Research & Policy Briefs From the World Bank Chile Center and Malaysia Hub No. 30 April 13, 2020 Financing Firms in Hibernation during the COVID-19 Pandemic Tatiana Didier, Federico Huneeus, Mauricio Larrain, and Sergio L. Schmukler The coronavirus (COVID-19) pandemic has imposed a heavy toll on economies worldwide, nearly halting economic activity. Although most firms should be viable when economic activity resumes, cash flows have collapsed, possibly triggering inefficient bankruptcies with long-term detrimental effects. Firms' valuable relationships with workers, suppliers, customers, governments, and creditors could be broken. Hibernation could slow the economy until the pandemic is brought under control and preserve those vital relationships for a quicker recovery. If all stakeholders share the burden of economic inactivity, firms are more likely to survive. Financing could help cover firms' reduced operational costs until the pandemic subdues. But financial systems are not well equipped to handle this type of exogenous and synchronized systemic shock. Governments could work with the financial sector to keep firms afloat, enabling forbearance as needed and absorbing part of the firms' increased credit risk, by implementing policies with proper incentives to keep firms viable. The coronavirus (COVID-19) outbreak has imposed a heavy toll policies complement other efforts by governments to support on economic activity worldwide. The shock has been sudden and households. The continuously growing policy trackers compiled concurrent across countries, and has been characterized by by the International Monetary Fund (IMF 2020), the World Bank significant uncertainty regarding its magnitude and duration. (2020), and Yale School of Management (2020), and discussed in Because of the rapid transmission of the virus in a highly places like Econfip (2020) and Elgin et al. (2020), provide just a globalized world, people around the globe have simultaneously glimpse of the many initiatives being implemented or proposed. isolated themselves following strict public health orders. Social This Research and Policy Brief discusses three broad issues distancing is an emergency measure that saves lives, but has led related to the financing of firms during the COVID-19 pandemic to a synchronized collapse in economic activity around the and the challenges for policy makers: first, why the COVID-19 world. Major stock market indexes have crashed, erasing close to crisis is different from previous financial crises in how it affects one-third of their value in just a matter of weeks, with some the financial sector; second, why the nature of the COVID-19 industries hit harder than others, reflecting expected losses in crisis implies that it is beneficial to provide credit to firms to keep the corporate sector (figure 1). them alive to maintain their relationships with stakeholders, Policy makers around the world have rapidly deployed a wide while health care policies try to mitigate the pandemic shock; arsenal of tools to cope with the inevitable economic recession, and third, which financial sector policies can help increase the pledging aid to private firms in Europe and the United States provision of credit, while posing different trade-offs. The last equivalent to their entire profits for the past two years (The section presents some final thoughts for further consideration Economist 2020). Many of those policies focus on helping firms when implementing policies that are related to different firms, manage the crisis, while improving their odds of survival. These countries, and generations. Figure 1. Magnitude of the COVID-19 Shock across Countries and Industries a. Decline in stock markets around the world b. Decline in U.S. stock market prices by industry Cumulative Changes in Stock Market Prices since Feb. 24, 2020 Covid-19 Pandemic GFC 2008-09 5 Δ (Stock Prices) Rank Δ (Stock Prices) Rank Telecommunications -24% 1 -35% 10 Cumulative change, percent 0 Technology -25% 2 -26% 3 -5 Health care -25% 3 -24% 2 Consumer services -30% 4 -29% 9 -10 Consumer goods -31% 5 -23% 1 -15 Utilities -35% 6 -29% 8 Basic materials -36% 7 -40% 12 -20 Transportation -36% 8 -26% 4 -25 Industrials -38% 9 -28% 7 Financial services -41% 10 -27% 6 -30 Real estate -41% 11 -27% 5 -35 Energy -54% 12 -39% 11 -40 Simple Average -35% -29% 0 1 2 3 4 7 8 9 10 11 14 15 16 17 18 21 22 23 24 25 28 29 Number of days since Feb. 24, 2020 S&P 500 Index -31% -28% S&P 500 DAX MSCI Emerging Markets Source: Refinitiv. FTSE 100 Nikkei 225 S&P 500 in the global Note: This table shows the stock market decline across industries in the financial crisis (post-Sept. United States, measured through iShares exchange-traded funds (ETFs). 14 2008) The changes in stock market prices are cumulative changes calculated over 30 days starting on February 24, 2020 for the Covid-19 pandemic, and September 12, 2008 for the global financial crisis (GFC). Source: Refinitiv. Affiliation: Tatiana Didier and Sergio Schmukler, World Bank; Federico Huneeus, Yale University and Central Bank of Chile; Mauricio Larrain, Financial Markets Commission and Catholic University of Chile. E-mail addresses: tdidier@worldbank.org, federico.huneeus@yale.edu, mlarrain@cmfchile.cl, sschmukler@worldbank.org. Acknowledgement: We received very useful comments from Alvaro Aguirre, Steen Byskov, Charlie Calomiris, José Ignacio Cuesta, Augusto de la Torre, Andrés Fernandez, Michael Fuchs, Alfonso García Mora, Cristobal Huneeus, Alain Ize, Aart Kraay, Norman Loayza, Fernando Mendo, Ernesto Pasten, and Rekha Reddy. We thank Rosario Cisternas Vial for able research assistance and Nancy Morrison for helpful edits. The World Bank Chile Research and Development Center, the Finance, Competitiveness and Innovation group at the Malaysia Global Knowledge and Research Hub, the Knowledge for Change Program (KCP), and the Research Support Budget (RSB) provided financial support for this brief. Objective and disclaimer: Research & Policy Briefs synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent, or the views of the Financial Market Commission of Chile or the Central Bank of Chile. Financing Firms in Hibernation during the COVID-19 Pandemic The Nature of the COVID-19 Crisis distancing to flatten the curve of infections and give health care systems a greater chance to treat the infected population. Cities The economic crisis triggered by the spread of the COVID-19 have shut down, mandatory quarantines have been virus is radically different from past economic crises. This time, implemented, and borders have been closed. Containment the shock did not originate in the financial sector and was not measures save lives, but bring economic activity to a near halt. the result of financial intermediaries or companies behaving irresponsibly due to ex ante moral hazard. This distinction has Unlike in previous global crises, during the COVID-19 important implications for how the shock has transmitted outbreak economies have faced a combination of a supply shock throughout the economy. It also matters for the menu of options (most immediately, employees cannot go to work, impairing available for policy makers. If firms that behaved well before the production, disrupting supply chains, freezing investments) and crisis do not survive the cash crunch while the outbreak persists, a demand shock (notably, households and firms cannot buy the shock could have long-term lagged and cumulative effects certain goods and services), which reinforce each other (hysteresis). Key relationships between firms and their (Eichenbaum et al. 2020; Guerrieri et al. 2020; Rogoff 2020). The stakeholders—including workers, suppliers (of intermediate shock has transmitted throughout the economy, affecting firms inputs, plant and equipment, commercial real estate, and so and industries across the board. Importantly, it has also forth), customers, governments, and creditors—would be disturbed a wide range of economic relationships, like those broken. between firms and their several stakeholders. Past economic crises (such as the Debt Crisis of the 1980s, With business revenue plummeting, corporate cash flows the 1997–98 Asian Crisis, and the 2008–09 global financial crisis) have collapsed at an unprecedented scale. Firms have struggled originated in financial vulnerabilities. Typically, financial to survive as their working capital gets depleted. The ensuing intermediaries (such as banks) took excessive risks, got in cash crunch can be depicted by the average number of days that trouble, suffered runs, lost access to funding, and, in turn, firms can continue to pay for their operating expenses with the stopped lending to the real sector. In other cases, debt markets cash they historically had on hand (figure 2). Some of the froze as borrowers became unable to rollover existing liabilities. industries that have been hit hard by the pandemic crisis, such as These problems in the financial sector transmitted to the rest of restaurants, retail stores, and service firms (hospitality, leisure, the economy, generally causing a recession. and hotels) will last for only a few weeks if revenues cease. A firm's ability to continue operating during the pandemic shock In contrast, the root of the COVID-19 crisis lies outside the thus depends on whether it can raise additional financing, as financial sector: a highly contagious virus transmitted from well on its ability to adjust expenses, such as payroll, supplier animals to humans. In a few months, since being spotted in payments, other overhead costs, and taxes. Wuhan, China, the virus has spread throughout populations across the world. The highly contagious nature of the virus has The resilience of the corporate sector is also tightly linked to meant that many people have gotten sick at once, and a the magnitude and duration of the pandemic shock and how much of the economic losses are borne by the different historically high percentage of those have required intensive stakeholders that interact with the firms. Because the source of care, rapidly overwhelming existing hospital capacity. the crisis this time around is specific to the COVID-19 pandemic, To diminish the number of concurrently infected people and once a vaccine or an effective treatment is found, the source of to accommodate proper hospital care for the sick, policy makers the crisis could basically disappear. That is, the health shock is were forced to take a dismal policy decision: impose social transitory in nature. Nonetheless, there has been a high degree Figure 2. Days of Cash on Hand across Industries Restaurants Multiline & specialty retail Consumer staples Textiles, apparel, & luxury goods Auto & components Other transport Utilities Industrials Hotels, resorts, & cruise lines Other consumer discretionary Airlines Materials Information technology Communication services Health care Energy 0 30 60 90 120 150 180 Number of days Source: Compustat. Note: Days of cash on hand refers to days of operating expenses covered by cash held, across U.S.-listed firms by industry. The figure shows 2000–16 averages. 2 Research & Policy Brief No.30 of uncertainty about its severity and the ramifications on the greater damage to the overall economy. Although financing overall economy. The longer the heightened levels of uncertainty alone is not enough, a well-functioning financial system can help and paralysis last, the tougher it will be for firms to withstand firms stay alive and preserve their relationships. and survive the shock. The losses incurred during the pandemic will need to be absorbed over time. Using Credit to Maintain Relationships during Hibernation Fundamentally, as long as the shock does not persist for too Firms depend on key and unique relationships with different long, most firms should remain viable: that is, their net worth stakeholders, such as workers, suppliers, customers, will still be positive. However, firms have faced a temporary governments, and creditors. The relative importance of slowdown or even a pause in business as a consequence of the operational expenditures to these different stakeholders varies COVID-19 pandemic and the containment measures taken by significantly across industries, depending on the nature of governments around the world. Furthermore, the shock has led businesses activities (figure 3). These relationships are costly and to a sharp and widespread increase in credit risk, as not all firms time-consuming to build, maintain, and adjust. Firms generally can survive a long-lasting lockdown, and those that do survive spend resources in building the best relationships for their might lose lines of business or customers. Industries as a whole needs. They usually require relationship-specific investments will weather the shock and survive. For example, the restaurant that involve the creation of knowledge and reputation. For industry will not disappear and neither will the airline industry. example, firms must find the best workers, suppliers, and But the same cannot be said about individual firms. Some will creditors that match their production processes. To do so, they cope with the shock or scrape by. Others will end up defaulting must learn about workers' skills and capabilities, develop and breaking contracts with their different stakeholders, even if methods to adapt specific intermediate inputs to production they do not shut down entirely. lines, and seek investors that might be better suited for their financing needs. Firms also have long-term relations with In fact, the heavy cost that the COVID-19 outbreak has governments that allow them to operate and with customers imposed on the world economy will eventually be borne by all that have become loyal to their products and services. These parties. Shock-hit firms have already suffered a collapse in relationships or matches, and the knowledge embedded in revenues. Shareholders have already lost a significant fraction of them, can be thought of an important intangible asset or their stakes in firms. Workers have been laid off or accepted organizational capital of firms. wage cuts. Suppliers have postponed receivables. Creditors have started to renegotiate debts. However, if firms start to default on Pushing firms into bankruptcy would mean that the different their debts, they risk being pushed into bankruptcy. To avoid relationships would need to be redeveloped in the recovery reaching this situation, credit in the form of rollover of payments following the crisis. Such a churning process of destroying and coming due and/or new financing could help. then recreating relationships and contracts is far from efficient, as it is generally slow and costly, leading to hysteresis. It is, thus, Despite the desirability for more credit, existing crisis inefficient to destroy the relationships between firms and their resolution mechanisms and bankruptcy codes, revised after stakeholders, even during the lockdown phase of the COVID-19 previous financial crises, are not designed to deal with an pandemic shock. A transitory shock that destroys a significant exogenous systemic shock such as the COVID-19 pandemic. They mass of relationships could lead to long-term scarring economic are focused on mitigating the spillovers of shocks that originate effects and a slow recovery. from the financial sector, and on preventing those shocks from materializing in the first place (such as deposit insurance, lender Avoiding bankruptcy for all, however, is not a forgone of last resort, and Basel III bank capital regulation). During past conclusion, given the uncertainties about the magnitude and crises rooted in the financial sector, policy makers would step in, duration of the pandemic shock. Although temporary, the shock resolve the financial intermediaries or creditors in trouble (the has already been large and widespread. Many firms have "bad apples"), while shielding the rest of the system from a suffered massive declines in revenues and severe cash crunches. collapse. Once policy makers addressed the main problems in In this context, honoring all preexisting commitments to the the financial sector, bank lending to the real sector resumed, and different stakeholders could quickly turn liquidity problems into economic activity started to recover. solvency ones. This time around, because the problem does not emanate Given the transitory nature of the shock, a good option might from the financial sector or from a particular firm or industry, the be hibernation: slowing the economy until the pandemic is solution is significantly more challenging. Policy makers must be brought under control, while using fiscal policy to compensate creative until the health crisis gets resolved, in the meantime for some of the many losses that the economy needs to adopting policies that mitigate the shock and the impact of the withstand. Hibernation means using the minimum bare cash social containment measures on the real sector. This involves necessary to withstand the pandemic. This would imply different working with the financial sector to improve the likelihood that thresholds for firms in different industries and countries. Some viable firms are not pushed into default and bankruptcy by a firms would be effectively shut down while the restrictions last financial infrastructure that is not prepared to deal with a (such as movie theaters and restaurants with no takeout or pandemic. It also involves policies related to the financial sector delivery options), whereas other firms could adapt and operate itself, which has been affected by the shock like all the other at a much reduced capacity (such as airlines maintaining some sectors in the economy, and which would naturally tend to flights and retailers selling only online). Hibernation is intended reduce lending in these circumstances. Because financial to freeze the firms' relationships with their stakeholders, but not systems play a key intermediary role in channeling savings to to freeze firms or the economy per se. Even firms that have productive activities, failure in this function could aggravate ceased operations during the lockdown would need some significantly the already sizable economic impact of the minimal funds to stay alive and remain ready to reopen when pandemic shock (Buera et al. 2020). Preserving the financial the lockdown passes (akin to the energy animals such as bears sector in good standing is essential, and would avoid even need during their hibernation). 3 Financing Firms in Hibernation during the COVID-19 Pandemic Figure 3. Payments to Key Stakeholders across Industries 100 90 80 70 60 Percent 50 40 30 20 10 0 Restaurants Airlines Other transport Health care Hotels, resorts, & cruise lines Multiline & specialty retail Industrials Other consumer discretionary Information technology Consumer staples Communication services Auto & components Materials Financials Textiles, apparel, & luxury goods Energy Real estate Labor expenses Accounts payables Interest payments Source: Compustat. Note: Payments to key stakeholders refer to the share of operating expenses owed to stakeholders, across U.S.-listed firms by industry. The figure shows 2000–16 averages. Hibernation would not be a simple solution, as the the short term, firms could turn to external financing from banks relationships between firms and their different stakeholders, (such as credit lines, leasing, receivables, and term loans) and and the contracts that support them, might need to be capital markets (bonds and equities). However, there are three renegotiated to somehow share the burden of the inactive unique set of challenges related to firm financing during the period. Borrowing to maintain all preexisting pandemic shock. contracts—assuming business as usual—could generate a high First, the private sector debt built up after the 2008 global and perhaps unbearable debt burden on firms by the time the financial crisis means that many firms have entered this shock recovery starts. An ensuing debt overhang problem could linger with high levels of debt. There was about US$75 trillion of for years. nonfinancial corporate debt outstanding in the world in Given the uncertainties about the duration and magnitude of September 2019 (IIF 2020). Nonfinancial corporations in the shock, a key question is the extent to which different emerging markets alone will need to pay back or refinance more stakeholders could absorb part of the losses associated with the than US$700 billion during 2020, which does not include the hibernation phase. That is, firms could increase their likelihood new financing needs that arise as a result of the COVID-19 crisis. of surviving the pandemic if they had some flexibility in Such high corporate indebtedness represents an important negotiating payments to their different stakeholders, while using source of fragility and could impose significant constraints on their cash and borrowing capacity to cover the reduced costs of firms' ability to borrow, especially for emerging economies with survival during the lockdown period. debts denominated in foreign currency, as many domestic currencies have plummeted. The relationships with the different stakeholders are tightly linked. For instance, the ability of firms to pay creditors depends Second, firms might have limited capacity to substitute on whether they have enough money left over after paying other across external financing sources during this crisis. During a stakeholders, especially while businesses are temporarily halted. typical financial crisis, if the banking sector shuts down and The flexibility in contracts with the different stakeholders will banks stop providing loans, some firms are able to substitute ultimately determine which relationship firms adjust to weather away from bank loans toward bond financing. During the the pandemic. For example, if part of a firm's suppliers' COVID-19 crisis, all markets across all countries have been payments is variable, with room for adjustments, then suppliers simultaneously hit; financing from both banks and capital could absorb a share of the costs of continuing the business. markets has dried up for many firms. They have been left with no This, in turn, might allow the firm to fire fewer workers and also obvious source of financing, during a period in which access to provide some slack to pay its creditors. Exploiting the flexibility finance might determine their own survival. of some relationships could help firms adjust their expenses, Third, and maybe most importantly, creditors in general and keep important relationships active, and reduce costly churning, banks in particular have become reluctant to lend to firms, while improving their prospects for the recovery. unwilling to absorb the higher credit risk of firms. Amid Creditors could provide a crucial margin of adjustment for widespread uncertainty regarding the magnitude and duration firms, especially if they could offer extra financing that would of the shock, creditors have faced challenges in evaluating the allow firms to avoid breaking up their other relationships. In likelihood of firm survival, given that assessments of credit risk 4 addition to internal financing options, which can be limited in under these circumstances have significant margins of error. Research & Policy Brief No.30 Firms that can cut workers’ wages or renegotiate accounts Adapting the Institutional Framework payable with suppliers would pose lower credit risks for creditors. Yet, the crucial challenge for creditors is that they have Although financial systems have worked as expected, they are ill imperfect information about such flexibility in the contracts that equipped to cope with a shock like COVID-19 because they are firms have with their other stakeholders. Thus, they might cut geared toward detecting idiosyncratic risk when it arises. Legal financing across the board. Furthermore, there could be and regulatory frameworks have been established to prevent externalities. Individual creditors might not look beyond their shocks and allow a clear plan of action whenever shocks happen, immediate contractual requirements or narrow self-interest to with the idea of safeguarding the stability of the overall system. fully understand the general feedback loop over time: firms that For example, when a firm fails to meet a payment, banks are are able to obtain financing during the hibernation phase would required to increase provisions to reflect the higher risk. In have greater chances of survival. Such market failures alone addition, the credit score of the firm is reduced. justify a role for policy intervention in order to restore firm During the COVID-19 crisis, signaling firms in trouble would financing. not be very informative or helpful, given that most firms have suffered a sizeable and unexpected negative external shock. To Policy Interventions to Sustain Firm Financing the extent that financial sector stability can be preserved, Policy makers could play a role in stabilizing the economy by allowing forbearance and avoiding undue increases in borrowing working with the financial sector to keep firms afloat. This would costs might be needed; otherwise, applying the standard improve the likelihood that viable firms are not pushed into procedures when firms cannot repay their liabilities would hurt default and bankruptcy. Financial sector policies, including these firms even more. forbearance, are complementary to the other actions that firms Because unnecessarily liquidating firms will impose even take with both private and public stakeholders to adjust previous larger costs to the economy in the longer term, policy makers commitments in response to the pandemic shock. around the world have started to adapt the legal and regulatory Policy makers around the world have tirelessly worked structures to the unique nature of the COVID-19 shock. Several toward stabilizing the economy amid the pandemic shock. A of these policy measures are geared toward existing credit lines. number of policies have focused on working with the financial For example, some financial regulators have allowed banks to sector to help firms manage their liabilities with different freeze the credit classification of firms to what they were before stakeholders, while improving their odds of survival. These the shock (say, December 2019) and their provisions when they policies could complement other possible efforts by renegotiate the terms of a loan with a client. As long as the loan governments, such as being the backstop for absorbing losses is not classified as nonperforming, the renegotiation would not affect the firm’s credit score. Other policies, such as for both the real economy and the financial sector (Beck 2020), evergreening loans so that only the interest payments must be acting as a payer of last resort (Saez and Zucman 2020), made, might also prove useful and deserve more attention exploring taxation tools such as a negative lump sum tax for (Brunnermeier and Krishnamurthy 2020). small and medium enterprises (SMEs) (Drechsel and Kalemli-Özcan 2020), or extending a liquidity life-line to An important margin of adjustment for these measures is the cash-strapped firms (Brunnermeier et al. 2020). Because choice of which set of firms to apply such forbearance measures. payments to the different stakeholders are tightly connected Some countries have provided differential treatment to certain with one another and jointly affect firms' prospects, the various firms, whereas others have applied them to all firms, such as policies are also closely interconnected. For example, a implementing automatic postponement of loan repayments. government policy that pays a portion of wages for workers that Whereas universal application is easy to implement and provides stay at home reduces the financing needs of firms to cover such relief for all firms, thus increasing their likelihood of survival, it costs. Prompt coordination across policy makers—central banks, creates significant risks for banks, especially because it imposes finance ministries, and regulators—is thus essential to ensure no conditions on firms, such as having a good credit standing policy effectiveness during this crisis. before the crisis. It also places banks at a disadvantage with An important goal of public policies for the corporate sector respect to other creditors, which would be in a better position to during the lockdown phase of the pandemic shock is to ensure act faster against failing borrowers. This type of measures might, that credit flows rapidly to firms, especially those facing severe in fact, encourage the survival of zombie firms by overriding cash shortfalls due to the collapse in their revenues. This means banks' ability to act on hard and soft information regarding firms' not only refinancing existing credit lines, but also extending new prospects and ability to repay. They could also discourage new lending by increasing the probability of further blanket financing to existing and new clients, given that funding needs forbearance measures (like a broad moratorium on payments to will likely increase with the ensuing economic recession. all creditors or automatic stays in court orders and bankruptcy It is important to take into account the trade-offs underlying procedures) if the crisis deepens further. In contrast, policies the different policy options that can foster firm financing, as well that allow for some screening of firms—drawing for example on as the incentives they generate. The effectiveness and fiscal good behavior before the crisis (say, those in good standing costs of the different alternatives are also key considerations. before the shock hit)—would probably entail smaller transfers Not all governments would have the fiscal or monetary space to and reduced fiscal costs, though screening could delay implement the much-needed mitigating policies and might need implementation and it would not offer the same chance of to borrow from the international community. survival for all existing firms. We group policies along two different and broad dimensions. In applying forbearance, it is important that regulators and One set of policies relates to adapting the institutional creditors do not provide the wrong incentives for borrowers to framework to meet the challenges imposed by the pandemic engage in moral hazard ex post and to fail to repay their loans. shock. A second set of policies is linked to the provision of credit This is usually hard to achieve, but to the extent that regulators to firms. and creditors can use tools to penalize firms engaging in bad 5 Financing Firms in Hibernation during the COVID-19 Pandemic behavior, they might want to deploy them. For example, When considering policies addressed to transfer credit risk to creditors could use convertible subordinated loans that the government, it is useful to distinguish between large transform into equity should firms be unable to repay. In corporations and SMEs. Whereas large firms use a combination addition, it is important to closely monitor the implementation of both bank credit and capital market financing, SMEs tend to of such measures and their potential impact to ensure the rely mostly on bank financing. Also, large firms have larger soundness of financial institutions, to preserve the stability of spillover effects and generate greater externalities in the the financial sector, and to signal the exceptional nature of the economy than individual SMEs. The failure of a large corporation changes while the COVID-19 crisis persists. could lead to more workers being laid off, possibly affecting local labor markets; more suppliers being unpaid, possibly disrupting Providing Credit to Firms supply chains; fewer exports, possibly affecting the availability of Policy makers around the world have considered several options foreign exchange in the country; and default on large debts, to enhance the provision of credit to firms. We divide these possibly affecting the liquidity and solvency of its creditors. At policies into monetary and regulatory policies, on the one hand, the same time, precisely because of their size, larger firms also and policies aiming to transfer risk to the government, on the have stronger bargaining power relative to their stakeholders other. than SMEs, and might thus be better able to cope with the shock. Monetary and Regulatory Policies To the extent that SMEs’ only access to external finance is Central banks have quickly responded by lowering interest rates. through banks, channeling funds to large firms through the However, standard monetary policy measures might have banking system may be inefficient because it could crowd out limited effects during the COVID-19 outbreak. In normal times, SMEs from this funding source. Some governments have monetary policy rate reductions by the central bank can lower supported financing to large corporations through capital the cost of funding for firms, thereby increasing firm revenues. markets. For example, they have provided a transitory capital With pandemic-related containment measures in place, as well injection by purchasing corporate liabilities traded in capital as the uncertainty about the magnitude and duration of the markets. That is, large firms issue securities (either senior shock, corporate investment in general might not be very responsive to lower interest rates. Moreover, in many countries, corporate debt or preferred equity), which can then be directly interest rates were already low before the pandemic hit, purchased by the government or the central bank. Once the reducing the space for interest rate cuts. Other monetary shock subdues, these large firms are expected to recover. The policies related to the provision of credit (for example, through government would then sell the securities purchased to others quantitative easing) can be linked to the policies discussed in the market, recouping its initial investment. Because there are below. generally only a few large firms in each industry, governments can monitor them closely (and, in some cases, even regulate Some central banks have also extended liquidity lines to them) if and when such funding is provided. banks, at low cost, with incentives to expand lending to the real economy. However, unlike a typical financial crisis, banks have Regarding SME financing, some countries have capitalized generally not encountered major liquidity problems. Instead, state-owned banks, which in many cases have explicit mandates they have had to deal with a discrete, sizeable, yet unknown to lend to SMEs. Other countries have scaled up public credit risk—the increased credit risk of firms that depends on the guarantee programs, which are focused on the public provision magnitude and duration of the pandemic shock. Liquidity of guarantees to loans made by banks to SMEs. Because these policies would work to the extent that banks pass through the programs absorb part of the firms' credit risks—in case of higher liquidity from the central bank to firms. Likewise, some default, the government bears a significant fraction of the financial regulators have reduced Basel III capital requirements costs—they provide incentives for banks to lend to such firms. charged to banks, such as countercyclical capital buffers, Other countries with fairly well-developed capital markets have conservation buffers, and systemic risk buffers. To be effective, moved toward allowing the central bank or the government to banks would need incentives to convert the released capital into engage in large-scale purchases of portfolios of SME loans. greater lending to firms in the context of increased credit risk, Under this arrangement, banks sell securities backed by those and these measures alone might not provide sufficient loans and in case of default, the government bears the risk. This incentives for them to do so. also gives banks some incentives to lend to SMEs. Other central banks have developed lending facilities to encourage investors to Transferring Credit Risk to the Government purchase securities collateralized by the portfolio of SME loans. Because uncertainty is high and lenders have retrenched, Both securitization policies can potentially have a multiplier governments have stepped in and absorbed the increased risk in effect in the financing available to SMEs if lenders were to use credit provision to ensure that firms have sufficient resources the capital obtained through those transactions to lend again to during the hibernation phase. Among other things, governments SMEs. The effectiveness of these policies could be enhanced if have capitalized state-owned banks; scaled up public credit they were to include both existing as well as new bank credit to guarantee programs (typically covering 70 percent to 90 percent of SMEs. the loans); and supported large-scale purchases of portfolios of loans. The feasibility of rapid delivery of these different policy Policies aimed at transferring credit risk to the government options varies across countries and depends on the institutional should be designed to minimize the cost to public coffers. Policy setting. For example, while some countries have important interventions would benefit from two characteristics. First, scale state-owned banks, others do not. Also, some countries have is crucial to allow for risk diversification, both across industries guarantee programs in place, while others do not. To the extent (some industries have been hit harder than others) and across that new distribution channels may need to be created, challenges firms within industries (not all firms in the same industry will go 6 to implement this set of policies will arise (El-Erian 2020). bankrupt because of the shock). Research & Policy Brief No.30 Second, providing incentives for both creditors and debtors is group, regarding the scope for policy action. Their different also important. For example, public credit guarantee schemes initial conditions determine the set of policies they are able to should be partial, so that banks retain some "skin in the game," implement and which costs they will face (Hausmann 2020; and thus have incentives to monitor and screen borrowers. Loayza and Pennings 2020). Countries with shallower financial Similarly, in the securitization policies, banks should keep a markets, less fiscal space, and more constrained central banks fraction of the loan portfolio in their balance sheets. Regarding will face greater challenges to channel credit to firms so as to firms, the challenge is to avoid the ex post moral hazard problem avoid a breakup in their relationships. Nonetheless, the fact that of firms not repaying their loans, which could turn out to be very developing countries generally have more informal firms might costly for credit providers. This source of concern becomes more help them reestablish relationships faster once the lockdown acute the longer the shock lasts. If the shock lasts for many measures are eased. Moreover, pressure from households and months, firms might find it more efficient or profitable to declare firms with fewer resources could make the lockdown period bankruptcy (with all its costs of broken relationships) and avoid shorter, triggering a higher rate of infection and more rapid herd repaying their creditors, only to then "reproduce" the business immunity, at a tragically higher mortality rate, but requiring with new credentials—like closing down one restaurant only to fewer resources for the quicker hibernation phase. open another one next door shortly thereafter. It would be difficult for creditors under such systemic shock to disentangle With the rise in global risk, developing countries have faced a whether firms defaulted strategically or not. But even when sudden stop in capital inflows, high costs to issue new debt in firms repay, another potential problem with incentives is that capital markets, and sharp depreciations of their domestic firms might not internalize the social value of the knowledge currencies. These significant macroeconomic challenges, embedded in their relationships and might be willing to destroy combined with the large financing needs that have arisen with more matches than is socially optimal. the pandemic shock, could trigger widespread sovereign debt restructurings (Blanchard 2020; Gourinchas and Hsieh 2020). In Conclusion turn, they could be followed by widespread turbulence in the corporate sector, especially in countries where firms entered the Governments have limited resources so they need to prioritize shock with high outstanding debt levels. The liquidity issues in and evaluate the trade-offs associated with different policies. For developing countries might thus rapidly turn into solvency example, they need to make decisions on how much to allocate problems—and not only at the firm level. Multilateral policy to large firms versus SMEs, to firms that have relationships that action, involving international financial institutions and creditor are more difficult to reconstruct, or to firms that would be more countries, might help resolve a problem that becomes common disruptive for value chains if they were to go bankrupt. They across developing countries. might even be pushed to decide whether some essential industries (such as basic infrastructure, health, and education) In designing policies for both developed and developing or industries hit hardest by the shock (such as travel, tourism, countries, it is useful to acknowledge the transfers across and many services) are worth assisting over others. different agents that can occur as a consequence of the Governments also need to think about how to allocate resources responses to the pandemic. The lockdown policies will tend to over time. Firms might be in hibernation and need funds for protect the more vulnerable older generation, while restricting several months, using bridge financing to make it through the the economic activities of the younger generation, which has a lockdown period. During this critical time, government lower risk of becoming seriously ill. This effectively induces assistance might be needed the most, as banks and investors transfers from the young to the old, given that some of the costs face higher uncertainty about the length of the pandemic and of such policies will not necessarily be recovered (Reis 2020). the related probability of firm survival. Eventually, surviving firms However, policies to keep firms alive do not produce the will need additional lines of credit to restart or jumpstart their same type of intergenerational transfers. Whereas they will be operations when they stop hibernating. Private lenders might be paid mostly by the young, that same generation will also benefit more willing to lend at that stage when uncertainty has the most from keeping the relationships between firms and their diminished and they would be in a better position to assess different stakeholders alive. Within the young generation, the firms' prospects and credit risks. socialization of losses still entails transfers. 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