Abstract
The paper considers that strain is the main source of inter-enterprise arrears in post-command economies. Strain can be linked with the structure of the economy and the size of resource misallocation. Inter-enterprise arrears “soften” markets and operate as a self-protecting device against the pressure for change. As temporary quasi-inside money, arrears fuel inflation. A paradox of policy credibility in undertaking structural adjustment is emphasized. Rising exports can be a possible side effect of arrears and a constraining factor: the size of the economy is seen as affecting the relationship between arrears and exports. An operational framework for containing arrears would Include: “breaking up” structure; Imposing a disciplining “straitjacket” on structure; industrial policy (“picking losers among losers”) and targeted external assistance. Containing arrears can not be a one shot policy-drive; here one deals with a process that will overlap in time with the evolving environment.
I. Introduction
Because of the impact inter-enterprise arrears have on stabilization policy and the transformation of post-command economies, the phenomenon has captured the attention of both theorists and decision makers. However, the diagnosis and solutions that have so far been proposed do not address directly what this paper considers to be the main source of arrears: strain. Strain can be linked to the structure of the economy and to the size of the resource misallocation. Therefore, in explaining the growth of arrears and in exploring ways to reduce them, this paper focuses more on the real side of the economy.
Section II of the paper deals with the macroeconomic implications of arrears. Arrears “soften” markets and influence the financial system in an apparently ambivalent way: they seem to operate as a self-protecting device against the pressure to proceed with swift and fundamental reforms. At the same time, by relaxing financial discipline, arrears can dangerously slow the speed of restructuring and adjustment. Arrears tend to perpetuate a soft-budget constraint syndrome. As temporary quasi-domestic money, arrears in fact fuel inflation by enabling firms to raise prices and wages without fearing immediate consequences. Paradoxically, however, arrears can also have an anti-hyperinflationary potential. Since they are only a temporary substitute for real money, arrears work to “endogenize” the money supply dynamics in a perverse way.
Section III stresses that the systems undergoing transformation have been under tremendous strain because of internal reforms and external shocks. Structure and magnitude of the resource misallocation are highlighted and it is argued that the system develops a momentum that involves the use of the inflation tax and real interest rates as implicit subsidies. Analogies are made with the adjustment in the industrialized countries following the oil price shock of the 1970s and early 1980s, as well as with the real interest rate shock that oil-importing developing countries underwent in the early 1970s. The dimension of the arrears problem in the various post-command economies is linked basically with their capacity to adjust, which in turn depends on the structure and the size of the required structural change (adjustment). A related paradox of policy credibility in undertaking structural adjustment is emphasized.
Section IV uses the Romanian experience as background to show rising exports as a possible side effect of arrears and as a constraining factor on their elimination. Arrears tend to restrain the evolution of enterprises along a common denominator path, which explains why those that have the capacity to grow try to escape the real liquidity constraint by pushing exports: even when exports seem unprofitable, a premium on liquidity can more than compensate for the value differential. Dollarization is mentioned in this regard, and the size of the economy is seen as affecting the relationship between arrears and exports.
Section V attempts to offer an operational framework for containing arrears. Four major areas for action are discussed. The first concerns “breaking up” structure by inducing a strategic alliance between creditors and isolating big offenders (debtors). The second involves imposing a disciplinary “straitjacket” on structure by modifying the set of rewards and penalties and thereby inducing agents to optimize in conformity with the thrust of transformation. In light of the heavily monopsonized labor markets, income control policy is seen as an essential component of the “straightjacket”. A third area for action is industrial policy, which is seen as part of the policy mix of stabilization and transformation and is viewed as a “damage-control device” (“picking losers among losers”). This allows some breathing space, which is needed to cope with the high degree of uncertainty about property rights, the clarification of which can mitigate the costs of resource reallocation. The fourth area focuses on targeting external assistance.
The concluding remarks in Section VI point out that the best one can hope for in fighting inter-enterprise arrears is, essentially, to try to contain them. However, containing arrears cannot be a one shot policy-drive; rather, it is process that will overlap in time with the evolving environment.
II. Macroeconomic Implications of Arrears
Inter-enterprise credits are a normal way of doing business in a market economy and their existence should not, normally, be a cause for concern. In a mature market economy, bank and nonbank credit are roughly of equal size (D. Begg and R. Portes, 1992, p. 9). When certain enterprises enjoy excess liquidity they lend it and, thus, nonbank credit emerges. Complications arise for both theory and policy when credits are not voluntary, or when overdue payments are, as a matter of fact, payments delayed sine die i.e., arrears with less than a very slim chance of being repaid.
Inter-enterprise arrears are a symptom of an economy under stress and it is conceivable that during recessions, the length of delays in making payments grows; the weaker, less competitive firms try to survive by resorting to arrears and, thereby, they spread financial strain around. But in a well functioning economy, market (financial) discipline (see T. Lane, 1992) is a golden rule of the game and, ultimately, failure befalls those companies that cannot deliver accordingly.
Ever more attention has been paid to inter-enterprise arrears In the transforming post-command economies recently, for two main reasons; 1) the peculiar nature of the phenomenon in these systems, with aggregate net arrears portraying congenital inefficiency (losses/incapacity to pay) and gross arrears reflecting the institutional primitiveness of the domestic market environment; and 2) the impact of arrears, as temporary quasi-inside money, on monetary policy and ultimately on stabilization policy. The evolution of arrears in the transforming economies, especially, in those that have started reforms later, has thrown more light on the extreme structural rigidities of these systems and raised questions about the microfoundations of macroeconomic stabilization policies during transition.
1. Arrears “soften” markets
It can be assumed--and empirical evidence supports it--that the more rigid (inadequate) system is structurally and institutionally, the more intensely arrears will show up as a structural problem. Arrears appear to influence the system in an ambivalent way: on one hand they seem to operate as a self-protecting device (like antibodies created by an organism) against the pressure for change--the entrenched structures withstand change; on the other hand, they can dangerously slow down the pace of restructuring and adjustment by relaxing financial discipline. In post-command economies arrears help to preserve an essentially soft-budget constraint syndrome (J. Kornai, 1980); enterprises have much more bargaining power than in a reformed centrally planned economy, whereas soft-budget constraints still operate. 1/ In this respect, one can detect a fundamental flaw of the system in transformation, namely the high degree of decision-making power enterprises have when they do not face hard-budget constraints.
Arrears “soften” markets--in the sense of relaxing market discipline--thereby, cushioning the impact of shocks by moderating the decline of output. 2/ The degree of this moderation depends on the dynamic of inflation; the higher is inflation the less will be this moderating effect. On the other hand, arrears help perpetuate soft budget constraints, complicate monetary policy and slow down restructuring (and, thus, preserve resource misallocation). Figure 1, which uses the conventional ISLM diagram, tries to show how arrears moderate an output decline once a monetary shock is applied. The tightening of monetary policy would normally mean a shift of LM to LM1, but due to the growth of arrears the shift is considerably smaller, to LM2. Consequently, the decline of output is moderated from Y0 to Y2 (instead of Y1). How durable the LM shift is depends on to what extent and how inter-enterprise arrears will be accepted (or tolerated) by the system. A way of portraying the softness of markets during transition is to distinguish between nominal net arrears and real net arrears, when net arrears are viewed as a measure of system inefficiency. Nominal net arrears take as granted the fungibility (mutual convertibility) of receivables and payables, which, on a net basis, obscures the degree of loss-making within the system. This is illustrated in Figure 1 by a shift of the IS curve from ISO to IS1; the real moderation in the output decline is smaller than the nominal one, as depicted by the fact that Y3 is smaller than Y2. The netting out of arrears--not through markets--is partially analogous to an attempt at having multilateralized payments inside the former COMECON trading bloc--a move that was resisted by all member countries because of the different “hardness” of goods exchanged. Nominal net arrears are always smaller than real net arrears since they involve transactions that would not occur were hard budget constraints strictly enforced.
Arrears “soften” Shocks and Markets
Citation: IMF Working Papers 1994, 054; 10.5089/9781451847451.001.A001
Arrears “soften” Shocks and Markets
Citation: IMF Working Papers 1994, 054; 10.5089/9781451847451.001.A001
Arrears “soften” Shocks and Markets
Citation: IMF Working Papers 1994, 054; 10.5089/9781451847451.001.A001
2. Arrears as temporary quasi-inside money
Arrears do not constitute money creation since, owing to currency constraints, sooner or later, the economy would be brought to a standstill if prices rose faster than the decline of output and if no financial innovation occurred that could significantly affect money velocity. It could be argued that arrears, themselves, form a financial innovation, but their temporariness as a means of liquidity invalidates this argument; arrears are only a temporary substitute for inside money (bank credit). 1/ A situation can be imagined in which cash and bank credit are used for wages and other payments that require currency only, whereas for the remaining transactions--which rely on arrears--payment would turn into compensation (barter) deals. 2/ In effect, it would be a dual monetary system with a demonetized segment of transactions. But this growing demonetization would still be subject to currency constraints and would have to stop when there is either a new injection of money to support additional money-based transactions (or their nominal growth due to wage Increases), or if inter-enterprise arrears start increasing again.
Arrears are Inflationary because they allow firms to raise prices and wages without fear of immediate consequences. An intended tight monetary policy--with low credit ceilings and high interest rates--would bring about a brutal drop in output if arrears did not provide a “window of opportunity” for enterprises to escape the financial constraint. But, paradoxically, arrears can also have an anti-hyperinflationary potential when they constitute a second-worst state of affairs as against a completely accommodative money supply (intended to finance, without restraint, loss-making enterprises and budget deficits). This is, surely, an overstatement since hyperinflation can coexist with growing arrears.
Since arrears are only a temporary substitute for real money, they work to “endogenize” the money supply dynamics in a perverse way. Growth of arrears relates to increases in prices and wages as both cause and effect--via inflationary expectations--and serves to make the cash constraint more binding, magnifying the dilemma for policymakers. Thus, these officials will have to decide whether to: try to control inflation--ultimately seen as a purely monetary phenomenon--by using only monetary policy and risking a crash-landing of the economy; or to accommodate money supply to the “needs” of the economy, which would maintain the momentum of inflation and cause hyperinflation.
III. Strain as an Explanation of Arrears
There are several major explanations for the growth of arrears during transition. These Include: fuzziness concerning property rights and how this affects enterprise behavior (S. van Wijnbergen, 1992; M. Khan and E. Clifton, 1992); the set of incentives that shape enterprise behavior and lead to “credit market failures” (D. Begg and R. Portes,1992); financial (institutional) underdevelopment and shortage of information (B. Ickes and R. Ryterman,1992); the real liquidity crunch, following the much higher than expected rise in prices after deregulation or liberalization (G. Calvo and F. Coricelli, 1992); and the lack of policy credibility (J. Rostowski, 1992). These explanations are linked and pinpoint two prominent features and issues that arise in tackling the arrears phenomenon in the transforming economies, namely, structure and resource misallocation. Once the combination of the internally engineered shocks (via reforms) and the external shocks have occurred, both of these features bring the system under strain, and one outcome of strain is arrears.
1. Structure
Structure refers to the network of institutional arrangements, including socially-Ingrained rules of conduct (D. North, 1981)) and the vested interests, which are based on material/productive interdependencies and the distribution of property rights. The interaction between these forces creates a system that holds individual enterprises captive. A legacy of the command system is that the vested interests are the result of the configuration of the industrial structure. This structure can be characterized as a system of chain links, whereas a market economy, which is a dynamic, complex system, relies essentially on parallel links. Thus, the industrial structure in transforming economies, with its extremely high concentration and reliance on chain links, explains the degree of market monopolization found in them.
a. The power of structure
One can talk of a “power of structure” (a concept quite familiar to business school students), which is well illustrated by the power of debtors over creditors--what Begg and Portes have named “creditor passivity”. This power is not of a conspiratorial nature--the “cartel” is unconscious because it rests on the rules of the functioning system. In this case, creditors, taken individually, find it prohibitively costly to attempt to enforce financial discipline and optimize by desisting from it.
b. Arrears limit freedom of choice and enhance the power of structure
As argued earlier, arrears are a by-product of structure. At the same time, arrears serve as a protective device of the existing structure and enhance its power. This happens since enterprises, which are caught in the web of interlocked receivables and payables, see their potential transactions limited to firms that accept arrears; companies that ask for real money as payment will avoid non-liquid partners. Thus, arrears limit “freedom of choice” and consequently the reduce the variety of transactions (K. Lancaster, 1979), which implicitly affects the quality of inputs and consequently the quality of output. For certain enterprises--those that do which do not have a “defensive survival mentality”, this limitation can increase the temptation to escape the trap of arrears and the “power of structure” 1/
2. Resource misallocation
The second feature and issue is the dimension of resource misallocation, i.e., the sheer scale of disequilibria--at the new relative prices--that indicates the magnitude of required structural adjustment as compared to the ability of the system to undergo broad reaching and rapid change.
a. Spread of profitability and dispersion of inefficient enterprises
Command planning, with its inherent impossibility of rational calculation and forced industrialization, left a legacy of resource misallocation that was brought conspicuously into the open by price liberalization. The new prices showed what was previously hidden by administrative prices and heavy redistribution of income: a very wide spread of profitability rates and the wide dispersion of units fitting several categories. The categories include negative value-added enterprises 1/; inefficient, yet positive value-added units, which, in turn, can be split into nonviable and potentially viable firms; and finally efficient enterprises.
The wide spread of profitability rates and wide dispersion of highly divergent performance in enterprises mean that should market (financial) discipline be strictly enforced, a large number of units would have to go under. As a sign of the start of profound reallocation of resources, aggregate output would go down substantially since market destruction is significantly more intense than market construction, at least in the first stage (the so-called J-curve effect). There are two important aspects involved in this process: one is the scope of reallocation (dislocation) and the other concerns the speed required for maintaining a balance between exit and entry into the market. A plausible assumption is that the larger the scope of reform and the faster the desired speed of the process are, the higher the imbalance will be and tension will build up within the economy. Actually, when we talk about “low supply-responsiveness” we mean this imbalance.
The problem of the scope and speed of resource reallocation can be posed for an economy operating at any level of employment; any significant change in relative prices would have to bring about resource reallocation. But, it makes sense to presume that, the lower is the level of employment the higher will be the reluctance to undergo change. 2/ In this regard, it may be interesting to note the experience in industrialized countries, when they had to absorb the oil price shock in the 1970s. They were able to undergo the required adjustment at a relatively leisurely pace owing essentially to the quality performance of their economies, their status as world price makers for manufactured goods and their ability to recycle petro-dollars. Incidently, because of these favorable conditions, monetary policy was also used to delay change, which led to a surge of world inflation.
The post-command economies, on the other hand, are fundamentally price takers. Once world prices started to govern all of their trade transactions after 1990, these countries had to absorb a major deterioration in their terms of trade (except for the Russian Federation and possibly Kazakhstan), and following the dismantling of the COMECON arrangements, they had to face an almost sudden collapse of trade in Eastern Europe. Additionally, there was a sharp compression of domestic trade and of related aggregate supply/demand owing to skyrocketing information and transaction costs for many enterprises--what Calvo and Coricelli have named “trade implosion” (1992, p. 1) and what I would call, at a more general level, “network deconstruction”. Because of the extreme fuzziness concerning property rights, it is justifiable to surmise that X-inefficiency (H. Leibenstein, 1967) was on the rise in many enterprises--a phenomenon that is accompanied by pervasive asset stripping. For the transforming economies, the strain caused by the magnitude of the required resource reallocation, combined with the primitive institutional arrangements and the lack of organizational capital (P. Murrell, 1991), has been compounded by severe exogenous shocks.
b. Inflation tax and negative real interest rates as implicit subsidies
In a system under substantial strain, there are strong forces that induce a propensity to generate inflation as a way of diffusing tension by spreading out, or putting off, the costs of adjustment. The Inflation tax and negative real interest rates are implicit subsidies for transforming economies that cannot make ends meet financially in a competitive environment. Inefficient enterprises develop a vested interest in raising prices at a faster pace than the dynamics of costs (wages), and, in addition, they form a strong lobby in favor of obtaining cheap credit. These endeavors are made easier since markets are heavily monopolized, a fixed exchange rate--as an anchor and a market disciplining factor--is almost a practical impossibility, and the control of money supply is shaky for both technical and political reasons. 1/
The moment stabilization policy is formulated to combat inflation and monetary policy is tightened, arrears form an escape route for enterprises to continue obtaining credit at no cost and the policy also enables them to push prices upward relentlessly. Moreover, inefficient enterprises would clearly view even the diminution of negative real interest rates as a major shock, when it means a substantial cut of the implicit subsidy and brings them “in the red”.
An analogy can be traced with the situation of the oil-importing developing countries which, in the aftermath of the oil-price shocks, became heavily indebted by borrowing at highly negative real interest rates--rates that were virtually identical to an invitation to borrow. When interest rates turned positive in real terms on world capital markets a chain reaction was triggered and the world debt crisis of the 1980s started to unfold. The basic difference is, however, that whereas domestic firms (in the transforming economies) can run arrears nations face what are essentially hard budget constraints and they are subjected to financial discipline by the international community. 1/
3. The size of the problem
Analysts have highlighted the relatively lower level of arrears in countries like the Czech Republic, Hungary, and Poland, as compared to Romania or its Russian Federation. Nonetheless, the pernicious effects of arrears trouble policymakers in all the transforming economies. It is noteworthy that even where the results of macrostabilization have been seen as comparatively remarkable--like in the Czech Republic, where the underlying inflation rate was 6 percent in 1992--arrears have been persistent and have also signalled substantial strain in the system. 2/ But the question remains: why have the first three countries above fared better in this respect? The answer can be pursued by looking at the structure of these economies, the size of their economies, their ability to export to western markets and to attract foreign investment. Furthermore, structure is linked to a history of partial changes (which, in some cases, have brought about ingredients of a market environment), to concentration of industry, and the existence of a private sector. Policy credibility 3/ can be singled out in explaining arrears (J. Rostowski), but, it depends on how much structural adjustment the system can undergo in the period covered by the respective policy. As initial premises for policy-making, the capacity to adjust depends, basically, on the structure and the dimension of the resource misallocation.
A paradox is at play here: those policymakers who need to be more credible are not (cannot be) because of the magnitude of needed adjustment and the related costs; whereas in countries that can afford not to undertake similar painful changes (e.g., Hungary), policymakers enjoy more credibility due to the relatively smaller scale of needed structural adjustment. Granted, there is a political element that has to be factored in as well; this factor encompasses the reform commitment and of the support enjoyed by the government.
IV. Arrears and Exports - Is There a Relationship?
M. Khan and E. Clifton (1992) have shown how arrears in Romania developed and became one of the most extreme cases in the post-command economies. At the end of 1991, gross arrears amounted to 1,777 Bin lei, or about 56 percent of the GDP valued at December of that year prices. The tremendous growth of inter-enterprise credits should not have come as a surprise if one bears in mind that this country had one of the most distorted economies under command planning. 1/ Also, there was an industrialization drive that blatantly ignored the country’s comparative advantages, there were trade policies that ran counter to the logic of a functioning domestic economy, as well as a sui generis shock therapy in the 1980s, when Romania paid back her entire external debt.
The extent of resource misallocation and the extreme repression of consumption--directly, through the squeeze on domestic absorption and, indirectly, by forced substitutions in consumption--led to a price explosion after their liberalization. This explosion came to a head with the tightening of monetary policy by means of low credit ceilings. After a futile search for other solutions and acquiescence to political pressure, the Romanian Government resorted to a “global compensation”. Although it was accompanied by sterilization measures aimed at neutralizing the influence of new money injection, the global compensation brought the moral hazard problem to the fore.
Arrears resurfaced immediately the following year (1992), in a climate characterized by the imposition of much higher nominal interest rates--in an attempt to make them positive in real terms; the more inexpensive bank credit increased the attractiveness of arrears as temporary quasi-inside money. Curiously enough, in spite of an annual inflation rate that approached 180 percent, gross arrears stood at a level of approximately 30 percent of GDP by the end of 1992. What lies behind this lower dynamic of arrears is a justifiable question, bearing in mind that one can hardly talk about restructuring without there being a concomitant dramatic change of the economic environment.
1. Exports as a side effect of arrears
It can be conjectured that selective money injections (subsidized credit for special sectors) and more prudent behavior on the part of enterprises might have caused arrears to grow less rapidly (to be smaller in relative terms). The money injection was used in an attempt to break the “solidarity” of debtors by favoring those enterprises whose products enjoyed highest salability (such as electricity) and, thus, could exact payment from debtors.
There may be, however, another explanation for the less rapid growth of arrears, which is linked to the constraint imposed on enterprises with growth potential. Arrears, as a temporary substitute for real liquidity, help firms to survive but they also constrain the development of enterprises that have the potential to grow. Specifically, in such instances arrears tend to restrain the evolution of enterprises along a common narrow path, which explains why firms that can grow try to escape the currency (real liquidity) constraint. And, the way to do it, when the economy is deprived of domestic liquidity and foreign borrowing is not available, is to push up exports. Even when exports seem unprofitable, a premium on liquidity can more than compensate the value differential in favor of receipts on domestic sales whose payment is highly uncertain.
As the recent experience of Romania seems to suggest, increased exports can be a side effect of arrears, which has the potential to contain the former’s growth. The data for 1992 (compared to the previous year) indicate an export growth of 13.8 percent and an increase in import of only 1.4 percent, while the economy continued to slide--GDP dropped by almost 18 percent. A substantial exchange rate devaluation (which occurred during the year) had also contributed to stimulating exports. This influence, however, needs to be put in the proper light by emphasizing that an implicit exchange rate (that applied to tied export and import transactions, through compensation deals) was functioning and very likely reduced, to a large extent, the room for deals valued at the official (inter-bank market) exchange rate. Exports were seen as ever more attractive for they enabled growth-oriented companies to do away with the liquidity constraint and avoid the growth-constraining effect of arrears; to escape the “network trap” and build new chains of reliable suppliers and customers; and to acquire a much prized asset (i.e., hard currency), which preserves both high liquidity and value.
This effect, via exports, was enhanced by the freedom enterprises were granted to hold hard currency accounts. In an inflationary and highly uncertain environment, this freedom has facilitated a tendency toward dollarization, which shows similar features to the process encountered in Latin America (P. Guidotti, C. Rodriguez, 1992). “Gresham’s Law in reverse” has been always present in command economies, but once traders were allowed to hold foreign exchange accounts, it seems to have gained “new currency”. As a matter of fact, the implicit exchange rate mentioned above rules over a territory criss-crossed with new liquidity gained through the impetus given to exports and full retention rights of hard currency. However, a note of caution is called for here: to the extent hard currency is hoarded (seen only as a store of value) and not used to mediate transactions, but by banks as a prudential baking practice (that apply 100 percent reserve requirements to their foreign exchange deposits) the dampening effect of exports on gross arrears is reduced.
2. Size of the economy and its impact
For a small open economy the relationship between arrears and exports should not come as a surprise: the monetary approach to the balance of payments provides the analytical framework for understanding why arrears can only delay the moment when a reduction in domestic credit will induce an inflow of liquidity (currency) from abroad. 1/
This relationship becomes less clear the larger is the size of the economy. A large economy that is less dependent on foreign trade and whose output is made up to a considerable degree, of nontradables—like the Russian Federation--acquires features of a closed economy and the open economy model becomes less suitable. In the latter case it is questionable that the stimulus for exports will be similarly strong and, consequently, whether the implied constraining effect on arrears will be substantially smaller or negligible. The closed economy argument can be extended by taking into account the degree of “softness” of output in the transforming economies; this “softness” impairs their ability to export. 2/
3. An additional argument for fighting arrears
Empirical evidence and analytical reasoning show that arrears can have a moderating influence on the decline of output, particularly in the context of a sharp tightening of credit policy. It was emphasized, however, that this across-the-board effect impedes restructuring along the lines of comparative advantage by constraining the room of action by firms that enjoy growth potential. Additionally, arrears increase the “collective lack of knowledge” (Ickes and Ryterman, 1992, p. 4) and make it harder to distinguish between good and bad enterprises; they further add to uncertainty, which reduces the propensity for long-term (productive) investment. The latter effect should be considered by also looking at the decumulation caused by excessive wages, which in turn is made possible by the buildup of arrears. 1/ Further, we consider the extremely low investment ratios in the transforming economies--a fact that is not surprising under the circumstances--the negative impact of arrears and their persistence has to be of concern to policymakers.
V. A Framework for Containing Arrears
Arrears can not be addressed effectively on a case-by-case approach that misses the magnitude and the nature of the problem. Moreover, the fight against arrears should not be construed as a campaign in itself; conceptually and operationally it should be integrated into the overall effort to stabilize and restructure the economy.
If one accepts the argument that the roots of arrears are to be sought in structure--so multifaceted--and the strain to which the economy is subjected, a conclusion becomes overriding: that both structure and strain have to be targeted by policy. Structure means a focus on the property rights issue, and since it is obvious that “privatization as the ultimate solution” (M. Khan and E. Clifton, 1992, p. 20; S. van Wijnbergen, 1992) is not at hand, corporate governance should be given priority. Relatedly, attention has to be given to the development of proper market institutions and to finding ways to erode the “power of structure” and change enterprise behavior. Strain, which mirrors the size of needed resource reallocation, should be approached starting from the premise that “structural adjustment is a slow process even in a most advanced market-based economy--even when reform is credible” (M. Bruno, 1992, p. 753).
Several working principles need to guide efforts in order to formulate a realistic strategy to deal with arrears. First, there is no quick fix to the problem! Arrears are a perverse phenomenon that will persist as a problem as long as the economy has a flawed mode of operation (i.e., as long as property rights are not clearly defined and markets are not sufficiently competitive). As a realistic way of stating it, trying to solve the problem is more a matter of arrears-containment, of imagining that there is a moving “optimum” level that helps the system minimize the costs of structural adjustment and enhances macrostabilization. Arrears cannot be eliminated--they cannot disappear completely--since, in a real world, there are no perfectly competitive markets, which should impose complete hardness of budget constraints.
Arrears exist in well-functioning market economies as well, and strain increases the likelihood they will spread and deepen. 1/ Since the problem is structural, the approach should be holistic, multitrack, taking into account the overall mode of functioning of the economy. The approach has to be evolutionary, with the dynamic of arrears seen in relation to the changing nature of the environment, i.e., in the context of new, market-attuned institutions, a growing private sector and a less inefficient (better managed) state sector, most likely which reduce arrears. The policy should strive to increase the level of transparency, to remove the veil on implicit subsidies and enhance the information gathering and generating capacity of the system. More transparency would help policy both directly, and indirectly by influencing behavior.
Government has a role to play; a hands-off policy is inappropriate not only because of the sheer scale of the problem, which implies social and political consequences, but also because the state is still the owner of most of the assets and, as such, it has to make decisions about their use 2/. Corporate governance is a code expression for describing the need for a managerial revolution in the state-owned enterprise sector. 3/
The struggle against arrears--with the caveats highlighted above under the guise of guiding principles--involves at least four major areas for action, all of which help to deal with both structure and strain: (1) trying to “break up” structure (the solidarity of debtors); (2) imposing a disciplinary “straitjacket” on structure; (3) implementing industrial policy that should reduce strain; and (4) targeting external assistance.
1. Breaking up” structure
The goal is to erode as much as possible the “power of structure”. At least two options appear to be available: (1) to identify the largest net debtors, which supposedly are the critical links in the chain of arrears expansion, to isolate them and block their potential to spread arrears; and (2) to undermine the debtors’ grip on creditors. A major impediment to this undertaking is the high number of large net debtors and their dispersion within the economy. Therefore, policymakers need to restrict the number of firms to those that concentrate a critical mass of net arrears. 1/ What such a critical mass means certainly remains a subject for debate.
Isolation of the worst offenders would need special banking arrangements. An option could be to set up (or to designate) a bank with a clear mandate to restructure and monitor performance. Such an arrangement would, presumably, relieve considerably the pressure on the other banks by improving their balance sheets. How such a bank would monitor performance and enforce financial discipline depends much on how determined and politically strong the government is, i.e., how capable it is to withstand pressure from the big loss-making units. 2/
Another approach, which was partially attempted by the Stolojan government in Romania, in 1992, is to try to break the debtors’ trap by inducing large creditors to form strategic alliance against them. Creditors, whose products are sine qua non inputs for debtors, would be granted new financing for their operations to the extent that they force their debtors to pay back by not supplying them with the essential inputs they need.
It is to be hoped that the improvement in the balance sheets (reduction in the stock of bad debts) and isolation of those that play a key role in triggering arrears (the flow) would serve as incentives for banks to modify their behavior. It would also help to enhance the activity of banks as agents of restructuring; “the objection that banks do not have the skills to do that right is less compelling than at first sight. The point is not that banks are good at doing this, but that they are likely to be better than anybody else” (S. van Wijnbergen, 1992, p. 114). The point becomes even stronger if the giant loss-making enterprises will be placed under the authority of a special agency that would work closely with one or several, especially designed banking units. 3/ Nonetheless, the crucial issue of skills remains, and joint ventures with foreign partners, or the direct involvement of foreign banks are more than welcome.
Breaking the “power of structure” from within needs to be complemented by outside action, notably by speeding up privatization. Private companies face hard budget constraints and, in general, they bear the brunt of not being repaid in due time; moreover, they are crowded out from getting credit from state-owned banks. Therefore, the more numerous such companies are, the more likely they it is that they will be able to exert effective pressure on arrears-producing enterprises.
2. Imposing a “straitjacket” on structure
The idea here consists of modifying the set of rewards and penalties so that agents optimize in conformity with the thrust of transformation. The “straitjacket” would be a disciplinary device for an economy that lacks a proper structure and clear rules about property rights. The set of measures should include:
- trying to achieve low positive real interest rates; 1/
- turning implicit subsidies into explicit subsidies and tightening the leash on enterprises (hardening budget constraints);
- imposing interest on outstanding debt and taxation of this income;
- assessing penalties on creditors who tolerate nonpayment;
- levying penalties on those who hold hard currency in their accounts, while running deeply in arrears;
- granting bonuses and equity-related incentives to managers who significantly improve the financial state of their enterprises; 2/
- closing several negative value-added enterprises, by using the bankruptcy procedure, in order to show that the government “means serious business” the effect of such a demonstration could be very powerful for it would signal the resoluteness of policymakers (and, thereby, increase policy credibility). It would also highlight a side of the public debate about bankruptcy that has been neglected, namely, that it does not necessarily entail the physical demise of assets or the destruction of jobs.
Such measures need to be embedded in a drive for recapitalizing banks and deserving enterprises. At the same time, an incomes-control policy should be a basic component of the “straitjacket” since labor markets are heavily monopsonized.
a. Recapitalization
There are several avenues that can be used simultaneously to recapitalize banks and prospering enterprises;
-cleaning up the books of banks by converting bad debts into government bonds, or by transferring bad debts into a special bank that is set up to deal with the large loss-making firms;
-introducing debt-equity swaps that turn banks into core owners, or powerful stakeholders, with clear incentives and a comparative ability to restructure an ailing company and turn it around in the right direction;
-selling equity in domestic banks to foreign banks, which would automatically improve the level of skills in the banking sector and would, furthermore, help accelerate restructuring and privatization process.
Recapitalization of viable enterprises could be made by using domestic funds (resulting from privatization proceeds), foreign direct investment, or external assistance targeted to restructuring.
Recapitalization means that government explicitly takes over bad debts. When external support is not available, it can cause difficulties for the financing of the budget deficit. This becomes more acute when claims on the budget grow (due to rising unemployment, as well) and the tax base diminishes. Therefore, recapitalization should be undertaken in conjunction with a proper evaluation of how and how much the budget deficit can be financed and not aggravate inflation in a non-aggravating inflationary way.
b. Turning implicit subsidies into explicit subsidies
A major benefit of this endeavor would be to unburden monetary policy so as to pursue its fundamental goal of preserving the soundness of domestic money. Additionally, by knowing that there is a clear financial constraint indicated by the explicit subsidies envisaged by the State budget, more pressure would be put on enterprises to trim down their expenditures. The goal would be to put into place a combination of ex ante (explicit) and some, unavoidable, ex post (implicit) subsidies that will increase transparency and help enterprise reform. 1/
A related technical issue is “programming” the dynamic of explicit subsidies when there is a time horizon covering the period of restructuring, or of liquidation of various enterprises. This issue is closely connected with reducing strain within the system by a gradual phasing out of nonviable enterprises.
c. Incomes control policy
The control of incomes (wages) is vital in order to be able to control inflation and, thereby, to maintain real balances at a level that reduces the propensity of enterprises to run arrears. 2/ How to attain it? Technically, in addition to conventional schemes (like tax-based incomes), something resembling M. Weitzman’s “profit sharing” scheme (1984), which would link wages with the dynamics of saleable output, could be examined. The trouble with profit-sharing is that one meets an asymmetry of behavior on the part of workers: they would share in positive profits, but not in negative profits, the latter signifying lower wages. A way out can be privatization, with employees’ acquiring a substantial stake in the fate of enterprises. Moreover, a Social Pact, like the one concluded in Poland at the beginning of 1993, could involve workers in the management of enterprises, and reduce considerably, thereby, the temptation to raise wages uncoupled of salable output dynamics.
In order to implement macroeconomic stabilization a consensus has to be found on how to distribute the costs of adjustment. The endowment of resources, as a legacy of command planning and hastened industrialization, can bring fortune to some and misery to others; it lies at the roots of what can be viewed as a “distributional contest” within society. The very wide range of profitability rates will show “who is who” in this contest. In such heavily monopolized and monopsonized economies inflation seems to be practically unstoppable, and a vicious circle can be at work: because of external and internal shocks real national income shrinks, pressure groups ask for and obtain higher nominal wages to keep pace with rising prices, the wage-price spiral is given a further twist, monetary and fiscal policies become tighter, output shrinks further and the vicious circle goes on. This scenario is more plausible the less mobile resources are and the less competitive markets are, arid additionally, when governments are weak and likely to give in easily to pressure from trade unions. “Stabilization will come when everybody agrees to share the burden of stabilization, rather than when a particular group concedes and bears the entire cost” (J. de Gregorio, 1991, p. 146). Thus, achieving a consensus becomes urgent, particularly when market reforms entail wide and increasing income discrepancies.
3. Industrial policy
Industrial policy can be a major tool for reducing strain in transforming economies. Its goal can be described as follows: a gradual phasing out of unprofitable activities in keeping with the capacity of the system to adjust. This capacity has to be related to maintaining a balance between job creation and job destruction, the functioning of a social safety net, and adequate retraining programs.
Under the circumstances of transition from command to market economy, industrial policy has been given too low a profile, or has been neglected altogether. This has crippled economic policy in general and stabilization in particular. Industrial policy can reduce the costs of stabilization, can help decisionmakers deal more effectively with the three major constraints (the foreign exchange gap, the budget deficit, and the low level of savings) in making choices about the trade-offs between external imbalance and internal disequilibrium (understood in a broad sense, namely as the degree of unemployment of resources). It can also help in dealing with the “Big Trade-off” (A. Okun, 1975) that has come into the open in the transforming economies: efficiency versus equality.
It is noteworthy that even the experience of frontrunner countries (e.g., Hungary) suggests the need for industrial policy (G. Szapary, 1992). There are also many reasons to have reservations about industrial policy, which can be seen as a means to “pick winners and losers", especially in an environment with so much uncertainty and lack of transparency. However, in the peculiar conditions of transforming economies, industrial policy should be viewed, rather, as a damage control device, one that aims to create the breathing space needed to cope with the high degree of uncertainty and fuzziness about property rights, and the question of “which are the truly nonviable enterprises?”. It also aims at mitigating the costs of restructuring and resource reallocation in these circumstances, industrial policy is about picking losers among losers. 1/
On this line of reasoning industrial policy is tightly linked with the action of making subsidies explicit and establishing a time horizon for their ultimate removal. There are two kinds of subsidies involved depending on which enterprises are targeted: those that are clearly nonviable and keeping them afloat is related to a public budget (resource) constraint; and those that are potentially viable, for which some time is needed to ascertain their actual prospects. In the latter case, the same resource -constraint applies. Negative value-added units should be closed without delay for it is less costly to pay workers unemployment benefits and retrain them than to keep such enterprises running. 1/ Nonviable enterprises would be programmed for gradual elimination so that unemployment be attenuated and its cost redistributed over time. With such an approach, the authorities would have an easier time in securing resources for a social safety net and for facilitating labor reallocation through training programs. The time horizon for phasing out nonviable enterprises is related to the advance of privatization and to securing adequate levels of capital inflows; the more intense is privatization and the larger are capital inflows (especially those used for long-term direct investments), the easier it is to phase out inefficient activities.
It can be argued that industrial policy slows down restructuring, if social and political constraints are dismissed. But for the sake of sustaining the process there is solid ground for advocating industrial policy as a way of easing structural adjustment and at the same time keeping a check on arrears.
4. External assistance
External assistance can be direct and indirect. Direct assistance can be split into three major categories:
- aid that reduces strain; for example, financial support that helps the functioning of an effective social safety net for those affected by economic restructuring;
- aid that improves structure, the market-attuned institutional framework of the economy. The main areas for action should be the banking system, the management of large (still, state-owned) enterprises, and the tax collection system;
- aid that focuses on structure by helping markets grow as they adjust to restructuring and privatization. This aid should target specific companies and sectors (for instance, agriculture in Romania, or the oil industry in the Russian Federation), and provide seed capital for private sector undertakings.
Indirect assistance should be related to the evolving international environment, which encompasses rising nationalism in international policy-making, including growing protectionism; global economic recession; and [rising?] real interest rates on world capital markets. It is unquestionable that these developments slow the transition process in post-communist countries and add to the strain in their economies. It is very unfortunate that transformation is undertaken in this unfavorable international context and that conditions do not give much hope for a substantial improvement. 1/
A concrete example of the distance between myth and reality in the rhetoric of support between country groups is the extent of access Eastern European producers have on EC markets where they send most of their main export items. Here, there is a relationship between needed sectoral adjustment in Western Europe and trade as a weapon for systemic adjustment (transformation) in post-communist Europe. 2/ Reducing strain in the latter involves increasing short-term difficulties in the former, and the decision on how to deal with such a trade-off is likely to be determined by political expediency. But, in a Western Europe still stunned economically by the blow of German reunification, with weak governments in power, prospects for Eastern Europe to gain significantly more access to EC markets are not encouraging at this in time.
VI. Concluding Remarks
Inter-enterprise arrears mirror the tremendous strain under which post-command economies are functioning. The existence of arrears is not a surprise since they can be detected in all real economies, including the relatively well-functioning advanced market economies. What is unusual in the transforming (post-command) economies are the magnitude of arrears, and their effects which constitute a structural trap for stabilization.
The fight against arrears means trying to contain them to a level that does not undermine efforts to stabilize the economy. Setting up a clearing house, securitization of inter-enterprise credits are only temporary or partial solutions; they do not focus on the primary sources of arrears--structure and the size of the required structural adjustment (resource misallocation). Since dealing with their primary causes of arrears will take time it makes sense to presume that containing them can not be a one shot policy; it is a process that will overlap in time and reflect an evolving environment that acquires ever more traits of a full-fledged market system. 1/ The more quickly restructuring and privatization proceed, the more competitive markets will become, the more mobile labor will be, and the less menacing inter-enterprise arrears will be for stabilization policy and the overall smooth functioning of the economy.
Containing arrears will help “stabilize” stabilization policy. Stabilization, itself, would have to be understood as a process, most likely, to evince a stop and go dynamic including setbacks. It can be surmised that the control of disequilibria during transition will reveal a stabilization policy path that moves in tandem with the speed of change of the domestic environment.
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Chief Economic Advisor, the National Bank of Romania and visiting scholar in the Research Department, International Monetary Fund. The author would like to thank Guillermo Calvo, Eric Clifton, Mohsin S. Khan, Edouard Maciejewski, Jacek Rostowski and Theodor Stolojan for useful comments and discussions. Thanks are due also to Steve Altheim, Dan Berg, Farid Dhanji, Monica Hargraves, Tricia Gallagher, Juhan Jaakson, Stephen Canner, William McCleary, John McDowell and Andreas Tsantis who provided helpful suggestions. The author bears sole responsibility for the views expressed in this paper.
“…the soft-budget constraint did change its dynamics because individual firms in general strengthened their positions vis-á-vis other economic agents as well as the authorities. They no longer have to bargain for new credits or subsidies, or tax reliefs. Their behavior can rather be described in terms of fait accompli. They do not pay, but nonpayment is not their problem; it is the problem of those who do not receive their due” (P. Jasinski, 1992, p. 32).
The moderating Influence of arrears on the decline of output can, itself, be moderated by an increase of the demand for transactionary balances. However, this counter-moderating effect has to be judged in conjunction with the reduction of the demand for speculative and precautionary balances.
If the equation of exchange (PY - MV) is put in a dynamic form by using logarithms: p + y - m + v; where p, y, m and v are the rates of change in prices, output, money supply and money velocity, respectively. When monetary policy is tightened, m - o, and (p + y) is above zero, v needs to be positive in order to alleviate the expected decline of output. In this case arrears appear as if they modify money velocity. If arrears are considered temporary quasi-inside money and velocity is kept constant, the relationship becomes: p + y - m(c, a), where c is cash and bank credit and a represents arrears. When c-o because of dear money policy, p + y - a.
Aside from new money injection, this would be the only way to make the shift of LM to LM1 durable.
This idea is developed in Section IV, which argues that exports can be viewed as a side effect of arrears and as a constraining factor on them.
See C. Senik-Leygonie and G. Hughes (1992) for an investigation of the size of negative value-added sectors in the former Soviet Union. In Romania, copper and lead mines in the northern part of the country, are known to be notoriously negative value-added activities.
One reason, for instance, is the smaller tax base for subsidizing those who lost their jobs; therefore, this base has to be taxed more heavily.
In particular, due to the highly inflationary domestic environment, and the likely scarcity of foreign exchange reserves. In Poland, the temporary relative success of using the exchange rate as a nominal anchor relied on a very substantial devaluation (overshooting).
There were signs of a systemic problem and the U.S. Brady Plan was, partially, a policy response to those signs. Almost all major banks needed recapitalization because of their bad loans to Latin America, in particular. But the overall policy response remained, essentially, a case-by-case approach.
In the Czech Republic, many companies are locked in a circle of bad debt caused by unpaid bills from customers…Officials fear that many other companies could be affected if major companies are allowed to go bankrupt (P. Blum, 1993, p. 2).
Defining policy credibility in post-command economies needs qualification since, with the exception of Hungary and Poland, there is no history of stabilization attempts. Without such a history agents react according to entrenched behavioral patterns, not on the basis of learning from past policies and their eventual reversal. Certainly, when wide ranging bailouts make up a policy goal, reversing the history in favor of stabilization starts off on the wrong foot and policy credibility is impaired from the very beginning. But still, one can pose the question: under what circumstances is policy credibility a realistic policy trait and what policy choices favor its attainment?
“The Romanian economy was one of the most tightly controlled and centralized in Eastern Europe. The Ceausesçu regime deprived the country of the experience of any significant economic reform, leaving the administration tied to a Stalinist model that had by that time been abandoned by almost all other countries in the region.” (D.G. Demekas, M.S. Khan, 1991, p. 8).
Arrears, as temporary quasi-Inside money, can compensate the reduction of domestic bank credit for a while only. Over time, arrears become ever more constraining and an inflow of real liquidity (foreign exchange) is triggered.
This “softness” can be viewed at as a relative “absence of ability to transform goods into one another in world markets at the initial world prices” (P. Desai and J. Bhagwati, 1979, p. 359). Often, low exportability (specific for “soft” goods) can turn into no exportability because of technology and quality-related constraints.
As was argued in subsection 11.2, arrears can, in fact, dichotomize the payment system and make wage disbursement the main (or the only) money-based transaction; this helps enterprises cope with the upward pressure of wages.
“Recession-hit companies now speak of a crisis within a business community unable or unwilling to break free from a vicious circle of overdue debt,.. The European Commission has just launched an investigation into late payment, which is spreading contagiously throughout the Community” (M. Cassell, 1993, p. 17).
Romania’s experience is telling in this respect: Law 15 of August 1990, on “Restructuring of State Economic Units” devolved power by creating confusion as to the owners of enterprise assets. In this way collusion phenomena were encouraged, management contracts were easily avoided by managers and, ultimately, the attributes of the state--as the owner of the still unprivatized property--were devoid of substance.
The “managerial revolution” that took place in the publicly-owned companies (regies autonomes) in France, in the 1980s may suggest avenues for action, though the scale and problematic in post-command economies are, comparatively overwhelming because of the different surrounding environment for the individual companies.
In the case of Romania, for instance, a McKinsey study found that the concentration of bad debts is fairly significant within the troubled industrial sectors. The metallurgy, chemical/petrochemical and machine-building industries are dominated by large vertically integrated companies accounting for the majority of the problem. The study found that for the three industrial sectors mentioned 112 large companies account for 77 percent of bad debts. And the three industrial sectors account for 45 percent of the bad asset problem of all commercial companies, though they comprise only 24 percent of the lending.
The Polish experience is relevant as to this political dimension and the pitfalls of concentrating the tasks to a single agency.
Like the State Ownership Fund (SOF) In Romania.
Reasons why high positive real interest rates are to be avoided are provided by G. Calvo (1991), and A. Bennett and S. Schadler (1992).
There are frequent cases when managers favor a worsening in the way enterprises function so that an eventual management buy-out will be eased financially. But, there is enough ground to assume that seeing this members of the work force would not stay idle and would force them out of power; workers actually operate as “managers-monitors”. Therefore, it seems that it would pay for managers to accept a deal (with the state as the owner of the enterprise) that would reward them with concrete stakes in the future of the company, to the extent they improve its financial standing. In a nutshell this philosophy says “why run down a company in order to buy it for nothing and risk losing it all (including reputation) by being ousted, instead of turning into an important share holder (stake-holder) of a possibly prosperous company”?
A problem could emerge with this conversion. Implicit subsidies are ex post and their size is an uncertain quantity, potentially unlimited. Explicit subsidies are ex ante so they are a known, limited in quantity. There is a danger, that if the economy gets less stable--because of various shocks, including politically-motivated policy decisions--the mix of subsidies could mean both a substantially higher fiscal deficit and very high inflation.
“Controls are more likely to be useful the larger is the desired reduction in inflation and the more serious is the credibility problem” (P. Persson, S. van Wijnbergen, 1993, p. 81).
Industrial policy is critical for bridging the gap between the effectiveness of controlling demand and stimulating supply. When supply responsiveness is pretty low, endangering the sustainability of stabilization efforts, industrial policy should correlate incomes-control measures with industrial restructuring (including privatization), which are undertaken by authorities on the basis of information provided by markets.
One qualification is, however, necessary in this respect. When these units are represented by producers of intermediate goods, the switching to other suppliers could involve significant costs to certain customers of those producers. But these costs are a one-time affair, as against the flow of subsidizing negative value-added activities.
One can compare it with the turnaround of several Latin American countries (Argentina and especially Mexico) In the 1980s, or the progress of Turkey over the same period. One should not downplay, however, the role of surging world markets, driven by a consumption-led recovery of the U.S. economy, in facilitating that transition. This contrasts strongly with the exogenous shocks that have struck the transforming economies.
The cases of the steel processing industry and of agriculture make big headlines.
“…where distortions have been long-standing, the process of correction can only be gradual…for a long-run control over inflation there is no substitute for a comprehensive package aimed at eradicating structural and macroeconomic distortions” (C. Borio, 1990, p. 27).
