The outbreak of COVID-19 spurred a public health crisis that quickly turned into the largest global economic crisis seen in more than a century. Governments responded quickly to mitigate the financial impact on households and businesses with large support measures and expansionary fiscal policy at an unprecedented scale.
Interlinkages between household, business, and government finances
While the crisis response was largely effective at stabilizing output in the short run, it created longer-term financial risks for household, corporate, financial and public sector balance sheets, which reinforce one another through multiple feedback loops.
When financial pressures on households and businesses lead to loan defaults, for instance, it damages the balance sheets of financial institutions, who respond by issuing less credit and charging more for it – a dynamic that can depress growth for the broader economy. Similarly, the financial health of households and businesses can likewise strengthen government financial stability through tax revenues, and weaken it when governments need to provide financial support to weather economic crises.
Governments and financial institutions, for their part, are connected through the domestic debt governments have raised to finance their fiscal response. This debt is mostly held by local investors, including banks, pension funds, and other financial institutions, which causes sovereign and financial sector balance sheets to stabilize or degrade together. The risk compounds for small open economies that issue debt in a foreign currency; if the local currency depreciates in value, servicing government debt becomes more expensive and often unsustainable relative to the local currency income of the borrower.
Why finance?
Though neither the COVID-19 health crisis nor the economic crisis is over, governments and institutions can take actions now to establish monetary, fiscal, and financial sector policies that turn these linkages from a potentially vicious cycle into a virtuous one. As countries shift their attention to rebuilding their economies, they can still make choices and pursue reforms that ensure access to finance to help households and businesses weather economic uncertainty and invest in opportunities; while simultaneously managing the financial risks created by the government response in a way that restores economic growth and preserves the ability to address adverse events in the future. Achieving an appropriate balance between financial access and risk management can strengthen credit markets, which are critical to a healthy economy and robust recovery.