Credit Where Credit Is Due: Policies to Mitigate the Pandemic Fallout

The Fall/Winter 2020 issue looks at the economic effects of the COVID-19 Pandemic on society and the economy.


The Fall/Winter 2020 issue looks at the economic effects of the COVID-19 Pandemic on society and the economy.

Nina Biljanovska

Businesses rely on cash flows from their operations, and-when cash flows are delayed or dry up-they use credit to weather what should hopefully be temporary shortfalls. Hit with the COVID-19 shock, firms worldwide increased borrowing to cope with business interruptions.

Firm’s in the United States massively increated their borrowing between March 11 and April 1, while a similar pattern in the euro area was observed in the 2020:Q2 ECB Bank Lending Survey. However, when such interruptions are persistent-as has been the case with the pandemic-frms’ profits and financial resources are eroded, and access to credit becomes difficult as lenders become more risk averse and start imposing stricter lending’standards.

A recent IMF study builds a quantitative macroeconomic model to analyze the economic impact of a pandemic when the financial conditions that firms face tighten over time. Initially, when the COVID-19 shock hits, workers cannot work as much as they did before (in the model, hours worked are assumed to drop by 20 percent) and revenues decrease. Luckily, bankers are keen to lend, and this enables firms to borrow and keep up with their payroll and other expenses. Subsequently, however, bankers grow skittish and lending conditions tighten, leaving firms no longer able to borrow as much as they need to handle their financial difficulties.

The economic impact of the COVID-19 shock depends on the ability of firms to borrow in response to the shock. When the COVID-19 shock hits and it becomes hard to. employ workers to the fullest, this alone causes output to fall by about 15 percent in the year of the pandemic. If banks keep the credit tap open, firms borrow and limit the impact of the shock. But if lenders also decide to curtail lending when the COVID-19 shock hits, then consumption and output take a larger hit during the pandemic, as shown in Figure 1.

Figure 1.
Figure 1.

Financial Amplification of Pandemics

Citation: IMF Research Perspectives 2020, 002; 10.5089/9781513564081.053.A004

Source: Author’s calculations.Note. The figure plots the simulated paths of asset prices,”consumption, output, and borrowing when the following events materialize: (1) COVID-19 shock hits the economy (COVID-19 line), and (2) financial conditions are tight and COVID-19 shock hits the economy (CC+COVID-19 line, where CC stands for “Credit constraints”). The responses of the variables are in terms of deviations from the long-term mean.

The study examines three policies that can help cushion this blow. The first is a subsidy on credit, in the form of a reduction of the interest rate equal to 1 percentage point. This policy resembles the Small Business Administration loans in the United States that attempt to reduce the cost of borrowing. This program does not lend money directly to businesses, but sets guidelines for loans made by the financial institutions with which it partners. The program reduces risk for lenders and makes it easier for them to access capital and extend loans to small businesses.

Second, a policy that provides credit guarantees is considered. Normally, small business loans are secured with collateral. But credit guarantees can reduce the collateral needed. Such a policy can come in the form of a government guarantee or direct government. lending via a development bank. Third, a combination of the credit subsidies and guarantees is put to the model’s test.

Looking at the impact of these policies through the lens of the model leads to two main takeaways (Table 1). First, credit policies are especially important and effective when times are darkest, and the pandemic has brought firms shortages of both credit and labor. Second, a package of policies is greater than the sum of its parts. Combining credit subsidies and guarantees gives both policies more bang for the buck than implementing each in isolation. Overall, the results highlight that credit subsidies and guarantees, especially when combined, can make a big difference at a time when workers and banks cannot deliver their normal amounts of labor and credit.

Table 1.

Financial Policy Responses

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Source: Author’s calculations.Note: The table reports welfare gains in terms of percentage compensating consumption variation for a 1 percent change in policy. For credit subsidies this is equivalent to a 1 percentage point decrease in the interest rate, while for credit guarantees it is equivalent to a 1 percent guarantee of the face value of the loan. For credit guarantees the 1 percent is rather low, but it is considered for comparability. That is, the table might seem to suggest that credit subsidies are more effective than credit guarantees, but in practice implementing an extensive government loan guarantee scheme is typically done at a higher percentage of the loans’ value than the 1 percent considered in the exercise for comparability.