Summary of WP/92/64
“Output Collapse in Eastern Europe: The Role of Credit” by Guillermo A. Calvo and Fabrizio Coricelli
Output collapse in Eastern Europe after the implementation of the recent economic transformation programs has exceeded expectations by a wide margin. This paper argues that a large proportion of the fall could be explained by “trade implosion,” that is, a situation in which trade--both domestic and international-- is destroyed for lack of market institutions, not just as a consequence of textbook changes in relative prices or movements along transformation frontiers.
We single out the credit market as one of the key underdeveloped institutions in Eastern European economies and advance the hypothesis that negative output effects associated with monetary contraction may be significant when credit markets are underdeveloped, as evidenced in the cases of Bulgaria, Czechoslovakia, Hungary, Romania, and especially Poland.
There are different ways to ensure that firms have access to the necessary liquidity to operate at full capacity. An obvious one is to adjust bank credit initially in order to ensure that “real” credit--in terms of input prices--stays unchanged. Afterwards, credit could be as tight as necessary to ensure the achievement of low-inflation targets. A common criticism of this approach is that the initially easy credit policy may impair the credibility of the program, making escalation from the initial price into persistent high inflation more likely. Another criticism is that credibility may be a function of credit tightness. Initially easy credit may thus end up being treated by firms as a substitute for previous subsidies. Since banks have no expertise in evaluating creditworthiness, they may be unable to detect “bad loans” until it is too late; and the central bank--to avoid financial panic--would be forced to monetize enterprises’ liabilities, jeopardizing the effectiveness of the stabilization program.
Tight credit could, however, have a negative effect on credibility. A single firm may be induced quickly to “put its house in order,” but if its managers realize that many other firms are in the same tight credit situation, they may decide to postpone adjustment in the expectation that the government will bail out everybody in trouble.
Another suggested solution to the credit-squeeze problem is a swap of government debt for enterprise debt. Through this operation firms receive government bonds, for example, in exchange for their own debt. However, this solution may not be effective for a PCPE because there usually is no well-developed market for government debt instruments.
Finally, a more gradualist policy, as in Hungary, may be followed, involving a gradual dismantling of subsidies and a consequent smoother increase in input prices. However, gradualism could detract from policy transparency and lead to speculative behavior and may invite future postponement of reforms.