This paper examines factors that determine the volume of bank credit allocated to the enterprise sector and the implications of this allocation for aggregate supply and macroeconomic performance in former socialist economies. It first develops 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 aggregate output and employment. The model suggests that if firms cannot obtain sufficient working capital, then production will be cut back. It is shown, however, that attempts to increase credit through inflation may exacerbate the credit crunch because of the effect of inflation on the demand for deposits.
The paper next examines factors that determine how bank credit is allocated 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 are examined. It is suggested that a preference for lending to the government, while perfectly rational from the perspective of individual banks, may create a vicious cycle of low output, low profits, high fiscal deficit, and, again, low credit to enterprises. The paper considers empirical evidence for a number of Eastern European countries that is consistent with this hypothesis and discusses a number of policy options for increasing the provision of credit to potentially viable enterprises.
Finally, the paper discusses the relative merits of bank finance and equity capital for medium- and long-term investments. In a credit market with imperfect information, liberalization of the banking sector would not necessarily lead to efficient allocation of long-term capital. This is due to the adverse selection effects that occur 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 in the case of 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 notes some policies that might be implemented to overcome them.