Debt crises worsen on Russian tanks

The catastrophic problem of hidden bad loans

A blog by leading World Bank experts notes that the debt crisis around the world is on the verge of worsening, and when Russian tanks rushed into Ukraine, private debt crises may already be brewing – albeit hidden – in many parts of the world, due to the economic disruption caused by the Corona pandemic (Covid-19). Now the war is pushing more countries into similar crises.

According to the blog of Carmen Reinhart, Senior Vice President and Chief Economist of the World Bank Group, and Leora Clapper, the Bank’s Chief Economist, the recovery from the pandemic has always been unequal. According to an analysis based on the latest World Economic Outlook reports released by the International Monetary Fund, per capita income reached a new high in nearly 37 percent of advanced economies in 2021, and this share drops to about 27 percent in middle-income countries, and lower than 21 percent in low-income countries. Perhaps these differences are about to deepen.

Early in the pandemic, many countries issued debt moratoriums to defer families and businesses at a time when many were facing a sharp drop in income, which made them struggle to meet their obligations. Debt suspensions were usually accompanied by policies that gave banks the regulatory flexibility that allowed them not to classify affected loans into a higher risk category, as was the norm, and helped enable banks to increase their capital reserves. avoid what would necessitate reclassification. Policymakers hoped banks would use available liquidity to continue lending.

But while the debt moratorium has already provided temporary relief to private debtors, and possibly mitigated the effects of the disruption caused by the early pandemic, it was not without flaws. In particular, tolerance policies have made it harder for bank supervisors to spot early warning signs of rising defaults, and this has given rise to the potentially disastrous “hidden” problem of bad loans.

With emergency debt suspensions now in place in many countries, at-risk households and businesses, especially small and medium-sized businesses, are facing repayments on loans they can no longer afford. It threatens to unleash a wave of default, with far-reaching consequences for economic recovery, especially in low- and middle-income countries that are already struggling to revive growth.

More time to limit damage. But it requires the active forces in the public and private sectors to recognize the problem before it degenerates into a comprehensive crisis, and to manage it effectively and efficiently. So far, there seems to be little appetite for the kind of transparency it would require. In fact, according to data provided by financial institutions to the International Monetary Fund, there is no problem: non-performing loan rates remained flat during 2019-2020 in a large sample of advanced and emerging economies that have adopted tolerance policies.

Data from the MasterCard Institute of Economics, which covers 165 countries, also tells us a very different story, with permanent business failures rising by almost 60 percent in 2020, compared to their base level before the pandemic (2019). Although the situation has improved in 2021, nearly 15 percent of countries, most of which are low- and middle-income, are still reporting increases in permanent business failures.

The World Bank’s Pulse Survey, which covers 24 low- and middle-income countries, provides a similarly turbulent picture. As of January 2021, 40 percent of the businesses surveyed expected to build up arrears within six months, including more than 70 percent of the businesses in Nepal and the Philippines and more than 60 percent of the businesses in Turkey and the South. Africa.

As more governments end their debt moratorium, the risks will increase. If we are led by the past, higher levels of non-performing loans will lead to fewer new loans, as financial institutions will try to exceed the limits of capital reserves, making them more risk averse. Not only will the credit crunch hamper economic recovery; It will also exacerbate inequality by affecting loans to low-income communities and smaller firms disproportionately.

Where one or more systemically important lenders do not have the capital to cover their losses, governments may have to step in to recapitalize those losses. It can simply mean that the solvency problem is shifted to the public sector at a time when governments are already facing heavy debt burdens and stretched budgets.

The war in Ukraine exacerbates the risks by intensifying inflationary pressures and undermining the recovery in many emerging economies. The impact of the war is becoming particularly acute in Central Asia, where banks are highly vulnerable to Russian financial institutions and are interconnected by massive cross-border overflow flows. New capital and foreign exchange controls also create risks for financial institutions.

It is time to acknowledge and address this hidden crisis. The World Bank’s World Development Report 2022 identifies concrete steps that policymakers can take. First, countries need to increase the transparency of financial sector budgets. Financial institutions should also develop their capacity to manage non-performing loans so that no increase in default prevents further loans.

Countries must also establish or strengthen legal insolvency mechanisms, including out-of-court hybrid options involving conciliation and mediation arrangements. Such systems – which are currently lacking in many emerging markets and developing economies – could accelerate debt relief and limit the damage to the financial sector.

Finally, regulators and lenders need to work to ensure that households and businesses retain access to credit. The extremely uncertain economic environment, coupled with a lack of transparency about the financial position of lenders, has increased risks and reduced the effectiveness of traditional methods of measuring these risks.

According to Reinhart and Clapper, experience has shown that loan quality issues do not correct themselves; Unless it is tackled for a moment, problems will continue to grow, implying higher costs for the financial system and the real economy. If we do not heed this lesson, it will soon become impossible to ignore the problem of hidden bad loans.

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