From protection to reallocation: Public credit guarantee schemes in the post-pandemic world

Public credit guarantee schemes (PCGSs) have been one of the main policy tools to alleviate the liquidity shock faced by firms during the COVID-19 outbreak and associated lockdowns. Governments in advanced economies as well as in emerging markets and developing economies (EMDEs) have mobilized unprecedented credit-risk mitigation support to get emergency bank lending flowing to firms. The primary objective of these interventions has been to protect firms and jobs.  

With economies approaching the recovery phase, bolstered by recent progress on vaccines, the challenge for governments will be to shift focus from protection to reallocation of capital and labor in a context where firms are still struggling. Many will be insolvent or nonviable, others will find it difficult to obtain credit—especially if a credit crunch kicks in—and governments will face the grim reality of limited fiscal resources.  

In such an environment, PCGSs can still play an important role in enabling the flow of credit to the productive sector.  Yet their strategic and operational framework will need to adapt to ensure they generate the expected impact while remaining financially sustainable.  

Here is a three-point plan on how PCGSs could support resource reallocation: 

1. Dealing with defaults. While borrowers’ defaults have not been observed on a large scale yet— especially because of unprecedented fiscal and monetary measures as well as widespread forbearance—that will change once stimulus measures phase out and lenders reclassify loans more conventionally. Under the circumstances, PCGSs will be facing significant payment demands from lenders for the (very high) share of loans guaranteed during the outbreak phase of the crisis. Unless PCGSs have waived their right of subrogation, they will take on all the rights that the lenders had against the borrowers for reimbursement. For nonviable firms that defaulted on their loans, PCGSs should try to maximize recovery of funds. For viable firms, PCGSs could offer to convert guaranteed loans into equity or quasi-equity instruments and transfer the exposures to other existing public institution (such as development banks) or newly established specialized investment vehicle, which can better manage those positions. For smaller firms, quasi-equity in the form of, for example, a future tax obligation might be a preferred option, given the high costs of monitoring an equity investment. 
    
2. Targeting new business. For viable firms with a solid capital structure, PCGSs remain the most efficient and potentially most effective government intervention to ease access to credit constraints. However, compared to the exceptional operational design features implemented during the outbreak phase, PCGSs should go back to “normal” to minimize moral hazard. This implies revising eligibility criteria to include only specific target groups (such as viable firms with little debt), lowering coverage rates to more traditional levels (for example, between 50 percent and 80 percent, depending on delivery modalities and leverage), and adopt risk-based pricing. It also implies restoring high standards of corporate governance and prudential regulation to maintain confidence and credibility. For viable firms with a weak financial profile—a likely dominant feature of the post-pandemic world—PCGSs could help rebalance firms’ capital structure by scaling up the provision of equity guarantees to cover initial capital investment losses for investors providing equity or quasi-equity such as private equity funds and venture capitalists. However, it is important that this process goes together with internal capacity building to properly identify and manage risks. 
    
3. Supporting green recovery. Post-pandemic recovery programs offer a unique opportunity to address the existential challenges posed by global warming and rebuild climate-resilient economies.  Many governments have designed or are in the process of designing strategies to green their economies. PCGSs can play a pivotal role in redirecting financial flows toward low-carbon activities, yet dedicated guarantee programs will need to be designed and implemented. In time, PCGSs could gradually converge toward an entirely green-oriented business model and provide green guarantees only. Green PCGSs such as the one piloted by Switzerland since 2015 or that recently announced by Sweden can help firms access the capital needed to finance investment in greenhouse gas-emission reduction technologies, supporting the transition to a low-carbon economic model. In so doing, PCGSs can represent a critical policy tool to meet countries’ intended nationally determined contributions.  

We are in the midst of a major transformation. While significant uncertainty around the pandemic’s trajectory remains, fiscally constrained governments in the post-COVID-19 world will face the formidable challenge to promote orderly debt resolution while preserving the ability of the financial sector to sustain lending and support green investment and recovery. PCGSs can play an important enabling role on both fronts, but their strategy and operations need to be retooled while building institutional capacity. The time to act is now.