the massive monetary policy response to the pandemic. As the economic recovery proceeds and stimulus measures are gradually withdrawn in advanced economies, interest rates will rise. This increase could threaten the solvency of firms, financial institutions, and governments in emerging economies that have benefited from short-term financing at low interest rates and will face higher refinancing costs going forward. Rising interest rates in high-income economies will also put pressure on the currencies of emerging economies, which increases the financial burdens faced by firms, financial institutions, and governments that have debt denominated in a foreign currency. In addition to a less benign interest rate environment, the recovery in emerging economies will also be affected by the lower growth of the world economy. In the aftermath of the global financial crisis, low-income economies were only moderately affected, largely due to robust growth in important emerging markets, particularly China, which accounts for a sizable share of bilateral lending and direct investment in low-income economies. By contrast, the economic effects of the COVID-19 crisis have been felt globally, and lower economic growth in China and other emerging markets could affect low-income countries through several channels, including commodity prices and a reduction in bilateral lending and direct investment.
Conclusion Although the immediate crisis response, which included extensive efforts to provide households and firms with liquidity, was essential to mitigate the hardships caused by income losses from the pandemic, few governments have the resources to sustain these programs until economic activity has fully recovered. This gives rise to the possibility that risk spillovers among the household, firm, financial, and government sectors of the economy will aggravate preexisting economic fragilities and pose a threat to an equitable recovery. Interconnected risks to the recovery are a concern, especially in emerging economies where such fragilities were already more pronounced at the onset of the pandemic. Well-designed fiscal, monetary, and financial sector policies can help reduce these risks and prevent them from affecting the wider economy. The following chapters explore the primary risks that affect each of the main sectors of the economy and propose policies that can counteract these risks with the goal of supporting an equitable recovery. Beginning with the concern that many households and firms will continue to face income losses resulting in loan defaults once debt moratoria are lifted, chapter 2 turns to the risk to the financial sector posed by uncertainty about the true extent of credit risk and the quality of assets on the balance sheets of financial institutions. The chapter examines the steps regulators can take to proactively increase transparency about credit risk and deal with distressed assets and, if necessary, troubled banks. Chapter 3 takes a closer look at how the establishment and reform of insolvency frameworks can help the recovery by allowing private sector borrowers to reduce their debts to sustainable levels. Chapter 4 then explores how financial institutions can continue to provide credit to households and firms through the recovery. It focuses on approaches to managing and mitigating risks in the face of heightened economic uncertainty, which limits the ability of lenders to form an accurate assessment of credit risk and reduces the recourse they have in the event of default. Chapter 5 discusses the risks posed by the dramatic increase in levels of government debt and describes policies that can improve debt management and avoid debt distress. Chapter 6 concludes the Report by outlining policy priorities for the recovery.
EMERGING RISKS TO THE RECOVERY | 71
