricia Katayama and Stephen Pazdan, who oversaw the overall publication process; Mary Fisk, who facilitated the multiple translations of the overview and chapter summaries; Bouchra Belfqih and the Translation team, who translated the texts; and Deb Barker and Yaneisy Martinez, who managed the printing and electronic conversions of the Report and its many ancil- lary products. Monique Pelloux Patron provided the team with resource management sup- port. The team also extends its appreciation to Maria Alyanak, Marcelo Buitron, Gabriela Calderon Motta, and Maria del Camino Hurtado for their help with coordination and high-level engagement strategies. Finally, the team apologizes to any individuals or organizations inadvertently omitted from this list and is grateful for the help received from all who contributed to this Report, including those whose names may not appear here. Like many people around the world, team members were working from home during the year it took to prepare this report. Our families deserve full author credit for the encouragement, entertainment, snacks, and distractions they provided throughout the development of this publication. ACKNOWLEDGMENTS | xvii Abbreviations ADR alternative dispute resolution AI artificial intelligence AMC asset management company AQR asset quality review ASEAN Association of Southeast Asian Nations BCBS Basel Committee on Banking Supervision BNPL buy now, pay later BP Banco Pichincha (Ecuador) BRSS Bank Regulation and Supervision Survey CAC collective action clause CBI Climate Bonds Initiative CDBP consolidated distance to break point CESEE Central, Eastern, and Southeastern Europe CG credit guarantee CGAP Consultative Group to Assist the Poor CIRP Corporate Insolvency Resolution Process COVID-19 coronavirus disease 2019 CRILC Central Repository of Information on Large Credits (India) CRSP credit reporting service provider DE JURE Data and Evidence for Justice Reform (World Bank project) DSA debt sustainability analysis DSSI Debt Service Suspension Initiative EAP East Asia and Pacific ECA Europe and Central Asia ECB European Central Bank ECL expected credit loss ECLGS Emergency Credit Line Guarantee Scheme EU European Union EWT early warning tool FMCG fast-moving consumer good FSAP Financial Sector Assessment Program (World Bank/IMF) FSB Financial Stability Board FV future value G20 Group of Twenty GBP Green Bond Principles GDP gross domestic product GTSF Global Trade Supplier Finance Program (IFC) HIPC Heavily Indebted Poor Countries Initiative (IMF) xix IADI International Association of Deposit Insurers IBBI Insolvency and Bankruptcy Board of India IBC Insolvency and Bankruptcy Code (India) ICMA International Capital Market Association IDA International Development Association IFC International Finance Corporation IMF International Monetary Fund LAC Latin America and the Caribbean MAS Monetary Authority of Singapore MDRI Multilateral Debt Relief Initiative (IMF) MENA Middle East and North Africa MFB microfinance bank MFI microfinance institution ML machine learning MSEs micro- and small enterprises MSMEs micro-, small, and medium enterprises NBFI nonbank financial institution NBMFC nonbank microfinance company NDCs  Nationally Determined Contributions (Paris Agreement) NPL nonperforming loan NPV net present value OECD Organisation for Economic Co-operation and Development P&A purchase and assumption PAYGo pay-as-you-go PCGS public credit guarantee scheme RBI Reserve Bank of India SAR South Asia Region; special administrative region SDGs Sustainable Development Goals SMEs small and medium enterprises SOE state-owned enterprise SSA Sub-Saharan Africa suptech supervision technology UNCITRAL United Nations Commission on International Trade Law UTP unlikely to pay VAT value added tax All dollar amounts are US dollars unless otherwise indicated. The cutoff date for the data used in this report was August 31, 2021, unless otherwise indicated. xx | ABBREVIATIONS Overview Introduction In 2020, as communities around the world were struggling to contain the spread of COVID-19 (corona­virus) and manage the health and human costs of the pandemic, governments implemented a wide range of crisis response policies to mitigate the worst social and economic impacts of the pandemic. The mobility restrictions, lockdowns, and other public health measures necessary to address the pan- demic rapidly produced the largest global economic crisis in more than a century. This was compounded by a drop in demand as the pandemic affected consumer behavior. Economic activity contracted in 2020 in about 90 percent of countries, exceeding the number of countries seeing such declines during two world wars, the Great Depression of the 1930s, the emerging economy debt crises of the 1980s, and the 2007–09 global financial crisis (figure O.1). In 2020, the first year of the COVID-19 pandemic, the global economy shrank by approximately 3 percent,1 and global poverty increased for the first time in a generation.2 To limit the impact of the crisis on households and businesses, governments enacted a swift and encompassing policy response that used a combination of fiscal, monetary, and financial sector poli- cies. The case of India, which like many other countries enacted a large emergency response to the first wave of the pandemic, offers an example of a decisive policy response that used a wide range of policy instruments to mitigate the worst immediate effects of the crisis. When the pandemic first erupted in India in March 2020, the government declared a two-month national lockdown that closed businesses and sent workers home. The lockdown halted all manner of economic activity, and incomes fell in tan- dem. Small businesses and low-income workers in urban areas and the informal sector were the most severely affected. The first measure adopted by the Indian government was a fiscal stimulus package that amounted to nearly 10 percent of the gross domestic product (GDP) and included direct support for poor households.3 Monetary policy reduced interest rates and eased lending conditions for banks and nonbank financial institutions. Financial sector policies were also part of the support plan; India instituted a debt repay- ment moratorium for households and firms that ultimately lasted six months. In addition, the Indian government introduced a large credit guarantee scheme aimed at ensuring that small and microenter- prises would continue to have access to credit. India’s response to the economic crisis was similar to that of many other countries. The strategy recognized that the sectors of its economy—households and businesses, financial institutions, and gov- ernments—are interconnected. A large shock to one sector can generate spillover risks that destabilize the economy at large if not addressed promptly and in an integrated manner. As the pandemic rolled on, producing multiple waves of infection, many countries extended relief measures beyond their original timeline. Although these policies have helped limit the worst economic outcomes of the pandemic in the short run, they also bring challenges—such as increased public and private debt burdens—that need to be addressed soon to ensure an equitable economic recovery. 1 Figure O.1 Figure O.1 Economic impact of COVID-19 in historical perspective Great Depression negative per capita GDP growth (%) 100 World World Global financial COVID-19 Share of countries experiencing War I War II crisis 80 60 40 20 0 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011 2021 Source: Holston, Kaminsky, and Reinhart 2021, based on data from Groningen Growth and Development Centre, Maddison Project Database 2020, Faculty of Economics and Business, University of Groningen, Groningen, The Netherlands, https:// www.rug.nl/ggdc/historicaldevelopment/maddison/releases/maddison-project-database-2020; International Monetary Fund, WEO (World Economic Outlook Databases) (dashboard), https://www.imf.org/en/Publications/SPROLLS/world -economic-outlook-databases. Note: The figure shows the percentage of countries experiencing negative growth in their per capita gross domestic product (GDP) from 1901 to 2021. Data are as of October 21, 2021. As the economic effects of the pandemic continue, policy makers aim to strike a balance between pro- viding enough support to mitigate the human costs of the crisis, while limiting the longer-term financial and macroeconomic risks that could emerge from higher debt levels resulting from the crisis. These risks are likely to arise more quickly in emerging economies and especially in low-income countries, where the public and private debt-carrying capacity is much lower than in advanced economies, and where eco- nomic conditions were, in many cases, challenging even before the pandemic.4 The evidence available so far suggests that the economic effects of the pandemic will be more per- sistent and severer for emerging economies. For example, after the collapse in per capita incomes across the globe in 2020 (figure O.1), 40 percent of advanced economies recovered and exceeded their 2019 out- put level in 2021. The comparable share of countries achieving per capita income in 2021 that surpassed their 2019 output is far lower for middle-income countries, at 27 percent, and lower still for low-income countries, at 21 percent, pointing to a slower recovery in poorer countries.5 This World Development Report examines the central role of finance in the recovery from what has been called a once-in-a-century crisis and charts pathways toward a robust and equitable recov- ery. Achieving an “equitable recovery” means that all adults, including vulnerable groups such as poor adults, women, and small businesses, are able to recover from losses of jobs, incomes, human capital, and assets.6 COVID-19 has widened inequality both within and across countries. Addressing financial risks is important to ensure that governments and financial institutions can support the recovery, includ- ing through investments in public services, such as health care and education. It is also critical that households and firms do not lose access to financial services that can strengthen resilience to economic shocks, including the loss of income and the unanticipated expenses many are incurring during the pandemic. Success in addressing these risks will help limit the damage to sustainable development out- comes and support an equitable recovery. This Report incorporates new research, data collected throughout the crisis, as well as country case studies to document the immediate financial and economic impacts of the pandemic, the government 2 | WORLD DE VELOPMENT REPORT 2022 responses, and the risks that have materialized or are imminent. These risks include an increase in nonperforming loans and financial sector distress; a lack of options for households and businesses to discharge debts incurred during the pandemic through formal insolvency; tighter access to credit; and elevated levels of sovereign debt. With the goal of directing countries toward options that can support an equitable recovery, this Report then highlights policies that respond to some of the adverse impacts of the crisis and mitigate spillovers of financial risks. The economic impacts of the pandemic Interconnected financial risks Although household and business incomes were most directly affected by the crisis, the consequences of this large shock have repercussions for the entire economy through numerous mutually reinforcing channels that connect the financial health of households and firms, financial institutions, and govern- ments (see figure O.2). Because of this interconnection, elevated financial risks in one sector can easily spill over and destabilize the wider economy if left unchecked. When households and firms are under financial stress, the financial sector faces a higher risk of loan defaults and is less able to provide credit. Similarly, when the financial position of the public sector deteriorates, for example, as a result of higher debt and debt service, its ability to support households and firms may weaken. However, this relationship is not deterministic. Well-designed fiscal, monetary, and financial sector policies can counteract and reduce these intertwined risks, and help transform the links between sectors economy from a vicious “doom loop” into a virtuous cycle (see figure O.3). of the O.2 Figure Figure O.2 Conceptual framework: Interconnected balance sheet risks Governments and central banks Global economy Financial Households sector and firms Precrisis / COVID-19 pandemic / Crisis recovery Source: WDR 2022 team. Note: The figure shows the links between the main sectors of an economy through which risks in one sector can affect the wider economy. OVERVIEW | 3 Figure 1.2 Figure O.3 Conceptual framework: Vicious and virtuous cycles a. Vicious cycle b. Virtuous cycle Lower tax revenue Bank instability Higher tax revenue Stable banks NPLs and Restricted Improved loan corporate access to performance Improved insolvencies credit credit supply Unfavorable Declining Favorable Stronger bond markets fiscal bond markets fiscal support support Governments and central banks Financial sector Households and firms Source: WDR 2022 team, based on Schnabel (2021). Note: NPLs = nonperforming loans. One example of policies that can make a critical difference are those targeting the link between the financial health of households, businesses, and the financial sector. In response to lockdowns and mobil- ity restrictions necessary to contain the virus, many governments supported borrowers through direct cash transfers and financial policy tools, including debt moratoria and credit guarantees. As the crisis unfolded, these policies provided much-needed support to households and small businesses and helped avert a wave of insolvencies and loan defaults, which could have threatened the stability of the financial sector. Looking ahead, ensuring that debt burdens for households and businesses are sustainable and that there is continued access to credit is essential for an equitable recovery. Similarly, governments, central banks, and regulators also used policy tools to assist financial insti- tutions and prevent financial sector risks from spilling over to other parts of the economy. In many countries, central banks lowered interest rates, injected liquidity into the market, broadened access to refinancing facilities, and reduced provisioning requirements. These measures enabled banks and other institutions to continue to offer financing to households and businesses. Like many other central banks, the Central Reserve Bank of Peru, for example, injected liquidity into the banking system through government-backed repurchase (repo) agreements, which reduced the interest rate on new credit. Cen- tral banks also made unprecedented use of unconventional monetary policy tools such as asset purchase programs. Twenty-seven emerging economies adopted such programs for the first time in response to the COVID-19 crisis.7 These measures were aimed at preventing a liquidity crisis and safeguarding finan- cial stability. However, debt moratoria and the provision of additional liquidity for the financial sector do not change the underlying economic conditions of borrowers. The risks now embedded in bank bal- ance sheets will have to be addressed to ensure that the financial sector is well capitalized going into the recovery phase and is able to fulfill its role of providing credit to finance consumption and investment. The crisis response will also need to include policies that address the risks arising from high levels of sovereign debt to ensure that governments preserve their ability to effectively support the recov- ery. The support measures adopted to mitigate the immediate impact of the pandemic on households and businesses required new government spending at a time when many governments were already 4 | WORLD DE VELOPMENT REPORT 2022 burdened by elevated levels of public debt. High debt levels reduce a government’s ability to support the recovery through direct support of households and firms. They also reduce a government’s ability to invest in public goods and social safety nets that can reduce the impact of economic crises on poverty and inequality. Managing and reducing high levels of sovereign debt are therefore an important con­ dition for an equitable recovery. It is also important to recognize that COVID-19 is a crisis within a larger crisis arising from the escalating impacts of climate change on lives and economies. Preserving the ability of governments ­ to invest in the transition to a green economy will be critical to counteract the inequitable impacts of climate change. Increased inequality within and between countries The economic impact of the pandemic has been highly unequal within and between countries. As the COVID-19 crisis unfolded in 2020, it became clear that many households and firms were ill-prepared to withstand an income shock of the length and scale of the pandemic. In 2020, more than 50 percent of households globally were not able to sustain basic consumption for more than three months in the event of income losses, while the cash reserves of the average business would cover fewer than 51 days of expenses.8 Within countries, the crisis disproportionately affected disadvantaged groups. In 2020, in 70 per- cent of countries the incidence of temporary unemployment was higher for workers who had completed only primary education.9 Income losses were similarly larger among youth, women, the self-employed, and casual workers with lower levels of education.10 Women, in particular, were affected by income and employment losses because they were more likely to be employed in sectors most affected by lockdown and social distancing measures, and they bore the brunt of the rising family care needs associated, for example, with the closures of childcare centers and schools. According to high-frequency phone survey data collected by the World Bank, in the initial phase of the pandemic, up to July 2020, 42 percent of women lost their jobs, compared with 31 percent of men, further underscoring the unequal impacts of the crisis by gender.11 The pattern of the crisis having a higher impact on disadvantaged groups applies to both emerging and advanced economies.12 Early evidence from a number of emerging economies points to significant increases in within-country inequality.13 It also reveals that initial disparities in job losses did not decline as lockdown and social distancing measures were relaxed. Those who suffered larger initial losses— women, younger workers, urban workers, and those with low levels of formal education—recovered more slowly than their counterparts or were not able to substantially reverse the initial disparities in losses.14 Not surprisingly, with average incomes contracting and the effects concentrated among the less well-off, the available global data suggest that the pandemic has had a substantial impact on global poverty.15 Similar patterns emerge for businesses. Smaller firms, informal businesses, and those with more limited access to the formal credit market were harder-hit by income losses stemming from the pan- demic. Larger firms entered the crisis with the ability to cover expenses for up to 65 days, compared with 59 days for medium-size firms and 53 and 50 days for small firms and microenterprises, respectively. Moreover, micro-, small, and medium-size enterprises were overrepresented in the sectors most affected by the crisis, such as accommodation and food services, retail, and personal services. These businesses were more likely to suffer from supply chain disruptions that limited their access to inventory or sup- plies. Emerging data from surveys also indicate that affected businesses had to contend with longer payment terms or payment delays from buyers, including the public sector.16 These indicators are particularly alarming because in many emerging economies small and infor- mal businesses account for a large share of total economic activity and employment. It is, for example, OVERVIEW | 5 estimated that the informal economy accounts for about 34 percent of GDP in Latin America and Sub- Saharan Africa and 28 percent of GDP in South Asia.17 In India, more than 80 percent of the total labor force is employed in the informal sector.18 The survival of small and informal businesses therefore has a direct impact on the broader economy. The pandemic also exposed and worsened preexisting fragilities in the financial sector. Similar to that of households and governments, the resilience of banks and financial institutions at the onset of the pandemic varied widely across countries. Some countries that were heavily affected by the 2007–09 global financial crisis had initiated meaningful financial sector reforms in response and ensured that their banking systems were well capitalized.19 In some countries, such as Ghana, reforms also strength- ened regulation and capitalization of the microfinance and nonbank sector. As a result, the financial sector in these countries was better able to weather the strains of the pandemic. Many emerging economies, however, had failed to address financial sector fragilities in the years prior to the crisis, which compounded the problems of chronically low levels of financial intermediation and credit in the private sector. As a result, the financial sectors of these countries were ill-prepared for a crisis of the magnitude of the COVID-19 recession, which further reduced their ability to finance con- sumption and productive investment through the recovery. The economic policy response to the pandemic: Swift but with large variation across countries There were also marked inequalities in the crisis response across countries, which reflect differences in the resources and policy tools available to governments. As the pandemic intensified in 2020, the size and scope of government support programs varied widely. Many low-income countries struggled to mobilize the resources necessary to fight the immediate effects of the pandemic, or had to take on sig- nificant new debt to finance the crisis response. Half of the low-income countries eligible for the Group of Twenty (G20) Debt Service ­ Suspension Initiative (DSSI), for example, were already in debt distress or close to debt distress prior to the pandemic.20 During the first year of the pandemic, the debt stock of these countries increased from 54 percent to 61 percent of GDP, further limiting their ability to respond to the possibility of a drawn-out recovery.21 While these debt levels are low by the standards of advanced economies, which have a much higher debt carrying capacity, they have been associated with the onset of debt crises in low-income countries.22 Figure O.4 shows the stark variation across countries in the scale of the fiscal response to the pandemic. The magnitude of the fiscal response as a share of GDP was almost uniformly large by any ­ historic metric in high-income countries and uniformly small or nonexistent in low-income countries. In middle-income countries, the fiscal response varied significantly, reflecting marked differences in the ability and willingness of governments to mobilize fiscal resources and spend on support programs. In many cases, fiscal emergency measures were supported by large monetary policy interventions. Sev- eral emerging economy central banks, for example, used unconventional monetary policies such as asset purchase programs for the first time in history. These programs supported the fiscal response and pro- vided liquidity at a time it was most urgently needed. However, the capacity of central banks to support the crisis response in this manner varied dramatically, so that these policy tools were both more widely used and more effective in higher-middle-income countries that had deeper capital markets and a more sophisticated financial sector. By contrast, in most low-income countries governments were constrained in their response to the crisis because monetary policy was not able to play a similarly supportive role. The initial impact of the pandemic translated into rising inequality across countries in large measure because of the constraints many governments faced in assisting households and businesses.23 Although 6 | WORLD DE VELOPMENT REPORT 2022 Figure O.4 Fiscal response to the COVID-19 crisis, selected countries, by income group 50 40 Share of GDP (%) 30 20 10 0 p. s r ina e a ico l p ia h e il y ia ia n ru il e e me te s ion ly n m ga ge ke az Re ine an om om es om ta pa I ta es Ind do Pe Ch Ch ex rat hio ne ta co Ni k is r Br lad Gh Ja on Tu p rab c in c in c ing dS M ili p Se -in -in de Et be ng Ind t, A le - le - dK Fe i te ow Ph ig h Uz Ba idd idd yp Un i te ian nl nh Eg Un -m -m ea ss ea M er er Ru M ow pp nu nl ea ea M M High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on IMF (2021a). Data from International Monetary Fund, Fiscal Monitor Database of Country Fiscal Measures in Response to the COVID-19 Pandemic, Fiscal Affairs Department, https://www.imf.org/en/Topics/imf -and-covid19/Fiscal-Policies-Database-in-Response-to-COVID-19. Note: The figure reports, as a percentage of GDP, the total fiscal support, calculated as the sum of “above-the-line measures” that affect government revenue and expenditures and the subtotal of liquidity support measures. Data are as of September 27, 2021. poverty increased globally, nearly all of those who have slipped into extreme poverty (measured as the number of people living on less than $1.90 a day) as a result of the crisis live in lower-middle- and low- income countries.24 In addition to the scale of the policy response, there has also been wide variation in the combination of policy tools that countries have used to fight the immediate economic effects of the pandemic. This is illustrated by figure O.5, which shows the percentage of countries within country income groups that adopted different types of fiscal, monetary, and financial sector policy measures. The figure highlights some differences in the policy mix that are explained by resource constraints, as well as some differ- ences that are explained by differences in the nature of economic risks faced by different countries. High- income and upper-middle-income economies, for example, made much more extensive use of financial sector policies, such as debt moratoria, given that financial institutions in these countries are much more exposed to household and small business loans, whose credit risk was severely affected by the pandemic. Figure O.5 also highlights that the immediate response to the pandemic included a number of policy tools that were either untested in emerging economies or altogether unprecedented at this scale. One example are the extensive debt repayment moratoria and freezes on credit reporting that were enacted in many countries around the world. Although these programs have played an import- ant role in mitigating the short-term liquidity issues faced by households and businesses, they did not necessarily address the future ability to repay, and had the unintended consequence of hiding loan losses, thereby creating a new problem: lack of transparency about credit risk and the true health of the financial sector. OVERVIEW | 7 Figure O.5 Fiscal, monetary, and financial sector policy responses to the pandemic, by country income group Tax breaks for firms Tax breaks for individuals Fiscal Direct cash transfers to individuals Income support for businesses Asset purchases Monetary Central bank liquidity Change in policy rate Debt moratoria for households Financial sector Debt moratoria for microfinance borrowers Debt moratoria for firms Regulatory forbearance 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 Share of countries adopting policy (%) High-income Upper-middle-income Lower-middle-income Low-income Sources: Fiscal measures: Lacey, Massad, and Utz 2021; monetary measures: World Bank, COVID-19 Finance Sector Related Policy Responses, September 30, 2021, https://datacatalog.worldbank.org/dataset/covid-19-finance-sector-related-policy -responses; financial sector: World Bank, COVID-19 Crisis Response Survey, 2021, http://bit.do/WDR2022-Covid-19_survey. Note: The figure shows the percentage of countries in which each of the listed policies was implemented in response to the pandemic. Data for the financial sector measures are as of June 30, 2021. Resolving financial risks: A prerequisite for an equitable recovery The impact of the COVID-19 economic crisis has created unprecedented financial risks that will force governments, regulators, and financial institutions to pursue short-term stabilization policies and longer-term structural policies to steer their economies toward a sustained and equitable recovery. Traveling this path will require timely action in four policy areas: 1. Managing and reducing loan distress 2. Improving the legal insolvency framework 3. Ensuring continued access to finance 4. Managing increased levels of sovereign debt. 8 | WORLD DE VELOPMENT REPORT 2022 Policy area 1: Managing and reducing loan distress In many countries, the crisis response has included large-scale debt relief measures, such as debt mora- toria and freezes on credit reporting. Many of these policies have no historical precedent; it is therefore difficult to predict their longer-term impacts on the credit market. As governments wind down such support policies for borrowers, lenders should expect to see increases in nonperforming loans (NPLs) of varying magnitudes across countries and sectors.25 Because many countries have relaxed the rules defining an NPL during the crisis, policy makers now face the challenge of interpreting increasingly opaque balance sheets. Banks’ incentives to underplay the true extent of exposure to problem loans will likely increase as moratoria end, other support measures are phased out, and the impact of the pandemic becomes clearer. If not countered by strong bank governance, robust regulatory definitions of NPLs, and careful bank supervision, hidden NPLs can create significant discrepancies between reported asset quality figures and the underlying economic realities. A lack of NPL transparency can stand in the way of a timely identification of potential banking system stress, weaken trust in the financial sector, and lead to reductions in investment and lending, which can hinder an equitable post­ pandemic recovery. Banks do have processes to manage NPLs in the normal course of business, but the scale and complex- ity of the possible increase resulting from the COVID-19 crisis could strain that capacity. This may, in turn, fuel a credit crunch, even in countries with sound financial institutions and, at worst, destabilize the financial sector. Banks confronting a decline in loan quality that severely affects capital tend to limit lending, and those reductions typically hit low-income households and small businesses the hardest. In this way, sharply rising NPLs can give rise to a negative feedback loop between deteriorating finan- cial sector performance and weakening real economic activity, which can also exacerbate Figure O.6 Capacity of banking systems to economic inequality. absorb increases in nonperforming loans, Therefore, managing the risk posed by by country income group opacity about rising NPLs should be a pri- break point (percentage points) ority to enable early and clear diagnosis of 55 50 Consolidated distance to emerging financial stress and thus facilitate 40 resolution of the problem, while recogniz- 35 ing that the degrees of stress and capacity to 30 absorb higher NPLs differ across countries 25 (figure O.6). 20 Microfinance institutions (MFIs) face 15 similar challenges and so warrant the same 10 attention from policy makers. Low-income 5 0 households and micro-, small, and medium Low- Lower- Upper- High- enterprises (MSMEs) in developing economies income middle- middle- income income income generally rely on MFIs instead of conventional banks for financial services. Although MFIs Source: WDR 2022 team, based on Feyen and Mare (2021). have so far weathered the pandemic better Note: The figure reports the percentage point increase in the nonperforming loan (NPL) ratio at the country level that wipes than initially expected, the challenges they out capital buffers for banks representing at least 20 percent face in refinancing their own debt and in pres- of banking system assets (see Feyen and Mare 2021). Higher sures on their asset quality—which so far have values denote higher capacity to absorb NPL increases. The been relatively stable in part because of gov- country distribution of the percentage point increase in the non- performing loan ratio is shown across country income groups. ernment support—may increase as moratoria The underlying bank-level data are from up to July 2021. Dots are are fully lifted and loans begin to come due. values falling outside the whisker range. OVERVIEW | 9 Past crises have revealed that without a swift, comprehensive policy response, loan quality issues are likely to persist and worsen over time, as epitomized by the typical increase in loans to “zombie firms”— that is, loans to weak businesses that have little or no prospect of returning to health and fully paying off their debts. Continued extension and rolling over of loans to such firms (also known as evergreening) stifles economic growth by absorbing capital that would be better directed to loans for businesses with high productivity and growth potential. Some financial institutions may be unable to cope with rising NPLs and will require recapitalization or resolution. If left unaddressed, rising NPLs can set the stage for systemic banking crises, which are associated with severe and prolonged recessions and consequent effects on poverty and inequality. A prompt comprehensive response is therefore critical to preserving the financial sector’s ability to support an equitable recovery and avoid mounting losses for the financial system. A strategy that supports timely identification and management of NPLs is necessary. The key elements of such a strategy are transparency, loan resolution, and problem bank resolution. Improving transparency and supervision and reducing incentives for mismeasurement An important first step is to establish enforceable rules and incentives that support transparency about the true state of banking assets. Assessing asset quality during the pandemic is complex because of the great uncertainty about economic prospects and the extent and persistence of income losses. The wide- spread use of debt moratoria and other support measures for borrowers has made it even more difficult for banks to assess the true repayment capacity of both existing and prospective borrowers. Indeed, debt moratoria and other support measures have reduced the comparability of NPL metrics across time both in countries and among countries. Accurate and timely indicators of loan quality are essential to gauge the overall health of the financial sector and the ability of banks to absorb credit losses that may materialize in the near future.26 The use of internationally agreed definitions of NPLs is critical for monitoring and assessing banks’ asset quality in a consistent manner.27 The easing of regulatory definitions obscures banks’ true asset quality chal- lenges and should be avoided. Robust regulatory definitions should be underpinned by effective banking supervision. Banking supervisors, responsible for enforcing these regulatory definitions, must ensure that banks comply with prudential rules in an increasingly challenging environment. As pressure on the asset quality of banks increases, they increasingly are susceptible to incentives to step up efforts to disguise the extent of their difficulties in an attempt to avoid a supervisory or market response. Faced with these incentives, some banks may exploit regulatory loopholes or engage in questionable practices such as evergreening loans or transferring loans off balance sheets to present an overly optimistic picture of asset quality, which, in turn, can make a banking supervisor’s job significantly more difficult. Resolving troubled loans through regulatory interventions Governments and banking supervisors can use various interventions to encourage banks to step up efforts to resolve troubled loans. To manage rising volumes of bad debt, they can require banks to adopt appropriate processes and dedicate sufficient resources to recovering past-due loans. Bank business models, organizational structure, strategy, and internal resources must all reflect a coherent approach to managing rising NPLs, including setting up dedicated internal workout units and devising methodologies to assess borrower viability. Banks hold primary responsibility for managing distressed loans. Public interventions may be nec- essary as well, however, if problem loans jeopardize a banking system’s capacity to finance the real 10 | WORLD DE VELOPMENT REPORT 2022 economy or threaten the stability of the financial system. Individual bank-level strategies may not be sufficient when the increase in NPLs is systemwide, as would be expected after a pandemic. Public policy interventions, such as national NPL resolution strategies for coordinating NPL resolution efforts across stakeholders in the economy, can play a useful role in accelerating the reduction of bad debts. For example, the government of Serbia established a national NPL working group in May 2015 after the banking sector NPL ratio rose to 23.5 percent after the global financial crisis. The working group, which included participants from the public and private sectors, developed and implemented a comprehensive strategy for reducing NPLs,28 which contributed to a fall in the NPL ratio to a historic low of 3.7 percent in December 2020. In response to sharp systemic increases in NPL volumes, some countries have established public asset management companies (AMCs) or a systemwide “bad bank” to manage problem loans removed from bank balance sheets. Such a step can help to restore public confidence in the banking sector and prevent unnecessary fire sales. For example, in response to earlier crises, public AMCs were created in Malaysia and Spain in conjunction with publicly funded bank recapitalization schemes to overcome capital space constraints that otherwise would have hindered efforts to recognize the full extent of banks’ exposure to problem loans. The case for and effectiveness of public AMCs depend on a country’s circumstances and on the soundness of the overall design. This is an area in which emerging economies have in practice often experienced challenges. Dealing with problem banks When banks are unable to absorb the additional financial stress from the pandemic and develop a viable recovery plan, authorities must be able to deploy a robust set of early intervention measures to turn around ailing banks and resolve failing ones. Measures for dealing with failing banks should include a legal regime that sets bank failures apart from the general insolvency framework and gives authorities more policy options and greater powers to allocate losses to shareholders and uninsured liability holders, thereby protecting depositors while shielding taxpayers against financial sector losses. Authorities responsible for handling troubled banks should always prioritize solutions led and funded by the private sector, building to the extent possible on the financial buffers of troubled financial entities. The use of public money to resolve a crisis should be a last resort, deployed after private sector solutions have been fully exhausted and only to remedy an acute and demonstrable threat to financial stability. Policy area 2: Improving the legal insolvency framework Many households and businesses are struggling with unsustainable debts as a result of the pandemic. Insolvency proceedings can be an effective mechanism to help reduce excessive levels of private debt. However, a sudden increase in loan defaults and bankruptcies resulting from the crisis (figure O.7) poses a significant challenge for the capacity of insolvency frameworks to resolve bankruptcies in a timely manner, even in advanced economies with strong institutions. This challenge stems, in part, from the complexity of court-led insolvency processes. According to World Bank data, resolution of a corporate bankruptcy case in the average country takes more than two years.29 Complex liquidations can take even longer, even in well-functioning judicial systems. For countries with weak insolvency frameworks, retaining the status quo creates the risk that more drastic and costlier action will be needed if NPLs and insolvency filings increase. The absence of effective legal mechanisms to declare bankruptcy or resolve creditor-debtor disputes invites political interference in the credit market in the form of debt relief mandated by the government because such OVERVIEW | 11 Figure O.7 Share of enterprises in arrears or expecting to fall into arrears within six months, selected countries, May–September 2020 100 90 Share of enterprises (%) 80 70 60 50 40 30 20 10 0 gh ad l is h M Ken n g a Sr ab ia a i L on ne a N al H Su er d n s s Gu ovo Pa Ind a ki ia ar va N old an Jo gua Vi Togn yz nz ria El om blic lv ia ba ia Ca oro ala bo o Uz Alb dia k ia jik gia ia In Pol ria Fe n d ra ia Ch n ad et o N am R pu a Zi rm or m e Gu Tu bia M m y Ta eor n lg n Af ngl epa at rke Ko ura Za bw on y Ba Nfric Se ank e i an es ta a on da G ista tio Bu ista n do an m cc G ol g Sa an m en be an de es Re an ig A ad ic o in M st rd rg Ta ige a n a A e h ut So Ky ss Ru Source: Apedo-Amah et al. 2020, based on World Bank, COVID-19 Business Pulse Survey Dashboard, 2020–21 data, https://www.worldbank.org/en/data/interactive/2021/01/19/covid-19-business-pulse-survey-dashboard. Note: The figure presents percentages for countries surveyed by the World Bank. action becomes the only alternative for resolving unsustainable debts. Indeed, emerging economies have made extensive use of politicized debt forgiveness programs. In the past, such programs have often damaged credit discipline and the ability of creditworthy borrowers to obtain loans in the lon- ger term.30 Even in economies that have effective insolvency laws, debt resolution can be inhibited by a slow, overburdened judicial system with insufficient resources to manage the legal and procedural complexity of the issues. Improving the institutional capacity to manage insolvency is critical for equitable economic recovery for several reasons. First, when households and businesses are saddled with unsustainable debts, con- sumption, job creation, and productive investment are suppressed. Second, the longer the time needed to resolve a bankruptcy case, the larger are the losses to creditors. Third, higher creditor losses reduce the availability of credit in the economy and raise its cost.31 Finally, the longer the bankruptcy process, the more time overindebted “zombie” firms have to absorb resources that could support equitable eco- nomic recovery if they were redeployed to more productive firms. In the aftermath of the COVID-19 crisis, the availability and efficiency of bankruptcy systems will determine how quickly unsustainable debt burdens can be reduced and, consequently, how quickly recovery can be achieved. Studies reveal that improvements in insolvency frameworks are associated with greater access to credit,32 faster creditor recovery, stronger job preservation,33 higher productivity,34 and lower failure rates for small businesses.35 Cost-reducing reforms can also create the right conditions for nonviable firms to file for liquidation,36 thereby freeing up resources that could be redirected toward more productive firms with better growth prospects. The following reforms can help to ease COVID-19 debt distress and facilitate an equitable economic recovery. These reforms can be taken up by economies at varying stages of development, with varying degrees of sophistication in their existing insolvency laws, and at varying levels of institutional capacity, and have been shown to be effective by evidence from numerous countries. 12 | WORLD DE VELOPMENT REPORT 2022 Strengthening formal insolvency mechanisms A strong formal insolvency law regime defines the rights and behaviors needed for orderly in-court and out-of-court workouts.37 A well-designed system includes incentives to motivate creditors and debtors to cooperate in the resolution process. Other tenets of a strong system are predictable creditor senior- ity rules that define the order in which debts are repaid;38 timely resolution, which creates a positive feedback loop motivating all actors to engage in out-of-court workouts;39 and adequate expertise in the complexities of bankruptcy law. Finally, early warning tools for the detection of business distress hold great promise to assist in the early identification of debtors in financial difficulty before this difficulty escalates to the point of insolvency. Facilitating alternative dispute resolution systems Alternative dispute resolution (ADR) frameworks can provide quicker and cheaper resolution of disputes than the formal court system, while retaining some of the rigor that courts provide. In an ADR pro- cess, the debtor and creditor engage directly. The process can be mediated by a third party; resolutions are contractually binding; and participants can maintain confidentiality. Variations of ADR processes include degrees of court involvement. Significant creditor buy-in and cohesion are needed in the ADR process because creditors unwilling to make concessions can bring the process to a halt. Active com- munications by regulators with the private sector, or legal mechanisms to prevent minority creditors from obstructing progress on a restructuring deal, are two methods that can help address the challenges associated with creditor cohesion. Establishing accessible in-court and out-of-court procedures for small businesses Small and medium-size businesses are less well capitalized than large businesses and frequently lack the resources and expertise to effectively understand and use complex, costly insolvency systems. Exacer- bating these structural problems, the pandemic has hit small businesses harder than large businesses. Because of these factors, dedicated reforms are needed to design insolvency systems that cater to small and medium-size businesses. Such reforms include increasing the efficiency of debt restructuring for viable firms by simplifying legal processes, allowing debtors to maintain control of their businesses when possible, making fresh financing available, and using out-of-court proceedings to keep costs down. With these reforms, policy makers can help facilitate the survival of viable but illiquid firms and the swift exit of nonviable firms. Promoting debt forgiveness and long-term reputational protection for former debtors Job losses, reduced operations, and declining sales stemming from the COVID-19 pandemic have pushed many historically creditworthy individuals and entrepreneurs into delinquency. For small businesses, which are often financed at least in part by debt personally guaranteed by the entrepreneur, business failures can have severe adverse consequences. Because many of these borrowers have been devastated through no fault of their own, courts should try to quickly resolve no-income, no-asset cases, and the law should provide a mechanism for discharge and a fresh start for natural person entrepreneurs. High costs (such as court filing fees) and barriers to access (such as overly burdensome or confusing procedures) should be reduced or eliminated for personal bankruptcy, in particular for no-income, no-asset cases. Policy area 3: Ensuring continued access to finance Many households and small businesses are at risk of losing access to formal finance because of multiple factors stemming from the pandemic. Although most lenders have not seen massive pandemic-related OVERVIEW | 13 liquidity challenges, they anticipate a rise in NPLs, and their ability to extend new loans is constrained by the ongoing economic disruption and the transparency issues discussed earlier. In these circumstances, lenders tend to issue less new credit, and the new credit they do issue goes to better-off borrowers. A review of quarterly central bank surveys on credit conditions in both advanced and emerging econo- mies finds that the majority of economies for which surveys were available experienced several quarters of tightening credit standards after the onset of the crisis (see figure O.8). In periods of tighter credit, the most vulnerable borrowers, including small businesses and low-income households that lack physical collateral or a sufficiently long credit history, tend to be the first cut off from credit. It is difficult to estimate how long it will take countries to fully recover from the pandemic and its economic repercussions. Because of uncertainty about the economic recovery and the financial health of prospective borrowers, financial institutions find it challenging to assess risk—a prerequisite for credit underwriting. Debt moratoria and freezes on credit reporting, while important for addressing the immediate impacts of the shock, have made it harder for banks to distinguish borrowers experi- encing temporary liquidity problems from those that are truly insolvent. As for low-income households and small businesses, their credit risk is difficult to assess even in normal times because they usually lack a credit history and audited financial statements. The widespread disruption of business activity Figure O.8 Quarterly trends in credit conditions, by country income group, 2018–21 40 COVID-19 onset Easing Net percentage of countries reporting 30 a change in credit conditions 20 10 0 –10 –20 –30 –40 –50 –60 –70 Tightening –80 18 18 18 18 19 19 19 19 20 20 20 20 21 21 21 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 All High-income Low- and middle-income Source: WDR 2022 team calculations, based on data from survey reports by the central banks of 38 countries published or accessed as of December 15, 2021: Albania, Argentina, Austria, Belgium, Canada, Chile, Cyprus, Czech Republic, Estonia, France, Germany, Ghana, Greece, Hungary, India, Indonesia, Ireland, Italy, Japan, Latvia, Lithuania, Mexico, the Netherlands, North Macedonia, the Philippines, Poland, Portugal, Romania, the Russian Federation, Serbia, Spain, Thailand, Turkey, Uganda, Ukraine, the United Kingdom, the United States, and Zambia. Note: The figure shows the net percentage of countries in which banks reported a change in overall credit conditions in quarterly central bank loan officer or credit condition surveys. The net percentage is the difference between the share of countries that report an overall easing in credit conditions and the share of countries that report an overall tightening of credit conditions relative to the previous quarter. A negative net percentage value indicates an overall tightening of credit conditions in the sample of countries covered. For Chile, Japan, Mexico, Poland, Russia, the United States, and Zambia, the overall credit conditions are estimated from an index of reported credit conditions in business and consumer segments. 14 | WORLD DE VELOPMENT REPORT 2022 and livelihoods has made assessment even more difficult. Banks and nonbank lenders therefore react by tightening credit and reallocating lending—where possible—to observably lower-risk borrowers. Lending innovations that incorporate new approaches for risk measurement and product design can counter this tendency. The accelerated digital adoption that occurred during the pandemic, coupled with the ongoing digital transformation of financial services and financial infrastructure (in a context of consumer and sector protection) could enable those innovations and help lenders better navigate COVID-19–related uncertainty to continue issuing credit. Mitigating risk by improving visibility and recourse The pandemic has made it more difficult to assess the credit risk of potential borrowers and limited lenders’ recourse when a borrower defaults. New data and technologies can be used to update existing risk models and increase visibility into a borrower’s ability to repay. For example, Konfío—a digital MSME lender that leverages electronic invoices and other alternative data to supplement traditional credit information—adapted its credit algorithm in the early months of the pandemic to integrate granular data on the impacts of COVID-19 on small firms in Mexico. It then doubled its monthly loan disbursements during the pandemic. Other strategies to enhance visibility include temporarily reducing loan tenors and leveraging digital channels to gather high-frequency current transactional data. The use of digital channels can also lower delivery costs to reach small businesses and households more effectively. Adapting loan product design and product selection can improve recourse in the event the borrower does not repay. Products that allow borrowers to pledge movable assets as collateral or that offer lend- ers less traditional forms of recourse, such as liens on future cash flows, can help offset the impacts of the pandemic on traditional collateral. Working capital financing that occurs within a supply chain or is embedded in the workflow of a commercial transaction links credit to an existing commercial relationship, as well as to an underlying economic activity and its associated data. Forms of embedded finance are expanding into payments, lending, insurance, and other product areas in various contexts, including e-commerce, logistics, order and inventory management, and other digital platforms. These and other forms of contextual lending provide both better visibility into the financial prospects of the borrower and additional recourse—for example, through automatic repayments from the borrower’s revenue through the platform. Supporting new lending by insuring credit risk Insuring against loss can help to restore credit growth when sufficient visibility and recourse cannot be achieved using the innovations just described. Credit guarantees give lenders recourse to the guarantor in case of default by the borrower. These instruments may be offered by governments, development banks, or donors to promote lending to priority segments where there are market failures in financ- ing such as small businesses. Guarantees have been a component of pandemic responses in advanced countries and several emerging economies, and partial guarantee schemes may continue to play an important role in the recovery. For example, in Burkina Faso the World Bank helped the government set up a credit guarantee scheme focused on restructured and working capital loans for small and medium enterprises struggling from the COVID-19 crisis, but with potential for long-term profitability. Such programs must be carefully designed to be sustainable. As economic conditions improve, guarantors and their partner lenders can progressively narrow eligibility to the sectors or customer segments that continue to be most in need, and guarantee programs can be leveraged to reduce the risk asso- ciated with longer-term investments to support priorities such as job creation and financial flows to low-carbon activities. OVERVIEW | 15 Adopting policies to facilitate access and manage risks Financial innovation has the potential to support responsible delivery of financial services, but unsuper- vised financial innovation can pose risks for both consumers and financial stability and integrity. Gov- ernments and regulators must modernize their policy frameworks to balance the sometimes conflicting imperatives of encouraging responsible innovation while also protecting customers and the financial sector’s stability and integrity. Updated regulatory and supervisory approaches should seek to recognize and enable entry into the market of new providers, introduction of new products, and innovations in the use of data and analytics; enhance consumer protection policies and rules around what finance provid- ers can and cannot offer; and facilitate collaboration between regulators and the government authorities overseeing different aspects of digital and embedded finance, as well as competition and market con- duct, to prevent regulatory gaps between agencies with overlapping authority. Policies should support modernization of financial infrastructure to facilitate operational resilience and access, including both “hard” infrastructure related to telecommunications networks, payment networks, data centers, credit bureaus, and collateral registries, and “soft” infrastructure around the policies and procedures that dic- tate standards, access, and rules of engagement. These government policy responses to support digital transformation can help foster a more robust, innovative, and inclusive financial sector. Policy area 4: Managing higher levels of sovereign debt The pandemic has led to a dramatic increase in sovereign debt. As shown in figure O.9, the average total debt burdens among low- and middle-income countries increased by roughly 9 percentage points of GDP during the first year of the pandemic, 2019–20, compared with an average increase of 1.9 percent- age points over the previous decade. Although interest payments in high-income economies have been trending lower in recent years and account, on average, for a little over 1 percentage point of GDP, they have been climbing steadily in low- and middle-income economies.40 Debt distress—that is, when a country is not able to fulfill its financial obligations—poses significant social costs. One study finds that every year that a country remains in default reduces GDP growth by 1.0–1.5 percentage points.41 During the pandemic, governments accumulated debt to finance current expenditures, but it came at the cost of limiting their ability to spend in the future, including on public goods such as education and public health. Underinvestment in these services can worsen inequality and human development outcomes.42 High debt and lack of spending flexibility also limit the capacity of governments to cope with future shocks.43 Moreover, because governments are often the lender of last resort, private sector debts can quickly become public debt if financial and economic stability is threat- ened in an economic crisis and public assistance is required. Protecting the ability of the government to invest in public goods, to act in a countercyclical manner, and to enable the central bank to deliver on its unique role as the lender of last resort is a central goal of managing sovereign debt. Managing sovereign debt to free up resources for the recovery Countries at high risk of debt distress can pursue several policy options to make payment obligations more manageable. The feasibility of these options is shaped by the specifics of the case, including the extent of a country’s access to private capital markets, the composition of the debt and creditors, and the debtor coun- try’s ability and willingness to negotiate and undertake necessary reforms. The options include modifica- tions of the structure of liabilities and schedule of future payments through negotiations with creditors and the effective use of refinancing tools (debt reprofiling). Proactive debt management can reduce the risk of default and free up the fiscal resources needed to support an equitable economic recovery. A reprofiling operation could be helpful when a country has multiple loans to be repaid in the same year. The country could issue new debt with a longer or a more even maturity profile. Debt reprofiling 16 | WORLD DE VELOPMENT REPORT 2022 Figure O.9 General government gross debt, by country income group, 2010–20 80 79.2 70 68.4 65.6 67.0 Share of GDP (%) 60.9 60 61.4 58.8 55.6 50 54.4 41.0 40 39.8 36.7 30 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on data from IMF (2021b); World Bank, World Development Indicators (database), https:// datatopics.worldbank.org/world-development-indicators/. Note: The figure shows the general government debt stock as a share of gross domestic product (GDP) by World Bank income classification. operations can also help address currency risk, which often adds to debt sustainability concerns. In this case, instead of changing the maturity of the existing debt, the debt reprofiling operation retires the existing debt denominated in one (more expensive or volatile) currency by issuing new debt in another (less expensive or more stable) currency. Countries facing elevated default risk also have the option of initiating preemptive negotiations with their creditors to reach debt restructuring. This option particularly benefits from transparency around the terms and ownership of the debt. Minimizing the chances of holdouts is important to ensure a speedy resolution. Some evidence shows that a preemptive restructuring is resolved faster than a post- default restructuring, leads to a shorter exclusion of the country from global capital markets, and is associated with a smaller loss in output.44 Resolving debt distress Once a government is in debt distress, the options to treat the problem are more limited and the urgency is greater. A primary tool at this stage is debt restructuring coupled with a medium-term fiscal and economic reform plan. Use of this tool requires prompt recognition of the extent of the problem, coor- dination with and among creditors, and an understanding by all parties that restructuring is the first step toward debt sustainability. International financial institutions such as the World Bank and the International Monetary Fund (IMF) play an important role in the debt restructuring process for emerg- ing economies by providing the debt sustainability analyses needed to fully understand the problem and often offering the financing to make the deal viable. A swift, deep restructuring agreement allows a faster and more sustained recovery.45 The historical track record, however, reveals that resolution of sovereign debt distress is often delayed for years. Even when a country enters negotiations with its creditors, multiple rounds of debt restructuring are often needed for it to emerge from debt distress (see figure O.10). The Democratic Republic of Congo, Jamaica, and Nigeria each had to negotiate seven debt restructuring deals before resolving their debt situations. OVERVIEW | 17 Figure O.10 Sovereign debt restructuring and time spent in default, selected countries, 1975–2000 Albania Algeria Antigua and Barbuda Argentina Bosnia and Herzegovina Brazil Bulgaria Chile Cook Islands Costa Rica Croatia Dominican Republic Ecuador Egypt, Arab Rep. Equatorial Guinea Gabon Guatemala Indonesia Iraq Jamaica Jordan Mexico Morocco North Macedonia Panama Paraguay Peru Philippines Poland Romania Russian Federation Slovenia South Africa Trinidad and Tobago Turkey Ukraine Uruguay Venezuela, RB Vietnam Yugoslavia 1975 1980 1985 1990 1995 2000 Period of default Debt restructuring Source: WDR 2022 team, based on Cruces and Trebesch (2013); Farah-Yacoub, Graf von Luckner, and Reinhart (2021); Meyer, Reinhart, and Trebesch (2019); Reinhart and Rogoff (2009). Note: The figure shows a timeline of sovereign defaults and debt restructuring from 1975 to 2000. The figure excludes coun - tries covered by the International Development Association (IDA) and the Heavily Indebted Poor Countries (HIPC) Initiative. 18 | WORLD DE VELOPMENT REPORT 2022 Restructuring sovereign debt may have become more complex. The creditor community now has a higher share of nontraditional lenders (such as investment companies, bondholders, and official credi- tors who are not members of the Paris Club46). Domestic sources of financing have also increased. Poten- tial off–balance sheet and often unrecorded public sector borrowing from state-owned enterprises and special-purpose vehicles has also trended higher. Collectively, these developments reduce transparency and may complicate the coordination between creditors. In emerging economies, reducing sovereign debt (particularly external debt) has often required debt restructuring, but governments have also pursued fiscal consolidation (lower expenditures, higher taxes, or both) to improve government revenue, fiscal balances, and debt servicing capacity. Other ways to reduce domestic currency–denominated debt have included liquidation through inflation or financial repression.47 Although these approaches have often delivered debt reduction, they frequently come with extremely high social and economic costs that can aggravate poverty and inequal- ity. Inflation is a regressive tax, which would compound the already highly regressive effects of the COVID-19 crisis. Looking ahead—improving transparency and reducing coordination problems The surge in sovereign debt during the COVID-19 crisis highlights the need for strategies that can facil- itate effective debt management, debt negotiation, and access to capital markets over the longer term. Three broad initiatives stand out: greater debt transparency, contractual innovation, and tax ­policy and administration reforms. Effective, forward-looking debt management requires comprehensive disclosure of claims against the government and the full terms of the contracts that govern this debt. Recent debt events have high- lighted the problem of “hidden” or undisclosed debt and the possibility of legal disputes about the lack of authority of government and quasi-government entities to enter into debt contracts. Transparency on amounts owed and the contracts themselves does not guarantee a speedy restructuring, but it cer- tainly sets the stage for a more rapid recognition of debt sustainability problems, thereby improving surveillance, and a more favorable entry point for negotiations among the debtors and creditors and the creditors themselves. Contractual innovations, for their part, can help overcome coordination problems and speed up the resolution of sovereign debt restructuring. These innovations include collective action clauses (CACs),48 which could lead to faster resolution; state-contingent debt contracts that insure the bor- rower against disaster risk; and legal reforms that address problematic enforcement practices against states. These innovations offer a positive way forward for new debt contracts. However, they have a more limited role in dealing with debts that require restructuring because state-contingent contracts account for a small share of the outstanding debt contracts of emerging markets. Contracts that include enhanced CACs account for only about half of outstanding contracts.49 A well-developed tax policy and administration are essential for debt sustainability. Higher tax rev- enue arises principally from long-term investments in tax capacity and from structural changes in countries’ economies. Taxing wealth through property, income, and capital gains taxes is an underused revenue generation strategy in most emerging economies that would also mitigate the adverse impacts of the COVID-19 crisis on poverty and inequality. Revenue mobilization strategies should also strengthen incentives for businesses to formalize. As governments pursue changes to manage their debt and promote pro-recovery practices, it is important that they recognize that the COVID-19 pandemic is a crisis within a crisis because of the ongoing impacts of climate change on countries and their economies. Governments’ plans to rebuild should place the need for green investments front and center. One promising avenue is issuing sovereign OVERVIEW | 19 green and social bonds. Pioneering governments are beginning to pave the way for similar debt issu- ances by the private sector. In 2017, Nigeria became the first African country to issue a sovereign green bond, which was followed by the first green corporate issuance from Access Bank.50 In 2019, Chile became the first green sovereign bond issuer in Latin America, followed by Banco de Chile, which issued a green bond to raise funds for renewable energy projects.51 These types of green investments will need to grow as a share of the recovering economy. Conclusion The COVID-19 pandemic and the unprecedented worldwide public health crisis it unleashed led to millions of deaths, job losses, business failures, and school closings. The ensuing economic and social ­ disruption both exposed and exacerbated existing economic fragilities, especially in emerging econo- mies, where poverty rates soared and inequality worsened. Addressing the interrelated economic risks produced by the crisis is a prerequisite for a sustained and equitable recovery. This will require prompt recognition of balance sheet problems, as well as active management of the economic and financial risks. In an ideal situation, governments would implement relevant policies to address each of the risks highlighted by the crisis: financial instability; overindebted- ness among households and businesses; reduced access to credit; and rising sovereign debt. However, few if any governments have the resources and political leeway to tackle all of these challenges at once. Countries will have to prioritize the most important policy actions needed. For many low-income coun- tries, tackling unsustainable sovereign debt will be the first priority. Middle-income countries whose financial sectors are more exposed to corporate and household debt may, in contrast, need to focus on policies supporting financial stability. Although this Report concentrates on the key domestic financial and economic risks produced by the pandemic, a country's recovery prospects will also be shaped by events in the global economy. One example is fluctuations in the price of primary commodities, which are an important source of revenue for many emerging economies. Another example is exchange rate and interest rate risks, which could emerge as economic activity in advanced economies recovers and stimulus programs are withdrawn, resulting in central banks tightening global liquidity and raising interest rates. These global develop- ments expose households, firms, and governments in emerging economies to financial risks. A carefully chosen policy mix must therefore take into account both domestic and global threats to an equitable recovery. At the same time, the necessity to address the risks created by the pandemic offers an immense oppor- tunity to accelerate the shift toward a more efficient and sustainable world economy. Climate change is a major source of neglected risk in the world economy.52 Failure to manage these risks will result in the continued mispricing of assets, capital misallocation, and a vicious cycle in which devastating climate disasters are compounded by spikes in financial instability.53 The financial sector can help activate a virtuous cycle by recognizing and pricing climate risks, so that capital flows toward more sustainable firms and industries.54 In the aftermath of the COVID-19 pandemic, governments have an opportunity to support the financial sector’s ability to perform this role by, for example, mandating risk disclosures and phasing out any preferential tax, auditing, and regulatory policies for environmentally unsustain- able industries. The COVID-19 pandemic is possibly the largest shock to the global economy in over a century. As fiscal, monetary, and financial stimulus programs are withdrawn, new policy challenges will emerge at both the domestic and global levels. Early diagnosis of the economic effects of the crisis and decisive policy action to remedy these fault lines are needed to sustain an equitable recovery. There is no room for policy complacency. 20 | WORLD DE VELOPMENT REPORT 2022 Notes 1. Global real GDP growth in 2020 is estimated at –3.1 24. Ferreira et al. (2021) and Mahler et al. (2021), building percent in the International Monetary Fund’s World on these poverty estimates, estimate a measure of Economic Outlook (IMF 2021c) and –3.5 percent in the additional poverty years induced by COVID-19. They World Bank’s Global Economic Prospects (World Bank assume, conservatively, that poverty stemming from 2021a). the pandemic lasts for one year and show that addi- 2. For more details, see Mahler et al. (2021). tional poverty years have a strong downward-sloping 3. Kugler and Sinha (2020). relationship with GDP per capita. 4. See Reinhart, Rogoff, and Savastano (2003) on “debt 25. This observation assumes that the definition of a non - intolerance.” performing loan has remained constant throughout the 5. Holston, Kaminsky, and Reinhart (2021). pandemic. NPLs, as defined by the Basel Committee 6. This definition builds on the broader definition of on Banking Supervision (BCBS 2017), are those loans equitable development in World Bank (2005), but it is with lower credit quality in terms of delinquency status adapted to the context of the COVID-19 pandemic. (unpaid for a certain period of time) or unlikeliness of 7. Fratto et al. (2021); IMF (2021b). repayment. 8. Andersen et al. (2020). Data from World Bank, COVID-19 26. Pancorbo, Rozumek, and Seal (2020). Business Pulse Survey Dashboard, https://www.world 27. BCBS (2017). bank.org/en/data/interactive/2021/01/19/covid-19 28. NBS and MFIN (2018). -business-pulse-survey-dashboard. 29. World Bank (2020b). 9. The difference in the rate of work stoppage between 30. Giné and Kanz (2018). low- and high-educated workers was found to be 31. Jappelli, Pagano, and Bianco (2005); World Bank (2014). statistically significant in 23 percent of the countries. ­ 32. Araujo, Ferreira, and Funchal (2012). For more details, see Kugler et al. (2021). 33. Fonseca and Van Doornik (2020). 10. Bundervoet, Dávalos, and Garcia (2021). 34. Lim and Hahn (2003); Neira (2017). 35. World Bank (2014). 11. World Bank, COVID-19 Household Monitoring Dash­ 36. Giné and Love (2006). board, https://www.worldbank.org/en/data/interactive 37. Based on data from World Bank, COVID-19 Business /2020/11/11/covid-19-high-frequency-monitoring Pulse Survey Dashboard, https://www.worldbank.org -dashboard. /en/data/interactive/2021/01/19/covid-19-business 12. Adams-Prassl et al. 2020; Chetty et al. (2020); Crossley, -pulse-survey-dashboard. Fisher, and Low (2021). 38. Based on data from World Bank, COVID-19 Business 13. Mahler, Yonzan, and Lakner (forthcoming). Pulse Survey Dashboard, https://www.worldbank.org 14. Agrawal et al. (2021). /en/data/interactive/2021/01/19/covid-19-business 15. Because of a lack of comprehensive data on many -pulse-survey-dashboard. countries, the estimates at the global level assume 39. Gadgil, Ronald, and Vyakaranam (2019). there are no changes in inequality. Lakner et al. (2020) 40. Kose et al. (2021). and Yonzan et al. (2020) estimate the impact of 41. Borensztein and Panizza (2009). COVID-19 on global poverty using a range of assump­ 42. Baldacci, de Mello, and Inchauste (2002); Furceri and tions on inequality within countries. Zdzienicka (2012); Ravallion and Chen (2009). 16. Intrum (2020). 43. Mbaye, Badia, and Chae (2018). 17. Medina and Schneider (2019). 44. Asonuma and Trebesch (2016). 18. See International Labour Organization, “Informal Econ - 45. Reinhart and Trebesch (2016). omy in South Asia,” https://www.ilo.org/newdelhi 46. The Paris Club, a standing committee of official creditor /areasofwork/informal-economy/lang--en/index.htm. countries formed in 1956, has been instru­ mental in the 19. World Bank (2020a). majority of sovereign debt restructur­ ings since its 20. WDR 2022 team, based on data from World Bank creation. and International Monetary Fund, Joint World Bank– 47. See Reinhart, Reinhart, and Rogoff (2015). International Monetary Fund LIC DSF Database (Debt 48. A collective action clause (CAC) is an article in bond Sustainability Framework for Low-Income Countries), contracts establishing rules in case of restructuring. In https://www.world bank.org/en/programs/debt-toolkit particular, if a majority of bondholders agrees to debt /dsf. restructuring, that agreement becomes legally binding 21. Based on data from IMF (2021b); World Bank, World for all bondholders, including those who voted against Development Indicators (database), https://datatopics the restructuring. .worldbank.org/world-development-indicators/. 49. IMF (2020). 22. Reinhart, Rogoff, and Savastano (2003). 50. Climate Bonds Initiative (2017); Fatin (2019). 23. Mahler et al. (2021) based on World Bank, Global 51. Climate Bonds Initiative (2019). Economic Prospects DataBank, https://databank 52. Gennaioli, Shleifer, and Vishny (2012); Stroebel and .worldbank.org/source/global-economic-prospects; Wurgler (2021). World Bank, PovcalNet (dashboard), http://iresearch 53. Gennaioli, Shleifer, and Vishny (2012). .worldbank.org/PovcalNet/. 54. Bolton et al. (2020); Carney (2015); Fender et al. (2020). OVERVIEW | 21 References Adams-Prassl, Abi, Teodora Boneva, Marta Golina, and Paper 27431, National Bureau of Economic Research, Christopher Rauh. 2020. “Inequality in the Impact of the Cambridge, MA. Coronavirus Shock: Evidence from Real Time Surveys.” Climate Bonds Initiative. 2017. “Nigeria First Nation to Journal of Public Economics 189 (September): 104245. Issue a Climate Bonds Certified Sovereign Green Agrawal, Sarthak, Alexandru Cojocaru, Veronica Montalva, Bond.” Media release, December 19, 2017. https://www and Ambar Narayan. 2021. “COVID-19 and Inequality: .climatebonds.net/resources/press-releases/2017/12 How Unequal Was the Recovery from the Initial Shock?” /nigeria-first-nation-issue-climate-bonds-certified With inputs by Tom Bundervoet and Andrey Ten. Brief, -sovereign-green. World Bank, Washington, DC. Climate Bonds Initiative. 2019. “Banco de Chile.” Green Andersen, Steffen, John Y. Campbell, Kasper Meisner Niel - Bond Fact Sheet, September 17, Climate Bonds Initia- sen, and Tarun Ramadorai. 2020. “Sources of Inaction tive, London. https://www.climatebonds.net/files/files in Household Finance: Evidence from the Danish Mort- /2019-08%20CL%20Banco%20de%20Chile.pdf. gage Market.” American Economic Review 110 (10): Crossley, Thomas F., Paul Fisher, and Hamish Low. 2021. 3184–230. “The Heterogeneous and Regressive Consequences Apedo-Amah, Marie Christine, Besart Avdiu, Xavier Cirera, of COVID-19: Evidence from High Quality Panel Data.” Marcio Cruz, Elwyn Davies, Arti Grover, Leonardo Journal of Public Economics 193 (January): 104334. Iacovone, et al. 2020. “Unmasking the Impact of Cruces, Juan J., and Christoph Trebesch. 2013. “Sovereign COVID-19 on Businesses: Firm Level Evidence from Defaults: The Price of Haircuts.” American Economic across the World.” Policy Research Working Paper Journal: Macroeconomics 5 (3): 85–117. 9434, World Bank, Washington, DC. Farah-Yacoub, Juan, Clemens Graf von Luckner, and Car- Araujo, Aloisio P., Rafael V. X. Ferreira, and Bruno Funchal. men M. Reinhart. 2021. “The Eternal External Debt 2012. “The Brazilian Bankruptcy Law Experience.” Jour- Crisis: A Long View.” Unpublished manuscript, World nal of Corporate Finance 18 (4): 994–1004. Bank, Washington, DC. Asonuma, Tamon, and Christoph Trebesch. 2016. “Sover- Fatin, Leena. 2019. “Nigeria: Access Bank 1st Certified eign Debt Restructurings: Preemptive or Post-Default.” Corporate Green Bond in Africa; Leadership in Green Journal of the European Economic Association 14 (1): Finance.” Climate Bonds Initiative (blog), April 2, 2019. 175–214. ht tps://w w w.climatebonds.net /2019/0 4/nigeria Baldacci, Emanuele, Luiz de Mello, and Gabriela Inchauste. -access-bank-1st- cer tified- corporate - green-bond 2002. “Financial Crises, Poverty, and Income Distribu - -africa-leadership-green-finance. tion.” IMF Working Paper 02/4, International Monetary Fender, Ingo, Mike McMorrow, Vahe Sahakyan, and Omar Fund, Washington, DC. Zulaica. 2020. “Reserve Management and Sustainabil - BCBS (Basel Committee on Banking Supervision). 2017. ity: The Case for Green Bonds?” BIS Working Paper 849, “Prudential Treatment of Problem Assets—Definitions of Monetary and Economic Department, Bank for Interna- Non-performing Exposures and Forbearance.” Bank for tional Settlements, Basel, Switzerland. International Settlements, Basel, Switzerland. https:// Ferreira, Francisco H. G., Olivier Sterck, Daniel G. Mahler, www.bis.org/bcbs/publ/d403.htm. Bolton, Patrick, Morgan Despres, Luiz Awazu Pereira and Benoît Decerf. 2021. “Death and Destitution: The da Silva, Frédéric Samama, and Romain Svartzman. Global Distribution of Welfare Losses from the COVID-19 2020. The Green Swan: Central Banking and Financial Pandemic.” LSE Public Policy Review 1 (4): 1–11. Stability in the Age of Climate Change. Basel, Switzer- Feyen, Erik, and Davide Salvatore Mare. 2021. “Measuring land: Bank for International Settlements. Systemic Banking Resilience: A Simple Reverse Stress Borensztein, Eduardo, and Ugo Panizza. 2009. “The Testing Approach.” Policy Research Working Paper Costs of Sovereign Default.” IMF Staff Papers 56 (4): 9864, World Bank, Washington, DC. 683–741. Fonseca, Julia, and Bernadus Van Doornik. 2020. “Financial Bundervoet, Tom, María Eugenia Dávalos, and Natalia Development and Labor Market Outcomes: Evidence Garcia. 2021. “The Short-Term Impacts of COVID-19 from Brazil.” Working Paper 532, Research Department, on Households in Developing Countries: An Overview Central Bank of Brazil, Brasília. Based on a Harmonized Data Set of High-Frequency Fratto, Chiara, Brendan Harnoys Vannier, Borislava Surveys.” Policy Research Working Paper 9582, World Mircheva, David de Padua, and Hélène Poirson. 2021. Bank, Washington, DC. “Unconventional Monetary Policies in Emerging Markets Carney, Mark. 2015. “Breaking the Tragedy of the Horizon: and Frontier Countries.” IMF Working Paper WP/21/14, Climate Change and Financial Stability.” Address at International Monetary Fund, Washington, DC. Lloyd’s of London, London, September 29, 2015. https:// Furceri, Davide, and Aleksandra Zdzienicka. 2012. “How www.bis.org/review/r151009a.pdf. Costly Are Debt Crises?” Journal of International Money Chetty, Raj, John N. Friedman, Nathaniel Hendren, Michael and Finance 31 (4): 726–42. Stepner, and Opportunity Insights Team. 2020. “How Gadgil, Shon, Bindu Ronald, and Lasya Vyakaranam. 2019. Did COVID-19 and Stabilization Policies Affect Spend- “Timely Resolution of Cases under the Insolvency and ing and Employment? A New Real-Time Economic Bankruptcy Code.” Journal of Critical Reviews 6 (6): Tracker Based on Private Sector Data.” NBER Working 156–67. 22 | WORLD DE VELOPMENT REPORT 2022 Gennaioli, Nicola, Andrei Shleifer, and Robert W. Vishny. Lakner, Christoph, Daniel Gerszon Mahler, Mario Negre, and 2012. “Neglected Risks, Financial Innovation and Finan - Espen Beer Prydz. 2020. “How Much Does Reducing cial Fragility.” Journal of Financial Economics 104 (3): Inequality Matter for Global Poverty?” Global Poverty 452–68. Monitoring Technical Note 13, World Bank, Washing- Giné, Xavier, and Martin Kanz. 2018. “The Economic Effects ton, DC. of a Borrower Bailout: Evidence from an Emerging Mar- Lim, Youngjae, and Chin Hee Hahn. 2003. “Bankruptcy ket.” Review of Financial Studies 31 (5): 1752–83. Policy Reform and Total Factor Productivity Dynamics Giné, Xavier, and Inessa Love. 2006. “Do Reorganization in Korea: Evidence from Macro Data.” NBER Working Costs Matter for Efficiency? Evidence from a Bank- Paper 9810, National Bureau of Economic Research, ruptcy Reform in Colombia.” Policy Research Working Cambridge, MA. Paper 3970, World Bank, Washington, DC. Mahler, Daniel Gerszon, Nishant Yonzan, and Christoph Holston, Kathryn, Graciela L. Kaminsky, and Carmen M. Lakner [randomized order]. Forthcoming. “The Impacts Reinhart. 2021. “Bust without a Boom? Banking Fragil - of COVID-19 on Global Inequality and Poverty.” Unpub - ity during COVID-19.” Unpublished manuscript, World lished manuscript, World Bank, Washington, DC. Bank, Washington, DC. Mahler, Daniel Gerszon, Nishant Yonzan, Christoph Lak- IMF (International Monetary Fund). 2020. “The Inter- ner, Raul Andrés Castañeda Aguilar, and Haoyu Wu. national Architecture for Resolving Sovereign Debt 2021. “Updated Estimates of the Impact of COVID-19 Involving Private-Sector Creditors: Recent Develop- on Global Poverty: Turning the Corner on the Pan- ments, Challenges, and Reform Options.” Policy Paper demic in 2021?” World Bank Blogs: Data Blogs, June 24, 2020/043, IMF, Washington, DC. https://www.imf.org 2021. https://blogs.worldbank.org/opendata/updated /en/Publications/Policy-Papers/Issues/2020/09/30 -estimates-impact-covid-19-global-poverty-turning / T h e - I n te r n a ti o n a l - A r c h i te c t u r e - fo r - R e s o l v i n g -corner-pandemic-2021. -Sovereign-Debt-Involving-Private-Sector-49796. Mbaye, Samba, Marialuz Moreno Badia, and Kyungla Chae. IMF (International Monetary Fund). 2021a. “Fiscal Monitor 2018. “Bailing Out the People? When Private Debt Update.” January, IMF, Washington, DC. Becomes Public.” IMF Working Paper 18/141, Interna- IMF (International Monetary Fund). 2021b. World Economic tional Monetary Fund, Washington, DC. Outlook: Managing Divergent Recoveries. Washington, Medina, Leandro, and Friedrich Georg Schneider. 2019. DC: IMF. “Shedding Light on the Shadow Economy: A Global IMF (International Monetary Fund). 2021c. World Economic Database and the Interaction with the Official One.” Outlook: Recovery during a Pandemic; Health Concerns, CESifo Working Paper 7981, Munich Society for the Supply Disruptions, and Price Pressures. Washington, Promotion of Economic Research, Center for Economic DC: IMF. Studies, Ludwig-Maximilians-University Munich, and Intrum. 2020. “European Payment Report 2020: Special Ifo Institute for Economic Research, Munich. Edition White Paper.” Intrum, Stockholm. https://www Meyer, Josefin, Carmen M. Reinhart, and Christoph Tre - .intrum.com/media/8279/epr-2020-special-edition besch. 2019. “Sovereign Bonds since Waterloo.” NBER -white-paper_final.pdf. Working Paper 25543, National Bureau of Economic Jappelli, Tullio, Marco Pagano, and Magda Bianco. 2005. Research, Cambridge, MA. “Courts and Banks: Effects of Judicial Enforcement on NBS (National Bank of Serbia) and MFIN (Ministry of Credit Markets.” Journal of Money, Credit, and Banking Finance, Serbia). 2018. “NPL Resolution Strategy: 37 (2): 223–44. Lessons Learned from the NPL Working Group in Kose, M. Ayhan, Franziska Ohnsorge, Carmen M. Reinhart, Serbia.” Presentation at FinSAC NPL Resolution Con- and Kenneth S. Rogoff. 2021. “The Aftermath of Debt ference, Vienna, May 15–16, 2018. https://thedocs Surges.” Policy Research Working Paper 9771, World .worldbank.org/en/doc/3c28bd04 8d78efd27 74 4 Bank, Washington, DC. 987253e2c44a-0430012021/original/NPLConference Kugler, Maurice, and Shakti Sinha. 2020. “The Impact of Day211MilanKovacMarijaRandelovic.pdf. COVID-19 and the Policy Response in India.” Future Neira, Julian. 2017. “Bankruptcy and Cross-Country Differ- Development (blog), July 13, 2020. https://www ences in Productivity.” Journal of Economic Behavior .brookings.edu/blog/future-development/2020/07/13 and Organization 157 (January): 359–81. /the-impact-of-covid-19-and-the-policy-response-in Pancorbo, Antonio, David Lukas Rozumek, and Katha- -india/. rine Seal. 2020. “Supervisory Actions and Priorities in Kugler, Maurice, Mariana Viollaz, Daniel Duque, Isis Gaddis, Response to the COVID-19 Pandemic Crisis.” Special David Locke Newhouse, Amparo Palacios-López, and Series on Financial Policies to Respond to COVID-19, Michael Weber. 2021. “How Did the COVID-19 Crisis Monetary and Capital Markets Department, Interna- Affect Different Types of Workers in the Developing tional Monetary Fund, Washington, DC. World?” Policy Research Working Paper 9703, World Ravallion, Martin, and Shaohua Chen. 2009. “The Impact Bank, Washington, DC. of the Global Financial Crisis on the World’s Poorest.” Lacey, Eric, Joseph Massad, and Robert Utz. 2021. “A VoxEU (blog), April 30, 2009. https://voxeu.org/article Review of Fiscal Policy Responses to COVID-19.” Equi - /impact-global-financial-crisis-world-s-poorest. table Growth, Finance and Institutions Insight, World Reinhart, Carmen M., Vincent Reinhart, and Kenneth S. Bank, Washington, DC. https://openknowledge.world Rogoff. 2015. “Dealing with Debt.” Journal of Interna- bank.org/handle/10986/35904. tional Economics 96 (Supplement 1): S43–S55. OVERVIEW | 23 Reinhart, Carmen M., and Kenneth S. Rogoff. 2009. This Growth.” Trade and Competitiveness Global Practice Time Is Different: Eight Centuries of Financial Folly. Note 343, World Bank, Washington, DC. https:// Princeton, NJ: Princeton University Press. documents1.worldbank.org/curated/en/9120414 Reinhart, Carmen M., Kenneth S. Rogoff, and Miguel A. 68178733220/pdf/907590VIEWPOIN003430Debt0 Savastano. 2003. “Debt Intolerance.” NBER Working Resolution.pdf. Paper 9908, National Bureau of Economic Research, World Bank. 2020a. “COVID-19 and Non-Performing Loan Cambridge, MA. Resolution in the Europe and Central Asia Region: Reinhart, Carmen M., and Christoph Trebesch. 2016. “Sov- Lessons Learned from the Global Financial Crisis for ereign Debt Relief and Its Aftermath.” Journal of the the Pandemic.” FinSAC Policy Note, Financial Sector European Economic Association 14 (1): 215–51. Advisory Center, World Bank, Vienna. https://pubdocs Schnabel, Isabel. 2021. “The Sovereign-Bank-Corporate .worldbank.org/en/460131608647127680/FinSAC Nexus: Virtuous or Vicious?” Address at London -COVID-19-and-NPL-Policy-NoteDec2020.pdf. School of Economics and Political Science public World Bank. 2020b. Doing Business 2020: Comparing Busi- online conference on “Financial Cycles, Risk, Macro­ ness Regulation in 190 Economies. Washington, DC: economic Causes, and Consequences,” Systemic Risk World Bank. Center, Frankfurt, January 28, 2021. https://www.ecb World Bank. 2021a. Global Economic Prospects, June 2021. .europa.eu/press/key/date/2021/html/ecb.sp210128 Washington, DC: World Bank. ~8f5dc86601.en.html. World Bank. 2021b. World Development Report 2021: Data Stroebel, Johannes, and Jeffrey Wurgler. 2021. “What Do for Better Lives. Washington, DC: World Bank. You Think about Climate Finance?” Journal of Financial Yonzan, Nishant, Christoph Lakner, Daniel Gerszon Mahler, Economics 142: 487–98. Raul Andrés Castañeda Aguilar, and Haoyu Wu. 2020. World Bank. 2005. World Development Report 2006: Equity “The Impact of COVID-19 on Global Poverty under Wors - and Development. Washington, DC: World Bank; New ening Growth and Inequality.” World Bank Blogs: Data York: Oxford University Press. Blogs, November 9, 2020. https://blogs.worldbank.org World Bank. 2014. “Debt Resolution and Business Exit: /opendata/impact- covid-19 - global-pover ty-under Insolvency Reform for Credit, Entrepreneurship, and -worsening-growth-and-inequality. 24 | WORLD DE VELOPMENT REPORT 2022 Introduction The COVID-19 pandemic sent shock waves through the world economy and triggered the largest global economic crisis seen in more than a century. The economic impacts of the pandemic were especially severe in emerging economies. Global poverty increased for the first time in a generation, and disproportionate income losses among disadvantaged populations led to a dramatic rise in inequality within and across countries. Governments responded at the onset of the pandemic with large economic programs that were successful at mitigating the worst human costs in the short run. However, this emergency response has also exacerbated a number of preexisting economic fragilities that may pose an obstacle to an equitable recovery. Policy Priorities The economic response to the pandemic will need to address the following areas in which economic fragilities have been highlighted and worsened by the pandemic: Addressing increased inequality within and between countries resulting from the highly regressive •  impacts of the crisis. Managing and reducing the interconnected financial risks created by the pandemic to prevent •  spillover effects that can threaten the return to economic growth. Ensuring continued access to finance to help households and businesses weather economic ­ •  uncer- tainty and invest in opportunities. Preserving and restoring market transparency to enable a prompt recognition of economic risks. •  25 Introduction The COVID-19 (coronavirus) pandemic triggered a global public health crisis that overwhelmed the health systems of many countries with over 200 million cases and close to 5 million deaths worldwide. The outbreak of the pandemic quickly turned into the largest economic crisis seen in more than a cen- tury, as countries enacted unprecedented emergency measures, such as travel bans, mobility restric- tions, closure of nonessential businesses, limitations on public gatherings, and mandatory home-based work, that severely affected economic activity. In response, household incomes, business revenue, and employment declined dramatically. Small businesses, low-income households, and vulnerable popula- tions were disproportionately affected, and global poverty increased for the first time in a generation. The economic crisis stemming from the COVID-19 pandemic stands out in its global scale, scope, and severity. In 2020, economic output contracted in 90 percent of countries, while the world economy contracted by approximately 3 percent.1 The share of countries experiencing negative output growth as a result of the pandemic surpassed that of both world wars and the Great Depression. The crisis is also distinct in its highly unusual indiscriminate impacts across the globe. Economic crises in the postwar period have typically hit advanced economies and emerging markets unevenly. For example, despite its designation as the global financial crisis, the 2007–09 financial crisis primarily affected advanced economies, whereas emerging markets, whose economies were supported by robust commodity prices and rapid growth in China, were far less affected. As a result, at the height of the global financial crisis in 2009, output contracted in only 63 percent of countries, and the world economy contracted by 2.2 percent, much less than in the first year of the pandemic.2 The COVID-19 economic crisis is also unique in its nature and origins. Unlike most crisis episodes in recent decades, the COVID-19 economic crisis did not originate as a financial crisis or as a debt crisis in the public or private sector. Instead, it was the result of a truly exogenous event that generated both an aggregate demand and an aggregate supply shock. By contrast, the economic crises of the 1980s were sparked by government debt and financial crises in emerging markets, and the 2007–09 crisis origi- nated from asset bubbles and financial distress in advanced economies. In most countries, the current crisis therefore does not fit the prototypical pattern in which a long economic expansion is followed by a recession during which borrowers who took out loans in boom times can no longer afford their debt payments. Instead, when the COVID-19 pandemic emerged, most countries had not been experiencing a robust economic expansion. It is not uncommon, however, for one form of crisis to morph into another. Although this economic crisis did not begin as a debt or financial crisis, the large increases in private and public debt incurred from the pandemic could very well turn it into one.3 This introduction explores the short- and medium-term implications of the COVID-19 crisis for emerging economies. It begins by documenting the dramatic immediate impacts of the crisis on house- holds and businesses, which were most immediately affected by income losses arising from the pan- demic. It then highlights the unequal economic impacts of the crisis within and between countries and the large government responses to the crisis, which made use of many unprecedented policy tools and was relatively successful at mitigating the worst effects of the crisis in the short run but may create longer-term economic risks that pose obstacles to an equitable recovery. Impacts on households Household incomes and employment were severely affected by the COVID-19 crisis and the public health measures adopted to contain the effects of the pandemic. Survey data covering 51 countries reveal that 57 percent of firms reduced employment during the first two quarters of the pandemic, directly affecting 26 | WORLD DE VELOPMENT REPORT 2022 Figure I.1 Figure I.1 Impacts of the COVID-19 crisis on households, by country income group Experienced reduced total income Received less in remittances Received partial or no payment Stopped working Skipped meals Completed school assignments 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 Share of households (%) High-income Upper-middle-income Lower-middle-income Low-income Source: World Bank, COVID-19 Household Monitoring Dashboard, https://www.worldbank.org/en/data/interactive/2020 /11/11/covid-19-high-frequency-monitoring-dashboard. Note: The figure shows survey data summarizing the economic impact of the crisis on households. Data are taken from the first wave of surveys, administered between April and July 2020, to ensure comparability across countries. household income.4 Similarly, World Bank high-frequency phone surveys5 from a sample representative of 1.4 billion adults in 34 low- and middle-income countries found that, on average, more than a third of respondents stopped working because of the pandemic, and 64 percent of households experienced reductions in income.6 This employment-income effect was compounded by a steep decline in remit- tances in those countries. Over 60 percent of households reported receiving less in remittances since the onset of the pandemic (figure I.1).7 The aggregate nature of the economic shock also made it more difficult for low-income households to rely on other risk-sharing mechanisms, such as informal credit and support from social networks.8 Rising global poverty Meanwhile, global poverty increased for the first time in a generation. Figure I.2 shows the annual year- on-year change in the number of poor for the last three decades. In this period, poverty increased only twice: during the Asian financial crisis and the COVID-19 pandemic. The 2007–09 global financial crisis did not lead to an increase in global poverty because its effects were felt primarily in advanced economies, whereas most emerging economies—where the majority of the world’s poor live—remained relatively unaffected. Although the full consequences of the COVID-19 crisis on poverty are still highly uncertain, preliminary estimates suggest that COVID-19 will have a significantly greater negative impact than the Asian financial crisis.9 This increase in poverty is likely to persist as unequal access to vaccines and the possibility of future waves of the pandemic pose obstacles to the recovery. Figure I.3 shows the global trend in extreme pov- erty from 2015 to 2021. For the projected years 2020 and 2021, the bars show the change in the poverty rate if prior trends had continued, compared with the estimated poverty rates adjusted for the impact of the COVID-19 crisis. Whereas before the pandemic 635 million people were projected to live in extreme INTRODUC TION | 27 Figure I.2 Figure I.2 Global annual change in extreme poor, 1992–2020 100 % change in extreme poor (millions) Asian financial Projections, 80 crisis 2018–20 60 40 20 0 –20 –40 –60 –80 –100 –120 –140 19 2 19 3 19 4 19 5 19 6 19 7 19 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 20 6 20 7 20 8 20 9 20 0 20 1 20 2 20 3 20 4 20 5 20 6 20 7 20 8 20 9 20 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 19 Historical and pre–COVID-19 projection COVID-19 projection Sources: Lakner et al. 2020; Mahler et al. 2021; World Bank, Global Economic Prospects DataBank, https://databank .world bank.org/source/global-economic-prospects; World Bank, PovcalNet (dashboard), http://iresearch.worldbank.org /PovcalNet/. Note: The figure shows the global annual year-on-year change in the number of poor in millions, calculated using the inter- national poverty line of $1.90 per person per day. Two growth scenarios are considered: “pre–COVID-19” uses the January 2020 Global Economic Prospects growth rate forecasts (World Bank 2020a), predating the COVID-19 crisis; “COVID-19” uses the June 2021 Global Economic Prospects forecasts (World Bank 2021a). Figure I.3 Figure I.3 Global extreme poverty, 2015–21 750 675 Number of extreme poor 600 525 (millions) 450 375 300 225 150 75 0 2015 2016 2017 2018 2019 2020 2021 Pre–COVID-19 projection COVID-19 projection Sources: World Bank, Global Economic Prospects DataBank, https://databank.world bank.org/source/global-economic -prospects; World Bank, PovcalNet (dashboard), http://iresearch.worldbank.org/PovcalNet/. Note: Figures are obtained following the approach developed in Lakner et al. (2020) and Mahler et al. (2021). Poverty is defined using the international poverty line of $1.90 per person per day. The year 2017 is the latest with sufficient pop - ulation coverage for a global poverty estimate. Subsequent years are projected. Two growth scenarios are considered: “pre–COVID-19” uses the January 2020 Global Economic Prospects growth rate forecasts (World Bank 2020a), predating the COVID-19 crisis; “COVID-19” uses the June 2021 Global Economic Prospects forecasts (World Bank 2021a). 28 | WORLD DE VELOPMENT REPORT 2022 poverty in 2020, after the onset of the pandemic the projected number of poor increased to 732 mil- lion. The COVID-19–induced poor, calculated as the difference in poverty trends with and without COVID-19, are thus estimated to be 97 million in 2020 and 2021. These numbers suggest that COVID-19 set back progress on poverty reduction at the global level by nearly half a decade, making the goal of eliminating extreme poverty by 2030 unattainable. If countries return to their historical average growth rates after 2021, about 7 percent of the global population will live below the international pov- erty line by 2030, or more than double the target level of 3 percent.10 Put differently, achieving the target would require all economies to grow at 8 percent per capita per year, which is equivalent to about five times the historical growth rates for Sub-Saharan Africa. Greater inequality across and within countries The impact of the crisis on households has been highly regressive across and within countries. Early evidence suggests that 2020 per capita gross domestic product (GDP) declined more in higher-income countries.11 However, these data may not tell the full story.12 Because many households in low- and middle-income countries work in the informal sector, the impact of the pandemic on them is harder to assess. It is then possible that the impact of the pandemic on those countries is being underesti- mated. Survey data indicate that the highest share of respondents who stopped working on account of the ­pandemic was recorded in middle-income countries.13 One in five of the pandemic-induced poor in 2021 are estimated to reside in low-income countries (which account for 9 percent of the world pop- ulation), and over 90 percent of those considered newly poor as a result of the crisis reside in low- or lower-middle-income countries.14 Between 2019 and 2021, the average income of the bottom 40 percent is estimated to have fallen by 2.2 percent, compared with a 0.5 percent decline in the top 40 percent.15 Meanwhile, low-income countries experienced a high incidence of income losses and food insecurity, despite having less pronounced disruptions in employment than higher-income countries. Twenty-four percent of households in low-income countries reported work stoppages, compared with 32.3 percent in lower-middle-income countries and 38.7 percent in upper-middle-income countries (figure I.1). This finding stems, in part, from the higher share of the population engaged in agriculture in low-income countries, minimizing the employment effects of lockdown measures. Nonetheless, even among agricul- tural workers who continued working, many experienced declines in income due to lockdown measures and reduced demand for agricultural products in urban areas. In low- and middle-income countries alike, more than two in three households reported reductions in total income related to the pandemic. More than a third of households in low-income countries and almost half of households in upper- middle-income countries had to reduce their overall consumption. Low- and lower-middle-income countries reported a higher prevalence of food insecurity and of having to resort to coping mechanisms such as selling assets or depleting emergency savings (figure I.4). Such effects of the pandemic increase these countries’ vulnerability to shocks that may arise during a protracted recovery and dampen the prospects for an equitable recovery. The recovery so far has been similarly uneven across countries, with advanced economies faring over- all much better than emerging economies.16 In low-income countries, which face risks to their growth outlook because of unequal access to vaccines and preexisting economic fragilities, GDP growth was forecast to be 2.9 percent in 2021—the second-lowest growth rate (after 2020) in the last 20 years—com- pared with 5.3 percent in high-income economies.17 Even if it is assumed that the impact of the pan- demic is distributionally neutral, the top 20 percent of the global income distribution was expected to recover around half of its 2020 income losses in 2021, while the bottom 20 percent was expected to lose an additional 5 percent of its income.18 INTRODUC TION | 29 Figure I.4 Figure I.4 Ways in which households coped with income losses from the COVID-19 crisis, by country income group Reduced total spending Used emergency savings Sold assets Received government assistance 0 5 10 15 20 25 30 35 40 45 50 Share of households (%) High-income Upper-middle-income Lower-middle-income Low-income Source: World Bank, COVID-19 Household Monitoring Dashboard, https://www.worldbank.org/en/data/interactive/2020 /11/11/covid-19-high-frequency-monitoring-dashboard. Note: Data from the first wave of surveys, collected between April and July 2020, are used to ensure comparability across countries. Beyond the immediate impact of the pandemic on incomes and employment, there are also channels through which the crisis is likely to aggravate inequality across countries in the longer term. One such channel is pandemic-related disruptions in access to education. Estimates based on data from 157 coun- tries suggest that the COVID-19 pandemic could lead to a loss of between 0.3 and 0.9 years of schooling, adjusted for quality. Pandemic-related income shocks could force close to 7 million students to drop out of primary and secondary education. And students from the current cohort could face a loss in lifetime earnings equivalent to a 5 percent annual reduction in income.19 The pandemic has also disproportion- ately affected female labor force participation, which is another channel through which the crisis aggra- vates preexisting inequalities.20 Within countries, the crisis has disproportionately affected disadvantaged groups. In 70 percent of countries, the incidence of temporary unemployment was higher21 for workers who completed only primary education.22 Income losses were similarly larger among youth, women, the self-employed, and casual workers with lower levels of education.23 These patterns are consistent with those observed in advanced economies.24 Although the impact of the pandemic on within-country inequality at the global level is not yet known, it seems likely it will increase. The regressive nature of impacts suggests that the impact of the crisis on global poverty is a lower-bound estimate. With a widespread increase in within- country inequality, the crisis would have an even bigger impact on global poverty.25 The COVID-19 economic crisis has also been unique in exacerbating gender inequalities. Analysis of firm-level data from the World Bank’s Enterprise Surveys reveals that women were more likely than men to be laid off after the onset of the pandemic.26 According to phone survey data collected during the first months of the pandemic, 42 percent of women stopped working, either temporarily or perma- nently, compared with 31 percent of men.27 Women were disproportionately affected by income and employment losses because they were more likely to be employees or owners of firms in the sectors most affected by lockdown and social distancing measures—such as services, hospitality, and retail, where the demand shock was hitting hardest.28 Indeed, women-owned businesses were, on average, more likely to be closed after the onset of the pandemic, especially microbusinesses and businesses in the hospitality industry. Female-led businesses were also less likely to have received public support.29 30 | WORLD DE VELOPMENT REPORT 2022 In addition, women bore the brunt of the higher care needs associated with closures of day-care centers and schools. Evidence from recent rounds of high-frequency surveys also reveals that the initial disparities in job losses were not reduced with the relaxation of mobility restrictions and other policy measures. Those who suffered larger initial losses—women, younger workers, urban workers, and persons with low levels of formal education—recovered more slowly than their counterparts and were not able to substantially reverse initial disparities in losses.30 By September 2020, men had recovered 49 percent of their initial employment losses, compared with 30 percent of women. Workers in urban areas had recovered only a third of their initial losses, compared with 58 percent of rural workers. Although the employment recov- ery was slightly faster for younger workers and those without a college education, this was insufficient to significantly reduce the gaps in job losses relative to older and college-educated workers.31 Similarly, school closures have been associated with substantial learning losses, particularly for children from low socioeconomic status households. Even with schools reopening, it is not clear whether these children will be able to catch up, thereby exacerbating within-country disparities in the future. Heightened fragilities on household balance sheets The impacts of income losses sustained during the pandemic were intensified by the fact that many households were already financially stretched at the beginning of the crisis. Although there was sig- nificant within-country and cross-country variation in how well households were positioned to cope with income losses, one pattern that is strikingly similar across advanced and emerging economies is that very few households have the resources to weather substantial income losses for more than a few months.32 This pattern underscores the immense value of emergency cash transfers for households facing large, prolonged income losses. ­ Intuitively, households can accommodate income shocks either by financing consumption with liq- uid financial assets, such as easily accessible savings, or by reducing expenditures to the bare minimum required for food, essential utilities, housing expenses, and debt repayment. Both coping mechanisms do not rely on external sources of funds such as the state or on credit markets, and they have little bearing on households’ future ability to borrow. The definition used in this Report therefore considers a house- hold to be fully “resilient” when, in the face of an income shock, it can sustain consumption in the short to medium term using its own liquid financial assets. Newly available data on household consumption and asset holdings that are comparable across countries make it possible to quantify the resilience of households to income losses as the ratio of a household’s total liquid wealth to its monthly consumption expenditure.33 This measure has a simple interpretation: conditional on an economic shock resulting in a complete loss of income, it is the number of months that a household can maintain its level of consumption by relying solely on its liquid finan- cial wealth. Figure I.5 shows the share of households whose resilience to a total income loss falls below three months, six months, and one year for a sample of 24 emerging and advanced economies for which comparable data are available.34 The figure reveals that the percentage of households not able to sustain basic consumption beyond three months is higher in emerging economies (50 percent) than in advanced economies (40 percent). However, the percentage of households that cannot self-sustain beyond one year is practically identical, reaching around 70 percent in both emerging and advanced economies. The same stress test approach can be used to examine how effectively different crisis response policies counteract income losses and enhance household resilience. Figure I.6, which shows the results of this exercise, first considers the effect of debt relief programs on household resilience. It reveals that if all household debt repayments35 were paused by law, household resilience would improve only marginally INTRODUC TION | 31 Figure I.5 Figure I.5 Household resilience to income losses, selected emerging and advanced economies Emerging economies Advanced economies South Africa Latvia Croatia Thailand Greece Lithuania India Hungary Slovenia Cyprus Slovak Republic United Kingdom Poland United States Estonia China Portugal France Italy Germany Belgium Luxembourg Netherlands Austria 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 Share of households (%) Households unable to cover expenses beyond: Three months Six months One year Source: Badarinza et al. 2021. Note: The figure shows for each economy and economy income group the share of households not able to sustain their baseline consumption with liquid assets for more than three months, six months, and one year in the event of an income loss. for advanced economies and would be unchanged in emerging economies. Debt relief as a policy tool is largely ineffective because in emerging economies it is mostly the wealthy—and therefore inherently more resilient—households that can access formal credit. This finding also suggests that debt relief may have adverse distributional effects because it benefits primarily wealthier households, while the cost of the policy, through taxation, is borne across the population. Similarly, figure I.6 shows that if households were able to liquidate their illiquid financial assets, such as retirement accounts, it would have almost no effect in emerging economies and only short-lived benefits in advanced ones. Roughly 40 percent of advanced economy households would continue to be vulnerable six months after the initial shock. Not surprisingly, a policy instrument that dramatically reduces vulnerability in both emerging and advanced economies is direct income support. Income support replacing 50 percent of regular income brings the 32 | WORLD DE VELOPMENT REPORT 2022 Figure I.6 Figure I.6 Impacts of alternative COVID-19 policies and coping strategies at different time horizons, emerging and advanced economies a. Emerging economies b. Advanced economies 90 90 80 80 Financial vulnerability Financial vulnerability 70 70 (% of households) (% of households) 60 60 50 50 40 40 30 30 20 20 10 10 0 0 0 3 6 9 12 0 3 6 9 12 Number of months after initial income shock Number of months after initial income shock Baseline Liquidation of illiquid financial assets Debt relief 50% income support Source: Badarinza et al. 2021. Note: The figure shows the impact of alternative support policies and coping strategies—income support, debt relief, and asset liquidation—on household resilience for different time horizons. total fraction of vulnerable households to near zero for the first six months in both sets of economies. This finding underscores the immense value of the large cash transfers used worldwide to enable house- holds to weather the immediate impacts of the crisis. Impacts on firms Business revenue declined dramatically as a result of lockdowns and other public health measures needed to contain the pandemic. Survey data collected from more than 100,000 businesses worldwide show that, overall, 70 percent of businesses closed at the peak of the first wave of the pandemic,36 and 84 percent of firms reported a drop in revenue. This decline in sales was large in magnitude—on average, firms experienced a 51 percent year-on-year reduction in revenue as a result of the first wave of pandemic- induced mobility restrictions (figure I.7, panel a). Declines in sales and revenues were also persistent—four months after the peak of the pandemic, average revenue was still more than 40 percent lower than in the same period one year earlier. The shock was sufficiently severe and long-lasting to threaten the survival of many firms. In the early stages of the pandemic, 46 percent of firms expected to fall into arrears on their outstanding supplier, wage, or loan payments over the next six months (figure I.7, panel b). The average business reported having cash reserves to cover expenses for less than 51 days. The impacts of business closures and the sharp, persistent decline in business revenue translated into a corresponding reduction in employment, mostly by reducing workers’ hours and requiring furloughs (both paid and unpaid). Per- manent layoffs were less common. In total, 57 percent of surveyed firms reduced employment. The impact of the COVID-19 crisis on businesses varied significantly across countries and sectors. Tourism, retail, and parts of the service sector were more severely affected by public health policies INTRODUC TION | 33 % of businesses % change in sales So So 30 40 60 80 90 0 10 20 50 70 100 –80 –70 –60 –50 –40 –30 –20 –10 0 ut ut hA hA Ba fri S r fric a ng ca iL Figure I.7 lad Af es gh ank h an a Af Ne is t gh Cô Tu an a n pal te n i s is t a d ' I ia vo Ke n i M nya N e re on g Ba m A r pal S r o lia iL ng e ni an lad a ka To Ko e s h so S go v E l Ke o Ho uda S a ny nd n l va a ur H d as M ond or N ad ur ag as M ige r old a o M sca old r G u va ov ine Ph Ni a Ko a ilip g e s 34 | WORLD DE VELOPMENT REPORT 2022 P a ov o pin r k G u es i /01/19/covid-19-business-pulse-survey-dashboard. N i is ta ca n G e nea Zi rag u o m A l r g ia ba a b bw Pa ani Ni e a Zi k is t ge m V i r ia ba a n bw El e tna Sa m J e l va Ind orda do on n r es G u I ta S u ia at da em ly n Ro ala M I tal m or y M a n ia Ni occ o and distance to the first peak of the pandemic. Data are as of July 31, 2021. or ca oc ra c g Tu o Ni ua ge a. Decline in sales rk ri Z a ey m Gu Bra a b a t zi J o ia em l rd Figure I.7 Impact of COVID-19 on businesses, selected countries ala A l an b T Ca ani Za ogo m a m Uz bod M b o n ia be ia go k is Tu lia ta r b. Businesses expecting to fall into arrears Gr n e C y key pr Ge ece us or g C C y ia B u ha pr lga d C r us G r r ia o e B u a tia Ru Vi ece lga ss et H u r ia ia n R o na m ng Fe ma a d e n ia ra Ru Po r y ti ss la Po on ia n S l o n d S l la n F e ve n ov d de ia e ra C n I n d ti o n U z roa ia b e tia on k is es ia Hu tan Source: World Bank, COVID-19 Business Pulse Surveys Dashboard, https://www.worldbank.org/en/data/interactive/2021 Note: The figure shows the average predicted percentage decline in sales (panel a) and share of businesses expecting to fall into arrears (panel b) by country. Estimates are obtained from a linear regression that controls for country, firm size, sector, Ch ng ad ar y limiting mobility or mandating temporary business closures or capacity restrictions. In addition, inter- national supply chains were disrupted, causing input shortages and price fluctuations that rippled through the global economy and eventually also reached sectors not initially affected by the crisis. Small and informal businesses most severely affected The impact of the crisis on businesses, like that on households, was highly regressive. Smaller businesses, informal businesses, and businesses with more limited access to the formal credit market were more severely affected. Smaller firms tend to face greater financial constraints, even in advanced economies. In the United States, for example, the median small business has fewer than 15 days in cash reserves.37 Thus even profitable small businesses can easily fall into arrears and insolvency due to a temporary shock to revenue. The same is true of the impact of the COVID-19 shock on businesses around the world. Larger firms were able to cover expenses for up to 65 days, compared with 59 days for medium-size firms and 53 and 50 days for small firms and microenterprises, respectively. More than 50 percent of all small firms expected to fall into arrears within six months of the onset of the crisis, compared with 45 per- cent of medium-size firms and 36 percent of large firms. Compounding the challenge, small businesses have far more limited access to external finance than larger firms, and thus were much more likely to be pushed into insolvency by the crisis.38 Women-led businesses have been disproportionately affected by the crisis, according to data from the World Bank’s COVID-19 Business Pulse Surveys conducted during the first year of the pandemic. Women-owned businesses are, overall, more concentrated in sectors that were harder-hit by lock- downs and mobility restrictions, and even within these sectors women-owned businesses fared worse. Women-owned businesses in the hospitality industry, for example, recorded larger declines in sales revenue than male-led businesses during the same period the previous year (–67.8 percent versus –60.4 percent), were able to cover costs for a shorter period of time (54 days versus 64 days), were more likely to fall into arrears (58 percent versus 51.6 percent), were more likely to reduce work hours (59.6 percent versus 53.7 percent), and had less access to public support (33 percent versus 37 percent).39 Surveys of some 26,000 business owners in over 50 countries with an active Facebook business page also reveal that the strictness of lockdown measures tended to exacerbate gender gaps in temporary business closures.40 Businesses relatively more affected by the initial impact of the COVID-19 pandemic were also expe- riencing greater difficulties recovering in 2021. Comparisons of first-round (May–November 2020) and second-round (November 2020–May 2021) data from the World Bank’s COVID-19 Follow-up Surveys in Europe and Central Asia, for example, show that small, young (founded within the last 10 years), and female-owned firms did not see improvements in sales in 2021, in contrast to larger, older, and male- owned firms. Larger firms were also more likely than smaller firms to receive payment deferrals and fiscal relief. Persistent economic uncertainty hampering business activity In addition to revenue losses, business activity has been affected by an uncharacteristically large and persistent increase in uncertainty about future business prospects, despite the presence of large support programs. Studies using data from advanced economies show that, because of its unique nature, the COVID-19 pandemic has generated more uncertainty in business sales and profitability expectations than a conventional economic downturn.41 The World Bank’s COVID-19 Business Pulse Surveys col- lected comparable data on business expectations worldwide and found strikingly similar results. They confirm that greater uncertainty about business prospects is associated with larger firm-level declines INTRODUC TION | 35 FigureI.8 Figure I.8 Economic uncertainty and employment during the COVID-19 crisis a. Business expectations and employment b. Uncertainty and employment 5 5 0 0 % change in employment % change in employment –5 –5 –10 –10 –15 –15 –20 –20 –25 –25 –100 –75 –50 –25 0 25 50 75 0 10 20 30 40 50 60 Expected sales growth, next six months Standard deviation of prediction Source: Apedo-Amah et al. 2020, based on World Bank, COVID-19 Business Pulse Surveys Dashboard, https://www.world bank.org/en/data/interactive/2021/01/19/covid-19-business-pulse-survey-dashboard. Note: The figure shows the relationship between expected sales growth and changes in employment (panel a) and uncer- tainty about sales growth and changes in employment (panel b), based on data from the World Bank’s COVID-19 Business Pulse Surveys collected during the first two quarters of the pandemic. The analysis first conditions on the variable on the x-axis and then calculates employment changes for businesses in each bin. in employment (see figure I.8). Even as pandemic-related risks are gradually resolved, prolonged uncer- tainty about the recovery of business revenue is therefore likely to suppress job creation and investment by businesses, as well as the availability of credit from their lenders in the longer term. Heightened fragilities on corporate balance sheets The precrisis period saw a significant buildup of financial risks in the corporate sector, which became increasingly apparent with the onset of the pandemic. This increase in risks was particularly severe in emerging markets, where an extended period of low interest rates globally had contributed to lending booms and dramatically increased leverage ratios in the corporate sector. Prior to the crisis, many firms in emerging markets were already struggling with unsustainable debt burdens and difficulties cover- ing short-term liabilities.42 Stress test simulations using precrisis corporate balance sheet data indicate that an economic shock of the size experienced by most emerging from the COVID-19 recession would push a large share of firms in these economies into insolvency (figure I.9).43 Some of the financial risks that have accumulated among emerging market firms have become apparent as a result of the crisis. Troubled assets in the real estate sector of important emerging markets that have come to light recently are one example of how credit-fueled asset bubbles that accumulate during times of high growth can trigger wider economic instability in the event of an unforeseen adverse shock.44 This phenomenon is not unique to the current crisis and, in fact, bears many similarities to the asset bubbles and subsequent 36 | WORLD DE VELOPMENT REPORT 2022 Figure I.9 Figure I.9 Percentage of corporate debt at risk after a simulated 30 percent shock to earnings, precrisis, selected countries, by income group Tanzania Montenegro Saudi Arabia Uruguay Argentina Venezuela, RB Latvia Ghana Morocco Bosnia and Herzegovina Bolivia Egypt, Arab Rep. Slovak Republic North Macedonia United Arab Emirates Ukraine Kenya Lithuania Malaysia Bulgaria Sri Lanka Côte d’Ivoire Zimbabwe Pakistan Vietnam China Indonesia Thailand South Africa Serbia Tunisia Jordan Peru Romania Bangladesh Turkey Georgia India Brazil Nigeria Oman Russian Federation Jamaica Poland Mexico Zambia Czech Republic Estonia Chile Philippines Kazakhstan Colombia Paraguay Slovenia Ecuador Hungary Qatar 0 10 20 30 40 50 60 70 80 90 100 Debt at risk (%) High-income Upper-middle-income Lower-middle-income Source: WDR 2022 team, based on Feyen, Dancausa, et al. (2020). Note: The figure reports the distribution across income groups of the fraction of debt of firms in a country considered “at risk” in terms of interest coverage ratio after a simulated 30 percent shock to earnings. The interest coverage ratio captures the ability of a firm to cover interest expenses with current earnings. A higher value indicates higher debt at risk for corpo - rations in a country. INTRODUC TION | 37 market corrections in previous crises, such as real estate bubbles in advanced economies prior to the global financial crisis.   In emerging economies, corporate solvency risks have been further exacerbated by a sharp increase in dollar-denominated debt over the past decade. Low interest rates in advanced economies over this period tempted firms to take on foreign rather than local currency debt.45 Since the beginning of the pandemic, the currencies of many emerging markets have come under pressure. This creates problems for firms that hold significant amounts of foreign currency–denominated debt, which is now more difficult to service because the value of the borrower’s local currency revenue has fallen. The expo- sure to currency risk is likely to become more acute if the recovery proceeds more quickly in advanced economies than in the rest of the world, which will lead to a further weakening of emerging market currencies. Impacts on the financial sector In contrast to the immediate large impacts of the COVID-19 crisis on households and firms, the short- term impacts of the crisis on the financial sector were relatively muted because of the large-scale emer- gency support and forbearance programs for borrowers aimed at preventing a spike in loan defaults. Moderate initial impacts masking longer-term risks Although extensive income support and debt forbearance policies have helped to insulate the financial sector from a wave of loan defaults in the short run, few if any countries have the resources to keep these policies in place in the longer term. Therefore, financial institutions around the world are likely to come under significant stress as debt moratoria and other support policies for borrowers are scaled back. In some economies, these risks are already becoming apparent. Loan defaults have been on the rise in India, Kenya, the Philippines, and a growing number of other middle-income countries. These emerging credit risks are also reflected in the worsening outlooks of the main international rating agencies for financial institutions as forbearance policies are lifted. How well financial sectors around the world are prepared to confront this challenge varies consider- ably. Some economies that were hard-hit by the global financial crisis of 2007–09 initiated meaningful reforms and ensured that their banking systems were well capitalized. However, given that the global financial crisis affected primarily advanced economies, many emerging economies did not enact such reforms. As a result, their financial sectors are poorly prepared to withstand a crisis of the magnitude of the COVID-19 recession. For example, in emerging economies the average levels of regulatory capital holdings (the risk capital banks are required to hold to protect their balance sheets in the event of loan losses) have remained flat, albeit at a relatively high level, since the global financial crisis.46 Moreover, bank debt-to-asset ratios, indicating greater balance sheet risk, have increased for smaller banks gener- ally, as well as for banks located in emerging economies.47 In many emerging economies, fragilities in the financial sector are compounded by extensive govern- ment ownership of banks, misallocation stemming from government-mandated lending programs, and financial repression policies such as the requirement that domestic financial institutions hold govern- ment debt, which links the asset quality of the financial sector to that of the government. In the years leading up to the COVID-19 crisis, the Financial Sector Assessment Program, a joint exercise carried out by the World Bank and the International Monetary Fund, highlighted problems in the resolution of nonperforming loans (especially in Sub-Saharan Africa and Eastern Europe), loan classification and provisioning, and bank exposure to the nonbanking sector. 38 | WORLD DE VELOPMENT REPORT 2022 There has also been significant concern about the rapid expansion of lending by nonbank financial institutions (NBFIs) and their links to the formal banking sector in many emerging markets. According to data from the Financial Stability Board, and using a narrow definition of the sector, in 2020 NBFIs accounted for 14.1 percent of the total financial assets of 29 jurisdictions.48 Nonbank lenders often face greater credit risks than banks, but are typically less regulated and can therefore accumulate significant hidden risks that can threaten financial stability. Regulators have become increasingly aware of these risks and have sought to adapt oversight of nonbank lenders.49 The short-term government response and its impact on public finances The COVID-19 crisis triggered an extraordinarily large government response aimed at stabilizing out- put and protecting incomes in the short run. Governments enacted comprehensive fiscal, monetary, and financial sector policies, many of which included policy tools that were unprecedented at this scale or had not previously been used in emerging economies. Examples include direct income support mea- sures, debt moratoria, and asset purchase programs by central banks. Most economists welcomed the speed and enormous scale of this response, pointing to the unparalleled scale of the economic shock and the lessons learned from past crises in which gradual approaches had proven less effective at stabilizing output and market expectations.50 Wide variation in the scale of the policy response The fiscal policy response to the COVID-19 crisis was swift and substantial. It consisted primarily of direct emergency payments to the households and firms most acutely affected by a sharp drop in incomes and revenue. Many countries conducted countercyclical fiscal policies during the crisis, a first for most emerging economies. The scale of the response, however, varied significantly across countries, depending on the capacity of governments to mobilize resources, as well as institutional capabilities and the availability of social safety nets, as illustrated by figure I.10. While the extent of the fiscal response was almost uniformly large by any historical measure in high-income countries and uniformly small or nonexistent in low-income countries, there was significant variation in the size of the fiscal responses among middle-income countries. This variation reflects, among other factors, large differences in gov- ernment debt burdens and the ability to finance the crisis response, as well as differences in the ability of central banks to support government spending through accommodative monetary policy measures. The scale and nature of the fiscal response were also shaped by political economy factors. For example, some recent evidence indicates that less politically polarized governments and societies were able to mobilize more fiscal resources to fight the immediate effects of the pandemic.51 In addition to rate cuts, central banks used unconventional monetary policy tools such as asset pur- chase programs to support the crisis response. Although asset purchase programs had previously been used almost exclusively in advanced economies, 27 emerging economies adopted such programs for the first time in response to the COVID-19 crisis.52 In addition to the fiscal and monetary policy response to the crisis, financial regulators around the world also implemented an unprecedented set of measures to prevent financial distress among borrowers and financial institutions. These policies were aimed at maintaining overall financial stability, preserv- ing critical financial market functions, averting preventable insolvencies, and ensuring the continued flow of credit to households and firms. Central banks helped financial institutions maintain liquidity INTRODUC TION | 39 Figure I.10 Fiscal response to the COVID-19 crisis, selected countries, by income group 50 40 Share of GDP (%) 30 20 10 0 p. es r a h o ina l me p ia e il y ia ia n ru il e e me te s ion ly n m ga ge ke az Re an om es om ta c pa I ta es Ind do Pe Ch pin i Ch ex rat hio ne ta co co Ni k is r Br lad Gh Ja on Tu rab in c in c ing dS M ili p Se -in -in de Et be ng Ind t, A le - le - dK Fe i te l ow Ph ig h Uz Ba idd idd yp Un i te ian nh n Eg Un -m -m ea ss ea M er er Ru M ow pp nu nl ea ea M M High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on IMF (2021a). Data from International Monetary Fund, Fiscal Monitor Database of Coun- try Fiscal Measures in Response to the COVID-19 Pandemic, Fiscal Affairs Department, https://www.imf.org/en/Topics /imf-and-covid19/Fiscal-Policies-Database-in-Response-to-COVID-19. Note: The figure reports, as a percentage of GDP, the total fiscal support, calculated as the sum of “above-the-line mea- sures” that affect government revenue and expenditures and the subtotal of liquidity support measures. Data are as of September 27, 2021. through reductions in the policy rate, asset purchase programs, and other interventions intended to quell market turbulence in the early stages of the crisis. To support borrowers and avert a wave of preventable insolvencies, financial regulators rolled out a variety of temporary debt relief measures for households and businesses, such as debt moratoria and debt restructuring programs. In many countries, these policies ultimately covered a large share of outstanding credit and played an important role in preventing loan defaults among borrowers facing ­ temporary liquidity problems. However, debt moratoria on the scale of those enacted during the pan- demic are a largely untested policy, and so far there is very little evidence of their longer-term impacts on borrower behavior and financial stability. One important concern is that, if left in place for too long, debt moratoria can have the unintended effect of masking the true extent of credit risk in the economy and delay rather than prevent the emergence of financial fragilities. In contrast to previous crises, many countries also implemented so-called regulatory forbearance policies for banks. Regulatory forbearance refers to the relaxation of regulatory requirements and accounting standards in the hope that this will make it easier for lenders to issue new credit. Although some of these policies used the flexibility embedded in existing regulatory frameworks (such as the Basel III regulations), some countries relaxed prudential regulation and accounting standards beyond the emergency measures allowed by these frameworks. This may have created some respite for banks, but could create significant longer-term risks to financial stability. Regulatory forbearance policies reduce bank balance sheet transparency by enabling banks to hide the true extent of their credit risk, delay the 40 | WORLD DE VELOPMENT REPORT 2022 resolution of nonperforming loans, and ultimately weaken the ability of the financial sector to provide financing to creditworthy borrowers during the recovery. Because regulatory forbearance policies can lead to the accumulation of significant hidden credit risks, they can also place further burdens on gov- ernment finances should government intervention be required to support ailing financial institutions once these risks materialize. In addition to the scale of the short-term crisis response there was also wide variation in the specific combination of policy tools used by different countries (figure I.11). This variation reflects differences in the ability to mobilize resources as well as different priorities for the crisis response. Low-income coun- tries made relatively greater use of simple cash transfer programs, whereas middle- and high-income economies, whose financial sectors are much more exposed to household and small business debt, made more extensive use of financial sector policies aimed at averting financial sector distress. Figure I.11 Fiscal, monetary, and financial sector policy responses to the pandemic, by country income group Tax breaks for firms Tax breaks for individuals Fiscal Direct cash transfers to individuals Income support for businesses Asset purchases Monetary Central bank liquidity Change in policy rate Debt moratoria for households Financial sector Debt moratoria for microfinance borrowers Debt moratoria for firms Regulatory forbearance 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100 Share of countries adopting policy (%) High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on Feyen, Alonso Gispert, et al. (2020); Lacey, Massad, and Utz (2021); World Bank, COVID-19 Finance Sector Related Policy Responses, Version 3, https://datacatalog.worldbank.org/search/dataset/0037999. Note: The figure shows the percentage of countries in which each of the listed policies was implemented in response to the pandemic. Data for the financial sector measures are as of June 30, 2021. INTRODUC TION | 41 A global increase in government debt triggered by the pandemic The large crisis response, while necessary and effective at mitigating the worst impacts of the crisis in the short run, led to a global increase in government debt that has given rise to renewed concerns about debt sustainability. Government debt levels have been rising steadily over the last decade in many emerging economies, and several suffered downgrades of their sovereign risk rating prior to the crisis (see figure I.12). In 2020, 51 countries—among them, 44 emerging economies—saw their credit ratings deteriorate. Although advanced economies have not been spared, sovereign downgrades are much more consequential for emerging economies, where credit ratings are at or near junk grade, and where the rating of the sovereign has a direct impact on the ratings of state-owned banks and state- owned enterprises. In more extreme cases, where sovereign restructuring becomes necessary—and these have been on the rise as well—banks and domestic investors will take outright losses on their holdings of government securities. Increases in government debt stemming from fiscal responses to the pandemic are therefore especially consequential for low-income countries. In emerging and advanced economies, the fiscal response to the pandemic was supported by sig- nificant monetary policy measures that made unprecedented use of new policy tools (box I.1). Build- ing on lessons from the global financial crisis, central banks lowered interest rates rapidly rather than through a series of gradual rate cuts. Because advanced economy policy rates were low prior to the crisis, emerging economies had more space to lower interest rates, with several central banks cutting rates by 100–200 basis points. Emerging economies were able to undertake especially ambitious monetary policy Figure I.12 in part because many were at a low point in the business cycle. With output below potential, responses there was less concern about overheating the economy and spurring capital outflows. Structural reforms enacted since the global financial crisis helped to create additional flexibility.53 Figure I.12 Global sovereign downgrades, 1980–2020 80 70 Number of countries 60 50 40 30 20 10 0 1980 1985 1990 1995 2000 2005 2010 2015 2020 Outlook—downward revisions, all economies Outlook—downward revisions, EMEs Sovereign downgrades, all economies Sovereign downgrades, EMEs Source: WDR 2022 team, based on Reinhart (2021). Data from Trading Economics, Credit Rating (database), https://trading economics.com/country-list/rating. Note: The figure shows the total number of sovereigns downgraded in a given year for all economies (gray line) and for emerging market economies (dashed black line) for which ratings data could be obtained. Emerging market economies (EMEs) are defined as in the International Monetary Fund's World Economic Outlook: A Long and Difficult Ascent (IMF 2020). 42 | WORLD DE VELOPMENT REPORT 2022 Box I.1 The interplay of fiscal and monetary policy In response to the pandemic, countries made Figure B1.1.1 extensive use of monetary policy to support the Figure BI.1.1 Asset purchase programs large fiscal programs that became necessary to of central banks during the COVID-19 support households and firms. In emerging econo- crisis, by country income group mies, interest rate cuts were a much more effective tool for stimulating the economy than in advanced 14 economies, where rates had been hovering around 12 Number of countries the zero lower bound prior to the pandemic. None- 6 theless, many emerging economies found them- 10 3 4 selves constrained in their crisis response because 8 2 of limited fiscal and monetary policy options aris- 6 2 2 5 ing from high levels of government debt, low pol- 4 icy credibility, or weaker-than-expected effects of 6 5 5 1 2 rate cuts. 2 Many economies adopted unconventional mon- 0 High- Upper- Lower- Low- etary policy tools to support the crisis response. The income middle- middle- income term unconventional monetary policy refers to policy income income instruments that go beyond the traditional regula- Government Corporate Both tory and interest rate-setting powers of a central bonds bonds bank. Examples include asset purchase programs Source: WDR 2022 team, based on Fratto et al. (2021). in which the central bank buys government or cor- Note: The figure shows the number of countries that porate bonds to inject liquidity into the economy introduced asset purchase programs in response to and keep interest rates low; extraordinary liquidity the pandemic, by income group, disaggregated by whether the central bank was authorized to purchase operations, such as the central bank providing the government bonds, corporate bonds, or both. Data financial sector with liquidity on the condition that for the Central Bank of West African States are con- it is used to issue new loans; or forward guidance, sidered for each individual member state. in which the central bank seeks to influence market expectations to stimulate economic activity. To mobilize the full set of policy instruments at In response to the COVID-19 crisis, between their disposal, central banks in emerging economies March and August 2020, 8 low-income countries, made extensive use of these new monetary policy 11 lower-middle-income countries, and 10 upper- tools, many for the first time. The most widely used middle-income countries initiated asset purchase instrument was asset purchase programs (figure programs.a Examples of countries that initiated BI.1.1), which before the COVID-19 crisis had been asset purchase programs include Angola, the Arab used almost exclusively in advanced economies— Republic of Egypt, Costa Rica, and Uganda. In sev- most notably by the US Federal Reserve Bank and eral countries, adoption of such programs required the European Central Bank in the aftermath of changes in the laws governing the operations of the global financial crisis. Where asset purchase the central bank. Brazil, for example, changed its programs are aimed at buying government bonds, constitution to allow the central bank to carry out they increase the demand for longer-term gov- monetary financing operations, including the direct ernment debt and reduce its cost, which directly purchase of government bonds. Thailand’s parlia- supports the government’s ability to finance future ment approved a law to set up a B 400 billion ($12.3 spending. billion) fund to buy corporate bonds. (Box continues next page) INTRODUC TION | 43 Box I.1 The interplay of fiscal and monetary policy (continued) Although the use of an expanded set of monetary require improved coordination between fiscal and policy tools has been beneficial to the COVID-19 monetary authorities, as well as safeguards for crisis response, it has also increasingly blurred the central bank independence. In response to these lines between fiscal and monetary policy and raised emerging challenges, some emerging economies the specter of governments trying to influence have introduced rules aimed at isolating central central banks to accommodate their fiscal needs. banks from political pressure to finance government In this situation, referred to as “fiscal dominance,” outside of emergency situations. In Indonesia, the central bank sacrifices price stability to support for example, the central bank was prohibited the government’s fiscal policy goals. In the past, this from buying government bonds in the primary practice has led to episodes of high or hyperinflation, market. This prohibition was suspended through which place a disproportionate burden on the emergency legislation but only for a limited time poor and pose a significant obstacle to sustained (the prohibition on government financing must be economic growth in many emerging economies and reinstated by law in 2023). However, such rules are efforts to tackle climate change and inequality. not always time-consistent, and it remains to be The greater interdependence between fiscal seen whether they can help countries strike the and monetary policy foreshadowed by the right balance between enabling an effective policy increased use of new monetary policy tools will mix and safeguarding central bank independence. a. Fratto et al. (2021). Overall, the swift and decisive policy response to the COVID-19 crisis has mitigated its worst eco- nomic impacts in the short run. However, some crisis response measures have also given rise to new risks that may pose an obstacle to an equitable recovery in the longer term. Among these, the most press- ing concerns are dramatically increased levels of public and private debt, as well as the significant risk of hidden debts and financial fragilities that will materialize once support and forbearance programs are scaled back. As the immediate effects of the pandemic subside, policy makers face the difficult task of striking the right balance between providing enough support to contain the worst human costs of the crisis, while limiting the longer-term risks that may arise from the crisis response. Given this con- text, chapter 1 of this Report highlights the mutually reinforcing links between the various sectors of the economy—households, firms, financial institutions, and governments—through which risks in one sector can affect the economy as a whole, and charts policies that can effectively reduce these risks and support an equitable recovery. Notes 1. Global real GDP growth in 2020 is estimated at –3.1 economic conditions in the two periods are not compa- percent in the International Monetary Fund’s World rable because of the wartime production under way Economic Outlook (IMF 2021b) and –3.5 percent in the during World War I as well as the stark differences in World Bank’s Global Economic Prospects (World Bank health and economic policy responses (Arthi and Par- 2021a). man 2021). 2. See World Bank (2011). Also see Reinhart (2020). 3. Bordo and Meissner (2016); Reinhart and Rogoff Although the COVID-19 pandemic evokes a comparison (2009). to the 1918 Spanish influenza pandemic, global 4. Apedo-Amah et al. (2020). 44 | WORLD DE VELOPMENT REPORT 2022 5. World Bank, COVID-19 High-Frequency Monitoring January 2020 and June 2021 Global Economic Pros- Dashboard, https://www.worldbank.org/en/data pects (World Bank 2020a, 2021a). /interactive/2020/11/11/covid-19-high-frequency 13. Khamis et al. (2021). -monitoring-dashboard. 14. Mahler et al. (2021) based on World Bank, Global Eco- 6. Bundervoet, Dávalos, and Garcia (2021). nomic Prospects DataBank, https://databank.world 7. The decline in remittances reported by households is bank.org/source/global-economic-prospects; World at odds with the aggregate data on remittances flows, Bank, PovcalNet (dashboard), http://iresearch.world which show global flows declining only by 1.6 percent bank.org/PovcalNet/. in 2020 with respect to the previous year. This differ- 15. Yonzan, Lakner, and Mahler (2021). ence stems, in part, from migrants switching from 16. See note 12. informal (carry) to formal (digital) channels of sending ­ 17. World Bank (2021a). remittances in response to mobility restrictions. Even 18. Yonzan, Lakner, and Mahler (2021). with these changes in the composition of remittances, 19. Azevedo et al. (2020). formal remittances declined by 10 percent or more in 20. See de Paz, Gaddis, and Müller (2021). the Europe and Central Asia (ECA) and Sub-Saharan 21. The difference in the rate of work stoppage between Africa (SSA) Regions and by 8 percent in the East Asia low- and high-educated workers was found to be statis- and Pacific (EAP) Region. For more details, see World tically significant in 23 percent of the countries. For Bank (2021b). more details, see Kugler et al. (2021). 8. Janssens et al. (2021). 22. Kugler et al. (2021). 9. Measurements of poverty rely on household surveys, 23. Bundervoet, Dávalos, and Garcia (2021). which become available with a lag. Data collection for 24. Adams-Prassl et al. (2020); Chetty et al. (2020); Cross- these surveys has also been affected by COVID-19. To ley, Fisher, and Low (2021). estimate poverty for 2020 and 2021, the most recent 25. Because of a lack of comprehensive data for many household surveys have been extrapolated using countries, the estimates at the global level assume there are no changes in inequality. Lakner et al. (2020) growth rates from national accounts. This requires and Yonzan et al. (2020) estimate the impact of additional assumptions: how much of GDP per capita COVID-19 on global poverty with a range of assump- growth feeds through to household consumption or tions on within-country inequality. income recorded in the survey and whether there have 26. See de Paz, Gaddis, and Müller (2021). been any distributional changes. The nowcasts 27. Bundervoet, Dávalos, and Garcia (2021). assume that 85 percent of growth in GDP per capita is 28. Goldstein et al. (2020). passed through to household incomes, following Lak- 29. Torres et al. (2021). ner et al. (2020). This pass-through rate is determined 30. Agrawal et al. (2021); de Paz, Gaddis, and Müller (2021); by comparing past growth in national accounts and Kugler et al. (2021). household surveys in a global sample of comparable 31. Agrawal et al. (2021). surveys. In the baseline estimates, it is assumed that 32. Gomes, Haliassos, and Ramadorai (2021); RBI (2017). all households grow at the same rate, so there are no 33. Badarinza, Balasubramaniam, and Ramadorai (2019). distributional changes. See the more detailed discus- Measuring consumption and asset holdings at the sion that follows on the likely distributional changes household level is challenging for two reasons: (1) rep- arising from COVID-19 in selected countries. resentative surveys often lack sufficiently detailed 10. Lakner et al. (2020); World Bank (2020c). data on assets and consumption, and (2) where such 11. Deaton (2021). data are available, they are often difficult to compare 12. Deaton (2021) finds that inequality between countries, across countries. Some recent research has managed measured as the dispersion in per capita GDP without to bridge this gap by collating a broad set of household accounting for population size, decreased in 2020. surveys for emerging and advanced economies. This is consistent with a larger decline in GDP per cap- 34. Badarinza et al. (2021). ita in higher-income countries. However, Deaton finds 35. Measured in the surveys as part of consumption that this dispersion increases when countries are expenditure, including self-reported exposure to infor- weighted by their population. Yonzan, Lakner, and mal loans. Mahler (2021) also find that population-weighted 36. World Bank, COVID-19 Business Pulse Surveys Dash- between-country inequality increased in 2020. Their board, https://www.worldbank.org/en/data/interactive study draws on distributions from household surveys, /2021/01/19/covid-19-business-pulse-survey-dash which are extrapolated using growth in GDP per capita board. Data for the first wave of the survey were col - and weighted by population. Both studies agree that lected between April and November 2020. the dispersion between countries in 2020 is highly sen- 37. Federal Reserve Bank of New York (2021). sitive to the growth forecasts of China and India. The 38. Emerging evidence also suggests there is a gender vintages of the growth data also make a difference. component to the impact on businesses. In response Deaton (2021) compares growth forecasts from the to the pandemic, women-owned businesses closed at October 2019 and October 2020 editions of World Eco- a higher rate than those owned by men. See, for exam - nomic Outlook (IMF 2019, 2020), while Yonzan, Lakner, ple, Goldstein et al. (2020) and Torres et al. (2021). and Mahler (2021) use growth forecasts from the 39. Torres et al. (2021). INTRODUC TION | 45 40. Goldstein et al. (2020). 49. India, for example, has introduced a new regulatory 41. Altig et al. (2020); Baker et al. (2020). framework for nonbank lenders that will come into 42. Acharya et al. (2015); Alfaro et al. (2019). effect in October 2022. See RBI (2021). ­ 43. Feyen, Dancausa, et al. (2020). 50. For example, see Gopinath (2020) and other essays in 44. Bottelier (2010); Rogoff and Yang (2021). Baldwin and Weder di Mauro (2020). 45. Especially low rates in the United States, as described 51. Aizenman et al. (2021). by Bruno and Shin (2017). 52. IMF (2021b), based on Fratto et al. (2021). 46. World Bank (2020b). 53. Aguilar and Cantú (2020); Arslan, Drehmann, and 47. Anginer et al. (2021). Hofmann (2020); Cantú et al. (2021). 48. FSB (2020). References Acharya, Viral, Stephen G. Cecchetti, José De Grego - Market Economies.” BIS Bulletin 20 (June 2). https://www rio, Şebnem Kalemli-Özcan, Philip R. Lane, and Ugo .bis.org/publ/bisbull20.htm. 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Washington, DC: .org/opendata/impact-covid-19-global-poverty-under World Bank. -worsening-growth-and-inequality. 48 | WORLD DE VELOPMENT REPORT 2022 Emerging risks to the recovery The immediate economic effects of the COVID-19 pandemic were felt most acutely by households and firms, which experienced dramatic income losses. Financial risks resulting from these income losses can ultimately affect the entire economy through multiple, mutually reinforcing links that connect the financial health of households, firms, the financial sector, and government. Because of this interconnection, elevated financial risks in one sector can spill over and destabilize the economy as a whole. For example, income losses among businesses and households can create spillover risks for the financial and public sectors through rising loan defaults and reduced tax revenue. Similarly, the governments of many emerging economies were already heavily indebted before the pandemic and further increased borrowing to finance their crisis response. These relationships between sectors of an economy are not, however, deterministic. Well-designed fiscal, monetary, and financial sector policies can counteract and reduce these risks over time to support an equitable recovery. Policy Priorities The pandemic has increased economic risks for households, firms, financial institutions, and govern­ ments. Counteracting these risks to ensure an equitable recovery will require policy action in the following areas:  ecognizing and resolving asset distress in the financial sector as support measures for households • R and firms are scaled back before economic activity has fully recovered. •  Supporting insolvent households and businesses that are unable to resolve their debts in countries with limited or no formal insolvency mechanisms. •  Ensuring continued access to finance in the face of tightening lending standards resulting from increased economic uncertainty and greater opacity about the true financial health of borrowers. •  Managing and reducing high levels of government debt, especially in countries that entered the pandemic with a high risk of debt distress. 49 Introduction The COVID-19 (coronavirus) pandemic sent shock waves through the world economy and heightened concerns about high levels of private and public sector debt. Although the immediate government response to the crisis was largely effective at stabilizing output and protecting incomes, it also aggravated some preexisting financial risks to household, firm, financial sector, and public sector balance sheets that may pose a threat to an equitable recovery in the longer term. These financial risks do not exist in isola- tion; rather, they are connected through a series of direct and indirect links, as illustrated in figure 1.1. This chapter outlines a conceptual framework that offers an encompassing view of the interrelated financial risks that will shape the economic recovery. The framework recognizes the important role of preexisting fragilities and global economic factors in the recovery prospects of emerging economies and highlights the important complementarities that exist between policies aimed at addressing the finan- cial risks that have accumulated across the economy. Addressing the economic risks that have arisen from the pandemic is important not only to ensure a return to economic growth, but also to counteract the dramatic impacts of the COVID-19 crisis on pov- erty and inequality. Reducing overindebtedness among households and firms is, for example, important in its own right, but it also reduces the risk of a credit crunch that disproportionately affects small busi- nesses and low-income households. Similarly, managing and reducing elevated levels of government debt preserve the ability of governments to assist vulnerable populations and support social safety nets that can mitigate the effects of the crisis on poverty and inequality in the longer term. The following Figure O.2 Figure 1.1 Conceptual framework: Interconnected balance sheet risks Governments and central banks Global economy Financial Households sector and firms Precrisis / COVID-19 pandemic / Crisis recovery Source: WDR 2022 team. Note: The figure shows the links between the main sectors of an economy through which risks in one sector can affect the wider economy. 50 | WORLD DE VELOPMENT REPORT 2022 chapters apply this conceptual framework to the various areas where balance sheet risks have accumu- lated as a result of the pandemic and highlight priority areas where decisive policy action can support an equitable recovery. Interconnected financial risks across the economy The initial impacts of the COVID-19 crisis were felt most directly by households and firms, which saw a sharp decline in income and business revenue. These income losses are likely to have repercussions for the wider economy through several mutually reinforcing channels that connect the financial health of households, firms, financial institutions, and governments. Economic links between sectors create spillover risks The financial health of households is connected to the larger economy through the so-called household–financial sector nexus and household–government nexus. When the financial health of households deteriorates, it can directly affect the financial sector through a rise in loan defaults and an increase in loan provisioning requirements, which reduce the ability of banks to issue new loans to creditworthy borrowers. Similarly, when balance sheet conditions in the financial sector worsen, banks supply households with less credit and charge higher interest rates, which depresses economic activity. The financial health of households is similarly connected with that of governments because gov- ernments can provide households with direct support in the form of transfer payments, social safety nets, insurance, and employment. These support measures can help households weather the effects of an economic downturn, or an aggregate shock such as the COVID-19 crisis, that overwhelms con- ventional insurance mechanisms. Governments, in turn, rely on households as a source of tax reve- nue, which declines when incomes are low, unemployment is high, and household balance sheets are under stress. Similarly, the corporate sector is connected to the wider economy through links with the financial sector—the so-called corporate–financial sector nexus—and through links with the public sector—the corporate–government nexus. The financial condition of the corporate sector affects banks and non- bank financial institutions directly through insolvency and loan defaults. The health of the financial sector, in turn, affects firms through the availability of credit: when there is stress on financial sector balance sheets, banks extend less credit and charge more for it. There are multiple feedback loops that can reinforce these links. First, banks are often tempted to delay recognition of nonperforming loans (NPLs) and keep channeling credit to firms that are de facto insolvent. Such “zombie lending” misallocates credit to unproductive firms, reduces the access of profit­ able firms to financing, and has historically been an important factor in prolonged periods of low eco- nomic growth. Second, in times of economic crisis lenders may not be able to distinguish between firms that face temporary liquidity problems and those that are truly insolvent. They may, then, ration credit to both, thereby further depressing economic activity.1 In emerging economies, government ownership of banks and the greater opacity of market information make these feedback loops more pronounced. The financial health of the corporate sector is also connected to that of the government. Govern- ment spending supports economic activity in the corporate sector directly through public procure- ment and indirectly through transfers, guarantees, infrastructure investments, and other support schemes, often aimed at priority sectors such as agriculture or small enterprises. Similarly, tax policy can stimulate economic activity and set incentives for the efficient allocation of resources. Through this channel, tax policy has a direct impact on productivity in the corporate sector. The financial EMERGING RISKS TO THE RECOVERY | 51 health of the corporate sector, in turn, affects governments directly through the taxation of firms and indirectly through the taxation of labor income and economic growth, which expands the tax base of the ­economy as a whole. The connection between the government and financial sectors has received the most attention in recent economic crises2 and is especially important in emerging economies where government debt and banking crises have often coincided.3 The domestic financial sector is connected to the financial health of the government through two direct and two indirect channels, collectively known as the government–financial sector nexus. As for the direct channels, first, banks are directly exposed to the government’s default risk if they hold government securities.4 Through this channel, a deterioration in the government’s financial position directly affects financial institutions’ balance sheets, increasing bor- rowing costs and reducing banks’ ability to supply credit. Conversely, banks are an important source of funding for the government through the purchase of government bonds. When financial sector balance sheets are weak, funding costs go up, making it difficult for governments to refinance existing short- term debt (known as rollover risk) and to finance new expenditures.5 The absence of well-functioning bank resolution and crisis management frameworks can amplify negative feedback loops, particularly if the government’s ability to support the financial system becomes compromised. Second, governments and central banks have in place explicit arrangements, such as emergency liquidity assistance, to support ailing albeit solvent banks in well-circumscribed conditions. These com- mitments are more extensive in countries with substantial state ownership of banks. There, the gov- ernment is directly exposed to losses in the financial sector through reduced dividends and losses in its equity holdings and is expected to provide liquidity and other types of support in times of crisis. However, even in countries with little or no state involvement in the financial sector, governments typ- ically are not able to abstain from bailing out systemically important financial institutions in a crisis. Such bailouts for “too big to fail” institutions can have a significant direct impact on the government’s financial position. The mere expectation of such bailouts can worsen fragilities in the financial sector by encouraging excessive risk-taking among banks.6 Risks to financial sector and government balance sheets are also connected through two indirect channels and feedback loops. First, the two sectors are connected through interactions between the fiscal and real (nonfinancial) sectors of the economy. A deterioration in the government’s financial position will ultimately require fiscal consolidation (mobilizing tax revenue and reducing expendi- tures), which dampens economic activity. This, in turn, may increase insolvencies and put pressure on the financial sector. Second, the financial sector and government are connected through interactions between the banking and real sectors of the economy. The production of goods and services depends on access to credit, which is reduced when the financial sector is distressed. This reduction slows eco- nomic activity, triggers automatic stabilizers such as countercyclical welfare expenditures, and lessens the government’s ability to raise tax revenue. In addition, many governments support specific sectors of the economy, such as agriculture and small businesses, through financial sector programs such as partial credit guarantees, directed lending, or public-private partnerships. When business conditions worsen, governments can be exposed to credit losses in these loans. In emerging economies, the interconnected risks of households, firms, the financial sector, and gov- ernment are exacerbated by external factors stemming from developments in the global economy. For example, in many small, open economies, households, firms, and government borrow in foreign cur- rency. When the value of the local currency depreciates, foreign currency debt becomes more expensive and often unsustainable relative to the local currency income of the borrower. Low- and middle-income countries, and low-income countries in particular, are also more dependent on commodity exports (32 percent of high-income countries are commodity-dependent, compared with 91 percent of low-income 52 | WORLD DE VELOPMENT REPORT 2022 countries).7 Global economic crises, such as the COVID-19 shock, often coincide with a decline in com- modity prices. This disproportionately affects government revenue in low-income countries, further reducing their ability to counteract the crisis through expansionary fiscal policy (higher government spending or tax reductions). Effective policies can counteract risks to the recovery Although the economic risks faced by households, firms, the financial sector, and government are inter- connected, the relationship between these risks is not predetermined (figure 1.2). Well-designed fis- cal, monetary, and financial sector policies can turn the links between sectors of the economy from a vicious cycle into a virtuous cycle. In response to the COVID-19 crisis, for example, many governments immediately used fiscal resources to support the balance sheets of households and businesses in order to prevent a wave of loan defaults and a spillover of the economic shock to the financial sector. Similarly, countries made extensive use of monetary and financial sector policies to strengthen the resilience of the financial sector and ensure that well-capitalized banks were in a position to continue supplying the economy with credit. However, the extent to which governments can mitigate the longer-term risks arising from the COVID-19 crisis differs dramatically across countries because of wide variation in preexisting economic fragilities and access to resources. This disparity makes an unequal recovery within and across countries a very likely outcome. For example, preventing a spillover of household and corporate balance sheet risks to the financial sector requires direct fiscal support to households and firms whose incomes have been affected by the pandemic. But given high preexisting levels of government debt and declining tax revenue during the crisis, few emerging economies had the capacity to finance such anticyclical policies. The result was one of two pitfalls: countries either were not able to enact support policies comprehensive enough to prevent a surge in insolvencies, loan defaults, and spillovers from households and firms to the financial sector, or the scale of support programs required significant new government borrowing, which will constrain the ability of governments to provide ongoing support in the event of a drawn-out recovery. Figure 1.2 Figure 1.2 Conceptual framework: Vicious and virtuous cycles a. Vicious cycle b. Virtuous cycle Lower tax revenue Bank instability Higher tax revenue Stable banks Monetary Fiscal policy Monetary Fiscal policy and financial and financial sector policy sector policy NPLs and Restricted Improved loan corporate access to performance Improved insolvencies credit credit supply Unfavorable Declining Favorable Stronger bond markets fiscal bond markets fiscal support support Monetary and financial Monetary and financial sector policy sector policy Governments and central banks Financial sector Households and firms Source: WDR 2022 team, based on Schnabel (2021). Note: NPLs = nonperforming loans. EMERGING RISKS TO THE RECOVERY | 53 In addition to different degrees of policy space, there is also wide variation in structural factors, such as the extent of informality in the economy, the quality of the legal system, the independence of the central bank, and the access to financial and nonfinancial technologies that can help or hinder the reduction of economic risks that may threaten the recovery. The COVID-19 pandemic is also the first crisis in which access to digital technology and infrastruc- ture plays an important role in determining both the severity of the crisis impacts and the speed of the crisis recovery. In economies with a strong digital infrastructure, a larger share of the workforce was able to work remotely, thereby reducing economic disruptions and job losses arising from the pan- demic. Moreover, digital payment channels were used where they were available to disburse support pay- ments to households and firms, allowing beneficiaries to receive relief payments more quickly. A strong digital infrastructure will also be an important factor in the crisis recovery because digital payments, e-commerce, and digital communications reduce the need for in-person interactions and enable normal economic activity to resume faster. New financial technologies can also reduce information asymme- tries, support sound risk management, and allow lenders to support the recovery through the uninter- rupted provision of credit to households and businesses. Where governments are able to enact effective crisis response policies, these policies can act as a circuit breaker that lessens balance sheet risks and gives rise to a virtuous cycle with positive spillovers between the sectors. Where governments are unable to enact effective policies, or where such policies are hampered by structural factors beyond their control, a vicious cycle can emerge in which risks in each sector accumulate and reinforce each other over time. From health crisis to financial distress: Emerging risks to the recovery The COVID-19 crisis and many of the policies enacted to counter it have reinforced the economic links between households and firms, the financial sector, and government. Although the immediate govern- ment response to the crisis was swift and largely effective at mitigating the worst human costs of the pan- demic, it also exacerbated preexisting financial fragilities by, for example, triggering a dramatic increase in private and public sector debt. These fragilities, if not addressed decisively, could pose a threat to a strong and equitable recovery in the longer term. One challenge policy makers face is that many of the policies undertaken during the COVID-19 crisis are altogether novel (such as central bank asset purchase programs in emerging economies), have not previously been used at this scale (such as debt moratoria and regulatory forbearance), or have the potential to create various longer-term risks to the recovery, such as hidden debts and contingent liabilities, which may become apparent only much later. As the immediate effects of the pandemic subside, policy makers face the difficult task of scaling back these policies without dampening the recovery or worsening the already highly regressive impacts of the crisis. Households and firms Despite the extensive fiscal support measures taken by governments worldwide, the pandemic has led to a significant tightening of household balance sheets. Although many countries enacted cash transfer and income support measures to support households and prevent spillovers to the financial sector, many of these programs were not sufficient to compensate for the full extent of income losses. As highlighted in the introduction to this Report (figure I.5), the majority of households in both emerging and advanced economies do not have enough liquid assets to sustain basic consumption for more than three months 54 | WORLD DE VELOPMENT REPORT 2022 in the face of a large income shock, and most governments lack the fiscal resources to maintain income support programs for a substantial amount of time. As a result, many income support programs had to be phased out before household earnings fully recovered. This was especially true in countries that were hit by multiple waves of the pandemic, lacked strong automatic stabilizers such as unemployment insur- ance and other social safety nets, and were unable to mobilize external fiscal resources for prolonged support measures. These factors increase the vulnerability of households, as well as the risk of spillovers to financial institutions through increases in nonperforming loans. Household incomes were especially hard-hit in countries with limited social safety nets (see figure 1.3) and a large share of employment in the informal sector. Because of the aggregate nature of the shock, Figure 1.3 Figure 1.3 Social safety nets and income losses during the COVID-19 crisis, by country income group 12 Average per capita transfer, precrisis (2011 US$, PPP) 10 8 6 4 2 0 –2 20 30 40 50 60 70 80 90 Share of households experiencing income losses (%) High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on data from World Bank, ASPIRE (Atlas of Social Protection Indicators of Resilience and Equity) (dashboard), http://datatopics.worldbank.org/aspire/; World Bank, COVID-19 Household Monitoring Dashboard, https://www.worldbank.org/en/data/interactive/2020/11/11/covid-19-high-frequency-monitoring-dashboard. Note: The figure shows the average per capita transfer of social protection payments, including transfer payments from social assistance, social insurance, and labor market programs. For each household, the per capita average transfer is the total amount of transfers received (constant 2011 US dollars adjusted for purchasing power parity, PPP) divided by house- hold size, for the latest precrisis year available for each country. Data on income losses were collected between April and December 2020. EMERGING RISKS TO THE RECOVERY | 55 informal insurance mechanisms that could have mitigated the impact of the economic shock, such as borrowing from family and friends, were largely ineffective. In the majority of emerging economies, government transfer payments could not compensate for the sharp decline in incomes and were an insufficient substitute for these informal insurance mechanisms. Moreover, access to available support schemes often varied dramatically across population groups and did not reach households employed in the informal sector or households without access to a formal financial account, who were among those most severely affected by the crisis. This uneven access to support programs is likely to increase poverty and inequality and weaken the resilience of households in the longer run (see spotlight 1.1). To ward off an immediate spike in defaults on consumer debt and spillovers to the financial sector, many governments supplemented income support measures with far-reaching debt forbearance poli- cies. Many of these debt relief measures also included a freeze on credit reporting—that is, borrowers who were late on their loan payments were not reported to credit bureaus and did not suffer a deteriora- tion of their credit score. Such policies create a difficult trade-off. On the one hand, they can be useful in the face of a transitory shock because they reduce the likelihood that borrowers are forced to default on their loans or lose access to credit as a result of temporary liquidity problems. However, such forbearance policies may not be sufficient to prevent spillovers to the financial sector if they are lifted prematurely, forcing defaults among otherwise creditworthy borrowers whose income has not yet recovered. On the other hand, if debt relief policies are left in place too long, they can hide the true extent of nonperform- ing loans and mask credit risks that materialize once debt moratoria are lifted. Box 1.1 describes how debt moratoria were used as part of the short-term response to the pandemic in India and were success- ful in warding off a large spike in loan defaults in the early stages of the crisis. Similarly, a broad range of policies have been enacted to provide liquidity to the corporate sector in the hope that, because the public health crisis will be temporary, so, too, will be the financial distress of firms. These policies have included direct grants and transfer payments, tax breaks, as well as credit subsidies and guarantees. Although the extension of direct support to businesses is sensible in the short run to prevent insolvencies of viable firms and associated job losses, it is important that support policies be designed in a way that does not distort the allocation of resources in the longer term. The pandemic has triggered structural changes in the world economy, which will ultimately necessitate a reallocation of resources between sectors. Some areas such as tourism and corporate real estate are expected to take a long time to recover to their precrisis levels, while areas such as e-commerce, services, and information technology are expected to expand their relative shares of the economy. Temporary support programs that are left in place for too long, or that target specific industries through preferential tax treatment, transfers, or credit subsidies, run the risk of channeling scarce resources to sectors and firms that the crisis has rendered unviable. Evidence from past crises shows that this type of misallocation tends to benefit large firms in stagnating sectors to the detriment of smaller and more efficient firms, as well as sectors with higher growth potential. Emerging evidence on the impacts of COVID-19 support programs suggests that this pattern also holds in the current crisis, with support programs disproportionately benefiting less productive firms in politically favored sectors.8 This discrepancy could slow the economic recovery and delay the reallocation of resources to more sustainable sectors. The financial position of households and firms will also be affected by feedback effects from the gov- ernment and the financial sector. Governments that entered the crisis with elevated debt and limited fiscal resources were either unable to mobilize sufficient resources for the crisis response or will have to phase out support programs prematurely. Data from the World Bank’s COVID-19 Crisis Response Survey reveal that the fiscal response to the pandemic was significantly constrained by limited access to domestic borrowing in 72 percent of low-income countries and 57 percent of lower-middle-income countries, by limited access to foreign borrowing in 83 percent of low-income countries and 61 percent 56 | WORLD DE VELOPMENT REPORT 2022 Box 1.1 Case study: Supporting borrowers and the financial sector in India The world over, governments and regulators $75 billion. This stimulus was expanded in later responded to the COVID-19 crisis with financial rounds, and by the end of 2021 the RBI had intro- sector policies aimed at supporting borrowers and duced monetary policy measures totaling $231 bil- reducing risks to financial stability. Many of these lion.a The first round of liquidity measures reduced policies, such as debt moratoria, had never been used interest rates by 100–200 basis points across the on this scale. It is possible to draw some first lessons yield curve and successfully averted financial dis- about the effectiveness of these policies from the tress among banks and nonbank lenders. Figure experience of countries that were confronted with B1.1.1 shows how the RBI implemented the mon- multiple waves of the pandemic and introduced sev- etary stimulus through the repurchase agreement eral rounds of support programs in response. (repo) market and how this action lowered interest The case of India offers an especially instructive rates and shifted the yield curve. example. India’s government and financial regulators put forth a large, decisive policy response to the first Debt moratoria: Covered 50 percent of all loans wave of the pandemic that used a variety of monetary in India, most stabilized and financial sector policies aimed at stabilizing the India’s first COVID-19 package also included a gen- financial sector and supporting households and firms. erous debt repayment moratorium for households and firms. Participation in this moratorium, which Monetary policy tools: Effective but cannot granted borrowers a freeze on loan repayments for be targeted 90 days, was voluntary, but nearly 50 percent of In March 2020, the Reserve Bank of India (RBI) bank loans were eventually covered by the pro- Figure B1.1.1 approved a first monetary stimulus totaling some gram. As lockdowns continued, another 90-day Figure B1.1.1 Use of monetary policy to reduce interest rates in India a. Effects of monetary stimulus through repo market, 2018–21 8,000 6.5 7,000 6.0 6,000 5.5 Rupees (billions) Interest rate (%) 5,000 5.0 4,000 4.5 3,000 4.0 2,000 3.5 1,000 3.0 0 2.5 20 18 19 21 19 20 21 20 20 20 20 20 20 20 n. ly ly n. n. ly ly Ju Ju Ja Ju Ju Ja Ja Reverse repo outstanding Reverse repo rate (right axis) (figure continues) b. Effects of monetary stimulus on yield curve, 2020 (Box continues next page) 7.0 6.2 EMERGING RISKS TO THE RECOVERY | 57 (%) 5,000 5.0 Rupees (bil Interest rat 4,000 4.5 3,000 4.0 2,000 3.5 1,000 3.0 0 2.5 20 18 19 21 19 20 21 Box 1.1 Case study: Supporting borrowers and the financial sector in India (continued) 20 20 20 20 20 20 20 n. ly ly n. n. ly ly Ju Ju Ja Ju Ju Ja Ja Reverse repo outstanding Reverse repo rate (right axis) Figure B1.1.1 Use of monetary policy to reduce interest rates in India (continued) b. Effects of monetary stimulus on yield curve, 2020 7.0 6.2 Interest rate (%) 5.4 4.6 3.8 3.0 Call rate 3-month CP 12-month 2-year 3-year 5-year 10-year G-sec G-sec G-sec G-sec G-sec February 1, 2020 September 1, 2020 Source: Reserve Bank of India. Note: The figure shows the effects of the Reserve Bank of India’s intervention in the repurchase agreement (repo) market. Panel a indicates its importance as a source of financing for financial institutions. Panel b indicates the shift in India’s yield curve (that is, the reduction of interest rates at different maturities) that resulted from liquidity infusion through this channel and other actions of the central bank. CP = commercial paper; G-sec = government security. extension of the program was introduced, which Loan performance in segments such as micro­ ultimately covered 40 percent of all outstanding finance was the most severely affected, with non- loans in India.b As the moratorium was eventually performing loans increasing from 1 percentage being phased out, the central bank opened up a spe- point to more than 5 percentage points. cial restructuring window for loans to consumers, Although India’s experience with a debt morato- micro-, small, and medium enterprises (MSMEs), rium was overall favorable, applying such a measure and larger firms to facilitate the reduction of debt repeatedly is challenging because it may affect bor- burdens. rowers’ behavior. India later enacted another debt Although banks were concerned about the high moratorium as part of its response to the severe share of loans covered by the moratorium, the out- second wave of the pandemic from March to June comes were relatively benign. In the six months 2021. However, the possible effects on hidden debts after the moratorium, banks managed to contain and credit discipline were a much-debated issue. additional nonperforming loans to 2–4 percent.c However, this relative stability masked consider- Guarantee schemes: Well targeted, but a able differences across segments, with consumer potential source of contingent liabilities loan delinquency rising while nonperforming loans The Indian government also introduced a partial among MSMEs and larger firms remained stable. credit guarantee scheme, the Emergency Credit (Box continues next page) 58 | WORLD DE VELOPMENT REPORT 2022 Box 1.1 Case study: Supporting borrowers and the financial sector in India (continued) announced, and most of the Rs 2.5 trillion ($34 bil- Figure B1.1.2 Figure B1.1.2 Support for new lending lion) allocated under this scheme went to small and through partial credit guarantees in microenterprises. India, by firm size However, the true cost of these guarantees to 700 70 the government will only become clear in the lon- ger term. Although India’s economic recovery from 600 60 the first waves of the pandemic has been remark- Rupees (billions) 500 50 ably robust and the immediate fiscal impact of 40 credit guarantee schemes is low, credit guarantees Percent 400 always carry the risk of turning into a liability for the 300 30 government if an economic downturn causes loan 200 20 defaults to rise. This risk is of particular concern in 100 10 the context of the COVID-19 crisis, in which busi- 0 0 ness prospects across countries and sectors of the Micro Small Medium economy remain uncertain in the face of possible Value of loans disbursed under ECLGS future waves of the pandemic. Share of outstanding loans benefiting from ECLGS (right axis) Rising inequality despite a strong crisis response Although a large spike in insolvencies and loan Source: Reserve Bank of India. defaults has been averted thanks to India's ambi- Note: The figure shows the amount of new lending to micro-, small, and medium enterprises under India’s tious policy response,d inequality has increased. credit guarantee scheme initiated in response to the While agricultural incomes have been remarkably pandemic. ECLGS = Emergency Credit Line Guaran- resilient, the 40 percent of India's informal work- tee Scheme. force outside the agriculture sector has suffered the brunt of the economic distress caused by the Line Guarantee Scheme (ECLGS). This scheme pandemic.e This is not unique to India and mir- enabled the government to provide the economy rors developments in many other countries where with additional liquidity with a minimal immedi- the pandemic has worsened inequality despite ate effect on its fiscal position (figure B1.1.2). Ini- extensive policy measures aimed at protecting the tially, guarantees of Rs 3 trillion ($40 billion) were incomes of the poor.f a. RBI (2021). b. RBI (2020a, 2020b). c. Even when the 2 percent of loans under the special restructuring window are included, the total addition in problem loans was only 5 percent of banks’ total loan portfolios. d. RBI (2021). e. See Azim Premji University (2021), CMIE (2021), and Dhingra and Ghatak (2021). While the data show stark increases in poverty and inequality during India's first lockdown, some recent evidence suggests that these trends may have been more muted and partly reversed later in the pandemic (Gupta, Malani, and Woda 2021). f. World Bank (2021b, 2022). of lower-middle-income countries, and by concerns about the overall sustainability of government debt in 83 percent of low-income countries and 70 percent of lower-middle-income countries (figure 1.4). Gov- ernments facing such tight fiscal limitations will be unable to protect households and firms from adverse events during the recovery. These include external economic shocks, which are a very real prospect for low- and middle-income countries, where the recovery is highly dependent on a favorable international EMERGING RISKS TO THE RECOVERY | 59 Figure 1.4 Figure 1.4 Fiscal constraints to the COVID-19 response, by country income group Access to domestic borrowing Access to external borrowing Access to foreign aid Government debt sustainability 0 10 20 30 40 50 60 70 80 90 100 Percent High-income Upper-middle-income Lower-middle-income Low-income Source: World Bank, COVID-19 Crisis Response Survey, 2021, http://bit.do/WDR2022-Covid-19_survey. Note: The figure shows the percentage of countries in which each of the listed factors was identified as a significant or moderate constraint to the response to the pandemic. Data are as of June 30, 2021. environment. Similarly, the survival of many viable firms depends on an ongoing supply of credit, which may be threatened if the financial sector comes under stress from external shocks, exposure to the gov- ernment risk, or an increase in loan defaults as government support programs are phased out. Households and businesses are also exposed to tightening public sector balance sheets through gov- ernment arrears. As a result of the crisis, many governments, particularly in low-income countries, have resorted to suspending or delaying the payments for goods, services, and works procured from the private sector. Some governments have also suspended or delayed paying the salaries of public sector employees. In Sub-Saharan Africa, for example, the government is one of the biggest purchasers of goods and services, and public procurement averages 12 percent of gross domestic product (GDP). Government arrears stood at a staggering 4.26 percent of GDP prior to the COVID-19 pandemic (figure 1.5).9 The economic contrac- tion stemming from the pandemic has only aggravated the problem. Conservative estimates for the region suggest government arrears increased by nearly 2 percent of GDP during the first year of the pandemic.10 Financing relief and recovery programs by accumulating arrears is economically costly because it directly counteracts stimulus efforts by depriving households of income and reducing firm revenue at a time when liquidity is crucial for their survival. The accumulation of government arrears is a prime example of an economic link between the public and private sectors that has been exacerbated by the crisis, has an asym- metrically larger adverse effect on small and informal firms, and poses a very real threat to the recovery. Financial sector In contrast to earlier crises, the COVID-19 recession did not originate in the financial sector and was not set off by a specific event, such as the failure of a systemically important institution. Nonetheless, a grad- ual deterioration of asset quality in the aftermath of the pandemic could lead to a longer-term outcome that looks very similar to that after a traditional financial sector crisis. Mandated by governments and regulators, financial institutions worldwide have granted grace peri- ods and moratoria for loan repayments on an unprecedented scale (figure 1.6). These forbearance pol- icies play an important role in preventing avoidable defaults among creditworthy borrowers suffering temporary liquidity problems. However, if left in place too long these policies can lead to credit market distortions and make it difficult for banks to distinguish between creditworthy and noncreditworthy borrowers, ultimately reducing new lending. 60 | WORLD DE VELOPMENT REPORT 2022 Figure 1.5 Figure 1.5 Government arrears in Sub-Saharan Africa 10 9 8 7 Share of GDP (%) 6 5 4 3 2 1 0 ina ire am he ba e so e A n ar S e ic a Za e U g p. ipe Ni e hA n Le na r r a i ti u s R w ia al ia da p ia da Ta ndi L ib ni la M ia Es ho Na wi ia au ia na n a B u ya go d m e nin ali u nd eon rd bw o ine bo ad C ha an C o mib Ca neg b Re go r ti er c ala n Fa biq T B u d ’ I vo a an C ô G ha S o e ro an t ge To ínc fr M hio m ru as wa Ve so Ke tsw Ga M b ia , nz Gu r B o, L ag Pr m Et bo m ng Bo M ut te Ca rk Zi oz e Ga M Si éa om oT Sã Arrears prior to pandemic Arrears, post COVID-19 projection Source: WDR 2022 team, based on Bosio, Ramalho, and Reinhart (2021). Note: The arrears are computed using the ratio of the number of days required to process payment beyond 45 days to the number of days in a year, multiplied by total public procurement as a percentage of GDP. Projections are based on data from the October 2020 IMF World Economic Outlook. See International Monetary Fund, WEO (World Economic Outlook Data- bases) (dashboard), https://www.imf.org/en/Publications/SPROLLS/world-economic-outlook-databases. Figure 1.6 Figure 1.6 Financial sector policies during the COVID-19 crisis, by country income group Debt moratoria for households Debt moratoria for microfinance borrowers Debt moratoria for firms Regulatory forbearance 40 45 50 55 60 65 70 75 80 85 90 95 100 Percent High-income Upper-middle-income Lower-middle-income Low-income Source: World Bank, COVID-19 Crisis Response Survey, 2021, http://bit.do/WDR2022-Covid-19_survey. Note: The figure shows the percentage of countries in which each of the listed policies was implemented in response to the pandemic. Data are as of June 30, 2021. EMERGING RISKS TO THE RECOVERY | 61 Some debt moratoria enacted in response to the COVID-19 crisis were accompanied by a freeze on credit reporting—that is, regulators instructed banks to not report delinquent borrowers to credit bureaus for the duration of the moratorium. Although such a measure protects borrowers from being excluded from the credit market because of a temporary liquidity shock, it complicates the task of assess- ing the true credit risk on bank balance sheets. So long as forbearance programs are in place, banks are largely unable to distinguish illiquid from insolvent borrowers, which may make them more reluctant to issue new credit. This pattern may already be evident in some economies. Since the fourth quarter of 2019, the percentage of loans to total assets has fallen, and lending standards have tightened in countries that were more severely affected by emergency measures (see chapter 2 for a discussion). Finally, debt forbearance programs always carry the risk of creating incentives for evergreening and zombie lending—that is, they tempt lenders to extend credit to insolvent borrowers to avoid having to classify these loans as nonperforming. Through the financial sector–corporate nexus and the financial sector–household nexus, evergreening and zombie lending have negative effects on the real economy because they depress lending to creditworthy households and viable firms. As a result, households and firms are less resilient to the adverse shocks that may arise during the crisis recovery period and are less able to finance new consumption and investment. In addition to debt moratoria, many countries have relaxed banking regulations, accounting stan- dards, and capital provisioning rules for bad loans in an effort to stimulate lending and prevent a credit crunch (see box 1.2). Although international regulatory standards, such as the Basel III framework, allow for some flexibility to enact such regulatory forbearance measures, some regulators relaxed prudential regulation beyond international standards in response to the crisis. This is an extremely problematic policy choice because the relaxation of prudential oversight encourages financial insti- tutions to originate poorly screened loans. This contributes to the accumulation of loans whose true credit risk is unknown, but likely much higher than accounted for by those institutions. In addi- tion, numerous political economy factors will make it extremely difficult to reverse the relaxation of regulatory standards once the crisis subsides, especially in countries with weaker institutions and limited central bank independence. In the longer run, the use of regulatory forbearance policies that go beyond the flexibility embedded in international frameworks will magnify financial sector risks and increase the vulnerability of countries to financial crises. This is illustrated by previous crisis epi- sodes in which such policies were used on a much more limited scale than in the COVID-19 crisis and had far-reaching negative consequences, including zombie lending and excessive risk-taking invited by lax regulatory oversight. In many emerging markets, nonbank financial institutions account for a high share of pri- vate credit. They are typically less regulated than banks and may therefore accumulate credit risks that are less apparent than the risks to bank balance sheets. Nonbank lenders—including microfi- nance institutions and fintech lenders—also account for a large share of lending to consumers and small businesses, which have been especially hard-hit by the pandemic. When the balance sheets of nonbank lenders come under stress, there are far-reaching repercussions for the real economy. In the Indian microfinance crisis of 2010–11, for example, the aggregate loan portfolio of microfinance lenders ­ contracted by 20 percent. This contraction had severe negative effects on household wage earnings and consumption.11 Nonbank lenders in emerging economies are also much more exposed to risks originating in the global economy. Unlike deposit-taking commercial banks, nonbank lenders refinance themselves in domestic and international markets, sometimes in foreign currency, which means their ability to supply credit is directly affected by exchange rate fluctuations and the international interest rate environment. Because nonbank lenders in emerging economies deal predominantly with low-income consumers and 62 | WORLD DE VELOPMENT REPORT 2022 Box 1.2 The unintended consequences of regulatory forbearance During the COVID-19 crisis, many countries exper- imented with regulatory forbearance policies that Table B1.2.1 Provisioning requirements relaxed capital requirements or accounting stan- by loan category, India, 2008 dards for banks in the hope they would provide bor- Asset NPL duration Provisioning rowers with temporary relief.a Although it is too early category (months) rate (%) to assess the impact of these regulatory forbearance policies, past experiences can serve as a useful illus- Standard — 0.25–1 tration of the longer-term risks such policies can Substandard <12  10 pose to financial stability and economic growth. Doubtful 12–24  20 One especially instructive example is India, 25–48  30 which lowered capital provisioning requirements in >48 100 response to the 2007–09 global financial crisis. In Loss — 100 2008, the Reserve Bank of India (RBI) announced it would apply “special regulatory treatment” to loans Source: Reserve Bank of India. under temporary liquidity stress. The policy relaxed Note: The table lists provisioning requirements on asset risk classification rules that govern capital various categories of loans as defined by the Reserve Bank of India. The provisioning requirements for stan - provisioning requirements for financial institutions dard assets depend on the industry sector of the loan, with the intent of making it easier for banks to pro- and thus the table indicates the range of provisioning vide forbearance to firms that had suffered tempo- rates across all industries. NPL = nonperforming loan. rary cash-flow shocks during the crisis. With the new regulation, banks were no longer This situation led to a significant buildup of required to automatically downgrade the asset stressed assets in the Indian banking system. State- quality of loans to substandard because of a missed owned banks, in particular, saw their stressed assets principal or interest payment. They could claim that pile up—a problem that became apparent once the delinquent firms merely faced temporary liquidity regulation was withdrawn (see figure B1.2.1).b The problems and place these assets into a new “restruc- marked difference in the accumulation of stressed tured” category. Under normal circumstances, all assets between private and state-owned banks loans in the restructured category would be sub- indicates that the negative consequences of the ject to immediate downgrades to substandard, and policy are not uniform and may be exacerbated by capital provisioning requirements would increase poor corporate governance. proportionately and substantially, as table B1.2.1 The rise in nonperforming loans (NPLs) resulting illustrates. In other words, banks would be required from diminishment of the crisis had a large impact to increase their capital reserves to protect them- on asset quality in the Indian financial sector. Prior selves against the higher default risk of these loans. to the global financial crisis, India had the lowest The RBI regulation did not provide explicit cri- NPL ratio (2 percent) of all G20 nations. Between teria for identifying liquidity-constrained firms, 2008 and 2018, the share of nonperforming and leaving it up to the banks to decide which loans restructured loans in India’s banking system rose to assign to the new restructured category. Banks dramatically, and by 2018 India had the highest NPL took full advantage of this ambiguity and exten- ratio (11 percent) among this group of countries. sively used the restructured category to avoid Contrary to the intention of the policy, regula- having to add to their capital reserves. In this way, tory forbearance also encouraged banks to channel the policy gave banks an incentive to obscure the credit to low-liquidity and low-solvency borrowers. true asset quality of the loans on their books and As a result, zombie firms emerged on a large scale offered them a route to continually postponing or in the Indian corporate sector. In 2016, approxi- altogether avoiding recognition of troubled assets. mately 40 percent of nonfinancial firms in India had (Box continues next page) EMERGING RISKS TO THE RECOVERY | 63 Figure B1.2.1 Box 1.2  The unintended consequences of regulatory forbearance (continued) Figure B1.2.1 Nonperforming loans in India, 2005–16 Ratio of NPLs to total advances 10 Policy announced Policy withdrawn 8 6 4 2 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Public banks Private banks Source: Chari, Jain, and Kulkarni 2021. Note: The figure shows the ratio of nonperforming loans (NPLs) to total advances for state-owned banks and private banks in India between 2005 and 2016. Dashed lines mark the announcement and withdrawal of the regulatory for- bearance policy. an interest coverage ratio (the ratio of revenue to balance sheets and necessitated large bank recap- interest payments) of less than 2, and 21 percent italizations. Because state-owned banks account of firms had an interest coverage ratio of less than for approximately 70 percent of the Indian banking 1, meaning that they were unable to cover their sector, recognition would have entailed significant debt payments with current revenue. The average costs for the government relative to budget-neutral interest coverage ratio of Indian firms fell by nearly forbearance schemes. half, from 6.92 in 2007 to 3.38 by 2015. At the same In light of the many regulatory forbearance pol- time, overall debt levels remained unchanged, sug- icies enacted in the wake of the COVID-19 crisis, gesting that the debt service capacity of the Indian India’s experiment with regulatory forbearance in a corporate sector had sharply declined. This increase past crisis serves as a cautionary tale. It may be chal- in zombie lending also made it more difficult for lenging to unwind improperly designed temporary healthy firms to obtain loans from banks, with obvi- forbearance measures, and many of these policies ous negative implications for economic growth. will have long-lasting negative effects on access to Meanwhile, regulatory forbearance functioned credit, industry structure, and financial stability even as an implicit subsidy for the financial sector that after a policy is withdrawn. As economies recover, allowed the government to delay costly bank active and costly intervention may be needed to recapitalization. Recognizing loan losses in a timely address some of these longer-term legacies, such as fashion would have undoubtedly weakened bank zombie lending and the undercapitalization of banks. a. Acharya, Engle, and Steffen (2021). b. Chari, Jain and Kulkarni (2021). small businesses, the impacts of external shocks on their ability to supply credit will have a dispropor- tionately negative effect on these vulnerable segments of the population. Financial fragilities in the postcrisis period could also arise from a tightening of the government– financial sector nexus (figure 1.7). Many governments have financed their COVID-19 response by issuing new debt that is held by domestic financial institutions. As the government’s fiscal position worsens and 64 | WORLD DE VELOPMENT REPORT 2022 Figure 1.7 Figure 1.7 Government debt and banking sector fragility during the COVID-19 crisis, by country income group 40 Consolidated distance to break point 30 (percentage points) 20 10 0 –10 0 25 50 75 100 125 150 175 200 General government gross debt, 2021 forecast (% of GDP) Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on Feyen and Mare (2021); World Bank Macro-Fiscal Model Data Base, see Burns and Jooste (2019); Burns et al. (2019). Note: The consolidated distance to break point is the percentage point increase in the nonperforming loan ratio that wipes out capital buffers for banks representing at least 20 percent of banking system assets (see Feyen and Mare 2021). GDP = gross domestic product. its credit rating falls, asset quality in the financial sector deteriorates. This deterioration in asset qual- ity has negative feedback effects on the wider economy because it limits the ability of banks to support the recovery through new lending. This situation raises the possibility of mutually reinforcing crises of government finances and the financial sector. In Tunisia and several other countries, for example, inter- national rating agencies, reacting to the crisis, downgraded both the ­ government’s issuer ratings, as well as the outlook for some of the country’s largest banks. The government–banking sector nexus could also become more precarious because of increases in the relative size of the banking sector, which makes it more difficult for governments to resolve systemwide distress in the event of a crisis.12 Governments In emerging economies, the challenges created by the pandemic go beyond household and firm balance sheets and encompass the financial position of the government. The large fiscal support programs enacted in response to the crisis led to a dramatic increase in government debt, with average debt loads increasing by roughly 7.4 percentage points of GDP since the beginning of the COVID-19 crisis, compared with an average of 1.8 percentage points over the previous decade. This increase in government debt was uneven in several respects (see table 1.1). First, higher-income countries were able to access financing more easily than lower-income countries. Second, upper-middle-income countries relied on international markets to mobilize resources for the crisis response, while, relative to the previous decade, lower-middle-income EMERGING RISKS TO THE RECOVERY | 65 Table 1.1 Change in average central government debt stocks, by country income group, 2010–20 Share of GDP (%) Change in average total Low- Lower-middle- Upper-middle- High- debt to GDP ratio income income income income All Total debt Average, 2010–19 2.88 1.82 1.46  1.20 1.84 2020 3.81 6.69 5.55 13.63 7.42 Domestic debt Average, 2010–19 0.79 0.59 0.97 –0.30 0.51 2020 0.86 3.04 1.80 9.24 3.73 External debt Average, 2010–19 2.09 1.23 0.49 1.41 1.30 2020 3.03 3.66 3.74 4.54 3.74 Source: Barrot 2021. Note: The table shows the changes in government total, domestic, and external debt stocks for the period 2010–19 and in 2020. GDP = gross domestic product. countries relied more heavily on domestic debt. Finally, low-income countries with market access turned mostly to external financing to meet increased funding needs for the response to the pandemic. In addition to increased global debt loads, other indicators point to latent risks that may endanger the financial position of governments. In 2020, five governments defaulted on their obligations to external private creditors, a worrying increase compared with the norm over the post–World War II period. In the previous decade, an average of two governments defaulted every year. Moreover, more than half of the countries eligible for relief under the G20 Debt Service Suspension Initiative (DSSI) are in debt distress or at high risk of debt distress. These heightened risks at the government level have direct implications for poverty and inequality, as well as for the economic resilience of households and firms. Governments that face dramatically increased debt loads may be unable to finance social safety nets and essential public goods, such as health care and education, and may not be able to mobilize the resources to support households and firms that have been directly affected by the crisis. The deteriorating financial position of governments will not be easily reversed because it is the com- bined effect of the fiscal response to the crisis, a dramatic decline in tax revenue (averaging almost 1.5 per- cent of GDP in 2020), the widespread use of tax forbearance schemes, and, in many emerging economies, the worsening balance sheets of state-owned enterprises. Many countries are counting on a rebound in economic activity and tax revenue to mitigate the economic damage resulting from the pandemic. How- ever, unequal access to vaccines, the need to keep public health measures in place longer than anticipated, and a worsening international economic environment have cast doubt on the prospects for a quick recov- ery. Following a positive trend in the fiscal position of governments, the onset of the pandemic brought about a dramatic reversal as GDP and tax revenue collapsed, widening primary deficits and undoing much of the progress in revenue mobilization efforts implemented in recent years (figures 1.8 and 1.9). Limited fiscal resources may require many governments to phase out fiscal support for households and firms and resume revenue mobilization efforts, including tax collection, before incomes and employ- ment have fully rebounded. This effort to raise revenue could put further pressure on household and firm balance sheets and threaten hard-won gains in poverty reduction. Historically, episodes of high 66 | WORLD DE VELOPMENT REPORT 2022 Figure 1.8 Figure 1.8 Change in average government revenue, by country income group, 2011–20 2 1 Share of GDP (%) 0 –1 –2 –3 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on data from IMF (2021b). Note: The figure shows the difference relative to the prior year in average revenue as a share of the gross domestic product (GDP) for each country group. Figure 1.9 Figure 1.9 Average primary government balances, by country income group, 2010–20 2 1 0 –1 Share of GDP (%) –2 –3 –4 –5 –6 –7 –8 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on data from IMF (2021b). Note: The figure shows the difference relative to the prior year in average primary balance (noninterest revenue minus non­ interest expenditures) as a share of the gross domestic product (GDP) for each country group. EMERGING RISKS TO THE RECOVERY | 67 fiscal deficits and significant increases in the stock of domestic debt have also been associated with higher inflation, which acts as a highly regressive tax on low incomes and exacerbates the impacts of a crisis on poverty and inequality. Elevated government risks can also spill over to the financial sector, particularly in low- and middle- income economies. Recent studies have evaluated the potential fallout from rising government debt levels. One study finds that about half of identified episodes of rapid debt accumulation across country groups are associated with financial crises, which tend to be severer than those occurring without the presence of a debt buildup in the public sector.13 Another study finds no association between debt build- ups and a higher likelihood that high-come economies undergo a financial crisis, but it confirms that debt buildups are associated with worse outcomes in the financial crises that do occur.14 Increases in government debt are thus potentially associated with a heightened risk of financial crises in emerging economies, and, once they occur, large debt loads pose a significant obstacle to crisis resolution. Against this backdrop, it is important to note that the fiscal response to the COVID-19 crisis has been significantly financed with domestic debt held by local investors such as banks, pension funds, and other financial institutions, thereby tightening the link between government and financial sector balance sheets. Government risk downgrades thus lead to a direct deterioration of asset quality on the balance sheets of financial institutions and reduce the financial sector’s ability to support the recovery. During 2020, one-third of the governments assessed by the three main rating agencies suffered a down- grade in their risk rating.15 This deterioration can, in turn, require governmental intervention to recap- italize financial institutions and potentially trigger shocks to government budgets through contingent liabilities and further increases in the debt stock. Recent research on the fiscal costs of contingent liabilities can help to quantify these risks. One study finds that when contingent liabilities materialize (such as when a government needs to rescue a state- owned enterprise or subnational entity), the average fiscal cost is 6 percent of GDP. The fiscal costs are even higher for contingent liabilities in the financial sector, where bailouts can cost as much as 40 percent of GDP.16 State-owned enterprises, which account for a large share of the corporate revenue base and essential services in many countries, are a source of significant contingent liability risks for governments. For example, in 2018 Angola faced downward pressure on its government credit ratings after an unex- pected one-off support payment of $8 billion (7 percent of GDP) to Sonangol, the national oil company, became necessary.17 Similarly, Indonesia’s largest utility company required a bailout at a cost of 4 per- cent of GDP to the taxpayer in 1998. In the same way, financial pressures on state-owned enterprises increased considerably during the pandemic. Many of the largest state-owned enterprises, especially in low-income countries, export natural resources, which are vulnerable to the commodity price shocks and exchange rate fluctuations that will occur during the crisis recovery period. Meanwhile, some COVID-19 crisis response programs have given rise to new contingent liabilities altogether. Many governments extensively used credit guarantee schemes to continue the flow of credit to households and firms during the crisis. Such programs are attractive in the short run because they have no immediate fiscal cost to the government, but they can create significant longer-term risks to government finances if loans covered by the program default. The magnitude of contingent liabilities stemming from credit guarantee schemes is typically difficult to estimate, but it can be substantial, as evidence from past crises illustrates.18 The global economy External factors will play an important role in shaping the recovery prospects of emerging economies (box 1.3). The COVID-19 crisis has taken place against the backdrop of a relatively benign economic environment characterized by historically low interest rates globally, which remained low because of 68 | WORLD DE VELOPMENT REPORT 2022 Box 1.3 External factors in the recovery: Will this “taper tantrum” be different? The link between developments in the global econ- scenario. As stimulus policies in advanced econo- omy and the crisis recovery in emerging economies mies are scaled back, interest rates will increase, is well illustrated by the withdrawal of stimulus pol- leading to an exit of portfolio investment, exchange icies in the United States after the 2007–09 global rate depreciation, and refinancing problems for financial crisis, which triggered an event that would firms and governments. However, because of the later be known as the “taper tantrum.” lack of economic growth, it is unlikely that the In response to the global financial crisis, the US same recipe applied to the taper tantrum can be Federal Reserve enacted in 2008 a massive mone- applied in the aftermath of the COVID-19 crisis. In tary policy stimulus. The stimulus relied largely on 2012, the Indonesian economy grew at 6.2 percent. quantitative easing, a form of unconventional mon- By contrast, in 2020 the economy shrank by 2.1 etary policy in which the central bank purchases percent. Tightening fiscal and monetary policy in securities on the open market to increase the this scenario threatens newly recovering economic money supply and keep interest rates low. In 2013, growth. Economic stabilization when growth is low the Fed contemplated winding down the program, is not a good option. and Federal Reserve chairman Ben Bernanke hinted At the same time, the risk of recurring taper at the Fed’s intentions in a hearing before Congress. tantrums seems lower than in 2013: Indonesia This statement had an immediate effect on experienced large capital outflows at the begin- emerging markets, including Brazil, India, Indone- ning of the crisis, making it less vulnerable to capi- sia, South Africa, and Turkey (known as the “fragile tal flight than in 2013.b In addition, the crisis led to five”). Stock prices fell, bond yields rose sharply, and a decline in production and investment. Because exchange rates depreciated significantly. The frag- more than 90 percent of Indonesia’s imports con- ile five were hit the hardest because their econo- sists of raw materials and capital goods, imports mies shared some important vulnerabilities: large have sharply fallen, resulting in a much smaller current account deficits financed with a high share current account deficit than in 2012–13. Since the of liquid portfolio investments rather than foreign taper tantrum, several other emerging markets, direct investment, large capital inflows, and a sharp such as India, have also markedly improved their appreciation in exchange rates while the US stimu- external vulnerability indicators, such as the short- lus was in place.a term debt to GDP ratio and the current account to In Indonesia, one of the most severely affected GDP ratio. emerging markets, the taper tantrum reversed eco- Still, several issues must be anticipated. The pan- nomic trends (figure B1.3.1). Faced with pressure demic has disrupted economic activity, increasing in financial markets, Indonesia’s government and the risk of nonperforming loans (NPLs). To assist central bank pursued a “stabilization over growth” businesses and the financial sector, Indonesia has approach to reducing the current account deficit. relaxed credit through regulatory forbearance, Among other measures, the government cut fuel which may mask the true extent of NPLs. The subsidies, a large item in the national budget. As a withdrawal of the stimulus in high-income econ- result, the cost of fuel increased by an average of omies will also increase risks for highly leveraged 40 percent. The central bank raised the base rate by companies that are exposed to exchange rate risks 175 basis points and allowed the Indonesian rupiah and “rollover risk” (the risk that a firm cannot refi- to depreciate. These classical expenditure-reducing nance short-term debt at higher interest rates). As and expenditure-switching policies successfully sta- in other emerging economies, this is especially true bilized the economy in a relatively short time. Net for state-owned enterprises, and it increases the capital inflows turned positive again in early 2014, risk of contingent liabilities for the government. less than a year after the onset of the taper tantrum. In addition, increases in the federal funds rate In the aftermath of the COVID-19 crisis, emerg- will create a dilemma for central banks in emerg- ing economies are likely to face a very similar ing economies, such as Bank Indonesia. On the one (Box continues next page) EMERGING RISKS TO THE RECOVERY | 69 Figure B1.3.1 Box 1.3 External factors in the recovery: Will this “taper tantrum” be different? (continued) Figure B1.3.1 Impacts of the “taper tantrum” on the Indonesian economy, 2005–15 180 14 160 12 140 10 120 8 100 6 US$ (billions) Percent 80 4 60 2 40 0 20 –2 0 –4 –20 –6 07 12 05 10 15 2 11 7 08 13 06 13 11 4 05 08 4 13 6 08 9 11 10 06 9 01 1 01 00 00 00 00 20 20 20 20 20 20 20 20 20 20 20 0 20 20 20 20 20 20 20 .2 t. 2 y2 .2 2 y2 t. 2 ril ril rch rch rch ne v. n. b. ly c. g. g. b. ne c. v. ly n. pt pt Ma Ma Oc Ap No Ap Oc Ju No De Ja Ju Fe Au De Fe Au Ja Ju Se Ju Se Ma Ma Ma Foreign exchange reserves CA/GDP (right axis) GDP growth, year‐ on‐year (right axis) IDR/US$ (right axis) Bank Indonesia rate (right axis) Source: Basri 2017, based on data from Economist Intelligence Unit and Bank Indonesia. Note: The figure shows the growth of GDP, the Bank Indonesia reference rate, the Indonesian rupiah to US dollar exchange rate, and currency reserves in the Indonesian central bank from 2005 to 2015. CA/GDP = current account/ gross domestic product; IDR = Indonesian rupiah. hand, if banks do not follow the US Federal Reserve budget deficit limit of 3 percent in 2023. It must do in raising interest rates, there is a risk of deprecia- so cautiously, however, because the combination tion of the local currency from capital outflows. On of concurrent fiscal and monetary tightening poses the other hand, if interest rates increase, the risk of a risk to the recovery. The timing of the stimulus insolvencies will increase, disrupting the recovery. withdrawal is crucial and must be based on eco- The Indonesian government plans to return to the nomic developments. In several countries such as Brazil, China, India, Indonesia, Mexico, and Turkey, the capital inflow was greater than the a.  absorption capacity of their national economies (Sahay et al. 2014). The share of foreign holders of Indonesian government bonds fell from 32 percent in April 2020 to 23 percent at the end b.  of May 2021. 70 | WORLD DE VELOPMENT REPORT 2022 the massive monetary policy response to the pandemic. As the economic recovery proceeds and stim- ulus measures are gradually withdrawn in advanced economies, interest rates will rise. This increase could threaten the solvency of firms, financial institutions, and governments in emerging economies that have benefited from short-term financing at low interest rates and will face higher refinancing costs going forward. Rising interest rates in high-income economies will also put pressure on the currencies of emerging economies, which increases the financial burdens faced by firms, financial institutions, and governments that have debt denominated in a foreign currency. In addition to a less benign interest rate environment, the recovery in emerging economies will also be affected by the lower growth of the world economy. In the aftermath of the global financial crisis, low-income economies were only moderately affected, largely due to robust growth in important emerg- ing markets, particularly China, which accounts for a sizable share of bilateral lending and direct invest- ment in low-income economies. By contrast, the economic effects of the COVID-19 crisis have been felt globally, and lower economic growth in China and other emerging markets could affect low-income countries through several channels, including commodity prices and a reduction in bilateral lending and direct investment. Conclusion Although the immediate crisis response, which included extensive efforts to provide households and firms with liquidity, was essential to mitigate the hardships caused by income losses from the pandemic, few governments have the resources to sustain these programs until economic activity has fully recov- ered. This gives rise to the possibility that risk spillovers among the household, firm, financial, and gov- ernment sectors of the economy will aggravate preexisting economic fragilities and pose a threat to an equitable recovery. Interconnected risks to the recovery are a concern, especially in emerging economies where such fragilities were already more pronounced at the onset of the pandemic. Well-designed fiscal, monetary, and financial sector policies can help reduce these risks and prevent them from affecting the wider economy. The following chapters explore the primary risks that affect each of the main sectors of the economy and propose policies that can counteract these risks with the goal of supporting an equitable recovery. Beginning with the concern that many households and firms will continue to face income losses resulting in loan defaults once debt moratoria are lifted, chapter 2 turns to the risk to the financial sector posed by uncertainty about the true extent of credit risk and the quality of assets on the balance sheets of financial institutions. The chapter examines the steps regulators can take to proactively increase trans- parency about credit risk and deal with distressed assets and, if necessary, troubled banks. Chapter 3 takes a closer look at how the establishment and reform of insolvency frameworks can help the recovery by allowing private sector borrowers to reduce their debts to sustainable levels. Chapter 4 then explores how financial institutions can continue to provide credit to households and firms through the recovery. It focuses on approaches to managing and mitigating risks in the face of heightened economic uncer- tainty, which limits the ability of lenders to form an accurate assessment of credit risk and reduces the recourse they have in the event of default. Chapter 5 discusses the risks posed by the dramatic increase in levels of government debt and describes policies that can improve debt management and avoid debt distress. Chapter 6 concludes the Report by outlining policy priorities for the recovery. EMERGING RISKS TO THE RECOVERY | 71 Notes 1. Stiglitz and Weiss (1981). 9. Bosio et al. (2020); IMF (2019, 2020). 2. Acharya, Drechsler, and Schnabl (2014); Brunnermeier 10. Bosio, Ramalho, and Reinhart (2021). et al. (2016); Gennaioli, Martin, and Rossi (2014). 11. Breza and Kinnan (2021). 3. Feyen and Zuccardi Huertas (2019); Laeven and Valen- 12. Feyen and Zuccardi Huertas (2019). cia (2018); Reinhart and Rogoff (2009, 2011). 13. Koh et al. (2020). 4. Regulation often forces banks to hold government 14. Jordà, Schularick, and Taylor (2016). bonds. In Ethiopia, banks must invest 27 percent of 15. Based on Reinhart (2021) and Standard & Poor’s, their loan portfolio in government bonds. Emergency Moody’s, and Fitch ratings, 51 countries—among them measures of this kind were also introduced in response 44 middle-income and 4 low-income countries— to the COVID-19 crisis. For example, in Ethiopia com - suffered a downgrade in 2020 of their sovereign risk mercial banks were mandated to invest annually at rating. See Trading Economics, Credit Rating (database), least 1 percent of their loan portfolio in bonds issued https://tradingeconomics.com/country-list/rating. by the National Bank of Ethiopia (NBE 2021), and insur- 16. Bova et al. (2016). ance companies were required to invest at least 40 per- 17. Moody’s Investors Service (2019). cent of their assets in treasury bills (Tadesse 2020). 18. In the United Kingdom, for example, the Office of Bud - 5. Farhi and Tirole (2018). get Responsibility estimates that up to 40 percent of 6. Acharya, Mehran, and Thakor (2016). participants in one of its most popular guarantee pro- 7. UNCTAD (2019). grams, the Bounce Back Loans Scheme, may default 8. See, for example, World Bank (2021a). (Browning 2021). Also see IMF (2021a). References Acharya, Viral V., Itamar Drechsler, and Philipp Schnabl. A New Dataset.” IMF Working Paper WP/16/14, Interna- 2014. “A Pyrrhic Victory? Bank Bailouts and Sovereign tional Monetary Fund, Washington, DC. Credit Risk.” Journal of Finance 69 (6): 2689–739. Breza, Emily, and Cynthia Kinnan. 2021. “Measuring the Acharya, Viral V., Robert F. Engle, III, and Sascha Steffen. 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National Bureau of Economic Research, Cambridge, MA. “The Invisible Burden: How Arrears Could Unleash a Bank- CMIE (Centre for Monitoring Indian Economy). 2021. “Con - ing Crisis.” VoxEU (blog), March 22, 2021. https://voxeu sumer Pyramids Household Survey.” https://consumer .org/article/how-arrears-could-unleash-banking-crisis. pyramidsdx.cmie.com. Bova, Elva, Marta Ruiz-Arranz, Frederik Toscani, and H. Elif Dhingra, Swati, and Maitreesh Ghatak. 2021. “How Has Ture. 2016. “The Fiscal Costs of Contingent Liabilities: COVID-19 Affected India’s Economy?” Economics 72 | WORLD DE VELOPMENT REPORT 2022 Observatory. https://www.economicsobservatory.com nbebank.com/wp -content/uploads/pdf/directives /how-has-covid-19-affected-indias-economy. /bankingbusiness/sbb-81-2021.pdf. Farhi, Emmanuel, and Jean Tirole. 2018. “Deadly Embrace: RBI (Reserve Bank of India). 2020a. Financial Stability Sovereign and Financial Balance Sheets Doom Loops.” Report. June. Mumbai: RBI. 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Review 99 (2): 466–72. Gennaioli, Nicola, Alberto Martin, and Stefano Rossi. 2014. Reinhart, Carmen M., and Kenneth S. Rogoff. 2011. “From “Sovereign Default, Domestic Banks, and Financial Financial Crash to Debt Crisis.” American Economic Institutions.” Journal of Finance 69 (2): 819–66. Review 101 (5): 1676–706. Gupta, Arpit, Anup Malani, and Bartek Woda. 2021. “Explain - Sahay, Ratna, Vivek Arora, Thanos Arvanitis, Hamid ing the Income and Consumption Effects of COVID in Faruqee, Papa N’Diaye, Tommaso Mancini-Griffoli, and India.” NBER Working Paper 28935, National Bureau of IMF Team. 2014. “Emerging Market Volatility: Lessons Economic Research, Cambridge, MA. from the Taper Tantrum.” IMF Staff Discussion Note IMF (International Monetary Fund). 2019. IMF Annual Report SDN/14/09, International Monetary Fund, Washing- 2019: Our Connected World. Washington, DC: IMF. ton, DC. IMF (International Monetary Fund). 2020. 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Directive SBB/81/2021, NBE, Addis Ababa. https:// EMERGING RISKS TO THE RECOVERY | 73 Spotlight 1.1 Financial inclusion and financial resilience F inancial resilience is an important aspect of financial inclusion—that is, when one has access to the appropriate financial tools (such as bank accounts, savings, credit, and digital pay- ments) that can be used safely in a well-regulated environment to meet one’s needs. Financial resilience refers to the ability of people and firms to recover from adverse economic shocks, such as job loss or unanticipated expenses, without suffering a decline in living standards. Before the pandemic, only half of the adult popula- depleting already limited savings and assets.3 The tion of emerging economies said they could come World Bank predicted that poverty would worsen up with emergency funds within the next month.1 in low-income countries and that about 100 mil- The shares were smaller for women (45 percent) lion people would fall into poverty in 2021.4 and poorer adults (34 percent). Among adults in Access to financial services is essential for resil- emerging economies who said they could access ience and economic recovery. Digital payments, emergency funds, a third said they would come up savings, credit, and insurance allow businesses with the money by picking up extra shifts at work and individuals to manage risk, smooth expenses, or by borrowing from their employer—options and invest. Evidence shows that households and that may be impossible or undesirable during a businesses that have access to such financial ser- crisis like COVID-19 (coronavirus). vices are better able to withstand adverse finan- COVID-19 underscored the importance of cial shocks than those that do not.5 Mobile money strengthening financial resilience. The crisis dis- helps people manage economic shocks by making proportionately hit micro-, small, and medium it easier to borrow money in an emergency from enterprises (MSMEs) and vulnerable groups, who a wider geographic and social network of fam- typically have meager cash buffers. These vulner- ily and friends.6 Research from Kenya found that able groups are overrepresented in sectors that mobile money services allowed families to become suffered the most from the crisis.2 Job and income less poor in the long term.7 Savings accounts boost losses driven by lockdowns and mobility restrictions financial resilience by providing a buffer against were deeply felt by individuals and e­ ntrepreneurs, unexpected expenses.8 Mobile credit can boost 74 | WORLD DE VELOPMENT REPORT 2022 financial resilience as well, to the extent that bor- core of any economic recovery effort.18 Access to rowing can help address the immediate impact credit, in particular, is central to the ability of of a shock, although these products also raise businesses to manage working capital and invest- consumer protection concerns.9 Lack of access to ment needs. Low-income households and busi- credit, on the other hand, can reduce resilience; in nesses typically do not have enough discretionary India, a reduction in micro­ finance was associated savings or insurance coverage to carry them with significant decreases in wages, income, and through an adverse income shock. Instead, they consumption.10 often rely on credit instruments to help smooth One study found that sustained credit flows consumption and safeguard business continuity. in the United States during periods of stringent Research from Africa and the United States con- financial constraints can boost small firms’ resil- firms that access to short-term credit can help ience by shielding their sales and employment.11 consumers smooth consumption in the face of A review of the literature suggests that MSMEs idiosyncratic shocks. This research offers evidence in Organisation for Economic Co-operation and that credit—if delivered responsibly—can be an Development countries with access to credit are important tool in ensuring the resilience of house- more likely to survive as employers and creators of holds with limited ways to manage risk.19 It is less economic value.12 And, as revealed in an analysis of clear that credit can play a significant role in help- the early impacts of COVID-19, a decline in output ing MSMEs and lower-income people cope with is less common among firms in low- and middle- the impacts of large systemic shocks. Borrowing income countries that had better access to finance as a resilience strategy relies on a timely recovery before the pandemic (although firms with stronger that restores the income needed to repay debts. fundamentals might have better access to credit).13 The COVID-19 crisis was characterized by a Financial inclusion also helps governments deliver large, rapid deployment of government initiatives services cheaper and faster.14 As the COVID-19 aimed at helping residents and businesses weather crisis erupted in 2019, countries with higher rates the economic shock, including through exten- of financial inclusion were able to leverage that sive loan repayment moratoria, credit guarantees, infrastructure to rapidly roll out government sup- and cash transfers.20 As chapter 1 describes, how- port, as evidenced by the experiences of China, ever, the ability of governments to support these Colombia, and India.15 measures was time-bound and limited for lower- In recent years, millions of adults have gained income countries, and programs often failed to access to accounts and other tools that help build reach all segments of the population. MSMEs, financial resilience—but exclusion remains wide- especially those operating informally, often did spread. Worldwide, over 1 billion adults lack access not receive commensurate support. As the broader to a transaction account. Lower-income adults recovery takes hold, however, the judicious use of in emerging economies access credit and savings credit could enable some enterprises and house- largely through informal channels, with very lim- holds to bridge cash-flow gaps. The residual uncer- ited access to insurance. For example, access to tainty around the timing of localized recovery crop insurance is practically nonexistent among suggests that government guarantees could play small farmers, despite widespread risk in the agri- a useful role. From a fiscal perspective, linking culture sector.16 At least 41 percent (130 million) of further expenditures to the actual realization of a formal MSMEs in emerging economies lack access negative outcome (such as yet another downturn to credit, which is viewed as a top obstacle to busi- in which credit guarantees are triggered) is less ness survival and growth.17 costly than blanket government support. Because MSMEs and the informal sector are As the health crisis diminishes and consumer the largest source of employment and livelihoods demand increases, credit for MSMEs and low- in emerging economies, their resilience is at the income households becomes an essential element of FINANCIAL INCLUSION AND FINANCIAL RESILIENCE | 75 the ability of businesses to invest in economic recov- 0.4 percent of GDP. Lund, White, and Lamb (2017) esti- lenders to ery. However, the ability of private sector ­ mate that emerging economies could save as much as 0.8–1.1 percent of GDP annually ($220–$320 billion) by lend has been reduced by weakening revenue and digitalizing government payments alone, with benefits for lenders’ reduced visibility into the economic pros- both governments and recipients. pects and creditworthiness of borrowers. Economic Agur, Peria, and Rochon (2020). 15.  shifts stemming from the pandemic have indeed A Global Findex survey of economies in Sub-Saharan 16.  rendered some borrowers less creditworthy, but the Africa found that, on average, one in three adults grows crops or raises livestock to produce their main household uncertainty has caused lenders to lose their appe- income, but only about 5 percent had purchased agri- tite for risk, and lending even to creditworthy bor- cultural insurance in the previous five years. Yet roughly rowers may be affected. As discussed in chapter 4, two-thirds of these adults faced a crop loss or significant loss of livestock in the last five years, and only a tiny share innovations that improve lenders’ visibility into received any kind of financial payout to help deal with the borrower viability and improve their ability to real- loss (Klapper et al. 2019). ize value from collateral can encourage safer lend- 17.  International Finance Corporation, MSME Finance Gap ing. Carefully crafted guarantee programs could (database), SME Finance Forum, https://www.sme financeforum.org/data-sites/msme-finance-gap. also bridge the gap between backward-looking risk Ayyagari, Beck, and Demirgüç-Kunt (2003). 18.  aversion and future credit performance. Bharadwaj and Suri  (2020);  Collins et al. (2009); Karlan 19.  and Zinman (2010); Morse (2011). Gentilini et al. (2020). 20.  Notes Demirgüç-Kunt et al. (2018). Respondents were asked if  1.  they could come up with the equivalent of 5 percent of the gross national income per capita, equal to approximately References $3,000 in the United States. Agur, Itai, Soledad Martinez Peria, and Celine Rochon.  2.  OECD (2020); Vardoulakis (2020). 2020. “Digital Financial Services and the Pandemic: Opportunities and Risks for Emerging and Developing Gomes, Haliassos, and Ramadorai (2020).  3.  Economies.” Special Series on COVID-19, Monetary and Mahler et al. (2021).  4.  Capital Markets Department, International Monetary Breza, Kanz, and Klapper (2020); Moore et al. (2019).  5.  Fund, Washington, DC. When hit with an agricultural shock, Kenyan households  6.  Amin, Mohammad, and Domenico Viganola. 2021. “Does with no mobile money access suffered a 7 percent drop Better Access to Finance Help Firms Deal with the in the use of goods and services, while those who did COVID-19 Pandemic? Evidence from Firm-Level Survey have mobile money experienced no such drop on average Data.” Policy Research Working Paper 9697, World Bank, (Jack and Suri 2014). In Tanzania, rainfall shocks resulted Washington, DC. in 6 percent lower consumption on average, but mobile Ayyagari, Meghana, Thorsten Beck, and Asli Demirgüç-Kunt. money users were able to maintain consumption due to 2003. “Small and Medium Enterprises across the Globe: improved risk-sharing (Riley 2018). A New Database.” Policy Research Working Paper 3127, El-Zoghbi, Holle, and Soursourian (2019); Suri and Jack  7.  World Bank, Washington, DC. (2016). Bakhtiari, Sasan, Robert Breunig, Lisa Magnani, and Jacque -  8.  In Chile, women who received free savings accounts lyn Zhang. 2020. “Financial Constraints and Small and reduced their reliance on debt and improved their abil- Medium Enterprises.“ IZA Discussion Paper 12936, Insti - ity to make ends meet during an economic emergency tute of Labor Economics, Bonn, Germany. (Kast, Meier, and Pomeranz 2018). Women in Nepal who Bharadwaj, Prashant, William Jack, and Tavneet Suri. 2019. received free savings accounts with no withdrawal fees “Fintech and Household Resilience to Shocks: Evidence were better able to manage unexpected health expenses from Digital Loans in Kenya.” NBER Working Paper 25604, than those who did not receive accounts (Prina 2015). National Bureau of Economic Research, Cambridge, MA.  9.  Bharadwaj, Jack, and Suri (2019). Bharadwaj, Prashant, and Tavneet Suri. 2020. “Improving 10.  Breza and Kinnan (2021). Financial Inclusion through Digital Savings and Credit.” AEA Papers and Proceedings 110 (May): 584–88. Chodorow-Reich (2014). 11.  Breza, Emily, Martin Kanz, and Leora Klapper. 2020. “Learn - Bakhtiari et al. (2020). 12.  ing to Navigate a New Financial Technology: Evidence Amin and Viganola (2021). 13.  from Payroll Accounts.” NBER Working Paper 28249, 14.  In a recent pilot in Albania, the World Bank estimated National Bureau of Economic Research, Cambridge, MA. that digitalizing 75 percent of the current paper-based Breza, Emily, and Cynthia Kinnan. 2021. “Measuring the transactions could potentially achieve savings of about Equilibrium Impacts of Credit: Evidence from the Indian 76 | WORLD DE VELOPMENT REPORT 2022 Microfinance Crisis.” Quarterly Journal of Economics 136 Analyzing Data from a New Module of the Global Findex (3): 1447–97. Database.” Policy Research Working Paper 9078, World Chodorow-Reich, Gabriel. 2014. “The Employment Effects of Bank, Washington, DC. Credit Market Disruptions: Firm-Level Evidence from the Lund, Susan, Olivia White, and Jason Lamb. 2017. “The 2008–9 Financial Crisis.” Quarterly Journal of Economics Value of Digitalizing Government Payments in Develop- 129 (1): 1–59. ing Economies.” In Digital Revolutions in Public Finance, Collins, Daryl, Jonathan Morduch, Stuart Rutherford, and edited by Sanjeev Gupta, Michael Keen, Alpa Shah, and Orlanda Ruthven. 2009. Portfolios of the Poor: How the Geneviève Verdier, 305–23. Washington, DC: Interna- World’s Poor Live on $2 a Day. Princeton, NJ: Princeton tional Monetary Fund. University Press. Mahler, Daniel Gerszon, Nishant Yonzan, Christoph Lakner, Demirgüç-Kunt, Asli, Leora F. Klapper, Dorothe Singer, San- Raul Andrés Castañeda Aguilar, and Haoyu Wu. 2021. iya Ansar, and Jake Hess. 2018. The Global Findex Data- “Updated Estimates of the Impact of COVID-19 on Global base 2017: Measuring Financial Inclusion and the Fintech Poverty: Turning the Corner on the Pandemic in 2021?” Revolution. Washington, DC: World Bank. https://doi World Bank Blogs: Data Blogs, June 24, 2021. https:// .org/10.1596/978-1-4648-1259-0. blogs.worldbank.org/opendata/updated- estimates El-Zoghbi, Mayada, Nina Holle, and Matthew Soursourian. - i m pac t- c ov i d -19 - g l o bal - p ove r t y - tu r ni n g - c o r n e r 2019. “Emerging Evidence on Financial Inclusion: Mov- -pandemic-2021. ing from Black and White to Color.” CGAP Focus Note, Moore, Danielle, Zahra Niazi, Rebecca Rouse, and Berber Consultative Group to Assist the Poor, Washington, DC. Kramer. 2019. “Building Resilience through Financial https://www.cgap.org/research/publication/emerging Inclusion: A Review of Existing Evidence and Knowledge -evidence-financial-inclusion. Gaps.” Financial Inclusion Program, Innovations for Gentilini, Ugo, Mohamed Almenfi, Ian Orton, and Pamela Poverty Action, Washington, DC. https://www.poverty Dale. 2020. Social Protection and Jobs Responses to -action.org/publication/building-resilience-through COVID-19: A Real-Time Review of Country Measures. -financial -inclusion - review- existing - evidence -and Washington, DC: World Bank. https://socialprotection -knowledge. .org/discover/publications/social-protection-and-jobs Morse, Adair. 2011. “Payday Lenders: Heroes or Villains?” -responses-covid-19-real-time-review-country. Journal of Financial Economics 102 (1): 28–44. Gomes, Francisco J., Michael Haliassos, and Tarun Ramado - OECD (Organisation for Economic Co-operation and Devel- rai. 2020. “Household Finance.” IMFS Working Paper 138, opment). 2020. Financing SMEs and Entrepreneurs 2020: Institute for Monetary and Financial Stability, Goethe An OECD Scorecard. Paris: OECD. https://doi.org/10.1787 University, Frankfurt. /061fe03d-en. Jack, William, and Tavneet Suri. 2014. “Risk Sharing and Prina, Silvia. 2015. “Banking the Poor via Savings Accounts: Transactions Costs: Evidence from Kenya’s Mobile Evidence from a Field Experiment.” Journal of Develop- Money Revolution.” American Economic Review 104 (1): ment Economics 115 (July): 16–31. 183–223. Riley, Emma. 2018. “Mobile Money and Risk Sharing against Karlan, Dean S., and Jonathan Zinman. 2010. “Expanding Village Shocks.” Journal of Development Economics 135 Credit Access: Using Randomized Supply Decisions to (November): 43–58. Estimate the Impacts.” Review of Financial Studies 23 (1): Suri, Tavneet, and William Jack. 2016. “The Long-Run Pov- 433–64. erty and Gender Impacts of Mobile Money.” Science 354 Kast, Felipe, Stephan Meier, and Dina Pomeranz. 2018. “Sav- (6317): 1288–92. ing More in Groups: Field Experimental Evidence from Vardoulakis, Alexandros P. 2020. “Designing a Main Street Chile.” Journal of Development Economics 133 (July): Lending Facility.” Finance and Economics Discussion 275–94. Series 2020-052, Board of Governors of the Federal Klapper, Leora F., Dorothe Singer, Saniya Ansar, and Jake Reserve System, Washington, DC. https://doi.org/10 Hess. 2019. “Financial Risk Management in Agriculture: .17016/FEDS.2020.052. FINANCIAL INCLUSION AND FINANCIAL RESILIENCE | 77 Resolving bank asset distress Debt moratoria, loan forbearance, and the relaxation of classification and provisioning rules during the COVID-19 crisis have created a lack of transparency about the health of bank balance sheets, particularly in the recognition of nonperforming loans (NPLs). Although not yet visible in reported asset quality indicators, rising borrower distress is likely to translate into rising NPL levels. If left unaddressed, high levels could reduce overall lending volumes and affect the financial sector’s capacity to support economic activity. Such an out- come can be particularly harmful to small businesses and lower-income households. To reduce these risks, banks should identify and report problem loans accurately and manage revealed exposures while under strong supervisory oversight. Policy Priorities The pandemic and the related government policies have reduced the transparency of bank balance sheets. For banking sectors vulnerable to rapid increases in NPLs, the following timely corrective policies to preserve financial stability will help to support the continued provision of credit: •  Ensuring clear, consistent practices for reporting on asset quality, enforced by effective supervision and with strong incentives to encourage speed and transparency. • D  eveloping the capacity to manage nonperforming loans to avoid a rapid increase in bad loans impairing the capacity of banks to finance the real economy. •  Dealing with problem banks swiftly to prevent broad distress in the financial system, misallocation of financial resources, and failure in the provision of credit. 79 Introduction The pandemic and the associated policy responses have significantly affected the financial position of households, firms, and governments. The payment and enforcement moratoria described in chapter 1 have supported borrowers by allowing a temporary halt in their bank repayment obligations. In applying these moratoria, banks have been able to help mitigate the economic fallout from COVID-19 (coronavirus). It is not yet clear which borrowers will be permanently affected by the pandemic and how debtors will adjust to the structural changes in the economy. It is evident, however, that many borrowers are facing financial difficulties that go beyond liquidity stress. This situation is an unprecedented challenge for banks and bank supervisors because the magnitude of the ongoing shock, the uncertainty of the impact, as well as the ensuing government support have made the screening, monitoring, and management of risk extremely difficult. Rising borrower distress is widely expected to translate into increases in nonperforming loans (NPLs) in the banking sector, although this is not yet clearly evident in reported NPL ratios. Data suggest that as of August 2021 the ratio of reported NPLs to total loans in most countries was broadly stable (figure 2.1).1 However, for several reasons the data may not reflect the full reality of NPL levels: • Moratoria and other borrower support measures were still in place in many countries in the second quarter of 2021,2 as were fiscal and monetary interventions aimed at cushioning the impact of the pandemic on households and firms (chapter 1). • Relatively tranquil global financial markets have also influenced countries’ domestic financing conditions, especially by easing pressure on government debt refinancing. • NPL data are often made available with a significant time lag. • Many countries continue to apply regulatory definitions of NPLs that are predominantly based on payment arrears (and are therefore backward-looking). Notwithstanding the seemingly positive data, bankers and policy makers anticipate that NPLs will increase significantly when governments lift moratoria and borrowers become obligated to repay their loans according to their original repayment schedules. Some countries are already reporting significant increases in special-mention loans (loans with potential weaknesses in repayment prospects, but not yet considered nonperforming) and an acceleration of preemptive loan restructuring that may delay the recognition of credit losses. These developments suggest that rising pressures on asset quality are forthcoming. Banks have processes to manage NPLs in the normal course of business, but the scale and complex- ity of the expected increase in NPLs could overwhelm the capacity of the banking system, creating pressures that affect the broader economy. For example, when dealing with large and rising volumes of NPLs, banks often stop financing both the supply side of the economy by denying lending to viable firms for investment and working capital and the demand side by declining to finance consumption and household credit. For banks highly exposed to slow-growing, low-productivity firms, capital can become tied up in low-performing sectors at the expense of high-growth ones. Looking ahead, then, a rise in NPLs could affect the banking sector’s capacity to support the economic recovery with fresh lending, while increasing the risk of bank failures. The concern is greater for emerging economies that are heavily exposed to credit risk and that tend to rely on bank credit to finance the real economy.3 If unaddressed, high NPL levels may thus severely dampen recovery from the pandemic. To pre- serve capital and manage uncertainty in periods of economic and financial distress, credit interme- diaries are incentivized to ration credit extended to higher-risk borrowers such as micro-, small, and medium enterprises (MSMEs) and underserved, vulnerable households. Similarly, international credit for low-income frontier markets, which have been especially hard-hit by the pandemic, may also dry up 80 | WORLD DE VELOPMENT REPORT 2022 Figure 2.1: as potential lenders lower their risk exposure Figure 2.1 Changes in nonperforming loan ratios, to preserve their capital. Taking early, deci- by country income group, 2020–21 sive action to address NPLs and to sustain, and where necessary restore, the strength of 0.3 the banking system is critical to ensure that 0.2 (percentage points) banks and other lenders have sufficient capi- Average change 0.1 tal to finance a strong, equitable recovery. Addressing rising volumes of NPLs is 0 therefore critical to maintaining a healthy –0.1 financial sector that can support recovery –0.2 from the pandemic.4 This chapter describes policy measures aimed at effective, timely –0.3 resolution of bank asset distress. Experience –0.4 shows that asset quality issues do not resolve High- Upper- Lower- Low- on their own without a swift, comprehen- income middle- middle- income income income sive policy response. If ignored, NPLs tend to grow, creating mounting losses for the Source: WDR 2022 team, based on data from International Monetary financial system. If distress becomes sys- Fund, FSIs (Financial Soundness Indicators) (dashboard), https:// data.imf.org/?sk=51B096FA-2CD2-40C2-8D09-0699CC1764DA. temic, losses in output are typically highly Note: For the 106 countries represented in the figure, the latest persistent, especially for the least developed observed data are from December 2020 (27 countries), February countries.5 2021 (1 country), March 2021 (27 countries), April 2021 (2 coun- A comprehensive NPL resolution strategy tries), May 2021 (5 countries), June 2021 (41 countries), July 2021 (2 countries), and August 2021 (1 country). is thus essential for governments and bank- ing sectors to manage bad loans in a way that protects viable borrowers, while swiftly dealing with nonviable ones so that they do not absorb produc- tive capital. Three components of an effective strategy are covered in this chapter: • Identifying NPLs—clear-cut, consistent practices for banks to use in reporting on asset health, reinforced by effective supervision and strong incentives to encourage speed and transparency. • Developing operational capacity for addressing NPLs—techniques to segment NPLs according to viability and complexity and to deploy the right management method. • Handling problem banks—decisive policies for dealing with banks at risk of failure. Banks are primarily responsible for resolving NPLs, and yet supervisory authorities should have a clear diagnostic of the factors driving the deterioration of a bank’s asset quality. Specifically, they should have accurate data gauging the NPL exposure of individual banks, as well as a breakdown between households and firms and between credit for investment and consumption, together with details on the sectoral composition of credit.6 Resolving NPLs also requires a legal system that balances the interests of creditors and borrowers and supports debt restructuring and reorganization of viable firms, as well as an orderly exit of unviable ones (the legal system is addressed in chapter 3). The themes discussed are commonly accepted building blocks of an effective NPL resolution strat- egy, but country-level priorities may vary, depending on the sophistication and strength of countries’ banking sectors, the severity of the economic impact of the pandemic, the capacity of firms to adjust, and developments in the legal, regulatory, and institutional environments. Administrative capacity is another important factor because countries vary in their ability to undertake complex and comprehen- sive legal, regulatory, supervisory, and taxation policies in a coordinated manner and in conjunction with public and private sector stakeholders. RESOLVING BANK ASSE T DISTRESS | 81 Policy makers and bank leaders should act with urgency on the advice laid out in this chapter as best fits their capacity—ideally before support measures are lifted and distressed asset levels rise— because developing the systems and capacity needed to deal with NPLs takes time.7 Those who prefer to wait and see risk missing the opportunity to get ahead of the problem. Such a delay not only prevents recovery of viable capital, but also can lead to long-term low investment across an economy. Why do NPLs matter? High NPL levels burden all levels of an economy. For borrowers, failure to repay a debt may lead to the loss of assets and business opportunities and jeopardize future access to credit, which has negative spill- over effects on the broader economy. For banks, asset quality problems can lead to capital misallocation, higher funding costs, and lower profitability.8 These issues can drive up the cost of finance for borrowers and impair a bank’s ability to run a viable, sustainable business. Banks may respond by reducing lending volumes, which often leads to the exclusion of underserved, higher-risk groups such as MSMEs, women, and the poor.9 At the aggregate level, high NPLs depress economic growth. Because capital is tied up in under­ performing sectors, growing sectors may have limited access to new capital, and so market confidence suffers.10 Banks with high exposure to NPLs and narrow capital buffers may be inclined to reduce the provision of credit11 and continue to finance weak or insolvent borrowers—so-called zombie lending.12 When banks’ capital is locked up in troubled sectors and companies, some second-round business fail- ures may be prevented, but it also diverts funds from more productive sectors of the economy. Inefficient firms could thus have a dominant impact on the functioning of input and output markets, translating into lower economic output, investment, and employment.13 The challenge is particularly acute following financial crises when bank exposure to problem assets often persists at elevated levels because of a lack of incentives and frameworks to resolve them. The ensuing weak growth, in turn, reduces fresh lending and slows the reduction in NPLs.14 The experiences of countries in Central, Eastern, and Southeastern Europe (CESEE)15 in the aftermath of the 2007–09 global financial crisis reveal the long-term problems and severer recessions that can result (see online annex 2A16). The increase in NPLs in the CESEE region was rooted in excess credit growth and lax under- writing practices by banks, whereas in the COVID-19 crisis the pressures on asset quality arise from an unprecedented economic shock and restrictions in economic activity that affect borrowers’ incomes and weaken their debt-weathering capacity. Another difference is that under the current circumstances governments’ ability to contain the impacts of the pandemic on firms and households affects which bor- rowers remain viable. Weaknesses in the macroeconomic, institutional, corporate, and banking sectors that have driven past crises are a factor as well. The experiences of the CESEE countries following the global financial crisis nonetheless clearly illus- trate the dangers of a delayed initial policy response.17 By allowing the underlying problems to fester, countries compromised the capacity of their banking sector to finance the real economy and ultimately were left trapped in a bad equilibrium of low growth linked to a weak financial system. Avoiding a repeat of this scenario is a priority for policy makers everywhere. Despite important differences in the two crises in the underlying causes and the starting positions of individual countries, the key lesson from the CESEE region, as well as from other regions and at other times, is that rising NPLs require a prompt, comprehensive policy response. This negative cycle of high NPLs leading to low economic growth is not inevitable. Evidence compar- ing countries that have proactively pursued strong measures to reduce the stock of NPLs in the wake of an economic crisis with those that have taken a more passive approach reveals that the former approach 82 | WORLD DE VELOPMENT REPORT 2022 results in superior economic and credit growth recovery.18 Sound ex ante policies play an important role in preventing NPL problems from building, while robust corporate governance, effective supervision, and regulation of banks facilitate NPL resolution. Policy makers and bankers can expedite financial recovery by addressing fragilities at both the individual bank level and banking system level, beginning with rules and incentives around transparency about the true state of banking assets. Identifying NPLs: Asset quality, bank capital, and effective supervision Accurate, timely indicators of bank asset quality are essential to assessing borrowers’ capacity to meet repayment obligations to their lenders and whether such capacity has been significantly and perma- nently eroded, leading to credit losses for banks. Policy makers need this information to understand the scale of emerging asset quality problems and thus articulate a well-informed policy response and an NPL resolution strategy, including judgments on whether to extend temporary moratoria and other forms of support to affected households, firms, and industries. This information is also critical to sep- arating weak banks from healthy ones, instilling public trust in the integrity of reported bank financial statements, avoiding disorderly runs and panics arising from opacity, and initiating timely supervisory action on weak banks. The support measures discussed in chapter 1 have eased short-term pressures on borrowers. But by their very nature, they have also made it harder to determine which borrowers are experiencing finan- cial distress likely to result in repayment difficulties once support is withdrawn.19 Uncertainty about future policy support—such as when moratoria will be lifted or whether new support may be added— may ­ create incentives for banks to hold back on detailed credit risk monitoring and management of emerging loan performance problems as they wait for additional information. This situation may only amplify the incentives for a bank to underestimate the deterioration of its asset quality. It will then report a stronger financial position because as soon as it classifies loans as under- or nonperforming, it must set aside provisions for anticipated credit losses, which lowers earnings and absorbs capital. These incentives are stronger for lower-capitalized banks—losses may signal financial weakness and trigger supervisory intervention and the need for new capital.20 This context of uncertainty and mixed incen- tives puts the onus on supervisors to establish a set of requirements for the asset quality indicators that banks must monitor and share. But setting such requirements is complicated. And national practices vary for many reasons.21 None- theless, banks and supervisory authorities are not entirely on their own. The Basel Committee on Bank- ing Supervision (BCBS) has published helpful guidance on defining nonperformance that highlights the importance of assessing borrower payment capacity (the unlikely-to-pay criterion), as well as payment performance—in particular, the degree of delinquency or number of days payments are past due, with 90 days past due an important threshold (see box 2.1).22 Standard setters have provided helpful additional guidance on the application of regulatory frame- works during the pandemic, promoting greater consistency.23 According to the BCBS, (1) periods of repay- ment moratoria should not be counted in days past due for assessing loan performance; (2) judgments of the ability to meet payment obligations should focus on the borrower’s ability to meet the requirements of rescheduled payments after the moratorium ends; and (3) borrower acceptance of a repayment mor- atorium or other relief measures such as guarantees should not automatically lead to the loan being categorized as forborne.24 To support their judgments on the ability of borrowers to meet rescheduled payments, banks must during the moratoria continue to monitor the financial health of borrowers and RESOLVING BANK ASSE T DISTRESS | 83 Box 2.1 International guidance on loan classification and problem assets No agreed-on international standard exists for loan that banks must provision, it does not affect the classification or the treatment of problem assets. assessment of whether a loan is nonperforming. Nonetheless, countries’ approaches have common In addition, if a bank has a significant exposure to features such as formal loan classification schemes a corporate borrower that is nonperforming, then based on loan quality.a To support greater conver- all exposures (on– and off–balance sheet) to the gence, the Basel Committee on Banking Super- borrower should also be considered nonperforming vision (BCBS) published detailed guidance on regardless of actual repayment status. defining nonperforming exposures (as well as for- Assessments of repayment likelihood should bearance), giving supervisors clear reference points draw on a comprehensive analysis of the financial (BCBS 2016). situation of the borrower based on specific indica- Two principal criteria guide nonperformance: tors. The BCBS also provided guidance on how to (1) delinquency—material exposures that are more recategorize nonperforming exposures as perform- than 90 days past due (that is, unpaid), and (2) unlikely ing should the counterparty’s situation improve and to pay (UTP)—full repayment under the contrac- full repayment is likely (as evidenced by successful tual terms (original or modified) is unlikely without payments during a probationary period). Related to the bank’s realization of collateral, regardless of forbearance, the guidance provides that forbear- whether the exposure is current and regardless of ance applies where there is financial difficulty—a the number of days the exposure is past due. borrower is experiencing difficulty meeting its The presence of arrears or evidence of UTP financial commitments—and a concession—a bank defines an exposure as nonperforming. Although grants a concession that it would not otherwise the availability of collateral affects the amount consider. The following is an example of a hierarchy of loan quality categories: normal, special mention (or watch), substandard, a.  doubtful, and loss. For details at the country level, see World Bank, BRSS 2019 (Bank Regulation and Supervision Survey, 2019) (dashboard), https://www.worldbank.org/en/research/brief/BRSS. conduct rigorous assessments of their repayment capacity and likely longer-term viability using a range of financial and economic indicators.25 Judgments about borrowers’ capacity to meet future debt service obligations can be challenging under the best of circumstances, let alone during a pandemic and a highly uncertain economic outlook. Still, this challenge should not discourage banks from proactively identifying borrowers that are likely to face solvency challenges, recognizing credit losses, and classifying and provisioning for such loans. In short, uncertainty and lack of an international standard need not prevent supervisors from requiring banks to adhere to rigorous criteria for defining and reporting on asset quality, with the BCBS definitions provid- ing a useful basis on which to build. Seeking accurate asset quality metrics for the banking system Asset quality is fundamental to analyzing a bank’s capital position and financial health. It highlights exposure to credit risk, especially whether borrowers are likely to fail to fulfill their repayment obli- gations, creating losses for the bank. High-quality indicators that enable banks and their supervisors 84 | WORLD DE VELOPMENT REPORT 2022 to assess borrowers’ payment performance and capacity, and thus the quality of the bank’s loan assets, are essential elements of strong bank management and effective supervision (see table 2.1), particularly in emerging markets that tend to have relatively simple, bank-centric financial systems.26 Drawing on the 2019 Bank Regulation and Supervision Survey (BRSS), which uses 2016 data, table 2.1 summarizes key features of asset classification systems in emerging economies prior to the guidance supplied by the BCBS.27 Most respondents deployed a consistent asset classification scheme, applied the principle that the availability of collateral does not affect the classification of loan performance, and required successful performance of restructured loans over a probationary period before classification could be upgraded. Such indicators underpin financial statements recording performance as well as financial strength. Indicators of deteriorating asset quality also serve as an early warning system for loan performance problems. They enable banks to take preemptive action to resolve problems and avoid the deadweight costs of nonperforming assets. Supervisory authorities also rely on asset quality data and corresponding measures of capital strength to gauge a bank’s capacity to absorb credit losses and its ability to supply new credit for a vigorous economic recovery. Underappreciation of a deterioration in underlying loan quality, and thus inadequate provisioning, leads to overstated capital levels. An overstatement hampers policy analysis, encourages complacency by banks and policy makers, and affects market functioning. At the onset of the pandemic, banks’ reported capital levels in many countries were higher than in the past because they had been bolstered by stron- ger regulatory standards following the global financial crisis. Nonetheless, significant differences across jurisdictions and regions (as well as within them) reflect the differing capacity of banking systems to absorb the pandemic shock. Table 2.1 Countries’ adoption of selected indicators of asset classification systems, by country income group Share of countries answering “yes” (%) Lower-middle- Upper-middle- Indicator Low-income income income Asset classification system under which banks have to report the quality of their loans and advances using a common 88 88 95 regulatory scale Availability of collateral allows banks to avoid classifying a loan as nonperforming  6  9 18 Banks allowed to upgrade the classification of a loan or advance 13 18 21 immediately after it has been restructured Source: Data from World Bank, BRSS 2019 (Bank Regulation and Supervision Survey, 2019) (dashboard), https://www .worldbank.org/en/research/brief/BRSS. Note: The fifth iteration of the BRSS collects information on 160 jurisdictions and the European Central Bank. This table reports information on low- and middle-income countries. It excludes both high-income countries and jurisdictions with a population of less than 500,000. The breakdown of countries by income level is low-income, 16; lower-middle-income, 34; and upper-middle-income, 38. RESOLVING BANK ASSE T DISTRESS | 85 Figure 2.2: Figure 2.2 Capacity of banking systems to absorb increases in nonperforming loans, by World Bank region and country income group a. By World Bank region b. By income group break point (percentage points) break point (percentage points) 55 55 50 50 Consolidated distance to Consolidated distance to 40 40 35 35 30 30 25 25 20 20 15 15 10 10 5 5 0 0 EAP ECA LAC MENA SAR SSA Low- Lower- Upper- High- income middle- middle- income income income Source: WDR 2022 team, based on Feyen and Mare (2021). Note: The figure reports the percentage point increase in the nonperforming loan (NPL) ratio at the country level that wipes out capital buffers for banks representing at least 20 percent of banking system assets (see Feyen and Mare 2021). Higher values denote a higher capacity to absorb NPL increases. The horizontal line dividing each box is the median value of each group. The height of the box is the interquartile range. The whiskers span all data within the 1.5 interquartile range of the nearer quartile. Dots represent values outside the whiskers. Panel a shows the distribution of the percentage point increase in the NPL ratio across World Bank regions. Panel b illustrates the distribution of the percentage point increase in the NPL ratio across country income groups. The underlying bank-level data are from up to July 2021. EAP = East Asia and Pacific; ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; MENA = Middle East and North Africa; SAR = South Asia Region; SSA = Sub-Saharan Africa. Figure 2.2, which is based on data up to July 2021, shows the percentage point increase in NPLs— known as the consolidated distance to break point (CDBP)—at which banks representing at least 20 percent of banking system assets would become undercapitalized.28 Countries with smaller CDBP values have banking systems with less capital space to absorb increases in NPLs and therefore are more vulnerable to a credit shock. The South Asia Region (SAR) is the most vulnerable, followed by the Middle East and North Africa (MENA) and Latin America and the Caribbean (LAC) Regions (figure 2.2, panel a). The weakest banks in the Sub-Saharan Africa (SSA) and Europe and Central Asia (ECA) Regions could, on average, sustain higher increases in NPLs before capital is depleted.29 In terms of income groups (figure 2.2, panel b), lower-middle-income countries show the greatest vulnerability because a smaller increase in NPLs (for the median country of approximately 7 percentage points) would deplete capital buffers for a significant portion of banking system assets. Asset quality indicators not only give banks insight into the existing portfolio, but also serve as the foundation of strong credit risk management standards, including underwriting of new credit. Robust standards increase the likelihood that available funds finance productive new investments. They also guard against competing pressures to prop up unviable borrowers, and thus support the efficient reallocation of capital to support the recovery. The need for strong underwriting standards is particu- larly relevant in countries with state-owned banks that expanded credit provision during the pandemic. Some countries also rolled out extensive additional public credit guarantee schemes to help support the economy through the pandemic. Care is needed to ensure that public funds help address market failures—for example, to extend credit to MSMEs facing temporary liquidity distress arising from the pandemic or to provide longer-term infrastructure financing that would strengthen the supply capacity 86 | WORLD DE VELOPMENT REPORT 2022 of the economy during the recovery. Authorities should avoid the temptation to lower underwriting standards and weaken credit assessments because such a step would increase potential losses, misallo- cate resources, and distort competition with private commercial banks. Guarding against incentives for mismeasurement Banks underreport the magnitude and extent of asset quality problems in several ways. For example, they may delay recognizing the failure of particular borrowers to pay and instead evergreen loans by simply rolling them over at maturity to “extend and pretend” rather than designate the loan as past due and nonperforming. Even when a bank has recognized that a borrower is facing a repayment problem, it may underrecord the severity of the problem in the hope that the borrower’s repayment capacity will improve over time. A bank may also place a high value on the collateral posted as security for a loan instead of seeking additional protection when market values decline. Meanwhile, banks can obscure their exposure to problem loans by transferring NPLs to off–balance sheet affiliates not reported in their consolidated financial position. Because this act is often conducted less than transparently to escape supervisory scrutiny, consolidated and cross-border supervision are particularly important in curbing this kind of arbitrage. Supervisors will need to develop a full understanding of financial groups’ busi- ness(es) and main shareholders, economic interests, and intragroup transactions following the principle of economic substance over legal form. Incentives to underplay the true extent of exposure to problem loans will likely increase as morato- ria end and other support measures are phased out. Weak banks face a particularly strong incentive to disguise problems because full recognition of credit losses may push their capital below the regulatory requirements, triggering reputational risks, an adverse impact on the costs and availability of funding, as well as heightened scrutiny and supervisory intervention to restore the bank’s position.30 If not countered by strong bank internal governance and intense, intrusive bank supervision, such incentives can create significant discrepancies between reported asset quality figures and the underlying economic realities, as illustrated by the asset quality reviews (AQRs) in countries facing banking stress in the aftermath of the global financial crisis.31 For example, following the AQR by the European Central Bank (ECB) when it assumed responsibility for banking supervision,32 a special diagnostic review con- ducted in Serbia in 2015 identified an additional 4.7 percentage points of NPLs in the total loan book (lowering the capital adequacy ratio by 1.76 percentage points).33 Similarly, an AQR in India in 2015–16 identified an additional 2.5 percentage points of bank advances as nonperforming.34 AQRs may become useful once there is more clarity about the longer-term economic impact of the pandemic. At this point, not all businesses are fully operational, relief measures are still in place, and there is major uncertainty about the ultimate credit losses stemming from the COVID-19 crisis. Recognizing the role of supervision Bank supervisors play a key role in establishing and upholding consistent, robust standards of credit risk management and loan asset classification. Policy makers and academics agree about the importance of strong, independent banking supervision in maintaining public trust in the banking system. The role of supervisors is especially important under the current circumstances because the growing pressures on asset quality may require them to take firm action. After the global financial crisis, the supervisory community strengthened frameworks for identifying and managing problem assets. The BCBS reinforced its “Core Principles for Effective Banking Super- vision,” which set out a minimum baseline for sound practices designed to be of universal applicability RESOLVING BANK ASSE T DISTRESS | 87 for all countries. To facilitate global application, the principle of proportionality underlying the require- ments recognizes that practices should be commensurate with the risk profile and systemic importance of the banks being supervised (see spotlight 2.1 for a discussion of the challenges facing microfinance institutions and their supervisors).35 The principles lay out clear expectations about the treatment of problem assets, provisions, and reserves, which were strengthened as part of the overall reinforcement.36 They clarify that supervisors should be granted, and where necessary apply, powers and remedial measures to ensure that loan clas- sification is appropriate and that provisioning, reserves, and capital are sufficient. In practice, this clar- ification entails conveying powers to a supervisor to require higher provisions when judged necessary and to set additional capital requirements to cover the risks of high levels of NPLs where remediation strategies appear weak.37 Notwithstanding the recent improvements, further progress in strengthening approaches in this area remains a priority. Detailed assessments of supervisory practices and processes undertaken during the joint World Bank/International Monetary Fund (IMF) Financial Sector Assess- ment Program (FSAP) reveal that supervisors continue to fall short in meeting the standards of sound practice.38 Undertaking a speedy self-assessment of conformance to the high-level criteria set out for the identification and management of problem assets may help authorities to make the needed improve- ments in view of the pervasive weaknesses in supervisory frameworks and the pressing urgency from the pandemic. Although supervisory reporting has been streamlined during the pandemic, banks must frequently report reliable, detailed, up-to-date information on credit quality. This information should cover the performance of loans that have benefited from borrower relief measures in order to contribute to high-quality prudential supervision and broader policy analysis of the impact of the pandemic. Super­ visors can also build on their information base using high-frequency digital data on economic activ- ity and financial prospects, as well as technology that facilitates analysis of data from a wide range of sources (see box 2.2). To support this process, credit bureaus, lenders, and supervisory authorities in some countries are exploring and expanding the use of alternative credit data such as account data and rental data (when permitted by the customer), in combination with advanced digital technology, to enhance the accuracy of credit scoring. The results have been positive, although the need to ensure com- pliance with consumer protection and privacy regulations remains critical (see chapter 4).39 Techniques such as stress tests may also supplement financial analysis and help identify emerging risk exposures. Even where moratoria are still in place, supervisors should encourage banks to undertake thorough assessments of borrowers’ likeliness to pay. Moratoria dampen signals of deterioration in repayment per- formance. Credit assessments can thus inform decisions on the need for, as well as the terms of, restruc- turing loans to viable borrowers. They can also guide early actions by banks to enforce and recover their claims when borrowers face high risks of insolvency. Banks should be required to perform periodic assessments and report a set of standard indicators on credit risk (such as the availability and quality of collateral and the repayment behavior prior to the pandemic). Using these indicators, supervisors can monitor the performance of these loans. Such information will contribute to policy judgments on whether to temporarily extend loans and on targeting of moratoria, regulatory, and supervisory mea- sures, as well as additional borrower support.40 Although the questions of when and how to phase out measures such as moratoria do not have simple answers, the general principle should be to unwind them as soon as economic circumstances and the pandemic allow. Decisions on extensions of moratoria should also be based on a thorough understanding of the financial position and debt-carrying capacity of borrowers. And not least, the financial impact of moratoria on banks needs to be carefully considered. An extension implies that banks must forego regu- lar debt repayments on a possibly significant part of their loan portfolio, which may affect their liquidity. 88 | WORLD DE VELOPMENT REPORT 2022 Box 2.2 The use of financial technology in banking supervision (suptech) during the pandemic Some advanced economies that had developed processing to gather international news and stay suptech tools before the pandemic have been able abreast of COVID-19–related developments. MAS to use these tools to monitor the impact of the has also used NLP to analyze consumer feedback pandemic on the health of their financial sector. on COVID-19 issues and to monitor vulnerabil- The Central Bank of the Netherlands, for example, ities in customer and product segments. Mean- is developing an interactive reporting dashboard while, as the pandemic unfolded MAS collected designed to give supervisors insight into banks’ expo- weekly data from regulated institutions to track sure to COVID-19–related risks. This tool draws on a the take-up of credit relief measures. Data aggre- variety of data sources and enables the monitoring of gation and transformation were automated and relevant indicators for specific banks, as well as peer visualized for monitoring. In the United States, a group analysis. Planned improvements in suptech Federal Reserve Bank is currently developing an include incorporating public COVID-19 information NLP tool to analyze public websites of supervised and analyzing comment fields using textual analysis. regulated institutions to identify information on The Monetary Authority of Singapore (MAS) has “work with your customer” programs in response deployed automation tools using natural language to the pandemic. At the same time, phasing out the measures will likely lead to an increase in total NPL volumes and provisioning charges, which will affect capital, particularly if banks operate with thin capital buffers.41 All this will create a more challenging environment for banking supervisors. As pressures on asset quality build, banks may step up efforts to disguise the extent of their difficulties. Supervisory work programs will likely shift toward thematic examinations and in-depth on-site inspections focusing on credit risk. These efforts will be necessary to clarify the true extent of the deterioration of asset quality and the corresponding credit losses. These challenges may be compounded by pressures on the oper- ational independence of prudential supervisors. In the face of mounting stress on bank asset quality, supervisors may be pushed to soften judgments and enforcement or to weaken regulatory standards altogether. Supervisors should also ensure that legitimate supervisory information needs are met, while avoid- ing unnecessary burdens. Formally assessing likeliness to pay is more challenging than counting days past due because it requires a more detailed analysis and judgment. In practice, then, some banks and supervisors may have placed more weight on the days past due in identifying NPLs and assessing pro- visions. However, taking full account of likeliness to pay is important, particularly under the current circumstances. Indeed, the judgments involved in assessing payment capacity on an ongoing basis over the full credit life cycle are an integral part of effective credit risk management, as again highlighted by the “Core Principles.” Illustrating the recommended approach, banks in India and Malaysia, encouraged by their regulators, increased provisions preemptively in 2020 during the moratorium, recognizing that underlying asset quality was deteriorating and that additional performance problems were likely to crystallize at the end of the repayment standstill.42 The National Bank of Rwanda also highlighted the supervisory expecta- tion that banks proactively assess borrowers’ repayment capacity even if not more than 90 days past due in order to accurately determine the level of problem loans, appropriately classify and provide for them, and ultimately assess the adequacy of capital. 43 RESOLVING BANK ASSE T DISTRESS | 89 While emphasizing the flexibility embedded in the regulatory framework to relieve the pressures of the pandemic, the BCBS and the Financial Stability Board (FSB)44 have noted the importance of upholding agreed-on minimum standards and applying consistent definitions and classifications. Some countries, however, have not complied fully with these recommendations. They have instead diluted definitions and weakened the application of loan quality standards. For example, Argentina and Tur- key relaxed definitions and diverged from international standards by stretching the 90 days past due criterion. Meanwhile, recognizing emerging problem loans, some banks in Colombia reset days past due to zero at the start of the pandemic for borrowers already experiencing repayment arrears. In other cases, supervisors are treating restructured, forborne NPLs as new loans, without undergoing the nor- mal probationary reentry period requiring borrowers to successfully make rescheduled repayments for one year.45 The various pressures to weaken loan quality standards apply equally to jurisdictions that have not yet had the capacity to implement the international guidelines. Resisting pressures to lower regulatory standards and soften supervision is critical. Although easing standards may lower measured NPLs, it does not address the underlying problem of banks’ exposure to troubled assets. It also weakens the comparability and consistency of reported data, and it creates opac- ity about the financial position of borrowers and banks that can lower trust in the financial sector. The risk is that neither banks nor supervisors see emerging asset quality problems in time to resolve them before they become embedded and much costlier to address. Where standards have been relaxed during the pandemic, supervisors should clarify that this relaxation is temporary and have plans to restore pru- dential standards of asset quality. Fortunately, such relaxation is rare. The majority of supervisors have maintained consistent regula- tory approaches and have provided helpful guidance on how to utilize the flexibility in the supervisory and regulatory frameworks, while taking account of moratoria and other temporary support measures.46 Nonetheless, until the pandemic and the economic crisis are over, political and industry pressures to dilute regulatory norms, soften supervisory enforcement, or challenge the independence of regulatory agencies may continue to increase as banks’ asset quality deteriorates. Supervisors in countries that traditionally have relied heavily on state-owned banks for economic management, and where the state acts not only as regulator but also as owner and promoter of a large part of the banking sector, may be in a particularly difficult position to fend off these pressures (see box 2.3). This is especially true when state-owned banks provide countercyclical lending to mitigate the Box 2.3 Bank supervision and state ownership of banks The state continues to play a prominent role in the state-owned banks typically operate under a nar- financial sector of many countries.a State-owned row policy mandate, may not collect deposits, and banks comprise financial intermediaries that range rely on direct lending instruments, as well as the from strictly commercial to purely developmental. provision of technical assistance. Commercial state- In general, commercial banks operate in competi- owned banks are usually under the purview of the tion with the private sector, target profit maximi- banking regulatory agency, whereas their develop- zation, take deposits from the public, and extend ment counterparts are often not regulated. The lat- loans directly to their customers without a specific ter may act as providers of public money to private policy mandate. At the other extreme, development banks, or they may, in some cases, also lend directly. (Box continues next page) 90 | WORLD DE VELOPMENT REPORT 2022 Box 2.3 Bank supervision and state ownership of banks (continued) A high degree of government ownership and discipline, and distorting resource allocation. These strategic control implies a direct and significant issues are particularly acute when the government influence over the allocation of financial resources. routinely backstops weak enterprises, financial insti- Although state-owned banks can be a helpful vehicle tutions, and asset markets. in mitigating the economic impacts of severe shocks, Many state-owned banks were asked to extend the debate over their pros and cons continues.b For credit and provide guarantees to ease the burden example, conflicts about incentives can arise from of COVID-19 on companies and households and to the multiple (and often opposing) roles of the state help cushion the immediate economic impacts.d as the owner, promoter, and regulator, impairing The long-term effect, however, depends crucially efforts by authorities to regulate and supervise the on the quality of underwriting standards and the financial system.c Bank supervisors may face political income-generating capacity of investment proj- pressures that prevent them from applying the full ects. Weaknesses in these areas increase the risk range of supervisory tools—such as the replacement that guarantees will be called on and the credit of management and board—thereby impairing their stimulus will resurface in the form of pressures on ability to enforce rules and standards. The enduring asset quality. This risk also highlights the impor- presence of the state may also create issues for pri- tance of corporate governance and risk manage- vately owned banks, such as reinforcing perceptions ment arrangements in state-owned banks, as of implicit guarantees, discouraging thorough credit well as supervisory independence and effective risk analysis at loan origination, weakening financial enforcement of sound regulatory standards. a. Panizza (2021). b. For an overview of the literature, see Cull, Martínez Pería, and Verrier (2018); Panizza (2021); and World Bank (2012). c. Barth et al. (2003). d. Medas and Ture (2020). economic impact of the pandemic (figure 2.3)47 because in these circumstances asset quality deteriora- tion could be underestimated for some time. State ownership of banks underscores the importance of the legal and operational independence of the supervisory agency and a mandate to focus solely on the safety and soundness of the financial sector, robust legal protection for supervisors, and sufficient pow- ers to address emerging banking vulnerabilities, among other things. Recent FSAP assessments indicate a relatively widespread need to further strengthen these supervisory foundations.48 Ensuring a robust regulatory and supervisory framework Although it is widely recognized that strong regulatory and supervisory frameworks are critical for timely identification of NPLs, many emerging economies continue to face serious challenges in this area. These challenges often stem from a combination of factors, including deep-rooted institutional constraints such as lack of enforcement powers, skill shortages, and weaknesses in the financial sector that predate the pandemic.49 Under these circumstances, implementing the full range of regulatory and supervisory policies outlined in this chapter can be a tall order. Putting the essential building blocks in place offers a practical way forward.50 The logical starting point is to establish a sound institutional base for banking supervision. This base is a legal framework that protects banking supervisors from political and industry pressures and RESOLVING BANK ASSE T DISTRESS | 91 Figure 2.3 Comparison of accumulation of nonperforming loans at public banks and private banks after adverse shock a. All economies b. Advanced economies c. Emerging economies 0.20 0.20 0.20 Average difference in NPLs Average difference in NPLs Average difference in NPLs 0.15 0.15 0.15 0.10 0.10 0.10 0.05 0.05 0.05 0 0 0 –0.05 –0.05 –0.05 –0.10 –0.10 –0.10 +3 ars +4 ars +5 ars s ye r +3 ars +4 ars +5 ars s ye r +3 ars +4 ars +5 ars s ye r +1 ck +1 ck +1 ck +2 yea +2 yea +2 yea ar ar ar o o o ye ye ye ye ye ye ye ye ye Sh Sh Sh Coefficient estimate 90% confidence interval Source: WDR 2022 team, based on Panizza (2021). Note: The graphs plot for three groups of economies the differential response of state-owned and private banks to a given GDP growth shock over the five years following the shock. A positive coefficient indicates that state-owned banks accumu - late higher nonperforming loans after such a shock. GDP = gross domestic product; NPLs = nonperforming loans. when they undertake acts in good faith, endows the agency responsible for banking supervision with a clear mandate, provides supervisors with an appropriate set of powers, and grants the agency the resources needed to attract and maintain a critical mass of qualified staff. Although these attributes are foundational to the effectiveness of banking supervision, they are often lacking, and efforts to put them in place are forcefully resisted by vested interests. Countries where political elites own or control important parts of the banking sector, or where the state’s role as owner and promoter of the banking sector outweighs its role as prudential regulator, may be particularly challenged in laying a sound insti- tutional base. The second step is to introduce NPL regulatory definitions aligned with international standards. Many emerging economies entered the pandemic with weakly defined NPLs and generous allowances that enabled banks to avoid rigorous loan classifications through questionable restructuring practices.51 In some countries, these allowances were further weakened in response to the pandemic. It is important to revert to prepandemic standards as soon as possible, while mapping out a transition to definitions aligned with international standards. In addition to the hard backstop of 90 days past due, standards should include the qualitative unlikely-to-pay (UTP) criterion and forbearance definitions aimed at preventing low-quality loan restructuring that aims to delay recognition of inevitable credit losses. Although application of the UTP criterion will require an element of judgment by banks, supervisors should ensure that banks proactively apply consistent approaches to making that assessment and clas- sify loans and provision accordingly on this basis. Sound regulatory definitions will have to be enforced by banking supervisors. Enforcement will often require developing the capacity of supervisors to support an upgrade from compliance-driven super­ visory approaches to approaches that tailor attention and responses to assessed risks. Supervisors must 92 | WORLD DE VELOPMENT REPORT 2022 also have the skills needed to challenge common practices that banks often use to underrepresent NPLs, such as overvalued collateral, “extend and pretend” loan restructuring, and transfers of losses to uncon- solidated but de facto affiliated entities. Moreover, supervisors will need to understand the broader busi- ness interests of the bank’s owners. Rigorous application of high-quality corporate governance standards and constraints on lending to related parties are essential steps. In the most challenged countries, reforms along these lines will take time and must be sustained over several years. Although the task can seem daunting, the rewards will be plentiful. Indeed, in recent years some countries have made remarkable progress in a comparatively short period of time. For example, with extensive World Bank support Uzbekistan introduced a new banking law in 2019 to prepare authorities for the transition to a banking sector with a more prominent role for private capital. The law established a “gatekeeper function” aimed at giving the central bank expanded pow- ers to ensure that private investors seeking to enter the banking sector met common fit and proper standards, de facto ownership structures are well understood and monitored continually, and related party lending would be contained. Another priority was to allow the central bank to legally exercise supervisory judgment in fulfilling its mandate in the face of dynamically evolving banking risks. This change was a drastic and sometimes controversial one because the former legal framework prioritized compliance checks with administrative requirements over the mitigation of risks. The new banking law has had a galvanizing effect on financial sector reform in Uzbekistan. Building on the momentum for financial sector reform, the World Bank has continued to support the central bank in overhauling the corpus of prudential regulations and undertaking extensive capacity building to upgrade super­ visory practices.52 Building capacity to manage rising volumes of bad debts In normal times, banks routinely manage NPLs. They know their clients and their capacity to repay and thus are in the best position to restructure, collect, and sell NPLs. Bank capacity to manage NPLs may be insufficient when the volume of NPLs increases significantly across the board, which is very likely in response to the pandemic. Strengthening the capacity of banks to deal with NPLs is critical because of the urgency of addressing bad debts. The recovery prospects for bad loans diminish quickly, and delays in the initial policy response will allow the underlying problems to build, with the risk of overwhelming banks once pressures on asset quality begin to increase. Methods to manage, recover, and resolve NPLs Banks can reduce NPLs through a combination of loan restructuring, legal action, write-off, and sale to third parties (see table 2.2).53 Bank decisions about how they manage NPLs and when to escalate from one method to another should be guided by the expected asset recovery for each method using net pres- ent value (NPV) calculations.54 These calculations should be based on conservative estimates for recov- ery, discount rates, and carrying costs. Poorly functioning insolvency regimes, for example, translate into lower recovery rates that banks must reflect in their calculations. Challenges in addressing NPLs in practice The ease with which banks can work out, collect, write off, or sell bad loans depends on the strength of the enabling environment, particularly the strength of creditor rights, enforcement mechanisms, and RESOLVING BANK ASSE T DISTRESS | 93 Table 2.2 Nonperforming loan (NPL) reduction measures Instrument Subcategory Typology Prerequisite Description Loan Short-term Rescheduling Borrower is experiencing Deferment of borrower’s restructuring restructuring short-term liquidity debt service obligations to a difficulties. Borrower is future date, usually in a net cooperative. present value (NPV)–neutral manner. Concessional Workout Borrower is distressed, but Loan restructuring that restructuring viability can be restored with entails a NPV reduction. restructuring that entails debt relief. Borrower is cooperative. Legal action Collateral Collection Debtor receives notice of Enforcement of the enforcement default from bank, which collateral or guarantee complies with the prescribed pledged against the loan notice periods. by taking in-court or out-of- court action to repossess and then sell collateral. Insolvency Debtor is unable to pay Initiation of an insolvency process debt as it matures or has petition to the borrower to liabilities in excess of reorganize or move toward assets. liquidation. Or the debtor may voluntarily file for insolvency, forcing the bank to prove its claim. Write-off Disposal No realistic prospect of Transfer of fully provisioned recovery. Loan is fully NPL to off–balance sheet provisioned. Bank must records. A write-off does demonstrate that all other not imply that a bank is measures have been forfeiting its claim on exhausted. the borrower, nor does it involve debt forgiveness. A write-off is instead a formal acknowledgment of uncollectability. Sale To a Disposal Bank and distressed debt Sale of NPL on commercial commercial investor agree on pricing terms to an investor. distressed and terms of sale for the Investor continues collection asset investor bank’s NPLs. Ownership effort, which may require rights are transferred to the establishment of a servicing investor. platform. A sale can be structured in various ways, the most common of which is a “true” sale, but profit sharing and securitization are practiced as well. To a public Used in systemic crises to Transfer of NPL to a asset complement the efforts of centralized agency that management individual banks. manages recovery efforts. company Source: Adapted from Baudino and Yun (2017). 94 | WORLD DE VELOPMENT REPORT 2022 insolvency and debt restructuring frameworks (figure 2.4). This is an area in which many emerging econ- omies stumble, resulting in low and unpredictable recovery prospects for lenders and restricting the range of methods for reducing NPLs. Borrowers may also be less inclined to repay according to their full financial capacity if they are able to delay enforcement proceedings. The result can be elevated, persistent NPLs.55 The financial crises in Asia—and globally a decade later—brought home the need for comprehensive reforms to address weaknesses in debt resolution, insolvency, and creditor rights, with separate tracks for corporate and retail bankruptcies. Because of their complexity and breadth, these reforms tend to be time-consuming and are therefore best initiated early on, before banks’ balance sheets become severely burdened with increasing NPLs.56 Poorly functioning enforcement and insolvency frameworks can also discourage banks from dealing forcefully with nonviable or uncooperative borrowers. Absent reliable mechanisms, banks may not be able to steer such borrowers toward an orderly exit through legal action. Political pressure, too, may stand in the way of decisive handling of nonviable state-owned enterprises or national champions. Banks may be pressured to keep such borrowers afloat through frequent rounds of loan restructuring, or they may be restricted in their ability to encourage distressed firms to undertake the operational mea- sures needed to restore financial sustainability and commercial viability. The result can be questionable loan restructuring practices (such as long grace periods, bullet payments,57 or frequent rescheduling) that exacerbate allocative inefficiencies by locking up the credit stock in highly indebted, underperform- ing economic sectors at the expense of more promising ones.58 Although unviable and uncooperative borrowers need to be dealt with resolutely, the depth of the recession puts a high premium on efforts Figure 2.4: Figure 2.4 Nonperforming loan reduction flowchart Borrower Nonperforming loan Net present value status reduction measure (NPV) analysis Loan restructure Viable/ cooperative Legal action NPV analysis is based on realistic recovery and discount rates. All costs are included. Write-off Nonviable/ uncooperative Sale Source: WDR 2022 team. RESOLVING BANK ASSE T DISTRESS | 95 to ensure that distressed but viable borrowers are given an opportunity to rehabilitate. Support from banks, underpinned by infrastructure that facilitates the efficient restructuring and workout of claims (as highlighted in chapter 3), is important. The quality of legal and institutional systems for recovering debt is also an important factor in deter- mining the feasibility of developing for distressed assets secondary markets that can play an important role in reducing NPL ratios.59 Efforts to develop secondary markets have been most effective for unse- cured problem loans such as retail loans and credit card debt. Because no collateral is needed, they are easier to price. Successful loan sales require a legal framework that enables a “true sale” of distressed assets so that (1) investors in those assets can acquire the same legal enforcement rights as the origi- nating bank; (2) these legal rights can be transferred to the investor without the debtor’s consent; and (3) investors can enforce and collect on these loans. Bank secrecy and data protection laws must not hinder due diligence by prospective investors. Although market development for distressed assets has largely been limited in most emerging economies, some in the ECA Region made important strides following the global financial crisis. Between 2015 and 2019, total NPL sales in countries that are part of the Vienna Initiative60 amounted to €14.5 billion. Although in the region the more developed member countries of the European Union (EU) such as Bulgaria, Croatia, Hungary, Romania, and Slovenia account for the bulk of the transac- tions, smaller deals have also taken place in less developed frontier markets in the Western Balkans. The latter is noteworthy because prospective investors in distressed assets must make sizable up-front investments in servicing platforms and market due diligence, and the opportunities to recoup these up-front costs are limited by the small size of domestic markets in the Western Balkans. The World Bank has supported efforts by client countries to develop secondary markets for distressed assets, including by bolstering in selected countries in Latin America and the Philippines a strong loan servic- ing ecosystem (specialized companies that for a fee make the collection effort on behalf of the investor in distressed assets). Faced with a challenging environment for legal enforcement and fledgling markets for NPLs, banks in emerging economies have typically relied heavily on write-offs to dispose of fully provisioned older vintages of NPLs (so-called legacy NPLs) for which there is no realistic prospect of recovery. Banks are often able to write off loans only after demonstrating that all other measures have been exhausted. Full tax deductibility may be granted only after obtaining a court ruling, which can be difficult and time-consuming. It is not unusual for banks to keep significant stocks of full-loss legacy NPLs on their balance sheets. Write-offs tend to be particularly problematic for state-owned banks, as bank managers risk accusations of mishandling state property. Accelerating write-offs can help bank management turn its attention to fresh lending. Onerous requirements can be streamlined, which many countries in the EU and ECA Region did in the after- math of the global financial crisis.61 Going a step further, Ireland, Portugal, Slovenia, and Spain intro- duced regulatory requirements mandating the write-off of legacy NPLs. Some emerging economies have taken similar steps. For example, in 2017 Malawi required banks to write off NPLs from their balance sheets, which helped to lower NPLs from 15.7 percent at the end of 2017 to 3.6 percent in September 2019.62 Organizational needs to manage rising volumes of NPLs To manage rising volumes of bad debt, banks will have to step up efforts to reclaim past loans—efforts that will have important repercussions for business models, organizational structure, strategy, and inter- nal resources. By starting preemptively to strengthen the internal capacity to work out rising volumes of 96 | WORLD DE VELOPMENT REPORT 2022 Box 2.4 Addressing problematic loans to micro-, small, and medium enterprises in Slovenia In 2017, the World Bank helped the Bank of Slove- size of the country and its banking system, the nia develop a handbook for the management and scope for substantially expanding its workout units workout of problematic loans to micro-, small, and was deemed limited. The problem was exacerbated medium enterprises (MSMEs).a After resolving the by skill shortages. At the same time, access to NPL nonperforming loans (NPLs) of large firms through servicing and collection companies had improved establishment of a national asset management com- and NPL markets had begun to develop, attracting pany (AMC), the Bank of Slovenia gradually moved interest from professional NPL investors. to working out the problem loans of the MSMEs The handbook recommended that banks place that are the backbone of Slovenia’s economy. MSME NPLs below €10,000 (so-called microexpo- According to the Bank of Slovenia, in mid-2016 sures) in a separate portfolio during the initial NPL MSME loans accounted for more than 70 percent segmentation process. The threshold at €10,000 of banks’ remaining NPL stock, totaling €1.5 billion, was based on careful analysis of the MSME NPL or around 4 percent of the gross domestic product portfolio in Slovenia. Because of the vintage of the (GDP). MSME NPLs were often small (36.5 percent NPL stock and low number of recoveries expected, were for less than €10,000) and frequently heavily a streamlined approach was adopted to enable in arrears. The handbook, developed as part of a banks to focus scarce internal workout capacity European Union–funded technical assistance proj- on larger, more complex cases. This approach ect completed in 2016, aimed to give banks guid- entailed a prompt write-off after full provision- ance in working out MSME NPLs. ing or sale of a portfolio to a third party. Taken The exercise highlighted how ill-equipped banks together, these measures accelerated the reduc- were to work out such NPLs. In view of the small tion of MSME NPLs. a. The handbook is available online. See World Bank and BoS (2017). NPLs, banks can avoid becoming overwhelmed once moratoria are phased out and asset quality issues emerge on their balance sheets. The urgency to do so stems from the fact that building up internal workout capacity takes time, and the pandemic has disproportionately affected households and MSMEs, creating large volumes of small retail loans that are labor-intensive to resolve (see box 2.4). Banks may not have the skills or incentives to build their internal NPL workout capacity. Some advanced countries have adopted a hands-on approach and require banks with asset quality difficulties to articulate NPL reduction strategies—that is, comprehensive action plans to achieve quantitative NPL reduction targets, which their supervisor must approve. The ECB has required banks to embed their NPL reduction strategies in their risk and capital strategies, review them annually, and ensure that a bank’s management body endorses them.63 The ECB guidelines are based on a sophisticated risk-based supervisory framework and may be difficult to replicate in full in less developed jurisdictions. Nonetheless, emerging economies may benefit from a more proactive supervisory engagement in banks’ NPL reduction efforts and could consider introducing parts of the ECB framework. A good start- ing point is to require banks with problematic NPL exposures to move problem loans away from the original relationship managers (who, with their focus on new loans, generally lack the knowledge and incentives to work out problematic exposures) to a dedicated workout unit. Creating an independent unit to deal with NPLs will help to eliminate potential conflicts of interest between the originating RESOLVING BANK ASSE T DISTRESS | 97 officer and the troubled borrower and build up expertise. 64 In workout units, separate teams are typi- cally responsible for different loan vintages and groups and for selecting the appropriate management method. Banks have often established a 90-day past due trigger for mandatory transfer to the workout unit (in practice the transfer may take place before reaching this point). In fact, some emerging econ- omies relied on this approach before the pandemic. The Bank of Tanzania, for example, required the country’s commercial banks to set up separate workout units as part of a broader strategy introduced in 2018 to lower NPLs.65 Banks will need to take the following steps to make their workout units fully functional: • Allocate the human and financial resources that workout units need for full functionality.66 The skills needed to deal with NPLs are often in short supply, particularly when demand for those skills surges in the face of systemwide stress on asset quality. Skill gaps can be filled by retraining loan origination staff, using external experts on a contractual basis, or, for subsidiaries from foreign-owned banking groups, using staff from elsewhere within the group. • Supply workout units with suitable information systems, which can be a challenge in banks with low levels of loan file digitalization. • Develop internal policies for the management and resolution of NPLs, including assessment of borrower viability, which determines whether a borrower should be considered for loan restructuring. Assessing borrower viability is particularly challenging under the current circumstances because the viability prospects for many borrowers depend to a large extent on the duration of the pandemic. But it is critical that, despite the uncertainty, banks pursue such assessments, starting with the identification of borrowers that are manifestly nonviable and so should be steered toward an orderly exit.67 Although banks usually develop their own approaches, regulators could guide the design of these internal meth- odologies to disseminate best practices and weed out perfunctory analyses by banks. If a bank decides to put a distressed borrower forward for concessional loan restructuring, it will have to conduct an affordability assessment to determine the debt level consistent with the borrow- er’s ability to pay based on the borrower’s liabilities, including debts owed to other creditors. To gather this information, banks can consult private credit bureaus, public registries, or other external sources, where available. Increasing the coverage of borrowers and of credit exposures can help to manage credit risk and problem exposures, as experienced recently in India.68 Banks also must compile a conservative assessment of the expected income of corporate borrowers, based on an analysis of financial statements and cash flows and adjusted for expenses and taxes. The bank can then determine a debt level consis- tent with the borrower’s debt-shouldering capacity and reduce the debt accordingly. Banks should seek to match rearranged repayment schedules with the borrower’s expected future income flows to avoid recurring repayment difficulties. Where struggling borrowers have exposures to multiple banks, effi- cient procedures for ensuring creditor coordination are important, as described in chapter 3. Systemwide NPL resolution Under normal circumstances, banks have primary responsibility for managing distressed loans. In the wake of a crisis, however, countries may resort to public policy interventions to complement banks’ NPL reduction efforts, especially if banks’ exposure to problem loans jeopardizes their capacity to finance the real economy or threatens the stability of the financial system. One intervention is to set up national NPL resolution strategies that establish policy priorities and coordination mechanisms based on a comprehensive diagnosis of obstacles to NPL resolution. Experience 98 | WORLD DE VELOPMENT REPORT 2022 Figure 2.5: Figure 2.5 Ratio of nonperforming loans to total loans, Serbia, 2010–20 30 Reforms implemented 25 20 Percent 15 10 5 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: WDR 2022 team, based on data from National Bank of Serbia, https://www.nbs.rs/export/sites/NBS_site /documents-eng/finansijska-stabilnost/pregled_grafikona_e.pdf. has shown that banks, left to their own devices, are slow to reduce elevated NPLs.69 Reducing high NPLs requires the participation of a broad range of stakeholders to align policies: representatives of private sector entities (banks, institutional investors, and third-party service providers), national authorities (central banks and banking supervisory agencies, finance and justice ministries), civil society groups (consumer organizations), and occasionally international financial institutions. Experiences in several ECA countries after the global financial crisis confirmed the importance of policy coordination. For example, Serbia established a national NPL working group in May 2015 that included as core members representatives of the Ministries of Economy, Finance, and Justice and the National Bank of Serbia, and as members representatives of the Chamber of Commerce and the Deposit Insurance Agency. In addition, the World Bank, IMF, International Finance Corporation (IFC), and European Bank for Reconstruction and Development were invited to play an active role in the working group and in the design of the strategy. The working group identified four strategic priori- ties: (1) improving bank capacity to deal with NPLs; (2) enabling conditions for development of the NPL market; (3) improving and promoting out-of-court restructuring; and (4) improving an in-court debt and mortgage resolution framework. Progress was reviewed and discussed on a quarterly basis. The strategy contributed to a rapid decrease in the NPL ratio, which reached a historic low of 3.7 percent in December 2020 (figure 2.5).70 Public asset management companies In addition to establishing systemwide policies, some regions and countries, including the European Union and Ukraine, have considered establishing public asset management companies (AMCs) to com- plement bank NPL reduction efforts.71 Public AMCs allow removal of NPLs from the financial system, while still maximizing the recovery value of these assets.72 Indonesia, the Republic of Korea, Malaysia, and Thailand, among other countries, used public AMCs in the Asian financial crisis in the late 1990s to clean bank balance sheets and to restructure distressed banks. 73 Advanced economies such as Ireland, Slovenia, and Spain also used public AMCs in the aftermath of the global financial crisis. And more RESOLVING BANK ASSE T DISTRESS | 99 recently, some countries, such as Vietnam (in 2013), Angola (in 2016), and India (in 2021),74 set up public AMCs to help address NPL problems.75 Public AMCs offer important benefits to banks and regulators seeking to resolve high NPL levels.76 Besides removing problem loans from bank balance sheets, public AMCs give regulators additional lever- age to force banks to recognize credit losses—an important step toward restoring public confidence in the banking sector and a critical one in countries where the integrity of reported indicators of asset quality is little trusted. Meanwhile, because of their size and specialization in certain kinds of loans and in recognizing the value of and selling these types of distressed assets, public AMCs can provide econ- omies of scale in the management of distressed assets and greater cost efficiency. This is particularly true if public AMCs can focus on a set of large, complex loans, such as those for real estate development. In addition, by gathering a large volume of homogeneous, distressed assets, public AMCs can help to overcome complex, multicreditor collective action problems and package the assets for sale to outside specialist investors. Public AMCs benefit from enhanced bargaining power with both buyers and sellers, and from having time to realize the value of these assets, thereby avoiding the unnecessary losses associ- ated with fire sales. Setting up a public AMC requires the availability of fiscal resources because finance ministries typically provide (part of) the initial capital and often a partial guarantee on the bonds that banks receive in exchange for the transferred assets. Achieving these benefits requires a well-designed public AMC, and this is an area in which emerging economies have experienced serious challenges. Without an appropriate design, public AMCs can be vulnerable to political interference in the form of pressure to support well-connected borrowers, stra- tegic sectors, or state-owned enterprises; pressure to include political appointees rather than seasoned workout experts; and rules that allow the public AMC to buy distressed assets at a premium over market prices, which gives banks a subsidy and discourages them from adhering to strong underwriting prac- tices when they originate loans. The outcome could be a buildup of significant contingent liabilities for taxpayers. Emerging economies have also struggled to make public AMCs time-bound. Sunset clauses help to encourage banks to quickly transfer bad loans to a public AMC and incentivize public AMCs to work out these assets within a reasonable time frame, mitigating the risk that they become warehouses for bad assets. In summary, although a public AMC is an option for NPL resolution, it is not a silver bullet. Public AMCs are most effective when they focus on a relatively homogeneous pool of large corporate loans; include a sunset clause; embrace robust governance, transparency, and disclosure arrangements; and are embedded in a comprehensive NPL resolution strategy, as advocated throughout this chapter. Dealing with problem banks Despite the best efforts of banks and governments to prepare for rising NPLs, some banks—especially if they were weak or failing before the pandemic—may be unable to absorb the additional pressure. Dealing expeditiously with these banks is essential to support a strong, sustainable recovery. A powerful lesson from previous episodes of severe banking stress is that delay is costly for two interrelated reasons. First, delay typically increases the scale of the problem.77 Weak banks generally become weaker absent remedial action: they face both higher funding costs and the risk of losing higher-quality clients and depositors due to a loss in confidence. In the worst case, the result will be bank runs and failure, conta- gion across the system, and financial crisis. Second, weak banks tend to both misallocate and restrict the supply of credit, which hold back the recovery and dampen future growth.78 Preserving financial system health by quickly addressing any bank distress that arises is critical to ensure the efficient and prompt 100 | WORLD DE VELOPMENT REPORT 2022 provision of the credit needed to spur investment and to foster employment and growth as economies recover from the pandemic. Building capital strength to absorb losses and finance recovery Banks were encouraged during the pandemic to utilize buffers above the minimum regulatory stan- dards—notably, countercyclical capital buffers designed to be released in a downturn. Use of such buf- fers enables banks to continue to extend credit to viable firms facing temporary stress and to finance new, productive investment, while also absorbing the pressures from weakening asset quality.79 Yet the amount of capital available varies across banks and countries, creating differences in the ability of banks to play this supportive role.80 In the years following the global financial crisis, many banks strengthened their balance sheets and built up capital and liquidity buffers, buttressed by the toughening of global regulatory standards.81 As highlighted earlier, however, reported capital adequacy figures must be interpreted with some caution because of the possibility of underreported credit risk, which inflates measured capital. In addition, in some countries the improvement in reported capital adequacy ratios may have been driven by a shift in bank lending toward assets that carry a low risk weight.82 Nonetheless, the consensus is that regulatory reforms have, on the whole, contributed to stronger buffers that have helped banks weather the crisis and continue to provide credit. In countries with banking systems suffering from preexisting vulnerabilities, however, pressures from a sharp increase in problem loans may be increasingly difficult to absorb. Although reported NPLs and capital measures currently seem reassuring, credit losses may increase rather quickly once morato- ria are discontinued, affecting capital. The phasing out of public credit guarantee schemes could exacer- bate these pressures because banks would face increasing risk.83 Over time, some banks may struggle to meet capital adequacy requirements, creating the need for viable capital restoration and recovery plans to retain market confidence. And indeed, some banks will be at risk of failing, potentially jeopardizing financial stability if authorities do not quickly and carefully resolve them. Taking early action to bolster the capital strength of the banking system helps to guard against under- capitalization and potential distress. In this vein, some countries have used favorable global financing conditions as a window of opportunity to raise capital. Furthermore, utilizing this window to raise longer-term finance would also strengthen the funding position of banks that draw on external whole- sale markets as a source of finance. In countries such as India, market conditions were sufficiently favor- able to support raising bank capital during the pandemic. Moreover, at the outset of the pandemic many authorities took action to encourage the preservation of capital by temporarily limiting and restricting bank dividend payments.84 Although the restriction temporarily reduces shareholder cash flow and may increase the cost of raising new equity, it sustains reserves within the bank to absorb potential losses.85 Some authorities subsequently lifted these restrictions for demonstrably strong banks, but retaining the restrictions during the continuing high uncertainty would provide helpful additional capital buffers. Recent evidence suggests that a failure to respond speedily and effectively to an undercapitalization of the banking system can be very costly to an economy.86 In addition to causing broader financial instabil- ity, weak banks with little chance of recovery tend to take excessive risks. With little to lose, they “gamble for resurrection” in the hope that an unlikely bet will pay off and thus allow the bank’s survival.87 But the costs and downsides of such risk-taking are borne by depositors and other creditors, not by bank management and shareholders. Moreover, such behavior affects the sustainable pricing of risk and thus could spill over and distort decisions by healthy banks. Finally, as noted earlier, weak banks are more RESOLVING BANK ASSE T DISTRESS | 101 likely than strong banks to misallocate credit by continuing to support insolvent borrowers (zombie lending) in the faint hope they will eventually recover and by restricting credit to new, productive uses to preserve dwindling capital.88 To guard against the risk of a lackluster recovery due to weak and distorted credit availability, bank supervisors should intensify their monitoring and analysis of individual banks, in addition to the overall banking system’s financial position and outlook. Beyond the usual wide range of tools for monitoring and evaluation, including financial analysis, scenario analysis, and stress tests, supervisors can draw on the tools needed to measure longer-term financial risks (such as climate-related and environmental) to align with emerging international good practices.89 Upon detecting an impending breach of the regu- latory capital standard, supervisors should urgently conduct an in-depth assessment rather than rely mechanically on the automatic supervisory triggers embedded in some regulatory systems. An in-depth assessment will reveal whether the breach is temporary and resolvable with a viable plan to restore capital strength over the medium term under strict supervisory oversight. The credibility and feasibility of medium-term recapitalization and restoration plans to facilitate recovery from the pandemic will vary according to characteristics such as ownership structure, finan- cial position and business model of the bank, financial market conditions, and economic outlook. For domestic, privately owned banks, recapitalization prospects are likely to depend heavily on market conditions and the risk appetite of investors, which, in turn, will depend on the bank’s business plan and the outlook for the banking system. Although the same variables will influence the recapitalization prospects for subsidiaries of foreign-owned banks, the financial position and business strategy of the parent bank may be a stronger driver.90 In financial sectors dominated by a state bank, the ability to transfer losses to private creditors, shareholders, or uninsured depositors is limited. Governments are thus directly exposed to financial sector losses, underscoring the critical role played by effective super- visory and financial stability frameworks, as well as a proper separation of ownership and supervisory functions to minimize conflicting objectives. Decisions on recapitalizing state-owned banks may figure in the overall government policy response, depending on the perceived role of such banks in the financial system, as well as on available fiscal resources and government debt sustainability. Strengthening frameworks to address bank failures The 2007–09 global financial crisis vividly demonstrated the inadequacies of the banking regulatory and supervisory frameworks at the time for dealing with bank failures. The standard corporate insol- vency framework had limited options for addressing the specific issues raised by banking sector prob- lems and proved ill-suited to address significant failures because of the tight financial and reputational connections within the financial sector and associated risks of contagion. How to maintain confidence in the banking sector and how to sustain access to funds and ensure continuity of key financial services are two questions that must be answered to manage failing banks. Moreover, deposit-taking banks fundamentally differ from nonfinancial companies and thus require different approaches to insolvency.91 Unlike failures of nonfinancial companies, bank failures can gener- ate significant wealth losses across the economy (such as by uninsured depositors) and can be associated with a disruption in the provision of critical financial services. In addition, a failed bank may cause knock-on effects that may destabilize the rest of the financial system by, for example, producing loss of depositor confidence and runs on multiple banks, lack of access to key banking services, and impacts on financial counterparties and markets. It is therefore problematic in the context of financial institu- tions that corporate insolvency measures can generally only be initiated at the point of insolvency. This timing would inhibit an early and decisive preemptive intervention designed to forestall banking sector 102 | WORLD DE VELOPMENT REPORT 2022 problems that may quickly become systemic. Another limitation of the corporate insolvency frame- work when applied to financial institutions is that it does not recognize the particular position of bank depositors, who, unlike creditors of nonfinancial companies, are numerous and not professional market participants, and who have claims on banks that play a major role in the wider functioning of the econ- omy. Application of the corporate insolvency law could thus aggravate systemwide losses and jeopardize financial stability.92 The expectation that public authorities will step in to prevent bank failure and preserve financial stability creates moral hazard, whereby banks increase leverage and take excessive risks, assuming they will benefit from the potential upside, while taxpayers underwrite potential major losses on the down- side.93 Thus for regulators, the introduction of effective crisis management frameworks has been an important priority in recent years, complementing the multiple initiatives to strengthen the resilience of financial institutions and the system as a whole. The overarching objective has been to resolve financial institutions without severe systemic disruption and with minimal exposure of taxpayers to losses, while sustaining vital economic functions and preserving financial stability. International guidelines are useful in developing and implementing national frameworks. In 2014, the Financial Stability Board issued “Key Attributes of Effective Resolution Regimes for Financial Insti- tutions,” together with guidance on information sharing and sector-specific implementation.94 The FSB framework defines the powers and associated legal safeguards, funding arrangements, and requirements for planning and cross-border cooperation needed to facilitate effective bank resolution. In parallel with international efforts to strengthen bank resolution schemes, the International Association of Deposit Insurers (IADI) developed core principles for deposit insurance schemes.95 Institutional and legal arrangements that vest in a national agency the responsibility, intervention powers, and tools required to undertake an orderly resolution of failing banks are pivotal. The desig- nated resolution authority (either an existing agency or a new one) should be given the legal authority to pursue financial stability by initiating resolution when it judges that a bank is, or is likely to be, no longer viable and has no reasonable prospect of becoming so.96 The resolution authority should have policy options and tools at its disposal, including stabilization options that support the continuity of key financial functions and liquidation options that enable the orderly winding down of parts or all of a firm’s business. As also described in table 2.3, the main tools would be the following: • Partial asset and liability transfer (also known as purchase and assumption). The resolution authority transfers the insured deposit book to a healthy bank, typically alongside a corresponding volume of performing assets. The remaining “bad” book of the failing bank can then be wound down over time. • Bridge bank. The resolution authority transfers performing assets and a proportion of liabilities to a government-owned bridge bank, while the remaining book is liquidated. The bridge bank can subsequently be sold or privatized. • Bail-in. The resolution authority has the power to write down and convert loss-absorbing liabili- ties of the bank in resolution into equity. • Liquidation. The resolution authority has the power to liquidate part or all of a bank’s book, enabling the separation and management of good assets and the continuity of key financial ser- vices, as well as supporting market discipline. Strong safeguards are integral to resolution frameworks because the use of intervention tools over- rides shareholders’ and managers’ normal decision-making powers and affects creditors’ interests. Key safeguards are that the hierarchy of claims in liquidation must be respected, and no creditor will be worse off from undertaking the resolution than under the fallback option of liquidation. Otherwise, RESOLVING BANK ASSE T DISTRESS | 103 Table 2.3 Principal bank resolution tools Tool Description Objective Prerequisites Partial asset and Transfer the insured Avoid the costs of and Enabling legal powers liability transfer (also deposit book to a risks to financial stability for the resolution known as purchase healthy bank, with a of liquidation and authority. and assumption, P&A)a corresponding volume of depositor payout, as well Willing healthy bank performing assets.b The as lower the risk of a fire prepared to take over remaining ”bad” book is sale of assets. the insured deposit book wound down.c and performing assets. Bridge bankd Transfer performing Avoid the costs and risks Enabling legal powers. assets and a proportion to financial stability of Used to buy time when of liabilities (at a liquidation and depositor there is insufficient minimum, insured payout, as well as lower notice or time to find deposits) to a the risk of a fire sale of a healthy bank to government-owned assets. undertake an immediate bridge bank, while P&A. the remaining book is liquidated. The bridge bank can thereafter be sold or privatized. Bail-ine Write down and convert Restore the balance Enabling legal powers. the loss-absorbing sheet and maintain bank Bank has sufficient liabilities of the bank in continuity. For large and loss-absorbing capacity resolution into equity. complex banks, avoid for confidence to be the costs and execution sustained.f risk of P&A and bridge banks. Liquidationg Liquidate part or all of a Support market Enabling legal powers. bank’s book. discipline. Sufficient protections Pay out insured May be used alongside to avoid runs and depositors if not other tools. instability.h previously transferred to another bank under P&A. Source: WDR 2022 team. a. Examples: Bradford and Bingley (UK, 2008); Washington Mutual, WaMu (US, 2008). b. With, if necessary and feasible, the deposit insurance fund to cover any gap in value (judged on the basis of least cost to the fund). The “bad” book is wound down over time either through transfer to a public or private asset management company, for c.  example, or through the standard liquidation process. d. Examples: Independent National Mortgage Corporation, IndyMac (US, 2008); Consolidated Bank (Ghana, 2018). e. Examples: Bank of Cyprus (Cyprus, 2013); Banco Espirito Santo (Portugal, 2014); Banco Popular (Spain, 2017). f. The experience in Cyprus in 2013 highlights how this approach can damage confidence when loss-absorbing capacity is inadequate. Regulatory initiatives to increase loss-absorbing capacity for globally systemic banks and for major domes - tic banks in some jurisdictions help to address this problem by implementing the international standard for total loss- absorbing capacity set out by the Financial Stability Board in 2015 (FSB 2015). g. Liquidation is used to wind down residual books that have not been transferred after P&A or use of a bridge bank, or for very small banks. h. Penn Square Bank (US, 1982) is an example of where this failed to apply. 104 | WORLD DE VELOPMENT REPORT 2022 compensation would be due. Taxpayer interests should also be protected if, in the event of a systemic banking crisis, public funds are needed to preserve financial stability and to support orderly resolution.97 The FSB’s “Key Attributes” set out the international standard for bank resolution98 and form part of the IMF and World Bank’s Standards and Codes Initiative and Financial Sector Assessment Program. Although many of the “Key Attributes” are broadly applicable to any bank resolution regime in any juris- diction, some of the elements focus on the challenges in resolving complex, globally systemic banks with extensive cross-border operations. A recent World Bank paper provides advice and guidance on how the “Key Attributes” may be applied proportionately in light of the structure and complexity of banking sys- tems and the capacity of authorities to achieve the desired objective—financial stability without loss of public funds—without imposing undue or unjustified operational burdens on authorities and financial institutions or creating market distortions.99 Thus some tailoring is needed.100 The following attributes appear to be appropriate to all jurisdictions and all types of banks: the power to remove management, appoint an administrator, operate and resolve a firm, override shareholder rights, transfer assets and liabilities, suspend creditor payment, impose a temporary stay on early termination rights, and liquidate an institution. However, the following attributes address issues found more commonly in large, complex banks: the power to ensure continuity of essential services that support critical functions, to establish a bridge bank, and to bail in shareholders and creditors. Planning for dealing with failing banks Planning is essential to ensure that the resolution authority has the information and tools to support orderly implementation. The “Key Attributes” require jurisdictions to establish an ongoing process for recovery and resolution planning, covering, at a minimum, domestically incorporated firms that could have systemic impacts if they fail. Requiring major firms to produce robust recovery and resolution plans under authorities’ oversight is a must for effective contingency planning. Over the last decade, authorities worldwide have made significant progress in developing and imple- menting resolution frameworks. They have also taken steps to strengthen other key aspects of the finan- cial safety net, such as deposit insurance schemes, which help to support depositor confidence in the banking system.101 Stronger frameworks have supported authorities in addressing failing banks and in restructuring and strengthening the banking system, which has helped improve resilience to meet the financial pressures from the pandemic (see box 2.5). Further progress, nonetheless, remains critical. Surveys by IADI suggest that, notwithstanding expansion of the available tools over time, significant gaps remain in the ability of some authorities to deal with problem banks (see figure 2.6). For example, only about half of the reporting sample of low- income countries had instruments other than liquidation available in their toolkit.102 Moreover, there may also be some practical challenges in applying the policy instruments, particu- larly in a context of widespread asset quality weakness and systemwide distress. Open bank bail-in strat- egies, for example, may prove difficult to execute because of the general lack of loss-absorbing financial instruments that can be bailed in, coupled with the difficulty of issuing eligible liabilities at times of high market volatility. Uninsured deposits are then the only feasible liability class that can be bailed in, which is politically unpopular and can jeopardize depositor and market confidence. Purchase and assumption (P&A) strategies that seek to transfer assets to stronger banks may be difficult to arrange if the entire sector is financially stressed and the appetite for takeovers is limited. And, if set up, bridge banks may be hard to unwind if no ready buyers emerge. Care should be taken that they do not become the “bridge to nowhere.” As experienced in the aftermath of the Penn Square Bank case in 1982,103 liquidation of a bank may prompt depositor runs and financial instability. RESOLVING BANK ASSE T DISTRESS | 105 Box 2.5 Restructuring the financial system in Ghana In recent years, Ghanaian authorities have overseen and liquidation. Fiscal assistance was provided to a major restructuring of Ghana's financial system to sustain depositor confidence (a formal deposit insur- address weaknesses.a This restructuring delivered ance scheme was only introduced in 2019), including a smaller but stronger and better capitalized bank- by funding shortfalls on asset transfers, funding the ing system, as well as a stronger microfinance and bridge bank, and providing some capital injections. nonbank sector. The reforms strengthened overall banking sys- A detailed asset quality review (AQR) in 2015–16 tem capital in Ghana, which rose from 18 percent revealed Ghanaian banks’ significant underprovi- in 2014 to almost 22 percent in 2018 before dip- sioning and capital shortfalls. In response, authori- ping slightly to close to 21 percent in 2019. At the ties implemented a series of reforms to strengthen same time, the number of banks fell from 36 at the the regulatory framework, as well as resolution start of 2017 to 24 in 2019 (nine closed while others powers and tools, supported by assistance from merged). The reforms also helped to reduce non- the International Monetary Fund (IMF) and World performing loans (NPLs)—and actions are ongoing Bank.b Authorities also introduced Basel II/III,c to address legacy problems, as well as to strengthen strengthened corporate governance, and took steps the underlying framework for NPL resolution. The to reinforce the regulatory framework for write-offs, reforms also addressed weaknesses elsewhere in large exposures, and related party lending; improve the financial system. A comprehensive restructur- the effectiveness of reporting to credit bureau(s); ing of special deposit institutions led to the revo- and facilitate loan and collateral recovery by bol- cation of licenses of almost 400 microfinance and stering the legal infrastructure for insolvency and microcredit institutions, as well as intervention in debt enforcement. In addition, authorities raised the 23 savings and loan firms and finance houses. minimum capital adequacy level from 10 percent to The reforms and cleanup have helped the Gha- 13 percent, with the new level serving as a bench- naian financial sector to weather the impact of mark for bank viability. Some banks raised capital to the pandemic.d Although NPLs had edged up to meet the new benchmark, while others merged and 17 percent of gross loans by the end of June 2021 some closed. Capital was also injected into some and remain at a high level, the regulatory capital state-owned banks. Meanwhile, authorities used a ratio stood at 20.8 percent, well above the regula- range of tools to support the system restructuring, tory minimum and comparing favorably with ratios including purchase and assumption, a bridge bank, of other emerging economies. a. IMF (2019). b. Cleaning up the banking system was one of the three elements of the IMF Extended Credit Facility Program for Ghana agreed on in 2015. IMF and the World Bank have also provided technical assistance on bank resolution and ongoing advice on bank supervision and the regulation and supervision of special-deposit institutions. c. Sets of international banking regulations issued by the Basel Committee on Banking Supervision. d. IMF (2021). Authorities responsible for handling troubled banks should prioritize private sector–funded solutions, building as much as possible on the financial buffers of troubled financial entities and the scope for extending them. Such an approach preserves market incentives and discipline and avoids the risks and costs to taxpayers associated with fiscal support. Completing the development of resolution frameworks to provide additional policy options is thus an important priority. To facilitate this work, the World Bank and IMF can help develop the capacity to identify and address weak banks and to strengthen resolution and crisis management frameworks proportionately. 106 | WORLD DE VELOPMENT REPORT 2022 Figure 2.6: Figure 2.6 Financial safety net and bank resolution powers, by country income group, 2016–20 a. Lower-middle-income b. Upper-middle-income c. High-income 100 100 100 80 80 80 60 60 60 Percent Percent Percent 40 40 40 20 20 20 0 0 0 2016 2017 2018 2019 2020 2016 2017 2018 2019 2020 2016 2017 2018 2019 2020 Purchase and assumption Bridge bank Liquidation Bail-in Source: WDR 2022 team, based on data from International Association of Deposit Insurers (IADI), Deposit Insurance Surveys (dashboard), Bank for International Settlements, Basel, Switzerland, https://www.iadi.org/en/research/data-warehouse /deposit-insurance-surveys/. Note: Percentages are computed for the total number of countries in each IADI survey year. Because of the scarcity of data for low-income countries, low- and lower-middle-income countries are reported together. The use of public money should be a last resort—deployed after private sector solutions have been fully exhausted, and only to remedy an acute, demonstrable threat to financial stability and critical financial services that cannot be taken over easily by other providers. In these circumstances, author- ities need to consider the case for additional fiscal support, notwithstanding the additional pressures on fiscal resources, as well as the risks of moral hazard and of a further tightening of the government– financial sector nexus (see chapter 1). In cases of severe systemic stress, where private sector resources are insufficient on their own or the policy tools and options currently available to authorities within the resolution framework are limited, government funds, such as temporary capital injections and resolu- tion funding, may be needed to preserve confidence and financial stability and to drive an orderly and speedy restructuring process, thereby facilitating the rebuilding of financial system health.104 A clear assessment of the extent of the asset quality problems and the potential capital shortfall in individual troubled banks and across the system as a whole is an important input into decisions on whether temporary public sector support is warranted. Banks should be adequately recapitalized to sup- port productive new lending and avoid the risk that they engage in evergreening to stay afloat.105 If time permits, an independent asset quality review, as well as stress tests, may be helpful in supporting policy decisions on bank capital recovery plans and in sizing any temporary public support. Strong safeguards are essential to protect taxpayers’ interests. An important first step is to ensure that all losses are recognized (and equity capital written down) before any government capital injection to avoid bailing out shareholders. Governance and management of the troubled bank should be enhanced and reinforced under strict supervisory oversight, and agree- ment should be reached on a comprehensive restructuring plan and timetable to restore the viability of the bank. The public sector ownership stake, which at times could extend to temporary nationalization, may be best managed by the finance ministry or a separate body rather than by the supervisor or central bank, both of which may have conflicts of interest. The public sector’s stake should be remunerated to RESOLVING BANK ASSE T DISTRESS | 107 limit moral hazard and to maintain a level playing field, and it should be managed at arm’s length to avoid the risk of politicization of day-to-day management decisions. To ensure strong accountability, there should be transparency on the extent and cost of the public support (and of recovery), as well as a clear plan for exit.106 The arrangements should also be buttressed by ensuring that resolution regimes, funding arrangements, and contingency planning build in sufficient flexibility to enable scope for later recovery of resources from the banking industry in the event of a deficit. Improving frameworks to address troubled banks will pay dividends because greater flexibility in the crisis management policy toolkit, combined with strong contingency planning and the development of robust recovery and reso- lution plans for major firms, will reduce the need for additional support and minimize the costs. Conclusion Dealing promptly and comprehensively with distressed assets and problem banks is essential for a well-functioning banking system and healthy, sustainable growth. History has shown that a strong ini- tial response prevents problems from festering, maintains the capacity of the banking sector to finance the real economy, fosters market and public confidence, and reduces the risk that countries become trapped in an equilibrium of low growth and lackluster financial sector performance. Avoiding such a scenario should be a top priority. Replicating the full range of policies discussed in this chapter may be particularly demanding for countries that face a combination of institutional constraints and serious preexisting financial sector vulnerabilities. Under these circumstances, some sequencing of measures is likely to be necessary, while some of the more complex reforms may need to be simplified. Whatever the situation, effective resolution of the banking sector must begin with an accurate under- standing of the scale of the problem. The starting point is full transparency about bank exposures to troubled assets, supported by a robust regulatory and supervisory framework so that banks properly identify NPLs and provision for credit losses. Supervisors must ensure that banks have sufficient capital buffers to support lending growth and economic recovery, while absorbing credit losses to minimize the risk that insolvency problems materialize and become a threat to financial stability. Encouraging banks to use favorable global financing conditions to strengthen capital and balance sheet resilience can support this process. Some countries, however, entered the pandemic with lax regulatory definitions and ineffectual super- vision. In these countries, it is critical that regulators and supervisors do not succumb to pressures to further dilute regulatory standards and soften supervisory enforcement. Instead, they should consider reversing any recent dilution of asset classification definitions and developing and implementing a plan for gradually introducing internationally agreed-on definitions for NPLs and forborne exposures to ensure rigorous monitoring of banks’ asset quality. That effort should be buttressed by ongoing efforts to strengthen the effectiveness of supervision. Supervisors should require banks with excessive NPL exposures to adopt NPL resolution strategies and reinforce their operational readiness to resolve rising volumes of bad loans. The creation of dedi- cated workout units tasked with handling problematic exposures is a good starting point. Banks will also need to implement internal policies to manage and resolve NPLs and to assess the viability of dis- tressed borrowers. The latter is vital to avoid questionable loan restructuring that delays the recognition of inevitable credit losses. At the national level, the government should coordinate the participation of public and private sector stakeholders and civil society representatives in resolving banking sector problems. Such institutional coordination would be particularly useful in jurisdictions where efforts to accelerate NPL resolution face 108 | WORLD DE VELOPMENT REPORT 2022 major legal impediments and taxation obstacles. In countries with a long history of unresolved asset quality problems, the establishment of a coordination body could signal authorities’ newfound determi- nation to clean up bank balance sheets and gain public and financial industry support for critical legal and regulatory reforms. Such a body could also help to prioritize policy actions, sustain momentum over a likely multiyear process, and ensure that reforms remain on track. Where helpful, IMF and the World Bank could provide assistance and advice on strengthening finan- cial supervision, including on NPL identification and strategies to resolve them. Strong crisis manage- ment frameworks that include a resolution toolkit for handling bank failures, as well as contingency planning for dealing with potential problems, will help to protect taxpayers while ensuring continuity in financial services. Reforms to develop such frameworks and strengthen crisis management planning have been a policy priority in recent years. Building on this progress to ensure that authorities have a broad range of policy tools remains important to ensure that banking systems are able to support a strong, sustainable, equitable recovery. Notes 1. However, early signs of distress are already visible in 5. Cerra and Saxena (2008). some countries. For example, in India bad loans as a 6. Analysis of the sectoral heterogeneity can reveal how share of gross loans surpassed 10 percent in the first COVID-19 is having a differential impact across and half of 2021 (Sanglap 2021). In the Philippines, the non- within loan portfolios. For example, Müller and Verner performing loan ratio is expected to double to 8.2 per- (2021) find that credit booms driven by household cent in 2022 (Villaneuva 2021). credit and credit to the nontradable sector are asso­ 2. The World Bank COVID-19 Crisis Response Survey ciated with lower growth in the medium term. (http://bit.do/WDR2022-Covid-19_survey) indicates 7. Countries enacting measures to support borrowers that as of June 2021, 25 upper-middle-income, 14 have stressed their extraordinary and temporary lower-middle-income, and 6 low-income countries had nature. Deciding when and how to unwind them is in place credit forbearance policies for individuals. nonetheless challenging. Withdrawing measures Also in response to the pandemic, 25 upper-middle- before the pandemic and the macroeconomic outlook income, 20 lower-middle-income, and 6 low-income have stabilized can permanently reduce economic countries had in place credit forbearance policies for growth potential through unnecessary insolvencies small businesses and firms. and unemployment, increasing NPLs and credit 3. The impact of the COVID-19 crisis on asset quality in losses and triggering disorderly adjustments of asset the banking sector varies across countries and depends prices (Kongsamut, Monaghan, and Riedweg 2021). on a complex interplay of factors, including the severity On the other hand, extending support measures risks of the pandemic, the duration and rigor of containment distorting resource allocation and asset prices, weak- measures, the importance of hard-hit economic sec- ening repayment discipline, postponing structural tors, as well as the financial capacity of banks to absorb adjustment in the economy, and draining fiscal rising credit losses and their operational readiness to resources. Policy dilemmas about whether to extend, work out rising volumes of bad debt. Some countries amend, or end support measures will likely become will be hit harder than others. acuter as the pandemic persists. Further discussion 4. Aiyar et al. (2015) document that NPLs in several of the timing and strategy for unwinding fiscal and European countries exceeded 10 percent between monetary supports appears in chapter 6. See also 2008 and the end of 2014. By reporting NPLs at their FSB (2021). historical average, the authors estimate that banks 8. A useful distinction is between high levels (stock) of could have provided new lending of up to 5.3 percent of NPLs and increases in NPL ratios (flows). High levels of the gross domestic product (GDP) of the countries in NPLs may influence permanently the provision of credit their sample at the end of 2014. The same authors also through regulatory restrictions, funding costs stemming argue that persistent, excessive NPLs are associated from market pressures, and risk-taking behavior such as with a private debt overhang, which entails weaker the tendency to invest in riskier assets to “gamble for investment and slower economic recovery after a resurrection” (Rochet 1992). Increases in NPL ratios recession. In addition, the negative economic effects temporarily affect income statements and may modify associated with high NPLs may be amplified by a lending policies while banks adjust provisioning (see previous large buildup of excessive credit, eventually Balgova, Nies, and Plekhanov 2016). leading to a severer economic recession and slower To9. keep bad loans in check and limit capital absorp- recovery (Jordà, Schularick, and Taylor 2013). tion due to higher regulatory requirements, banks may RESOLVING BANK ASSE T DISTRESS | 109 try to limit lending to riskier borrowers such as MSMEs banks” and public asset management companies, and (as described by DeYoung et al. 2015). The most vul- strengthening the enabling legal framework. See Ari, nerable borrowers may be also affected by, for exam - Chen, and Ratnovski (2021). ple, not providing collateral (which lowers both risk 19. Dijkman and Salomao Garcia (2020). weights and the proportion of a loan that needs to 20. Recapitalization may be unpalatable to shareholders be provisioned) against requested financing. See because the new capital would be used primarily to Cucinelli (2015). stabilize bank liabilities. In addition, external discipline 10. Diwan and Rodrik (1992). on bank risk-taking behavior could be also hindered by 11. As discussed in chapter 4, lower lending entails the presence of a formal financial safety net (such as negative real effects. For example, Granja and Moreira a deposit guarantee system) and implicit guarantees (2021) document a decrease in product innovation in of uninsured creditors (World Bank 2020b). Appropri- the consumer goods sectors following disruptions in ate supervision is therefore key to prevent banks from the supply of credit. delaying recognition of losses and engaging in zombie 12. Evidence from Japan indicates that following the lending and evergreening—see Acharya (2020) and bursting of the asset price bubble in the early 1990s, Chopra, Subramanian, and Tantri (2021) for the case banks with lower capital buffers were more reluctant of India. to write off loans and more likely to provide frequent 21. These reasons include whether jurisdictions apply rounds of loan restructuring—also known as accounting or regulatory rules in determining provi- evergreening (Giannetti and Simonov 2013; Peek and sioning requirements; the different methods for valu - Rosengren 2005). European banks, in the aftermath of ing collateral; and the differences in the regulatory the global financial crisis, exhibited similar behavior treatment of the accrual of interest income on nonper- (Acharya et al. 2018, 2019; Andrews and Petroulakis forming loans and asset write-offs (Baudino, Orlandi, 2019; Blattner, Farinha, and Rebelo 2019; Bonfim et al. and Zamil 2018). 2020; Schivardi, Sette, and Tabellini 2021). European 22. BCBS (2016). In its guidance, the Basel Committee on banks with thin capital buffers have reduced their Banking Supervision has also advocated use of the exposures to weak borrowers significantly less than to term nonperforming exposures (NPEs), which covers stronger ones (Dursun-de Neef and Schandlbauer a broader range of problem assets than the term non- 2021). Recent evidence points to similar patterns performing loans. NPEs comprise NPLs, as well as in some emerging economies, particularly for nonperforming debt securities, other amounts due government-owned banks. See, for example, Chopra, (including interest and fees), and certain off–balance Subramanian, and Tantri (2021) and Kulkarni et al. sheet items such as loan commitments and financial (2021) for the case of India and Tan, Huang, and Woo guarantees. In practice, however, most countries con- (2016) for the case of China. tinue to use NPLs as the metric. 13. Acharya et al. (2019); Adalet McGowan, Andrews, and 23. BCBS (2020); FSB (2020a). Millot (2018); Banerjee and Hofmann (2018); Blattner, 24. BCBS (2020). Farinha, and Rebelo (2019); Caballero, Hoshi, and 25. BCBS (2020). Kashyap (2008). 26. In the majority of emerging economies, financial inter- 14. According to Ari, Chen, and Ratnovski (2021), out of 92 mediation occurs primarily through banks, as opposed banking crises in 82 countries since 1990, 30 percent to through nonbank institutions such as credit unions, of the crises saw NPLs exceed 7 percent of total peer-to-peer lending solutions, asset-backed lenders, loans. In these countries, output growth six years after and microfinance institutions. Credit risk in the form a crisis was 5 percent lower than in countries with a of losses resulting from a borrower’s failure to repay a relatively low NPL level (that is, below 7 percent of loan is the main risk that banks in these economies total loans). In earlier research, Reinhart and Rogoff encounter. Data as of year-end 2019 reveal that the (2009a, 2009b) found that the peak-to-trough out- country median value of the claims of deposit money put decline after a banking crisis is approximately banks on the domestic real sector is 63 percent of 9 percent. GDP, compared with 18 percent of GDP of the claims 15. CESEE countries are Albania, Belarus, Bosnia and of nonbank financial institutions. See World Bank, Herzegovina, Bulgaria, Croatia, the Czech Republic, GFDD (Global Financial Development Database), Estonia, Hungary, Kosovo, Latvia, Lithuania, Moldova, https://www.worldbank.org/en/publication/gfdr/ Montenegro, North Macedonia, Poland, Romania, the data/global-financial-development-database. Russian Federation, Serbia, the Slovak Republic, 27. BCBS (2016). Slovenia, Turkey, and Ukraine. 28. The 20 percent threshold of banking system assets is 16. Annex 2A can be found at http://bit.do/WDR2022 associated with systemic banking crises. See Feyen -Annex2A. and Mare (2021) for details. 17. World Bank (2020a). 29. The analysis uses a so-called reverse stress test 18. That approach may include measures that promote approach, assessing for the most fragile banks in the identifying unrecognized NPLs, building banks’ capac- system how much NPLs would have to rise before cap- ity to handle rising volumes of bad debt, adopting sys- ital ratios are depleted. See Feyen and Mare (2021) for temwide NPL resolution mechanisms such as “bad details. 110 | WORLD DE VELOPMENT REPORT 2022 30. These may include measures to raise capital levels 44. The Financial Stability Board (FSB) brings together and restrictions on the payout of dividends and execu - and coordinates national financial authorities and tive bonuses and on the launch of new products. international standard-setting bodies as they work 31. An asset quality review is a detailed forensic assess - toward developing strong regulatory, supervisory, and ment of underlying loan quality (Gutierrez, Monaghan, other financial sector policies. and Piris 2019). This point-in-time assessment of the 45. Shortening or eliminating this period allowed banks to accuracy of the book value of a bank’s assets can be release provisions and thus present a superficially a useful tool to bring much-needed transparency on stronger financial position. the financial position of banks and to underpin strate - 46. This is in line with recommendations and guidance in gies for the restructuring of weak or failing banking IMF and World Bank (2020). systems. 47. Bertay, Demirgüç-Kunt, and Huizinga (2015); Levy 32. The AQR led to a significant increase in the stock of Yeyati, Micco, and Panizza (2007). nonperforming loans. See ECB (2014). 48. Dordevic et al. (2021). 33. NBS (2015). 49. Dordevic et al. (2021). 34. RBI (2016). 50. The Basel Committee on Banking Supervision’s “Core 35. BCBS (2012). Principles for Effective Banking Supervision” set out a 36. In particular, principle 18 specifies that “the supervi - universally applicable framework for regulation and sor determines that banks have adequate policies and supervision (BCBS 2012). processes for the early identification and manage - 51. Dordevic et al. (2021). ment of problem assets, and the maintenance of ade- 52. Dijkman and Gutierrez (2019). quate provisions and reserves” (BCBS 2012, 12). To 53. World Bank (2020a). Following a sale of NPL portfo- guide this determination, the principle specifies 12 lios, the buyers—often investors that specialize in col - essential criteria for supervisors to fulfill, covering, lecting on bad debts—step up collection efforts by among other things, the quality, timeliness, accuracy, initiating legal action, and a write-off typically takes and prudence of bank loan classification schemes place only after a creditor has attempted to recover and provisioning policies. the debt through legal action. 37. Caruso et al. (2021); D’Hulster, Salomao Garcia, and 54. To determine the net present value of an asset, the Letelier (2014); Gaston and Song (2014). annual net cash flow (cash payments of principal, 38. For example, significant weaknesses in asset classifi - interest, and fees minus the bank’s out-of-pocket cation and provisioning frameworks were noted in costs for legal fees, consultants, and so forth) is cal- about 65 percent of the 29 detailed FSAP assess- culated. Each of these amounts, or future values ments of emerging economies conducted since 2012, (FVs), is then discounted to the present by using an and practices for valuing collateral, upgrading restruc- appropriate market-based discount rate. The sum of tured loans, supervisory definitions, and supervisory the FVs equals the NPV. oversight also fall short of best practices in some 25–40 percent of the same assessments (Dordevic 55. World Bank (2021). et al. 2021). 56. On the demand side, it is often a challenge to 39. The Hong Kong Monetary Authority and the Hong encourage borrowers to reach out to banks once they Kong Applied Science and Technology Research Insti- anticipate repayment difficulties. A late start of tute have outlined a strategy and road map for the use negotiations between debtors and banks generally of alternative credit data to support credit risk assess- increases losses and reduces the chances of a ment for MSMEs (HKMA and ASTRI 2020). In a recent successful rehabilitation. survey in the United States, 96 percent of the partici- 57. A lump sum payment with repayment at maturity of pating financial institutions agree that in times of eco - the contract. nomic stress alternative credit data allow them to 58. World Bank (2020a). more closely evaluate consumers’ credit­ worthiness 59. There are information asymmetries between buyers and therefore reduce their credit risk exposure (Expe - and sellers of distressed assets. Buyers would fear rian 2020). that the assets they are bidding for are of low quality 40. Kongsamut, Monaghan, and Riedweg (2021). and bid at a correspondingly low price. The sellers, 41. World Bank (2020a). being able to distinguish between low- and high-quality 42. Bank Negara Malaysia (BNM 2021) notes that around assets, trade only in the former—the lemons—whereas 40 percent of additional provisions in 2020 were from the market for the remaining assets fails (ECB 2016). application of management overlays by banks over One approach to lessen this problem is the development and above the expected credit loss (ECL) model provi- of standardized “data tapes,” which provide full details sions. This development reflects the ongoing chal - of the terms and conditions governing the assets as lenges faced by banks in incorporating forward- well as the payment performance. looking information into the measurement of ECL 60. The Vienna Initiative monitors NPL transactions for given the prevailing uncertainties about the economic Albania, Bosnia and Herzegovina, Bulgaria, Croatia, recovery path and reduced visibility into the debt ser- the Czech Republic, Estonia, Hungary, Latvia, Lithua- vicing capacity of borrowers under loan moratoria. nia, Montenegro, North Macedonia, Poland, Romania, 43. BNR (2021). Serbia, the Slovak Republic, and Slovenia. RESOLVING BANK ASSE T DISTRESS | 111 61. In absence of a full provision, the act of writing off a rapid disposal and generation of returns through mar- loan would lay bare an additional credit loss for the gins on resale rather than buy-and-hold strategies bank—the uncollateralized portion of the loan (Bauze with workouts of troubled assets. Reliance on short- 2019). term funding can exacerbate pressure to generate 62. Eyraud et al. (2021). Although write-offs remove NPLs quick returns and may preclude time-consuming from bank balance sheets, they do not imply debt workouts. See Cerruti and Neyens (2016). relief for the borrower. The social and economic bene- 73. Lindgren et al. (1999). fits of allowing good faith debtors to make a fresh 74. India’s National Asset Reconstruction Company Ltd start must be balanced against the need to ensure (NARCL), incorporated as a bank-sponsored asset that they are incentivized to repay to their full financial reconstruction company (ARC), is one of several ARCs capacity. Ideally, these borrowers should undergo a authorized by the Reserve Bank and in operation since formal liquidation process, with a court-ordered dis - 2002. charge at the end of the process for a natural person 75. Some public AMCs, such as Danaharta (Malaysia) and debtor. Automatic discharge could be considered for SAREB (Spain), were created in conjunction with pub- first-time debtors, followed by extinction of the debt. licly funded bank recapitalization schemes to over- In some cases, a limitation period could be considered come capital space constraints that otherwise would before the extinction to avoid the sudden discovery of have hindered efforts to recognize transparently the assets after discharge of the borrower’s debt. full extent of banks’ exposure to problem loans. Banks 63. See ECB (2017) and EBA (2018). weakened from the burden of NPLs were given a one- 64. Banks can go a step further by transferring NPLs, off opportunity to recapitalize with public support, so together with all related support staff, into a legally that prudential banking regulations would not be separate entity, a so-called bad bank. NPLs are, how- breached. In exchange, banks that benefited from the ever, likely to be transferred at prices below their book scheme underwent significant restructuring to secure value, crystallizing losses that could necessitate rais- their long-term viability. ing new capital. The bad bank also needs its own fund- 76. Dobler, Moretti, and Piris (2020). ing and must expend resources to comply with regula - 77. See, for example, Claessens et al. (2011) and Homar tory requirements. Therefore, bad banks are typically and van Wijnbergen (2017). only considered after exhausting measures to deal 78. See, for example, the discussion in Schwert (2018) with NPLs in-house. and references therein. 65. BoT (2018). 79. BCBS (2020); FSB (2020b); IMF and World Bank 66. Officers of the workout units are often assigned an (2020). excessive number of cases, which risks undermining 80. Some banks have been unwilling to use their capital the effectiveness of collection efforts and can back- buffers as a response to real or perceived financial fire in the form of lower recoveries and longer recovery market pressure. Bondholders may require banks to terms (World Bank 2016; World Bank and BoS 2017). maintain higher capital ratios to reduce default risk, 67. Although the appropriate benchmarks depend on while shareholders may lean on banks to continue div- country-specific circumstances and industry features idend payments rather than use excess capital to lend (such as the capital intensity of the sector), as a rule of or to absorb losses. thumb a debt to EBITDA (earnings before interest, 81. IMF (2020) notes that banks in Europe and in emerg- taxes, depreciation, and amortization) ratio of more ing markets significantly strengthened their capital than 5, an interest rate coverage of less than 1 for a position in the decade following the global financial sustained period of time (such as greater than two crisis. Moreover, according to Hohl et al. (2018), the years), and persistent negative operating income are vast majority of countries have adopted or are con­ common red flags. sidering adoption of stricter definitions of capital. 68. The Reserve Bank of India set up a Central Repository 82. See Anginer et al. (2021) and World Bank (2020b) and of Information on Large Credits (CRILC) in 2014 to references therein. collect, store, and disseminate credit data to lenders. 83. Ehrentraud and Zamil (2020). The CRILC addresses the problem of cross-bank infor- 84. Feyen et al. (2021). mation asymmetry and inconsistencies in asset 85. Awad et al. (2020). classification. 86. Acharya, Borchert, et al. 2020; Acharya, Crosignani, 69. EBCI (2012). et al. 2020; Andrews and Petroulakis (2019); Blattner, 70. NBS (2021). Farinha, and Rebelo (2019); Giannetti and Simonov 71. A public asset management company is a statutory (2013). body or corporation, fully or partially owned by the 87. Rochet (1992). government, usually established in times of financial 88. Acharya, Lenzu, and Wang (2021); Ben-David, Palvia, sector stress to assume the management of dis­ and Stulz (2019); Bonaccorsi di Patti and Kashyap tressed assets. (2017). 72. Although this section is devoted to public AMCs, pri- 89. For example, see the Basel Committee on Banking vate AMCs can be found in some countries, such as Supervision for a discussion of the causal chains from Turkey, where local private AMCs are effectively the climate risk drivers to financial risk (BCBS 2021) and only category of buyers of distressed assets. The the Network for Greening the Financial System on how business model of private AMCs often focuses on to design scenarios to model the impact of climate 112 | WORLD DE VELOPMENT REPORT 2022 change and climate policy (Scenarios Portal, Paris, or the deposit insurer. An important element in all https://www.ngfs.net/ngfs-scenarios-portal/). arrangements is addressing potential conflicts of 90. In addition to parent banks based in advanced coun- interest and balancing operational independence for tries, new players from World Bank client countries the resolution function with approaches that facilitate have accounted for much of the growth in cross- the synergies with the supervision function (Baudino, border banking in recent years. This has led in a few Sánchez, and Walters 2021; Dobler, Moretti, and Piris cases to establishment of holding companies (such as 2020). Ecobank in Togo and Colombian banks in Panama) in 97. Dell’Ariccia, Detragiache, and Rajan (2008). jurisdictions where the group has a limited footprint 98. FSB (2014). and the home authority limited incentives to financially 99. Nolte and Hoelscher (2020). support cross-border subsidiaries (World Bank 2018). 100. Tailoring may also be applied in other areas—for exam - 91. See box 1 of Brierley (2009) for a more detailed dis - ple, resolution funding and cross-border arrange- cussion of the reasons why corporate insolvency law ments (Nolte and Hoelscher 2020). is inappropriate for banks. 101. As of April 1, 2021, 146 jurisdictions had deposit insur- 92. Limited use of the framework in the early phase of the ance in place. See International Association of Deposit 2007–09 global financial crisis (such as for Lehman Insurers, Deposit Insurance Systems Worldwide Brothers) exacerbated systemwide stress and ampli - (dashboard), Bank for International Settlements, fied the crisis. Authorities were forced to provide mas - Basel, Switzerland, https://www.iadi.org/en/about sive public sector support and assistance to backstop -iadi/deposit-insurance-systems/dis-worldwide/. the financial system and prevent collapse. For exam - 102. Even among the larger emerging economies that are ple, UK authorities had to nationalize the bank North- members of the FSB, progress has been mixed. ern Rock in the absence of an effective resolution According to the latest Resolution Report, no jurisdic- mechanism to preserve its financial stability. Similar tion in emerging economies has yet applied all the ele- approaches were taken by other countries in response ments (FSB 2020b). to bank failures during the global financial crisis. 103. Penn Square Bank was liquidated in 1982 following 93. Financial leverage is the fraction of assets funded poor underwriting practices on energy loans. The fail- through debt. The higher the reliance on debt to ure prompted queues of uninsured depositors and finance bank activities, the higher is the risk of default contagion of other banks exposed to Penn Square, (because a larger share of profits would be devoted to including Continental Illinois Bank, which failed in paying debt obligations) and the lower is the share of 1984 and was at that time the largest bank failure in capital to absorb losses. US history. The failures prompted a tightening of US 94. FSB (2014). financial regulations. 95. IADI (2014). 104. Dobler, Moretti, and Piris (2020). 96. Various arrangements have been successfully 105. Brei, Gambacorta, and von Peter (2013); Giannetti and applied—for example, assigning the resolution author- Simonov (2013); Homar (2016). ity function to the central bank, supervision authority, 106. Dobler, Moretti, and Piris (2020). References Acharya, Viral V. 2020. 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Republic of Serbia: Third Quarter 2021." https://www “IADI Core Principles for Effective Deposit Insurance .n bs.r s/exp o r t /si tes/ N B S _ si te /do c u m e n ts - e n g Systems.” IADI, Bank for International Settlements, /finansijska-stabilnost/pregled_grafikona_e.pdf. Basel, Switzerland. https://www.iadi.org/en/assets/File Nolte, Jan Philipp, and David Hoelscher. 2020.“Using the /Core%20Principles/cprevised2014nov.pdf. FSB Key Attributes to Design Bank Resolution Frame- IMF (International Monetary Fund). 2019. “Ghana: works for Non-FSB Members: Proportionality and Selected Issues Paper.” IMF Country Report 19/368, Implementation Challenges.” Working paper, Finance, IMF, Washington, DC. https://www.imf.org/en Competitiveness, and Innovation Insight: Financial Sta- /Publications/CR/Issues/2019/12/18/Ghana-Selected bility and Integrity Series, World Bank, Washington, DC. -Issues-Paper-48884. Panizza, Ugo. 2021. “State-Owned Commercial Banks.” IMF (International Monetary Fund). 2020. Global Financial CEPR Discussion Paper DP16259, Centre for Economic Stability Report: Bridge to Recovery. Washington, DC: Policy Research, London. IMF. Peek, Joe, and Eric S. Rosengren. 2005. “Unnatural Selec - IMF (International Monetary Fund). 2021. “Ghana: Staff tion: Perverse Incentives and the Misallocation of Credit Report for the 2021 Article IV Consultation.” IMF Coun- in Japan.” American Economic Review 95 (4): 1144–66. try Report 2021/165, IMF, Washington, DC. https:// RBI (Reserve Bank of India). 2016. “RBI Releases June 2016 www.imf.org/en/Publications/CR/Issues/2021/07/23 Financial Stability Report.” Press release, June 28, 2016. 116 | WORLD DE VELOPMENT REPORT 2022 https://rbi.org.in/Scripts/BS_PressReleaseDisplay World Bank. 2012. Global Financial Development Report .aspx?prid=37342. 2013: Rethinking the Role of the State in Finance. Wash- Reinhart, Carmen M., and Kenneth S. Rogoff. 2009a. “The ington, DC: World Bank. Aftermath of Financial Crises.” American Economic World Bank. 2016. A Toolkit for Out-of-Court Workouts. Review 99 (2): 466–72. Washington, DC: World Bank. Reinhart, Carmen M., and Kenneth S. Rogoff. 2009b. This World Bank. 2018. Global Financial Development Report Time Is Different: Eight Centuries of Financial Folly. 2017/2018: Bankers without Borders. Washington, DC: Princeton, NJ: Princeton University Press. World Bank. Rochet, Jean-Charles. 1992. “Capital Requirements and the World Bank. 2020a. “COVID-19 and Non-performing Loan Behaviour of Commercial Banks.” European Economic Resolution in the Europe and Central Asia Region: Review 36 (5): 1137–70. Lessons Learned from the Global Financial Crisis for Sanglap, Ranina. 2021. “Indian Central Bank Takes Steps the Pandemic.” FinSAC Policy Note, Financial Sector to Dampen NPL Formation amid COVID-19 Resur- Advisory Center, World Bank, Vienna. https://pubdocs gence.” Banking (blog), May 9, 2021. https://www .worldbank.org/en/460131608647127680/FinSAC .spglobal.com/marketintelligence/en/news-insights -COVID-19-and-NPL-Policy-NoteDec2020.pdf. /latest-news-headlines/indian-central-bank-takes-steps World Bank. 2020b. Global Financial Development Report -to-dampen-npl-formation-amid-covid-19-resurgence 2019/2020: Bank Regulation and Supervision a Decade -63881838. after the Global Financial Crisis. Washington, DC: World Schivardi, Fabiano, Enrico Sette, and Guido Tabellini. 2021. Bank. https://www.worldbank.org/en/publication/gfdr “Credit Misallocation during the European Financial Cri - /report. sis.” Economic Journal. Published ahead of print, April World Bank. 2021. “How Insolvency and Creditor-Debtor 29, 2021. https://doi.org/10.1093/ej/ueab039. Regimes Can Help Address Nonperforming Loans.” Schwert, Michael. 2018. “Bank Capital and Lending Rela - Equitable Growth, Finance, and Institutions Note– tionships.” Journal of Finance 73 (2): 787–830. https:// Finance, World Bank, Washington, DC. doi.org/10.1111/jofi.12604. World Bank and BoS (Bank of Slovenia). 2017. “Handbook Tan, Yuyan, Yiping Huang, and Wing Thye Woo. 2016. for Effective Management and Workout of MSME “Zombie Firms and the Crowding-Out of Private Invest- NPLs.” World Bank, Ljubljana, Slovenia. https://www ment in China.” Asian Economic Paper 15 (3): 32–55. .bsi.si/en/publications/other-publications/handbook Villanueva, Joann. 2021. “Banks’ NPL Ratio to Remain -for-msme-npl-management-andworkout. in Single Digit until 2022: Diokno.” Philippine News Agency, September 22, 2021. https://www.pna.gov.ph /articles/1154356. RESOLVING BANK ASSE T DISTRESS | 117 Spotlight 2.1 Strengthening the regulation and supervision of microfinance institutions L ow-income households and micro-, small, and medium enterprises (MSMEs) in emerging economies often rely on microfinance institutions (MFIs) instead of conventional banks for financial services. The microfinance sector consists of a diverse group of regulated and unregu- lated financial service providers.1 Microfinance institutions are often the sole provid- Effects of the pandemic on ers of financial services to vulnerable segments of a population. They play a critical role in local econ- MFIs and the policy and omies, household resilience, and women’s financial regulatory responses inclusion. One source suggests that up to 80 per- MSMEs and low-income households were affected cent of MFI borrowers in emerging economies are disproportionately by the COVID-19 (coronavirus) female, and 65 percent are located in rural areas.2 pandemic and the ensuing containment measures. Many MFI clients, suffering significant income MFIs rarely become large enough to threaten the losses, were unable to pay loan installments. Mean- stability of the financial system when they are in while, some clients had no way to make payments financial distress. But because many MSMEs and in person during lockdowns and lacked digital low-income households, including very poor, hard- payment alternatives. Moratoria were introduced to-reach populations, depend on MFIs as a source to give MFI clients breathing room, while avoiding of credit and as a custodian of their financial assets, steep increases in capital buffers for MFIs, which the safety and soundness of the microfinance sec- would constrain lending.3 At the same time, credit tor are critical for this population. moratoria delayed borrower payments, which 118 | WORLD DE VELOPMENT REPORT 2022 meant MFIs had less liquidity. However, this prob- and the realities of microfinance clients.6 In some lem was to some extent mitigated by a slowdown instances, measures arrived too late in view of the in new disbursements on the back of weakening short-term nature of microfinance loans and the demand. On the whole, then, these liquidity pres- early impacts of the pandemic on low-income cus- sures were short-lived. tomers and MSMEs. Similarly, some central bank Policy makers and regulators responded to the liquidity facilities that targeted MFIs imposed eli- pandemic with support measures, which varied gibility or collateral requirements that could not be across countries and markets. Although unregu- met by MFIs. lated nongovernmental organizations only bene- The credit moratoria also raised consumer pro- fited from broader policy measures such as fiscal tection issues that may resurface as prudential support, regulated MFIs received support similar challenges in the future. In many cases, missing to that offered to commercial banks:4 or inadequate regulatory guidance for the use of • Relief for MFI clients, such as mandated moratoria saddled borrowers with additional debt credit moratoria or permission for MFIs burdens through fees and compounded interest to offer credit moratoria, with or without that they did not always understand. In addition, prior consent of customers; easing of loan when moratoria were lifted some deferred pay- restructuring requirements; and protection ments came due as a lump-sum payment that of borrowers’ credit histories. borrowers struggled to repay.7 Some MFIs were • Relief for MFIs, lending support, and capital also unprepared to follow up with each borrower conservation, such as direct liquidity sup- and process a sudden increase in requests for loan port for MFIs or indirect support via credi- restructuring. This led to blanket moratoria with tor banks (for example, guarantee schemes); automatic opt-ins without borrower consent and temporary changes in prudential stan- without considering the potential negative effects dards, including reduction of collateral, on borrowers, including on their credit history. provisioning, and risk-weighted capital Furthermore, in some cases weaknesses in inter- requirements for small and medium enter- nal controls led to the embezzlement of unsolicited prises (SMEs) or microfinance loans; reduc- loan disbursements by MFI staff. Finally, there was tion of the capital adequacy ratio, reserve a spike in disbursements of high-cost, short-term requirement, liquidity ratio, leverage ratio, loans by lightly regulated or unregulated lenders— and minimum paid up capital; deferment or loans sought by low-income clients who were suspension of supervisory activities (MFIs unable to meet their need for immediate cash by have been subject to enhanced reporting borrowing from regulated MFIs. of priority data); and suspension of discre- The limited data and anecdotal evidence avail- tionary payments (such as dividends) aimed able indicate that at the onset of the pandemic at conserving capital. there was a short-lived but dramatic drop in loan The general thrust of these measures was to repayments and disbursements. Disbursements boost the sector’s resilience and avoid liquidity and were made only to the best clients, or in some cases capital constraints that would limit MFI lending. were halted altogether. Subsequently, in July 2020 But the measures did not always achieve those goals reported NPLs began to increase as broad-based because support measures largely mirrored those credit moratoria were phased out or replaced with for conventional banks and were not customized more targeted borrower support measures (that for the distinct features of microfinance portfolios5 often provided MFIs with greater discretion in STRENGTHENING THE REGUL ATION AND SUPERVISION OF MICROFINANCE INSTITUTIONS | 119 Figure S2.1.1 Figure S2.1.1 Credit risk ratio and restructured portfolio ratio, by size of microfinance institution and World Bank region, 2019 and 2020 a. Credit risk ratio 30 20 Percent 10 0 Total Small Medium Large ECA LAC MENA SAR SSA MFI size Region b. Restructured portfolio ratio 15 Percent 10 5 0 Total Small Medium Large ECA LAC MENA SAR SSA MFI size Region 2019 2020 (Q4) Source: CGAP and MFR 2021. Data from MicroFinanza Rating, Atlas (dashboard), https://www.atlasdata.org/; Consultative Group to Assist the Poor, CGAP Global Pulse Survey of Microfinance Institutions (dashboard), https://www.cgap.org/pulse. Note: Panel a: 2019 data, 375 microfinance institutions (MFIs); 2020 (Q4) data, 152 MFIs. Panel b: 2019 data, 457 MFIs; 2020 (Q4) data, 158 MFIs. The sample includes only MFIs that entered the pandemic with an above-average portfolio-at-risk 30 ratio (PAR 30—loans overdue more than 30 days) of more than 8.5 percent. The credit risk ratio is calculated as the mean of the sum of write-offs, restructured loans, and PAR 30, all divided by the average gross outstanding portfolio. ECA = Europe and Central Asia; LAC = Latin America and the Caribbean; MENA = Middle East and North Africa; SAR = South Asia Region; SSA = Sub-Saharan Africa. terms of debtor selection and types of support mea- loan restructuring or new disbursements rather sures offered).8 The combination of slowing dis- than moratoria extensions. The portion of the bursements, rising provisioning expenditures, and MFI portfolio under moratoria declined from over ongoing fixed operational expenditures (including 90 percent in March/April 2020 to around 20 per- salaries) translated into pressures on profitability. cent by December 2020.9 Although MFIs have so Figure S2.1.1 compares the credit risk ratio far weathered the pandemic better than initially (panel a) and the restructured portfolio ratio (panel b) for 2019 with that for the fourth quarter of 2020 expected, the situation is still fluid, and pressures by size of MFI and by World Bank region. As econ- on asset quality—which so far have been relatively omies reopened, MFIs and their clients opted for stable—may increase as moratoria are fully lifted 120 | WORLD DE VELOPMENT REPORT 2022 and restructured loans begin coming due. This  7. CGAP (2020a); Dias (2021). may happen in the context of the continuing global  8. CGAP and Symbiotics (2020). impact of the pandemic and a generally uncertain  9. CGAP and Symbiotics (2020). economic outlook. 10. A recent example is a consultative document released by the Reserve Bank of India in June 2021, which advocates harmonizing microfinance regulation for all regulated Regulation and supervision entities (RBI 2021). It also proposes revising the defini- tion of microfinance loans and the limits applicable to of MFIs such loans. During the pandemic, the prospect of growing pressure on asset quality and solvency put a spot- References light on the long-standing weaknesses in microf- BCBS (Basel Committee on Banking Supervision). 2016. inance regulation and supervision. For example, “Guidelines: Prudential Treatment of Problem Assets; large nonprofit MFIs, including deposit-takers, do Definitions of Non-performing Exposures and Forbear- ance.” BCBS, Bank for International Settlements, Basel, not always fall within the regulatory perimeter, Switzerland. https://www.bis.org/bcbs/publ/d403.htm. and they are not required to transform into com- CGAP (Consultative Group to Assist the Poor). 2020a. panies whose ownership is organized via shares. “Debt Relief in the Pandemic: Lessons from India, Peru, and Uganda.” COVID-19 Briefing: Insights for Inclusive Moreover, regulatory, resolution, and consumer Finance, CGAP, Washington, DC. https://www.cgap.org protection frameworks in emerging economies /sites/default /files/publications/2020 _12 _COVID are often inadequate and accompanied by under- _Briefing_Debt_Relief.pdf. CGAP (Consultative Group to Assist the Poor). 2020b. resourced supervisory functions that lack microf- “Microfinance in the COVID-19 Crisis: A Framework for inance expertise and reliable data. Some of these Regulatory Responses.” COVID-19 Briefing: Insights for weaknesses are rooted in the origins and structure Inclusive Finance, CGAP, Washington, DC. https://www .cgap.org/sites/default/files/publications/2020_06 of the microfinance sector, which is often chal- _COVID_Briefing_Framework _Regulatory_Response lenging to regulate and supervise because of the .pdf. sheer number of entities, their legal status, often CGAP (Consultative Group to Assist the Poor). 2020c. “Typol - ogy of Microfinance Providers (MFPs).” COVID-19 Brief- remote locations, and underdeveloped informa- ing, CGAP, Washington, DC. https://www.cgap.org/sites tion systems. Reforms have been overdue, and it is /default/files/research_documents/2020_06_Typology now time to prioritize the reform of microfinance _Microfinance_Providers.pdf. CGAP (Consultative Group to Assist the Poor) and MFR regulation, beginning by widening the regula- (MicroFinanza Rating). 2021. “COVID-19 Impact on Finan - tory perimeter; strengthening regulatory, resolu- cial Service Providers.” Presentation at virtual meeting, tion, and consumer protection frameworks;10 and World Bank, Washington, DC, June 14, 2021. CGAP (Consultative Group to Assist the Poor) and Sym- improving supervisory capacity and data collection biotics. 2020. “MFIs on the Rebound, but Will It Last?” systems. There are also important lessons to learn COVID-19 Briefing: Snapshot, MFIs during the Crisis, from the pandemic on how to be better prepared CGAP, Washington, DC. https://www.cgap.org/sites /default/files/2020-11/11-2020-COVID19-Briefing-Snap for the next crisis by tailoring response measures shot-MFIs-During-the-Crisis.pdf. such as credit moratoria to the specific needs of Convergences. 2018. Microfinance Barometer 2019. Paris: Con- MFIs and their clients. vergences. https://www.convergences.org/wp-content /uploads/2019/09/Microfinance-Barometer-2019_web-1 .pdf. Dias, Denise. 2021. “Regulatory Flexibility during the Pan - Notes demic: Emerging Lessons.” With contributions of Loretta  1. CGAP (2020c). Michaels. Center for Financial Inclusion, Cambridge, MA. https://www.centerforfinancialinclusion.org/regulatory  2. Convergences (2018). -flexibility-during-the-pandemic-emerging-lessons.  3. CGAP (2020b). RBI (Reserve Bank of India). 2021. “Consultative Document on  4. CGAP and MFR (2021); Dias (2021). Regulation of Microfinance.” RBI, Mumbai. https://www  5. BCBS (2016). .rbi.org.in/Scripts/PublicationsView.aspx?id=20377.  6. Dias (2021). STRENGTHENING THE REGUL ATION AND SUPERVISION OF MICROFINANCE INSTITUTIONS | 121 Restructuring firm and household debt The COVID-19–induced economic crisis and the temporary government measures intended to protect firms and households from bankruptcy have created unprecedented opacity about the financial health of households and businesses. Some borrowers are temporarily short on liquid assets, while others are facing longer-term structural difficulties and should exit the market. The challenge, then, is sorting the illiquid from the insolvent. Historically, court-led bankruptcy systems have performed this sorting function, and so these systems are scrutinized in times of financial crisis. Effective insolvency systems can help to quickly resolve high levels of debt distress to prevent collapse of the financial sector without relying on costlier forms of policy intervention. Reforms to strengthen bankruptcy systems also improve the underlying economic conditions and so are critical to an equitable recovery. This chapter lays out a blueprint for bankruptcy reforms that will help governments manage high levels of debt distress while laying the groundwork for economic recovery. Policy Priorities Countries can mitigate the risk of an onslaught of insolvent households and businesses by investing in four policy reforms:  trengthening formal insolvency mechanisms so that the rules that define the rights and behaviors • S of debtors and creditors are in place, giving each an incentive to negotiate and come to an agreement, whether in court or out of court. Facilitating alternative dispute resolution systems such as conciliation and mediation to enable •  faster and cheaper resolution of disputes than in the formal court system, but with some of the rigor that courts provide.  stablishing accessible and inexpensive in-court and out-of-court debt resolution procedures • E for micro-, small, and medium enterprises to facilitate the recapitalization of viable but illiquid firms and the swift, efficient market exit of nonviable firms. Rules designed for small entities can help resolve their debts more quickly and cheaply with less burden on the judicial system than requiring the same rules regardless of firm size. Promoting debt forgiveness and discharge of natural person debtors so that solo entrepreneurs •  and individuals unable to pay their debts—through no fault of their own—can be discharged of those debts and more quickly move on from them, avoiding the stigma and loss of productivity that come from long-term debt distress. 123 Introduction Building on chapter 2 on financial institutions, this chapter looks at the consumers of finance—house- holds and firms—and especially at the insolvency systems countries can use in facilitating an equitable recovery from the COVID-19 (coronavirus) economic crisis. Those systems—debt enforcement laws and their institutional framework—are essential to achieving recovery. The reforms highlighted in this chap- ter, informed by the World Bank’s “Principles for Effective Insolvency and Creditor/Debtor Regimes” and the “Legislative Guide on Insolvency Law” issued by the United Nations Commission on International Trade Law (UNCITRAL),1 focus on mechanisms for restructuring or discharging debt. Effective debt resolution, which these reforms facilitate, can contribute to economic growth and contain the wider economic impact of business distress. In addition to establishing fairness for debtors ­ by providing a pathway out of perpetual indebtedness, well-functioning insolvency systems can spur future innovation and economic growth by freeing up capital for lending to new and productive enter- prises. To deliver on this potential, insolvency systems have to find an effective balance between the need, on the one hand, to address individual instances of overindebtedness and, on the other, to dis­ courage borrowers from engaging in unnecessary risk-taking. Why should anyone care about insolvency systems? Financial crises typically draw attention to insolvency systems because they are an effective way to man- age and reduce high rates of nonperforming loans (NPLs).2 However, this ex post argument for strong insolvency systems is accompanied by an ex ante justification for pursuing insolvency reforms as well.3 Improvements in insolvency systems are associated with greater access to credit,4 improved creditor recovery, strengthened job preservation,5 higher productivity,6 and lower failure rates for small busi­ nesses.7 Cost-reducing reforms can also create the right conditions for nonviable firms to file for liq- uidation,8 which can help resolve the problem of so-called zombie firms, discussed shortly. In short, the rationale for reforms to strengthen insolvency frameworks in the COVID-19 era is a mix of crisis management and recovery planning. This chapter highlights the positive benefits of insolvency systems (a primer on those systems appears in box 3.1). But it is also important to recognize the risks of maintaining the status quo for those coun- tries lacking sound insolvency systems. One characteristic of inadequate insolvency frameworks is the lengthy processes that can reduce the returns to creditors because of the costs of recovery proceedings Box 3.1 A short primer on the insolvency process Despite differences in insolvency frameworks is unable to meet one or more of its contractual across countries, most involve a contractual rela- obligations in the ordinary course of business or tionship between a firm or individual (the debtor) if the total of the debtor’s assets is less than the and one or more creditors. This relationship can total of its liabilities. If a debtor company becomes be for the provision of goods and services (such as insolvent under the law, the debtor or the credi- utilities or suppliers), labor (such as employees), or tor (in some jurisdictions) can seek a court order debt financing (such as lenders). In most jurisdic- declaring that the company is to cease operations tions, a debtor will be insolvent under the law if it and its assets are to be sold to repay, to the extent (Box continues next page) 124 | WORLD DE VELOPMENT REPORT 2022 Box 3.1 A short primer on the insolvency process (continued) possible, what creditors are owed (also known as The outcomes of liquidation and restructuring liquidation). are different. In liquidation, the business is eventu- An alternative to liquidation is restructuring a ally deregistered. In restructuring, the ultimate aim company’s affairs so it can continue to operate and is for the business to resume normal operations. meet its debt obligations (or meet altered obliga- Components of restructuring can include debt tions to which the creditors agree or are required forgiveness, debt rescheduling, debt equity con- to accept). Restructuring typically occurs in circum- versions, or sale of the business (or parts of it) as a stances in which the alternative is liquidation, and it going concern. Failed restructuring can ultimately can occur either before or after court liquidation is result in liquidation. sought. Identification of the assets and obligations Three additional mechanisms can augment a of the debtor is required for both liquidation and typical insolvency framework. First, early warning restructuring to determine how to proceed. tools can detect or predict a borrower’s inability Liquidation and restructuring are collective pro- to repay its debts before that inability arises. Sec- cesses. They are designed to address a situation in ond, credit reporting frameworks serve as a clas- which a debtor is no longer able to pay its creditors. sification system for borrowers’ inability to meet Both liquidation and restructuring provide a mech- their debt obligations. They are most relevant in anism for the equitable treatment of all creditors— the period after default, but before engaging the that is, they avoid a race to the bottom in which court. Third, out-of-court workout options can pre- individual creditors seek to enforce their own con- vent liquidation using varying degrees of court or tractual rights.a noncourt supervision. They can be instituted at any These processes vary across countries. They may time between failure to pay and liquidation, with be implemented by an insolvency practitioner, who some technical limitations on what can be negoti- is tasked with administering such formal insolvency ated once the court is involved. procedures. Depending on the jurisdiction, the Figure B3.1.1 depicts the key elements of the insolvency practitioner may operate under a license insolvency process in a timeline format. granted by their country’s insolvency authority. Figure B3.2.1 Figure B3.1.1 Insolvency process timeline PRE-COURT COURT Restructuring Plan implementation Discussions (including prepackaged) and emergence with creditors Restructuring fails and Borrower suppliers Sale of assets, Business Liquidation Liquidation unable proceeds to resumes sought ordered to repay creditors operations Workout fails Out-of-court workouts Plan implementation (contractual) and emergence Source: WDR 2022 team. a. IMF (1999). RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 125 and deterioration of the value of underlying assets. Long processes also delay the redeployment of capital tied up in nonviable firms to viable businesses and productive sectors. Nonviable zombie firms9 generate enough income to repay interest on outstanding debts but not enough to repay the outstanding debt balance. They drain productivity from the economy by absorbing resources that would produce better returns if they were used to finance healthier businesses.10 The rela- tionship between insolvency systems and zombie firms is supported by empirical findings that higher barriers to restructuring are associated with “zombie congestion” in high-turnover industries and with a lower ability to attract capital.11 Effective insolvency systems reduce such barriers. Restructuring and forcing the market exit of zombie firms have significant political economy dimen- sions. Most important are the jobs lost by the employees of restructured or liquidated companies. Com- plicating matters further, in the present crisis it is very difficult to distinguish between liquid and illiquid firms because even healthy firms have experienced a temporary collapse in liquidity.12 The COVID-19 emergency government measures aimed at preventing widespread business collapse have made this identification process even murkier. This difficulty was of little consequence in the short term because propping up both zombie firms and viable firms likely produced economic benefits in the form of continued employment for workers at zombie firms at a time when new job opportunities were severely limited. However, over the longer term government measures that inhibit the exit of zombie firms should be removed, while recognizing that these actions may create other challenges. For example, simplifying the liquidation or restructuring process for nonviable companies may produce rapid job losses in certain sectors, even as it creates higher returns for creditors and releases more value into the economy. At scale, however, delaying liquidation or restructuring of zombie firms because of fears of job losses may be counterproductive. Actual job losses may also be less than feared: empirical evidence suggests that zombie firms tend to use loans to build up cash reserves instead of contributing to economic activity through hiring or spending.13 The absence of effective insolvency frameworks especially hurts small businesses and individuals. With- out a working framework for restructuring debts, businesses experiencing a temporary inability to repay their loans are more likely to have to exit the market.14 Sole proprietors in countries that subject the propri- etors to personal bankruptcy regimes may face the threat of a lifetime of debt because of the unavailability of discharge (cancellation of debt).15 Small and medium enterprises (SMEs), particularly unincorporated enterprises where the line between individual and business is blurred,16 are inherently more vulnerable to insolvency because of their informality, low operating margins, and constrained access to credit (see spot- light 3.1 for a discussion of the microfinance institutions overcoming this constraint). SMEs are widespread in emerging economies, where the challenges of inadequate insolvency regimes are more pronounced.17 Countries that lack effective bankruptcy frameworks have limited options for dealing with high NPL levels other than blunt public intervention. Governments may be forced to turn to borrower bailouts (in which the cost is borne by the taxpayer, insulating creditors) or bail-ins (in which the cost is borne by the creditor, insulating debtors and the taxpayer).18 For some industries or in some circumstances, these approaches may be desirable,19 but they come with substantial risks. Studies of borrower bailouts suggest that the short-term benefits of debt relief come with long-term costs. In particular, future borrowers may be more likely to engage in a strategic default in the belief that they will not have to repay, and creditors may, in turn, respond by restricting access to credit. Although some studies have found that debt relief programs can have positive welfare effects and lead to positive outcomes in certain cases,20 research indicates that, overall, the risk of future strategic loan default rises, especially among previously “good” borrowers, and there are no improvements in real outcomes.21 A study of debt relief in India in the wake of the global financial crisis found a subsequent increase in strategic default and a decrease in new lending to the sectors that were bailed out.22 Another study of a mortgage modification program for delinquent borrowers in the United States revealed that 126 | WORLD DE VELOPMENT REPORT 2022 announcement of the program was followed immediately by a 10 percent relative increase in delinquen- cies, predominantly attributable to new delinquencies among borrowers otherwise deemed least likely to default.23 Other studies showed the same—that previously “good,” or nondistressed, borrowers were more likely to strategically default or take longer to repay their loans after a bailout.24 Risks emerge for the political economy of credit as well. In India, defaults were found to be sensitive to the electoral cycle, and the pattern was magnified after the bailout.25 Furthermore, borrowers who are angrier about the economic situation, who trust banks less, and who want to see more banking regulation are more likely to default strategically. Borrowers are more willing to default as knowledge of others defaulting and media coverage of the same become more widespread.26 Ad hoc bailouts, as opposed to those conducted systematically, put governments in the position of picking winners—a skill they usually lack. The problems are compounded for emerging economies because there is less budget flexibility for bailouts.27 The moral hazard risk may be exacerbated in juris- dictions in which declaring bankruptcy is not a viable alternative or even an option in the current legal framework.28 Bail-ins, by contrast, are likely to increase the risk of financial sector collapse and may result in reduced future lending.29 International best practice, empirical research, and lessons from previous high-profile financial crises point to four critical areas for legal reform of insolvency: (1) strengthen formal insolvency mecha- nisms; (2) facilitate alternative dispute resolution systems such as conciliation and mediation; (3) estab- lish accessible, inexpensive liquidation, in-court, and out-of-court procedures for micro-, small, and medium enterprises (MSMEs);30 and (4) promote debt forgiveness and discharge of natural person debt- ors. The remaining sections of this chapter address these four areas and elaborate on how to manage the expected increases in nonperforming loans in a way that enables an efficient and effective recovery. Strengthening formal insolvency mechanisms A strong formal insolvency law regime is critical to the successful functioning of an insolvency system with both formal and informal options. Strong formal regimes have default rules and boundaries within which creditors and debtors can mediate or otherwise negotiate debt outside, but “in the shadow” of, formal insolvency law.31 Participants in out-of-court processes know how their case would be treated in ­ the in-court system and behave accordingly. Furthermore, if out-of-court bargaining fails, participants have recourse to the formal system. A strong formal system thus creates the right incentives and defines the rights and behaviors needed to make both in-court and out-of-court workouts orderly, which, in turn, spurs innovation and economic growth, as articulated in the introduction to this chapter. Both debtors and creditors should have incentives to engage with the insolvency system and partic- ipate in good-faith negotiations. For creditors, the key incentives of a strong insolvency system include the possibility of negotiating an out-of-court debt restructuring plan that may yield a greater return than a forced liquidation. Effective insolvency systems also enable creditors to feel secure in their rights. Thus rather than resort to a unilateral approach, they are willing to coordinate with other creditors in the expectation that coordination will maximize returns. A strong insolvency regime creates incentives to negotiate a debt restructuring plan in good faith. Creditors may make concessions, and the plan may open a path to the continued operation and turn- around of the indebted business. In regimes in which management loses control of the business once the company enters administration, debtor companies may prefer to negotiate out of court to avoid losing control of their business. If the court system provides an avenue for creditor recourse, debtors are also less likely to misbehave by using out-of-court processes to stall or defer repayment. For these reasons, functioning insolvency laws underpin the reforms recommended in this chapter. No one-size-fits-all model will work in all jurisdictions and all circumstances. However, strong formal RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 127 insolvency systems exhibit the following characteristics: (1) predictable creditor priority rules; (2) timely resolution of insolvency proceedings; and (3) strong, accessible bankruptcy expertise among private practitioners and government officials. These three characteristics warrant particular attention because they are versatile—they can be implemented or improved within the multitude of extant frameworks worldwide—and there is empirical support to suggest they can improve the efficiency of insolvency regimes. These character- istics are generally achieved by writing formal legal requirements into legislation, combined with the ongoing efforts of adequately resourced institutions. For example, strict court deadlines written into an insolvency law to speed up the insolvency process may not work if there are not enough judges to hear cases within the specified time frame. These characteristics are an important part of the World Bank’s “Principles for Effective Insolvency and Creditor/Debtor Regimes” and will be especially important in navigating the post–COVID-19 recovery. Role of the judiciary in the insolvency process A country typically relies on its judicial system to play a critical role in the insolvency process because of the legal and procedural complexity of the issues and the need to balance the interests of debtors, cred- itors (including employees), and the public at large. Even in well-functioning judicial systems, the time between an application for liquidation and the final distribution of funds to creditors can take years, particularly for large companies with complex affairs. For example, in Australia insolvency proceed- ings launched in 1991 for one set of companies were finally resolved in 2020. The main trial was held between July 2003 and September 2006, consuming 404 days of court time. The 26,430-page judgment was drafted over two years.32 Clearly, then, insolvencies can place heavy demands on court resources and time. Improving the legal capacity to manage insolvency is therefore critical to economic recovery. A sudden rise in NPLs is likely to strain even the most sophisticated, well-resourced, and well-structured judiciary33 because insolvency court cases require technical specialization and expertise.34 Without reforms to simplify and scale the process, judiciaries are likely to experience a case backlog, resulting in further delays. Countries cannot afford the delay. Longer court cases can reduce the value of assets and the ultimate recovery rate for creditors. Systemically, low recovery rates for creditors reduce the availability of credit within an economy and raise its cost.35 Weak enforcement, or the perception of weak enforcement, that may arise from backlogs can lead to late payments. They, in turn, can create further insolvencies for businesses connected within supply chains.36 Characteristics of strong insolvency frameworks 1.  Predictable creditor priority rules Insolvency systems should provide clear, predictable rules of priority when there are competing claims for or interests in the same assets.37 Such rules facilitate an orderly process if a debtor is unable to repay its debts, and they increase the appeal of a jurisdiction where investors have greater certainty about what will happen if the debtor fails to repay. Clear priority rules also benefit other aspects of insolvency frame- works. In particular, for out-of-court resolution to work effectively in the shadow of the law, parties must know their rights and how their claims would be treated if they go to court. Jurisdictions differ widely in their priority rules, in the balance between debtor and creditor rights, and in the domestic policy choices and frameworks that underpin different approaches. For example, some jurisdictions treat employee entitlements as having no priority in the order of repayment, whereas 128 | WORLD DE VELOPMENT REPORT 2022 others give employees the highest priority. These matters are important policy and political choices for governments that may be influenced by other factors such as the existence of social safety nets for partic- ular groups. Some frameworks give secured creditors absolute priority, while others give creditors that provide an illiquid business with fresh financing higher priority than preexisting creditors.38 Notwithstanding these variations, predictability can play an important stabilizing role in credit mar- kets. A clear priority order that remains the same before and after the onset of insolvency proceed- ings increases predictability and fairness, which can, in turn, increase the availability and lower the cost of credit. On the other hand, the absence of clarity and predictability decreases the availability and increases the cost of credit because creditors factor the uncertainty into their decision-making or restrict their lending within a jurisdiction. If the law is not clear and predictable (such as on the relative position of creditors), parties may also exploit the court system. For example, creditors may unilaterally seek liquidation of a viable business, and debtors may seek to delay debt repayment or stall on relinquish- ing control of their business. In the 1994 Mexican tequila crisis, systemic financial sector weaknesses, including those in the bankruptcy law, prolonged and frustrated repeated government efforts to stabi- lize and reduce NPLs. Ultimately, from a high of 30–45 percent in 2002, NPL rates only began to decline meaningfully one year after comprehensive insolvency reforms were adopted. Around the same time, domestic credit began to rise again as a share of the gross domestic product (GDP) after having bottomed out at 12 percent in 2001 (see online annex 3A).39 2.  Timely resolution Reducing the amount of time needed to satisfy creditors after the filing for insolvency in court is a common target for reform because of the benefits of moving faster.40 Timely resolution of insolvency proceedings correlates strongly with higher returns to all creditors41 and allows the rapid redeployment of capital from unproductive to productive enterprises.42 In this way, timely resolution creates a positive feedback loop that motivates all actors to engage in out-of-court workouts, confident that, should the situation escalate, in-court options are available and efficient. One method commonly used by governments to resolve insolvency proceedings is the imposition of time limits for some stages in the process. Many jurisdictions temporarily extended these time limits in the context of COVID-19 either through legislation or through a more lenient approach in the courts. For example, Australia extended the response time to a bankruptcy notice from 21 days to six months.43 In Mauritius in November 2020, the Supreme Court granted the administrators of Air Mauritius a long extension (seven months) to hold a watershed meeting.44 Extensions like these should be phased out as the recovery continues to prevent the perpetuation of zombie firms and facilitate the reallocation of capital from nonviable to viable firms (see chapter 1). Divergent views among creditors are another source of delay. These can be managed with measures that (with a court order) allow restructuring agreements to proceed without the support of all credi- tors. In a “cramdown,” the majority of a creditor class binds the minority in that class. In a “cross-class cramdown,” a majority in a creditor class binds a minority in other creditor classes. The United States ­ has cramdown mechanisms in place,45 and they were recently introduced in the United Kingdom.46 Momentum is growing for their introduction in other jurisdictions as well47—in some cases unrelated to the COVID-19 pandemic. Institutional capacity reforms can also speed up the insolvency process by clearing backlogs and increasing efficiency within the courts. For example, in Indonesia a judicial reform program enacted in the aftermath of the Asian financial crisis helped to reduce the time needed to conclude SME insolvency from 72 months in 2004 to 13 months in 2012.48 Among other reforms, responsibility for administration of the courts was transferred from the executive to the judicial branch; a centralized unit was established RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 129 for judicial training and development; and commercial court judges with jurisdiction over insolvency cases received insolvency-specific training. Similarly, reforms to Chile’s insolvency law in 2014 included a requirement for insolvency law training for civil judges dealing with insolvency proceedings. As a result, the time to resolve insolvency dropped from 3.2 years in 2014 to 2 years in 2018. The improvements in various metrics in India also demonstrate the value of institutional reforms like these, which are espe- cially important to address the anticipated increase in judicial caseloads described earlier in this chap- ter. Ongoing research and experimentation by the World Bank’s Data and Evidence for Justice Reform (DE JURE) project have pointed to the potential for improving the efficiency of judicial decision-making through the use of data-based performance metrics (see online annex 3B).49 3.  Expertise in bankruptcy Expert practitioners, judges, and regulators are key to the success of well-designed insolvency legislation. Insolvency is a technical field at the intersection of law, finance, and policy. The availability of workable valuation estimates of a business and its property is fundamental for avoiding a sell-off, if reorganiza- tion is intended. For judges, insolvency presents complex legal and factual matrixes. Countries attempting to develop these sorts of capacities should strive to develop sustainable institutional capacity, including through ongoing training. Also critical are systems to oversee and regulate private bankruptcy profes­ sionals, particularly in a crisis, when the opportunities for bankruptcy fraud and abuse of power are greater.  With this in mind, many economies have embarked on reforms to bolster the capacity of their judicia- ries. Some have sought insolvency-specific reforms, while others have aimed to boost capacity generically (which will nonetheless have benefits in the insolvency space). In Brazil, the National Justice Council introduced standardized procedures for judicial reorganization proceedings during the COVID-19 pan- demic.50 Spain announced its intention to create 100 additional judicial units within three years.51 Simi- larly, many countries have pursued or are pursuing judicial capacity-building programs in collaboration with the World Bank Group. These training programs educate judges about insolvency law, as well as about practical aspects of their work such as case management and drafting judgments. Digitalization is also increasing. For example, Nigeria has announced measures to deploy digital facilities to enable taking evidence and alternative dispute-resolution filing.52 Beyond technical capacity, an effective insolvency regime requires stakeholder commitment. In the aftermath of the 1997 Asian financial crisis, the impact of insolvency reforms was limited by a “culture of non-payment” that, according to a report by the Organisation for Economic Co-operation and Devel- opment (OECD), prevailed in the affected countries.53 That culture emerged because borrowers rarely faced consequences when they failed to repay their loans. To prevent this type of situation, countries must embed specific rules in their broader legal, economic, political, and social contexts, and insol- vency judges and practitioners must have access to the training needed to abide by and enforce the rules correctly. The institutional framework for insolvency includes courts and enforcement agencies, collateral reg- istry and credit reporting systems, insolvency regulators, and insolvency practitioners. It requires judges able to interpret the law and manage caseloads. It also requires professionals (liquidators, administrators, receivers, conservators, and legal advisers) who have the technical ability to discharge their obligations to the court effectively.54 In many cases, these bankruptcy professionals play a critical role in an efficient bankruptcy system. In many countries, they can be a key determinant of the speed of a reorganization. The presence of professionals with skills in these areas will increase the efficacy of the reforms discussed in the balance of this chapter because they will provide the solid formal legal foundation needed to facil- itate out-of-court resolution of creditor-debtor disputes. Box 3.2 describes the comprehensive efforts in India to strengthen its institutional insolvency framework. 130 | WORLD DE VELOPMENT REPORT 2022 Box 3.2 Comprehensive and ongoing institutional insolvency reforms in India, 2016–20 In 2016, India overhauled its business and personal toward establishing insolvency expertise and spe- insolvency law framework, the Insolvency and Bank­ cialization within the judiciary and the insolvency ruptcy Code 2016 (IBC). It was then updated in 2018, profession and redressing the issues just described. 2019, 2020, and 2021.a The consolidated national The IBC established the Insolvency and Bankruptcy law is designed to address the fragmentation of the Board of India (IBBI) to administer the law as well previous regime, which made it difficult for firms and as to accredit and supervise insolvency profes- individuals to understand their rights. Prior to the sionals. The National Company Law Tribunal was overhaul, there were different rules for the rescue designated the sole court with jurisdiction over or rehabilitation of industrial companies and other first-instance corporate insolvency proceedings.h businesses,b different recovery powers for financial Meanwhile, the number of registered insolvency institutions and other creditors,c and different rules professionals steadily expanded, from 1,812 at the for personal insolvency that varied by region.d As a end of 2018 to 3,309 at the end of 2020.i result of this patchwork of arrangements, many dif- Early evidence suggests that the reforms have ferent court jurisdictions heard insolvency proceed- had numerous positive effects. The overall recov- ings. And the time needed to conclude insolvency ery rate for creditors increased from $.27 on the was, on average, 4.3 years,e which allowed debtors dollar before reforms to $.72 on the dollar in 2020, to avoid repaying or restructuring debts for long and the time needed to settle insolvency more than periods without consequences.f halved in that period, from 4.3 years to 1.6 years. In addition to the changes in the legal frame- Case backlog remains an issue (figure B3.2.1) and is work,g the 2016 reforms took significant steps the subject of an ongoing reform effort.j Figure B3.2.1 Figure B3.2.1 Insolvency backlog in India, 2018–20 2,000 1,800 1,600 Number of cases 1,400 1,200 1,000 800 600 400 200 0 Sept. Dec. March June Sept. Dec. March June Sept. Dec. 2018 2018 2019 2019 2019 2019 2020 2020 2020 2020 Ongoing CIRPs (180 days or longer) Ongoing liquidations (one year or longer) Source: Insolvency and Bankruptcy Board of India, Quarterly Newsletter, various, https://www.ibbi.gov.in/publication ?title=quarterly&date=. Note: Corporate Insolvency Resolution Process (CIRP) arrangements are meant to be finalized within 180 days. (Box continues next page) RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 131 Box 3.2 Comprehensive and ongoing institutional insolvency reforms in India, 2016–20 (continued) In response to COVID-19, India temporarily ₹ 1 crore (10 million rupees) from Rs 1 lakh (to about amended the business and personal insolvency law. $130,000 from about $1,300).l In April 2021, the gov- Most significantly, it suspended creditors’ ability ernment permanently amended the IBC to include to initiate insolvency proceedings on the basis of a framework for insolvency for MSMEs, which may defaults arising between March 25, 2020, and March help prevent a further backlog and delays by easing 24, 2021.k It also raised the minimum default require- the demand for the Corporate Insolvency Resolu- ment for the purposes of corporate insolvency to tion Process (CIRP), a restructuring framework.m a. Insolvency and Bankruptcy Code (Amendment) Ordinance(s), 2018, 2019, 2020, and 2021. b. The Sick Industrial Companies (Special Provisions) Act (SICA) 1985 governed industrial companies. c. Recovery of Debt Due to Banks and Financial Institutions Act (RDDBFI) 1993. d. The two laws were the Presidency Towns Insolvency Act 1909 and the Provincial Insolvency Act 1920. e. World Bank (2014a). f. BLRC (2015). g. For further analysis of these changes, see World Bank (2020, 54). h. And for appeals, the National Company Law Appellate Tribunal and subsequently the Supreme Court of India. i. IBBI (2020). j. Shikha and Shahi (2021). k. Insolvency and Bankruptcy Code (Amendment) Ordinance, 2021. l. PIB (2020). m. Amendments are carried out through the Insolvency and Bankruptcy Code (Amendment) Ordinance, 2021. See PIB (2021). Early warning tools Systems for detecting and responding to potential insolvencies before they arise are important to strengthen insolvency frameworks. The earlier a debtor perceives financial difficulties, the higher is the probability of avoiding insolvency.55 Similarly, if the viability of a business is permanently impaired, the liquidation process will be more orderly and efficient the earlier it begins. For these reasons, policy mak- ers are increasingly aware of the importance of alerting businesses to upcoming troubles, especially in the European Union after the introduction of the Restructuring Directive in 2019.56 An early warning tool (EWT) is a means of helping businesses detect financial difficulties so they can be addressed proactively. Within this broad definition, EWTs may take many different forms, ranging from purely internal control systems involving corporate bodies to external control systems that rely on the intervention of third-party experts. The French alert procedure,57 which relies on the workers’ council and corporate auditors to alert the debtor’s managers of upcoming difficulties, is a well-known example of an internal control system. Of external systems, the Danish approach is among the most developed, leveraging an algorithm run by the Danish Business Authority that detects companies potentially at risk. At-risk companies are then referred to a network of restructuring consultants who advise the debtor. Until recently, EWTs were typically designed to alert creditors and public authorities about the upcoming distress of corporate and special debtors. However, EWTs now focus on debtors to enable them to take early action. Although this tool is aimed at serving all debtors that engage in economic 132 | WORLD DE VELOPMENT REPORT 2022 activities, EWTs are likely to be particularly useful for SMEs because those facing financial difficulties often do not have the resources they need to cope with high restructuring costs, such as advisers who can prevent or mitigate the effects of insolvency. Strong insolvency frameworks in the context of COVID-19 recovery In addition to the financial measures adopted to staunch the worst of the damage from the COVID-19 economic crisis, many governments undertook temporary legal changes in their insolvency frameworks. According to a joint World Bank/INSOL International survey spanning both advanced and emerging economies, 67 of the 69 surveyed economies enacted some insolvency reforms in 2020.58 The purpose of the reforms was to “flatten the curve” of insolvencies by creating breathing room for businesses, individ- uals, and financial institutions and preventing widespread economic collapse. The most common reforms were relaxing debt repayment requirements (80 percent); placing mor- atoria on the initiation of insolvency proceedings by creditors (43 percent); and altering or tempo- rarily suspending the obligations of directors and firm managers to enter insolvency proceedings in circumstances in which they ordinarily would be required to do so (30 percent). Relaxed debt repay- ment requirements included measures addressing borrowers’ diminished ability to make payments, such as moratoria on or extensions of loan repayment terms (about 34 percent); measures addressing the effects of nonpayment, such as prohibiting the acceleration of contractual terms (about 55 percent); suspension of judicial proceedings (about 28 percent); and suspension of the execution of certain debtor-owned assets (about 4 percent). In 2021, the World Bank designed a survey to identify the characteristics of corporate debt restructur- ing frameworks, as well as the types of insolvency-related COVID-19 emergency measures that jurisdic- tions had introduced.59 The World Bank team worked with INSOL International and the International Association of Insolvency Regulators to distribute the survey.60 Experienced insolvency professionals in 135 economies were contacted, and at least three independent contributors were contacted in 100 jurisdictions. Responses were forthcoming from 114 economies, including multiple responses from 71 percent of those economies. The survey found that OECD economies introduced measures to stymie debtor (57 percent) or creditor (54 percent) bankruptcy filings more frequently than non-OECD econ- omies (24 percent and 17 percent, respectively). By contrast, debt repayment emergency measures (that is, those contract modification measures addressing either the prospects of repayment or the effects of nonpayment) as well as suspension of judicial procedures were more evenly distributed.61 This finding is consistent with the fact that advanced economies tend to have more robust insolvency systems and insolvency usage. Most of the insolvency-related emergency measures introduced after the onset of the pandemic included sunset clauses determining the timing for winding them down. Although many of these measures were extended (and they may be further extended or even reintroduced), a clear picture has emerged of their duration. Debt repayment measures, preventing the crystallization of insolvency, were estimated to have the longest duration—on average, 451 days or about 15 months.62 Three-quarters of economies wound down debt repayment measures within 600 days, though in one country a measure was set to last 1,035 days. Suspension of judicial procedures measures was much shorter-lived—on average, 273 days. Three-quarters of the economies studied halted these measures in just over 400 days. As for measures to increase barriers to creditor-initiated insolvency filings, they lasted 384 days, on average, with three-quarters of the economies winding down these measures within 550 days. Finally, measures to avoid forcing debtors to file for bankruptcy lasted, on average, 324 days, with three- quarters of the economies drawing these measures to a close in just under 500 days. All in all, only a RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 133 Figure 3.1 Share of enterprises in arrears or expecting to fall into arrears within six months, selected countries, May–September 2020 100 90 Share of enterprises (%) 80 70 60 50 40 30 20 10 0 gh ad l is h M Ken n g a Sr ab ia i L on ne a N al H Su er s s Gu ovo Pa Ind a ki ia ar va Vi Togn yz nz ria El om blic N old an Jo gua ba ia Ca oro ala bo o jik gia ia In Pol ria ra ia a d n et o N am R pu a lv ia Zi rm or Gu Tu bia Uz Alb dia k ia Ta eor n Fe n d Ch n ad m e M m y lg n Af ngl epa at rke Ko ura Za bw on y Ba Nfric Se ank e i an es ta a on da G ista tio Bu ista n do an m cc G ol g Sa an m en be an de es Re an ig A ad ic o in M st rd rg Ta ige a n a A e h ut So Ky ss Ru Source: Apedo-Amah et al. 2020, based on World Bank, COVID-19 Business Pulse Survey Dashboard, 2020–21 data, https://www.worldbank.org/en/data/interactive/2021/01/19/covid-19-business-pulse-survey-dashboard. Note: The figure presents percentages for countries surveyed by the World Bank. few of the insolvency-related emergency measures introduced in the context of COVID-19 were expected to remain in place at the end of 2021. As governments ease short-term support measures, experts expect to see an increase in COVID-19– related business and personal insolvencies stemming in no small part from widespread business distress (see figure 3.1). The International Monetary Fund (IMF), the Bank for International Settlements, and others predicted that beginning in 2020 business insolvencies would exceed pre–COVID-19 levels by 20–35 percent.63 Facilitating alternative dispute resolution systems such as conciliation and mediation Alternative dispute resolution (ADR) systems will be an essential mechanism for economies seeking to emerge stronger after the COVID-19 pandemic. Effective ADR frameworks allow quicker and cheaper resolution of disputes than the formal court system, while retaining some of the rigor that courts pro- vide.64 ADR in the insolvency context involves direct engagement between debtor and creditors to come to a resolution about an outstanding debt. ADR is typically, but not necessarily, overseen by a third party, and any resolution is contractually binding. ADR can be initiated voluntarily by the parties or at the order of a court. Third-party mediators ideally facilitate, as opposed to actively participate in, the reso- lution of intercreditor differences.65 One of several structural obstacles to effective ADR deployment in the insolvency context is the chal- lenge of convincing multiple parties with varied interests to agree on a resolution that is consistent with the obligations of the parties under the broader insolvency law. Before the pandemic, many countries 134 | WORLD DE VELOPMENT REPORT 2022 had already introduced or were in the process of introducing schemes that sought to facilitate ADR sys- tems that addressed these challenges (see online annex 3C). Ideally, this trend will continue in the near to medium term—a possibility that underlies the guidance offered in this section. Aristotle would likely have found ADR preferable to in-court proceedings because “an arbitrator goes by the equity of a case, a judge by the strict law.”66 There is growing evidence that ADR can be cheaper, quicker, and more satisfactory than court proceedings.67 In the insolvency context, out-of-court resolu- tion of debt disputes has the added advantage of occurring confidentially, which allows participants to avoid harm from public knowledge of debt distress, including constraints on capital and supply chains.68 Although the data on the efficacy of ADR in the context of insolvency are limited, a 2012 pilot program in the District Court of Amsterdam found that over 70 percent of cases resulted in successful solutions at greater speed and less cost when measured against the alternative—litigation.69 An oft-cited example of a jurisdiction with a successful insolvency ADR regime is the United Kingdom. The “London approach,” a nonlegislative set of cultural norms and principles fostered by the Reserve Bank,70 guides the manner in which creditors voluntarily and collectively approach debtor distress. It does not require a third-party mediator or a conciliator. The London approach has four key tenets: (1) creditors keep existing facilities in place and do not rush to appoint receivers; (2) reliable financial information about the debtor exists and is shared among creditors; (3) creditors work collectively to resolve the issue; and (4) the burden of debtor concessions is shared equally among creditors.71 Because of its informal, confidential nature, limited empirical evidence is available on the merits of the London approach. It requires significant creditor buy-in and cohesion. However, these may be lacking in jurisdictions without the requisite trust in debtors or the underlying system to enforce legal rights. For example, creditors from multiple jurisdictions may be unable or unwilling to attempt a coher- ent approach to the problem. Or they may be willing to make concessions only if other creditors make equivalent concessions. Thus creditors unwilling to make concessions can frustrate the process.72 The challenge of creditor cohesion has been addressed in some jurisdictions by mechanisms that allow, in certain circumstances, for the courts to approve (and bind creditors to) restructuring plans negotiated outside of court. The French conciliation approach consists of a two-part model toward this end. In the informal method (mandat ad hoc), the court appoints a representative to medi- ate a nonbinding resolution of the debt distress. In the semiformal method (conciliation), the court approves and makes binding the output of mediation.73 In practice, debtors tend to begin within the mandat ad hoc framework and then proceed to conciliation to obtain court approval of the restructur- ing agreement.74 Several advanced economies have included variations on this model (court endorsement of out-of- court negotiations) in their COVID-19 reforms. Germany has introduced a new conciliation scheme (Stabilization and Restructuring Framework) in which the debtor can apply for a court-appointed medi- ator (“restructuring facilitator”) to assist in negotiations with creditors for up to three months. After suc- cessful mediation, the court can confirm the agreement, which protects the participants from avoidance or liability claims.75 The Netherlands has introduced reforms that enable debtors to offer their creditors restructuring plans outside of the formal bankruptcy procedure. If approved by a court, these plans can bind unwilling creditors (including secured creditors) to a restructuring arrangement in a cross-class cramdown.76 Another way of managing the problem of creditor cohesion is use of an intercreditor agreement—a contract among creditors—that sets the general rules for approaching restructuring, while allowing flexibility for individual restructuring. A recent example of this approach is Turkey’s updated Framework Agreements on Financial Restructuring. Such an approach, which is in effect a co-regulatory model RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 135 subject to the oversight of the regulator with a more limited role for the courts, may be attractive in jurisdictions with fewer court systems. Poland’s experience demonstrates how the adoption of out-of-court restructuring can quickly take the heat out of widespread and rising NPL levels and lay the foundation for future economic health by putting banks on a firmer footing to extend new credit. As part of a larger effort in the early 1990s to establish a market-based economy, Poland adopted the Act on Financial Restructuring of Enterprises and Banks.77 In effect until 1996, this legal framework for insolvency was intended to supplement formal bankruptcy and liquidation proceedings when the state-owned national bank was split into nine commercial banks—a step that revealed high levels of nonperforming loans in the banks’ portfolios.78 The act empowered financial institutions to design and implement a process for restructuring enterprises through which they brokered conciliation agreements with debtors and divested NPLs on the secondary market.79 The banks received an influx of capital to facilitate the restructuring process.80 By mid-1995, about 85 percent of the conciliation agreements had been finalized.81 Common fea- tures of the agreements included debt write-offs or extensions of the payment period, more favorable terms for small creditors, and debt-for-equity swaps (in about one-third of cases). Less than 1 per- cent of borrowers were required to make immediate partial payments. Meanwhile, the more viable firms (23 percent) went into conciliation, while the financially weaker firms went into liquidation or court bankruptcy. The firms that entered bank conciliation accounted for 46 percent of the debt owed at the end of 1991, reflecting the unequal distribution of debt within the economy. Overall, thanks to the Polish concilia- tion scheme the NPL rates of bank portfolios fell rapidly, from 31 percent in 1993 to 9 percent in 1996.82 Loans were written down or swapped without widespread debt forgiveness,83 leaving banks in a better position to extend new loans on market-oriented terms. Despite these improvements, the increase in conciliation and restructuring alone failed to address the underlying problems of firm mismanagement and unprofitability. Restructuring plans did not require changes in management or operational restructuring, and less than half of firms committed to asset sales or reduction of staff. As a result, during the first two years of implementation businesses subject to conciliation saw their average operating profit decline, and few were privatized. Because MSMEs were excluded from the conciliation scheme (the threshold debt level was high, and the cost was substantial), they struggled to access credit over the course of the recovery.84 Thus, although the adoption of legal frameworks to facilitate ADR can contribute significantly to the swift resolution of NPLs, regulators should push for workout agreements to include commitments that put businesses on a path to viability, lest they merely prolong or defer the underlying economic challenges. Establishing accessible and inexpensive in-court and out-of-court debt resolution procedures for MSMEs MSMEs play a critical role in economic growth and employment, particularly in emerging economies, but they have been the enterprises hardest-hit by the COVID-19 pandemic. They are more vulnerable than large enterprises to debt distress and less equipped to seek recourse in either the debt market or the legal system. It is therefore not surprising that they have shorter survival times (figure 3.2).85 Post– COVID-19 insolvency reforms should therefore address the specific needs of MSMEs to facilitate the recapitalization of viable but illiquid firms and the swift but least painful market exit of nonviable firms. This is particularly important in emerging economies, where MSMEs represent a large proportion of total firms.86 136 | WORLD DE VELOPMENT REPORT 2022 Figure 3.2 Enterprise ability to survive a drop in sales, selected countries 24 22 20 18 Share of enterprises (%) 16 14 12 10 8 6 4 2 0 a ia a n ala r ia ia ce on e lia us Ro l ta Ge ly g ia c a H o e n ia as ep y n ia lic n ia n ia P o tia l b ia co a ad d r ga do ar bw b li ov t vi ali gu ti o la n I ta an on ub go ur ee pr Ch oc oa a lga em ua ba to or m r tu ng l va old m pu La ra M ra ba ov m Po ed nd Cy Gr or Za Cr Es th Al So Bu Hu ca de Re at Sa Sl m M ac M hR M L ii Gu Ni Fe Zi ak El M ec ia n ov r th Cz Sl ss No Ru Large (100+ employees) Small (5–19 employees) Source: World Bank, COVID-19 Business Pulse Survey Dashboard, 2020–21 data, https://www.worldbank.org/en/data /interactive/2021/01/19/covid-19-business-pulse-survey-dashboard. Why MSME procedures matter The World Bank’s Business Pulse Survey, conducted on a rolling basis of enterprises in 50 countries, has revealed the outsize impact of the COVID-19 pandemic on MSMEs, especially microenterprises. From June to September 2020, of the firms reporting they were in arrears or expecting to be in arrears within six months, 48 percent were MSMEs (including 53 percent of microenterprises within that group), compared with only 36 percent of large enterprises (figure 3.3). Furthermore, 83 percent of MSMEs ­ (including 84 percent of microenterprises within that group) reported lower monthly sales than in the previous year, compared with 73 percent of large enterprises (figure 3.4). Most insolvency frameworks subject MSMEs and large companies to the same rules and processes.87 Complexity, length, and cost are obstacles to the use of these frameworks by MSMEs.88 In the circum- stances, insolvency can be “a luxury that many MSMEs cannot afford.”89 This is a critical factor in why small enterprises are more likely than large enterprises to become zombie firms. Financially distressed small businesses with limited or no prospects for future rehabilitation continue to operate because the obstacles to liquidation are too high. Targeted insolvency frameworks could help them, while also facil- itating access to credit for viable MSMEs.90 RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 137 Figure 3.3 Share of enterprises in arrears or Figure 3.4 Share of enterprises with lower Figure 3.3 Figure 3.4 expecting to be in arrears within six months, monthly sales than in the previous year, June–September 2020 June–September 2020 90 90 80 80 Share of enterprises (%) Share of enterprises (%) 70 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 Micro MSMEs Large Overall Micro MSMEs Large Overall Source: World Bank, COVID-19 Business Pulse Survey Source: World Bank, COVID-19 Business Pulse Survey Dashboard, https://www.worldbank.org/en/data/interactive Dashboard, https://www.worldbank.org/en/data/interactive /2021/01/19/covid-19-business-pulse-survey-dashboard. /2021/01/19/covid-19-business-pulse-survey-dashboard. Note: MSMEs = micro-, small, and medium enterprises. Note: MSMEs = micro-, small, and medium enterprises. Lessons learned from MSME insolvency reform during the Asian financial crisis In the late 1990s and early 2000s, firms in Southeast Asia experienced widespread debt distress. In fact, NPL rates exceeded 40 percent in some jurisdictions (see figure 3.5). MSMEs were unable to obtain credit or were subjected to high interest rates. In Indonesia, the number of MSMEs fell by about 7 percent between Figure 3.5 1997 and 1998 and did not return to their former level until 2000.91 In Thailand, in 1998 a greater pro- portion of MSMEs (55 percent) than large enterprises (45 percent) experienced a reduction in employees.92 Figure 3.5 Nonperforming loans, selected Asian countries, 1998–2005 50 NPLs as share of total loans (%) 45 40 35 30 25 20 15 10 5 0 1998 1999 2000 2001 2002 2003 2004 2005 Indonesia Thailand Malaysia Korea, Rep. Source: Lee and Rosenkranz 2019. Note: NPLs = nonperforming loans. 138 | WORLD DE VELOPMENT REPORT 2022 In response, countries adopted various reform measures (see online annex 3D). Of countries in ­ outheast Asia, Thailand’s reforms resulted in the most rapid reduction in NPL rates, but there was a long S tail: rates remained above 10 percent until 2005, and only 48 percent of NPLs in Thailand were resolved by mid-2003. By contrast, 77 percent of the debt referred to Malaysia’s Corporate Debt Restructuring Committee was resolved by that time. In the Republic of Korea, by mid-2003 restructuring agreements were reached for about 80 percent of registered cases representing about 95 percent of total (corporate) debt. Thailand did the least to address restructuring, and it did not enforce any changes in management. Its approach can be attributed to deficiencies in the formal insolvency framework and the lack of politi- cal will to force change in large companies.93 Echoing the experience in Poland, in Thailand the absence of substantive restructuring of large companies likely delayed resolution. Reforms to facilitate MSME insolvency proceedings As noted earlier, in 2017 the World Bank published a comprehensive review of MSMEs and insolvency frameworks, setting out the characteristics and requirements.94 The 2021 “Principles for Effective Insol- vency and Creditor/Debtor Regimes” and an updated version of the UNCITRAL “Legislative Guide on Insolvency Law” (see online annex 3E) together provide a series of principles and recommendations on insolvency frameworks aimed at assisting MSMEs with insolvency. Drawing on those sources, table 3.1 sets out some priority areas of reform in the context of COVID-19 recovery. It is important to note that the World Bank’s “Principles” and UNCITRAL’s “Guide” include significant flexibility in how a MSME insolvency framework can be achieved. Even before the onset of the pandemic, some jurisdictions implemented reforms tailored to MSMEs. For example, in February 2020 Myanmar implemented a MSME-specific insolvency regime that included a business rescue framework under a debtor-in-possession model. In the United States, the 2019 Small Business Reorganization Act introduced a distinct insolvency framework for small enterprises. Mean- while, the Lao People’s Democratic Republic’s December 2019 Enterprise Rehabilitation and Bankruptcy Law contains provisions for small enterprises.95 The COVID-19 crisis spurred other jurisdictions to follow suit with temporary reforms. For exam- ple, Colombia introduced a temporary fast-track restructuring framework administered by the Chamber of Commerce for MSMEs.96 Similarly, in December 2020 Singapore introduced a temporary Simplified Insolvency Program that lowers the proportion of creditors required to approve an MSME insolvency plan,97 which expired on July 28, 2021.98 The United States temporarily raised the debt threshold for busi- ness restructuring (thereby increasing the accessibility of more heavily indebted businesses to restructur- ing) and implemented other temporary insolvency reforms. These changes were initially set to expire in 2021, but were extended to 2022.99 Addressing obstacles to creditor recovery, New Zealand introduced the COVID-19 Response Legislation Act 2020, which put in place a business debt hibernation scheme,100 and Spain extended the duty of administrators to request the declaration of bankruptcy, while also increasing the standard of the liquidity test.101 Other jurisdictions have implemented longer-term reforms in response to COVID-19. These reforms are aimed at simplifying and demystifying the bankruptcy process for small businesses. In terms of simplification, legislation pending in Chile will streamline liquidation and reorganization proceedings for small businesses.102 And in January 2021, the United Kingdom introduced a simplified process for restructuring and liquidating small businesses. As for demystification, in 2021 Australia introduced per- manent reforms that create a role for a “small business restructuring practitioner” to advise and guide MSME debtors through the various stages of restructuring: development of the plan, approval by credi- tors, and implementation.103 Also in 2021, Greece implemented a simplified electronic scheme for small RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 139 Table 3.1 Principles for adapting insolvency frameworks for MSMEs Principle Rationale Lower or remove Inadequate record keeping can mean MSMEs, especially microenterprises, are documentation unable to provide the required pre-filing documentation such as audited historic requirements financial records.a Keep the debtor in Although it can increase the risk that debtors dispose of assets in a manner control of the business adverse to the creditor’s interests, a debtor-in-control model makes more sense in the context of MSMEs because the owner/manager is more likely to be indispensable to the continued operation of the business. Australia, India, and the Republic of Korea are examples of jurisdictions in which MSME debtors maintain control of their business.b Ensure supervision by an An experienced, knowledgeable practitioner could ascertain business viability insolvency/restructuring faster and more affordably than a court. practitioner Simplify plan approval Measures like this are appropriate in the context of COVID-19 recovery, although mechanisms and policy makers should be aware of the trade-offs involved in facilitating restructuring subsidize the costs of approval at the expense of minority creditor rights. Alternative measures such engaging facilitators/ as reducing the formalities involved in obtaining court approval (also part of the insolvency practitioners Singapore reforms described earlier) may be a more neutral way of simplifying restructuring plans. Simplify procedures Some jurisdictions implemented temporary fast-track liquidation schemes that for the liquidation of removed procedural steps and evidentiary burdens and operated on a faster businesses timetable.c Many of these temporary measures have since expired, revealing the need for more permanent reforms specific to small businesses, such as the removal of procedural steps, shortening time frames, and easing evidentiary burdens. Provide access to fresh Debt-to-equity financing allows MSMEs to continue operating without incurring financing (including more debt. It also gives creditors greater visibility into business operations.d debt-to-equity financing) Increased visibility may help reduce the extent to which creditors, lacking positive information, seek to liquidate viable businesses.e International best practice is for fresh financers to be given priority over the existing unsecured creditors, but not over secured creditorsf because regimes that protect the absolute priority of claims increase the confidence of secured creditors.g Ensure minimal or no Using scarce resources on court proceedings for MSMEs is inefficient. Providing use of the courts ways to resolve insolvency outside court can have a large impact on managing large volumes of insolvent firms. Sources: United Nations Commission on International Trade Law (UNCITRAL), UNCITRAL Legislative Guide on Insolvency Law (dashboard), https://uncitral.un.org/en/texts/insolvency/legislativeguides/insolvency_law; World Bank 2021c. Note: MSMEs = micro-, small, and medium enterprises. a. World Bank (2017). b. For Australia, see, for example, Corporations Amendment (Corporate Insolvency Reforms) Act 2020 (Cth); Frydenberg (2020). For India, see, for example, Sen (2020). A case study on this aspect of Korea’s insolvency law appears in World Bank (2017). In India, the Pre-Packaged Insolvency Resolution Process for MSMEs, which keeps the debtors in possession, is an option only for the creditors. The main Corporate Insolvency Resolution Process, with creditor in possession, remains an alternative. c. For example, in September 2020 the Australian government introduced a temporary new liquidation framework designed to allow insolvent MSMEs to exit the market quickly and cheaply. d. Empirical evidence suggests that, for creditors lending to small enterprises, lack of information contributes to a greater likelihood they will seek liquidation, or it may raise credit costs. See Cook, Pandit, and Milman (2001). e. Information asymmetry about MSMEs (that is, when creditors do not know as much as debtors about the debtors’ operations) can affect the decision-making of creditors. See ICCR (2014). f. Adalet McGowan and Andrews (2016). g. Armour et al. (2015); Djankov (2009). 140 | WORLD DE VELOPMENT REPORT 2022 business insolvency that places a degree of responsibility with a trustee, reducing the burden on the courts. Another category of reform is India’s Insolvency and Bankruptcy Code (Amendment) Ordinance, 2021, which introduces a prepackaged insolvency resolution process for MSMEs. Promoting debt forgiveness and discharge of natural person debtors This section addresses the bankruptcy of natural person debtors—that is, individual entrepreneurs or just individual debtors. Because the pandemic has devastated many people’s livelihoods through no fault of their own, debt forgiveness and discharge, as well as reputational protections, are critical tools in the COVID-19 recovery. The law and the courts should aim to quickly resolve no-income, no-asset cases and provide a discharge and fresh start for all natural person debtors. Despite the potential benefits of personal bankruptcy frameworks, a significant proportion of emerg- ing economies have none. In 2011, a World Bank survey of 25 advanced and 33 emerging economies found that 48 percent of emerging economies lacked a legal framework for the discharge or cancellation of an insolvent individual’s debt, compared with 12 percent of advanced economies. Of the emerging economies, 51 percent lacked a legal framework for the restructuring of individual debt obligations, compared with 20 percent of advanced economies.104 Personal bankruptcy frameworks can benefit individual debtors both in their capacity as consum- ers and producers and in their ownership of unincorporated businesses because there is no legal sepa- ration between owners and their businesses. Personal bankruptcy laws, and particularly a pathway to discharge, are important for MSMEs, which are often financed at least in part by debt that has been per- sonally guaranteed by the entrepreneur.105 Comparable global data are limited on the share of personal bankruptcies resulting from business debt, partly because of the different ways in which business debt and nonbusiness debt are classified. However, statistics published by the Australian personal insolvency regulator suggest that between July 2019 and October 2021 about one in four personal bankruptcies was of a sole trader, partner in a partnership, or company officer.106 Personal bankruptcy laws provide an orderly framework for repaying or discharging the debts of individual debtors. This framework is especially helpful in periods of high levels of personal insolvency because the lack of a credible alternative to recover a debt often drives creditors to pursue piecemeal approaches. Those approaches can result in the unnecessary destruction of value stemming from court filing fees, enforcement costs, and the lost opportunity costs of a negotiated pathway to solvency and repayment.107 Piecemeal approaches also clog the courts and impose avoidable hardships on debtors, including the loss of domicile and the stigma of ongoing debt collection. Reforms of personal bankruptcy frameworks in response to COVID-19 have been minimal. One reform includes a framework for bankruptcy for natural persons in China’s Shenzhen Special Economic Zone. The first of its kind in China, the framework provides for a three-year probationary period during which the bankrupt person’s spending is subject to supervision before debts are discharged.108 Tempo- rary reforms enacted in Australia increase the threshold for the value of debts outstanding required to commence bankruptcy proceedings and facilitate the use of personal insolvency agreements for debt resolution.109 In addition to personal insolvency reforms, many countries have reformed their legal frameworks for dealing with the insolvency of MSMEs. To the extent that these reforms also apply to the owners of unincorporated businesses and address their personal liability for business debt, they fall into the category of personal insolvency reforms because they provide a pathway out of overindebtedness for individuals, including through discharge.110 RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 141 A principal purpose of a personal insolvency regime is to rehabilitate insolvent debtors and restore their economic capacity.111 In circumstances in which there is no prospect of repayment (or the societal cost of enforcing repayment outweighs the value of the repayment), there is no benefit to enforcement for creditors. However, the extent to which policy makers can and will allow debt forgiveness is a politi- cal decision and will depend on the context. Excessive filing costs can deter debtors from filing for personal insolvency.112 These obstacles should be removed for low-income and asset debtors. Examples of jurisdictions with frameworks to alleviate filing costs for low-income and asset debtors are Ireland, New Zealand, Scotland, and the United Kingdom (and Wales).113 Regimes can target these procedures at those who are genuinely unable to meet their obliga- tions. Digitalization also holds some promise as a means of lowering costs and increasing accessibility. In October 2020, Australia introduced a digital bankruptcy application process for personal bankruptcy.114 Another avenue for the protection of individual debtors is credit reporting frameworks. Many juris- dictions responded to the COVID-19 crisis by temporarily altering credit reporting frameworks to limit the long-term reputational harm to debtors temporarily unable to meet their debt obligations as a result of the pandemic. Crises tend to lower the credit scores of affected borrowers. A study of the impact of natural disasters on the financial health of US residents in affected regions found that credit scores declined by as much as 22 points.115 Forbearance programs to temporarily pause or reduce installments for a limited time were used in the COVID-19 pandemic by 57 percent of the 65 countries surveyed by the International Committee on Credit Reporting.116 During the forbearance period—often three or six months and in some places up to a year—accounts were “frozen/paused” so that clients were reported as current even if payments were reduced or suspended. To reflect the forbearance programs, credit reporting bureaus implemented or used existing special reporting codes to flag the type of facilities affected by COVID-19. In the United States, the CARES Act provided for 180 days of forbearance for federally backed loans, and credit providers were encouraged to consider their own programs for similar modification.117 The main credit reporting agencies adjusted their algorithms to ensure that accounts affected by the COVID-19 pandemic were not negatively impacted. Kenya, Malaysia, and Greece took a more direct approach by barring the submission of negative credit data for a period of six months, nine months, and the pandemic period, respectively. During the prescribed period, credit bureaus did not include delin- quency data on the credit report and scores. Four countries—Denmark, the Netherlands, Norway, and Tanzania—did not implement any specific measures to protect borrowers, which was largely consistent with the health policy positions of these countries during the pandemic. In the absence of any relief, delinquencies affected the borrowers’ credit report and score in the ordinary manner. Policies suspending adverse reporting on borrowers during a grace period should be phased out with an eye toward maintaining the integrity of the credit reporting system. In the absence of complete infor- mation, credit providers lack a full view of borrowers, and they may adopt a cautious lending approach that is counterproductive to the recovery. Suppression of data also introduces operational challenges. In the absence of data, TransUnion estimates that when full file information reporting resumed in Kenya, 12 percent of borrowers shifted to a high-risk score, reflecting increasing delinquencies.118 In addition, banks’ requests for credit bureau reports declined from 3.1 million a month in March 2020 to a low of 1.6 million in June 2020, but recovered to 3.6 million in December 2020.119 Conclusion Debt is critical to prosperity and progress, but the complexity of the problems that arise when debtors cannot meet their obligations requires sophisticated legal and institutional frameworks. This is true 142 | WORLD DE VELOPMENT REPORT 2022 in ordinary times, but the challenges are amplified when many debtors cannot meet their obligations within a short stretch of time. Inaction or mismanagement in such circumstances can lead to substantial economic harm. The reforms advocated in this chapter are directed at strengthening courts so they can continue to function in a period of high nonperforming loans, capture the value of debt for economic recovery in the form of new investment, and provide individual debtors with a degree of protection. Notes 1. In the aftermath of the 2007–09 global financial crisis, 17. World Bank (2017). the Financial Stability Board created in 2011 the Insol- 18. van Zwieten, Eidenmüller, and Sussman (2020). vency and Creditor Rights Standard (ICR Standard) and 19. Casey (2021). designated it as one of its key standards for sound fi - 20. Agarwal et al. (2017); Bolton and Rosenthal (2002); nancial systems (FSB 2011). The unified global stan - Mukherjee, Subramanian, and Tantri (2018). dard for insolvency is represented by two international 21. Alston (1984); De and Tantri (2014); Guiso, Sapienza, instruments: the World Bank’s “Principles for Effective and Zingales (2013); Kanz (2016); Mayer et al. (2014); Insolvency and Creditor/Debtor Regimes,” first pub - Rucker and Alston (1987). lished in 2001 and periodically revised (World Bank 22. Giné and Kanz (2018). 2021c), and UNCITRAL’s “Legislative Guide on Insol - 23. Mayer et al. (2014). vency Law,” which was first adopted in 2004, with new 24. See De and Tantri (2014); Mukherjee, Subramanian, “parts” added over time. See UNCITRAL Legislative and Tantri (2018). Guide on Insolvency Law (dashboard), United Nations 25. Giné and Kanz (2018). Commission on International Trade Law, Vienna, 26. Guiso, Sapienza, and Zingales (2013). https://uncitral.un.org/en/texts/insolvency/legisla 27. G30 (2020, 3, 30). tiveguides/insolvency_law. The ICR Standard informs 28. Ayotte and Skeel (2010). the findings in this Report because it is integral to help - 29. Calomiris, Klingebiel, and Laeven (2004). ing countries further develop such systems. 30. Cirmizi, Klapper, and Uttamchandani (2012); World 2. Terminology in this area can be confusing because Bank (2021b, 2021c, 2022). different terms are used to describe similar processes 31. World Bank (2021c). in different jurisdictions. In this chapter, the terms 32. The case is Bell Group (UK) Holdings Limited (In Liqui- insolvency and bankruptcy are used interchangeably to dation) [2020] WASC 347. describe both liquidation and restructuring. Restruc­ 33. Laryea (2010). turing can refer to both formal and informal (out-of- 34. This was identified as a particular challenge in respond­ court) processes to reorganize a firm’s operations, ing to the Asian financial crisis. See OECD (2001). finances, or both. 35. Jappelli, Pagano, and Bianco (2005); Menezes and van 3. Consolo, Malfa, and Pierluigi (2018); D’Apice, Fiordelisi, Zwieten (forthcoming). and Puopolo (2021). 36. Esposito, Lanau, and Pompe (2014). 4. Araujo, Ferreira, and Funchal (2013). 37. World Bank (2021c). 5. Fonseca and Van Doornik (2020). 38. More in-depth comparative analysis is available in 6. Lim and Hahn (2003); Neira (2017). Adalet McGowan and Andrews (2016). 7. See Acharya and Subramanian (2009); Araujo, Ferreira, 39. Chapter 3 annexes can be found at http://bit.do and Funchal (2013); Dewaelheyns and Van Hulle (2010); /WDR2022-Chapter-3-Annexes. Gamboa-Cavazos and Schneider (2007). 40. See, for example, Gadgil, Ronald, and Vyakaranam 8. Giné and Love (2006). (2019). 9. Zombie firms are firms unable to cover debt servicing 41. See Menezes and van Zwieten (forthcoming). costs from current profits over an extended period. 42. Menezes and van Zwieten (forthcoming). 10. Andrews, Adalet McGowan, and Millot (2017); 43. This measure, now ended, is summarized in AFSA Banerjee and Hofmann (2018). (2021). 11. Menezes and van Zwieten (forthcoming). 44. Air Mauritius (2020). A watershed meeting describes 12. Laeven, Schepens, and Schnabel (2020). the turning point at which critical decisions are made 13. Acharya et al. (2019). about the future of an insolvent business—in particular, 14. Menezes and van Zwieten (forthcoming). whether it will undergo restructuring or proceed to 15. Menezes and van Zwieten (forthcoming). liquidation. 16. The issue of quantifying informal MSMEs is consid - 45. Via confirmation of a restructuring plan under Chap-ter ered by Stein, Ardiç, and Hommes (2013) and Interna- 11 of the Bankruptcy Code (§ 1129). tional Finance Corporation, MSME Finance Gap (dash- 46. Corporate Insolvency and Governance Act 2020. board), SME Finance Forum, https://www.smefinance 47. Harris (2017). forum.org/data-sites/msme-finance-gap. 48. World Bank (2019b). RESTRUC TURING FIRM AND HOUSEHOLD DEBT | 143 49. This program is led by the World Bank’s Development 85. The survival rates of MSMEs may also be shorter than Impact Evaluation (DIME) team. See World Bank those of large firms when sales fall off because they (2019a). are not well managed or have less liquidity. 50. INSOL International and World Bank (2021a). 86. The World Bank’s 2017 “Report on the Treatment of 51. INSOL International and World Bank (2021d). MSME Insolvency” is a comprehensive review of the 52. INSOL International and World Bank (2021c). economic importance of MSMEs, their particular 53. OECD (2003). needs and challenges, and the insolvency reforms 54. A regulatory framework for professional insolvency recommended for addressing these challenges. ­ practitioners is a key component. Many countries— 87. Gurrea-Martínez (2021). such as Australia, Brazil, Canada, China, Japan, Mex- 88. World Bank (2017). ico, the Republic of Korea, the Russian Federation, and 89. Gurrea-Martínez (2021, 4). the United Kingdom—have facilitated the develop - 90. World Bank (2018). ment of an insolvency practitioner profession whose 91. Tambunan (2018). members manage the economic and operational as- 92. Bakiewicz (2005). pects of a proceeding. Practitioners are subject to 93. Mako (2005). strict qualification, training, monitoring, and licensing 94. World Bank (2017). or registration requirements. 95. For a more comprehensive review of such reforms, 55. See, among others, EC (2011). see Gurrea-Martínez (2021). 56. Directive 2019/1023 on Restructuring and Insolvency. 96. Decreto Legislativo 560 de 2020, https://dapre.presi 57. Procedure is applicable to the largest companies only dencia.gov.co/normativa/normativa/DECRETO%20 (société anonyme). See Article L234-1 of the French 560%20DEL%2015%20DE%20ABRIL%20DE%202020 Commercial Code. .pdf. 58. World Bank (2021a). 97. Insolvency, Restructuring and Dissolution (Amend- 59. Menezes and Muro (forthcoming). ment) Act 2020. 60. INSOL International is a worldwide federation of 98. Ministry of Law, Singapore (2021). national associations of accountants and lawyers 99. For a summary of the CARES Act and COVID-19 who specialize in turnaround and insolvency. It has Bankruptcy Relief Extension Act, see ABI (2021). over 10,500 members. For more information, see 100. COVID-19 Response Legislation Act 2020. https://www.insol.org/. For information on the Inter­ 101. INSOL International and World Bank (2021d). national Association of Insolvency Regulators, see 102. INSOL International and World Bank (2021b). https://www.insolvencyreg.org/. 103. Corporations Amendment (Corporate Insolvency Re- 61. INSOL International, International Association of In- forms) Act 2020 (Cth). See Frydenberg (2020). solvency Regulators, and World Bank (forthcoming). 104. World Bank (2014b). 62. In constructing these estimates, it was assumed that 105. World Bank (2017). all measures were introduced on March 1, 2020. 106. The share is 8,889 of 34,339 personal bankruptcies. 63. See Allianz Research (2020); Banerjee, Cornelli, and See Australian Financial Security Authority, Quarterly Zakrajšek (2020). Personal Insolvency Statistics (dashboard), https:// 64. World Bank (2022). w w w.afsa.gov.au/about- us/statistics/quar terly 65. World Bank (2021c). -personal-insolvency-statistics. 66. Part 13, Aristotle ([350 BCE]). 107. IMF (1999); World Bank (2014b). 67. A review of the empirical evidence of alternative dis- 108. Reuters (2020). pute resolution in civil law, family law, and workplace 109. Attorney-General’s Department (2021). law is available in Veen (2014). 110. For more detailed consideration of the blurred lines 68. Cutler and Summers (1988). between personal and corporate insolvency frame- 69. Boon et al. (2019). works, see Spooner (2019). 70. Armour and Deakin (2001). 111. World Bank (2014b). 71. Kent (1993). 112. Heuer (2020). 72. Lucarelli and Forestieri (2017). 113. Respectively, “Debt Relief Notice,” “No Asset Proce - 73. Kastrinou (2016). dure,” “Minimal Asset Process,” and “Debt Relief 74. Lucarelli and Forestieri (2017). Order.” 75. Madaus (2020). 114. AFSA (2021). 76. 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In low- and middle- income countries, small firms are vital for job creation, economic growth, provision of goods and services, and poverty alleviation. Formal and informal MSMEs make up over 90 percent of all firms and account, on average, for 60–70 percent of total employment and 50 percent of GDP worldwide.1 Yet despite their important economic role, these businesses struggle to access formal financial services. About 130 million, or 41 percent, of formal MSMEs in low- and middle-income countries faced credit constraints before the COVID-19 pandemic, and the MSME finance gap (the difference between current supply and potential demand, which can potentially be addressed by financial institutions) was estimated at $5 trillion.2 The demand for finance from informal enterprises was an estimated $2.8 trillion, equivalent to 11 percent of GDP in these countries. Policies to support the continuity of financial The sector’s reach is much larger when nongovern- services to MSMEs and the informal sector and mental organizations (NGOs), cooperatives, and protect these clients through restructuring pro- informal savings and loan groups are included. cesses are essential to avoid a delayed recovery. In 2018 the global microfinance sector oversaw Although microfinance institutions (MFIs) are $124 billion in outstanding loans and $80 billion in often small and may seem unimportant in balance savings. Specialized microfinance investors had a sheet terms, they serve a segment of an economy $17 billion portfolio in MFIs.4 that is macro­economically significant. MFIs typi- cally have detailed operational knowledge of local business conditions and the skills and abilities of The state of MFIs during individual entrepreneurs, which enables them to COVID-19 and the policy direct funds from recapitalized institutions to pro- ductive lending opportunities. Globally, the formal response micro­finance sector provides over 140 million low- During the pandemic, several governments took income clients with credit and savings services.3 important steps to protect MFIs when borrowers SUPPORTING MICROFINANCE TO SUSTAIN SMALL BUSINESSES | 149 began to default on their loans. The differences for payments (such as government-to-person trans­ - between MFIs and conventional banking institu- fers) that regulators and policy makers can leverage tions required a tailored approach. Whereas most to support recovery. banks rely on asset-based lending, MFIs maintain As the lockdowns and decline in economic close relationships with their clients to assess and activity precipitated by the COVID-19 pandemic ensure each client’s willingness and ability to repay. took hold, experts anticipated that MFIs would Microfinance lending is typically high-touch, with face swift deterioration of their performance frequent, even weekly, in-person meetings with metrics, especially liquidity and asset quality. But borrowers. But such meetings became difficult, if based on a global assessment of MFIs in July 2021,5 not impossible, under lockdowns. Moreover, MFI the overall impacts of the pandemic on MFI bal- balance sheets are highly granular and may con- ance sheets seem to have been mixed based on sist of hundreds of thousands of borrowers with MFI characteristics, government assistance, and relatively small short-term loans. Thus the sheer specific market dynamics, among other things volume and varying circumstances of individual (also see spotlight 2.1 on MFIs). Key factors in MFI borrowers can make blanket moratoria on loans resilience during the pandemic are national gov- and formal loan rescheduling difficult to organize ernment and regulatory responses (box S3.1.1), the and implement—and borrowers may not even want nature and type of institution (such as whether them. Finally, with their links to the informal sec- deposit-taking or credit only), the prepandemic tor and their deep knowledge of local economies financial and operational strength of individ- and communities, MFIs are important c ­hannels ual institutions (box S3.1.2), and how individual Box S3.1.1 How Pakistani MFIs and regulators managed the crisis As the economic crisis arising from the COVID-19 Microfinance Investment Company, to resched- pandemic unfolded in Pakistan, MFI operations ule wholesale lending to the sector. Anecdotal became severely restricted, and some MFIs were reports also suggest that handshake agreements forced to close temporarily. Many MFIs acted with other MFI lenders to extend repayment quickly, however, to initiate business continuity terms, as well as the continued availability of plans to ensure the health and safety of staff wholesale funding for creditworthy MFIs, helped and clients and work around lockdowns. Dig- buoy the sector. ital financial services and branchless banking Overall, these measures appear to have surged. In the first year of the pandemic, the averted a liquidity crisis among Pakistan’s MFIs number of active branchless banking accounts in the short term, particularly those regulated, increased by 53.7 percent, from 27.7 million to deposit-taking, and digitally enabled.b Indeed, dur­- 42.6 million.a Meanwhile, from March 2020 to ing 2020 loans totaling approximately $635 mil- March 2021 regulators enacted a debt morato- lion in the sector were deferred or rescheduled. rium to ease the financial crunch on borrowers Some MFIs even experienced an increase in caused by lockdowns and the decline in eco- business. Microfinance banks (MFBs) saw a net nomic activity. In addition, nonbank micro­ increase in deposits in 2020 of 29 percent, and finance companies (NBMFCs) were shielded gross loan portfolios increased from $1.97 billion by federal guidelines asking commercial banks to $2.02 billion during 2020.c However, results and other lenders to MFIs, such as the Pakistan were mixed across the sector. The largest MFBs (Box continues next page) 150 | WORLD DE VELOPMENT REPORT 2022 Box S3.1.1 How Pakistani MFIs and regulators managed the crisis (continued) saw growth continue, while the smaller players, their weaker balance sheets no longer meet pru- including the vast majority of NBMFCs, saw dential requirements once temporary regulatory declines in their portfolios and asset quality. By forbearance is lifted. Recapitalization of insti- the end of 2020, many Pakistani MFIs had tem- tutions focused on MSME lending, especially porarily suspended their lending operations, and MFIs, may be necessary and critical to restoring the demand for credit declined slightly as peo- the viability of private sector MSMEs. The gov- ple suffered income losses.d ernment’s Kamyab Pakistan Programme, rolled Whether some consolidation and solvency out in September 2021 to provide subsidized support, particularly for smaller institutions, are or interest-free loans to SMEs and agricultural needed in the sector remains to be seen. Going workers, could also have mixed impacts on the forward, it will be important to distinguish via- stability and future growth potential of the ble MFIs from those likely to fail. MFIs, espe- microfinance sector by distorting the price of cially those unable to restart lending and return credit and increasing the moral hazard of strate- to prepandemic levels of growth, may find that gic future default. a. Compare the relevant data in SBP (2020) and SBP (2021). b. A study of 31 economies found that firms with an online presence were more likely to stay in business during the pandemic than those with no online presence, suggesting that digital technology helps small firms innovate and adapt to changing market conditions (Muzi et al. 2021). c. See Basharat, Sheikh, and Fatima (2021). d. The number of active borrowers in Pakistan dropped from 7.25 million to 7 million. Box S3.1.2 Case study: A compounded crisis in Lebanon The Lebanese economy entered a recession A survey conducted by the Consultative in 2019, pressured by fiscal and trade balance Group to Assist the Poor (CGAP) and the deficits, declining capital inflows, and dwin- Lebanese Micro-Finance Association of almost dling foreign exchange reserves. Acute polit- 1,000 microfinance borrowers in Lebanon ical and financial crises ensued, leading to a found that their situation deteriorated sharply run on banks, default by the government between mid-2019 and the last quarter of on debt obligations, and a proliferation of 2020. Half of the respondents had stopped exchange rates in a historically dollarized mar- working or had a less stable income. Entre- ket. Along­side the COVID-19 pandemic and preneurs, who account for the majority of MFI the catastrophic explosion at the Port of Bei- clients, saw a 94 percent decrease in sales and rut, the compounded political and financial faced challenges arising from exchange rate crises have had devastating effects on MFIs fluctuations and loss of customers. Fifty per- and their clients. cent of those employed experienced salary (Box continues next page) SUPPORTING MICROFINANCE TO SUSTAIN SMALL BUSINESSES | 151 Box S3.1.2 Case study: A compounded crisis in Lebanon (continued) cuts, and 20 percent lost their jobs. Women, sector began downsizing. By 2021, portfolios who make up half of borrowers and are gen- stood at $150 million for some 100,000 loans. erally self-employed, were the most affected, But NPLs in the newly disbursed portfolio were with three times as many women as men still manageable at 8–10 percent. reporting they had stopped working, and most Nonetheless, the financial crisis exposed saying they had to handle family care alone some of Lebanon’s large top-tier MFIs—repre- during the pandemic. senting 75 percent of the market—to potential Purchasing power declined dramatically in solvency issues stemming from their significant Lebanon from mid-2019 to mid-2020 as the assets, liabilities, and currency mismatches. On pound’s exchange rate deteriorated and infla- the liabilities side, because of the previous ease tion rose. In mid-2019, spending by a typical of borrowing from foreign lenders, MFIs had borrower’s household was more than $1,000 accumulated outstanding foreign debt total- a month for 4.5 members, or $7.90 per person ing $80 million, but capital controls imposed per day. A year later, inflation-adjusted spend- by local banks on external transfers prevented ing had dropped by more than half, to $3.40, them from servicing it. On the assets side, indicating that the 35 percent real contraction MFIs’ loan values fell to about 10 percent of in GDP had hit the poorest more severely. With precrisis values as the exchange rate depre- curtailed income, 40 percent of microfinance ciated, including the US dollar–denominated clients were no longer able to meet their basic loans that clients were repaying in pounds at needs. Sixty percent cut consumption, includ- the officially pegged rate. The future value ing of meat or fruit; 50 percent of households of MFIs’ $45 million in local deposits is uncer- were forced to tap into savings; and 43 percent tain. They could be written off in whole or in sold movable assets, primarily gold. In the face part, stretched out, or mandatorily converted of impoverished clients and lower levels of eco- into local currency, depending on how the bank- nomic activity, MFIs saw their nonperforming ing sector is restructured. These MFIs are at a loans (NPLs) rise from 2 percent in mid-2019 to de facto standstill with their creditors. Clearly over 20 percent in 2020.a recapitalization, together with debt restructur- In 2019, prior to the crisis, the microfinance ing and relief, will be needed. Left unaddressed, sector had roughly 1,000 staff members and an this need could result in less access to finance, aggregate outreach of about 150,000 clients for with disproportionate impacts on a significant a loan portfolio of $220 million. However, activ- portion of low-income borrowers in a context of ity rates dropped as the crisis deepened, and the rising poverty and unemployment. Source: Chehade (2021). CGAP, Lebanese Micro-Finance Association, and Consultation and Research Institute (2020). a.  MFIs responded as market conditions changed. and July 2020, they did not face greater problems Borrower profiles undoubtedly play a role in MFI in repaying their loans.6 Meanwhile, a survey of experiences as well. For example, World Bank 225 microfinance institutions of different sizes phone surveys in Sub-Saharan Africa suggest that, and in different regions in the early months of although female-led MSMEs experienced a greater the pandemic found that although liquidity prob- drop in sales than male-led firms between March lems among MFIs were not severer than they were 152 | WORLD DE VELOPMENT REPORT 2022 prior to COVID-19, small MFIs were nearly twice diligence ­requirements, which are rendered even as likely as medium-size ones to face liquidity con- more complex and uncertain in the context of straints.7 In Latin America and the Caribbean and government support such as loan moratoria. Sub-Saharan Africa, problems were worse than Nonetheless, policy makers should pursue in other regions. However, by the first quarter measures that support the provision of finan- of 2021 liquidity problems were receding. As for cial services to MSMEs and the informal sector. asset quality, in the early months of the pandemic Encouraging the emergence of markets for secured there was a spike in restructured portfolios and transactions and better credit information shar- portfolio-at-risk levels. A year later, a strong recov- ing could enable a broader range of funding and ery was under way in all regions except Africa, lending instruments and help manage MFI lend- where portfolio growth rates remained negative.8 ing risks going forward. Digital transformation of MFI operations and service delivery should also be encouraged—successful MFIs will draw on new Looking ahead technologies for better risk management, develop As moratoria are lifted, questions linger about the new business models that leverage their infra- asset quality of MFI portfolios. Questions also structure and client positioning, and offer prod- remain about the ongoing solvency of the smaller ucts that are more accessible to the informal sector MFIs that do not take deposits, especially those and micro and small businesses. A lesson from the that at the onset of the pandemic had weak finan- Lebanese experience is that it may be prudent for cial positions, including limited capital buffers. future microfinance models to limit currency risks. Identifying those MFIs viable in the new environ- There, blended finance options could be explored ment will be a challenge. A restructuring and con- to allow renewed investments by development solidation exercise could effectively clean up the finance institutions and microfinance investment sector by closing or consolidating weak and poorly vehicles, but all of them require, first and foremost, governed institutions. Past MFI crises have demon- macroeconomic stabilization. strated that out-of-court restructuring or workout processes and the use of distressed asset facilities Notes that specialize at the sector level are the best prac- For more information on MSMEs in emerging economies, 1.  tice. In addition, markets for distressed assets could see Department of Economic and Social Affairs, United enable microfinance providers to better manage Nations, “Micro-, Small, and Medium-Sized Enter- prises (MSMEs),” https://sdgs.un.org/topics/capacity their balance sheets by shedding nonperforming -development/msmes; World Bank, “Small and Medium assets to focus on building sound portfolios of Enterprises (SMEs) Finance,” https://www.worldbank.org productive loans. However, success in exercising /en/topic/smefinance. these options is not guaranteed: distressed MFI For more information on the MSME finance gap, see 2.  the International Finance Corporation, IFC MSME Finance loan assets are typically difficult to collect because Gap database (updated October 2018), https://www.sme of the inherent characteristics of microlending, financeforum.org/data-sites/msme-finance-gap, and the which involves uncollateralized, high-touch loans, associated report (IFC 2017). 3. Convergences (2018). often based on the relationship between the MFI 4. Symbiotics (2019). agent and the borrower. Furthermore, distressed 5. CGAP and Symbiotics (2021). asset purchases are especially risky in the micro- 6. IFC (2021). lending context because of the relatively large 7. Spaggiari (2021). numbers of loans involved and the associated due 8. CGAP (2021). SUPPORTING MICROFINANCE TO SUSTAIN SMALL BUSINESSES | 153 References Basharat, Ali, Zeenoor Sohail Sheikh, and Tehreem Fatima. IFC (International Finance Corporation). 2017. “MSME 2021. “Pakistan Microfinance Review 2020.” Draft, Paki - Finance Gap: Assessment of the Shortfalls and Opportu- stan Microfinance Network, Islamabad. https://www nities in Financing Micro, Small, and Medium Enterprises .cgap.org/sites/default/files/datasets/2021_07_COVID in Emerging Markets.” IFC, Washington, DC. _MFI_Symbiotics.pdf. IFC (International Finance Corporation). 2021. “COVID-19 CGAP (Consultative Group to Assist the Poor). 2021. “Micro - and Women-Led MSMEs in Sub-Saharan Africa: Exam - finance Solvency and COVID-19: A Call for Coordina - ining the Impact, Responses, and Solutions.” IFC, Wash- tion.” COVID-19 Briefing: Insights for Inclusive Finance ington, DC. https://www.ifc.org/wps/wcm/connect (September), CGAP, Washington, DC. https://www.cgap /industry_ext _content/ifc_external_corporate_site .org/research/covid-19-briefing/microfinance-solvency /financial+institutions/resources/covid19-and-women -and-covid-19-call-coordination. -led-firms-in-africa. CGAP (Consultative Group to Assist the Poor), Lebanese Muzi, Silvia, Filip Jolevski, Kohei Ueda, and Domenico Micro-Finance Association, and Consultation and Viganola. 2021. “Productivity and Firm Exit during the Research Institute. 2020. “Impact of Economic and COVID-19 Crisis: Cross-Country Evidence.” Policy Research COVID-19 Crises on Microcredit Borrowers.” Slide Deck, Working Paper 9671, World Bank, Washington, DC. November 26, CGAP, Washington, DC. https://www.findev SBP (State Bank of Pakistan). 2020. “Branchless Bank- gateway.org/slide-deck/2020/11/impact-economic-and ing Statistics (Jan–Mar 2020).” Agricultural Credit -covid-19-crises-microcredit-borrowers. and Microfinance Department, SBP, Karachi, Pakistan. CGAP (Consultative Group to Assist the Poor) and Symbio­ https://www.sbp.org.pk/acd/branchless/Stats/BBSQtr tics. 2021. “Global Microfinance Recovery Continues, -Jan-Mar-2020.pdf. Especially in Africa, but Pandemic’s Long-Term Impact SBP (State Bank of Pakistan). 2021. “Branchless Banking Remains Uncertain.” COVID-19 Briefing, Snapshot: MFIs Statistics (Jan–Mar 2021).” Agricultural Credit and during the Crisis (July), CGAP, Washington, DC; Symbio­ Microfinance Department, SBP, Karachi, Pakistan. tics Group, Geneva. https://www.findevgateway.org/paper https://www.sbp.org.pk/acd/branchless/Stats/BBSQtr /2021/07/global-microfinance -recover y- continues -Jan-Mar-2021.pdf. -especially-africa-pandemics-long-term-impact. Spaggiari, Lucia. 2021. “COVID-19 and Microfinance: What Chehade, Nadine. 2021. “Preserving Decades of Develop - the Data Says About Risk in the Sector.” CGAP (blog), ment: A Plea for Lebanon.” CGAP (blog), February 10, September 29, 2021. https://www.cgap.org/blog 2021. https://www.cgap.org/blog/preserving-decades /covid-19-and-microfinance-what-data-says-about-risk -development-plea-lebanon. -sector. Convergences. 2018. Microfinance Barometer 2019. Paris: Symbiotics. 2019. “2019 Symbiotics MIV Survey: Market Data Convergences. https://www.convergences.org/wp-con- and Peer Group Analysis.” 13th ed. Symbiotics Group, tent/uploads/2019/09/Microfinance-Barometer-2019 Geneva. https://symbioticsgroup.com/wp - content _web-1.pdf. /uploads/2020/02/symbiotics-symbiotics-2019-miv -survey.pdf. 154 | WORLD DE VELOPMENT REPORT 2022 Lending during the recovery and beyond The ongoing impact of the COVID-19 crisis on business performance and household incomes could inhibit new lending because of increased credit risk. Risk can be mitigated by better visibility into borrower viability and improved recourse in the event of default. Reassessing credit models to take into account the “new nor- mal,” as well as innovations in digital finance that leverage alternative data and tailor loans to the borrower and the lending environment, can help keep credit flowing. Regulatory frameworks that enable innovation can support credit in the recovery while ensuring consumer and market protections. Policy Priorities Mitigating the environment of uncertainty and the lack of transparency that are making the traditional approaches to measuring risk less effective calls for the following measures:  •  Creating an enabling environment to leverage alternative data. Lenders should look to adapt underwriting approaches, with support from supervisory model validation and regulatory frameworks that open access to data while ensuring privacy and consumer protection. • E  mbracing innovations in product design and embedded finance that tailor loans to customer and market conditions or link credit to underlying business transactions to increase visibility and improve recourse.   •  Providing well-tuned guarantee programs where needed to bridge the gap between lenders’ risk aversion and the role of credit as a driver of an equitable recovery. •  Advancing the regulatory framework and financial infrastructure to support innovation; adjust the regulatory perimeter; provide clear, effective, and enforceable consumer and market protections; and facilitate digital payments, information exchange, and asset registration.  155 Introduction Previous chapters focused on the actions countries can take to reduce damage to the financial sector if long-term, widespread income losses stemming from the COVID-19 (coronavirus) pandemic force borrowers to default on their debt. For the economy, however, the risks associated with past loans are not the only concern. A separate challenge is the ability of financial service providers to continue extending credit to fuel the recovery. As countries embark on the road to recovery and policy makers wind down the exceptional fiscal and other policy support measures put in place to help the economy through the pandemic, it is paramount that businesses and households have adequate access to credit to withstand economic uncertainty, invest in opportunities, and take part in the recovery. The onset of the pandemic extensively disrupted economies worldwide. Lockdowns, business inter- ruptions and closures, and job losses in the real sector (the activities associated with goods and services) were reflected almost immediately in the financial sector by a tightening of lending conditions. Bank supervisors and lenders worried that the crisis would rapidly translate into loan losses and cash with- drawals by the public. As discussed in chapter 1, unprecedented government intervention and regulatory forbearance to mitigate the impacts of the crisis have so far helped banks maintain capital levels and liquidity. Yet the ongoing impacts of the crisis on business performance and household incomes, as well as the expected rise in nonperforming loans (NPLs) and tightening of monetary policies, will create challenges for new lending. Continued economic disruptions and uncertainty will increase credit risk, reduce visibility into borrower viability, and diminish the realizable value of traditional sources of recourse in the event of default. Reporting practices around loan moratoria and debt restructuring further cloud visibility into the actual credit performance of certain customers. In this environment of heightened risk and continued uncertainty, finance providers need to adapt credit models and product offerings if they are to continue lending. Ways of doing this include making changes in product design—the terms and lengths (tenors) of loans—as well as integrating new types of data into credit models. These adaptations will benefit from the continuing adoption of new technol- ogies and digital channels supporting payments, credit information, and secured transactions. A silver lining of the pandemic is that it accelerated digital adoption in the economy as a whole, as well as among finance providers and borrowers, thereby laying the foundation for better credit analysis and monitor- ing, greater product diversity, and a broader range of credit providers. Financial service providers, infrastructure providers, governments, and the regulatory community can all help advance the adoption of solutions to facilitate access to credit during the recovery. This chapter describes approaches available to finance providers for adjusting their operations and products to continue lending. It also describes the role of governments, regulators, and financial infrastructure in helping the credit market adapt to the new environment—such as by integrating new data and business models—and in countering market tendencies to limit credit to larger firms and better-off borrowers. As credit conditions improve, markets that have been able to roll out these solutions and restrain a “flight to quality” will be in a better position to tackle long-standing credit gaps and foster financial inclusion. Examples in this chapter illustrate how financial service providers have delivered credit to under- served customers and entrepreneurs during the pandemic by mitigating risk through product design, or by integrating new technologies or improved data models for credit underwriting and servicing. Innovations in channels, products, and processes have enabled the expansion of lending to riskier and previously underserved segments. Although these innovations will be pivotal to achieving additional visibility and recourse in the pandemic context, even for previously well-served segments, the rollout 156 | WORLD DE VELOPMENT REPORT 2022 of certain products, business models, and data may not be feasible in all markets. Their adoption will require thoughtful consideration of systemic and institutional factors as well as consumer protection. The borrowers referred to in this chapter include the small and medium businesses that make up the majority of enterprises providing jobs in most emerging economies,1 as well as households and micro­ entrepreneurs. These groups find it challenging to access formal credit even when the economy is sound and growing, and all have been significantly affected by the pandemic. Nonetheless, the credit needs of small businesses differ from those of microentrepreneurs, for example, and they are often served by different financial services providers, offering different solutions. Solving the COVID-19 risk puzzle: Risk visibility and recourse Beyond its profound impacts on the credit risk of households and businesses, the pandemic significantly impaired the visibility that lenders have into a borrower’s capacity and willingness to repay a loan, and it limited lenders’ options for recourse in the increasingly likely event of a default. Policy responses to help alleviate the impacts of the pandemic reduced near-term risks, but further reduced visibility into and certainty about the underlying viability of borrowers. The protracted effects of the pandemic on the economy and the financial sector may over time affect the liquidity and capital of finance providers, diminishing even more their willingness and ability to take on risk. A lender’s decision to extend credit and the associated terms reflect the amount of risk the lender is willing to take based on estimates of both the borrower’s probability of default and the anticipated loss in the event of a default. The ability to assess the likelihood of repayment depends on the available infor- mation about the borrower and the context of the loan (visibility), whereas estimates of loss in case of default are based on the market for collateral or the enforceability of guarantees (recourse). As noted in earlier chapters, the pandemic and associated lockdowns had a profound impact on eco- nomic activity, affecting borrowers (businesses and households) directly and increasing credit risk. For some sectors and businesses, the impact was transitory and it diminished as lockdowns were lifted. For others, the effects will last longer. For example, in Rwanda business sectors that rely on in-person work (such as construction and accommodation and food) were more affected by the lockdowns than sectors that could transition some of their activities to remote working. Once lockdowns were lifted, however, construction quickly recovered well above precrisis levels, but for the accommodation and food sector, where face-to-face interactions with customers are necessary, the crisis dragged on.2 When lenders con- front uncertain conditions, they typically respond by tightening credit standards and reducing credit supply, shifting to safer assets. If lenders lack solid information with which to assess risks, they reduce credit not only to insolvent businesses and households, but also to everyone else because they are not able to distinguish between the two groups. Although uncertainty has always been part of lender business models, before the pandemic finance providers were better able to determine a borrower’s ability and willingness to repay and the probability of default by taking into account credit and payment histories, income, or assets; nonfinancial infor- mation (such as home address, relevant sector of the borrower’s business, and length of banking rela- tionship) that can act as a proxy for income; the purpose of the loan (home loans or loans for business equipment have a different risk profile than loans for consumption or working capital); and the time horizon for the loan (visibility tends to be higher over shorter time horizons). For business loans, lenders would rely on heuristics and models to take into account sector or demographic norms (such as typical inventory turns or balance sheet ratios for a given industry). The significant structural break caused by the crisis diminished, however, the value of past data and heuristics. Traditional credit data sources are largely backward-looking. But with so many sectors, LENDING DURING THE RECOVERY AND BE YOND | 157 businesses, and individual incomes disrupted, past performance is no longer as strong an indicator of future performance. Typical reporting delays by lenders and infrequent updates of credit registries and credit bureau data are a challenge in the rapidly evolving pandemic. Even for sectors that might be expected to recover, lenders might not have the timely relevant information needed to accurately deter- mine whether an existing or prospective borrower would still have the income and ability to navigate the new economic environment. Even the more qualitative relationship-based methods that lenders typically use to smooth lending over an economic cycle were compromised. Loan officer visits were limited or delayed by lockdowns and social distancing.3 Lenders had difficulty meeting new clients, verifying customer identity, and evalu- ating a borrower’s business operations on site, and they curtailed the in-person collections and group meetings central to many microfinance business models. These and other operational challenges were particularly acute earlier in the crisis. Many of these challenges have since been overcome through the use of digital tools, but operational constraints continue to be a factor in many markets. The unprecedented level of policy interventions—including government transfers, debt moratoria, loan reschedulings, and suspension of NPL classifications—further clouded lender visibility by reducing the usefulness of financial data and credit information as predictors of a borrower’s ability to repay. Lenders must be able to distinguish whether a borrower’s business is sustainably recovering due to sound fundamentals or is dependent on government support of the business or its customers. Even rela- tively recent data can be misleading.4 Positive cash flows or increases in account balances resulting from government support programs do not indicate longer-term viability. Eventual winding down of that support could later affect ability to repay. Thus policy interventions that stabilized markets may have, paradoxically, made it more difficult in some cases for lenders to extend the credit needed to resume growth. Along with these challenges around visibility, the pandemic has also affected the traditional forms of recourse that limit lenders’ losses in the event of default. Having recourse also dissuades borrowers from defaulting in the first place. Typical forms of recourse are collateral and personal guarantees, and both play multiple roles. Lenders use collateral to (1) assess a borrower’s financial condition; (2) motivate repayment because a borrower would want to avoid losing the asset; and (3) offset losses in the event of default by seizing and selling the collateral. Personal guarantees signal that the borrower has reputable relationships that the lender can call on to repay a loan in the event the borrower defaults; this is both an indicator of financial standing and a loss mitigant in the event of default. Guarantees also formalize an element of social pressure to motivate repayment. Provid- ing collateral or personal guarantees has long been a challenge for micro-, small, and medium enterprises (MSMEs) and households in emerging economies. Group guarantees as part of microfinance lending are an attempt to fill that gap for individual microentrepreneurs. Guarantees from government or develop- ment finance institutions are another form of recourse, and these may be made more available to MSMEs under some programs. Less traditional forms of recourse—such as automatic repayments, liens on future digital receipts and cash flows, and exclusion from marketplace platforms in case of default on a loan from the platform—can be incorporated into MSME and consumer lending, particularly in the embedded finance models discussed later in this chapter. The bankruptcy and resolution frameworks described in previous chapters can influence how effectively and efficiently lenders can use certain types of recourse. Recourse options during the pandemic were reduced by moratoria, and the value of traditional forms of collateral was altered. Will a commercial building losing tenants (due to the pandemic) be as valuable as it was with full occupancy? If many restaurants are going out of business, what is the resale value of a commercial oven? Beyond the theoretical value of an asset, will a bank be able to realize that value during a period of economic uncertainty? Monetary policy and moratoria temporarily forestalled defaults and liquidations, supporting asset prices. Implemented over long periods, however, debt moratoria, rent 158 | WORLD DE VELOPMENT REPORT 2022 holidays, and credit guarantees can have the unintended effects of heightening volatility and further eroding collateral asset values. The lifting of moratoria and government support measures could pro- voke further post-default liquidations, triggering fire sales of assets.5 These factors have reduced not only the degree to which lenders can rely on traditional forms of recourse, but also their ability to project the value of that recourse. Reacting to the combined effects of higher credit risk in the economy, low visibility, and reduced recourse, lenders have tightened credit standards and reduced the amount of new credit available to support the recovery.6 A review of quarterly central bank surveys on credit conditions from both emerg- ing and advanced economies finds that the majority of economies have experienced several quarters of tightening credit standards since the onset of the crisis. Figure 4.1 presents the quarterly net change in credit conditions relative to previous quarters for a sample of 38 countries, as reported in the central bank or monetary authority surveys of credit conditions in those countries. March 2020 onward saw a sharp increase in the share of countries whose financial service providers tightened credit standards compared with the previous quarter. Although the pace of tightening appears to have slowed in 2021 with lenders across many countries beginning to ease credit conditions, the data suggest that for many of the countries surveyed credit standards remain substantially tighter than their prepandemic levels. Figure 4.1 Quarterly trends in credit conditions, by country income group, 2018–21 40 COVID-19 onset Easing Net percentage of countries reporting 30 a change in credit conditions 20 10 0 –10 –20 –30 –40 –50 –60 –70 Tightening –80 18 18 18 18 19 19 19 19 20 20 20 20 21 21 21 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 All High-income Low- and middle-income Source: WDR 2022 team calculations, based on data from survey reports by the central banks of 38 countries published or accessed as of December 15, 2021: Albania, Argentina, Austria, Belgium, Canada, Chile, Cyprus, Czech Republic, Estonia, France, Germany, Ghana, Greece, Hungary, India, Indonesia, Ireland, Italy, Japan, Latvia, Lithuania, Mexico, the Netherlands, North Macedonia, the Philippines, Poland, Portugal, Romania, the Russian Federation, Serbia, Spain, Thailand, Turkey, Uganda, Ukraine, the United Kingdom, the United States, and Zambia. Note: The figure shows the net percentage of countries in which banks reported a change in overall credit conditions in quarterly central bank loan officer or credit condition surveys. The net percentage is the difference between the share of countries that report an overall easing in credit conditions and the share of countries that report an overall tightening of credit conditions relative to the previous quarter. A negative net percentage value indicates an overall tightening of credit conditions in the sample of countries covered. For Chile, Japan, Mexico, Poland, Russia, the United States, and Zambia, the overall credit conditions are estimated from an index of reported credit conditions in business and consumer segments. LENDING DURING THE RECOVERY AND BE YOND | 159 Reduced credit in the context of crises is particularly challenging for MSMEs and other segments of the economy such as women and informal entrepreneurs who even before the crisis were viewed by financial institutions as riskier and more challenging to serve.7 These businesses tend to be more thinly capitalized, have fewer assets and little excess liquidity, and be relatively undiversified in terms of prod- uct markets and customer base. The systemic, negative, real sector shock of the pandemic interrupted revenue streams of the segments already viewed as riskier.8 Because of this differential impact on their customer base, specialized lenders, including credit unions, savings banks, microfinance institutions (MFIs), and other nonbank financial institutions that focus on MSMEs and underserved households, faced operational and fundraising challenges that affected their ability to deliver credit. In addition, access to short-term trade finance was a challenge for small and medium enterprises (SMEs) during the COVID-19 pandemic as costs and application rejection rates increased.9 The International Chamber of Commerce reported that banks either retrenched from segments perceived as high risk such as SMEs or hiked prices for short-term trade financing for them.10 Many lenders lack the capacity to mitigate effectively the new risks introduced by the COVID-19 crisis and have responded by limiting credit to all but the lowest-risk borrowers. If financial markets continue this trend, they could unleash a vicious cycle (see figure 1.2 in chapter 1). In such a cycle, the widespread reduction in credit to MSMEs forces more of them out of business before they can recover and drive growth, with follow-on impacts on the households whose members are employed by or other- wise depend on these businesses for income, products, or services.11 Business failures can have a dom- ino effect, with the first failures pushing upstream companies out of business because of the reduced demand for their products or services. Over time, accelerating business failures increase the bad debt burden on lenders and reduce their capital and capacity to lend, as well as their willingness to take risk. Movement in this direction would cut government tax revenue while at the same time increasing the need for fiscal support for households, firms, and potentially financial institutions in need of bailouts. Markets in which lenders are able to manage and mitigate the risk of new lending to meet the financ- ing needs of businesses and households despite the heightened uncertainty could unleash a virtuous cycle, supporting the efforts of small and large businesses and households to restart spending and to invest in the economic recovery. For example, a small shop may be solvent and viable but need addi- tional working capital to replace spoiled inventory and cover costs until retail activity recovers. Or a manufacturer may need to invest in raw materials and production well before it receives income from sales. For households, credit could help them maintain consumption—such as paying fees for school or childcare—or meet financial emergencies before their income has fully recovered, with benefits for the broader economy through spending. Improved prospects for businesses and households have a positive impact on the income and capital of the lenders serving them, further increasing lenders’ capacity to lend and their risk appetite. Regulators have a central role in supporting a virtuous cycle by encouraging the financial sector’s efforts to adapt while monitoring financial stability. Recovery of economic activity and spending can raise tax revenue and allow governments to shift their focus from broad-based fiscal support programs to targeted ones to support those parts of the economy hardest-hit by the crisis and to lower the risk associated with longer-term investments to support job creation and a sustainable recovery. Finally, as economic conditions stabilize in the recovery, lenders that have successfully adapted to the “new nor- mal” may become better able to extend longer-term financing to support capital investments by MSMEs and to reach low-income households and informal businesses previously excluded by the financial sec- tor, thereby further reducing the need for government intervention. To prevent onset of the vicious cycle and unleash a virtuous one, lenders will have to embrace tools that allow them to overcome the visibility and recourse challenges affecting their ability to measure and manage risk. 160 | WORLD DE VELOPMENT REPORT 2022 Improving risk mitigation This section highlights strategies that lenders can adopt to manage or mitigate risk so they can provide financially viable borrowers with credit in an environment of heightened risk and uncertainty. Digital­ ization, which accelerated during the pandemic, can facilitate the feasibility and adoption of many of these strategies. To continue to lend through the pandemic and the recovery, finance providers need new approaches to measuring risk, as well as new approaches to product design, both of which can improve visibility and strengthen recourse in order to balance risk. Lenders can start by reassessing their existing sector and borrower scoring models and updating them where possible based on information on economic activity by sector or geography. Most lenders have by now recognized that there has been a structural break, and both business models and financial models need to be retuned. Supervisors can help ensure this is done in a timely fashion and that any approvals needed to adapt underwriting and collection procedures or deploy updates of risk models are expedited. Some banks have assessed the impact of lockdowns by characterizing the risk for each industry- geography intersection.12 Banco Pichincha in Ecuador personalized repayment terms and adapted its financial and nonfinancial services to support borrowers and continue lending, while Konfío in Mexico took time to adapt its credit algorithms before resuming its growth. 4G Capital in Kenya piloted mobile surveys to seek to incorporate a measure of borrower financial stress in its credit underwriting.13 Lend- ers can also improve the data and analytics they use for risk modeling, adjust product mix and design, and incorporate risk-sharing facilities where available. These approaches, and their potential impacts on visibility, recourse, and credit risk to the lender are outlined in figure 4.2. Figure 4.2 Impacts of selected risk mitigation strategies on visibility, recourse, and risk Improve Strengthen visibility recourse Reduce risk Risk measurement Alternative data Enhanced analytics Product choice and design Loan tenor Secured credit Embedded finance Supply chain finance Insuring risk Credit guarantees Source: WDR 2022 team. Note: Shaded circles indicate the increasing relevance of each solution for the respective challenge, from not applicable ( ) to degrees of relevance ( ) to highly relevant ( ). LENDING DURING THE RECOVERY AND BE YOND | 161 Policy makers can also help by establishing the infrastructure and regulatory environment needed to support new approaches to visibility and recourse and to encourage innovation and the growth of new players with diverse business models and risk appetites. For riskier sectors and segments, governments may also have to continue deploying risk mitigation instruments, such as well-calibrated credit guar- antees, to support access to finance. Targeted liquidity or income support schemes may continue to be required for those in need for whom borrowing is not appropriate. Alternative data Although the pandemic reduced lenders’ visibility into credit risk, they are not without options. Alter- native data sources can inform risk assessments and allow lenders to fill pandemic-related information gaps. As risk and uncertainty decline, these approaches can also be used to extend credit to underserved segments that were informationally opaque even before the pandemic. The term alternative data refers to information not included in traditional credit reports, which focus on outstanding loans and repayment history. For example, a wide range of transactional data are available from financial service providers, mobile network operators and other utilities, traditional businesses and online platforms, and governments. These data include bank deposits and withdraw- als, mobile money use, airtime top-ups and utilities payments, payroll, rent, taxes, supply orders and deliveries, sales orders, invoices, and business receipts. Nonfinancial data from social media footprints, psychometrics, online behavior, and telecommunications usage, including top-up and calling patterns, contacts, and global positioning system (GPS) data, can supplement transactional data.14 These data have been found to provide information that is at least as predictive as that held by credit bureaus. Many of these data are considered “big data”—that is, data produced by digital channels and characterized by high volume, variety, and velocity.15 One study found that in Germany credit scoring models based on digital footprints were better at pre- dicting creditworthiness than credit bureau scores. The two assessments can complement each other for greater sensitivity.16 A study of loan data from a large fintech lender in India showed that use of mobile and social footprints can improve risk assessments for individuals with credit scores and be an effective indicator for individuals who lack credit bureau records.17 Research from South America found similar results from the use of call data records to predict credit repayment outcomes for individuals lacking a credit history.18 Meanwhile, a US study found that transaction data can be used to create risk profiles capable of serving individuals otherwise excluded or charged higher interest rates.19 Finally, research from China found that the use of big data to assess the probability of default led to increased credit access for borrowers who otherwise would have remained unbanked or who would have been required to pledge collateral to access financing.20 Alternative data can also help lenders to update sector and business assessments (see box 4.1). Because some industries have been more (and some less) directly affected by the pandemic, standard market reports are no longer as accurate. Retuning existing models is an important first step to improving risk assessments, although the scale and depth of the crisis will likely continue to require lenders to update or reset benchmarking data over time. Despite the opportunity presented by the growing abundance of alternative and big data, several challenges are posed by issues of availability, validation, and interpretation in underwriting. Availability is affected by a prospective borrower’s use of the services and platforms that generate and hold alter- native data. These platforms are often owned and controlled by private third parties, and so lenders must secure access to the data. For example, although a bank may have payment transaction data, the mobile operator collects call records, and the electric company has utility billing and payment records. 162 | WORLD DE VELOPMENT REPORT 2022 Lenders may collect some data directly from the borrower’s phone, which raises privacy concerns about, for example, other people’s data that may reside in the borrower’s contacts list and text message records. Some prospective borrowers may have documents such as bills or payment records containing these data, but these can be hard to assemble and validate. In some markets, credit registries and bureaus, as well as new fintech data companies, are beginning to collect and validate this information (see box 4.8 later in this chapter). Data privacy and open banking frameworks are increasingly seeking to vest ownership and control of data in data subjects,21 enabling those subjects to grant permission to third parties—including lenders—to access their data. The 2021 World Development Report discusses issues related to accessibility and intellectual property of this type of private intent data.22 In addition to accessing and validating new data, lenders need ways to confirm its interpretation as credit-relevant and incorporate it into underwriting models, while ensuring fairness and validity. Box 4.1 Case study: Adaptive underwriting in Mexico Konfío is a Mexican technology-based company that as recently as February 2021 a large share of seeking to boost the growth of underserved micro-, MSMEs previously served by banks were suffering small, and medium enterprises (MSMEs) by way of challenges in accessing financing.c an array of offerings, including financial services, Konfío also reduced lending in the first months payment solutions, and business tools. Through of the crisis in response to tightening credit stan- its digital lending platform, Konfío provides these dards and a drop in loan applications. It adapted its MSMEs with the working capital funds they are credit algorithm to integrate data on the impacts of unable to borrow from banks, often because they COVID-19 containment measures across industry lack the collateral and credit history that banks subsectors. The result was a new index to inform require.a portfolio collection strategies, loan renewals, and Konfío, which launched operations in 2014, uses new loan originations. Konfío’s leadership believes the data generated by MSMEs to meet government- that approach enabled them to limit portfolio established electronic invoicing requirements in its delinquencies and to recalibrate credit underwrit- underwriting. Konfío developed an algorithm that ing to identify lower-risk MSMEs. As demand for supplements traditional financial history with elec- credit among MSMEs picked up, Konfío was able to tronic invoicing data, as well as data on a firm’s net- resume lending to both existing and first-time cli- work and digitally acquired information from payroll ents. In August 2020, Konfío began to rapidly grow and annual statements. The company employs its new loan bookings. Indeed, it achieved records technology and machine learning to integrate these in both the number and volume of monthly loans forms of alternative data in its underwriting and disbursed as of February 2021 (figure B4.1.1). automate much of the traditional manual MSME As economic conditions and outlook evolve, credit scoring and underwriting process. Konfío continues to track business performance by After the first measures to contain the spread industry and economic activity to continually recal­ of the COVID-19 virus were enacted in Mexico ibrate how it classifies performing versus under- in March 2020, MSMEs’ access to finance signifi- performing industries. By dynamically adapting its cantly deteriorated.b Faced with heightened port- credit policies, Konfío has been able to gradually folio risk and great uncertainty, lenders tightened expand its coverage. The company claims that as loan requirements and reduced lending to MSMEs. of July 2021 it was serving more than 90 percent of A national survey of Mexico’s businesses found the industries and regions in Mexico. (Box continues next page) LENDING DURING THE RECOVERY AND BE YOND | 163 Box 4.1 Case study: Adaptive underwriting in Mexico (continued) Figure B4.1.1 Growth in loan disbursements by Konfío, 2019–21 250 COVID-19 onset Normalized value of monthly loan disbursements (%) 200 150 100 50 0 19 19 19 Ju 021 9 9 0 0 20 ch 1 ay 1 Ju 19 ch 0 20 Se 020 21 01 01 02 2 02 02 02 20 20 20 20 20 20 20 20 .2 .2 2 2 .2 .2 2 2 ly n. ch ay n. ne n. ay ly ov pt ov pt Ja Ju Ja Ja M ar M M ar ar Se N N M M M Source: Konfío, proprietary portfolio data, 2021. Note: The figure shows the ratio between the value of monthly loan disbursements and that for January 2020. a. IFC (2017b). b. National Institute of Statistics and Geography (Instituto Nacional de Estadística y Geografía), ECOVID-IE (Survey on the Economic Impact Generated by COVID -19 on Enterprises) (dashboard), Aguascalientes, Mexico, http://en.www.inegi.org .mx/programas/ecovidie/. This survey on the impact of COVID-19 on businesses in Mexico found that as of April 2020, 12 percent of MSMEs had suffered a reduction in access to financial services. c. ECOVID-IE. As of February 2021, 8 percent of MSMEs still suffered from lower access to finance. An earlier economic census by Mexico’s National Institute of Statistics and Geography found that access to finance is historically limited for MSMEs in Mexico. In 2019, an estimated 11.4 percent of microenterprises (0–10 employees) and 25.7 percent of small and medium enterprises (11–250 employees) had access to finance (INEGI 2020). Regulators typically require lenders to ensure the explicability of their credit scoring models and algo- rithms and of the data they use.23 This is particularly important in the use of nontraditional data to predict creditworthiness. Reliance on such data can lead to unintended biases due to the differential availability or use of some of the data sources. The sheer newness of complex algorithms may be a factor as well (see box 4.2). The widespread use of alternative data, which depends on a customer having access to utilities, mobile money, smartphones, e-commerce or social media platforms, or other data genera- tors, could result in “digital redlining”—that is, the exclusion of individuals whose activities, location, or socioeconomic situation are data-poor. For example, alternative data such as the operating system used by a borrower’s smartphone, the timing and location of a loan application, or device data on mobile phone top-ups and e-commerce activity, can indicate asset ownership and the regularity of behavior and cash flows.24 In some markets, however, they may also map to the protected characteristics25 of potential borrowers or exclude borrowers who do not have smartphones. ­ 164 | WORLD DE VELOPMENT REPORT 2022 Box 4.2 Credit and algorithmic biases How will credit risk modeling innovations such as However, when the gender of the applicants was machine learning and alternative data affect the revealed in the data, loan officers exhibited a pos- distribution of credit? Who can access credit, and itive bias, approving 22 percent more applications at what cost? Gender bias and discrimination in from women than those based on an anonymized face-to-face loan officer decision-making are well review, without leading to an increase in defaults. documented.a As the COVID-19 crisis accelerates When the algorithm was exposed to gender infor- the adoption of machine learning and big data, mation, it was better able to predict defaults than there is potential to reduce the historical biases on loan officers, but it approved 16–21 percent fewer gender and race stemming from human discretion applications from women than when it was fed in lending decisions. On the other hand, new types anonymized data. of discrimination through algorithms and biases in A study that examined data on over 9 million programming and data could be introduced.b The loans from the US mortgage market found that emerging academic literature on the topic paints a moving from “traditional” statistical models to nuanced picture of whether these new sources of machine learning models improved the accuracy of bias reduce or exacerbate the overall level of dis- default predictions, leading to an overall reduction crimination in financial services.c in default risk for the median borrower.e However, A study from Pakistan of 5,500 digital loan as shown in figure B4.2.1, the benefits from the applications compared outcomes of submissions new technology are not distributed equally across randomly assigned for review by loan officers or groups in society. The researchers in this case con- by a machine learning algorithm. The study found cluded that gains from new technology are skewed that the algorithm achieved a 21 percent reduc- in favor of racial groups who already have better tion in loan defaults while serving a similar share access to credit, while disadvantaged groups are of female and ethnic minority group borrowers.d less likely to benefit. The study also found that Figure B4.2.1 Share of borrowers who appear more creditworthy when using a machine learning model than when using traditional statistical methods All borrowers 12.2 Asian 15.6 White non-Hispanic 12.7 White Hispanic 4.4 Black 1.3 0 2 4 6 8 10 12 14 16 Share of borrowers (%) Source: WDR 2022 team, adapted from Fuster et al. (2021). Note: The figure shows the share of borrowers assigned a lower risk of default as lenders move from traditional predictive technology (a “Logit” classifier) to machine learning technology (a “Random Forest” classifier) in the US mortgage market. (Box continues next page) LENDING DURING THE RECOVERY AND BE YOND | 165 Box 4.2 Credit and algorithmic biases (continued) both the improved predictive power from machine on personal characteristics.f The results of the US learning models and its unequal outcomes stem mortgage study suggest that in a different context from the ability of this new technology to learn algorithms may use available borrower characteris- how nonlinear combinations of characteristics pre- tics (such as income, credit score, or collateral value) dict default. to implicitly proxy for a borrower’s race or gender, These studies indicate that, although machine effectively (though not always intentionally) side- learning algorithms appear to be more efficient stepping fair lending regulations. Legal scholars, than other methods in assessing credit risk, in some economists, and computer scientists have debated contexts artificial intelligence may lead to unde- how the texts of fair lending laws could need to be sirable biases. The results from the Pakistan study adjusted to take into account the realities of data- are consistent with nondiscrimination laws, which driven lending and prevent intended or unintended typically do not allow lending decisions to be based discrimination.g a. Montoya et al. (2020). b. World Bank (2021c). c. Morse and Pence (2020). d. Kisat (2021). e. Fuster et al. (2021). f. For a more detailed discussion of potential biased and discriminatory outcomes, see World Bank (2021a, 2021c). g. Bartlett et al. (2020); Gillis and Spiess (2019); Yang and Dobbie (2020). Enhanced analytics for underwriting Just as important as the data used to measure and assess creditworthiness are the models that lenders use to analyze that data. Conventional statistical models, which are based on multivariate regression analysis and similar tools, can be adapted to incorporate a wide range of data. Yet it is difficult to adapt them quickly and dynamically in fluid situations such as the one sparked by the COVID-19 pandemic. Even if the overall form of the models is maintained, retuning the parameters requires a period of data measurement under the new conditions to validate predictive capacity. If typical monthly or quarterly data were used, by the time the impact of one wave of the pandemic has been incorporated, many mar- kets could be in another wave, with potentially different sectoral impacts. Although subject to many of the same constraints related to data access and validation, machine learning (ML) models can more easily integrate real-time, high-frequency data and adapt to changing economic situations. Because ML models continually adapt to changes in data, they can tune and retune as a situation evolves, with poten- tially higher predictive capacity over time than traditional multivariate models and analyses.26 The benefits of alternative data, artificial intelligence (AI), and ML for improving visibility in credit underwriting have become increasingly well understood by financial institutions, but the barriers to adoption—technical, operational, and regulatory—can be significant.27 On the technical side, legacy systems often lack the capacity and flexibility to support the data processing and analysis requirements of AI applications. Effectively employing AI therefore requires significant investments in platform mod- ernization, as well as investments in the AI models themselves. It also requires access to expert data scientists and software development engineers, who are in short supply in both emerging and advanced economies.28 On the operational side, adoption of AI technology by the leading financial institutions 166 | WORLD DE VELOPMENT REPORT 2022 is steadily increasing, yet an industry survey estimated that, going into the pandemic, just 25 percent of financial sector firms relied on ML to detect fraud or support underwriting and risk management.29 Increasingly, software-as-a-service solutions as well as integrations with specialized technology allow for modular offerings and subscription models that are reducing barriers to entry and time-to-market for incumbent finance providers. In the regulatory realm, slow supervisory approvals may delay adop- tion of underwriting innovations by financial service providers. Lack of adequate or clear regulations on data usage, privacy, and permitted credit information sharing could prevent financial institutions from taking full advantage of the data available to them.30 Alternative lenders with operating models designed to leverage technology for process automation and to incorporate alternative data in credit underwriting grew rapidly in the years prior to the pan- demic. COVID-19 demonstrated that these lenders could also withstand a major shock.31 The business models of alternative lenders vary widely, as do the size and economic status of the borrowers they tar- get. The range of business models includes crowdfunding and marketplace platforms; mobile phone lenders that access transaction and mobile phone data; lending to MSMEs based on invoices, payment flows, or order information from suppliers; and personal loans based on regular salary or remittance income.32 Many of these business models target formalized small businesses and middle-income to afflu- ent individuals. However, some alternative lending models specifically focus on microloans and micro- leases to individuals or working capital for informal businesses and MSMEs. Although it is too early to conclude that during the pandemic alternative lenders as a whole demonstrated greater resilience than traditional financial services providers, the case studies in this chapter on Konfío (box 4.1) and MYbank (box 4.6) show that these models can adapt to a new normal for a tier of borrowers that otherwise would find it difficult to access credit. Scaling up the use of alternative data and AI to enable equitable access to finance during the pandemic recovery will require investments not just by alternative, digital-first lenders, but also by traditional banks and other financial service providers, including those that serve lower-income households and microenterprises. Meanwhile, alternative finance businesses serve too few customers relative to the scale of finance likely to be needed to drive the recovery in most markets. More specifically, alternative finance providers represent less than 1 percent of credit flows worldwide. Lending by fintech and technology companies in 2019 was estimated to be 5.8 percent of the stock of credit in Kenya, 2 percent in China, 1.1 percent in Indonesia, and less than 1 percent of overall credit to the private sector in other major markets.33 Incumbent financial institutions, by contrast, have the capital, size, and client relationships to supply credit to drive a broader recovery in their economies. It will be imperative that they overcome any cultural and capacity constraints and regulatory frictions that limit their ability to innovate to both support the recovery from the pandemic and compete longer term with new technology-driven lenders. Two areas needing attention in the near term to ensure that innovations in the use of data and ana- lytics—and, indeed, all of the technological advances discussed in this chapter—are truly beneficial are consumer protection and cybersecurity. Globally, supervisors listed cybersecurity (78 percent) and con- sumer protection (27 percent) among the top three growing risk areas related to the use of financial technology emerging during the pandemic because of the accelerated transition to digital services and remote interactions.34 A significant risk from which consumers need protection is cybercrime. Surveys of users of digital financial services in Kenya and Nigeria found that over 50 percent of respondents reportedly experienced fraud or attempted fraud when using a financial service since the onset of COVID-19.35 Meanwhile, cybersecurity breaches increased by an average of 15 percent for fintech firms during the pandemic.36 Recent reports from the G20/OECD Task Force on Financial Consumer Protection (FCP) and the World Bank provide extensive policy guidance on FCP in the digital age.37 LENDING DURING THE RECOVERY AND BE YOND | 167 Consumer protection guidelines must also ensure that digital financial service providers deliver prod- ucts appropriate for a given customer. Financial literacy levels among households and MSMEs remain low.38 The proliferation of digital finance has outpaced the financial literacy of many consumers, as well as their ability to use credit wisely. Mobile lending apps in Kenya and Tanzania provide just one exam- ple.39 Because the use of new data can reveal borrowers’ willingness and ability to pay, those data can be exploited to bring prices in line with what lower-income segments can afford. These data can also be used for predatory pricing. Although the price discrimination enabled by AI-powered models is a form of economic efficiency, it can lead to unfair outcomes for riskier or less financially literate borrowers.40 Digital technologies can play a role in helping to address this challenge. Consumer advocates can use technology channels to deliver simple, actionable, accessible, and personalized financial education, especially to youth. Many governments delivered financial education messages through digital chan- nels during the pandemic. Innovations such as personalized financial counseling and behavioral nudges related to financial goals can also strengthen financial consumer protection.41 Technology, and social media in particular, can also be used to achieve a more robust redress mechanism for consumers.42 Although digital delivery of financial education promotes financial resilience in several ways, it requires basic digital skills and access to information infrastructure (such as a smartphone and broadband/ internet). Lack of connectivity may exclude the households most in need of financial literacy support.43 Substantial evidence is emerging of a lasting “digital dividend” of the pandemic related to the adop- tion of digital channels for the delivery of and access to financial services (see box 4.3). However, many of the access gaps that existed before the crisis persist, risking a further deepening of financial and eco- nomic exclusion for those segments of the population that lack mobile phones or internet access. As dis- cussed in detail in the 2021 World Development Report, countries will be limited in their ability to adapt many of the innovative mitigation strategies without investing in digital infrastructure and supportive regulatory frameworks.44 Box 4.3 The COVID-19 digital shock The pandemic created near-immediate challenges Digital payments and mobile and internet bank- for financial service providers across all facets of ing helped financial institutions continue to serve their operations. The most immediate impact customers during lockdowns.c In many countries, was on physical branch operations, which in sev- this was a massive transition because most finan- eral countries closed to protect clients and staff. cial transactions used cash prior to the pandemic.d Although banks were often considered essential The first wave of lockdowns spurred a spike in services and so were exempted from lockdowns, downloads of digital banking apps.e A study of 71 the microfinance institutions (MFIs) and mobile countries estimated that the pandemic led to an money agents that act as front-line providers of increase of 21–26 percent in the rate of daily down- financial services to low-income and rural cus- loads of finance-related mobile applications from tomers did not always receive similar dispensa- the countries’ first confirmed COVID-19 cases tions. Within a matter of weeks, institutions had through December 2020.f to combine on-site activities with remote work to Likewise, mobility restrictions fueled a surge in keep operations running and ensure staff safety.a the adoption of digital payments.g In Indonesia, the Remote working operations of financial institutions value of e-money transactions grew about 39 per- in emerging economies were significantly limited by cent between 2019 and 2020.h In India, the monthly deficiencies in internet access and systems.b volume of digital payments as of November 2021 (Box continues next page) 168 | WORLD DE VELOPMENT REPORT 2022 Box 4.3 The COVID-19 digital shock (continued) was 57 percent higher compared to the year before. i as 44 percent of large enterprises reported that A survey in Pakistan found that active mobile money they adopted or increased use of digital channels users increased from 8 percent of adults in February– for their business, compared with just 27 percent of March 2020 to 14 percent by the end of the year.j microenterprises.p These new banking behaviors resulted in several Women and rural residents have less access to challenges for financial institutions. In India, for the key enablers of financial access, such as mobile example, repeated service outages led the Reserve connectivity and accepted forms of identification Bank of India to ask one of the country’s largest (ID), than men or urban dwellers. A GSMA report commercial banks to temporarily halt the rollout of estimates that 234 million fewer women than new digital financial services.k men use mobile internet.q Continued lack of con- The growth in digital financial services spurred nectivity or ID risks entrenching precrisis financial by COVID-19 was in many ways built on a foun- exclusion. Surveys in Pakistan revealed that gains in dation laid well before the pandemic. The share mobile money adoption in 2020 were concentrated of adults who made or received a digital payment among urban and financially literate groups.r grew from 32 percent in 2013 to 44 percent in Beyond payments, financial service providers 2017.l In Sub-Saharan Africa, the number of mobile had to ensure the continuity of a wide range of money accounts surpassed 500 million in 2020.m In operations, from account opening to loan under- several emerging economies during the pandemic, writing and loan collections. Prior to the pandemic, an initial drop in digital payments concurrent with the majority of financial institutions relied fully or in a decline in economic activity was followed by a part on face-to-face engagement of their staff with rapid recovery and growth of digital payments and clients. A survey of International Finance Corpora- electronic transactions that surpassed previous tion (IFC) financial institution clients on the early levels. For example, data for the first semester of impacts of COVID-19 found that over 60 percent of 2021 from Colombia’s Superintendencia Financiera respondents indicated that the crisis had led them show that the number of monetary transac- to introduce or prioritize the digitalization of inter- tions conducted through a mobile phone doubled, nal operations or the rollout of digital channels.s replacing ATMs as the most common transaction Technology and digital channels can significantly channel.n lower operating costs for lenders and enable them The uptake of digital platforms did not occur to sustainably offer small-value loans and products, evenly across or within countries. Figure B4.3.1 reach underserved segments, and maintain viable shows how the adoption of digital channels among operations through the crisis.t businesses was greater in middle-income coun- Among MFIs, adoption of technology and digital tries, albeit with significant differences across financial services has been slower historically. How- markets. Some of the larger markets and markets ever, anecdotal evidence indicates that institutions that already had a certain percentage of connected were better able to maintain operational resilience residents saw the highest growth in the share of and support access to financial services if they had businesses that adopted or increased use of digi- invested in back-office automation and digital chan- tal channels during the pandemic. By contrast, in nels prior to the pandemic. For example, Bancamía, low-income countries and markets with low inter- one of the largest MFIs in Colombia, played a cen- net penetration, the impact of the pandemic on tral role in the government’s digital cash transfer the use of digital channels among businesses was programs.u The institution also leveraged its agent also lower.o Surveys conducted in 2020 also found network and mobile banking services and acceler- that firm size influenced digital adoption: as many ated the rollout of a process automation initiative (Box continues next page) LENDING DURING THE RECOVERY AND BE YOND | 169 Box 4.3 The COVID-19 digital shock (continued) Figure B4.3.1 Impact of the COVID-19 pandemic on adoption of technology by businesses, by country income group 90 Share of businesses that began or increased use of technology 80 70 in response to COVID-19 outbreak (%) 60 50 Average 40 Average Median 30 adoption 20 Average Average 10 0 10 20 30 40 50 60 70 80 90 Share of individuals using internet, 2019 (%) High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, based on International Telecommunication Union, Statistics (database), https://www.itu.int /en/ITU-D/Statistics/Pages/stat/default.aspx; World Bank, COVID-19 Business Pulse Survey Dashboard, https://www .world bank.org/en/data/interactive/2021/01/19/covid-19-business-pulse-survey-dashboard; World Bank, Enter- prise Surveys (data­base), https://www.enterprisesurveys.org/. Note: The figure shows, by country income group, the share of firms that started using or increased the use of inter- net, online social media, specialized apps, or digital platforms, or invested in any new equipment, software, or digital solution in response to the COVID-19 outbreak. The vertical axis indicates the percentage of firms in low- and middle- income countries that adopted or increased use of digital channels after the onset of COVID-19. The horizontal axis indicates the percentage of individuals within a country using the internet by the end of 2019, or the most recent value before then. (Box continues next page) 170 | WORLD DE VELOPMENT REPORT 2022 Box 4.3 The COVID-19 digital shock (continued) to facilitate remote work for part of its back-office operations. As Nigeria eased restrictions, the staff. Likewise, LAPO Microfinance Bank in Nige- microfinance bank continued to rapidly scale up ria was able to rely on its agent network to con- its agent network, more than doubling transaction tinue to provide basic services to customers during volumes over precrisis levels by August 2020.v an early lockdown that required it to stop branch a. See International Monetary Fund, Policy Responses to COVID-19: Policy Tracker (dashboard), https://www.imf.org/en /Topics/imf-and-covid19/Policy-Responses-to-COVID-19. b. Garrote Sanchez et al. (2021). c. Klapper and Miller (2021). d. McKinsey (2020). e. Koetsier (2020). f. Fu and Mishra (2020). g. Auer et al. (2020). h. Crisanto (2021). i. RBI (2021b). j. Ghosh (2020); Karandaaz (2021). k. The temporary ban issued on new digital initiatives to safeguard consumer protection and systemic stability was partially lifted in August 2021, allowing the concerned bank to issue new credit cards. l. World Bank, Global Findex Database 2017 (Global Financial Inclusion Database), https://globalfindex.worldbank.org/. m. GSMA (2021b). n. SFC (2021). o. Apedo-Amah et al. (2020); World Bank, COVID-19 Business Pulse Survey Dashboard, https://www.worldbank.org/en /data/interactive/2021/01/19/covid-19-business-pulse-survey-dashboard. p. Adian et al. (2020). q. GSMA (2021a). r. Khan and Jaffar (2021). s. IFC (2021). t. Pazarbasioglu et al. (2020). u. Banca de las Oportunidades (2020). v. Froeling, Garcia Vargas, and Savonitto (2021). Product choice and design In addition to improving data and analytics, lenders can manage the heightened credit risk environment of the pandemic by focusing on credit products and product features that offer higher levels of visibility and recourse. For example, shorter-term loans require less information to gauge a borrower’s ability and willingness to repay than loans with longer tenors. A projection of the next year’s income and risks may not be necessary if a loan’s duration is only one month, and yet a one-year projection would offer inade- quate visibility for a three-year unsecured loan. Alternatively, a loan secured by inventory may not require as much visibility into future cash flows. This logic applies to personal lending as well. For example, a mortgage has different terms and longer tenor than an unsecured loan because recourse to the property reduces both the probability of default and loss in the event of a default. Lending products linked to other revenue-generating activities may provide greater visibility of the borrowers and enable credit losses to be offset by other revenue streams, thereby increasing the ability of lenders to assume credit risk. LENDING DURING THE RECOVERY AND BE YOND | 171 Loan tenor Matching the exposure period of a loan to the time frame over which the lender has visibility into the borrower’s prospects is an age-old way to manage credit risk. During the COVID-19 recovery, lenders may reduce tenors for new loans to avoid having to predict longer-term economic outcomes. The chal- lenge with shorter-term loans is that the costs of origination and servicing are essentially fixed, which reduces the potential profit from the loan. Digital technologies can reduce these costs by automating credit underwriting, monitoring, and collection and by using low-cost digital disbursement and repay- ment processes, making short-term loans to digitally connected MSMEs and households more viable. Digital loans offered through mobile phones are one example of short-tenor loans that have grown rapidly in emerging economies (box 4.4). Research from Kenya found that access to these products increases household resilience in the face of economic shocks.45 On the other hand, concerns have arisen about the cost, transparency, and consumer risks of these types of loans.46 However, if these loans are appropriately designed and regulated, they have the potential to help unbanked customers build or rebuild credit history and gain access to more formal, larger, and longer-term loans. Well-known products such as installment plans and point-of-sale financing are additional lend- ing approaches that mitigate credit risk through short tenors and ongoing reviews of borrower risk. Installment plans allow borrowers who do not have enough cash to buy a product outright to divide a Box 4.4 Case study: Mobile money overdrafts in Kenya In Kenya, the migration of payments, savings, lend- products have proven useful to many borrowers ing, and investment to digital channels predates the but raise concerns about transparency, appropri- COVID-19 pandemic. By 2019, 79 percent of adults ateness, high rates of default, and overindebted- had a mobile money account, and nearly 60 percent ness.d Emerging research suggests that they can be of micro- and small enterprises used mobile money an important tool for smoothing consumption and for business transactions.a Short-term digital loans financial management.e According to survey data, had also become mainstream: survey data indicate during the pandemic entrepreneurs and households that 14 percent of adults borrowed digitally in 2019, across Kenya found it challenging to access tradi- compared with the 9 percent of adults who had tional bank and nonbank credit, while digital credit access to traditional sources of bank and nonbank continued to be used widely to support short-term credit.b liquidity and smooth consumption, complementing The number and types of digital lenders and the social networks and informal risk coping channels.f products they offer range from bank loans disbursed During the crisis, lenders tightened credit stan- into mobile money accounts (such as M-Shwari) to dards significantly on both digital and traditional digital loan apps (such as Tala, Branch) that were products in response to increased uncertainty.g mostly unregulated until December 2021.c These New regulations issued in April 2020 introduced products typically allow customers to conve- a moratorium on loan repayments and set a min- niently access short-term, low-value credit from imum threshold for negative reports to credit their phones. The lenders manage risk by analyzing bureaus for both.h As a result, disbursements for alternative data and limiting exposure through low- the two largest digital term loan products fell sig- value loans that can be easily renewed. These credit nificantly (a 41 percent year-on-year decrease as of (Box continues next page) 172 | WORLD DE VELOPMENT REPORT 2022 Box 4.4 Case study: Mobile money overdrafts in Kenya (continued) March 2021) stemming both from a reduction in active users more than double, from 0.7 million to demand and from lenders rejecting applications for 1.7 million between April 2020 and September 2021, smaller-value loans and focusing on a smaller pool and the disbursement value grew by 62 percent of lower-risk borrowers.i Digital loan apps saw the year-on-year.k The 2021 FinAccess Survey results largest decline in use, from 8.3 percent of adults in indicate that 18.3 percent of adult respondents 2019 to 2.1 percent in 2021, according to the 2021 used Fuliza in the last 12 months.l By allowing mobile FinAccess Household Survey.j money account holders to complete payments or By contrast, Fuliza M-PESA, the mobile money execute transfers even without sufficient balance overdraft facility launched in 2019 by Safaricom, in their accounts, the Fuliza facility effectively in partnership with NCBA Bank Kenya and KCB functions as low-value, short-term credit, most Bank Kenya, grew rapidly (figure B4.4.1). The Fuliza commonly used for household expenses, emer- M-PESA overdraft facility saw its number of daily gencies, and business expenses.m The overdraft is Figure B4.4.1 Growth of merchant payments and mobile money overdrafts in Kenya, 2019–21 700 +85% 650 600 Kenyan shillings (K Sh, billions) 550 500 450 400 350 300 250 +83% 200 150 100 50 0 October 2019– April–September October 2020– April–September March 2020 2020 March 2021 2021 Merchant payments, Lipa na M-PESA Overdraft disbursements, Fuliza M-PESA Source: Safaricom 2021b. Note: The value of payments for goods and services through the Lipa na M-PESA platform grew from K Sh 353 bil- lion ($3.4 billion) in October 2019–March 2020 to K Sh 653 billion ($5.9 billion) in April–September 2021. The value of overdraft disbursements grew from K Sh 132.4 billion ($1.3 billion) in October 2019–March 2020 to K Sh 242.6 ($2.2 billion) in April–September 2021. (Box continues next page) LENDING DURING THE RECOVERY AND BE YOND | 173 Box 4.4 Case study: Mobile money overdrafts in Kenya (continued) automatically credited back when payments or cash account holders much-needed flexibility to execute arrive in the borrower’s mobile money account. digital payments to merchants—including through bility These product features offer lenders more visi­ the Lipa na M-PESA merchant payment service— and recourse than a term loan product, allowing and business transactions in a context of height- lenders to ­continue providing liquidity to Fuliza ened uncertainty and payment delays. Although users through the crisis. the growth of the Fuliza overdraft product has Together with government policies that tempo- democratized access to low-value credit, including rarily removed transfer fees for low-value mobile for low-income consumers,o concerns about trans- payments, the overdraft product is likely to have parency,p the cost of these short-term digital prod- been an important factor in the doubling of digital ucts, and the risk they pose to consumers suggest a payments processed in Kenya in 2021.n Fuliza gave need for careful oversight. a. CBK (2019, 2021c). b. For a more detailed review of the Kenyan credit market in 2019, see Gubbins (2019). c. CBK (2021b). d. Burlando, Kuhn, and Prina (2021); Izaguirre, Kaffenberger, and Mazer (2018). A study in Mexico found evidence that delay- ing digital loan disbursements can significantly reduce default rates, suggesting that easy access to loans may lead to significant impulse and temptation buying. e. Bharadwaj and Suri (2020). f. Blackmon, Mazer, and Warren (2021); FSD Kenya (2021). g. CBK (2020a, 2020b, 2021a). Credit officer surveys show a progressive tightening of credit standards for households and personal loans starting in March 2020. h. CBK (2020c). i. Safaricom (2021a). j. CBK, KNBS, and FSD Kenya (2021). The report attributes the decline in usage of digital loan apps to competition from formal digital credit products (including Fuliza), unfair debt collection practices, the impact of new regulation prohibiting listing of small-value loan borrowers to credit bureaus, and anticipated regulation by the CBK. k. Safaricom (2021b). l. CBK, KNBS, and FSD Kenya (2021). m. Putnam, Mazer, and Blackmon (2021). n. Safaricom (2021a). Total Fuliza M-PESA transaction value grew 58.2 percent year-to-year, while the volume of Fuliza M-PESA transactions grew 29.8 percent year-to-year as of March 2021. The Fuliza M-PESA ecosystem saw increased activity as customers took advantage of no fees on Lipa na M-PESA transactions below K Sh 1,000 (approximately $9). o. CBK, KNBS, and FSD Kenya (2021) identifies Fuliza as the likely driver of the increase in adoption of formal credit products regulated and supervised by the Central Bank among lower-income segments of the population. p. For a discussion on transparency of overdraft accounts, see Sule et al. (2018). purchase into smaller payments that are collected over time. Installment loans can be used for house- hold purchases as well as for the machinery or equipment needed for a small business. These lending products have a long history, with many examples of positive uses, as well as some abuses by bad actors. Data from Poland’s credit bureau (figure 4.3) show that, although demand for consumer loans fell in the months following the outbreak of the pandemic, lenders reacted by significantly tightening credit conditions for consumer cash loans, leading to a significant reduction in loan approval rates. For install- ment products, which typically offer more visibility to lenders, approval rates fell only slightly and rapidly returned to precrisis levels. 174 | WORLD DE VELOPMENT REPORT 2022 Figure 4.3 Impact of the COVID-19 pandemic on consumers’ loan approval rates, by product type, Poland, 2019–21 120 COVID-19 onset Relative change in loan approval rates (%) 110 100 90 80 70 60 1 19 19 19 19 20 20 20 20 21 21 21 02 20 20 20 20 20 20 20 20 20 20 20 .2 n. ril ly t. n. ril ly n. ril ly t. pt Oc Oc Ju Ju Ju Ja Ap Ja Ja Ap Ap Se Cash loans Installment loans Source: Biuro Informacji Kredytowej S.A. (Credit Information Bureau) analysis based on proprietary data. Note: The figure shows for Poland the relative change in approval rates for cash and installment consumer loan products from January 2019 to September 2021, compared with their respective approval rates as of January 2019. Approval rates are defined as the share of customers who applied for a cash or installment loan during a two-week period and were granted the respective loan product by any Polish lender. Short-term financing is not appropriate for all borrowers. For example, a short-term loan, even with rollovers, may not be suitable for long-term projects or capital investments. Short-duration credit terms can, however, help lenders improve visibility on certain informationally opaque borrowers and open the door to subsequent longer-term financing. Secured credit Another approach to mitigating risk is through product configurations that improve recourse. Tradi- tional recourse options are limited for many borrowers in emerging economies because real estate is the preferred collateral for most banks, and many small firms and individuals do not own property. As a result, loan applications from small firms are frequently rejected for lack of collateral, accord- ing to World Bank Enterprise Surveys data.47 Because the pandemic introduced uncertainty around the value of collateral, financial institutions increased collateral requirements, making it harder to obtain financing, even for those who do have qualifying assets. In quarterly surveys of credit conditions in Mexico, for example, firms reported a progressive increase in bank collateral require- ments through June 2021.48 Other forms of recourse more common for lower-income borrowers, LENDING DURING THE RECOVERY AND BE YOND | 175 such as personal guarantees and the reputational sanctions characteristic of group microfinance lending models, may also have been affected by the pandemic. For example, social distancing pre- vented group meetings. Widening the range of assets accepted as collateral could enable lenders to find effective means of recourse where hard collateral is not available, allowing them to better manage the risk of extending credit through the pandemic and the recovery. Movable assets account for roughly 78 percent of enter- prise capital stock in emerging economies, and yet many lack modern, secured transaction regimes that would permit the use of movable assets as collateral.49 The modernization of legal frameworks for secured transactions and the introduction of movable asset collateral registries create new options to mitigate credit risk. Technology, including digital ledgers, can be implemented to facilitate the design and implementation of collateral registries, as well as for the creation and transfer of digital assets to be used as collateral.50 A study found that collateral registries for movable assets effectively address infor- mation asymmetries and foster access to finance. In countries that introduced registries, the number of firms with access to finance increased by an average of 10 percentage points, interest rates declined, and tenors lengthened, with stronger impacts on smaller and younger firms.51 Asset-based lending can thus reduce the risk of default and create the conditions for lenders to pro- vide larger loans and serve borrowers with no previous credit history. A study in Kenya found that farmers who were offered an asset-backed, small down payment loan to purchase water tanks were much more likely to make the investment than farmers offered a standard collateralized loan—and the repayment rates were comparable.52 Another study in Pakistan found that hire purchase agreements—a type of leasing contract—motivated an MFI to finance business assets worth several times its prevail- ing borrowing limit, while maintaining low default rates and offering flexible repayment options. The asset-based finance contracts had significant and persistent effects on the resilience and growth of the microenterprises, as well as on corresponding household wealth, compared with the MFI’s traditional loan products.53 Another type of asset-based, flexible leasing contract known as pay-as-you-go (PAYGo) had been emerging as an effective product for small asset financing prior to the pandemic, and it has shown resil- ience through the crisis. The product was originally developed to enable households to finance solar home systems, but it has also been used for the purchase of two-wheel transport and appliances.54 Some PAYGo providers incorporate innovative forms of recourse, such as a remote “lockout” that makes the asset unusable for nonperforming borrowers (see box 4.5). Box 4.5 Case study: Pay-as-you-go home solar systems An estimated 590 million people in Africa live with- 18 percent fall in off-grid solar lighting sales in out access to electricity. COVID-19 deepened this 2020.b In a challenging year for off-grid energy, challenge, in part because some governments redi- however, pay-as-you-go (PAYGo) financing models rected limited resources from energy subsidies to swiftly recovered, proving to be an accessible, resil- funding for emergency response measures.a The ient way to support access to electricity for house- impact of lockdown measures on household bud- holds and microentrepreneurs. gets, as well as on the operations and supply chains PAYGo is a form of asset-based financing that of solar energy providers, also contributed to an relies on mobile technology to offer flexible financing (Box continues next page) 176 | WORLD DE VELOPMENT REPORT 2022 Box 4.5 Case study: Pay-as-you-go home solar systems (continued) for small asset purchases such as solar home sys- tems and consumer electronics. Low-income con- Figure B4.5.1 Volume of off-grid lighting sumers who lack credit histories or collateral are products sold as cash products and via able to acquire these types of assets with a rela- PAYGo, 2018–21 tively small down payment.c For solar home sys- tems, borrowers also enter into a contract, typically 3.5 Number of units sold (millions) ranging from one to three years, to buy credits for 3.0 daily, weekly, or monthly energy usage. By purchas- ing credits, borrowers pay down the loan interest 2.5 and principal. When credits run out, the system automatically shuts off until the user tops up the 2.0 balance. Embedding loan repayments in a fee-for- 1.5 service model (akin to buying mobile phone airtime) is a flexible form of financing that allows clients to 1.0 reduce or pause payments in the event of a shock. The lockout technology likewise reduces the risk 0.5 for providers that would have no recourse in the 0 event of default other than to repossess the asset— 18 18 19 19 20 20 21 an expensive option. Although the lockout technol- 20 20 20 20 20 20 20 1 2 1 2 1 2 1 ogy does not necessarily reduce loss in the event of H H H H H H H default, it encourages borrowers to behave in a way Cash PAYGo that reduces the probability of default. According to industry data, PAYGo solar compa- Source: GOGLA 2021. nies have been able to weather the COVID-19 crisis Note: Products are classified as cash when sold in a single transaction (including products purchased relatively well (figure B4.5.1). Cash sales for solar via tenders) or as PAYGo when the customer pays systems through June 2021 were well below those for the product in installments over time or pays for for previous years, whereas sales through PAYGo use of the product as a service. H1 and H2 refer to the first and second halves of the fiscal year, respec - contracts recovered and continue to grow. Perfor- tively. PAYGo = pay-as-you-go. mance data on 20 PAYGo providers found some signs of distress, including an increase in write- offs and receivables at risk. But many performance which may indicate that consumers facing lock- measures remained consistent with pre–COVID-19 downs anticipated the need for reliable electric- metrics.d ity at home and so took advantage of the PAYGo The resilience of the PAYGo market can be model to acquire it at low initial costs. They were attributed to a few factors. Most fundamentally, then able to use (and pay for) the asset only when electricity is a basic need, and therefore some gov- they needed it. ernments gave solar companies essential business Finally, a field experiment in Uganda demon- status, like that given to the traditional power sec- strated the viability of PAYGo asset-secured financ- tor. High demand also helped buffer the effects of ing models beyond their initial use to acquire the the pandemic. Many PAYGo companies reported solar home systems. The study found that the record sales during the early months of COVID-19, lockout technology can enable lenders to leverage (Box continues next page) LENDING DURING THE RECOVERY AND BE YOND | 177 Box 4.5 Case study: Pay-as-you-go home solar systems (continued) the solar asset as collateral to secure other types compared with default rates for uncollateralized of household finance—in this case, school loans. loans. Researchers concluded that the recourse The fact that the lender could temporarily disable provided by the asset lockout feature led to a the flow of energy to solar home systems led to a reduction in adverse selection and moral hazard 19 percentage point reduction in default rates among borrowers.e a. IEA (2020). b. GOGLA (2021). c. This is typically a lease-to-own contract with down payments lower than 20 percent of the value of the asset. d. The PAYGo COVID Impact Monitor, an initiative by the Consultative Group to Assist the Poor (CGAP), Global Off-Grid Light- ing Association (GOGLA), and International Finance Corporation (IFC) under the PAYGo PERFORM program, collected data from 20 companies to gauge the effect of COVID-19 on the sector. See Global Off-Grid Lighting Association, “PAYGo COVID Impact Monitor (PCIM),” Amsterdam, https://www.gogla.org/sites/default/files/overview_paygo_covid_impact _monitor_17082020.pdf. e. Gertler, Green, and Wolfram (2021). Embedded finance Where data on a borrower’s credit history are no longer reliable and visibility into future economic activ- ity is limited, linking lending directly to an underlying economic activity is a powerful way for lenders to mitigate credit risk. Contextual finance provides credit in the context of another transaction, such as the payment of a utility bill or the purchase of an appliance or business inventory. The category of embedded or contextualized finance55 includes a wide range of products and credit underwriting modalities, which typically combine features that lead to greater visibility and recourse in the context of a monitorable transaction or a broader relationship with the borrower. When lending in the context of another transaction, lenders typically have access to a range of current data on the borrower, the other parties involved, the use of funds, and the timing of the underlying eco- nomic activity. Lending in the context of supply and distribution chains, for example, has a long history dating back to early trade and commerce between regular counterparties. In increasingly digitalized economies, lenders connected to or integrated with a marketplace or a transaction platform can com- bine contextual information about the current transaction with historical, high-frequency transaction data to further improve visibility. Embedding credit in another transaction motivates borrowers to repay the loan, as doing so helps maintain the ability to engage in future transactions with that counterparty. Embedded lending may also have recourse through a lien on future cash flows between the parties, or it may benefit from the effect of automated payments on delinquencies.56 Merchant cash advances, which are based on patterns of credit and debit card receipts, are one example of automated payments. These loans are typically repaid as a percentage of daily or weekly receipts directly from the account through which the mer- chant’s card payment receipts flow. Providing finance in the context of another transaction may also motivate lenders to take on more risk than they would in the context of a stand-alone loan. For example, a seller might offer credit to a buyer that lacks collateral because the seller is willing to bear the risk in order to make the sale. Merchant working capital provided by an online marketplace platform allows the merchants to do more business on the platform, generating more revenue for the marketplace. Buy now, pay later (BNPL) products are 178 | WORLD DE VELOPMENT REPORT 2022 an example of lending in which sellers bear all or some of the costs and risks of providing credit to their customers in order to increase sales.57 Although embedded finance is not new, innovative uses and larger scale are now possible in the context of digitally enabled economic activity. The disaggregation and reconfiguring of financial ser- ­ vices by fintech innovators have lowered the barriers to entry for nonbanks. Likewise, technology plat- forms are enabling embedded financial products to scale by inserting them directly into the workflows of an inventory order, invoicing process, crop planting, or e-commerce transaction.58 This insertion can lead to significant cost efficiencies in customer acquisition and loan processing. Loans may be offered directly by the platform (or other business counterpart), or they may be originated and serviced by the platform using its customer information and transaction processes, but funded by a third-party finan- cial institution. The surge in digital adoption during the pandemic created opportunities to turn to digital channels and platforms to extend credit to consumers and businesses. The major e-commerce platforms are increasingly offering embedded financing to merchants selling on their marketplaces. These platforms use data about their sellers—including their sales, revenue, and returns history—to underwrite work- ing capital loans. Platform providers with a wealth of data have been shown to have better visibility into credit risk than traditional lenders.59 Some e-commerce marketplaces such as Amazon, Mercado Libre, and Alibaba lend directly or through subsidiaries (box 4.6). Others, such as Hepsiburada, Jumia, Lazada, and Shopee, provide data to third-party banks and accredited finance providers that offer loans via the marketplace. The loans may be disbursed and collected by the platform or by a partner financial institution.60 Box 4.6 Case study: Doubling down on MSE finance throughout the pandemic MYbank, an online bank serving mostly micro- and between access to working capital financing during small enterprises (MSEs) in China, continued to the early months of the pandemic and higher sales grow throughout the COVID-19 pandemic, nearly revenue. The average loan size was ¥38,000 (less than doubling its reach from 21 million MSEs in 2019 to $6,000) with an average term of about 12 months.c 40 million MSEs as of June 2021.a MYbank has MYbank leverages channel integration with expanded its customer base beyond e-commerce Alibaba Group e-commerce platforms and Alipay merchants, reaching millions of offline merchants, to serve e-commerce customers. Alipay offers rural and agricultural customers, and supply chain electronic payments and a broader range of digital MSEs, among others. MYbank was able to accom- financial services to more than 1 billion customers plish this expansion by using its unique data part- and 80 million MSEs across China. MYbank’s credit nerships and digital business model to adjust its underwriting uses machine learning techniques to underwriting models during the pandemic. MYbank integrate payments and transaction data, as well also broadened its reach by partnering with other as other user information from these platforms to banks to offer MYbank’s adaptable scoring and inform its risk profiles.d Such techniques not only risk management through them. Approximately enable more accurate risk assessments, but also 80 percent of MYbank’s MSE clients had fewer than reduce the risk of excessive lending. As of June 10 employees, and most had limited or no access 2021, MYbank’s nonperforming loan ratio was 1.52 to finance from banks.b An analysis of over 40,000 percent. Research has found that smaller businesses MSE clients of MYbank found a positive association and enterprises in less-developed cities benefit the (Box continues next page) LENDING DURING THE RECOVERY AND BE YOND | 179 Box 4.6 Case study: Doubling down on MSE finance through the pandemic (continued) most from big tech lenders because proprietary data in its model in the first quarter of 2020 and contin- allow these lenders to compensate for the lack of ues to adjust its underwriting through regular sec- traditional data from credit assessment.e Although toral analysis and client updates. MYbank is a stand-alone bank, its ability to rely on One of MYbank’s responses to the COVID-19 e-commerce and payments platforms allows it to crisis was initiating in March 2020 a partnership better assess the customer’s ability to repay (visibil- with the All-China Federation of Industry and ity), as well as take advantage of recourse features Commerce to collaborate with over 100 banks to such as automatic loan payments from the client’s offer a jointly financed and administered loan prod- Alipay account. uct.h Through this partnership, banks were able to China’s economy improved faster than many provide access to finance for MSEs by leveraging other markets during the second half of 2020, MYbank’s loan processing facility and its trans­ but the impact of the COVID-19 crisis on Chinese action data. Each bank followed its in-house credit firms was severe. A survey on the early impact of policies using MYbank’s updated sector-level and the pandemic revealed that more than half of the firm-level assessments to provide additional risk Chinese MSE respondents expected their income mitigation. MYbank’s role in providing MSEs with to fall by 50 percent in the first quarter of 2020.f As access to credit during the pandemic using alterna- of June 2021, an index of MSE operations indicated tive forms of data is consistent with earlier research that smaller businesses had not yet returned to on 2 million Chinese firms that received credit from prepandemic levels.g MYbank was able to use real- MYbank and from traditional banks between 2017 time business transaction information to adjust its and 2019. i In the study, researchers found MYbank’s credit underwriting models and strategy to con- underwriting to be less dependent on the financial tinue to lend to these customers and expand its cycle than that of traditional lenders and therefore reach in China. MYbank made nearly 100 changes potentially less affected by a negative shock. a. Businesswire (2021). b. Sun et al. (2021). c. Sun et al. (2021). d. Gambacorta et al. (2020). e. Huang et al. (2020). f. Sun et al. (2021). g. PSBC (2021). h. China Banking News (2020). i. Gambacorta et al. (2020). Embedded finance opportunities can be found across many types of digital platforms. Kobo360 is an African e-logistics platform for truck drivers and small-fleet operators in Ghana, Kenya, Nigeria, Togo, and Uganda. Because Kobo360 has insight into the portion of a truck operator’s cash flow that stems from bookings through the platform, it can offer participating operators working capital financing. The platform underwrites loans using proprietary data on the trip and income history of the driver or com- pany, as well as on supply, demand, and bookings. Because payments for trips booked on the platform flow through Kobo360’s systems, the company can automate loan repayments.61 Moreover, because driv- ers rely on Kobo360 for future trip bookings and income, they would be more likely to prioritize repay- ment of a loan to the platform relative to other expenses. 180 | WORLD DE VELOPMENT REPORT 2022 Supply chain finance Supply chain finance shares many of the features of embedded finance in terms of its ability to mitigate risk by linking credit to a commercial interaction. By tying short-term credit exposures to the movement of goods or inventories in the context of an established relationship between supply chain participants, supply chain finance improves visibility into the borrower’s probability of default.62 Even though credit in a supply chain transaction is typically unsecured, lenders gain recourse from the fact that trans­ actions take place within a network that includes anchor buyers or distributors on whom the borrower depends for business. These relationships within a supply chain mitigate risk, improve efficiency, and lower the cost of providing finance. Larger corporate buyers or distributors often provide their value chains with financing. For example, buyers may decide to pay their suppliers faster to support their working capital and operations, or sellers and distributors may allow downstream MSMEs to pay later or in installments. This form of supply chain finance depends on the liquidity of these corporate anchors and their willingness to take on the risk of providing—and typically subsidizing—credit to ensure the viability of their value chains. As the pandemic broke out, many corporate anchors sought to support the liquidity of their suppliers and dis- tributors.63 For example, 10 global fast-moving consumer goods (FMCGs) manufacturers increased their own use of working capital during the first half of 2020, largely to support their commercial counter- parties. 64 To protect the liquidity of their distributors, seven of the 10 FMCGs manufacturers on-lent working capital by extending receivable payment terms. The same corporate anchors reduced accounts payable by around 10 percent, thereby channeling working capital to suppliers. The anchors increased their outstanding debt by 13 percent (approximately $45 billion) from the end of 2019 to the second quarter of 2020, effectively intermediating between the capital markets and their value chains to take on credit risk that banks or other lenders may not have been willing to assume. Not all anchors are willing or able to take on the balance sheet volumes and risks involved in extending financing to their suppliers and distributors. Supply chain finance programs that involve a third-party financial institution (such as factoring or reverse factoring programs) can be very effective in reducing risk and supporting access to finance for suppliers.65 Lenders in these programs—embedded between a corporate buyer and its suppliers, often SMEs—use invoice data to gain visibility into the future cash flows of the borrowing suppliers. In some programs, the lender may have additional recourse to the buyer that established the program. Hepsiburada, a Turkish e-commerce platform, facilitates financing for merchants and suppliers both directly and by enabling bank lending through an internal platform that submits a supplier’s or merchant’s invoices to the lending bank as evidence of receivables.66 Supply chain finance can be less risky than a standard (unsecured) working capital line even when the lender is not a direct participant in the supply chain. Through the pandemic, the supplier finance program of the International Finance Corporation (IFC) saw greater growth and borrower uptake (see box 4.7). Digitalization has significantly reduced the operating costs of supply chain accounts.67 Digital tech- nologies enable supply chain partners and lenders to automate processes and lessen the burden of doc- umenting receivables, tracking amounts due, and collecting payments. Advances in the use of digital technologies in both commerce and finance are enabling supply chain finance programs to scale up and serve more businesses with a broader range of loan sizes, including smaller loans that were previously uneconomical to service. In Latin America, Citibank announced in October 2020 its partnership with PepsiCo and the fintech Amigo PAQ to digitalize payments and offer small shops working capital lines of credit. The partners underwrote, monitored, and collected payment for a portfolio of small loans to thousands of tienditas. By the end of 2020, the partnership was serving more than 4,000 SMEs in Peru, with ongoing operations LENDING DURING THE RECOVERY AND BE YOND | 181 Box 4.7 The supply chain finance response to the pandemic The pandemic profoundly disrupted international year ending June 2019 to just over $2 billion in the trade and domestic supply chains. Faced with a sud- year ending June 2021. Sixty-five percent of this vol- den drop in revenue and greater uncertainty about ume was disbursed to suppliers based in six lower- future cash flows and operations, many buyers middle-income countries: Bangladesh, Cambodia, sought to reduce inventory by delaying or cancel- Honduras, Pakistan, Sri Lanka, and Vietnam. ing orders. They also sought to preserve liquidity by The increase stemmed from the growth in vol- extending their payment terms with suppliers. The ume financed by existing suppliers in the program, suppliers, for their part, were also concerned about some of which had previously used bank finance preserving liquidity and attempted to provide dis- that became less available during the crisis, and by counts for early payments in an attempt to cash in new anchor buyers that joined in 2020 to broaden receivables. Despite these efforts, many struggled the availability of finance to their suppliers. For to remain viable. On average, the crisis led to an example, a GTSF anchor buyer in the automotive immediate increase in working capital requirements industry—one of the sectors most affected by the for firms, driven by the reduction in revenue and the pandemic—saw 300 percent growth in the number increase in accounts receivables and inventory.a of its suppliers that joined the program and more During the pandemic, the trade finance pro- than 10 times the volume financed. Overall, the grams of the International Finance Corporation number of suppliers actively participating in IFC’s (IFC) saw a surge in interest from suppliers driven GTSF Program surged 230 percent between the by these factors. For example, IFC’s Global Trade year ending June 2019 and the year ending June Supplier Finance (GTSF) Program, which provides 2021. This activity suggests the value during the short-term financing to suppliers that sell to large pandemic of a program enabling buyers to help domestic buyers or export to international buyers, their suppliers access finance, thereby stabilizing saw total commitments rise from $1.2 billion in the the buyers’ supply chains. a. PwC (2021a, 2021b). in Mexico and Guatemala.68 The size and number of these loans would not have been feasible if the end- to-end processes had not been digitalized.69 As digital order, inventory, and payment systems become more widely used and the track records of smaller borrowers and supply chain instruments are estab- lished, the receivables assets can be bundled and transferred, so funding could move from corporate balance sheets to bank balance sheets, the capital markets, or to other investment vehicles. Such devel- opments would create new options for the external finance of downstream payables.70 Insuring credit risk and catalyzing long-term investments This chapter has highlighted examples of lenders adopting innovative and often tech-enabled approaches to improving visibility and recourse so they can continue and even increase lending. Achieving the right mix of risk management approaches is challenging in a high-risk and rapidly changing context. For that reason, credit guarantees (CGs) have been, and will continue to be, a useful tool for motivating lenders to continue offering credit during high-risk periods. By having recourse to a guarantor when a borrower defaults, lenders are able to significantly reduce their losses. Guarantors are often government agencies or public institutions, but mutual guarantee 182 | WORLD DE VELOPMENT REPORT 2022 systems are available in some markets, especially in Europe. Private trade credit insurance also plays an important role in global markets and particularly trade finance. Public development banks and develop- ment finance institutions also play an important role in promoting lending to MSMEs, other productive sectors, and areas of policy priority.71 Credit guarantee schemes have been a central pandemic response by governments in advanced and several emerging economies. In 2020, public credit guarantee schemes amounted to an estimated 2 percent of global gross domestic product (GDP).72 Evidence from some countries such as Spain that embraced CGs during the COVID-19 crisis indicates that CGs have improved MSMEs’ access to finance and have imposed a smaller fiscal burden relative to government-backed grants or direct lending.73 A recent study of the impact of COVID-19 on SME failures estimates that loans backed by govern- ment guarantees can be more effective and efficient than cash grants for limiting bankruptcy rates and returning trends to precrisis levels.74 Furthermore, guarantees played a crucial role in supporting the access of SMEs to trade finance products. A survey of member countries of the Organisation for Eco- nomic Co-operation and Development (OECD) found that commercial banks and trade credit insurance providers displayed a diminished appetite for risk, while government-supported export credit agencies saw a significant increase in applications and volume.75 As economies reduce the use of broad fiscal and monetary support measures, guarantors may have to continue supporting lenders where credit risk remains high and visibility and recourse remain limited. Because CGs play a role in balancing the risk equation for lenders even during normal times, they could be among the last fiscal measures to be reduced or withdrawn, possibly playing an even bigger role than before the crisis. In addition to reducing the risk of financing MSMEs and sectors especially affected by the crisis, guarantee programs can be adjusted to reduce lenders’ risk of providing longer-term financ- ing to support investments by businesses in adapting to their new economic reality as well as to de-risk financing to emerging areas and sectors with the potential to support a sustainable, inclusive recovery. In the transition from pandemic response to economic recovery, guarantors should, however, adjust CG program parameters gradually and in sync with the unwinding of fiscal support measures. Many of these adjustments may require tightening the program design to ensure that only firms that are well run yet need support benefit from guarantees.76 Like cash grants and loans by state-owned banks, CGs can potentially misallocate resources to weak “zombie firms,” or to strong firms that do not need the CG to survive. A recent analysis concludes that the more common resource misallocation is use of guarantees for firms that did not need them (thus tying up limited capital).77 Digital technologies can enable the collection and analysis of data to facilitate timely performance assessments of CGs and ensure transparent reporting. As the economy recovers, stricter screening should aim to exclude zombie firms and reduce the portion of each loan that is guaranteed to motivate strong underwriting practices by loan originators and maintain program sustainability to reduce the fiscal burden. To direct resources toward smaller enterprises, governments could lower the size cap for eligible borrowers. An appropriately priced guarantee premium could help discourage lenders from over- using guarantees; guarantors should revise pricing as economic conditions improve. (For more on the design and execution of effective credit guarantees, see spotlight 4.1.) Beyond insuring against credit risk, development banks, as well as regional and international finan- cial institutions, will continue to play an important role in the recovery by providing long-term finance and support for capacity development and digital transformation. That role could include catalyzing pri- vate lending that can produce positive long-term returns, such as adapting to climate change or shifting to low-carbon business models. It could also include reaching those underserved parts of the economy (such as women and their businesses, minorities, rural areas, and migrants) at risk of being excluded from the economic recovery because of lack of access to finance. LENDING DURING THE RECOVERY AND BE YOND | 183 The experience of Banco Pichincha (BP), the largest commercial bank in Ecuador, illustrates how technical assistance and funding from development finance institutions can help financial institutions achieve their strategic objectives despite the crisis. In 2017, BP, with the support of IFC and other insti- tutions, significantly expanded its MSME portfolio and tackled the country’s large gender gap in access to finance.78 It did so by addressing biases in credit review and customizing credit products for women entrepreneurs. BP entered the pandemic having doubled its portfolio of women entrepreneurs. As the pandemic unfolded, the bank continued to focus on women entrepreneurs, adapting its financial and nonfinancial services offerings to continue growing its portfolio. Between March 2020 and August 2021, BP’s MSME loan portfolio grew by 16 percent, with over 50 percent of new loans disbursed to MSMEs owned by women.79 Policies to enable access to credit and address risks Approaches to restoring credit growth involve adapting or innovating ways in which finance providers manage risk. Product features and existing approaches to risk modeling can be adapted to the pandemic economy, while other measures to improve visibility and recourse may depend on digital channels and tools. Many of the solutions supporting new lending in this context will be technology-driven. Policy makers should therefore consider taking measures to facilitate such innovations in business models and products, including by supporting the participation of new types of credit providers in the market and by enabling use of new types of data and analytics. Upgrades in financial infrastructure can further foster access to finance and support resilience in credit markets. However, financial innovation may also pose new risks to businesses and consumers, as well as to financial stability and integrity (see online annex 4A80). Addressing these risks requires adequate oversight by regulators. In fact, in many countries legacy financial sector regulatory and supervisory frameworks and approaches need to be updated.81 This section reviews some of the policies that may help foster innovation and access to credit while minimizing risks to consumers and the financial sector. Facilitating innovation through new providers, products, and uses of data and analytics The digital transformation of finance is enabling the atomization of services, the recombination of value chains, and the participation of nontraditional providers.82 These advances can contribute to greater efficiency, more diverse and inclusive markets, and the expanded availability of credit. New entrants, from challenger banks to fintech lenders, can improve the range of products and the appetite for risk in a market that includes banks, MFIs, supply chain finance providers, and others. Regulatory and super- visory frameworks can support healthy innovation by allowing diverse lenders with modern business models to participate in the market. The entry of new financial service providers may require adjustments in the regulatory perimeter. Digital credit providers, for example, offer products similar to those provided by regulated banks, but may not be subject to oversight by the financial regulator because of the current definitions of regulated activities or institutions.83 For example, in Kenya between 2016 and 2019, the providers of app-based, short-term, small-value loans operated outside of the regulatory perimeter. During those years, use of these products expanded from 0.6 percent to 8.3 percent of adults and resulted in instances of irrespon- sible lending.84 This is one example of a new provider playing an important role that should be encour- aged, but also overseen within an expanded regulatory perimeter.85 Regulators worldwide are developing 184 | WORLD DE VELOPMENT REPORT 2022 capacity and assessing their approaches to regulating institutions and activities to accommodate the entry of new providers on a level playing field, while ensuring soundness, financial integrity, consumer protection, and inclusion. Rapid innovation and shifts to new providers and infrastructure can pose risks to stability.86 Some promising approaches to managing these risks include expanding the regulatory perimeter, deploying differentiated licensing requirements proportionate to the risks presented by a product or provider, and introducing activity-based regulation. New guidance is also emerging from the global standard- setting bodies.87 The need for well-designed regulatory and supervisory frameworks applies not just to new entrants, but also to all providers to encourage sound experimentation with new channels, products, and pro- cesses. Regulatory or supervisory restrictions could impede revisions of risk models to adapt to sec- toral shifts and new economic conditions, as well as the adoption of new technologies, products, and processes needed to adapt to changing postpandemic markets. There is scope to provide more latitude for experimentation and innovation without sacrificing institutional or systemic soundness, such as by allowing innovative products or business models to be deployed within a given risk envelope or expo- sure limit. For example, in 2018 the Bank of Thailand indicated a move from specific product reviews to umbrella approvals covering a range of related products or setting exposure thresholds.88 New regulatory approaches to spur innovation will naturally require that regulators build their own internal capacity to understand new technologies and monitor the market to ensure that experimenta- tion is consistent with the broader goals of a stable, productive financial sector. Regulatory innovation hubs and sandboxes can help regulators be digitally informed and narrow the gap between regulation and financial innovation. A survey of regulators in 2020 found that 16 percent had introduced regula- tory sandbox initiatives, while about 36 percent had accelerated deployment during the pandemic.89 Supervision technologies (suptech) can also enable supervisory agencies to monitor a broader and more complex financial sector more efficiently.90 Just as financial service providers are reaping gains from technology, regulators and supervisors can embrace technology to improve market surveillance, enforce market conduct and consumer protection standards, and better respond to complaints. During the pandemic, many supervisors either accelerated or introduced new suptech initiatives.91 Technology can also lower the cost to collect and analyze data for regulators, to identify potential discrimination in lending practices, and to inform policy design. The example of Chile92 indicates that consideration can be given to producing anonymized gender disaggregated data for the financial sector, with the goal of capturing differential developments in borrowing and credit risk, identifying potential discrimination in lending practices, and informing market and policy efforts to close the gender gap in credit access. The bigger role of data, coupled with advanced analytics enabled by machine learning and AI, also requires new regulatory and supervisory policies. Financial institutions will provide some of the data used to measure risk during and after the pandemic. Other data will come from third parties such as credit bureaus, utilities, employers, and government databases. Data governance frameworks will be crit- ical for defining the rules around data ownership and use. For example, a rights-based data governance framework can enable data sharing while protecting against misuse.93 Fair lending frameworks should encompass algorithmic accountability and transparency to reduce the chances that bias becomes hard- wired into AI-based decision models (see box 4.2 earlier in the chapter). Several jurisdictions are crafting policies for algorithmic transparency and accountability.94 Regulation should address the ownership of and access to data, protection of data (including cybersecurity), and potential bias in data analysis. Adoption of emerging technologies such as cryptocurrency and decentralized finance will also require new regulatory frameworks. Cryptocurrency and blockchain technologies do not appear to be LENDING DURING THE RECOVERY AND BE YOND | 185 positioned to play a significant role in access to credit during the near-term pandemic recovery. But applications such as remittances and central bank digital currencies are being deployed, and the under- lying distributed ledger technology could have applications in capital markets and credit markets and as foundational infrastructure for permissioned sharing of validated data such as identity or credit history. These technologies bear monitoring from financial regulatory and market conduct perspectives, with the goals of supporting sound innovation in financing and equal access to digital solutions. Authori- ties, the private sector, and development institutions need to work together to address technology gaps, enhance digital literacy, and ensure adequate transparency and management of cyber risks. Operationalizing advances in technology, new products, alternative data, and data protection frameworks requires infrastructure that protects data subjects from breaches and cybercrime. Reg- ulators will therefore have to strengthen their capacity to address cyber risks, enhance international coordination, and implement guidance and evolving best practices on operational resilience from international standard-setting bodies.95 Efforts by regulators to address data governance, fair lending, and cybersecurity will not only enable lenders to develop and deploy innovative approaches to lending, but also improve the transparency, equity, and consumer protection needed to create trust and drive responsible adoption. Improving financial sector infrastructure Financial infrastructure comprises the legal and regulatory frameworks and public and private sector institutions and practices that support the efficient and sound functioning of the financial systems. This infrastructure must also keep pace with digitalization to support the evolving needs of lenders. Digital identity, an important element of financial infrastructure, can enable broader access to finance while maintaining system integrity. A recent study revealed that 49 percent of surveyed reg- ulators implemented measures related to eKYC (electronic Know Your Customer) and digital identity during the pandemic. Examples include digital contracts and signatures to support access to and resil- ience of financial services.96 Payment systems are another key element of financial infrastructure. The physical infrastructure used by clearinghouses and switches, as well as the soft infrastructure of rules and practices on partici- pation, origination, recission rights, and finality, must be modernized to cope with the digital transfor- mation of finance and the shift away from cash accelerated by the pandemic. Credit infrastructure includes the hard infrastructure of asset registry systems and credit bureau databases and the soft infrastructure of laws and institutions designed to support efficient and respon- sible allocation of credit in the economy. Together, they reduce lending costs and frictions and facili- tate access to credit.97 For the data-driven innovations discussed in this chapter to be broadly usable, lenders must be able to access and integrate a wider range of data into their underwriting models. Credit bureaus such as Creditinfo, CRIF, Dun & Bradstreet, Experian, and TransUnion are working toward expanding access by leveraging technology to incorporate alternative data to enrich their data sets (see box 4.8). Regulators must also update their credit information-sharing regimes to guarantee the safe use of alternative data.98 Credit information system regulations that guide credit bureaus and registries should ensure that nontraditional lenders also have access and report their credit exposures because a gap in reporting by any set of lenders renders the credit information system less valuable to everyone. The People’s Bank of China, for example, granted alternative lenders access to its credit registry.99 Another form of infrastructure that can facilitate access to credit during and after the pandemic is the laws and registries that allow lenders to accept innovative forms of collateral, such as movable 186 | WORLD DE VELOPMENT REPORT 2022 Box 4.8 Case study: Use of alternative data by credit bureaus during the pandemic The COVID-19 pandemic accelerated efforts by incentives to integrate these new models and over- credit reporting service providers (CRSPs), such as come the risk management and regulatory barriers credit bureaus, to integrate alternative data into that had stifled adoption of third-party scoring credit reports to help address the limitation of his- innovation (the most popular third-party scoring torical repayment data and inform credit under- model used in 2020 was based on data from before writing decisions through the crisis. the 2007–09 global financial crisis).e As governments provided direct financial sup- The three main US credit bureaus have launched port, regulatory authorities implemented morato- partnerships with data aggregators to supplement ria, and credit bureaus adopted adjusted technical traditional credit scores with consumer permis- reporting codes, traditional credit data became less sioned data on positive repayment behavior.f For useful to inform risk assessments. Some of these example, Experian reported that as of March 2021 measures would tend to result in “false positives”— nearly 7 million consumers in the United States and that is, borrowers with the ability to service exist- the United Kingdom had connected to its Experian ing debt and apparently qualified to borrow further, Boost service. Launched in 2019, the service allows despite their underlying viability being compro- customers to authorize Experian to access real-time mised by job loss or permanent business closure. payments data from customers’ utility, telecom, Other measures exacerbated “false negatives”— and streaming service providers. The credit bureau that is, borrowers who otherwise would be able to reported that by adding real-time alternative data, meet debt obligations but were flagged as ineligible the majority of Experian Boost users improved their because of the short-term impacts of the COVID-19 credit score—for example, 22 percent of users with crisis on their ability to meet loan obligations. For “poor” credit ratings were shifted to a “fair” score example, in South Africa the rate of false negatives band.g increased from its precrisis level of 1.5 percent of Meanwhile, the data analytics company FICO credit applicants to 8 percent in October 2020.a and three consumer reporting agencies (Equifax, To address this gap in usability of traditional TransUnion, and Experian) launched products in the data, many CRSPs accelerated efforts to incorpo- summer of 2020 incorporating analytics and sector rate alternative data into their scoring.b Alterna- data for users who are experiencing financial distress tive data typically increase the precision of credit from the pandemic or have benefited from morato- score models,c especially during periods of stress.d ria. Similar products were launched across the world, The crisis also gave lenders and policy makers new including in Croatia,h the Baltics, and Iceland.i a. E xperian (2021). b. GPFI (2018). c. Djeundje et al. (2021). d. Gambacorta et al. (2019). e. FinRegLab (2020). f. FinRegLab (2020). g. Gambacorta et al. (2019). h. Fina (2021). The COVID Score developed by the Financial Agency of Croatia (Fina) is an input in the process used to e ­ valuate applications by businesses and income-generating professions for government support. The Fina COVID Score evaluates the impact of the pandemic on a business, assesses the results of previous government support, and estimates whether there will be any need for additional financing. The score has seven risk elements, including business, industry, staffing levels and ability to meet salary payments, and credit risk. i. Creditinfo (2021). Launched by Creditinfo, the COVID-19 Impact Score is a synthetic score designed to help identify com­ panies hardest-hit by the COVID-19 crisis and likely to soon have solvency problems. The score incorporates data on supply chain, health, and proximity to industries most affected, such as tourism. LENDING DURING THE RECOVERY AND BE YOND | 187 assets and receivables. For example, Pakistan launched an electronic registry in 2020 to enable finan- cial institutions to register rights in movable assets (machinery, furniture, inventory, accounts receiv- able, and digital assets) and accept these as collateral for loans. The launch was particularly timely considering the urgent need for credit by low-income households and MSMEs arising from the pan- demic.100 Collateral registries must adhere to harmonized requirements for secured transaction law and prudential regulation, specifically capital and loan-loss provisioning requirements.101 Product- or sector-specific digital platforms can complement this core infrastructure by accepting security in the form of assets such as invoices and warehouse receipts.102 An example is Mexico’s Nafinet invoice financing platform. Finally, digital infrastructure in the form of reliable fixed and mobile telephony and data services underpins the functioning of digital economies and all noncash financial services. Gaps in coverage and high costs continue to exclude significant portions of the population of emerging economies. Likewise, disruptions of information and communications technology, the communications network, and energy supplies can be a serious source of operational risk to financial service providers. Policy makers should ensure that core telecommunications and energy infrastructure is robust and that competitive markets produce adequate capacity, fault tolerance, and redundancy. The systems on which financial services delivery depends have also become more complex because technology has enabled the atomization of service components and the reconfiguration of what had been internalized processes owned by distinct service providers.103 One example of the consequences of these dependencies is the widespread internet outage in February 2021 that affected Fiserv, a major financial services technology outsourcer. That outage resulted in interruptions in payment acceptance at many businesses across the United States.104 In another example, a hardware failure in June 2018 disrupted the Visa network in Europe, halting digital payments across the continent.105 The growing adoption of digital financial services, coupled with the concentration of infrastructure in large pay- ment networks and cloud computing platforms, will make even rare events more damaging. Financial regulators must set minimum standards for risk management and operational reliability that cover outsourcing and partnership arrangements. Individual regulators are increasingly doing this, as are standard-setting bodies.106 Increasing collaboration among regulators Digitalization has increased the cross-border and cross-sector dimensions of financial services. A country’s regulator defines when a foreign provider can offer services to domestic customers and what services it can provide, but compliance relies on cooperation across jurisdictions. The digital trans­formation of finance also brings multiple domestic regulators into play. A digital finance provider or product may fall within the jurisdictions of telecommunications, information, data, consumer pro- tection, competition, and other regulators. Regulators need to establish modes of collaboration both within and across borders and within and across regulatory domains.107 In Bangladesh, for example, the Central Bank and the Telecommunications Regulatory Commission are part of a multistakeholder consultative committee on Unstructured Supplementary Service Data (USSD) communications, a key enabler of mobile money.108 A coordinated regulatory approach can narrow disparities between regula- tory frameworks and anticipate new risks. The growth of alternative lenders, including fintechs, big techs, and other embedded finance pro- viders, has the potential to change the market structure of the financial sector, with implications for 188 | WORLD DE VELOPMENT REPORT 2022 competition as well as consumer protection.109 Digital technology and new entrants in the credit market can foster competition, increase innovation and efficiency, and challenge incumbents.110 On the other hand, economies of scale and scope in data and network effects can compound the existing scale advan- tages of incumbents’ capital and customer bases. Crossover big tech platforms may provide additional competition in financial services, bringing their own scale advantages, but market abuses by some big tech companies are already a concern in their core product areas. Financial regulators must work with competition authorities as well as consumer protection entities to monitor and prevent anticompetitive or abusive practices as the sector evolves in each market. Open access to customer data and financial infrastructure could reduce the tendency toward market concentration, particularly as data and credit infrastructure become critical factors for lending in the COVID-19 crisis recovery. By leveling the playing field, open data frameworks can empower smaller players and increase contestability and competition. However, open access to personal and financial data is technically difficult to implement securely. A proliferation of entities involved in providing a sin- gle service could reduce accountability for service quality and data use and leave consumers wondering who is responsible when a transaction fails or fraud occurs. Although data portability can increase bank lending, the effects on consumer welfare can be nuanced.111 Efforts to spur competition through open banking112 need to move in tandem with cybersecurity, privacy protections, consumer financial educa- tion, and an analysis of market dynamics. Conclusion The ability of credit markets to reach and serve businesses and households—including micro- and small businesses and low-income households—will be central to an equitable recovery. To effectively support the recovery, lenders will have to adjust their credit models and product portfolios to improve visibil- ity and recourse in a way that manages heightened risks and counters the impacts of the pandemic. Digitalization of economic activities and adoption of financial technology can enable development of the solutions and product innovations needed. Governments and regulators should support sound innovations in financing, particularly those for MSMEs and vulnerable segments; facilitate upgrades in data-driven underwriting; encourage product diversification; and enable the entry of innovative lenders such as fintechs into the market. Maximizing the benefits of innovation in the financial sector will require modernizing regulatory and supervisory approaches, along with financial infrastructure. Collaboration among regulators will become increas- ingly important as financial activities cut across sectors and the powerful advantages of scale and scope in networks, data, and capital lead to greater provider concentration. Although credit markets can effectively support MSMEs and households in the recovery, govern- ments may need to continue to help balance the risks and returns for lenders serving the most affected segments and sectors of the economy. In addition to enabling markets through the measures outlined above, some credit markets may benefit from well-targeted guarantee schemes. The solutions and policy recommendations discussed in this chapter are aimed primarily at coun- tering a reluctance to lend in the context of the heightened risk and uncertainty of the pandemic and ensuring adequate access to finance to allow even the more affected households and entrepreneurs to take part in the recovery. These measures can also serve as the foundation for more efficient and resilient credit markets that can address structural constraints, progressively reduce long-standing gaps in access to finance, and foster responsible financial inclusion. LENDING DURING THE RECOVERY AND BE YOND | 189 Notes 1. Ayyagari, Demirgüç-Kunt, and Maksimovic (2011). 43. OECD (2021a). 2. Byrne et al. (2021). 44. World Bank (2021c). 3. Berger et al. (2021) found that relationship clients of 45. Bharadwaj and Suri (2020). some US financial institutions were more negatively 46. Gwer (2019); Melzer (2011); Morse (2011); Skiba and affected by loan contract terms than other borrowers. Tobacman (2019). 4. Haughwout et al. (2021). 47. Fan, Nguyên, and Qian (2020). 5. Shleifer and Vishny (2011). 48. Banco de México (2021). 6. Bodovski et al. (2021). 49. World Bank (2019c). 7. Wagner and Winkler (2013); Wehinger (2014). 50. World Bank (2020a). 8. Apedo-Amah et al. (2020). 51. Love, Martínez Pería, and Singh (2016). 9. OECD (2021d). 52. Jack et al. (2016). 10. ICC (2020). 53. Bari et al. (2021). 11. Gourinchas et al. (2021b). 54. GOGLA (2021); Waldron (2016). 12. Koulouridi et al. (2020). 55. Feyen et al. (2021). 13. Simanowitz, Hennessy-Barrett, and Izaguirre (2021). 56. Automation of payments is a behavioral strategy to 14. World Bank (2019b). overcome inattention. See Moulton et al. (2014). 15. Some definitions of big data add a fourth “v”—veracity. 57. Buy now, pay later (BNPL) products—an e-commerce It is a characteristic needed so that the data are truly version of point-of-sale financing—experienced a surge useful. See Lukoianova and Rubin (2014). Some add a in adoption, fueled by the growth in e-commerce and fifth “v”—value (BBVA 2020). digital payments during the pandemic. See Alfonso et 16. Berg et al. (2020). al. (2021). 17. Agarwal et al. (2020). 58. Feyen et al. (2021). 18. Björkegren and Grissen (2020). 59. Gambacorta et al. (2019). 19. Jagtiani and Lemieux (2018). 60. World Bank (2020c). 20. Gambacorta et al. (2020). 61. Amosun and Unger (2020); Maylie (2020). 21. A data subject is a person who can be identified directly 62. IFC (2019). or indirectly through personal data identifiers. 63. Caniato, Moretto, and Rice (2020). 22. World Bank (2021c). Parlour, Rajan, and Zhu (2020) 64. Dunbar and Singh (2020). examine the impacts of financial technology (fintech) 65. For a review, see IFC (2019). competition in the payments market, concluding that, 66. SEC (2021). although payment innovations promote financial inclu - 67. IFC (2017a, 2020c). sion, they may lead to ambiguous effects on consumer 68. Perú21 (2021). welfare. 69. Citigroup (2020). 23. Ostmann and Dorobantu (2021). 70. See Meki, Quinn, and Roll (2021) for another example of 24. Berg et al. (2020); Hurley and Adebayo (2017). how technology can enable product innovations that 25. Personal characteristics are regulated by legislation allow anchors to sustainably take on more risk to seeking to prevent discrimination or bias. Although improve the performance of a last-mile distribution these characteristics may vary by legislation, com- network leading to higher profits for microdistributors monly regulated characteristics include gender, famil- and a substantial increase in sales for the anchors. ial status, race, disability, religion or belief, and sexual 71. See Xu, Marodon, and Ru (2021) for an effort to map orientation. development banks worldwide. 26. Leo, Sharma, and Maddulety (2019); Ostmann and 72. Calice (2020). Dorobantu (2021). 73. Corredera-Catalán, di Pietro, and Trujillo-Ponce (2021). 27. Feyen et al. (2021). 74. Gourinchas et al. (2021a). 28. IFC (2020a). 75. OECD (2021d). 29. McKinsey (2019). 76. World Bank and FIRST Initiative (2015). 30. Alonso-Gispert et al. (2022). 77. Gourinchas et al. (2021a). 31. Ziegler et al. (2021). 78. Ecuador has one of the largest gender gaps in access 32. For a comprehensive review, see Teima et al. to finance in Latin America. Men are twice as likely as (forthcoming). women to borrow from a financial institution or use a 33. Cornelli et al. (2020). credit card, and they are nearly 40 percent more likely 34. World Bank and CCAF (2020). than women to have a savings account. See BCE (2020) 35. Blackmon, Mazer, and Warren (2021). and World Bank, Global Findex Database 2017 (Global 36. World Bank and CCAF (2020). Financial Inclusion Database), https://global findex. 37. OECD (2018, 2021b); World Bank (2017, 2021a). worldbank.org/. 38. OECD (2021c). 79. Banco Pichincha (2021). 39. Izaguirre, Kaffenberger, and Mazer (2018). 80. Annex 4A can be found at http://bit.do/WDR2022 40. Calvano et al. (2020) find that AI/ML techniques can -Chapter-4-Annex. encourage collusive behavior. 81. Alonso-Gispert et al. (2022); IMF and World Bank 41. Carpena et al. (2017). (2018); World Bank (2021c). 42. Garz et al. (2021). 82. Feyen et al. (2021). 190 | WORLD DE VELOPMENT REPORT 2022 83. World Bank (2021a). 97. Pazarbasioglu et al. (2020). 84. CBK (2019). 98. World Bank (2019a, 2020b). 85. CBK (2021b). Since December 2021, an amendment to 99. Pazarbasioglu et al. (2020). the Central Bank of Kenya Act has provided the finan - 100. Ruch (2020). cial sector regulator with the power to license and over- 101. IFC (2020b). see app-based lenders. 102. Pazarbasioglu et al. (2020). 86. Feyen et al. (2021). 103. Feyen et al. (2021). 87. Alonso-Gispert et al. (2022). 104. Dailey and Taylor (2021). Fiserv serves about 6 per- 88. IMF (2019). cent of the merchant acquiring market. 89. World Bank and CCAF (2020). 105. Togoh and Topping (2018). 90. Broeders and Prenio (2018); di Castri et al. (2019). 106. For example, see IOSCO (2020); MAS (2018); OJK 91. World Bank (2021b); World Bank and CCAF (2020). (2017a, 2017b); and RBI (2021a), paragraph 17 and 92. Data2x (2016). annex VI. 93. World Bank (2021c). 107. Alonso-Gispert et al. (2022). 94. European Parliament (2019). For example, the Euro - 108. Plaitakis, Wills, and Church (2016). pean Parliamentary Research Service put forward 109. Feyen et al. (2021). four policy elements: (1) awareness-raising: educa- 110. Claessens (2009). tion, watch­ dogs, and whistleblowers; (2) account­ - 111. Parlour, Rajan, and Zhu (2020). ability in public sector use of algorithmic decision- 112. He, Huang, and Zhou (2020) highlight that although making; (3) regulatory oversight and legal liability; and open banking favors new entrants in the credit market, (4) global coordination for algorithmic governance. it may under certain conditions negatively affect bor- 95. Major elements include BCBS (2021); BIS and IOSCO rowers because of its impact on market dynamics and (2016); FSB (2018, 2020); and G-7 (2016). because of its signaling effect on borrowers, who may 96. World Bank and CCAF (2020). decide to opt out from sharing data. References Adian, Ikmal, Djeneba Doumbia, Neil Gregory, Alexandros for the Post-Pandemic World.” SUERF Policy Note Ragoussis, Aarti Reddy, and Jonathan Timmis. 2020. 193, European Money and Finance Forum, Vienna. “Small and Medium Enterprises in the Pandemic: https://www.suerf.org/policynotes/16645/inclusive Impact, Responses, and the Role of Development -payments-for-the-post-pandemic-world. 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McKinsey. 2020. “The 2020 McKinsey Global Payments “Financial Services Authority Circular Number 18/ Report.” Global Banking Practice, McKinsey and Company. SEOJK.02/2017 Regarding Information Technology Meki, Muhammad, Simon Quinn, and Kate Roll. 2021. Risk Management and Management in Information “Mutuality and the Potential of Microequity: Credit with Technology-Based Lending.” [In Indonesian]. https:// Performance-Contingent Repayment for Gig Workers.” www.ojk.go.id/id/regulasi/otoritas-jasa-keuangan In Putting Purpose into Practice: The Economics of /surat-edaran-ojk-dan-dewan-komisioner/Documents Mutuality. Oxford, UK: Oxford University Press. /Pages/SEOJK-Tata-Kelola-dan-Manajemen-Risiko Melzer, Brian T. 2011. “The Real Costs of Credit Access: -Teknologi-Informasi-pada-Layanan-Pinjam-Meminjam Evidence from the Payday Lending Market.” Quarterly -Uang-Berbasis-Teknologi-Informasi/SAL%20SEOJK Journal of Economics 126 (1): 517–55. %2018%20FINTECH.pdf. Montoya, Ana María, Eric Parrado, Alex Solís, and Raimundo OJK (Financial Services Authority of Indonesia). 2017b. Undurraga. 2020. “Bad Taste: Gender Discrimination “OJK Issues Regulation on IT-Based Lending Services.” in the Consumer Credit Market.” IDB Working Paper Press Release SP 01/DKNS/OJK/I/2017, January 10, IDB-WP-1053, Department of Research and Chief Econo- 2017. https://www.ojk.go.id/en/berita-dan-kegiatan mist, Inter-American Development Bank, Wash­ ington, DC. /siaran-pers/Documents/Pages/Press-Release-OJK Morse, Adair. 2011. “Payday Lenders: Heroes or Villains?” -Issues-Regulation- on-It-Based-Lending-Services Journal of Financial Economics 102 (1): 28–44. /SIARAN%20PERS%20POJK%20%20%20%20FIntech Morse, Adair, and Karen Pence. 2020. “Technological Inno - -ENGLISH.pdf. vation and Discrimination in Household Finance.” NBER Ostmann, Florian, and Cosmina Dorobantu. 2021. “AI in Working Paper 26739, National Bureau of Economic Financial Services.” Alan Turing Institute, London. Research, Cambridge, MA. https://www.turing.ac.uk/research/publications/ai Moulton, Stephanie, J. Michael Collins, Cäzilia Loibl, and -financial-services. Anya Samek. 2014. “Effects of Monitoring on Mort- Parlour, Christine A., Uday Rajan, and Haoxiang Zhu. 2020. gage Delinquency: Evidence from a Randomized Field “When FinTech Competes for Payment Flows.” Working Study.” Journal of Policy Analysis and Management 34 paper, Haas School of Business, University of California, (1): 184–207. Berkeley. OECD (Organisation for Economic Co-operation and Pazarbasioglu, Ceyla, Alfonso Garcia Mora, Mahesh Uttam- Development). 2018. “G20/OECD Policy Guidance: chandani, Harish Natarajan, Erik H. B. Feyen, and Financial Consumer Protection Approaches in the Dig- Mathew Saal. 2020. “Digital Financial Services.” World ital Age.” OECD, Paris. https://www.oecd.org/finance Bank, Washington, DC. https://pubdocs.worldbank.org /G20 - OECD -Policy- Guidance -Financial- Consumer /en/230281588169110691/Digital-Financial-Services -Protection-Digital-Age-2018.pdf. .pdf. OECD (Organisation for Economic Co-operation and Devel- Perú21. 2021. “More Than 4 thousand Winemakers Will opment). 2021a. “Digital Delivery of Financial Education: Benefit through ‘Amigo PAQ.’ ” Economy, February 3, Design and Practice.” OECD, Paris. https://www.oecd 2021. https://peru21.pe/economia/emprendedor-mas .org/financial/education/Digital-delivery-of-financial -de-4-mil-bodegueros-se-beneficiaran-a-traves-de -education-design-and-practice.pdf. -amigo-paq-pepsico-cbc-citi-pos-movil-prestamos OECD (Organisation for Economic Co-operation and -noticia/. Development). 2021b. “Lessons Learnt and Effec - Plaitakis, Ariadne, Thomas Kirk Wills, and Bryan Church. tive Approaches to Protect Consumers and Support 2016. “Regional: Promoting Remittance for Develop - Financial Inclusion in the Context of COVID-19.” G20/ ment Finance” and “Digital Payment Systems, Mobile OECD Report. OECD, Paris. https://www.oecd.org/daf Money Services, and Agent Banking: Bangladesh, Nepal, /fin/financial-education/g20-oecd-report-on-financial and Sri Lanka.” ADB Technical Assistance Consultant’s -consumer-protection-and-financial-inclusion-in-the Report, Asian Development Bank, Manila. https://www -context-of-covid-19.htm. .adb.org/sites/default/files/project-document/195971 OECD (Organisation for Economic Co-operation and Devel- /48190-001-tacr.pdf. opment). 2021c. “Navigating the Storm: MSMEs’ Finan - PSBC (Postal Savings Bank of China). 2021. “Release of the cial and Digital Competencies in COVID-19 Times.” G20/ Economic Daily–PSBC Small and Micro-Sized Enterprise OECD-INFE report. OECD, Paris. https://www.oecd.org Operating Index Report of June 2021.” PSBC, Beijing. /financial/education/navigating-the-storm-msmes https://www.psbc.com/en/products_and_services -financial-anddigital-competencies-in-covid-19-times /corporate/samseoi/202107/t20210713_108141.html. .htm. 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Taylor, David. 2021. “Mobile Money 1 Year into a Pandemic: PwC (PricewaterhouseCoopers). 2021b. “Working Capital A Shift away from Cash towards a Cash-Lite Economy.” Study 20/21: From Recovery to Growth in the Face of Blog, September 30, 2021. https://www.fsdkenya.org Supply Chain Instability.” PwC, London. https://www /blogs - publications/mobile - money-1-year- into -a .pwc.co.uk/services/business-restructuring/insights -pandemic-a-shift-away-from-cash-towards-a-cash /working-capital-study.html. -lite-economy/. RBI (Reserve Bank of India). 2021a. “Master Directions, Teima, Ghada O., Ivor Istuk, Luis Maldonado, Miguel Sori- Non-Banking Financial Company: Peer to Peer Lending ano, and John S. Wilson. Forthcoming. “Fintech and Platform (Reserve Bank) Directions, 2017 (Updated as SME Finance: Expanding Responsible Access.” Techni - on October 05, 2021).” RBI, Mumbai. https://www.rbi cal Note, Future of Finance Report, World Bank, Wash- .org.in/Scripts/NotificationUser.aspx?Id=11137. ington, DC. RBI (Reserve Bank of India). 2021b. “Payment System Togoh, Isabel, and Alexandra Topping. 2018. “Visa Out- Indicators—November 2021.” https://rbidocs.rbi.org.in age: Payment Chaos after Card Network Crashes; As /rdocs/PSI/PDFs/PAYMENTNOVEMBER 2021105 It Happened.” Guardian, June 1, 2018. https://www.the 57582EEF946AB8DBA2A8442DA8DDF.PDF. guardian.com/world/live/2018/jun/01/visa-outage Ruch, Madigan. 2020. “MicroCapital Brief: Pakistan - payment- chaos-af ter- card - network- crashes-live Launches Electronic Registry of Movable Assets, -updates. with Support from IFC.” MicroCapital, May 20, 2020. Wagner, Charlotte, and Adalbert Winkler. 2013. “The Vulner- https://www.microcapital.org/microcapital- brief ability of Microfinance to Financial Turmoil: Evidence -pakistan-launches-electronic-registry-of-movable from the Global Financial Crisis.” World Development 51 -assets-with-support-from-ifc/. (November): 71–90. Safaricom. 2021a. “Results Booklet for the Year Ended 31st Waldron, Daniel. 2016. “Tugende: Analog Credit on Dig - March 2021.” Safaricom PLC, Nairobi, Kenya. https:// ital Wheels.” Consultative Group to Assist the Poor, w w w.safaricom.co.ke/images/Downloads/F Y21 Washington, DC. https://www.cgap.org/blog/tugende ResultsBooklet13May2021.pdf. -analog-credit-digital-wheels. Safaricom. 2021b. “Safaricom PLC Results Booklet for Wehinger, Gert. 2014. “SMEs and the Credit Crunch.” Finan- the Six Months Period Ended 30th September 2021.” cial Market Trends 2013 (2): 115–48. Safaricom PLC, Nairobi, Kenya. https://www.safaricom World Bank. 2017. 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(blog), October 11, 2021. https://www.cgap.org World Bank. 2020a. “Collateral Registry, Secured Transac - /blog/it-possible-estimate-financial-stress-it-harms tions Law and Practice.” Distributed Ledger Technology -borrowers. and Secured Transactions: Legal, Regulatory, and Tech- Skiba, Paige Marta, and Jeremy Tobacman. 2019. “Do nological Perspectives; Guidance Notes Series, Note 1, Payday Loans Cause Bankruptcy?” Journal of Law and World Bank, Washington, DC. Economics 62 (3): 485–519. World Bank. 2020b. “Credit Bureau Licensing and Super­ Sule, Alan, Mehmet Cemalcilar, Dean Karlan, and Jonathan vision: A Primer.” World Bank, Washington, DC. Zinman. 2018. “Unshrouding: Evidence from Bank Over- World Bank. 2020c. “Embedding Digital Finance in drafts in Turkey.” Journal of Finance 73 (2): 481–522. E-commerce Platforms during the COVID-19 Pan- Sun, Tao, Alan Feng, Yiyao Wang, and Chun Chang. 2021. demic.” Discussion note, World Bank, Washington, DC. “Digital Banking Support to Small Businesses amid World Bank. 2021a. “Consumer Risks in Fintech: New Mani - COVID-19: Evidence from China.” Global Financial festations of Consumer Risks and Emerging Regulatory LENDING DURING THE RECOVERY AND BE YOND | 197 Approaches.” Policy research paper, Finance, Compet- /financialsector/publication/principles-for-public itiveness, and Innovation Group Practice, World Bank, -credit-guarantee-schemes-cgss-for-smes. Washington, DC. Xu, Jiajun, Régis Marodon, and Xinshun Ru. 2021. “Mapping World Bank. 2021b. “The Next Wave of Suptech Innovation: 500+ Development Banks: Qualification Criteria, Styl - Suptech Solutions for Market Conduct Supervision.” ized Facts, and Development Trends.” New Structural Technical note, World Bank, Washington, DC. Development Financing Research Report 2, Institute of World Bank. 2021c. World Development Report 2021: Data New Structural Economics at Peking University, Beijing. for Better Lives. Washington, DC: World Bank. https://www.nse.pku.edu.cn/dfidatabase/database World Bank and CCAF (Cambridge Centre for Alternative reports/517163.htm. Finance). 2020. “The Global Covid-19 FinTech Regu - Yang, Crystal S., and Will Dobbie. 2020. “Equal Protection latory Rapid Assessment Report.” World Bank, Wash- under Algorithms: A New Statistical and Legal Frame- ington, DC; CCAF, Judge Business School, University work.” Michigan Law Review 119 (2): 291–395. of Cambridge, Cambridge, UK. https://www.jbs.cam Ziegler, Tania, Rotem Shneor, Karsten Wenzlaff, Krish­ na­ .ac.uk/faculty-research/centres/alternative-finance murthy Suresh, Felipe Ferri de Camargo Paes, Leyla /publications/2020-global-covid-19-fintech-regulatory Mammadova, Charles Wanga, et al. 2021. The 2nd -rapid-assessment-study/. Global Alternative Finance Market Benchmarking World Bank and FIRST Initiative. 2015. “Principles for Pub - Report. Cambridge, UK: Cambridge Centre for Alter- lic Credit Guarantee Schemes for SMEs.” World Bank, native Finance, Judge Business School, University of Washington, DC. https://www.worldbank.org/en/topic Cambridge. 198 | WORLD DE VELOPMENT REPORT 2022 Spotlight 4.1 Public credit guarantee schemes P ublic credit guarantee schemes (PCGSs) are a policy tool used widely by governments to ease access to finance for firms—especially small and medium enterprises (SMEs)—while limiting the burden on public finances. Akin to an insurance product, a PCGS provides a guarantee on a loan to a firm by covering a portion of the default risk of the loan. In the case of default by a firm, the lender recovers the value of the guarantee. The lender is also usually obligated to proceed with the collection of the loan and share the proceeds with the guarantor. Guarantees are usually provided for a fee covered by the firm, the lender, or both. PCGSs, typically operated by an independent crisis more than 40 countries, especially advanced company, a development finance institution, or a economies and emerging markets, relied on PCGSs government agency, are used to alleviate the con- to support firms’ financing needs arising from straints facing SMEs in accessing finance.1 Lend- pandemic-induced shocks.2 ers are usually reluctant to extend credit to firms The expansion of PCGSs triggered demand that do not have the necessary amount and type for good practices in their design, execution, and of assets that could serve as collateral for the loan. evaluation. An effective, efficient PCGS is one that Moreover, SMEs, especially small and young com- maximizes outreach (the number of firms served) panies, have a limited credit history and opaque and additionality (among other things, its intended financial statements. Sometimes, they are unable outcomes in terms of additional credit mobilized, to prepare bankable business plans. As a result, improved terms and conditions, and jobs created), many SMEs with economically viable projects while maintaining financial sustainability. Against cannot obtain the necessary financing from the this background, in 2015 the World Bank, in part- formal financial sector. nership with international associations of PCGSs In use by many countries since the beginning of and lenders and with the support of the FIRST Ini- the twentieth century, PCGSs experienced unprec- tiative, developed a set of high-level principles to edented growth in the aftermath of the 2007–09 guide the operations of PCGSs.3 global financial crisis, when they were widely The principles recommend adoption of a set of embraced to stimulate the flow of countercycli- legal, regulatory, governance, and risk manage- cal finance to small businesses. Thanks in part to ment arrangements. They also include operational that experience, during the COVID-19 (coronavirus) conduct rules for PCGSs, which are expected to PUBLIC CREDIT GUAR ANTEE SCHEMES | 199 lead to better outcomes for beneficiary firms. The scarce. In view of the massive uncertainty, many principles draw from the sound practices of PCGSs governments have opted instead to include large implemented in jurisdictions such as Chile and the segments of sectors and firms. This strategy has European Union. The principles are also aligned ensured wider reach and speed, but it will have with the practices of those PCGSs whose financial unintended consequences for long-term growth if and economic impacts have been positively eval- it ends up zombifying parts of the economy, espe- uated.4 Although the principles have been widely cially where complemented by loan moratoria and adopted across countries, some gaps remain.5 where zombie firms were proliferating even before The unprecedented economic distress caused by the pandemic.7 the pandemic and the need to act swiftly to pre- The design of a PCGS also has a bearing on the serve economic stability have necessitated in many fiscal risk assumed by a government. The state cases a departure from the principles, especially bears a contingent liability in all countries, and those on the legal and institutional framework, yet the type of exposure may depend not only on risk-sharing, and pricing. Although the vast major- the size of the scheme but also on how it is imple- ity of jurisdictions already had a legal and insti- mented.8 The contingent liability is direct when tutional framework in place to issue guarantees, the guarantees are issued and administered by the especially in Europe, Latin America, and parts of central government, such as in Belgium, and indi- Asia, changes have been made to adapt PCGSs to rect when the guarantees are channeled through the unique circumstances created by the pandemic, public independent entities, such as in Morocco. such as in Colombia. Some credit guarantee pro- In some cases, the contingent liability is supple- grams have been used to target specific sectors or mented by funds channeled to the public financial marginalized communities for credit. For example, institution, such as in Chile. Finally, PCGS design Burkina Faso has a specific program that targets features can impose costs on the financial sector. small businesses owned by women. In some coun- Loose credit requirements and ultra-low interest tries such as South Africa that had no PCGS, it rates may eventually propel a rise in nonperform- has been established. There have also been adjust- ing loans once moratoria and suspension of classi- ments to credit guarantee schemes, such as exten- fication criteria are lifted. sions to loan tenors so borrowers have more time It is too early for an impact assessment of the to make payments and increases in the coverage unprecedented use of PCGSs in the context of the ratio of the guarantee to expand eligibility. How- COVID-19 crisis, but several governments have ever, some countries such as Argentina have raised promised robust ex post evaluations, especially the coverage rate of the guarantee up to 100 per- because of suspicions of significant fraud.9 Yet cent, especially for the most vulnerable borrowers, some preliminary conclusions are emerging: at thereby increasing the risk of moral hazard. In sev- least in the European context, where PCGSs have eral cases (such as in Italy), fees have been capped been designed without too much consideration for or waived altogether, decoupling pricing from risk. fiscal capacity, use of the schemes was positively These design features of PCGSs have involved correlated with the drop in economic activity, and difficult trade-offs, with important implications demand for guarantees plateaued in mid-2020 for the reach of the guarantee programs, the risk after an initial burst.10 As economies have entered of “zombification” of economies, the size and the rebound if not recovery phase, the challenge type of the contingent liability for governments, for governments will be to shift their focus from and the impacts on financial sectors.6 Although protection to reallocation of capital and labor in the midst of a pandemic PCGSs should ideally in a context of high corporate leverage and more target viable but temporarily illiquid firms, in limited fiscal resources. In such an environment, practice distinguishing viable from unviable busi- PCGSs could still play an important role in facili- nesses is difficult, especially when information is tating the flow of finance to the productive sector, 200 | WORLD DE VELOPMENT REPORT 2022 and yet their design will have to adapt to that role References to remain relevant and effective. Anderson, Julia, Francesco Papadia, and Nicolas Véron. Countries relying on PCGSs will have to pursue 2021. “COVID-19 Credit-Support Programmes in Europe’s at least three strategic and operational changes Five Largest Economies.” Working Paper 03/2021, Brue- gel, Brussels. to support the process of resource reallocation.11 Banerjee, Ryan, and Boris Hofmann. 2020. “Corporate Zom - First, because PCGSs will have to confront a wave bies: Anatomy and Life Cycle.” BIS Working Paper 882, of borrower defaults, at least in jurisdictions where Monetary and Economic Department, Bank for Interna- the government has not directly underwritten the tional Settlements, Basel, Switzerland. Calice, Pietro. 2016. “Assessing Implementation of the Prin - COVID-19–related risk, it may be necessary to ciples for Public Credit Guarantees for SMEs: A Global maximize recovery for the exposures to nonviable Survey.” Policy Research Working Paper 7753, World firms and to convert into equity or quasi-equity Bank, Washington, DC. Calice, Pietro. 2021. “From Protection to Reallocation: Pub - instruments the exposures to viable businesses. lic Credit Guarantee Schemes in the Post-Pandemic Second, PCGSs will have to return to “normal” to World.” Private Sector Development (blog), January 21, minimize moral hazard, phasing out the excep- 2021. https://blogs.worldbank.org/psd/protection -reallocation-public-credit-guarantee-schemes-post tional design features implemented during the -pandemic-world. COVID-19 crisis. Such a return implies adopting Emre, Ender, Alessandro Gullo, Cristina Müller, Mia Pineda, the highest standards of risk management and Mario Tamez, and Karla Vasquez. 2020. “Legal Con - siderations on Public Guarantees Schemes Adopted more targeted eligibility criteria. It also implies in Response to the COVID-19 Crisis.” Special Series on developing new products such as equity guaran- COVID-19, IMF Legal Department, International Monetary tees to help firms rebalance their capital structure. Fund, Washington, DC. OECD (Organisation for Economic Co-operation and Devel- Finally, PCGSs could play a pivotal role in redirect- opment). 2016. “Evaluating Costs and Benefits of Policy ing financial flows toward low-carbon activities, Interventions to Facilitate SME Access to Credit: Lessons thereby supporting the green recovery. That would from a Literature Review.” Document DAF/CMF(2016)17, Committee on Financial Markets, Directorate for Finan- imply a redesign of PCGSs’ mandate, corporate cial and Enterprise Affairs, OECD, Paris. governance and risk management framework, eli- OECD (Organisation for Economic Co-operation and Devel- gibility criteria, and product range. opment). 2021. “One Year of SME and Entrepreneurship Policy Responses to COVID-19: Lessons Learned to ‘Build Back Better.’ ” OECD Policy Responses to Corona­ virus (COVID-19), OECD, Paris. https://www.oecd.org Notes /coronavirus/policy-responses/one-year-of-sme-and  1.  Credit guarantee schemes can also be private, and in - e ntre pre ne urship - policy - responses - to - c ovid -19 many economies they are run by private companies, - lessons - learned - to - build - back- bet ter- 9a2302 20 cooperatives, or consortia of firms. However, they are /#boxsection-d1e30. often financially supported, directly or indirectly, by the Thomas, Daniel, and Stephen Morris. 2020. “ ‘A Giant Bonfire public sector. of Taxpayers’ Money’: Fraud and the UK Pandemic Loan Scheme.” Financial Fraud (blog), December 20, 2020. OECD (2021).  2.  https://www.ft.com/content/41d5fe0a-7b46-4dd7-96e3 World Bank and FIRST Initiative (2015).  3.  -710977dff81c. See OECD (2016) for a review of the literature.  4.  World Bank and FIRST Initiative. 2015. “Principles for Pub -  5.  Calice (2016). lic Credit Guarantee Schemes for SMEs.” World Bank,  6.  Anderson, Papadia, and Véron (2021). Washington, DC. https://www.worldbank.org/en/topic /financialsector/publication/principles-for-public-credit Banerjee and Hofmann (2020).  7.  -guarantee-schemes-cgss-for-smes. Emre et al. (2020).  8.  Thomas and Morris (2020).  9.  Anderson, Papadia, and Véron (2021). 10.  Calice (2021). 11.  PUBLIC CREDIT GUAR ANTEE SCHEMES | 201 Managing sovereign debt Governments around the world mobilized enormous resources to pay for the COVID-19 pandemic response. Many emerging economies, already heavily indebted at the outset of the crisis, took on additional debt to support households and firms. During 2020, this led to an increase in the total debt burden for low- and middle-income countries of 9 percentage points of gross domestic product (GDP), compared with an average annual increase of 1.9 percentage points over the previous decade. Managing and reducing elevated levels of sovereign debt improve the ability of governments to continue providing support through the recovery, especially to low-income households and small businesses, which is key to ensure an equitable recovery. However, coordination between debtors and creditors has become more difficult than in previous crises because of the greater number of creditors and the higher participation of commercial and nontraditional creditors in the market for sovereign debt. Policy Priorities Governments can take proactive policy approaches to mitigating the risks posed by high levels of sovereign debt to an equitable recovery: •  Governments at high risk of debt distress can pursue proactive debt management approaches with creditors through, for example, debt reprofiling, which replaces existing debts with new debt with a different currency or maturity profile. •  Governments in debt distress must coordinate with creditors to restructure debt. Effective restructuring requires the prompt and comprehensive recognition of debts, coordination with and among creditors, and a medium-term plan of reforms needed to achieve debt sustainability.  overnments and their creditors can benefit from improvements in sovereign debt transparency, • G which requires comprehensive disclosure of claims against the government and terms of the contracts that govern the debt. •  Contractual innovations can help overcome coordination problems and speed up the resolution of unsustainable debts, but they are not a universal cure. •  Well-developed tax policy and investments in tax administration can support debt sustainability in the longer run by increasing the government’s ability to mobilize revenue. 203 Introduction The impacts of the COVID-19 (coronavirus) crisis on sovereign debt are unusual in the speed and global synchronicity of the surge in debt levels. If the economic recovery from the pandemic is delayed or fal- ters, the buildup of sovereign debt will threaten debt sustainability in many emerging economies, and could produce longer-term economic and social consequences that look very similar to those of debt crises in the past. Many emerging economies entered the pandemic with record levels of sovereign debt,1 and they took on additional debt to pay for programs aimed at limiting the economic and human costs of the pandemic. This was a practical choice driven by limited options: increasing taxes in a struggling economy is not viable, and reducing other public spending is, in most cases, not sufficient to cover the magnitude of additional financing needs. The resulting debt burdens will have to be managed carefully to prevent them from becoming a drag on the economic recovery. Managing and reducing elevated levels of sovereign debt is crucial to ensure a strong and equitable recovery. Sovereign debt crises are costly for sustained growth. One study finds that every year a country remains in default reduces its GDP growth by 1–1.5 percentage points.2 High levels of sovereign debt also have significant social costs. They reduce the government’s ability to spend on social safety nets and public goods such as education and public health, which can worsen inequality and human development outcomes. When debt sustainability problems are not resolved, they tend to worsen over time because the choices of each government constrain the options of future governments as more revenue is directed to debt service. Sovereign debt crises also frequently coincide with other types of economic crises— such as financial sector crises, rising inflation, and output collapses—that have far-reaching negative consequences for poverty and inequality.3 Importantly, debt dynamics, financing opportunities, and options to manage debt differ significantly between emerging and advanced economies.4 For example, advanced economies tend to have better market access and financing options. They are also able to rely more heavily on domestic borrowing, and many can issue debt in their own currency and at different maturities, which facilitates borrowing and debt management. There are also important differences in the ability of advanced and emerging econ- omies to service debts. Many observers have noted that since the 2007–09 global financial crisis, eco- nomic growth globally has remained above the effective interest rates on sovereign debt, thereby keeping debt service burdens manageable.5 However, this observation masks important differences across coun- tries. Although interest payments in advanced economies have been trending lower in recent years and account, on average, for only around 1 percent of GDP, the cost of interest payments for emerging econ- omies has been rising steadily, and reached nearly 8 percent of GDP in 2020.6 This chapter examines the impact of the COVID-19 crisis on sovereign debt. It documents the sharp increase in sovereign debt stemming from the crisis and charts the options available to policy makers to manage dramatically increased debt burdens, while differentiating between countries based on characteristics such as market access and income levels.7 Learning from past experience is essential to inform the policies governments will need to adopt to address debt sustainability concerns as the immediate effects of the COVID-19 pandemic begin to recede. To this end, this chapter highlights the importance of addressing debt sustainability problems promptly and proactively, as well as the substan- tial economic and social costs of delayed action. The impact of COVID-19 on sovereign debt The COVID-19 crisis led to a dramatic increase in sovereign debt, with average total debt burdens among low- and middle-income countries increasing by roughly 9 percent of GDP during 2020, compared with an average of 1.9 percent of GDP per year over the previous decade.8 204 | WORLD DE VELOPMENT REPORT 2022 This increase in debt burdens has serious implications, especially for low-income countries, whose financial position had already been deteriorating before the pandemic. Between 2019 and 2020, the aver- age domestic and external debt stock of low-income and lower-middle-income countries increased by roughly 7 percent of GDP (figure 5.1). Over the same time period, the average debt stock of countries eligible for the Group of Twenty (G20) Debt Service Suspension Initiative (DSSI) increased from 50 to 57 percent of GDP. By 2019, half of the countries in this group were in debt distress—that is, unable to meet their financial obligations to creditors—or at high risk of debt distress (figure 5.2).9 This trend accelerated after the onset of the pandemic and was poised to accelerate further with the expiration of DSSI in December 2021.10 Sovereign debt burdens are unlikely to decrease in the near future because they are the combined result of large fiscal support programs necessary to mitigate the worst effects of the pandemic and the contemporaneous collapse in government revenue due to the global slowdown in economic activity. Tax revenue as a share of GDP, for example, declined in 96 of the 133 low- and middle-income countries in 2020.11 The costs of the pandemic are far exceeding the amount of money countries can easily shift from other areas of their budgets; countries that have access to credit markets have taken on new debt to finance emergency expenditures. The prospect of a slow recovery places further pressure on government budgets, even as the immediate effects of the pandemic subside. During an economic crisis, governments can and often do function as the lender of last resort for firms and households, which means that private debts can quickly become public debts in a large, protracted economic crisis. When an economic crisis threatens the survival of economi- cally important sectors and firms, governments have often taken on significant additional debt to stabilize those sectors or firms. Some of the debt-financed stimulus programs implemented during the COVID-19 crisis are examples of how governments step in to absorb economic risks when the private and financial sectors are unable to do so. If successful, the stimulus should result in economic growth and the delever- aging of private borrowers. However, such a solution comes at the cost of higher public debt burdens.12 Figure 5.1 General government gross debt, by country income group, 2010–20 80 79.2 70 68.4 65.6 67.0 Share of GDP (%) 60.9 60 61.4 58.8 55.6 50 54.4 41.0 40 39.8 36.7 30 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 High-income Upper-middle-income Lower-middle-income Low-income Source: WDR 2022 team, using data from World Bank, World Development Indicators (database), https://datatopics.world bank.org/world-development-indicators/; International Monetary Fund, World Economic Outlook Database: Download WEO Data, April 2021 Edition (dashboard), https://www.imf.org/en/Publications/WEO/weo-database/2021/April. Note: The figure shows the general public debt stock as a share of the gross domestic product (GDP) by World Bank income classification. MANAGING SOVEREIGN DEBT | 205 Figure 5.2 Level of risk of external debt distress, low-income countries, 2011–21 100 Share of low-income countries (%) 90 80 70 60 50 40 30 20 10 0 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 Risk level: Low Moderate High Source: World Bank and International Monetary Fund, Joint World Bank–International Monetary Fund LIC DSF Database (Debt Sustainability Framework for Low-Income Countries), June 2021 data, https://www.worldbank.org/en/programs /debt-toolkit/dsf. Note: The figure shows the risk of debt distress among low-income countries on which a debt sustainability analysis (DSA) has been run. As of June 2021, this information was available on 66 of the 73 countries eligible to participate in the G20 Debt Service Suspension Initiative (DSSI). The latest available risk rating has been extrapolated pending a new DSA. If more than one DSA exist for one country in a calendar year, the most recent rating is used. The 2021 ratings are as of June 30, 2021. The high-risk category includes countries assessed to be in debt distress. For the DSA, see Interna- tional Monetary Fund, DSA LIC (Debt Sustainability Analysis Low-Income Countries) (dashboard), https://www.imf.org/en /publications/dsa. For the DSSI, see World Bank, DSSI (COVID 19: Debt Service Suspension Initiative) (dashboard), https://www.worldbank.org/en/topic/debt/brief/covid-19-debt-service-suspension-initiative. In countries where state-owned banks and state-owned enterprises (SOEs) are an important part of the economy, governments are more directly exposed to the risks of a prolonged economic downturn. Significant contingent liabilities might materialize if, for example, systemically relevant financial insti- tutions or SOEs need to be rescued by the government. When such contingent liabilities arise, they often lead to a significant deterioration of the government’s financial position that may require new borrow- ing.13 In past crises, the cost of bank bailouts, for example, has totaled as much as 40 percent of GDP.14 Between 2017 and 2020, Ghana’s ailing energy and financial sectors required a cleanup that added an estimated 7 percent of GDP to its debt stock.15 In 2018, Angola faced downward pressure on its sovereign credit ratings after the government had to make an unexpected, one-off support payment of $8 billion (7 percent of GDP) to the national oil company.16 Similarly, Indonesia had to bail out its largest utility company in 1998 during the country’s financial crisis at a cost of 4 percent of GDP. In emerging economies, government finances may come under additional pressure from developments in the global economy. In the COVID-19 pandemic, unequal access to vaccines, among other factors, will likely lead the economic recovery to proceed faster in advanced economies than in the rest of the world. As the United States and Europe phase out their unprecedented monetary stimulus programs, global interest rates are bound to increase. This could have outsize effects on borrowing costs for emerging economies and make it more difficult for governments and private enterprises to refinance their debt. The normalization of monetary policy in high-income countries may also spur capital outflows from emerging markets, exert pressure on exchange rates, and aggravate debt sustainability concerns. A high-risk scenario is one in which a large share of the global population remains unvaccinated or one in which mutations render the existing vaccines less effective. This would delay the recovery of 206 | WORLD DE VELOPMENT REPORT 2022 incomes and government revenue, and yet governments will need to maintain spending to cope with the consequences of the pandemic and protect households and firms from further economic disruptions. Meanwhile, elevated levels of sovereign debt can also weaken the recovery, through their impact on the financial sector. Many governments have financed their COVID-19 response by issuing new domes- tic debt that is held predominantly by domestic financial institutions. While this helped governments mobilize resources for the crisis response, it exposes financial institutions to sovereign risk as the finan- cial position of the government deteriorates. This, in turn, reduces the ability of the financial sector to issue new credit and support economic growth. High levels of sovereign debt, particularly in the rela- tively shallow domestic markets of many emerging economies, can also dampen economic activity by leading to higher interest rates and affecting the prices firms and households pay for financing. High levels of sovereign debt also affect the private sector directly, such as through the government’s inability to provide ongoing support in a prolonged recession or economic setbacks during the recovery. Governments that are near or in debt distress do not have room to provide even temporary fiscal support to firms and households. Moreover, an increase in the risk of debt distress typically leads to a downgrade in the sovereign credit rating, which sets off self-fulfilling dynamics because the downgrade itself dete- riorates macroeconomic fundamentals and the access to capital by private firms.17 Finally, it is important to note that the COVID-19 pandemic is a “crisis within a crisis.” Countries may face additional pressure on government finances from other economic disruptions, some stemming from the risks posed by climate change. Policy makers will need to confront these risks by mobilizing fiscal resources to combat the effects of climate change. The human costs of debt crises Managing and resolving elevated levels of sovereign debt are essential to ensuring an equitable recov- ery from the COVID-19 crisis. Long-lasting debt distress has far-reaching negative consequences for the economy and population. These consequences are typically borne disproportionately by vulnerable populations, low-income households, and small businesses, and tend to worsen pre-existing poverty and inequality. Sovereign debt crises affect human development in many ways because they rarely occur as an iso- lated event and often are only one component of a conglomerate crisis affecting multiple sectors of the economy.18 Debt distress or default often coincide with a myriad of economic problems that may include output collapses, financial crises, currency crashes, and high inflation, which disproportionately affect the poor. Though the initial crisis trigger and order of events may differ, conglomerate crises have larger economic and human costs than crises confined to one sector of an economy. Because the COVID-19 pandemic simultaneously weakened private sector, financial sector, and government balance sheets (and weakened the ability of governments to mitigate spillover risks), many countries are at risk of experienc- ing these types of mutually reinforcing crises in the aftermath of the pandemic. Evidence shows that sovereign debt crises are often associated with large output collapses that have significant human costs.19 Data on economic crises during the 1980s and 1990s, for example, indicate that the number of people living in poverty increased by as much as 25 percent during large contractions in output.20 Not surprisingly, aggregate economic shocks that weaken the government’s ability to provide public goods, such as health care and education, are also associated with a deterioration in human devel- opment and social indicators.21 On this point, there is significant heterogeneity between advanced and emerging economies. In advanced economies, where households can draw on insurance mechanisms that do not necessarily depend on current government spending, health and education outcomes are consid- erably less affected during crises. However, in emerging economies they deteriorate rapidly—for example, MANAGING SOVEREIGN DEBT | 207 a 10 percent decline in GDP is associated with an increase of 1.5 child deaths per 1,000 live births.22 Iden- tifying and resolving debt sustainability problems can restore the government’s ability to invest in public goods and reverse these trends, as the case study of Rwanda in box 5.1 illustrates. Sovereign debt crises also often go hand in hand with high inflation and sharp exchange rate depre- ciations, disproportionately burdening the poor. Low-income households spend a higher share of their income on basic goods, whose price increases with inflation. They are also more likely to rely on wage Box 5.1 Case study: Debt relief to create space for social spending in Rwanda In 1996, the World Bank and International Mon- decreases were associated with better outcomes, etary Fund (IMF) launched the Heavily Indebted such as lower infant mortality rates, that were Poor Countries (HIPC) Initiative to ensure that linked to increases in social expenditures.b How- low-income countries do not face unmanageable ever, other contributions to the literature find debt burdens. In 2005, HIPC was complemented by little evidence of debt relief affecting the level the Multi­lateral Debt Relief Initiative (MDRI), which or composition of public spending, growth, also includes the African Development Bank. In investment rates, or the quality of policies and 2007, the Inter-American Development Bank joined institutions.c this initiative. Together, these initiatives provided Rwanda was one of the countries that used the 38 countries with debt relief totaling over $100 bil- HIPC Initiative successfully. It received full debt lion. Rwanda is one of those countries. relief from the HIPC Initiative in April 2005 (com- The main rationale underlying the HIPC and pletion point). Over the next four years, Rwanda related initiatives was that debt service obligations increased its poverty-reducing expenditures by made it difficult for low-income countries to meet almost 50 percent, compared with an average of poverty reduction–related expenditures, including 3 percent for the remaining HIPCs that reached a social spending and investment in infrastructure. completion point (see figure B5.1.1). Furthermore, The target of these initiatives was low-income coun- over the previous four years Rwanda also substan- tries facing unsustainable public debt that could not tially increased its expenditures on poverty reduc- be solved through a traditional debt restructuring. tion—expenditures that were tracked as one of To be eligible for HIPC relief, countries needed to the conditions for obtaining full debt relief. Among commit to developing and implementing a poverty other things, Rwanda reformed and operated pri- reduction strategy. mary teacher training centers and implemented Notwithstanding the goals of the initiatives, health plans to reduce mortality from malaria, as the economic literature on debt relief (without well as infant and maternal mortality.d broader reforms) is inconclusive about its impact Since the HIPC Initiative completion point, on economic outcomes. Establishing the impacts Rwanda has made important progress toward in practice is difficult. Although high levels of debt increasing its gross domestic product (GDP) per may constrain economic development, it is also capita and reducing extreme poverty. GDP per plausible that the same factors that lead to worse capita almost doubled, from $465 in 2005 to $849 economic outcomes (such as conflict and weak in 2020, and the share of people living in poverty, institutions) are responsible for high levels of debt defined as those living at most on $1.90 a day, in the first place. Nonetheless, some studies find fell from 69 percent of the population in 2005 to that decreases in debt service resulting from the 56 percent in 2016.e These improvements, while HIPC Initiative were accompanied by increases in significant, reveal how much more room there is for poverty-reducing expenditures, such as on basic further growth and poverty reduction. health care, primary education, basic sanitation, and However, debt relief is not a silver bullet, and HIV/AIDS programs.a Furthermore, debt service benefits can vary substantially across countries. (Box continues next page) 208 | WORLD DE VELOPMENT REPORT 2022 Box 5.1 Case study: Debt relief to create space for social spending in Rwanda (continued) Figure B5.1.1 Poverty-reducing expenditures in Rwanda versus other HIPC countries 160 140 Share of GDP (%) 120 100 80 60 t–4 t–3 t–2 t–1 t t+1 t+2 t+3 t+4 HIPC countries, excluding Rwanda Rwanda Source: IMF and World Bank 2019. Note: In the figure, t represents the year of the completion point (full debt relief received). The data for year t are nor- malized to 100. The other years should be read in reference to this. GDP = gross domestic product; HIPC = Heavily Indebted Poor Countries (Initiative). This is especially true of the diverse 38 recipients of Thus Rwanda is now at a moderate risk of debt dis- HIPC relief. Some countries were in fragile or con- tress. Debt relief, then, is not sufficient to ensure flict situations; some were resource-based econo- long-term debt sustainability. Excessive debt is mies in need of economic diversification; some had often a symptom of deeper structural and institu- better governance structures. For the same debt tional weaknesses that need to be addressed first relief initiative, each of these factors and others can to achieve debt sustainability. produce different impacts for countries. In middle-income countries, such reversals are Debt cycles and the reversal problem are also evident. Argentina and Ecuador, both par- another issue. Seventeen of the countries that ticipants in the Brady Plan debt relief initiative in reached the completion point in the HIPC Initiative 1989,h have also experienced these reversals, which are currently in debt distress or at high risk of debt involved subsequent defaults and deep economic distress.f Even Rwanda’s external debt has been crises with their tragic effects on social outcomes.i steadily increasing to levels close to the pre-HIPC These effects highlight the importance of timely number (external debt of 76 percent of the gross and commensurate debt restructuring to ensure national income in 1996 versus 62 percent in 2019).g debt sustainability in the long run. a. IEG (2006); IMF and World Bank (2019). b. Primo Braga and Dömeland (2009). c. Depetris Chauvin and Kraay (2005). d. IMF and IDA (2005). e. World Bank, World Development Indicators (database), https://datatopics.worldbank.org/world-development-indicators/. f. See World Bank, DSA (Debt Sustainability Analysis) (dashboard), https://www.worldbank.org/en/programs/debt-toolkit/dsa. g. See World Bank, World Development Indicators (database), https://datatopics.worldbank.org/world-development-indicators/. h. Under the Brady Plan, banks could exchange nonperforming debt for a new security, a Brady Bond, collateralized by a long- term, zero-coupon US Treasury bond. i. Farah-Yacoub, Graf von Luckner, and Reinhart (2021); Reinhart and Rogoff (2009). MANAGING SOVEREIGN DEBT | 209 Figure 5.3 The lost decade of development in countries defaulting on sovereign debt a. Indexed GDP per capita of 41 countries defaulting between 1980 and 1985 105 Indexed GDP per capita 100 95 90 85 80 t t+1 t+2 t+3 t+4 t+5 t+6 t+7 t+8 t+9 t + 10 Average for all 41 defaulting countries Average for the 20 defaulting countries with worst output losses b. Cumulative change in real GDP per capita 10 years after default, countries with worst output losses 0 Change in real GDP per capita (%) –5 –10 –15 –20 –25 –30 –35 –40 –45 5 3 80 3 83 82 1 3 4 2 1 85 1 1 1 2 81 2 2 3 98 98 98 98 98 98 98 98 98 98 98 98 98 98 98 19 19 19 19 19 ,1 r, 1 ,1 ,1 ,1 ,1 i, 1 ,1 ,1 l, 1 ,1 ,1 1 r, 1 ,1 ia, ia, iti, a, d, o, on ire ar ru ipe nia lic as na es law ga ge do ric lan xic liv mb Ha sc Pe ub pin ur ya ro vo ma ínc ne Ni ua Af Ma Bo Me Po ga nd me Gu ep d'I Za ilip Se Ec Pr Ro th da Ho nR Ca te Ph u nd Ma Cô So ca éa fri om lA oT ra nt Sã Ce Sources: Farah-Yacoub, Graf von Luckner, and Reinhart 2021; International Monetary Fund, World Economic Outlook Data base: Download WEO Data, April 2021 Edition (dashboard), https://www.imf.org/en/Publications/WEO/weo-database/2021 /April. Note: In panel a, time t is defined as the year in which the country defaulted, provided that this initial default occurred between 1980 and 1985. The group of 41 countries consists of all countries defaulting between the two years. The subgroup of 20 countries consists of those requiring the longest time to reach their predefault levels of real gross domestic product (GDP) per capita. In panel b, the country name is followed by the year of the default. Real GDP is the value of the goods and services produced by an economy over a specific period and adjusted for inflation. 210 | WORLD DE VELOPMENT REPORT 2022 incomes and transfer payments, whose purchasing power is eroded by inflation when these payments are not indexed to inflation, and households do not have access to financial tools that would allow them to cope with rising prices. Empirical evidence shows the disproportionate impact of inflation on low- income households.23 Exchange rate depreciations have similarly disproportionate effects on low-income households because a sudden depreciation in the value of the local currency can make basic goods inaccessible for most of the population.24 Because most lower-income countries import a large share of consumer goods, a depreciation of the local currency can render imported goods prohibitively expensive for low-income households. These goods include medical products essential for dealing with the COVID-19 pandemic. Exchange rate depreciations also increase the burden of servicing debt denominated in a foreign cur- rency, resulting in the government diverting more resources from social spending, thereby preventing an equitable recovery. The most recent systemic debt crisis in emerging economies illustrates the dire economic and social consequences that arise when policy makers delay the resolution of escalating levels of sovereign debt.25 In the 1980s, many countries, especially in Latin America and Sub-Saharan Africa, suffered a “lost decade” of development (figure 5.3, panel a). Inflation surged, currencies crashed, output collapsed, incomes plummeted, and poverty and inequality increased across these regions. The 41 countries that defaulted on their sovereign debt between 1980 and 1985 needed an average of eight years to reach their precrisis GDP per capita. For the 20 countries with the worst drops in output, the economic and social fallout from these debt crises continued for more than a decade (figure 5.3, panel b). New challenges in managing and resolving sovereign debt The COVID-19 crisis has played out against the backdrop of a rapidly changing market for sovereign debt, characterized by the increasing complexity in creditor composition and the legal structures used to issue debt. This situation has reduced the transparency of sovereign debt and made it more difficult for governments to manage, renegotiate, and restructure their debt when debt sustainability problems become apparent. One of the most significant developments is the increase in the type and number of creditors. As of 2020, countries eligible for the G20 DSSI had, on average, more than 20 distinct creditor entities (exclud- ing bondholders). 26 Some countries had many more. Creditors have increasingly included private and offi- cial lenders that are not part of the Paris Club, a standing committee of official creditor countries formed in 1956 that, since its creation, has been instrumental in the majority of sovereign debt restructurings.27 There has also been a marked change in the types of creditors that hold claims on sovereign bal- ance sheets. Over the last three decades, these have included non–Paris Club foreign governments, quasi-sovereign entities, SOEs, and corporations not traditionally engaged in sovereign lending, such as commodity traders and producers.28 They now account for a significant portion of sovereign debt, especially in emerging economies (figures 5.4 and 5.5). The rise of China as a bilateral creditor, for example, is a well-documented trend. In 2000, China accounted for 0.4 percent of the debt stocks of low- and middle-income countries. By 2019, it accounted for 4.8 percent. For low- and lower- middle-income countries, China accounted, on average, for 11 percent of total external public and publicly guaranteed debt, although for 20 countries in this group it accounted for more than one-fifth and up to two-thirds in the most extreme cases. While the rise of non–Paris Club lenders has given emerging economies new avenues to financing public expenditures, it may also complicate the resolution of debt distress. One concern is the lack ­ of transparency surrounding debt contracted with non–Paris Club lenders. Many new bilateral debt MANAGING SOVEREIGN DEBT | 211 Figure 5.4 External debt in low- and middle-income countries, by creditor type, 1980–2019 1,600 1,400 1,200 US$ (billions) 1,000 800 600 400 200 0 96 00 08 12 16 84 86 90 94 98 02 06 10 14 18 80 82 88 92 04 20 19 20 20 20 20 20 20 20 19 19 19 19 19 20 19 19 19 20 19 20 20 Bilateral, excluding China Private creditors, bonds China Private creditors, banks Multilateral Private creditors, others Source: World Bank, International Debt Statistics (database), https://databank.worldbank.org/source/international-debt -statistics#. Note: The figure shows total public and publicly guaranteed external debt by creditor type in low- and middle-income coun - tries. The data are for 120 low- and middle-income countries, of which 73 are low- and lower-middle-income countries. Figure 5.5 Composition of creditors in all countries and in low- and lower-middle-income countries, 1989 and 2019 a. All countries b. Low- and lower-middle-income countries 100 100 Share of creditors (%) Share of creditors (%) 80 80 60 60 40 40 20 20 0 0 1989 2019 1989 2019 Bilateral, excluding China Private creditors, bonds China Private creditors, banks Multilateral Private creditors, others Source: World Bank, International Debt Statistics (database), https://databank.worldbank.org/source/international-debt -statistics#. Note: The figure shows the trends in creditor composition overall (panel a) and in low- and lower-middle-income countries (panel b). The data are for 120 low- and middle-income countries, of which 73 are low- and lower-middle-income countries. 212 | WORLD DE VELOPMENT REPORT 2022 contracts contain expansive nondisclosure clauses, making it difficult for other creditors to reliably assess the true financial position of the government or the seniority of one creditor’s claim on the gov- ernment relative to those of other creditors. 29 However, concerns about transparency are not limited to government loans with non–Paris Club creditors. Debts taken on through SOEs or using legal forms not typically recognized as debt have also added to the difficulty of assessing the full extent of sovereign liabilities.30 Not only does this complicate debt resolution in the event of a crisis, it also may deter lenders from offering loans to countries in the first place. These issues extend beyond the central government. In many emerging economies, subnational entities, such as SOEs or regional governments, also enter into external credit arrangements. Between ­ 2009 and 2019, debt issuance by SOEs and subnational entities grew sevenfold, to about $140 billion.31 Such borrowing by SOEs creates a risk of contingent liabilities that may not be reflected in government accounts because the debts of SOEs are often not fully integrated into the public sector’s balance sheet. Moreover, not all liabilities of SOEs are structured in ways that make them recognizable as debt, which further obfuscates the true financial position of the sovereign. This approach to liabilities can give rise to significant hidden risks (discussed in more detail later in this chapter), and it is especially important in the current context in which many SOEs are directly affected by the pandemic. Public utilities, for example, have seen a dramatic decline in revenue stemming from moratoria on utility payments or the inability of customers to pay their bills. There has also been a shift in the type of legal structures used to issue sovereign debt. New debt instru- ments and contractual innovations have proliferated to meet the needs of particular creditor-debtor pairings. Specifically, secured lending, novel de facto seniority structures, complex guarantees, swap lines, central bank deposits, and commodity-based lending structured as forward sales have become more popular over the last two decades.32 A recent report on debt transparency finds that commodity- based lending represents 10–30 percent of external debt stocks for the median low-income country in the year following the signing of the commodity-based arrangement.33 This practice has become par- ticularly prevalent in Sub-Saharan Africa, where this type of lending accounted for 10 percent of new borrowing from 2004 to 2018.34 Although syndicated loans (loans issued by a small group of banks organized by an “agent” bank) were the dominant debt instrument in the 1970s and 1980s, they have since given way to bonds as the most prevalent instrument for sovereign debt from private creditors. This shift has direct consequences for debt resolution. For example, because bondholders are more dispersed and more difficult to coordi- nate than bank syndicates, every time a central government needs to seek debt treatment, a bondholder committee must form.35 It is also notable in today’s context that more than one bondholder committee may form for any given restructuring. This increases coordination problems among debtors and further complicates the management of sovereign debt. While some contractual innovations can improve the ability of debtors to resolve disputes with ­ specific creditors, they can also hamper coordinated resolution efforts. For example, certain creditor types have become reluctant to participate in broad restructuring initiatives because of their perceived unequal contractual treatment relative to others. One set of contractual innovations is aimed at improv- ing the seniority and security of their claims, including through collateralization.36 Such innovations can add significant complexity for the sovereign borrower if debts need to be restructured. An analysis of this class of debt contracts found that they often include broader nondisclosure clauses than is typical. Such clauses obscure the true financial position of the sovereign borrower and create significant obsta- cles in negotiations involving multiple creditors.37 Although this class of contractual innovations has not been tested in the courts—and it is unclear whether they would prevail—the signaling effect and cost of litigation may be enough to tilt, and lengthen, resolution practices.38 MANAGING SOVEREIGN DEBT | 213 Managing sovereign debt and resolving sovereign debt distress Effective management of sovereign debt can reduce pressure on government finances, free up resources for urgent fiscal expenditures, and avert the large social and economic costs of a full-blown debt crisis.39 This section reviews tools that governments can use to better manage elevated levels of sovereign debt and resolve distress when it materializes. It also looks at the longer-term policies and reforms that can make government finances more resilient to unanticipated shocks such as the one resulting from the COVID-19 crisis. At times, similar tools can be used for both managing elevated levels of sovereign debt and for resolving debt distress. The difference is often the degree to which the available tools are applied and which combination of available policy options is chosen. The degree of relevance of these tools depends on countries’ individual circumstances—for exam- ple, their degree of market access and their income level—as well as macroeconomic factors such as the exchange rate regime. Most of the options presented in what follows are applicable across the spectrum because the basic principles of timely recognition of the problem, negotiation, and burden reduction are relevant to all types of debt. A critical first step is to identify a country's risk of falling into debt distress. International financial institutions typically play a central role in providing debt sustainability analyses (DSAs),40 which are the basis for classifying debt risks and designing strategies for debt reduction. For example, DSAs are an integral part of Paris Club debt restructurings and often play a key role in restructurings with private creditors as well. Because a reliable DSA is the basis for successful debt management and debt reduction, it is critical that such an analysis be based on accurate information as well as transparent and realistic assumptions. Accurate assumptions are crucial in three areas. The first is growth, comparing expected growth rates with historical growth rates and allowing for realistic worst-case scenarios, especially in fragile, low- income, and commodity-exporting economies. The second is fiscal. Assumptions should take into account the expenditures needed to achieve development goals—such as reducing poverty, adapting to climate change, meeting the Sustainable Development Goals (SDGs)—as well as assumptions on the amounts and terms of the debt instruments used to fill future funding gaps. The third is realistic dis- count rates. Assumptions should differentiate between debt due now and debt due in the future.41 To do this, DSAs use present value estimates, which discount future payments by a given discount rate. Unrealistic discount rate assumptions are often overlooked as a reason that expectations and reality diverge. The use of overly optimistic discount rates that make the present value of a sovereign’s liabilities look manageable can lead to surprises when the economic environment turns out to be less benign than the forecast and insufficient relief if debt distress materializes. Managing sovereign debt Countries at high risk of debt distress, as opposed to countries already in debt distress, have a number of policy options for making their repayment obligations more manageable. Sovereigns at high risk of default can, for example, modify the structure of their liabilities and the schedule of future payments through negotiations with creditors and the effective use of refinancing tools—whether these creditors are private or official. In this way, proactive debt management can reduce the risk of default and free up the fiscal resources needed to support the recovery from the pandemic. Debt reprofiling to temporarily free up fiscal resources One of the primary tools governments have at their disposal to manage debt pressures before they become untenable is debt reprofiling. In debt reprofiling, the sovereign issues new debt in order to change 214 | WORLD DE VELOPMENT REPORT 2022 its debt service profile. Multiple characteristics can be targeted by such operations. Most commonly, debt reprofiling operations modify the maturity or currency exposure of existing debt. This usually happens in one of three ways: (1) new debt is issued, and the proceeds are used to retire old debt; (2) old debt is exchanged for new debt (similar to a debt restructuring, but market-based); or (3) new debt is issued at the time of maturity of the old debt but has significantly different characteristics. The debt is thus rolled over, but the emerging liability service profile is different and more advantageous for the borrower. Debt reprofiling could, for example, be helpful when a country has multiple loans that come due in the same year and would place an excessive strain on government finances. The sovereign could choose to issue new debt with a longer or more even maturity profile that is easier to service. The sovereign would then use the capital raised from this new debt issue to retire some of the loans for which matur- ities were bunched in the same year. More typically, the operation would retire debt maturing in the near future and replace it with debt of longer duration. In recent years, some sovereigns have also begun to issue amortizing bonds, which pay principal down at different points of their life. Use of this method helps to manage debt service ex ante by spreading out debt payments over time. Reprofiling can also target currency composition, which is an important factor in debt sustainability, irrespective of a country’s exchange rate regime. In this case, instead of changing the maturity of exist- ing debt, the debt reprofiling operation aims to retire existing debt in one currency by issuing new debt in another currency. In a recent debt reprofiling operation in Ghana, for example, a foreign currency bond was issued to partially retire domestic currency debt. The rationale for this choice was to take advantage of abundant hard currency liquidity to increase space in the aggregate balance sheets of the domestic financial sector.42 Of course, the risks of greater foreign currency debt exposure, particularly in the context of significant currency depreciation, must be weighed against the costs of domestic debt service in a relatively shallow domestic market. Other operations can retire expensive debt if the sover- eign’s cost of funds has fallen in capital markets (see box 5.2 for an example). The details of reprofiling operations vary, depending on the characteristics of a country’s debt and debt service profile. Although debt reprofiling receives more attention when pursued with private cred- itors, it is not uncommon for debt reprofiling operations to involve official creditors. Thus this option is available to debtor countries whatever their creditor composition. Countries with access to bond mar- kets are, in theory, in a better position to take advantage of debt reprofiling, but they may also be more reluctant to do so to avoid risking a downgrade in their credit rating. Designing a reprofiling operation that effectively manages the risks associated with sovereign debt is not trivial and requires extensive analysis, typically carried out by the country’s debt management office in conjunction with international financial institutions and possibly other advisers. Overall, a country seeking to reprofile its debt needs to ascertain whether realistic financing options are available and whether the resulting changes to its debt profile would be sufficient to solve the prob- lem. Although debt reprofiling can free up liquidity and make a country’s debt payments more man- ageable, it typically will not reduce the debt stock and is therefore not a long-term solution for debt sustainability issues. Preemptive negotiations with creditors to prevent debt distress Sovereigns that are at high risk of or are in debt distress have the option of initiating preemptive nego- tiations with their creditors to reach a debt restructuring before they fail to meet their contractual obligations.43 There are many historical examples of preemptive restructurings aimed at averting out- right default, including Chile (1987 and 1990), Algeria (1992), the Dominican Republic (2005), and, most recently, Ukraine (2015–16) and Belize (2020).44 The option to pursue a preemptive restructuring depends largely on the creditor’s willingness to negotiate, the debtor’s credibility, and agreement on the debtor MANAGING SOVEREIGN DEBT | 215 Box 5.2 Case study: Seizing market opportunities for better debt management in Benin The COVID-19 crisis has had a profound impact on problem. Benin was also able to mobilize substan- Benin’s economy and people. Between 2017 and tial funding to address new financing needs arising 2019, Benin’s real gross domestic product (GDP) from the pandemic. was growing at 6.4 percent per year. In 2020, with Benin had experience in proactive debt man- the pandemic under way, real GDP growth dropped agement. In 2018, it was able to obtain commercial to 3.8 percent per year. Gains in poverty reduc- loans for €260 million ($312 million) through the tion were partially reversed. According to World World Bank’s Policy-Based Guarantee. The terms Bank estimates, the percentage of people living of these loans were 4 percent interest and 12-year under the international poverty line of $1.90 a day maturities. Benin used the loans to buy back shorter- increased from 45.5 percent in 2019 to 45.9 percent term domestic debt.g Although Benin replaced local in 2020.a Because of this fragile situation, the gov- currency debt with foreign currency debt, it was ernment now faces greater than usual difficulties in able to take advantage of improved financing con- collecting taxes, as well as more demands for addi- ditions with a small increase in its exposure to cur- tional spending on health and social programs to rency risk because Benin’s currency is pegged to the contain the impacts of the pandemic. euro. Overall, however, this operation is an example In the years prior to the pandemic, Benin’s total of how Benin has effectively used the instruments public debt increased significantly, from 22.3 per- available through international financial institutions cent of GDP in 2014 to 41.2 percent of GDP in 2019.b such as the World Bank and the International Mon- But it was not the only country in this situation: 45 of etary Fund (IMF) to optimize market access, as well 48 countries in Sub-Saharan Africa saw an increase as to manage its sovereign debt. in debt levels over the same period.c Benin’s increase Another example of how Benin has been able in debt partly resulted from better access to com- to effectively combine financing instruments from mercial debt. Benin first entered the Eurobond mar- international financial institutions and the bond ket in March 2019 with an issuance of €500 million market is Benin’s July 2021 issuance of a Sovereign ($600 million) and a final maturity of seven years for Sustainable Development Goals (SDGs) Bond.h The a coupon of 5.75 percent. The bonds were to be €500 million ($600 million) mobilized through this amortized over the last three years of their life (2024, issuance will be used toward achievement of the 2025, 2026).d These terms placed significant pres- SDGs as described in the Benin SDG Bond Frame- sure on the government to mobilize the resources work.i Benin was able to secure a maturity of 14 years needed to meet the debt service demands. In partic- with a coupon of 4.95 percent for this bond, com- ular, the 2023 external debt service-to-revenue ratio pared with a maturity of 11 years and a 4.875 percent was expected to triple, reaching 20 percent in 2024 coupon in the previous operation (table B5.2.1). due to amortization of the Eurobonds.e Benin has also successfully tapped into sources To meet the growing financing needs triggered other than commercial funding to finance its by the pandemic, as well as the looming debt ser- COVID-19 response. As a low-income country eligi- vice pressures, Benin looked at different financing ble for International Development Association assis- options, including reentering the bond market. tance, Benin has access to concessional loans from It issued a new Eurobond in January 2021. This the World Bank and IMF. Benin obtained $177.96 issuance had two tranches: (1) €700 million ($840 million in emergency assistance from IMF in Decem- million) with an 11-year maturity and a coupon of ber 2020, in addition to the $103.3 million approved 4.875 percent and (2) €300 million ($360 million) earlier, in May 2020.j Benin also secured $50 million with a 31-year maturity and a coupon of 6.875 per- in emergency financing from the World Bank in 2021 cent.f Overall, Benin succeeded in mobilizing €1 to fight the COVID-19 pandemic, in addition to the billion, which allowed it to buy back 65 percent of $100 million in budgetary support disbursed in 2020.k the previous Eurobond issuance (from March 2019), Successful debt management requires optimiz- reduce its debt cost, and address the debt service ing complicated contracts with different moving (Box continues next page) 216 | WORLD DE VELOPMENT REPORT 2022 Box 5.2 Case study: Seizing market opportunities for better debt management in Benin (continued) Table B5.2.1 Benin’s debt profile and recent issuances in the Eurobond market, 2019–21 a. Debt profile   End of 2019 End of 2020 (est.)   External Domestic External Domestic Nominal debt (US$, millions) 3,623.90 2,611.00 4,055.80 3,247.00 Interest payments (% of GDP) 0.5 1.0 0.5 1.2 Weighted average interest rate (%) 2.1 6.1 1.8 5.9 Average term to maturity (years) 10.9 2.8 10.8 3.6 Share maturing in one year (%) 3.2 24.2 3.4 21.7 b. Recent issuances January 2021, January 2021, March 2019 tranche 1 tranche 2 July 2021 500 700 300 500 Amount (€, millions) ($600 million) ($840 million) ($360 million) ($600 million) Maturity (years) 7 11 31 14 Coupon (%) 5.75 4.875 6.875 4.95 Used to repurchase maturing No Yes, partially Yes, partially No debt? Sources: CAA 2019; MEF 2021. Note: Panel a considers all external and domestic debt, including concessional lending. Panel b provides further details on bond issuance since 2019. For bonds alone, weighted average coupons evolved from 5.75 percent in 2019, to 5.5 percent in January 2021, and then to 5.35 percent in July 2021. The corresponding average maturities evolved from 7 years in 2019, to 15.5 years in January 2021, and then to 15 years in July 2021. GDP = gross domestic product. parts—maturity, currency, interest rate, and amorti- best match their country’s interests and financing zation schedules, among others. Debt management needs. Benin is a good example of how countries offices need to be aware of market movements, as can mitigate pressures on government finances well as actions and initiatives by donors and multi- and preserve their ability to meet urgent financing lateral organizations, to find the opportunities that needs through proactive debt management. a. World Bank (2021b). b. IMF (2020b). c. WDR 2022 team calculations, based on data from International Monetary Fund, World Economic Outlook Database: Down- load WEO Data, April 2021 Edition (dashboard), https://www.imf.org/en/Publications/WEO/weo-database/2021/April. d. Government of Benin (2019). e. IMF (2020b). f. Government of Benin (2021b). g. IMF (2020b). h. CAA (2021). i. Government of Benin (2021a). j. IMF (2020b). k. For more details on the financial engagement of the World Bank in Benin, see World Bank, Overview: Strategy, World Bank in Benin, https://www.worldbank.org/en/country/benin/overview#2. MANAGING SOVEREIGN DEBT | 217 country’s needs. For countries with market access, these negotiations usually take the form of convening a meeting with bondholders. When these negotiations are pursued with official creditors, they take the form of either separate bilateral negotiations or a meeting with multiple creditors that could be coordi- nated by a group such as the Paris Club or an international financial institution. Whatever the creditor pool, the objective is a reduction of the debt stock or some present value reduction of the debt burden through reduced payments, extended maturities, or extended grace periods. Evidence shows that where preemptive restructuring is undertaken, it is resolved faster than post­ default restructuring, leads to a shorter exclusion of the country from global capital markets, and is asso- ciated with a lower decline in output.45 This option is not available to all governments, however, because it requires a high level of transparency about who holds the country’s debts and on what terms. This is important because a preemptive restructuring relies on debtors and creditors agreeing on the probability of debt distress and reaching an agreement acceptable to all creditors. Although this discussion suggests that countries can reap clear benefits from renegotiating high debt burdens preemptively, the evidence also shows that preemptive restructuring does not make countries more resilient to debt sustainability problems in the longer term. The probability of defaulting within 24 months following a restructuring does not differ between countries that pursue preemptive versus postdefault restructuring (the relapse probability is 39 percent in both strictly preemptive and strictly postdefault restructuring).46 This finding suggests that in the future countries should use the improved breathing space and stability offered by preemptive restructuring to more rapidly lay the foundation for longer-term debt sustainability. Resolving sovereign debt distress Once a government is in debt distress—most often marked by a default—the options to treat the problem are more limited. The primary tool at this stage is debt restructuring. It requires prompt recognition of the true nature of the problem (sustainability), coordination with creditors, and an understanding by all parties that restructuring is the first step toward debt sustainability (that is, reaching a level of debt that allows the government to pay its current and future obligations). These broad principles for sovereign debt restructuring are very similar to the principles for restruc- turing private sector debt covered in chapters 2 and 3, with a few important differences. First, there are no bankruptcy or insolvency courts for sovereign debt, which remains a significant gap in the present financial architecture. To restructure sovereign debt, there are, at best, creditor committees (such as the ones set up by the Paris Club, bondholders, or the London Club in the past) so debtors can meet to negotiate and come to an agreement. However, it is often a difficult, lengthy process to enforce such agreements or seize the assets of the debtor as in a regular commercial insolvency case. Typically, the assets of the sovereign are either covered by sovereign immunity (for example, central banks’ reserve accounts with other central banks) or outside the jurisdiction of the courts adjudicating the contractual breach. With rare exceptions, only assets pledged as collateral and covered by clauses forgoing immunity are readily reachable by creditors. Second, despite the term public debt, there is often a lack of informa- tion about a country’s lenders and the total amount of debt. Credit registries or credit bureaus track corporate debts. Although these databases may not be perfect, they tend to be more complete than the information available on sovereign debt (see box 5.5 later in this chapter on the hidden debt problem). Third, sovereign debt restructuring involves lenders from different countries, with the result that debt contracts are often established under different jurisdictions with different instruments and different levels of implied seniority. Although corporate debt can also have an international component, this is less common, especially in the case of micro-, small, and medium enterprises. 218 | WORLD DE VELOPMENT REPORT 2022 The importance of timely debt restructuring When a country is unable to service its debt, there are strong arguments in favor of it quickly acknowl- edging the problem so it can take steps to reduce debt loads and allow for faster recovery. Evidence from past debt crises shows that the average default spell lasts eight years,47 and the indebted country typically goes through two debt restructurings before it emerges from default (figure 5.6).48 Indeed, Jamaica and Poland each engaged in seven debt restructuring deals with private external creditors before resolving their default spell so they are capable of financing the necessary spending. Chad, one of the first three countries to apply for the G20 Common Framework for Debt Treatment beyond the DSSI (see box 5.3), is currently seeking its third debt restructuring since 2014. Such extended timelines have far-reaching social and economic consequences in which development goals suffer significant setbacks, delaying an equitable recovery. This is part of the post–COVID-19 reversal problems many low-income countries are already experiencing (see box 5.1). The resolution of sovereign debt distress can be a lengthy process for several reasons. First, the increased importance of new types of lenders impedes transparency and makes it more difficult to estab- lish the true extent of a country’s outstanding debts, which complicates the coordination of different creditors. Second, governments are often tempted to delay debt restructuring for strategic or political reasons. In addition, creditors are often reluctant to grant debt relief that is extensive enough to perma- nently solve a country’s debt sustainability problem. Although the explanations vary case by case, the common outcome is that the initial restructuring is often delayed and falls short of what is necessary to achieve debt sustainability. One common—and misguided—approach is to postpone debt resolution efforts until economic conditions improve.49 However, such a strategy can itself deepen and prolong an economic downturn because the unresolved debt crisis prevents a country from recovering capital inflows. Creditors and debtor governments should thus view debt restructuring as part of the initial resolution and recovery plan rather than as a subsequent step, as is often the practice for private debt. Sovereign debt restructuring typically involves five steps: 1. The debtor country announces its intention to pursue an agreement with one or several of its key creditors. 2. Creditor committees are formed (if no standing committee exists), and conversations are initiated. 3. The debtors, creditors, and their respective advisers take inventory of the existing claims against the debtor nation and validate them in order to agree on the set of contracts to be discussed—a process called claim reconciliation. This process includes a review of existing contracts to ascer- tain the truthfulness and validity of the claims. This is often a time-consuming process, and countries would benefit from conducting such an analysis as part of their ongoing debt manage- ment efforts. 4. Negotiations cover aspects of the contracts the parties want to change. 5. When an agreement is reached and a debt exchange offer is completed, creditors exchange the old debt contracts for new and amended debt agreement contracts that reflect the negotiated settlement. This process is applicable to countries at all income levels and to all creditor compositions. What changes is the degree of complexity involved. When a country defaults because of a temporary shock such as the COVID-19 crisis, sufficiently extending maturities and spreading debt service payments more evenly into the future may achieve debt sustainability. However, it may not be possible to determine in real time whether a shock is temporary, and the cost of erring in favor of a shallow restructuring can extend the duration of default spells and MANAGING SOVEREIGN DEBT | 219 Figure 5.6 Sovereign debt restructuring and time spent in default, selected countries, 1975–2000 Albania Algeria Antigua and Barbuda Argentina Bosnia and Herzegovina Brazil Bulgaria Chile Cook Islands Costa Rica Croatia Dominican Republic Ecuador Egypt, Arab Rep. Equatorial Guinea Gabon Guatemala Indonesia Iraq Jamaica Jordan Mexico Morocco North Macedonia Panama Paraguay Peru Philippines Poland Romania Russian Federation Slovenia South Africa Trinidad and Tobago Turkey Ukraine Uruguay Venezuela, RB Vietnam Yugoslavia 1975 1980 1985 1990 1995 2000 Period of default Debt restructuring Source: WDR 2022 team, based on Cruces and Trebesch (2013); Farah-Yacoub, Graf von Luckner, and Reinhart (2021); Meyer, Reinhart, and Trebesch (2019); Reinhart and Rogoff (2009). Note: The figure shows a timeline of sovereign defaults and debt restructuring from 1975 to 2000. The figure excludes coun - tries covered by the International Development Association (IDA) and the Heavily Indebted Poor Countries (HIPC) Initiative. 220 | WORLD DE VELOPMENT REPORT 2022 increase their human and economic costs. Data from recent studies suggest that more than half of the debt restructurings that ended a default spell included a reduction in face value.50 The role of insufficient debt reduction in future defaults One reason why countries typically require several rounds of debt restructuring to emerge from debt distress is that creditors often find it difficult to agree to restructuring deep enough to make debt bur- dens sustainable and future default unlikely. From the creditor’s perspective, sovereign debt restructuring follows a simple logic: the restructuring should grant sufficient debt relief to ensure repayment but avoid reducing debt more than is strictly necessary. For low-income countries, official lenders equate debt relief with aid, and so they may be more willing to agree to larger debt reductions. However, the debtor country’s ability to service its debt depends on a wide range of factors (such as economic growth, international economic conditions, and the ability to raise tax revenue), which are difficult if not impossible to forecast at longer time horizons. In this situation, it is tempting for lenders to buy in to overly optimistic forecasts because those forecasts imply that smaller debt write-offs are required to ensure debt sustainability in the future. In reality, however, by relying on overly optimistic forecasts creditors systematically underestimate the amount of debt reduction needed, thereby laying the foundation for future debt distress. To avoid this common cause of prolonged debt distress and recurring rounds of default, creditors and sovereigns need to agree on a set of realistic (ideally independently assessed) growth projections, which can provide the basis for a more reliable debt sustainability analysis. The importance of effective creditor coordination to debt resolution Debt restructuring requires coordination between the sovereign and its creditors. Because there is typ- ically one debtor and many creditors, a creditor committee is formed to facilitate the process and min- imize holdouts and litigation.51 Whether a restructuring is attempted preemptively or after distress has materialized, negotiating through a creditor committee is the most common approach to resolving sov- ereign debt distress. Depending on the composition of the creditors, creditor committees can be made up of multilateral, bilateral, and private sector creditors. Coordination problems are typically difficult to resolve for any of these types, but historically multilateral and bilateral diplomacy between official creditors has helped (box 5.3). Because the growing importance of nontraditional lenders has obfuscated the full extent of coun- tries’ debts and made creditor coordination more difficult, new solutions are needed to overcome coor- dination problems in debt negotiations. Past crises may offer some guidance on how better coordination between creditors can be achieved in a more complex market for sovereign debt. For example, commer- cial creditors, which account for a growing share of sovereign debt, could be enticed to participate in restructurings by their own governments. During the debt crises of the 1980s, US commercial banks held substantial amounts of emerging market debt, especially in Latin America. Defaults on these assets threatened to develop into a banking crisis in the United States,52 thereby giving the US government an incentive to offer bilateral debt relief. The result was the Brady Plan, named for US Treasury Secretary Nicholas Brady. Under the program, banks could exchange nonperforming debt for a new security, a Brady Bond, collateralized by a long-term, zero-coupon US Treasury bond. The initiative was, in most cases, a success for debtors and for the United States. After these restructurings, debtor countries expe- rienced higher growth rates, renewed capital inflows, and improved credit ratings.53 The stock market capitalization of US banks with emerging market exposure also increased substantially.54 Today, the debt of emerging economies is not nearly as concentrated in a handful of large banks as it was then. Nonetheless, countries whose commercial banks and nonbank lenders are newly exposed MANAGING SOVEREIGN DEBT | 221 Box 5.3 The role of multilateral coordination in the looming debt crisis: The G20 Debt Service Suspension Initiative and the G20 Common Framework Multilateral coordination is essential when many debtor nations are facing distress. It is especially Figure B5.3.1 Participation of countries important when the sovereigns in distress are in DSSI, by level of risk of debt distress low-income countries, whose largest creditors are governments and multilateral organizations. 100 Share of eligible countries (%) 90 The G20 Debt Service Suspension Initiative 80 Responding to this reality, in April 2020 the G20 70 (Group of 20), along with multilateral financial insti- 60 tutions, including the World Bank and International 50 Monetary Fund (IMF), launched the Debt Service 40 Suspension Initiative (DSSI), which sought to pre- 30 empt debt distress from the pandemic by offering 73 20 low-income countries the option of forbearance— delayed payment—on bilateral loans.a Since it came 10 into effect in May 2020, the initiative has provided 0 High risk or Moderate Low 48 economies with temporary cash-flow relief, and in debt distress risk risk by the end of June 2021 it had delivered about $10.3 billion in debt service suspension (a national devel- Participants Nonparticipants opment bank participated as a private creditor). On Source: WDR 2022 team. average, participants in DSSI faced more elevated Note: The figure presents the percentage of the 73 risks of debt distress than those economies that eligible low-income countries participating in the abstained (see figure B5.3.1). Debt Service Suspension Initiative (DSSI) within each Multilateral institutions provided much relief class of risk of debt distress as defined by the World Bank–International Monetary Fund debt sustainabil- through the initiative. From April 2020 to June 2021, ity analyses. the World Bank committed $52.4 billion in Interna- tional Bank for Reconstruction and Development (IBRD) and International Development Association (IDA) financing to DSSI-eligible countries. Its total bank mentioned earlier, have not offered forbear- gross disbursements to these countries—IBRD, ance under the DSSI. Because private credit is now IDA, and Recipient Executed Trust Funds (RETFs)— a much larger share of sovereign debt than when amounted to $31.1 billion, of which $8.8 billion was the Paris Club was founded, creditor coordination provided on grant terms ($28 billion in net trans- to date appears more difficult than in the past. fers). International Finance Corporation (IFC) sup- port amounted to $4.9 billion in commitments (own The G20 Common Framework for Debt Treatment account and mobilization) and $2.0 billion in dis- The DSSI was followed in November 2020 by bursements (own account). However, multilateral the G20 Common Framework for Debt Treat- institution actions alone are insufficient to relieve ment beyond the DSSI, which covers the same 73 countries of the debt pressures faced. Commer- low-income countries eligible for the G20’s DSSI. cial creditors, except for the national development The Common Framework seeks to expand on the (Box continues next page) 222 | WORLD DE VELOPMENT REPORT 2022 Box 5.3 The role of multilateral coordination in the looming debt crisis: The G20 Debt Service Suspension Initiative and the G20 Common Framework (continued) DSSI’s provision of relief by establishing a process the comparable treatment of creditors—that is, to restructure debts, including those held by non– upon reaching an understanding with the par- Paris Club official and commercial creditors. The ticipating official creditors, the debtor nation is process of debt treatment is initiated by the debtor obliged to seek similar debt relief from its other country. Eligible debt includes all public and pub- creditors. Still, so far only three countries have licly guaranteed external debt maturing in at least applied for treatment: Chad, Ethiopia, and Zam- one year. How much debt needs to be restructured bia. Many eligible countries remain reluctant to and the related financing needs for the country seek assistance because of concerns about rep- are determined by IMF–World Bank debt sustain- utational credit risks and access to capital. All ability analyses (DSAs) and an assessment by the three major credit agencies have made it clear participating official creditors in conjunction with that requesting commercial creditor forbearance the debtor country.b Treatment should comport on G20-comparable terms could lead to a down- with the parameters of an IMF upper credit tranche grade of credit rating. That certainly would be the loan—that is, the program, amount, and policies scenario if comparability of treatment triggers should lay the groundwork for a return to debt sus- private debt restructuring. tainability. Modifications considered by the process In summary, the international community can include (1) changes in debt service over the course take the following steps in the event of debt distress: of the IMF program; (2) debt reduction in net pres- (1) determine whether the restructuring deal and ent value terms; and (3) extension of maturities. policy package returns the country to debt sustain- The framework reserves the right to cancel or write ability and thus offsets creditworthiness concerns; off debts for the “most difficult cases.” Determina- (2) ensure participation by all relevant creditors; and tion of such need also follows the IMF–World Bank (3) advocate for concessional sovereign financing DSA and the collective assessment of the partici- until the state can access finance from the market, pating official creditors. including by increasing concessional options. As The key driving principle of the G20 Common the historical track record shows, these steps have Framework, much like that of the Paris Club, is been difficult to achieve. For the DSSI, see World Bank, DSSI (COVID 19: Debt Service Suspension Initiative) (dashboard), https://www.worldbank a.  .org/en/topic/debt/brief/covid-19-debt-service-suspension-initiative. For the DSA, see World Bank, DSA (Debt Sustainability Analysis) (dashboard), https://www.worldbank.org/en/programs b.  /debt-toolkit/dsa; International Monetary Fund, DSA LIC (Debt Sustainability Analysis Low-Income Countries) (dashboard), Washington, DC, https://www.imf.org/en/publications/dsa. to sovereign debt are in a position to implement a similar approach. Nonperforming debt could, for example, be swapped for new securities backed by creditors’ sovereigns and held in escrow to reduce risk in the same way as the Brady Bonds. Such an initiative could prove fruitful in encouraging commercial lenders to participate in resolving debt distress and at the same time reduce risks to the lender country’s financial system, as occurred with the Brady Plan. Nonetheless, Brady Bond–like arrangements require significant subsidies from the government, donors, or international financial institutions and there- fore come at a cost to taxpayers. This may help explain why about eight years passed after the onset of Mexico’s debt crisis before the first Brady deal in 1990. MANAGING SOVEREIGN DEBT | 223 The high social and economic costs of liquidating sovereign debt without restructuring Significantly reducing sovereign debt in emerging economies typically requires debt restructuring, there are other means to achieve this end. The most orthodox approach is fiscal consolidation, which involves reducing government expenditures, raising taxes, or both. Similarly, debt burdens can be reduced through robust economic growth, which improves government revenue, fiscal balances, and debt servicing capacity. Sovereign debt can also be reduced using less orthodox macroeconomic policies, such as deficit monetization (central bank financing of budget deficits) or financial repression (forcing negative real ­ interest rates and proscribing capital outflows). Such policies have often accompanied debt crises and arguably are a forced response to debt distress in situations where other options are limited.55 Nonethe- less, when policy makers are confronted with unsustainable debts denominated in local currency, held by local creditors, or adjudicated under domestic law, they often see deficit monetization and financial repression as soft options that they should attempt before default or restructuring.56 Because both types of policies require action by the central bank, they can not typically be applied in countries that are members of a currency union. Unanticipated inflation has also played a role in debt reduction in both advanced and emerg- ing e­ conomies.57 The degree to which inflation spikes can reduce debt depends on the currency pro- file and maturity profile of a country’s debt stock and the extent to which inflation expectations are well anchored, among other factors. In many countries, particularly in Africa and Latin America, the monetization option has proved to be a slippery slope, often leading to high, persistent inflation. Financial repression measures, often coupled with higher inflation, are another path that many countries have taken to manage domestic debt servicing costs and reduce debt loads.58 For example, ­ Ethiopia, one of the first three countries to apply for the Common Framework, has maintained signifi- cantly negative real (inflation-adjusted) interest rates since 2006. Financial repression measures also include financial market regulation, such as caps on interest rates, and capital controls. Directed lending to the government by “captive” institutions or public programs has played a role as well. For example, governments may require banks, pension funds, or other domestic financial institutions to purchase sov- ereign debt, often to the exclusion of other assets, or to lend directly to the government (or government- sponsored enterprises) at below market rates. In short, financial repression is a transfer from savers to borrowers, with government often being the single largest borrower in most low-income countries. Historically, numerous countries have used financial repression policies to reduce their sovereign debt. Studies document that between 1945 and 1980 financial repression was among the most widely used paths to debt deleveraging in countries as diverse as Argentina, France, India, and the United States.59 More recently, in some countries financial repression policies have been employed specifically to help finance the COVID-19 response.60 Even though they are often used to reduce domestic debt stocks, financial repression policies can have pernicious effects on economic growth, the allocation of capital, and inequality.61 Forcing domestic financial institutions to finance sovereign debt crowds out credit to the private sector and reduces eco- nomic growth in the longer run. It also exposes the domestic financial sector to sovereign risk and can undermine financial stability, and it increases the magnitude of contingent liabilities and the likelihood they will materialize. Perhaps most important, financial repression policies have severe negative effects on poverty and inequality. By keeping nominal interest rates artificially low, such policies punish savers and reward debtors. In addition, they often coincide with high inflation, which further erodes the value of wage income and precautionary savings, with disproportionate impacts on the poor. As described in box 5.4, in Argentina financial repression policies have been used extensively, but this policy choice has had adverse consequences. 224 | WORLD DE VELOPMENT REPORT 2022 Box 5.4 Case study: The social and economic costs of financial repression in Argentina At the turn of the millennium, Argentina faced one of the severest economic crises in modern history. Figure B5.4.1 Poverty and financial Accumulated vulnerabilities, delays in pursuing repression, Argentina, 1995–2002 restructuring, and a three-year recession brought 18 10 about significant economic turmoil. Fiscal vulnera- bilities, loss of competitiveness, the rigidity of the 16 Share of population (%) 5 currency board system, overly optimistic growth 14 assumptions, and political instability were all cited 12 0 Index (%) as key factors leading to this conglomerate crisis.a 10 As a result of the crisis and the delayed policy –5 8 actions to address it, Argentina’s economy shrank 6 –10 20 percent in 2002 and, according to national statis- tics, 53 percent of the population was living in pov- 4 –15 erty in May 2002, up from 38 percent in October 2 2001.b Based on the World Bank’s international pov- 0 –20 erty line of $1.90 per day, the poverty rate peaked at 95 96 97 98 99 00 01 02 19 19 19 19 19 20 20 20 the height of the crisis in 2002 (figure B5.4.1). In addition to loans from the International Mon- Poverty rate (left axis) etary Fund (IMF) and the World Bank, debt restruc- Financial repression index (right axis) turing, and changes in tax policy, the Argentine Source: WDR 2022 team, based on data from Banco government instituted a number of standard finan- Central de la República Argentina; Ilzetzki, Reinhart, cial repression policies, which effectively distributed and Rogoff (2019); and World Bank's World Develop - losses across the population. These policies included ment Indicators Database. Note: In the figure, the poverty rate is the poverty forced conversion of foreign currency deposits, cap- headcount ratio at $1.90 a day (2011, purchasing ital controls, and requirements that domestic finan- power parity–adjusted), expressed as a percentage cial institutions finance the government (see figure of the population. The financial repression index is B5.4.2). These policies had several objectives. Their calculated as the parallel exchange rate premium primary goal was to stem the flight of private cap- minus the real interest rate on deposits (the differ- ence between the interest rate on deposits and ital, which was gathering steam in 2000 and 2001. inflation). This measure captures the difficulty In addition, financial repression was used to reduce in safeguarding liquidity in foreign currency (as sovereign debt loads by generating real negative expressed by the parallel market foreign exchange interest rates.c In essence, the government forced premium, which is the percent difference between parallel market exchange rates and official exchange domestic savers and financial institutions to bear rates) and the implicit inflation tax the government the costs of reducing its excessive debt burden by is imposing on this liquidity that becomes trapped in freezing their capital inside the domestic financial domestic currency (as expressed by the real interest system, forcing savers and financial institutions to rate, which in these cases is often negative). convert foreign currency to domestic currency, requiring financial institutions to buy new sovereign 2001, the government declared a bank holiday and debt denominated in local currency, unifying and implemented an array of banking controls to fight floating the exchange rate, and maintaining tight the ongoing bank run. This package of measures control of all foreign currency flows. would become known as El Corralito.e Deposits These measures had significant social costs. were frozen, savings denominated in US dollars They were accompanied by a rise in poverty, which were forcibly converted at the official rate of Arg$1 mirrored a dramatic fall in employment and in per US dollar, and weekly withdrawal limits of household incomes and wealth.d On December 1, Arg$250 were imposed. As convertibility ended, the (Box continues next page) MANAGING SOVEREIGN DEBT | 225 Box 5.4 Case study: The social and economic costs of financial repression in Argentina (continued) Figure B5.4.2 Financial measures affecting savers during Argentina’s economic crisis, 2001–02 November 2001 March 2002 June 2002 October 2002 De facto cap placed Affected savers are The Options Plan Monthly cash on bank deposits by offered a swap of offers a swap of withdrawal limit imposing a 100 percent frozen time deposits government bonds under El Corralito liquidity requirement for government for frozen sight is increased to on nearly all interest- bonds. deposits. Arg$2,000. bearing deposits. December 2001 April 2002 September 2002 December 2002 El Corralito begins with The Tapon Law: Another swap of El Corralito ends. a freeze on deposits, Litigating depositors government bonds pesoization of US$ can access funds only for deposits is offered. savings, withdrawal after adjudication is limits, and capital complete. controls. Source: WDR 2022 team. peso quickly depreciated to Arg$1.8 per US dollar on of delayed policy action rather than an effective the first day of unified floating (February 11, 2002), response to the debt crisis. Because Argentina rendering depositors instantly poorer in terms of had followed a fixed exchange rate regime (cur- both the incomes they earned and the wealth they rency board) prior to the crisis, adjustments had to had saved. The central bank also moved to control come either from the fiscal side, through increases all sources of foreign currency through a combina- in sovereign debt, or from the real economy. The tion of requirements on exports and transactions resulting vulnerabilities—unsustainable levels of involving foreign currencies.f sovereign debt, in particular—continued to accu- Although financial repression measures are mulate. This accumulation ultimately contributed likely to have been a factor in the stabilization of to the depth of the Argentine economic crisis and the Argentine economy, their effects were not only left the government with little choice but to resort unpopular but also highly regressive. In Argentina, to policies that had severe negative effects on pov- repressive measures can be viewed as a consequence erty and inequality. a. Daseking et al. (2004); Feldstein (2002); Hausman and Velasco (2003); Mussa (2002); Perry and Serven (2002). b. Cruces and Wodon (2003). c. Reinhart and Sbrancia (2015). d. Cruces and Wodon (2003). See Daseking et al. (2004), appendix 2, for a thorough recap of the measures. e. The term El Corralito (a bank account withdrawal limit or a freeze on a bank account) was popularized by Argentine journalist Antonio Laje to refer to the measures. See La República, “Argentina: Una década después del corralito,” Decem - ber 4, 2011, cited by El Economista, https://www.eleconomista.com.mx/economia/Argentina-una-decada-despues-del -corralito-20111204-0089.html. f. For example, any amounts in hard currency held by banks or exchange bureaus over a specified limit had to be deposited daily in the central bank. Taxes on exports were increased. Export receipts were required to be sold exclusively to the central bank. The purchase of foreign banknotes or transfers abroad for amounts over $100,000 required the central bank’s prior approval. See Daseking et al. (2004). 226 | WORLD DE VELOPMENT REPORT 2022 Looking ahead: Reforms to mobilize revenue, improve transparency, and facilitate debt negotiations The challenges of managing higher debt levels and resolving a rising number of debt crises in the after- math of the COVID-19 crisis highlight the need for reforms that can facilitate revenue mobilization, better debt management, debt negotiation, and access to capital markets in the longer term. This section explores how improved transparency, as well as legal and tax reforms, can make sovereign debt markets more efficient and sovereign balance sheets more resilient. Dependence of sovereign debt sustainability on mobilization of new tax revenue Prior to the COVID-19 pandemic, most countries saw a sustained rise in tax revenue—in lower-middle- income countries tax revenue as a share of GDP increased from 17 percent to 22 percent between 2000 and 2019.62 Half of this revenue growth came from indirect taxes (especially the value added tax, VAT), 30 percent from direct taxes on income, and 20 percent from payroll taxes. This upward trend in revenue mobilization was driven by the greater efficiency of tax administrations, technological innovations, and improvements of tax designs. Can governments continue to increase tax revenue over the next decade? The COVID-19 pandemic has created a short-term but drastic revenue shortfall, but it could reinforce revenue mobilization in the medium term by legitimizing the role of the state as a provider of insurance and redistribution. However, there are no magic bullets—higher tax revenue arises principally from long-term investments in tax capacity and from structural changes in countries’ economies bolstered by international efforts to address tax avoidance. Three areas of reforms can nonetheless raise revenue while balancing equity and efficiency considerations. However, progress on mobilizing new tax revenue may be threatened by a delayed or anemic recovery or social backlash, as was seen recently in Colombia.63 First, governments increasingly have the capacity to target high earners with progressive taxes. Currently, in low- and middle-income countries personal income taxes and property taxes account for only a small share of GDP (3 percent and 0.5 percent, respectively), which is a much lower share than in high-income countries. The long-run transition from self-employment to employment in firms is a key enabler of modern personal income taxes. However, this evolution in employment structure must be accompanied by investments in a tax administration’s capacity to target high earners and to tax their income from all sources (including capital) at rising marginal tax rates. Thus the tax effort is borne principally by those with the means to contribute.64 Taxes on property are another progressive source of revenue. But despite a visible tax base, the current revenues are low. As urbanization drives property values up in many cities, modern property registries, documented and accessed by means of technology, make real estate valuation and administration easier. Thus taxes on personal income and property are an untapped source of government revenue and simultaneously can help curb inequality. Second, structural changes arising from the digitalization of economies and the climate emergency present not only challenges but also opportunities to mobilize revenue. As transactions go digital and taxpayers file electronically, tax administrations can compare self-reported economic activity with third-party reports to uncover discrepancies and better target audits. Similarly, large online platforms that aggregate transactions can be used as withholding agents and as mechanisms to formalize smaller firms that want to participate in online markets. Another key evolution is related to the climate emer- gency; it justifies taxes aimed at limiting energy consumption and could raise additional tax revenue. Policy responses could take the form of removal of energy subsidies and the imposition of fuel taxes or more ambitious carbon taxes. Whatever their shape, taxes must be tailored to each country’s tax MANAGING SOVEREIGN DEBT | 227 capacity and energy structure and compensate vulnerable households for any increases in their tax bur- den.65 Better use of health-related taxes (such as taxes on the consumption of alcohol and tobacco) could also add more resources to the public purse while aligning personal incentives with a reduction in the pressure on public health systems. Third, the design of taxes can be simplified to improve their transparency and efficiency. The princi- pal tax instruments (the VAT and corporate and personal income taxes) are riddled with tax exemptions and tax credits. By narrowing tax bases, exemptions reduce revenue collection and the efficiency of taxes and provide opportunities for tax avoidance. Although some tax exemptions are justifiable, other gov- ernment tools might be more appropriate to address the underlying issues. A contentious example is the removal of exemptions from the VAT base. Typically, products such as food and energy are minimally taxed or not taxed at all to introduce progressivity. However, exemptions also benefit the rich, espe- cially in countries where poor households mainly purchase goods in the informal sector.66 Zero rating goods is thus a coarse tax instrument for introducing progressivity. Conditional on compensating poor households through transfers, the removal of exemptions could be socially acceptable and would collect revenue while also improving efficiency.67 To follow the suggested path to tax reforms, governments will need to overcome political challenges and the opposition of interest groups. To achieve successful reforms, governments must build wide sup- port, clearly communicate the intended effects, and compensate poor households for tax increases. Even then, it is difficult to gather support for even well-designed tax policies, such as removing tax exemp- tions. Such considerations might dictate the set of feasible reforms. Furthermore, where the informal sector is large, complementary policies to develop the private sector and expand the tax base are para- mount. Finally, because of the increased mobility of capital and of high earners, some tax revenue gains will depend on greater international tax cooperation. Recent developments on the minimum taxation of multinational companies hold promise, but it remains unclear how these agreements will be applied in practice and how much they will benefit low- and middle-income countries.68 It is equally important to rationalize public expenditures and target public spending and investments effectively. To set priorities for the allocation of public funds and to avoid inefficient spending, waste, and corruption, governments must have a well-designed public finance management system. Effective public finance management can also enhance the transparency of public expenditures and the accountability of government officials. At a time when governments are pressured to increase health expenditures to address the effects of the pandemic, a well-managed public expenditure process can make this task less daunting. The importance of transparency to debt management and resolution of debt distress Some of the main obstacles to the prompt recognition and resolution of sovereign debt distress stem from opaque fiscal accounts and unreliable debt data. A prerequisite for expedient sovereign debt repro- filing and restructuring is creditors’ access to reliable granular information about the country’s overall debt as well as the seniority (when applicable) of their own claim relative to that of other creditors. Transparent data on a country’s sovereign debt help creditors and multilateral institutions arrive at bet- ter debt sustainability assessments and financing decisions, which are ultimately helpful to both debtors and creditors and to overall market stability. When a country faces problems servicing its debt, better data reduce the time needed to negotiate with creditors to resolve the problem. Hidden debts, in their many guises, have been a recurring obstacle to prompt action, and not just in low- and middle-income countries as the 2011 Greek and 2015 Puerto Rican debt crises highlighted. 228 | WORLD DE VELOPMENT REPORT 2022 Debt transparency has two main dimensions: transparency in debt reporting and transparency in debt operations.69 For transparency in debt reporting—probably the best-understood dimension—exist- ing and new debt must be disclosed to the public in a timely, comprehensive manner. Transparency in debt operations refers to the process of entering a new debt contract or altering an existing debt contract, which includes but is not limited to having a well-designed legal framework. Recent studies and proposals related to the international debt architecture have emphasized the central importance of transparency in debt reporting to successful debt management. Building on ­ earlier work by the World Bank and International Monetary Fund (IMF), in 2019 the G20 endorsed ­ a set of Voluntary Principles for Debt Transparency drafted by the Institute of International Finance and targeting private sector lenders. Meanwhile, the Organisation for Economic Co-operation and Development (OECD) is in the process of developing a disclosure platform based on these principles. These developments are a positive step toward further strengthening transparency in terms of both comprehensiveness and accessibility, but more can be done. Effective, forward-looking debt management requires comprehensive disclosure of claims against the government, as well as the terms of the contracts that govern this debt. In practice, very few countries meet this standard of transparency. In the market for sovereign debt, contracts are often not made public, and some even include explicit nondisclosure clauses.70 In addition, it is often difficult to develop a com- prehensive picture beyond the central government, as this is typically the level of debt reporting. Unfor- tunately, the majority of low-income countries do not yet have consolidated public sector accounts.71 One important prerequisite for transparency in debt reporting and operations is therefore an unam- biguous legal framework that clarifies which entities are authorized to contract debt that is enforceable against the sovereign.72 This framework should also require debt contracts to be made public in a central repository. Although various government agencies can be signatories of sovereign debt contracts, the claims arising from these contracts are ultimately enforced against the underlying sovereign state and its population. Some recent debt events have highlighted the problem of hidden or undisclosed debt and the pos- sibility of legal disputes about whether a government and quasi-government entities have the author- ity to enter into debt contracts. Clarifying which state-owned entities are authorized to contract debt on behalf of the government and which subnational entities can raise claims against the government, including through guarantees and debt exchanges, can significantly facilitate debt management and reduce the risk of hidden debts, thereby helping to avoid costly and disruptive disputes. Such clarification would also ensure that any domestic accountability mechanisms that may be in place have sufficient information to operate properly. However, it is important that these legal requirements be accompanied by strong underlying institutions and by a domestic and international commitment to respecting those rules. Otherwise, even if the law clearly states who can approve debt contracts, the enforcement of those rules may be lacking, as in Mozambique (box 5.5). Improved debt transparency can also contribute to the adoption of debt instruments, such as state-con- tingent bonds, which are efficient for debtors and creditors, but remain underutilized. One example is GDP- or commodity-linked bonds, which generate variable returns that move with the business cycle or commodity prices. Such bonds automatically reduce the burden on sovereign balance sheets during downturns and could also prove beneficial for investors. At present, these instruments have been used most commonly as value recovery instruments (securities that allow the creditor to share in the recovery of the country if it agrees to restructure debt during times of distress). GDP-linked bonds were used in the 2015–16 Ukrainian debt restructuring. In the past, Nigeria and República Bolivariana de Venezuela have issued commodity-linked warrants. However, the willingness of creditors to enter into such con- tracts depends heavily on reliable data on a broad array of financial and economic indicators. Although MANAGING SOVEREIGN DEBT | 229 Box 5.5 Case study: The curse of hidden debt in Mozambique As in any credit market, timely access to information How has this affected Mozambique’s financial is essential for a well-functioning sovereign debt standing? market. If there is any hint of undisclosed informa- In Mozambique’s 2015 debt sustainability analysis, tion about a country’s debt, lenders may become the World Bank and International Monetary Fund less willing to provide financing, and new financing (IMF) projected the country’s external public and may become more expensive as lenders demand publicly guaranteed debt for 2016 to be 61 per- an additional premium to account for the potential cent of GDP.e The equivalent document published risks associated with hidden information. Because in 2018 estimated the external public and publicly of hidden debt, in Mozambique access to funding guaranteed debt for 2016 to be 104 percent of GDP.f by the government was significantly reduced and These hidden debts had significant implications therefore public investment was substantially cut. for Mozambique’s ability to service its debt, as it In 2013 and 2014, external loans amounting dramatically increased the amount of interest and to more than $1 billion were contracted by state- amortization due in a given year. In particular, prior owned companies in Mozambique under guaran- to the disclosure of these debts, the market was tee by the central government. In other words, the operating under the assumption that 11 percent of Mozambique government would be liable for these Mozambique’s tax revenue would suffice to cover loans if the state-owned companies were unable the debt service for 2016. With the disclosure of to repay them.a This publicly guaranteed debt was these debts, it was clear that at least 22 percent never disclosed to the public (including debtors and of tax revenue, or about $600 million, was needed citizens) until 2016, when the media uncovered it.b (figure B5.5.1). The projected increase in debt service was even bigger in 2017 and 2018. This increase was How did this happen? too large for the Mozambican economy to endure, The hidden loans, as well as a state-guaranteed and Mozambique defaulted on its debt in 2016.g As bond, were contracted without the proper approv- a result, credit rating agencies downgraded Mozam- als.c In Mozambique, the Ministry of Finance and bique to selective or restricted default. Similarly, the parliament have oversight over the issuance Mozambique, which had been classified as in mod- of new debt (including publicly guaranteed debt). erate risk of debt distress by the World Bank–IMF in However, for external borrowing by Mozambique’s 2015, was classified as in debt distress in 2016.h state-owned enterprises, those checks and bal- The deterioration of Mozambique’s fiscal posi- ances were not implemented. Because of the lack tion and risk rating had far-reaching economic of proper oversight as well as corruption allegations consequences and turned a crisis of transparency against the parties involved in these loan transac- into wider economic turmoil that had many char- tions, in 2019 Mozambique’s attorney general filed acteristics of a conglomerate crisis. The debt crisis a lawsuit to nullify the government guarantee of was accompanied by a significant real exchange the loan contracted by one of the state-owned rate depreciation starting in 2014, a rise in infla- companies.d In early 2022, the lawsuit was ongoing tion, reduced space for fiscal expenditures, as well because the lender appealed the original court deci- as loss of confidence by external investors and sion. In the meantime, Mozambique has been rene- the international community, leading to an acute gotiating its debt, even as it waits to see whether downgrade in the country’s sovereign credit rating. the court decides the loan and guarantee contracts Concessional lending from international financial are illegal in their entirety and thus void. institutions—often used to resolve debt crises in (Box continues next page) 230 | WORLD DE VELOPMENT REPORT 2022 Box 5.5 Case study: The curse of hidden debt in Mozambique (continued) Figure B5.5.1 Mozambique’s external debt service projections (2015–27) before and after the 2016 disclosure of hidden debts a. DSA projections of amount of debt a.1. Before disclosure a.2. After disclosure 1,800 1,800 1,600 1,600 1,400 1,400 US$ (millions) US$ (millions) 1,200 1,200 1,000 1,000 800 800 600 600 400 400 200 200 0 0 21 23 24 25 26 27 15 16 17 18 19 20 22 15 16 17 18 19 20 22 21 23 24 25 26 27 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 b. DSA projections of share of government revenue, excluding grants, needed to service debt b.1. Before disclosure b.2. After disclosure 32 32 28 28 24 24 20 20 Percent Percent 16 16 12 12 8 8 4 4 0 0 25 26 27 21 22 23 24 15 16 17 18 19 20 15 16 17 18 19 20 21 22 23 24 25 26 27 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 Other debt amortization EMATUM amortization Previously undisclosed debt amortization Other debt interest EMATUM interest Previously undisclosed debt interest Source: IMF 2018. Note: DSA = debt sustainability analysis. EMATUM bonds were widely covered in the financial press as "Tuna Bonds." They were issued by Proindicus, EMATUM (The Mozambican Tuna Fishing Enterprise), and Mozambique Asset Management and were involved in a controversy over authorizations. (Box continues next page) MANAGING SOVEREIGN DEBT | 231 Box 5.5 Case study: The curse of hidden debt in Mozambique (continued) emerging economies—was no longer available. decree on public investment management; and new Only in 2019 was Mozambique’s debt classified as government-approved regulations to strengthen sustainable on a forward-looking basis—eliciting debt and guarantee management (including bor- enough confidence that the World Bank and IMF rowing by state-owned companies). Nonetheless, provided financing in the aftermath of Cyclone Idai. Mozambique is still in debt distress while renego- One important step to rebuilding confidence was tiating its debt, and the legal battle over its hidden improving transparency in debt reporting and debt debts continues. Meanwhile, Mozambique still operations implemented since. Improvements were faces unfavorable borrowing conditions that imply the publication of periodic debt reports, including a high cost of credit not just for the government but information on state-owned companies; a new also for firms and households. a. IMF (2018). b. England (2016). c. The hidden loans from companies covered by a sovereign guarantee were as follows: $622 million for Proindicus and $535 million in favor of Mozambique Asset Management (MAM). The authorities also disclosed the existence of $133 million in direct loans from bilateral lenders contracted between 2009 and 2014. This set of hidden debts was in addition to the EMATUM corporate bond, which was originally issued in September 2013 (also backed by a state guarantee) and then restructured as the MOZAM 2023 sovereign bond in March 2016. The government managed to restructure the MOZAM bond to mature in 2031. Although the EMATUM bond was not a hidden loan, it was part of the same package of projects underlying the undisclosed debt scheme. d. See Spotlight on Corruption, “Mozambique and the ‘Tuna Bond’ Scandal,” Wells, Somerset, UK, https://www.spotlight corruption.org/mozambique-and-the-tuna-bond-scandal/. See also IMF (2019). e. IMF (2015). f. IMF (2018). g. From the Fitch report on Mozambique in 2016: “On 21 November the Ministry of Economy and Finance published a docu - ment confirming that Mozambique failed to make a capital and coupon payment, due 23 May 2016, on the USD535m loan to state-owned enterprise Mozambique Asset Management (MAM). The document also confirms that the MAM loan is guaranteed by the Republic of Mozambique. The arrears on the loan amount to approximately USD175.5m. In line with its criteria, Fitch therefore judges Mozambique to be in default on its sovereign obligations” (Fitch Ratings 2016). h. IMF (2016). it is recognized that such state-contingent contracts are a desirable way forward, such contracts remain a minority in existing debt stocks. Technological advances are another path to improve transparency in sovereign debt reporting and operations. One example is blockchain technology, which has been revolutionizing credit and capital markets. International financial institutions, such as the World Bank, but also sovereigns, such as the government of Thailand, have recently begun to use blockchain technology to issue and trade a subset of their bonds.73 The key contribution of blockchain technology is that it immutably documents own- ership status over tokenized assets in a decentralized and typically transparent ledger that is visible to all market participants. In other words, blockchain technology allows for more transparent and timely information on the ownership and terms of debt contracts housed in this environment. It then makes it possible to trace who owns the underlying asset at any given point in real time. For debt markets, the ability to trace and act on current ownership of instruments in a timely manner implies enormous effi- ciency gains. If implemented comprehensively, this ability could, for example, drastically reduce the time required to trace and reconcile the full list of claims against a country, which is a necessary step before a country can enter into a restructuring negotiation with creditors. Because of today’s architecture, this is an inefficient, time-consuming procedure, and some small creditors remain unidentified even after the 232 | WORLD DE VELOPMENT REPORT 2022 restructuring is completed. Thus potential gains in transparency through blockchain due to the ability to identify the holders of a sovereign’s outstanding debt instruments could be extremely useful in avoid- ing delays in debt restructuring. The role of contractual innovations in reducing coordination problems and facilitating debt resolution Several contractual innovations can help overcome coordination problems and speed up the resolution of sovereign debt. One innovation is collective action clauses (CACs), which could lead to faster resolu- tion of sovereign debt restructuring and thus more stability.74 Preliminary studies have found that these clauses tend to reduce the presence of holdout creditors during restructuring. CACs that permit aggre- gation, in which a majority of creditors can overrule a minority of holdout creditors, appear to be most effective at achieving faster resolutions in restructuring negotiations.75 However, it may be too optimistic to assume that CACs are sufficiently embedded in debt contracts to resolve debt crises in the near future. Indeed, it may be too early to claim that debt crises were in fact shortened by the introduction of the newest generation of CACs in 2014.76 Recent analyses argue that the sample on which preliminary findings were based is too recent and draws heavily from a period of relative moderation.77 Moreover, shortening restructuring processes and shortening debt crises are two different concepts.78 First, historically bringing sovereign debt crises or default spells to an end has required, on average, two restructurings.79 Second, it is difficult to argue that enhanced CACs are the secure, de facto market standard because only about half of the outstanding stock of sovereign bonds is estimated to contain these features, and a substantial portion of this legacy debt stock is still at least 10 years from maturity.80 In addition, of the 62 countries for which bond data are available, 16 have bonds with no CACs, as well as bonds with second-generation CACs or beyond (figure 5.7). This hetero- geneity can complicate debt restructuring and highlights the need for broader changes. Figure 5.7 Sovereign bond principal maturation in selected low- and middle-income countries, by share and type of collective action clauses included in the bonds, 2021–33+ 100 Share of type of CAC in bonds (%) 90 80 70 60 50 40 30 20 10 0 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033+ Fourth-generation CAC Second- or third-generation CAC CAC information not available No CAC Source: WDR 2022 team, based on data from Munevar (2021); Refinitiv, Refinitiv Data Catalogue (dashboard), https://www .refinitiv.com/en/financial-data. Note: The data cover 62 low- and middle-income countries and bonds maturing in January 2021 and beyond. The figure shows the share and type of collective action clauses (CACs) included in bonds issued by low- and middle-income countries. MANAGING SOVEREIGN DEBT | 233 Recent debt negotiations, such as the Argentine and Ecuadorian restructurings of 2020, highlight another practical limitation of CACs: debt contracts can be modified and renegotiated in ways that weaken the efficiency-enhancing features of CACs. In response to Argentina’s proposed use of aggre- gated voting and creditor designation mechanisms, certain creditors demanded a rollback to pre- 2014 CAC language.81 Ultimately, negotiations led to a compromise that included changes to allow for creditor redesignation (a provision through which Argentina could choose which creditors would be pooled for voting) and the subsequent launch of a uniformly applicable offer (an exchange offer with a menu of options deemed equitable to all creditors) once certain initial approval thresholds had been met.82 Unfortunately, like state-contingent contracts, only about half of outstanding debt contracts carry enhanced CACs, and the share is even lower for low-income countries.83 Another type of contractual innovation that can accelerate debt resolution and shield countries from unanticipated increases in sovereign debt is state-contingent debt contracts that insure the borrower against disaster risk. Such contracts are especially useful as climate risks become more widespread. The recent debt restructurings of Grenada (2015) and Barbados (2018), for example, have included natural disaster clauses. To be effective, contingency triggers should be protected from manipulation or oppor- tunism—that is, the terms of the contract (reduced debt service or access to additional liquidity) should be triggered by an objective and independently verifiable event. By reducing a country’s debt service in the event of an unanticipated shock, these types of contracts can free up fiscal resources when they are needed most. In the aftermath of the COVID-19 pandemic or future events that trigger an increase in sovereign debt, this safeguard could be especially useful for countries that are also exposed to height- ened risk of natural disasters or climate change. A final set of legal developments that can potentially improve creditor coordination and speed up debt resolution are legal reforms that address problematic enforcement practices against states. Creditors face legal and practical challenges when enforcing claims against a state. In response, specific creditors (such as holdouts and so-called vulture creditors), have eschewed collective negotiation in favor of indi- vidualized enforcement. This approach has jeopardized creditor coordination and payments to other creditors, thereby preventing the prompt resolution of debt distress. Because of lack of a sovereign bank- ruptcy mechanism that could incentivize coordinated action, several national jurisdictions have taken legislative steps to address problematic credit enforcement practices. These have included profit-capping statutes for vulture fund lawsuits (United Kingdom, 2010) and legal protections for payment-clearing platforms, such as Euroclear (Belgium, 2015). In addition, international bodies have formulated non- binding “soft law” guidelines and resolutions, such as the UNCTAD (United Nations Conference on Trade and Development) Principles on Responsible Sovereign Borrowing and Lending (2012) and the UN General Assembly Resolution on Basic Principles for Sovereign Debt Restructuring (2015). Although such soft law guidelines do not carry penalties for violation, they reflect legal principles in certain domestic jurisdictions and could represent emerging international norms. Further work to solidify these princi- ples into national and international law would be beneficial for market efficiency. Conclusion The COVID-19 crisis has highlighted and aggravated preexisting vulnerabilities in public debt, particu- larly among low-income countries. Addressing debt sustainability problems promptly and proactively is crucial for a strong, equitable recovery. Because the historical track record on this front is not particu- larly encouraging, it is critical that new initiatives, such as the Common Framework, be strengthened to deliver more expedient outcomes. Effective management of sovereign debt and resolution of debt distress play an especially important role. In a crisis, governments can essentially act as a lender of last resort to the economy, and well-designed 234 | WORLD DE VELOPMENT REPORT 2022 fiscal support can act as a circuit breaker that can reduce financial risks in other sectors and prevent them from affecting the wider economy. Such support, however, requires healthy public finances, which enable governments to spend on public goods and provide households, firms, and the financial sector with emergency support. When the government’s ability to carry out this function is compromised by high debt burdens, its ability to support the recovery is limited—a challenge that an increasing number of countries now face because the COVID-19 crisis has outlasted original expectations. Policy actions to prevent or resolve debt distress depend on many economic, political, and social fac- tors, and no easy one-size-fits-all solutions are offered here. Debt sustainability analyses are the instru- ment most widely used to determine a country’s risk of debt distress and is therefore the right course of action to prevent and resolve debt sustainability problems. For those countries already in debt distress, it is paramount to recognize the problem and not delay the restructuring process. As in the resolution of past crises, fiscal adjustment and structural reforms will be part of the debt restructuring process. Where public debt is denominated in domestic currency (a rising trend in emerging economies), infla- tion as well as financial repression measures have in some cases been used successfully to avoid default when governments were not able to meet their domestic debt obligations. However, these measures impose significant costs on citizens, especially the poor. Countries that face sharply increased debt burdens as a result of the COVID-19 crisis have policy options for reducing the risk of falling into debt distress, including debt reprofiling and preemptive nego- tiations with creditors. For example, countries can take advantage of more favorable market conditions to extend maturities or lower the cost of debt service. Negotiating better terms for a country’s debt is much easier when the country still has a relatively solid credit standing than when it is on the verge of default. Tracking credit market conditions can be very fruitful, as can taking advantage of the tools available to low-income countries. Examples include SDG Bonds, which can provide better terms for financing investments (see spotlight 5.1). Most emerging economies will need to make these types of poverty-reducing investments in any case, and, by using these bonds, they can get better lending terms, while improving their ability to attain the Sustainable Development Goals. Beyond these more immediate actions, increasing debt transparency, adopting contractual innova- tions that reduce coordination problems in debt resolution, and securing the tax revenue needed to pro- vide public services as well as repay the debt are essential. Although these are medium- to longer-term actions, they can significantly improve the resilience of government finances going forward. Apart from debt reduction through sustained robust growth, all the approaches discussed here pose their own brand of social and economic costs and aggravate many of the economic fragilities outlined in chapter 1. A realistic assessment of past debt reduction strategies thus offers some guidance but does not deliver silver bullets. Notes 1. Kose et al. (2020, 2021). www.imf.org/en/Publications/WEO/weo-database 2. Borensztein and Panizza (2009). /2021/April. 3. Baldacci, de Mello, and Inchauste (2002); Furceri and 9. In the context of the Joint World Bank–IMF Debt Sus- Zdzienicka (2012); Ravallion and Chen (2009). tainability Framework, debt distress is defined as a 4. Kose et al. (2021). situation in which any of the following are observed: 5. Kose et al. (2021). (1) arrears in public and publicly guaranteed external 6. Kose et al. (2021). debt exceeded 5 percent during the previous three 7. Kose et al. (2021). years; (2) a Paris Club restructuring of external debt 8. Although GDP deceleration contributed to the net was undertaken; (3) large disbursements were made result, the main driver of the increase was the sheer in excess of 30 percent of the quota for IMF growth in nominal debt. See International Monetary Stand-By Arrangements or Extended Fund Facilities; Fund, World Economic Outlook Database: Download (4) a restructuring of commercial debt was pursued; WEO Data, April 2021 Edition (dashboard), https:// or (5) default was executed on public and publicly MANAGING SOVEREIGN DEBT | 235 guaranteed external debt. See World Bank and Interna - there is no bankruptcy code. However, a de facto quasi- tional Monetary Fund, Joint World Bank–International seniority structure exists based on decades of practice Monetary Fund LIC DSF Database (Debt Sustainability and conventions. See Gelpern et al. (2021); Schlegl, Framework for Low-Income Countries), https://www Trebesch, and Wright (2019). .worldbank.org/en/programs/debt-toolkit/dsf. 30. Consider, for example, the case of commodity-based 10. Calculations based on International Development lending by official or private creditors, which are usu - Association (IDA) eligibility, including Blend countries ally structured as a large forward sale; the case of (that is, those eligible for IDA funding based on per cap- Chinese swap lines; or the case of the deposit by the ita income but which are also deemed creditworthy by central bank of Saudi Arabia in the central bank in the markets), and debt and GDP data from International Pakistan. Monetary Fund, World Economic Outlook Database: 31. See International Monetary Fund, DSA LIC (Debt Sus- Download WEO Data, April 2021 Edition (dashboard), tainability Analysis Low-Income Countries) (dash- https://www.imf.org/en/Publications/WEO/weo-data board), https://www.imf.org/en/publications/dsa. base/2021/April. 32. These practices are not entirely new. Similar types of 11. Calculations based on data from International Mone- debt contracts were common during the nineteenth tary Fund, World Economic Outlook Database: Down- century and the first part of the twentieth century. They load WEO Data, April 2021 Edition (dashboard), https:// were used to borrow through project companies, guar- www.imf.org/en/Publications/WEO/weo-database antee debt, and secure loans against government reve- /2021/April. nue or specific income streams, including commodity 12. Mbaye, Badia, and Chae (2018). sales or tax receipts. However, these lending forms fell 13. Bova et al. (2016). out of favor in part due to concerns about giving exter- 14. Bova et al. (2016). nal actors financial control over domestic affairs. 15. IMF (2021). 33. World Bank (2021a). 16. Moody’s Investors Service (2019). 34. World Bank (2021a). 17. Brooks et al. (2004); Schumacher (2014). 35. This arrangement is unlike the de facto standing pri- 18. For example, analysis spanning more than a century vate creditor committees of the 1970s and 1980s. The finds that, for each year a country has been in default London Club, for example, was an informal group of since 1900, there was a concurrent banking crisis or an private creditors (most of them international commer- inflation crisis, or both, in one in three of the years. See cial banks) that represented its members in renegotia- Reinhart and Rogoff (2009). tions of the sovereign debt owed to them. 19. Borensztein and Panizza (2009); Reinhart and Rogoff 36. Gelpern et al. (2021). (2009). 37. Gelpern et al. (2021). 20. Calvo (2010); Conceição et al. (2009). 38. Gelpern et al. (2021). 21. Calvo (2010); Conceição et al. (2009). 39. See Reinhart, Reinhart, and Rogoff (2015). 22. Conceição et al. (2009); Ma et al. (2021). 40. The World Bank and IMF produce debt sustainability 23. See Albanesi (2007); Bulir and Gulde (1995); Easterly analyses on low-income countries, and IMF produces and Fischer (2001); Romer and Romer (1998). Binder debt sustainability analyses on market access coun- (2019) finds that, although the relationship between tries. These assessments are used frequently as a the inflation tax and inequality varies over regions basis for determining the adjustments needed to reach and time, it has remained positive in the Americas debt sustainability. See International Monetary Fund, and Africa—regions in which a majority of countries DSA LIC (Debt Sustainability Analysis Low-Income are developing. Countries) (dashboard), https://www.imf.org/en 24. Diaz-Alejandro (1984). /publications/dsa; International Monetary Fund, DSA 25. See Farah-Yacoub, Graf von Luckner, and Reinhart MAC (Debt Sustainability Analysis for Market-Access (2021). Countries) (dashboard), https://www.imf.org/external 26. This group includes mostly low-income countries. /pubs/ft/dsa/mac.htm. 27. The Paris Club has been involved in over 470 restruc- 41. There are other areas for improvement in DSA risk turing agreements with over 100 countries. Its mem- analysis. For example, improvements in the evaluation bers are Australia, Austria, Belgium, Brazil, Canada, of contingent liabilities and SOE debt are crucial to the Denmark, Finland, France, Germany, India, Ireland, effectiveness of a DSA as a risk mitigation tool. How- Israel, Italy, Japan, the Republic of Korea, the Nether- ever, for the purposes of this section the focus is on the lands, Norway, the Russian Federation, Spain, Sweden, aspects of a DSA that tend to carry the most impor- Switzerland, the United Kingdom, and the United tance at both the risk mitigation stage and distress res- States. Any official or government creditor outside of olution stage because the DSA becomes an integral this group is classified as a non–Paris Club lender. part of resolution efforts in estimating a country’s 28. For example, Glencore has been a lender to govern - needs. The three identified factors are the most rele - ments in Sub-Saharan Africa, while Sinopec is a key vant at both stages. participant in complex arrangements with Chinese 42. Reuters (2021). state-owned banks lending to oil-rich countries. 43. Asonuma and Trebesch (2016). 29. Technically, the concept of seniority in the traditional 44. Asonuma and Trebesch (2016). sense is not applicable to sovereign finance because 45. Asonuma and Trebesch (2016). 236 | WORLD DE VELOPMENT REPORT 2022 46. WDR 2022 team calculations; Asonuma and Trebesch 68. OECD (2021). (2016). 69. See World Bank (2021a) for a more complete discus- 47. Defined as a default on private external creditors. sion on the debt transparency framework. 48. Based on restructurings of defaults since the end of 70. Gelpern et al. (2021). World War II. Farah-Yacoub, Graf von Luckner, and 71. Aytekin Balibek (2021). Reinhart (2021); Graf von Luckner et al. (2021). 72. For a consideration of issues of sovereign authoriza- 49. Benjamin and Wright (2009). tion, see Lienau (2008, 2014). Through debt manage- 50. WDR 2022 team calculations, based on Asonuma and ment performance assessments, the World Bank mea- Trebesch (2016) and Farah-Yacoub, Graf von Luckner, sures several relevant aspects of a well-designed legal and Reinhart (2021). Using a subset of default spells framework for debt management. See World Bank, for which the reported default spell end dates in both DeMPA (Debt Management Performance Assessment) studies match and restructuring deal details are avail- (dashboard), https://www.worldbank.org/en/programs able, 41 of 68 spell-ending restructurings had a face /debt-toolkit/dempa. value reduction. Using only Asonuma and Trebesch 73. Cision PR Newswire (2020); Duran and John (2018). (2016) data, 51 of 94 spell-ending restructurings 74. IMF (2020a). involved a face value reduction. 75. Fang, Schumacher, and Trebesch (2021). 51. Fang, Schumacher, and Trebesch (2021); Pitchford and 76. IMF (2020a). Wright (2012); Schumacher, Trebesch, and Enderlein 77. Graf von Luckner et al. (2021). (2021). 78. See Reinhart and Rogoff (2009). 52. Friedman (1983). 79. Graf von Luckner et al. (2021). 53. Reinhart and Trebesch (2016). 80. IMF (2020a). 54. Arslanalp and Henry (2005). 81. The debtor argued that it could amend the contracts to 55. Reinhart, Reinhart, and Rogoff (2015). oblige the pool of voting creditors to redesignation 56. Reinhart, Reinhart, and Rogoff (2015). using a voting threshold of 50.00 percent of the princi- 57. Reinhart, Reinhart, and Rogoff (2015). pal of each series, as opposed to the 66.67 percent 58. Reinhart, Reinhart, and Rogoff (2015); Reinhart and aggregate and 50.00 percent of principal per series, or Sbrancia (2015). 75.00 percent of aggregate principal, necessary to 59. Reinhart, Reinhart, and Rogoff (2015); Reinhart and amend reserved matters. Under the proposed amend- Sbrancia (2015). ment, Argentina would have been able to pool creditors 60. Calice, Diaz Kalan, and Masetti (2020). amenable to its offer even after the votes had been 61. Easterly (1989); Easterly and Schmidt-Hebbel (1994). cast and launch a subsequent exchange offer, includ - 62. International Centre for Tax and Development, ICTD ing to the holders of new exchange bonds and the hold - Government Revenue Dataset, Institute of Develop- ers of old bonds who rejected the offer. Creditors ment Studies, Brighton, UK, http://www.ictd.ac/data argued that, by doing this, Argentina could have forced sets/the-ictd-government-revenue-dataset. creditors to gang up and dilute their individual rights. 63. 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Wright. 2012. “Holdouts in lein. 2021. “Sovereign Defaults in Court.” Journal of Sovereign Debt Restructuring: A Theory of Negotiation International Economics 131 (July): 103388. in a Weak Contractual Environment.” Review of Eco- World Bank. 2021a. Debt Transparency in Developing Econo- nomic Studies 79 (2): 812–37. mies. Washington, DC: World Bank. Primo Braga, Carlos A., and Dörte Dömeland, eds. 2009. World Bank. 2021b. Macro Poverty Outlook. Washington, Debt Relief and Beyond: Lessons Learned and Chal- DC: World Bank. https://thedocs.worldbank.org/en/doc lenges Ahead. Washington, DC: World Bank. https:// /77351105a334213c64122e44c2efe523-0500072021 openknowledge-worldbank-org.libproxy-wb.imf.org /related/mpo-sm21.pdf. /handle/10986/2681. 240 | WORLD DE VELOPMENT REPORT 2022 Spotlight 5.1 Greening capital markets: Sovereign sustainable bonds T he economic stress arising from the COVID-19 (coronavirus) pandemic propelled expansion of sovereign sustainable bond issuances. The Climate Bonds Initiative (CBI) reports that the number of sovereign green, social, and sustainable bonds more than doubled in 2020. By the end of the year, sovereign green bonds amounted to $41 billion, or a 65 percent increase over 2019. That trend continued into 2021, with Italy raising approximately $10 billion in Europe’s largest green bond debut to date. Other advanced and emerging markets also intend to issue sovereign green bonds.1 Sustainable bonds are defined as bonds for which own criteria and definitions for eligible green and proceeds are used to finance or refinance green, social projects. In turn, the CBI provides separate blue, or social projects. A green bond is a debt secu- categories of sector-specific green definitions and rity issued to raise capital specifically to support criteria.5 climate-related environmental projects.2 Voluntary To ensure the transparency and accuracy of best practice guidelines for sustainable bond issu- information disclosed by issuers to stakehold- ances—the Green Bond Principles (GBP)—were ers, the GBP recommends pre- and post-issuance established in 2014 by a consortium of investment external reviews. For any proposed thematic bond, banks.3 Sustainable bonds align with the four core an issuer should appoint external review providers components of the GBP. The current monitoring to assess the alignment of its bond or bond frame- and development of the GBP guidelines are man- work with the core components of the GBP. After aged by the International Capital Market Associa- issuance, the GBP recommends that an issuer’s tion (ICMA).4 management of proceeds be reviewed by an exter- As of January 2022, there were no universally nal auditor to verify the allocation of funds from agreed-on definitions of green, social, or sustain- green bond proceeds to eligible projects.6 able bonds, and the GBP do not provide details on Despite significant growth in recent years, what qualifies as such bonds—those definitions are sovereign green, social, and sustainable bonds largely left up to the issuers. The World Bank and account for only 0.5 percent of the sovereign International Finance Corporation (IFC) use their bonds market.7 The first green bonds were issued GREENING CAPITAL MARKE TS: SOVEREIGN SUSTAINABLE BONDS | 241 in 2007 by the European Investment Bank and in 2008 by the World Bank.8 These pioneer bonds Figure S5.1.1 Share of countries defined eligibility criteria and introduced impact with government-issued sustainable reporting as an integral part of issuance pro- instruments, by country income group, cesses. The World Bank issuance also piloted 2020–21 a new model of partnership and collaboration 70 among stakeholders, including investors, devel- Share of countries (%) opment agencies, commercial banks, and pri- 60 vate sector players.9 Currently, the green model 50 is applied to bonds that are raising financing for 40 the 17 Sustainable Development Goals (SDGs).10 Multilateral development banks were the sole 30 issuers of green bonds until 2012, when the first 20 corporate green bonds emerged. In 2017, Poland issued the first sovereign green bond. 10 Almost a third of governments worldwide, 0 led by high-income countries, have issued sover- High- Upper- Lower- income middle- middle- eign green, social, and sustainable instruments income income through a mix of local and national entities.11 About 60 percent of all high-income countries Source: WDR 2022 team, based on 2020 data from Climate Bonds Initiative; 2020/21 data from Interna- have government-issued sustainable instruments. tional Finance Corporation; 2021 data from Refinitiv, This share is significantly lower for upper- and Refinitiv Data Catalogue (dashboard), https://www lower-middle-income countries (see figure S5.1.1). .refinitiv.com/en/financial-data; World Bank, World Development Indicators (dashboard), https://data Governments in low-income countries have so topics.worldbank.org/world-development-indicators/. far not issued any sustainable instruments. As for origination, green, social, and sustainable instru- ments have been issued both locally and nationally issuances in a nonlocal market (12),16 followed by in 15 countries. Government-backed entities have Hong Kong SAR, China (8).17 issued sustainable bonds in 34 countries, and in 16 Social bond issuance worldwide jumped seven- of these countries such instruments were issued fold, to $148 billion, in 2020, primarily targeting only by government-backed entities.12 health care, education, and small and medium In 2020, about 60 percent of sovereign green enterprises. Most of these bonds were issued by and social bond issuances were driven by the governments and multilateral development agen- COVID-19 pandemic, and two-thirds were issued cies.18 Although public issuers, unlike private in domestic markets. Most pandemic-driven sus- ones, have a direct mandate to provide social ser- tainable bonds were issued by governments across vices, private social bond issuance has also gained Africa.13 These were followed by bonds to finance momentum. Private issuers of social bonds have clean transport projects (17 percent), led by Chile. aimed to finance programs to support stakehold- Proceeds from other green and social bonds have ers, employees, customers, and local communi- been allocated to aquatic biodiversity conserva- ties.19 These bonds also give firms an opportunity tion, eligible green projects, energy efficiency, and to broaden their pools of investors.20 Overall, sus- other related areas.14 Côte d’Ivoire has the high- tainable debt reached a new peak in 2020, amount- est number of sustainable sovereign bonds issued ing to a record high of $732 billion across bond and domestically (25).15 Meanwhile, Chile has the high- loan varieties raised with environmental and social est number of sovereign green and social bond purposes for a resilient post–COVID-19 recovery.21 242 | WORLD DE VELOPMENT REPORT 2022 Although the global sovereign sustainable bond About 30 percent of these bonds have maturities market is still small, some evidence of “greenium” of at least 10 years (the sustainable bond with the (a premium in the pricing of green bonds) is begin- longest tenor—of 50 years—was issued in April ning to emerge in both developed and emerging 2020 by the government of Indonesia).27 Similarly, markets. In 2020, Germany introduced a unique Bulgaria; Chile; Hong Kong SAR, China; Hungary; twin bond structure that included a conventional and Poland have issued sustainable bonds with ten- vanilla bond and a green bond—the only difference ors of 30 years or more. In 2021, green and social between the two was the use of proceeds. The Ger- sovereign bonds issued in the range of less than man green bond, priced with a greenium, main- 5 years and 6–10 years comprised 50 percent and tained a lower yield in the secondary market and 30 percent of the issuances, respectively. By con- exhibited lower volatility than its vanilla twin.22 trast, sustainable bonds issued by corporate enti- Green bonds in emerging markets have shown ties tend to have lower tenors, typically 5–10 strong performance. For example, in 2020 the years.28 However, longer term maturities may not emerging market subset of the J.P. Morgan Green be in line with a country’s debt strategy because of Bond index (6.6 percent) outperformed its conven- the implied higher yields. tional index (5.4 percent). Overall, the green subset Although there is no conclusive cross-country showed lower volatility for similar performance pattern, some sovereign green and social bond than regular bonds in emerging markets.23 How- issuances have paved the way for similar debt issu- ever, the evidence of green bonds premia—which ances by the private sector. For example, in 2017 would provide greater incentives for issuance of Nigeria became the first African country to issue green bonds—is still mixed.24 a sovereign green bond, which was followed by the Sovereign issuers can include sustainable bonds first green corporate issuance from Access Bank.29 in their medium-term debt management strate- Similarly, in 2019 Chile became the first green gies. This approach offers an opportunity to attract sovereign bond issuer in Latin America, and, soon and expand the investor base, while allowing a after, Banco de Chile issued a green bond to raise wide range of funding alternatives. Yet any new funds for renewable energy projects.30 borrowing should be consistent with fiscal spend- In line with bond issuance trends, further analy- ing and deficit plans to keep public debt on a sus- sis shows a strong correlation between the share of tainable path. Moreover, issuers should have large green and social bonds in total sovereign issuances green expenditures that they can support with and gross domestic product (GDP) per capita (see sustainable debt. Other challenges include limited figure S5.1.2). Lower-income countries usually have impact investing in emerging markets because of less fiscal space for bond issuances because of their credit rating restrictions and lack of understanding limited financing capacity, weaker institutions, of green instruments, coupled with narrow regula- lack of strong regulatory frameworks, and limited tory mandates.25 Some countries use monetary pol- awareness of and experience in financial markets.31 icy levers to encourage green financing. China, for Similarly, the extension of domestic credit to the example, offers green lending incentives by consid- private sector (as a percentage of GDP) is signifi- ering qualified green bonds and accepting certain cantly correlated with the issuance of sovereign green loans as collateral in its medium-term lend- sustainable bonds—countries that issue sovereign ing facility—a key monetary tool used to manage sustainable bonds tend to have more developed liquidity needs in the banking system.26 financial sectors and stronger macroeconomic fun- Government-issued green and social bonds damentals.32 Ultimately, determining the specific often provide longer tenors than corporate bonds. underlying drivers affecting governments’ ability As of August 2021, at least 175 green and social or willingness to issue sustainable debt requires sovereign bonds had been issued worldwide. further research. GREENING CAPITAL MARKE TS: SOVEREIGN SUSTAINABLE BONDS | 243 Sustainable finance regulation has improved Figure S5.1.2 Correlation between recently, especially in emerging markets. In 2020, share of green and social bond issuances the central bank of the Philippines issued the coun- and GDP per capita try’s first sustainable finance framework. Similarly, 8 Colombia’s banking regulator established a frame- Share of government sustainable work for issuing and investing in green bonds. On bonds in total bonds (%) a larger scale, in the European Union (EU) the EU 6 Taxonomy and EU Green Bond Standard have increased transparency and comparability, as well 4 as provided further guidance for green bond issu- ance. The EU Taxonomy also introduced a classi- 2 fication system for environmentally sustainable economic activities.37 In the meantime, it was 0 reported in November 2020 that public develop- 0 30 60 90 120 ment banks had joined forces to support economic GDP per capita (US$, thousands) and social transformations toward a sustainable Source: WDR 2022 team, based on data from Refin - future.38 The International Financial Reporting itiv Data Catalogue (dashboard), Refinitiv, New York, Standards Foundation is also working on sustain- https://www.refinitiv.com/en/financial-data; 2021 ability reporting standards.39 But despite these data from World Bank, World Development Indicators (dashboard), https://datatopics.worldbank.org/world advances, worldwide the overall level of sustainable -development-indicators/. regulatory development remains low (figure S5.1.3).40 Note: The relationship is statistically significant at To meet their green goals and help channel more 1 percent; t = 3.3; number of observations = 41. financing to sustainable activities, countries need GDP = gross domestic product. to actively advance sustainable finance. A grow- ing number of high- and middle-income countries Some emerging markets are noteworthy in have developed sustainable regulatory frameworks, their proactive approach to developing green bond and some emerging markets have made significant markets. In 2016, following the adoption of the progress in implementing sustainable policies. 2015 Paris Agreement on Climate Change, Nigeria However, much more progress is needed world- ratified its Nationally Determined Contributions wide. In addition, the private sector must adopt sus- (NDCs) committing it to reducing greenhouse tainable investment practices outside of regulatory gases.33 And, as noted, in December 2017 Nigeria mandates. Stock exchanges can support issuers to issued Africa’s first sovereign green bond—only determine what types of climate-related risks and the fourth globally—of $29.7 million with a five- opportunities need to be disclosed to investors and year maturity.34 Malaysia’s sustainable finance should have a say in the disclosures required by law. market accounted for 22 percent of the total Asso- By developing sustainability listing requirements ciation of Southeast Asian Nations (ASEAN) mar- in collaboration with regulatory authorities, stock ket in 2020.35 To promote issuances of sustainable exchanges can help to ensure compliance among sukuk and bonds, Malaysia actively participates listed companies and set the standard for non- in the development and implementation of cap- listed corporations. Exchanges should work closely ital market integration and connectivity initia- with listed companies to ensure the accuracy and tives undertaken by the ASEAN Capital Markets consistency of reported data.41 Further alignment Forum. Domestically, the Securities Commission and implementation of global standards and policy has been playing a pivotal role in supporting devel- frameworks would help further mobilize capital opment of responsible investment.36 directed at sustainable economic activities.42 244 | WORLD DE VELOPMENT REPORT 2022 Figure Figure S5.1.3 Regulatory coverage of sustainability factors in capital markets, by country S5.1.3 income group Sustainability factors covered in bond market’s regulatory frameworks Sustainability factors captured in voluntary industry principles or practice Markets have a sustainability bond listing segment Markets issue annual sustainability report Exchanges have written guidance on ESG reporting 0 10 20 30 40 50 60 Number of countries High-income Upper-middle-income Lower-middle-income Source: International Finance Corporation sustainability dataset, 2021, forthcoming (see note). Note: No low-income country has any of these regulatory features. ESG = environmental, social, and governance. The global sustainability dataset was compiled by the International Finance Corporation’s Development Impact team between June and October 2021. It covers more than 70 indicators across five thematic areas: government bonds, cor- porate bonds, equity, regulatory framework, and institutional investors. A variety of primary and secondary sources were used in collecting the data, including desk research (mostly for country-specific sources), Climate Bonds Initiative, Inter- national Capital Market Association, Refinitiv, Bloomberg, International Monetary Fund, Asian Development Bank, and Sustainable Stock Exchanges Initiative. Notes Fatin (2021).  1.  The banks are Bank of America Merrill Lynch, Barclays  3.   2.  World Bank (2015). As defined by the International Capi - Corporate and Investment Bank, BNP Paribas, Citi, Crédit tal Market Association (ICMA), green bonds are any type Agricole, Daiwa, Deutsche Bank, Goldman Sachs, HSBC, of bond instrument whose proceeds or an equivalent JPMorgan Chase, Mizuho Securities, Morgan Stanley, amount will be exclusively applied to finance or refinance, Rabobank, and SEB. in part or in full, new or existing eligible green projects. See Climate Bonds Initiative, “Green Bond Principles and  4.  They are aligned with the four core components of the Climate Bonds Standard,” https://www.climatebonds Green Bond Principles. Social bonds are use-of-proceeds .net/market/best-practice-guidelines. bonds that raise funds for new and existing projects with Broad green project categories suggested by the Green  5.  positive social outcomes. The four core components are Bond Principles include energy; buildings; transport; the same as those set for green bonds. Sustainable bonds water management; waste management and pollution are bonds that intentionally mix eligible green and social control; nature-based assets, including land use, agri- projects. Sustainability-linked bonds are any type of bond culture, and forestry; industry and energy-intensive com- mercial; information technology; and communications. instrument for which the financial or structural character- See Climate Bonds Initiative, “Green Bond Principles and istics can vary, depending on whether the issuer achieves Climate Bonds Standard,” https://www.climatebonds.net predefined sustainability objectives. /market/best-practice-guidelines. GREENING CAPITAL MARKE TS: SOVEREIGN SUSTAINABLE BONDS | 245  6. ICMA (2021). S&P Global (2020). 19.  Fatin (2021).  7.  Mutua (2020). 20.   8. IFC (2016). The bonds were issued under the label Cli- BNEF (2021). 21.  mate Awareness Bonds with the proceeds dedicated to Harrison (2021). Based on secondary market data, the 22.  renewable energy and energy efficiency projects (World average emerging market greenium stands at –3.4 basis Bank 2008). The World Bank issued its first green bond points, which represents 3.5 percent of the average in November 2008 for a group of Scandinavian investors; spread of bonds in the sample. it was valued at $267 million with a maturity of six years. Amundi and IFC (2021). 23.  The bond was listed on the Luxembourg Stock Exchange. In February 2013, IFC issued a green bond worth $1 bil- A study by the International Monetary Fund suggests 24.  lion to support climate-friendly projects in emerging that, although some issuers claim that tapping the green economies. The issue was heavily oversubscribed and bond market lowers their borrowing costs, a discount marked the largest climate-friendly issuance up to 2013. is rare (Economist 2020). A 2019 study showed that, on Through this issuance, IFC was able to change the pri- average, a greenium of two basis points was found in a vate placement format of the green bond market to public sample of euro- and US dollar–denominated bonds, while mainstream. in 2020 another study comparing 640 pairs of bonds revealed no difference in yields of green versus nongreen World Bank (2019).  9.  bonds (Affirmative Investment Management Partners World Bank (2018). 10.  Limited 2021). Some studies project an expansion of the Between 2007 and 2021, seven countries—China, France, 11.  emerging market greenium given the high-yield nature of Germany, Japan, the Republic of Korea, Sweden, and the market (Amundi and IFC 2021). the United States—issued over 100 sustainability instru - World Bank (2020). See also Kim (2021). 25.  ments. The United States has a record number, with over PBC (2018). 26.  1,350 issuances, followed by Germany with 162. In terms of volume, France is the world leader, with issuances Murdoch and Jefriando (2020). 27.  worth more than $81 billion by 2020, followed by Ger- According to historical data, tenors do not differ based 28.  many with $23 billion. on the market of issue. For example, sovereign sustain - International Finance Corporation sustainability dataset, 12.  able bonds issued domestically are just as likely to have 2021, forthcoming. See figure S5.1.3 for a description of tenors as long as similar bonds issued in international this dataset. markets. See Harrison and Muething (2021); Refinitiv, Refinitiv Data Catalogue (dashboard), https://www Refinitiv, Refinitiv Data Catalogue (dashboard), https:// 13.  .refinitiv.com/en/financial-data. Within a given market, www.refinitiv.com/en/financial-data. the sovereign issuer typically issues at longer maturities International Finance Corporation sustainability dataset, 14.  than firms because the sovereign provides the benchmark 2021, forthcoming; Refinitiv, Refinitiv Data Catalogue yield curve for corporate bond issuers. By this means, the (dashboard), https://www.refinitiv.com/en/financial sovereign sends a pricing signal so that firms can price at -data. a margin over the “risk-free” rate at each tenor. Côte d’Ivoire’s economy remains stronger than that of 15.  CBI (2017); Fatin (2019); SBN (2020a). 29.  many of its peers. The country was recently upgraded CBI (2019). 30.  by all three international rating agencies—S&P, Moody’s, and Fitch. The political risk diminished significantly after SBN (2020b). 31.  the peaceful elections of March 2021. And the country International Finance Corporation sustainability dataset, 32.  was able to make a quick V-shaped recovery from the 2021, forthcoming. onset of the pandemic (Murdoch 2021). When preparing NDCs, some countries attached condi- 33.  Social bonds are becoming more common in Chile as 16.  tions to the implementation of some measures. These the government prepares to fight the long-term social are referred to as conditional contributions as opposed impacts of the COVID-19 pandemic. Bond issuances by to unconditional ones. See Jacobsen (2020). Chile under the COVID-19 Transitory Emergency Fund Hassamal, Abolo, and Ogaga (2021); Whiley (2018). 34.  focus on social projects as outlined in the country’s sus- Nguyet et al. (2021). 35.  tainable bond framework. The government can use the SC (2021). 36.  proceeds to fund a wide range of initiatives, including community support through job creation, access to edu- Amundi and IFC (2021). 37.  cation, food security, essential health services, and pro- FiC (2020). 38.  grams designed to prevent unemployment derived from IFRS (2021). 39.  socioeconomic crises (BNP Paribas 2021). Amundi and IFC (2021). Since 2012, the IFC’s Sustainable 40.  International Finance Corporation sustainability dataset, 17.  Banking Network (SBN) has supported policy and indus- 2021, forthcoming; Refinitiv, Refinitiv Data Catalogue try initiatives to promote sustainable finance in emerg - (dashboard), https://www.refinitiv.com/en/financial ing markets. Currently, 39 countries are members of the -data. SBN and are committed to developing and implementing BNEF (2021). 18.  sustainable finance frameworks in line with international 246 | WORLD DE VELOPMENT REPORT 2022 standards. The SBN supports members through techni- -green-social-sustainability-sgss-bonds-how-far-and cal resources, capacity building, and peer-to-peer knowl- -how-fast-could-they-grow. edge exchange. According to the SBN’s 2019 Global FiC (Finance in Common). 2020. “Joint Declaration of All Progress Report, of the 11 low-income countries in the Public Development Banks in the World.” Finance in SBN, four are in the “advancing” stage of their sustain - Common Summit, Agence française de développement, able finance journeys (SBN 2019). Paris. https://financeincommon.org/sites/default/files 41.  SSE (2021). /2021-06/FiCs%20-%20Joint%20declaration%20of%20 Such global initiatives include developing benchmark 42.  Public%20Development%20Banks.pdf. green taxonomies, establishing the Network for Greening Harrison, Caroline. 2021. “Green Bond Pricing in the Pri - the Financial System, enforcing green bond standards, mary Market H2 2020.” Climate Bonds Initiative, London. implementing the recommendations of the Task Force https://www.climatebonds.net/files/reports/cbi_pricing on Climate-Related Financial Disclosures, and building _h2_2020_01e.pdf. capacity and technical assistance for emerging markets. Harrison, Caroline, and Lea Muething. 2021. “Sustainable See Amundi and IFC (2021). Global State of the Market 2020.” Climate Bonds Initia- tive, London. Hassamal, Komal, Paul Abolo, and Andrew Ogaga. 2021. 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IRFC and PFC Certified from India: Plus 责人就扩大中期借贷便利（ MLF）担保品范围答记者问 ” US, Swedish, Italian, German, Malaysian, Japanese and [Questions on expanding the scope of collateral for the Chinese Issuance and More!” Climate Bonds Initiative medium-term lending facility]. June 1, PBC, Beijing. (blog), January 19, 2018. https://www.climatebonds.net http://www.pbc.gov.cn/goutongjiaoliu/113456/113469 /2018/01/december-market-blog-nigeria-issues-1st /3549916/index.html. -african-sovereign-green-bond-its-climate-bonds. S&P Global. 2020. “A Pandemic-Driven Surge in Social World Bank. 2008. “World Bank and SEB Partner with Scan - Bond Issuance Shows the Sustainable Debt Market dinavian Institutional Investors to Finance ‘Green’ Proj- Is Evolving.” S&P Global Rating (blog), June 22, 2020. ects.” Press release, November 6, 2008. https://www https://www.spglobal.com/ratings/en/research/articles .worldbank.org/en/news/press-release/2008/11/06 /200622-a- pandemic - driven -surge -in -social - bond /world - bank- and - se b - par tne r- wi th - scandinavian - issuance - shows -the - sustainable - debt- market- is -institutional-investors-to-finance-green-projects. -evolving-11539807. World Bank. 2015. “What Are Green Bonds?” Investor Rela - SBN (Sustainable Banking Network). 2019. “Innovations in tions, Capital Markets Department, World Bank, Wash- Policy and Industry Actions in Emerging Markets.” SBN ington, DC. Global Progress Report, International Finance Corpora- World Bank. 2018. “From Evolution to Revolution: 10 Years tion, Washington, DC. of Green Bonds.” News, November 27, 2018. https:// SBN (Sustainable Banking Network). 2020a. “Case Study 7, www.worldbank.org/en/news/feature/2018/11/27/from Nigeria: Issuing Sovereign and Corporate Green Bonds -evolution-to-revolution-10-years-of-green-bonds. to Finance NDCs.” In “How Low-Income Countries Are World Bank. 2019. “10 Years of Green Bonds: Creating the Adopting Sustainable Finance to Address Poverty, Cli- Blueprint for Sustainability across Capital Markets.” mate Change, and Other Urgent Challenges,” edited by News, March 18, 2019. https://www.worldbank.org/en SBN, 40. SBN Task Force Report, International Finance /news/immersive-story/2019/03/18/10-years-of-green Corporation, Washington, DC. -bonds-creating-the-blueprint-for-sustainability-across SBN (Sustainable Banking Network). 2020b. “How Low- -capital-markets. Income Countries Are Adopting Sustainable Finance to World Bank. 2020. “Engaging with Investors on Environmen - Address Poverty, Climate Change, and Other Urgent Chal- tal, Social, and Governance (ESG) Issues: A World Bank lenges.” SBN Task Force Report, International Finance Guide for Sovereign Debt Managers.” World Bank, Wash- Corporation, Washington, DC. ington, DC. 248 | WORLD DE VELOPMENT REPORT 2022 6 Policy priorities for the recovery The COVID-19 crisis has given rise to a wide range of new and elevated economic risks, some of which will only become apparent with time. Few governments have the resources and political leeway to tackle all of these challenges at once. Countries will need to identify the risks that pose the most immediate threat to an equi- table recovery and prioritize their policy responses. This concluding chapter reviews the most urgent risks and highlights global issues that may arise as countries recover from the economic repercussions of the pandemic at different rates. Policy Priorities Pursuit of the following priorities can help set countries on the path to a more equitable and sustained economic recovery: •  Mobilizing resources for the recovery. In many low-income economies, high levels of sovereign debt pose the most urgent threat to the recovery. Countries facing this scenario can free up resources for the recovery through improved debt management. •  Safeguarding financial stability. In middle-income economies, financial sector risks tend to pose a larger threat to the recovery. These countries should focus on identifying and resolving financial sector risks to ensure the continued provision of credit. •  Scaling back support in a transparent manner. Support policies should be withdrawn in a predictable manner and scaled back first for the most resilient households and firms to counteract the highly regressive impacts of the COVID-19 crisis. •  Managing exposure to global economic risks that threaten an equitable recovery. These include interest rate and currency risks that are likely to arise as advanced economies scale back stimulus policies. •  Supporting the transition to a green economy. Economic policies for the recovery should aim to support sustainable growth by facilitating the reallocation of resources to green sectors and business models. 249 Introduction The economic disruption caused by the COVID-19 (coronavirus) pandemic will affect countries for many years to come. As the immediate impacts of the pandemic subside, resource-constrained govern- ments will face the challenge of scaling back support policies in a way that does not threaten the recov- ery. Because of uneven access to vaccines and economic fragilities predating the pandemic, emerging economies, in particular, face the very real prospect of a slow crisis recovery. Mobilizing the resources needed for proactive management and reduction of financial risks arising from the crisis, as well as for longer-term structural reforms, is essential for a strong and equitable recovery. This Report has examined the primary financial and economic risks that have been exposed or exac- erbated by the pandemic, and it has highlighted concrete steps policy makers can take to address them. In an ideal situation, governments would implement relevant policies for each of the priority areas dis- cussed: financial stability, household and business insolvency, access to credit, and sovereign debt sus- tainability. However, few if any governments have the resources and political leeway to tackle all of these challenges at once. Countries will have to decide which policy areas to prioritize and how to best allocate scarce resources to support the recovery. This chapter offers some guidance for doing that within a globally connected economy, taking a the- matic perspective on the options and trade-offs available. The chapter emphasizes that the prompt rec- ognition of economic risks is critical for the design of effective policies and highlights how new data and analysis can help evaluate the crisis response and guide evidence-based policy in the future (box 6.1). Box 6.1 Evaluating the success of the crisis response: A research agenda The response to the COVID-19 crisis has included continue to supply firms with credit, but it may many policy tools never applied in emerging econ- come at the cost of reducing the government’s abil- omies or tried on this scale. Examples include large ity to support households and firms directly. cash transfer programs, debt forbearance, and Evaluation of the impacts of the economic cri- asset purchase programs. Although it is still too sis and the progress toward an equitable recovery early for a conclusive assessment of these policies, thus requires detailed data on the financial positions a thorough analysis of the successes and limitations of households, firms, the financial sector, and the of the crisis response is essential to guide future budgets of national and subnational governments. policy making. In some cases, such data are already available. In others, they would have to be collected either from Understanding interrelated economic risks conventional sources, such as nationally represen- As this World Development Report highlights, tracing tative surveys or administrative data, or from newly the economic impact of the crisis response requires available “big data,” such as mobile banking and digi- understanding the links between the balance sheet tal payments records. These data are useful not only risks of households, firms, the financial sector, and to conduct a retrospective analysis, but also to offer the government because policies targeting one sec- practical guidance on how to best target support tor will have implications for the wider economy. and choose between alternative policy approaches. Helping households with government cash trans- The use of microdata on household balance fers, for example, increases pressure on government sheets is a good example. As shown in chapter 1, budgets, but reduces loan defaults and risks to the when policy makers have access to comprehensive financial sector. Recapitalizing banks may help them data on the assets, liabilities, and expenditures of (Box continues next page) 250 | WORLD DE VELOPMENT REPORT 2022 Box 6.1 Evaluating the success of the crisis response: A research agenda (continued) households, they are able to evaluate which types women-owned businesses and low-income and of support policies (income support, debt relief, female-headed households. Where such data are or improved access to credit) will most effectively available, policy makers can use them to target sup- strengthen household resilience during a recession. port to financial institutions instrumental in lending It is also possible to assess how households at dif- to those segments of the population most at risk ferent income levels would benefit from each of of losing access to credit because of the crisis. Such these policies. However, in most countries stan- data can be collected by regulators or the private dard household surveys do not collect information sector. In some emerging markets such as India, on household assets that is sufficiently detailed to some household and firm surveys also collect infor- allow for such an analysis, and, even where such mation on the banking relationships of respondents. data are available, they are still rarely used to inform Such data collection efforts should be extended to policy making.a the nonbank financial sector, which accounts for a growing share of lending in emerging economies. The distributional impacts of the crisis response This is a promising direction for future research that Detailed data on the balance sheets of households, could not only provide policy makers with practical firms, and the financial sector can also be a power- guidance, but also examine to what extent support ful tool for tracing the distributional implications of of the financial sector actually helps marginal bor- the crisis and crisis response. Fiscal support in the rowers to maintain access to credit in a crisis. form of direct cash transfers has been a lifeline for many households and businesses during the cri- Transparent government budgets sis. However, access to these payments typically The pandemic has also had a profound impact requires a bank account, and low-income countries on the financial position of many governments. in particular have increasingly disbursed payments Evidence from past crises suggests that delays in through mobile money accounts and other digi- resolving high levels of sovereign debt are asso- tal channels. Although these programs have been ciated with lower spending on public goods and very effective at disbursing payments quickly, they worse health and education outcomes. Transparent also raise concerns that households and businesses data on government budgets can be used in analysis without an account may be excluded from such of the mechanisms that explain this link. They can, support programs. Combining data on financial for example, allow researchers and policy makers to inclusion that have become available in recent years analyze which types of government spending are with information on household incomes and busi- cut first when governments face debt sustainabil- ness revenue can help policy makers assess exactly ity issues, the extent of the resulting social costs, which households and firms benefit from a given and how equally or unequally they are distributed transfer program.b across the population. As for fiscal and financial Similarly, government support for the financial sector policies, this type of analysis can give policy sector in the form of bank bailouts and recapital- makers specific guidance on the social cost of bud- izations has vastly different implications for inequal- get consolidation and the benefits of prioritizing ity, depending on which borrowers are financed by certain types of social expenditures over others. a particular financial institution. In most countries, Better data on the structure and extent of gov- the currently available data can give researchers ernment debt are also crucially important for the and policy makers only an imperfect picture of management and efficient resolution of high lev- what share of a bank’s lending goes to small and els of such debt—a task facing many emerging (Box continues next page) POLICY PRIORITIES FOR THE RECOVERY | 251 Box 6.1 Evaluating the success of the crisis response: A research agenda (continued) economies in the years ahead (see chapter 5). One of including innovations in financial technology, algo- the most important steps in restructuring sovereign rithmic lending, and risk assessment, have offered debt is debt reconciliation, which entails reviewing new paths to improving transparency and support- contracts to ascertain the validity of the debt claims. ing the crisis response. But for the more vulnera- This often time-consuming process could be signifi- ble and less financially experienced, digitalization cantly shortened if more and better transparent debt of government transfer payments and wages also records are maintained, reducing the time needed poses risks of informal fees, financial fraud, and for debt restructuring and thereby ensuring a bet- predatory lending. Assessing how effective these ter outcome. Such data could also help researchers innovations have been at channeling government to better understand the factors that slow the res- payments to households and firms at the bottom of olution of sovereign debt, which is associated with the income ladder and preventing them from los- severe negative impacts on poverty and inequality. ing access to formal credit requires detailed data. Fortunately, data on digital transactions are easily The role of digitalization in the crisis response available. A more challenging task is to combine Finally, the pandemic is arguably the first truly these data with information from household and global crisis in the digital age. Digital channels, such firm surveys to enable future research to paint a as mobile money, have been used extensively to comprehensive picture of the role of new financial disburse support payments, and digital solutions, technologies in crisis recovery. a. See Badarinza, Balasubramaniam, and Ramadorai (2019); Badarinza et al. (2021). b. See, for example, data from World Bank, Global Findex Database, https://globalfindex.worldbank.org. Tackling the most urgent sources of risk One of the main themes running through this Report is that the sectors of an economy are inter­ connected through multiple mutually reinforcing channels. These links create pathways along which risks in one sector can affect the wider economy. However, well-designed fiscal, monetary, and finan- cial policies can counteract these risks, lead to positive outcomes across multiple areas, and support an equitable recovery. Using the framework of interrelated risks laid out in this Report, countries that need to make difficult choices about how to prioritize resources for the recovery can identify both the risks confronting their economy and where policy action is likely to be most effective at reducing economic fragilities worsened by the pandemic. The areas in which the risks are the most pronounced and are most likely to be the source of damaging spillovers warrant the most attention. This is not to say that countries with a high degree of risk in one area should ignore the other areas, but rather to emphasize the importance of urgent action in the areas where the threats are highest or where a further accumulation of risks is more likely to create spillover risks for the economy as a whole. A common scenario in low-income countries is that the formal banking sector primarily serves wealth- ier, more resilient households and larger, more established businesses, while low-income households and small businesses most severely affected by the pandemic are less likely to have access to bank credit. As a result, the possibility of rising loan defaults is typically a less pressing issue in these countries. Moreover, 252 | WORLD DE VELOPMENT REPORT 2022 borrowers in low-income countries tend to be more reliant on nonbank lenders, such as microfinance institutions, and so those countries might benefit from guidance on regulating and supporting these institutions (as discussed in spotlights 2.1 and 3.1). Yet in these same countries, deteriorating public finances threaten the ability of the government to support the recovery and pose a risk to the domestic financial sector, which often holds large amounts of sovereign debt.1 Low-income countries also tend to face greater external threats to an equitable recov- ery. As high-income countries begin to recover from the crisis, low-income countries that borrow in foreign currency face the risk that their debt payments and import costs will become more expensive as global interest rates rise and their local currencies depreciate. In this scenario, a focus on improved sovereign debt management can help countries manage existing debt burdens and free up resources for the recovery (as discussed in chapter 5). By contrast, addressing financial sector fragilities is a more pressing policy priority for many middle-income economies. The financial sector in these countries is typically more developed and therefore more exposed to household and small business debt. As outlined in chapter 1, income losses arising from the pandemic have led to a sharp deterioration in the financial health of households and firms, and could trigger a sharp rise in loan defaults. This could, in turn, threaten the capital position of many lenders. Thus, as outlined in chapters 2 and 3 of this Report, regulators in these countries should take steps to improve the resilience of the financial sector, promote greater transparency of bank asset quality, and expedite the restructuring of bad debts. Overall, middle-income countries also introduced larger and more encompassing fiscal and financial sector policies in response to the pandemic, including cash transfers, debt moratoria for households and firms, and credit guarantee schemes for businesses. In these countries, policy makers need to ensure that support measures are withdrawn in a careful, predictable manner to avert a wave of loan defaults that will threaten financial stability and create contingent liabilities for governments. Managing domestic risks to the recovery Scaling back the stimulus In the short term, resource-constrained governments face the challenge of scaling back fiscal support to households and firms without dampening the recovery. In many countries, direct payments to house- holds and firms have served as the main pillar of the crisis response and were designed to protect the livelihoods of economically disadvantaged groups—such as workers in the informal sector and those in unskilled occupations—and the survival of businesses in the sectors most severely affected by the crisis. However, few countries have the resources to maintain these policies in the longer term, and in many cases countries will need to phase out support before economic activity has fully recovered. As governments withdraw stimulus programs, policy makers must balance equity and efficiency con- siderations. Support should, for example, be scaled back first for firms that are financially resilient and have access to credit and capital markets that can help bridge temporary liquidity problems. Similarly, for households support should be scaled back first for those that are financially resilient, while support that protects the incomes and livelihoods of vulnerable populations that have been especially hard-hit by income losses stemming from the pandemic should be kept in place until their recovery prospects have materially improved. It is, moreover, essential that the withdrawal of support policies is imple- mented in a transparent and predictable manner to avoid adding to the economic uncertainty that is already dampening economic activity. POLICY PRIORITIES FOR THE RECOVERY | 253 Managing risks to government budgets Governments will also need to mobilize new revenue to pay off debts incurred for the crisis response and preserve their ability to support the recovery. The potential return to economic growth during the recovery will help. However, governments must also pursue complementary, longer-term struc- tural policies to increase their revenue base. Most emerging economies, for example, lack the insti- tutional capacity to tax incomes and instead rely primarily on taxing consumption. This approach is highly inefficient—for example, in 2020 Mexico, which relies heavily on consumption taxes, raised only 18 percent of its gross domestic product (GDP) in tax revenue,2 while countries in the European Union, relying primarily on income taxes, raised 41 percent of GDP in tax revenue.3 Taxing consumption is also highly inequitable because it places a disproportionate burden on the poor, who spend most of their income on consumption. Taxing wealth through property, income, and capital gains taxes is an underused revenue generation strategy in most emerging economies and could help mitigate the adverse impacts of the COVID-19 crisis on poverty and inequality. Revenue mobilization strategies should also strengthen incentives for businesses to formalize, which brings additional benefits such as improved access to credit. Managing risks to financial stability In many economies, the withdrawal of stimulus programs may also pose a threat to financial stability. Because many support programs will be scaled back before the incomes of households and businesses have fully recovered, regulators and financial institutions should be prepared to address an increase in loan defaults. Chapters 2 and 3 discuss policies that can counteract these risks and reduce the likelihood of a credit crunch that would disproportionately affect small businesses and low-income households and could weaken the recovery. The policies discussed in chapter 2 focus on managing loan distress and safeguarding financial stability. Those featured in chapter 3 are aimed at improving and establishing a well-functioning legal insolvency framework for households and businesses. Effective policy action in both areas can prevent the risks posed by loan defaults escalating to the point that banks reduce lend- ing. The challenges presented by elevated levels of nonperforming loans require a quick, comprehensive policy response on the three main fronts laid out in chapter 2: (1) improving transparency on banks’ exposure to problem assets; (2) developing the operational capacity to address rising volumes of bad loans to ensure the resolute and efficient handling of borrowers considered nonviable; and (3) providing supervisors and bank resolution authorities with the tools they need to deal decisively with distressed banks in a manner that protects taxpayers and ensures the continuity of key financial services. Policies should encourage timely action before nonperforming loans rise to problematic levels. Both regulators and financial institutions should therefore be prepared to address an increase in problem assets as sup- port programs are withdrawn.   An important tool to help resolve high levels of private debts in the economy is a functioning legal insolvency framework (see chapter 3). Because many emerging economies either lack legal or institu- tional frameworks for debt resolution or suffer from weak implementation or enforcement capacity, they would likely see benefits from concentrating efforts in these areas—notwithstanding the fact that the legal reform process can be lengthy. Even in countries where institutional capacity is limited, small improvements in the bankruptcy code can make a difference. For example, the experience of several emerging economies suggests that reforms that simplify bankruptcy proceedings can improve loan performance and increase the availability of credit. 254 | WORLD DE VELOPMENT REPORT 2022 Ensuring continued access to credit for households and businesses Many households and businesses are at acute risk of losing access to formal credit as a result of the COVID-19 crisis. Such a loss could dampen the recovery because access to credit is an important insur- ance mechanism that strengthens the ability of households and firms to weather economic risks that might arise during an extended recovery (see spotlight 1.1 for a review of the evidence). Credit also finances investment and consumption, which are essential to support the recovery. The ongoing economic disruptions and persistent economic uncertainty resulting from the pandemic have also increased credit risk and diminished the realizable value of collateral as well as other forms of recourse for lenders. Coupled with the fact that government programs have had the unintended con- sequence of reducing credit market transparency, many lenders are finding it challenging to accurately measure credit risk and have responded by tightening credit conditions across the board. Innovations in financial technology and lending models can help counteract the resulting contraction in lending and stimulate continued lending to households and firms. Where lenders have sufficient liquidity but are reducing lending, new financial technologies and lend- ing models—often using alternative data sources to assess creditworthiness—can compensate for the lack of credit information. Similarly, better matching the duration of loan terms to the time horizon over which lenders can assess credit risk can facilitate risk management in times of heightened uncertainty. These advances can partly compensate for reduced credit market transparency and help lenders iden- tify creditworthy borrowers. In situations in which lenders are reluctant to issue new credit because of economic uncertainty, governments and central banks could pursue other options such as partial credit guarantees. In these programs, often provided through state-owned banks, a guarantor (usually the gov- ernment) absorbs part of the credit risk of loans to specific groups of borrowers. Although such programs require the lender to assume part of the credit risk, they must be implemented selectively (as discussed in spotlight 4.1) because they can distort incentives for lenders to collect payments and borrowers to repay credit. They also carry the risk of creating contingent liabilities for the government if borrowers default. Managing interrelated risks across the global economy Beyond efforts to support the domestic economy, governments must also consider developments in the global economy that could pose a threat to an equitable recovery. Connections forged through global credit markets, international trade, foreign aid, and other areas create interdependencies. These con- nections have noticeably affected the recovery, perhaps best illustrated by the disruption of vital global supply chains through the temporary shutdown of factories, shipping, warehouses, and other essential infrastructure. One important global risk is the uneven pace of recovery between advanced and emerging economies. The faster recovery in advanced economies is likely to precipitate an increase in global interest rates, which will expose public and private sector borrowers to refinancing risks and put downward pressure on the currencies of emerging economies. These risks are especially acute for low-income countries with high levels of foreign currency–denominated debt, and they create a dilemma for the central banks of emerging economies. If they do not follow the interest rate hikes in advanced economies, they face the risk of capital outflows and a depreciation of the national currency. However, if they raise interest rates, they risk dampening the domestic economy by exerting pressure on borrowers and increasing the cost of servicing domestic sovereign debt. In view of these trade-offs, a carefully chosen policy mix that addresses interest rates, exchange rates, and macroprudential policy is crucial. This is especially important in countries with financial sectors POLICY PRIORITIES FOR THE RECOVERY | 255 that rely on credit and capital markets for wholesale finance because financial institutions that cannot refinance themselves will have less capacity to supply credit during the recovery. It should also be a high priority in countries where state-owned enterprises account for a significant share of the economy. When state-owned enterprises cannot refinance short-term debt or service foreign currency debt, the risk of contingent liabilities for governments is even higher. The recovery in emerging economies is also affected by economic growth in the rest of the world, and it could be impeded by slower growth in important emerging markets such as China. In view of China’s role as the most important bilateral creditor for emerging economies, a protracted deleveraging of the Chinese banking sector could expose economies that previously borrowed heavily from China to sizable refinancing risks (see chapter 5). Moreover, a slowdown in Chinese economic activity could affect the economic recovery in emerging economies by reducing the global demand for their exports. For exam- ple, in 2020 China’s share of the total trade of Sub-Saharan Africa was 26 percent, or about equal to the combined shares of the European Union and the United States.4 Seizing the opportunity to build a more sustainable world economy Recovery from the COVID-19 pandemic will call for far-reaching structural changes in economies around the world. This presents an enormous opportunity to accelerate the transformation to a more efficient and sustainable world economy. The consequences of climate change are already affecting lives and livelihoods in all countries. Although climate change is a global phenomenon, its impacts are felt most severely in low-income countries and low-income communities, where they compound existing vulnerabilities such as lack of access to clean water, low crop yields, food insecurity, and unsafe housing. Governments and regulators have a variety of policy instruments at their disposal to support this transformation and adapt their economies to the realities of climate change, which is a major source of neglected risk in the world economy.5 Governments can, for example, use the tax code to incentivize green investments, or central banks and supervisors could mandate higher risk provisioning for loans to sectors engaged in unsustainable activities that contribute to climate risks. Governments and central banks can also provide financing to lenders on preferential terms, conditional on meeting specific sus- tainability targets. Indeed, many countries have begun to use such regulatory incentives to accelerate the shift to a more sustainable economy. Such policies can have an important impact on the reallocation of financing to green sectors and technologies. In China, for example, green lending targets as well as regulation that incentivizes green lending have shifted bank lending portfolios toward sustainable sectors. Similarly, regulatory incentives can help the financial sector and activate a virtuous cycle by rec- ognizing and pricing climate risks so that capital flows toward more sustainable firms and industries.6 In the aftermath of the pandemic, governments have a unique opportunity to support the financial sec- tor’s ability to perform this role by, for example, mandating risk disclosures and phasing out preferential tax, auditing, and regulatory treatment for unsustainable industries. Notes 1. Daehler, Aizenman, and Jinjarak (2020).  4. Data from International Monetary Fund, DOTS (Direction 2. Data from Organisation for Economic Co-operation of Trade Statistics) (dashboard), https://data.imf.org and Development, Revenue Statistics 2021—Mexico /?sk=9D6028D4-F14A-464C-A2F2-59B2CD424B85. (database), https://www.oecd.org/tax/revenue-statistics 5. See Gennaioli, Shleifer, and Vishny (2012); Stroebel -mexico.pdf. and Wurgler (2021). 3. Eurostat (2020). 6. Carney (2015); Fender et al. (2020). 256 | WORLD DE VELOPMENT REPORT 2022 References Badarinza, Cristian, Vimal Balasubramaniam, Louiza Eurostat (Statistical Office of the European Communities). Bartzoka, and Tarun Ramadorai. 2021. “How Has the 2020. “Taxation in 2019: Tax-to-GDP Ratio at 41.1% Pandemic Affected Household Finances in Develop- in EU; a One-to-Two Ratio across Member States.” ing Economies?” Economics Observatory: Families News Release 160/2020, October 29, 2020. https://ec and Households (blog), June 29, 2021. https://www .europa.eu/eurostat/documents/2995521/11469100 .economicsobservatory.com/how-has-the-pandemic /2-29102020-BP-EN.pdf/059a7672-ed6d-f12c-2b0e -affected-household-finances-in-developing-economies. -10ab4b34ed07. Badarinza, Cristian, Vimal Balasubramaniam, and Tarun Fender, Ingo, Mike McMorrow, Vahe Sahakyan, and Omar Ramadorai. 2019. “The Household Finance Landscape Zulaica. 2020. “Reserve Management and Sustainabil - in Emerging Economies.” Annual Review of Financial ity: The Case for Green Bonds?” BIS Working Paper 849, Economics 11 (December): 109–29. Monetary and Economic Department, Bank for Inter­ Carney, Mark. 2015. “Breaking the Tragedy of the Horizon: national Settlements, Basel, Switzerland. Climate Change and Financial Stability.” Address at Gennaioli, Nicola, Andrei Shleifer, and Robert W. Vishny. Lloyd’s of London, London, September 29, 2015. https:// 2012. “Neglected Risks, Financial Innovation and Finan - www.bis.org/review/r151009a.pdf. cial Fragility.” Journal of Financial Economics 104 (3): Daehler, Timo, Joshua Aizenman, and Yothin Jinjarak. 452–68. 2020. “Emerging Markets Sovereign CDS Spreads Stroebel, Johannes, and Jeffrey Wurgler. 2021. “What Do during COVID-19: Economics versus Epidemiology You Think about Climate Finance?” Journal of Financial News.” NBER Working Paper 27903, National Bureau of Economics 142: 487–98. Economic Research, Cambridge, MA. POLICY PRIORITIES FOR THE RECOVERY | 257 ECO-AUDIT Environmental Benefits Statement The World Bank Group is committed to reducing its environmental footprint. In support of this commitment, we leverage electronic publishing options and print-on- demand technology, which is located in regional hubs worldwide. Together, these initiatives enable print runs to be lowered and shipping distances decreased, resulting in reduced paper consumption, chemical use, greenhouse gas emissions, and waste. We follow the recommended standards for paper use set by the Green Press Initiative. The majority of our books are printed on Forest Stewardship Council (FSC)–certified paper, with nearly all containing 50–100 percent recycled content. The recycled fiber in our book paper is either unbleached or bleached using totally chlorine-free (TCF), processed chlorine–free (PCF), or enhanced elemental chlorine– free (EECF) processes. More information about the Bank’s environmental philosophy can be found at http://www.worldbank.org/corporateresponsibility. The COVID-19 pandemic triggered the largest global economic crisis in more than a century. In 2020, economic activity contracted in 90 percent of countries, the world economy shrank by about 3 percent, and global poverty increased for the first time in a generation. Governments responded rapidly with fiscal, monetary, and financial policies that alleviated the worst immediate economic impacts of the crisis. Yet the world must still contend with the significant longer-term financial and economic risks caused by, or exacerbated by, the pandemic and the government responses needed to mitigate its effects. World Development Report 2022: Finance for an Equitable Recovery examines the central role of finance in the economic recovery from COVID-19. Based on an in-depth look at the consequences of the crisis most likely to affect low- and middle-income economies, it advocates a set of policies and measures to mitigate the interconnected economic risks stemming from the pandemic—risks that may become more acute as stimulus measures are withdrawn at both the domestic and global levels. Those policies include the efficient and transparent management of nonperforming loans to mitigate threats to financial stability, insolvency reforms to allow for the orderly reduction of unsustainable debts, innovations in risk management and lending models to ensure continued access to credit for households and businesses, and improvements in sovereign debt management to preserve the ability of governments to support an equitable recovery. ISBN 978-1-4648-1730-4 SKU 211730