INDUSTRY AND ENERGY DEPARTMENT WORKING PAPERINDUSTRY SERIES PAPER No. 35

Tightening the Soft Budget Constraintin Reforming Socialist Economies

May 1990

The World Bank Industry and Energy Departmernt, PRE

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TIGHTENING THE SOFT BUDGETCONSTRAINT IN REFORMING

SOCIALIST ECONOMIES

Suoo NmokIzak Atlyas

May 1990

lndutzy Development DiionIndustry and Energy DepartmentPolicy, Research and Extemal Affairs

TABLE OF CONTENTS

Page No.

EXECUTIVE SUMNIARY .............................................. i

L INTRODUCrION .. 1

IL THE hECHANISM OF THE SOFT BUDGET CONSTRITT.. 3

A. Contingent aes and Subsidies. 3B. Contngent Capiha Subsidies. 6C Contingent Price Regulation. 8

]IL CAUSES OF SOFT BUDGET CONSTR-AINTS .......................... 10

A. Why Does the Government Help LAs Maken? .................... 10EL Why Do Commecial Banks and Other Eamnomk Entities

HelpL insMakers? ................................. 12C. Restricted Capital Ownerip and Soft Budget Constraints .... ........ 15

IV. CREDIBILITY OF HARD BUDGET CONSTRANS . ................... 17

A. Mhe Hard Budget Constraint May Not Be Credible in an Economywith a Monopolstic Supply Structure .......................... 17

B. Surpluses and Soft budget constraints ........................... 22

V. STRATEGIES FOR TIGHTEING THE SOFT BUDGET CONSTRAINT 24

A. Establishing Effective Adjustment Assistance for Workes. 24B. Reducing Discretion and Incentives for the Goverment

to Help Enterprises Ex Post. 25C Crating Incentis for Autonomous Adjustment. 26D. The Role of Commercial Bank and the Financial Sgstem .27

STATISCAL APPENDIX

REFERENCES

We are grateful to Nancy Barry, Car Dahiman, C3audlo Frischtak and Alan Oelb for comments. Worldprocessing support was provided by Anna Marie Maranon and Wilson Peis Editorial assistance wasprovided by Stephanie Gerard. lhe views presebted here are our

EXECUTIVE SUMMARY

ii The soft budget constraint exists when the strict relationship between an enterprisesexpenditures and earnings is relaxed and the excess of expenditurm over earnings is compemated for bysome other insdtution, typically the state. It is a key structural charateristic of socialist economies and afundamental cause of inefficiency and chronic shortages in those economies.

ii Tightening the soft budget constraint is thus widely recognized as one of the centralstructul reform Issues in socialist economies. This paper analyzes major causes for the persistence of softbudget constraints and suggests countermeasures for tightening them.

iii. Mecheanisms and Consequences f the soft budget constnt. Budget constraints becomesnftened in four ways: soft subsidies (e.g., negotiable according to cost overruns); soft taxation (negotiableaccording to an enterprises financial situation); soft credit (for firms in constant financial distres, withoutpossibility of repayment); and soft regulation (e.g., administrative prices set according to a central "cost pluseprinciple). Budget constraints are softened not only by the government but also by financial institutions.Although these facwors may not be unique to socialist economies, their frequent use and magnitude havebeen much higher in socialist economies.

iv. Economic consequences of the soft budget constraint are profound. First, firms become lesssensitive to changes in interest rates, exchange rates, and relative output prices Second, a shortage economyresults, where no restraint inhibits demand for inputs and investment. Tird, with the bankruptcy risk absentand the old production lines protected, innovation and development are undermined.

V. Why does the soft budget constraint cause enterprises to respond slowly to pricing and otherpolcy canges? Ihe firm would like to avoid restructuring and output reductions, if it can change the fiscal,financial and regulatory environment in its favor. Thus, the soft budget constraint helps explain thestructural rigidities and weak supply response to external and policy shocks in socialbst economies.

vL The soft budget constraint may raise the investment level of the economy, if the governmentcan accommodate investment demand by limiting income and consumption of the population. However, aswil be discussed in Sections mII and IV, the soft budget constraint can reduce the quality of investments andentrepreneurial efforts, offsetting and reversing any gain from higher investment. In fact, the negative effectof soft budget constraints on dynamic efficiency seems to be one of the most plausible explanations for thepoor growth performance of socalist economies, despite high investment rates.

vii Causes of Soft Budget Costrbaints Why do governments and commercial banks tend toprovide ex-post support to loss-making enterprises? Three main motives are apparent: compensation forpes lmbed auoomy, diegence of social surplus fom pit, and the sank ost ap.

viiL In terms of the fitst factor, when enterprise managers and workers place responsibility fortheir current poor performance on past government policies and enterprse controL their avoidance ofresponsibility generates the often cited paternalism of sodalist goverments Since the effects of weakenteprise autonomy and heavy centralization of income are cumulatve, governments also find it difficultto assign primary responsibility to enterprises even after the enterprlses have been given substantialautonomy. Thus, providing autonomy does not automatically put the govanment In a position to transferthe responsibility to enterpries unless financial problems left over from past interventions can be settledat the same time.

ix. In terms of the dhiergence between enterprise-level profits and social surpluses, there arethree key situations in which such divergence has become a structural chararstic of socialist ecnomiesmonopolistic supply structures, exporting at ovealued exchange rates, and binding price controls In eachcase, enteprise-level profits typically are lower than the socal surplus generated by their activities. Thsphenomenon creates an incentive for the government to subsidize enterprise loes an undermines the

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credibility of the ovenmenet's announced intentions to tighten the budget constraint. This in tn destroysenterptse Incentives to respond to adverse shocks and to undertake restructuring measures that would makeex-post subsidization unnecesary. As a result, the economy becomes trapped In a situation where fims donot restrUcture and the n t finds itself compelled to subsidize them

x. Thi analysis has important poLcy implications for socialist economies' reform efforts.Efforts by the governuent to tighten the soft budget constraint-without making the structural reforms toeliminate monopolistic stuures, overvalued exhange rates, and price controls-are likely to be bothunsuccessful and costly. In the absenac of such structural reforms, a tough govnment strategy would needto convnce enterprises that the govemment would be willing to sacifice the sodal surplus for the sake offinancial disciple Such a strategy would take time; until enterprises were convinced about govermentalms, they would not restructure, and the economy would suffer from the sizable foregone efficiency gains.

xL In terms of the sunk cost trap, even when a project as a whole cannot yield an adequatereturn, previous inestments still may justify additional investments. ie., when past investments cannot beredeployed easily or when they are sunk. Although provision of additional finance may seem reasonable expost, it creates incentive distortions ex ante. Enterprises may feel less incentives to increase productivityor reduce costs at any stage of a project if they expect to receive additional financing. Exacerbating the sunkcost factor in socialist economies is the underdeveloped nature of factors, in particular finandal markets,which makes resource mobility low.

xil. At the same time, there seems to exist strong incentive distortions for commercial banksin socialist economies to finance loss makers through rescheduling. Generally, they have thres options fordealing with debt overhang fom loss makers: liquidation, takeover and resucturing, or contiL ed supportof those enterprises through debt reduction or refinancing/rescheduling. Banks in socialist economies tendto take the refinancing option since the option for takeover has essentially been closed (with all enterpr-ises either state-managed or self-managed) and debt reduction reduces the amount of expected governmentsupport to the loss maker or to the bank (even in the form of compensation to bank management, whichis based on accounting profits).

xni In socialist economies, expectations of goverment bailouts exist in an aggravated form,unlike In most market economies, where government bailouts of banks or their debtors is expected tohappen only when faiures are widespread and threaten the stability of the banling system. By contrast, thebanking system In Hunguy, for instaUnce, has simply inherited loans from the National BanL Commealbanks can claim to have no responsibility for lending dedsions taken by the gvernment prior to the banks'takling over the ans Bailout expectations also encourage banks to prolong the surval of borrowes whoare unlikly to regain viability. lhus, adjustment in the enterprise sector becomes unduly slow. Effecivelywhat happens is an operatonal partnership between the bank and its major borers at the expense of thegovernment or taxpayas.

xiv. O pghts and soft budget onstbints The problem of restricted ownership rightsin socalist economies has two aspects FIst, the right to appropriate enterprise income is ambiguous. Thishas a partcularly adverse effect on the behavior of profitable enterprises, while the incentive effecs of softbudget constraits are parficulary detrimental to the decisions of enterprises with negatie or low profits.However, by undemining profit-making incentives, the ambiguity in ownership rights causes entepriseprofits to diminish and thereby makes a larger share of the enterprise sector subject to the perese effectsof the soft budget censtraint.

xv. Second, decision-making power ad rights to control assets are either ambiguous or difficultto tsfer. In paticular, creditors canmot easily assume control rights when enterprises accumulate arrarsThis makes fnancial Isitutions unwiing to lend for major restrucuing operations Since liquidation iscostly, they recedul debts and Interest payments Thereore, ing efforts camnnot be efficiently

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supported by the financial system, and the state has to assume the role of a flnancial Institution, which intun tends to soften the budget constraint

XnL Credbllwt of bard bueet ansst Although the existence of a gap between sodalsurplus and private surplus may make it optmal for the govemment to provide ex-post support to lossmakers, this would not be harmful for the economy If this support created no adverse incentive effectsHowever, such advse Incentive effects are liely to exist. In fact, the gap between social surplus and ptofitundemines the credibility of hard budget constaints and can substantially hurt dynamic efficiency gains inindustry. This is because a firm can appropriate the differn between sodal surplus and profit by undet-inmestment.

xvii Also, a soft budget constraint partularly hurts the wliingness of enteqises to adjust tolarge shocks (see formal presentation in subsection -A, which focses on the monopolistic supply struteas a stural cause for the gap behteen social surplus and profit).

XiiiL igteIng the soft budget coustrat Mghtening the soft budget constraint requies thefollowing measures. First, structural reforms that reduce or elminate the gap between enterprise profitsand the social surplus are neded to remove the govnmentU s e-post incentives to help enteri Ssond,the government needs to establish effective adjustment assistance for workes; this can mean redirecingfinancial and other assistance that formerly supported loss-making enterprises. This polcy will helpeliminate current biases in govement policies that bvor efforts to maintain the status quo or rehabilitateagainst eaLt. Tbhr the panment should also reduce its diaction to help loss-mainag enterpries byleaving allocation of investment resoures to financial institutions. This policy must complement theestablshment of an adequate banking regulaton and superision system. Fnly, if cmmercal bans areto particpate in serious restructuring and impose finandal discipline on enterpries, there must bearrangements to enable creditors to assume control of enterpries in financal distress Privatization or thetransformation of enterprises into shareholding companies is an efflcient instrument to implement this policy.An alternative is to create bankptcy reorganion mechanim that eplicitly guarantees creffitors theright of controL

I. INTRODUCTION

1.01 lhe concept of the soft budget constraint was Introduced by KornalY as a fundamentalcause of chuonic shortages in socialist economies: 'the softening of the budget costraint appears when thestrict relationship between expenditures and ernings has been relaxed, because excess expenditure overearnings will be paid by some other institution, typicaly by the state** The soft budget constraint has beenrecognized as a key suctural charactristic of socialist economies, and tightening of the soft budgetconstraint is regarded as one of the central Issues in the economic reform of these economies.

1.02 Most literature has focused on analyzing the consequences of soft budget constraints;relatvely less attention has been devoted to its causes. Kornai goes only as far as assodating the softbudget constraint with the paternalistic role of the state. The objective of this paper Is to analyw thecauses of the soft budget constraint and to suggest effective strategies for tightening it.

1.03 ThIs secton reviews how the budget constraint Is typically softened and what are itsconsequencs, based on Kornai's analysis. He identifies four ways In which budget constraints becomesoftenedL

* Soft sbsidis Subsidies are negotiable and adjusted to past, present or future costoverruns.

Soft tation. Taxcs are negotiable and taflonnade to the financial situations of enterprises

* Soft credit. Credit contracs are not enforced; unreiable debt service, postponement andrescheduling are tolerated. Soft credit is used to assist firms in chronic financial trouble,without real hope of repayment.

soft ad _In e prkes. Prices are set administratively acording to some pemsive'cost pluse principle.

1.04 These facts contributing to soft budget constraints are not peculiar to socialist economiesEa-post subsidies, tax exemptions and soft loans to loss-making enterprises have been widely used in manymarket economies. Granting trade protection to declining industries is another instrument that evenWestern govnments have used to help companies in financial difficulty (Huffbauer and Rosen (1986, Hall(1986)). Also, it has been recognized that deposit insurance schemes utilized by financial intermediaries,while widespread, can reduce financial discipline on banks and enc&urage their excessie rik takig. Yetwhile soft budget practices exist elsewhere, their frequenc and magnitude have been much higher in socialisteconomies.

1.05 Kornai (1986) indicates three major consequences of the soft budget constraint

* The price responsiveness of the nra dedInes. Fims become less sensitive to changes ininterest rates, excange rates, and relative output prices.

* The system becomes a shortge economy. No self restraint inhibits demand for inputs and

investmeant

J/ Kornal (1960) and Kornal (1986a).

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*AocatiNW and xImInCsh.wles. he soft budget constrait protects the old produc-tion line, the Inecient firm aist constructive destruction and thus impedes innovationand development.'

1.06 Ibe reason that soft budget comtraints cause enteis to respond slowly to prie changesIs dtear. Rodlk (1989) recently has given a more fMl Inteetation. A negative shock to the resourceconstraint of a fim increases the intensity of its effort to chauge the fiscal, financial and regulatoryenvironment in its favor, to anmmodate the shock Tis, in tur, enables the fim to avoid reducing itsoutput in response to the shock. Thus, the soft budget constraint helps explain the structural rigidities andweak supply response to external and policy shocks in socialist economies

1.07 The reason for unbridled demand for inputs also seems straightforward. The budgetconstraint ultimately must be acoompanied by redistribution of Incme among enterpries via high-leveltaxation or inflation. Yet each fim deciding its level of expenditure does not fully take into account theultimate general tax increase or inflation that Inevitably accompanies every firm's effort to soften its budgetconstraint. lherefore, the soft budget constraint makes the private cost of expenditure smaller than itsshadow cost and tends to create aggregate demand in excess of aggregate output}

108 The effect of the soft budget constaint on dynamic efficiency may not be as clearcut asthe f&rst two conequences It might be expected that a strong drie for investment, due to the soft budgetconstraint, would a1o imply a strong drive for investment in cost reduction. Howeer, as will be discussedin Sections III and IV, the soft budget constraint may reduce the quality of investments and entrepreneurialeffrs, offsetting and reversing any gain from higher Inwastment. In fact, the negative effect of soft budgetcstraints on dynamic efficiency seems to be one of the most plausible explanations for the poor growthperformance of socialist economies, despite high inmestment rates.

1.09 Section I of this paper reviews the major mechanisms by which budgets are softened andges a short aount of recent reform measur underken in Hunary and Poland. In Section II, wediscuss the major reasons behind soft budget constraints. Section IV focuses on the divergence of socialsurplus ftm profits, discusses how such gaps undermine the credibility of hard budget constraints, and howthey resuit in dynamic efficiency losses. Section V proposes strategies for tightening the soft budgetconstaint.

In this regard, soft administered prices may have diffrent implications for macroeconomicequilibrium, compared to other sources of the soft budget constrainL This is because the first ordereffect of a price increase is only a tansfer of income from onmumeas to the enterprise and thereforedoes not result in an Immediate Incase of aggregate expenditure. Nevetheless, exess demandpressures may build up I higher pries lead to higher wages.

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II. THE MECHANISM OF THE SOFI BUDGET CONSTRAINT

201 In tradidonal ceontral planned economies production and Investment plans were deterinedby govnment, with enteprises responsible mainly for implementing the plans. Resoures we allocatedcentally. Enterprises were de acto administrative units within the govenment hierarchy, with littleautonomy and accountability. Fims did not have independent financal responsibility since the govenmentessentally bore all costs of implementing the plans he budget constrait was extemely soft, with fnancialflows determined by socal and political objectives.

2.02 Eoonomic reform in socialist economies has reduced the tole of plans. Enterprise autonomyhas increased As early as 1968, Hungary abolished all production aud investment directives to enterprises.Sir staps were taken in Yugoslavia in the early l950s and in Poland in the 1970Ls. Profit has beomeincreasingly accepted as the most important measure of enterprise performance. Remuneration ofmanagement and workers has also become linked with the profit performance of enterprises, through profit-sharing schemes.

2.03 However, the potentially positive impact of profit making objecties has been distorted andundermined by the pervasive Impact of soft budget constraints. Instnuments of soft budget constraints canbe classfied into three groups: curent tak exemptins and subsidies; capital subsidies; and contingentregulations. This section reviews the past functioning of these instruments and recent reform measus.

A. Continet Taxes and Subsidies

2.04 In socialist economies, enterprises are subject to heavy curent taxes and subsidies. InHungary, in the aggregate, enterprises were taxed at about 57% of their value-added in 1985. At the sametime, enterprise subsidies amounted to 41% of enterprise taxes. As shown in Appendix Table 1, taxes andsubsidkes were highly non-uniform across sectomr Some sectors recived subsidies far exceeding their valueadded. Subsidies and tax write-offs have been invesely related to the profitabilty of enterprises Taxes,including dividends and interest payments, have been negotiabl ex post, fvoring loss-makling enterprieMaw subsidy schemes have tended by design to acoommodate the production cost increases of enterprises.

2.05 It is not the mere existence of tax exemptions and subsidies that generates the soft budgetconstraint problem. Whether taxes and subsidies act to soften budget constraints depends on the rulesgoerning their imposition and implementation and, more important, on how rigorously these rules can beenforced. In particular, given that prices are highly distorted due to extensive controls, the imposition ofproduct-specific taxes and subsidies could in theory correct these dtrtion_V Even if prices are not dis-torted, production taxes and subsidies, if dependent only on those parameters beyond the control ofenterpries, would result only in the loss of allocative emcincy.

2.06 However, in practice, tax exemptions and subsidies have been signflcantly contingent onproduction costs of enterprises. lbis is because

even when tax exemptions and subsidy rules have no built-in mechanism for covering thelosses of each enterprise, as in the case of wage taxes, their applications have beennegotiable ex-post by each enterprise, and

31 For exampl, among the 500 largest entrpries in Poland, most loss-makers were in the foodproducts and agricultural inputs industries; products of both industries sold at state-controlled prices,which we set vey low (Sdcffer (1990)). Without subsides, these products would have beenunder-produced.

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othea tax and subsidy systems have built-in mechanisms for covering the production costsof each enterpise.

Since costs are sigaificantly affected by how much effort workers and magers put into reducing them, thismakes taxes and subsidies wntingent on their performance, creating severe incentive problems 'heseadverse incentive effects make tax exemptions and subsidy schemes in sociaUst economies sources of softbudget constraints}

2.07 First, let us look at taxes. In socialist economies the enterprise t u often a dominantsource of goverment fiscal revenue. For example, enterprise taxation contributed more than 90% ofPoland's tax revenues in 1989. Enterprises are taxed for turnover, investment, employment and profit.These taxes are often negotiable ex post. It is reported that 1,200 to 2,500 decrees cocerning enterprisetax regulations were issued yearly by the Ministry of Finance in Hungary in early 1980s Crardos (1986)).Fifty percem of these decrees are said to have had a retrogressive effect, i.e., they often changed the tax onincome eaned in the past. In paricular, loss-maklng enterprises often are exempted from paying taxes andinterest. In 1985 and 1986, Hungarys 26 largest loss-making enterpris received special exemptions fromtax and interest obligations, amounting to 16% of their value added.

2,08 Second, let us look at subsidy schemes. The stated objectives of the subsidy schemes inalist economies are diverse: subsidizing a particular group of consumer goods such as food, fuel and

medicde; offsetting cost disadvantages for cenain domestic industries against foreign producers, such as inthe coal and steel industries in Hungr, compensating for losses due to CMEA E trade (the CMEA pdieequalization scheme); and encouraging expoRs. Subsidies may be provided not only in the form ofgrnment's current expenditure but also through allocation of underpriced resources such as foreignexchange, raw materials and energy. Supporting loss-making enterprises through the allocation ofunderpriced resources is widely seen in China.

2.09 Most subsidies intended to offset the cost disadvantage of domestic industries are clearlycontingent on the cost of production: the higher the production cost, the higher the subsidy. For example,in Hugairy subsidies provided to the coal and metallurgical industries simply fill the gap between domesticand foreign costs Similarly, although the CMEA price equalization scheme is often claimed to offset pricedistortions existing in CMEA trade, it also tends to be contingent on production costs. This is becausegoverments guarantee that producers do not suffer losses from exporting to other CMEA countries. Evenconsumer price subsidies are contingent on production costs, despite the fact that they are normaly paidto consumers, wholesalers or retailers. This is because the subsidy rate often is designed to make up thedifference between production costs and politically determined consumer pricels. Thus, although the statedobjectives of subsidy schemes are diverse, all of them tend to be contingent on the producion costs ofdomestic industry.

2.10 The muting effect of these contingent tax and subsidy schemes on the profit incentive hasbeen found to be very strong. Kornai (1986) reports that for Hungars state enterprises in 1982, the actual(iLe., before taxes and subsidies) profitability of enterprises had almost no correlation with their final

See Vodopivec (1989, 1990) for a review of the literature on the adverse effects of tax and subsidyschemes on productivty in socialist economies and an empirical investigation of the case ofYugoslavL

CMEA = Coundl of Mutual Econoumc Assistanceb

financial profltabilit, Thus, tax and subcidy schemes redisttibute income from profitable enterprises to loss.makers so strongly as to leave almost no incentive effect based on profltability.i'

2.11 In a similar study on large enterprises in Poland, Schaeffer (1990) finds that the tax-subsidysystem was again operated to equalize profitability of enterprses Most enterprises whose pre-tax/pre-subsidy profits were negative ended with larger than average profits after taxes and subsidies. In the caseof profit-making enterprises, the correlation coeMcient between original and final profits was positive butIn the case of loss-making enterprises it was negative. This suggests that loss-making enterprises with thelowest original profhtability ended up with the highest final profitability.

2.12 In the case of Polnd, subsidies have been clssified as product-specific and enterprise-specific. The former are supposed to compensate for unfavorable output or input prices that result, forexample, from price controls. The latter may be paid, for example, 'to enterprises with old equipment and,therefore, high operating costs.' Amcording to Polish statistics, only a tiny fion of subsidies are supposedto be 'enterprLse-specific' (Schaffer, 1990). However, Schaffer's econometric work on subsidies reveals thatsales have been subsidized at a negative rate and costs have been subsidized at a positive rate, the two ratesbeing approximately equal in absolute value. Hence, rather than taxing or subsidizing specific inputs oroutputs, which woud be the case if subsidies were simply counteracting unvorable prices, the subsidyscheme was really a profit/loss subsidy. Furthermore, there was also evidence that the subsidy schemetreated profit- and loss-making enterprises asymmetricaly. Although among loss-makers a 1% increase inlosses increased subsidies by 1%, the rate was much lower in the case of profit makers, about 15% to 30%.Finally, Schaeffer also finds evidence of firm-specifcity in the distribution of subsidies. Jo other words,controlling for observable firm characteristics such as cost and sales, subsidies differed signicantly acrossfims, suggesting the presence of substantial negotiability.

ReenW Deelopments

2.13 Fundamental reform of tax and subsidy schemes has been one of the central issues in thesocialist economies Recently, both Hungary and Poland have taken drastic measures to reduce both thelevel and variability of enterprise taxes and subsidies.

2.14 In Hiungary a complete reshapmg of the tax system took place in 1988. Personal incometax and a valueadded tax were intrcduced, eliminating wage taxes, turnover taxes, and some other enterprisetaxes. This reform automatically implied elimination of all existing and potential preferenes andexemptions. The replacement of wage taxes by a personal income tax was a highly strategic move: wagetaxes had been paid by enterptises and were subject to bargaining with the govrnment. Income taxes, onthe other hand, are paid by workers and are much less negotiable, if at all. As a result, although the totallabor cost burden of enterpries (wage costs plus taxes) has declined only slightly, the potentially negotiablepart of total labor costs (Le., the wage tax) has vanrshedV Loss-making enterprises may be able to get wagetax concesions from the government, but they cn hardly get ooncessions from the labor market. Budgetatycontrol over subsidies also has been tightened although no drastic measures, such as with tax reform, havebeen undertaken.

mThe adverse effects of redistribution of income on work incentives resulted in low productivity.Vodophvec (1990) prvides empirical evidence that both intrafinm and interfirm redistribution ofincome in Yugoslavia resulted in substantial output losses.

71 Before the tax reform the total cost of labor was equal to wage tax plus wage cost. After thereform, it is equal to wage cost only, which in tum consists of personal income tax and net returnto labor.

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2.15 lbe Polish reform aboUshed a wide range of pdre aontrols that bad necessitated enterprisesu)sldlesi nI reduced the percentage of controUed prices from 50% In 1989 to 10% by Januaty 1990. Thescope and size of subsidies have been reduced from about 14% of ODP in 1989 to a planned 6% of GDPin 1990. 'Me stated intention is that state subsidies will be product-specific and not enterpriespcic. Taxexemptions also he been severely curtailed. Te government also intends Strict enforoement of sharplyincreased dividend requirements on state-contributed capitaLU Moreover, the goernment is planning tointroduce a personal income tax and value-added tax in 1991 to reduce and streamine enterprie taxation.

2.16 The governments of Hungay and Poland appear to have made substantive progress insignificantly reducing contingent taxes and subsidies In many other socialist countries, such as China andYugoslavia, tax and subsidy schemes sti play a significant ex-post Inoome redistibution role.

2.17 Even in Hungary and Poland It remains to be soen to what extent tax reform will beenforced and uniformity in tax rates wil be acved. There is a possibility of exemptions from new taxeMorover, even if the refonn of the fiscal system can be sustained, the fiancial system may prolong the softbudget constraint. Terefore, whether the soft budget consaint can be tightened will depend on policiestoward loss-maki enterprises, industril restructurin& and bankrupties.

B. Contient CApial Subsidies

2.18 When a subsdy or tax abatement does not cover carrent losses sufficiently, the solvency ofloss-making enterprises becomes threatened. In sodalist economies, however, govenments often providefd .l support, such as debt writeoffs, substitution of debt by equity, provision of new aedit, or newequity grants to ensure the survival of enterprises with low profitabflity. In 1985-86 the volume of capitalsubsidies provided to lurge loss makers in Hungary was three times as large as current subsidies(Appendix Table 2).

219 The availability of capital subskides to unprofitable enterprlses does not imply that there wasno exit mechanism for these enterprises. On the contrary, the administrative mechanism for liquidation hasexisted for a long time in these economies Moreover govnments in principle have had the authorityto replae inefficient t, or at least to block its reappointment, by involdng their right to monitorand control enterprises. Furthermore, state finandal support has been provided normally under sozecDnditonalmties. For example, govenumt may provde financial support in exchange for commitment froman enterprise to raise the level of production effidency. Rehabilitation programs also stipulate suchcommitments by enteprises

Enterprise assets were reauated in Januar 1990. Enterprises have to pay 32 percent per year onthe value of state-contributed capitaL Failure wll trigger the pgm t assessment of enterprises,which would lad to restructuring, sales or liquidation of the enterprises. See Sectien V for morediscussion On dividend requirements

2/ In fact, exemptions and exceptions are already widespread in the current tax system in Hung(Gray (1990)).

12/ For example, in Hungaq the 1977 law on state enterprises stipulates that the supevisoy authoritymay lquidate the enterprise if (1) the national economy does not require its actIvity, (2) profitableactivity of the enterprise amnot be e _nd, or (3) the acvity can be more profitable within thefrmework of ather enteise

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2.20 Nevertheless, this adminbtrative mechanism for dealing with lossmakers has genefraly faiedto impose signflcant financial diipine on entewrprises because of the strong bias for government to supportrehabiltatim 7he foliowing pattears are typical:

(i) Rare lIquia Loss-maldng state enterprs are almost never liquidated. iUquidationof cooperatives is relatively common, however. Rebabilitation or state-supported mergershave been the common approach for state entrrises in finandal trouble.

(i) Lmited santons on a nd wober It Is uncommon in large loss-makingenterpries for management to be replaced, even when substantial state financial supportmust be proviJed for its survial Mis suggests that the bargaining power of the governmti wecak

(iii) vsm1 ent subsdis for rehablitat Goverment provides investment subsidies for loss-mking enterprise to restore production effciency. Typicaly the government provides stateequity support for the rehabilitation inmestment, since the enterprises canwt obtaincommercial finance.

(Iv) LOW or negatie coraion betwe Prftbiity and bnvstmenL Profitable enterprises orsectos do not receive more investment resources than unprofitable ones. Available evidcesuggests a peverse relationshlplV enterprises or sectors with low profitability receive moreinmestments. Kornai (1986) repots a negative correlation between original, as well asreported, profitability and subsequent investmeat actvity (investment expenditurehalue ofphysical assets) for Hungarian enterprises for 1975 to 1979. Knight (1984) repors a positivecrrelation between investment in 1981 and the losses during the previous year for Yugoslavlndustries*Y

Recent Deepments

2.21 As a major step for strengthening finanl discipHlne, bankruptcy laws have been enactedin Poland (1981), Hungary (1986), and China (1986). These allow creditors to Initiate the process ofliquidation. Before the introduction of bankruptcy laws, final institutions did not have such a right; itblonged solely to the govnment.

2.22 Bankruptcy laws are generally expected to produce the following two effect. First, financialdiscipline may be strengthened by the laws, since financial hstitutions with profit and loss responsibility areexpected to be able to force liquidation of unprofitable production mote easly than govments can. theremay be an immediate economic gain simply due to the closure of inefficent production facilities. Second,bankuuptcy laws provide safeguard mechanisms for creditors, which improves the efficieny of credit marketsOpportunistic behavior of enterprises wifi be detred more effectively, and access to credit by efficiententerprises wUI improve. is is the long-term gai

2.23 As of early 1990, no major effects of ructhurng measures or bankruptcy laws are evitent.Commerc banks have not been very active in liquidating or in supportng enterprse rsucuringObservers not that in Hungary the original Idea of the bankuptcy law (the liquidation of low-efficiency

1l/ Of course, the welfare implications of such eidence are unclear since accounting profitability doesnot reflect economic profitabilty under widespred diortions.

IV Konoalov (1969) report thkat inetment hwas no sigifiant relation at all with profitabity,measured either in terms of the ratio of net operating inome to busness fund or in tems of wagesfor Yugoslavian fifms in 1985 and 1986

-8-

workshops and batories) has lost ground (Sipos and Tardos (1986)). Frustrated by the inaction ofcommeral banks, the government of Hungary s considering a bankruptcy law that would automaticallytrigger bankruptcy proceedings when payments asrears reach a certain level.

2.24 In Poland, the concept of bankruptcy was introduced through the law on the improvementof government-owned enterprSies-a law that deas with rehabilitation of enterprises as well as enterprisefailure Neverheless, few companies have been dedared bankrupt by their creditors. Between 1984 and1987, out of a total of 142 enterprises (46 state enterprises and 96 cooperatives) that failed, only three wereliquidated. The rest either were taken over by other companies or divided into smaller independent units(Sewerynlk, 1989). In January 1990, the bankruptcy legislation was amended to allow any creditor whoseobligations were not met on time to initiate bankruptcy proceedings.

2.25 These socialist governments themsehes stil support the rehabilitation of large industrialenterprises. The bankruptcy law stipulates the mechanism for state-supported rehabilitation in Hungary, forexample. The necessity of state support for rehabilitation-including financial support from the rehabilitationfund-is decided by the Rehabilitation Office of the Ministry of Fnance after consultation with releva-itministries and organizations. l%vo sets of conditions for state-initiated economic rehabilitation are specifiedby the bankruptcy lw. necessity of rehabilitation with respect to regional employment, defense andinternational obligations (futher exceptions can be dedded by the Council of Ministers); and adequateperspective to restore production profitability through the implementation of a rehabilitation plan. Inaddition to these stated criteria, the need for foreign exchange seems to be another major reason for thegovernment to provide financial support for rehabilitation.

2.26 In China, the bankuptcy law is still largely symbolic since it is very unlikely that commercialbanis wfli start liquidating state enterprises on a large scale in the near future, given the fact that creditdecisions are still strongly under the control of the government. Non-state enterprises, on the other hand,go out of business quite frequently.

C. ContiWent Price Regulation

2.27 Although economic reform in the past has significantly increased the scope of enterpriseautonomy, enterprises in socialist economies have been subject to various regulations covering pricinginvestment, and wages and employment. The problem in socialist economies is that the regulatory conditionshave been negotiable and have tended to accommodate inefficient enterprises.

2.28 One of the most persistent regulatory interentions in socialist economies is price regulation.Given the shortage of many goods, unregulated pricing could lead to substantial price increases-andIncreased profits for the producers of these goods. Instead, enterprises in the socialist economies are allowedto set prices that only barely or even Insufficiently cover their costs.

2.29 Even in Hungary, one of the most advanced in price reform among socialist economies, priceregulation is stil significantly contingent on production cost. Hungary initiated price reform in 1968, withthe aim of setting prices at or close to border prices. In pailcular, prices of important industrial inputssuch as energ and steel have been centrally set at convstible currency import prices instead of atproduction cost. In the industrial sector, around 20% of industrial product is subject to this CIF referencepricing (see Table 3 in Appendix). However, pricing of most industra goods is subject to a genal prigrule, which imposes the following three conditions on the pricing decisions by enterprises:

* The price wel should be set so as to balance domestic supply and demand.

* The level of prices should reflet a consideration of the cost of production.

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* lhe setting of pries must obseve the trm of the Law on Unfir Ewnomic Prctc Inpariula, the level of pri should not eweed the conmerible cumncy Import prike of aiilr good, adjusted for quality dierceL

230 If the refeen convertible currency Import prie could be unmbiguously agreed betweeenteprises and the goernmeat, price regulation would not be contingent on production cost. However, alarge ar of exportable products are not impoted. Terefore, the aovrtile crncy impor. pricescannot disciplne or provide a teference for a bulkc of export oriented indusies. In fact, in 1987, theHunarin govrment abolished the eport priing rule, which had gvened the pricing of more tha40% of industial products, In favor of the genal pring rule he reason for this shift was precisely thatunder the export pricing rule enterpris could Inawe domestic pdrcs In eces of production cost incaeaseswhen the exchae rate was devalued. The general pricing rule prevented such icas.

Remo D

2.31 Hungay and Poland have been making significant progress in deregulating economies Withrespect to price reorm, the Polish venment has dedded to Mlbe essentialy all industrial prices TheHungaian goverament has also liberald prices significantly by reducing the scope of the goods the pdresof which are centrally determined, although all pricing decisions are stiUl subject to the general pricing rule

ly The export pricing rule imposes three conditions on enterprises

(1) the avage profit margin on domestic sales must not be higher than that on convetblecurmenc exort;

(2) the avage prce increase of domestic sals must not be higer than that of convtiblecurrency export; and

(3) the domestic sales price of idividual product must not be higher than the convertiblecurrenc Import prie of a similr good, adjusted by quality darenc

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m. CAUSES OF SOFT BUDGET CONSTRAINT

3.01 HavIng anazed the major channels thrugh whih budget constaints are %softened, wecan now conentrate on the auses of soft budget constraints. In this secton we fist diss why govern-ments and commercal banks have systematialy tended to pode ex-post support to icssmakingenterises. he section then anabzes how the ambiguity of ownleship rights has reinforced and exacerbatedthis tendency.

A. Why Does the Govemnment Help Los Makers?

3.02 Te literature as well as our inteis with govenment officials and enterprises revealthree main motives for the governments of socialist enomies to hip lss makers: compensation for pastlimited autonomy, divgence of social surplus if from profit, and the sunk 0St trap.

Compensation for past lmited autoomy

3.03 Loss-making enaerprse have strongly pressured gonments for financial help by arguingthat their losses are the responsibility of the state sine enterprise autonomy had been limited andenterpries heavily taxed in the past. Ascording to Papanek (1986), half the financy troubled Hungarianenterprises reviewed by him listed state intervention among the most important causes of their trouble.Budvaril (1968) gves the following accunt: 'espite public acusations, backstage the leadership was fullyaware that in most of the cases insolvency could not be blamed on cmpany mismanagement. Rather, thecauses could be traced back to the unpreditability of govenment regulations, the burden of supplyregulations, the confusion and instability of the price system, and last but not least to chaotic COMECONcontaus and prioes Under the circumstances it would have been absurd to oonduct bankruptcy proceedigsagainst the companies that went bankrupt due to one of the above causes.

3.04 Since the effects of weak enterprise autonomy and heavy centraliation of income arecumulative, governments find it difficult to assign major responsibMity to enterprises even after theeterpris have been given substantial autonomy. Provding autonomy does not automatically put thegoverment in a position to transfer the responsibility to enterprises unlss financial problems letover frompast interventions can be setled simultaneouslygX

Diven of soia surplus om prft

3.05 The second major factor behind govements' help to loss malers is more of a pureeconomic or structural nature and has to do with the existence of the social surplus that would be lost ifa loss maker goes out of business. A loss maker can still generate a positive socal surplus when prices aredistorted or when the absence of alternative supplers puts conumers' surplus at stake. A positive socialsurplus in turn provides an economic reason for the govment to prevent the exit of a loss maker. Ex-post this increases the national welfa However, as we formally show in Section IV, this generates acredibility problem for the hard budget constaint and creates an Incenive distortion against improvingefficiency: realizing that hard budget constraints are not credible and that ex-post the government wil haveto help the loss-making enterprises, neither manages nor workers have Incentives to restore efficiencythrough more eflbrt.

L/ Social surplus here means the total economic benefit of production, which my not be identical tothe profit appropriated by the producing firm under distorted and/or noncompetitive economies.

IN See Kornal (1986b) for a simiar explanation of the paternalistic attitude of the state bureaucracy.

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3.06 There are three especialy imponrat cases where the socal surplus dierges from the privatesurplus overvlued domestic currenc, a monopolistic supply strucure, and binding price controls All seemto be prevalent in socialist economies.

3.07 Overvlued domestc currency and foein excbne shortages. One of the major reasonsmentioned by the Hungarian government for state support to the oal mining and the metallurgical sectorsis the need for foreign exchange. Although Hungars geological codtions are not favorable for coalmining, the government considers it worthwhile to support coal under the circumstance of an acute foreignexchange shortage. Similarly, since steel Is a major export item for the convertible currency market, statesupport for the metallurgical sector is considered warranted. The foreign exchange shortage is a significantconsquence of ovevalued domestic currency, which is probably one of the most important price distortionsin socialist economies. Given an overvalued currency, a loss-making enterprise may stll be considered worthsaving if it is a significant exporter. The govenment then finds it wonhwhile to save major foreign exchangeeaners or savers from bankruptcy even if this undermines financal discipline.

3.08 Monopolstc supply structure a domesde shortages. Another major reason for agovernment to support lomaking enterprises stems from the monopolistic supply structure in the socialisteconomies. Exits are likely to cause bottlenecks in the domestic economy since an alternative supply usualyis not availableW Tardos (1986) states: 'Thus, at least concerning the short-term, they (enterprises infinancial trouble) negotiate a favorable situation by convincing their state administration partners that thepostponement of assistance or its extemely low degree may came such problems which will result inunfvorable consequences (production interruption, worsening of product supply, unemployment, etc.).*

3.09 Reviewing the policy discussions concerning the liquidation of the Business Machine andPrecision Engineering Enterprise (IGV) of Hungary, Voszka (1986) states that IGV's monopolistic positionin home production spoke, therefore, against liquidation or the cessadon of the enterprises lines ofproduction, as this would cause supply problems in a situation aggravated by foreign exchange restrktionsand the mechanism of the CMEA cooperation.' Althougb IGV was liquidated-a rare case of liquidationof a state enterprise in Hungary-its position as the only home producer of many precision engineeringproducts clearly caused serious goveanment cncern over its exit.

3.10 Bindit price controls Another important souroe for the gap between social surplus andprofit is prie controL For example, due to the control of food prices in Poland, los-making enterpriseshave been ooncentrated in food pocessing industries. When binding price controls reduce sales prices belowtheir shadow values, the government may find it optimal to provide ex-post support rather than have theplants close down.

Sunk cost trap

3.11 Sunk cost iS a third major cause behind government support to loss makes Even I It isfound ex post that a project as a whole cannot yield an adequate return, previous investments still mayjustify additional investments. This often ocus when past investments cannot be redeployed easily orwhen they are sunklY Although sunk costs may make provision of additional finance reasonabl ex post,they create incentive distortions ex ante. If enterprises expect to obtain additional finance by demonstrating

IN Buyers will try to prevent an enterprise's exit by surrendering thei- consumer surplus. Howevr,there is a free rider problem. When the number of buyers is lare, their coordinated support tothe suppler will become very difflalt to achieve.

17 For example, besides the need for foreign exchange, the effective use of existing resources, labor,ad facilities was one of most important reasons for supporig restuctur investments in the comining scaor In Hungary.

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that, gien pase ivStments, more vestmn ts will pay off, they bhae less incentives to increase productiiyor roduco costs in the earlier periods of a projet Although such an incentive distordon exists everywhere,its degree seems to be high in socalist economies. This is partculary so because in these economies theundeloped nature of actors, in partular fliancial nmrkets, makes sunk costs high.

3.12 Ihe magnitude of sunk costs depends not only on technological factors but also on marketopportunities for reurc redeployment In particular, as we shall see in the neat section, the absence ofcontrol rights biases financial Istitutions against ptoviding resources for restrutuig Imestments tofinancall troubled enteprises. Consequenty, the possbility that liquidations may result in economic lossesis hi ff the genment does not inteveneN However, when the government does intervene andsubstitutes for missing financial institutions, It finds it more diffult to reject refinancing projects that canbe Isaved'.1

B. Why Do Commercial Banks and Other Economic Entites Help Loss Malers?

3.13 Commeral banks. One of the major objectives of establishing a commercial bankingsystem in socalist economies is to tighten the soft budget constraint by linking the allocation of fidancialresouces to the credit-worthiness of enterprises. Somewhat surprising in Hungay and Yugoslavia is theapparent wilingness of commercial banks and other economic entities to finance loss-madkg enterprises.The folowing incentive distortions seem to awoount for this development.

3.14 Commercal banks generally have three options for dealing with loss-makers with debtuverhang liquidation, takeover, or continued support of those enterprises through either debt reductionor tefinancing (rescheduling or refinancing interest payments), as shown in Table 1. In socialist econmiesa stronger bias exists for commecal banks to take the refinancing option. Eis is bemause, flrst, the optionfor takeover has essentiaDy been dosed, since almost all enterprses are either state-managed or self-managed. Commercial banks cannot oontrol even those enterprises that cannot meet repayment obligationsunless they are transformed into share-holding companies with no restrictions on the participation of external(ie, non-state or non-worker) investors. Although Hungarys association law (1988) and the law of

fomation (1969) allow the establishment of share-holding companies, this transformation of existingenterprises cannot take place without the consent of state or enterprise councils. Without such approval,commercil banks bave no other choice than to support edsting oss makers through either debt reductionor refinancing, since liquidation is costly.

3.15 Sond, there is a bias toward refinancing rather than debt reduction or lquidation, becausedebt reduction reduces the amount of expected government support to the loss maker or to the bank Itis Well known that for enterprises that cannot repa their curent obligations but that may become profitableif they undertae restucturing Ivesments and increase cost reducion eforts, debt reduction may bebenecial for both banks and borrowem Under these circumstance, a high level of inherited debtdiminihes the incentives for firms to undertake restrucuring investments and increase effort because thereturns to higher effienq are completely appropriated by creditos However, if such firms do not reganeffiency, creditors cannot be repaid since there wUi be no surplus to approprlate. Therefore, reducing theface value of debt to a level that would make it wonhwhile for the debtor to regain production eficienqmay be beneficial for both the creditor and the debtor. In most cases, debt reduction needs to becomplemented by provision of additional funds from creditors so that restructuring can take piace. Hence,potentaBlly viable enterprises would expect a package of debt reductions and new money, while banks wouldforce liquidatdon of unvable firms

IN Tbis point is emphasized by Tardos (1986), who states that a general hardening of the financialconstraints would lad to mass bankruptcy in Hungauy, ghien its underdevlp financil markeL

9J/ As we discuss more extensively in Section m c, underdevelopment of the fancal market has beencaused inter adla by restrictions on capital ownerhip.

I Thds argument often is made in the international debt literature Se Froot (1988) and aaessensand Dwa (198.

Tablet STRATEGIC OPTIONS FOR COMMERCIAL BANKS IN DEALING WrTH LOSS-MAKERS

Prvat Incentil_ for Commeal Bank Pivate and Sodgal ml_m forLl*d ReW Banks

Statei EfcB on Optio VA"e of Effec an Eff On Losd FEap*eOouenaient Debt mdite Cociog Value as a GoinSsupporto A _a3ntlg Prct so Ditoslo Due to Concn

Entapdu ~~~~~Commerci Banks Debt Owdang

A. U3quio NoWe 0 +

(Bankruptc kw muated) (laop nea*0e

D. Takow Yes 0 + 0

intiate ofn'PIpe Ito dwe

C Su_ 8da npihes

Cl Debt Redn None + 0

C.ZReflnncln None 0 0 0 0 0

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3.16 Howver, cmnmeal bank decisions In socialist eoonomics are significantly distorted bythe possibility of goverment support to either enterprises or banks-and due to the fact that compensationto bank management is regulated on the basis of accounting profits

3.17 Ihe problems aised by the epc tion of govanment financial support are, of course,not spedfic to socialist economies Financial intemediaies in many developing countries and in the UnitedStates-in the case of savings and loans institutions-often refinance economically unviable projects insteadof initiating bankuptcy pocdngs and liquidating them. When most liabilities of a bank are insuredimplcitly or explicitly, a bank has incentives to provide workout loas even if such loans are sociallywasteful, that is, even if the revenue that the new loan is expected to generate is lower than its opportunitycost. The reason is that limited liability combined with deposit insurance allows the bank to shift losses thatemceed its equity position to the government. Further, if the bank itself e s the government to bailout a faltering enterprise, the bank would try to maintain the nominal value of its claims or provide workingcapital even when the economic viability of the firm is dismal Absent debt reduction, enterprises have noincentives to exert effbrt for restructuring or cost reduction.

3.18 In socialist economies, expectations of government bailouts exist in an aggravated form:in most market economies government bailouts of banks or their debtons often are expected to happenwhen failures are widespread and threaten the stability of the banking system. By contrast, in Hungary,the banking system has simply inherited loans from the National Bank without evaluation. Hence, bankscan credibly claim to have no responsibility for lending decisions taken by the govenment prior to thebanks' existence. Thus, expectations of government bailouts are prone to be more widespread. This problemof 'inherited portfolios also exists in Poland where the commercial banks have similarly assumed their loanportfolios from the National Bank Furthermore, deposit guarantees also exist in socialist economies,although only implicitly. While there is no formal deposit insurance scheme, given that banks are ownedby the state, it Is safe to assume that depositors consider their deposits as safe assets

3.19 Bailout expectations also encourage banks to prolong the survival of borwers who areunlikely to regain viability. Thus, adjustment in the enterprise sector becomes unduly slow. Effectvelywhat happens is an operational partnership between the bank and its major borrowers at the expense ofthe goverment or taxpayrs.

3.20 ldnd, compensation to bank management is regulated by the government according to thelevel of acoounting profit"Y Consequently, when the stock of outstanding loans declines due either toliquidation or debt reduction, revenue dedines as well, cauing a reduction in both crrent profit and theupper limits on compensation. Furthermore, the increase of future accounting profit, which would occurif liquidation or debt reduction took place swiftly, does not necessarily accrue to Bank employees Futurebank regulation or pvernment decisions to lt profitable bank absorb the accumulated losses of chronicallyloss-making enterprises, if this should happen, can easily absorb such profit. Consequently, commercialbank are Likely to prefer to postpone rather than realize losses.

3.21 Inter.t se redi Another major source for financing loss makers is inter-nterprisecredit, especially from suppliers. The exnive development of inter-enterprise credit is reported by Knight(1984) for Yugoslavia for 1981 to 1983. A similar development has been observed recently in Hungawy.Inter-enterprise credit for loss-makers is often regarded as constituting an additional softening of the budgetconstraint.

2J See, for example, Herring (1989).

2W See for example, the 1986 Decree of the Minister of Finance on the Regulation of Incomes of Banksand Eaings of Bank Employees for Hungary.

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3.22 Credit from suppliers is voluntary. They would like to be paid immediately, but even Ifarrears accumulate they tend to keep supplying to bss ruaers. Promissory notes received by suppliers sellonly at hrge discounts, Implying that credits extnded by suppliers to loss makers have a arge 'subsldycomponent.

3.23 However, In some cases such lending may be effcient. Suppliers may be extending Implicitinsurance contracts to their buyers, as do closely related enterprises in market economies. Such implicitinsuanmce may be important, since insurance can be more efficently provided between entities that canmonitor each other. Suppliers also may provide credits in order to protect their market stake in lossmakers. This is because liquidation can result in large-scale oss of the suppliers' markets and profits-suppliers generally suffer most duning liquidations sice their claims are typically unsecured. Still, suchdefensive lending may help alleviate the shortage of risk finace: when ceilings on lending rates on loamfrom financl institutions are binding, some borrowes wil be rationed out of the loan markets. In suchcases, suppliers can relax credit rationing by increasing effective leoding rates through higher margins on thegoods they supply. Tus, inter-enterprie credit may reduce the ineffidencies inherent in the finandal andinsurance markets, which are especially severe in socialist economies.

3.24 The major source of the inefficiency of inter-enterprise aedits seems to lie, again, in theexpectation of government bailouts and in the estrictions on capital ownership. Similar to commercialbanks, suppliers may continue supplying on credit, hoping they will eventually be paid by the government.They can record a higher immediate acoounting profit by accumulating accounts receivables that may notbe honored, rather than stopping sales to the loss maker immediately. Although suppliers inevitably haveto reaHze losses sometime in the future, this can be done when accounting profits are high for other reasonsand to avoid possible expropriation of excess profit by the state.

C Restrlded Capital Ownership and Soft Budget Constraints

3.25 The problem of ownership in sodalist economies has two important aspects Fffst, theappropriability of the residual value of enterpries is not well established. On the one hand, thegovenments seem to have steadily given up their positions as residual daimants. On the other, thevagueness of ownership is refected in the fact that enteries still perceive a high risk that the gvernentwill expropriate the streum of returns generated by the enterp. In effect, this ambiguity is similat to thatgenerated by highly variable taxation systems They mainly effect the incentives of insiders, Le., managersand worker and discourage enterprises from inmesng improving technology, or increasing x-effiency byallating more effort.

3.24 The economic consequences of the ambiguity of rights to appropriate returns are diferentfrom those of the soft budget containt. Incentive problems generated by this ambiguity are especallyrelevant for profitable enterprises, since the risk of epropriation discourages furher improvements. Incontrast, the soft budget constraint discurages i tments for efficiency improvements in enterprises withrelatively low profits. Even if the ambiguity is removed and, say, the right of Insiders to appropriate returnsis dearly and credibly established, loss-making enterprises may still underinvest and remain ineffcient as longas the soft budget constraint remains

3.26 Neverts examples are numerous where the problem of appropriabiity exacerbates theconsequences of atl other suces of soft budget consaints. For example, because It diswourages activitiesthat maintain or improve efficiency, the appropdability problem increases the chance that profitableenterprises eventualy become less profitable. In other words, the appropriability problem makes it morelikely that enterprises for which Incentive distortio from soft budget cotraints do not matter eventuallyturn into those were thee distoroms do matter. In cases where sunk costs are imporant, theapproprlability problem ineases the possity that because enterprises put in less effort in the earlier

- 16 -

periods, additional financing becomes necessary later. In both cases, the appropriablilty problem worsensthe economic consequences of the soft budget constaints.

3.27 The second aspect of the ownership problem has to do with the distribution of controlrights. Over the years, management has estabished de acto, albeit possibly Incomplete, control ri&gts overenaw:prise assets Here we would like to concentrate, hower, on the control fights of aeditors. Whena fim experences financial troubles, conficts of interests between management and ceditors are bound toarise. These conflkts discourage potenta extfnal Investors The problem could be resolved byredistributing control when enterprises become fnancWly distressed. However, this has been impossible inmost socialist countries, where the choice for crditors is simply between liquidation, which may be costly,and preservation of the status quo with refinancing As discused in the previous subsection, takeovers, oneof the ways of redistributing control rights, are often not an available option. Similarly, temporaryacquisition of control rights by creditors is also nOt possible. As a result, the Piancial system becomesinefficent in undetaking financal engineering or restuctg operations, and risk capital prvided byexternal sources for loss-making but viable enterprises becomes extemely imited.

328 In that case, the government must act as a fnancial Institution. However, once thegovenment becomes the sole provider of external finance, the possibility of generating a soft budgetconstraint is ina_ased substantially. First, since the government is not an independent economic institu-tion with profit and loss responsibilities and in principle cares about social rather than prvate welfue, allthe motivesspelled out in Section m A-that inducc pvernments to help loss makers become operatiMoreover, involvement of the govenment in the distribution of funds automatically generates severeincentive problems (discussed in the next section). Also, the monopolistic structure of financial resourceallocation itself may make it more likely that the financial system would be burdened with projects that willnever be profitable in the long run. Such projects nevertheless continue to get financing because of the sunknature of previous investments. As argued by Dewatripont and Maskin (1989), when exenal funds areprovided in a competitive system where finandal resources ae more fragmented, managers foresee that theywi have to be judged creditworthy by the whole financial system and not just by the central agency. Thatdiscourages managers with non-viable projects from requesting funds in the first place,

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IV. CREDIBILITY OF HAD BUDGET CONSTRAINTS

4.01 It was argued in Section III that the existence of a gap between social surplus and privatesurplus may make it optia for the gvernment to prvde ex-post suppor to loss makets This would notbe harmful for the economy if this support created no advse Incentive effecs Hower, this secdon arguesthat such adverse incentie effects are likely to exist. We argue that the gap betwen social surplus andproflt undermines the credibility of hard budget constraints, and can substantialy hurt dynamic efflciencygains in industry. This is because a firm can appropriate the difference between socal surplus and profitby underanvestment

4.02 We also show that a soft budget constrint paricularly hurts the willingness of enterprisesto adjust to large shock. For concreteness, the formal presentation in subsection A fcuses on themonopolistic supply structure as a structural cause for the gap between social surplus and profit, althoughthe analysis applies to any other cause generating such a gap, as illustrated in subsecdon B.

A. Tbe Had Budget Constraint may not be Credible in an Econony with aMonopolistic Supply Structure

4.03 As discussed In the last section, a major reason for state support to loss mkers is shortages.When a major loss maker in the protected steel sector, for example, goes out of business, it negatively affectsthe production capability of user industries This repercussion results from the monopolistic supply structurein these economies: domestic Industry is highly concentrated, imports are tihtly controlled due to foreignewchange problems, and industrial poUles have been inward looking.

4.04 Let us assume that a steehlaker experiences a sudden large increase in Its input prics,threatening its soency. However, it is technically and economicaDly feasible for this fim to reduce totalcost and to remain solvent. We argue that when exiting is oostly and the govenmt is not expected tohelp, the enterprise will undertake rationalization investment to reduce cosst However, the enteprise anowsthat the government wants to prevent economic bottlenecks created by the decline of steel production, soit expects to be rescued. Therefore, the steel enterprise does not undertake the full effirt toward ostreduction, and the govement is in fact obliged to help the enterprise

4.05 Thi argument can be formally demonstrated as follows: Consider a monopoly fim thatarns operating income Y, equivalent to (P-C)Q where P is price, C is the constant mainal cost of

production, and Q is output, as shown in Figure 1. The margital cost depends on input price r and rationa-lization investment L

C - C(r,I), C, > O, Ci c O, Cs > O

Let a stand for profits, *(r,) = Y(r) - L he flrm iassumed to be concered both with profits and thelevel of I, since rationalization investment involves some non-pecuniary costs, in the form of disutility ofeffort*

U = U(w(r,l),I), U1 > 0, U2 c 0

a/ Suppose, for exumple, evey unit of imestment requies a unit of effort in order to reduce costs.

- 18-

FIGURE 1: MONOPOLY PROFIT AND CONSUMER SURPLUS

p

wP

Q Q

- 19 -

4.06 be consumer surplus from the ouput of the fim, ncluding the user Idustes, is dotedby W, which is the area under the demand cumve In Figue 1. Since Invetment reduces cost, the onsumesurplus is Increasing I investment, .W/el > . The sequencdag of events is as follows Once the inputprice is obsered, the firm deddes whether It wil stay or exit. If h stays, It also decides on the level of cost-reducing investment that it must undertake. Once the production technolog is thus established, output isproduced. If the firm decides to exit, it Incurs a fixed oost, given by F >, in that case, its utity Is gby U- U(-F,0).

4.07 Suppose now that the firm e encs a shock that increases the input pice to such a levelthat in the absence of rstruurng invtment, the firm becomes I0solvent. LItg rb stand for the inputprice after the shock, then we have w(rbO) c Q Hover, assume that if the fim stys and Invests at theutility maximizing level, It becomes solnnt; that Is, letting I" stand for the lvel of intMent thatmaxhims U given rrb, assume that w(rbJ) > Q Wben the budget constrait is hard, exit owius In oneof the folowing ways If finanial profits are lss tban zero, the fim caot produce anytng becausesupples do not pvide any inputs; bence the firm bas to eit. When profits wre positie the ext decisonof the firm depends cn the folowing comparison. he utility orresponding to stag and inveting IsU(a(rH),P) If the fim exits, it gets less income-incurs a loss of Fbut saves on the disutility of effortLet " be defined by

U(XH,M = U(-F,O)

Then, if "(rb,l) > *H the firm wil undertake the investment, regai soln and stay. Essentialy, the COStof exit acts as a discplning factor on the enterprie and induces the finn to exped effort In order toincease cost effciency.

4.08 However, the hard budget cnstint may not be credble. To see that, we have to specifhow the gvement responds to the actions of the fim Th gvernm ca res sbout the consumer suplus.Therefore ex-post, if the ned arses, It wi be wllng to prvide a subsidy to the fim In order to ensurethat it produces the output. Let 0 stand for the fiscal cost of that subsidy. Suppose that e-post thegovenmet has the abiity to make a take-t or eave-it offer to the fim In that case, If the frm'sivestment level is such that the firm ecpects positive proft from production, the gvnmet does not needto provide any subsides, since ex-post it is in the interest of the enterprise to produce. Let I be the levelof investment at whch the enterprise just breaks even w(rbj) 0 Q Then for IH > I > J, the govenment'soptima reaction is to set 0 0. Hover, if I < 1, then prducon will ot take place, saice the firmi insolt and has to exit. in that ease, it is optimal for the govenment to pwide a laev of subsidythat wi make the enterprise just wiig to prodce as long as the fsca cost of this subsidy is less thn tconsumer surplus. Hence, for I < 1, the opmal reacton of the pvernent Is

G(l) 8 m-(rA)as bng as A0Q c W(l)

Here 5 is the shadow oost of govement finacl rou Hence, when I < t, hard budget constaintsare not credible as long as the fisc cost of the goenment subsidy is kowertmha the consumer surplus thatwould be lost If the fim did not produce anythig.

4.09 Anticipating this reaction by the govenmen, the firm makes the folowing calculasto. Ifit stay, its utility cresponding to various lvel of Inetment (and efirt) is give by

U(X(r ifJ) I > IU(0,1) if 0 C I d T

4.10 Ebao of these utiity lvels quikly revl that if the opimal kel of ivestment,conditonal on staying, ib highwe tan I, it is equ to lr. If the optimal kvd of Ivestment is below !, thenit is set equal to e. effet to deide on its cus of acton the fim chooses Om of the fofowingalternatvs It can exit and obtain U'. It can stay and choose an inestment level of 0, whih would yield

- 20 -

a utility level of U(O0,). Or It can stay and choose an investment level of I", attaining a uUlity lvel ofU(w(rb,M,). U is clearly dominated by U(O,0) so the finm never exits; it at east prefet to stay, obtaina subsidy and produce, without gaining any profits and without spending any effort either. If cost reductionincreases profits sufficiently, it stays and undertakes a restructuring investment.

4.11 How does this solution differ from the pure hard budget constraint case? Let v be defnedby

U(.O,H) - U(%O)

Henoe, undet the soft budget constraint, the firm undertakes restring if .(rbn,l) > a. Clma*l, * > *H.

This compadiso brings out the Incentive effect of soft budget constraints. When the budget constraint issoft, It takes a higher lewl of profitability to induce the fim to undertake restructuring, Effectively, thesoft budget constraint socializes the exit cost and renders It no lnger a threat for the firm. Absent exitcosts, the finm can afford to stay and not spend any effort, relative to the case when the budget constraintIs hard. However, if the profitability of the firm is high enough, then te firm still is wilng to restructuHence the soft budget constraint does not affect the incentives of firms whose post-restructuring profitabflityis vey high.

4.12 This last statement can be recast in terms of the Input price shock. Relative to an initialsituation, U the increase in the input price is not large, then the firm has incentives to reduce costs. In thatcae, monopoly power does not give rise to soft budget constraints and does not affect incentives for costreduction. Effelively, the hard budget constaint equilibrium coincides with the soft budget constraintequlibrium. If, however, the input price increases a lot, It may make hard budget constraints not ctedibland may mute incentives to undertake rationalization investments. The implication is that a monopolisticenterpise may be equaly flexible in responding to smaLl shocks as a competitive firm, but it does vetypoorly in responding to large shocks.

4.13 These cases are shown in Figure 2a and 2b. Under a hard budget constaint, the reactionfunction of the government would be given by the vertal line at G - 0, since In this case the government'sactions would not depend on the firm's actions The frms reaction function would be given by thehorizontal liHe PP. Equilibrium would take place at point H, and the firm would imest an amount PH.Howev, the hard budget constraint is not credible. The line HCS shows how the pg nment reacts todifferent levels of investment undertaken by the firm. When the kvel of investment is between IV and T,the line Is stDI vertca, since the govrnment does not have to grant any subsidy. For I < 1, it is downwardsloping.V Supposing, as we have done above, that the fiscal cost of subsidies is alwas smaller than theconsumer surplus, the reaction function is defined up to I - 0, given by point & If U, the indff cecurve of the firm at point H acoses the reaction function of the govenp mt, the soft budget equilibriumtakes place at point S. This is shown in Figure 2b. The point S is the soft budget equilbrium, which Isalso dynamialy cnsistent unless the govement has no discreton to help the firm e-post. Ili, on theother hand, the indifference cuve does not cross HCS, then the equlbrium is at IL TIs se is shownIn FIgue 2a.

w4/ For I < , G< O foLovs from the fact that w(.,() > O in this reglL TllIs,in tW, is becausewis coave and rehs a maximum at a level of investment low than IN.

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FIGURE 2: EQUILIBRIUM UNDER HARD AND SOFT BUDGET CONSTRAINTS

i U

K0 H-.... FF

0

(a) A small shock

U U

-i FF

___± ~~~~~G0

(b) A large shook

- 22-,

4.14 When rb is vey bW the fiscal cost of a gove_ment subsidy to induce the fim to producewithout any cst reduction would be lager than the consumer sufplusI that would be lost if the firm did notproduce a=ytin& In thes cases, one of the folowing may happen. Either the hard budget comnaintbecomes credible and the fim undertakes restructurin& or the firm undetakes the minimum amount ofeffort to make it worthwhie for the govenment to subsidie the firAm In othe words, let Is > 0 be thelevel of investment, which makes the necessaty subsidy just equal to the consumer surplus:

Cl(P) = -u(rb,) W=

Then the fim compares U(O,I') with U(*(rb),). If the former is larger than the latter, the firmundertak only partial resruacturing and ears zero profits In this caw, the soft budget constraint stillaffets the frs inhtves to resuctur Othrwie the firm undertakes complete resturing.Graphicaly, this case is similar to those displayed in Figures 2a and 2b, except that point S CoDfesponds toI I iathert n I-0.

B. Surpluses and Soft Budget Contants

4.15 The result obtained in the last section can be generalized to any crcumstance where thegovernment attaches values to the decline of the social surplus caused by the exit of a loss-malking enterprise.Let us analyze the case af a oss-making exporter. Helping loss makers in order to shore up foreignexchange eanings can be interpreted as caused by the mismatch between social surplus and profit, as follows.

4.16 Exit of a firm with substantial foign xchae earnings can appreciably reduce the socialsurplus In economies with overvalued cumrences. Figure 4 illustrates this poinL Since the offidal exchangerate (EXO) is significantly undervalued in most socalist economies (market exchange rate EXM > officialexchange rate EEXO), a loss-makdng but converdble fc-earning or saving enteprise may still generatea positive socia surplus, even i it is perfecty competitive in a product markeL In figure 4, the socialsurplus is given by ES, which is equivalent to the gap between exports evaluated at market or shadowexhange rates and exports evaluated at the offidcal exchange rate, since the short-run operating surplus (Y)is equal to the fixed capital costs.

4.17 Under this circumstance, it is welfre-improvng for the government to prevent the exit ofsuch an enterprise (caused by a negative input cost shock) by providing financial supporLt However,anticipating this gvenment action, the enterprise does not Improve efficiency as hard as it might, uyingto capture some of socal surplus ES.

-23 -

FIGURE 3: SHORT-RUN OPERATING PROFIT AND SOCIAL SURPLUS

MC

PI*EXM

3 0 0 0 0 E (Export)

-24 -

V. SIRATEGIES FOR TIGHTENING THE SOFT BUDGET CONSTRAINT

S1 I Sections m and TV we discussed the major economic causes of soft budget constraintsin sodalst enomles. It Is useful to summarize those causes in order to discuss countermeasures:

rePs lmi autonomy. Both enterprises and commecial banks do not feel fully responsiblefr their financial situation due to their past limited autonomy.

* Gap bete socal surplus ad prdfL The government cannot credibly threaten bankruptcysince It also has a stake In the sun"Ial of enterprises in a shortage eonoamy.

* hRestited capit owesh Restricted capital ownership slows down the autonomousprocess for restructuring. Due to the appropriabilWty problem, managers and workers lackadequate incentives for restructuring or for adt. The control-rights problem causes anundesupply of risk funds from commerial banks for restucturig. Banks prefer refinancigrather than reorganization deals Consequently governments are forced to act as investmentbanking institutions, with the result of supporting loss makers.

5.02 We propose that the strategies for tightening soft budget constraints have the foilowing threedimensons:

* sFind, the government has to establish effective adjustment assistance for workers; this canmean redirecting the financial and other assis!ance that formerly supported loss-makingenterpises

* Seond, it is necessary for the government to eliminate major price distortions and barriersto competition In order to eliminate major gaps between social surplus and profit. Simul-taneously it is importnt for the government to reduce its discretion to help enterprises cPost.

Thrd, restrictions on capital ownership have to be removed quickly, so that adequateIncentives and mechanisms for autonomous adjustment can be created.

We elaborate on these three dimensions in more detl In the following sections.

A. E blshing Effecte AdJustment Assistance for Workers

5.03 As dicussed in Section IL, under strong pressure from enterprises, governments haveprovided fiacal and other assistance to financiaBy troubled enterprises so that they survive In fact, thisnecesity to compensate individuals suffering economic hardship win remain even after eonomic reformprovides a greater measure of autonomy to enterprises. Compensating workers who are the most severelyaffected by economic reform may be the only way to implement fundamental economic reform.

5.04 However, financial and other assistance to the enterprise sector has two major drawbacks.First, such assistance is contingent on the financial losses of the enterpries and thus undermines financialdiscdpln Seeond, assistance is strongly biased toward rehabilitation of enterprises and against aet or

- 25 -

change in the line of businessAY Hence, it is biased towards preserving the status quo and the inefficientuse of resources

5.05 A cear alternative is to provide adjustment asistance to dislocated workers direty.Government can assist workers adapt to economic changes through unemployment compensation for acerain period, worker retraining, and support payments to fired worker

5.06 Adjustment assistance to workers has dear advantages in tightening the soft budgetconstraint:

First, since under the adjustment assistance framework the government guarantees neitherthe solvency nor the employment size of enterprises, the threats of bankuptcy and laborrationaliztion remain. Adjustment assistance to workers only reduces the cost of losingjobs, and if properly targeted to those workers who are unemployed it does not materiallydistort the incentives faced by managers and skiled workes As a corollary, switchnfiancial and other assistance from loss makes to adjustment assistance will sigficantlyimprove incentives for managers and skilled employees

* Second, under adjustment assistance the amount of benfits received from the governmentwould depend on relatively clearly specified eligibility criteria so the danger that govermentmight perversely subsidize inefficient enterprises will decline*

5.07 Switching to adjustment assistance has the additional benefit of substantially neutralzingthe incentives between restructuring and exit. This aspect wil be disacssed in Section C

B. Reducig Disetion and Incenmtives for the Government to Help Enterprises Ex Post

5.08 The second major issue is to reduce both the discretion and incentives of the governmentto help loss-making enterprises ex post. Both reducing the degree of intervention and achieving unityin fiscal, financial and regulatory policy across enterprises meet this objective. A crtical step in this regardis to leave investment resource allocation to financial institutions. However, as long as the govement findsit optimal to help enterprises ex post, there is significant danger that it maywithdraw its earlier commitmentfor non-intervention. Therefore, the fundamental measure is to eliminate the govnment's ex postincentives to help loss makers. This requires implementation of structual reforms, eliminating major gapsbetween social surplus and profit. We discuss both of these aspects below.

(1) lam Investment resoure siono to finncia s with proft mad lssm _ponslft

5.09 There are two reasons for this. First, financial institutions with profit and los responsi-bilities wil be able to resist political pressures for supporting loss makers more than the goverment can.Seeond, the fact that financial institutions are concerned with profit but not with social surplus will make

gI For example, in Hungary the rehabilitation fund essentially supports enterprses' reinvestment in theorWnal sector (e.g convsion from deep mining to surface mining in the coal sector).

;I Hungary, Poland and some provinces in China, such as Shenzen, hae tecently introducedadjustment assistance schemes. In Hungar an Employment Poliq Fund was created in 1988 toprovide umemployment compensation, strengthen worke retaiing and help unemployed wkersstart their own busineses Poland has established a generous unplyment compenation sceme.

- 26-

a hard budget craedle Enterpries cannot take cnsumer surplues or foreig echange eanings hostageainst ptofit-seeking financial institutions.

5.10 At present in most socalst eoonom the wo-_ments are in the process of transferringthe power of Investment resource allocation to the banig sector. However, the govnments are stillheavily involved in cedit decdsions in countries such as Cbina. Moreover, In countes with autonomousbahng sector such as Hungar, the government still retains significant investment resources to supportnational priorities. These resources should be prvie to the industrial secor according to clear targetingcritetia based on extealities (eg., enironment, techolog deelopment) or on a competitive basis (seeSection D).

(2) E13mate Major Gaps betwe NeAt .d Sodh Suplus

5.11 The most effective strategy for making a bard budget ceible is to eliminate the ex-postincentive for the pgverment itself to help loss makers In order to do this, gverment must first-andquickly-eliminate major price distortions in the economy. Gross underluation of foreig exchange andenergy and raw material prices is a common problem in soalist economies. As long as major pricedistortions exist, forcing enterprises disfavored by price distortions into bankuptcy may entail econmicosses-a government conoered with that loss is obliged to help them. As already discussed, this creates

severe incentive distortions. Second, artificial domestic shortages caused by foreign exchange restrictions andimport restritions have to be eliminated, especially in aw material and intermediate goods. This measurewill make bottlenecks less likely. Thi, domestic competition has to be encoaed both by brealdng upmonopolistic enterprises and by encouraging new entries, especaly In those industries where tradeliberalation cannot achieve a competitie supply strcture.

5.12 Unless these structurl measures are undertk, loss-making enterprises that are majorforeigp echbange eaners or major suppliers of raw material and intemediate goods are not credbtlythreatened by bankluptcy, since the govment has an ex-post incentive to help these enterprses Themost strai d method to eliminate major price distortions as wel as domestic shortages is tradeliberalization and price L lation. The 1990 Polish refm, which underook almonst full priceliheralation and trade libelization, is a very signifcant step in this regard.

5.13 Of coure, instead of undertaking strucal measue the ovenmen may try to build areputation for being "tough"; to coavince firms that It will not help them ex-post even though it is sociayoptimal to do so. Howevr, this is likely to be a wasteful stfategy.I Sinc ex-post soft budget constraintsare optimal, the prior belief of fims is lkey to be that the pwg ment cannot afford to be tough;' hence,fitms would require a substantial amount of convndng. Withi the famework developed in the previoussection, changing firns' beliefs would require a long period where entrpes do not undertwke retucgbut nevertheless find out ex-post that they cannot obtain support. Until workers and managers areconvinced, restructuing would not take place and the economy would lose both dynamic eency gains andits consumer surplus.

C Creatng Incenves fbr Autoomous A4ustent

5.14 The necsity of widespread stutuin in dustqy makes the task of ightening the budgetconstraint more dificlt. Tbe problem that govements fce is the f*wing. On the one hand is theattempt to harden the budget constraint. That would predude al financi subddies to enterprises On theother hand, if Investment funds were available, there are fims that could restuctur and gain viability.Denyig them access to funds may caus unneaq liquidadons, resultag in an inability to transformindustry. The ovrment instead needs a strategy that would nduce the closing down of inefcent firms--that is, fims that would not become profitable even with restructuring-and make funds available to firmsthat can beome proftable after restructuring.

- 27-

S.1S Eliminat subsidies and introdudg compedtion do not neosarIy Induce Ineffident frmsto edt by themselves. Gien asymmetric nfmatio amog enterprises, fincial bstiutin, and thegoverment, and restrdtions on capital owership, It b saof to asume that workes ani managers wouldprefer to obtain funds and attempt to resuctr em f the probabilty of suoes Is low. lbe alteratwould be to accept income decline, ud hdshp Hmnoe, unprofitable enteprises haincenvs to preset themseles as potenilly profitable There, finana insdtuos are saddled withthe task of sorting out good fims from bad ones

5.16 To avoid the situation wheo fiancia stitutiom support effient entepries whileredudng roures available for effient entpr It I maemazy to provide adequate intives forinefficient enterprises to edt voluntawy. he strateV for Idstril restrutg st inpoate incenticompatible between financal institutios and enterprses

5.17 To achieve ientive compatiblty, fit is essential to have genent poliy that is atleast neutral betweea restructurig and ait Curtly, enterpise can get Investment subsdies If theydemonstrate that rehabi}ltation is feasib, while they get no support If they deelop retreat pbas Proviigeffective adjustment assistance for afected workers, while significantly reduciog inWvestmet subsi forrebabilitatio, wi Crrect this incentive distortion. At the minimum, resuctuing should not be subsidizedagainst exit.

5.18 Semid, removing the resrction on capital ownership is also entia.L les whopovide funds for restrtg must have adequate control duing resuuring as wel as entitlement tothe aociated risk and retu Currently, whether enterp are sdf managed or state managd, thegoenment bears the ultimate financal cmon ence of adjustment or absence of adjutment. Non-stateentities, including workers, are not fully entled to the nease in value of successfly restrcuredenterpries nor to the capital value of eit.

5.19 One stre purued by the Polish govement to tighten soft buget co is todemand high divdend payments on the capital that the state has contributed, as discussed in Secton IHLHigh divdend payments may reduce barers for labor mobity by reducing the capital t avlable forworkers This is becauseworkers may wish to stay In enterprises ith high profitabilty, ev U the marginalproductivy of labor is below market wage, only because they are entitled to capital rent

5.20 However, such a ste also has ts drawbac. Evwen if we asume that capial ntconstitutes an important exit barier for redundant woker, Imposing dividend requirements on theaccounting value of ste-ontr capital canot properly popria tsib Lis Is because some enter-prses have a lare share of their own funds inved, or because the mae value of capital i signfcantlydiferent from its accounting value PFrhermo, this saeg can endanger the solvency of many enter-prises As demonstated in the last secdion, the distortio due to soft budget cnsaints becomes largerwhen the lkelhood of enterre Insohen is hig Consequently, as lng as some ballout epctatoremai, a igher dMdend tequirement can acually worsen the ditortons frm the soft budget

D. lhe Role om Daubs nd the Finaia System

521 It was argued above that the goverment sboudd ret from the buiness of prvidingvestment funds, inldin those tatd for restrctg and ddepte these fucio to the finani

sector. Tbis process has already ste in Polnd and Hun. Morover, once most tax and subsdyschem are eliminated, finanial Itituon wl become the man aents delng with lossmaingentprises. l hese delopments se the questo of how iulnerable the fancal stor wM be to thedanger of maintinig sOft budget _onait

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5.22 In Section m C we argued that commerca banks evea in nmarket economies have biasesfor refinancing inefficient enterprises but that such biases are stronger in socblist economies due toadditional distortions. Goenments therefore have to taMe corrective measures to reduce or elminatethese distortions. Otherwise commercial banks may be able to enforce financial discipline no better thanthe government.

5.23 Thst, the government has to develop effeive supeavision and regulation of the bankingsystem In particular, banks have to develop a substantial capital base so that they do not take exesiverlsk at the expense of the tax payers. Both Poland and Hungary are in the process of developing asupervisory and regulatory framework, a proces that wiU undoubtedly take some time.

5.24 In particular, the govemnment has to encourage commercal banks to setle bad loansnherited from the national baok Commercial banb in both Hungar and Poland have simply inherited

the loan portfolo of the central bank without any evaluation of the market value of these loasConsequently some commercial banks may already be insolvenLZ

5.25 SsCond, the control rights of commercial banks with respect to loss-malkng entewrprises haveto be strengthened. In both Hungary and Poland creditors can initiate bankruptcy proceedings againstenterpres This threat of bankruptcy and the consequent lss of jobs should encourage some financialdiscipline by entprises. However, in many cases, liquidation through bankruptcy would be too exeme aresponse to the financial problems that enterprises face and also wasteful in tems of protecting the claimsof the creditors In cases where the value of the fim as a going concem, conditional on restructuring ishigher than would be its liquidation value, the threat of liquidation is not credibl and therefore would playno role in discplning firms. In particular, arrangements through which creditors can threaten theenterprises, either by the removal of managers or similar intermediate measures that just fal short ofliquidation, may be required. Such measures require the creditors to have aceess to control rights, eventempoi.

5.26 In some market economies, commercal banks can obtain control ihts over enterprises bybuying their shares in the stock market. Even if such a buyout does not actually oocur, the mere fac thatit is possible allows mmerc banks to take significant controL This option is, however, ciosed for self-managed or state-managed enterpries Instead, one option is to allow commerdial banks to transform self-managed or state-managed enterprises into shaeholding companies

5.27 Another option is to create a bankruptcy reorganization mehanism that explidtly guaranteescreditors the rtight of controL In some countries, bankuptcy prodeedings grant substantial control tocreditors, ranging from monitoring an enterprise's day-to-day operations to the right to change itsnmanment. Such a framework may prove useful in limiting the adverse effects of conflits betweencreditors and debtors and introducing intermediate steps between Uquidation and continud operation.

5.28 lbln, the state's equity investment has to be provided ok a compettiVe basis. StateInvestment in socialst economies often has taken the form of a finandal cntract requiring a fixed and oftenlow dividend rate. Tbis shows that uniess supported by a competiive meanism, the ovefnment's capacityis limited in differentiating risk and in setting appropriate return among enterprises and over tm Stateequity investment has been essentially investment subsidies.

I This problem of inheriting bad loans could have been partly resohled if loais had been assumedvoluntar by commercial banks or if they had been auctoned. Absence of reliable informationabout the value of these loan in the aftermath of ecoomi rdorm and the necessity of quicktasition to the two-tier bankin system probably would hv made that route dfficult to take.

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5.29 Indusria restr ig acompan1g an ecsomic refotm progrm may require a sizeabbnow eqty infsion into ndusty. lb govement of Poland is now establisig the Banlk for Restrutthe BEoomy (BRE), whch Is expected to start operations by May 1990. lTe BRE wi be able to lendfnds (sice the main trget entewses are those In fIanc trouble, lendig Is atualy dose to eqityinestment) or buy shares ink state enterpis that are in fiancl difficulties Mhe Huarian govenmentsuppots eabilaon by equity bvesm t and conveion of debt into equity both thogb its StateDevelopment nsttute (SDI) and the Rdeabitation F'nd. Hower, the exansion of state equityinvestments an easily undermin fnancia discipline

530 One key alternative is to transform or prvatie lss-making enterri (self managed orstae managed) into companies where the state's p paton is limited to that of a minority shareholder(eg, onethird). he transeability of saes, as well as the participadon of non-state vets, woulddgnificantly belp reduce the incenttb for the state to susde inecent eneprie

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STATISTICAL APPENDDI

be k IERPRISE SUBSIDY AND TAX (Hpy. 135)

Value Add i Subd TA

I Mbda4 59 bFt 3.6 bWt (61%) 41. bt (71.4%) 2 aeoIwy 19 0.0 (0.1) S1 (2.3)3 Nsahu_ 10 11.7 (1140) 76 c3)4 Eneda 104 8 )4 (51.)5 1ia Mateda 14 03 55 (39.5)6aiemu 49 11.3 (2.) 29.0 (59.1)7 14bt 46 (9.1) 2.4 (.)8 Food 16 300 (1910) 15(9 Mao-emm S 0. (2.0) 2.5 (453)

Toa 323 75.0 (J%) 18S.0 (573)

Samuu StatbUm Yearbooak

i Numbem In bd ue ammis to vae added

Mml CURRENT AND CAPfrAL SUiDSIIS TO 26 LARGE LOSS-MAKERS (Hwunay)(Commhmeal in 1985 ad 1966)

Reaalatl Fnd 3.7 bFt (7%) Debt Wmfteo6 210 bFt

T E.pdm is (3%) late Bquy Afloctoe 171

Intered LAW 7.3 (13%) Debt RecheduiS ndNew n8 L7

Toal 12.9 M3) TOX 39.8

Saw= May of Fidane

if PAtlo valadded

Table BREAKDOWN OF SECrORAL OUTPUT BY PRICING SCHEM1967, IN % OF SALES OF

c _sedUv Fid or OcsaldClift Maxmum Pddq

(CF) R_me Prim Subl lg Rule Subtotala b c-a+b 4 e l-e+e

MImnin 70 9 79 1S 21EkM* y0so 10 90 10 10MtAUU_ 4 - 4 96 - 96

chmy -- - (100)11 100 (0) 100Cao_buti AMmtal - 16 16 - (30) 84(M4) 64Chemicl 40 - 40 25 (48) 35(12) 60Lot labbY 2 2 4 (73) 94(25) 98Msnodhm Iuauy 100 100Fo bdIm - 8 8 92 92

Total lndmty 19 3 22 10 (44) 68 (34) 78

Co_mtim - 25 (65) 25 (65) - 7 (3) 75 (35)AVcultue (bok) - 60 60 - 40 40

SWar _ as- SS 6 - 1S ISi - 75 7.5 25 25

Ttade ( e )too - - - 100 100

Toa MaW" Psuduedoa 10 30(20) 30(32) (25) 6S(43) 70(68)

A Number In bracket the peentage In 1965.

Souse Data pnvded by the Hung n au_tdtes.

-32.

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. 33 -

Sipos, A. and Tardos, ., (1986), Ewnoilc Control and the Strurn OfOrganizatins lo la Hgary at the Second Deizde of Refor,' VoL 37, pp. 241-265.

Scwezynlk, L (1989), 'Some Problems Regardin Bankruptcy of Eewpises In the Pol Econoty,PublUc zLs VoL 1, No. 2.

TaIos bL (1986), MTe Condidons of Dveloping a Regolatd Maret, ' VoL 36 (1-2),6749.

(1987), 'Why We Do Not Take Better Cue of Public Ae, Mm.

Vodopivec, Milan (1989), troductvig Effects of Redstributio In a Sodast Econo Ie Canse oYupslavh unpublished Ph.D. dissertation, Unesity of Mamyan at Colege Prk.

(1990), Productivity Effes of Redisrbution l-i a Socilist Economy. lhe Case ofYugoslavaW processed, the World Bank

Voszka F. (1986), 'Company Liqudation Without a Lel Succewr,' Aaa VoL 37 (1-2),pp. 59-71.

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IDUSRY SRS PES

No. 1 Japanese Direct Foreig Investment Patterns and Implications forDeveloping Countries, Febury 1989.

No. 2 Emerging Patterns of International Competition in Selected IndustrialProduct Groups, February 1989.

No. 3 Changing Firm Boundaries: Analysis of Technology-Sharing Alliances,February 1989.

No. 4 Technological Advance and Organizational Innovation in theEngineering Industry, March 1989.

No. S Export Catalyst in Low-Income Counies, November 1989.

No. 6 Overview of Japanese Indr!trial Technology Development, March 1989.

No. 7 Reform of Ownership and Control Mechanisms in Hungary and China,April 1989.

No. 8 The Computer Industry in Industrialized Economies: Lessons for theNewly Industrializing, February 1989.

No. 9 Institutions and Dynamic Comparative Advantage Electronics Industryin South Korea and Taiwan, June 1989.

No. 10 New Environments for Intellectual Property, June 1989.

No. 11 Managing Entry Into International Markets: Lessons From the EastAsian Experience, June 1989.

No. 12 Impact of Technological Change on Industrial Prospects for the LD,June 1989.

No. 13 The Protection of Intellectual Property Rights and IndustrialTechnology Development in Brazi, September 1989.

No. 14 Regional Integration and Economic Development, November 1989.

No. 15 Specialation, Technical Change and Competitveness in the BrazilianElectnics Industry, November 1989.

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INDUSI1 ME= PAfERS LMt'd

No. 16 Small Trading Companies and a Successful Export Response: LessonsFrom Hong Kong, December 1989.

No. 17 Flowers Global Subsector Study, December 1989.

No. 18 The Shrimp Indusrry: Global Subsector Study, December 1989.

No. 19 Garments: Global Subsector Study, December 1989.

No. 20 World Bank Lending for Small and Medium Enterprises: Fifteen Yearsof Experience, December 1989.

No. 21 Reputation in Manufacaured Goods Trade, December 1989.

No. 22 Foreign Direct Investment From the Newly Idus d conomies,December 1989.

No. 23 Buyer-Seller Links for Export Development, March 1990.

No. 24 Technology Strategy & Pohcy for Industrial Competitiveness: ACase Study of Thailand, February 1990.

No. 25 Investment, Productivity and Comparative Advantage, April 1990.

No. 26 Cost Reduction, Product Development and the Real Exchange Rate,April 1990.

No. 27 Overcoming Policy Endogeneity. Strategic Role for DomesticCompetition in Indusal Policy Refonn, April 1990.

No. 28 Conditionality in Adjustment Lending FY8O. The ALCID Database,May 1990.

No. 29 InternationalCompetitiveness: Determinants and Indicators,March 1990.

No. 30 FY89 Sector Review Industry, Trade and Finance, November 1989.

No. 31 The Design of Adjustment Lending for Industry: Review of Current Practice,June 1990.

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INDUSMRY SERIES PAPERS cont'd

No. 32 National Systems Supporting Technical Advance in Industjy The BrazilianExperience, June 26, 1990.

No. 33 Ghana's Small Enterprise Sector: Survey of Adjustment Response andConstraints, June 1990.

No. 34 Footwear: Global Subsector Study, June 1990.

No. 35 Tightening the Soft Budget Constraint in Reforming Socialist Economies,May 1990.

No. 36 Free Trade Zones in Export Strategies, June 1990.

No. 37 Electronics Development Strategy: The Role of Government, June 1990

No. 38 Export Finance in the Phflippines: Opportunities and Constraints forDeveloping Country Suppliers, June 1990.

No. 39 The U.S. Automotive Aftermarket Opportunities and Constraints forDeveloping Country Suppliers, June 1990

Nob: For extra copies of these papers please contact Miss Wendy Young onextension 33618, Room S-4101

- 37 -

ENERGY SERIES PAPERS

No. 1 Energy Issues in the Developing World, Februay 1988.

No. 2 Review of World Bank Lending for Electric Power, March 1988

No. 3 Some Coniderations in Colecting Data on Household Energy Consumption,March 1988

No. 4 Improving Power System Efficiency in the Developing Countries throughPerformance C6ntracting, May 1988.

No. S Impact of Lower Oil Prices on Renewable Energ Technologies, May 1988.

No. 6 A Comparisn of Larps for Domestic Lghting in Developing Countries, June1988.

No. 7 Recent World Bank Aceivities in Energy (Revised October 1989).

No. 8 A Visual Overview of the World Oi Markets, July 1988.

No. 9 Current International Gas Trades and Prices, November 1988.

No. 10 Promoting Investment for Natural Gas Exploration and Production inDeveloping Countries, January 1988.

No. 11 Technology Survey Report on Electric Power Systems, February 1989.

No. 12 Recent Developments in the US. Power Sector and Their Relevance for theDeveloping Countries, Febnrury 1989.

No. 13 Domestic Energy Pricing Policies, April 1989.

No. 14 Financing of the Energy Sector m Developing Countries, April 1989.

No. 15 The Future Role of Hydropower in Developing Countries, April 1989.

No. 16 Fuelwood Stumpage: Considerations for Developing Country Energy Planning,June 1989.

No. 17 Incorporating Risk and Uncertainty in Power System Planning, June 1989.

No. 18 Review and Evaluation of Hisoric Electricity Forecasting Experience, (1960.1985), June 1989.

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ENERGY SERIES P&= contd

No. 19 Woodfuel Supply and Eniuet ManagOment, JUly 1989.

No. 20 The Malawi Charcoal Project - Experience and Lessons, January 1990.

No. 21 Capita Expenditures for Electric Power in the Developing Countries in the1990s, February, 1990.

No. 22 A Review of Regution of the Poe Sectors In Develp Countries,Febrar 1990.

No. 23 Summary Data Sheets of 1987 Power and Commercil Energy Statistcs for100 Deveoping Counties, March 1990.

No. 24 A Review of the Treatment of Environmental Aspects of Bank Energ Projects,March 1990.

No. 25 The Status of Lquifled Natural Gas Worldwide, March 1990.

No. 26 Population Gmrth, Wood Fuels, and Resource Problems m Sub-SaharanAfrica, March 1990.

No. 27 The Status of Nuclear Power Technology - An Update, April 1990.

No. 28 D e aommIssioning of Nuclear Power FacilIties, April 1990.

NQ 29 Interfuel Substuton and Changes in the Way Households Use Energy.The Case of Cooklng and Lighting Behavior in Ubanx Java, June 1990.

N: For cta copies of these papers please call MS. Mary Fetnandez on extension33637.