5.3. Efficiently choosing policies that achieve the food and fuel goals

Adalet McGowan et al. (2018) show that market congestion due to an increase in zombie lending is associated with lower investment and employment growth.

This puts a premium on policy action to support timely identification and management of NPLs. Regarding the former, there is currently lack of a transparency about the build-up of credit risks in financial institutions’ balance sheets and the true health of the financial sector (WDR, 2022). Research has shown that recognizing and provisioning for loan losses reduces zombie lending as it removes the incentive to hold on to these loans (Bonfim et al. 2020). Hence, strengthening supervisory policies to ensure transparent and timely reporting of bank asset quality is an essential first step to understanding and managing the pressures on banks and the financial system from rising nPL problems. Although the current risks of credit misallocation are largely the result of the pandemic crisis support measures (for example, regulatory forbearance and repayment moratoria), these risks can be amplified in countries with weak financial institutions. Acharya et al. (2017) show that under-capitalized financial banks are more prone to zombie lending, so as to avoid incurring losses on their portfolios. Therefore, supervisory authorities should ensure that banks maintain sound capital positions and provision adequately for loan losses on a forward-looking basis.

Effective insolvency frameworks are an integral part of the policy arsenal needed to mitigate the risks of credit misallocation. The effectiveness of efforts to manage nPLs is limited if insolvency frameworks are hostile to efficient corporate restructuring. That is, the faster the process of corporate restructuring and exit (and thus the resolution of nonperforming loans) is, the sooner the resources tied to the failing firm can be reallocated to more productive uses. for example, Andrews and Petroulakis (2019) show that improvements in a bank’s financial condition—making it better able to absorb losses resulting from writing off non-performing loans—are more likely to be associated with a reduction in the prevalence of zombie firms where insolvency regimes facilitate restructuring. Consolo, Malfa, and Pierluigi (2018) provide evidence that better insolvency frameworks lead to faster NPL reductions and to lower NPL increases during economically turbulent times. Insolvency systems remain at early stages of legal and regulatory maturity or rely on suboptimal institutional settings in many countries around the world (Menezes and Muro, 2022).

Fostering credit to the private sector to ensure adequate support of economic activity. As discussed earlier, rising corporate, sovereign, and financial sector vulnerabilities could all be associated with a more challenging landscape for private sector financing. As discussed earlier, the depth and structure of financial systems vary widely in the EAP region, indicating that the challenges of access to finance will also vary across countries. While some countries have relatively shallow financial systems, others have under-developed (or non-existent) equity markets, and are thus dependent on debt financing for the private sector. Research has provided evidence that access to diversified sources of financing in particular can improve firm resilience and help firms better cope with shocks. firms with limited access to multiple sources of financing are more prone to the effects of adverse supply-side shocks, such as those associated with tighter financing conditions (Becker and ivashina, 2014). Larger firms are typically those with better access to markets and thus are better able to cope with such shocks, especially publicly-listed firms with access to capital markets (Cortina et. al, 2021). for smaller firms dependent on banks for external financing, small fluctuations in bank credit can have sizeable effects on their investments and productive growth. Unlocking firm financing through deeper and more diversified financial systems can thus support private sector resilience and development.

Regarding both food and fuel, EAP governments must meet the triple goals of affordability, security, and sustainability. in both cases, the political imperative today is to prioritize affordability for consumers and firms. This goal is being pursued by keeping consumer prices low through food and fuel subsidies as well as export restrictions. These measures provide relief to consumers and producers, and may be the only immediately feasible measures, but they have economic costs even when they are temporary. They shrink fiscal space, inhibit switching of consumption to cheaper commodities,