Private-debt risks are hiding in plain sight

By Carmen M. Reinhart and Leora Klapper

WASHINGTON, DC — When Russian tanks rolled into Ukraine, private-debt crises were probably already brewing, albeit hidden from view, in many parts of the world, as a result of the economic disruptions caused by the COVID-19 pandemic. Now, the war is pushing even more countries towards similar crises.

The pandemic recovery has always been uneven. According to analysis based on the International Monetary Fund’s (IMF) most recent World Economic Outlook, per capita income hit a new high in almost 37 per cent of advanced economies in 2021. That share drops to about 27 per cent in middle-income countries and under 21 per cent in low-income countries. And these disparities may be about to deepen.

Early in the pandemic, many countries introduced debt moratoria, in order to give households and businesses a reprieve at a time when many faced a sharp income decline that left them struggling to meet their obligations. The moratoria were often accompanied by policies that gave banks the regulatory flexibility not to reclassify the affected loans in a higher risk category, as is typically required, thereby enabling banks to avoid the higher capital provisioning that reclassification would entail. Policymakers hoped that banks would use the available liquidity to continue lending.

But while the moratoria did provide temporary relief for private debtors and may have limited the fallout of the early pandemic disruption, they were not without drawbacks. In particular, forbearance policies made it more difficult for banking supervisors to detect the early warning signs of rising loan defaults, resulting in a hidden, but potentially disastrous, non-performing loan (NPL) problem.

With the emergency moratoria having now ended in many countries, vulnerable households and businesses, particularly small and medium-size firms, confront loan repayments they can no longer afford. This threatens to lead to a wave of defaults, with far-reaching implications for the economic recovery, especially in the low- and middle-income countries that are already struggling to revive growth.

There is still time to limit the damage. But this will require private- and public-sector actors to acknowledge the problem before it erupts into a full-blown crisis and manage it effectively. And so far, there seems to be little appetite for the kind of transparency that this would demand. In fact, according to the data financial institutions have provided to the IMF, there is no problem at all: NPL rates remained flat between 2019 and 2020 in a large sample of advanced and emerging economies that adopted forbearance policies.

Data from the Mastercard Economics Institute, which covers 165 countries, also tells a very different story, with permanent business failures rising nearly 60 per cent in 2020 from their pre-pandemic (2019) baseline. Although the situation improved in 2021, roughly 15 per cent of countries, most of them low and middle income, still recorded increases in permanent business failures.

The World Bank Pulse Enterprise Survey, covering 24 low- and middle-income countries, presents a similarly troubled picture. As Chart 1 shows, as of January 2021, 40 per cent of surveyed businesses expected to be in arrears within six months, including more than 70 per cent of firms in Nepal and the Philippines and over 60 per cent of firms in Turkey and South Africa.

As more governments unwind debt moratoria, the risks will only grow. If the past is any guide, rising NPLs will lead to less new lending, as financial institutions attempt to avoid exceeding their capital-provisioning limits and become more risk averse. A credit crunch would not only hamper the economic recovery; it would also exacerbate inequality by disproportionately affecting lending to low-income communities and smaller businesses.

Where one or more systemically important lenders lack the capital to cover their losses, government may need to step in to recapitalise them. This could mean simply transferring the solvency problem to the public sector at a time when governments already face heavy debt burdens and strained budgets.

Russia’s war on Ukraine compounds the risks by intensifying inflationary pressures and undermining the recovery in many emerging-market economies. The war’s impact is particularly acute in central Asia, where banks are highly exposed to Russian financial institutions and connected to one another via large cross-border remittance flows. New capital and foreign-exchange controls are also creating risks for financial institutions.

It is time to recognise and address this hidden crisis. The World Bank’s 2022 World Development Report lays out concrete steps policymakers can take. First, countries must increase the transparency of financial-sector balance sheets. Clear, consistent practices for reporting on asset quality, enforced by effective supervision, are essential. Financial institutions must also develop their capacity to manage NPLs, so that an increase in defaults does not prevent further lending.

Countries should also establish or enhance legal insolvency mechanisms, including hybrid out-of-court options involving conciliation and mediation arrangements. Such systems, which many emerging-market and developing economies currently lack, can hasten the resolution of debt distress and limit damage to the financial sector. Accessible and inexpensive debt-resolution procedures that reduce the extent of court involvement in restructuring are particularly important for micro, small, and medium-size enterprises, as well as for entrepreneurs and individuals.

Finally, regulators and lenders must ensure that households and businesses retain access to credit. An exceptionally uncertain economic environment, together with a lack of transparency about borrowers’ financial condition, has increased risks and reduced the efficacy of traditional methods for measuring them. Lenders must explore new, technology-enabled approaches to risk management and loan delivery, enabled by revised government regulations that both support innovation and ensure enforceable consumer and market protection.

Experience has shown that loan-quality issues do not fix themselves; unless addressed in a timely fashion, problems continue to grow, implying higher costs for the financial system and the real economy. If we do not heed this lesson, the hidden NPL problem will soon become impossible to ignore.

Carmen M. Reinhart is chief economist of the World Bank Group. Leora Klapper is lead economist of the Finance and Private Sector Research Team of the Development Research Group at the World Bank. Copyright: Project Syndicate, 2022. www.project-syndicate.org