South Asia Must Reform Debt-Accumulating Banks and State-Owned Enterprises to Avoid Next Financial Crisis
WASHINGTON, June 29, 2021-South Asia’s heavy reliance on state-owned commercial banks, state-owned enterprises, public-private partnerships and other national and subnational public entities masks its vulnerability to the accumulation of levels unsustainable debt, according to a new World Bank report, Hidden debt: solutions to avoid the next financial crisis in South Asia, released today.
South Asia is more exposed to the risk of âhidden debtâ of state-owned commercial banks (SOCBs), state-owned enterprises (SOEs) and public-private partnerships (PPP) due to its greater reliance on them compared to other regions. But the report offers key areas for concrete policy actions and reforms that can help governments leverage public capital more responsibly through these types of entities to advance economic development.
âThe COVID-19 pandemic has highlighted rising levels of public debt in South Asia. The region is more exposed to the risk of hidden debt because it depends heavily on the involvement of governments in the markets to help economic development, said Hartwig Schafer, World Bank Vice President for South Asia. “But the crisis demonstrates the critical importance of the wise use of public debt-financed commitments and debt transparency to build back better, more sustainably and more equitably.”
Hidden debt examines the trade-offs between addressing development challenges directly through the presence of the state in markets and the risk of accumulating high levels of debt due to the economic inefficiencies of off-balance sheet operations. It focuses on SOBCs, state-owned enterprises, and PPPs and their contingent liabilities – obligations that governments incur off their balance sheets that have payment triggers. Over time, some of the debt comes to light as it hits the central government budget and outstanding debt, but much remains hidden under the radar of existing financial disclosure standards.
“The efficiency of South Asian state-owned banks and other state-owned enterprises is far below the international benchmark,” mentionned Hans Timmer, World Bank Chief Economist for South Asia. “As governments recover from the shock of the COVID-19 pandemic and work to avoid future financial crises, they should clearly separate the social and business goals of these companies in order to reduce inefficiencies, while maintaining socially beneficial investments. “
Governments often promise grants to public enterprises to run programs such as improving access to electricity for underserved populations and small businesses. SOCBs are asked to run government programs to promote financial inclusion or lend to underserved or riskier small and medium businesses, often without compensation for losses that private markets avoid. They are also asked to stimulate economies in times of downturn or to financially support large PPPs which have concentrated the risks. These hidden mandates are based on requests that are often ad hoc and without consideration of risks or costs.
âIn episodes of systemic shock – such as the global financial crisis or the COVID-19 pandemic – when many banks are struggling simultaneously, private banks deleverage and reduce their lending, while state-owned commercial banks receive government debt and capital support to continue or increase lending, ‘said Martin Melecky, chief economist of the World Bank and author of the report. “But this short-term stabilization function has the effect of crowding out other social spending, as public funds are spent on bank recapitalization and poor credit allocation, away from successful businesses and especially small and medium-sized ones. companies, allowing for an uneven recovery. “
The report estimates that a systemic macro-financial crisis can trigger PPP failures that would cost South Asian countries more than 4% of revenues, and the potential costs of struggling state-owned enterprises have been even more crushing. In Pakistan, the total liabilities of chronic loss-making state-owned enterprises have stood at 8-12% of GDP in recent years, several times higher than the country’s public expenditure on education in fiscal years 19-20. In Sri Lanka, the liabilities of loss-making public enterprises represent around 4-5% of GDP. In each country studied, the top 10 loss making public enterprises account for more than 80% of the total losses in the public enterprise sector.
Distressed public officials at the subnational level also inflict substantial costs on the real economy and local businesses. When a subnational government is affected by a contingent liability shock, local investments suffer for several years. For example, local investment in Indian states drops dramatically in the year of a contingent liability shock, continues to decline the following year, and remains well below trend for three years after the event.
These downside risks associated with raising public capital can be mitigated and the upside benefits enhanced through four key reform avenues:
- Goal. Clearly define the goal SOCBs, public enterprises and PPPs by specifying their social mandates in relation to commercial mandates.
- Incentives. Structure institutions, rules and contracts in a way that creates incentives perform in a manner consistent with the defined objective. It is important to note that the nature and extent of the operational costs of SOCBs, SOEs, and PPPs – which often exceed market costs – need to be determined and linked to the government’s fiscal and debt management frameworks from the outset. the start so that central governments can apply greater financial discipline – including through tight budgetary constraints.
- Transparency. Ensure debt transparency and data collection so that central and subnational governments can understand how SOCBs, state-owned enterprises and PPPs shape fiscal space and contribute to overall public debt, including direct obligations and explicit and implicit guarantees. Economic transparency is also needed, starting with public disclosure of the purpose of SOCBs, SOEs and PPPs, the theory of change that underpins their operations, and strong monitoring and evaluation frameworks to demonstrate their impact on the development.
- Responsibility. Engage financial markets, industry associations, media and civil society to demand the responsibility government to leverage the accountability of public capital in its off-balance sheet operations so that it cannot use them for personal political interests or side deals.