A. Reinforcing Private Debt Resolution Frameworks to Flatten the Insolvency Curve

The initial policy response to the COVID-19 shock included interim measures to reduce the filing of new insolvency cases in most countries in the region The pandemic has temporarily reduced the activity of courts and the number of new insolvency cases. In addition, some countries (e.g., Singapore, Australia, India) suspended wrongful trading liability of directors to avoid premature insolvencies.⁶ A few countries have also implemented moratoria on debt enforcement activities, including for insolvency cases. For instance, in India the moratorium on insolvency cases has been absolute, with the courts not even taking voluntary cases, i.e., cases initiated by debtors. While serving as a stop-gap response to an unprecedented shock, these measures are not sustainable as they interfere with the rights of creditors to recover their loans and delay necessary corporate restructuring and resource reallocation.

Authorities should prepare now to scale back these measures in the recovery phase so that the solvency problems of enterprises can be addressed expeditiously. Actions will depend on the severity of the economic downturn and the potential number of insolvencies, and on each country’s institutional capacity to deal with a surge of insolvency cases. Information from applications for financial support by firms can help gauge the likely extent of corporate sector distress once liquidity support is scaled back and other interim measures are removed. In parallel, policymakers should identify remaining weaknesses of their insolvency regimes, and address them in anticipation of a significant increase in insolvency cases. This includes allocating resources to expand the capacity of the court system and other relevant institutions, bearing in mind that substantial increases in court capacity are achievable only in the medium term.

The policy objective should be to “flatten” the insolvency curve so that courts are not overwhelmed once interim measures are lifted. The fundamental function of insolvency systems is to rescue viable enterprises and reallocate the resources of non-viable enterprises to more productive uses. A sudden wave of insolvency cases can prevent the courts from fulfilling this function. Where insolvency cases are likely to surge, a “transition phase” may be needed involving a series of special mechanisms, such as out-of-court or hybrid restructuring procedures, that allow for corporate debt restructuring without or with much-reduced court involvement (Liu, Garrido and DeLong, 2020). This approach effectively “flattens” the insolvency curve by reducing the number of cases adjudicated by the courts to a level that is commensurate with their administrative capacity, while ensuring that corporate financial distress is addressed expeditiously (Chart IV.1).

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Flattening the Insolvency Curve

Citation: IMF Working Papers 2021, 016; 10.5089/9781513568096.001.A001

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The process of flattening the insolvency curve should start with a “triage” of insolvency cases. The triage process would seek to identify viable firms experiencing relatively straightforward financing problems and address them through informal out-of-court debt restructuring or hybrid restructuring that requires little court involvement. This would leave the court system to focus mainly on firms with major viability problems, which require a formal bankruptcy proceeding to achieve financial restructuring and operational reorganization (Figure IV.2). Separately, in some cases, authorities may identify insolvent firms that merit preservation because of their social or strategic role. These firms, which may be state-owned or private, should be dealt with separately through the provision of fiscal solvency support.

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Decision Tree for the Triage of Enterprises in Distress

Citation: IMF Working Papers 2021, 016; 10.5089/9781513568096.001.A001

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Performing a triage in the current environment will be challenging as the pandemic is altering business models in many sectors. The triage can start with an analysis of firms’ financial condition immediately before the pandemic, where a record of sustained profits would be a sign of potential viability. As the pandemic evolves, additional indicators of viability can be developed, including those differentiated by economic sectors and the age of firms. Performance under health restrictions, and projections that take the expected duration of such restrictions into account, can also be integrated into the viability analysis.

Relatively straightforward financial restructuring cases for viable firms should be resolved using special out-of-court mechanisms. Country experience shows that enhanced out-of-court restructuring mechanisms can provide a cost-effective, market-friendly and speedy alternative to formal insolvency proceedings, which can play an important role in a crisis when caseloads rise sharply. In the 1997/98 Asian financial crisis (AFC), the capacity of the insolvency systems in many of the affected countries was minimal. Insolvency laws were often weak and court systems unprepared to resolve complex cases. Because improvements of the legal framework and court capacity take time, several countries (Indonesia, Korea, Malaysia, and Thailand) established special out-of-court debt restructuring mechanisms to tackle corporate distress. This is generally the most effective solution to overcome a gap between court capacity to handle cases and the number of firms that need financial restructuring (Garrido, 2012). Out-of-court mechanisms also fit well into the legal culture in Asia and the Pacific, which tends to prefer negotiated solutions over litigation (Tomasic and Little, 1998).

Out-of-court restructuring mechanisms require a number of features to be effective. They should be market driven but can also benefit from some government involvement, including possibly the provision of financial, regulatory, or tax incentives. General protocols of debt restructuring principles or master restructuring agreements can be employed to foster creditor participation, while restructuring experts can provide support in the out-of-court process and disputes can be resolved through mediation or arbitration. Stand-by agreements can ensure that participating creditors and the debtor abstain from taking actions that alter the relative positions of creditors in the restructuring process. Finally, the option to initiate a fast-track insolvency case (“pre-pack”) to obtain a prompt and binding judicial confirmation of a proposed restructuring plan can help deal with situations where holdout creditors hinder agreement (Box 1).

Efficient out-of-court restructuring for SMEs may require a more standardized approach. Large numbers of distressed SMEs can create immense pressure on court systems, even where a simplified treatment of smaller claims exists. A special out-of-court restructuring regime for SMEs can help avoid such an outcome, and several countries in the region already have them in place (Japan, Korea, Malaysia, Thailand). These mechanisms are less complex than those designed for large corporates and often feature support to entrepreneurs by the government through advisory services and financial programs.⁷ However, the capacity to provide such support may need to be scaled up if there is a sharp increase in insolvency cases. A more aggressive approach could be based on standardized solutions (i.e. restructuring plans which are adjusted to reflect some basic characteristics of each debtor), which can accelerate the restructuring of elevated numbers of SMEs. On the spectrum of restructuring approaches, standardized solutions fall between tailor-made solutions and across-the-board measures, such as general moratoria or general debt forgiveness.⁸ They can be adapted to the circumstances of each case and offer a less precise, but simpler and less costly solution than restructurings based on individualized viability analysis.⁹

Effective insolvency frameworks are necessary to tackle more complex cases Special, temporary out-of-court restructuring mechanisms can facilitate the restructuring of viable enterprises without overwhelming the court system. However, court-led insolvency procedures are also necessary to allow for the reorganization of viable enterprises that require more extensive restructuring. Countries should assess their insolvency systems against international standards to identify gaps for improvement.¹⁰ Some of the features of effective insolvency systems that would be most relevant in the context of this crisis include the following:

• Debtor-in- possession (DIP) reorganization —Debtors should be allowed to continue managing their businesses while in reorganization. This creates a strong incentive for debtors to use the process at an early stage, instead of delaying until the only option available is liquidation. Most Asian systems have incorporated debtor in possession proceedings, but there are exceptions (India) and also cases where practical implementation could be improved (China).

• Post-petition finance One of the main reasons for the failure of reorganizations is the lack of financing for enterprises that have entered insolvency proceedings. Enabling such financing requires giving priority to the providers of fresh funds, with safeguards for existing creditors. Many Asian countries give priority to post-petition financing (China, India, Japan, Korea), but others do not (Indonesia) or lack specific rules (Vietnam). Legislation is necessary but not sufficient as banks and other financial institutions must be incentivized to provide this financing. Even with this priority claim, the regulatory framework can discourage them from lending to companies undergoing reorganization (see next section). Less constrained, specialized distressed assets funds increasingly provide this financing, especially in large markets, such as China and India, which have the scale to attract these funds.

• Hybrid restructuring procedures—Hybrid insolvency procedures combine informal negotiations between debtors and creditors and minimal judicial intervention in the form of a stay of creditor actions and the confirmation of plans. Procedures include “pre-packaged” and “pre-arranged” plans that benefit from fast court approval if agreed with creditors (already in use in Japan, Korea, the Philippines, and to a lesser extent, in China), as well as preventive insolvency procedures, e.g. those put in place after the European crisis by France, Italy, Spain, and more recently, the UK. These procedures reduce the intervention of the courts, allowing the insolvency system to deal with other cases. For example, intensive use of pre-packaged and pre-arranged plans can be equivalent to a five-fold increase in judicial capacity.^{11 12} Some Asian countries, such as Indonesia, India, and Thailand, would benefit from the use of prepackaged plans to accelerate corporate debt restructuring. Other countries with the common law tradition could improve the features of their schemes of arrangement by enabling a wide stay of creditor actions and cross-class cramdown of plans (Australia, Sri Lanka).¹³

• Simplified regime for micro- and small enterprises—The growing trend towards simplified insolvency procedures for SMEs reflects the problem that general insolvency procedures are often too complex and costly for their needs (see Bergthaler et al., 2015). Simplification and cost-reduction may be necessary for SMEs as insolvency procedures were designed primarily for larger enterprises in mind. In Asia, Japan, Singapore, Thailand, and Korea have introduced special procedures for small enterprises. Australia is in the process of doing so.

• Specialization of judges and insolvency professionals—Increasing specialization of the judiciary, including through the creation of dedicated insolvency courts as in China, India, Korea and Thailand, should be part of the long-term strategy to strengthen insolvency systems. For most countries, building a robust insolvency profession is still a work-in-progress. India has established a strong structure for the regulation and qualification of insolvency professionals, and other countries could follow suit.

• Use of technology and data— Greater use of technology in the insolvency process, such as through electronic case management; electronic communications; virtual meetings and hearings, can also help increase efficiency and capacity. Countries should also devote resources to the collection and analysis of insolvency data to help assess performance and support the design of reforms to address remaining shortcomings (Garrido et al., 2019).

The insolvency regime will also perform the function of liquidating non-viable enterprises. However, at this stage of the crisis, the emphasis should be on the reorganization of viable enterprises as there is typically a narrow window of opportunity for reorganization, and the liquidation of viable enterprises has high economic costs (Bernstein et al., 2019a and 2019b).

With these broad principles as a guide, countries in Asia and the Pacific should take further steps now to strengthen their insolvency frameworks. While many countries now have modern court-based insolvency procedures in place, effective out-of-court restructuring mechanisms are currently only available in some economies (Table IV.1). Malaysia and Korea have preserved the special restructuring mechanisms put in place during the AFC, while Japan has over the years developed robust informal restructuring practices. These countries can use their established restructuring mechanisms to increase the capacity of their insolvency systems if needed. Indonesia and Thailand should consider restoring and upgrading the special restructuring frameworks they used on a temporary basis during the AFC. Other countries can take steps to strengthen informal restructuring mechanisms they have put in place in more recent periods (e.g., India and China).

^{Table IV.1.}

Insolvency Regimes in Asia and the Pacific: Available Tools for Restructuring and Reorganization

^{Table IV.1.}

Insolvency Regimes in Asia and the Pacific: Available Tools for Restructuring and Reorganization

	Out-of-Court		Hybrid	In-Court
	Enhanced Restructuring	SME debt restructuring	Hybrid Restructuring/Pre-packs	Reorganization	SME Simplified Reorganization
Australia			✓	✓
Bangladesh			✓	✓
China	✓		✓	✓
Hong Kong SAR			✓
India				✓
Indonesia				✓
Japan	✓	✓	✓	✓	✓
Malaysia	✓	✓	✓	✓
Philippines	✓		✓	✓
Singapore		✓	✓	✓	✓
Korea	✓	✓	✓	✓	✓
Sri Lanka			✓	✓
Thailand		✓		✓	✓
Vietnam				✓

View Table

^{Table IV.1.}

Insolvency Regimes in Asia and the Pacific: Available Tools for Restructuring and Reorganization

	Out-of-Court		Hybrid	In-Court
	Enhanced Restructuring	SME debt restructuring	Hybrid Restructuring/Pre-packs	Reorganization	SME Simplified Reorganization
Australia			✓	✓
Bangladesh			✓	✓
China	✓		✓	✓
Hong Kong SAR			✓
India				✓
Indonesia				✓
Japan	✓	✓	✓	✓	✓
Malaysia	✓	✓	✓	✓
Philippines	✓		✓	✓
Singapore		✓	✓	✓	✓
Korea	✓	✓	✓	✓	✓
Sri Lanka			✓	✓
Thailand		✓		✓	✓
Vietnam				✓

For countries where insolvency practice is minimal, a different restructuring approach is required. Filling all the gaps of the legal and institutional framework will generally not be possible in time to address cases of corporate financial distress caused by the pandemic. Countries without a functioning insolvency system should instead concentrate on supporting the solvency of strategic enterprises and setting up special restructuring mechanisms for both larger companies and SMEs. A longer-term strategy would require the revision of insolvency laws and the strengthening of the courts and insolvency profession.

B. Ensuring Adequate Financing to Support Corporate Restructuring and the Recovery

Successful corporate restructuring is critically dependent on the availability of fresh financing. Banks will have to play a critical role in providing such financing given their still dominant role in most financial systems in Asia and the Pacific, especially in emerging and low-income economies.

Authorities should use the flexibility built into existing regulatory and supervisory frameworks to avoid a procyclical credit contraction in the pandemic (IMF and World Bank, 2020a). Supervisors have encouraged banks to work with affected borrowers to prudently restructure loans for viable firms and individuals impacted by the crisis. They can clarify how banks should assess loan performance in the current environment, prudentially treat restructured loans, and estimate credit losses, building on guidance issued by international standard-setting bodies. India has provided supervisory guidance regarding asset classification and loan provisioning to facilitate restructuring and resolution of corporate loans. In Korea, banks have bilaterally rescheduled principal and interest on loans amounting to about 4 percent of GDP (through August, 2020). Such bilateral loan rescheduling based on commercial criteria tends to be more targeted and less prone to moral hazard and credit misallocation than “blanket” moratoria. Supervisors should also intensify the on-site monitoring of asset quality to ensure that banks are prudently classifying loans and provisioning appropriately.

Easing of macroprudential policy settings may also be an appropriate response. This can help avoid an undue tightening of financial conditions for firms that could amplify the impact of the pandemic shock through adverse feedback interactions between the real and financial sectors (IMF 2020). Where appropriate, relaxing sectoral tools can help reduce financial distress and facilitate debt restructuring. In Asia and the Pacific, several jurisdictions have already eased policy settings by increasing loan-to-deposit ratios (Korea), reducing the required stable funding factor for short-term loans to individuals and businesses under the net stable funding ratio (Singapore), excluding central bank reserves from the calculation of the leverage ratio (Japan), and lowering the liquidity coverage ratio (Korea, Thailand).

Beyond these measures, ensuring that banks have capital well above regulatory minimums will be critical to support corporate restructuring and new lending. Experience from past crises suggests a positive link between bank capitalization and credit growth.¹⁴ Many of the region’s banks entered the pandemic in a strong financial position as regulatory reforms following the GFC have led to marked increases in the quality and quantity of capital and liquidity (Table IV.2). However, a few countries were already confronting asset quality problems before the pandemic hit (China, India). Amid heightened uncertainty about pandemic-induced credit losses, banks in the region may now face broader pressures to conserve capital by curtailing corporate lending.

^{Table IV.2.}

Capital Adequacy and Liquidity in Banking Sector: Selected Economies

1/ as of 2009 Q3 2/ as of 2017 Q4. 3/ as of end-2010. Sources: Financial Soundness Indicators and Haver Analytics.

^{Table IV.2.}

Capital Adequacy and Liquidity in Banking Sector: Selected Economies

	Tier 1 Capital Ratio		Liquid Assets to Short Term Liabilities
	GFC (2008)	COVID-19 (2019)	GFC (2008)	COVID-19 (2019)
Japan	9.1	15.1	43.31	47.8
Australia	7.1	13.1	27.5	34.2
Korea	8.8	12.9	102.5	101.22
Singapore	11.5	15.3	77.9	73.8
Hong Kong SAR	11.2	18.5	50.0	176.1
China	10.1	11.8	42.23	55.3
India	9.1	14.7	48.3	22.9

1/ as of 2009 Q3 2/ as of 2017 Q4. 3/ as of end-2010. Sources: Financial Soundness Indicators and Haver Analytics.

View Table

^{Table IV.2.}

Capital Adequacy and Liquidity in Banking Sector: Selected Economies

	Tier 1 Capital Ratio		Liquid Assets to Short Term Liabilities
	GFC (2008)	COVID-19 (2019)	GFC (2008)	COVID-19 (2019)
Japan	9.1	15.1	43.31	47.8
Australia	7.1	13.1	27.5	34.2
Korea	8.8	12.9	102.5	101.22
Singapore	11.5	15.3	77.9	73.8
Hong Kong SAR	11.2	18.5	50.0	176.1
China	10.1	11.8	42.23	55.3
India	9.1	14.7	48.3	22.9

1/ as of 2009 Q3 2/ as of 2017 Q4. 3/ as of end-2010. Sources: Financial Soundness Indicators and Haver Analytics.

A forward-looking diagnostic of potential loan impairments can help gauge possible capital needs of banks. Supervisors in many jurisdictions in Asia and the Pacific already conduct regular systemwide stress tests. These may need to be updated to reflect some of the specific characteristics and the intensity of the COVID-19 shock, including differentiated impacts across sectors and the prospect of depressed bank profits due to “low for even longer” interest rates in the aftermath of the crisis (Carletti et. al., 2020). The results from such pandemic stress tests will help reassess the risk that banks that currently appear solvent may need additional capital, both to meet prudential requirements and maintain adequate lending for the recovery.

Banks can use existing capital buffers to absorb possible losses from restructuring loans while maintaining lending. Prudential capital buffers under the Basel III framework are designed to be used in times of stress.¹⁵ Counter-cyclical capital buffers are most suited for release but in Asia and the Pacific only Hong Kong SAR had a non-zero buffer at the onset of the pandemic.¹⁶ While the capital conservation buffer (CCB) is not a releasable tool, banks can make use of the buffer on a temporary basis. However, even where regulators encourage banks to use the CCB or provide other temporary relief from capital requirements, banks may be reluctant to use these margins knowing that they will eventually have to return to their higher, steady state level of capital ratios (Blank et. al., 2020).

Consideration should be given to temporarily restrict capital distributions to preserve the level of capitalization in banking systems (Awad et. al., 2020). During times of stress, retained earnings are often a key channel for banks to increase capital (Cohen and Scatigna, 2016). The Basel standards already limit distribution of dividends, share buybacks, and discretionary staff bonus payments when capital buffers are drawn down. However, the uncertainty surrounding the impact of the pandemic shock provides an argument to restrict distributions even earlier, as the benefits from avoiding a credit squeeze due to capital shortages are likely to outweigh any costs of temporary overcapitalization (Blank et. al., 2020). Restrictions on capital distributions should apply to all banks to avoid stigma. Among the major economies in Asia and the Pacific, Australia, India, Korea, Singapore, Thailand, and Vietnam have issued recommendations or directives limiting or deferring dividend payouts following the COVID-19 shock.

The authorities can also provide incentives for banks to raise additional private capital. In times of stress, banks and investors are often reluctant to consider capital increases because financial markets tend to react negatively to new equity offerings. ¹⁷ Stigma can also be a concern. Authorities can try to address these collective action problems, using their convening power and supervisory dialogue to nudge banks to proactively increase capital buffers.¹⁸ A more forward-leaning approach would be to provide financial incentives such as matching public capital contributions at a low cost to compensate banks for the higher cost of raising private capital.¹⁹ Tax incentives can also be used to decrease the cost of equity financing, for instance, by allowing banks to deduct a notional return (interest) on their equity from taxable income.²⁰

A publicly funded bank recapitalization fund can serve as a useful backstop if capital cannot be immediately raised from private sources. The use of public funds for bank recapitalization should generally be considered as a last resort when there is a risk to financial stability or when a market failures limit timely access to private capital (Dobler et. al., 2020). Where access to private capital is temporarily interrupted by the uncertain pandemic environment, setting up a public fund that solvent banks can tap preemptively to raise capital could be considered. Such an equity backstop can accelerate the replenishment of capital buffers and support confidence. In Asia, during the GFC, the Korean authorities set up two largely publicly funded vehicles to offer banks and other financial institutions access to fresh capital in the form of preferred stocks, hybrid bonds, or subordinated bonds, conditioned on commitments to sustain lending to the real sector (Box 2).²¹ The United States also created a public capitalization vehicle through the Capital Purchase Program (CPP) under the Troubled Asset Relief Program (TARP). However, in all cases, public capital injections should be subject to safeguards that address concerns of moral hazard, conflict of interest, and taxpayer protection (see Dobler et. al., 2020).

Institutions other than banks, such as special investment vehicles, can also play an important role in support of corporate restructuring. In some economies non-bank financial institutions play a significant role in the provision of corporate credit and many of the earlier considerations for banks apply as well. In countries with more developed capital markets, investment vehicles can help promote a market for impaired assets (such as non-performing loans, junk bonds, and real estate funds). They can also step in to acquire distressed firms for turnaround (buyout funds), thereby complementing creditor-led restructuring frameworks. A conducive regulatory environment and operational flexibility is key to encouraging the emergence of such players. ²²

C. Pivoting to Equity Support for Non-Financial Firms

Extending equity support to non-financial firms can complement the liquidity assistance that is already being provided to address the crisis. As noted earlier, private investors may not be able or willing to come forward now and provide sufficient financing to avoid large-scale bankruptcies. In these circumstances, public equity support schemes may be needed to temporarily fill the gap, supplementing liquidity support. Equity, or equity-like, support for viable firms has the advantage of immediately strengthening balance sheets, and expand firms’ capacity to borrow and invest until access to private capital is restored. Equity intervention also allow governments to “capture some of the upside” gains from their interventions.

Public equity support should be targeted at firms and industries most affected by the pandemic and with positive externality benefits. In addition to tax and regulatory reforms, policymakers could utilize public resources directly for equity injections, with adequate safeguards. For example, Korea established a “Key Industry Stabilization Fund” in May, managed by the Korean Development Bank and co-funded by private investors to provide conditional equity support to strategic sectors hit hard by the pandemic, such as airlines and the shipping industry. The EU’s proposed Recovery Fund at considered a solvency support instrument managed by the European Investment Bank to support equity investment in economically viable firms (EC, 2020). Similarly, countries in Asia and the Pacific could consider allocating a portion of their public investment program to establishing a time-bound “Pandemic Equity Fund” that, alongside the private sector, could invest in companies looking to retool. This could be in the same spirit as the Asset Management Companies established after the Asian financial crisis, such as KAMCO in Korea or IRCJ in Japan, to stabilize and restructure the corporate sector. Over time, these funds also helped to deleverage the corporate sector and jumpstart a private-led market for distressed debt and assets.

To be effective, public equity funds would require strong governance, including a clear mandate, high transparency, and a clear exit policy. Given the risks to public funds and the need to avoid costly delays in corporate restructuring, public interventions should clarify upfront selection criteria for distressed but viable firms, specify any broader economic and social goals to be pursued, and feature a high degree of transparency and governance, especially with regard to valuation criteria. This would also include conditions such as caps on executive compensation and restrictions on dividends and share buybacks. Interventions should be time-bound and have a clear commercial mandate to maximize recovery value. This will protect taxpayer resources and avoid warehousing bad assets. On the seniority of the public sector’s claims, policymakers will need to weigh the tradeoff between limiting fiscal risks through greater protection in case of insolvency and discouraging more junior, private financing later. Accepting pari passu protection with other investors would allow the government to leverage the financing and expertise of the private sector while still maintaining upside gains. Past interventions have also allowed owners to repurchase shares at a premium, such as through equity warrants.

The provision of equity support by governments would require a shift in the government mindset from that of a creditor looking to recover principal to that of a portfolio equity investor serving as a “venture capitalist of last resort”. Authorities would have to be willing to take on additional risk and accept some losses in exchange for longer-term or broader social gains (Mazzucato, 2011; Stein, 2020). As some ventures are likely to fail, the performance of the public funds should be evaluated based on an overall ex-post rate of return of the portfolio rather than individual investments. This will incentivize long term capital gains and protect public agencies from political criticism on individual losses.

Where the social and economic cost of mass SME insolvencies is high, equity-like support tailored to small firms could also be considered (IMF, 2020b). For incorporated SMEs, these measures could include non-voting preferred shares or convertible bonds with long repayment periods that would provide funds upfront and whose conversion to equity would be conditional on the firm’s performance. In return for lengthening repayment and not assuming managerial control, the public sector could receive a share of the upside through dividend payments or temporarily higher future corporate tax payments.²³ For all types of SMEs, including those that are not incorporated, hybrid financing through subordinated loans or profit participation loans (where interest payments depend on the profits of the firm) could also be considered. Germany and other European countries have experience with the use of these instruments, which also require adequate reporting and controls. As with support for larger firms, strong governance arrangements would be critical to avoid prolonging the life of nonviable SMEs. This could include industry-level benchmarking of key financial ratios, as was done in Italy as an early warning guidance for more timely restructuring, closer monitoring and reporting requirements for firms receiving state support, as well as penalties for misreporting and fraud.

In the recovery phase, firms in Asia and the Pacific will also need to mobilize more private equity to reduce debt overhangs and adjust to the post-pandemic world. As firms emerge from restructuring and look to adjust their business model and expand operations, the need for risk capital is likely to increase, especially for firms unable to take on more leverage. Equity will be needed to absorb idle labor, shift resources into more productive areas, and disseminate new technology and practices. Even before the pandemic, startup rates in Asia and globally have been on the decline, constraining firm dynamism and productivity growth (IMF, 2018). Expanding the supply of private equity would facilitate this resource reallocation and deleveraging. The public sector will also need private equity to take over eventually its holdings in supported firms.

The relative lack of risk capital in Asia and the Pacific may be a constraint in this structural transformation of the corporate sector. Asia has a large pool of domestic savings, but much is invested in low-yielding bank deposits, government securities, or real estate. Equity markets are generally smaller than those in the U.S. and Europe. While the institutional investor base in Asia has expanded, the financial system remains bank-centered with limited development of markets for longer-term and riskier capital funding capital funding.

Thus, policies in the recovery phase should seek to promote the raising of new corporate equity. This will allow a greater role for the market to differentiate between viable and nonviable firms (providing a useful signal to banks) and avoid the “zombie” problem that has plagued previous corporate restructuring efforts in Asia and elsewhere. (Caballero et. al. 2008, BIS, 2020). While broader capital market reforms will take time, authorities can take a few immediate measures to encourage the issuance of equity:

• Eliminate the tax bias against equity—As is the case globally, tax systems in Asian and the Pacific allow for interest deduction on debt but not on dividend payments on equity. Eliminating the bias in the tax code by removing the interest deduction would be the preferred solution. Alternatively, a temporary subsidy to equity issuance can help support a healthier capital structure, albeit at a fiscal cost. For example, Belgium, Italy and Turkey have introduced an allowance for corporate equity (ACE) that adds a deduction for the normal return on equity, alongside the deduction for interest (IMF, 2016).

• Provide incentives for debt to equity conversions and subsequent disposal of equity holdings—Banks may be reluctant or are unable to convert debt to equity because of either restrictions on owning nonfinancial companies, time limits for disposing the converted equity, and/or a higher capital charge for holding equity (Daniel et. al., 2016). Supervisors could reduce holding limits or temporarily lower the capital charge on debt-equity conversions, while tax authorities could eliminate the tax on debt-equity swaps to encourage banks to accept losses upfront and make this substitution. After the Asian financial crisis, several countries introduced tax and regulatory incentives for debt-equity swaps and other institutional improvements to promote issuing equity. Currently, the Financial Services Agency (FSA) in Japan is considering a proposal to relax the 5 percent limit on equity ownership in nonbank companies to encourage regional banks to engage more directly in assisting companies. Ensuring proper valuation and a return to normal capital charges on these equity holdings would provide strong incentives for their timely disposal and avoid moral hazard risks.

• Simplify regulations and reduce costs for startups To promote entrepreneurship and technology diffusion, reforms could prioritize reducing the cost or providing incentives for startups. For example, regulators could reduce the number of procedures, time and minimum paid-in capital requirements associated with starting a business. Tax incentives could be provided for job hires by startups. Addressing corporate governance gaps would improve investor confidence in financing startups.