This paper discusses the case against countries using a laissez-faire approach to resource allocation in restructuring the inherited state industrial sector. The analysis focuses on externalities associated with supply bottlenecks and adjustment costs. While much of the concern with bottlenecks has centered on impediments to international trade, bottlenecks can also arise whenever the requirements for certain inputs to production are stochastic (such as needs for energy sources or spare parts) and the opportunity cost of holding inventories is high. These conditions are likely to prevail in the state industrial sector--whose creditworthiness is currently limited by its outdated production technologies--once budget constraints are hardened and credit markets begin to function effectively.
In modeling the externalities associated with production bottlenecks and considering the policy implications in the presence of adjustment costs, the paper recognizes that producers have incentives to enter into pooling arrangements, supported potentially by market mechanisms, for reallocating stocks of critical inputs. Such arrangements, however, do not suffice to eliminate the externalities. Moreover, the externalities rise in a highly nonlinear manner (for example, exponentially) as critical inputs become more scarce.
However, many other factors need to be considered in designing policies to influence resource allocation. The analysis suggests, first, that once budget constraints are hardened and credit markets begin to function appropriately, the externalities associated with production bottlenecks and adjustment costs provide a case for subsidizing the costs of critical inputs for the state industrial sector but not for the new private sector. Second, the appropriate policy has an important time dimension, with the optimal subsidy declining as the private sector grows. Finally, countries should “finance” the subsidy by taxing the wage income generated in the state sector, which will strengthen incentives for workers to move out of that sector. It is also suggested that the provision of such subsidies be governed largely by rules rather than by discretion and that eligibility requirements be made conditional on maintaining wage restraint and meeting prespecified benchmarks in restructuring and in other enterprise reforms.
Although financing requirements constrain the size of the subsidies that can be provided to the state sector without undermining macroeconomic stability, countries should view the amount of financing to raise as a fundamental policy choice in designing their reform strategy. Their willingness and ability to finance a gradual or moderate-speed contraction of the state industrial sector--and thereby to avoid a rapid contraction of that sector--may be crucial in maintaining popular support for the transformation effort and making it credible that the reform program can be sustained. This in turn may be crucial for obtaining the financial support of domestic savers and foreign private investors.