DP15055 Support for Small Businesses amid COVID-19
A sizeable proportion of enterprises, especially SMEs, in receipt of financial assistance
from the government, will fail to repay. In this paper we asked whether,
and to what extent, it may be beneficial to apply a screening mechanism to deter
those mostly likely to fail to repay from seeking such financial assistance in the
first place. The answer largely turns on the relative weights attached for the objectives
of stabilisation as compared with allocative efficiency. For this purpose, we
develop a two-sector infinite horizon model featuring oligopolistic small businesses
and a screening contract in the presence of a pandemic shock with asymmetric information.
The adversely affected sector with private information can apply for
government loans to reopen businesses once the pandemic has passed. First, we
show that a pro-allocation government sets a harsh default sanction to deter entrepreneurs
with bad projects from reentering and improves aggregate productivity
in the long run, but the economy suffers persistent unemployment in the near term.
However, a pro-stabilisation government sets a lenient default sanction or provides
full guarantees to reach full employment in the short term, but the economy will
be shifted to a lower equilibrium in the long run. The optimal default sanction balances
the trade-off between allocation and stabilisation. Then, we derive an analytic
measure of “Stabilisation Proclivity” and characterise the parameter space and the
macro-financial frictions that render the government either more pro-allocation or
more pro-stabilisation. Finally, we solve for the optimal default sanction numerically
and conducts comparative statics for various policy analyses.