This report—the product of a joint working group convened by the Center for Global Development and the Inter-American Development Bank—focuses on firms and labor markets in Latin America and the Caribbean during the COVID-19 crisis and the highly uncertain recovery phase now underway. The ongoing Russian war in Ukraine, volatility in international financial markets, and fears of global stagflation (low growth and high inflation) combine with the impacts of the pandemic to make the economic environment particularly challenging.
Through a balance sheet analysis, the report describes how larger firms have navigated the crisis by cutting back on variable costs and investment. It also focuses on small and medium-size enterprises (SMEs), which appear to have suffered more in terms of closures and restrictions on credit access. The impacts on labor markets were unprecedented, with steep falls in employment and participation rates.
A key question is whether the reallocation of resources, favoring firms in sectors that were hit less hard and able to take advantage of digital technologies, will persist. Key dangers are that informality is higher than ever, that productive resources remain trapped in small and less productive or ultimately unviable enterprises, and that firms are not rebuilding their capital stocks quickly.
Drawing on an analysis of firms and labor markets, the report provides a set of recommendations for policymakers in the region and suggestions for international financial institutions to assist productive firms to invest, support the growth of new firms, and enhance labor market performance.
Understanding firm mortality during the pandemic
Official data on firm closures and filings for insolvency reveal that business bankruptcies have been below the levels that were expected at the beginning of the pandemic. The ratio of firm failures in the formal sector in 2020-21 was similar to or even lower than prior years. In some countries, there was even greater net firm creation (net of mortality). Likewise, insolvency filings declined during the pandemic in some countries. These data appear to be at odds with surveys that indicate severe damage from the pandemic to businesses in the region. This surprising result can be explained by a number of factors:
- Government support programs, including government assistance to households together with credit guarantees and deferrals of loan repayments, helped firms, especially SMEs, to stay afloat during the worst of the pandemic. Although some of these programs have ended, others remain in place or have been replaced with new programs. Still, there remains uncertainty as to whether the support programs have only postponed rather than eliminated firm closures.
- Formal bankruptcy procedures, while improved, are cumbersome and costly, and firms may have avoided their use, seeking less formal procedures instead.
- Lack of sufficient, high-quality data may have resulted in an underreporting of firm closures. Informality is prevalent but in general the available data only include formal firms. Mexico is an exception where the data include all firms and reveal much greater closures.
There is also evidence that the number of smaller firms in the region has been growing relative to larger firms. This is worrisome as productivity in the region has been stagnant and the combination of many smaller firms and high informality may lower productivity still further.
How are firms emerging from the pandemic?
The revenues of listed (normally larger) firms fell by about 20 percent at the peak of the pandemic.
Still, by the end of 2021, revenues had fully recovered in some sectors (mining; oil and gas extraction; agriculture, forestry, and fishing; and higher-capital-intensity manufacturing). In contrast, revenues remained significantly below pre-pandemic levels in several other sectors (professional services; business services; retail trade; transportation excluding air transport; air transport; health, legal, education, and social services; communications; construction; wholesale trade; hotels and restaurants; amusement and museums; and other sectors) .
As might be expected, the profits of firms in the recovered sectors returned to positive territory by the end of 2021, while profits in the damaged sectors were still around 20 percent lower than before the pandemic. The analysis uncovers significant scarring in firms left by the pandemic.
First, investment in the region fell sharply, rebounding only recently, mostly in the recovered sectors. In both the recovered and damaged sectors, a significant amount of cumulative investment was sacrificed, as reflected in the decline in fixed assets, which have remained depressed. As fixed assets are normally considered firms’ productive assets, this decline will likely restrict output going forward.
Second, costs fell across sectors and remain depressed in the damaged group, likely reflecting lower labor costs and the adverse impact on the demand for formal workers.
Third, while debt rose during the pandemic, the proceeds were used to build higher cash reserves rather than to finance real investment. Those cash reserves have since been depleted, likely to pay down debt, which has now fallen back to pre-pandemic levels.
How can firms finance investment going forward and bring the capital stock back to at least pre-pandemic levels? Given the current volatile international capital markets, increasing global interest rates, and concerns about a global recession, it is unlikely that firm revenues will continue to rise well above pre-pandemic levels or that firms will be in a strong position to raise more debt or attract more direct investment in the form of equity. Failing a robust policy response, it may take considerable time to replace the capital stock lost as a result of the crisis, limiting growth prospects in the region.
Labor market performance
Labor markets were deeply impacted by the pandemic with steep falls in employment and in participation rates. Unlike previous recessions, informal employment fell by more than formal employment. During the recovery, employment came back more slowly than economic activity. While employment across the region has now returned to close to pre-pandemic levels, it remains below pre-pandemic trends and there is considerable variation across countries and sectors. Informal employment returned more strongly than jobs in the formal sector, and informality is now higher than before the crisis. Female employment lagged as did female participation rates, which remain lower than before the pandemic.
The pandemic exacerbated structural challenges facing labor markets in the region. High informality lowers productivity, reduces the incentives to acquire skills, and shrinks the tax base. Lower female employment heightens inequality and lowers the potential output of the region.
In addition, the pandemic appears to have accelerated the trend towards digitalization and yet the region may not be able to take full advantage of this trend owing to inadequate digital infrastructure and a shortage of workers with the right skills.
To help countries in the region overcome these challenges, the report provides a set of recommendations to support firms and enhance labor market performance:
Create new programs to support firms
Countries should consider creating a public-private institution with a limited time mandate and a professional staff hired largely from the private sector to support firms with strong growth potential. The institution—which could take various forms, such as a fiduciary fund—would evaluate and develop techniques for identifying firms with good business prospects and provide support through a range of instruments including equity injections. The governance structure of the institution should ensure that it would be independent from political influence in lending decisions. IDB Invest and/or the IFC could advise on the institutional design and provide resources as appropriate. The institution would have its own resources and provide expertise to strengthen corporate governance. The capital injections could lead to an initial public offering on the country’s stock exchange, widening the capital base of the firm and providing funds for the public-private institution to exit. In some cases, capital injections could be used to facilitate consolidation in affected sectors. The institution should aim to be profitable and, apart from initial financing, not require fiscal support. It would be critical to hire a high-quality team and ensure that the institution worked professionally and independently.
Boost the entry of high-quality firms with high growth potential
Countries should consider supporting improved access to venture capital through international networks or the development of a local market.
Reform firm reorganization and bankruptcy procedures
Countries should consider reforms to improve formal insolvency codes, following five broad principles: flexibility, transparency, debtor-in-possession financing, human capital expertise, and procedural efficiency.
Create a new insolvency forum
Regional integration and more frequent cross-border issues within insolvency procedures, coupled with the lack of national expertise particularly in smaller countries, call for the creation of a new forum to provide technical support to enhance national firm resolution processes. The forum would assist national authorities to develop robust, reliable, and more standardized firm insolvency procedures across the region while at the same time allowing national rules to have greater flexibility. The forum would seek to avoid or reduce conflicts, ring-fencing of assets, and other inefficiencies.
Strengthen investment protection
Many existing investment protection systems provide mechanisms to facilitate consultations between countries and investors to advance common aims and avoid disputes, striking a balance between immediate concerns in the context of a crisis such as the pandemic and the longer-term goal of attracting stable and productive foreign investment. When available, these systems should be used. Where such systems are absent, countries should develop new mechanisms to facilitate substantive and transparent consultations.
Promote digitalization and technology adoption
To prevent the region from falling farther behind in the adoption of digital technologies, countries should develop an explicit digitalization strategy. The strategy could include investment in digital infrastructure, incentives for firms to digitalize, and robust systems for digital identities, cybersecurity, and data protection. In addition, training schemes to boost the skills needed to support the digital transformation should be developed; such training could be subsidized through vouchers or tax incentives.
Improve short-cycle programs for technical training
Short-cycle programs for technical training can play a particularly useful role in the current context but existing programs fall short of meeting this potential. Countries could improve short-cycle programs by developing better information systems, enhancing oversight and monitoring, creating flexible pathways between these programs and more traditional degree or certification programs, and providing scholarships to students from poorer households.
Adopt more general labor market reforms
Countries should consider more general labor market reforms, including a concerted effort to reduce informality. Reducing hiring costs for formal jobs by financing social security and health benefits from more general taxation and reducing labor taxes would decrease the incentives for informality. Well-designed savings or insurance schemes could support workers through periods of unemployment and rather than protecting jobs, protecting mobility would enhance efficiency. Policies to support female employment should also be considered, such as boosting the provision of preschool education and care for seniors and the ill. Reforms should be tailored to country circumstances and international financial institutions are well-qualified to provide advice on the relevant specific labor market interventions.
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