The formerly socialist countries of Eastern Europe face the double challenge of implementing profound structural change and achieving macro-economic stability. These goals may conflict insofar as the proposed reforms may jeopardize the financial sector and thereby threaten the stability of the whole economy.
Under the traditional socialist financial system, credit allocation was a by-product of the central plan, and solvency was guaranteed through (more or less explicit) subsidies and distorted prices. Although the reforming countries of Eastern Europe have made progress in dismantling this monolithic structure, they have not yet had time to develop a fully market-based financial system. More immediately, banks’ inherited loan portfolios have been significantly impaired by the growing insolvency of their borrowers, and their liabilities have been inflated.
In this paper, a model is developed that clarifies the role of banking in centrally planned and emerging market economies and the nature of the problem associated with bank insolvency in these economies. In an overlapping- generations model with long-term investments, the sudden withdrawal of subsidies and the liberalization of prices lead to a brief consumption surge, bank runs, and the premature liquidation of investment. The decapitalization of the economy results in a low level of output and investment for a prolonged period. Similarly, an anticipated decline in returns on existing capital, despite an increase in the return on prospective investments, leads to bank runs, erosion of the capital stock, and persistently low and fluctuating output. In either case, banks individually act in a rational manner in restricting lending and calling in loans, but the aggregate outcome is negative net investment, which perpetuates the disruption. The problem is compounded when each household tries to be the first to withdraw its deposits from the loss-making banks.
The real costs of the reform effort will be increased and perpetuated by failure to mobilize resources to cover the costs of restructuring the banking sector. If higher inflation is to be avoided, these resources can be generated in the short term only by reducing government expenditure and raising taxes, in particular, by lowering subsidies to enterprises and imposing consumption taxes.