The great reallocation

Op-ed from Mr Agustín Carstens, General Manager of the BIS, for Project Syndicate,12 October 2020.

In the first several months of the COVID-19 crisis - the acute phase - the main economic fallout was a liquidity crunch, which governments countered with aggressive monetary and fiscal stimulus. But now, as the pandemic has dragged on, the crisis is moving to a new phase, marked by significantly higher solvency risks for firms. Policymakers face a dilemma: How can they support needy businesses without propping up those that are not viable? 

Initial emergency measures certainly did as much as could have reasonably been hoped, if not more. Firms have remained largely solvent, and jobs and wages have been protected, with fewer corporate bankruptcies in the first half of 2020 than in the previous five years.

As it stands, market indicators suggest that investors expect defaults and insolvencies to remain low. But this might be wishful thinking: Historically, there is a lag between declining GDP growth and rising bankruptcies and unemployment, which tend to peak a year after the initial shock and remain high for another two years.

Without additional policy support, the world may be headed for just such a future. The Bank for International Settlements estimates that bankruptcies among advanced-economy firms could rise by more than 20% (from the 2019 baseline) next year.

The message is clear: policymakers must offer continued support to businesses, in order to prevent a costly wave of closures and insolvencies. But precisely what kind of support is needed?

To answer that question, policymakers must first recognize that the economic landscape may have fundamentally changed. It is well known that during the pandemic, the adoption of digital technologies, such as in e-commerce, has accelerated significantly. This trend is unlikely to be reversed.

In fact, consumer attitudes and spending behavior may never return fully to pre-pandemic patterns. More people are likely to work remotely, even after social-distancing protocols are a thing of the past. And they may travel, shop, or eat out less, well into the future.

While such shifts in economic activity will strengthen some sectors, they will also turn once-thriving businesses into deadwood. And if policymakers prop up such businesses, they could add pressure on the financial sector and ultimately bring about an even larger economic contraction and higher job losses.

Determining whether a firm merits additional relief will not be easy. Pre-crisis performance alone will not provide an accurate guide. And the economic outlook remains highly uncertain.

But while there is no perfect method for identifying which firms are viable in the long run, banks - which have plenty of experience carrying out such assessments to guide their lending - can offer valuable insight. And banks themselves will need to discontinue lending to unprofitable firms in some cases, even if that means incurring losses.

However the reallocation of resources is carried out, it is clear that, during this protracted phase of the crisis, policymakers can no longer depend solely on fiscal and monetary stimulus. Structural reform and targeted support are also needed.

The challenge is twofold. First, businesses that can succeed in this new economy need help - including help formulating effective strategies - as they undergo debt restructuring and repair their balance sheets. To this end, broad-based fiscal measures could be scaled down, in favor of financial support for firms that have accumulated unsustainably large debts, but are likely to remain viable in the long term.

Second, policymakers must encourage and enable businesses in the most severely damaged sectors to reallocate their resources toward those sectors that are more likely to thrive in the post-pandemic economy. Just as governments have worked over the years to make launching a business easier, they now must simplify the process of unwinding failed enterprises. The faster resources are freed up, the sooner they can be channeled toward growth-enhancing activities.

Streamlining bankruptcy procedures and labor regimens could be helpful here. Incentives for firm-level restructuring are also essential. As for displaced workers, policymakers can provide incentives and opportunities for them to acquire the skills they need to shift to more dynamic sectors.

To steer the reallocated resources - including human capital - toward sectors that will genuinely benefit the national economy in the long term, policymakers should consider formulating forward-looking industrial strategies (where they don't already exist) that foster investment in infrastructure, climate-friendly industries, and health care. At the same time, reaping the benefits of technological innovation requires a favorable regulatory and legal environment, including adequate property rights, and a financial system that provides the necessary equity financing.

This unprecedented reallocation will require concerted action by all stakeholders, private and public, including debtors, creditors, central banks, fiscal authorities, and many other governmental agencies, such as tax authorities, courts, social security administrations, labor departments, and subnational governments. International coordination will also be essential. It is thus vital that governments resist the siren song of protectionism.

Economic growth will eventually return. But its engines will not be the same as before the pandemic. The sooner policymakers recognize this and develop targeted economic-support strategies - which must include a heavy dose of structural reform - the faster, stronger, and more resilient the recovery will be.