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Chapter 6. Policy priorities for the recovery

The COVID-19 pandemic has confronted countries with a wide range of new and increased economic risks, some of which may only become apparent with time. Ideally, governments would devise policies to address all areas in which the pandemic has revealed or exacerbated economic fragilities: financial sector stability, the legal insolvency framework for households and businesses, access to credit, and government debt sustainability. However, few if any governments have the resources and political leeway to tackle all these challenges at once. They will have to identify the risks that are the most immediate threats to an equitable recovery in their specific context and prioritize policy responses accordingly.

Managing domestic and global risks

As governments gradually withdraw stimulus measures, policy makers must balance equity and efficiency considerations. For example, support should 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. In supporting firms through the recovery, governments should resist the urge to target specific industries for aid based on their precrisis size and ensure that support policies do not trap resources in sectors that have become less viable as a result of the crisis. Similarly, for households support should be scaled back first for those that are financially resilient, whereas 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 these populations’ recovery prospects have materially improved. Prioritizing disadvantaged groups in this way can help counteract the impacts of the pandemic on poverty and inequality.

Policy makers will also need to address global economic risks that may threaten a robust, equitable recovery. One such risk is the uneven pace of recovery of advanced and emerging economies. The more rapid recovery in advanced economies is likely to precipitate a rise in global interest rates, which will put pressure on borrowers through increases in the cost of servicing domestic debt (public and private). Loan defaults may result.

An additional external risk is private and public sector exposure to exchange rate risk and foreign currency debt. This is especially important in countries whose financial sectors rely on credit and capital markets for wholesale finance because financial institutions (including microfinance lenders) that face refinancing risks will have less capacity to supply credit during the recovery. Managing currency risk should also be a high priority in countries with dominant state-owned enterprises that have taken on significant amounts of foreign currency debt in the decade since the global financial crisis.

Tackling the most urgent sources of risks

One of the main themes of this Report is that the sectors of an economy are interconnected. These links create pathways along which risks can spill over from one sector to others. Along these same paths, well-designed fiscal, monetary, and financial policies can mitigate risks and generate positive outcomes that support economic recovery.

Governments that need to make difficult choices about the prioritization of resources to realize the recovery should therefore examine the specific nature of the risks confronting the economy and then identify areas where policy action is most likely to reduce economic fragilities worsened by the pandemic. This is not to say that governments facing a high degree of risk in one area should ignore other areas. Instead, they should emphasize the importance of urgent action in areas in which economic fragilities are greatest or in which allowing additional risks to accumulate is most likely to create spillover risks that could threaten the recovery.

Likely scenarios in low-income countries

A common scenario in low-income countries is that the formal banking sector primarily serves the wealthier, more resilient households and the larger, more well-established businesses, whereas the low-income households and small businesses most severely affected by the pandemic often lack access to bank credit. The possibility of rising loan defaults among private sector borrowers is therefore often a less pressing issue in these countries. However, because borrowers in low-income countries are typically more reliant on nonbank lenders such as microfinance institutions, they may benefit from efforts to regulate and support these institutions (see spotlights in chapters 2 and 3).

Meanwhile, in these countries deteriorating public finances threaten the ability of governments to support the most vulnerable and pose a risk to the domestic financial sector, which often holds large amounts of government debt. Low-income countries also tend to face greater external threats than middle- and high-income countries to an equitable recovery. 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 government debt management may help governments manage debt burdens and free up resources for the recovery (see chapter 5).

Likely risks in middle-income countries

Addressing financial sector fragilities is a more pressing policy priority for many middle-income countries. Because the financial sector in these countries is typically more developed, it is also more exposed to household and small business debt. Income losses arising from the pandemic have led to a dramatic deterioration in the financial health of households and firms and could precipitate a sharp rise in loan defaults once support policies are withdrawn. This situation could, in turn, threaten the capital position of many lenders. One important priority for policy makers in middle-income countries is therefore to ensure that the financial sector remains adequately capitalized and that regulators and financial institutions establish the proper frameworks for prompt, comprehensive recognition of financial sector risks (see chapter 2).

Overall, the governments of middle-income countries introduced larger and more encompassing fiscal and financial sector policies in response to the pandemic. These included 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 scaled back in a careful and predictable manner to avoid a wave of insolvencies and loan defaults in the event that stimulus policies are withdrawn before economic activity has fully recovered (see chapter 3).

Finally, the continued impact of the COVID-19 crisis on the economic prospects of households and firms could inhibit new lending because of increased credit risk and persistent economic uncertainty. The risk that heightened economic uncertainty dampens the recovery by leading to a reduction of credit can be partly mitigated through improved credit market transparency and better recourse in the event of default. Bank supervisors can encourage banks to reassess credit models, responsibly adopt innovations in digital finance that rely on alternative data, and tailor loans to the borrower and the lending environment. Regulatory frameworks that foster innovation can support credit during the recovery, while ensuring that consumers and markets are protected from misuse of data (see chapter 4).

The crisis as an opportunity: Accelerating the transition to a sustainable world economy

Despite the numerous challenges posed by the pandemic, the COVID-19 crisis also presents an enormous opportunity to accelerate the transformation toward a more efficient and sustainable world economy. Climate change is a global phenomenon, but its impacts are felt most severely in low-income countries and among low-income communities, where it often compounds the existing vulnerabilities such as lack of access to clean water, low crop yields, food insecurity, and unsafe housing.

Governments and central banks have a variety of policy instruments at their disposal to support the transformation to a greener economy through the appropriate pricing of carbon emissions and support for green finance and sustainable technologies. Governments can, for example, revisit the tax code to incentivize green investment, while central banks and supervisors can mandate higher risk provisioning for loans to sectors engaged in unsustainable activities. The reforms necessitated by this once in a century crisis offer governments an opportunity to adapt their economies to the reality and the largely neglected risk of climate change.