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Equity interventions by governments, rather than large loans, could help prevent financial instability across Latin America.

Amid the devastation caused by Covid-19 to global health and economic activity, there is a growing awareness that pandemic-related lockdowns and corporate bankruptcies will have a serious impact on global banks. 

But emerging market (EM) banking systems are in an even more vulnerable position. Fiscal packages of 9% of gross domestic product (GDP) on average were announced in advanced economies to assist households and firms, but they are much smaller in other countries – around 3% of GDP on average in Latin America and the Caribbean, for example. Standard & Poor’s cited deteriorating asset quality, a heavy dependence on external funding and a lack of government support as the three main drivers for placing as many as one third of EM banks on negative watch.

Moreover, recent statistics on asset quality underestimate the problem. In many EMs, banks have reprogrammed loans with long grace periods. Given the large losses to borrowers’ income, credit risks have risen and yet these loans typically continue to be reported as performing. The quality of banks’ loan books is becoming more and more uncertain.

There are also challenges related to large public loan guarantee programmes announced in some countries. Fearing fiscal liabilities, and legal risks for public officials, partial guarantees are the norm. But the high perceived credit risk has meant banks have been unwilling to lend; take-up of these guarantees has been limited. 

We have analysed these and other issues in a recent report which provides recommendations for policy-makers in Latin America and the Caribbean, based on the deliberations of a highly qualified expert group, but which are also relevant for other EMs.

A key conclusion is that loan guarantees may not be the right instrument for most EMs, as many are made up of small, family-owned firms which are often not fully formal. To support these firms, and assuming there is fiscal space, small grants might be a more appropriate instrument. 

To ensure such programmes stimulate activity, rather than allow unproductive firms to persist, grants should be accompanied by a system to gather information about the performance of grants’ recipients. And where it is revealed that a firm is no longer viable, the support should be curtailed. If the firm supports poor families, the grant could morph into an existing social transfer programme.

Government equity support

Given the level of uncertainty caused by Covid-19, government support through equity (or an equity-like instrument) might be preferable to loans for larger, formal firms. Leverage has risen significantly across EM corporates and more debt may be counterproductive. Equity injections would provide the public sector with upside as well as downside risk, potentially minimising fiscal losses. 

But public equity injections have had a mixed record at best. In those countries that have public development banks with adequate governance, these institutions could be retrofitted to undertake this function. Or public-private councils could be developed to guide investment decisions towards viable firms rather than those that are politically connected. The World Bank’s International Finance Corporation and the private sector arms of regional development banks could provide funding and advice on how to adapt current institutions, or design new ones to guard against cronyism and corruption. This proposal might also provide a useful conduit to ensure good corporate governance, lacking in many countries.

Finding the right approach to support viable firms is critical to reduce the economic costs of the crisis, support employment and limit losses to banks. It is more efficient to assist firms, ex ante, than face widespread defaults and be forced to support banks ex post. Still, the economic fall-out may entail the resolution of weaker banks. Many emerging economies have improved frameworks, although work remains to ensure they are fully operational and ensure adequate legal protections for bank supervisors.

Emerging markets, and especially those in Latin America, are now the epicentre of the pandemic; the health and economic crisis is far from over. The longer the crisis persists the higher the risk to banks. Financial instability would only trigger even greater suffering especially for the most vulnerable. EM banks came into this crisis with high liquidity and capital buffers, but to ensure they can play a constructive role in the recovery, policy-makers will have to navigate the coming months very carefully, taking great care to employ limited resources in the most effective manner and ensure crisis does not beget crisis.

Andrew Powell is the principal advisor of the Inter-American Development Bank’s research department and the former chief economist of the Central Bank of Argentina. Liliana Rojas-Suarez directs the Latin America Initiative at the Centre for Global Development and is a former senior official at the International Monetary Fund.

This article first appeared in the November edition of The Banker magazine. View a digital edition here.

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