98825 Building Sound Finance in Emerging Market Economies Edited by Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane . Proceedings of a Conference held in Washington, D.C. June 10 - 11, 1993 International Monetary Fund World Bank © 1994 International Monetary Fund Library of Congress Cataloging-in-Publication Data Building sound finance in emerging market economies : proceedings of a conference held in Washington, D.C., June 10-11, 1993 /edited by Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane. p. cm. Includes bibliographical references. ISBN 1-55775-380-6 1. Finance-Developing countries-Congresses. 2. Banks and banking. Central-Developing countries-Congresses. 3. Central planning-Europe, Eastern_:Congresses. 4. Privatization-Mexico- Congresses. I. Caprio, Gerard. II. Folkerts-Landau, D. F. I. (David Fokke Ihno), 1949- III. Lane, Timothy D. (Timothy David). 1955- HG63.B85 1994 94-7903 332' .09172'4-dc20 CIP Price: US$27.50 Address orders to: International Monetary Fund, Publication Services 700 19th Street, N.W., Washington, D.C. 20431, U.S.A. Telephone: (202) 623-7430 Telefax (202) 623-7201 Cable: Interfund Foreword In the process of transition from central planning to a market econ- omy, one of the key tasks facing authorities is to create the conditions for a sound financial system. Price stability, which can come only with stable macroeconomic management, is essential for market activity-and finance-to flourish. Needed improvements in fiscal and monetary policies, however, must go hand in hand with struc- tural reforms, including reforms of the financial system and restruc- turing of the real sector. If the essence of transition is to increase the private sector's share of economic activity, the task of the financial sector is to fund this process, that is, both to mobilize funds by offer- ing attractive rates of return and to allocate capital to its most efficient uses based on the signals sent by the market. Building a sound, efficient financial system is thus critical to ensuring that prudent mac- roeconomic policies will translate into sustained economic growth. The importance of structural reforms in the financial area has been clearly recognized through the Fund's extensive technical assistance programs in many economies in transition, as well as the World Bank's support for financial and real sector restructuring. It is like- wise essential for our institutions to be engaged in this process at another level: the development, discussion, and dissemination of ideas. Transition is a new phenomenon, one that can benefit from the application of general principles, combining the insights of economic analysis with the experience of both industrialized and developing countries, as well as the early experience of the economies in transi- tion themselves. It is in this spirit that the Conference on Building Sound Finance in Emerging Market Economies was held, under the auspices of the Fund and the World Bank. The conference attracted a distinguished gathering of academic experts and policymakers from both industrialized countries and economies in transition, as well as staff members of the two interna- tional financial institutions. The papers presented during the confer- ence, which are collected in this volume, provoked lively and thoughtful discussion-a good part of which is included here-on a wide range of issues. These included methods of dealing with the legacy of bad debts, the appropriate design of a payment system, fostering a financial structure best suited to' the changing landscape that will characterize transitional economies over the next decade, and an analysis of disruptions in credit supply that have been seen in v vi Foreword some economies in transition. Although, in the end, there are still many questions on which there is not general agreement, the exchange of views has been useful in advancing our understanding of these issues. MICHEL CAMDESSUS Acknowledgments The papers collected in this volume were presented at the Confer- ence on Building Sound Finance in Emerging Market Economies, which 'fas sponsored jointly by the International Monetary Fund and the Worl~ Bank and held at IMF Headquarters in Washington, D.C., June 10-11, 1993. The editors are especially indebted to Elin Knotter of the Fund's External Rel.ations Department, who edited the entire manuscript and coordinated \~he production of this volume. Norma Alvarado pro- vided expert word processing assistance. Finally, the editors thank all the participants in the conference, who contributed to two days of stimulating discussions. vii Contents Page Foreword v Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vii 1. Introduction Gerard Caprio, David Folkerts-Landau, and TimothyD. Lane . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Part I. Old and New Debts 2. Financial and Enterprise Restructuring in Emerging Market Economies Steven M. Fries and Timothy D. Lane . . . . . . . . . . . . . . . . . 21 Comment-Georg Winckler . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 3. Dealing with Bad Debts-The Case of Poland Stefan Kawalec, Slawomir Sikora, and Piotr Rymaszewski . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 4. Financial Underdevelopment and Macroeconomic Stabilization in Russia Barry W. Ickes and Randi Ryterman . . . . . . . . . . . . . . . . . . . 60 Comment-Jacek Rostowski ....................., . . . . . . 84 Part II. The Central Bank and the Payment System 5. Payment System Reform in Formerly Centrally Planned Economies David Folkerts-Landau, Peter Garber, and Timothy D. Lane . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91 6. The Russian Payment System Bruce J. Summers ................................... 113 Comment-David B. Humphrey ........................ 129 Part III. Creating a Sound Financial Structure 7. The Role of Financial Institutions in the Transition to a Market Economy Hans J. Blommestein and Michael G. Spencer .......... 139 Comment-Jacob S. Dreyer ............................ 190 ix X Contents Page 8. Strengthening the Russian Banking System: The International Standard Banks Program Millard F. Long and Samuel H. Talley ................. 195 Comment-Peter Garber, Carl-Johan Lindgren, and Henry Schiffman ................................... 206 9. Revising Financial Sector Policy in Transitional Socialist Economies: Will Universal Banks Prove Viable? David H. Scott ..................................... 211 Comment-George G. Kaufman ........................ 233 10. Lessons from Bank Privatization in Mexico \ Guillermo Barnes ................................... 238 Comment-Diana McNaughton ........................ 252 Part IV. Credit Provision in Transitional Economies 11. Credit Market Imperfections and Output Response in Previously Centrally Planned Economies Guillermo A. Calvo and Fabrizio Coricelli ............. 257 Comment-Rudiger Dornbusch ........................ 295 12. China's Collective and Private Enterprises: Growth and Its Financing Shahid Yusuf ....................................... 298 Comment-Linda M. Koenig ........................... 331 Part V. Roundtable on Financial Reforms and Their Implementation Manuel Guitian .................................... 335 Ian Plenderleith .................................... 340 Salvatore Zecchini .................................. 343 List of Participants ......................................... 357 The following symbols have been used throughout this paper: to indicate that data are not available; to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist; between years or months (e.g., 1991-92 or January-June) to indicate the years or months covered, including the beginning and ending years or months; between years (e.g., 1991/92) to indicate a crop or fiscal (financial) year. "Billion" means a thousand million. Minor discrepancies between constituent figures and totals are due to rounding. The term "country," as used in this paper, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis. l Introduction Gerard Caprio, Dovid Folkerts-Landau, and Timothy D. Lane Building a sound, efficient financial system is at the heart of the transformation from central planning to a market economy. The vital function that the financial system performs in a market economy in allocating resources over time is well recognized. Perhaps even more important is the financial system's role in coordinating economic activity: the cost of finance and its availability for a particular use is fundamental in determining which productive investments are undertaken. Financial discipline-:--the condition that debts incurred must eventually be repaid-is essential in ensuring that investments undertaken are socially efficient. At the same time, control through the financial system permits decentralization in decision making-the hallmark of a market economy: provided that some entrepreneur or group of investors is prepared to assume the risks of undertaking a project with borrowed funds and that some lender believes that the loan will be repaid, the project can go ahead. In the world of central planning, finance plays a passive record- keeping role, while the allocation of resources is controlled mainly by the central plan itself. In this environment of soft budget constraints, the solvency of participants is irrelevant to lending decisions: the criterion under which credit is granted is that the activity for which . the funds are needed must be stipulated in the plan. With the aboli- tion of central planning, a coordination vacuum emerges. To fill this vacuum, it is necessary that the conditions be established under which lending is rationed by price and constrained by borrowers' solvency-that is, that there be sound, market-based finance. Building sound finance in emerging market economies requires more than observing and·imitating the institutions of mature market economies. There are at least four additional considerations that jus- tify further investigation. First, there is the need to come to grips with the legacy of central planning-and, to a certain extent, of the sojourn 2 Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane in the no-man's land between plan and market. In many countries, a sizable portion of enterprises and financial institutions are already insolvent, owing to the debts accumulated not only under central planning but also in most cases in the succeeding period of output collapse. This legacy implies that suddenly imposing hard budget constraints on all agents is an unworkable solution-and indeed is unlikely to be tried-because of the immediate, widespread, and largely arbitrary bankruptcies that would result. A second consideration is that finance may play a critical role in transforming the economy itself, as distinct from serving a working market economy. In particular, finance is-or can be-crucial in facili- tating the transfer of ownership from state to private sector, and in determining what kind of structure to establish to ensure that priva- tization results in genuine changes in the way enterprises are run. A third issue is that formerly centrally planned economies typically face more severe constraints than do mature market economies: given their limited financial and human resources, they cannot incorporate every detail of a sophisticated financial system.1 This makes it impor- tant not to import institutions wholesale but to ii'-Ssess carefully which features of the financial system are basic and which are secondary- and particularly, which features depend on the pre-existence of other institutions. For example, establishing sophisticated money and secu- rities markets may depend on the pre-existence of efficient banks-in which case the latter should be given priority and the others left until later. Most would agree that one should resist the dazzle of high-tech finance and concentrate on the basics, but there is room for disagree- ment on which features are indeed basic. A final problem is that the financial systems prevalent in advanced market economies are by no mean~ all alike, and so there continues to be debate on which version should be emulated. Discussions in the context of emerging market economies have brought to the fore the differences between various systems-and in particular, advice from Anglo-Saxon countries tends to be different from that coming from either Continental Europe or Japan. It is important to assess which features of these alternative capitalist systems would be useful for formerly centrally planned economies and which might be less appropriate. These are some of the issues that have guided research and discus- sion of financial sector reforms in emerging market economies. These 1 Here, as in many areas, the exception that proves the rule is east Germany, which because of its own particular circumstances has adopted an existing system lock, stock, and barrel. 1 • INTRODUCTION 3 themes also run through the paper's collected in this volume. The papers are the proceedings of a conference sponsored by the IMF and the World Bank held at IMF headquarters on June 10-11, 1993. Partici- pants included staff members of these two sponsoring institutions, as well as academic experts and policymakers both from formerly cen- trally planned economies and from developed market economies. The participants were chosen to give a wide range of insights into the issu_es involved in building a financial structure suitable for econ- omies in transition. · The papers were organized around four main topics. The first is the problem of old and new debts-not only how best to clear up bad debts but how to ensure that new debt is properly priced. The second is the development of a sound and efficient payment system, particu- larly with regard to how to limit the associated credit risks. The third is the development of an appropriate financial structure-including the respective roles of banks and other financial institutions in the financial system, the problems of supervision and regulation, and the issues involved in bank privatization. The fourth is the importance of credit in the development of the real economy. In the remainder of this overview paper, each of these topics will be discussed briefly. · Old and New Debts Establishing a sound financial structure in emerging market econ- omies typically means trying to enforce financial discipline in the face of widespread insolvency. Enterprises had often accumulated large debts under central planning, which turned into bad debts for rea- sons that are mentioned in the paper by Steven Fries and Timothy Lane, and elaborated in Georg Winckler's comments. In most ·cases the debts have been substantially augmented during the transition. There have been proposals for a general write-off or socialization of debts-a solution that recommends itself because these debts are to a certain extent an artifact of the old order and do not convey much information about the potential profitability of the enterprises.2 The issue is less clear cut for debts incurred-and still being incurred- after the demise of central planning as a result of the supply and demand shocks associated with transition, the enterprises' inex- perience in dealing with a market· economy, and the heightened incentive to borrow associated with negative real interest rates. In 2 Debt socialization implies that the debts are no longer the liability of the enterprise but of the state itself. Se!! Calvo and Frenkel (1991). 4 Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane addition, the increased autonomy of state enterprises without effec- tive enterprise governance, which gave enterprise insiders (such as workers and managers) scope to appropriate its resources at the cred- itors' expense, can contribute to a debt buildup. The case for a sweeping solution to the debt problem, such as a general cancellation of old debts, is based on the desirability of avoid- ing widespread bankruptcies while avoiding the moral hazard prob- lems associated with banks whose loan portfolios are riddled with bad debt-as well as with enterprises that continue to operate while already insolvent. Although the case for some kind of debt reduction in most countries is persuasive, there are also some disadvantages, as noted in the paper by Fries and Lane. Canceling the debts may itself pose moral hazard problems, either by creating the expectation of a further cancellation, or simply by transferring resources to enterprise insiders who can then appropriate them. Existing debts, provided that they are not too large to service, may play a valuable disciplining role, forcing enterprises to turn over some of their cash.flow. This may be a particularly important consideration in economies that are in the early stages of transition, where there may be severe fiscal constraints owing to the loss of tax revenue from state enterprises, the time required to introduce new forms of taxation, and the absence of financial markets that would permit nonmonetary financing of a deficit. These considerations argue for a selective, case-by-case solu- tion to the debt problem. Important alternative ways of implementing a case-by-case solution exist, however. One form-a centralized debt workout agency-is dis- cussed in the paper by Fries and Lane. A c~ntralized agency like the German Treuhandanstalt could concentrate expertise in dealing with problem loans and make decisions in each case on whether to restruc- ture the debts or liquidate the indebted enterprise. Such an outside body could perhaps cut through the informal networks carried over from the old system that are widely viewed as perpetuating the status quo-making the problem more transparent by reducing banks' incentives to roll over bad loans to avoid acknowledging them. Such a body could also take into account some of the wider social implica- tions of its decisions. However, as Georg Winckler points out, it is important not to view a debt workout agency as a "deus ex machina." A centralized agency also faces important constraints, several of which are mentioned in the Fries and Lane paper. In particular, it would face the same limita- tions on human resources, the same political pressures to keep per- manently loss-making enterprises afloat, and the same budgetary constraints as would the individual creditors. There are also moral 1 • INTRODUCTION 5 hazard problems associated with taking the bad debts off the banks' books, as argued in the paper by Stefan Kawalec, Slavomir Sikora, and Piotr Rymaszewski, who suggest that removing the problem loans from the banks' books may make things too easy for them and may inhibit their learning. If banks are to start to behave truly like banks, they have to start developing collection capabilities, and this might be accelerated by having them deal with the problem loans themselves. Such was largely the motivation for the Polish approach to dealing with bad debts, which, as detailed by Kawalec, Sikora, and Rymaszewski, involves the banks heavily in the workout process. Banks are to establish workout departments, and are given a range of options for dealing with the bad debts, including debt restructuring or write-downs, debt-equity swaps, liquidation, or sale of the loan on the open market. 3 The choice between the two solutions depends mainly on a judgment of which type of institution-a centralized agency or the individual bank-is more likely to be able to resist the political and insider pressure against needed restructurings and, where appropriate, liquidations, and which is more likely to be able to assemble the needed expertise to assess the prospects of com- panies that on paper are insolvent. This judgment would no doubt depend on the political, legal, and institutional environment of the country in which it is implemented. One form of existing debt that has attracted particular attention is the explosion of interenterprise arrears, notably in Russia in 1992. These arrears were to a certain extent a voluntary phenomenon, dis- intermediation associated with a tightening of banking sector credit, as argued both in the paper by Barry Ickes and Randi Ryterman and in comments by Jacek Rostowski. Ickes and Ryterman note the par- ticular prevalence of interenterprise arrears within groups of com- panies that are well aware of one another's activities. One may inter- pret this, as the authors do, as reflecting the efficient use of information about the creditworthiness of companies with which a firm has direct dealings; alternatively, it may be viewed as mutual assistance within the insider networks carried over from the old regime-with a government bailout at the end of the road. In particu- lar, even if interenterprise arrears had a negative nominal expected return, enterprises producing inputs for which their customers could not pay may have believed it to be more advantageous to ship the 3 The latter solution appears to entail a "market for lemons" problem, since the banks would presumably sell the loans that, based on their own information, they believe are worth no more than the price offered-which in turn must be low enough to reflect buyers' low valuation of the loans that the banks are prepared to offer for sale. 6 Gerard Caprio, David Folkerts-Landau. and Timothy D. Lane goods anyway and hope to collect later through a clearing of arrears rather than facing the disruption associated with stopping produc- tion. The exist~nce of large stocks of interenterprise credit may com- plicate the establishment of financial discipline, as pointed out by Rostowski, to the extent that companies may claim (possibly with some justification) that they are unable to pay owing to arrears in their payments receivable from other companies. It may also make it more difficult to resolve the bad loan problem, possibly requiring a multilateral approach that goes beyond the workout of bank loans. Along with resolving the bad loan problem, it is important to main- tain financial discipline during the transition. Here, Ickes and Ryter- man discuss a controversial proposal made by Ronald McKinnon. Sorting enterprises into two categories, the first are given decision- making autonomy but are required to self-finance, and the second are kept under tight central control and kept afloat with credit. Ickes and Ryterman argue that the cash flow constraint that this would impose on the liberalized enterprises would be unduly severe, particularly given the uncertainties about the timing of receipts that result from the insufficiently developed payment systems in these countries. In the same vein, Fries and Lane emphasize the need for providing financing for the restructuring of enterprises, which typically requires investments that would yield returns in the future. If restructuring is to be guided by market incentives, it would be desirable to provide financing for privately owned firms, if this is compatible with a pru- dent assessment of risk by lending institutions. Fries and Lane accordingly suggest various expedients for easing the credit constraints-such as equipment leasing and bank financing for the purchase of shares in privatized firms. Such arrangements would facilitate the transfer of ownership and control into private hands, despite the limited wealth of the population, and would help finance the needed restructuring. Sound and Efficient Payment Systems A payment system is the arrangement through which '~good funds" -the items generally acceptable as final settlement for transactions-are delivered to sellers of goods, services, or assets. Almost universally, these acceptable items are limited to currency, deposits at the central bank, or deposits of other banks. The scarcity of these media, when combined with an inappropriately designed payment mechanism, can slow the tempo of transactions. On the other hand, a payment system can encourage a larger flow of pay- 1 • INTRODUCTION 7 ments by allowing participants to use credit to settle their transac- tions, thereby imposing excessive credit risk on the system. The design of a payment system always involves some compromise between the goal of maximum speed and volume in settling payment orders and that of controlling the usual moral hazard problems by limiting the credit provided through the payment mechanism. This tension is inevitable and is resolved in industrial countries in different ways: some insist on a tight limitation of credit risk on the payment system whereas others provide large amounts of credit to generate maximum flows. The choice of the best combination on the payments volume-credit risk frontier has depended on the demands made by the financial system of the individual economies, but most industrial countries are now moving toward limiting credit risk on their pay- ment systems. The two papers presented in the session on the payment system by Summers and by Folkerts-Landau, Garber, and Lane both describe in detail the principles and technical factors surrounding the proper operation of a payment system. These considerations include the distinction between clearing and settlement and the natur~ of finality of payments; the trade-off between gross settlement and net settle- ment; the operations of a clearinghouse; the relationship between the nature of the payment system and the institutions in the money mar- kets; the need for clarification of the legal status of payment media; and the nature of the communication and transportation system for bank advices and documents. The discussions of these issues in both papers can best be described as a characterization of the parameters that establish the position of a country's payment system on the payments volume-credit risk frontier. Both papers further apply the principles of sound operation of a payment system to an analysis of the institutions of the economies in transition. Specifically, Summers considers the problems of the Rus- sian payment system, while Folkerts-Landau, Garber, and Lane con- centrate on similar issues in the East European context, notably the Polish case. In both Russia and Eastern Europe, the payment system problems are almost identical, except that Russia has the added prob- lem of clearing and settling cross-border payments with the other countries of the ruble zone. The countries in transition to market economies have inherited payment systems with the drawback both of permitting excessive credit to participants and hindering the flow of transactions. In the monobank systems that predominated under the communist re- gimes, the making of payments to suppliers took on primarily a finan- cial accounting role and was not a means of disciplining the actions of 8 Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane the participants in the payment system. Credit in the form of float or explicit loans was freely granted by the monobanks to enterprise payors that were short of funds, and all payments were guaranteed. In this environment, because speed of settlement was not an issue, the infrastructure of clearing and settlement of payments remained primitive. Payment orders and checks can still take weeks to settle, so credit must inevitably be granted to payees to cover imbalances, which can create either credit or debit float. But because payment is not certain, lack of sufficiently fast settlement may constrain transac- tions, forcing many of them onto a purely cash basis. As the payment systems of the economies in transition are gener- ally inefficient, some reform proposals would permit a greater vol- ume and speed of payments without compromising the soundness of the system. For example, Summers suggests creating availability schedules for funds depending on typical clearing patterns across cities to avoid large fluctuations in float. Both papers recommend that a banking firm should have a single, consolidated account at the central bank rather than individual accounts for each branch. Banking firms would then be much less likely to run payment imbalances at the central bank, and accounting could be decentralized from the books of the central bank to those of the banking firm. Similarly, both papers recommend technical improvements in the communications and transportation systems used by the banks to process payment orders; and Summers recommends changes in the legal system to define clearly the rights and responsibilities of users of checks and to deter counterfeiting. Other policy proposals encounter the trade-off, alluded to earlier, between the speed and volume of payments and the credit risk to which the system is exposed. Advice on these issues depends on the nature of the financial system that is desired and the authorities' taste for risk. For example, for large-value interbank payments, the author- ities might opt for a gross settlement system-in which each payment order is accompanied by the final settlement medium such as deposits at the central bank. Under gross settlement, no credit is provided directly through the operation of the payment system. Since banks must have a positive deposit in the central bank before the system will process a payment order, banks will have a relatively large demand for reserves. Such a system will restrict payment vol- umes, especially if there are active financial markets generating wholesale payment flows. Alternatively, the authorities might opt for a net settlement system-in which only the net of all the day's pay- ments and receipts must be settled at the end of the day. Such a system permits a larger volume of payment orders to be processed 1 • INTRODUCTION 9 with. fewer deposits at the central bank Nevertheless, this gain is I provided by increasing the credit risk on the system and absorbing the risk of a systemic crisis if one of the participants in the clearing defaults. In line with developments in industrial country payment systems aimed at eliminating systemic risk, Summers recommends the choice of a gross settlement system for the economies in transition. Folkerts- Landau, Garber, and Lane point out the trade-off inherent in the choice between gross and net settlement and indicate that the choice will depend on the kind of financial system that the authorities ulti- . mately want to develop. Nevertheless, they too warn of the moral hazard that arises if credit is provided on the payment mechanism. This caution is especially applicable in economies in which the sol- vency of the financial institutions participating in the payment system is chronically in doubt. Creating a Sound Financial Structure The next important question is how to structure a sound financial system that could .provide firms with the necessary financing while playing a key role in corporate governance. This issue would remain even if all the pre-existing bad debt problems were solved. Some unresolved questions in this area include how much transitional economies should rely on bank versus nonbank financing; how bank- ing can be made safer; whether universal banking is a sensible choice for transitional economies; and whether bank privatization is part of the solution, and if so, when and how should it be accomplished. McKinnon's view, noted above, is that bank lending should not be relied on as a source of finance during the transition process, as the riskiness of the environment, the absence of skilled bank supervision (and bankers), and moral hazard problems probably mean that lend- ing will be unprofitable and misguided. Adherents to this school of thought also argue that because of the scale of the privatization effort that will be a key part of the transition process, stimulating the devel- opment of capital markets is the first order of· business, and that banking is unimportant or irrelevant to transition. They have added fuel to this debate by proposing a technologically sophisticated-and expensive-payment network to facilitate nonbank finance. In contrast, most of the participants in the session on creating a sound financial structure emphasized the importance of banks in the transition process, though they disagreed about appropriate policies in the financial sector. As Blommestein and Spencer argue, banks are 10 Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane important because they provide short-term working capital and occupy a key position in the payment process. Without the provision /1 of good funds" from the central bank, as well as commercial banks' readiness to provide "lender-of-first-resort" funds to other financial institutions, trade in commodities and financial assets will probably be far less than it would be otherwise. Banks also are important because of their role as gatherers of information in an environment that is anything but transparent. Whereas in advanced economies the profusion of information has recently begun to allow the "securi- tization" of financing formerly conducted through nontradable bank loans, the underdevelopment of information markets-the absence of reliable accounts and of accountants and auditors-as well as the difficulty in enforcing contractual agreements makes securitization a futuristic solution to finance in emerging market economies. A principal point of contention for those concerned with putting the banking sector on a sound footing is restructuring of banks. Many observers, including Blommestein and Spencer, recognize that banks are important and that when they are allowed to operate with nega- tive net worth the likelihood of suboptimal decisions emerges. How- ever, a marked divergence of views from that point emerges. Blom- mestein and Spencer make the case that banks must be restructured early in the transition process, whereas others argue that restructur- ing should be delayed until the conditions are in place to ensure that they will not be rapidly decapitalized again.4 One way to sort through these issues is to focus on the condition of the banking sector on the eve of reform and what is being asked of it in transitional economies. As is commonly recognized, financial inter- mediaries mobilize savings, make payments and facilitate transac- tions, select firms to finance, monitor firm managers and provide some form of corporate governance, and facilitate risk management. Before the onset of the transition process, so-called banks in the econ- omies in transition did not perform these functions but rather pas- sively fulfilled the goals and directives of the planning ministry. s 4 See Levine and Scott (1993) and Caprio and Levine (1994) for a discussion of when to restructure banks. In many regions, including Eastern Europe, bank restructuring without more fundamental reforms-including improving supervision and regulation, raising capital requirements, and training bankers-has proved to be short-lived; some restructured banks and banking systems have lost their new capital in short order. This argument is not against recapitalization, but it does suggest that it should occur later in the reform process. 5 The degree of passivity undoubtedly varied, but the only country in the second half of the 1980s to which this generalization does some injustice is Hungary, where the transition process commenced earlier in the decade. 1 • INTRODUCTION 11 Often one large savings bank charged with mobilizing resources transferred the funds to the central bank, which then allocated them among the few specialized lending banks. Lending banks in turn did little to screen firms or to monitor their loans, as the risk was born by the government, which regularly reimbursed the banks for any losses. Other financial products and services designed to reduce or trade risk were largely absent, except for some insurance of commer- cial risks for trade-related industries. Given this base, what are banks in transitional economies being asked to do? Economies in transition by definition have small but growing private sectors and large and shrinking state-owned enter- prise (SOE) sectors. However, in most cases the private economy does not appear instantaneously but rather emerges over time, while the SOEs show no signs of disappearing. An important job for the financial system, in addition to mobili.Zing resources and facilitating payments, is to allocate resources between these two disparate parts of the economy. A quick and complete restructuring of the banking system might then not be needed and might not stand any chance of success, unless and until the nonfinancial sector was being imme- diately restructured and privatized as well. If the private sector is to remain small for a while, the urgency for bank restructuring and privatization appears to diminish. Moreover, in most economies new, small firms do not get bank finance but rather resort to self-finance until, having reached a more moderate size, they have achieved a track record and have accumulated some collateral. One could envisage that the needs of the newly emerging private sector would be served by new (private) banks, including foreign and joint venture efforts, with perhaps some parts of the former state banking sector being split off and privatized also. The state-owned banking sector that remains-not a banking sector as is known in market economies, but more of a "hospital" or restructuring arm of the government budget-would be' charged with carrying out the government's wishes for the SOE sector. An important job would then be to ensure that the share of credit going to the SOE sector declined over time. The notion that the entire stat'e-owned banking system cannot be "fixed" overnight is also featured in the paper by Millard Long and Samuel Talley. This paper recommends that a special license, of Inter- national Standard Bank (ISB), should be awarded to a handful of banks meeting rigorous criteria. This con_troversial proposal, designed for Russia, is intended to apply to a situation in which there has been essentially free entry. Its goal is to create a number of "good" banks that would ultimately become the core of the future 12 Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane Russian banking system. The plan would operate by offering banks a combination of carrots-allowing them to advertise their special license, borrowing at a lower rate from the discount window, perhaps lower deposit insurance premiums and easier approval of branch applications-and sticks-higher initial capital, meeting the Basie cap- ital adequacy guidelines, an annual audit by qualified firms, adequate loan loss reserves, and tight limits on single borrower exposures. One critique of the plan argues that it is a good idea that does not go far enough. Although an 8 percent risk-adjusted capital adequacy ratio might be appropriate for well-diversified and macro- economically stable countries of the Organization for Economic Coop- eration and Development (OECD), recent debate suggests that regu- lators believe that it may not be high enough even in the OECD context. The same ratio may be dangerously low when applied to economies in transition. 6 Although it is difficult to find historical examples similar to the transition process, it is useful to recall that in the nineteenth century, capital/asset ratios in U.S. and German banks were often 25 percent and higher.7 One might well ask whether it can be convincingly argued that today's emerging market economies are any less risky than the U.S. and German economies during their industrialization effort. This critique would then imply that if the ISB approach is adopted, extremely high capital ratios must be imposed. A second critique, offered by Garber, Lindgren, and Schiffman, asserts that the plan is impractical and perhaps even misguided. Regarding practicality, they maintain that because the supply of qual- ified supervisors is insufficient, a significant lag in verifying ISBs' compliance with the requirements would occur, and they doubt that even sincere bankers could comply with the commitments that they would be required to make. On a more fundamental level, these critics are concerned that the formation of ISBs could prompt a run on the non-ISBs, and that it is detrimental to give preferential treatment to one class of institution. Raising the capital requirements substan- tially above those required by the Basie committee would answer some of these critiques-it would certainly reduce the number of institutions needing supervision. Still, it is not possible to dismiss 6 Another suggestion that the 8 percent standard is too low even in OECD countries is the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) in the United States, which accords wide powers to banks satisfying a 10 percent risk- adjusted capital ratio, with limitations on powers increasing as capital falls from this level. 7 See Tilly (1966) (for Germany) and Hammond (1957) (for the United States). 1 • INTRODUCTION 13 these concerns, as they are legitimate issues, particularly about the phasing in of such a system. A policymaker might be inclined to ask what are the alternatives in a truly "wild west" banking environment. One response might be to let the "market" work, that is, to allow depositors to lose their funds and thus serve as monitors of the banking system. This laissez-faire view presumes that depositors can monitor banks, which are inher-. ently nontransparent institutions, and that it is practical to deny at least partial deposit insurance to economies in transition. s Officials might well reason that passing on large losses to depositors would evoke calls to halt or reverse the reform process. If neither of these presumptions holds, some method for selectively limiting entry and increasing the franchise value of bank licenses will help to improve the incentives facing bankers and induce them to invest in making their institution safe and sound. Another important issue for policymakers is the activities that banks should be allowed to undertake. Many of the economies in transition-in particular those in Eastern Europe and Central Asia- are attracted by the German model of universal banking and have granted universal banking powers to the banks. David Scott advo- cates delaying the emergence of such institutions until both banking and supervisory skills are sufficiently developed. Nonbanks- institutions not funded by deposits-could provide the skills to help with the restructuring process and with equity finance. In effect, as noted by George Kaufman, this model is the U.S. banking system of the 1940s to the 1970s, and he basically argues that it is appropriate for economies in transition if one deals satisfactorily with the deposit insurance issue. 9 Some might argue that whereas the bankers in economies in transi- tion may not be the best finance professionals imaginable, they are the only ones around. Given the paucity of financial expertise in these economies, the banks might be the best hope for exerting ratio- nal corporate governance and should accordingly be allowed to take an equity position in enterprises. Scott does not contradict this, but nonetheless suggests that banks should be prohibited from under- writing, trading, or distributing corporate debt or equity securities. 8 See Caprio and Summers (1994) for a discussion. 9Given the underdeveloped banking and supervisory skills, Kaufman's views on structuring capital requirements and deposit insurance to allow supervisors sufficient time to intervene before bank capital is exhausted are quite consistent with the remarks above on the desirability of a high capital ratio. 14 Gerard Caprio, David Folkerts-Landau, and Timothy D. Lane Although disagreement on the limits that should be placed on banks' powers abounds, perhaps the most convincing compromise was offered by Winckler, who noted that nations' position in this debate depends on how they view the trade-offs between transpar- ency, economies of scale and scope, and concentration in finance. Outsiders may have little to contribute to the debate other than to note that the trade-offs exist and how to cope with the choices. Less controversial is the argument that a market-oriented financial system needs private banks at the heart of the banking system and that therefore at some point some parts of the state-owned banking system will need to be sold off. Unfortunately, few countries have much experience with bank privatization, but Guillermo Barnes was able succinctly to recount some of the very practical lessons of great- est interest to the authorities in formerly centrally planned econ- omies. In addition to presenting the mechanics of the process, he argued that authorities should start with small banks, as officials learn much in the process and will thereby make fewer costly mis- takes. They can also establish a track record for honesty and transpar- ency that will have positive externalities for other parts of their pro- gram. He also asserted the need to build up the supervisory system so that it will be ready for a large private banking sector. On economic grounds, the authorities in economies in transition do not have to privatize their banks within the short time span (13 months) observed in Mexico, but there is no substitute for getting started. As argued above, this may initially involve selling off only small parts of the state-owned banking system, relying on new entrants to fill out the remainder of the private banking group. The Provision of Credit Many of the papers in this volume have illustrated, in various applications, the role of financial discipline in guiding the allocation of resources during and after the transition to a market economy. But some observers have sounded a cautionary note, in the context of the output declines that occurred in Central and East European countries in the early 1990s. Guillermo Calvo and Fabrizio Coricelli argue that if financial discipline is imposed too early, severe macroeconomic con- sequences may result. In their interpretation, an important ingredient of the output decline was that central banks indicated that they would no longer be willing to provide unlimited and automatic credit. This change in the role of the central bank led to a vacuum in credit markets that could not immediately be filled, given the absence of the 1 • INTRODUCTION 15 information, trust, rules, and institutions needed to enable a private credit market to function. No private mechanism was immediately available to offset the decline in the stock of credit associated with the price jumps that followed price liberalization at the onset of the reform programs. Calvo and Coricelli focus on enterprises' response to a reduction in liquidity, which they associate with credit. They assume that enter- prises face a liquidity-in-advance constraint, requiring liquidity in proportion to output. Prices are assumed to increase exogenously, while the nominal quantity of liquidity or credit is limited, leading to an output collapse. The liquidity crunch may to some extent be offset through lower wages, with the firm in effect borrowing from its workers.10 However, assuming that there is some floor to wages, or that for some other reason workers are unwilling to lend enough to the firm, output will nonetheless decline. An expansion of interen- terprise arrears would partly offset the effects of the credit contrac- tion, but the imperfection of private enforcement mechanisms may limit the scope for interenterprise arrears without a government guarantee. The analysis of Calvo and Coricelli focuses mainly on the macro- economic aspects of credit provision as an explanation of output decline. In addition to the aggregate decline in real credit the authors discuss, the distribution of credit among firms may also have played a role in the output decline.11 More generally, their argument points to the difficulty of establishing working credit markets in economies in transition and its importance for economic activity. However, the quantity of output is not the only criterion by which economic policy should be judged, and even if one accepts the view that a credit crunch was responsible for the output decline, this has to be weighed against the view, discussed earlier, that financial discipline may influ- ence significantly the composition and efficiency of production. Moreover, as the authors acknowledge, macroeconomic solutions to a liquidity crunch may not work: for instance, increasing the nominal quantity of credit may undermine the disinflation effort and thus further decrease the real quantity of credit. This leaves the policy- maker with a dilemma: how to impose financial discipline without drying up the credit that is needed to finance economic activity. In China, not only does finance appear initially to have played a lagging role, but it also has presented quite the opposite case from the 10 They assume that firms do not have access to international capital markets.but that. workers do. 11 See the comment by Rudiger Dornbusch. 16 Gerard Caprio, David Folkerts-Landau. and Timothy D. Lane Calvo-Coricelli credit crunch. The Chinese reform strategy, implicitly or explicitly, has featured a reliance on nonstate firms as the engines of growth. As with virtually all young firms in any economy, these nonstate enterprises have relied heavily on self-finance, with workers and township and village residents taking equity in their firms. A high initial savings rate helped fuel this process. The Chinese finan- cial sector benefited substantially from relatively little financial repression: except for a brief inflation spike, real interest rates on deposits have remained positive or zero since 1980. This absence of significant repression probably contributed to the high savings rate, which has underwritten the self-finance boomlet. In addition, China has benefited from a large amount of foreign direct investment, which has financed investment especially along the southeast coast. Shahid Yusuf also argues that recently some signs indicate that bank financing is on the rise, as might be expected as firms mature and become more established. China has not yet experienced the credit crunch discussed by Calvo-Coricelli; both the high savings rate and capital controls make it easier for many demands for investment to be satisfied. However, as investment demand rises in the nonstate sector, and as it becomes necessary to rein in monetary growth to check inflationary pressures, conflict between the state and nonstate sectors may well arise, ren- dering some type of crunch more likely. However, the main problem that the central bank will face will be reining in the expansion when a significant amount of liquidity exists in the system. This can become an important issue in transitional economies where many of the tools of monetary policy are lacking. A resort to direct controls, while effective in the short run, risks being so blunt as to reduce growth sharply, though, to be sure, a continuation of accelerating inflation would damage the real economy even more. Summary Many of the issues raised above underline what has been learned in developing countries, namely, that financial reform is a process, not an event. It is a process because it takes time to build skills and institutions and to change incentives. And financial systems do not function in a vacuum, but rather depend heavily on, and in large part reflect, the nonfinancial sector. Since the latter's transformation takes more time than was thought at the start of the transition process, it is not surprising that financial reform is slow going. 1 • INTRODUCTION 17 Nonetheless, efficient financial intermediation will make an impor- tant contribution to improving the allocation of resources which, after all, is the goal of the transition process. It is to be hoped that the lessons and discussion set out by this conference and others like it will accelerate the transition process and help to build sound financial systems in transitional economies. References Calvo, Guillermo A., and Jacob A. Frenkel, "Obstacles to Transforming Cen- trally Planned Economies: The Role of Capital Markets," in The Transition to a Market Economy in Central and Eastern Europe, ed. by Paul Marer and Salvatore Zecchini (Paris: Organization for Economic Cooperation and Development, 1991). Caprio, Gerard, and Ross Levine, "Reforming Finance in Transitional Social- ist Economies," World Bank Research Observer, Vol. 9 Oanuary 1994), pp. 1- 24. Caprio, Gerard, and Lawrence Summers, "Financial Reform: Beyond Laissez Faire," in Financing Prosperity into the 21st Century (London: Macmillan, forthcoming, 1994). Hammond; Bray, Banks and Politics in America From the Revolution to the Civil War (Princeton, New Jersey: Princeton University Press, 1957). Lane, Timothy D., "Financial. Sector Re~orm: Banking, Securities, and Pay- ments," in Government and Markets, ed. by Hans J. Blommestein and Ber- nard Steunenberg (Boston: Kluwer, forthcoming, 1994). Levine, Ross, and David Scott, "Old Debts and New Beginnings: A Policy Choice in Transitional Socialist Economies," World Development, Vol. 21 (March 1993), pp. 319-30. Tilly, Richard, Financial Institutions and Industrialization in the Rhineland, 1815- 1870 (Madison, Wisconsin: University of Wisconsin Press, 1966). PART I Old and New Debts 2 Financial and Enterprise Restructuring in Emerging Market Economies Steven M. Fries and Timothy D. Lane1 Building sound financial systems is fundamental to developing via- ble market economies where central planning once prevailed. In a market economy, it is the financial system that channels savings among alternative uses, either through competing intermediaries or in markets, guiding the composition of economic activity and its rate of expansion. Accompanying this provision of financing are various forms of control over the use of capital-the voting rights of share- holders, restrictive covenants in lending agreements, and shifts in control associated with bankruptcy. Within the discipline thereby imposed, a market economy permits a large degree of decentraliZa- tion. The transformation from a centrally planned to a market econ- omy thus entails, in large measure, a shift from bureaucratic adminis- tration to financial control. Financial restructuring in emerging market economies is not only limited to building a sound financial system that effectively controls the use of capital. 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 change the organization and deployment of productive resources-including paring down large SOEs from their often vast scale and scope and liquidating chronic loss-making enterprises. In the void created by the breakdown of bureaucratic administration, strengthening financial control can be an important means of achieving this economic restructuring. Enforcing existing 1 This is a revised version of the paper that was prepared for the conference. The authors thank Georg Winckler, the discussant, and other conference participants for helpful comments on the earlier draft. The views expressed are those of the authors, and do not necessarily represent those of the International Monetary Fund. 21 22 Steven M. Fries and Timothy D. Lane debts can be used to force inefficient SOEs to shed physical assets, while providing new financing to support enterprise sell-offs and leasing can facilitate the transfer of productive assets into the nascent private sector. However, the financial structure of new private firins, which shapes the incentives faced by their owners, creditors, and managers, should reflect their preferences rather than those of a cen- tral authority. ·· Because of both the discipline imposed by a sound financial sys- tem in a market economy and the need to provide finance for eco- nomic restructuring, an overhaul of the financial systems in emerg- ing market economies is of pressing importance. This overhaul includes not only an upgrading of the physical and human capital of banks and other financial institutions, but also a fundamental shift from finance as the passive record-keeping mechanism under cen- tral planning to finance as the primary instrument of control over the use of capital. The legacy of bad loans from the era of central planning and the early period of transition to a market economy, however, severely hampers the overhaul of both state banks and SOEs in some emerg- ing market economies. These doubtful loans were made mostly to SOEs by state banks; in some cases, they constitute substantial pro- portions of both state bank assets and enterprise liabilities. State banks are also hindered by the sectoral and geographical concentra- tion of their loans that resulted from their typical origins as either regional offices of monobanks or as specialized financing agencies for particular industries.2 This paper examines alternative approaches to building sound financial structures in some emerging market economies. The fore- most task is to resolve the bad loan problem and to recapitalize insol- vent state banks. By restoring an incentive for banks to price accu- rately the risks of new lending, the resolution of bad loans would be an important first step in strengthening financial control. However, this endeavor is only part of the task at hand; the remainder is to provide financing that facilitates the economic restructuring of SOEs .. A comprehensive strategy may combine discipline derived from enforcing existing loans to SOEs with adequate funding for new forms of ownership, including financing for enterprise sell-offs and leasing. 2 The "pocket banks" in the former Soviet Union, which were established largely to channel funds-usually central ·bank credit-to particular state enterprises are an extreme example. 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 23 Origins of the Bad Loan Problem Although loan defaults did not occur under central planning, the origins of the current bad loan problem in some emerging market economies can be traced to the old system. Under the monobank structure, a single bank performed both commercial and central bank- ing functions. In commercial banking, a monobank typically played a passive role, providing book-entry credit to SOEs for all investment projects approved under the central plan and disbursing cash for payment of wages. An attempt was usually made to maintain a strict separation between cash and credit money: the former was used for wages and household consumption and the latter for interenterprise transactions. Since credit money could not be spent without the plan- ners' approval, and credit could be created automatically with the planners' approval; the lending decisions of the monobank were not guided by the opportunity cost of funds or by the ability to repay. The concept of bad debt was therefore irrelevant. Because the enterprise sector as a whole was typically solvent-being the main source of revenue for the government-the creditworthiness of individual SOEs was not of primary concern to planners. In many of the centrally planned economies, the initial reform efforts scaled back central planning and granted more autonomy to SOEs. At the same time, more banks were created. In some countries, such as Poland, the monobank' s commercial banking functions were devolved onto newly created commercial banks, whereas in others, such as Russia, many new banks were established. However, bank operations adapted slowly to the greater degree of decentralization. Without both the constraints imposed by central planning and effective financial control, SOEs stepped up their borrowing. Sharply negative real interest rates in some countries further stimulated this effort. Moreover, where high real interest rates prevailed, the adverse selection may have impeded the efficient allocation of credit. Since banks had not begun to discriminate between borrowers' credit- worthiness, high interest rates may have discouraged borrowing by solvent enterprises whose managers and workers expected to have a stake in the firm, whereas those SOEs whose debt far exceeded their assets may have been undeterred, never expecting to have to service the new lending (see Dooley and Isard, 1992). 3 Restrictive credit poli- cies, compounded by shortcomings in credit and payment systems, 3 Also, in some countries, such as Poland, official policy sanctioned interest capitalization. 24 Steven M. Fries and Timothy D. Lane may also have contributed to the overall deterioration of the enter- prise sector in some countries (Calvo and Coricelli, 1992 and 1993). The large shocks to which SOEs in Central and Eastern Europe were subjected in the early 1990s were another source of the bad loan prob- lem. First, price and trade liberalization worked to undermine the prof- itability of the enterprise sector: SOEs that had produced goods subject to shortages, purchasing inputs at controlled prices and selling their output under conditions of excess demand, suddenly hit the demand constraint. Many enterprises faced a large contraction in demand and were unable to adapt to altered market conditions (Blanchard and others, 1991; and Borensztein, Demekas, and Ostry, 1993). 4 Second, the breakdown of trade among the countries of the former Council for Mutual Economic Assistance (CMEA) and among the states of the former Soviet Union exacerbated the plight of the enter- prise sector (Rodrick, 1992). This breakdown was intensified by deep distrust among some of these countries and because the previous pattern of trade had been to some extent artificially promoted in the interest of maintaining fraternal relations among the socialist coun- tries (Wolf, 1990). The shocks affecting the enterprises, together with the banking system's failure to discriminate according to credit- worthiness, contributed to substantial further accumulations of bad debt after some reform programs had begun. The pattern of lending in the initial period of reform illustrates three aspects of the lack of financial control. First, many SOEs were confronted with permanent changes in their economic setting-in their input prices and in markets for their outputs-that would not permit them to survive in their present form; nevertheless, these SOEs continued to receive bank credit that enabled them to perpetu- ate chronic loss-making activities.s Second, reflecting the breakdown of central control of SOEs, some enterprise managers may have used their access to credit to buy industrial peace by granting higher wages (Coricelli and Lane, 1993) or to further their own interests, expecting that the debts would be serviced by someone else.6 Third, the explo- 4 1n some cases-notably Poland in 1990-rapid inflation early in the reform pro- grams boosted the profitability of SOEs, as they earned profits on inventories and foreign currency deposits, and as real (product) wages fell owing to the incomes policy. These profits were subsequently reversed, however. See Lane (1991). 5 Hughes and Hare (1991) estimate that between one-fourth and one-third of SOEs in Bulgaria, the former Czechoslovakia, Hungary, and Poland were producing negative value added at world prices. 6The diversion of credit for personal use was not limited to SOEs, as Poland's 1991 Art B scandal demonstrates (Folkerts-Landau, Garber, and Lane, Chap. 5 of this volume). This scandal is a reminder that in addition to the incentive problems of 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 25 sive growth in interenterprise arrears after initiation of reform pro- grams may also point to the lack of financicil control, although some growth in this form of credit may have reflected normal business practices (Clifton and Khan, 1993; and Ickes and Ryterman, 1993). Why did banks not exercise a greater degree of financial control after the initiation of reforms? First, they had no clear-cut incentive to maxi- mize profits, since they remained under state ownership. Even where their profits were shared with employees, uncertainty about how long this arrangement would last may have given them a very short-term perspective. Second, those banks that were themselves insolvent had no incentive to withhold credit from-unworthy borrowers. Under these circumstances, lending to enable insolvent debtors to service their obli- gations could be rational, since it enabled the troubled banks to report the loans as performing, and thereby postpone the day of reckoning (Mitchell, 1993). Third, the quality of information on outstanding debts was very poor, because few facts were available on which to assess the long-term viability of SOEs or even the quality of their receivables from other enterprises. Finally, the strength of insider networks and custom- ary relationships may have perpetuated lending patterns established in the era of central planning. The bad loans in emerging market economies are a serious problem because they distort the incentives of both creditors and debtors. Banks whose bad loans are so large that they are insolvent do not make efficient lending decisions, since at the margin no incentive exists to price accurately the risks of new loans. Under these circum- stances, a serious moral hazard problem could arise, as managers of state-owned banks would see little benefit from prudent lending rela- tive to a high-risk gamble that could keep them in business. More- over, as long as banks are saddled with such a large proportion of nonperforming assets that they have negative net worth, they cannot be privatized. Bad loans also pose a similar moral hazard problem for insolvent SOEs, destroying the incentive for maximizing enterprise profits and significantly impeding their privatization (Levine and Scott, 1993). Fiscal Constraints in Emerging Market Economies To eliminate quickly the moral hazard problem associated with the debt overhang and to pave the way for privatization, sweeping solu- SOEs, there is the danger of outright fraud, which existing supervisory structures may be inadequate to prevent. 26 Steven M. Fries and Timothy D. Lane tions to the bad loan problem have been suggested. These involve either debt cancellation-eliminating claims of state banks on SOEs and of SOEs on one another-or debt socialization-replacing existing bank loans to SOEs with claims on the government's budget (Calvo and Frenkel, 1991; Begg and Portes, 1993; Calvo and Kumar, 1993; and Levine and Scott, 1993). However, any such solution to the bad debt problem must take into account its impact on the fiscal position of the government overseeing the transition to a market economy. This impact arises largely from the extent to which the government guarantees deposits in state banks, which usually account for the bulk of the private sector's claims on the public sector. The government's ability to raise revenues with which to fund a bailout of depositors is limited, however. In emerging market econ- omies, revenues are largely derived from the enterprise sectors, whose profitability has been squeezed by initial reform efforts (Tanzi, 1991 and 1993). Steps have been taken in some countries to move toward new tax bases-such as personal income tax and value-added taxes-but new forms of taxation often take time to yield much reve- nue. 7 In parts of the former Soviet Union, this problem may be exac- erbated by disagreements on the right to tax the enterprises, and on the ambiguity of property rights in general (Shleifer and Vishny, 1994). This suggests that, if a debt write-off or socialization further reduces a government's ability to derive revenues (including debt service payments) from the enterprise sector, a heavier burden would fall on those forms of taxation that can be most readily collected, including the inflation tax (Lipton and Sachs, 1990). The fiscal constraint would be less binding if there were well- developed markets for government securities (bills and bonds). Such financing opportunities would permit the government to achieve its desired intertemporal distribution of the tax burden. The appropriate choice of intertemporal tax incidence would then depend on antici- pated improvements in tax collection and on expected increases in income over the long haul to minimize the deadweight losses from the taxation. This choice could also take into account intergenera- tional equity, possibly shifting to future generations some of the costs of the economic transformation from which they will likely benefit in the form of higher incomes. However, in many emerging market economies, the absence of well-developed money and securities mar- 7 For instance, Hungary introduced a personal income tax and value-added tax in 1988, whereas Poland and the former Czechoslovakia introduced value-added taxes in 1993. In each case, administrative and other start-up costs were substantial. 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 27 kets limits the amount of government debt that can be sold to finance the cancellation of old loans. The debt socialization proposal aims to avoid large-scale sales of government debt into underdeveloped markets by swapping these obligations for the claims of banks on SOEs. As a first approximation, debt socialization is equivalent to lending by insolvent banks that benefit from an official guarantee of their deposits, substituting an explicit liability of the government for its contingent liability. Two key differences make debt socialization preferable, however. It is more transparent, recognizing the transaction as a financing item in the government's budget rather than as a contingent liability; and it paves the way for solving the moral hazard problem associated with insolvent banks and SOEs. If the debt socialization approach is followed, however, how much debt should be socialized and what should a government do with the claims that it obtains on the SOEs? As a starting point, it is assumed that the state banks are to be privatized. If this privatization takes place by selling shares in a liquid equity market, the net fiscal cost of any debt socialization is limited to the negative net assets of the bank, because the government recoups the amount of any excessive debt socialization through increased privatization revenues (Beg$ and Portes, 1993). However, if-as seems more realistic-banks are sold in relatively illiquid equity markets, or if they are given away to the public through some kind of voucher scheme, the benefits of exces- sive debt socialization are unlikely to be fully reflected in share prices, and thus would to some extent accrue to the new owners of the banks. With respect to the claims on SOEs that governments would receive from banks, such debts could be retained at least in part to impose financial control over the managements of SOEs and to bol- ster government revenues. Provided that these debt contracts can be enforced, they could be used to pry productive resources away from inefficient SOEs. If financing for enterprise restructuring is available, the existing debts of SOEs could be used to mop up free cash flows that may be generated by the sale of productive assets (Jensen, 1986). Also, with respect to profitable SOEs, the existing debts could limit the discretion of managers over the use of operating profits. In both cases, the existing debts of SOEs could also provide the government with a source of revenue. However, the fiscal benefits from enforcing the existing debts of SOEs must be counterbalanced against the adverse incentives faced by the managers of insolvent SOEs. A blanket solution to the bad loan problem in emerging market economies, such as a generalized debt socialization or write-down, is 28 Steven M. Fries and Timothy D. Lane unlikely to strike the appropriate balance between quickly restoring solvency to banks and SOEs and limiting the fiscal impact of a bail- out. An indiscriminate bailout would not promote the restructuring of SOEs needed to achieve more efficient deployment of productive resources and more competitive market structures. Rather, to resolve the bad loan problem, a case-by-case approach is necessary. Resolving the Bad Loan Problem of State Banlcs It is perhaps best to begin with the state banks, since the provision of new, high-quality loans and other services is key to strengthening financial control and to restructuring the enterprise sector in emerg- ing market economies. With respect to the banking overhaul, several important issues musi: be addressed. First, the responsibility for undertaking the resolution must be assigned. Two alternative approaches are a decentralized route, in which responsibility for resolving the problem rests with the banks themselves, versus a cen- tralized approach carried out through a specialized agency. The sec- ond issue is whether the banks should be recapitalized and, if so, how this should be accomplished. Finally, as with' any bailout, the moral hazard problem must be combated, which in this case requires the privatization of banks .. Decentralized Versus Centralized Strategies One approach to resolving the bad loan problem is to leave the individual banks that are so burdened to sort out the problem, as in the decentralized strategy recently adopted in Poland to address the bad loans of its nine major commercial banks. In this case, a certain portion of the banks' doubtful loans were segregated in their balance sheets and subjected to special monitoring. This approach has also been used in Argentina, Malaysia, the Republic of Korea, Thailand, and the United Kingdom (during the secondary banking crisis). 8 An alternative approach is to carve out bad loans from the banks' balance sheets and to transfer them to a centralized agency created by the banks or the government to resolve the bad loan problem. Recent examples of this approach are the creation of the Resolution Trust Corporation in the United States, the Cooperative Credit Purchasing sA variant of this approach has been used in the United States and in some Nordic countries, where separately capitalized entities have been established to dispose of banks' problem loans. 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 29 Company in Japan, and the Spanish Guarantee Fund. This approach has also been used in Chile, the Philippines, and Uruguay. The experience in industrial and developing countries reveals that the choice of a decentralized or centralized strategy for resolving the problem often reflects a number of factors. Foremost among them appears to be the size and scope of the problem (Saunders and Som- mariva, 1993). In banking crises that involve a large number of prob- lem banks with a substantial proportion of the banking system's loans, the doubtful assets are often transferred to a restructuring agency. In the other cases, a more decentralized approach is typically used, in which individual institutions retain responsibility for resolv- ing the bad loan problem. 9 By both official and unofficial accounts, the number of troubled banks and the proportion of doubtful loans in some emerging market economies are very large, calling for the use of a centralized solution. In addition, a number of unique factors have a bearing on the appropriate choice of a resolution strategy in an emerging market economy, some of which also weigh in favor of the centralized approach (Blommestein and Lange, 1993). First, this approach decou- ples the banking overhaul from enterprise restructuring and may help to sever the symbiotic relationship between banks and SOEs. Because the restructuring and privatization of large SOEs is likely to be protracted, retaining bad loans to SOEs on the balance sheets of banks may impede the banks' overhaul. The relatively quick reha- bilitation of banks' balance sheets afforded by the centralized approach would allow the management of these institutions to turn to the business of making new, high-quality loans. Moreover, the substantial reduction in banks' credit exposure to loss-making SOEs would be an important first step in breaking the spiral of bank lend- ing to support these troubled enterprises. If banks are adequately recapitalized when the bad loans are removed from their books, they would no longer be compelled to roll over old loans to maintain the pretense of solvency. However, regulations to curb new bank lending to SOEs-for example, rules pertaining to large exposures-may be necessary to establish an arm's-length relationship between banks and SOEs and to encourage the formation of broadly diversified loan portfolios. In contrast, if the bad loans are retained on the balance sheets of 9This empirical regularity suggests that there may be some economies of scale in undertaking bad loan resolutions, but the precise source of these gains is difficult to pinpoint (for example, administrative cost savings or greater control over the disposi- tion of assets). 30 Steven M. Fries and Timothy D. Lane banks, their close relationship with SOEs would probably be pre- served, as would the banks' concentrated credit exposures. Although in principle banks could be recapitalized sufficiently to enable them to charge off the nonperforming loans, the resolution of the bad loans could require the banks to become closely involved with the manage- ments of SOEs. This involvement would not be limited to isolated business failures, but would be pervasive, given the financial condi- tion of the enterprise sector. The extensive commingling of banking and commercial activities has been resisted throughout much of the history of Anglo-Saxon banking (Corrigan, 1991). The two main con- cerns have been about conflicts of interest and concentrations of eco- nomic power. Delegating enterprise restructuring to banks may thus impede the paring down of large SOEs. However, in other countries, such as Germany, the cartelization of banking and industry has been viewed as an engine of development (Hellwig, 1991). The second consideration that favors a centralized approach is the pace at which bank privatization could proceed. The cleaning up of banks' balance sheets would enable them to be more precisely valued and reduce the time required for due-diligence investigations before their sale. Moreover, privatization in this manner is likely to be more enduring because it makes a clear break with the past. The govern- ment could credibly argue that any losses on loans are in the first instance the responsibility of banks' private owners and managers (Levine and Scott, 1993). Third, a centralized resolution agency may facilitate the restructur- ing of SOEs. One impediment to their restructuring is the diffuse control of SOEs with the loss of central government authority after the collapse of communist regimes. Workers, incumbent managers, and local governments now vie for dominant positions in these enter- prises (Dinopoulos and Lane, 1992; van Wijnbergen, 1992; and Shl- eifer and Vishny, 1994). In bargaining with these various stake- holders, an agency backed by the government may have greater authority and leverage than banks. In principle, the agency must devise a resolution strategy that combines enough "carrots and sticks" to prevent these stakeholders from blocking the restructuring of enterprises. One possible incentive is the transfer of shares in privatized enterprises as needed to one or more of these groups (van Wijnbergen, 1992), whereas channeling new bank loans away from chronic loss-making SOEs toward enterprise restructuring is a poten- tial way to discourage obstruction (Perotti, 1992). The main argument against adopting the centralized approach is that the administrative demands of this solution would be difficult to satisfy in many emerging market economies, where such expertise is 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 31 in short supply. This, in fact, was the main reason why the Polish Government opted for a decentralized approach to resolving the bad loan problem of its nine largest banks (Kawalec, 1994). A centralized agency may also become a focal point for rent-seeking activities that could undermine its efforts to restructure enterprises, although indi- vidual banks would not be immune to such pressures. Bank Recapitalization Given an assignment of administrative responsibility for resolving the bad loan problem, the issues arise of whether and, if so, how, the banks should be recapitalized. The case for recapitalizing insolvent banks rests on several considerations. Two of the more important are the building of confidence in the banking system and the preparing for the privatization of state banks. Failure to protect depositors would risk financial instability and jeopardize the attempt to impose market discipline through financial control. At the same time, recap- italization is a necessary first step for the sale of banks to private investors to help combat the moral hazard problem associated with a bailout of depositors (see below). Concern over the fiscal impact of the bailout, however, could lead to the imposition of losses on deposi- tors, especially through high inflation and negative real deposit rates, or to the adoption of inefficient schemes that attempt to hide its true cost. Many industrial countries experienced periods of financial insta- bility, particularly in the 1930s and in periods surrounding major wars, that involved widespread failures of financial institutions, sharp declines in asset prices, and disruptions to payment systems and credit intermediation. The perception that this instability contrib- uted to significant declines in real activity and employment have led most industrial countries to adopt financial policies aimed at promot- ing financial stability and at containing the spillover effects from financial crises onto the real economy. These policies include exten- sive explicit and implicit guarantees of bank deposits. The official safety net for banks and other financial institutions in industrial countries consists primarily of the central banks' authority to act as lender of last resort, typically on the basis of collateral, and explicit deposit insurance schemes. The structure of these schemes differs widely, however, in terms of the extent of their coverage, the institutions allowed or obligated to participate, the relative roles of private and public insurance, and the extent to which insurance funds have been used. Nevertheless, in instances of financial insta- bility, authorities typically have come quickly to the rescue of trou- 32 Steven M. Fries and Timothy D. Lane bled institutions, mobilizing both public and industry resources. For troubled banks, preserving confidence in the system has usually necessitated providing enough liquidity to protect depositors and to give time until the situation could be fully assessed and resolved in an orderly fashion (Corrigan, 1990). In emerging market economies, the potential for financial insta- bility is substantial. Initial reform efforts have seriously impaired the financial position of many SOEs and, in turn, that of their creditor banks. Moreover, owing to a lack of reliable accounts and financial disclosures, the distribution losses within banking systems are largely unknown to depositors. To maintain financial stability and to lay the foundation for the shift to financial control over the use of capital, many governments overseeing transitions to a market economy have pursued a policy of de facto guaranteeing 100 percent of deposits in major state banks, notwithstanding their loss in value through infla- tion as in Russia.10 The choice of recapitalization often reflects the trade-off among conflicting objectives, in particular maintaining financial stability versus minimizing fiscal costs.n In industrial countries, attempts to strike a balance between these goals, however, sometimes have led to efforts aimed at concealing the true cost of recapitalizations, which often raise their ultimate costs. For example, governments can suffi- ciently restrict competition among banks, allowing them to earn extraordinary profits from wide net interest margins that can be used to rebuild their capital. This approach, while keeping the recapitaliza- tion costs off the government's books, imposes an equivalent burden of distortionary taxes on consumers of banking services to fund the recapitalizations. This is not in general an efficient way to distribute the tax burden. In the early stages of the U.S. savings and loan crisis, the deposit insurance. agency resorted to the widespread use of loan guarantees to avoid making cash outlays. These guarantees, which weakened the incentive to collect on problem loans, ultimately proved to be very costly. In emerging market economies, the status quo of allowing banks with negative net assets to continue operating with the benefit of a de facto 100 percent guarantee of deposits has appeal, because in part it conceals the true cost of bank recapitalizations. In such circum- stances, the government effectively borrows by having state banks 10 A combination of inflation and wide interest rate margins increased banks' net worth dramatically in Poland in the early 1990s, although this solution was temporary and probably unintended. See Lane (1991). 11 Another objective is imposition of market discipline (see below). 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 33 issue deposits and using the proceeds to fund their negative net assets. The status quo has appeal also because the interest on this borrowing is paid by creating additional bank deposits, rather than by using government revenues. However, allowing banks with negative net assets to continue their operations runs the danger of escalating the bad loan problem, because little incentive exists to collect on old loans or to price accurately the risks of new lending. Any effort to recapitalize banks in emerging market economies thus must overcome the appeal· of the status quo. One way to tip the balance in favor of explicit recapitalization is to craft a plan that to some extent replicates the present situation. Since both the banks and the SOEs fall within the public sector, banks can be recapitalized by the government exchanging its debt for bank claims on the SOEs. This balance sheet operation does not affect the consolidated net worth of the government, taking into account its commitment to depositors. Thus, in effect, this method of recapitalizing banks simply substitutes explicit government borrowing for its implicit borrowing in the form of bank deposits. Although it is possible to craft recapitalization plans that largely replicate the status quo, any explicit recapitalization of banks would make the costs transparent. This transparency could impose political costs on the government and run afoul of attempts to achieve targets for benchmark levels of the fiscal deficit-which is of particular con- cern to international financial institutions. Nevertheless, an explicit recapitalization would allow the authorities to establish accountability for keeping these costs at a minimum. Moral Hazard and Bank Privatization In most official efforts to recapitalize troubled banks, the govern- ment's aim of preserving financial stability cuts against the need to maintain market discipline for banks, as the losses are not confined to their shareholders and private creditors. Indeed, the fundamental dilemma is that; while official assistance can limit the impact of finan- cial instability on real activity and employment, the expectation that such assistance will be forthcoming may alter the behavior of banks' managers, shareholders, and unguaranteed creditors in such a way as to make future instability more likely (Lane, 1993). In industrial countries, the moral hazard problem associated with the official safety net for banks is combated in several ways. First, replacement of the bank's management is typically a precondition for official assistance to a troubled institution. Second, the shareholders' claims on the bank are substantially diluted or written off in return for 34 Steven M. Fries and Timothy D. Lane government assistance. Thus, the management and shareholders of a troubled bank bear the costs of failure to the fullest extent possible. Third, to minimize the likelihood of failure, governments implement comprehensive systems of banking regulation, including capital requirements, limits on concentrated credit exposures, and pruden- tial examination. The present banking troubles in emerging market economies do not, in the first instance, pose precisely the same moral hazard prob- lem as those in industrial countries, since the government is the prin- cipal shareholder in the banks. By virtue of the de facto 100 percent deposit guarantee, the government is essentially a shareholder with unlimited liability and, thus, internalizes fully the costs of the bank- ing troubles. Also, although bank managers in emerging market economies may not have acted entirely in the interests of the govern- ment, establishing accountability at the level of bank management is hampered by the short supply of capable managers. Significant redundancies in banking industries are simply not feasible. The first line of defense against future banking troubles in emerg- ing market economies is thus privatization of the banks and a credible government commitment not to protect the private shareholders. The most effective preventative measure against future troubles is placing private capital truly at risk in the banking system. With private capital at stake, the banks' owners would have an incentive to ensure that risks of new lending are appropriately priced and that risk manage- ment procedures are adequate. If future losses are sustained, the private capital would serve as an initial buffer to absorb these costs, before recourse is made to public funds. The government's commit- ment not to protect bank shareholders in the event of future losses would be made more credible by removing the bad loans to SOEs from the banks' balance sheets before their sale (Levine and Scott, 1993). Overhauling State-Owned Enterprises The other side of the bad loan problem in emerging market econ- omies is the restructuring or liquidation of SOEs that cannot service their debts. In principle, a bad loan can be restructured to reduce its principal amount or the present value of its interest payments. This approach typically enables the borrower to continue operating as a going concern at the expense of bank profitability over time. Alter- natively, the operations of the borrower can be wound up, with the creditor receiving the proceeds from the disposition of assets. The 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 35 unpaid loan balances must then be charged off. Moreover, these two types of resolution are sometimes undertaken simultaneously, in which case partial asset sales are used to pay off some debts, while others are restructured in a way that reduces their net present value. Whereas formal bankruptcy proceedings provide one forum for resolving bad loans, restructurings and liquidations (or combinations thereof) can also be achieved, often at lower cost, through bargaining between creditors and debtors. However, the credible threat of enforcing the loan agreement (by seizing collateral) or the risk of bankruptcy often underpins such negotiations (Huberman and Kahn, 1988; Hart and Moore, 1989). The reform of bankruptcy and related laws would thus facilitate the overhaul of SOEs; however, the passing of legislation and the building of administrative capacity are time consuming (Aghion, Hart, and Moore, 1994; Mitchell, 1993). A cen- tralized resolution agency can also perform some of the functions of bankruptcy proceedings, as well as allow for the social benefits and costs associated with enterprise restructuring. Restructuring Versus Liquidation Evidence from industrial countries, while limited, confirms the general preconception that firms filing to restructure their liabilities in bankruptcy tend to be larger and in better financial condition than those seeking to liquidate. However, the net assets of both types of firms are on average significantly negative. 12 A study conducted for the U.S. Department of Justice found that the average ratio of total assets to liabilities of firms that file for Chapter 11 bankruptcy was 0.71, while that of firms that filed for Chapter 7 bankruptcy was 0.14 (Ames and others, 1983, as reported in White, 1989). The ratio of assets to secured liabilities of these two types of firms was 1.67 and 1.0, respectively. One reason that loss-making firms may seek to restructure their liabilities is the ability gained to generate an adequate stream of profits with a lighter debt burden (Fries, Miller, and Perraudin, 1993). Such a restructuring also preserves the firm's value as a going con- cern Oensen, 1989). However, if the firm's losses are large enough, 12 This result contrasts with the prevalent notion in the economics literature that a firm with negative net assets should be closed immediately. However, the option to put the assets of the firm onto its creditors associated with limited liability of shareholders can at least in part compensate them for the negative net assets of their firm. See Fries, Miller, and Perraudin (1993). 36 Steven M. Fries and Timothy D. Lane debt restructuring may not sufficiently improve the outlook for profits, in which case the firms are liquidated. The choice between informal debt restructuring and bankruptcy proceedings appears to be influenced largely by the presence of a dominant creditor. In the United States, private negotiations over debt restructuring are more likely to succeed if banks are the primary creditors and less likely to succeed if there are a number of distinct creditor groups (Gilson, Kose, and Lang, 1990). It is widely believed among practitioners that costs of informal debt restructuring tend to be less than those of bankruptcy. Similarly, in Japan, where informal debt restructurings are not uncommon, a distressed firm with close ties to a main bank tends to perform better than a distressed firm with no such ties (Hoshi, Kashyap, and Scharfstein, 1990). One interpreta- tion of these facts is that a dominant creditor can effectively serve to keep the costs of financial distress to a minimum. The restructuring or liquidation of SOEs is subject to several con- straints, however. First, the absence of well-functioning bankruptcy procedures limits the amount of restructuring or liquidations that could be undertaken through the courts. Bankruptcy laws in emerg- ing market economies are relatively new and untested, with Hun- gary, Poland, and the former Czechoslovakia enacting such legisla- tion in 1990-91 (Aghion, 1992). Only in Hungary, where the bankruptcy law came into effect at the beginning of 1992, have there been a significant number of bankruptcy petitions. By the end of 1992, the Hungarian courts had registered 3,658 restructuring and 7,062 liquidation applications (9 percent of enterprises with 33 per- cent of GDP).13 However, only 27 percent of these cases have been completed owing to limited court capacity. Even if the legal capacity existed, the substantial social benefits and costs associated with enterprise restructuring may point to the need for a resolution that does not focus narrowly on the interests of credi- fors. If prevailing structures of large SOEs, with their extensive verti- cal and horizontal integration, were left intact, productivity gains from a more efficient deployment of productive resources would be forgone and the risks of monopoly abuses would be high (Carlin and Mayer, 1992). 14 In addition, the unemployment consequences of 13 The vast majority of the liquidations are thought to involve small firms, but precise data are not available. 14 An important lesson to be learned from the experience with privatization in indus- trial countries is that pro-competitive restructurings should precede privatization. See Vickers and Yarrow (1988). Moreover, Komai (1990) cautions against pseudo reforms that do not fundamentally alter the organization and conduct of the enterprise sector. 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 37 enterprise restructuring are often serious because SOEs provide housmg and other social services and prolonged because of the rela- tive immobility of workers (Dooley and Isard, 1992). Finally, the lack of effective recourse to bankruptcy undermines the ability of banks and SOEs to reach an informal agreement on the resolution of bad loans. The absence of restrictive loan covenants that could give creditors leverage by threatening to seize collateral or to restrict enterprise operations in other ways also undermines the bar- gaining position of state banks.ls Resolution Agency's Role in Restructuring The above considerations-creditors with little leverage to restruc- ture debt outside the courts, nonexistent or poorly functioning bank- ruptcy procedures, and significant social benefits and costs to restructuring-argue for a resolution approach that does not conform precisely to approaches in industrial countries. The Treuhand, a gov- ernment agency charged with responsibility for restructuring and pri- vatizing east German SOEs, provides such an example. In effect, a government agency can compensate for shortcomings in the legal framework, including corporate governance, and allow for social benefits and costs (Carlin and Mayer, 1992). The Treuhand has among its main functions: evaluating the balance sheets of SOEs and writing off their old debts; reorganizing and closing enterprises; and setting employment and investment targets. The Treuhand called upon a team of west German managers to analyze the potential viability and balance sheets of east German SOEs. Its evaluation of viability was based on whether SOEs had marketable products, capable managements, and links with west German firms. To mitigate the initial arbitrary conditions imposed on SOEs by their inherited debts, the liabilities to the state bank of the former east German regime were written down to the point at which their equity was in line with that of comparable west German firms.16 The Treuhand' s power to restructure enterprises stems from a 1991 law that allows it to carve out parts of SOEs for sale. If necessary, the Treuhand can circumvent management opposition to restructuring by dismissal. Finally, although the net worth on the adjusted balance sheets of SOEs serves as a benchmark, the Treuhand adjusts sales 15 Uncertainty about ownership claims in emerging market economies has made it difficult to offer property as collateral. 16 The Treuhand estimates that about 70 percent of the old debts will be written off. 38 Steven M. Fries and Timothy D. Lane prices in privatizations according to the investments that the buyers guarantee to undertake and the number of jobs that they preserve. Although the majority of enterprises will be restructured and pri- vatized, recent estimates indicate that between 20 and 30 percent of east German SOEs will be liquidated. The industries slated for the greatest share of enterprise closures are mining, metal goods, leather- ware, synthetics, textiles, electronics, and chemicals-all tradable goods. 17 Firms may be closed by liquidation under the auspices of the Treuhand or by a more formal court liquidation. The Treuhand liquidations tend to preserve where possible the value of enterprises as going concerns by carving out those parts that are viable and negotiating their sale to new investors. In formal bankruptcy pro- ceedings, the Treuhand loses the power to dispose of assets, and the narrow interests of creditors tend to prevail. As a result, more jobs are preserved in Treuhand liquidations (33 percent) than in formal bank- ruptcy liquidations (23 percent). The Treuhand' s approach of emphasizing the preservation of enter- prise employment is not necessarily feasible in other emerging mar- ket economies, however. The criteria adopted by the Treuhand have no doubt been appropriate in east Germany, where the social safety net makes unemployment very costly from a fiscal standpoint, whereas the tax base of Germany as a whole is large enough to support an expensive bailout of SOEs. The massive increase in the costs of the Treuhand's restructuring efforts relative to initial expecta- tions may nevertheless represent one of the drawbacks of a central- ized resolution agency. It may face considerable political pressure not to liquidate chronic loss-making enterprises, even when they have little prospect of returning to profitability. However, as pointed out above, individual banks may be subject to much the same pressure under a decentralized approach. Other aspects of the Treuhand' s approach, while suitable for east Germany, may also be less applicable to other emerging market econ- omies. These include the heavy reliance on expertise, and the intro- duction of the established legal system, from west Germany. Such an extensive use of "outsiders," let alone the wholesale introduction of laws and law enforcement procedures from outside, would not be possible nor politically acceptable in other countries in transition. These considerations suggest that, in other emerging market econ- omies, a resolution agency may adopt a more narrowly focused and less costly approach than that of the Treuhand. For example, such a 171n contrast, enterprise restructuring and privatization is proceeding most rapidly in the construction, services, and distribution sectors. 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 39 government .agency, as the holder of claims on SOEs after a debt socialization, could concentrate on enforcing these debts.ls This could include selling off viable parts of SOEs as going concerns and using the proceeds to pay off their outstanding debts. Enterprise assets could also be sold piecemeal to leasing companies that would, in turn, lease the structures and capital equipment to private firms. Provided that these asset sales are valued accurately (see below), this approach would effect the writing-down of outstanding enterprise debt to its market value and, at the same time, boost productivity and foster more competitive market structures. The strategy could be tai- lored to the agency's administrative capacity, provided that tight con- trols can be imposed on SOEs awaiting restructuring.19 Financing for Enterprise Restructuring While a resolution agency can play an important role in reducing the inefficient scale and scope of large SOEs and in creating more competitive market structures, such restructuring requires financing to acquire productive assets from the SOEs. In principle, the stock of private savings could be used for the purchase of these divested assets; however, their value may well outstrip the amount of private wealth, both domestic and foreign, that could be mobilized in the short run for this purpose (Aghion and Burgess, 1992). This con- straint on asset sales could be eased if the government accepted claims on the cash flows generated by the assets (Bolton and Roland, 1992). To the extent that individual wealth is mobilized to acquire assets from SOEs, asset sales may classify potential buyers by their wealth rather than by their ability to use the assets efficiently (Bolton and Roland, 1992). If ability and wealth are not highly and positively correlated, asset sales to the private sector may not achieve the maxi- mum possible efficiency gains from redeploying enterprise assets. The potential trade-off between the ability and wealth of those that purchase enterprise assets could be eased in several ways. First, restructuring of SOEs prior to their sale would lessen the amount of wealth required to purchase a particular set of enterprise assets. Sec- ond, the provision of financing to purchasers of divested assets by banks and private investors could ease the trade-off between wealth 18 Burda (1991) examines the extent to which the private sector can absorb displaced workers in the former Czechoslovakia and east Germany. 19 Carlin and Mayer (1992) discuss the Treuhand's role in compensating for the lack of effective governance of enterprises. 40 Steven M. Fries and Timothy D. Lane and ability. Finally, acceptance by the government of noncash bids (claims on cash flows) for enterprise assets could provide purchasers with an alternative source of financing. What is the appropriate financial structure to support sell-offs from SOEs? The answer depends in part on the relationship between the new firm's owners and its managers. In an owner-managed firm, management decisions are taken in the owner's interest, but at the expense of a potential exposure to firm-specific risks. If ownership extends beyond the firm's managers to include outside shareholders, risk is better diversified, but the managers must be given a stronger incentive to act in the owners' interests. Mechanisms that serve to combat this incentive problem include managerial compensation con- tracts based on (noisy) measures of performance, monitoring by boards of directors, and shifts in control associated with bankruptcy. The problems of constructing incentive contracts and monitoring are particularly difficult for firms operating under highly uncertain conditions (Tirole, 1992). This consideration is particularly important in emerging market economies, in which demand and cost conditions are often volatile. For example, highly sensitive performance con- tracts may expose managers to substantial risks beyond their control, while ex post monitoring of whether a firm lost money because of an adverse shift in market conditions or because of poor managerial performance could be difficult. One solution to the incentive versus risk-sharing problem appears to lie with having an inside shareholder group, which may involve a majority stake (Demsetz and Lehn, 1985), to solve the incentive problem, and outside equity investors to spread the risks. Moreover, high leverage in the face of great uncer- tainty risks frequent bankruptcies that do not necessarily reflect man- agerial performance. To achieve the desired financial structure for enterprise sell-offs, external financing in the form of bank loans and outside equity must be available, in addition to the wealth of insiders. To facilitate the provision of debt financing by banks, sell-offs could be offered free of old debts. Private equity investors could then use the unencumbered assets to attract bank loans that could be used to fund part of the acquisitions. If sufficient bank loans cannot be mobilized, the govern- ment or resolution agency could retain a debt claim on the sell-off. The appropriate degree of leverage could then be gauged from com- parable divestitures for which only banks provided the debt funding. The provision of outside equity is, even in industrial countries, difficult and costly, especially for new firms. Initial public offerings in a number of industrial countries are on average priced at substantial discounts to their post-offering prices (Smith, 1986; and Jenkinson, 2 • FINANCIAL AND ENTERPRISE RESTRUCTURING 41 1990). This underpricing of initial public offerings reflects at least in part the limited information that investors and underwriters have about the prospects of firms tapping the equity market for the first time. This problem is likely to be more severe in emerging market economies. One solution is for the government to retain equity stakes in divested companies to achieve some spreading of risks during the initial high-risk period. 2 0 These holdings could then be sold in tranches to develop a liquid market for the shares and to maximize the revenues from the sale to private investors. Public offerings of equities that are already traded on markets tend to be priced close to prevailing secondary market prices (Smith, 1986). In addition to sell-offs, shifting. economic activity to a smaller scale can be achieved by either bank affiliates or the government leasing productive assets. Leasing is partly an alternative to collateralized borrowing, which has the advantage of economizing on the amount of financing needed by the lessee (Smith and Wakeman, 1985). A lease needs financing for only the interest cost and the amount of the productive asset that is depreciated while in the lessee's possession. Also, it has desirable incentive effects in that the lessee pays a fixed amount for use of the asset and receives at the margin the benefits from its efficient use. However, leasing has certain adverse effects not associated with outright ownership of an asset: the lessee has less of an incentive to invest in maintenance and improvement of the asset than if the asset were owned. Where it is difficult to specify such responsibilities contractually, there may be a moral hazard problem in which either the lessor or the lessee may refrain from undertaking investments that would be beneficial. In emerging market economies, short-term leases have the desir- able property of tending to lessen the need for information about the value of the asset being leased (Flath; 1980), whereas with out- right sales, considerable information would have to be gathered about the value of the asset. In a period of rapid economic transi- tion, when any valuation is highly speculative, this information could be very costly, if not impossible, to produce. With a short- term lease, the lessee only agrees to rent the asset's services for a limited period; therefore, less is at stake in the initial valuation. In addition, the assets can be sold outright later when there is a sounder basis on which to value them. 20The retention of equity claims on the SOEs would also provide the government with a source of revenue. See Blanchard and others (1991) and Borensztein and Kumar (1991). 42 Steven M. Fries and Timothy D. Lane Conclusion The legacy of bad loans from the passive role of finance under central planning and the early transition period, as well as the exces- sive scale and scope of large SO Es, substantially hinder the successful transition from central planning to a market-based economy. The overhang of debt creates several potential pitfalls for this transition: (1) insolvencies pose moral hazard problems for both creditors and debtors; (2) moral hazard problems increase the fiscal cost of the bailout that will eventually be needed; and (3) insolvencies prevent the privatization of banks and SOEs. Large SOEs tend to be ineffi- cient in their size and scope, and failure to restructure them before privatization risks creating concentrated market structures. This paper examines how such 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 can 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 under- take to resolve the bad loans with the SOEs and could use these loans as leverage to pry productive assets away from SOEs. For this effort to succeed, however, financing must be available to acquire enterprise assets. This effort could include insiders providing new bank loans and purchasing equity. Sources of outside equity would probably be more difficult to tap initially, and governments could retain equity stakes in enterprise sell-offs to diversify risks somewhat. Leasing could also play an important role by transferring productive enter- prise assets to new private firms. References Aghion, Philippe, "Implementing Bankruptcy Legislation," in Annual Eco- nomic Review (London: European Bank for Reconstruction and Develop- ment, 1992), pp. 4-10. - - , and Robin Burgess, "Financing and Development in Eastern Europe and the Former Soviet Union," Special Paper No. 46, London School of Economics, LSE Financial Markets Group (May 1992). 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Comment Georg Winckler The paper by Steven Fries and Timothy Lane, "Financial and Enterprise Restructuring in Emerging Market Economies,'' is a com- prehensive and well-written survey of the financial problems cur- rently plaguing the previously centrally planned economies, espe- cially in Central and Eastern Europe. The paper is well based on microeconomic and macroeconomic reasoning. Many of its issues will be discussed in more detail in specialized sessions over the next two days. Owing to the paper's excellent survey and because I agree with most of its contents it is hard for me to comment critically on the paper. I would like to add only two general points and comment on one specific issue. The first general point seeks to cast further light on the cause of the current financial difficulties in Eastern Europe, whereas the second one deals with the role of universal banks in solving these problems, a role somewhat neglected in the paper by Fries and Lane. The cause of the current problems is related to what Steven Fries and Timothy Lane call the legacy of the past. When analyzing this legacy, one has to go back to the period when the economies of Central and Eastern Europe were still centrally planned. Then, ide- ally, money was important only as a medium of exchange, not as an asset. The classic monobank of the old system financed enterprises so that they could pay for the variable costs of production such as labor. These funds were paid back by the receipts from sales. For house- holds, financial or real assets, except for durable consumer goods, were of no importance. They received the wages and spent them on consumption. Investment was financed through special channels. However, as is well known, huge imbalances occurred in this sys- tem, especially in the 1980s. To put it simply, on the one hand unsold inventories were accumulated, and on the other, a monetary over- hang came into existence. When the reform programs were launched and a two-tier banking system was set up, these imbalances were taken over. The newly established commercial banks started to act as financial intermediaries, receiving the monetary overhang as deposits and inheriting the loans that had been made to state-owned enter- prises. In an economic sense, unsold inventories served as collateral for the loans. As the issue of the creditworthiness of debtors did not play a role at the beginning of the reform process, the unsoundness of the financial system could be dealt with later. 47 48 Georg Winckler There are several ways of making the system sound again. The first option is to inflate away or to (partially) confiscate the deposits. The use of inflation as a means of getting rid of financial burdens can be witnessed in many countries, but this approach is, of course, incon- sistent with the effort to achieve macrostability. The confiscation of deposits was introduced, in Germany and Austria, for example, after 1945, along with currency reforms. Under the second option, deposits are preserved. Then the cancellation of bad debts has to be accompanied by a recapitalization of banks (in one or in several steps), or banks are allowed to dump these debts onto some other agency, such as a state agency. The latter approach is used in the Czech Republic. One has to be very careful about the allocation and distribution effects that these different options entail. It is especially important to assess whether firms or households, producers or consumers, carry the burden of financial reform. In Germany and Austria after 1945, firms and banks could get rid of their liabilities, and it was the house- hold sector that lost most of its assets. Obviously, it was of interest that firms .quickly started investing and producing again; the eco- nomic loss for the households was not politically challenging. In Central and Eastern Europe, things developed differently. For various reasons, the reforms tried to link deposits with positive real rates of interest and to make them convertible. The deposits were only partially reduced by higher prices. This decision put much pres- sure on the financial sector, using the liability side of the balance sheets of banks as a disciplinary device for the whole system. Disci- plining the banks should ultimately discipline the indebted firms. The reform scheme of rewarding the households and disciplining the firms was, in addition, timely from a political point of view. The basic problem with this approach, however, is that there is a conflict between granting interest-bearing, convertible deposits to households and the priority of a government keeping technically insolvent enterprises afloat. In addition, one can argue that the exist- ence of these deposits is only an economic illusion, as they have to be taxed away or will be lost when firms go bankrupt or have their debts canceled. My second point refers to the role that universal banks may play within the financial sector when the economies of Central and East- ern Europe are being reformed. Some recent literaturel stresses that 1 Martin Hellwig, "Banking, Financial Intermediation, and Corporate Finance," in European Financial Integration, ed. by Alberto Giovannini and Colin Mayer (Cambridge, England: Cambridge University Press, 1991), pp. 35-63; and Colin Mayer, "New Issues 2 • COMMENT 49 the issue of whether banks _or capital markets should provide finance to industry deserves systematic analysis,' since institutional differ- ences between financial systems may explain some of the variation between U.S., British, German, and Japanese growth patterns. On a theoretical level (see Hellwig, 1991), what seems to be impor- tant is .the interpretation of financial intermediation by a universal bank as delegated monitoring within a contractual relationship, thereby allowing firms to lengthen their investment horizon. For example, as reported by Hellwig, page 47, von Thadden demon- strates in a two-period model with "good" and "bad" types of firms, in which the long-term strategy has relatively low expected returns in the first period but relatively high returns in the second, that without monitoring, banks may see low first-period returns as proof of a ''bad'' firm, and hence discontinue financing: ''Anticipation of such behavior induces firms to opt for the short-term investment strategy even though the long-term strategy may eventually be more profita- ble." Monitoring a firm, with close links between banks and industry, may avert this problem by shortening the investment horizon, since banks receive additional information about what is ''good'' and what is "bad." Of course, the German or Japanese kind of linkage between univer- sal banks and industry does not create only benefits. Close links between bank and industry managers may, for example, create insider systems, in which the method of self-monitoring no longer works. In addition, a cartelization of banks and industry may occur, thus making the bank-oriented economies less efficient than the market-driven ones. Why may universal banks be of interest for Central and Eastern Europe? Besides the economic arguments developed in Hellwig (1991), my basic point is a sociological one. In most of the countries of this region (but also in many others of continental Europe), there is either no or only a short tradition of allocating resources via markets. Instead, there were hierarchical, bureaucratic societies. As a result, the marketization of the economy cannot be achieved just by pro- mulgating new laws but has to be seen within the context of democra- tizing the society and the effective building up of appropriate institu- tions. Hence, until these institutions are established, insider systems, representing close bank-industry linkages, may serve as excellent monitors of the economy, which may be more effective than any monitoring by anonymous, barely organized markets. If monopoly rents exist as a result of a cartelization of the economy, these rents can in Corporate Finance," European Economic Review, Vol. 32 Gune 1988), pp. 1167-83. 50 Georg Winckler be used as shock absorbers. Of course, insider systems need outside disciplining, but this can be achieved by opening up the economy and by making it sufficiently export oriented. This export orientation seems to have helped the German and Japanese economies to become highly productive after the war. This consideration of the role of universal banks leads me to a final comment on a specific issue raised by Steven Fries and Timothy Lane. They suggest that a centralized workout agency would have greater authority and leverage than a diverse group of banks in restructuring state enterprises. In their paper, this centralized agency somehow /1 /1 appears as a deus ex machina, solving all relevant problems. In contrast, as I have tried to outline above, I see a more positive role for banks in this business of restructuring enterprises. 3 Dealing with Bad Debts: The Case of Poland Stefan Kawalec, Slawomir Sikora, Piotr Rymaszewski We would like to present to you the principles of the bank restruc- turing program designed at Poland's Ministry of Finance. We will concentrate on the distinctive characteristics of the program as well as its controversial features, which were the subject of the most heated disputes. Before presenting the program itself, however, we would like to say a few words about the environment in which it is being implemented. The bank restructuring program was introduced as part of the broadly instituted reform of the Polish financial sector. This reform started in early 1989 with the creation of a two-tier banking system and has gained momentum since the stabilization program of 1990 brought to the Polish economy macroeconomic stability and micro- economic liberalization, and when interest rates became positive in real terms. The main elements of the financial sector reform are (1) introducing the proper regulatory framework; (2) improving the quality of super- vision of the banking sector; (3) introducing, through corporatization and privatization, internal incentives for the more efficient perfor- mance of banks; (4) strengthening competition by opening the market to newcomers, including foreign banks; and (5) developing a modern clearing and settlement system. All of these elements are being vigor- ously implemented and significant progress has been achieved over the past four years. Banks Affected by the Program The Polish restructuring program concentrates on the nine state- owned commercial banks that were separated from the National 51 52 Stefan Kowalec, Slawomir Sikora, Piotr Rymaszewski Bank of Poland in 1989 as part of the creation of a two-tier banking system. In 1991, the Government decided that these banks should be privatized. As the first step, the banks were transformed into joint-stock companies, with the State Treasury remaining the sole shareholder. The members of the banks' supervisory boards were selected by the Ministry of Finance, primarily from professionals in the fields of finance, law, and other relevant subjects. Thus, even before their privatization, the banks were forced to operate as quasi- private institutions. To improve their internal operations, they entered into long-term technical assistance contracts with a number of reputable foreign banks. These so-called twinning arrangements were set up with the assistance of the World Bank and the Interna- tional Finance Corporation. In April 1993, the first of these nine banks, WBK of Poznan, was privatized with a capital injection from the European Bank for Recon- struction and Development and huge oversubscription by domestic and foreign investors. Another one, Silesian Bank of Katowice, will be privatized later this year, without the prior injection of new capital being necessary. The remaining seven banks will be privatized between the beginning of 1994 and the end of 1996, having been recapitalized in 1993. The Polish Government came to the conclusion that it could not privatize a bank unless it was confident that the bank was financially stable and its organizational structure met the necessary standards. It desperately wanted to avoid having to bail out any recently privatized institutions. Although we are very enthusiastic about bank privatiza- tion, we want to privatize each bank only once. In 1991, the Ministry of Finance commissioned a financial portfolio analysis of the nine commercial banks. The audits, carried out by international auditing firms, revealed that although the financial situ- ation of individual banks differed, the percentage of substandard loans was on average very high. This was true not only for loans inherited from the centralized economy, but also for loans in the private sector credit portfolio. The creation of sufficient loan-loss pro- visions (100 percent for "loss" category and 50 percent for the "doubtful" category) in most of the banks would result in a decrease in the banks' capital adequacy ratio (Cook's ratio) to much below the 8 percent level required by Polish prudential regulations. Choice of Restructuring Method The Polish Government turned to the World Bank, the Interna- tional Finance Corporation, and the European Bank for Reconstruc- 3 • DEALING WITH BAD DEBTS: THE CASE OF POLAND 53 tion and Development with an invitation to engage in the preparation of the bank restructuring program and the financial support needed for the recapitalization of the banks. The international financial insti- tutions had agreed with the concept of recapitalization, but had ini- tially had many doubts about the methodology of restructuring pro- posed by the Ministry of Finance. During the discussions, most experts representing the international financial institutions proposed the standard approach to the bank restructuring process, which can be described as a centralized, one- time solution that aims at improving banks' assets by transferring their bad loans to a specially created loan-recovery institution and replacing them with interest-bearing treasury bonds. We in the Gov- ernment rejected such an approach. First of all, we did not believe that a centralized, government- sponsored agency could vigorously and effectively recover bad debts. We did not believe in our ability to create, within a reasonable time, a strong institution in terms of the high quality of its staff and internal organization. Nor did we believe in the possibility of devising an adequate incentive system that would ensure the institution's active approach toward the indebted enterprises. We also did not believe that such an institution could resist political pressure. Second, we felt that the centralized solution did not address the causes of the problem, which we believed lay primarily in the banks' lack of experience and expertise in handling credit activities in a mar- ket environment. By painlessly removing the burden of bad debt from the banks, the centralized approach creates a danger that a bad loan portfolio will re-emerge in the near future. It does not contribute to the growth of the banks' experience and expertise in conducting credit operations and resolving bad debt problems. We proposed an alternative solution, which may be called a decen- tralized approach. It consists of recapitalizing the banks to such a level that they will be able to create adequate provisions for the bad loans and of introducing mechanisms that will encourage and even force the banks to undertake specific actions with respect to the bad debtors. The amount of ex ante recapitalization is not dependent on the amount of bad loans to be recovered by the individual banks. This creates incentives for the bank to recover as much of the bad debt as possible. Many experts have cautioned about the danger resulting from the fact that our proposal does not terminate the financial ties between the banks and the bad debtors. The danger consists of the possibility of the debtors financing the old debt with the new loans, and that the bank preoccupied with the old debt may be unable to introduce new 54 Stefan Kawalec, Slawomir Sikora, Piotr Rymaszewski standards for its credit operations. We therefore attempted to intro- duce safeguards against these dangers. The Polish Program Preliminary Steps In early 1992 the nine banks were required by the Ministry of Finance, acting as their owner, to (1) separate the loans classified by the auditors as being in the "doubtful" and "loss" categories, and (2) set up new internal organizational units (workout departments) to manage bad loan portfolios. The managers of these departments were selected through managerial contests between candidates who had not previously been involved with the credit activities of the bank whose department they would head. All of them are members of their bank's management board. The workout departments were made responsible for developing the bad debt restructuring strategy and are obliged either to sell or to restructure-according to predeter- mined procedures-the loans classified as substandard. At the same time the Ministry began work on the new Law on Financial Restructuring of Enterprises and Banks, which would serve as an administrative tool for facilitating the restructuring process. This law, which became effective in March 1993, established a frame- work for the restructuring program and introduced instruments per- mitting its effective implementation. Recapitalization The program requires the banks to create recapitalization provisions at 100 percent for "loss" category loans and 50 percent for "doubtful" category loans. The recapitalization amount was calculated ex ante on the basis of the credit portfolio analysis as of December 1991, and was set at a level sufficient to ensure that on creating the necessary provi- sions the banks will reach a Cook's capital adequacy ratio of 12 percent. Because the banks have no liquidity problem, the recapitalization will be performed by means of the treasury bonds transferred to the banks in the fiscal year ended December 31, 1993. Duties and Limitations on Banks Subject to Recapitalization The Law on Financial Restructuring of Enterprises and Banks imposes on banks subject to recapitalization certain duties and limita- 3 • DEALING WITH BAD DEBTS: THE CASE OF POLAND 55 tions on the loans separated from the total loan portfolio according to the audit for December 1991. These loans constitute the basis for calculating the amount of recapitalization. The banks are obliged to complete the restructuring of these loans by end-March 1994-the deadline set by the Minister of Finance as authorized by the law. Until this deadline, the banks are not allowed to extend new credit to enterprises whose debt has been placed in the bad debt portfolio unless such credit is given in connection with a conciliation agreement. Such an agreement may be obtained as the result of a conciliation proceeding (similar to the U.S. Chapter 11 bankruptcy procedure) introduced into Polish law by the Law on Financial Restructuring of Enterprises and Banks. This provides that creditors of an enterprise unable to pay its debts can work with the management to draw up a financial and business restructuring plan. Under the conciliation agreement to implement such a plan, the cred- itors may reschedule claims, write off part of them, or convert them into equity in the firm. The conciliation agreement, upon signature by the debtor and creditors holding at least 50 percent of the claims of the debtor, becomes binding on all creditors. The law requires the banks to ensure that before the March 1994 deadline one of the following events takes place: • the loan is recovered in its entirety; • a conciliation agreement with the bad debtor has been reached (or alternatively an arrangement agreement according to the old Pol- ish Law on Arrangement Proceedings has been reached); • the debtor's bankruptcy has been declared by the court; • liquidation of the debtor has been initiated either under the pri- vatization law or under the Law on State Enterprises; or • the debtor has regained its creditworthiness, which has been proved by at least a three-month record of servicing the debt. If the bank fails to restructure the debt through any of the above- mentioned alternatives or decides that none of these methods is fea- sible, the Law on Restructuring obliges it to sell the loan in the open market before the March 1994 deadline. Public debt sale is a pro- cedure also introduced by the Law on Restructuring that in effect suspends the bank secrecy regulations with respect to the loans in the bad loan portfolio that are offered for sale. Incentive Mechanism The structure of the program described shows a two-tier incentive mechanism. The first tier is provided through the creation of a quasi- private, profit-driven institution. Transformation of the banks into 56 Stefan Kowalec. Slawomir Sikora, Piotr Rymaszewski joint-stock companies with market-oriented supervisory boards, the creation of workout departments operating as separate profit centers, and the prospect of privatization are all expected to stimulate appro- priate responses by the banks to the restructuring program. The second tier of the incentive mechanism is provided by the administrative supervision of the banks' compliance with the Law on Financial Restructuring of Enterprises and Banks. Conciliation and Debt Sale It might be useful to concentrate on one of the choices that the banks taking part in the restructuring program will have to make-the choice between a conciliation proceeding and the public sale of debt made in the context of timely obligatory debt restructuring. Banks are, by nature, very cautious when it comes to conciliation involving significant debt reduction. Thus, without special incentives the banks would be unwilling to negotiate debt reduction even with those debtors that could generate a reasonable level of operational profit after the reduction. Because the Law on Financial Restructuring of Enterprises and Banks fixes a specific timetable for the restructuring or sale of the debt, the banks in many cases will have to choose between a substan- tial reduction in the debt's value under a conciliation agreement and a significant discount under a compulsory public debt sale. In a public sale of a nonperforming debt, the banks can be expected to deal with two potential groups of debt purchasers. The first group consists of firms with financial obligations to the bank debtors. They may be interested in purchasing the debt to set off the claims. According to the Polish Civil Code, the mutual claims may be automatically set off against each other, without the need for either side's consent. The second group of purchasers are investors buying the debt to demand the conversion of the debt purchased for the equity of the indebted enterprise (through a new mechanism introduced by the Law on Financial Restructuring of Enterprises and Banks). Nevertheless, when a bank offers nonperforming debt for sale, it should expect a significant discount, forcing it seriously to consider sound restructuring proposals from the debtors. The bank may con- clude, for example, that a 30 percent reduction under a conciliation agreement is a better alternative than a sale at a 60 percent discount. The bank may also decide that a cash sale of a bad debt at a 60 percent discount of face value is more reasonable than accepting a 30 percent reduction under a financially dubious restructuring plan. Thus, we 3 • DEALll\IG WITH BAD DEBTS: THE CASE OF POLAND 57 hope that this mechanism will encourage the banks to enter into conciliation agreements offering good prospects for the recovery of the debtor. At the same time, the mechanism will discourage the banks from entering into economically unfeasible arrangements. Subsidiary Government Intervention The program, as described above, requires the banks to cease any financial cooperation with the debtor if the bank is not persuaded that such cooperation is based on sound commercial grounds. Strict implementation of the program will result in the termination of finan- cial cooperation with a number of enterprises that are regarded by the Government as sensitive and important from the socioeconomic per- spective. The goal of subsidiary government intervention is to address the situations in which sudden and unstructured liquidation of such enterprises would cause severe negative macroeconomic and social consequences of a scale that would be intolerable to. the Government. The intervention mechanism introduced will permit the Govern- ment to support the restructuring or cushion the liquidation of enter- prises that are regarded by the Government as important from the sociopolitical perspective and that have been unable to reach a concil- iation agreement with their creditors. Access to the mechanism is strictly limited. To qualify for government help, an enterprise must prepare a sound restructuring proposal that envisages profound organizational and financial restructuring, or alternatively, it must prepare a liquidation plan. If the debtor submits a restructuring proposal, it must apply for corporatization; the creditors must have agreed to conduct conciliation or arrangement proceedings;· and the qualifications of the incumbent management will be reassessed and appropriate actions taken. The intervention mechanism itself will consist of financing and monitoring the restructuring or liquidation of the qualifying enter- prises. The financing of this mechanism is provided for in a line item in the budget and will be supported in its entirety by the enterprise and financial sector adjustment loan that was approved by the World Bank Executive Board in April 1993 for the purpose of supporting the Government's enterprise and bank restructuring program. We view the subsidiary government intervention as an indispens- able element of the financial restructuring program. Its main goal is to isolate the banks and enterprises participating in the restructuring 58 Stefan Kowalec. Slawomir Sikora. Piotr Rymaszewski program from political pressure, thus facilitating the establishment of sound commercial practices in the economy. Budgetary Cost and Sources of Financing In addition to the expenses of subsidiary government intervention, the Government will bear the cost of recapitalizing the banks. Even though the Government realizes that the cost of ex ante recapitaliza- tion may theoretically be greater than the cost of ex post capitaliza- tion, it is convinced that the incentives the proposed mechanism creates will result in improving the banks' financial situation and achieving a better price for the banks when they are privatized. The total recapitalization amount for the seven banks covered by the program will reach 11 trillion zlotys (approximately $630 million). Since the banks possess sufficient liquidity, the Government will cap- italize them with 15-year redeemable treasury bonds. These will be denominated in Polish currency, indexed to a basket of foreign cur- rencies, and will bear an interest rate close to the market level. Until the privatization of the banks, the bonds will be serviced and redeemed by use of budgetary resources. After the privatization, both the interest payments on the bonds as well as their redemption will be financed through the Polish Bank Privatization Fund, which pres- ently amounts to over $600 million. This fund is financed through grants and loans originally extended by foreign governments to sup- port the stabilization of the Polish zloty. Conclusion Under the Polish program described, in contrast with the central- ized approach that we mentioned, the "cleaning" of banks' assets is not accomplished overnight, but is performed in a limited time frame by the banks themselves. In addition, it is the banks that undertake the active restructuring and that adjust their organizational structure so that they will be able to deal with the problems of bad debt in the future. In the process, the banks' personnel will acquire invaluable experience in debt recovery. They will learn how better to assess credit risk-an experience that they will find of use in future credit operations. The painful experience of losses also acts as a positive incentive for more cautious and calculated activities in the future. For all of these reasons, we believe that the method chosen by the Polish Government is superior to the centralized approach, which in our view fails to affect the banks at their operational level. 3 • DEALING WITH BAD DEBTS: THE CASE OF POLAND 59 By combining enterprise restructuring with bank rehabilitation, we hope to speed up privatization of both industrial companies and banks, and ensure that this is a "once-and-for-all" operation leading to the elimination of bad borrowers and the provision of new credit to the more efficient users. · 4 Financial Underdevelopment and Macroeconomic Stabilization in Russia Barry W. Ickes and Randi Ryterman1 Macroeconomic stabilization has proved to be one of the most prob- lematic aspects of .the transition in Russia. This fact is troubling because macroeconomic stabilization is merely a precondition to the more important aspects of economic reform: creating a market econ- omy. The introduction of the institutions of a market economy are critical for any improvement in Russian economic performance. A destabilized economy, however, inhibits the development of these institutions. That stabilization has proved to be more complex than optimists envisioned is due to many factors. In this paper, we focus on one key factor: financial underdevelopment. Financial markets play a critical role in market economies- coordinating the behavior of savers and investors and fostering an efficient payment system. Thus, one may view them as important institutions for the market economy, once it develops. In the context of the Russian transition, however, the role of the financial sector is also critical. Unfortunately, the underdeveloped state of the financial sector in Russia has become a key roadblock in the transition to markets.. Financial underdevelopment has hindered market reform in Russia in two important ways. First, macroeconomic stabilization has been hindered because of the Government's inability to impose a regime of hard budget constraints. This failure, we argue, can be directly related to financial underdevelopment. Second, market reform has been hindered by a lack of restructuring. With ineffective capital mar- kets, it is hard for enterprises to raise funds for restructuring. These 1 The views expressed should not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries. 60 4 •MACROECONOMIC STABILIZATION IN RUSSIA 61 problems are exacerbated when policymakers attempt to implement a stabilization program in a financially underdeveloped environment. This program induces agents, especially enterprise directors, to adapt their behavior in unexpected and often undesirable ways. And these adaptations are most often inimical to market reform. If financial underdevelopment has such serious consequences, why has it been such a low priority? One reason, no doubt, is that given the relative irrelevance of financial institutions under central plan- ning, the importance of the financial system in the transition has caught many policymakers and observers off guard. More important, however, is the view that financial development is inimical to stabili- zation. We explore this argument below. The purpose of this paper is to examine the link between finan- cial underdevelopment and market reform in Russia. We find that the absence of efficient systems of payment and financial inter- mediation have had important real effects on the level of produc- tion and, consequently, on the amount of taxes collected. In addi- tion, the absence of these systems has led to the development of an informal financial market-the interenterprise credit market- which has undermined the credibility of macroeconomic policy. Hence, we argue that the failure of the Russian Government to stabilize the economy is, in large part, due to its level of financial underdevelopment. Stabilization and Financial Underdevelopment Financial development in Russia has been arrested by the complica- tions presented by the need to stabilize the economy. Financial disci- pline is critical to economic reform for incentive reasons; as long as enterprises face soft budget constraints, they have little incentive to restructure. The need to impose financial discipline on enterprises is also important for budgetary reasons. Until privatization can be com- pleted, financial losses of enterprises result in public sector deficits. In the period between the onset of the transition and the transfer of ownership, there are good reasons to expect that this fiscal motive will be important. The demise of planning leads to a decline in coor- dination among enterprises. This decline in coordination reduces out- put and, hence, tax collection because enterprises in the former Soviet Union and Eastern Europe contribute the bulk of tax revenue. Consequently, there is a direct fiscal motive for imposing financial discipline on enterprises. 62 Barry W. Ickes and Randi Ryterman Ronald McKinnon has argued that financial development must be postponed in order to gain macroeconomic stability. 2 In McKinnon's view, early financial liberalization reduces central financial control. Therefore, in the early stages of the transition it is better for the financial opportunities facing enterprises to be limited. McKinnon (1991, p. 139) argues that an optimal sequencillg of liberalization would involve two stages: Stage 1: Liberalized enterprises are confined to self-finance and to borrowing from the nonbank capital market. Then, after a lapse of some years, when price stabilization has been achieved: · Stage 2: Commercial banks begin limited and fully collateralized short-term lending to liberalized enterprises according to the "Real Bills Doctrine." McKinnon' s reasoning is based on the fact that, in the early stages of the transition, state-owned enterprises lack the financial discipline to make prudent economic decisions. Premature financial liberaliza- tion affords these enterprises the opportunity to borrow from nascent financial institutions that possess neither the incentives nor the infor- mation needed to provide loans on a commercial basis. Enterprises will use these loans to raise wages, which, in turn, will fuel inflation. Hence, in the early stages of the transition, the financial opportunities facing enterprises should be limited. McKinnon' s argument is intimately tied to considerations of macro- economic balance. McKinnon argues for financial development to lag other reforms because of the need to impose financial discipline on enterprises. 3 Postponing financial development may impose micro- economic costs, since enterprises must operate under self-finance, but these costs must be borne to achieve macroeconomic stability. This argument reflects what seems to be conventional wisdom, that there is a trade-off between the macroeconomic benefits of an under- developed financial system in terms of monetary control and the microeconomic costs of an inadequate financial system in a modern 2 McKinnon is nonetheless a well-known advocate of the role of financial develop- ment for economic growth. 3 "Such reliance on self-finance is the simplest technique for imposing financial restraint on liberalized enterprises. Bankruptcy would be virtually automatic if their internal cash flows became negative for any significant length of time" (McKinnon, 1991, p. 139). McKinnon is clearly correct that self-finance is the most transparent rule for implementing a hard budget constraint. There are two problems, however. First, it is not clear that the inability to self-finance is the optimal liquidation rule. Second, as we explain below, it is not clear whether a government can credibly commit to such a rule under the conditions of transition. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 63 economy. The key point, however, is that this trade-off is illusory. One reason is that, with underdeveloped financial markets, imple- menting tight monetary policies is exceedingly difficult. The central bank· does have greater control over the stock of money if financial markets are underdeveloped. But using this control is complex in economies in transition because restructuring and stabilization can- not in fact be separated. 4 As we demonstrate below, financial under- development weakens the credibility of a stabilizing government. The second reason why financial underdevelopment does not con- tribute to stabilization is that the attempt to impose financial disci- pline in such an environment leads to the development of informal financial markets. These informal markets, which are impossible to regulate, increase the opportunities for tax evasion, as well as pre- serving structures inimical to economic reform. Sources of Financial Underdevelopment The primary cause of financial underdevelopment in Russia and in the former socialist econqmies in Eastern Europe and the former Soviet Union is the passive role of the financial system in a centrally planned economy. Although financial flows are present in command economies, they serve primarily as a record-keeping device that can be used to monitor enterprise transactions (Grossman, 1963). Nev- ertheless, these financial flows do create patterns of surplus and defi- cit in enterprise bank accounts that must be financed. Under central planning, this financing is nearly automatic and is provided by the state bank using funds from the state budget. Because the financial system is passive in a command economy, financial flows between enterprises have little effect on resource allocation. In effect, the guarantee of the state to provide funds to finance deficits in enterprise accounts guarantees the solvency of all enterprises without regard to their creditworthiness. Consequently, the size of the surpluses and deficits have little economic meaning other than the presence of product prices that do not equate supply with official demand. With the demise of planning and the autonomy of enterprises, financial flows must be transformed from passive to active flows. The state banking system must be transformed from a collection device to 4 This problem does not plague most countries that have underdeveloped financial systems because they usually have underdeveloped industrial systems as well. What makes Russia, and by extension other previously centrally planned economies, inter- esting is that the development of the latter proceeded so far ahead of the former. 64 Barry W. Ickes and Randi Ryterman an intermediary that coordinates the actions of savers and investors, allocating credit based on commercial criteria. In Russia, the former state bank, Gosbank, did smooth out the irregularity of payments and receipts-essentially providing trade credit to enterprises-but in an environment in which both payment and receipt were a response to the economic plan. Now, the newly privatized branches of Gos- bank and other new private banks must create the correct system of incentives to ensure that the nascent financial sector is able to provide the basic services that are fundamental to market transactions. We describe below these basic services-settlement of accounts and financial intermediation-and their implications for enterprise behavior. Settlements A functioning payment system is so fundamental to a market econ- omy that its role is usually taken for granted. Yet, with enterprise autonomy, it is crucial that enterprises be able to make and settle payments rapidly.s Without the means to make payments in a rapid and certain fashion, enterprises must routinely extend credit to their trading partners, relying on their history of trade with one another as ''collateral'' for the loan. 6 This reliance on historical relationships as a basis for obtaining credit has two important consequences. First, it creates a powerful disincentive for enterprises to adjust. Entry into new markets requires new sources of supply and, hence, new suppliers. However, without a history of trade, these new sup- pliers are reluctant to sell goods without some guarantee of payment, such as payment in advance. However, if the official payment system is poorly functioning, the ability of the enterprise to pay in advance is sharply curtailed. · Second, reliance on historical relationships increases the impor- tance of enterprise directors in traversing the complex terrain of the underdeveloped financial system. Most historical relationships are based on personal friendships between enterprise directors rather than institutional relationships between enterprises. Consequently, workers in enterprises view the individual occupying the position of director as key to the survival of the enterprise. This feature of finan- cial underdevelopment provides many enterprise directors with a 5 The nature of the payment system and its role in generating interenterprise arrears is analyzed in Ickes and Ryterman (1992). 6Enterprise directors frequently emphasize the role of "historical relationships" in discussing the financial system in Russia in 1992. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 65 perverse incentive to undermine the development of financial and other institutions that rely on arm's-length transactions, at least to the extent that it jeopardizes his or her employment.7 The system·of payments inherited from the Soviet period was a paper-oriented system, designed to monitor the behavior of enter- prises. Since financial flows under planning are a means of assessing the fidelity of an enterprise to the plan, rather than an initiator of economic activity as in a market economy, the speed at which pay- ments flow through the system is of little importance. Consequently, the payment system that was in place at the onset. of the Gaidar stabilization program in January· 1992 was highly centralized and used the poorly functioning postal system to transmit payments. This centralization forced the incredibly large mass of payments to flow through a single institution, the Central Bank of Russia, thereby delaying settlement. The Central Bank maintained a network of approximately 1,400 cash settlement centers, through which pay- ments were made (Su~ers, 1992). Every branch of every bank maintained an account at its local center. Payments flowed from the various cash settlement centers and through the Central Bank itself by paper, through the public mail, cr~ating two effects. First, the system utilized reserves inefficiently because a bank spread its accounts over various centers. Second, because payments were pro- cessed physically, the time lag was further lengthened. The time delay in settlement exacerbated the liquidity problems of the banking sector owing to the nature of the accounting system used by the Central Bank of Russia. The account of the payor is debited when payment is made, but the account of the payee is not credited until the payment is received. In the interim, the funds are, in effect, frozen, creating what is called "payment system float" (Summers, 1992). The longer it takes for payments to be made, the larger is the float. This credit float shows up on the balance sheet of the Central Bank of Russia, but if it is not offset by the Central Bank, it results in a decline in the liquidity of the banking system. Thus, the technical delays associated with processing transactions further aggravate the problem of inadequate reserves, which, in turn, exacerbates the prob- lems of the payment system. The delays in settlement between banks and the difficulties that enterprises faced in obtaining working capital combined to bring the payment system to a crawl. Enterprises were often forced to wait for 7 Enterprises are very active in creating banks. However, as we explain in the final section, the dominant purpose of these banks is not to conduct arm's-length financial transactions, but to provide their founders with low-interest sources of credit. 66 Barry W. Ickes and Randi Ryterman receipts to be credited at the bank before they could make payments. The lag between delivery of goods and receipt of payment became larger. Hence, a mismatch existed between the timing of flows of goods between enterprises in production and the corresponding flows of payments between enterprises. Intermediation In a market economy, an important role for the financial sector is intermediation. The savings of households are deposited in banks and other financial institutions. These institutions then lend these funds to qualified enterprises for working capital and investment. At present, financial institutions in Russia do not play this role. Financial institutions are not intermediaries between households and enter- prises, but rather between the public sector, via the Central Bank, and enterprises. Credit in Russia is provided to commercial banks by the Central Bank, which is then lent to enterprises. This problem is a legacy of the prior regime. Under central plan- ning, the Government generated investment funds by taxing profit- able enterprises, then reallocated these profits across enterprises based on criteria related to economic development. The savings of individuals could be deposited in the former state savings bank, Sber- bank, but these deposits did not play an important role in the provi- sion of financial capital to enterprises. At present, interbank markets in Russia are developing, but funds allocated through this process are still less important than funds pro- vided by the Central Bank. Low real interest rates on deposits make the incentive for individuals to deposit their savings in commercial banks low. Under these circumstances, commodities and deposits in foreign financial institutions become more attractive stores of wealth. The integral role of the Central Bank of Russia in the provision of credit has important implications for the allocation of credit in the economy. Currently, the Central Bank is pursuing a policy of target- ing specific enterprises as recipients of low-interest loans. Commer- cial banks compete for these loans, using personal connections to attract the attention of the Central Bank. This feature provides com- mercial banks that are former branches of Gosbank with a distinct advantage, since many Central Bank staff are also former employees of Gosbank. Another important aspect of financial intermediation is the alloca- tion of credit to the most qualified borrowers. To perform this func- tion effectively, commercial banks, first, must be able to assess the creditworthiness of prospective borrowers and, second, must have 4 • MACROECONOMIC STABILIZATION IN RUSSIA 67 the correct incentives to provide the most creditworthy of the pro- spective borrowers with loans. Underdevelopment of the financial system makes adequate perfor- mance of these two aspects of credit allocation difficult. To asse!>S the creditworthiness of enterprises accurately, bank officers must evalu- ate the credit history and net worth of enterprises. However, the relatively short period of transition diminishes the importance of an enterprise's credit history in this evaluation. Furthermore, without well-functioning capital markets, accurate information on the va}ue of an enterprise's assets is not available. Consequently, bank officers are forced to base their assessment largely on the liquidity of the enter- prise. However, with underdeveloped financial markets, this infor- mation is even more scant. Imperfections in the formal sector cause informal credit markets to arise, as we explain below. These markets are difficult to monitor. Hence, they complicate any analysis of liquidity. Without adequate information to assess the creditworthiness . of prospective borrowers, bank officers must rely on collateral to secure their loans. However, for many enterprises, their title to their ~ssets is still ambiguous. Consequently, bank officers often resort to personal relationships as a basis for allocating credit. Many bank officers previ- ously worked in Gosbank and, consequently, have a long history of relations with enterprises that were their clients in the prior regime. Again, the importance of trust in the allocation of credit has impor- tant effects on the behavior of enterprises. In particular, it makes continuity in top management critical to their survival. Given the difficulties in assessing the solvency of enterprises one may suppose that the optimal policy is, following McKinnon, ~o impose self-finance, or a cash flow constraint on enterprises. This cqn- straint would force enterprises to cover their costs out of their current revenues and retained earnings. The problem is that the replacement of soft budget constraints with cash flow constraints is an exceedingly harsh regime change, even in an economy where payments can easily be made. In an economy where payments take several weeks, or even months, to clear, moving to a cash flow constraint would be disas- trous. But it is not just the lag in payments that renders the cash .flow constraint impossible to implement. Given the economy's distance from equilibrium at the onset of the transition, imposing such a con- straint could imply shutting down a large portion of the economy. s 8 The implications of this problem on the credibility of announced changes in the monetary regime are discussed below. 68 Barry W. Ickes and Randi Ryterman Self-finance has more deleterious consequences for economies in transition than for market economies. In the transition, enterprises are unlikely to respond to the imposition of financial discipline by restraining their demand for labor and goods. Enterprises in the tran- sition are survival oriented. We explain this behavior below. Survival-Oriented Enterprises During the early phases of the transition to a market economy, survival is the primary motivation of enterprise management. 9 In any system, enterprises are concerned with survival, but, during the tran- sition, the extreme uncertainty that they face induces peculiar forms of behavior. The primary distinguishing characteristic of the survival-oriented enterprise is that it operates in an environment in flux. The enterprise in a planned economy and the firm in a market economy each operate in a relatively stable environment. By a stable environment, we refer to the status of the other "players" in the economy and to the rules that govern the survival of organizations. In a planned economy, the enterprise takes the survival of other enterprises as given, since enter- prises are not permitted to fail. In a market economy, entry and exit occur, but the number of enterprises that enter or exit an industry in any period is small compared with the size of the industry as a whole. 10 Thus, in both cases, the industrial structure can be taken as given for short-term decision making by the organization. In the transition economy, on the other hand, the industrial struc- ture is in a state of flux. The rules that govern the survival of the organization are no longer evident. The transition from a system with no exit to a system with exit entails a period of uncertainty as direc- tors of survival-oriented enterprises learn how bankruptcy criteria will be implemented. Moreover, impending privatization may alter the picture as well, as the director may find himself no longer in control of the enterprise. But these uncertainties are compounded by the fact that they apply to all enterprises in the economy. It is this potentially simultaneous restructuring that makes decision making at the enterprise level so complex. One of the most important implications of survival orientation is that it causes enterprises to resist restructuring. Enterprises are very 9 For a discussion of the survival-oriented enterprise, and its implications for the transition, see Ickes and Ryterman (1993b). 10 Especially if measured in terms of value added or employment. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 69 dependent on their present network of suppliers and customers.11 Presently, they are very uncertain about their ability to find new suppliers and customers. By identifying strategies that enable them to resist restructuring, enterprises and their trading partners can ensure their survival. In addition, the struggle for control rights makes direc- tors reluctant to shed workers for fear that this will hurt their chances to stay in control of the enterprise. The problem for enterprise direc- tors is first to stay in control; only after this has been achieved can their focus be reoriented toward the longer run.12 When enterprises are survival oriented, they respond to attempts to impose financial discipline differently from how we would expect a firm in a market economy to respond. In Russia, the first attempt to impose financial discipline led to an explosion of interenterprise lend- ing. The arrears crisis is an excellent example of how enterprise adap- tation to stringency may lead to unintended consequences. Interenterprise Credit Markets in Russia One of the most fascinating consequences of the Russian economic reform program has been the phenomenal growth in interenterprise arrears that took place in the first half of 1992, when they grew from less than Rub 40 billion to over Rub 3.2 trillion. We view interen- terprise arrears as a response by survival-oriented enterprises to sur- vive tight credit policies in an economy with an underdeveloped financial market.13 With underdeveloped financial markets, interenterprise lending seems inevitable. Under central planning, the enterprise sector was the primary source of savings.14 In the early phases of the transition, household savings were inadequate to meet the needs of the enter- prise sector, not just for restructuring, but even for trade credit. If financial markets were well developed, enterprise savings could be intermediated by institutions. In the Russian environment, however, the inadequacy of financial information inhibited the growth of these 11 For a discussion of the vertical dependence of enterprises in Russia and its rela- tionship to industrial concentration, see Brown, Ickes, and Ryterman (1993). This dependence is clearly a force that leads to the formation of financial-industrial groups. 1 2 u is the same as the problem for the cowboy trying to ride a bronco (never having ridden a horse before) from Moscow to Paris. At first, the cowboy does not care whether the bronco is going north, south, east, or west. All he cares about is not being thrown off the horse. Only after the horse is under control does the cowboy turn the horse toward the sunset. 13 For more on the arrears crisis in Russia, see Ickes and Ryterman (1992, 1993a). 14 For more discussion of savings under the old system, see Ickes (1993). 70 Barry W. Ickes and Randi Ryterman markets, at least with respect to the state-owned sector, leading to the interenterprise lending results. Trade credit is an important component of finance in modern econ- omies. In the United States, for example, total trade credit of nonfi- nancial corporations was $973.5 billion in the first quarter of 1992 (United States, 1992). Trade credit was thus about the size of the narrow money supply (Ml) and about one-fifth of GNP. In an indus- trial economy, firms borrow from their suppliers and customers on a regular basis. There is one critical difference, however, between trade credit in the Unites States and interenterprise lending in Russia. In the former, the interest rates that are charged tend to be quite high, and certainly higher than interest rates charged by banks Gaffee and Stiglitz, 1990, p. 879). The nominal interest rate on interenterprise lending in Russia, on the other hand, is almost always zero, translat- ing into a negative real rate. Trade credit in the United States is a means of financing that firms use when they cannot gain access to bank credit. 15 The higher interest rate reflects the increased risk asso- ciated with the loan. The fact that real interest rates are negative for interenterprise lending suggests either that enterprises have few alternative investments or that lending to trading partners has the highest return for an enterprise's survival. The problem of large interenterprise arrears is not unique to Russia and the former Soviet Union.16 Economic transition has severed the connection of enterprise balances to the government budget, so that the financial losses of enterprises may become manifested in arrears. What distinguishes the experience in Russia from that of other previ- ously centrally planned economies is the explosive growth in the level of arrears. The resulting large stock of arrears proved to be a great hindrance to economic reform.17 Arrears· make privatization of state enterprises problematic by making it impossible to assess the finan- cial viability of relevant establishments. Also, large outstanding debts tend to exacerbate the difficulties of enterprises seeking to secure further credits, especially from banks. Furthermore, arrears are an important mechanism through which the problems of some loss- 15 Large firms in the United States tend to have greater access to bank credit and the commercial paper market than do small firms. Therefore, large firms often borrow from banks and lend to small firms Gaffee and Stiglitz, 1990, p. 879). 16 For a discussion of the Romanian case, see Clifton and Khan (1993). For Hungary and the former Yugoslavia, see Mitchell (1993). 17To a large extent, the growth in arrears reflects the contradictions in the reform process. That is, arrears have risen precisely because many enterprise directors did not believe that the program's calls for hard budget constraints were credible. As they continued to behave as if it was business as usual, the arrears have been the outcome. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 71 making enterprises are spread throughout the entire economy. The rapid growth in the level of arrears indicates that this phenomenon is more than the natural mismatch of expenditure and receipts in a modern economy. The growth of arrears in Russia is linked to financial underdevelop- ment in two important ways. First, the malfunctioning of the system of payments caused long delays between delivery ~nd payment. While enterprises waited for payments to clear, their own liquidity and, indeed, their solvency .was subject to payments risk from other enterprises. Delays in payments, by themselves, can cause growth in interenterprise arrears (Ickes and Ryterman, 1992). Second, financial underdevelopment causes arrears through the loss of financial information. One role of financial markets is to enable market participants to distinguish illiquid from insolvent firms. This capacity was conspicuously absent in 1992. Consequently, enterprises were unable to borrow to finance short-term liquidity. In an environment of underdeveloped financial markets, the finan- cial autonomy of enterprises poses a severe constraint. Imposing hard budget constraints in such an environment essentially imposes a cash flow constraint.on enterprises. This constraint is more severe than the net worth constraint that most firms operate under in market econ- omies. Even in an interdependent economy-let alone one with a slow system of payments-imposing a cash flow constraint is proba- bly a sufficient condition to create a large chain of arrears. In the case of Russia, however, the cash flow constraint was not the only factor that worked in this direction. A critical factor was the survival orientation of enterprises. Survival orientation leads to arrears because the enterprise has more to fear from failure to meet payrolls than from debts to other enterprises. The consequence of the former is the very survival of the enterprise. If the director wishes to stay in control, a necessary, but hardly sufficient condition is that the enterprise stay in operation. Survival requires payrolls to be met. Delays in paying for materials could, in principle, result in delays in their delivery. But even if delays in delivery occur, the consequences for the enterprises are less acute. The basic reason why survival-oriented enterprises refrain from restructuring is that, at present, there are better uses for their funds. Because of the high level of economic uncertainty that characterizes transition, the return to long-term investment in Russia is not always clear. This information problem is compounded because directors of state-owned enterprises, through loss of employment, may not be able to appropriate the gains from investments with future benefits. Consequently, investments that promise a rapid return and are 72 Barry W. Ickes and Randi Ryterman highly liquid are preferred. Of course, such investments are limited. One present in the current environment is speculating against the ruble. · Perhaps the best use of funds, however, is to lend to other enter- prises with which historical relationships are important. This is a direct investment in survival, since the survival-oriented enterprise perceives that its survival depends on the viability of its suppliers and . customers. This influence certainly works against the development of capital markets. A capital market would move funds to higher-valued uses, but this move may not coincide with higher "survival investments.'' It is interesting to note how the growth in interenterprise arrears strengthens the role of the current directors in the enterprise. Enter- prises can get away with arrears because suppliers are unwilling, or unable, to cut them off. But such an informal credit market works because of the historical relationships that enterprise directors have built up over the years. If the enterprise becomes reliant on this source of finance, the enterprise director's marginal product is signifi- cantly enhanced. Replacing the director may jeopardize the relation- ships that have been built up, both with other enterprises and with banks, that are critical to survival. There is a widespread belief among observers in both Russia and the West that the arrears crisis is history. It is certainly true that the level of accumulated arrears is presently much below the peak reached in June 1992. Institutional changes, such as prepayment, have had some effect. The system of prepayment has greatly increased the problems of enterprises. The sudden change in the system of credit has made it very difficult for enterprises to obtain inputs. Prepayment requires enterprises to pay for inputs before selling the goods produced from them. When external sources of credit are limited or inflation is high (rapidly eroding the real value of internal financial reserves), this constraint is severe. This difficulty in obtaining inputs has two effects. First, enterprises have drawn down their inventories of inputs. During the first half of 1992, enterprises accumulated inputs, often involuntarily. When pre- payment became the rule, they drew them down. In a sense, the growth of arrears allowed enterprises to develop a cushion, which they used in the summer of 1992. The stock of inventories is not unlimited, however. The second effect of prepayment, therefore, is a decline in production. This decline in itself reduces the flow of new arrears; with lower production, less interenterprise credit is needed to finance production. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 73 The system of prepayment is not universal. Enterprise directors still give credit to customers with whom they have historical relation- ships .18 Nonetheless, one might have expected that prepayment would have had an even more disruptive effect than it seems to have had. The reason that it has not is that the Central Bank has increased its credit emissions dramatically since the summer of 1992. Between June and October, central bank credit to commercial banks trebled, from Rub 580 billion to Rub 1.5 trillion, an increase in real terms of 100 percent. 1 9 These credits were then lent to enterprises, often at interest rates that were highly subsidized.20 The importance of subsidized, targeted credit cannot be over- emphasized. In 1992, directed credits from the Central Bank of Russia and the Ministry of Finance ·to enterprises were approximately 23 percent of GDP, and most of this was concentrated in the second half of the year. These credits are typically targeted by the Government to important enterprises. The Central Bank of Russia extends credits to commercial banks for the express purpose of lending to these enter- prises, at annual interest rates far below the rate of inflation, and far below the interest rate in the interbank market. 21 The key point is that as long as monetary policy remains loose, arrears should not be expected to grow. Arrears are the response of enterprises to tight credit policies. Moreover, institutional adaptation has taken place in Russia. The proliferation of banks that are used to acquire central bank credit suggests that the next time that credit is tightened in Russia the crisis will manifest itself differently. 18 This response was common among enterprise directors interviewed in October and November 1992. · 19 The Economist, December 26, 1992, p. 107. Central bank credit to commercial banks is especially important in Russia because deposits from the public (except for those in Sberbank) are almost nonexistent. These credits were part of a program of directed credits targeted to industry. The credits came from the Central Bank, with an interest subsidy paid by the Government. It seems to be true, however, that the Finance Ministry borrows from the Central Bank to finance the interest subsidies. 20 Central Bank of Russia credits to industry that were "not subsidized" carried interest rates 3 percent above the Central Bank's refinance rate. This rate was 80 percent annually in the fall of 1992. With inflation at 25 percent a month, 80 percent still seems quite a good value. 21 There are really two parts of the subsidy. First, the explicit subsidy is the difference between the central bank finance rate and what the enterprise was charged. But the central bank rate is itself below market; hence, it embodies an implicit subsidy. One measure of this implicit subsidy is the difference between the central bank rate and the nominal interest rate that would make the real interest rate equal to zero. 74 Barry W. Ickes and Randi Ryterman The Link Between Enterprise Behavior and Stabilization The role of financial development in macroeconomic stabilization is not well understood. Some economists argue that development undermines central financial control because it expands the variety of credit instruments that are available; hence, it weakens the connec- tion between base money and nominal income, as velocity becomes more unstable. They argue, therefore, that financial development, as well as financial liberalization, should be postponed to a later stage in transition. However, such an argument ignores two important effects that financial underdevelopment has on the ability of a government of a country in transition to provide macroeconomic stability. First, the absence of efficient systems of payment and financial intermediation have important real effects on the level of production and, conse- quently, on the amount of taxes collected. Second, the absence of these systems leads to the development of certain systemic features that undermine the credibility of macroeconomic policy. Loss in Tax Revenues Financial underdevelopment undermines the ability of the govern- ment to collect taxes. In Russia, the delay in payments between enter- prises led to a delay in the realization of profits. It also resulted in enterprises searching for more efficient, and often unrecorded, means of transacting. This delay and decline resulted in a significant reduction in the real value of taxes collected.22 But perhaps more important and more subtle is the loss in taxes associated with the loss of output owing to financial underdevelop- ment. Problems in both the system of payments and the allocation of credit were significant economic shocks to enterprises. Without inter- vention by the government and other nonbank providers of credit, these shocks might have initiated widespread failures of illiquid, yet technically solvent, enterprises. Enterprises responded to these shocks by creating an ihteren- terprise credit market and other informal mechanisms to facilitate payment, such as barter and coupons redeemable for goods. Although these informal mechanisms alleviated some of the pressure created by the underdeveloped financial system, they are necessarily inferior to a well-functioning financial system. First, these informal mechanisms use real enterprise resources in their operation. For 22 See Ickes and Ryterman (1992) for a discussion of the tax implications of arrears. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 75 example, negotiation of interenterprise credit or barter transactions or the creation of near money use the time of senior enterprise man- agers, which could have been devoted to supervising production. In addition, transactions involving barter require the use of physical resources, such as labor and trucks to transport the goods. Second, these informal mechanisms tend to operate based only on local information .. For example, enterprises provide credit to their trading partners, in part because they do not possess information about the creditworthiness of other enterprises.23 Because the alloca- tion of credit is not based on full information, it cannot be optimal in a first-best sense. Finally, these informal mechanisms tend to rely on personal con- nections to make them work. As we explain above, this reliance on personal connections dissuades enterprises from adjusting. To adjust, enterprises must break away from historical relationships and create relationships with new trading partners, new bankers, and other agents. When the principal mechanisms of payment and finance are informal, this movement away from historic relationships introduces extra costs. Consequently, financial underdevelopment provides an important motive not to adjust. In this sense, underdevelopment is responsible for the gains from adjustment and for forgone taxes. Loss in Credibility The central paradox facing reformers in Russia today concerns the potential cost of signaling a commitment to market incentives in an environment ripe with the potential for market failure. The decline of communism affords policymakers the chance to alter fundamentally the rules of behavior in the economy. This is advantageous if the impediment to change is expectations developed in response to the old policy regime. It is dangerous, however, when that impediment is not expectational but structural. The idea behind a commitment to the policy mix of low fiscal defi- cit, tight money, and hard budget constraints is that enterprise direc- tors will change their behavior sufficiently that the threat of bank- ruptcy will not have to be executed. This threat must be credible; otherwise behavior will not change. Enterprise directors must believe that the policy regime has changed. It is apparent that hardening budget constraints is a necessary con- dition for economic reform, but how to accomplish this objective is 23 Enterprises also tend to favor their trading partners in the allocation of credit because they benefit directly from the continued operation of their trading partners. 76 Barry W. Ickes and Randi Ryterman not clear. Early in the transition, it was thought by some (and still is · today) that hard budget constraints could be imposed by will alone. The problem with this view is that, in the transition from planning, many enterprises will have to be shut down because they are not viable in a market context. Hardening budget constraints can alter the behavior of viable enterprises, but, for those without positive net worth under current credit conditions, the enterprise will fail no mat- ter how vigilant the monetary authority. More than credibility is at stake here. This fact is often forgotten when analyzing the consequences of shock therapy. 24 Shock therapy does involve a regime change, and the comprehensive nature of the changes combined with the stakes involved may suggest that the assumption that the change is credible is warranted. But even if direc- tors believe that the regime has changed, bankruptcies will still occur simply because some enterprises will not be viable in a market context. It is useful to distinguish between two types of state-owned enter- prises that are present at the onset of transition. These are enterprises that cannot adjust in a market context, the CA, and enterprises that will not adjust, the WA, because adjustment is costly. The key difference between the two types is that the lack of adjustment by the WA is a function of inadequate incentives, while the CA do not adjust because the opportunity cost of the resources they use is too high. It is evident that the CA will shut down, but the question is when. The pace at which the CA are shut down depends, among other factors, on the stance of monetary policy. One of the costs of a strict monetary policy is that enterprise liquidations occur sooner than might otherwise happen. If the policymaker was indifferent to the timing of bankruptcy, there is no cost to a tighter policy that shuts them down quickly. But, if there are costs, the policymaker may wish to postpone shutdowns until the transition is sufficiently under way that labor can be absorbed elsewhere.zs A policymaker could be sensitive to the timing of shutdowns for various reasons. Timing could be important for political reasons. The policymaker could assume that if too many enterprises shut down at once, he will be fired. An economic argument about timing could point to congestion externalities; if many enterprises are shut down at once, the resources cannot immediately be absorbed into other uses. 24 Shock therapy is too simplistic a term to describe the reform policies employed in Russia (or Poland), but the name, unfortunately, has stuck. 25 Ericson (1994) analyzes the problem of how to shut down enterprises optimally in the transition. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 77 Or, social safety nets may be inadequate to cope with mass liquida- tions. Alternatively, the policymaker may believe that with time some of the CA can restructure, so that if bankruptcies can be delayed they can be avoided altogether. The goal for the policymaker is to induce separation of the CA and the WA. The policymaker has some prior beliefs on the proportions of CA and,WA in the economy as a whole. This probability judgment affects his or her willingness to commit to the tight money regime. If the proportion of CA is high, the tight monetary policy will precipi- tate their shutting down. To avoid adverse effects, the policymaker may prefer a more gradual sequence. Let A be the proportion of enterprises that are CA (:h = CA/(CA + WA)). It is important to note that A is a function of credit policy. The higher are interest rates, the greater the proportion of enterprises that cannot adjust. The extreme case is where there is no credit, so a cash flow constraint exists; in that case, any enterprise that cannot cover its current costs is a CA. The policymaker must estimate the likely behavior of enterprises, but the actions of enterprise directors (at least of the WA) depend on their expectations of what others will do. If all the WA adjust, and if A is low, then for an enterprise not to adjust is costly, because it will stand out. If the director expects that others will not adjust, or if he expects that A is high, then the likelihood that the director will not adjust increases. An essential strength-in-numbers phenomenon is at work here.26 A mixture of two uncertainties pertains here. First, there is uncer- tainty over types-whether the enterprise is CA or WA. The policy- maker cannot distinguish these types ex ante. Second, there is uncer- tainty over actions-whether others will adjust or not. It is. the presence of the uncertainty over types that allows for the possibilities for pooling. If A = 0, the government induces adjustment by impos- ing a sufficiently strong penalty, which in equilibrium it never has to enforce. It is much more difficult for policymakers to be credible about hard budget constraints when Ais high than when Ais low. When Ais low, few enterprises actually have to be shut down. When A is high, and thus it is easier for WA enterprises to pool, it is much costlier for the government to carry out its threat. But it is precisely the credibility of the threat that is needed to get WA enterprises to adjust. The ability of the government to minimize the economic dislocation that occurs 26 Calvo and Coricelli discuss the role of strength in numbers in generating arrears in Chap. 11 of this volume. 78 Barry W. Ickes and Randi Ryterman when hard budget constraints are imposed depends on the extent to which the government's commitment to this policy is deemed cred- ible by enterprises. The more credible the commitment, the greater the number of enterprises that will adjust. Consequently, a credible commitment leads to fewer enterprise failures. However, in Russia during 1992, the credibility of the Govern- ment's commitment to hard budget constraints was undermined in four important ways. First, the credibility of the Government's policy announcements was weakened by intergovernmental conflict. The Central Bank of Russia was not under the authority of the Govern- ment of Yeltsin, but rather answered to Parliament, until the events of October 1993. But the Central Bank is the key provider of credit to enterprises. Therefore, even if the Government stuck to its policy, the Central Bank could let enterprises off the hook. The Government's commitment to a low fiscal deficit is not a sufficient condition to ensure tight money. Thus, during 1992, the Government was rela- tively successful in reining in the fiscal deficit, but credit growth was still excessive. Second, the relationship between net debt and gross interen- terprise debt is arbitrary.27 Consequently, the government could not know, ex ante, how many enterprises would fail if the policy was, in fact, implemented. Hence, it could not identify the full economic costs of this policy before its implementation. This uncertainty pro- vided opponents of this policy fertile ground for dissent. It is in this aspect that the transition problem in Russia differs most markedly from that of stabilizations in other countries. The problem in Russia is not just that the loose fiscal policies of the Government relieve the pressure to adjust, but that the legacy of central planning is an indus- trial structure that is ill-suited to markets. Unfortunately, the Govern- ment does not know how ill-suited it is; only through marketization will this information be revealed. Third, in Russia, the decision about the viability of enterprises focuses almost solely on the liquid position of the enterprise. In a real economy, the decision about viability should be based on the net worth of the firm. To calculate net worth, informatio~ about the value of an enterprise's assets is needed. However, without developed financial markets, this information cannot be obtained. In Russia, assets are valued at historical values, which, given the developments in Russia during 1992, renders them useless. 28 This lack of informa- 27 For an explanation of this relationship, see Ickes and Ryterman (1992). 28 Assets were revalued in October 1992, but given the monthly inflation rates in the last quarter of 1992, book values have again lost any serious meaning. 4 • MACROECONOMIC STABILIZATION IN RUSSIA 79 tion makes it nearly impossible for enterprises to borrow against future income. The measure of viability of enterprises in such a re- gime is not the net worth of the enterprise, but rather its current cash flow. Under such circumstances, imposition of a hard budget con- straint may not only result in the wrong enterprises being shut down, but also in directors making decisions that lead to declines in the present value of the assets. With()ut information regarding the finan- cial viability of enterprises, no arbiter can evaluate the proper disposi- tion of an illiquid enterprise. Finally, enterprises themselves can affect the level of information about enterprises that is available in the economy, specifically, by manipulating the l.evel of payments in arrears. As explained above, the absence of financial markets heightens the importance of informa- tion about the liquidity of enterprises when assessing their viability. 29 When many receivables remain uncollected and many debts remain unpaid, even the liquid position of most enterprises is difficult to assess. Consequently, arrears provide enterprises with a weapon to sabotage the government's commitment to hard budget constraints. Interenterprise credit plays a crucial role here. The ability of WA enterprises to pool requires a source of credit. First, credit is needed by the CA to stay open. "Normal lenders" would refuse to lend to a CA. Interenterprise credit plays an important role, because it is moti- vated largely for reasons other than expected profitability. Enterprises lend to others because of survival orientation. Also, many do not know if they are WA or CA; this is an important characteristic of the noisy phase of the transition. · · Interenterprise ·credit expands the strategy space of enterprises. Without this credit, the government would find it much easier to enforce separation between CA and WA. Moreover, without this source of credit, the cost to WA enterprises of not adjusting would b~ much higher. It is the presence of this type of funding that makes this strategy preferable. · The development .of financial markets is a critical step to enable policymakers to distinguish CA from WA. The purpose of financial institutions is to separate these two types of enterprises. When finan- 29This information problem also makes difficult an oft-heard suggestion for dealing with this problem-securitization. The idea of allowing secondary markets in arrears seems appealing. But under the conditions that prevail in Russia it is precisely the trading partners of an enterprise that are most informed about (or at least interested in) its viability. The lack of information explains the absence of other lenders. Who would buy the "securitized" arrears? If agents were willing to lend to these enterprises, why have they not simply lent to them directly? Such markets have not yet formed precisely because of these information problems. 80 Barry W. Ickes and Randi Ryterman cial institutions are underdeveloped, there is little information at the enterprise level. As we have emphasized, financial underdevelop- ment in Russia makes it extremely difficult to distinguish insolvency from illiquidity. What does this tell us about stabilization and regime change? At the very least, it suggests that it is naive to think that tight credit policies can be enforced without severe consequences. The idea that enterprises will adjust to a credible tight monetary policy would be valid if A. were close to zero. As Russia must restructure from a position where A. is much higher, tight money is just not credible. This feature suggests that imposing financial discipline on enterprises will be a prolonged process. · Given that hard budget constraints cannot be enforced imme- diately, what should policymakers do? To improve efficiency, it is important to convert subsidies from ex post to ex ante. Subsidies that are ex post do not induce cost-minimizing behavior because the gov- ernment will pick up the losses. Ex ante subsidies, on the other hand, alter the incentives that enterprises face. It is also critical to induce enterprises to operate in financial markets rather than interenterprise debt markets. The goal of policymakers should be to improve information at the enterprise level. Adaptation Even (especially) in an underdeveloped financial system, banks and enterprises adjust to financial shocks. One of the effects of the arrears crisis was a change in the behavior of banks and enterprises. These adaptations to financial stringency have effects on the function- ing of the system. In particular, if banks and enterprises adapt by adopting more infonnal mechanisms, the effectiveness of the financial system decreases, as does the capacity of the center to control events. Financial innovation as a response to tight monetary policy is a common phenomenon. In the United Kingdom and the United States, the adoption of precommitted monetary targets in the late 1970s led to a series of financial innovations that have severely weak- ened the relationship between monetary aggregates and nominal incomes. 30 30Goodhart (1989, pp. 377-80) provides an excellent analysis of this process. In the United Kingdom and the United States, the effect of monetary targeting in a period of high inflation was to increase the variation in the burdens of tight money (since large depositors could receive market rates of interest). This increase in variation, in tum, led to pressure to deregulate and to financial innovations around restrictions. These 4 • MACROECONOMIC STABILIZATION IN RUSSIA 81 We have already explained how interenterprise arrears exploded as a response to tight credit in Russia in 1992. But this experience has also induced financial innovation by Russian enterprises. Indeed, as Thornton (1993) emphasizes, "the build-up of inter-firm arrears has provided a means by which managers of firms with poor long-run prospects can capture the income from production in the short-run while leaving the government with the obligations to print rubles to cover the unpaid costs of the firm." Thornton quotes Nikita Kirichenko (Kommersant, Vol. 42, October 18-24, 1993, p. 4): Many enterprises have already undergone a process of clearing arrears and know how it is done. Among other things, they know how to acquire subsidized credits: simply arrange a sham contract to supply a shell organization with a few units of output at fantastic prices and the desired credits will be forthcoming . . The essential point is that in an environment of underdeveloped financial markets enterprise directors, who control rather than own their enterprises, are innovative at finding means of decapitalizing the assets. Our argument is that this process is enhanced by financial underdevelopment. Perhaps the most important example of this is the proliferation of banks, formed by groups of enterprises, as a means of obtaining subsidized credit from the Central Bank. The vast majority of these banks act more as agents than as financial intermediaries. Thornton (1993) refers to them as "quasi-state organizations" because their activities are largely oriented to preferential or subsidized financing, responding to administrative rather than market-based incentives. As the proliferation of quasi-banks is the response to the oppor- tunities to obtain subsidized credit in an environment of inflation, it becomes increasingly difficult to assess the viability of individual enterprises or the quality of loan portfolios of these banks. The dan- ger inherent in this situation is that when the next credit crunch occurs, the crisis will be centered in the banking system. In this case, financial underdevelopment will continue to make tight monetary policy problematic, but the manifestation will not be interenterprise arrears, but arrears from enterprises to banks. If this happens, a future credit crunch may pose grave danger to the entire banking system. Another important innovation to the current environment in Russia is the development of financial-industrial groups. These developments in tum weakened the relationship between monetary aggregates and nominal income. 82 Barry W. Ickes and Randi Ryterman groups solve two problems for their members. They secure deliveries for enterprises by strengthening vertical relationships. In this way, they enable enterprises to circumvent the difficulties posed by an inefficient distribution system. This tends to solve an important prob- lem for enterprises: maintaining supply relationships in the wake of the collapse of the state supply system (Gossnab). For our purposes, however, the more important function that these groups provide is financial. These groups enhance enterprise viability by being a source of finance to the members. The proliferation of these financial-industrial groups may result in a "balkanization" of financial markets. 'Such a process could have important long-run effects for Russian economic development. These groups are likely to be regional in nature. Moreover, they tend to preserve existing relationships between enterprises rather than pro- mote restructuring and market reform. The likelihood that the next financial crisis will appear in a different form is enhanced by the efforts of these financial-industrial groups to insulate ·themselves from the next credit crunch by establishing banks. For these groups, banks serve as a means of securing for themselves a source of finance. It is also a means of circumventing an ineffective payment system. However, a banking system that is cre- ated out of these motives is not likely to be stable. The arguments we present in this paper suggest that, in an econ- omy in transition with an underdeveloped financial system, mone- tary policy must be sufficiently restrictive to encourage enterprises to adjust, but not so restrictive that enterprises choose to react in a way that undermines economic reform. If the government chooses to tighten credit too quickly or too severely, the credibility of the policy will once again be brought into question. Moreover, as long as finan- cial markets are underdeveloped, tight credit policies have delete- rious unintended consequences, such as gridlock in the payment sys- tem and arrears in the payment of taxes. Efforts to impose financial discipline on enterprises must therefore be associated with progress in developing the financial system in Russia .. References Brown, Annette, Barry Ickes, and Randi Ryterman, "Myth of Monopoly: A New View of Industrial Structure in Russia," working paper, 1993. Clifton, Eric V., and Mohsin S. Khan, "Interenterprise Arrears in Transform- ing Economies: The Case of Romania,'' Staff Papers, International Monetary Fund, Vol. 40(September1993), pp. 680-96. Ericson, Richard E., "Cost Tradeoffs in Activity Shutdowns: A Note on Eco- nomic Restructuring During the Transition," in The Post-Communist Eco- 4 •MACROECONOMIC STABILIZATION.IN RUSSIA 83 nomic Transformation: Essays in .Honor of Gregory Grossman, ed. by Robert Campbell (Boulder, Colorado: Westview Press, forthcoming, 1994). Goodhart, C.A.E., Money, Information, and Uncertainty (Cambridge, Massa- chusetts: MIT Press, 2nd ed., 1989). Grossman, Gregory, "Notes for a Theory of the Command Economy," Soviet Studies, Vol. 15, No. 2(October1963). Ickes, Barry W., "Saving in Eastern Europe and the Former Soviet Union," in World Savings: An International Survey, ed. by Arnold Heertje (Cambridge, Massachusetts: Basil Blackwell, 1993). - - , and Randi Ryterman, "The Interenterprise Arrears Crisis in Russia," Post-Soviet Affairs, Vol. 8(October-December1992), pp. 331-61. --(1993a), "Roadblock tQ Economic Reform: Inter-Enterprise Debt and the Tra~sition to Markets," Post-Soviet Affairs, Vol. 9 Guly-September 1993), pp. 231-52. --(1993b), "From Enterprise to Firm: Notes for a Theory of the Enterprise in Transition," in The Post-Communist Economic Transformation: Essays in Honor of Gregory Grossman, ed. by Robert Campbell (Boulder, Colorado: Westview Press, forthcoming, 1994). Jaffee, Dwight, and Joseph Stiglitz, "Credit Rationing," Chap. 16 in Handbook of Monetary Economics, ed. by Benjamin M. Friedman and Frank H. Hahn, Vol. 2 (New York: North-Holland, 1990), pp. 837-88. McKinnon, Ronald I., The Order of Economic Liberalimtion: Financial Control in the Transition to a Market Economy (Baltimore; Maryland: Johns Hopkins University Press, 1991). Mitchell, Janet, "Creditor Passivity and Bankruptcy: Implications for Eco- nomic Reform," in Capital Markets and Financial Intermediation, ed. by Colin Mayer and Xavier Vives (Cambridge, England: Cambridge University Press, 1993), pp. 197-224. Summers, Bruce J., "Russian Payment Institutions and the Medium of Exchange Function of the Ruble" (unpublished; Federal Reserve Board, 1992). Thornton, Judith, "Privatization and Financial Markets in the Russian Far East," paper presented at 25th Annual AAASS Meetings, Honolulu, November 1993. United States, Board of. Governors of the Federal Reserve System, Flow of Fund Accounts: Financial Assets and Liabilities (Washington, 1992). Comment Jacek Rostowski The magnitude of the interenterprise debt problem seems to have diminished sharply in Russia recently. Whereas payments arrears on the kartoteka dva-that is, as calculated by commercial banks- accounted for Rub 3 trillion (about 50 percent of annual GDP in June 1992-at June 1992 prices), by December the estimate for "accounts receivable" was Rub 5 trillion, or only about 16 percent of GDP. 1 The question is whether the problem will return in its acute form after stabilization. The Polish experience2 shows that if a stabilization program is cred- ible, interenterprise debt will decline in real terms rather than increase. In Poland after stabilization the real value of such debt fell by almost half (from 18 percent to 10 percent of GDP), and has since remained at approximately that level. This occurred in spite of an almost complete absence of bankruptcies in the first six months of the Polish program. The key factor seems to have been high interest rates on loans and particularly on deposits. The latter made suppliers unwilling to give credit to customers. Just how likely this is to happen in the Russian case depends to a large extent on one's explanation for the decline in real interen- terprise debt since the summer of 1992. The optimistic explanation for this decline is that, although there was a multilateral clearing of such debt in August-September 1992, it came too late to save the enter- prises that had extended this credit from severe losses owing to the fall in its real value. In this case, one can be quite optimistic about the likely behavior of interenterprise debt upon stabilization. The 1 I am grateful to B. Granvelle for the figures for monthly GDP in June and December _1992, which allowed the calculation of annual GDP in June and December 1992 prices through the simple expedient of multiplying by 12, and to Russian Economic Trends, Vol. 1, No. 3, for the June 1992 figure for interenterprise debt. The December 1992 figure for receivables was provided by the Russian Government's Center for Economic Reforms. The figure given by Ickes and Ryterman seems to relate receivables at end-1992 to nominal GDP throughout 1992. Since inflation was very rapid, this would understate GDP in December 1992 prices and thus overstate the receivables/GDP ratio. However, all GDP figures for Russia in 1992 (and particularly those for monthly GDP) must be very tentative. The extent to which the arrears data for June and December 1992 are comparable is also questionable: the first figure comes from the kartoteka dva (the so- called File No. 2) on bank accounts and is therefore exhaustive; the second is merely an estimate by various Russian Government institutions. 2 Described in Jacek Rostowski, "The Inter-Enterprise Debt Explosion in the Former Soviet Union:_ Causes, Consequences, Cures," Communist Economies and Economic Transformation, Vol. 5, No. 2 (1993), pp. 131-59. 84 4 • COMMENT 85 pessimistic interpretation would put most of the stress on the very rapid rate of growth of nominal credit since the multilateral clearing exercise. However, the fact that the ratio of bank credit to nongovern- ment GDP rose only slightly, from 12 percent in June 1992 (which was when real interenterprise debt reached its peak) to 14 percent in March 1993, inclines one toward the optimistic interpretation. Nevertheless, given the quality of current economic data in Russia, it is as well to be prepared for the possibility of a surge in interen- terprise debt after stabilization as occurred in 1992 after liberalization. How should such an explosion of interenterprise debt be dealt with? The worst action is to inject money into the economy. The next worst is a multilateral clearing, as this is in effect a government-sponsored equalization of the value of all debtors' interenterprise liabilities and also the setting of their real value equal to their nominal value. As such it causes severe moral hazard problems. The best way of han- dling a surge in interenterprise debt is to do nothing: Latvia, which had an interenterprise debt/GDP ratio very similar to that of Russia in May 1992, refused to carry out a multilateral clearing, and now has inflation of a few percent a month and a fully convertible currency that has been appreciating against the U.S. dollar. An important part of doing nothing is, of course, to have positive real interest rates as part of the stabilization program. However, if there are doubts about the authorities' political ability to resist calls for inflationary solutions such as multilateral clearing or money creation, makfug interenterprise debt tradable should be con- sidered. One of the main reasons for the difficulties surrounding such debt is that a properly functioning bankruptcy system does not exist in most previously centrally planned economies, 3 so that interen- terprise claims cannot effectively be enforced directly against debtors. If this debt is made tradable, creditors can obtain liquidity by "by- passing" their debtors and selling their claims at a discount to the debtors' debtors. The creditor's liquidity gain is the debtor's loss, as the debtor will not then obtain the money he is owed by his own debtor. For this to happen, the debtor's debtor must be able to set the face value of his creditor's liability against his own liability to his creditor, and only be required to pay any residual. Debtors them- selves would of course be able to bid for their own liabilities by offer- ing to buy them at a discount in exchange for immediate payment. 3 The existence of a bankruptcy law is not the same as the existence of a bankruptcy system. Only Hungary has an efficient bankruptcy system. Poland has had a law since the beginning of its reforms and a system that is still very inefficient but is slowly improving. The Czech Republic's bankruptcy law only came into force in April 1993. 86 Jacek Rostowski Tradable debt is after all the solution that has been generated by the market in that other area in which bankruptcy is impossible- sovereign debt. The simplest way of ensuring that interenterprise debt is tradable is to require suppliers to obtain a properly executed bill of lading, bear:- ing the signatures of the relevant authorized persons representing the customer. If such a bill is not obtained when goods are delivered, the goods would be deemed by law to be a gift from the supplier to his client. If the bill is obtained, it is deemed a formal liability of the client, obliging him to pay within a certain period, and can therefore be sold by the supplier at will. The question of what happens if the debtor goes into liquidation while it has outstanding interenterprise debt that has been bought by one of its debtors is not an insurmountable problem. First, the right to offset a debtor's interenterprise liabilities against his assets is needed because of the absence of a functioning bankruptcy system. Thus, problems in exercising this right will not normally arise as a result of bankruptcy. Second, the right to offset interenterprise liabilities against assets could only be made good against the debtor before his bankruptcy has been declared, as with other kinds of liability; after this . date they would have to be submitted to the liquidator for settlement.4 The most important result of such an interenterprise debt market is that it eliminates the danger of a "liquidity logjam," by which whole chains of enterprises can claim that they cannot pay each other or- possibly more dangerously-the budget, because they have not them- selves been paid. If interenterprise debt is tradable it will allow liquid- ity to flow to where it is most needed, possibly cutting out whole bands of nonpayers, and at the same time revealing the true revenues of suppliers.s In this way, most of the arguments for inflationary solutions to the interenterprise debt problem will be eliminated. The pressure to increase the money supply so that it can affect the existing nominal mass of payments due should disappear when the nominal value of these payments can adjust itself automatically to the existing money supply. 4 A market of this kind exists in the interenterprise debt of Polish coalmines, and these liabilities are used as payment to the mines by some of their customers. In Poland the right to set interenterprise assets and liabilities against each other derives from the civil code. 5 1t is of course these and not the formal sales prices that must be taken into account in calculating profit and sales taxes. 4 •COMMENT 87 Furthermore, interenterprise debt trading will-if public-generate useful information regarding the standing of various enterprises. A firm, its suppliers, and its direct customers are likely to be as well informed about its financial situation as any group of actors in the economy, and in public auctions of interenterprise debt their collec- tive assessment would become available to all. If such auctions exist- ed, and if, furthermore, this debt was made convertible into equity (at nominal value into the book value of enterprises' "own funds"), this could be a powerful tool for the privatization of the economy. Some- thing similar is being done in Poland under the enterprise and bank financial restructuring program. As part of a compact between credi- tors and a bad debtor, bank and interenterprise debt can be traded, and any holder of more than 30 percent of a bad debtor's liabilities can have them converted· into equity at par (subject to the approval of ·the Ministry of Privatization). PART II The Central Bank and the Payment System 5 Payment System Reform in Formerly Centrally Planned Economies David Folkerts-Landau, Peter Garber, and Timothy D. Lane1 A payment system capable of speedy settlement of transactions in goods, services, and basic securities is a linchpin of a functioning market economy. Measures to ensure the integrity of the payment mechanism and eliminate long and uncertain delays in settlement. are therefore an essential part of financial system reform in formerly cen- trally planned economies.2 An effective payment system combines two vital elements. The first is trust among the participants, expressed as a willingness to post- pone settlement of an obligation in good funds. For example, a seller of goods may be willing to accept a promissory note in payment and not insist on settlement in currency or bank deposits. Similarly, banks may extend credit to each other to meet payment imbalances rather ·than insisting on settlement in currency or bank deposits. Such arrangements expedite payments, allowing a greater range of mutu- ally beneficial transactions to take place. A second vital requirement of a payment system is discipline. Because credit may be extended automatically in the process of effect- ing payments, there is the potential for abuse: transactors could use the system to incur unsustainable imbalances between their pay- ments and receipts. Discipline requires that settlement in good funds . 1 The authors are grateful for country-specific information provided by V. Sundarara- jan of the IMF's Monetary and Exchange Affairs Department. The views expressed here are those of the authors alone and do not necessarily represent the views of the International Monetary Fund. 2 An overview of issues in financial sector reform in formerly centrally planned economies is provided in Lane (1994). 91 92 David Folkerts-Landau, Peter Garber, and Timothy D. Lane be made at sufficiently frequent intervals; other rules may also be needed to prevent an unbridled expansion of credit in the system. 3 The failure of either trust or discipline can impair the efficiency of the payment system, and indeed of the financial system as a whole. If households and firms distrust each other but have confidence in banks, they will insist on settlement in bank deposits, and the conse- quent large holdings of deposits will allow banks to intermediate between borrowers and lenders on a large scale. If the banks distrust each other, they will insist on settlement in .central bank deposits; banks will then hold large amounts of reserves or securities that the central bank will discount and will intermediate far less between pri- vate borrowers and lenders. More transactions will require settlement in central bank liabilities, and the central bank or the treasury will have to intermediate between borrowers and lenders. Such a system . is usually characterized as being illiquid. A failure of discipline can also undermine the payment system. The Achilles' heel of financial discipline is the prospect of a bailout: if transactors ultimately expect to be indemnified for any losses result- ing from bad debts, they have no incentive either to insist on settle- ment in good funds or to monitor the creditworthiness of their counterparties. In this case, arrears in payments will continue to mount, both within the banking system and elsewhere in the econ- omy; when a bailout does occur, therefore, it will have to be huge. If the creation of credit through the payment system is unchecked, it frustrates the system's purpose of facilitating the exchange of objects of value; it may instead become a mechanism through which transac- tors try to obtain a larger share of the eventual bailout. Trust and discipline in the payment system are both serious con- cerns in economies in transition. Discipline has hitherto been defi- cient, as state-owned banks and enterprises have operated under "soft budget constraints" (Kornai, 1980) with the assurance that their debts are underwritten by the state. Even where the supply of credit provided by the banking system has been limited, there has been an explosion of interenterprise credit, typically in the form of arrears (Tyson, 1979). There have also been long delays in settlement within the banking system, as banks have taken advantage of the credit automatically extended through the payment mechanism. '.fhis situation is expected to change. If the authorities in formerly centrally planned economies manage to distance themselves from the state enterprises-by privatizing them, or at least by making a cred- ible commitment to limit bailouts-credit risk will become a much 3 The issue of market discipline is explored in a more general context in Lane (1993). 5 • PAYMENT SYSTEM REFORM 93 more important consideration. It is difficult to evaluate a counter- party' s creditworthiness in this setting, though, as this depends on the creditworthiness of that party's debtors, and so on, which have never been put to the test. Moreover, many participants in the pay- ment system may actually be insolvent, which could make transactors reluctant to accept credit and lead them to insist on payment in good funds. The result could be an illiquid system, resulting in high trans- action costs and a consequent implosion of trade.4 This paper will focus on the wholesale, interbank payment system, bearing in mind the broader issues of payment system development. It is through interbank transactions that sizable payments among firms and households are intermediated. Transactions among banks are also central to bank liquidity management and money market development, which in turn are essential to any move toward market- based implementation of monetary policy. The next section discusses in greater depth the importance of the wholesale payment system-not only in intermediating payments among enterprises and households, but also in enabling banks to engage in more rational liquidity management, and consequently in the development of money markets and the implementation of mone- tary policy. The following section describes the salient features of the existing state of payment systems in formerly centrally planned economies, explaining why this concern has only recently emerged. Then the policy issues involved in establishing a clearing and settle- ment system for interbank payments are discussed, especially the allocation of settlement risk, along with steps already taken or planned to reform interbank payment systems in various Central and East European countries. Why Is the Interbank Payment System Important? The establishment of an efficient system for payments among banks is important for several reasons: intermediating payments involving households and other firms; permitting active liquidity management; facilitating the development of security markets; and establishing the basis for implementation of monetary policy. 4 This may already have occurred with respect to cross-border trade in the successor states of the former Soviet Union. It has been argued that something similar took place in Poland in 1990, accounting for the abrupt decline in output (Calvo and Coricelli, 1992); this argument remains controversial, as it depends on the credibility of the authorities' announcement that a bankruptcy law would henceforth be enforced. 94 David Folkerts-Landau, Peter Garber, and Timothy D. Lane Clearing and Settlement A payment system is a mechanism whereby financial institutions, other firms, or households can transfer funds to discharge their obli- gations. From the standpoint of firms and households, payments may be carried out in cash or by check or giro; the latter two media depend on an effective means of transferring funds among banks when payor and payee have accounts in different banks. This process can be divided into two parts: clearing-the transmission and record- ing of the instructions to make a payment; and settlement-the actual transfer of some medium generally acceptable in fulfillment of the payment instruction. In most Central and East European countries, interbank payments are so sluggish that there may be delays of as much as several weeks during which neither payee nor payor has access to the funds. This results in the widespread use of cash, which is less convenient and secure in other respects. In a complex financial system, in which payments in many direc- tions take place on any given day, the risk of payment bottlenecks could be reduced by some form of netting arrangement (Bank for International Settlements, 1989). Under a netting arrangement, each participant needs to have reserves sufficient only to cover the net balance owed to the system, rather than enough funds at any moment to cover its gross payments. In this case, the large-scale payment system is used only to settle the· net balance owed by or owing to each bank. · A clearinghouse often provides facilities for netting payments, as well as for the exchange of checks and other payment orders among its members to minimize operating costs. In advanced market econ- omies, clearinghouses may be voluntary associations of financial institutions or they may be operated by a central bank. The clearing- house rules specify conditions for membership and members' rights and obligations and provide facilities to exchange checks drawn on each member institution, as well as standardizing other details such as the times by which checks must be presented to be made part of the settlement for a particular day's business, and the standard for- mat in which checks must be presented for clearing. Clearinghouses have also typically been active in developing methods of speeding the clearing and settlement of checks and reducing the operating burden on each member, fostering innovations such as automatic clearing- houses, electronic check presentment, and magnetic tape exchange. Another implication of clearinghouse rules is the allocation of settle- ment risk among the members, by specifying procedures to be fol- 5 • PAYMENT SYSTEM REFORM 95 lowed in the unlikely event that one of its members cannot settle its net position at the final settlement. This procedure may require the unwinding of transactions made by the defaulting member, or it may include provisions for sharing of losses incurred in the day's pay- ments associated with the insolvency of any of its members . . An efficient interbank system is at most a necessary, not a suffi- cient, condition for an .efficient retail payment system. Inefficiency in internal bank organization can also lead to slow payments, even when the banks can transfer funds readily among themselves. Banks may also have the incentive to delay payments in cases where they enjoy interest-free use of the funds in transit. The interest forgone is not the only resulting cost to the transactors in heavily distorted financial markets, where the payee who is deprived of the use of the f1mds may not be able to borrow at a market interest rate. The delay and uncertainty of payment thus impose a particularly heavy penalty on trade in an illiquid environment such as that of formerly centrally planned economies, and may disc01:1rage trade that is otherwise advantageous to the parties involved. Bank Liquidity Management If banks cannot readily transfer funds among themselves, it is diffi- cult for them to engage in active liquidity management, for they lack means of investing funds for short periods or obtaining funds at short notice. The inadequacy of facilities for money transfer in Central and East European countries is reflected in banks' typically large excess reserves, which constitute a drain on their resources. This may also make it more likely that an unexpected excess of payments over receipts may lead a bank to become illiquid, possibly generating a banking crisis. The holding of large excess reserves as well as the risk of crises may be attenuated by the central bank's acting as a lender of last resort. Central bank intervention may engender moral hazard problems, however; for example, banks on the verge of collapse may turn to the central bank for funds when other financial market participants quite rationally refuse to lend to it. It is harder for the central bank to scrutinize the creditworthiness of banks that turn to the discount window for funds where regulation and supervision of the banking system are in an embryonic state, as in Central and East European countries. These considerations also point to the desirability of reduc- ing uncertainty in the timing of settlements, so that banks do not normally need to turn to the central bank for funds to deal with everyday fluctuations in their payments and receipts. 96 David Folkerts-Landau, Peter Garber, and Timothy D. Lane Funding Across Disparate Intermediaries Another important function of the wholesale payment system is to provide facilities for longer-term interbank lending to promote a more efficient allocation of funds. At any moment, some banks may be experiencing inflows of deposits that exceed loan opportunities avail- able, while for other banks the converse may be true. Such imbal- ances are structural in economies in transition, where the banking system is largely a relic of central planning. Typically, a state savings bank network specializes in collecting deposits from households, but has few outlets for lending, whereas other institutions, including commercial banks and particularly the specialized banks such as agri- cultural development banks or investment banks, have lending opportunities but little deposit base. There are two ways to deal with this mismatch between deposit base and lending opportunities. One is to implement a general restructuring of the banking system and to bring about a more bal- anced portfolio structure for each of the banks. A more expedient alternative is to promote the development of an interbank market, through which banks with excess liquidity can lend funds to other banks more specialized in finding appropriate lending opportunities. Development of the wholesale payment system is essential for this interbank lending to deal effectively with disparities in the availability of funds and of opportunities for profitable use of funds. Money Market Development Similar considerations govern the payment system's role in facili- tating money market development. Assets' liquidity depends on the speed with which "good funds" -the medium acceptable in final settlement-can be obtained by selling these assets: a bank will proba- bly not invest excess funds in the money market if long delays ensue in reselling and receiving settlement for these assets when funds are again needed. Moreover, long and unpredictable delays in obtaining funds for securities sold or in borrowing funds at short notice increase the risk faced by market-makers; the bid-ask spreads needed to cover these risks may stifle budding money markets. A money market provides a basis for developing the spectrum of financial markets that guide the allocation of savings in the economy. Active and deep money markets permit active liquidity management by securities dealers, which reduces their costs and risks of operation, and in turn enables them to make markets in securities of other matu- rities as well as in equities. These longer-term markets will them- 5 • PAYMENT SYSTEM REFORM 97 selves be more liquid and flexible, and thereby more effective as a means of allocating resources, to the extent that they are supported by a liquid money market, and more flindamentally by an efficient system of interbank payments. Implementing Monetary Contr:ol The effective market-based implementation of monetary policy is a medium-term goal of financial sector restructuring in Central and East European countries (see Khan and Sundararajan, 1991). Effective monetary control is essential in achieving the price level stability that is part of an environment in which market economic activity can flourish. Payment system reform facilitates market-based monetary control in several ways. Most obviously, if sufficiently deep money markets do not exist, there is no way of carrying out meaningful open market operations: the instruments of indirect monetary control are simply unavailable. Moreover, if banks cannot engage in active liquidity management, they tend to hold large and variable excess reserves. This makes reserve money programming a difficult, perhaps nuga- tory, exercise. Moreover, if banks lack the means ofobtaining reserves from other banks at short notice at market interest rates, tightening monetary policy will either risk making one or more banks illiquid or lead to an offsetting expansion of the monetary base through the refinance facilities. Without a smoothly functioning payment system, short-term inter- est rates do not provide good indications of financial market condi- tions owing to transaction noise. Thus, the authorities cannot depend on interest rate signals to control quantities such as base money or reserve aggregates. Reducing this transaction noise by modernizing the wholesale payment system would increase the effectiveness of policy, as well as making interest rates a better guide for banks and other economic agents. Finally, central bank float-credit extended by the central bank to the banking system pending settlement of payments-can be reduced ·with an improved payment system. In Central and East European countries, cash i.tems in the process of collection or awaiting settle- ment have often been a substantial component on the balance sheets of the banks and of the central bank; this has added to the uncertainty of monetary programming, making it more difficult to· forecast money, credit, and reserve aggregates. Reform of the interbank payment system will therefore facilitate the market~based implementation of monetary policy both by adding the 98 David Folkerts-Landau; Peter Garber, and Timothy D. Lane necessary tools to the central banks' kit and by improving the quality of information the central banks can use in implementing monetary control. Background in Central and Eastern E~rope Dissolution of the Monobanks In characterizing the existing state of the interbank payment sys- tems in the Central and East European countries formerly under cen- tral planning, it is important to consider the legacy of the monobank system. Under this system, a single bank carried out the functions of both central and commercial banking. It was therefore typically sup- plemented by specialized banks, including a national savings bank, a foreign exchange bank, and an agricultural development bank. Enter- prises were often restricted to doing business solely with one particu- lar bank. This structure had the effect of limiting the volume of interbank payments. It also limited the amount of competition in the system. Enterprises were typically authorized to borrow virtually unlimited amounts from the bank to which they were assigned in making trans- actions authorized under the central plan. Enterprises were not required to have funds available in their accounts to make authorized expenditures. In general, enterprises' decisions were constrained not by the funds available to them or by their overall solvency, but by the allocation specified in the central plan and the availability of raw materials and other inputs. Furthermore, central planning did not attach any time value to money, so enterprises were not particularly concerned about receiving funds promptly. These aspects of the cen- tral planning system-the limited number of banks, the lack of com- petition in the system, and the lack of urgency for banks' customers to obtain speedy clearance of their payment orders-together with the underdeveloped telecommunications system, led to a payment sys- tem that was very slow. The monobank system has been largely dismantled in many for- merly centrally planned economies: in Hungary in 1987, in Poland in 1989, and in several other countries in 1990. The monobanks' assets and liabilities together with their branch operations were devolved onto newly formed commercial banks. In general, these commercial banks were regionally concentrated: in Poland, for example, nine new commercial banks were established; each inheriting the National Bank of Poland's commercial 'banking activities in a particular region 5 • PAYMENT SYSTEM REFORM 99 of the country. In the former Czechoslovakia, one new commercial bank was established in the Czech lands and one in Slovakia. In Hungary, several new banks were established to take over the National Bank of Hungary's commercial banking operations. As the monobanks were broken up, what had been intrabank transactions became .interbank transactions, making the establish- ment of an interbank payment system an important goal. Initially, the newly formed commercial banks were uneq1.1ipped to carry out trans- actions among themselves; any interbank settlements were settled on the books of the national bank, with no netting or other arrangements to facilitate them. Comm~rcial banks therefore had to hold large amounts of excess reserves, and the vagaries of the payment system resulted in large fluctuations in reserves. The clearing of payments was often very cumbersome. For example, in Poland in 1990, all pay- ment orders below $10,000 were transmitted by ordinary mail, and even the establishment of the special interbank mail courier system was considered a major step toward making the payment system efficient. Anecdotal evidence suggests that lags in check clearing of three weeks or more were common. Interbank and Intrabank Transactions Because the newly formed commercial banks in formerly centrally planned economies were carved out of the branch netWorks of the monobanks, establishing an efficient. interbank payment system entails some particular problems. One is the need for consolidation of each bank's branch accounts to treat each bank rather than each branch as a unit. By contrast, for example, the National Bank of Poland until recently treated each separate branch independently so that each.bank maintained multiple clearing accounts with it. Under these arrangements, a bank was concerned not only with its aggre- gate balance with the National Bank, but also with the balance of each of its branches. Each bank made an agreement with the National Bank about the amount of refinance credit available to it, and then allocated this refinance credit across its branches, informing the National Bank of the allocation. If a particular branch had a negative balance with the National Bank because of an imbalance of its settle- ment of payments, the National Bank automatically supplied that branch with refinance by providing payment credit at the minimum interest rate, If the branch exceeded its refinance credit allocation, it had to borrow at a penalty rate even if other branches of the same bank, which deal with the same branch .of the National Bank, had excess reserves. As a result of the separate treatment of each bank 100 David Folkerts-Landau, Peter Garber. and Timothy D. Lane branch, banks had to use the facilities of the National Bank to transfer funds among branches; this meant that intrabank payments occupied a large part of the telegraphic transfer facilities of the National Bank. Consolidation of bank branch accounts, implemented in 1992, was expected to lighten the traffic on the telegraphic transfer network and permit a larger proportion of interbank payments to take place through telegraph.ic transfers. It would also permit bank-wide liquid- ity management, which had hitherto been next to impossible. Lack of Banking Skills and Techniques A feature of the banking systems of many of the Central and East European countries that impedes the effective use of an interbank system is the inefficiency of the management of these banks. In many banks-particularly the state savings banks, in which the majority of household deposits are held-transactions are carried out by hand rather than electronically. In addition, procedures carried over from the days when banks were essentially record keepers for the central plan have exacerbated delays in processing payments. Cumbersome procedures adopted by the central banks of these countries often aggravate the problem. For example, the develop- ment of a market in bills issued by the National Bank of Poland was hindered by National Bank rules in early 1991. If the bank wanted to purchase bills as a temporary repository for liquid funds but chose to leave these bills for safekeeping, it had to send an official to the National Bank to take possession of the bills and carry them to another window in the same office to place them in safekeeping. The absence of any mechanisms for carrying out such transactions over the telephone without physical transfer of paper, let alone a system of electronic "book-entry" transfers of government securities, impeded the development of the money market. Telecommunications Facilities Another important factor in most Central and East European coun- tries is the primitive state of the telecommunications system. It has been extremely difficult to effect transactions by telephone, and the establishment of an interbank payment system involving the elec- tronic transfer of funds between different banks would be impractica- ble with the existing facilities. In the establishment of an interbank payment system, attention has typically been focused on the purely technical requirements for the electronic transfers of payment orders. Although this is an important 5 • PAYMENT SYSTEM REFORM 101 condition for an efficient payment system, it is not the only one: attention also needs to be given to the economic policy underlying the transfer of funds through the payment system. Refinance Credit from the central bank to the banking system also frequently plays an important supporting role in relation to wholesale pay- ments. In formerly centrally planned economies, the issues are some- what different from those in developed market economies, however. In the monobank system, credit from the central bank to other banks was hardly needed, because of the latter's limited role. Within this system, the specialized banks could often run current account over- drafts at the national bank, and similar overdrafts could be run between different branches of the national bank. After the dismantling of the monobank, central bank refinancing has often had two roles. Some refinancing-usually taking the form of overdrafts on current account-is associated with liquidity needs and in some cases even from a simple failure to settle accounts. The danger with this form of credit is that it may become open-ended. The central bank then cannot limit the credit it provides to some financial institutions, which continue to incur overdrafts. Any quantitative limits the ce.ntral bank sets on these overdrafts are routinely exceeded and ratified ex post (as illustrated, for example, by the frequent over- drafts of the Bank for Food Economy in Poland). Some refinance credit is also closely linked to the provision of preferential credit to households and enterprises. For example, in Poland before 1990, refi- nancing was provided at preferential interest rates to subsidize the commercial and specialized banks' provision of credit for agriculture, housing, and central (officially approved) investment. These different aspects of refinancing have often resulted in a plethora of different lines of refinance credit. Supervision and Regulation The weakness of the structure of bank regulation and supervision, with an attendant danger of manipulation and fraud, poses particular problems for the establishment of a wholesale payment system. ' When weak banks are allowed to have direct access to the interbank payment system, they create severe risks of nonsettlement. The chal- lenge to the regulator when such banks are present is to prevent an insolvent institution from pumping a large proportion of its liabilities through the payment system so that the payee has access to the funds 102 David Folkerts-Landau, Peter Garber, and Timothy D. Lane before settlement. Such access would spread a single bank's insol- vency throughout the system. This challenge exists both in high- volume electronic systems and in paper check-clearing systems. The problem needs to be controlled through strong regulations limiting the amount of credit implicitly extended through the payment system by requiring settlement before the payee is allowed access to funds. Supervision must be continuous to ensure that regulations are not circumvented, especially in an environment in which the quality of bank management is at best untested. Poland's 1991 Art B scandal provides an example of the potential for fraud that arises if the interbank payment system is inadequately regulated. Art B, a private company, was able to write certified checks on accounts in which there were no funds. If these checks were deposited in another bank, the company would immediately be cred- ited with funds in that bank, while it would take several days before the check cleared and the account on which the check was written would be debited. With a certified check, the bank in which the check was deposited was immediately credited with the funds by the National Bank of Poland, while the bank on which the check was written was not debited until the check cleared. Art B would therefore have the use of funds until the check cleared. This check kiting scheme was possible largely because banking regulations at that time specified that settlements corresponding to transactions exceeding the equivalent of $10,000 had to go through the National Bank of Poland's wire transfer system, while checks for less than that amount would be cleared by mail. Art B therefore wrote many checks for amounts slightly less than $10,000 so that the checks would be pro- cessed by mail and would take several days or even weeks to clear. Art B was allegedly able to do this because its bank, BSK, was pre- pared to certify checks written on accounts with zero balances, in return for a guarantee by the state savings bank, PKO-BP. An esti- mated $200 million of fraudulently obtained funds were taken out of the country. When the scheme was exposed, criminal charges were filed against officials of the National Bank, PKO-BP, and BSK. The Art B affair had serious ramifications for Poland's banking system. First, it resulted in an extension of the National Bank's float by as much as 7 percent of narrow money, with a corresponding increase of the measured money supply. Second, the National Bank of Poland changed the regulations pertaining to interbank clearings, ·requiring that all interbank clearings associated with check transac- tions be handled by telecommunication methods. This measure was designed to help reduce the float and to aid in monitoring interbank transactions. This episode illustrates the potential for abuse when the 5 • PAYMENT SYSTEM REFORM 103 regulatory structure is inadequate to discipline the extension of credit through the payment system. Policy Issues in Payment System Reform In designing payment systems for formerly centrally planned econ- omies, some important policy issues must be addressed. These per- tain to the allocation of risk among participants and the appropriate role of government in establishing and sustaining the system. It is important to address these issues and put the right set of arrange- ments in place from the start, to ensure the payment system's ability to withstand the strains that will inevitably result from an increasing volume of transactions under conditions of massive restructuring of the financial sector and of the economy as a whole. Allocation of Risk The operation of a payment system involves two important types of risk. One is liquidity risk-the risk that a participant, even though solvent, might be unable to make a timely transaction because of a lack of readily available means of payment. A second is credit risk-a risk that in the event of bankruptcy of one of the participants, other participants would be faced with losses. These risks may be of par- ticular importance to policymakers because they may become systemic-that is, they may spread throughout the system. For exam- ple, a default by one participant may lead to such large losses by other participants that they in tum may be unable to discharge their obliga- tions, resulting in a chain of failures (Humphrey, 1986). Associated with the issues of liquidity and credit risk is the notion of finality of settlement-that is, once a payment message is sent, it is certain that the payee will receive good funds that cannot be reversed, even if the payor subsequently becomes insolvent. Finality is generally a desirable characteristic of the payment system because it eliminates the risk faced by payees in the melee of the day's pay- ment operations. However, it comes at a price, since the risk associ- ated with default cannot be eliminated in the system; it can only be 'I shifted either to the central bank, the members of the clearinghouse, I or other, unsecured creditors of the defaulting party. Finality can also be achieved at the cost of delays in carrying out payments, for exam- ple, by retarding the processing of payment messages until the payor has good funds available to make a payment. This might entail forgo- ing some of the benefits of netting arrangements. 104 David Folkerts-Landau, Peter Garber, and Timothy D. Lane Role of Government Governments play a role in developing and regulating the payment system for several reasons. One relates to the behavior of the system in case of a financial crisis. If a bank is perceived as risky, other banks may refuse to engage in payment transactions with it for fear that the settlement will subsequently fail, leaving them highly exposed. A troubled bank may then find itself isolated from the payment system and be unable to continue to carry out transactions even if it is not actually insolvent. To avert this situation it may be desirable for either the members of the payment system as a whole or the government to share some of the credit risks. This is in large part the basis of the "lender of last resort" function of the central bank: to provide funds to financial institutions that are illiquid but not insolvent to prevent a liquidity crisis. It is also the basis of some central banks' provision of "daylight overdrafts" to permit payments to be processed without the need for each payment system participant to assess the credit- worthiness of other participants. There may also be moral hazard problems associated with the government assuming such a role, how- ever. There may be some benefit to having banks take account of the creditworthiness of their counterparties, since in some cases they may have information on this creditworthiness that is .not imme- diately available to the authorities. Moreover, the authorities may not be entitled to exclude a bank from the credit offered through the payment system unless they are convinced that the bank should immediately be closed; other banks, if their own money is at risk, may respond to available information in a more timely manner. A system in which the authorities extend credit through the payment system, by transferring risk from other banks to the government, . removes banks' incentive to monitor one another and to act on the information they obtain. A second aspect of moral hazard pertains to the troubled bank itself. A bank that becomes insolvent may be able to pay off a substantial portion of its liabilities using the credit provided through the payment system, and thus shift losses from the bank's other creditors onto the central bank. Such a shift, which amounts to an unintentional bailout of the failing bank's creditors, has the same adverse incentive effects, and budgetary consequences, as any bailout. These opposing concerns-systemic risk versus moral hazard- argue for the importance of making a policy decision about the appro- priate division of risk among the individual banks in the payment system and the government. 5 • PAYMENT SYSTEM REFORM 105 Another possible role of government in the payment system is in assessing banks' fitness to participate. As an extension of their gen- eral responsibility for regulating financial institutions, monetary authorities generally have a responsibility to scrutinize the accounts of the banks and protect against fraud and inordinate risk taking. In so doing, they typically have information about the soundness of particular banks that is unavailable to other banks that participate in the payment system. The authorities may therefore have a role in regulating banks' right to participate in interbank payments. The judicious use of the information available to the central bank may aid in preserving the integrity of the interbank payment system. Some Examples These principles can be illustrated by considering some examples of payment systems in which these risks are dealt with in different ways (see Folkerts-Limdau, 1991). · Fedwire One example is the U.S. Fedwire, which is used for making a large proportion of interbank transactions. In this system settlement is immediate and final. .If the payor has a positive balance with the Federal Reserve, its balanc;e is debited by the amount of the payment. Participants in Fedwire are allowed to run daylight overdrafts-that is, their balances with the Federal Reserve may be negative during the course of the day. At the end of the day, however, they are required to obtain funds to cover these overdrafts, either by carrying out transac- tions with market players to move funds from other banks, by bor- rowing from other banks through the federal funds market, or by obtaining Federal Reserve credit .through the discount window. ff, however, a participant turns out to be insolvent during. the course of the day, .the risk associated with the transactions that have already been carried out on Fedwire are borne by the Federal Reserve. The payees in these transactions do not suffer any loss. CHIPS An alternative method of risk allocation is the Clearinghouse Inter- ·bank Payment System (CHIPS), a private mechanism for large- volume dollar transactions operated by the New York Clearinghouse. CHIPS transfers are primarily related to international transactions. In 106 David Folkerts-Landau, Peter Garber, and Timothy D. Lane this system, the participants' positions are netted continually through the day, and at the end of the day net obligations are settled through Fedwire transfers. If some participants are not able to meet their obligations, the participants in the CHIPS system share the losses according to a formal loss-sharing agreement backed by collateral. Of course, in the event of a large failure to settle, this amount may provide CHIPS insufficient resources to settle, so its promised "set- tlement finality'' is not foolproof. SIC The Swiss Interbank Payment (SIC) system provides another exam- ple of how risk associated with interbank settlements can be allocated (Vital and Mengle, 1988). In the Swiss system there are no daylight overdrafts and no settling arrangements. Instead, a queuing system effects payments only when the payor has good funds available to transfer in settlement. The advantage of the Swiss system is that it ensures finality of settlement without requiring that any risk be borne either by the central bank or by the clearinghouse members at large. Its main drawback is the possibility of payments bottlenecks or even gridlock. In such a situation, gross payments in the system may be blocked entirely, even though net payments for the day for each bank are small relative to available reserves. This danger is particularly important if the payments being settled through the system are large. Discipline Versus Speed of Payments These various solutions to the wholesale payments operation underscore the trade-off between the allocation of risk in the payment system, which affects discipline, and the system's efficiency in effect- ing payments; this tension always constrains the design of a payment system. Systems such as the Swiss system that carry out payments only when the payor has good funds available imply strict discipline-as they reduce the credit risk associated with a payment system-but are susceptible to occasional bottlenecks that disrupt the smooth flow of payments. Systems like Fedwire and CHIPS reduce the risk of bottlenecks by shifting some of the credit risk of the system onto the central bank or the collective members of the payment sys- tem, respectively, but this entails moral hazard problems. If the credit risk associated with the payment system is borne by the central bank, this may adversely affect participants' incentives to monitor their exposures to credit risks associated with other participants. In the Fedwire system, the Federal Reserve has attempted to reduce the risk 5 • PAYMENT SYSTEM REFORM 107 borne by the central bank and the attendant moral hazard problems by placing limits on members' daylight overdrafts. But these limits in turn increase the danger that the system might be gridlocked under some circumstances. Current Situation in Central and Eastern Europe Considerations concerning the allocation of risk among the various participants in the payment system are only beginning to be of practi- cal relevance in Central and East European countries. In these coun- tries, the state-owned banks often have little sensitivity to risk considerations-in some cases because they are already insolvent owing to the legacy of bad loans on their books. Enterprises with soft budget constraints, which continue to exist, know that losses will be underwritten either by subsidies or by easy credit from the banking system. Other enterprises are therefore willing to extend credit to them or to allow them to accumulate arrears. In Central and Eastern Europe, few bankruptcies have occurred; in particular, few bank fail- ures have occurred, despite the apparent insolvency of many of the major state banks in several of the countries. It is widely expected that at some stage the commercial banks will be recapitalized, and this may make market participants less concerned about the creditworthi- ness of their counterparties than they would otherwise be. However, as market-oriented reforms progress in these countries, it is expected that budget constraints will harden. The banks are to be made independent joint-stock companies, and in many cases, plans for privatization of the banks are under way. Several of the reforming governments in Central and East European countries have declared the intention of establishing enterprise financial discipline. In a reformed environment, banks and other financial market participants would have to take account of counterparty creditworthiness. In sum, although the allocation of settlement risk in payments is not yet a major issue in the payment systems of Central and Eastern Europe, it will· grow in importance as the other reforms of the financial system progress. The enormous volume of transactions on the western large-scale interbank payment systems is accounted for largely by the impor- tance of money market and foreign exchange transactions. Since such large-scale securities and foreign exchange transactions are not yet of practical relevance iil' Central and Eastern Europe, the volume of interbank payments will be much smaller in proportion to the volume of banking system assets and liabilities than in the large western economies. When money markets eventually develop, the large vol- I I 108 David Folkerts-Landau, Peter Garber, and Timothy D. Lane ume of transactions among dealers and large banks that characterize an advanced system of financial markets will emerge. Likewise, for- eign exchange trading, which in most Central and· East European countries has typically been the province of the central bank or of the specialized foreign exchange bank, is likely to become an area in which many financial institutions play an active role. Payment system design for the Central and East European countries should provide for the risk associated with the volume of transactions likely to emerge as other financial sector reforms take effect and as domestic financial and foreign exchange markets develop. It is important to establish a payment system that can deal adequately with the needs that ongoing financial system development will place on the inter- bank payment mechanism. Reform Plans in Central and Eastern Europe Reform of interbank payment systems has begun in several Central and East European countries. In many cases a priority is to upgrade the actual facilities for electronic transfer of funds. In some cases, this involves the establishment of completely new facilities. For instance, in Poland, a telex transmittal service for large-value payments was introduced in late 1990; then, in 1992, the National Bank of Poland wire network was developed, providing continuous settlement for interbank and other transactions. In the former Czechoslovakia, a fully computeriz~d real-time clearing network began operations in early 1992. A system for large-value payments on the books of the National Bank of Romania was also introduced in the same year. Transitional improvements can also be made with the existing tech- nology, pending the introduction of new systems. These improve- ments include steps as mundane as requiring banks to use banking mail rather than regular mail service to transport paper documents and organizing efficient local physical exchanges of paper checks and other payment documents. Another important step is to link more banks with existing systems; for instance, a priority in Bulgaria was to link all the banks with the automatic payment system. Such upgrad- ing requires both new hardware and the establishment of standards for the transmission of payments information, whether by paper or electronic means. Clearinghouses with netting schemes to expedite clearing of trans- actions have also been organized. Clearing arrangements are often established on a regional basis; for instance, in Bulgaria, three regional clearing centers in addition to the one in. Sofia were estab- 5 • PAYMENT SYSTEM REFORM 109 lished. Such arrangements are often considered the responsibility of the commercial banks themselves. For instance, in Hungary, the new clearing and settlement system that began operations in mid-1992 is under the auspices of the Clearing, Settlements, and Transactions Company. In Poland, the task of establishing clearinghouses has been assigned to the Polish Payments Association, of which the commer- cial banks are members. Although clearinghouses may not need government involvement in their establishment, they do require a clear legal and regulatory framework governing payments. Some components of this structure must include a clear definition of the rights, obligations, and liabilities of all parties in the payment system, a requirement that banks act promptly on payment instructions received, and a clear definition of the rights of consumers in the system. An appropriate legal structure is necessary to reduce uncertainty regarding the timing and finality of payments. Several countries have made a priority of reducing the central bank's involvement from its pervasive role under the monobank sys- tem. The central banks typically assume commercial banking risks. Also, they are involved in peripheral activities. For example, the national banks of several countries provide data processing facilities for the commercial banks, and only relatively recently did the National Bank of Hungary divest itself of customer account information. The reforms of the payment system carried out thus far have often been successful in speeding up settlements, although in some cases the potential gains have not been realized. For example, in the Czech and Slovak Republics, despite a system that in principle allows clear- ing and settlement to take place in one day, in practice banks often drag their feet, leading to delays that may still amount to many days or even weeks. Similar delays have· been noted in other countries despite improvements in technology. The central bank refinance system needs to be reformed so that it can perform the function of lender of last resort-underpinning the payment system by providing credit to solvent commercial banks to enable them to deal with temporary shortfalls in liquidity (Goodhart, 1987). The legacy of the central planning system has typically been a patchwork of facilities for specific purposes, often at preferential rates. Priorities in this area are therefore to simplify the system, removing the preferential element and confining the role of central bank credit to very short-term (within-day or overnight) liquidity needs. One way of opening up refinancing to market forces, as well as fostering the development of money markets, is to establish a 110 David Folkerts-Landau, Peter Garber, and Timothy D. Lane market for central bank repurchase agreements (repos), whereby the central bank purchases and agrees to resell qualified liquid assets (government and national bank securities, bills of exchange, etc.) at a specified price; a repo market was established in Poland in April 1991. However, if, as in Central and East European countries the money markets are not highly developed, it may only be possible to establish sufficiently deep repo markets for a limited number of maturities-as, for example, in Poland where National Bank of Poland bills were offered for one month's maturity and repos on these bills for two weeks; in this case, the authorities may choose to supplement the repurchase facilities with other (non-market-based) credit facilities, perhaps by providing overnight credit to banks and other financial agents. Conclusion Reform of the wholesale payment system is an integral part of reform in Central and East European countries. The operation of an interbank payment system was not important under the system of central planning. The monobank system obviated the need for a large volume of interbank transactions; other aspects of the system reduced the urgency of ensuring swift and predictable settlements; and the official guarantee of bank solvency rendered the risk alloca- tion issues irrelevant. The breakup of the monobanks, together with reforms designed to increase the autonomy of the banking system and to "harden budget constraints," have made the design of an efficient system for interbank settlements increasingly relevant. Such a system is crucial because of the increasing importance of risk con- siderations and the lack of other mechanisms for controlling it, the influence of the banking structure on the need for interbank lending, and the anticipated development of money and eventually securities markets. In addition to its importance to the banking system, an efficient wholesale payment system is an essential condition for market-based implementation of monetary policy. It is a necessary condition for the development of an active and liquid money market in which open market operations might be conducted. An efficient payment system also reduces the noise affecting the relationship between monetary targets and instruments, both by reducing the size and variability of central bank float and by permitting banks to engage in active liquid- ity management and thereby reduce their need to hold large and volatile excess reserves. 5 • PAYMENT SYSTEM REFORM 111 Payment system reform is not only essential but also includes some key policy issues. These issues are intimately related to the need to establish both trust and discipline in the system-a need that is reflected in the trade-off between achieving final settlement promptly and avoiding the moral hazard problems that arise when finality is guaranteed by the authorities. These policy issues are best addressed before new payment facilities and arrangements are established: it is best to get the right system in place from the start, anticipating the needs and strains that financial market development will place on the payment system. References Bank for International Settlements, Report on Netting Schemes (Basle: Bank for International Settlements, 1989). Calvo, Guillermo A., and Fabrizio Coricelli, "The Stagflationary Effects of Stabilization Programs in Reforming Socialist Countries: Enterprise-Side and Household-Side Factors," World Bank Economic Review, Vol. 6 Ganuary 1992), pp. 71-90. Dooley, Michael P., and Peter Isard, "Establishing Incentive Structures and Planning Agencies that Support Market-Oriented Transformations," IMF Working Paper 91/113 (Washington: International Monetary Fund, 1991). Flannery, M.J., "Payments System Risk and Public Policy," in Restructuring Banking and Financial Services in America, ed. by William S. Haraf and Rose Marie Kushmeider (Washington: American Enterprise Institute, 1988). Folkerts-Landau, David, "Systemic Financial Risk in Payment Systems," in Determinants and Systemic Consequences of International Capital Flows, Occa- sional Paper 77 (Washington: International Monetary Fund, 1991). Goodhart, Charles A.E., "Why Do Banks Need a Central Bank?" Oxford Economic Papers, Vol. 39 (March 1987), pp. 75-89. Humphrey, David B., "Payments Finality and Risk of Settlement Failure," in Technology and the Regulation of Financial Markets: Securities, Futures, and Banking, ed. by Anthony Saunders and Lawrence J. White (Lexington, Massachusetts: Lexington Books, 1986). Khan, Mohsin S., and V. Sundararajan, ''Financial Sector Reforms and Mon- etary Policy," IMF Working Paper 91/127 (Washington: International Mon- etary Fund, 1991). Kornai, Janos, Economics of Shortage (Amsterdam: North-Holland, 1980). Lane, Timothy D., "Inflation Stabilization and Economic Transformation in Poland: The First Year," in Carnegie-Rochester Conference Series on Public Policy, ed. by Allan S. Meltzer and Charles Plosser, Vol. 36 Guly 1991), pp. 105-56. - - , "Market Discipline," Staff Papers, International Monetary Fund, Vol. 40 (March 1993), pp. 53-88. - - , "Financial Sector Reforms in Formerly Centrally Planned Economies: Banks, Securities, and Payments," in Government and Markets, ed. by Hans 112 David Folkerts-Landau, Peter Garber, and Timothy D. Lane J. Blommestein and Bernard Steunenberg (Boston: Kluwer, forthcoming, 1994). Summers, Bruce J., "Clearing and Payment Systems: The Role of the Central Bank," Federal Reseroe Bulletin, Vol. 77(February1991), pp. 81-91. Tyson, Laura D' Andrea, "Enterprise Demand for Money and Illiquidity Crises in Yugoslavia," European Economic Review, Vol. 12 (February 1979), pp. 53-71. Vital, Christian, and David L. Mengle, "SIC: Switzerland's New Electronic Interbank Payment System," Federal Reseroe Bank of Richmond Economic Review, Vol. 74(November/December1988), pp. 12-27. 6 The Russian Payment System BruceJ. Summers1 Russia has embarked on a difficult transition from a monopolized command economy to a market economy. A necessary condition for a successful transition to an efficient market economy is the develop- ment of banking and financial markets. A crucial aspect of the devel- opment of Russia's domestic banking and financial markets is the payment system, which is used by enterprises and individuals to discharge obligations incurred in a market economy. This paper describes some of the key concepts that underlie the operation of payment systems in market economies and applies these concepts to Russia's transition to a market system. Attention is given to the effects of payment operations, especially central bank payment operations, on the public's balance sheet. The respective roles of the private and public sectors in payment system development and the importance of marketplace competition in determining payment ser- vices are discussed. Special attention is given to the need for a large- ruble transfer system. Although the primary focus of the paper is the development of Russia's domestic payment system, attention is also given to the proposed new Interstate Bank, which is initially being designed as a multilateral clearinghouse for central banks to facilitate settlement of cross-border payments in the Commonwealth of Inde- pendent States. There is no one pre-existing payment system model that tan be prescribed for Russia. Many variables, some of which are unique and which involve local customs, public preferences, and legal norms, lThis paper is based on an article published in the March 1993 issue of the Russian journal Money and Credit and a paper given at the International Banking Congress in St. Petersburg in April 1993. The author acknowledges many discussions with Russian commercial and central bankers leading to the development of the ideas expressed here and to helpful comments received from Thomas Simpson and Lewis Alexander of the Board of Governors of the Federal Reserve System. 113 114 BruceJ . .Summers must motivate the development of each country's payment system. Accordingly, this paper does not attempt to prescribe a particular model of the payment system for Russia. Rather, it attempts to illus- trate the practical significance of key concepts of a payment system as they might be applied in Russia. The concepts described here, how- ever, may be considered to be "universal," as they have been devel- oped over the past several years by bankers from the developed economies of Europe, North America, and Asia. Accordingly, they are building blocks for the payment system in any developed, or developing, economy. Key Concepts of a Payment System and Their Application The payment system is the apparatus through which obligations resulting from economic activity are discharged by transfers of mone- tary value. Obligations can be discharged through the-payment sys- tem using cash (ruble currency) or ruble deposits held in banks. For payments made using bank deposits, it is necessary to use some form of payment instrument-such as a paper or electronic credit or debit payment-to move funds. For a debit payment, such as a check, the receiver of money (the payee) initiates an instruction to the bank holding the deposit of the sender of money (the payor), ordering the paying bank to pay. This is done by presenting a ch_eck, which must·be honored by the payor, who is the customer of the paying bank, once the check is authenti- cated. 2 For a credit payment, such as a payment order, the party making the payment initiates an instruction to his bank to pay money to the intended receiver by initiating a payment order. Obviously, the owner of the deposit held at the paying bank, which is used to make payments, has more control over the funds when a credit payment, such as a payment order, is used. When using deposit money in banks to make payment, the process for discharging an obligation can be divided conceptually into two parts. The first part is clearing, the process by which payment infor- mation is conveyed between the payor and payee and between the banks holding the accounts of the two parties to the transaction. Once a payment is initiated, clearing should take place quickly and reliably 2 This basic process would also apply to a payment demand order, the instrument that was commonly used in Russia for interenterprise payments until the summer of 1992. Payment demand orders are discussed below. 6 •THE RUSSIAN PAYMENT SYSTEM 115 in .order to maximize efficiency and minimize financial risk as funds are being transferred. Because they provide account services to the public, commercial banks play an important role as intermediaries in the clearing process. It is not essential, however, that banks actually perform all of the physical processing associated with the clearing of payments. This function can be equally well performed, and indeed frequently is performed, by data processing service bureaus. The second part of the process for discharging an obligation using deposit money in banks is settlement, in which the actual transfer of monetary value associated with the payment is made. Banks, of course, play the key role in settlement because it is through the accounts held on their books that the transfer of monetary value occurs. Commercial banks settle for the nonbank public and some- times for other banks with which they have correspondent account relationships. The central bank, where all commercial banks hold accounts, is often used by commercial banks as the settlement entity for interbank transfers. A key settlement concept is that of finality. A final payment is an irrevocable and unconditional transfer that discharges the obligation to make the payment. Payments made by the irrevocable transfer of balances between accounts that commercial banks hold with the cen- tral bank are said to be made in central bank money. Because balances held with the central bank are free of credit risk (because the central bank by definition cannot fail), use of balances held with the central bank is the surest form of payment. Settlement of payments occurs on either a gross or a net basis. In gross settlement, monetary value is transferred for the total amount of each individual payment. In net settlement, the banks exchanging payments offset the amounts they are due to pay to and receive from each other, and a single debit (net debtor) or credit (net creditor) position is calculated for each bank, across all the payments subject to the netting. The banks participating in the netting will transfer only the monetary value necessary to settle the net obligations, which is much less than the total of all the underlying, gross obligations. 3 The offsetting of payable and receivable amounts can occur between two parties, called bilateral netting, or among many parties, called multi- lateral netting. Multilateral netting is the basis for the settlements that are resulting from transactions on a number of financial exchanges 3for examples of the effects of netting on interbank obligations, see George R. Juncker, Bruce J. Summers, and Florence M. Young, "A Primer on the Settlement of Payments in the United States,".federal Reserve Bulletin, Vol. 77 (November 1991), pp. 847-58. 116 BruceJ. Summers and clearinghouses in Russia today. Accordingly, an understanding of netting and the benefits and risks it entails is a very important public policy issue in Russia. Netting has a number of benefits, including economizing on the balances that need to be maintained to settle payment flows. At the same time, multilateral netting, in particular, results in a mutualiza- tion of risk among the participants in the netting arrangement. The failure of one net debtor bank to meet its settlement obligation arising from the multilateral netting can lead to the failure of the entire settle- ment, and consequently a failure to settle all of the gross payments included in the netting calculation. The mutualization of risk result- ing from multilateral netting therefore has special systemic risk impli- cations, which are described below. The settlement process gives rise to certain risks that must be man- aged by the parties to the payment transaction. These risks include liquidity risk and credit risk. Liquidity risk is the risk that the counter- party in a transaction who owes funds will not meet his obligation on time, thus reducing the liquidity of the recipient of the payment who may, in turn, have planned to use the funds to make further pay- ments. Credit risk is the risk that the counterparty in a transaction who owes funds will not meet his payment obligation because of insolvency, leading to an actual loss of funds by the intended recip- ient of the payment. Of primary interest from a public policy standpoint is a third type of risk-systemic risk~which includes the possibility that one bank's inability to settle its payment obligations will cause other banks to be unable to meet their obligations, either to their customers or to other banks. In the case of mutualized risk, especially that resulting from 11 multilateral netting arrangements, systemic risk involves domino" or "knock-on" effects, with adverse consequences for the entire financial system and possibly the economy at large. Multilateral net- ting of payments must be accompanied by sound risk control pro- cedures that help control systemic risk. Such risk control procedures should be embodied in legally binding contracts among the partici- pants in the netting arrangement. 4 Clearing and settling payments can be complex, especially in a large country such as Russia, where there are many banks distributed over a wide geographic area. An efficient payment system therefore 4The methods for controlling risk in netting arrangements are laid out in Bank for International Settlements, Report of the Committee on Interbank Netting Schemes of the Central Banks of the Group of Ten Countries (Basie: Bank for International Settlements, November 1990). 6 • THE RUSSIAN PAYMENT SYSTEM 117 requires a high degree of cooperation and coordination among banks, which usually occurs through a clearinghouse. A clearinghouse is a legal entity, owned and controlled jointly by its member banks, whose primary function is to coordinate the exchange and settlement of payments among its members. The activities of the clearinghouse might be limited simply to coordinating the physical exchange of payments among banks, for example, by organizing efficient and speedy transportation of payment documents. Clearinghouses may also, however, provide processing services to their members, in which they may operate fairly large data processing and data commu- nications systems to process payment instructions. Clearinghouses sometimes serve as settlement agents, acting on behalf of their mem- bers to calculate net settlement positions for an exchange of payment . orders. Special payment arrangements may be organized to support settle- ment resulting from trading in securities, foreign exchange, or com- modities, to ensure that there is a value-for-value transfer at the designated time of settlement. The simultaneous transfer of value, say, money for securities, minimizes the risk to the parties in the transaction that they will give something up without receiving some- thing in return. Payment versus delivery refers to a clearing and settlement mechanism that synchronizes delivery of the financial or physical asset underlying the contract with the payment for the asset. Because buyers and sellers in emerging markets will demand a reli- able and safe settlement mechanism as a condition of their participa- tion in these markets, payment versus delivery systems are important even in the early stages of development of Russia's payment system. Indeed, settlement for purchases of government securities in the newly introduced public auctions conducted through the Moscow International Foreign Currency Exchange is based on the concept of payment versus delivery. Balance Sheet Effects of Payment Operations The timing of balance sheet credits and debits resulting from pay- ments can have an important effect on the amount of liquidity sup- plied to the economy by the banking system. In the vernacular of banking, the balance sheet effects of differences in the timing of credits and debits from payments is referred to as payment system float. If credits are systematically made before offsetting debits, the bank- ing system will be providing liquidity to the economy, essentially in. 118 Bruce J. Summers the form of loans made through the payment system. Conversely, if debits are systematically made before offsetting credits, then liquidity will be withdrawn· from the economy. In general, an efficient pay- ment system should synchronize, on average, the timing of credits and debits arising from payments, thereby having a neutral overall effect on liquidity. Because central bank accounting practices for pay- ments affect the liquidity of the entire commercial banking system, and thereby the nonbank economy, these practices are treated here in detail. When the central bank operates part of the payment system and clears payments between commercial banks, as does the Central Bank of Russia, its balance sheet can reflect float vis-a-vis the commercial banking system. If the central bank credits the account of the bank receiving funds before it debits the account of the bank paying funds, debit float is created and the central bank increases the reserves of the commercial banking system, thereby increasing banks' lending capacity. Conversely, if the central bank debits the account of the bank paying funds before it credits the account of the bank receiving funds, credit float is created and the central bank decreases the reserves of the commercial banking system, thereby reducing banks' lending capacity. Similarly, if commercial banks debiting and credit- ing their customers' accounts do not make both settlement entries for a payment simultaneously, the balance sheets of commercial banks can reflect float vis-a-vis their customers. The predominant payment instrument used in Russia today is the payment order. Under current procedures, the Central Bank of Russia debits the account of a commercial bank originating the payment order (note that the commercial bank has already debited its cus- tomer) upon receipt of the payment order. Some payment orders may take days or even weeks to reach the central bank office holding the account of the commercial bank receiving the payment order on behalf of its customer, who ultimately receives the payment, and the offsetting credit is not made until that time. Consequently, the Rus- sian banking system generates a large amount of credit float as a result of current accounting practices combined with inefficiencies that result in long clearing times for payment instruments. These accounting practices begin with the Central Bank of Russia and are carried forward by commercial banks. The result is a substan- tial reduction in commercial bank reserves and thereby a withdrawal of liquidity or working capital from the Russian economy, simply as a result of payment system operations. Moreover, because clearing times are quite variable, changing partly in response to random trans- portation delays, a good deal of uncertainty is introduced to the com- 6 • THE RUSSIAN PAYMENT SYSTEM 119 mercial bank reserve management process. This uncertainty compli- cates Russian monetary policy, as it makes it more difficult for the Central Bank of Russia to estimate the total amount of reserves it supplies to, and that are demanded by, commercial banks. The drain of working capital from the Russian economy resulting from systematic debiting of payments earlier than crediting, which is a direct result of the Central Bank of Russia's policies, can be amelio- rated by adopting funds availability schedules for payments. Funds availability schedules would be calculated based on detailed analyses of clearing patterns between Central Bank of Russia and commercial bank offices throughout the country, resulting in estimated clearing times between pairs of offices. For any particular pair of offices, the debit to the account of the bank originating a payment would be deferred by the amount of time it is estimated to take to deliver the payment to the central bank office that credits the payment to the account of the commercial bank receiving the payment. On average, credits and debits would offset, and float would be reduced to near zero, leading to an increase in working capital for the Russian economy. 5 Role of the Public and Private Sectors Orderly development of Russia's payment system will benefit from a clear delineation of the roles of the private and public sectors. In this regard, the payment needs of the nonbank public will ultimately best be met by private organizations, such as commercial banks. Payment services are an essential component of the deposit and money man- agement services that banks offer to their customers, including both enterprises and individuals. As in other markets, competition in the market for payment services will ensure that the public has access to the best available services produced as efficiently as possible. More- over, a variety of payment services will be offered from which the public can choose. Public policy responsibility for the payment system usually rests with central banks. Central banks are naturally interested in the pay- ment system because it is a key component of the operation of finan- cial markets and has important implications for the trading efficiency of the real economy. Moreover, the payment system is one of the first SThis program was organized by the U.S. Federal Reserve with the cooperation of several other central banks, and sponsored by the International Monetary Fund and the Organization for Economic Cooperation and Development. 120 Bruce J. Summers places where financial stress will manifest itself as firms in financial difficulty fail to meet their payment obligations. Of particular concern to central banks are clearing and settlement in financial markets where trading results in large payment obligations, such as the secu- rities, commodity, interbank funds, and foreign exchange markets. It is in markets such as these that netting is often employed and that systemic risk is greatest. Indeed, multilateral netting is being widely employed by the regional financial exchanges and clearinghouses springing up in many regions throughout Russia. The central bank will also participate in the payment system as a provider of interbank payment services. The stage of development of a nation's payment system will influence the extent to which the central bank needs to play a role in operating the interbank payment system. In the early stages of a market-based payment system, which is the situation in Russia today, it is necessary that the Central Bank of Russia play an active operating role. This is because the central bank has a functional network of offices and processing facilities in place that can tie the national economy together. The Central Bank of Russia also holds accounts for all commercial banks, which can be used for interbank settlement.6 In this manner, the Central Bank of Russia performs some of the functions of clearinghouses. An active role by central banks in the operation of the payment system should be undertaken in a manner that does not restrict potential competition and that allows for the possibility of turning over operations to the private sector. Along these lines, there are important benefits from pricing the payment services that central banks provide to the banking industry. Prices for payment services should be set to recover at least the full cost of production of these services. Competition for interbank payment services will then be encouraged, or at least not discouraged, and efficiency and innova- tion will be stimulated. Moreover, because the users of services will have to pay fees based on the cost of production, these services will be used more wisely and will not be wasted. Overuse of a "free good" is a natural consequence of the subsidy provided by offering services without charging a fee. 6 As is the pattern in most former command economies, every branch of every bank holds an account with the central bank. An early priority in Russia is to introduce a streamlined accounting relationship between the Central Bank and ·the commercial banks, whereby the commercial banks assume greater responsibility for reserves and liquidity management and consolidate their account relationships with the Central Bank of Russia. 6 • THE RUSSIAN PAYMENT SYSTEM 121 The Central Bank of Russia has recently formed a steering commit- tee on the payment system with representatives pf both the Central Bank and the commercial banking system. Advisors to the Central Bank from official institutions, such as the International Monetary Fund, the World Bank, and cooperating central banks will participate in the work of the steering committee. The primary role of the steer- ing committee will be to evaluate major reform initiatives in the Rus- sian payment system to encourage and coordinate worthwhile initia- tives. Formation of this steering committee, which began its work officially in the summer of 1993, is a potentially major positive devel- opment that will help rationalize the collective efforts of Russia's public and private sectors in achieving reform of the payment sysf,'m. As the transition to a market economy progresses in Russia, the operation of the interbank payment system might be organized by . commercial banks themselves, through clearinghouses. Oearing- houses are a very important part of a national payment system and shouid be encouraged to the extent ·that they adhere to prudential standards of operation. As part of their coordinating role, clearing- houses can develop, propagate, and enforce rules and technical stan- dards for handling payments. A legitimate concern of the central bank, however, is that private consortia of banks not be allowed to turn clearinghouses into exclusive clubs that unnecessarily restrict participa- tion by potential members that meet financial and operational entrance standards. In short, it is not desirable to allow the development of de facto monopolies under the guise of clearinghouses. The central bank also has a clear supervisory role in the payment system, including supervision of clearinghouses, because the stability of the financial system depends, in part, on the integrity of the pay- ment system. One of the most important central bank oversight func- tions is to ensure that private participants employ proper measures to protect themselves against payment system risks, especially the risks that arise through participation in exchanges and clearinghouses that use multilateral netting. Large-Ruble Transfer Systems With respect to wholesale payments, commonly referred to as large-value payments, the heart of the banking system in an advanced market economy is its large-value transfer system. The large-value transfer system should provide same-day settlement with finality. Such a system, if properly designed, can increase payment system efficiency and greatly reduce payment system risk. 122 Bruce J. Summers A same-day settlement system with finality for ruble payments will epcourage the development of money markets and contribute to the Central Bank of Russia's ability to perform its monetary control func- tion. By allowing large blocks of money to be transferred reliably and safely on the same day in response to the demand for and supply of liquid assets, liquidity will be readily transferred from surplus to defi- cit enterprises. In this manner, trading of short-term, liquid funds, probably centered in the interbank market, will develop to help ease the working capital shortages that enterprises face. Markets for short-term funds exist in Russia today in rudimentary form on some organized exchanges but especially in the over-the- counter market. Limitations on interbank settlement, however, have stunted the development of these markets. For example, minimum maturities for interbank funds and large corporate deposits are mea- sured in weeks, because it may take several days or more to settle a transaction using traditional payment methods when the counterpar- ties are located in the same city. This settlement delay is much larger, and the timing of settlement more uncertain, when the counterparties are located in different regions. With a same-day settlement system, participants in the interbank funds and corporate deposit markets will be able to shorten the time gap between trading and settlement, providing a foundation for the development of new types of money market instruments that require speedier settlement. Final same-day settlement will also contribute to the development of a securities market, including the market for gov- ernment securities, by providing an assured method of payment for securities transfers. An active interbank funds market in Russia will be the primary vehicle used by banks to manage their reserves held with the Central Bank of Russia. Equilibrium between the supply of and demand for bank reserves will be governed by the price of the reserves that banks lend to and buy from each other. This price will be a short-term, probably overnight, interest rate set in the market for bank reserves. This overnight rate on interbank funds will be an important monetary policy indicator to the Central Bank of Russia, revealing how loose or tight the market is for reserves. Combined with the development of a government securities market, an overnight interbank funds market will greatly enhance the effectiveness of new monetary policy tools of the Central Bank of Russia. By buying (selling) government securi- ties, the Central Bank of Russia will be able to add (withdraw) reserves to the banking system, and the effects of its actions will be visible through changes in the overnight rate in the market for inter- bank funds, which, in turn, will influence other interest rates. The 6 • THE RUSSIAN PAYMENT SYSTEM 123 market for interbank reserves will ensure that the overall supply of reserves is allocated to the banks needing reserves, and thus the effects of purchases and sales of securities will be more predictable. The development of the interbank funds and government securities markets, however, is possible only if a large-ruble transfer system is introduced. The large-ruble transfer system should be operated by the Central Bank of Russia. 7 It should be a gross settlement system and operate in .what computer experts call "real time. " 8 Because settlement is gross, that is, payment-by-payment, counterparty credit risk can be assessed directly and final settlement for large numbers of underlying payments need not be delaye~ owing to concerns about the ability of one institution to meet its obligation, which is a risk in netting schemes. A central bank gross settlement system operating in real time mini- mizes the time delay between the initiation of a payment and its final settlement. Of course, the Central Bank of Russia would take on a . large burden in operating such a system, as it would guarantee the finality of all payments it agrees to settle. The Central Bank of Russia must be exceedingly careful, therefore, to define and build the opera- tional controls that allow it to manage its credit risk vis-a-vis the users of the large-ruble transfer system. Development of the Russian Payment System Payment system development can be explained as consisting of four stages. These stages, which represent different ways to carry out a transaction or market exchange, are (1) barter; (2) ·cash (physical money); (3) deposit money; and (4) deposit money combined with a credit system. Russia is somewhere between stages two and three- between cash and deposit money. There are, however, clear signs of falling back to stage one-barter. Barter is especially evident in trans- actions involving firms in different states of the former Soviet Union. Settlement for these cross-border transactions has become more diffi- cult as the ruble zone dissolves and the new countries adopt their own currencies, which are nonconvertible. 7 See Bruce J. Summers, "Clearing and Payment Systems: The Role of the Central Bank," Federal Reseroe Bulletin, Vol. 77 (February 1991), pp. 1-91. 8 Recent advances in computing and communications technology have significantly reduced the cost barriers to the establishment of real-time computer systems. The skills necessary to apply these techniques in the Russian banking system are readily available in Russia today. · 124 BruceJ. Summers The performance of any payment system that is based upon a mon- etary unit, whether that unit is in the form of cash or deposit money, depends critically on the public's acceptance of the monetary unit. In periods of high inflation, the value the public attaches to money diminishes, to the point where money loses its usefulness as a store of value and medium of exchange. In these circumstances, public preferences would shift to a more primitive system, based on barter, or a system based on use of foreign currencies. High inflation under- mines the public's confidence in a nation's money and leads to use of barter or foreign currency. An efficient payment system was not important in Russia under state socialism and the old monobank system. Production and the physical flow of goods between enterprises were governed by the state plan. The financial component of the physical flow was simply a record-keeping procedure determined by the product of planned physical units times their respective administered prices. Within the parameters of the physical plan, credit was automatic and payments were assured through the Gosbank. Because of this, enterprises did not need to have a speedy payment system, nor was it necessary to assess the creditworthiness of other enterprises to which goods were sent or from which goods were received. The Russian payment system at the time of emergence from state socialism was technologically underdeveloped and did not have the institutions and institutional relationships that could respond to the needs of a market economy. In a market economy, the payment system must respond to complex economic relationships in which time is criti- cal. Moreover, the providers of payment services, especially commer- · cial banks, must be prepared to manage the credit risk that arises in connection with meeting the payment needs of their clients. Likewise, the central bank must be prepared to manage its credit risk vis-a-vis the commercial banks to which it provides settlement services. Three types of payment instruments are used in Russia today: cash, payment orders, and checks. The payment demand order, a debit payment instrument, was traditionally the most heavily used instrument for transferring funds among enterprises. Payment demand orders, however, were forbidden by the Central Bank of Russia beginning in July 1992, owing to the difficulty this instrument caused businesses in managing counterparty credit risk. The Central Bank of Russia, consistent with the prevailing view in market econ- omies, evidently determined that debit instruments are inherently more risky than credit instruments, and for this reason has forbidden their use, at least for large-ruble interenterprise payments. 6 • THE RUSSIAN PAYMENT SYSTEM 125 Almost all retail payments iri Russia are made using cash. Although cash has many virtues as a payment instrument, its vulnerability to theft and counterfeiting, unsuitability for making payments over long distances, and awkwardness for large-value purchases, such as con- sumer durables, are serious drawbacks. Accordingly, Russian con- sumers need a more efficient payment instrument to supplement their use of cash. Attempts have recently been made to encourage the use of checks in Russia. In 1992 particular emphasis was placed on the so-called Russia check, which was introduced in the form of a book that had a preauthorized ruble limit placed on each check and on the total num- ber of all checks in the book. The Russia check was offered to the public by the commercial banking-system but designed, and its intro- duction organized, by the Central Bank of Russia. These checks are prepaid and cannot be used for transactions over a certain value. The Russia check was designed to reduce bank overdrafts, which pose an especially great risk in Russia because of the long time it takes to collect a check. Long collection times have led to serious abuses of the check in Russia. In particular, counterfeiting has proved to be a serious prob- lem with the check, just as it can be a serious problem with cash. The Central Bank of Russia has responded to the rise in counterfeiting by placing severe restrictions on the use of the Russia check, including limitations restricting its use to local areas. Consequently, the Russia check has not succeeded in giving consumers and businesses an effective new payment vehicle. Successful introduction of checks will require adoption of careful verification methods by those who accept checks for payment, including individuals, enterprises, and banks. For checks to become useful, it is imperative that collection times be shortened so that opportunities to commit fraud are limited. Moreover, the law and its enforcement should be strengthened, if necessary, to deter counter- feiting. Efforts are now under way to pilot a new checking scheme that is based on a carefully constructed set of rules that clearly sets out the rights and responsibilities of the users of checks and the allocation of financial risks among the users of checks. In addition, a speedy collection system based on check truncation is being used in the pilot. This pilot, which involves the Central Bank of Russia and a group of regional commercial banks with electronic data connections to the Central Bank, could provide a breakthrough in efforts to introduce an efficient noncash form of payment for broad use in the economy. 126 Bruce J. Summers Interstate Bank The economy of the former Soviet Union was highly decentralized and determined, to a large extent, by fiat, not by competitive markets. This is reflected in the wide geographic dispersion of the component elements of the manufacturing and assembly process for goods, creat- ing a high degree of economic interdependence among regions of the country. These economic interdependencies remain even though the political structure has changed and several separate countries have emerged from the former Soviet Union. Although it is likely that these economic interdependencies will change over time in response to market forces, the current reality is that there are unusually high payment flows between and among the states of the former Soviet Union that reflect traditional economic patterns. The foregoing discussion of the domestic payment situation in Russia generally applies also to the other states of the former U.S.S.R., as these nations until recently all functioned under the same monobanking regime. Many of the payment patterns that have been described also apply to interstate payments within these states. Now, however, special difficulties have arisen about the timeliness and reliability of interstate payments. The interstate payment diffi- culties are attributable not only to the physical operation of the pay- ment apparatus, which needs improvement, but, in addition, to inef- ficiencies in interbank settlement, that is, the transfer of value among banks to achieve settlement for interstate payments. A discussion of interbank settlement for interstate payments must take into account two factors. First, the Russian Federation has a structural surplus in its trade with the other republics of the former Soviet Union. Accordingly, over the long run, trade positions must come into balance or settlement for interstate payments between Russia and the other republics must be financed by sources outside the interrepublican trade matrix. Second, many of the countries that have emerged from the former Soviet Union have left, or are in the process of leaving, the ruble zone and are well on their way to adopt- ing their own currencies. Ruble deposit money held with commercial banks located in these different countries no longer trades at parity. Accordingly, there is a de facto separation of most ruble currencies, which further complicates interbank settlement. In essence, payment and settlement for transactions between economic actors in the states of the former Sovient Union pose issues similar to those arising in connection with cross-border, multicurrency payment and settlement in other nations, including those with convertible currencies. An 6 • THE RUSSIAN PAYMENT SYSTEM 127 important difference, of course, is that these republics' currencies are not convertible. In January 1993, the heads of state of the majority of countries that are members of the Commonwealth of Independent States signed an agreement to form an Interstate Bank. At least initially, the primary function of the Interstate Bank will be to serve as a multilateral clear- ing and settlement organization for the central banks of the countries that are members. The monetary unit that will be used to settle pay- ments through the Interstate Bank will be the Russian ruble. The central banks of the countries that are members of the Interstate Bank will hold deposits with it denominated in Russian rubles. Besides credit obtained directly from the Central Bank of Russia, which is the central bank of issue for the settlement currency, these deposit bal- ances can be increased only by transfers among member countries (buying and selling of bank funds held on deposit at the Interstate Bank) or by purchasing Russian rubles in the foreign exchange market. The Interstate Bank holds considerable potential to facilitate the efficiency of interstate payments through multilateral netting. At the same time, the mutualization of risk that arises in connection with any multilateral netting arrangement must be carefully managed. Further, clear arrangements must be set up by which the currencies of the member countries in the Interstate Bank can be converted into Russian rubles in the market. The operation of the Interstate Bank will necessarily depend on efficient settlement facilities, that is, large-value transfer systems operated by the Central Bank of the Russian Federation and the cen- tral banks of the countries that are members of the Interstate Bank. The large-value transfer systems are needed for the settlement of foreign exchange deals involving the Russian ruble and other "soft" currencies in which trade is denominated and for which payment and settlement will ultimately occur through the Interstate Bank. As currently envisioned, the Interstate Bank will support settle- ment only for payments channeled through the clearing systems operated by the central banks of the member countries of the Com- monwealth of Independent States. In fact, however, "international" correspondent banking relationships are being established within the Commonwealth of Independent States, and in some cases these pri- vate arrangements account for a large share of cross-border pay- ments. A pattern that appears to be emerging is for trade taking place under official, or governmental, agreements to be settled through the central banking system with private trade being settled through the 128 ·Bruce J. Summers commercial banking systems. At some point, the institutional bene- fits of an organized multilateral clearing and settlement arrangement, such as that supported by the Interstate Bank, should be opened to the commercial banking system. Conclusions The development of the payment system is a necessary part of the development of Russia's banking and financial markets, including the interbank funds and government securities markets. Payment · system development is also necessary to support efficient trading in goods and services. Consequently, payment system development needs to be a high priority in Russia's transition to a market economy. Enhancing cross-border, multicurrency settlement involving the soft currencies of the states of the former Soviet Union through new, specialized institutions such as the Interstate Bank also warrants early attention. Russia's current payment system is still based primarily on cash, and it has shown signs of moving to barter and use of foreign curren- cies: Increasing the operational efficiency of the current, paper-based payment apparatus and adopting accounting methods that reduce the drain on working capital resulting from the operation of the pay- ment system are high priorities. Use of availability schedules and the formation of clearinghouses are straightforward ways to address these challenges. Finally, an electronic large-value transfer system based on real-time computer processing, operated by the Central Bank of Russia, will contribute substantially to the development of the markets for interbank funds and government securities and will enhance the Central Bank of Russia's ability to carry out monetary policy. · The methods for enhancing the Russian payment system described in this paper are well within the current technological and financial capabilities of the Russian banking system. A clear delineation of the roles of the private and public sectors will help stimulate these enhancements. Comment David B. Humphrey The two papers, "Payment System Reform in Formerly Centrally Planned Economies" and "The Russian Payment System," are both concerned with the need to improve the operation of, and reduce the risk on, large-value payment systems in formerly centrally planned economies. To note only the most important aspects, improvement of domestic large-value payments in these countries is needed for effi- cient enterprise exchange, safe interbank payments, development of a liquid money market, mobilization of domestic savings, and improved monetary control. · The first paper by Folkerts-Landau, Garber, and Lane provides an excellent discussion and summary of the many complex issues associ- ated with payment reform, the best l have seen in a single paper. The second paper by Summers focuses directly on the issue of payment reform in one country-Russia-and contains a rich discussion of the operational details of how large payments are actually made today in a formerly centrally planned economy. Overgeneralizing, it could be said that the first paper is essentially theoretical whereas the Sum- mers paper is essentially practical, although both range over the same broad topics associated with payment reform. Reform of large-value payment systems in formerly centrally plaru1ed economies involves a trade-off of "trust" (a willingness to extend credit) with "discipline" (the need to settle credit extensions in good funds). But trust creates moral hazard from credit extensions whereas discipline is associated with reducing systemic risk from a settlement failure. Both papers ask an important question: What is the appropriate division of payment risk among (1) individual banks on a payment network, (2) all banks together on the network, and (3) the govern- ment or the central bank? Although it explicitly poses this question and notes many of the issues fnvolved, the Folkerts-Landau paper does not provide an answer. And, although the Summers paper does provide ait. answer to the question, the logic is not spelled out. My task will be both to attempt to answer the question and to spell out the logic. In doing so, I shall note some specific areas where one or the other of the papers could usefully be clarified. Three Types of Payment Finality When large values are being transferred, it is absolutely essential that the parties to the transaction clearly understand when, and the 129 130 David B. Humphrey . conditions under which, the transaction is final or cannot be reversed. In practice, there are a number of points at which' a pay- ment may or may not be final once funds are sent and the receiver is notified on a large-value payment network. First, there is sender finality, where the sender cannot reverse the transaction once it has been made. All major large-value net or gross settlement networks have this type of payment finality. Second, there is settlement finality, which has been and still is an important, unre- solved, and contentious issue on a number of existing large-value net settlement networks in Europe. Settlement finality seeks a method to "guarantee" that the movement of settlement funds will not be reversed and that the settlement will not be unwound and recalcu- lated. Settlement finality can be guaranteed by the central banks, as is typical on a gross settlement network (such as Fedwire in the United States or the Swiss Interbank Payment System-SIC-in Switzerland) or by the posting of high-quality, liquid collateral that could be used to obtain funds necessary to cover the failure to settle by a participant on a net settlem~nt network (such as CHIPS in the United States). While many large-value networks have settlement finality, others do not. Last, there is receiver finality. Receiver finality exists when a receiv- ing bank cannot take back funds received that customers are allowed to use either before or after settlement. No major network has receiver finality, largely because receiving banks do not wish to give up their right to attach funds received for a customer in one account to cover possible overdrafts of that same customer in a different account or to compensate the bank for a loan default by the customer. ''Guidelines'' for Assigning Risk The question posed above deals w~th the assignment of the risk of, and hence responsibility for, settlement failure on either a net settle- ment or a gross settlement large-value payment network. In this regard, it is useful to outline some guidelines for risk assignment applied in the insurance industry and found in case law. In general, liability should be borne by the party in the best position to (1) absorb, spread, and/or insure against the cost or risk of settlement failure; (2) detect, control, and prevent settlement failures; or (3) provide good funds for the payments being sent, thereby ensuring settlement. The first guideline is, in effect, a "deep pockets" approach to risk assign- ment. It would be unacceptable on a payment network because it implies that the ability to pay among sending bank, receiving bank, or central bank determines the liability for a settlement failure. Because 5 and 6 • COMMENT 131 the party with the deep pockets may not.also be the party that creates the risk, inoral hazard is created. Such an approach to risk assign- ment therefore would increase the probability of a settlement failure, worsening the situation rather than improving it. The second guideline is more reasonable in that the party best able to intervene and prevent a settlement failure is the party to which the liability would be assigned. In practice, this party is most likely the receiving bank. The receiving bank is in a good position both to assess the likelihood that the sending bank may fail to settle and, if this likelihood is deemed to be strong, to intervene by not releasing to the customer funds received before settlement. If the sending bank fails to settle, the receiving bank thus need not be placed in the illiquid position of having already released funds to the customer and be required either to retrieve these funds immediately· or to find financ- ing elsewhere to fund a settlement shortfall. Although seemingly reasonable, this guideline has not been the one most followed on payment networks: it places liability for a settlement failure on the party that did not cause the failure and so, like the first guideline, creates moral hazard. The third guideline is the one typically applied on payment net- works because it can address the moral hazard problem. Sending banks are typically required to pay for their net debits by obtaining covering funds (on SIC and BOJ-NET in Japan) or pay for central bank credit extended to cover their net debit (on Fedwire in 1994). The exception is CHIPS, where receiving banks provide collateral to cover a settlement failure. Receiving banks on CHIPS have made a credit judgment to receive funds-up to a real-time enforced bilateral net credit limit-from each of the other participants on the network. In sum, sending banks have usually, but not always, been assigned the major responsibility for ''guaranteeing'' against a settlement fail- ure. On some other large-value networks, where senders or receivers do not yet play this role, the central bank-by design or default-is assigned the risk of settlement failure, creating moral hazard. Settlement Finality Versus Daylight Overdrafts On a net settlement system, payment debits and credits are made against a zero balance account and so daylight overdrafts are an inherent operational problem on those networks with end-of-day set-. tlement. If settlement is next day or next week, overnight overdrafts will exist as well. But even with daylight (or overnight) overdrafts, there are ways to ensure settlement finality. 132 David B. Humphrey On net settlement systems, there can be shared sender responsibil- ity for a settlement failure, as currently exists on CHIPS. Participant banks on CHIPS post high-quality, liquid collateral with the central bank based on a pro rata share of each bank's internally determined limit on intraday credit that it would be willing to extend to a sending bank. The total collateral posted is set so that it covers the largest net debit of any one participant. In addition, there is a "cap" or maxi- mum value established for each participant's net debit. This net debit cap is enforced on a real-time basis so that the collateral posted on CHIPS would always be sufficient to cover the failure to settle of any one participant. This point is unclear in the Folkerts-Landau paper, which states " ... in the event of a large failure to settle, [the posted collateral] ... may provide CHIPS insufficient resources to settle, so its promised 'settlement finality' is not foolproof." What the authors mean to say is that in the event of multiple failures to settle on the same day-a very unlikely event-the posted collateral may or may not be sufficient, depending on the net debits of those participants who fail to settle. This is the only settlement risk that currently exists on CHIPS, and the consensus view has been that this remaining risk is acceptable considering the added costs of other settlement finality alternatives. , One alternative collateral arrangement that eliminates even the small remaining settlement risk on CHIPS would have required each sending bank to post collateral sufficient to cover its own net debit, and where the real-time net debit cap would be set equal to this posted collateral for each participant so it could not be exceeded. It was determined that the total posted collateral under this alternative would have been so large as to affect significantly the liquidity of the participant banks and reduce earnings. A large portion of the high- quality, liquid government security assets that could be used as CHIPS settlement collateral were already tied up as assets required to be pledged against state, local, and federal government deposits at participant banks. Thus only a portion of the government security assets on bank balance sheets were actually free to be used as CHIPS collateral. And, of that portion that was free, most of it was already used to collateralize overnight federal funds borrowings through repurchase agreements (repos). Repos are a cheaper source of overnight borrowings than are stan- dard federal funds because they provide collateral for the overnight , loan. Thus, transferring the collateral used for repos to CHIPS would incur a yearly extra funding cost equal to the spread between the repo and the federal funds rate times the value of the collateral transferred. In ·addition, if this available collateral was less than needed, partici- 5 and 6 • COMMENT 133 pant banks would have to reduce either government deposits (freeing up collateral that could be shifted to CHIPS) or future lending to business (to purchase more securities to be used as CHIPS collateral). In either case, earnings would have fallen. Government deposits are a· cheaper source of funds than are the purchased funds that would replace them, and business loans, even after adjusting for the risk of loan losses, earn a higher return if only because their longer maturity is associated with a historically upward-sloping yield curve. For these reasons, it was cost effective to reduce the CHIPS collateral require- ment from that of covering the sum of all participant net debits to the level that would cover the largest possible net debit of a single participant. · On a gross settlement system the central bank typically provides for settlement finality. If reserve or clearing balances are insufficient during the day, payments are still made over Fedwire with the central bank providing the daylight credit necessary to transfer the funds and simultaneously guarantee the .settlement. The cost of providing set- tlement finality here will involve (in 1994) a price for the total value of central bank daylight credit provided, which is the sum of all bank net debits, rather than a price applied against only the largest net debit of a single participant. In this sense, pricing daylight overdrafts is very similar in concept to having all network participants provide collateral for their own net debits, a ·solution seen to be more expensive than the shared posting of collateral on CHIPS. Finally, on the SIC gross settlement system, reserve or clearing balances are always sufficient to effect settlement, otherwise the pay- ment is not made. The cost of an SIC system appears to be the oppor- I tunity cost of holding idle reserve or clearing balances, a cost which, if only an overnight funds market exists, equals the overnight funds I rate and is therefore quite high. · Fortunately, cheaper alternatives exist, and I will note three of I them. First, payments can be netted outside a payment network with I the underlying payment instrument acting as collateral for the trans- j action. This approach has been taken for settlement of bankers' acceptances and commercial paper in the United States (and may I later be applied to bank certificates of deposit). Second, payments for future delivery of, say, foreign exchange can be netted by contract novation so that only the net amount due at the settlement date is transferred over a large-value payment network rather than the sum I of all the previous gross positions. These types of ·"institutional adjustments," along with others of a similarly creative nature, reduce substantially the need to purchase priced central bank daylight credit or to hold idle balances for clearing purposes. They also serve to 134 David B. Humphrey reduce the realized cost of settlement finality for banks on these networks. Third, partial payments may be instituted when a given single payment would be so large as to be rejected on SIC (owing to insuffi- cient balances) or would lead to use of priced daylight credit on Fed- wire. Partial payments are, in certain instances, already being used on SIC. Partial payments save costs by reducing the level of idle balances needed to make payments on SIC and, at the same time, reduce the probability of a payments "gridlock" associated with holding lower balances. Such an arrangement requires some added expense for reconciling payment flows to determine when the entire payment has been received, however. But this expense is not large and already exists for government security transfers on Fedwire where partial delivery of securities against payment has for some time been required (to reduce the cost of securities failures), and the maxi- mum limit on a securities transfer is $50 million. Such developments could usefully be noted in the Folkerts-Landau paper, which focuses on the possibility of a payments gridlock on SIC, or on Fedwire with binding net debit caps, and does not mention that the gridlock issue is already being dealt with effectively. Settlement Finality in Formerly Centrally Planned Economies The above discussion makes reasonably obvious the choice of how best to implement settlement finality in formerly centrally planned economies. As noted, on net settlement systems such as CHIPS, daylight overdrafts are inherent, but the systemic risk of a settlement failure can be "controlled" by the posting of high-quality, liquid col- lateral. The CHIPS solution has the lowest cost because it conserves the need for collateral, compared with an arrangement where each sending pank posts collateral sufficient to cover its own net debit. However, three factors argue against the use of the CHIPS solution for formerly centrally planned economies. First, there is a severe lack of high-quality, liquid collateral in these economies that can be used to guarantee settlement finality on a net settlement system. Second, the CHIPS solution requires receiving banks to be able carefully and accurately to determine the credit risk involved in receiving funds from other network participants. At pres- ent, both the information and the credit assessment ability needed for this are severely constrained. Third, the shared posting of collateral to cover the maximum net debit of any network participant, while con- 5 and 6 •COMMENT 135 serving the need for collateral, still contains systemic risk in the event of multiple failures to settle on the same day. Although this residual risk is judged to be exceedingly small for banks on CHIPS, it would not be so judged for banks in formerly centrally planned economies. For these reasons, the CHIPS solution and the alternative arrange- ment of each sending bank posting collateral sufficient to cover its own net debit are both likely to be unworkable until a sufficiently large, sophisticated, and liquid money market arises in these countries. This leaves a gross settlement system for large-value payments in formerly centrally planned economies. This is the same conclusion reached in the Summers paper, probably for the same reasons. Sum- mers, however, seems to favor a Fedwire type of solution, as he talks about a gross settlement system run by the Russian central bank with finality and ''. . . operational controls that allow it to manage its credit risk [or overdrafts].'' In my view, Fedwire may not be a useful model. Overdrafts should not be free, and the provision of priced central bank credit is unlikely to lead to the types of low-cost institutional changes in payment practices envisioned in the United States. It has been determined that institutional change in the operation of the interbank federal funds market could virtually eliminate daylight overdrafts, and hence central bank risk, on Fedwire. Pricing daylight credit is expected to lead to such overdraft-reducing behavior as the substitution of term for overnight federal funds and the use of con- tinuing contracts and rollovers in place of one-day funds. The possi- bility also exists of netting using contract novation for multiple gross flows outside a payment network, to be settled by a single net trans- fer over Fedwire. These and other responses to pricing require a sophisticated money market, a precondition not met in formerly cen- trally planned economies. For these reasons, the most workable outcome consistent with min- imizing systemic and central bank risk is likely to be a gross settle- ment system similar to that of SIC. The potential problem of pay- ments gridlock, as noted earlier, can be addressed using a system of standardized partial payments and should not therefore pose a practi- cal problem and, in any event, would allow lower reserve or clearing balances to be held than would otherwise be necessary. In the longer run, as solvency information on banks in these economies becomes more accurate, credit assessment abilities improve, and sophisticated money markets develop, these countries can consider potentially lower-cost collateral arrangements similar to those that now exist on CHIPS. PART III Creating a Sound Financial Structure 7 The Role of Financial Institutions in the Transition to a Market Economy Hans J. Blommestein and Michael G. Spencer1 Policymakers in the formerly centrally planned economies face the formidable task of creating functioning market economies in environments in which market mechanisms have been suppressed for decades. In this task policymakers face a conflicting set of objec- tives: although the transformation toward a market economy implies that the government should withdraw from its dominant role in the economy, a multitude of new tasks exists for which government action is needed. The development of a market-based financial system is such a task. These economies already possess significant concentrations of specialized productive capacity for which the kinds of informal sources of finance that characterized early capitalist development in the developed market economies are insufficient. Yet they lack most of the important institutions of market economies: competitive markets for most factors, goods, and services; a well-capitalized and competitive financial system; and the legal and regulatory framework to safeguard the financial system. This paper analyzes the role of different financial institutions- banks, capital markets, and investment funds-in the transformation from a planned economy to a market economy. It has been generally agreed that essential elements of this transformation are price liber- alization and the privatization of a significant proportion of the existing productive capacity. While some progress has been made on the first front, privatization has proceeded very slowly in most of 1 The views expressed in this paper are those of the authors alone and do not necessarily represent those of the Organization for Economic Cooperation and Devel- opment or the International Monetary Fund. 139 140 Hans J. Blommestein and Michael G. Spencer the economies in transition. However, for privatization to succeed at all in improving enterprises' efficiency, the system of central control over enterprise management must be replaced by another mecha- nism that not only provides managers with the r.esources they need to finance restructuring but also gives them the incentives to respond to market prices in the most efficient manner feasible. Market-based financial institutions play a key role in achieving these objectives. The financial system inherited from the system of central planning is in a poor state. The banking systems in most of the formerly cen- trally planned economies are plagued by low capital, large stocks of nonperforming loans to state enterprises, loan portfolios that are con- centrated both geographically and sectorally, small branch networks for other than the savings banks, and managers that have little experi- ence in appraising loan applications and in measuring and managing risks. Equity and bond markets are either nonexistent or extremely small and illiquid, and both the small- and large-value payment sys- tems are incomplete and inefficient. In this environment, payments are frequently made on a cash or barter basis and firms have created extensive networks of interenterprise credits. Yet the process of trans- formation from central planning to a market system, and especially the privatization of state enterprises, will place tremendous demands on the financial system. Given this environment, we attempt in the paper to identify the priorities for financial sector reform. One approach argues that the structural problems in the banking sector are so serious that they cannot soon be resolved and that the authorities should therefore first concentrate on developing the nonbank financial sector. In an extreme exposition of this view, McKinnon (1992) argues that banks should be prohibited from lending to privatized firms in the early stage of the transformation and should be allowed to make only fully collateralized short-term lending in the later stage. Other writers similarly argue that the introduction of a secondary market for equity cannot wait for the completion of the restructuring of the banking sector. In contrast, Brainard (1990), for example, argues that reforms should begin with the commercial banking sector. Corbett and Mayer (1991) and Saunders and Walter (1992), among others, go even further to argue that reforms should be based on the principle of creating a bank-dominated system following the models of conti- nental Europe or Japan. This paper argues that the highest priority must be given to the restructuring and privatization of the banking sector. In market econ- omies, banks are the principal source of firms' short-term working 7 •TRANSITION TO.A MARKET ECONOMY 141 capital and provide highly liquid investments in which firms can store ·receipts. They are also the principal source of human capital trained in evaluating credit risk and therefore provide the basis for ensuring an efficient allocation of financialresources. 2 This financial efficiency is translated directly into improved efficiency in production and thereforejn welfare generally. The structure of financial markets also argues strongly for giving priority to banking reform. Banks' access to "good funds" from the central bank provides liquidity that maintains confidence in the pay- ment system, which in turn facilitates trade in commodities and in financial assets. Moreover,· the readiness to provide liquidity as a "lender of first resort" to other financial institutions, including secu- rities firms and private clearinghouses, places banks at the heart of the financial system. However, the primacy of ensuring the health of the banking sector does not imply that the development of securities markets, for exam- ple, is of little significance. The development of government securi- ties markets is an important consideration in economies in transition with high budget deficits and is also important from the point of view of promoting money markets. In addition, the initial allocation of assets arising from privatization may not coincide with the desired distribution-particularly from the point of view of corporate control. Secondary markets for equity provide a way for individuals' holdings of shares to be reallocated and their demand for liquidity satisfied. More fundamentally, true privatization-the transfer· of ownership and management of firms from the public to the private sector, lead- ing to effective private control of the businesses-can only be said to have occurred if shares in firms can be treated as private property to be bought and sold at will. But in the environment of. great uncer- tainty that characterizes transformation, equity markets cannot be expected to provide significant sources of new capital. More impor- tant, securities markets rely heavily on banks as participants and as providers of liquidity to function efficiently. Therefore, even the sec- ondary markets will be hampered if the banking system has not first been thoroughly restructured. Therefore, assuming government resources and expertise are not unlimited, the first priority for action must be the restructuring of the banking system. Banks must be relieved of their inherited asset prob- 2 Bank lending is not completely efficient, however. Informational asymmetries between banks and potential lenders can resUit in credit ratioriing. However, these kinds of inefficiencies are endemic to the financial system and are generally just as problematic for nonbank financial intermediaries. 142 Hans J. Blommestein and Michael G. Spencer lems, recapitalized, and provided with incentives to operate as profit- oriented, competitive institutions. Considerable resources must be devoted to the training of bank personnel and the installation of accurate. accounting, risk ~valuation, and management practices. Other important priorities are the establishment of an efficient large- value payment system and the implementation of effective banking regulation and supervisory regimes. It should be recognized from the outset that these tasks will be time-consuming. Although secondary markets for debt and equity should not be repressed, neither should their development be considered a priority. The authorities' role in the early development of the nonbank financial sectors should be confined to establishing the legislative and regulatory conditions for their operation. These considerations set, in broad terms, the agenda for financial sector reform in the formerly centrally planned economies and the role of a market-based financial system in the transformation process. However, an active institution-building role by the government does not mean that it is possible or desirable to construct an "optimal" set of market institutions and rules. In market economies, financial insti- tutions reflect largely the needs of the private sector, which differ across countries and change over time; this implies that there is no unique blueprint that can be transplanted to the economies in transi- tion. It is the role of the public authorities to lay out clearly the principles and rules governing the safe and efficient operation of the financial system and to enforce these rules. The next section discusses the role of the banking sector in allocat- ing financial resources and in supporting securities markets. The fol- lowing section outlines the corporate control function of the financial system, which is largely missing in the economies in transition and which is essential to the creation of a market-based system. The role of banks and capital markets in providing a market-based system of corporate governance is also discussed. Then the potential contribu- tions of universal banks, capital markets, and hybrid investment ·funds are evaluated and recent developments in formerly centrally planned economies-Poland, Hungary, and the Czech and Slovak Republics-are discussed and related to the previous discussion. The final section briefly sums up. Role of the Banking Sector One of the core challenges facing the formerly centrally planned economies is the decentralization of financial resource allocation. 7 •TRANSITION TO A MARKET ECONOMY 143 Indeed, part of the economic motivation. for the transformation to a market system in the first place has been the recognition that central planning did not result in an efficient allocation of capital and that physical resources were therefore not directed to their most produc- tive uses. The essence of the market in this respect is that it minimizes the extent to which noneconomic factors influence the allocation of resources, and thereby improves such allocation as well as, ulti- mately, the productivity of investment. The central issue to be decided is what will replace the planning mechanism in the intermediation between economic units with sur- plus financial resources and those with insufficient capital to finance their investments. In the industrial market economies, this intermedia- tion has traditionally been dominated by the banking sector. 3 Competi- tion with other banks and with nonbank intermediaries forces banks to develop expertise in credit risk evaluation and in the identification of the most profitable investments. In doing this, they acquire valuable information about borrowers and lenders alike, which allows them to identify the most profitable investments. In recent years in certain industrial countries the dominance of banks as financial intermediaries has been reduced somewhat with the emergence of nonbank inter- mediaries and the further development of corporate debt markets, which give firms direct access to individual savings. However, the development of these institutions and markets depended to a consid- erable degree on the expertise and practices-credit risk measurement for example-developed by the banks. Moreover, in these economies, the financing of smaller enterprises-which dominate most economies 3 However, the most important source of finance has historically been retained earn- ings rather than external finance. Of the external sources of finance-loans, equity, and bonds-bank loans have generally been the most important. Even though Taggart (1985) provides evidence that in the United States internal funds appear to account for a smaller proportion of total financing today compared with earlier decades this cen- tury, this proportion remains above 50 percent. The share of financing accounted for by stock issues has also declined, from 19 percent in the 1930s and 1940s to 5 percent of less in the postwar period. Mayer (1989) provides evidence that bank loans accounted for at least 40 percent of gross financing of nonfinancial enterprises in France, Italy, and Japan, and over 20 percent in Germany, the United Kingdom, and the United States during 1970-85. Bonds, equity, and other short-term securities contributed less than 13 percent of gross financing over this period in all of these countries. Retained earnings accounted for at least 30 percent-more than 65 percent in the United Kingdom and the United States-of gross financing. On the other hand, Singh and Hamid (1992) find that large corporations in developing countries rely on retained earnings to a considera- bly lesser extent-and on equity issues to a considerably greater extent-than is appar- ently true for industrial country firms, although there may be a firm size bii;ts in their data. · 144 Hans J. Blommestein and Michael G. Spencer in terms of their contribution to employment and output_..:,is still gener- ally performed by banking institutions. Although it is not necessary for the formerly centrally planned economies to repeat the historical development of financial markets elsewhere, it is nonetheless true that securitization and nonbank institutions are unlikely to compete strongly with the banking sector in these countries during the transformation period. For the most part, the population is inexperienced in making the kinds of financial decisions required of direct financing of enterprises. Nor does the judicial system yet have experience in adjudicating financial conflicts that may arise between bond holders and debtor enterprises. For example, most of the economies in transition (except Poland, which has recently prepared draft legislation on secured lending) still lack laws on securitized lending, which provide for a central registry of collateral and protection of creditors' claims on pledged assets. In addition, insurance and pension funds, often the most important nonbank financial institutions, are relatively small in these economies and need restructuring. While steps should certainly be taken toward making these funds fully funded and freeing up their investment opportunities, they are unlikely to provide a significant source of capital in the immediate future. One important class of nonbank financial institutions is the investment funds that have emerged in the Czech and Slovak Republics, for example, out of their voucher privatization programs. These are discussed below. Moreover, the economies in transition have underdeveloped pay- ment systems-both retail and large-value systems-which are gener- ally provided by banks. The improvement in these systems is an important objective in the overall restructuring of the financial sys- tem. 4 However, to provide security in these systems, it is important to ensure that the participants are creditworthy-that is, that the banks that have access to these systems are well capitalized and have portfo- lios that are not excessively risky. Indeed, one of the motivations for bank regulation is the protection of the payment system. However, the development of a competitive banking sector in the economies in transition is fraught with many structural obstacles. 5 4 See Folkerts-Landau, Garber, and Lane (1994) for a discussion of payment system reform in formerly centrally planned economies. SThe creation· of a perfectly competitive banking system is, of course, not the objec- tive. Because of banks' importance to the real economy and because the failure of a large bank can have consequences for the rest of the financial system and the real economy, and because in many jurisdictions bank deposits are insured by govern- ments, in no country are banks subject to perfect competition. Capital and liquidity 7 •TRANSITION TO A MARKET ECONOMY 145 The most immediate problem is that many of the employees of state- owned banks have little or no experience in judging the creditworthi- ness of loan applicants or of measuring the credit risk to which the bank is exposed. Thei:-efore they lack the basic expertise needed by a market-oriented commercial bank. In addition, these banks are fre- quently highly segregated geographically and, except for the tradi- tional savings banks, have limited branch networks. Moreover, under central planning, banks did not have to compete for deposits or in the market for. loans and so have little experience in marketing or in pricing their products. Bank Recapitalization and Privatization The characteristic of banks in the formerly centrally planned econ- omies that has attracted the most attention-probably rightly so-is the nature of their portfolios. As a consequence of the banks' regional focus, their loan portfolios are frequently concentrated geographically or by industry, resulting in overexposure to the risk of relative eco- nomic decline in a given region or sector. In addition, their balance sheets often reflect very specialized activities that they were given under the previous regime. For example, it is common for a country in transition to have a savings bank and a development bank and perhaps sector-specific banks servicing, for example, agriculture or housing (see Table 1). Consequently, for example, the savings bank's liabilities may be dominated by retail deposits, and its assets may be dominated by loans to other banks, which would be the primary source of funds for the latter institutions. Perhaps the most serious obstacle to the efficient functioning of the banking system is the "bad loans" problem (see Table 2). Many banks have large stocks of nonperforming loans outstanding to state-owned enterprises. For example, as much as 26 percent of the assets of the banking sector in Poland were thought to be nonperforming in 1992, whereas for the former Czechoslovakia and Hungary the correspond- ing estimates were 21 percent and 11 percent, respectively. 6 The pro- portion of bad loans is highest in the state-owned ba:nks. Under- capitalized banks with large exposures to virtually bankrupt large enterprises may be inclined to roll over outstanding loans and to capi- requirements and the need to obtain a banking license limit competition in the indus- try. Moreover, banks' activities in individual markets are generally restricted (for exam- ple, prohibitions against underwriting securities issues and position limits in foreign exchange dealing). 6 In May 1993, 19 percent of the assets of all banks in Poland were reported to be nonperforming. Table 1. Structure of the Banking System in Selected Central European Countries Former Czechoslovakia Hungary Poland Bulgaria Rom State-owned commercial banks1 2 4 9 59 4 State-owned foreign exchange banks1 3 3 State-owned savings banks1 2 12 1 Other state-owned,. specialized banks1 11 3 8 Private sector banks (of which: have foreign stake)3 43 (18) 38 (15) 72 (7,) 7 (3) 9 (5 State-owned banks' assets as percentage of total banking system assets 43 (1991) 85 (1993) 20 (1993) 80 (1 Household deposits as percentage of savings bank deposits 100 (1990) 80 (1987) 30 (1993) 100 (1990) 90 (1 Sources: Official government reports and documents. 1Number at time of creation of two-tier banking system. 2Excluding savings cooperatives. 3Most recent data; number excludes representative offices. For former Czechoslovakia includes five privatized banks. 7 •TRANSITION TO A MARKET ECONbMY 147 talize interest rather than force enterprises into bankruptcy or restruc- turing. The assumption that loans to state-owried enterprises are backed by the state relieves banks of the need to consider the credit- worthiness of their clients. This moral hazard problem undermines the banks' ability to provide an objective assessment of corporate profitability and to ensure that resources are distributed efficiently and argues in favor of a thorough restructuring and recapitalization of the banks. While there are a variety of options for relieving the banks of these nonperforming loans, they generally include some form of conrli- tional ''bailout'' or other use of government funds to recapitalize the banks. 7 At the same tune, the restructuring of bank portfolios to relieve their exposure to nonperforming loans can be used to correct any structural imbalance in the geographical or sectoral composition of their portfolios. The key to a successful bank recapitalization is that it is accompanied by credible measures· to ensure that, once relieved of their bad assets, banks shift toward commercial lending behavior based on risk-return criteria. This means that solutions to the bad assets problem that rely on explicit or implicit guarantees to the banks (and enterprises) that their future losses on nonperforming loans to enterprises will be covered by the state budget are to be avoided or terminated. Cleaning up bank portfolios without changing the incen- tive structure in which they operate will impede banks' conversion to behaving as market-based entities and will allow the bad debt prob- lem to resurface quickly. There are two main approaches to the financial restructuring of the banks, which have different implications for the corporate gover- nance function of the banks in the initial stage of the privatization of ·the real sector (see Table 2). The decentralized approach-adopted in Poland-relies on the banks themselves to manage the debt restruc- turing, usually by creating a separate loan workout department. Con- sequently, the banking sector would be given a central role in the restructuring of state-owned enterprises. The danger in this approach lies in the relatively weak position of the banks. While they may have the power to force firms into bankruptcy if they cannot reach agree- ment on how to restructure the firm and its finances, as happens in the Polish scheme, they may also have the same incentive as under the previous regime to continue lending to these firms in the hope that they can "grow out" of the problem. Moreover, this approach requires banks to devote significant amounts of human capital to 7 For a discussion of how to resolve the bad loans problem, see Fries and Lane (1994). Table 2. Balance Sheet Restructuring and Bank Privatization in Selected Central European Countries Former Czechoslovakia .Hungary Poland Bulgaria Romania Loan Standard, substan- Standard, substan- Pass, substandard, Only past due pay- classification dard, suspicious, dard, doubtful, bad doubtful, loss (1992) ments are classified nonperforming (1991) (1992) Required loan loss Substandard-20 Substandard-20 Substandard-20 Determined by the reserves percent percent percent central bank Suspicious-SO Doubtful-50 Doubtful-50 percent percent percent Nonperforming- Bad-100 percent Loss-100 percent 100 percent Incentives for loan Two percent of aver- Loan-loss reserve Reserves can be set Banks can set aside loss reserve creation age medium- and creation from pre- aside from pre-tax a maximum of 30 long-term credit and tax profits profits only for loans percent 9f pre-tax 10 percent of over- which can be profits to cover prin- due credits can be proved to be non- cipal, but there is no deducted from recoverable ceiling on reserves gross profit set aside to cover capitalized interest Amount of problem Suspicious-Kcs 55 Bad-Ft 125 billion Lei 122 billion assets (local cur- billion (1992) (1992) (end-1990) rency) Nonperforming-Kcs Doubtful-Ft 90 bil- 75 billion (1992) lion (1992) Substandard-Ft 50 Problem assets in (a) all banks: 21 per- (a) all banks 11 per- (a) all banks: 26 per- (a) all banks; cent cent (1992) cent (1992); 19per- (b) state-owned (b) four largest state- cent(1993) banks (in percent of owned banks: 15 (b) nine state-owned total) percent (1992) commercial banks: 30-60 percent (1992) Balance sheet Kcs 11 o billion of Government guar- Doubtful and loss Government guar- Corporate deb restructuring of revolving inventory anteed Ft 10.5 billion assets are trans- anteed the principal lei 280 billion w state-owned loans (pre-1990) pre-1987 enterprise ferred to separate and interest pay- off against gov banks transferred to newly debt(1991); workout units in ·ments on all nonper- ment deposits established state- _ restricted dividend each bank. The Law forming' pre-1991 banks (1990); owned Consolida- policy (1991-92); on Mutual Settle- loans to state-owned lei 125 billion r tion Bank in 1991 Ft 102.4 billion in ment of Debt pro- enterprises plus nanced by cen along with some bad assets (loans vides for a interest capitalized bank(1990); le associated bank that were 360 days secondary market since end-1990 billion (pre-199 liabilities past due, or loans for loans, and for debt) written o made to bankrupt or debt-equity swaps (1991); agricul liquidated com- (effective 1993) debt: lei 65 bil panies) were trans- 1984-88 debt ferred to newly ten off against established state- ernment depo owned fund, Hun- (1990); lei 111 garian Investment (1989-90 debt and Development ten off (1992) Co. (HID) in March 1993 Table 2 (concluded). Former Czechoslovakia Hungary Poland Bulgaria Romania Recapitalization Kcs so billion of five- HID issued Ft 82 bil- The Law on Financial Leva S billion (the Government pr of state-owned year state bonds lion in 20-year bonds Restructuring of maximum allowable vided lei 9S billi banks carrying market with interest rate Enterprises and annually) in state capital transfer interest rates trans- linked to 90-day Banks (March 1993) bonds carrying an (1991-92) ferred to banks in treasury bill rate to proposes to recap- interest rate of one- conjunction with banks in conjunction italize banks by issu- third of the base rate loan transfers to with asset transfer ing zloty-denomi- transferred to banks Consolidation Bank covering SO percent nated Treasury in conjunction with (1991) of pre-1992 bad bonds redeemed write-off of nonper- assets, 80 percent of with funds from the forming assets (1992) 1992 bad assets, Polish Bank Recap- and 100 percent of italization Fund, claims on state- which was recently owned enterprises converted from the named by the State S1 billion exchange Property Agency stabilization fund (1993) established in 1990. To be eligible for recapitalization the bank must: (1) obtain a financial audit; (2) isolate non- performing loans in a workout depart- ment; (3) submit a loan portfolio restructuring plan to the Ministry of Finance Bank privatization Banks included in Target ownership For the nine state- Consolidation of 58 All banks excep strategy the mass privatiza- structure: foreign = owned commercial small banks into 6 Savings Bank tion by voucher pro- 25 percent, state = banks the target large banks in 1992- included in mass gram (1992) 25 percent, portfolio ownership structure 93; privatization vatization (1992) investors = 50 per- is foreign investors = expected to begin state retains 70 p State retained 37-53 cent by end-1996 20-25 percent, state in 1994 cent stake throu percent stake = 30 percent, State Ownership employees = 10 Fund percent, portfolio investors= 35-40 percent. For other state-owned banks privatization is on a case-by-case basis Banks privatized 5 2 Sources: Official government reports and documents; The Hungarian Economy; Central European: Clifton and Khan ( 1993). 152 Hans J. Blommestein and Michael G. Spencer correcting problems inherited from the past rather than to improving current lending practices. · In contrast, a centralized approach essentially relies on the transfer or sale of bad assets to a central entity, generally a govemment- sponsored institution created specifically for this purpose. Usually, a portion of the bank's liabilities would also be transferred to this insti- tution. This approach envisages a role for the banks only after the financial restructuring-and possibly privatization-of the state- owned enterprises, to avoid a situation in which banks continue lend- ing to insolvent state-owned enterprises whose debts are thought to be guaranteed by the state. Moreover, the decoupling of bank reform and enterprise restructuring will help banks put their once subser- vient relations with state-owned enterprises on a sound commercial footing. This suggests that bank recapitalization and restructuring shoulcl precede enterprise restructuring. Not only would this help prevent a recurrence of the bad loans problem, but placing bank lending on a firm commercial basis would also support the imposition of a hard budget constraint on state-owned enterprises. The newly restructured and recapitalized banks are in a position of strength vis-a-vis enterprises that are to be, or have been, privatized, in that they can impose financial discipline. In other words, the capacity to influence management has increased; for example, it would now be easier for banks to refuse new loans to enterprises that show insuffi- cient willingness to restructure. Regardless of how the bad loans .problem is handled, however, the banks can only be expected to operate on a purely market- oriented basis if they themf;lelves are privatized. As long as they remain state owned, the possibility that credit allocation decisions will be tainted by political considerations persists. Banks can only enforce market behavior on their customers if they themselves oper- ate in a competitive market environment. While the economies in transition have begun to privatize banks, progress to date has been very slow (see Table 2). Meanwhile, the absence of strict licensing requirements in some of the economies resulted in the emergence of literally thousands of small privately owned banks in Central and Eastern Europe. Unfortunately, these banks tend to be seriously undercapitalized and undersupervised and are often simply finan- cial agents for the enterprises that own them and have themselves accumulated significant amounts of nonperforming loans, to the point of becoming insolvent. Although consolidation of private banks has begun, notably in Russia and Poland, much more needs to be done if these institutions are to provide healthy competition for the (formerly) state-owned banks. 7.• TRANSITION TO A MARKET ECONOMY 153 Before bank privatization--'and: perhaps even .restructuring-is undertaken on a significant scale, it.is important to ensure that the general environment under which the banks will operate is specified. While it is surely not necessary to pass an entire range of detailed financial laws, the broad parameters outlining admissible banking activities and responsibilities should be declared. One important aspect of this environment is the question of whether, and how, banks will be involved in securities trading; this question will be taken up later. Another important element of this environment is the possibility that bank deposits will be insured. As is well known, deposit insurance can create incentives on the part of bankers to take excessive risk, since they may not bear the full consequences of bad decisions. It is important to send a clear message that bank share- holders and managers are fully responsible for both their successes and failures by committing to a regime in which they will be the first to suffer losses if their banks fail. · Finally, transformation itself generates risks and uncertainties that need to be taken into account in market-based lending decisions. Even in the initial stages of the post-privatization period (after both banks and enterprises have been financially restructured), the role of banks in providing fresh funds may be modest without government involve- ment. The recent experience in Germany is instructive in this regard. German banks have demanded guarantees to keep credit flowing to firms in the former East Germany. Whereas it was initially expected that equity markets would play a role in the (post-)privatization pro- cess, their contribution was negligible (for example, venture capital funds contributed less than 1 percent of the financing). Since there was no substitute for hank funding in the restructuring and privatization process, government guarantees to the banks were provided (OECD, 1993c). Likewise, many bank loans granted in formerly planned econ- omies in support of privatization are part of government-sponsored programs. The loans are extended by the commercial banks, but they are all refinanced by the central bank. Although this type of govern- ment intervention could be justified on the grounds of information externalities (see Nakamura (1993) for a general discussion), the provi- sion of" soft loans" runs counter to the objective of developing a bank- ing culture in which loans are provided on market terms. Market Structure and the Role of Banks Although it has been argued· above that in the formerly centrally planned economies the banks' role in providing finance to enterprises is compromised by their inherited portfolio problems and lack of 154 Hans J. Blommestein and Michael G. Spencer experience with market-based lending, it is nonetheless true that emphasis should be placed on improving the position of the banks rather than supporting alternative institutions. This conclusion is based in part on the observation that a sound, competitive banking system lies at the heart of any efficient securities market. Securities market participants rely heavily on bank credit to ensure liquidity in these markets; and the creation of securities markets in an economy with a weak banking sector will unduly increase systemic risk. 8 Securities markets can be segregated for discussion between the primary markets in which the securities are issued, and the secondary market in which they are traded among investors. It is by means of an issue in the primary market that firms raise capital. However, firms are not entirely ambivalent about the development of the secondary market. The greater the liquidity in the secondary market, and the greater the information available to participants, the more efficient will be the price discovery process and therefore the more reliable will be these prices as indicators of how new issues should be priced. Moreover, a liquid secondary market increases the range of potential primary market investors by improving the maturity transformation role of the market. Investors wanting short-term assets will be pre- pared to purchase long-term bonds if they are confident that they can sell them on the secondary market when they want to. Banks' involvement in the primary markets is both direct and indi- rect. In many formerly centrally planned economies, banks are permit- ted to underwrite security issues either directly or through subsid- iaries. However, even if this is not permitted, underwriters will often turn to banks for credit. The underwriters' demand for credit stems from their need to hold securities during issue, to support prices imme- diately after the initial issue, and to hold undistributed securities. In the secondary market, the same considerations apply. Brokers will on occasion need to accumulate large amounts of stock to satisfy a block purchase, or sell off large blocks piecemeal, for which they may need short-term credit. In addition, large purchases are often made with funds borrowed from the brokerage. The broker itself may acquire the funds by drawing on a line of credit with a bank. 9 Dealers will demand 8 Systemic risk is loosely defined as the possibility that a failure of one financial institution will lead to failures of other institutions with which it has had dealings, with the result that the flow of financial payments is significantly restricted. 9 The bank may be unwilling to lend directly to the individual investor because the loan would be backed only by the securities purchased, whose value may fluctuate significantly. However, a loan of the same amount to the broker would be backed by the broker's more extensive securities and capital, making default less likely. 7 • TRANSITION TO A MARKET ECONOMY 155 credit to finance their proprietary positions and to facilitate the buying and selling required of them in their role as market makers. In securities exchanges, banks are relied upon to provide same-day ''good funds'' to finance margins. In addition, brokers and dealers will need access to credit to manage settlement delays or failures. The exchange clearinghouses themselves will need to maintain borrowing rights to protect the market against defaults by one or more members of the exchange. Obviously, the potential demand for bank credit can be reduced by requiring brokers and dealers and securities exchanges to maintain larger reserves. However, to ensure that temporary liquid- ity shortages do not result in the complete collapse of the securities markets, lines of credit will be needed to provide support in very large settlement failures. It must be possible to draw on these lines of credit immediately upon recognition of a problem. This generally means that the potential creditor needs to be ah institution with access to same- day central bank funds, which is g~nerally restricted to the commercial banks that participate in the large-value payment system. Clearly, the development of securities markets cannot be consid- ered in isolation from the health of the banking sector. It is important to ensure that the banks that provide credit to securities market par- ticipants are able properly to assess the risks involved. They must have expertise in securities market trading to understand the transac- tions they are ultimately financing, and they must be able to assess the credit risks involved. Finally, banks' exposure to securities market lending should be monitored. This discussion suggests that the banks' restructuring and recapital- ization should precede their involvement in securities markets. The introduction of securities markets and the necessary creation of lines of immediate credit with highly variable amounts of credit actually being demanded will greatly increase systemic risks if the banks providing these credit lines are themselves undercapitalized and illiquid. This suggests, however, that the development of the securities markets will itself be constrained by the progress in bank restructuring. · Financial Structure and Discipline Privatization and Separation of Ownership and Control Among the fundamental challenges of.the transfort;nation period is the privatization of state-owned enterprises. Financial institutions are expected to play many roles in privatization. First, they may. be expected to play an important role in the restructuring of state-owned 156 Hans J. Blommestein and Michael G. Spencer enterprises awaiting privatization. Second, they are expected to mobilize domestic and foreign funds and make them available for financing ownership transfers to the private sector as well as to pro- vide working capital and investment finance to enterprises after they have been privatized. Third, financial institutions will provide finan- cial advice and other specific services, for example, payment services. Finally, as will be argued below, financial institutions play an impor- tant role in the monitoring and control of managerial activities. Privatization policy faces many challenges: the huge numbers of firms and individuals involved, the considerable difficulty in valuing enterprises, underdeveloped capital markets, the need to restructure enterprises, conflicts about the fairness of the different privatization schemes, administrative bottlenecks, a weak banking sector, and legal uncertainties. 10 Different privatization strategies have been adopted in the various economies in transition reflecting, inter alia, differences in starting points, political concerns about equity, and other country- specific considerations. However, in broad terms, the objectives are similar: a speedy transfer of property rights resulting in effective private control of the privatized enterprises by the new owners. These considerations prompted the authorities in the economies in transition to adopt multitrack approaches to the privatization of large enterprises by using combinations of the following basic methods (Blommestein, Geiger, and Hare, 1993): (1) public offering of shares; (2) sales of shares to a private buyer or group of buyers; (3) free distribution of shares to the employees or population (for .example, direct transfers of shares, distribution through vouchers, and distri- bution through intermediaries); (4) restitution to former owners; and (5) buy-outs, buy-ins, and other forms of "bottom-up" or "insider" privatization. For example, the Hungarian approach to privatization has favored methods (1), (2), (4), and especially (5), whereas the Czech and Slovak Republics pioneered the mass privatization approach (3). Other formerly centrally planned economies, Poland, Romania, and Russia, for example, have also proposed voucher privatization programs. The different methods employed in privatization emphasize differ- ent financial institutions. In each country, banks have been playing, or will be expected to play, a significant role in the restructuring of the enterprises both before and after privatization. In Poland, for exam- ple, the restructuring of enterprises is to be carried out by the banks 10 For recent discussions of privatization in the e·conomies in transition, see OECD (1993a) and Earle, Frydman, and Rapaczynski (1993). 7 •TRANSITION TO A MARKET ECONOMY 157 as part of their own restructuring and recapitalization. Where adopted, voucher privatization has resulted in the creation of invest- ment funds that hold concentrations of shares in privatized firms, and provides for broad participation by the population through own- ership of interests in investment funds. The implementation of methods (1), (2), and (3) creates an immediate demand for the cre- ation of a secondary market in equity. The challenge will be to ensure that privatization of enterprise own- ership results in market-oriented behavior on their part. One of the important characteristics of a market economy is that it includes a set of rules and institutions that promote the efficient allocation of resources. In market economies characterized by many large enter- prises in which managers may not be the sole or even the most important owners, this allocation mechanism needs to provide the proper incentives for managers to respond rationally to informa- tion conveyed in market prices, while simultaneously limiting their incentive to act in ways that are detrimental to the interests of credi- tors and shareholders. Central to this mechanism is the maintenance of effective corporate control, which itself relies to a large extent on the existence of private property rights and markirt-based financial institutions. These market-based control mechanisms are missing in the formerly centrally planned economies. Consequently, an important goal of privatization is to ensure that the transfer of property rights from the state to the private sector is combined with the development of institutions and rules that provide an effective corporate governance structure in an economy domi- nated by private agents. The concept of "effective corporate gover- nance'' is based on an understanding of the institutions and rules that govern the allocation of resources in a market economy. A proper understanding of the factors that shape the structure of corporate control in market economies is fundamental to the analysis of the role of financial institutions in the process of transformation, including privatization. Agency Problems in Privatized Firms The broad distribution of shares in privatized firms and asymme- tries of information between the managers of the firm, its share- holders, and its creditors creates the potential for conflicts between these groups in which one group attempts to increase its own welfare at the expense of the welfare of the others. Shareholders and credi- tors run the risk that managers will take actions that reduce the value of either or both of these claims, while if shareholders have some 158 Hans J. Blommestein and Michael G. Spencer control over the firm, they may take actions that increase the value of their claims at the expense of the value of the firm's debt ("asset substitution"). These conflicts can fruitfully be discussed in terms of a principal-agent model in which, for example, the manager acts as the agent for the principal (shareholders or creditors). 11 The essence of such conflicts is the inability to observe other parties' actions com- bined with a divergence of interests. If access to information is asym- metric among managers, shareholders, and creditors, such conflicts cannot generally be contracted away entirely. Agency conflicts are costly to the firm because they can result in suboptimal investment decisions. For example, the less protection creditors have against asset substitution, the less willing they will l;>e to lend to the firm, resulting in an increased cost of capital. Likewise, investors will be less willing to purchase equity if they cannot prevent managers from appropriating more than their agreed share of profits. The conflict between managers and investors can be alleviated by providing creditors and shareholders with a mechanism for monitoring the behavior of the agent. Provided this monitoring ability is combined with an enforcement mechanism, second-best contracts can be designed that reduce the agency cost. In a centrally planned economy these agency costs are reduced because the state is the only shareholder and, in theory, dictates instructions to the managers and is able to verify both that these instructions are carried out and that their reported effect is accurate. The challenge of privatization is to replace .!his direct monitor- ing and control by the state with market-based mechanisms. This provides the basic rationale for the corporate control function . · of financial institutions.12 The challenge is to create an incentive struc- ture in which the interests of the managers, shareholders, and credi- tors can be reconciled or the conflicts controlled. Three classes of resolution of the principal/agent problem exist: using product and labor markets to reward or punish managers' behavior; changing the firm's capital structure; and introducing direct control mechanisms to enforce efficient behavior. The precise structure of corporate control is, therefore, dependent on a number of interrelated factors, incluCi- ing (1) shareholders or debt claimants; (2) the legal infrastructure, in 1 particular, the type of bankruptcy rule and other asset restructuring rules such as loan workouts; (3) the relative importance of the bank- 11 The application of principal/agent methodology to corporate finance was initiated by Jensen and Meckling (1976). See Barnea, Haugen, and Senbet (1985) for a review of agency theory. 12see Harris and Raviv (1991) and Holmstrom and Tirole (1989) for surveys of the literature on corporate control mechanisms. 7 • TRANSITION TO A MARKET ECONOMY 159 ing system (vis-a-vis the capital market) in long-term lending to large enterprises and equity holdings by banks; (4) the presence and role of large shareholders; and (5) the composition and structure of enter- prise boards. Despite the fact that one can identify some basic forces that shape the ·general framework for corporate control by financial institutions, understanding of these mechanisms remains limited. Moreover, the (endogenous) outcome of the interaction between these factors-the management of large enterprises and other economic agents-is impossible to predict. ·However, a brief discussion will provide a number of insights that will be helpful in analyzing the role of finan- cial institutions in the transformation. One approach to controlling managerial behavior is to give man- agers an incentive to act in the interests of the owners by linking their income to the firm's performance. Thus, for example, they can be given shares or stock options that link a significant portion of their income to the market value of the firm. However, in the highly uncer- tain environment of the economies in transition, the market value of the firm will be affected by systematic uncertainty unrelated to the performance of the manager. Therefore, the direct link between the actions of the manager and the value of the stock is weakened, which increases the agency cost. Moreover, linking managerial compensa- tion to current stock value can cause a certain myopia on the part of managers. Along similar lines, managerial discipline has been linked to the labor market for managers .13 It is argued that a desire to maintain a reputation as an effective manager-and thereby retain access to alter- native employment opportunities-induces managers to increase their effort. 1 4 If so, they have an incentive to ensure good perfor- mance by the firm, since it provides them with a reputation for excel- lence. However, in the formerly centrally planned economies, this mechanism will be weakened as it will be difficult to identify the degree of the manager's responsibility for the success or failure of the firm. Capital Structure and Discipline The capital structure of the firm itself provides one source of con- trol. A debt contract carries an obligation to make regular interest 13This argument was made by Fama (1980). 14Managerial "effort" is broadly interpreted to mean the total of their activities and the quality of their decisions affecting the operation of the firm .. 160 Hans J. Blommestein and Michael G. Spencer payments, and failure to meet this obligation allows the creditor to force the firm into bankruptcy or liquidation. This can exert a disci- plining effect on management, since a manager of a highly indebted firm who wants to avoid bankruptcy will expend more effort to avoid low profits. 15 If managers own stock in the firm, they have a share in all profits earned in excess of interest payments and therefore have an additional incentive to increase their effort. Moreover, an increase in debt decreases the free cash flow (net return to the project minus interest payments), thereby reducing the extent to which managers can appropriate corporate earnings to increase their own welfare. Loan contracts also give banks an incentive to monitor closely the behavior of the managers and the firm's performance to ensure that the loan is repaid and to avoid being forced to continue lending to large firms that threaten to default on their obligations. In addition, a bank can choose to cut off the firm from future lending if it considers the bank a poor credit risk. This is a potentially important sanction because, in evaluating the loan application, the bank has access to confidential information about the firm's prospects. Therefore, an announcement that access to credit is being suspended sends a very . strong negative signal to other potential lenders to the same enterprise. The effectiveness of debt in promoting managerial effort is limited, however, since the manager of a highly indebted firm also has an incentive to engage in asset substitution. For example, once the terms of debt contracts are locked in, investments in projects with greater return variability would shift wealth from bondholders and other creditors to shareholders. Several instruments or institutions have been developed to counter this problem, thereby reducing the poten- tial conflict between debt and equity holders: (1) the inclusion of debt covenants to restrict asset substitution (for example, limits on divi- dends and new borrowing, and constraints on the use of funds); (2) the issue of convertible debt instruments and securitized debt; (3) the use of rating agencies to monitor firms and provide an objective valu- ation of their debts; and (4) the joint provision of debt and equity financing by banks that are also major shareholders. The last mecha- nism is discussed below. 15 See Grossman and Hart (1982), Jensen (1986), and Stulz (1990). This reasoning assumes that bankruptcy is costly to managers because it tarnishes their reput!ltion, which will reduce their value on the labor market. If managers can easily move into new jobs with no significant change in their total income, they will be less concerned about going bankrupt than if, for example, they want to protect their reputation as effective managers to attract outside employment opportunities or if their income is otherwise adversely affected by bankruptcy. 7 • TRANSITION TO A MARKET ECONOMY 161 Equity contracts also affect the incentives faced by managers. The principal advantage of equity over debt is that it allows firms to share the risk they face with the shareholders rather than bearing it all themselves.· The absence of a contractual obligation to make fixed payments reduces the penalty faced by firms in the event of an adverse shock. However, this flexibility in paying dividends is also the principal disadvantage of equity. Since managers know they have to share the rewards from successful projects with the shareholders, they may be less likely to increase their own effort in making projects successful, and more likely to· divert resources and profits to. their own uses or to engage in other self-promoting activities that do not maximize the value of the firm. · The principal weakness of equity finance is that there is no explicit mechanism for monitoring or controlling management as there is in a debt contract. Individual shareholders with small stakes have little incentive to impose discipline on managers because the costs of mon- itoring and controlling managerial behavior generally outweigh the increase in the value of their shareholdings that would result. This public good aspect to managerial discipline makes it unprofitable for individual shareholders to monitor managers. Even large share- holders can only express their concerns at infrequent shareholders' meetings unless they have direct representationon the board of direc- tors or in management. 16 Indirect mechanisms to mitigate the agency conflict between managers and shareholders have been created or have evolved spontaneously: (1) linking managerial pay to perfor- mance through ownership of stocks and stock options as well as through the payment of cash bonuses; (2) monitoring by large share- holders and the board of directors; (3) the threat of takeovers; (4) policies on the payout of dividends that limit the scope for managerial discretion through reputational · forces; and (5) an increase in leverage. This discussion assumes that minority shareholders have little or no ability to influence managerial behavior. However, there is an internal source of control: the directors of the company, who have a fiduciary responsibility to protect shareholders' interests. This requires that they monitor the activities of the managers and disci- pline managers who consistently fail to act in the shareholders' inter- ests. Of course, there is the problem of ensuring that the directors act appropriately, since in inany cases they are appointed by manage- ment. This can be achieved, for example, by legislating codes of con- 16Bondholders are in a worse position than shareholders, since they have access to the same information but no direct means of influencing managerial behavior. 162 Hans J. Blommestein and Michael G. Spencer duct and responsibility for directors, by having directors nominated by all claimants on the firm, and by having outside directors. The capital market itself provides an external control mechanism: the threat of takeovers. If ownership is a marketable commodity, a firm that is perceived to be underperforming relative to potential can be purchased by an outsider that installs a new managerial team that can correct the problems and earn greater profits for the firm. If the firm's shares are traded on an open market, the daily share price provides an indication of the firm's prospects. A potential raider can then determine how the market value of the firm relates to the value he places on the firm. Again, takeovers are likely to influence man- agers' behavior only if they perceive a personal cost to being taken over. In practice, however, takeovers are not always effective. They may be a weak disciplinary tool because it is relatively easy for managers to protect themselves against personal losses owing to takeovers, for example, by creating "golden parachutes" that give them extremely generous severance packages. Moreover, the information asymmetry between firm insiders and raiders can reduce the probability that the takeover will be profitable. Insiders will only be inclined to sell their shares if they think the market overvalues them. Small shareholders will have an incentive to free ride on the takeover bid since they can expect the value of their shares to rise either because of a successful bid and restructuring or because the raider has to pay a premium to acquire a majority share. Therefore, takeovers can result in the raider paying too much for the company. 17 If this free rider problem is significant, takeovers will generally only be profitable if the raider values the firm differently than the current shareholders or if the raider can exploit minority shareholders through equity dilution after the takeover. In the formerly centrally planned economies, the most important sources of corporate control are likely to be bank debt and monitoring by large shareholders. The dominant sources of uncertainty are sys- temic in nature, which makes it difficult to determine how much of a firm's performance reflects the quality of its management. Therefore, managerial contracts will have a large noncontingent element, which does not induce them to increase their effort. Moreover, contract enforcement is still weak in these economies, which reduces the strength of purely contractual arrangements. However, the control 17 See Grossman and Hart (1980) for an elaboration of this idea. Shleifer and Vishny (1986) note that if the increase in the value of the raiders' shares exceeds the amount spent to induce minority shareholders to sell, the takeover will be profitable. 7 •TRANSITION TO A MARKET ECONOMY 163 mechanism provided by bank loans-assuming banks' decisions are guided by purely economic motivations-is effective. So too is the potential role of holders of significant blocks of voting shares, since they have a greater influence on managerial activities than do small shareholders. The privatization programs in place or envisaged in the economies in transition will, in principle, allow for concentrations of shareholdings of this sort. Universal Banks and Capital Markets Universal Banks Many authors have argued that the universal banking system, such as that of many continental European countries-Germany in particular-should be established in the formerly centrally planned economies. is In fact, many of the countries in transition have already passed legislation providing for the creation of universal banks (see Table 3). In such a system, banks provide both commercial and invest- ment banking services such as the underwriting of securities issues and participation in secondary markets, although the latter may be relegated to subsidiaries. Most important, universal banks are often permitted to hold significant amounts of equity in the firms to which they lend and to represent themselves, as well as shareholders whose shares they hold in trust, on the boards of directors of these firms. The central argument for such an arrangement is that by internaliz- ing the debt/equity conflict identified above, universal banking allows for an allocation of financial resources that is more efficient and that allows firms to concentrate on longer-term objectives. In a universal banking system, banks are in a position to monitor closely and to influence the decisions taken by the managers. ·They can therefore discipline poor managers in two ways: by pressing for their removal by the board of directors and by withholding credit. In addition, the combination of commercial banking and investment banking activ- ities is thought to allow universal banks to capture economies of scale and scope, and therefore to provide both kinds of services at reduced costs. /1 Kindleberger (1984) has argued that the role of banks as engines of growth" in Europe has been overplayed. Moreover, a structure 18 See, for example, Saunders and Walter (1992) and Corbett and Mayer (1991). Gerschenkron (1962) and Cameron (1991) have argued strongly that the universal banking model played a key role in the development of continental Europe. Table 3. Regulatory Environment for Banks in Selected Central European Countries Former Czechoslovakia Hungary Poland Bulgaria Romania Universal banking? Yes Yes Yes Yes Yes Limits on equity par- Participation in non- Long~term invest- Participation in other Ten percent of share Twenty percent ticipation by banks banks limited to 25 ments in nonfinan- institutions (including capital of non bank share capital of percent of capital cial institutions loans) limited to 25 without prior consent bank without pri and reserves without limited to 15 percent percent of capital of central bank; consent of centr prior consent of cen- of warranty capital and reserves without excludes shares and bank tral bank; may for commercial and prior consent of cen- Interests acquired in acquire a 10 per- specialized banks tral bank debt settlement pro- cent share of capital and 40 percent of vided they are sold of nonbank without. warranty capital for within three years prior consent of cen- investment banks. Sum total of invest- tral bank No bank can hold ments of bank in more than 51 per- immovable prop- cent share in nonfi- erty, equipment. nancial firms shares, and interest Sum total of shares in nonfinancial held by a bank in a undertakings limited nonfinancial institu- to own capital tion may not exceed 60 percent of war- ranty capital Above calculations can exclude securi- ties held by bank for Foreign owners of S12 million for com- Foreign owners: $6 Domestic operations Lei 20 billion (1992 Minimum capital universal banks: S10 mercial bank; $6 million or equivalent only: leva 200 million requirements for opening a new million or equivalent million for spe- in convertible Domestic and for- bank in koruny or convert- cialized or invest- currency eign operations: ible currency mentbank Domestic owners: leva 500 million ZI 70billion Except for financial Government will None None Limits on ownership Foreign financial of banks institutions' partici- institutions, maxi- determine limits on potion in privatiza- mum stake for a sin- size of foreign inves- tion of state-owned gle investor is 25 tors' equity stake in banks limited to 25 percent (limitation privatization of state- percent; can be applies to govern- owned banks waived on a case- mentfrom 1997) Ownership of any by-case basis Total foreign partici- individual share- Nonbank share can- potion in banks in holder limited to 50 not exceed 10 per- excess of 10 percent percent of bank's cent of bank capital requires government capital without prior consent approval of the central bank Foreign financial institutions' partici- potion in privatiza- tion of state-owned banks limited to 25 percent Banks established Banks established Banks established Eight percent transi- Eight percent by Risk-weighted capi- before 1991: before 1991: 8 per- before 1989: 8 per- tion period to be end-1994 tal adequacy requirements (a) 6.25 percent by cent according to cent with transition determined end-1993 Hungarian account- period and inter- Table 3 (concluded). Former Czechoslovakia Hungary· Poland Bulgaria Romania (b) 8 percent by ing standards. mediate targets end-1996 (including 4 percent determined on a core capital); cen- case-by-case basis New banks: 8 per- tral bank can grant by the central bank cent exemption until 1994 · New banks: 8 per- New banks: 8 per- cent cent Bankruptcy law Bankruptcy law New bankruptcy law Bankruptcy law No separate bank- Bankruptcy Law o enacted 1991- came into effect dates to 1934, ruptcy law; tempo- 1887 still in effect implemented in April 1/1/92 amended by the rary provisions part new legislation 1993 Insolvency Act of of 1989 decree on before parliamen Debtor must declare 1990 economic activity Banks can initiate bankruptcy if any Law 76 of July 199 bankruptcy pro- payment obligations Banks can initiate Banks can initiate allows banks to in ceedings are overdue by bankruptcy pro- bankruptcy pro- ate bankruptcy p more than 90 days ceedings or liquida- ceedings ceedings tions under the Law Liquidation pro- on State Enterprises cedure can be initi- ated by banks Law on Mutual Set- tlement of Debts (effective 1993) gives banks the lead role in negotiating creditor agreements with firms 7 • TRANSITION TO A MARKET ECONOMY 167 that was appropriate in nineteenth century Europe, for example, is not necessarily appropriate for the economies in transition today; in fact, such a model might be particularly inappropriate for these coun- tries. First, the universal banking model gives significant equity stakes to the commercial banks. In the Czech and Slovak Republics and in Poland such investments can reach 25 percent of the bank's capital, and in Hungary they may reach 15 percent, without requiring central bank approval. Hence, an important part of bank assets will be composed of shares in newly privatized firms. But these shares are extremely difficult to value, and market determinations of this value are likely to fluctuate widely. Also, the dominant source of uncer- tainty in the transitional economies will be systemic in nature. There- fore, diversification of banks' portfolios will not necessarily eliminate inuch of this variability. The monetary authorities may therefore want to enforce strict compliance with prudential regulations that set broad limits on bank ownership of nonfinancial enterprises and on equity positions of core capital (see Table 3). Second, commercial bank participation in the management of a large number of enterprises threatens to dilute already scarce human capital in financial management. Securities market activities require expertise similar to that employed in commercial bankirig: evaluating potential risks and returns to investments and being able to price financial assets. If these skills are not well developed, both banking and securities operations will suffer. Since bank lending· will likely contribute more to corporate growth than securities, it would be desirable to concentrate whatever financial expertise there is on the banks' core lending activities, Moreover, bankers do not necessarily make good managers or directors, and thrusting them into this role would divert their attention away from the activity in which they presumably have a comparative advantage. There is also an important managerial issue. Banks have limited experience with risk and credit management skills. They therefore need to establish strict internal guidelines that ensure that loans are based on sound credit analysis. If they are allowed to hold significant equity stakes in firms to which they also lend, they may face the same perverse incentive to continue lending to insolvent, or at least unprofitable, enterprises as .occurred under the previous regime. This incentive can be controlled by the maintenance of "fire walls" between the investment banking and credit operations of the bank, but such controls can be difficult to erect and monitor. A similar consideration is that it is much more difficult to supervise and regulate universal banks than narrower commercial banks or investment banks. As a simple prescription, banks should not be 168 Hans J. Blommestein and Michael G. Spencer allowed to engage in activities that' regulators cannot be certain they can monitor. If bank supervision and regulation is weak, as in the economies in transition, the full range of universal banking activities should not be permitted in the initial stages of the transformation process. It is easier to allow commercial banks to broaden their activ- ities and become universal banks later (if that is the desired path of financial development) than to force universal banks that have run into difficulties to shed their securities market-related activities. If banks are eventually to be allowed to have a direct role in securities markets, these activities should be confined in separately capitalized subsidiaries to ensure that the failure of the securities business does not affect the capital that supports the commercial banking activities. Finally, Steinherr and Huveneers (1990, 1992) and Muldur (1992) find no evidence of economies of scale or scope in universal banking and warn that such a system leads to excessive cartelization in the financial sector and underdevelopment of securities markets. They also raise the possibility that banks will become captive to the firms in which they hold significant equity stakes and may not fully exercise their corporate governance role. Thus, in the economies under trans- formation, universal banking may simply add to the riskiness of banks' portfolios without significantly improving their corporate gov- ernance role, their own profits, or the allocation of capital. These considerations argue in favor of at least delaying .the establishment of universal banking institutions until the supervisory and regulatory authorities have developed 'the capability to enforce fire walls and prudential regulations, economic uncertainty relating to the transfor- mation process has diminished significantly, and bank managers have established successful track records. Capital Markets Capital markets in formerly planned economies potentially have a number of ·important roles to play in the transformation process, including facilitating the process of privatization; providing risk capi- tal or long-term debt finance for restructuring and expansion; provid- ing a mechanism for noninflationary finance for the government; providing mechanisms for corporate control; and providing domestic and foreign savers (including institutional investors) with instru- ments to diversify their portfolios, thereby encouraging savings and the mobilization of fonds. Unfortunately, existing capital markets in these economies are ill equipped to perform such tasks soon. Trading of stocks is generally insufficient to support significant new issues, and much of the trad- 7 •TRANSITION TO A MARKET ECONOMY 169 ing that does occur is unregulated and unsupervised. In addition, in the current inflationary environment in many of these countries, cor- porations are reluctant to issue bonds. So the provision of new capital through the equity and bond markets is unlikely to be significant under current conditions. However, secondary markets for equity will provide a valuable .means of transferring ownership rights- thereby giving real meaning to privatization. Equity Markets In addition to the risk-sharing be~efits of equity, the transformation to a market economy creates a special motivation for the development of equity markets: privatization. Although the current state of equity markets does not make privatization through initial public offering a viable option for most enterprises, alternative strategies such as voucher privatization. will result in large numbers of individuals and institutions holding claims to former state-owned enterprises or to investment funds. Since the initial distribution of privatization vouchers or shares is unlikely to coincide with individuals' preferred holdings, a secondary market for these instruments would allow a more efficient distribution of equity ownership. In addition, a second- ary market for such claims will provide individuals with some liquid- ity in their investments. The development of a viable equity market, however, is difficult and time consuming and includes an important role for the authori- ties. Although it is preferable that the actual structure of the market- for example, exchange trading versus over-the-counter trading, brokers versus dealers, call market versus continuous trading-is determined by its participants, the authorities must.ensure that activ- ity is appropriately regulated and supervised and that the essential preconditions to efficient market operation are provided. First, as indicated above, priority should be given to the develop- ment of a competitive banking system. Liquid interbank markets- supported by an efficient large-value payment system-are a key institution for the development of securities markets. 19 Efficient clear- ing and settlement of securities transactions depend on the existence of a banking system capable of providing liquidity to securities firms and clearinghouses. The delay in providing appropriate clearing and settlement systems owing to problems with the large-value transfer system for domestic payments and/or the inability to process the 19 See Blommestein (1993a and b), Summers (1994), and Folkerts-Landau, Garber, and Lane (1994). 170 Hans J. Blommestein and Michael G. Spencer potentially large volume of securities transactions of low value has been an important constraint on market development in the formerly centrally planned economies: It is also important to address the minimum regulatory require- ments. At the very least, the existence of a secondary market for equity requires the legalization of free disposal of private property; limited liability for shareholders; commercial law specifying the rights and responsibilities of firms, managers, shareholders, and directors; and securities legislation prohibiting market manipulation and fraud and specifying penalties for infractions. Such legislation requires a body that is empowered to enforce the law, capable of carrying out sanctions, and removed from political influence. The authorities need to avoid unnecessary legal or fiscal restrictions on· the transfer of shares. More generally, the regulatory framework must be efficient, taking into account the type of investors (small or large) and the business involved. Investor confidence is important to the continuation of any asset market, and particularly in the formerly centrally planned economies, in which, for the most part, experience with trading financial assets is limited. Participants must be confident that the market is fair and that there is an effective authority actively seeking to maintain this fair- ness. It is vitally important, therefore, to· provide avenues for the dissemination of information about the market and listed companies. This requires the use of widely agreed accounting and auditing stan- dards and regular financial statements from listed companies. The so-called emerging markets provide an indication of how well equity markets in the transitional economies might function. A num- ber of common characteristics can be identified: (1) these markets are thin, even where they are relatively old; relatively few firms, corre- sponding to a small fraction of total capital in the economy, are listed; (2) these markets are highly illiquid, with trading concentrated in only a small subset of the firms listed; (3) they are volatile, with the average weekly rate of change in the index exceeding that of the more developed markets; (4) they are prone to speculative bubbles and collapses; and (5) they are vulnerable to fraudulent activity. Another source of concern is the inefficiency of asset pricing in these markets. Even if there were liquid markets in equity, the prob- lems of determining asset values without standard financial state- ments and with almost meaningless historical price and output fig- ures make objective pricing extremely difficult. Therefore, for the foreseeable future, prices will be highly unreliable. Nor will it be any easier to price the investment trusts. Moreover, simply because investment trusts may hold large portfolios, they may not be much 7 •TRANSITION TO A MARKET ECONOMY 171 less risky than individual firms. The most important source of risk in the economy is likely to be political risk, which cannot be diversified. This brief examination of the immediate prospects for well- functioning equity markets in the formerly centrally planned econ- omies is less than encouraging. The institutional preconditions for the effective operation of primary and secondary markets for equity-a sound banking system capable of providing liquidity, an efficient pay- ment system capable of effecting timely payment versus delivery, and the requisite regulatory and legislative foundation-will necessarily take time to erect. In addition, private pension and insurance funds, which are key participants in equity markets in industrialized coun- tries, are so far missing in the economies in transition. These contrac- tual savings institutions, when fully funded and permitted to. invest in equity and bonds, will play an important role in promoting these markets. However, such developments will take time. In the mean- time, equity prices will likely prove to be unreliable and markets will be illiquid. In such circumstances it is unlikely that equity markets will provide substantial new capital. Bond Markets In more developed capital markets firms raise capital by issuing debt securities of their own (for example~ commercial paper, corpo- rate bonds). These instruments are attractive because they provide cheaper and more flexible sources of finance than, say, bank loans, as they reduce the role of the intermediary between the firm and the I ultimate investors. Investors hold corporate debt because it provides I an attractive return and because it is a tradable asset and so is not significantly less liquid than deposits. However, access to the bond market is usually restricted to only the most profitable and reputable firms, because holders of debt securi- ties generally are less able to monitor managers' behavior than are banks and perhaps even equity investors. They therefore will usually be prepared to invest in debt securities only if an effective control mechanism has already been established. This control problem is solved at least partly by requiring that bcmds must be rated on an ongoing basis by an independent agency with access to the same confidential financial information provided to banks. Bondholders thereby leave it to the rating agency to monitor the quality and activ- ities of the firm's management, the return on the firm's investments, :, I and other considerations that determine its ability to service its debt. In addition, commercial banks provide a signal to investors about the firm's ability to service its debt through their willingness to lend to 172 Hans J. Blommestein and Michael G. Spencer the firm, particularly if bank loans are junior to debt securities. Finally, bondholders can exert a certain amount of direct control through the use of bond covenants restricting, for example, the firm's ability to take on more debt, particularly if that debt would be senior to the existing debt, or to increase its dividend payments. The development of the corporate bond markets requires the same institutional and regulatory preconditions as those of the equity mar- kets. In addition, the existence of liquid markets in bonds with shorter maturities is a general precondition for bond issues of longer maturity. Clearly, therefore, the government's financing activities will assist in the development of this market. By providing a relatively safe, homogeneous asset with a range of maturities, the government can build up investors' experience in trading financial assets, thereby providing a pool of potential investors, and facilitate pricing of longer-maturity instruments. The development of the bond markets is also supported by interest rate deregulation. Capital Market Development in Central Europe The development of capital markets in the formerly centrally planned economies is still at a relatively early stage (see Tables 4 and 5). There are stock markets in Bulgaria, Hungary, Poland, Ukraine, the former Yugoslavia, and the Czech, Russian, and Slovak Repub- lics. However, with the possible exception of the Warsaw Stock Exchange, where weekly turnover has recently reached record levels of over $100 million, these exchanges see very little activity. The Bud- apest Stock Exchange is open five days a week, but weekly stock turnover is usually only in the range of $1-4 million. The Prague Stock Exchange generally has turnover of less than $100,000 with one day of trading per week, while turnover on the Bratislava Stock Exchange in listed and unlisted stocks is usually less than a tenth of that amount. In general, there are few issues listed and even fewer see active trading. For example, the Prague Stock Exchange has 957 unlisted stocks eligible for trading but fewer than 10 percent of these have seen any activity. Reporting requirements are often weak-for example, the unlisted stocks on the Prague Stock Exchange and the Bratislava Stock Exchange are not required to provide any information-and supervision of these markets is still incomplete. Most of the securities trading takes place outside the organized exchanges and is therefore almost entirely unregulated. Over-the- counter trading in equity in the Slovak Republic was recently esti- mated to exceed trading on the Bratislava Stock Exchange by a factor of ten. The second round of trading on the RM System, an electronic 7 • TRANSITIQN TO A MARKET ECONOMY 17 3 over-the-counter stock trading system that competes against the Prague Stock Exchange and Bratislava Stock Exchange, had turnover of Sk 252.4 million in the Czech Republic in July, compared with weekly turnover on the Prague Stock Exchange of less than Sk 1 million. Furthermore, there are no reporting requirements for the unlisted stocks on the Prague and Bratislava Stock Exchanges. Generally speaking, with the possible exception of the Warsaw Stock Exchange, turnover is simply too low-even including over- the-counter trading-and the number of issues being actively traded is too small to provide hope that firms will raise substantial amounts of new capital soon. In addition, the markets are· extremely volatile, often driven by frenzied buying ofonly a small number of stocks and frequently tainted by the suspicion of illegal trading activities. There are comparatively active bond markets in 111ost of the for- merly centrally planned economies. Indeed, turnover on the Prague, Bratislava, and Budapest Stock Exchanges is dominated by trading in bonds. Until recently, 90 percent of the turnover on the Bratislava Stock Exchange was in bonds, although that proportion has now fallen to about 70 percent. On the Prague and Bratislava Stock Exchanges the proportion of on-exchange trading accounted for by bonds exceeds 80 percent. However, except for orie corporate bond traded on the Prague Stock Exchange, these are government bonds; Investment Funds The previous sections suggest that the financial systems in the formerly centrally planned economies may not yet be capable of pro- viding the two services identified as essential for the transformation to a market economy: directing resources to their most efficient uses-for example, for restructuring-and providing effective corpo- rate governance. Several countries have therefore created new types of financial institutions--,.hybrid investment funds-adapted to fit the spe~ial economic circumstances such countries face: a shortage of domestic sa~gs, rudimentary capital markets, and difficulties in evaluating risks (Table 6). The innovative feature of these hybrid funds is that they are intended.to play a threefold role (Blommestein, 1992): (1) serving as a mechanism for the transfer of 'ownership to large segments of the population while permi,tting portfolio diver- sification to small investors; (2) playing an important corporate con- trol role in privatized enterprises; and (3) raising new financial funds for the restructuring of privatized enterprises. Over time these.funds are also intended to contribute to the development of capital markets. Table 4. Regulatory and Legislative Framework for Securities Markets in Selected Central European Countries Czech Republic and Slovak Republic Hungary Poland General securities law Stock Exchange Act (1992) Act on Public Offering of Securities and Act on Public Trading Act on Securities and Bonds (1992) the Stock Exchange (1990) Securities and Trust Government Securities Act of Czech Funds (March 1991) Republic (1993) Supervisory structure Ministry of Finance, through the Stock State Securities Supervision Board Securities Commission Exchange Commissioner Location of exchanges Prague and Bratislava stock Exchanges Budapest Stock Exchange (June 19, Warsaw Stock Exchan opened April 6, 1993 with trading in 1990) (April 16, 1991) bonds only. Trading in shares began Budapest Commodity Exchange (March June 22 in Prague, July 1 in Bratislava. 16, 1993) Bratislava Options Exchange opened April 2, 1993 trading futures and options on stocks Organization Screen-based, order-driven; listed, Order-driven, partially screen-based Screen-based, order- unlisted stocks traded on the (Central Market Support System) driven, limit prices in exchanges, which compete with RM- Monday to Friday, 11 :00-12:30 effect (10 percent fluc System, an off-exchange electronic ation allowed) trading system Monday, Tuesday, Thu Limit prices were in effect on Prague day, 10:30-1 :00 Stock Exchange until September 1993 (20 percent fluctuation-SO percent for previously untraded stocks) Prague Stock Exchange trades on Tuesdays-plan to add Thursday sessions in October 1993; · Bratislava Stock Exchange trades listed stocks on Tuesdays; and unlisted stocks on Wednesdays . Clearing and Centre for Securities (SCP) in each suc- Book-entry through the Central Clearing National Depository settlement cessor republic; book-entry House and Depository for Budapest Securities, screen- Stock Exchange trades, physical transfer based, order-driven for over-the-counter market trading T+5 T+4 Sources: Official government reports and documents; Bloomberg; Business Eastern Europe; Butterworths Journal of International Banking and Fina Law; Central European; Euroweek; Euromoney; International Finance Review; International Financial Law Review; International Securities Regul Report and PlanEcon Business Report. · Table 5. Types of Securities Issued and Trading Activity in Selected Central European Countries Czech Republic Slovak Republic Hungary Poland Government paper Treasury bills: 1-, 2-, 3-, Treasury bills: 5-day, Treasury bills: 30-, 90-, 180-, Treasury bills: 4, 8, 13, 2 4-month 1-month · 360-day 39, 52 weeks Treasury bonds: 2-, 3-year Treasury notes: 1-year Treasury bonds: 1-, 3-ye State bonds State bonds Bonds convertible into State bonds: 2-, 3-, 4-, Rehabilitation Bonds: 5-, shares in privatized ent 5-year 10-year prises Corporate paper Commercial paper Bonds Commercial paper Bonds: up to 5-year Bonds: 1-, 2-year Stock exchange Initial capital= Kc 120 mil- 7 listed stocks End-1992 capital.: Ft 47 bil- End-1991 capital: ZI 1,5 lion ($4.3 million) 8 unlisted stocks lion in equity, Ft 155 billion billion government bonds in bonds End-1992 capital: ZI 3,5 1st day turnover: Kc 4.4 billion million Aug. 13 turnover: 1992 turnover: Ft 33.7 bil- Aug. 26, 1993 capital: Aug. 20 turnover: Kc 1.7 Sk 82,505-listed stocks, lion (82 percent in bonds) ZI 33,209 billion million in stocks, Kc 7.5 mil- Sk 77 ,040-unlisted stocks, Aug. 25-29turnover: End-1991 turnover: ZI 1 lion in corporate and gov- Sk 623,067-bonds Ft 252.4 million in stocks, billion/month ernment bonds Ft 65.2 million in bonds Stock futures and options End-1992 turnover: ZI 3 Stocks: 957 unlisted, two traded on Bratislava 26 stocks, 11 bonds, 9 billion/month listed; 3 bonds listed, one Options Exchange treasury bills, 1 compensa- Week ended Aug. 20 unlisted; 53 stock tion coupon, 4 investment turnover: 53 stock exchange mem- exchange members funds, stock options ZI 2, 115 billion in stocks bers Foreign trading restricted deutsche mark-, U.S. ZI 30 billion in bonds to one-third of total dollar-government bond 19 stocks (plus 1 on par futures at Budapest Stock lel market), 6 bonds Exchange; deutsche mark traded and U.S. dollar futures at 44 stock exchange mem- bers, some one-third are foreign Taxation 1 percent bond adminis- Certain purchases of Hun- Dividends taxed at 20 p tration fee garian shares are tax cent; capital gains gen 25 percent withholding tax deductible ally tax exempt Sources: Official government reports and documents; Bloomberg: Business Eastern Europe: Butterworths Journal of International Banking and Finan Law: Central European: Euroweek: Euromoney; International Finance Review: International Financial Law Review; International Securities Regula Repor~ and PlanEcon Business Report. 178 Hans J. Blommestein and Michael G. Spencer The role of the investment funds is essentially to concentrate capital ownership and thereby act as large shareholders that have an incen- tive to provide corporate control since individuals would invest in these investment funds rather than directly in private firms. In the context of voucher-based privatization, individuals can sell their vouchers to the funds or exchange them for shares in the funds them- selves. As large shareholders, the funds could also play an active role in enterprise management; the needed expertise could be provided in part by allowing foreign "experts" to manage these funds. (To offset the possibility that oligopolistic behavior by the investment funds would simply replace similar behavior by former state-owned enter- prises, entry into the investment fund industry should be relatively free of restrictions.) The combination of what are essentially investment banking and portfolio diversification services makes these funds unique and com- plicates their design. For example, it is probably inappropriate to model these funds on open-end mutual funds as are found in indus- trial countries, although both closed-end and open-end funds have been created in some of the economies in transition. Open-end funds must continually ensure sufficient liquidity to be able to satisfy demand for redemption of outstanding shares. Since the funds' investments-shares in former state-owned enterprises and invest- ments in restructuring projects-will probably be highly illiquid, an open-end structure would either limit the funds' ability to invest in restructuring or require them to maintain possibly expensive lines of credit with commercial .banks. More important, open-end mutual funds typically do not exercise a control function, serving instead simply as a means for individual investors to hold a diversified portfolio. It would seem preferable, therefore, to limit the ability of investors to redeem their shares either by setting up the investment funds as closed-end funds or by restricting redemptions during an initial period. However, it would be permissible for individuals to trade in investment fund shares among themselves on a secondary market. In this way, the initial capital base of the investment funds would at least be partly protected-although it would of course fluctuate with the value of the funds' investments-while promoting the develop- ment of an equity market. The latter effect would be only marginal at first. The considerable uncertainty during the transformation period, the lack of reliable financial information on many enterprises, and the lack of a market for most enterprises' shares make it very difficult to value investment fund shares reliably. They are therefore likely to 7 •TRANSITION TO A MARKET ECONOMY 179 suffer from thin trading and. high price volatility. In the same vein, the portfolio diversification benefits of investment funds should not be overestimated. The overwhelming sources of uncertainty during the transformation are systemic in nature and therefore not diversifia- ble. This tendency for the value of all enterprises owned by the investment funds to move together is exacerbated if the investment fund managers have decided to channel the bulk of their investments to a few sectors. The investment banking operations of the investment funds could be arranged in one or both of two broad patterns: the investment funds could simply assist enterprises in their search for external investors and creditors, in which case the loans, for example, would be made direct from commercial banks to the enterprises; or the investment funds could themselves borrow from commercial banks- perhaps using their capital base to borrow on terms more favorable than those available to individual enterprises-and use these funds to finance the enterprises they .control. The features of investment funds that have been established or are on the drawing board raise a number of important questions regard- ing regulation. When funds are essentially providing a portfolio diversification service to small investors, regulations are designed to protect the investors by limiting risk-taking by fund managers. Regu- lation of investment banks, on the other hand, necessarily places less emphasis on limiting risk than on protecting the capital base of these institutions, while ventµre capital firms face much less regulation. Therefore, the regulation of investment funds must somehow forge a compromise between the interests of the funds' investors and the objective of facilitating the reconstruction. However, no compromise should be made in eliminating fraud or the improper use of funds by investment fund managers. Such activity, and illicit financial transac- tions generally, would undermine confidence in financial markets (Blommestein, 1992, 1993b). Regulation should therefore take into account the unique objectives and features of the investment fund, but at the same time should be stringent in fighting against fraud and serious conflicts of interests. Markets for Derivative Securities The possibility of introducing markets for financial derivatives in the formerly centrally planned economies has already been consid- ered (Antowska-Bartosiewicz and Malecki, 1992). Indeed, such secu- rities are already available in some of these economies and are being Table 6. Investment Funds in Selected Central European Countries Czech Republic and Slovak Republic Hungary Poland Legislation Act on Investment Companies and Law enacted Nov. 1991, effective Act on Public Trading in Secur Investment Funds (April 1992) January 1992 and Trust Funds (March 1991) Types of investment Open- or closed-end funds Open- or closed-end funds Open-end funds Portfolio value of After first round of privatization, State Property Agency had Ft 814.6 assets investment funds held approxi- billion in assets at end-May, 1993 mately 70-75 percent of the mar- and had sold Ft 105.2 billion in ket value of privatized enterprises, assets since March 1990 estimated at Kcs 522 billion Investment restrictions -No more than 10 percent of fund Up to 10 percent of a bank's a assets may be invested in one can be invested abroad or in issuer's securities, except for state than publicly traded securities bonds more than 5 percent of its asse -No more than 5 percent of fund can be invested in the securiti assets may be invested in one a single issuer piece of real estate or movable asset -Fund may not invest in more than 20 percent of the securities issued by one issuer Types of funds Private: Private: Private: Czech and Slovak American Enter- Austria-Hungary Fund Pioneer First Polish Trust Fund prise Fund Budapest First Fixed-Income Fund Polish Private Equity Fund Czechoslovakia Investment Corpo- COFINECSA Poland-American Enterprise F ration, Inc. First Hungary Fund Hungary-American Enterprise Fund Some 400 or more investment funds Hungarian Investment Co. emerged during the voucher priva- Hungary Investment Partners tization process · Hungary Government Debt Fund 6 privatization-related investment funds Supervision of state administrative authorities as State Securities Supervision Board investment funds defined by the Czech National Council and the Slovak National Council Sources: Official government reports and documents; Bloomberg: Business Eastern Europe; Butterworths Journal of International Banking and Fin Law: Central European: Euroweek: Euromoney: International Finance Review: International Financial Law Review: International Securities Reg Report: PlanEcon Business Report. and Risk. 182 Hans J. Blommestein and Michael G. Spencer planned for others. 20 The argument in favor of their introduction is that the transformation from a centrally planned system to a market system implies such large shocks to commodity and asset prices and to interest rates and exchange rates that investors and firms alike need to be able to hedge their exposures to these shocks. In most instances, markets for trading derivatives are not presently viable in the economies in transition, because of the mechanisms such markets require. The principal use for derivatives contracts by firms is in allowing them to hedge against adverse financial price develop- ments. However, in general the maintenance of a hedge requires the ability to trade both the derivative security and the underlying instru- ment at short notice and without causing adverse price movements. Therefore, such derivatives can only be effective if there is a highly liquid market for the underlying instrument. For example, there should be liquid spot foreign exchange and money markets. 21 More- over, these markets rely heavily on settlement and payment systems and bank liquidity to satisfy margin requirements on futures exchanges. More fundamentally, liquid markets for the government bonds or currencies underlying the contracts are needed to price the derivative securities in the first place. Without a liquid underlying market, investments in these securities would essentially be speculative. Sim- ilarly, forward currency contracts are priced from the yield curve on government securities, which requires a liquid money market with a range of maturities. The danger posed by a premature introduction of these markets is not that they will not be used, but that their use will increase the risk to other parts of the financial system, particularly the banking sector, which is directly linked to the real sector of the economy. If banks are not adept at credit risk evaluation, their involvement in derivatives markets could have serious systemic repercussions. 20 In Hungary the Budapest Commodities Exchange and the Budapest Stock Exchange have both introduced futures contracts for U.S. dollars and Hungarian Gov- ernment bonds. Stock futures and/or options are also traded on the Budapest Stock Exchange and the Bratislava Options Exchange. There are also dozens of commodity exchanges in Central and Eastern Europe, many of which offer standardized deriva- tives contracts. Finally, financial derivatives are frequently contracted on a bilateral basis between enterprises, although such activity is entirely unregulated. 21 Interbank foreign exchange markets are relatively new in the formerly centrally planned economies, but reasonably liquid markets are emerging in Hungary and Poland and in Moscow. In Hungary, for example, a reference rate for the exchange rate is fixed each morning by the central bank and commercial banks are permitted to exchange currencies at rates 0.5 percent above or below this rate. Daily turnover in May 1993 was approximately $120 million a day. 7 • TRANSITION TO A MARKET ECONOMY 183 Role of Financial Institutions in the Transformation in Poland, Hungary, and the Czech and Slovak Republics Restructuring of Banking Sector The introduction of central bank legislation and new banking laws marked the beginning of a market-based financial system in Hungary, Poland, and the Czech and Slovak Republics (see Tables 1, 2, and 3 for a summary of the structure of the banking system in these coun- tries). Three objectives can be distinguished: (1) to establish a two-tier banking system by separating central banking operations and com- mercial banking functions; (2) to provide the central bank with the means to conduct monetary policy and to supervise the banks (Blom- mestein, 1993a); and (3) to grant greater autonomy to the banks in making lending decisions on the basis of commercial criteria. Much of the necessary legal and accounting framework for restruc- turing of the banking sector has been put in place in these four coun- tries. The existing legal framework gives the central banks the basis for issuing regulations covering reserve requirements, liquidity, for- eign exchange exposure, lending limits to individual clients, and capi- tal adequacy (see Table 3). However, banks in Hungary, Poland, and the Czech and Slovak Republics continue to face serious structural problems, which are hindering their ability to contribute as competi- tive market-based institutions to the success of the transformation process, including privatization and the development of the private sector more generally. Credit allocation remains concentrated in a relatively few state-owned banks, which are saddled with large and growing amounts of nonperforming assets-primarily of inefficient and loss-making state-owned enterprises. Bank lending remains biased toward these same firms owing to ''captive-lending'' relations (Blommestein, 1993a). Consequently, the asset portfolios of the larger state-owned banks (and some of the smaller private banks) are highly illiquid. In response to these problems, governments have started to take measures for the restructuring of the larger state-owned banks. Banks have been encouraged to increase capital and set aside loan loss reserves from profits (see Table 2). It is a positive sign that the priva- tization of banks has begun. Nonetheless, most of the state-owned banks remain severely undercapitalized and cannot hope to meet international capital adequacy ratios in the near term using theii- own resources. In addition, the amount of nonperforming loans is sub- stantial. Table 2 provides official estimates of nonperforming assets for Poland, Hungary, and the Czech and Slovak Republics. Unofficial 184 Hans J. Blommestein and Michael G. Spencer estimates are higher. In addition to their financial weakness, banks lack adequate personnel with modem banking skills. Rather than supporting the transformation process, the weak banking system is currently a serious obstacle because of its continued misallocation of capital to the state sector, while crowding out creditworthy new entrepreneurs and recently privatized enterprises. The growth of interenterprise arrears in the region is additional evidence of the adverse incentive structure underlying the disfunctioning of the banking sector. Finally, the underdeveloped and fragile state of the banking system is also hindering the development and functioning of a capital market, including investment funds. Development of Capital Markets and Investment Funds The first stock exchange to reopen its doors in Central and Eastern Europe since World War II was the Budapest Stock Exchange, in June 1990. Transactions in treasury bills, corporate bonds, and company shares on the Budapest Stock Exchange are regulated on the basis of the Law on the Public Issue and Trading of Securities, adopted in January 1990. This law established a State Securities Supervision Board to regulate the public issuance of securities and the rights and obligations of security traders to ensure an adequate level of investor protection. The Budapest Stock Exchange started with a two-tier structure: the first tier for listed securities, and the second for unlisted but registered securities. The public offering of lbusz shares in 1990 was the first major privatization of a Hungarian company through a public offering on the Budapest Stock Exchange (see Apathy (1993) for a detailed account). Although this transaction was an important boost to the development of the Hungarian capital market in its initial stages, the market remained quite narrow and illiquid. This is illus- trated by the fact that with about 20 quoted shares, 64 percent of trading in 1991 was in the shares of just three companies. Very few of the companies listed or registered on the Budapest Stock Exchange were the result of a privatization-related flotation. The other com- panies were new private companies that raised new risk capital to finance expansion. The two major reasons that more companies did not do the same are external funds can be more cheaply and easily raised through debt instruments and the thriving over-the-counter market, and it is not very attractive to raise capital in an illiquid market with volatile price movements. In 1991, the first full year of trading, the Budapest Stock Exchange index went from 1,000 in Janu- ary, to a peak of 1,200 in March, to about 800, where it remained for much of 1992. In response, the stock exchange authorities launched a · 7 •TRANSITION TO A MARKET ECONOMY 185 third tier to the market in Jui:ie 1992, in a move to draw over-the- counter trading onto the market floor. The third tier is meant for the trading of securities that do not meet the full listing requirements but have a newly formulated, simplified set of rules. The Warsaw Stock Exchange was reopened in July 1992. The legal basis for the Warsaw Stock Exchange is the Law on Public Trading of Securities and Trust Funds, which was passed in April 1991. But some trading in securities-mostly stocks-was already taking place in early 1989, at several quasi-exchanges and as over-the-counter transactions (Szomburg, 1993). The securities law defines the roles of the Securi- ties Commission, the Stock Exchange, the securities firms, and trust funds. It allows banks to undertake brokerage activities provided that their securities trading operations are financially and organizationally separate. By the end of 1992, 23 stock brokerage firms and more than 100 stockbrokers had been licensed. Many of the companies quoted on the Warsaw Stock Exchange are enterprises privatized through an initial public offering. The capital market in Poland is narrow, charac- terized by high volatility and illiquidity. Since the Polish mass pro- gram has not yet been launched, the volume and value of stock trad- ing on the Warsaw Stock Exchange will continue to develop gradually in the near future. In contrast, the government securities market developed fairly rapidly, is relatively liquid, and is underpinned by modern secondary market arrangements. The sophisticated clearing and settlement system for government securities is also used for other securities. To improve liquidity, each listed company nominates a specialist who helps to match buy and sell orders but is not obliged to make a two-way market in the shares. Capital market legislation for the Czech and Slovak Republics is in place, and stock exchanges began operating in Prague and Bratislava iit April 1993. On both stock exchanges, trading is allowed in listed and unlisted securities. In addition, unlisted securities are traded on off-exchange markets, including the computerized RM System devel- oped for the voucher privatization scheme. The major financial institutions-including investment funds-also arrange block trades of unlisted. securities among themselves rather than on the exchanges. It was explained above that special investment funds are intended to play an important role in the mass privatization process of some countries and that both investment funds of the OECD type and so- called hybrid funds are also expected to contribute· to the develop- ment of capital markets (Table 6). In Poland and the Czech and Slovak Republics, investment funds are to play a threefold role: (1) to allocate vouchers (in the Czech and Slovak Republics) or participation certifi- 186 Hans J. Blommestein and Michael G. Spencer cates (in Poland) and to permit portfolio diversification to small inves- tors; (2) to support and strengthen management; and (3) to mobilize capital for restructuring purposes. In contrast, in Hungary, invest- ment funds are primarily designed as conventional investment funds to collect savings from small investors, and no direct role is envisaged for them in the process of privatization. The Polish authorities expect that investment funds will play an important role in both the restruc- turing and privatization of large enterprises as part of the Polish mass privatization program (see Blommestein (1992); and Szomburg (1993) for details). Indeed, hybrid investment funds are seen as an institu- tional innovation to speed up restructuring as well as to contribute to more efficient corporate governance in the form of better control and supervision of management performance. Investment funds in the Czech and Slovak Republics are important in the allocation of vouchers. The 9 largest funds-there are more than 400 altogether-control almost half of all voucher investment points. Thus, the ownership transfer phase of the voucher privatiza- tion scheme has been completed. The next phase concerns the trans- fer of the tradable ownership titles to individual investors and invest- ment funds, that is, the underlying shares in the enterprises. It remains to be seen how the investment funds will behave in their corporate governance role. Some of them (in particular those that are seriously undercapitalized) will probably be under considerable pres- sure to raise cash by selling on the capital market; this type of invest- ment fund might also behave more like OECD-type portfolio man- agers. Other investment funds might be more active managing the firms in which they own shares, in particular when they are putting up or raising the capital for the restructuring of the privatized enter- prises. Foreigners could not participate directly in the voucher priva- tization scheme, but they are allowed to buy shares in the secondary market. Conclusions The two most important contributions of financial institutions in the transformation from central planning to a market-based system are to maintain a corporate governance mechanism and to provide and allocate capital. This paper has investigated the possible roles of banks, equity and bond markets, and investment funds in perform- ing these tasks. This brief examination suggests that, as weak as they are now in many of the formerly centrally planned economies, the 7 •TRANSITION TO A MARKET ECONOMY 187 banks are still likely to be the most important sources of both corpo- rate control and finance. Therefore, the priority of the authorities in these countries should a be the creation of well-capitalized, competitive banking system- preferably one not complicated by a universal banking structure dur- ing the transformation itself-and the simultaneous creation of com- petent supervisory and regulatory agencies capable of enforcing therr prescriptions. 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Dreyer My first impulse, after reading Blommestein and Spencer's com- pact, but nonetheless fairly comprehensive, overview of actual and possible functions of various financial institutions in the present-day formerly centrally planned economies, was to engage the authors in a debate about the merits and demerits of alternative structural models of the financial sector. Although few would quarrel with their obser- vation that neither the banking system inherited by these countries nor their nascent capital markets and institutions are capable of pro- viding the basis for successful transition to a market economy, the particulars of the structure they favor are subject to challenge. We know, for example, that banks need not be the sole source of liquid- ity, that there are ways of mobilizing financial resources other than through the banking sector, that the desirable structure of corporate governance is certainly not solely, and perhaps even not mainly, a matter of managerial efficiency, that capital markets can be very dif- ferently organized in terms of the required supporting institutions, and so on. It can be argued, therefore, that the authors make, at most, a good case for a specific transition path to the financial sector of their favorite design rather than a case for this particular design itself. Consideration of alternative arrangements, for example, of partially substituting the credit provision services traditionally supplied by commercial banks for a combination of securitized short-term debt and instantly redeemable shares in investments pools, would be, in my opinion, most interesting, but is not possible in the short time allotted to me to comment on the paper. But this is not why I suppressed my initial impulse to comment on the authors' substantive policy prescriptions. To explain why, I must make a brief personal digression. Digression After going through the program of this conference, I realized that I am a minority of one among its participants-I toil in the private financial sector. So, to justify my presence here, let me introduce myself by confessing to what I am doing for a living. Broadly speak- ing, I analyze institutional activity in capital markets and also assist people in forming and operating capital market institutions-mostly pooled investment vehicles, such as investment funds or unit invest- ment trusts-and in setting up supporting facilities, such as transfer 190 7 •COMMENT 191 agencies, depositories, registries, custody arrangements, or clearing- houses. The bulk of my client base consists of private financial institu- tions in developed countries. However, in the last few years, I have spent some time providing technical advice to various entities in the economies in transition. The institutions that sought my assistance were in countries stretching from Warsaw to Alma-Ata and included both quasi-commercial entities, such as Ceska Sporitelna-the largest Czech savings bank-to Russian Government agencies such as the GKI-the State Committee for the Management of State Property. The assignments ranged from setting up underwriting and asset management functions at a bank to evaluating the trading capacity of a stock exchange or the potential profitability of a proprietary compu- terized trading network. For the sake of full and fair disclosure, I may add that I am conversant in some of the languages spoken in the area. I am confessing to all these transgressions to emphasize the stark distinction between the perspective of Blommestein and Spencer and my own vantage point. If theirs is a bird's view, mine is a dog's sniff. Accordingly, my remaining brief comments both on the issues raised in their paper and the paper itself will be offered from a dog's vantage point. Abstraction Versus Reality '1 To dispense with the obvious, let me state at the outset that the I differences in our respective perspectives notwithstanding, I share I the authors' basic assessment of the state of the banking sector and I capital market institutions in the formerly centrally planned econ- ,I omies. Similarly, I do not have much to say about their invocations of parallels and contrasts with the operation of financial institutions in developed countries. Their juxtapositions lead one to a noncontrover- sial conclusion-that uncritical grafting of western arrangements, practices, and procedures onto the existing financial sector in these economies will not be successful. :1 '1 My main problem with the paper is that it is so remote from reality I as to be virtually vacuous in providing useful policy guidelines. If we j could start with a tabula rasa, perhaps there would be a point in trying to formulate a neat objective function and a set of constraints and then simulate dynamic paths to see which one generates the highest level of welfare. In such a world the authors may be correct in advo- cating a particular chronology: first, restructuring of the commercial banks, then, nurtured development of debt and equity markets, for- mation of investment funds, and so on. 192 Jacob S. Dreyer But that is not the world the policymakers face. In Russia, for example, the disastrous state of its banking system requires no elab- oration. But there are also dozens of forums, labeled exchanges, for trading commodities and commodity contracts, including some non- standardized oil futures contracts, and financial instruments; hun~ dreds of virtually unregulated brokerage firms; an active interbank debt and foreign exchange market;· regional property funds that resemble U.S. venture capital funds and investment pools that resemble closed-end funds that are not yet tradable. In addition, sev- eral hundred enterprises are being privatized every month, with the number of shareholders increasing by perhaps a million every month. But there is no infrastructure to accommodate this growth: no third- party registrars, no interconnected depositories, no transfer agency facilities, no meaningful custody arrangements. Fraud, including out- right theft, is rampant. Some enterprise managers and managers of regional property funds maintain their own lists of shareholders, thus deterring workers from selling their shares and thereby subverting the very purpose of mass privatization. The securities act is an incom- plete compendium of broad proscriptions and mandates rather than a set of enforceable regulations, and, in any event, the newly estab- lished Securities and Exchange Commission has no way of monitor- ing compliance, let alone enforcing the regulations even if they existed. The authors argue that financial reform must begin with the restruc- turing of the banking system.· Further, they say that "the primacy of ensuring the health of the banking sector does not imply that the development of securities markets, for example, is of little signifi- cance." Now, I wonder what is the exact meaning of this state- ment, especially to the policymakers, say, at the Russian Ministry of Finance and the GKI who are faced with the situation I have just sketched out. From my vantage point, the ongoing process of restructuring, reform, and creating financial institutions in these economies is one of crisis management rather than of a carefully designed and orderly implemented transformation. The crisis is more acute at some times and in some places than in others but it is a crisis nonetheless, at least in the sense of requiring quick responses. Contrary to the authors' recommendations, policymakers in Russia, and for that matter even in the currently more placid economies in transition, cannot delay expanding efforts, energies, and resources to bringing a modicum of order to capital markets or even to fashioning their development until the banking sector is restructured and ready to provide liquidity to · securities firms and other services to capital markets. 7 • COMMENT 193 Dominance of Political Considerations My second comment on the differences between the optimal hier- archy of priorities and the sequencing of steps as advocated by Blom- mestein and Spencer and the real-life choices pertains to the domi- nance of extraneous political imperatives and ·constraints in the decisions affecting the shape of reform of financial institutions in the economies in transition: To illustrate my point, compare the design of the mass privatization process in Poland and the former Czechoslovakia. In the latter the choice was made to transfer owner- ship claims from the state to the population rapidly, massively, and irrevocably without apparently much regard for the problems of man-- aging the privatized enterprises that would inevitably arise down the road. In Poland, by contrast, the issues of corporate governance and the implied effective managerial control have been part of the design of the mass privatization program from the beginning. This difference in approaches most certainly did not arise because the Poles wanted to gain some time to restructure their banking sector whereas the Czechs and Slovaks were oblivious to the necessity of having a viable banking sector for the equity markets to operate efficiently. Other policy considerations carried the day; The Russian decision to mass privatize at a breakneck speed with virtually no infrastructure in place is perhaps the most blatant exam- ple of decisions that crucially affect the future structure of financial institutions being made for reasons· that have little to do with opti- mality or efficiency criteria. As a result, the policymakers in the econ- omies in transition and their advisors always have to make their choices among several nth best solutions under constraints that vary from place to place. For this reason, and given the diversity of initial conditions, I do not believe that a generalized and universally appli- cable ''optimal'' hierarchy of decisions and chronology of implemen- tation can exist . . To conclude, consider the structure of share ownership in the Czech Republic and Russia or what is likely to emerge in Poland once the privatization vol,lchers are distributed. In the Czech Republic, where distribution of vouchers preceded bidding for shares ·of pri- vatized companies, most vouchers were immediately converted into investment fund shares, but very limited consolidation of vouchers in private hands took place. And even though the incidence of equity ownership among the Czechs is extremely high (about three times what it is in the United States), the bulk of this equity is held by a few hundred investment funds. A near complete institutionalization of the market was achieved overnight. In Russia, by contrast, voucher 194 Jacob S. Dreyer holdings are being rapidly consolidated by individuals who are buy- ing up these vouchers to bid, among others, for shares of continu- ously privatized enterprises. The result is a rapidly growing number of owners of shares in individual companies. In addition, of course, all kinds of pooled investment vehicles are springing up, thousands of them. In Poland, consolidation of voucher holdings is also certain to occur. But the number of investment funds accepting vouchers will be limited by licensing to about 15. Unlike the Czech or Russian funds, they will be state sanctioned, their operations will probably be subsidized, and their portfolio choices somewhat circumscribed. Because of just these differences in the structure of share ownership, the pattern of corporate governance in the Czech Republic, Poland, and Russia will be quite different also. So will the structures of their equities markets, which will require rapid creation of supporting institutions with different characteristics, in a different sequence, and at a different pace. Of course, in all cases, well-capitalized and effi- ciently operating banks are nice to have, but life must go on even without them. 8 Strengthening the Russian Banking System: The International Standard Banks Program Millard F. Long and Samuel H. Talley1 In Russia, financial reform has lagged behind privatization. Con- cern is now developing that the advantages of privatization may be reduced and the economic recovery slowed by the absence of ade- quate financial services. Signs of this are already apparent. The pay- ment system has not been able to cope with the expanded number and changed nature of payments. lnterrepublican trade has been greatly hampered by payments problems, but payments problems are even apparent in intrarepublican trade where clearance may take weeks. Payments are simply illustrative. Problems abound in all areas of finance. The growth of interenterprise arrears in 1992 had multiple causes but highlighted the inadequacies of interindustry trade finance. Household savings were traditionally and still are primarily held as deposits in Sberbank. Other banks are dependent on enter- prise deposits and borrowing from the Central Bank, leaving them with uncertain sources of funding and a volatile deposit base. Bank credit as a percentage of GDP has fallen very sharply since the end of 1991. Inflation has provided substantial relief to debtor enterprises but at the expense of deposit holders. Because of highly negative real interest rates, banks are not able to mobilize new deposits. Without further credits from the Central Bank, enterprise and household liquidity is at a minimum. Nor does the banking system have the resources to provide large reconstruction credits. Even if the funds were available, the banking system lacks the expertise to judge credit 1 The views expressed should not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries. 195 196 Millard F. Long and Samuel H. Talley risk or to monitor and supervise enterprises to which loans are extended. Another problem is the structure of the banking system. The large state banks are not true banks, but rather act as conduits for directing Central Bank and budgetary funding to selected enterprises. At the other extreme, 1,600 small, mostly new banks do little more than provide treasury services to their founding enterprises. A large num- ber of banks are either already technically insolvent or will become insolvent when the Government eventually cuts back on subsidies and credit to enterprises. The infrastructure of the banking system is deficient. The commercial banking law has serious shortcomings, the bank supervisory capacity of the Central Bank is minimal, and the banking system does not employ proper accounting standards. The lack of proper accounting standards and adequate disclosure of bank financial statements largely eliminates market discipline from the Russian banking system. In sum, the financial system in Russia is ill prepared at present to serve the newly emerging private sector. The problems are so serious that various proposals are appearing to establish what would essentially amount to alternative banking sys- tems: for example, the proposal to pass large amounts of foreign assistance for reconstruction through nonbank government institu- tions or newly established development banks. During the 1970s, governments in developing countries (often supported by the inter- national donors) attempted to use draft measures to develop the real sectors of the economy, at the cost of financial sector development. Experience shows that this procedure was a mistake. Moreover, although the banking system in Russia is behind in terms of prepara- tion for market activity, it may not be far behind. Most of the newly privatized firms will take some time to formulate their strategy, and by the time the firms have well-developed plans for reconstruction, the banks could be prepared to make and supervise loans. The evi- dence from some of the other East European countries (Poland, the Czech Republic, Hungary) suggests that with the proper incentives the banks can prepare themselves for the market as rapidly as the enterprises. An important reason for a lack of progress in Russia has been the absence of any central authority interested in and able to tackle the problems of financial reform on a systemic basis. We would like to suggest that development of the regular banking system should not be neglected in terms of policy and assistance even though some supplementary institutions may be needed to handle the financing of the largest and most problematic enterprises. That reforms in finance have lagged behind those in privatization should not be taken to imply that little has changed or that no prog- 8 •THE INTERNATIONAL STANDARD BANKS PROGRAM 197 ress has been made. The structure of the banking system in Russia has gone through turbulent change over the past five years from the transformation of the monobank into several large state banks and then the breakup of those state banks into many independent banks coupled with the proliferation of new banks sponsored by enter- prises. The existence of so many new and small banks is in fact one of the problems. But in other areas change has been more constructive .. Considerable effort has gone into drafting new banking and other business laws (most of which are yet to be enacted), developing better systems for financial accounting, preparing plans for payment system reform, training bankers, initiating a system for bank supervision, and developing a program for limited deposit insurance. But even in these areas, although plans have been drafted, little has yet been implemented. In the early stages of the debate on financial reform in Eastern Europe, the question was raised whether to attempt to restructure, reform, and recapitalize the existing banks or to scrap the existing institutions and establish new banks unencumbered with problem portfolios and bad banking habits. In practice, all of the governments opted to restructure the existing institutions, although some have created new development banks or issued licenses to new commercial banks. Even if an appropriate legal framework could be developed for the Russian banking system, the Central Bank does not now have an adequate supervisory capacity to enforce the laws or monitor the banking system to root out unsafe and unsound banking practices. In part, this is due to Russia having over 1,700 banks-the result of the Government not implementing appropriate licensing standards. After an initial analysis of the situation in Russia, we discussed with the authorities delicensing the many small banks that were acting only as funding agents for their founding enterprises. These banks represented pathological examples of insider lending. The authorities preferred an alternative solution, which has come to be known as the international standard banks program. During 1992, the World Bank worked with the Central Bank of Russia on the development of this program. In the opinion of the World Bank, as well as a number of officials at the Central Bank, this program could make a significant positive contribution to the development of the Russian banking sys- tem during these extremely difficult times. In this paper we will describe the international standard banks program. This program is not a complete program in that it does not directly deal with the three major state banl r. The inequality states that the marginal return to liquidity used to purchase inputs pf' (m) - 1 is greater than the marginal return to liquidity left in the hands of the workers r. Thus, by lending to firms, workers get a rate of return larger than r. The version of the model discussed above adopts a series of sim- pli£ying assumptions that do not crucially affect the main results. Before pointing to some natural extensions of the model, it is worth noting that the above model focused on the case of fixed exchange rates and tradable inputs and output. With flexible exchange rates it is less obvious how the real stock of liquidity can fall below full capacity. Indeed, the contraction of nominal liquidity would lead to an appre- ciation of the exchange rate, which could in turn maintain the real stock of liquidity at its full capacity. To generate the same result dis- cussed in the text, the model has to be modified in one of two ways: (1) assuming some form of price-setting rigidity and/or (2) assuming an asymmetric distribution of liquidity before the program started. In both cases a contraction in liquidity would lead to output effects. Rigidities in price setting may arise because of the presence of a significant share of input prices that is administered, or because of anachronistic cost-plus pricing in sectors not exposed to foreign com- petition. The asymmetric distribution of liquidity implies that the increase in the price level will determine liquidity constraints for liquidity-poor firms, whereas liquidity-rich firms would still be char- acterized by excess liquidity. To avoid the output decline, a realloca- tion of liquidity across firms would be necessary. Thus, the effects of a credit crunch are likely to be at work also with flexible exchange rates, as long as there is segmentation in credit markets. 3 As a consequence of the assumption of strict concavity of the production function. 264 Guillermo A. Calvo and Fabrizio Coricelli The main results of the model do not depend on the specific form of credit market segmentation, which was introduced by superimposing a lower bound on wages. In a richer-and perhaps more realistic- model the limits on enterprise borrowing from workers can arise from the fact that workers-households may face liquidity constraints as well. In addition, the main thrust of the above model carries over to a more realistic setting in which firms' liquidity can be altered by bank credit (see Calvo and Coricelli (1992) for such extensions). 4 Finally, a more realistic model would incorporate inventories and interenterprise arrears. Indeed, the cash constraint may be loosened by the presence of these two elements. However, both the download- ing of input-inventories and the accumulation of arrears in payments to suppliers, although effective at the level of the single firm, may have negative aggregate effects on output as they create difficulties for firms that produce inventories and for suppliers of inputs. Nev- ertheless, the introduction of inventories and arrears would not alter qualitatively the basic result relating to the impact effect on output of a liquidity contraction. Whether the use of inventories and the accu- mulation of arrears may eliminate the liquidity crunch is an empirical question. The definition of liquidity of the firm is modified, but not the nature of the constraint (1). Nevertheless, as discussed in the next section, the presence of interenterprise arrears may have important dynamic effects. The model implies that output converges toward its full-capacity level as firms accumulate liquidity over time. The actual experience of previously centrally planned economies seems to indicate that the speed of recovery is rather low. Even in countries like Poland that began to grow during 1992, the level of output remains depressed (Chart 2). There are several possible channels of low-output persis- tence, some of which are explored in the next section. The simple model discussed above obviously neglects the presence of exogenous shocks, like the demise of the CMEA, which may depress output. Although empirically relevant, these shocks do not alter the validity of the theoretical model. In fact, the CMEA shock itself could be seen as a case of trade implosion deriving from the destruction of a system of centralized credit and payment. In our model this can be 41n the case of binding credit ceilings, the model is basically unchanged. When credit ceilings are not binding, the behavior of the stock of credit is demand- determined and depends on the path of interest rates on bank loans. However, in the relevant case in which interest rates are initially high and are expected to decline over time, the main results of the simple cash-in-advance model still hold. 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 265 Chart 2. Industrial Output Indices 130 Hungary 120 ;·•• Former Czechoslovakia ... . 110 .. 100 90 80 70 60 50 40 1989 1990 1991 1992 characterized as a tightening of the liquidity constraint determined by a contraction of foreign credit. Moreover, there are other channels accounting for a slower recov- ery that can be easily incorporated in the simple model exposed above. They relate for instance to the horizon of the firms, endo- genous inflation, and its effects on money demand. These modifica- tions, while altering the quantitative implications of the model in terms of speed of adjustment, do not change the main thrust of the simple model. In contrast with these "incremental" changes of the simple model, we discuss in the next section the possibility of a qualitative change in the properties of the dynamic adjustment implied by the simple model. In particular, we develop a model with multiple equilibria, with each equilibrium distinguished by different levels of output and liquidity. In this type of model the issue is not simply the speed of adjustment, as countries may get stuck in the initial state of depressed output. Low-Output Persistence This section presents three extensions of the basic model discussed above, which help to explain low-output persistence. · 266 Guillermo A. Calvo and Fabrizio Coricelli Short Enterprise Horizons A salient characteristic of most transformation processes is the will- ingness to restructure and privatize a large. portion of the originally socialized sector. In general., this type of expectation shorild have an effect on the firms' incentives. Thus, for example, if the firm were to be privatized at time T, the sum in expression (3) worild have to run from 0 to T, which lowers incentives for liquidity accumrilation and depresses output. More interestingly, if privatization time, T, is unknown, and the probability of its occurring in the "next instant," if it has not occurred before, is o(a constant), then one corild argue that the optimal strategy for the enterprise is to maximize a 'sum like (3), where now the discount factor is (1 - o) I (1 + r) (which corresponds to Yaari (1965) in discrete time). Consequently, the steady-state first- order condition (4) now becomes '"() l+r (4') ·P1 m = 1-o· Therefore, under privatization, risk output will be permanently lower than the social optimum (where condition (4) holds), even if the sys- tem converges quickly to its steady state. The insight from this model is _straightforward. Either privatize quickly, or make a credible announcement that privatization is unlikely to happen.s Endogenous Inflation Our simple model in the previous section assumes fixed exchange rates. However, it is easy to extend it to cases in which, for instance, the rate of devaluation is constant. Let the rate of devaluation be denoted by e. Then one can prove that steady-state condition (4) becomes pf' (m) = (1 + r) (1 + e) =1 + i = 1 + nominal interest rate. (4") Given exogeneity of relative prices, the domestic rate of inflation is also equal toe. Thus, condition (4") implies that the higher the rate of inflation, the smaller is the demand for cash by enterprises (a per- fectly conventional result). Besides, since output is given by f(m), it 5 A more complete analysis will, of course, have to take into account the inefficien- cies associated with quick privatization as well as those associated with keeping enter- prises in government hands. 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 26 7 follows that higher inflation is associated with smaller steady-state output. Let. us now consider ari economy that depends on seigniorage to finance (part of) its budget deficit. In such a case the rate of expansion of cash is afunction of the price level: the higher the latter, the higher will be tµe former. As is well known (see, for example, Calvo (1992)), such money supply endogeneity may give rise to equilibria with dif- ferent inflatio11 rates. In other words, the same set of "fundamentals" may be associated with low or with high inflation, depending on the state of expectations. Since, as noted above, the level of output is inversely related to inflation, this extension of the model illustrates the possibility that the economy locks mto a "bad" equilibrium with low output and high inflation. There is more than one way in which an economy could lock into a bad equilibrium. One possibility is that, before the start of the trans- formation program, inflation was high. Thus, it would be perfectly normal for people to expect that it will take a while for inflation to decrease:--possibly forcing the monetary authority to validate expec- tations, undermining the program's credibility, and lengthening even more the period of high inflation/low output. Another possibility, which is of even greater relevance for previ- ously centrally planned economies, is that the bad equilibrium is a consequence of the initial liquidity crunch. The latter increases nom- inal interest rates, which could, in turn, be interpreted by individ- uals as a signal of higher future inflation. Higher inflationary expec- tations lower the demand for money, which, as argued above, may induce the monetary authority to validate the high-inflation equilibrium. The solution implied by the model is deceivingly simple: just push the economy to the hig4-liquidity equilibrium. However, effective implementation of such a solution is not easy. For example, a natural candidate would seem to be a one-step increase in money supply. However, for this policy to be effective, it is necessary for people to believe· that it will result in lower inflation-an unlikely outcome given that the public ()bserves money supply increasing. In fact, people may infer that the central bank is conducting "business as usual" by once again heavily relying on the inflation tax. Therefore, the demand for money may not incr.ease-it m,ay actually decrease-making high steady-state inflation even harder to overcome. In addition,· in the period that the policy is implemented, the inflation rate may exhibit a very large spike (because money supply suffers a sizable jump, while money demand is constant or declines)-making a mockery of the stabilization plan. 268 Guillermo A. Calvo and Fabrizio Coricelli Alternatively, the government could launch a propaganda cam- paign aimed at lowering inflation expectations. This campaign could announce, say, that the currency will be pegged to the U.S. dollar. However, this policy may backfire. First, it will unravel quickly if the public is not persuaded about the effectiveness of the stabilization program. The demand for money will remain low, which will force the government to resort to a large infusion of money to finance the budget deficit-thus eventually leading to a balance of payments crisis. Second, if to avoid a balance of payments crisis the exchange rate is allowed to float, the low-inflation/high-output equilibrium can be achieved only if prices and nominal wages fall by, possibly, a substantial amount. Otherwise, without the above-mentioned dan- gerous one-step increase in nominal money, real monetary balances will not be able to increase toward the "good" equilibrium. For this to work out, however, public sector prices and wages must also fall by, in principle, the same proportional rate. In fact, to enhance the cred- ibility of the shift toward the good equilibrium, public sector prices and wages should take the lead. If, as is unlikely, there are no fric- tions and all prices and wages fall by the necessary amount, success would be granted. However, if private sector prices and wages fall by less than is necessary, the relative position of government will be impaired. The fiscal deficit is likely to increase, the best workers in the public sector will be attracted to the private sector, and those that. remain may shirk more and be more willing to go on strike. All of which may push the economy back to the bad equilibrium. 6 Interenterprise Arrears. A salient characteristic of transformation programs has been the rapid development of interenterprise credit channels (see Begg and Portes (1992), Calvo and Coricelli (1992), Ickes and Ryterman (1992), Clifton and Khan (1993), Daianu (1993), and Rostowski (1993)). How- ever, interenterprise credit is large also in market economies (see Rostowski (1993) and Begg and Portes (1992)). Therefore, the growth of interenterprise credit in previously centrally planned economies should, in principle, be viewed as a welcome development. Unfor- tunately, however, the rapid growth of that market has been accom- 6 Another interesting case of endogenous inflation is when prices are set at time t before knowing money supply at t. Under those conditions, a government that is averse to unemployment may end up validating more than one inflation level. A solution for this problem is sometimes sought in incomes policies. For a discussion of wage policy in the context of Poland, see Calvo and Coricelli (1992). 11 • CREDIT MARKET IMPERFEPIONS AND OUTPUT RESPONSE 269 panied by the emergence and, occasionally, the ballooning of interen- terprise arrears, that is, involuntary interenterprise credit. The latter is in principle undesirable, since 'it very much occupies the place that shirking and stealing take in regular market economies. To capture interenterprise arrears, let us assume that firms can acquire their inputs by paying with cash or by falling into arrears. Let ()indicate the share that is, in equilibrium, paid in cash. Taking the extreme case in which arrears are expected never to be paid back, the competitive nominal price of inputs and outputs (recall that inputs and outputs are fully tradable and their foreign currency price is unity whereas, in the simplest model, the exchange rate was set equal to unity) must be 118. To put a natural break on arrears, we will assume that they are costly, and that the present discounted value of the cost (in terms of input) of additional arrears is proportional to the latter, where the factor of pro- portionality is denoted by K > 1~ Hence, focusing exclusively on.firms that sell to other firms, the analog of cash accumulation equation (2), where now m is expressed in terms of input becomes ~ mt + 1 = f ~ > 0. Notice that, by equation (5), optimal xt will be chosen to maximize the right- hand side of that equation. Thus, at an interior maximum, we have (6) 270 Guillermo A. Calvo and Fabrizio Coricelli Moreover, the no-accumulation-of-arrears corner solution obtains if (7) whereas the maximum-accumulation-of-arrears corner solution holds if (8) Let us now turn our attention to optimality conditions for w. To simplify, we will focus exclusively on steady states, where ()t = () = constant through time. As in the previous sections, we will assume that the bounds on w are wide enough for optimal w to be interior to its feasibility region. If f!. < () < 1, then increasing the wage bill by 1 more unit at time t implies, by equation (5), () less units of real mone- tary balances at the beginning of period t + 1, which, if used to pay input in period t + 1, saves KO in cost of arrears. Thus, the wage bill in period t + 1 could increase by K units. In view of expression (3), if the perturbation is taken at the optimal point, a necessary condition for an interior optimum will be K = 1 + r-a highly unlikely situation. Therefore, as expected, solutions will in general be at () = 1 or () = f!.. Consider the case in which () = 1, that is, no accumulation of arrears. This case is similar to that in the previous section. Therefore, at optimum, f'(m) = 1 + r, which, combined with equation (7), implies that K > 1 + r. Finally, if() = ()then, by equations (3) and (5), at optimum, f' (; )!!. = (1 + r) !!_ + K (1 - !!_) • (9) When the latter is combined with inequality (8), it implies that K s 1 + r. Consequently, we have shown that no arrears will take place if K > 1 + r, whereas maximum accumulation of arrears will occur if the inequality is reversed. Therefore, disregarding the possibility of an interior solution, the economy could exhibit a minimum liquidity equilibrium (that is, () = !!.), MLE, and a no-arrears equilibrium (that is, () = 1), NAE, which corresponds to the equilibrium discussed in the previous section. Notice that, because when() = 1, we have f'(x) = 1 + r, equation (9) implies that, as expected, output is lower at an MLE than at an NAE. Given K and r (1 + r -:/= K), one of the two equilibria will emerge. However, these variables are, to some extent, endogenous. First, as noted above, the effective interest rate (that is, r + o) is affected by the 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 271 firm's horizon. If the latter is short, the effective interest rate will be large, and a bad MLE is likely to materialize. Second, if as above, the model allows for inflation (nominal interest rate i > r), then one can show that all the above conditions hold with i substituting for r. Thus, when inflation increases beyond the critical point at which 1 + i = K, the economy will suddenly shift from the NAE to the MLE. This reinforces the possibility of a bad equilibrium taking hold, because the shift from an NAE to an MLE represents a catastrophic decline in the demand for money (which comes on top of the decline empha- sized at the beginning of this section). In addition, the marginal direct cost of arrears, K, is likely to be affected by the amount of arrears. The larger the latter is, the smaller may be the marginal direct cost of arrears, K. Thus, an initial liquidity crunch, for example, may force firms into arrears. As the latter accumu- late, firms realize that they are not the only ones in trouble and, there- fore, that penalties cannot be as severe as when just a few firms fall into financial difficulties. As a result, K may decline so much that the ball MLE takes hold. In other words, an initial credit crunch could generate a situation in which interenterprise arrears accumulate without boun~ and output is permanently lower than in the no-arrears situation. Obviously, much of the previous policy discussion applies to the present case. The present model, however, allows us to address the question of whether the clearing of arrears could be an effective policy to drive the economy to the good NAE. The model suggests two rea- sons for being skeptical. First, firms' horizons could be very short and, thus, K would have to be very large to induce firms to avoid falling into arrears. Besides, large KS may be hard to implement because bank- ruptcy is either nonexistent or bankruptcy procedures are exceedingly slow. Second, K may depend not only on past arrears but also on expected arrears. Thus, the MLE could be quickly regenerated if firms expect that the previous arrears situation will re-emerge in the future. Our skepticism is supported by experience in countries like Romania, where the elimination of arrears has quickly been followed by a buildup of new ones. Therefore, our discussion suggests that the solution in such cases must be found in massive privatization and effective bankruptcy regulations. A Closer Look at the Evidence The above discussion has suggested that (1) a contraction in real liquidity of enterprises is likely to lead on impact to a fall in output; (2) real wages tend to decline on impact. The speed of recovery of wages 272 Guillermo A Calvo and Fabrizio Coricelli depends on the characteristics of the workers' objective function, on the workers' horizon, and on the timing of wage payments.7 (3) The initial contraction in output may be sustained by a short horizon of the firms, by a fall in money demand, and by a "demonetization" of enterprise transactions, associated with the blossoming of interen- terprise arrears. The model in previous sections implies a relatively homogeneous impact effect of the credit contraction. By contrast, the dynamic adjustment is likely to be highly heterogeneous. Indeed, even start- ing from similar initial conditions, countries may settle down on very different equilibria. The channels affecting convergence toward a spe- cific equilibrium are diverse and are likely to play different roles across countries and over time within countries. Limitations on data availability severely constrain the empirical test of these implications. In particular, we will not attempt to carry out an in-depth analysis of the dynamic adjustment in the different coun- tries. Nevertheless, there are a host of stylized facts and more detailed evidence on some of the countries that lend support to the simple models developed in the previous sections. These stylized facts depict countries that seem to share the initial contractionary effects of credit tightening, whereas their dynamic adjustment after the initial shock is significantly differentiated. Although the experi- ence with stabilization is too fresh to permit clear distinction of the successes from the failures, there seems to be a marked differentia- tion between one group of countries-the former Czechoslovakia, Hungary, and Poland-which, despite large initial costs, appears to be on a path toward the good equilibrium, and another group of countries-Romania and Russia-which has not yet succeeded in sta- bilizing inflation nor shown signs of recovery of economic activity. Available information, however, does not allow us to analyze in detail the dynamic adjustment of the various countries. The following sections provide evidence that the difficulties of sta- bilizing these economies could have partly resulted from an excessive initial tightening of liquidity conditions. Once the economy has set- tled into an equilibrium with low liquidity and low output, relaxing monetary policy tends to be ineffective to reactivate production. 7 In the linear specification of the workers' utility function discussed above, wages will stay at their minimum level to maximize the speed of recovery of the steady-state level of output. Calvo and Coricelli (1992) show that with a concave utility function, real wages grow along the path to the steady state. Finally, it can be shown that if wages enter the liquidity in advance constraint of the firm, optimal paths exist along which wages grow at the same rate as liquidity, and output remains constant. 11 • CREDIT MARKET lry1PERFECTIONS AND OUTPUT RESPONSE 27 3 Thus, monetary expansion tends to be reflected in higher inflation, giving rise to the stop-go cycle observed in countries like Ru~sia and Rom~a. As discussed below, the same nature of the response of the economy to the initial liquidity contraction tends to exert pressure for a relaxation of policies. In addition to factors related to credit markets, uncertainty on prop- erty rights and.on the timing and characteristics of changes in owner- ship and control of enterprises plays a fundamental role in affecting the supply response during the transition. Initial Credit Crunch Table 1 shows that-except for Hungary-all Central and East European countries were characterized by a sharp drop in real credit to enterprises at the beginning of their reform programs. This drop was partly planned, as indicated by the credit targets. However, the actual decline was much larger than planned, especially for the for- mer Czechoslovakia and Poland. The larger-than-expect~d decline in real credit was determined by a larger-than-anticipated jump in the price level. With Poland as an outlier, there seems to be a correlation between the pre-liberalization ratio of broad money to GDP-a very rough proxy for ex ante monetary overhang-and the size of the initial price level jump (Chart 3). However, the price jump has invari- ably been higher than anticipated, and the size of the initial adjust- Chart 3. Initial Price Level Jump Post-reform inflation l 300 Russia 250 I - • - 200 I- - 150- - Bulgaria 100 I - Poland • - • - 50 - Romania • Former Czechoslovakia Hungary• • Q.__~~~--C-~--'--~~~~~~~~~~~~~~~~~~~ 1 1 1 0 0.5 1.0 1.5 2.0 M2/GDP pre-reform 11nflation during the first month after price liberalization (in percent). 27 4 Guillermo A. Calvo and Fabrizio Coricelli ment seems to have been tightly connected with the increase in administered prices and the devaluation of the exchange rate. Accordingly, the behavior of the price level seems to have reflected some rigidity in. the price system, either because of the large initial devaluation of the exchange rate followed by a fixed peg-as in Poland and the former Czechoslovakia-or because of the large increase in administered prices. In fact, in some countries both factors played a role (see also the discussion in Bruno (1992)). Thus, the assumption of an initial exogenous contraction in real bank credit appears plausible.a For Poland, data availability-especially cross-section data- permits a more detailed empirical analysis. At a macroeconomic level the association between the contraction in credit and the drop in output is striking. Indeed, the fall in output accompanying the credit crunch was sudden, concentrated in the first two months of 1990. The empirical analysis of the output-credit link cannot be based on a time series analysis, as January 1990 coincided with a change in regime for the Polish economy. However, a closer inquiry into the role of credit factors in the initial collapse of output could be based on cross-section information. The cross-section analysis may shed some light on· the relation between the initial structure of credit markets inherited from the past and the sectoral behavior in response to the policy changes of January 1990. In particular, the first model developed above implies that the initial distribution of liquidity across sectors is a key determinant of the output behavior foll9wing the credit crunch. Indeed, with credit market segmentation, the effect of a credit contraction is likely to have heterogeneous effects across sectors. Specifically, sectors that are more dependent on outside sources of finance, in particular bank credit, are likely to be harder hit, as they cannot easily replace bank credit with alternative sources of financing. An empirical test of our view would in principle require information on the initial liquidity position of firms/sectors, and on the possible sources of liquidity for firms, in particular the stocks of input inventories, whose movements alter the liquidity constraint of firms at a point in time. Unfortunately, we do not have data on the sectoral distribution of liquidity. We are thus forced to use bank credit as a proxy for enterprise liquidity. 8 An additional, indirect indication that the credit contraction at the beginning of the reform programs was not determined by an exogenous decline in the financing needs of enterprises is suggested by the fact that interenterprise credit (or arrears) increased in relation to bank credit in every country (see discussion below). 11 •CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 275 Table 2. Poland: Regressions on Output and Credit, 1990.l/1989JV1 (Dependent variable: change in real output) OLS TSLS 2 (1) (2) (3) Constant -0.24 -0.19 -0.20 (12.89) (6.70) (6.10) Change in credit3 0.02 0.20 (0.71) (2.10) "Credit dependence"4 -0.27 (2.45) R2 0.01 0.07 Observations 85 85 85 1figures in parentheses are t-statistics. 2rwo-stage least-squares. Instruments: constant and credit dependence as defined above.· · · 3Log-difference. 4 Ratio of bank credit to total costs at the end of 1989. Notwithstanding these caveats; the negative association between ex ante credit dependence and the change in output at the beginning of 1990 shown in regression (2) in Table 2 is suggestive of the impor- tance of the inherited credit market structure on output behavior. 9 Of course, one would like to go beyond this simple correlation between ex ante credit dependence and initial output performance and try to assess the quantitative impact of the change in the liquidity condi- tions of enterprises on output. As shown in Table 2 a simple ordinary least-squares (OLS) regression on changes in output and changes in credit indicates a very weak statistical relation between credit and output across sectors. However, one might have expected to find a weak correlation between output and credit,· given that the change in bank credit may be a poor proxy of the change in liquidity of enter- prises. Indeed, the output effect of the credit contraction is mediated by the adjustment of· other variables-for instance, inventories- affecting the liquidity of firms, in a way that makes the change in output at the firm/sector level only slightly related to the change in credit to that firm/sector. This phenomenon may arise, for instance, if we assume that reduc- ing the stock of inventories gives rise to adjustment costs, resulting in 9Credit dependence is measured by the ratio of bank credit to total costs before the implementation of the stabilization program in the last quarter of 1989. 27 6 Guillermo A. Calvo and Fabrizio Coricelli output losses, which are not very sensitive to the size of the inventory adjustment. In the limit, these adjustment costs may be fixed, thus totally independent of the size of the change in inventories. In this case, the output loss associated with an inventory reduction induced by a credit crunch is going to be evenly spread across sectors, and thus uncorrelated with the size of the sectoral contraction in credit. At the macroeconomic level, .one would still observe a correlation between credit contraction and output decline. However, at the microeconomic level, the direct association between credit and output is lost. Therefore, even without resorting to the presence of price rigidities, the credit crunch could have large output effects through the reduction in inventories.10 In addition, if one assumes price rigidi- ties, the output decline would be determined by the reduction of the demand for inventory goods by firms that deplete their stocks of input inventories (see discussion in Calvo and Coricelli (1992)). Even in this case the cross-section regression would likely generate no significant impact of credit on output, as the effect of credit on output depends a1 :JO on the distribution of inventories across firms. 11 The above discussion suggests that the role of financial constraints can be better detected by analyzing the behavior of inventories in response to the contraction in bank credit. An extended version of our model incorporating inventories would have clear cross-section implications, as firms/sectors suffering a more severe credit squeeze should display a sharper decline in inventories (see discussion in Calvo and Coricelli (1992)). Table 3 contains the results of several regressions on the behavior of input inventories in the first quarter of 1990 for 85 branches of Polish industry. The macroeconomic importance of the behavior of invento- ries can be appreciated by noting that during the first quarter of 1990 the stock of input inventories in our sample dropped in real terms by about 30 percent. We focus on input inventories as they are the relevant aggregate for the credit view exposed above. Nevertheless, it is worth noting that credit factors have a large and significant effect on the behavior of firiished goods inventories (see also Berg and 10 An analogous phenomenon would apply to interenterprise arrears, as discussed above. Indeed, a credit contraction would lead to an increase in arrears, which produce output losses independently of the size of the arrears at the individual firm. Unfor- tunately, we do not possess at this time sufficient information to carry out an econo- metric analysis of interenterprise arrears. 11 For instance, firms rich in inventory will have the opportunity of replacing a large proportion of bank credit and maintain output, while firms with poor inventory would suffer output losses even if they suffered, relative to the other firms, a smaller propor- tional decline in bank credit. ' · 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 277 Table 3. Poland: Regressions on Inventories and Credit, 1990.l/1989.IV1 (Dependent variable: change in input inventories) OLS TSLS2 ( 1) (2) (3) (4) Constant 0.64 0.40 0.86 0.36 (16.68) (7.97) (20.19) (5.78) Change in credit3 0.13 0.08 . 0.18 (3.25) (5.98) (2.40) Change in salesa '· 0.38 0.33 (2.26) (4.44) "Credit dependence"4 -0.27 (3.34) R2 0.11 0.38 0.11 1sample: 85 observations; figures in parentheses are t-statistics. 21nstruments: constant. change In sales and credit dependence as defined above. 3Log-difference. 4Ratio of bank credit to material costs at the end of 1989. Blanchard (1992)). We concentrate on nominal values, since a relevant price deflator for input inventories is not available, both for invento- ries and credit. However,. most of the results are robust to the use of real measures of both inventories and credit, and to different. price deflators. The first regression in. Table 3 displays the result of a simple bivari- ate regression, including only the change in bank credit as an explan- atory variable. The coefficient on the credit variable is significant at the 2 percent level, and the point estimate implies that on average about 15 percent of the change in inventories is explained by the change in credit. In the second regression we control for other factors that may affect the change in inventories by introducing the change of sales as an additional explanatory variable. Although slightly reduced, the coefficient .on the credit variable remains significant at the 3 percenflevel. Moreover, we ran simple OLS regressions using an ex ante mea- sure of credit dependence instead of the change in credit. The sign of the credit dependence variable is negative as expected and significant at the 1 percent level. This result confirms the importance of the ex ante credit dependence on the sectoral behavior, suggesting the empirical relevance of credit market segmentation. In addition, the use of an ex ante measure of credit dependence is immune from problems of endogeneity of the credit variable. · 278 Guillermo A. Calvo and Fabrizio Coricelli To further account for the possibility of endogeneity of the credit variable we also carry out a two-stage least-squares (TSLS) regres- sion, using the credit dependence index as an instrument for the credit variable. The results of the TSLS estimation essentially confirm those of the OLS regressions. In sum, all specifications yield a significant and quantitatively important effect of the credit variable on inventory behavior. These results are suggestive of the importance of the credit channel at the beginning of the Polish reform program, although the inventory equations cannot help establish the quantitative effect on output of the credit contraction. Nevertheless, the above analysis suggests that a large proportion of the output behavior that in the output-credit regression is captured by the constant can in fact be associated with the credit channel through the output effect of the inventory contrac- tion. Moreover, the fact that the ex ante credit dependence proves to be consistently significant both in inventory and output equations is suggestive of the important role of credit market factors in the behav- ior of real variables in the initial stages of reforms in Poland. This is somehow a remarkable result, if one takes into account the degree of noise present in a system like Poland in 1990 undergoing a radical change in economic regime. Another way, consistent with the first model above, of establish- ing the importance of the credit view is to analyze the behavior of wages at the outset of the stabilization programs. In the same sec- toral sample used for the output and inventory regressions for Poland in 1990, we find that the change in credit has a positive, and statistically significant, impact on the sectoral change in the wage bill (Table 4).12 More generally, the phenomenon of "borrowing from workers" predicted by the first model above seems to have been relevant not only in Poland but also in Bulgaria, the former Czechoslovakia, and Romania at the outset of reforms, as shown by increases in wages below the ceilings imposed in the stabilization programs (see Calvo and Coricelli (1993)). 12However, the results are highly sensitive to the specification of the regression. In particular, in a log-linear specification the coefficient on credit was not significant. Nevertheless, the linear specification arises naturally from the budget constraint of the firm. 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 279 Table 4. Poland: Regressions on Wages and Credit, 1990.l/1989.IV1 (Dependent variable: change in nominal wage bill) OLS Regressions ( 1) (2) Constant 8667 8890 (4.84) (5.48) Change in credit2 0.10 0.05 (8.07) (3.07) Change in sales2 0.01 (4.35) R2 0.01 0.07 Observations 85 85 1figures in parentheses are t-statlstics. 2first difference. Dynamic Response: Inflation, Firms' Horizon, and Interenterprise Arrears As shown in Chart 2, despite some signs of recovery in the former Czechoslovakia, Hungary, and especially Poland, three years into the reform programs economic activity remains rather depressed, particu- larly in industry. The first model discussed above, based on a "repre- sentative firm,'' implied that the optimal behavior of a firm that maxi- mizes the welfare of its workers would lead to a relatively fast recovery toward steady-state output_ It was also stressed that uncertainty on the timing of privatization, by shortening the horizon of the workers (that is, increasing the "effective" discount rate from r to r + o), could hinder the output recovery. This factor likely played an important role in most previously centrally planned economies, perhaps with the exception of the former Czechoslovakia and Hungary. In Poland, Romania, and Russia, after a short-lived initial period of wage modera- tion, real producer wages increased significantly. In Poland, for instance, although during the first months of the program wages were set well below the wage ceilings, by the end of 1990 they overshot the ceilings and stayed above them for most of 1991. Despite falling output and growing unemployment, the share of enterprise value added appropriated by labor increased sharply. 13 13 In industry, the share of the wage bill in gross value added increased from about 18 percent at the beginning of 1990 to 45 percent at the end of 1991. 280 Guillermo A. Calvo and Fabrizio Coricelli As a result, profitability fell over time, reducing the source of self- financing for enterprises. This seems to support the view of a short- ening of the horizon of firms. Interestingly, in 1992 there was a switch in behavior. Apparently, the fear of continued wage pressure and decapitalization of firms was averted. A possible explanation for the change in wage behavior may be associated with a lengthening of firms' horizons owing to a reduction of privatization risk (o in the model of the first part of the previous section). Indeed, the continued delay of the mass privatization program may have signaled a gener- alized delay in privatization. In addition, and perhaps more impor- tant, programs of enterprise restructuring have emphasized the vol- untary character of privatization-privatization becoming increasingly a "negotiated" process-and have enhanced the role of the insiders, both managers and workers, in the privatization process. This is likely to have reduced the risk of privatization, either by postponing the eventual date of privatization or by providing the workers a stake in the process. Both factors should induce a lengthening of the workers' horizon.14 As discussed above, another important channel hindering the recovery of output is related to the persistence of inflation, and the consequent decline in money demand. Inflation following stabilization varied sharply across countries. The former Czechoslovakia, Hungary, and Poland have been charac- terized by relatively low rates of inflation in the first two-three years after reforms. By contrast, Romania and Russia have failed to reduce inflation significantly after the initial price level jump. In fact, in Russia inflation has not abated more than one year after price liberal- ization and is hovering near hyperinflationary levels (Chart 4). High-inflation countries have also displayed a continuous decline in real monetary balances, while low-inflation countries did not expe- rience such a process of sustained "demonetization." Chart 5 shows the behavior of money velocity and identifies a clear differentiation between the behavior of Romania and Russia on one side and the former Czechoslovakia, Hungary, and Poland on the other. Velocity jumped in the aftermath of price liberalization in Bulgaria, Poland, 14This pattern seems to have been the one prevailing in Hungary since 1990 (Cori- celli and Lane, 1993). Moreover, the importance of privatization risk in affecting wage behavior seems to be confirmed by the experience of the former Czechoslovakia. Indeed, in the former Czechoslovakia the initial drop in real wages has not been followed by any significant wage pressure. The very rapid process of privatization and the direct stake given to every citizen, through the purchase of vouchers, may have been important factors in determining wage moderation. For a discussion of privatiza- tion and the role of insiders in Eastern Europe, see Frydman and Rapaczynski (1993). 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 281 Chart 4. Inflation Panel A. Monthly CPI Inflation ao~--~-------~ 30~----------~ Poland Former Czechoslovakia 70 25 60 \ 20 50 40 15 30 10 20 5 10 0 OL__ __i_..--lllU..Jll.lllll-.l.lh.-.lidLlJ 8 30 Hungary Romania 7 \ 25 \ 6 5 4 20 ' 15 3 2 10 5 0 -1 '--------'-------"-------'-----'-' o'--------"--- 1989 1990 1991 1992 1989 1990 1991 1992 250 Russia 200 \ 150 100 50 1989 1990 1991 1992 282 Guillermo A. Calvo and Fabrizio Coricelli Chart 4 (concluded}. Panel B. Monthly Inflation Rates After Reform 30 Russia 25 Romania 20 Former Czechoslovakia '1 I I I I I 15 Poland I I I I 10 .... I \ \ \ ,, \ I \ 5 0 ... 1990 1991 1992 1993 1The arrows indicate the date of price liberalization. In Romania price liberalization took place in stages. Romania, and Russia, while it remained stable in the former Czechoslovakia and in Hungary. In the second year of their reforms, velocity declined significantly in Poland and, to a lesser extent, in the former Czechoslovakia and Hungary, indicating a process of "remon- etization." By contrast, velocity continued to increase in Romania, signaling a continued fall in money demand. Even when appended to privatization risk and endogenous money demand, the model of the "representative firm" provides an incom- plete account of the dynamic adjustment of countries in transition. Indeed, independent of the incentives at the level of the individual firm, there could be problems in coordinating the recovery to the full- employment output in a system with interdependent firms. As shown in the previous section, when firms interact with each other the good equilibrium with output recovering its full-employment level is only one of the possible equilibria. Bad equilibria with low output and low liquidity can arise. A main force determining this multiplicity of equilibria is associated with interenterprise arrears. Arrears have grown in some countries from zero to amounts larger than overall bank credit or broad money (Table 5). Moreover, the heterogeneity of the behavior of arrears across countries may offer an 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 283 Chart 5. Money Velocities1 5.0 I Russia2J 4.5 I I 4.0 ../--·' 3.5 ,,·"I I 3.0 I Hungary ,,-" .... ........... ····· :;='-:. I 2.5 ... ·.:.:: ... ·· ... / I ......... . 2.0 ·-.Romania . / " -·---.,, : ,c'-,-:',....__ _ 1.5 1.0 ____________?" I Former Bulgaria I Czechoslovakia 0.5~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1988 1989 1990 1991 1992 1velocity is measured as GDP/average broad money (M2). 21992 data are up to June. Table 5. lnterenterprise Arrears1 (Ratio of interenterprise arrears to bank credit] Former Poland Romania Hungary Czechoslovakia Russia 1989.IV 1.6 0.2 0.0 1990.I 1.7 0.1 0.0 1990.11 1.2 0.2 0.0 1990.111 0.9 0.2 0.1 1990.IV 1.0 0.1 0.2 0.1 1991.1 0.9 0.5 0.2 0.1 1991.11 0.9 0.7 0.2 0.2 1991.111 0.8 1.1 0.2 0.2 1991.IV 1.0 1.9 0.2 0.2 0.0 1992.1 0.9 0.2 2 0.9 1992.11 0.9 1.1 2.3 1992.111 0.9 0.83 1992.IV 1For Poland, the figures refer to interenterprise credit, whereas for the other countries they refer only to arrears, that is, overdue credits. 2At the beginning of the year arrears were cleared through the global compensation scheme. 3 The figure is for July. In July bank credit was Injected into the system to clear the arrears. 284 Guillermo A. Calvo and Fabrizio Coricelli important clue for understanding the different macroeconomic situa- tions characterizing the various countries. Interestingly, the countries that we identified above as unsuccessful in stabilizing their econ- omies are those displaying an explosive behavior of arrears. 15 Interenterprise Arrears In the area of interenterprise arrears country experiences were remarkably heterogeneous (Daianu, 1993; Rostowski, 1993). Specifi- cally, arrears have literally exploded in Romania and Russia, whereas they have increased much less in Hungary and Poland. Moreover, after operations to clean up the arrears, both in Romania and Russia, arrears have rapidly grown again (Chart 6).16 In the model on interenterprise arrears in the previous section the main determinant of arrears was summarized by the parameter K, a proxy for the marginal cost of running into arrears for the individual firm. It was also suggested that such a cost is a decreasing function of the aggregate size of arrears. If firms cannot coordinate ex ante their behavior, there can be multiple equilibria with different levels of arrears. If firms attach a positive probability to the government validation of the arrears through money creation, the likelihood of the high arrears equilibrium obviously increases. The cases of Romania and Russia clearly illustrate such a phenomenon of self-fulfilling prophecy. Indeed, in both countries the government response to the explosion of arrears has been a generalized cleanup effected through injection of bank credit. Not surprisingly, arrears have grown rapidly soon after these cleanup operations were implemented, confirming the important role of the expectation of a bailout for the growth of arrears. In particular, as this expectation is probably linked to the size of aggregate arrears, the latter may be one of the channels through which K becomes a decreasing function of aggregate arrears. The time-series behavior of arrears in Poland offers additional evidence on the importance of credibility of the stabilization program in affecting the accumulation of arrears. Indeed, at the beginning of the program, when credibility was probably high, interenterprise credit fell 15 The former Czechoslovakia is somehow an outlier. Indeed, arrears grew very rapidly in a context of low inflation. This suggests-contrary to what is argued in Rostowski (1993)-that credibility of the stabilization program is not the only factor affecting interenterprise arrears. Nevertheless, in relation to bank credit, arrears in the former Czechoslovakia remain much lower than in Romania and Russia. 161n Romania with the so-called global compensation scheme at the end of 1991 (see Clifton and Khan (1993)), and in Russia in July 1992. Chart 6. lnterenterprise Arrears (PP/ deflated) - - - Bank Credit · · · · · · · · lnterenterprise Credit ~ 160[ Poland 900[ Former Czechoslovakia 140 800 ······ 700 120f- ~-- -j 600 500 1001. _J ········ .. ........... 400 80H r ..... 300 .. ... ... 200 ...... ... 60 40 v 100 0 ····· 1989 1990 1991 1992 1990 1991 120 600 115 Hungary Romania .· .. 500- 110 ···. ... • 105 .... ·· 400 >-- ... 100 300- ··· 95 90 200- 85 ·.·· 100 80 ~ 75 0 .. 1989 1990 1991 1990 1991 1992 286 Guillermo A. Calvo and Fabrizio Coricelli together with bank credit. As the credibility of the program weakened starting in the second half of 1990, interenterprise arrears began to move in the opposite direction to bank credit. The correlation coeffi- cient between interenterprise credit and bank credit, or enterprise money, is indeed negative after the first half of 1990. The change in the behavior of interenterprise arrears mirrors the change in wage behavior discussed above. In addition to the issue of credibility of the no-bailout stance, insti- tutional factors may affect the perceived individual cost of running into arrears. Ultimately, these institutional factors relate to unclear property rights and the consequent lack of credible bankruptcy threat, which in tum rules out the possibility of enforcing private contracts. Finally, the possibility for suppliers to switch to different customers is another important factor in affecting the expected cost of running into arrears. Given the highly concentrated structure of domestic markets and the rigid network of relations imposed by the central plan, in the initial stages of reform the flexibility of supplier-customer relations is likely to be associated with opportunities for exports. Hungary and Poland stand out as the countries with a more rapid growth of exports to market economies. This may have implied a high K for these economies, which in turn can account for the moderate increase in interenterprise arrears. In sum, the multiple equilibrium model of the previous section helps characterize the different experiences across countries as different equi- libria, largely associated with different perceived microeconomic costs of running -into arrears (the parameter K). However, the model also illustrates certain key features of interenterprise arrears. Specifically, it generates a network, or chain, of arrears in a system in which all firms are viable-have nonnegative profits. This condition is important because it permits a view of interenterprise arrears as a form of stable equilibrium. The presence of loss-making firms would imply that in the chain of arrears a group of firms is subsidized by other firms, an unlikely sustainable phenomenon. Of course we do not deny that arrears reflect also the presence of loss-making firms. However, we claim that this is not the dominant feature of arrears. The mechanics of the chain of arrears, its features, and potential inefficiencies are illus- trated graphically in Figure Al in the annex. The empirical relevance of the vie_w of arrears as an equilibrium network can be analyzed for Romania, for which micro data on all state-owned industrial enterprises are available for 1992. These data permit analyzing (1) the degree of "circularity" of the process, namely, how important are the debts of firms that have a roughly 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 28 7 balanced debt-credit (payables and receivables) position; and (2) the role of loss-making firms in the network of arrears. Finally, we report some suggestive evidence from a small-scale enterprise survey that provides qualitative answers on the features and determinants of arrears in Romania. One simple measure of the degree of circularity is given by the ratio of total net arrears, defined as the sum of net debt positions of net debtor firms, to total gross arrears. This ratio has hovered between 25 and 30 percent during 1991 and 1992, indicating that most arrears are a substi- tute for enterprise liquidity. Perhaps even more relevant is the number of firms involved in the network of arrears and the number of firms with significant net debt positions. For instance, in June 1992, out of 1,692 state industrial firms, 1,455 displayed arrears in payments to suppliers, while most net arrears were concentrated in a handful of firms. 1 7 There- fore, the vast majority of Romanian firms have both debts and credits of similar magnitµdes, clearly illustrating the phenomenon of chain of arrears, where net arrears are not highly significant. Regarding the importance of loss-making firms, only 200 firms, or 12 percent of the total number of firms, are loss making, and they do not absorb a disproportionately large share of arrears-in relation to their sales, for instance. Their share in total gross arrears is about 15 percent, while their share in total sales is about 10 percent (September 1992 data). Although loss-making firms are important recipients of net arrears, they do not play a crucial role in the whole chain of arrears. In addition, results from a small-scale survey (of 30 firms) carried out at the end of 1992 by the World Bank seem to confirm the above discussion. In assessing the main causes of arrears in payments to suppliers, the most important reason is perceived to be the arrears in payments by their own customers. This seems consistent with the concept of a self-sustaining network of interenterprise arrears. The survey also shows that in the sample only between 5 and 25 percent of firms' purchases are effected in cash. Firms revealed that in the hierarchy for the use of cash, wages are the first priority, whereas payments to suppliers are the last, coming after wages, banks, and taxes. This seems to be consistent with a system in which transactions among enterprises take place with very little use of cash, while cash is mainly used for wage payments. Finally, the survey indicated that at the end of 1992-one year after the cleanup of arrears-almost 80 percent of firms expected a new government bailout. 17Jndeed, 80 percent of net arrears were concentrated in 100 firms, accounting for 27 percent of sales, while the largest 10 debtors accounted for 50 percent of net arrears. 288 Guillermo A. Calvo and Fabrizio Coricelli The same features of arrears just described may also help explain the pressures for government intervention. As noted in Calvo and Frenkel (1991), the interlocking relations induced by arrears hinder the possibility of an efficient selection among good and bad enter- prises, and it creates the risk of a domino effect with good firms being dragged into trouble by firms in difficulties. Therefore, it is the far- reaching ramification of this network that seems to have triggered government intervention in countries like Romania and Russia. Another important implication of the model of arrears in the pre- vious section is that with arrears domestic prices tend to be higher than world market prices and that the price level is directly propor- tional to the share of arrears in sales. The model provides a possible explanation for the puzzling price jump in producer prices in Russia in 1992, which was much higher than the increase in consumer prices. Moreover, within producer prices, the increase in prices of inputs for production was much higher than the increase in prices of consumer goods. This phenomenon, indeed, could reflect the lack of cash payments for intermediate products, in contrast with the domi- nance of cash payments for consumer goods .1s Concluding Remarks The paper supports the conventional view that structural reforms are essential t9 improve allocation and utilization of resources in pre- viously centrally planned economies. Firms have to be given incen- tives to operate under long planning horizons, and bankruptcy regu- lations have to become effective. Unfortunately, however, these reasonable objectives could take an inordinate amount of time. Priva- tization is a lengthy process, and for bankruptcy regulation to become effective legal courts must not be hampered by other offsetting regu- lations and the legal profession must learn to navigate in the new waters. In the meantime, thus, palliatives and extra caution in choos- ing macropolicies is required. In that respect, the approach adopted in the paper suggests that credit markets should be carefully monitored. A key characteristic of previously centrally planned economies at the beginning of their eco- nomic transformation programs is the lack of well-developed credit markets. In particular, the economy strongly depends on the existing, IBLipton and Sachs (1992) have argued that one of the main reasons for high pro- ducer prices in Russia was associated with the lack of use of cash for enterprises' purchases. Their explanation is different from ours. They argue that there was an excessive supply of credit-of noncash rubles-for enterprise transactions. 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 289 largely official, banking system. Therefore, for example, a cut in bank credit is tantamount to a cut in total credit, implying that a stabiliza- tion program aimed at sharply lowering inflation may excessively reduce the amount of credit available to enterprises and, thus, cause an unduly large fall in output. The paper has further argued that the initial credit contraction could put the economy on a path in which output is pennanently lower than its potential. Once the economy is locked into the "bad" low-output equilibrium, however, credit expansion may just result in higher inflation, not higher output. Con- sequently, this fundamental asymmetry would call for ensuring that the credit market is not unduly strained during the first stages of an economic transformation program. Specifically, the vulnerability of the credit market and its dependence on official sources strongly suggests that an effective anti-inflation policy should be accompanied by measures that prevent an unduly large credit contraction when the transformation program starts. In that connection, it is essential to deactivate the price/wage "engine." As argued in the paper, short horizons and low default costs are conducive to low-output equilibria. Thus, until privatization and bankruptcy regulations become effective, it would be necessary to give further incentives to enterprises to try to offset those distor- tions. One possibility that has been experimented with in several recent programs is a ceiling on wages. The effectiveness of this mea- sure, however, is highly dependent on the government coming to a binding agreement with labor (like in the Mexican Pacto)-not a very likely precondition in previously centrally planned economies. There- fore, wage ceilings may have to be supplemented by other measures that give further incentives to enterprises to stay below the ceiling. For example, credit itself may be a function of whether a firm com- plies with the wage ceiling regulation.19 Moreover, managers' salaries could be subject to cuts, or managers themselves could be subject to dismissal, if their firms fail to comply. The agenda for future research is still long and crowded. First, we need to know more about the actual mechanics of credit markets in previously centrally planned economies, which can only be obtained through thorough data gathering. In this respect, the above models could serve as a guide on what to look for. For example, the models 19 Alternatively, enterprises could be taxed on wages in excess of the ceiling. How- ever, Poland in 1990 suggests that this is not a very effective policy (see Calvo and Coricelli (1992)), because when workers are set to "cannibalize" a firm, they may not really much care about its net worth, since they are not the owners. In contrast, a credit crunch has immediate consequences. 290 Guillermo A. Calvo and Fabrizio Coricelli suggest that private and public firms must behave differently about liquidity accumulation, since private firms likely display a lower rate of effective time preference. Second, we should explore models that incorporate oligopolistic and key political economy aspects of previ- ously centrally planned economies. Third, a more systematic testing of models should be carried out. 11 • CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 291 ANNEX The Mechanics of the Chain of Arrears Figure Al represents a system of three interconnected firms, labeled Fl, F2, and F3, which are forced to conduct "cash" transac- tions with households. Solid lines connecting firms indicate flows of goods or services, while dotted lines indicate flows of "cash." Num- bers directly above the lines indicate values ("peso" sums). There- fore, in this system F3 sells final goods to households valued in 20 "pesos" in exchange for the same amount in "cash." Fl is the other firm dealing with households. It hires labor for cash" -the wage bill II being 10 "pesos." In add,ition, the production process requires F2 to supply inputs to F3, valued at 120 "pesos," F3 to Fl, valued at 100 "pesos," and Fl to F2, valued at 110 "pesos." However, contrary to the -firms-households trades, the "cash" counterpart of interen- terprise trade is significantly less than the value of goods supplied. Thus, F2 pays nothing to Fl, and F3 pays only 10 "pesos" to F2 on a 11 11 transaction valued at 120 pesos. More interestingly, F3 sells inputs to Fl by 100 "pesos" and, in addition, lends 10 "pesos" in "cash" to Fl. This allows Fl to hire workers. The network depicted in Figure Al could have come to life after the initial price/wage jump. The jump gave rise to a "cash" shortage, and thus "cash" ended up being exclusively utilized for transactions between firms and households, with interenterprise transactions financed by falling into arrears. However, no firm is a net borrower- no firm is implicitly subsidized by borrowing more than it could repay if its debtors did not default. This is so because each firm increases its arrears by 110 "pesos" each period but, at the same time, its cus- tomers also do so by the same amount. The system is feasible and could, in principle, continue operating indefinitely. However, gross arrears grow without limit. Notice that the system as a whole uses less cash and, thus, conventional statistics will exhibit a fall in real liquidity. Arrears may be a poor substitute for "cash" when firms are interconnected as in Figure Al. The equilibrium there, for example, I depends on F3 being willing to lend 10 "pesos" to Fl, even though the latter will not be able to repay the loan, and even though the loan ,I is not directly connected with the goods sold to Fl. In contrast, if F3 I keeps the 10 "pesos" for itself, Fl will not be able to hire labor, which I implies that there will be no inputs for F2. F2 output will collapse, and F3 will not be able to produce. Thus output everywhere grinds to a complete halt. Leaving aside the externalities stressed in the model of interenterprise arrears, these arrears are not per se detrimental to 292 Guillermo A. Calvo and Fabrizio Coricelli Figure A1. lnterenterprise Arrears: A Circular System with Viable Firms ············ 10 10 .......................... 120 i ;20 20 .· .· ... Goods or labor .......... Cash 11 •.CREDIT MARKET IMPERFECTIONS AND OUTPUT RESPONSE 293 output. In fact, their presence may have cushioned the impact of the initial liquidity crunch. However, the major drawback of interen- terprise arrears is that they slow the process of adjustment. In the case portrayed in Figure Al, for example, input prices are indepen- dent of "cash" supply. The same real equilibrium could be attained if F3 billed Fl for 200, Fl billed F2 for 220, and F2 billed F3 for 220 "pesos." Thus, interenterprise trades without the discipline of "cash" payments result in weak price signals. Another implication of Figure Al is that once the network of interenterprise arrears is estab- lished, the health of a given firm becomes intimately dependent on the health of the system as a whole, which again interferes with adjustment (see Calvo and Frenkel (1991)). References Begg, David, and Richard Portes, Enterprise Debt and Economic Transfonnation: Financial Restructuring in Central and Eastern Europe, Centre for Economic Policy Research, Discussion Paper No. 695 (1992). Berg, Andrew, and Olivier Jean Blanchard, "Stabilization and Transition: Poland 1990-1991," International Monetary Fund Seminar Series No. 1992-07 (April 1992). Berg, Andrew, and Jeffrey Sachs, "Structural Adjustment and International Trade in Eastern Europe: The Case of Poland," Economic Policy, No. 14 (April 1992), pp. 117-73. Bruno, Michael, "Stabilization and Reform in Eastern Europe: A Preliminary Evaluation," IMF Working Paper, WP 92/30 (May 1992). Calvo, Guillermo A., Are High Interest Rates Effective for Stopping High 11 Inflation? Some Skeptical Notes," World Bank Economic Review, Vol. 6 ijanu- ary 1992), pp. 55-69. - - , and Fabrizio Coricelli, "Stabilizing a Previously Centrally Planned Economy: Poland 1990," Economic Policy, No. 14 (April 1992), pp. 176-226. - - , "Output Collapse in Eastern Europe: The Role of Credit," Staff Papers, International Monetary Fund, Vol. 40 (March 1993), pp. 32-52. Calvo, Guillermo A., and Jacob A. Frenkel, "From Centrally Planned to Market Economies: The Road from CPE to PCPE," Staff Papers, Interna- tional Monetary Fund, Vol. 38 Oune 1991), pp. 268-99. Clifton, Eric V., and Mohsin S. Khan, "Interenterprise Arrears in Transform- ing Economies: The Case of Romania,'' Staff Papers, International Monetary Fund, Vol. 40 (September 1993), pp. 680-96. Coricelli, Fabrizio, and Timothy D. Lane, "Wage Controls During the Transi- tion from Central Planning to a Market Economy," World Bank Research Observer, Vol. 8 Only 1993), pp. 195-210. Daianu, Daniel, Arrears in Post-Command Economies: Thoughts from a 11 Romanian Perspective" (unpublished; 1993). 294 Guillermo A. Calvo and Fabrizio Coricelli Frydman, Roman, and Andrzej Rapaczynski, ''Privatization in Eastern Europe: Is the State Withering Away?" Finance and Development, Vol. 30 Oune 1993), pp. 10-13. Ickes, Barry W., and Randi Ryterman, "The Interenterprise Arrears Crisis in Russia," Post-Soviet Affairs, Vol. 8(October-December1992), pp. 331-61. Lipton, David, and Jeffrey D. Sachs, "Remaining Steps to Achieve a Market- Based Monetary System" (unpublished; 1992). Rostowski, Jacek, "The Interenterprise Debt Explosion in the Former Soviet Union: Causes, Consequences, Cures," Communist Economies and Economic Transformation, Vol. 5, No. 2 (1993), pp. 131-59. Shell, Karl, "Optimal Programs of Capital Accumulation for an Economy in Which There Is Exogenous Technical Change," in Essays on the Theory of Optimal Economic Growth, ed. by Karl Shell (Cambridge, Massachusetts: MITPress, 1967). Ward, Benjamin, "The Firm in Illyria: Market Syndicalism," American Eco- nomic Review, Vol. 48(September1958), pp. 566-89. Yaari, Menahem E., "Uncertain Lifetime, Life Insurance, and the Theory of the Consumer," Review of Economic Studies, Vol. 32 (April 1965), pp. 137-50. Comment Rudiger Dornbusch With the devastating decline in output of transition economies to be explained, the Calvo-Coricelli paper offers a welcome hypothesis and even evidence of a channel so far largely disregarded. Their claim that the compression of real working capital must account for some of this output decline is altogether plausible-if working capital is pro- ductive, then, other things being equal, a sharp reduction in the real value of these assets must have real effects. How much of an effect real credit contraction has, and in what exact ways it influences out- put, is another issue, although even here the authors make progress by offering empirical evidence. The emphasis on credit as an important aspect of the financial :transmission mechanism is entirely fashionable. 1 In U.S. macro- economics the question of money versus credit continues to be hotly debated. Interestingly, the working capital perspective has not been an important part of that discussion. Rather the link has been made between financing and investment rather than between finance and production. It would be interesting therefore to investigate further whether the authors' working capital hypothesis could be identified in the context of advanced economies. Whatever the findings might be, Calvo and Coricelli are right to emphasize that the price shock of Eastern Europe offers a natural experiment. The price liberalization, without commensurate expansion of money and credit aggregates, leads to an exogenous real contraction. In segmented credit markets in which firms cannot replenish their finance fully by borrowing, real credit contraction limits their ability to finance inputs and hence pro- duction. In principle we therefore can unscramble how money and credit work. The more segmented and imperfect credit markets are, the more strongly their effect should come to the forefront. In the model discussed here there is a lag between the application of inputs and the resulting output. Let a and b be the unit labor and material coefficients of a competitive firm, P, W M, and i the price, wage, materials cost, and nominal interest rate. With competitive capital markets and a one-period input-output lag for materials and for a share of wages, discounted price would equal marginal (aver- age) cost. Output at the level of the firm is indeterminate. Pt+ 1 1(1 + z) = XaWt + bMt + (1-}..)Wt + 11(1 + i). (1) 1 5ee Bernanke (1993) for a fine survey. 295 296 Rudiger Dornbusch Tight credit in this situation of perfect capital markets means higher real interest rates. Accordingly the relation between future prices and current costs will change. But there are no implications for output. To look at output, the demand response to changes in the relative prices of credit-intensive goods would have to come into play. But with a credit constraint Kt, one moves away from a pricing equation to a limitation of output. The amount of output Q that a firm can produce, supposing the expected price is right, becomes con- strained by cash flow, or, letting lowercase variables represent measurements in wage units (m = MIW) so that one has Qt = [(Pt - (1 - A)a)Qt _ 1 + Kt(1 - z)]/(Aa + bmt). (3) A price rise in period t will raise current revenue but it will also reduce the purchasing power of revenue and working capital in terms of current wages and materials. A rise in nominal interest rates, given credit, further intensifies the financing constraint. The framework immediately suggests that not running up interest arrears or postpon- ing the payment of wages are effective ways of lessening the bite of the financing constraint. Equally apparent is the manager's call for increased credit as a means of sustaining production. The Calvo-Coricelli model does not offer a sharp distinction between the level of credit in the economy and the distribution of that credit among forms. In segmented credit markets, that distinction is all important. With an uneven distribution, some forms might be altogether unconstrained whereas for others the lack of credit becomes the effective limit to production. The manner in which credit allocations are decided would therefore have a first-order impact on production. Likewise, it would be useful to make a distinction among firms in their credit intensity. Production with long gestation periods would be more vulnerable than industries where production and sales more nearly coincide. Building a tanker, for example, is not the same as fixing shows. Similarly, the role of inventories deserves attention. In the short run firms can liquidate inventories to obtain cash for production. That is an important consideration because, in fixed-price, random supply, planned economies, inventories at each stage of production were high. Accordingly, the immediate credit squeeze may not have been so important because of the possibility of liquidating inventories. Of course, firms in the aggregate cannot acquire an increase in their 11 • COMMENT 297 credit position except as a result of an economy-wide increase in credit or a recJ.uction in households' balances. Most of the inventory liquidation therefore might result, together with arrears, in a redis- tribution of credit among firms and industries. _ Two further points deserve attention. In the decontrol experience one would expect strong immediate effects and more dampened per- sistent ones. Capital markets are segregated, but there are always means to lessen credit dependence and force implicit borrowing in any number of ways, including nonpayment of credit or interest. All these channels will tend to come into play over time and hence lessen the role of tight credit. In concluding, one would like to see the role of shocks to working capital in settings other than transformation economies. Such possi- bilities do exist. For example, in 1990 Peru increased oil prices thir- tyfold, leading to a vast blip in the price level and a corresponding reduction in real money and credit. Output instantly dropped sharply. Other examples no doubt exist. In hyperinflation experi- ences of the 1920s, as reported by Bresciani-Turroni (1937), there is discussion of Kapitalaufzehrung as a result of extreme inflation. One can think of this as the reduction in the real value of working capital- a reduction not reflecting voluntary increases in the velocity of credit, but an involuntary reduction in the purchasing power of working capital. The Calvo-Coricelli hypothesis may thus have interesting implications for the interpretation of very different experiences, including the output drop in the context of extreme, unrepressed inflation. References· Bemanke, Ben, "Credit in the Macroeconomy," Federal Reserve Bank :of New York, Quarterly Review, Vol. 18 (Spring 1993), pp. 50-70. Bresciani-Turroni, Costantino, The Economics of Inflation: A. Study of Currency Depreciation in Post-War Germany (London: Allen & Unwin, 1937). 12 China's Collective and Private Enterprises: Growth and Its Financing Shahid Yusuf1 Overview China's experience with economic growth since the start of reforms in 1979 can be divided into two periods. During the first, which extended through 1984, growth was driven by agriculture. Thereafter, much of the impetus has come from nonstate industry, primarily located in rural areas, and, to a lesser extent, from large, state-owned enterprises. As nonstate industry now accounts for over 52 percent of industrial output and has expanded at an annual average rate of 19 percent for the past six years, it is the principal determinant of eco- nomic performance. In the first quarter of 1993, the collective and private sector was responsible for 75 percent of China's growth. Both agriculture and rural industry owe their dynamism to the transfer of administrative and fiscal powers to subnational govern- ments; the redefining of ownership rights to property; and the increased availability of financing through multiple channels. The focus of this paper will be on rural collective industry, especially the private and joint venture segments.2 Simply put, China's nonstate economy has grown with unusual rapidity, mostly because factor inputs, chiefly the volume of invest- IThe author is indebted to Shahid Javed Burki for comments and to Xiaofeng Hua for assistance with the statistics. The views expressed should not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries. 2 China's nonstate industry has four principal components: collectively owned enterprises, which currently account for the largest share; cooperatives; individually (privately) owned enterprises; and others, principally enterprises in which foreign investors have a stake or those that are wholly owned by foreigners. 298 12 • CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 299 ment, have been extremely large. Why investment has reached such a scale and its increasingly flexible allocation across subsectors is the outcome of several intertwined factors. The Government's success in reviving commune and brigade industry in the 1970s was the first step. It restored a tradition of small-scale rural industry suppressed since the early 1950s. 3 As decentralization began transferring fiscal resources and policymaking powers to the counties in the early 1980s, local governments exploited the potential of rural enterprises to fill numerous industrial niches in light consumer goods, building mate- rials, machinery, and agricrtltural inputs. They did this by investing directly in production enterprises and by building supporting infra- structure. In this fashion, the most fortunate, strategically located coastal provinces were able to enter a virtuous spiral. Investment in rural enterprises enriched the community, broadened the tax base, and served to generate fiscal resources for a further round of invest- ments. Over time, as individual wealth increased, there was a "crowding in" of capital, accumulated by households, into rural industry and services. Public investment and fiscal incentives helped initiate the virtuous spiral, but it has derived much· of its force from entrepreneurial energy and individual effort released by a new perspective on institu- tions governing property rights. Private ownership of small busi- nesses was legally recognized in 1981 and has spread steadily since. More important, collective and cooperative ownership has changed in character, with the local community retaining residual property rights, but de facto ownership now residing with managers and/or workers. Shared ownership gives local authorities· claims on collec- tive resources. It also means that business risks are, in part, shoul- dered by local governments. This has encouraged entrepreneurship in what is a fluid and uncertain business environment. It has also facilitated the mobilizing of finance for industry: Initially, a high proportion of the capital needed by the collective sector was drawn from budgetary funds, retained earnings, or, in private enterprises, from the savings of the extended farr\ily and friends. However, the growth of the nonstate sector has powerfully stimulated financial development, with the result that banks and 3 Views differ on policies toward rural industry. Riskin (1978) discusses the· gradual revival of rural 'industry in the sixties following closures of enterprises after the Great Leap. Communes visited by Burki (1969) in the mid-1960s had a substantial level of nonagricultural production. Development of rural mdustry'in the mid-1970s, particu- larly its linkage with agricultural activities, is described in American Rural Small-Scale Industry Delegation (1977), especially in Chapters 8 and 9. 300 Shahid Yusuf other intermediaries, formal as well as informal, have enlarged their share of funding for the nonstate sector. In this instance, government policy has been largely reactive. It has not done much building ahead of demand. Current trends suggest that financial markets could over- shadow other sources of capital within a decade. Hence, the interac- tion between collective and private enterprises on the one hand and financial intermediaries on the other will have a strong bearing on the speed of future growth. Its stability will be decided by government macropolicy. Whereas fiscal and financial channels, along with other resources, fund the bulk of investment; · in recent years foreign direct investment-a large proportion of it in equity joint ventures-has emerged as a major source of capital, chiefly for the export-oriented manufacturing sector. Growth of the '1other'' component of the non- state sector rivals that of private enterprises, and its share, already sizable in the southeastern coastal provinces, is likely to become sub- stantial in all the open coastal areas during the 1990s. One striking feature of the nonstate sector's development has been its speed. A second and even more arresting feature is the dispersed and spontaneous nature of the entire process. The princi- pal contribution of the Central Government has been to allow many hundreds of flowers to bloom rather than attempting a close and direct management of transition. It has whittled away at physical, institutional, and ideological controls, thereby releasing energy bot- tled up for decades. The state's achievements have been twofold. First, its success in calibrating the release of energy has held the pace of change to socially acceptable limits. Second, by realizing the futility of micromanaging such a complex affair, the state has wisely provided only the broadest of guidelines, allowing those closer to the action maximum leeway in adding content and specificity to policy. This paper will have attained its goal if it not only describes what happened but also imparts a sense of the relatively sponta- neous way it happened. The paper starts with a brief description of the composition of the nonstate sector and of emerging trends in structure and financing and then examines the contribution of administrative and fiscal decentral- ization, both in providing policy stimulus as well as financing for collective enterprises. It analyzes mstitutional changes related to ownership, which have spurred entrepreneurship and facilitated financing, and reviews the factors contributing to the nature and direction. of financial development, as well as the manner in which this has influenced sources of capital for the nonstate sector. It then assesses the significance of foreign direct investment for nonstate 12 • CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 301 sector growth and sketches the concerns demanding policy action by central and local authorities. The Nonstate Sector: Composition and Trends By the early decades of the twentieth century, China was well on its way to acquiring modern industrial capability4 and a supporting entrepreneurial tradition, anchored to kinship networks that are the building blocks of Chinese society. 5 Because industry needed finan- cial services, indigenous banks, which had long supported commer- cial activity, began lending for working capital and, to a lesser degree, for fixed investment. In the large coastal cities, their operations were buttressed by foreign banks that became deeply involved in trade but also made loans to the larger business houses. 6 ,Following the establishment of a communist government in 1949, traditions of private entrepreneurship and indigenous banking, along with the budding institutions of property ownership, were gradually suppressed. Ownership was concentrated in the hands of the state and of communities; a centralized, monobanking system took control of all financial transactions, and industrial entrepreneurship became a bureaucratic function carried out by planning agencies and industrial bureaus. What little rural industry existed withered7 as the agri- cultural economy was parceled into communes that imposed admin- istrative discipline and brought farm production within the ambit of planning. The rising cost of tightly regulating economic activity in terms of forgone employment opportunities, distortion of incentives, and inadequate supplies of light manufactures finally prompted an easing of restraints in the early 1970s. With encouragement from the center, rural-based communes and brigade enterprises multiplied. Between 1970 and 1979, they averaged an annual growth rate of 25 percent. 8 Rural industrialization received fresh impetus from the gradual return to household farming, which commenced in 1979 and was largely completed in five years.9 The household responsibility system loosened the constraints on ownership and began changing attitudes 4Rawski (1989). 5 Redding (1990, 1991) and Kao (1993). 6 Hao (1986), Rawski (1989), and Perkins (1975). 7 However, see footnote 3. ssiu (1989) and Islam (1991). See also American Rural Small-Scale Indu~try Delega- tion (1977). ' 9for a discussion of agricultural reform during this stage, see Perkins and Yusuf (1984). 302 Shahid Yusuf Table 1. Industrial Output by Size and Ownership Categories 1 (Percent of total output) 1978 1985 1989 Large-scale sector 41.5 42.3 42.2 State 41.5 41.9 40.5 Other 0.4 1.1 Urban medium/small 49.4 38.8 29.4 State 35.8 22.9 15.6 Collective 13.6 15.9 13.9 Rural medium/small 8.7 14.6 19.6 Township 4.8 7.8 10.0 Village 3.9 6.8 9.6 Very small-scale 0.4 3.4 7.1 Urban 0.3 0.6 Rural 0.4 3.1 6.4 other: medium/small 0.8 1.7 Total 100.0 100.0 100.0 Source: Naughton (1992). 1Large-scale other output is estimated. 1978 is calculated from constant 1970 price output data; 1985 and 1989 are calculated from current price output. toward private activities, as well as profit making. In a short time, it both shifted outward the agricultural production function and helped widen the scope for a whole range of nonfarm activities. 10 By the mid-1980s, the great agricultural spurt was almost spent, but a series of reform initiatives, by widening the role of markets, giving enter- prises more autonomy, and strongly encouraging collective industry, had dramatically changed the tempo of industrial activity. This accel- eration, which shows no evidence of slackening in the 1990s, has altered the industrial structure significantly. Most notably, rural industry has emerged as a major player and _the relative shares of state and nonstate industry have shifted toward the latter. In the late 1970s, three-fourths of industrial production was con- centrated in urban, state-owned enterprises, with large enterprises claiming a little over half of this production. 11 Urban collectives accounted for another 14 percent, and the balance-9 percent-was produced by rural units (see Table 1). By the mid-1980s, the propor- tions had begun to shift, but the rural share was still under 18 per- 10 The importance of the household responsibility system to the growth of agricul- ture during 1978-84 is quantified by Lin (1992). 11Naughton (1992). 12 •CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 303 cent. Since then, the distribution of output has changed quite radi- cally. Urban state enterprises in the medium and small categories have lost ground and are now responsible for an estimated 11 percent of industrial output (1992), as against 36 percent in 1978. Large, well- financed state enterprises have gained from economies of scale and the demand for industrial raw materials and capital goods. Their share has remained relatively stable over 15 years and in 1992 was a little under 37 percent. The large gains have been registered by collectives, individual (or private) enterprises, and firms in the "other" (mostly joint ventures or foreign owned) category.12 The majority of these are located in rural townships and villages that have gained not just from decentral- ization (discussed below), but also from the lower cost of labor, negli- gible social overheads, and flexibility in hiring practices.13 Collective industry grew annually by 20 percent from 1985 to 1991, and enlarged its share by a few points (see Table 2). But individual and "other" sectors expanded by 36 percent and 48 percent, respectively, albeit from small bases. Growth in each of these categories increased yet further in 1991-92, as administrative checks, 14 introduced in 1989-90, were dismantled. For instance, collectives averaged a 25 percent rate and "other" enterprises, 55 percent. A rough calculation would put the share of private and other enterprises at about 8 percent each in 1992, or between 15 and 17 percent of industrial output. The actual share of private enterprises might be considerably larger because pri- vate firms are at a disadvantage in dealing with officialdom. They are often subjected to additional levies and have every incentive to wear 1 2 Field (1992, p. 589) observes that decentralization and the granting of greater autonomy to enterprises were intended to stimulate state enterprises. But collectives were the ones that derived the larger benefits. Their output rose five times between 1980 and 1990. That of township and village enterprises (TVEs) rose tenfold. Wu (1992) examines the surge in growth during 1985-90 and the large contribution by rural industry. See also Prime (1992, p. 31) and Findlay and others (1992). 13State and large collective enterprises have a work force nearly three-fourths of which still enjoys lifetime tenure and is lavishly provided with allowances and benefits. This so-called iron rice bowl greatly increases overheads. 14 0dy (1992) describes the use of credit controls to slow growth in 1989-90. These measures were slanted initially toward TVEs and rapidly contained the level of activity. They also increased the rate of exit from the subsector. The experience of 1989-90 suggests that on the margin, credit restraint exercised through formal channels was able to influence TVE activity strongly in the late 1980s. How effective it would be in the mid-1990s, if the number of financial intermediaries increases, is less certain, although the dependence on credit is likely to continue increasing. See also Tam (1991, p. 521). 304 Shahid Yusuf Table 2. Sources of Output (GVIO) Growth in Industry Average 1985 1987 1989 1991 1985-91 Million Industry total 1,045,679 1,381,299 1,889,251 2,274,012 1,630,549 State-owned enterprises 678,229 825,009 1,059,126 1,203,869 932,100 Collective 335,470 478,174 674,287 811,839 57.1804 Township 81,850 128,419 188,250 241,610 159,235 Village 71,321 116.535 181,715 236,198 149,800 Individual 19,345 50,239 90.756 129,535 71.738 Urban 3,593 5,027 7,697 10.407 6.426 Rural 15,751 45,212 83,059 119.128 65,312 other 12,636 27.877 65,081 128,769 54.907 Percentage Shares Industry total 100.0 100.0 100.0 100.0 100.0 State-owned enterprises 64.9 59.7 56.1 52.9 58.2 Collective 32.1 34.6 35.7 35.7 34.8 Township 7.8 9.3 10.0 10.6 9.5 Village 6.8 8.4 9.6 10.4 8.9 Individual 1.8 3.6 4.8 5.7 4.1 Urban 0.3 0.4 0.4 0.5 0.4 Rural 1.5 3.3 4.4 5.2 3.7 Other 1.2 2.0 3.4 5.7 3.0 Growth Rates Industry total 21.8 20.5 13.2 13.2 15.1 State-owned enterprises 16.5 15.5 11.7 9.8 11.0 Collective 34.9 24.4 11.8 13.5 18.8 Township 34.9 27.8 11.3 17.9 22.2 Village 34.9 35.7 16.5 17.5 24.2 Individual -0.8 58.9 25.4 19.6 32.8 Urban -0.8 68.5 22.8 15.6 18.7 Rural -0.8 58.0 25.6 20.0 35.8 Other 52.2 66.9 43.5 46.4 48.4 Source: China Statistical Yearbook, various issues. the badge of collective ownership.ls Over the past two years, how- ever, such discrimination has begun easing because of the widening acceptance of market principles and a fuller realization of the demon- stration effects on local entrepreneurs and potential foreign investors. 1syoung (1989, 1991). 12 • CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 305 Recent trends, if allowed to persist, point toward an industrial system with three leading sectors: ·large state enterprises, private firms, and joint ventures or wholly owned foreign companies.16 For the next several years, smaller state-owned enterprises and collec- tives will still account for a substantial proportion of industrial out- put. But ongoing enterprise reforms will rapidly diminish the num- bers of small state enterprises through mergers, bankruptcy, and a change in ownership status .17 As the legal standing of private firms acquires greater acceptance with time and the judicial validation of newly bestowed rights, many of the smaller collectives-urban and rural-will emerge as private firms leaving a residual of medium and large collectives.18 Barring any sudden reversal in the political mood of the country, in five years the share of industrial output claimed by collectives may have shrunk to less than half of what it is now-or about 15 percent. There is another reason for believing that state and collective own- ership will have a much lower profile. China's services sector is still relatively small.,-27 percent of GDP in 1992. From all indications, it should sustain double-digit rates of growth well into the next decade. 19 Probably a majority of new entrants will be private firms, and many of the existing collectives will switch to different forms of ownership, nearer the private end of the spectrum. The sectoral shares of GDP in 1992 were as follows: industry, 53 percent, services, 27 percent, and agriculture, 20 percent. Farming has already been almost completely privatized. 20 About 40 percent of industrial production will very likely have been annexed by private and "other" firms within seven years. Furthermore, perhaps as much as two-thirds of services wilt be in private or joint ventures. 1 6In the first two months of 1993, three-fourths of China's economic growth-which was running at an annualized rate of 14 ·percent-was provided by collective and private enterprises. These were expanding at the annualized rate of 47 percent and 77 percent, respectively (Zhongguo Xinwen She News Agency, Beijing, March 9, 1993). 17See Gao and Sen (1990). 1 BPrivate enterprises are most numerous in Guangdong (30,000), followed by Zhe- jiang, Liaoning, and Shandong (China Daiiy, February 23, 1993). Field (1992, p. 599) notes that official projections also assume a more rapid growth of individual and cooperative enterprises than of collectives above the township level. 1 9ln Beijing, for instance, nearly 200,000 individuals are engaged in sma:ll-scitle retail activities, which require relatively little capital to start up (China Daily, April 18, 1993). In the first quarter of 1993, there was a net addition of 2,300 "street businesses." This is merely the ground level of the services sector. There is increased _activity at higher levels and a great deal to come (Drucker, 1993). 20'fhe share of state farms was 3 percent of agricultural output in 1991 (China Statisti- cal Yearbook, 1992). 306 Shahid Yusuf Such an accounting suggests that the division between state and private ownership around the turn of the century will be much like Western Europe today. The state might be controlling between 40-50 percent of GNP, and the balance would be held by private owners. Thus, in roughly 21 years, China would have made a largely painless transition from high socialism to a prosperous, mixed economy-not dissimilar, at least in terms of basic ratios, to that of most countries of the Organization for Economic Cooperation and Development. The far-reaching change in the composition of industry that has occurred, and the trends now apparent, are the outcome principally of decentralization, a gradual recalibration of property rights, and the effective deployment of fiscal and financial resources. How each of these has contributed is discussed below. Decentralization Administrative and Financial Aspects So long as the parameters of economic decision making were deter- mined by planners in Beijing and resource allocation was subject to central control, room for local initiative was limited and lower-level government had little incentive to mobilize additional resources, explore profitable investment opportunities, control costs, or raise productivity. A large proportion of investment funds were channeled through the budget, and the entire process of capital spending was rigidly circumscribed by the planning system. In 1978, budgetary revenues amounted to 31 percent of GNP, and about 40 percent of these (13 percent of GNP) were allocated for capital construction, either directly by the Central Government, or according to guidelines defined by the center (see Table 3). The single most important aspect of China's reforms was the recog- nition that such a large economy could not be effectively managed or even reformed from Beijing. Hence, the successive rounds of fiscal and administrative decentralization, starting in the late 1970s, were of critical significance. 21 In the first place, they have permitted local governments to retain a larger proportion of tax revenue, and, since 1982, have given them the latitude to raise, for their own purposes, 21 The significance of local community resources and especially fiscal resources in the early 1980s is described in World Bank (1982). On fiscal decentralization and the extra- budgetary funding, see Donnithome (1989) and World Bank (1993). Also see Yusuf (1993b). 12 •CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 307 Table 3. Central and Local Revenues and Expenditures as Percent of GNP 1978 1980 1985 1987 1990 1991 Budgetary expenditures1 30.96 27.13 21.53 21.67 19.84 20.39 Central 14.21 14.56 . 9.76 9.13 7.89. 8.05 Local 16.75 12.57 11.77 12.53 11.95 12.34 Extrabudgetary expenditures 16.05 16.29 15.56 Central 6.56 6.56 5.96 Local 9.49 9.73 9.59 Total expenditures 37.58 37.95 35.4 Central 16.32 15.69 13.85 Local 21.26 22.26 21.54 Budgetary revenue2 31.25 23.32 20.73 19.46 16.88 16.81 Central fixed revenue 2.92 7.21 6.52 5.70 4.91 Central revenue after tax sharing 10.22 9.41 7.61 Local revenue 20.39 13.52 12.95 11. 18 11.89 Local revenue after tax sharing 10.52 10.05 9.27 Extrabudgetary revenue 10.43 12.47 17.86 17.95 15.57 Central 7.42 7.33 6.17 Local 10.43 10.63 9.40 Sources: China Statistical Yearbook, 1990 (English), Tables T6.13 and T6.14. and update from China statistical Yearbook. 1991; Ministry of Finance data; and author's' own calculations. 1Expendltures refer to administration of expenditures. 2Excludes debt issue. extrabudgetary funds from a variety of fees, surcharges, and special contributions.22 These funds rose from negligible levels to over 10 percent mthe early 1980s and have remained there since. Second, state and collective enterprises have been allowed to retain a much higher proportion of their earnings, a decision that directly augments local extrabudgetary resources. Third, defense spending was sub- stantially reduced, and many expenditures, such as those for sub- sidies, infrastructure, and industrial restructuring, were transferred to the provinces. Fourth, along with the reassignment of fiscal responsibilities, the center has allowed subnational governments scope for sanctioning investments up to Y 200 million, for routine 22 Extrabudgetary revenues encompass surcharges on taxes set by local· govern- ments; fees imposed by administrative departments; and retained profits and depr¢cia- tion allowances of state-owned enterprises and collective enterprises. 308 Shahid Yusuf policymaking, and, within limits, for experimenting in various areas of reform. Last, Beijing has been especially generous with the coastal provinces, both in the tailoring of fiscal contracts (especially with Guangdong and Fujian), 23 but also in allowing them discretion to use tax incentives, credit policy,24 and infrastructure building to stimulate local industry and attract foreign direct investment. The extent of decentralization can be discerned from a few key indica- tors. Between 1978 and 1991, the revenue/GNP ratio declined to 17 percent, even though China's real GNP increased by about 9 percent per annum. With the Central Government collecting 42 percent of revenues and controlling 45 percent of expenditures, in fiscal terms, it is now a smaller player. During this period, extrabudgetary funds, in the provin- cial domain, reached 10 percent of GNP-almost the same level as pro- vincial tax revenues. A third of these are fiscal extrabudgetary resources at the disposal of subnational governments, and supplementing them are off-budgetary funds obtained through informal channels. Another, somewhat indirect, indicator is the financing of invest- ment. Investment, as a ratio of GNP, was 32.2 percent in 1980. By 1992, it had risen to almost 39 percent (with fixed capital accounting for about 30 percent) of GNP, but the budgetary financing of capital construction was down to less than 4 percent of GNP from 13 percent in 1978, with the center responsible for three-fourths of this. From the fiscal perspective, the shift in power is unmistakable. Decentralization, although greatly diminishing the flow of resources through formal budgetary channels, has nonetheless expanded the de facto fiscal envelope controlled by local authorities, significantly augmenting their ability to spend on local projects. This has stimu- lated resource mobilization, mainly through extrabudgetary and financial channels (see below).25 In addition, local governments now have more incentive to invest heavily in productive assets and infra- structure to promote development, which also enlarges the revenue base. 26 In other words, decentralization in the 1980s imparted a cor- 23 Until recently, Guangdong's fiscal contract required the province to transfer to the center a fixed amount of revenues. Any excess was retained by the province. 24 Decentralization also enabled local officials to increase control over financial chan- nels and use these to support pet ventures (Vogel, 1989, p. 115). 25 By virtue of their extensive administrative powers, local governments are able to prevail upon enterprises to contribute to community expenses or build projects that benefit the larger community as well. 26 Watson (1992) talks about the heavy investment by local governments (Shandong province) in fixed capital, following the introduction of tax contracting. He views it as each county creating its own "palace economy." Vogel (1989) also notes the pressure by local officials on banks to lend to businesses. 12 • CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 309 poratist orientation to local governments in China and gave officials command over resources with which to pursue developmental objec- tives. The better-organized and managed units quickly grasped the opportunity to use resources, traditions, and locational advantages to the fullest.27 The most notable feature of this entire effort is that it has been motivated and directed almost exclusively by the public sector and has drawn a substantial share of the finances from public sources. In true corporatist mode, local government entrepreneurship has been responsible for galvanizing communities and inducing individuals to take up business opportunities. Thus, private entrepreneurs have taken their cues from the public sector and the example set by local officials.28 Many of the economic success stories about communities along the coastal belt are linked to initiatives taken by one or a hand- ful of well-connected, public officials. Through tireless effort and full use of their administrative and party connections, these individuals were able to extract the maximum benefits from the reforms. Public entrepreneurship has been doubly effective from being amply supplied with capital. Although in the early 1980s a significant volume of funding for investment was obtained from the budget, this declined rapidly, and, in addition to bank credit, much of the financ- ing for capital construction came from the retained earnings of enter- prises and extrabudgetary funds accumulated by various levels of government. Because the former accrue mostly to the state and collec- tive enterprises, their disposition, if not controlled by government agencies, will be strongly influenced by government directives. Thus, direct public spending on capital construction, along with investment indirectly induced through state and collective enterprises, has been one of the principal sources of growth. It has created production capacity, and it has developed infrastructure. In the process, it has stimulated capital accumulation by private and cooperative enter- prises. Such investment has also served as an inducement for capital from overseas.29 Although it is difficult to establish empirically, decentralization pro- vided local governments with control over fiscal and other resources, as well as the administrative authority to conduct development activ- · 2 7Rural enterprises are most prominent in the coastal areas, home to a thkd of the populace. In western and central China, the per capita output of rural enterprises is less than a fourth (China Trade Report, 1993). 28The encouragement provided by village leaders to local enterprises is described by Putterman (1989). Typically, many of the new entrepreneurs are well-connected former cadres. 29Thoburn and others (1990). 310 Shahid Yusuf ities at the community level. In many instances, the local leadership responded to the challenge with entrepreneurial zeal and innovative policies. They also invested heavily in manufacturing and in social overhead capital. The demonstration effect was profoundly influen- tial. It helped stimulate household savings and, from the late 1980s, a surge in private and quasi-private sector development. Fuzzy Property Rights Although growth during the 1980s was motivated by local and central governments, its dynamism, and the degree to which it has harnessed the energies of enterprises of all kinds, need further expla- nation. One possibility is that the Chinese approached the use of property rights in a way that optimally balanced risks and rewards.3b In a market economy where property rights are clearly delineated, there is little ambiguity regarding ownership, the assignment of risks, and the distribution of gains and losses. Within an orderly, well- developed market environment, clarity concerning the rights of pri- vate owners sharpens individual incentives. Even though risk can on occasion deter action and interfere with the raising of capital, sophis- ticated market systems generally evolve insurance techniques for con- taining these problems. When markets are undeveloped and there is considerable uncer- tainty on the direction of government policy, risk can become a diffi- cult hurdle. Among other things, it discourages long-term investment and can increase the cost of financing. China entered the 1980s with two major handicaps: there was great uncertainty about the future course of reforms; and individual property rights-the basis of a mar- ket economy-were undefined.31 Fortunately, both of these problems were handled adroitly. First, decentralization increased the flexibility and responsiveness of the economy. It also started an informal pro- cess of assigning and redistributing property rights more widely with local governments supplying the initiative. Second, since the vast majority of enterprises were publicly owned, the approach taken was a gradual increase of enterprise autonomy within a loose framework of collective (or state) ownership that is still lacking a formal company law. This allowed much room for variation. What it achieved, during 30Yusuf (1993b). 31 The uncertain nature of property rights relating to enterprises is noted by Watson (1992, p. 184). The significance of the underlying web of social and kinship linkages in the running of enterprises and the allocation of their earnings is also discussed (pp. 184-86), as is the provision of credit to enterprises at the instigation of the county. 12 • CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 311 the most difficult stage of transition, was a balancing of three inter- twined concerns: supervisory agencies sought to retain control over enterprises to ensure that they adhered to official goals and would service the revenue requirements of local governments. Enterprises sought maximum decision-making autonomy so that they could pur- sue opportunities as they arose and capture much of the benefits for employees. Both parties sought a viable sharing of risks, and this implicitly served to demarcate ownership rights. The community, represented by local authorities, was protective of its ownership rights over enterprises, but realized that by shouldering all the risks it would in effect be underwriting inefficiency. Managers and workers have little incentive to work hard, or be competitive, if they are shel- tered from losses. The enterprise had to weigh the advantages of independence against the risks of operating in a highly fluid environ- ment, in which market information was scarce, financial channels underdeveloped, and where the state would remain the key player for the foreseeable future. Emerging from all this is a system of fuzzy rights, which leaves the margins between collective, cooperative, and private ownership quite vague. This has brought into being a sharing of risks between enter- prises and local government, at least for the broad mass of nonstate enterprises in the rural areas, and has had a profound effect on financ- ing. Byretaining vestiges of collective ownership, an enterprise gains some protection from risk of failure, more easily obtains resources from banks, and possibly derives other favors in the form of budg- etary grants, subsidized inputs, or sales to government bodies. Such an arrangement has also increased the readiness of households to invest. The price of such sharing is the claim that local authorities can exercise on enterprise income and assets. Because a private entity could not easily ward off official requests, seeking collective status was not just good economics, it also acknowledged sociopolitical reality. .Although much has been made of the importance of private prop- erty rights for creating an efficient market economy, China has clearly not suffered by limiting the domain of private property and cultivat- ing a wider, informal system of partial ownership in the rural sector. An individual's ownership of a collective enterprise is in many I instances totally accepted within a county, although the enterprise technically remains a property of the community. In those instances where ru~al enterprises have distributed shares, mostly among owners and the work force, it is broadly accepted that local govern- ments have a claim on enterprise revenues. Coinsurance by the Gov- ernment has not exacerbated moral hazard problems because town- 312 Shahid Yusuf ship social networks that link government and business impose joint liability and facilitate both agreement of performance criteria and their enforcement. As markets mature, and the need for risk sharing diminishes, more collectives will cross the line into private ownership. But for many years ahead, fuzzy property rights are likely to remain a feature of the economy, reflecting an ideological predisposition, a stage of fiscal development, the poorly articulated state of markets, and a contin- gent response to the difficulties of raising capital in uncertain condi- tions and with weak financial markets. Financing Nonstate Industry As indicated above, a substantial part of investment funding comes either from retained earnings of enterprises or is provided through a variety of fiscal channels. Although appropriate for a centrally planned economy in which banks had a peripheral role, it is bound to change radically as markets develop, the nonstate sector grows, and the continuing growth of savings results in a deepening of the finan- cial system. Until fairly recently, financial development tended to lag behind industrial change, but it seems now that the spontaneous appearance of new financial institutions may be powerfully reinforc- ing the forces of expansion, particularly in the nonstate sector. 32 After a slow start in the mid-1980s, the refinement of the financial system has picked up speed. In addition to the four specialized banks and the two national comprehensive banks, there is now a vast net- work of rural and urban cooperatives, as well as several hundred nonbank financial intermediaries-trust and investment companies (TICs), finance companies, leasing companies, and security corpora- tions.33 Since 1990, these have been joined by stock exchanges in Shanghai and Shenzhen, and stock markets flourish in scores of cities.34 Low inflation throughout the 1980s and moderate interest 32 Since the mid-1980s, rural industry has taken the lead in introducing new instru- ments such as bonds and shares (Tam, 1991). 33 Bowles and White (1989). The importance of commercial banks, saving companies, postal savings, and various cooperatives to the development of Taiwan Province of China's rural sector is discussed in Adams, Chen, and Camberte (1993). The contribu- tion of private and government finance institutions to postwar, small-scale industry growth in Japan is described by Friedman (1988, pp. 166-68). 34fairlamb (1993). 12 • CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 313 rates, which on average have provided .savers with zero or positive real returns, have continually stimulated resource mobilization. 35 However, unlike Japan or Taiwan Province of China, the Govern- ment has not made a deliberate effort to create a financial infrastruc- ture that serves the needs of rural industry. 36 Instead, the incentives released by industrialization have induced existing institutions to expand and reorient their activities. They have also drawn new inter- mediaries into the fray. The institutions of immediate relevance are, first and foremost, the Agricultural Bank of China (ABC), whose branches extend down to the township level. Affiliated to the ABC and operating at the township level and below are more than 60,000 rural credit cooperatives (RCCs) and 3,500 urban credit cooperatives (UCCs). The former are collectively owned by farmers and are the main providers of c.redit to farmers and to the rural industry. From small beginnings in Zhejiang,37 Jiangsu, and Fujian, locally owned informal banks have appeared, restoring a tradition that had flour- ished earlier in the century. Increasing, but still relatively small, amounts of credit are flowing to the nonstate sector by way of TICs and finance companies set up by the specialized banks to tap. more lucrative markets in which they often cannot lend directly. 38 Finally, after years of an unswerving commitment to vertical inte- gration, many of the large state enterprises in the coastal cities, for example, Shanghai and Hangzhou,. are subcontracting on a growing scale for reasons of flexibility and lower cost. This trend, which is sure to gather momentum as experience accumulates on both sides, is beneficial to rural enterprises in at least four ways: it enlarges their markets; the large state-owned enterprises provide secondhand equipment; they are a source of technology and skills; and, because they enjoy much easier access to credit from the specialized banks, they can provide subcontractors with some amount of working capital. 351£ 1988, the year of an inflationary spike, is excluded, the average one-year deposit rate between 1979 and 1991 was 8.3 percent, whereas the average retail price inflation was 4.7 percent. The figure for deposit rates is biased somewhat by the high deposit rates introduced in 1989. . 36See Adams, Chen, and Camberte, (1993) and Friedman (1988). 37.See Blecher (1991). The emergence of informal monetary transactions among households and the growth of nongovernmental finance associations as well as credit unions have been noted by many observers. 38See Xiao and Xiu (1993). 314 Shahid Yusuf Although distressingly sparse, the data-especially with respect to working capital-are examined below in more detail, to define the part played by finance in the growth of collective and private enterprises. Rural Banking Institutions Rural household savings were insignificant in the late 1970s but have since risen very strongly in line with overall growth in house- hold accumulation, which reached 19 percent of GNP in 1991; see Tables 4 and 5. Much of these savings take the form of deposits in the ABC and the credit cooperatives. Enterprise deposits have also increased sharply. Between 1979 and 1991, ABC's total deposits rose twelvefold. Whereas enterprise deposits have the bigger share-58 percent-they have also climbed the fastest-by an incredible 75 times. The experience of the rural credit cooperatives is similar. Total deposits have grown tenfold, with savings deposits accounting for the largest share-85 percent-and for the biggest increase, 24-fold. During the first half of the 1980s, the expansion of the deposit base was not matched by lending to rural industry. 39 In fact, the evidence Table 4. Savings (Percent of GNP) 1987 1988 1989 1990 1991 Gross national savings1 39.6 38.8 37.8 39.5 40.4 State budget (current account surplus) 4.6 3.0 2.4 2.5 1.8 Enterprises and other2 18.2 18.5 19.0 18.4 19.9 Households3 16.5 17.2 16.4 18.6 18.7 Of which: Financial savings 9.5 9.9 10.0 12.9 13.2 Source: People's Bank of China. 1Estlmated as gross domestic investment plus the balance on external account. 2Calculated as a residual; mainly state-owned and collectively owned enterprises and extrabudgetary operations of local government. aDoes not take into account borrowing by households, which Is negligible, and purchases of securities issued by nongovernment entities. 39 Feder and others (1989) note that deposits of rural households were larger than loans in their sampled counties. Thus, credit shortages might be more perceived than real. 12 •CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 315 Table 5. Household Bank Savings Deposits (Biiiion yuan) 1978 1979 1980 1985 1988 1991 Total household deposits 21.06 28.10 39.95 162.26 380.15 911.03 Urban household deposits1 15.49 20.26 28.25 105.78 265.92 679.09 Increase over previous year (percent) 30.79 39.44 36.21 28.61 30.78 Rural household deposits2 5.57 7.84 11.70 56.48 114.23 231.94 Increase over previous year (percent) 40.75 49.23 28.92 13.58 25.94 Total household deposits/ GNP (percent) 5.87 7.05 8.94 18.96 27.12 45.88 Sources: statistical Yearbook of China, 1992; Qian Vingyi (1993). 1oeposits held by households in the state banking system. 2oeposits held by households in rural credit cooperatives only. from financial and other sources points to a transfer of resources from the rural to the urban sector. 40 Since then, the tempo of lending by the ABC and RCCs for rural industry has quickened, although it may not yet have fully utilized the lending potential of these institutions and has made minimal inroads into the lending of other banks and on financial entities. Table 6 shows that the loan/deposit ratio for the RCCs in 1991, while it has risen threefold since 1989, was 67 percent, with approxi- mately 56 percent of loans being to township and village enterprises. An examination of total bank lending in 1989 shows that the nonstate sector, including agriculture, absorbed about 20 percent of all bank lending, and a third of this was to rural industry (Table 7). Thus, at a time when rural industry was producing close to a fourth of industrial output, it was absorbing 8 percent of bank lending for fixed invest- ment as well as working capital. 40Sheng (1991) has computed intersectoral transfers through price and nonprice mechanisms for 1952-88. For the period up to 1986, there was a net outflow from agriculture, primarily because of price pol~cy. Ther~after, the outflow tapered off and might even have been reversed. 316 Shahid Yusuf Table 6. Rural Credit Cooperative Activities (Billion yuan) 1979 1980 1985 1988 1990 1991 Total deposits 21.59 27.23 72.49 139.98 214.49 270.93 Loans to households 1.09 1.60 19.42 37.24 51.82 63.14 Loans to TVEs 1.42 3.11 16.44 45.61 76.07 100.73 Loans to collective agriculture 2.24 3.45 4.14 8.01 13.41 16.99 Total loans/total deposits (percent) 22.0 30.0 55.2 64.9 65.9 66.8 Sources: Statistical Yearbook of China, 1992: Qian Yingyi (1993). Table 7. Bank Lending to Nonstate Sector as Proportion of Total Outstanding Bank Loans (Percent) 1985 1986 1987 1988 1989 Urban collectives 4.95 5.11 5.47 5.58 5.15 Urban individuals 0.17 0.13 0.16 0.17 0.11 TVEs 5.63 6.82 7.25 7.59 7.39 Agriculture 6.85 6.68 7.28 7.19 7.12 Total nonstate loans 17.60 18.94 20.16 20.53 19.97 Sources: Almanac of China's Finance and Banking, 1990; Qian Yingyl (1993). A glance at Tables 8, 9, and 10 on fixed investment and its financing can help sharpen the picture somewhat. Two things are striking. The first is the relatively small share of investment by collective and other enterprises relative to state firms. The ratio is less than 30 percent, even though the shares in production were fairly close. Second, at the aggregate level, domestic and foreign loans were a minor part relative to self-raised funds and others. Although the volume· of domestic loans rose by 80 percent between 1987 and 1991, the ratios have changed little. However, rural township and village enterprises are more dependent on bank loans than state or the larger collective enterprises (Tables 10 and 11), though the average is a third of total financing. This brings us back to extrabudgetary resources and the importance of other informal channels for raising funds. The nonstate sector and, in particular, rural industry obtains a small proportion of total loans, which are still funneled disproportionately to the state sector. And to a degree perhaps not fully appreciated, well over half of all fixed investment is still being financed by other means. 12 • CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 317 Table 8. Investment by Sector and Source of Financing (Billion yuan) 1987 1988 1989 1990 1991 1992 Gross domestic investment 448.7 557.4 618.3 641.4 730.8 Fixed investment1 390.7 469.9 442.1 464.2 547.3 758.2 By ownership State units 229.8 276.3 253.6 273.3 338.2 510.6 Collective units 56.7 71.2 57.0 52.9 62.9 123.3 Construction by households 79.6 102.2 103.2 103.5 109.2 124.3 Other2 24.6 20.2 28.3 34.5 37.0 By source of finance State budget3 47.1 40.9 33.7 38.2 36.5 Domestic loans 56.1 65.4 52.6 64.9 93.8 Foreign loans 15.7 23.9 24.8 20.4 27.6 Self-raised funds and other 271.8 339.7 331.0 340.7 389.7 Stockbuilding and work in progress4 58.0 87.5 176.2 177.2 183.5 Source: State Statistical Bureau. 11nvestment In plant and equipment plus equipment renewal and technical transformation. 2Not separately identified by ownership (Investment by enterprises not covered by the plan). 3These data are not comparable with the budgetary data for investment because of differences In recording method and coverage. 4lncludes stock of materials, goods in process of production, and finished goods. Table 9. Total Fixed Investment by Source 1985 1987 1988 1989 1990 1991 (Billion yuan) Budget 40.78 47.55 41.00 34.16 38.77 37.30 Loans 51.03 83.59 92.67 71.64 87.09 129.22 External capital 9.15 17.54 25.90 27.42 27.83 31.63 Self-financing 153.36 174.52 . 290.09 . 235.55 232.95 287.86 Other 40.88 45.01 58.30 64.88 Total 254.32 364.09 449.65 413.77 444.93. 550.Q1 (Percentage share) Budget 16.03 13.06 9.12 8.26 8.71 6.78 Loans 20.06 22.96 20.61 17.31 19.57 23.49 External capital 3.60 4.82 5.76 6.63 6.25 5.75 Self-financing 6Q.30 47.93 64.51 56.93 52.36 52.34 other 11.23 10.88 13.10 11.80 Total 100.00 100.00 100.00 100.00 100.00 100.00 Source: China statistical Yearbook, 1992 (In Chinese); p. 145. 318 Shahid Yusuf Table 10. Rural Fixed Investment by Source, 1990 (Percentage share] Other Estimated Government Bank Borrow- Own Total Sources1 Loans ing2 Funds3 Other National 100.00 8.60 30.39 26.63 26.63 6.82 Beijing 100.00 14.30 38.07 5.78 27.59 3.32 Tianjin 100.00 13.02 36.70 11.23 24.19 6.75 Liaoning 100.00 11.53 35.72 8.87 23.64 5.53 Shanghai 100.00 17.97 35.31 8.16 18.61 7.95 Jiangsu 100.00 5.64 27.73 9.09 35.51 9.98 Zhejiang 100.00 7.57 29.25 7.10 37.09 8.89 Fujian 100.00 11.20 21.06 56.85 25.14 3.97 Shandong 100.00 6.04 34.51 8.77 32.14 8.83 Guangdong 100.00 7.59 34.47 30.54 25.77 6.24 Hebei 100.00 3.74 43.01 11.02 16.27 3.84 Anhui 100.00 15.29 25.60 5.67 29.38 6.25 Jiangxi 100.00 11.79 35.76 5.21 26.32 6.28 Henan 100.00 9.04 33.47 11.39 30.22 4.06 Hubei 100.00 8.38 36.90 5.28 22.65 5.92 Sichuan 100.00 6.36 17.01 7.92 22.42 4.87 Source: China TVE Yearbook, 1991 (in Chinese), pp. 188-91. 1TVE support fund and fund from supervisory agencies. 2Borrowing from other units/individuals/external sources. 3Retained profits and pooled funds. Table 11. TVE Capital by Source Own Resources Borrowed Resources Outside Retained source profit Bank Government Payables State support Development Loans from Budget Procurement fund fund bank and revolving payable rural credit fund State support Welfare fund Other borrow- Taxes pay- allocation ing able Local budget Bonuses fund Other allocation Town and Enterprise local invest- fund ment fund Investment by Education other units/ fund individuals Major mainte- nance fund Labor insur- ance fund Source: China TVE Management Encyclopedia (Beijing: Agriculture Publishing House, November 1987). p. 294. 12 •CHINA'S COLLECTIVE AND PRIVATE ENTERPRISES 319 Table 12. Distribution of Loans1 1988 1989 1990 1991 1992 (Billion yuan, end of period) Total loans 1,142 1,347 1,654 1,981 2,243 lndustry2 563 675 837 1,015 1,156 Working capital 425 518 639 741 832 Industrial enterprises3 310 387 489 575 639 Construction organizations 49 60 67 72 84 Collective enterprises and individuals 66 71 83 95 109 Fixed investment 139 157 198 274 324 Commerce4 410 477 576 668 703 Agricultures 169 196 241 298 384 (Percentage change from previous year) Total loans 16.5 18.0 22.8 19.8 21.4 Industry 15.5 19.8 24.1 21.3 21.8 Working capital 13.0 21.9 23.4 16.0 17.9 Fixed investment 24.0 13.2 26.2 38.5 33.1 Commerce 17.0 16.4 20.8 16.0 18.7 Agricultures 18.4 15.8 23.3 23.4 25.8 (As percentage of total loans) Industry 49.3 50.1 50.6 51.3 51.5 Working capital 37.2 38.4 38.6 37.4 37.1 Fixed investment 12.1 11.7 12.0 13.9 14.4 Commerce 35.9 35.4 34.8 33.7 31.3 Agricultures 14.8 14.5 14.6 15.0 17.1 Source: People's Bank of China.