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Money Demand, Bank Credit, and Economic Performance in Former Socialist Economies

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1994
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A SALIENT CHARACTERISTIC of former socialist economies is the strong and persistent fall in (measured) output, which has taken most economists and policymakers by surprise. Although initial output disruptions were expected, their size and persistence were not. In fact, it was expected that the better incentive mechanisms of a market‐oriented system would quickly unleash productive power by pushing the economy to its “production frontier.”

One possible explanation for the collapse in output is that the necessary economic transformation is very profound and, thus, sizable destruction is needed before construction takes place. For this to be so, however, output fall must be concentrated in sectors and activities displaying negative value added. Thus, if aggregate output were measured correctly, GDP should rise, not fall. Berg and Sachs (1992), for example, argue that the fall in output in Poland in 1990 was substantially less than recorded but still conclude that the fall was about 7 percent. Thus, this type of explanation appears insufficient.

Another explanation is “market failure.” The main argument in that respect is that political events have overtaken economic reforms. There has been very little time to develop the institutions, the information base, and the expertise required for the normal operation of a regular capitalist economy. Market failure has been reflected in a number of interrelated areas such as trade and the provision of credit. Following the onset of reform, trade—particularly domestic trade—slowed markedly, exacerbating the consequences of the collapse of trade among the partners of the former Council for Mutual Economic Assistance (CMEA). Bruno (1992) notes, for instance, that the size of the output decline in East European countries in 1991 was directly related to their dependence on the CMEA market. Thus, according to this explanation, the proximate cause for the decline in output has been trade implosion.

Given the rudimentary nature of the bond and equity markets, commercial banks, mostly state owned, continue to dominate the financial sector in former socialist economies, and enterprises are heavily dependent on bank credit for both working capital and investment. A common characteristic of all these economies has been a massive fall of real credit at the beginning of their transformation programs and, as argued in Calvo and Coricelli (1994), firms resorted to informal and/or illegal devices like cutting wages below the statutory ceiling, falling into arrears with one another, with banks, or the government. Despite these efforts, weak credit may have been an element in output declines, and may continue to be important in the sluggish recovery under way in some of the former socialist economies in Eastern Europe.

In this paper we pursue the “market failure” approach and, in particular, focus on issues related to the operation of credit markets in the reform process. We examine the conditions under which output declines may reflect inadequate credit—not only at the beginning of the reform process, but also subsequently—and explore two key factors influencing the provision of credit to the enterprise sector: first, demand for bank deposits, which determines the availability of loanable funds; and second, constraints on the banking sector, both endogenous and exogenous, that limit the credit that banks may want to extend to productive firms, whether in the state or the private sector, for a given amount of deposits.

These two explanations are complementary in that even if the banks are able to provide credit, a number of factors may constrain their willingness to do so. In the context of providing direct subsidies to the enterprise sector as a way of making up for the inadequate credit provided by the banking sector, the paper also explores the policy trade‐off between inflation and output. Such a trade‐off is particularly important in the early stages of the transformation process when the liberalization of prices and trade, together with inherited monetary overhang, leads to serious problems of inflation stabilization and in the balance of payments. In addition to the provision of working capital, the paper also briefly notes the constraints on the banking sector in providing longer‐term finance. These constraints are in addition to those likely to inhibit lending in the short run and arise mainly because of the nature of lending contracts. The paper notes the role that equity funds could play in this context.

The following section provides a brief overview of the performance and policies in former socialist economies during the transition and notes the salient structural features of the economies. Section II sketches the basic conceptual framework that identifies some key characteristics of imperfect credit markets, paying special attention to their short‐run macroeconomic effects and the trade‐off between inflation, employment, and output. Section III explores implications of the model for the relationship between interest on bank deposits. money demand, and bank credit. Section IV discusses the relationship between the provision of liquidity to the enterprise sector and the financing of public sector deficits. Section V examines more closely both the incentives and the constraints on the newly created commercial banks, most of which are still state owned. Section VI briefly discusses the relative merits of debt and equity capital for the longer‐term financing needs of the enterprise sector, and a final section summarizes the main conclusions of the paper.

I. Policies and Performance: A Synopsis

Recent Performance

There are four striking aspects of the performance of former socialist economies in the transition to a market‐based system. First, as noted above, output has declined sharply, which in several of the East European countries has ranged cumulatively between 20 percent and 40 percent over 1990–92 (Table 1). While output has begun to recover in Poland and the former Czechoslovakia, it continues to decline, albeit at a much reduced pace, in other Central European countries. The decline in output has been accompanied by sharp increases in unemployment—in several countries close to 15 percent of the work force—compared with virtually negligible open unemployment before reform. In the states of the former Soviet Union, which embarked on the transformation process in early 1992, the declines in output appear to be just as marked, if not greater, although open unemployment is as yet limited.

Second, in the period immediately after price liberalization—but not only then—inflation increased sharply. While in several East European countries it has been markedly reduced, it still remains above 20–30 percent a year in most countries. In Russia and the Ukraine, inflation rates have exceeded 25 percent a month, and a move toward hyperinflation has appeared possible.

Third, in most countries large fiscal deficits have emerged or persisted. A key feature has been the dramatic decline of tax revenue, largely because of the steep drop in output, which has cut tax revenue on turnover and business profits (Tanzi (1993)). Business tax revenue was also adversely affected by the collapse of institutional arrangements whereby the government had direct access to state enterprises’ profits. The pronounced fall in government revenue has not been matched by an equal drop in public spending. despite the large cuts in public subsidies and in government infrastructure investment implemented in almost all countries (Table 2).

Fourth, although the external current account position improved initially owing both to a sharp decline in imports and an increase in exports of goods diverted from the former CMEA markets, it has subsequently worsened in several countries. A deterioration in the current account has, in general, not been offset by any marked increase in capital inflows. The real effective exchange rate of most countries has appreciated significantly since the onset of the reforms, adversely affecting the competitiveness of the industrial sectors.

Policies and Economic Structure

Table 1.Eastern Europe: Output, Investment, and Inflation(Percentage change, or as indicated)
1989199019911992
Bulgaria
GDP–0.5–9.1–11.7–5.7
Gross investment–6.2–13.6–58.6–16.4
Stocks (change in percent of GDP)–1.50.6–1.0–4.1
Fixed investment–2.3–19.0–72.723.9
Gross investment (percent of GDP)32.131.512.814.5
Unemployment rate0.01.615.615.0
Consumer prices6.421.6333.582.0
Former Czechoslovakia
GDP4.5–0.4–15.9–8.5
Gross investment29.79.0–31.6–15.0
Stocks (change in percent of GDP)–0.22.6–1.7–5.1
Fixed investment32.70.0–29.95.1
Gross investment (percent of GDP)27.730.726.823.1
Unemployment rate0.83.25.7
Consumer prices1.410.859.011.0
Hungary
GDP–0.7–3.5–11.9–4.4
Gross investment–0,4–7.9–17.0–24.7
Stocks (change in percent of GDP)–1.0–0.3–3.0–4.5
Fixed investment5.1–8.7–5.5–4.7
Gross investment (percent of GDP)26.125.420.819.0
Unemployment rate0.41.77.712.3
Consumer prices17.028.936.423.0
Poland
GDP0.2–11.6–7.61.0
Gross investment–10.7–37.6–14.2–2.8
Stocks (change in percent of GDP)–2.7–7.5–1.6–1.0
Fixed investment–2.1–10.6–4.52.5
Gross investment (percent of GDP)28.727.521.517.7
Unemployment rate2.66.28.414.0
Consumer prices251.1585.870.343.0
Romania
GDP–5.8–7.4–13.7–15.0
Gross investment–11.4–3.5–0.3–24.1
Stocks (change in percent of GDP)–3.110.25.7–73
Fixed investment–0.4–37.6–28.8
Gross investment (percent of GDP)26.727.833.525.6
Unemployment rate3.45.72.86.4
Consumer prices0.94.7161.1210.3
Source: IMF, World Economic Outlook Data Bank.
Source: IMF, World Economic Outlook Data Bank.
Table 2.Eastern Europe: Government Balances and Monetary Variables(Percentage change, or as indicated)
1989199019911992
Bulgaria
Government revenue (percent of GDP)57.952.542.936.8
Government expenditure (percent of GDP)58.565.150.543.3
Capital expenditure (percent of GDP)5.56.61.91.9
Fiscal balance (percent of GDP)–0.6–12.6–7.6–6.5
Domestic credit9.625.0148.354.2
Broad money11.679.244.647.8
Short‐term deposits1.04.054.065.0
Exchange rates (US$/NC)–8.2–13.7–88.4–22.1
Real effective exchange rate
Former Czechoslovakia
Government revenue (percent of GDP)49.347.651.847.0
Government expenditure (percent of GDP)52.854.052.050.7
Capital expenditure (percent of GDP)7.97.06.36.0
Fiscal balance (percent of GDP)–3.5–6.4–0.2–3.8
Domestic credit2.79.720.316.9
Broad money3.50.526.816.9
Short‐term deposits3.05.011.011.0
Exchange rates (US$/NC)–4.5–16.1–38.13.5
Real effective exchange rate
Hungary
Government revenue (percent of GDP)59.657.457.952.6
Government expenditure (percent of GDP)60.958.261.160.7
Capital expenditure (percent of GDP)6.65.94.26.7
Fiscal balance (percent of GDP)–1.3–0.8–2.7–8.0
Domestic credit15.211.17.211.1
Broad money14.429.634.527.4
Short‐term deposits
Exchange rates (US$/NC)–14.6–6.6–15.4–4.8
Real effective exchange rate1.34.113.37.9
Poland
Government revenue (percent of GDP)30.833.325.827.1
Government expenditure (percent of GDP)36.932.732.134.4
Capital expenditure (percent of GDP)3.32.82.41.7
Fiscal balance (percent of GDP)–6.10.7–6.3–7.3
Domestic credit222.72,746.9–80.272.9
Broad money236.0121.936.957.5
Short‐term deposits85.0145.048.035.5
Exchange rates (US$/NC)–70.1–84.9–10.0–22.5
Real effective exchange rate12.9–15.754.30.6
Romania
Government revenue (percent of GDP)51.137.734.337.6
Government expenditure (percent of GDP)42.737.635.439.6
Capital expenditure (percent of GDP)17.67.84.33.9
Fiscal balance (percent of GDP)8.40.1–1.0–6.1
Domestic credit8.519.5110.2–1.2
Broad money5.617.4100.848.7
Short‐term deposits2.53.018.060.0
Exchange rates (US$/NC)–4.3–33.5–77.7–71.7
Real effective exchange rate–3.2–31.6–5.2–37.9
Source: IMF, World Economic Outlook Data Bank.
Source: IMF, World Economic Outlook Data Bank.

The above stylized facts of performance reflect, and have been affected by, the stabilization and structural reform policies pursued in many countries. The initial focus of macroeconomic policies was on containing the inflationary consequences of price liberalization and what was considered to be a significant monetary overhang. Hence, the policy package consisted of a tight monetary and fiscal stance, with strict credit ceilings especially on credit to the enterprise sector. In addition, to reduce inflationary expectations, extensive use was made of nominal anchors, including a fixing, or a preannounced crawl, of the nominal exchange rate, and ceilings on nominal wages.

The macroeconomic policies were complemented by major structural reforms to increase competition, improve the microeconomic efficiency of the economies, and to hasten the way to a market–oriented system. Major reforms were envisaged and implemented in the trade sectors, making the economies more open, and in the fiscal sector, reducing the direct involvement of government in the economy. However, the restructuring and privatization of industrial enterprises, as well as of the financial sector, has in general made little headway. The privatization of large enterprises, in particular, is proceeding slowly, in part because of the concerns about the further rise in unemployment that would result.

Nevertheless, the structure of the economies is changing, although not nearly as fast as had been anticipated. The share of the private sector in total output has expanded sharply in countries such as Poland and Hungary, accounted for mainly by newly created, rather than privatized, firms.1 Despite this, the bulk of industrial output still originates in the state sectors. Similarly, the financial sector continues to be dominated by the commercial banks, which, originating from the monobank system, are mostly state owned, and despite a number of significant measures continue to be saddled with a high proportion of unserviceable loans.2 There is an active and rapidly growing government securities market in several countries, while equity and commercial bond markets are in their infancy. As the discussion below shows, the weak loan portfolio of banks, combined with the growth of securities markets, appears to have significant implications for the volume of credit channeled to the enterprise sector as a whole.

II Basic Conceptual Framework

In this section, a simple model is developed to emphasize the role of working‐capital credit in determining employment and output. It is motivated by the observation that the transition to the market economy entails a switch from a regime in which credit is independent of the demand for money to a regime in which it is dependent on it. The reason for this switch in regime is elaborated in the model and hinges on the fact that the bulk of credit in the transition economies is provided by the banking sector. The model also illustrates the likely short‐run macroeconomic consequences of attempts to increase output by increasing government subsidies to firms.

A Model of Money Demand and Credit

Consider the case in which output is produced by labor alone under constant returns to scale. Labor is applied at time t and output is obtained at time t + 1. Firms have no initial liquidity, and wages have to be paid at the beginning of the production process (that is, at time 1).3 Thus, under this assumption, credit is essential to enable the firm to operate; if credit is not available, output collapses even though the firm may be perfectly viable from an economic point of view.

We will denote the average (= marginal) labor productivity by γ. Thus, profits per unit of employment at t + 1 are given by the following expression:

where P, W, and i are the nominal price of output, wage, and bank interest rate on loans, respectively; and r and w are the real interest rate on bank loans, that is, 1+rt=(1+it)Pt/Pt+1, and the real wage, respectively.

We assume initially that firms are price takers, wage takers, and interest rate takers. Therefore, if profits are positive, profit‐maximizing firms will try to expand without limit, which would not be consistent with labor market equilibrium.4 On the other hand, if profits are negative, no production will be carried out. Therefore, equilibrium with positive and finite production requires the expression in brackets in equation (1) to be equal to zero, or, equivalently, that

Let Bt denote bank loans, in nominal terms, granted at time t. The liquidity‐in‐advance constraint referred to above takes the following form:

where N denotes employment at firms.

To close the model, we assume that labor supply is perfectly elastic at real wage w. Thus, total output, y, satisfies

The infinite‐elasticity assumption captures a situation in which workers have employment opportunities outside the enterprise sector—the “informal” sector, say. The informal sector is not subject to the liquidity-in-advance constraint because production techniques are more primitive (that is, labor productivity is lower than in the enterprise sector) and output is obtained within the same period in which inputs are applied.5 Thus, total output (at steady state) falls when resources are shifted away from the enterprise sector (that is, when N falls).6 (We will offer another, perhaps more plausible, interpretation below.)

By liquidity‐in‐advance equation (3) and the labor supply equation, we have

Consequently, by equations (4) and (5), real credit determines employment at enterprises and output: the larger is real credit, the larger are employment at enterprises and national output.

Another scenario that would give essentially the same relationship between real credit and output is one in which total employment at enterprises is constant (= 1, say), but effort is variable and proportional to the real wage. Thus, equation (5) would become Bt/Pt=wt.Moreover, we would interpret variable N as effort, and assume N=w/w (that is, proportionality between effort and the real wage). These assumptions, in conjunction with equation (4), would yield

which is also implied by equations (4) and (5). This alternative interpretation is attractive, because it implies a low (here, zero) response of employment to a fall in output, which is a salient characteristic of former socialist economies during the first stage of the transformation process. Also, if less effort is equivalent to more shirking, equation (4) would fully capture the standard GDP concept.7

We will now endogenize real credit. Assuming, for simplicity, that commercial banks hold no wealth or foreign assets, we have

where H and M are bank reserves (held in the form of high‐powered money) and deposits (assumed to be entirely held by households). Thus, assuming that neither households nor firms hold cash, M can be identified with money supply. Moreover, at equilibrium, H equals total high‐powered money.

We assume that the minimum reserve requirement, δ, is binding. Thus, δMt=Ht. Moreover, by equation (6),

where L() denotes the demand for real monetary balances, M/P.

Implications of the Model

We can illustrate the main implications of the model in the special case in which the demand for real money is a constant, l. Combining equations (5) and (7), we get the following employment‐determination equation:

Thus, a fall in the demand for money, l provokes a fall in employment at enterprises and, by equation (4), in GDP. Notice that we get a contractionary effect from a decrease in the demand for money even though prices and wages are assumed to be perfectly flexible. The fundamental reason for such a relationship is that credit is essential for undertaking production at enterprises, and the real value of credit is intimately linked to the demand for real monetary balances by the public.8

One way the government may try to increase output is via inflation. For instance, it could increase subsidies to firms and finance these simply by printing high‐powered money, H. Recalling that δMt=Ht we have

Therefore, in the present setup, inflation is proportional to the rate of growth of high‐powered money, H. The liquidity‐in‐advance condition (normalizing the total number of enterprises to unity) is now

where Ht+1Ht is the subsidy. Thus, under inflation, the employment‐determination equation becomes

where πt+1=Pt+1/Pt1 equals the inflation rate between periods t and t + 1. The second term on the right‐hand side of equation (10 reflects the fact that the government is using the inflation tax to “finance” the enterprise sector.

Equation (11) illustrates an important policy trade‐off between inflation and employment and output. The trade‐off is more relevant in the short run when the demand for money, l is inelastic with respect to inflation. Eventually, however, the demand for money adjusts in a direction opposite to inflation. Thus, lower inflation eventually results in higher l and possibly, recalling equation (8), higher employment and output. Notice, incidentally, that the employment‐maximizing inflation rate (at steady state), for δ<1, is less than the rate that maximizes revenue from inflation (that is, the value of π that maximizes δπL()); moreover, if the reserve requirement, 8, is low enough, the employment‐ maximizing inflation rate (at steady state) could be zero or negative.9

III. Banks and Arrears

We will now examine the operations of commercial banks more closely, in particular the constraints and the incentives facing them. For simplicity, we assume that the operational costs of running banks are negligible. Therefore, if loans are fully serviced, nominal bank profits in the period from t to t + 1 are

where st is the nominal deposit interest rate for the period from t to t+1. By factor‐price frontier (2), if, as assumed, w<γ, then the real interest rate on bank loans, r, will be positive. Consider now the realistic case in which inflation is non‐negative. Then, the nominal interest rate on bank loans, it is also positive (since 1+it=(1+rt)(πt+1)). Thus, if the deposit interest rate, st, is zero, banks will display positive profits, unless the reserve requirement is 100 percent (that is, δ = 1). Therefore, there is room for banks to offer positive interest rates on deposits without violating their budget constraints (zero bank profits st=(1δ)it). Since the demand for real monetary balances is an increasing function of the deposit rate, a possible employment‐increasing policy is to pay interest on bank deposits. The trade‐off here is that if banks’ profits are subject to taxes, higher interest on deposits by reducing bank profits would reduce tax liability and increase the fiscal deficit.

As noted above, firms in former socialist economies reacted to the credit crunch by falling into arrears with each other, banks, or the government. Thus, in our example above, firms may choose not to repay their bank debts, implying that the liquid funds available to firms at the beginning of period t + 1—assuming that no new credit is extended to the delinquent firms—will be Bt(1+it) which may well exceed the amount of credit received by firms if they had repaid their bank debt in full. However, firms’ nonpayment may be counterproductive because it may fuel inflation and firms’ real liquidity may fall, undermining their ability to increase employment and output.10 We will expand on this point in the following discussion.

Consider first the case in which interest on bank deposits, s, equals zero. Then default on Bt drives bank profits to −Bt. However, banks would not go bankrupt in period t + 1 as long as the demand for bank deposits does not decline (that is, if Mt+1Mt). The latter condition is likely to be satisfied if inflation is non‐negative and no panic (specifically, bank run) is produced. In this scenario, banks make “bad” loans, but the ultimate claimants (depositors) do not, on average, call them (by not withdrawing their bank deposits). However, even under these extremely favorable conditions, macroeconomic difficulties may occur. In the first place, it is unlikely that banks would have incentives to lend any further to enterprises, since they are likely to expect firms also to default on new bank credit.11 Besides, bank profits are usually heavily taxed. Therefore, default on bank credit lowers fiscal revenue and increases fiscal deficit. The latter, if monetized, increases inflation, undermining the firms’ benefit from default, as noted earlier.

We will now consider the polar case in which the interest rate on bank deposits is set so that bank profits are zero (this would he their equilibrium level if banks operate under perfect competition and there is no risk of default). Under these circumstances, banks may run into difficulties if depositors fail to increase their demand for money (deposits) in period t +1 to at least Mt(1+st), that is, to its level in period t plus interest accruals. Moreover, the same argument shows that if the situation remains unchanged, deposits will have to keep increasing at a rate at least equal to the interest rate on bank deposits. Thus, in order for this to happen, the rate of inflation will also have to be equal to st—if the demand for real monetary balances remains constant—or higher if the demand for money falls with inflation—thus tending to invalidate the employment‐enhancing effects of default in period t +1 and causing a deterioration of the firms’ real liquidity position later on.

The central policy dilemma is whether government intervention is called for under these circumstances. Not intervening likely implies higher inflation and lower output, as suggested by the above discussion. Furthermore, banks are likely to sue delinquent firms eventually, threatening to paralyze the enterprise sector and provoking a sizable fall in output and employment in the short run.

Alternatively, government may intervene by bailing out banks saddled with nonperforming loans. For example, this may take the form of the central bank lending new money to banks in exchange for their nonperforming loans. This is directly inflationary. Thus, if firms are not restructured and banks refuse to lend new funds to them, real liquidity at enterprises will fall, giving rise to higher unemployment. Therefore, to be successful, the bailout operation must also involve some kind of debt forgiveness that initially lowers enterprises’ incentives to default. However, the main drawback of this rescue operation is that it entails “moral hazard”—it may lead firms to expect similar operations in the future, resulting in a loss of control over money supply. The latter, in turn, by fueling inflationary expectations, lowers the demand for money and, by equation (11), lowers employment at enterprises even further.

To recapitulate, our discussion has revealed that if enterprises are heavily dependent on bank credit for their day‐to‐day operations, output is likely to be very sensitive to changes in the stock of real monetary balances. Thus, this approach helps to rationalize the fall in output that occurred in conjunction with price liberalization. As shown in Calvo and Coricelli (1994), real bank credit suffered a precipitous fall immediately such reforms were implemented. Moreover, as the evidence in the following sections illustrates, real bank credit to firms has continued to decline even during the last year or two, although the reasons for this decline are somewhat different.

Our approach also sheds light on why it may be so difficult to improve output performance without igniting hyperinflation. Although, in our interpretation, one cause for low output is the low liquidity of enterprises, injecting more liquidity through central bank credit could be counterproductive. Conceivably, more nominal credit could result in more real enterprise liquidity and, thus, output; however, more nominal credit implies higher inflation, which reduces the demand for money and the stock of real bank credit and, thus, output. The latter effect of higher inflation is likely to swamp the first effect beyond relatively low inflation levels. It is, of course, true that in the short run an increase in output because of higher nominal credit could lead to an increase in the demand for money, thus dampening the inflationary consequences. Nevertheless, even in this scenario, the effect on inflationary expectations could be substantial. Thus, inflation does not seem to be a promising strategy.

An unrealistic feature of the above example is that firms would (at equilibrium without default) exhibit zero profits. If profits were positive, reflecting in part the continuing oligopolistic structure of industry, then firms would be able to accumulate liquidity over time which, as argued in Calvo and Coricelli (1992), would help output recovery. As noted in Calvo and Coricelli (1994), however, this process of recovery could be slow if inter alia inflationary expectations remain high. Firms themselves may prefer to operate at low output levels if the opportunity cost of holding liquid assets is high, and, in addition, uncertainties are engendered by the speed and the extent of the privatization process.

The process of enterprise liquidity accumulation could be enhanced in a noninflationary way by endowing firms with an initial stock of liquidity. However, if a further rise in the initial price level is to be prevented. households’ liquidity will have to shrink simultaneously. This could be achieved, for example, by an initial partial confiscation of households’ bank deposits. The main difficulty with such a policy is that if it is not swiftly carried out, it may give rise to high inflation (which, as argued above, does not bode well for an output recovery program). As soon as the public anticipates a sharp price rise or deposit confiscation, it will try to get rid of most of its monetary balances.

The latter difficulty explains the general reluctance to increase enterprise liquidity at the beginning of reform programs. However, our discussion suggests that the government should avoid burdening firms with liquidity‐using transactions in the short run. For example, if firms start with a stock of debt (possibly acquired in the context of central planning) that has to be serviced in the short run, a case could be made for debt rescheduling.

IV. Bank Credit and Fiscal Deficits

The above analytical framework can readily be extended to help shed light on an important but puzzling feature of recent economic performance in several East European countries: that is, how, despite increasing fiscal deficits, inflation stabilization has been relatively successful. As discussed below, the answer to this puzzle lies mainly in increased private saving, or perhaps more accurately, in a rechanneling of private saving into the financial sector. That is, an increase in money demand led to an increase in loanable funds. However, the increased availability of funds was not used to provide increased credit to the enterprise sector but was used instead largely to finance fiscal deficits. Thus, as the analysis below shows, the availability of loanable funds is a necessary but not sufficient condition for the provision of credit to the enterprise sector.

The factors behind the increase in, or continuation of, fiscal deficits are similar across countries. In all countries the share of government revenue in GDP has fallen considerably following tax reforms, which lowered tax burdens. In addition, falls in consumption squeezed consumption tax revenues, and the plummeting activity in the enterprise sector reduced revenues from state enterprise profits taxes (Table 2).12 Tax liabilities of the emerging private sector have been, in any case, difficult to monitor, and avoidance and evasion have been common. With regard to government expenditure, although subsidies and current and capital expenditures have been cut, social safety net expenditures (including pensions, unemployment benefits, and social assistance) have increased rapidly. Therefore, in general, the share of expenditure in GDP has remained rather stable. The net result has been a marked increase in fiscal deficits in countries such as Poland and Hungary where in 1992 they exceeded 7 percent of GDP.

Although the countries differ considerably in their access to foreign financing, the key to the above puzzle lies in the surge, or quite likely a rechanneling, of private saving intermediated through the banking sector. Private financial saving increased in part owing to an increase in precautionary saving and cessation of subsidized mortgage loans (Schwartz, Stone, and van der Willigen (1993)). For instance, household financial saving as a share of disposable income in Hungary rose from 6 percent during 1989–90 to 14 percent during 1991–92, while in the former Czechoslovakia money incomes minus expenditures increased to 7 percent of income in 1991–92, from about zero in 1990.

As money remains by far the most important financial asset and instrument of saving, the increase in saving manifested itself not so much in direct lending to the government but through a growing demand for broad money, intermediated through the banking system.13 There has been a noticeable decline in money velocity in several countries during the last year or two (Figure 1). The fall in inflation in Hungary and Poland, together with interest rate deregulation, initially pushed up deposit rates in real terms and played an important role in inducing larger holdings of financial assets (Figure 2).

However, these financial assets were by no means denominated only in domestic currency. As Table 3 illustrates, at end‐1991, foreign currency deposits in both Poland and Hungary accounted for about 30 percent of total deposits, with this ratio declining somewhat over the following year. From the perspective of public finance, such dollarization has a number of offsetting implications. On the one hand, dollarization would be expected to reduce the domestic monetary base and aggravate the inflationary impact of government deficits. On the other hand, as Rostowski (1992) suggests, such dollarization may actually increase total money supply (domestic plus foreign), which, in the framework of our model, could help maintain the level of output and hence be beneficial from a fiscal perspective.

Figure 1.Money Velocity in East European Countries

Source: IMF, World Economic Outlook.

Note: Velocity is measured as nominal GDP/average of broad money (M2).

However, as Calvo and Végh (1992) point out, dollarization also has important implications for the banking sector. At the limit, banks will be forced to operate without a lender of last resort and would be particularly vulnerable to a mismatching of assets and liabilities in terms of currency or maturity. Moreover, to the extent that dollar deposits have higher reserve requirements, or have to be paid higher interest, lending rates would increase. Higher lending rates would, in turn, increase the problems of moral hazard and the probability of default. To counteract these factors, banks may prefer relatively liquid, and safe assets, which, in the context of the East European countries, would essentially amount to investing in government securities.14

In terms of the analysis in Section II above, equation (6) can thus be extended to include lending to the government, so that

Figure 2.Household Deposits in Poland and Hungary

Sources: Narodowy Bank Polski, Information Bulletin, various issues; National Bank of Hungary, Monthly Report, various issues, and Monthly Bulletin of Statistics.

Table 3.Domestic and Foreign Currency Deposits—Poland and Hungary
PolandaHungaryb
Date

(End of period)
Domestic

currency
Foreign

currency
Foreign as

percent of total
Domestic

currency
Foreign

currency
Foreign as

percent of total
December 1991139,83657,38629.130213030.1
March 1992159,08969,34830.431713630.1
June 1992178,08471,94328.835214028.5
September 1992199,54379,01228.439815327.8
December 1992230,60690,79928.243015226.2
March 1993287,095108,84927.547817026.3
Sources: Nordowy Bank Polski, Information Bulletins; and National Bank of Hungary, Monthly Reports.

Data, in billions of zlotys, are for deposits of the nonfinancial sector.

Data, in billions of forint, are for savings deposits of the household sector.

Sources: Nordowy Bank Polski, Information Bulletins; and National Bank of Hungary, Monthly Reports.

Data, in billions of zlotys, are for deposits of the nonfinancial sector.

Data, in billions of forint, are for savings deposits of the household sector.

where Gt denotes purchase of government securities by the banks. This, of course, raises a number of additional questions about the factors determining the distribution of bank credit between government and the productive sector.15 These factors are discussed in the next section where several specific constraints on bank lending to firms are examined.

Whatever the reasons for those constraints, there is now, as part of the transition to a market economic system, a sharper separation between government and state enterprises than under central planning. Therefore policies that channel bank credit to the central government could eventually have a negative effect on enterprise liquidity and output. This would obviously be so if, as at present, the government finances a larger share of its deficit, or accumulates international reserves, through the issuance of public debt. Public debt instruments are guaranteed by the state and are therefore likely to be more attractive than enterprise debt— particularly under the circumstances in which enterprises are in a legal limbo and ownership is still to be properly defined.

As Table 4 shows, in Hungary credit to the government has increased noticeably relative to credit extended to the enterprise sector; a similar development has taken place in the other East European countries. Specifically, there has been an increase in both Poland and Hungary in the share of government securities in banks’ asset portfolios (Figure 3).16 This evidence probably understates the relative decline in real credit to the enterprise sector, since a proportion of the nominal increase in enterprise credit consists of a capitalization of interest arrears. Moreover, although there is no detailed evidence, it also appears that the relative share of the newly emerging private sector in total credit may have declined the most (see Varhegyi (1993)).

Redirecting credit from enterprises to government could actually give rise to tax arrears. The initial effect of such redirecting will be lower output, which will increase the firms’ incentive to default on any obligation they may have, such as taxes.17 Tax arrears, in turn, worsen the fiscal deficit and—if money supply is kept under control—induce further public debt growth, possibly setting the economy on a vicious cycle. Large amounts of tax arrears have already accumulated, particularly in the state enterprise sector. As of early 1993, these arrears are estimated at 3 percent of GDP in Hungary and 2½ percent of GDP in Poland. As illustrated in Figure 4, tax arrears in Poland as a proportion of total enterprise liabilities increased by nearly 50 percent between August 1991 and December 1992.18

Table 4.Hungary: Composition of Lending Portfolio of Commercial Banks and Specialized Financial Institutions(In percent of total)
DatesEnterprise sectorGeneral governmentHouseholdsNonresidentsTotal
January 1, 199273.87.29.99.1100.0
December 31, 1992a62.522.08.07.5100.0
January 1, 1993b51.226.515.27.1100.0
July 31, 1993c51.929.112.07.0100.0
Source: National BanK or Hungary, monthly Report, 8‐9/1993.

Without credit consolidation.

These data differ from those of December 31 because of credit consolidation and changes in classification.

Preliminary data.

Source: National BanK or Hungary, monthly Report, 8‐9/1993.

Without credit consolidation.

These data differ from those of December 31 because of credit consolidation and changes in classification.

Preliminary data.

Figure 3.Bank Credit to Government and Enterprises in Poland and Hungary

(In percent)

Sources: Narodowy Bank Polski, Information Bulletin, various issues; National Bank of Hungary.

a As a percentage of credit to enterprises.

b Data are adjusted for loan consolidation and reclassification of loans to the Government in April 1991, December 1992, and March 1993.

Figure 4.Poland: Enterprise Liabilities to the Budget

Source: Biuletyn Statystyczny, various issues.

a Liabilities to the budget as a percentage of total liabilities.

V. Portfolio Problems and Credit Allocation

A key feature of the banking sector in former socialist economies is that the state banks, which dominate the banking sector, are undercapitalized, and their asset portfolios contain a large proportion of nonperforming loans (see Calvo and Kumar (1993)). A large number of the bad loans stem from the pre‐reform system when credit was extended without regard for the performance of enterprises or their ability to service debts. Moreover, subsequently, the collapse of CMEA trade, declines in output, and significant changes in relative prices have adversely affected the profitability of enterprises and compounded the difficulties for the banks’ balance sheets. Some of the bad loans also stem from the extension of new credits to inviable enterprises, resulting partly from the banks’ own inability to distinguish between the riskiness of different enterprises in a rapidly changing economic and financial environment and partly from external pressures on them to lend to specific enterprises for essentially political reasons.19

Although the precise magnitude of the portfolio problem is difficult to assess, there is a general consensus that it is substantial and that, instead of diminishing over time, it may actually have increased.20 In Poland, for instance, at the end of 1992, some 20 percent of the assets of large banks were estimated to be substandard, a somewhat higher figure than at the end of 1991. Similarly, in Hungary, some 30 percent of bank loans were regarded as unserviceable at the end of 1992, markedly higher than two years earlier, while in Bulgaria, the share of bad loans, which was already high, is also considered to have increased.21

The balance sheet difficulties of banks are related to the problem of interenterprise claims. These claims, which derive largely from arrears to suppliers, have accounted for a sizable proportion of enterprises’ debt; in countries like Romania and Russia, the arrears have exceeded overall bank credit or broad money. (For a discussion of the arrears problem in Romania, see Clifton and Khan (1993).)22 The start of the reform process brought about a sharp increase in these arrears, essentially as a result of attempts by enterprises to increase their liquidity and circumvent the strict credit ceilings. Although a large proportion of the debts could be netted out within the enterprise sector, a considerable share corresponded to an increase in the enterprises’ net debt to banks; if one enterprise did not repay another, the latter was not able to repay interest on its bank credit, increasing further the share of nonperforming loans.

It is worth emphasizing that the problem of these arrears is not simply that of separating “good” from “bad” firms, that is, firms with and those without high net arrears. Given the chain links between enterprises, with most firms having both debts and credits of similar magnitudes, the enterprise sector as a whole is affected (see Calvo and Coricelli (1994)). Moreover, as the experience of Romania and Russia illustrates, unless the incentives and constraints facing enterprises change in a credible way—that is, unless expectations of a bailout change—even when eliminated through money creation, arrears can very quickly reappear.

The low quality of loan portfolios, exacerbated by the arrears problem, has led to an understandable concern about the broader impact of insolvent banks on the transition process. This concern, together with the desire to prepare banks for eventual privatization, has led several countries to implement major policy initiatives toward recapitalizing banks and consolidating loans. Although some of these policies may appear to yield short‐term specific benefits for improving the banks’ books, the implications for the banks’ performance, for the allocation of credit to the enterprise sector, and for government finances have not received adequate attention.

The policies adopted by different countries for strengthening bank balance sheets vary considerably, but all entail a fiscal burden. In general, whereas no resource flows may be involved in the balance sheet cleanup operations, the replacement of bad loans with government debt does imply an ensuing debt‐servicing burden.23 In Poland, for instance, which has recently adopted a “decentralized” approach to the portfolio problem (noted below), the recapitalization plan currently under consideration would nevertheless be financed largely by domestic bond issues.24

In addition to this direct government effort, the banks are, to a varying extent, also required to provision against bad loans, and as a result are paying markedly less in profit taxes. For instance, in Hungary, where bank provisioning was highest (Table 5), the impact on the budget in 1992 has been estimated at 2 percent of GDP. The implication is not, of course, that adequate provisioning is undesirable or unnecessary—especially from a longer‐term perspective—but that in the short term it can have considerable effects on both output and the budget that should be taken into account in assessing the cost of bank restructuring.

Table 5.Hungary: Loan Loss Provisions, 1991
Operating

profits


Provisions


Pre‐tax profits
Forint

(millions)
Forint

(millions)
Percent of

operating profits
Forint

(millions)
Percent of

operating profits
Five large banks52,20935,5856816,62432
Medium‐sized banks13,9292,6471911,28281
Large and medium‐sized banks66,13838,2325827,90642
Total75,32041,1295534,19145

The process of recapitalization and loan consolidation appears to have made banks excessively cautious in lending to enterprises for a number of reasons. First, as in Poland, state banks have been required to complete restructuring of their loan portfolios by March 1994. Toward this end, banks have been warned and discouraged against extending credit to enterprises with bad or doubtful debts, unless such credit is given as part of a “conciliation” agreement to reschedule claims, write off part of them, or convert them into equity.25 Given banks’ limited expertise in assessing the riskiness of enterprises, complicated by the problem of interenterprise arrears, these exhortations have essentially led to a dampening of banks’ overall lending to the enterprise sector and in particular to the small and medium‐sized firms. Instead of distinguishing between the degree to which firms would be potentially profitable, and solvent, and adjusting the terms of the loans accordingly, banks appear to have retrenched in terms of their lending.

In Poland, the process could have been exacerbated by the new incentives given to banks’ management. Generous stock options have been provided to hank executives to be exercised upon privatization, which would in turn depend on the health of the banks’ balance sheets. This action has further propelled banks into holding an increasing proportion of their assets in government securities and into building up liquidity.

A similar development appears to be evident in Hungary, where the 1992 bankruptcy law (which has since been amended) led to a large number of small and medium‐sized firms, which may have had short‐run liquidity problems, being declared insolvent. However, this outcome, far from benefiting the banks, actually aggravated their portfolio problem, given the interlinkages between firms, and was an element in the sharp increase in provisioning noted above. To the extent that credit in nominal terms has increased, it largely reflects the capitalization of interest arrears and some new lending to a few, not necessarily the most efficient, large enterprises.

At the same time, the above factors, combined with limited competition in the banking sector, have led to marked increases in lending margins. As Figures 5 and 6 suggest, while deposit rates in real terms declined, there was virtually no equivalent decline in loan rates, resulting in high or increasing margins in Poland and Hungary. High loan rates may exacerbate the adverse selection problem whereby inefficient firms or essentially insolvent firms, which are most likely to default, are the ones that end up obtaining credit.

Figure 5.Poland: Real Interest Rates

(Percent per annum)

Sources: Narodowy Bank Polski, and Biuletyn Starystyczny, various issues.

a Nominal loan rate adjusted for changes in producer price index.

b Nominal deposit rate adjusted for changes in consumer price index.

As shown by the model in Section II above and by the evidence in Calvo and Coricelli (1994), lack of credit has an adverse effect on a firm’s output. Some further illustrative evidence on this issue is provided in Table 6, which examines the relationship for Poland in 1992 between bank credit, profitability, and output across 25 major sectors of the economy. It shows a positive relationship between changes in real credit and in output, taking into account differences in profitability. Although this evidence cannot be regarded as conclusive, given the methodological problems inherent in this type of analysis, it nevertheless provides some support for the argument concerning the importance of bank credit for sustaining activity in the economies in transition.

What are the options for increasing credit and output? As shown above, a macroeconomic policy of loosening the monetary policy stance is likely to be counterproductive. An increase in inflation that such a policy will entail would reduce, not increase, real credit. To the extent that inflation generates uncertainty and makes it even more difficult to assess firms’ creditworthiness, it could further exacerbate the credit crunch. A reduction in fiscal deficits could, of course, lead to less credit being pre‐empted by the public sector, but, for the reasons noted earlier, it may not automatically lead to any corresponding increase in credit to the enterprise sector.

Figure 6.Commercial Bank Interest Rate Spread in Poland and Hungary

Sources: Narodowy Bank Polski, Information Bulletin, various issues; National Bank of Hungary, Monthly Report, various issues.

a Rate on lowest risk credit minus three‐month deposit rate.

b Rate on one year or less enterprise credit minus one‐year deposit rate.

Table 6.Poland: Changes in Output, Credit, and Profitability a
Equation: Δoutputti=α+βΔcreditti+γprofitt1i+ϵti
SectorsαβγR¯2
All0.0070.2610.149
(25)(5.330)(2.008)
0.0070.2610.0010.151
(5.192)(1.962)(0.189)
Sectors with0.0080.2720.0020.150
 moderate inflation

(21)
(5.231)(1.947)(0.210)

Dependent variable is the change in real output in 1992 in 25 (or 21) major sectors of the economy. The explanatory variables are change in real credit and the average profit rate in 1991; t‐statistics are provided in parentheses.

Dependent variable is the change in real output in 1992 in 25 (or 21) major sectors of the economy. The explanatory variables are change in real credit and the average profit rate in 1991; t‐statistics are provided in parentheses.

A possible solution could be to modify the strategy for reform of the banking sector to encourage banks to lend to enterprises, so long as that does not lead to excessive risk for themselves. Thus, while the resolution of the portfolio problem should certainly not be neglected, the specific policies for such resolution should be re‐examined. More important, policies should be implemented to encourage banks to become more adept at assessing risk than they have been until now. Both these aspects of the problem could he tackled by privatizing the state‐owned banks, allowing much greater participation by foreign banks, and obtaining additional external expertise in assessing and pricing credit risk.

VI. Credit, Equity Capital, and Investment

The analysis of bank credit as a source of working capital can be extended to the use of such credit by firms in former socialist economies to finance investment and undertake product and market diversification in the medium and long term. Although bank loans in the short run are virtually the only formal source of credit, other sources of finance such as venture and equity capital may also be available over a longer time horizon. Over such a horizon, issues related to the relative merits of these alternative sources of finance become important and are briefly discussed below.

At present, and as the earlier discussion has emphasized. given the banks’ reluctance to lend even for short‐term working capital. credit for longer‐term investments in several of the East European countries seems virtually unavailable. However, it has been argued that once the commercial banks are fully restructured and placed on a sounder footing. they could actively participate in the provision of term finance (Brainard (1991)). As banks build up information and expertise in evaluating operations of firms borrowing from them, they could be active in screening, monitoring, and restructuring these firms. Since the equity‐ownership of firms being privatized is likely to be highly diffused and the individual owners may have neither the information nor the incentive to exercise corporate governance, the banks’ role could be especially important.

Even if the current constraints on banks are removed, however, it is unclear whether they will be able to oversee management decisions in a constructive way. More fundamentally, there could be endogenous constraints in credit markets, resulting from asymmetric information, adverse selection and incentive problems. which would prevent banks from providing investment finance. These constraints have been analyzed at length in the existing literature on financial sector liberalization in developing countries. They are contingent, in part, on the possibility that a bank’s return from lending to a specific group of borrowers may not be a monotonically increasing function of the interest rate it charges to borrowers (see Stiglitz and Weiss (1981) and Cho (1986)). This is so for two reasons: the first is the adverse selection effect—higher interest rates discourage the safe borrowers that the banks prefer; the second is the incentive effect—if borrowers have a choice of projects, they will tend to favor those projects with a higher probability of default when the interest rate is increased. These two effects could discourage banks from raising their interest rates in response to an excess demand for credit.

The above constraints imply that banks avoid financing a new, productive group of borrowers, who may be perceived to be risky even when the banks are risk neutral and free from interest rate ceilings. The difficulty that new productive customers have in obtaining finance from banks comes essentially from the fixed‐fee contract nature of bank loans (see Stiglitz (1991) and Diamond (1991)). The borrowers are concerned about the upper tail of the distribution of investment outcome while the lenders are concerned with the lower tail of the distribution. In this situation, banks may totally avoid lending to specific groups of potential borrowers unless they have information that enables them to rank each borrower and charge appropriate interest rates according to each borrower’s riskiness so that they can ensure a profitable expected return.

The issue then is whether, without this information, equity markets could play a role in supplying investment capital to enterprises. It could be argued that precisely because of the above constraints and the risk‐ return trade‐off, enterprises might be more able to raise capital from equity markets, since equity holders would be concerned with the entire distribution of returns. In addition, for the privatization of enterprises or banks to make any progress, the development of equity markets is essential. However, in practice, as the experience to date has shown, equity markets in the former socialist economies are developing more slowly than had been anticipated. For instance, as of end–August 1993, despite a sharp increase in equity prices, market capitalization of the Polish Stock Exchange was less than $1 billion, with only 20 firms quoted and very limited active trading. Similarly, the Hungarian Exchange had a capitalization of less than $0.5 billion and also limited activity.26

Equity markets in East European countries have not developed rapidly enough for a number of reasons. First, the slow development is due to the slow pace of the privatization program itself, which has severely limited the supply of equity.27 Second, the regulatory regime, in particular the enforcement of legal requirements and regulations, remains weak, engendering uncertainty and imposing high transaction costs. This is exacerbated by the weak accounting and opaque reporting standards of firms’ financial information. There is not enough reliable information about the current, much less the future, prospects of quoted companies to enable the potential domestic investor to take rational decisions about investing in equities. These factors also explain why the inflow of foreign portfolio capital has also, in general, remained limited.

If it is accepted that banks may not be able to provide adequate investment finance and that the equity markets can make a contribution in this regard, a number of policy measures need to be implemented to encourage the growth of these markets: in addition to speeding up the privatization process, accounting and reporting standards of firms need to be improved dramatically; initial public offerings need to be priced realistically; and finally, to increase confidence in the market operations, regulations against insider trading should be stringent and laws ensuring that private contracts are honored should be enforced.

VII. Concluding Remarks

The main focus of this paper has been on analyzing factors in former socialist economies that are likely to determine the volume of bank credit allocated to the enterprise sector and the implications of this allocation for aggregate supply and macroeconomic performance. The paper developed a model to explain how changes in the demand for money by the household sector directly influence the volume of loanable funds and credit, which in turn determines output and employment in the productive sector. If firms cannot obtain sufficient working capital, production will be cut back. The model showed, however, that attempts to increase credit by inflation may actually exacerbate the credit crunch because of the effect of inflation on the household demand for deposits.

The paper also examined factors that determine the allocation of bank credit between enterprises and other borrowers, in particular the government. The reasons why banks may prefer to finance government deficits rather than make potentially more profitable loans to enterprises include limited information about enterprises’ current performance, considerable uncertainty about their future prospects, lack of expertise in evalating risk, and pressure from the government to improve the quality of banks’ asset portfolio. These reasons for preferring credit to the government, although perfectly rational from the perspective of individual banks, may create a vicious cycle of low output, low enterprise profits, high fiscal deficits, and, again, low credit to enterprises. Empirical evidence for a number of East European countries seemed to be consistent with the analysis. A number of policy options for increasing the provision of credit to potentially viable enterprises were noted.

Finally, the paper discussed the relative merits of bank finance and equity capital in financing medium‐ and long‐term investment. In a credit market with imperfect information, liberalization of the banking sector would not necessarily lead to efficient allocation of term capital: adverse selection and moral hazard effects arise when debt contracts are used in the presence of asymmetric information. Equity contracts, however, are free from the adverse selection effect and thus could overcome inefficient allocation of capital when the same degree of imperfect information on borrowers exists as with debt contracts. However, a number of important constraints exist on the development and efficient functioning of equity markets in the former socialist economies, and the paper noted some policies that might be implemented to overcome them.

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Guillermo A. Calvo is a Professor of Economics, and Director of the Center for International Economics, at the University of Maryland. At the time of writing this paper, he was a Senior Advisor in the Research Department of the IMF. Manmohan S. Kumar, a Senior Economist in the Research Department, is a graduate of the London School of Economics. He received his Ph.D. from Cambridge University, where he also taught prior to joining the Fund. The authors are grateful to Gerard Belanger, Adrienne Cheasty, Ajai Chopra, Fabrizio Coricelli, Eduard Hochreiter, Mark Lutz, Donald Mathieson, John Odling‐Smee, and Mark Stone for helpful comments and suggestions and to Nadine Orosa for research assistance.

In Poland, for instance, the private sector share of GDP increased from under 30 percent in 1989 to nearly 45 percent in 1992, whereas in the former Czechoslovakia and Hungary, respectively, the share increased from under 5 percent to 20 percent, and from 39 percent to 45 percent (see Schwartz, Stone, and van der Willigen (1993)).

In Poland, although private banks have proliferated, they collectively account for a very small share of banking activity.

Equivalently, one can think of production occurring at time t, when labor has to be paid, but sales revenues do not accrue until time t+1. It is worth noting how the presence of initial liquidity and initial inventories change the main argument of the paper. Regarding initial liquidity, it is assumed that there was a liquidity crunch at the beginning of the transition process; if there was no crunch, there is little left to explain. Regarding the initial stock of inventories, at least for Poland, there is no evidence that this stock in the hands of manufacturing firms at the beginning of the transition process was unduly large (see, for instance, Calvo and Coricelli (1992)).

For the time being, we will assume that firms intend to honor their contractual obligations.

Thus, the informal sector may not appear to be an adequate way of modeling the emerging private sector in these economies, since the latter is supposed to be more efficient than traditional enterprises. However, in the context of the present model, since the informal sector is more labor intensive, labor productivity might fall (even though total factor productivity might increase).

Under this interpretation, total output should also include output from the informal sector. However, given the productivity differentials between the formal and informal sectors pointed out above, output as given by equation (4) is positively correlated with the all‐inclusive output measure (which includes informal sector output).

For a more explicit shirking model with variable effort, see Calvo and Wellisz (1979).

The analysis does not assume that there was a shift in the demand for money. Rather, the main argument is based on the fact that there was a decline in M/P; at the beginning of the transition process owing simply to the sharp increase in prices following their decontrol combined with monetary restraint.

Russia has recently been the paramount example of trying to employ the inflation strategy to prop up output, with no visible success. This discussion has disregarded the fact that the existence of positive government subsidies to enterprises implies that firms will now exhibit positive profits. The latter would help to relax the liquidity constraint in future periods. This topic will he picked up in Section III.

Although massive default may be counterproductive for enterprises, the individual firm may still find it optimal to default, because the pnce level is determined by the market, not by the individual firm. The latter takes prices as given by the market, and in that context failing to repay bank debts adds to the firms’ liquidity and ability to employ labor. This rationalizes the possibility that atomisticfirm behavior may result in massive default on bank credit, even though, at the end of the day, no firm benefits from such action.

This issue is discussed in detail in Section V below where additional constraints on bank lending to firms are discussed. Here, notice that even if, in principle, banks are capable of “riding the storm,” they would run against bank regulations. Experience shows that banks are likely to try hiding their “bad” loans from the regulator, but they are eventually caught (by the regulator or by reality).

In Poland in 1990 and in the former Czechoslovakia in 1991, enterprise profits were artificially inflated by the revaluation of inventories, and, as there was little or no inflation adjustment in the profits tax, most of these paper profits were transferred to the government. As Schaffer (1993) shows, about half of the swing in Poland’s budget position, from a surplus in 1990 to a deficit of over 5 percent of GDP in 1991, was accounted for by the fall in profit taxes (owing largely to a decrease in the inflation bias).

Even where the public can directly subscribe to government bonds, as in Hungary, for instance, the share of government securities in total household savings remains very small.

Russia, also, similar factors have led to the banks keeping a large proportion of their assets liquid, but in the form of holdings of U.S. dollars (see Easterly and da Cunha (1993)).

In addition to the distributional concern, there is concern about the sustainability of current saving rates, especially since some of the factors underlying the initial increase in private saving may now be waning (see, for instance, Gomulka (1993)).

The data for Hungary in Figure 3 are adjusted for various credit consolidations and changes m classification that inflated outstanding credit to the government.

Section V below provides some impressionistic evidence on the positive relationship between the lack of availability of credit and declines in output in Poland in 1992, consistent with the evidence provided for an earlier period by Calvo and Coricelli (1994).

The irony here is that barely a year or two ago, the development of government securities markets was regarded as likely to bestow significant benefits for financing fiscal deficits (for a discussion of the issues, see Calvo and Kumar (1993)).

Considerable literature now exists on the portfolio problems of banks and the policies that have been, or should be, adopted to deal with them. In addition to Calvo and Kumar (1993), see Fries and Lane (1994) and Varhegyi (1993).

The difficulties in accurately assessing the bad loan problem arise in part from inadequate information about the current and prospective performance of enterprises as well as inadequate bank auditing procedures.

These estimates are derived from Hogan, Rhyne, and Dod (1993) for Poland; Buyske and Vogel (1993) for Hungary; and Davis, Hogan, and Vogel (1993) for Bulgaria.

For a broader discussion of issues relating to interenterprise arrears, see Calvo and Coricelli (1992), Clifton and Khan (1993), and Rostowski (1993).

It is worth noting that a substitution of had loans for government bonds may not necessarily have any short‐run implications for liquidity to the enterprise sector (banks would now receive interest that they might then use to buy more bonds), but it would have significant fiscal implications in the long run.

The plan aims to increase capital to asset ratios for large banks to 12 percent or more. In addition to the bond issue, the plan may also draw on the $1 billion stabilization fund originally instituted in 1990 by bilateral donors.

25 For details of this restructuring strategy, see Hogan, Rhyne, and Dod (1993).

For a discussion of issues on the role of equity markets in former socialist economies, see Brainard (1991), Borensztein and Kumar (1992), and Calve and Kumar (1993). For a discussion of the issues about the importance of equity markets in developing countries, see, for instance, Singh and Hamid (1992).

The important exception in this regard is the Czech stock market where, since June 1993, shares have been traded in a large number of companies following their privatization through the voucher schemes.

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