Building sound financial systems is key to developing viable market economies where central planning once prevailed. In a market economy, it is the financial system that channels savings among alternative uses; and accompanying this provision of financing are various forms of control over the use of capital. Within the discipline thereby imposed, a market economy permits a large degree of decentralization. The transformation from a centrally planned to a market economy thus involves, in large measure, a shift from bureaucratic administration to financial control.

Financial restructuring in emerging market economies is not limited to building a sound financial system that implements effective control over the use of capital, however. The economic and financial structure of state-owned enterprises (SOEs), including their privatization, is also of crucial importance. For the transformation to a market economy to enhance efficiency, it must involve the paring down of large SOEs to reduce their often vast scale and scope and to create less concentrated market structures, as well as the liquidating of chronic loss-making enterprises. In the void created by the breakdown of bureaucratic administration, strengthening of financial control can be an important means to achieve this economic restructuring.

However, the legacy of bad loans from the passive role of finance under central planning and the early transition period, as well as the excessive scale and scope of large SOEs, impose significant obstacles to the successful transition from central planning to a market-based economy. The overhang of debt creates several potential pitfalls to this transition: (1) insolvencies pose moral hazard problems with respect to both creditors and debtors; (2) moral hazard problems enlarge the fiscal cost of the bailout that will eventually be needed; and (3) insolvencies prevent the privatization of banks and SOEs. Moreover, large SOEs tend to be of inefficient scale and scope; and failure to restructure them before privatization risks perpetuation of concentrated market structures.

This paper examines how the above problems can be tackled within the fiscal constraints faced by reform governments. Priority is given to restoring the solvency of banks because of the important roles that they could play in strengthening financial control and in providing finance for enterprise restructuring. One way to restore soundness to the banking system is to undertake a case-by-case exchange of bad loans for government debt. A centralized agency could then undertake to resolve the bad loans with the SOEs. Moreover, the centralized agency could use these loans as leverage to pry productive assets away from SOEs. For this effort to succeed, however, financing must be available for the acquisition of enterprise assets. This could involve the provision of new bank loans and equity purchases by insiders. Sources of outside equity would in all likelihood be more difficult to tap initially. Governments could retain equity stakes in enterprise sell-offs to achieve some diversification of risks. Leasing could also play an important role in transferring productive enterprise assets to new private firms.