In its latest report, the World Bank has underlined the growing risk of financial fragility that Covid-19 crisis and rising debt burden pose to developing countries. It says that as rising inflation and interest rate increases pose further challenges to recovery, developing countries need to focus on creating healthier financial sectors.

According to the World Development Report 2022: Finance for an Equitable Recovery, risks may be hidden because the balance sheets of households, businesses, banks, and governments are tightly interrelated. Further, high levels of non-performing loans and hidden debt block access to credit and finance for low-income households and small businesses.

To quote World Bank Group President David Malpass, “The risk is that the economic crisis of inflation and higher interest rates will spread due to financial fragility. Tighter global financial conditions and shallow domestic debt markets in many developing countries are crowding out private investment and dampening recovery. It is critical to work towards broad-based access to credit and growth-oriented capital allocation. This would enable smaller and more dynamic firms – and sectors with higher growth potential — to invest and create jobs.”

The WB report says that the global public health crisis triggered by Covid-19 created the largest global economic crisis in more than a century, resulting in major setbacks to growth, increased poverty rates, and widened inequality. In response to the coronavirus crisis, governments around the world devised emergency support measures, which helped mitigate some of the worst social and economic impacts.

But at the same time, there was an increase in sovereign debt levels – already at record highs in many countries before the crisis. Another problem faced in this context is the lack of transparency in reporting non-performing loans, delayed management of distressed assets, and tighter or no access to credit for the most vulnerable households and businesses.

To tackle the situation, the World Development Report has identified several priority areas for action, including early detection of financial risks. Since few countries have the fiscal space and capacity to address all challenges simultaneously, it outlines how countries can prioritise resources depending on their context.

According to the report, surveys of businesses in developing countries during the pandemic revealed that 46 percent expected to fall into arrears. Loan defaults could sharply increase, and private debt could quickly become public debt, as governments provide support. Despite the severe contraction in incomes and business revenues resulting from the crisis, the share of non-performing loans remains largely unimpacted and below expectations. This may be due to forbearance policies and relaxed accounting standards that are masking significant hidden risks that will become apparent in the coming days.

The way out, as suggested by Senior Vice President and Chief Economist of the World Bank Group, Carmen Reinhart, is to plan ahead and take targeted action to support a healthy financial system that can provide the credit growth needed to fuel recovery. If this is not done, the hardest hit will be the poorest and most vulnerable sections of the population.

The report also calls for the proactive management of distressed loans. Many households and firms are confronted with unsustainable levels of debt due to lower income and revenue. According to the report, effective insolvency mechanisms can help avoid the risk of long-term debt distress and lending to ‘zombie’ firms that undercut economic recovery. Improving insolvency mechanisms, facilitating out-of-court workouts, especially for small businesses, and promoting debt write-off can help enable the orderly reduction of private debts.

Especially, in low-income countries, high levels of sovereign debt need to be managed in an orderly and timely manner. The historical track record shows that delays in addressing sovereign debt distress are associated with protracted recessions, high inflation, and fewer resources going to essential sectors such as health, education, and social safety nets, with severe impact on the poor.

Equally important is the need to work toward inclusive access to finance to support the recovery from a historic pandemic. In low-and-middle income countries, 50 percent of households are unable to sustain basic consumption beyond three months. The average business reports that they only have cash reserves to cover two months of expenses.

Households and small businesses have been at greatest risk of being cut off from credit, although access to credit improves the resilience of low-income households and enables small businesses to navigate shutdowns, stay in business, and eventually grow and support the recovery.

In this connection, digital financial tools and products can play a critical role in assessing borrower risk and providing recourse in the event of default, thus improving management of credit risk, enabling lending, and fostering new economic opportunities. The World Bank report recommends that long-term policy reforms are necessary to achieve an equitable recovery and they also offer governments and regulators an opportunity to accelerate the shift toward a more efficient and sustainable world economy. The World Bank report has special importance for countries like Pakistan which are in the process of creating a social safety net for the weaker sections of society.